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Islamic finance’s green bond equivalent fails to gain much traction

11 February 2022 Max Tingyao Lin

Green bonds saw explosive issuance growth in recent quarters, boosted by increased appetite for low-carbon investments. But interest in a similar instrument in Islamic finance is heading in the opposite direction.

According to Climate Bonds Initiative (CBI) data obtained by Net-Zero Business Daily, $869 million worth of green sukuk were issued last year, compared with nearly $2.56 billion in 2020.

In contrast, global green bond issuance—inclusive of the sukuk figures—jumped to a record $517 billion in 2021 from $297 billion in 2020.

Finance experts said the subdued market can be attributed to high issuance costs, a lack of common standards, and limited, albeit growing opportunities to fund decarbonization projects in many mostly Muslim countries.

In an email to Net-Zero Business Daily, Emre Tiftik and Khadija Mahmood from US-based trade body the Institute of International Finance (IIF) said there is a shortage of "knowledge at the issuer and investor level about the process and benefits" for the new instrument.

Michael Grifferty, president of the Gulf Bond and Sukuk Association, said the current obstacles could be overcome as market mechanisms develop and investors gain more confidence.

"I don't think that the problem is with green sukuk [itself] at all," Grifferty told a virtual forum last month. "If there is a problem, it's more … [like] growing pains."

An Islamic financial instrument

Sukuk are a fixed-income product that complies with Sharia law, Islam's legal system, which prohibits interest payments and investments deemed unethical by Muslims.

In practice, sukuk work in a similar fashion to bonds by offering regular payments of "profits" rather than interest. Investors redeem their capital when their sukuk mature.

While the instrument in itself needs to be Sharia-compliant, there are no restrictions on the religious beliefs of sukuk issuers and investors. The Muslim world has dominated the sukuk market, whose standards are set by the Accounting and Auditing Organisation for Islamic Financial Institutions, but the UK is among the sovereign issuers in recent quarters.

Market participants say sukuk issuance has expanded rapidly in recent years due to strong appetite from both Islamic and non-Islamic investors. Fitch data showed new sukuk sales reached $252 billion in 2021, up 36.1% year on year.

Bashar Al-Natoor, global head of Islamic finance at the ratings agency, said last month that sukuk volumes will continue to grow in 2022 due to "robust Islamic investor appetite, funding diversification goals, and Islamic finance development agendas in a number of countries."

The green element

In 2017, Malaysia's Tadau Energy raised RM 250 million ($58 million) by issuing what many described as the world's first green sukuk to fund a solar photovoltaic project.

Advocates of the instrument, including the World Bank, believe green sukuk has great appeal to green investors of different religious beliefs as their issuers need to commit the proceeds to decarbonization projects.

"Sustainability is an additional parameter to [being] Islamic. Combining both meets demand from both markets, which can be beneficial," said Omar Shaikh, managing director of the Islamic Finance Council UK (UKIFC).

So far, green sukuk has failed to take off. IIF data shows total issuance since 2017 has amounted to just $12.1 billion. New sales of all sukuk amounted to $560 billion in total between 2017 and 2020, according to the latest figures from International Islamic Financial Market, a trade body.

Mike Davis, global head of wholesale banking at Abu Dhabi Investment Bank, said sukuk investors are generally not willing to offer premiums for the green variant. This is because sukuk by default already need to be ethical, he added.

"Sukuk investors are … niche investors and have already benefiting from the S and the G components of ESG [environment, social and governance] investing," Davis said during the forum. "They are not valuing green sukuk sufficiently above just straight sukuk.

"Banks and asset managers need to do a little bit more education around that [environmental credential]," he added.

In general, green sukuk issuers need to follow sustainability frameworks aligned with the International Capital Market Association's Green Bond Principles and receive second-party opinions from independent evaluators. This leads to additional costs of at least tens of thousands of US dollars.

"That extra effort … is just not being rewarded today," Davis said. "The issuers are not seeing an additional upside from trying to get a green certification."

Other issues

Indonesia, the world's largest green sukuk market with $7.1 billion in issuance according to IIF data, has developed the official Green Bond and Green Sukuk Framework. In Malaysia, the second largest market with $1.41 billion in issuance, the government has published the Sustainable and Responsible Investment Sukuk Framework.

Saudi Arabia and the United Arab Emirates are the only other two markets up and running so far, with $1.3 billion worth of green sukuk and $1.2 billion floated, respectively. But associated regulations are unclear in the two countries.

Grifferty admitted there are "sukuk standardization" issues in the Middle East. "Their region is a little bit later in the game. So, the overall volume has been lower," he said.

Tiftik and Mahmood said: "There is a significant need for coherent, widely accepted taxonomy and classification frameworks to accelerate the ESG integration in sukuk markets."

There are also concerns over the narrow base of issuers so far. IIF figures show 10 of the 15 companies that have issued green sukuk are from the energy sector. In contrast, 37% of the 252 green bonds that hit the market between March and December 2021 were issued by energy firms.

Tiftik and Mahmood said there are challenges in identifying projects and assets that can meet green sukuk criteria. The four existing markets only committed to net-zero emissions in 2050 or 2060 last year and have yet to introduce decarbonization policies across various sectors. Many other countries in the Muslim world are lagging further behind.

Nasser Saidi, chairman of the Clean Energy Business Council, said countries should push ahead with decarbonization policies while integrating green sukuk into public finance. That way, sovereign states would be able to fund infrastructure to counter climate change and play a leading role in the fledging market, he added.

To date, Indonesia has been the sole sovereign issuer.

"Once you do that [green sukuk issuance], you have a benchmark, and then the private sector can then price itself against the benchmark," Saidi said.

Optimism remains

Looking forward, some experts still believe green sukuk has a bright future as the overall demand for suitable investments increases.

"Investors' demand for ESG-linked debt continues to grow exponentially and this is set to accelerate the ESG-linked issuances in global bond markets, including sukuk," Tiftik and Mahmood said.

Assuming that governments and multinational organizations ramp up their efforts in promoting green sukuk, the UKIFC estimates the market could expand by another $30 billion to $50 billion by 2025.

"Sharia-compliant investors cannot invest in green bonds, and thus green sukuk are in demand," Shaikh said.

Grifferty said: "The link between Islamic, ethical, green, and sustainable finance is quite strong. So, I'm fairly hopeful and confident that this [market] will grow."

Posted 11 February 2022 by Max Tingyao Lin, Principal Journalist, Climate and Sustainability

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