COP27: Islamic capital markets can take the lead

This article was first published in Islamic Finance News.

The floods in Pakistan and the famine in East Africa this year bring a greater urgency to the need to address climate change at COP27 [2022 United Nations Climate Change Conference] in Egypt, combined with a renewed focus on achieving the social development goals, as the world emerges from the COVID-19 pandemic with heightened inequality. The fact that COP28 [2023 United Nations Climate Change Conference] next year will also be in a Muslim-majority country (UAE) gives a rare multiyear opportunity for Islamic finance to be at the heart of the financing solutions that are needed to create a fairer, greener world. FARMIDA BI explores.

COP26 [2021 United Nations Climate Change Conference] in Glasgow last year acknowledged this by establishing a high-level working group with the aim, over the following three years, to develop and promote green and sustainability Sukuk to attract the investment needed to support the achievement of the SDGs. The unprecedented level of involvement by the Islamic financial institutions and, especially, the IsDB at this year’s COP is an encouraging sign of the progress that could be made.

Finally, the need for climate finance to fund projects that provide clean energy and, increasingly, help countries affected by climate change to adapt to new conditions is a good fit for existing capital market structures such as Sukuk.

Green and sustainability Sukuk issuance in the first half of 2022 was US$4.4 billion, following a record issuance of US$6.1 billion in 2021. Yet this is only 4% of total Sukuk issuance (and 1% of total ESG bond issuance), showing there is potentially greater appetite in the market for these products, not least because 54% of investors have already integrated ESG criteria within their Shariah compliant portfolios according to the Refinitiv Green and Sustainability Sukuk Report 2022. This is also reflected in the conventional markets where many institutional investors are incorporating ESG components within their investment strategies, so a Shariah compliant ESG Sukuk would allow those investors to satisfy both their ESG criteria and give them exposure to debt in the emerging markets. There is an opportunity for Islamic financial institutions to take the lead in attracting private investment through Sukuk, with appropriate structures and experienced market participants already in place.

The government of Indonesia leads in ESG Sukuk issuances, and by the first half of 2022 had issued US$5.83 billion. It issued the first sovereign green Sukuk in 2018, followed by the first retail green Sukuk in 2019, and has since issued two green Sukuk annually, one in the domestic market and the other in the eurobond market. It has also published the Regulation on the Issuance and the Terms of Green Bonds in 2017 and the Sustainable Finance Roadmap for 2021–25.

Green Sukuk are a vital part of Indonesia’s approach to its climate commitments, with its first green Sukuk being issued to contribute to the US$50 billion in financing needed to meet the country’s climate commitments and to achieve its national emissions-reduction goals by 2030, and it is working with the United Nations Development Programme to increase the role of green Sukuk in climate financing.

Increasing Islamic finance’s role in green finance can only help consolidate its credentials as a form of ethical finance, and reinforcing the convergence between Islamic finance and Islam’s ethical teachings could significantly broaden Islamic finance’s reach across Muslim and non-Muslim countries.

The IsDB has announced that it will fully align its sovereign operations with the objectives of the Paris Agreement by the end of 2023. The IsDB is also a leading issuer of green and sustainable Sukuk, having issued its first green Sukuk in November 2019 (a EUR1 billion (US$997.92 million) issuance that notably appealed to green investors who had not previously invested in Sukuk), and a total of US$5.13 billion in ESG Sukuk by the first half of 2022.

The proceeds of its Sukuk are allocated to green projects, including renewable energy and sustainability initiatives in energy, transportation and water management across the IsDB’s member countries, a further example of how Islamic finance can form a conduit for funding to the most vulnerable developing countries.

In addition to Indonesia and the IsDB, there have been a significant number of corporate issuers of green and sustainability Sukuk from the GCC, including Saudi Electicity Co’s US$1.3 billion issue, Majid Al Futtaim’s US$1.2 billion issue and Bahrain’s Infracorp issue of US$900 million.

The UAE has committed to achieving net zero by 2050 and Saudi Arabia by 2060, committing huge sums to achieving the energy transition by investing in clean energy, which can be funded in part by the capital markets. The Malaysian government also issued its first sustainability Sukuk of US$800 million in 2021 with the proceeds to be used for social and green projects.

Both conventional bonds and Sukuk before the 2020 pandemic were focused on the environment, with little focus being placed on the S or G in ESG. The only non-green Sukuk had been issued by HSBC Amanah Malaysia in 2018. The COVID-19 crisis in 2020 resulted in many more sustainability-linked bonds being issued in the conventional markets, with a tenfold increase in the issuance of conventional sustainability-linked bonds from US$11 billion in 2020 to US$110 billion in 2021 (although this is still less than one-fifth of green bond issuance).

The shift is more marked in the Sukuk markets. The IsDB issued a US$1.5 billion sustainability Sukuk facility in June 2020 and Etihad Airways issued its first sustainability-linked Sukuk in October 2020, but by 2021, of the US$6.1 billion in global ESG Sukuk issuance, 25% consisted of green Sukuk and 75% of social and sustainability Sukuk.

The IsDB has also developed its own Sustainable Finance Framework that harmonizes with global standards, such as those set out by the International Capital Market Association in, for example, its Green Bond Principles. One of the most important challenges for the global capital markets is developing agreed standards for ESG bond issuance, and by developing their own standards to harmonize with existing international norms, the IsDB, Indonesia and other leading players in the Islamic finance market are seeking to do so.

It is vital however that the various standards that are developed are consistent and do not create added complexity to a market that can be seen as opaque, thus deterring conventional investors interested in ESG funding or investors in one jurisdiction being deterred from investing in another.

Investors are most concerned about disclosure being transparent and easily comparable among different transactions, both at the time of issuance and in the ongoing reporting processes.

Egypt’s presidency of COP27 has unlocked unprecedented interest from Islamic financial institutions in climate finance. In the coming weeks, we will see what is agreed at COP27 and the detailed proposals that emerge, but with planning for COP28 in Dubai in the UAE already underway, this is unquestionably the moment for Islamic finance to take the lead.

Statistics taken from:

• Refinitiv report (with GEFI and UKIFC) on green and sustainability Sukuk.
• Reuters article with figures on global conventional green/sustainable bond issuance.