Hurdles to Growth of Green Islamic Finance

Green and sustainability-based sukuk are well placed to take advantage of growing demand from institutional investors, finds report.

Increased willingness and appetite among traditional Islamic investors will be key to realising the full ESG potential of sukuk bonds, as well as the continued adoption of international standards, according to a new in-depth report.

Green and sustainability-based sukuk could raise US$30-50 billion of capital that could be allocated by 2025 to meeting the UN Sustainable Development Goals (SDGs), said the High-Level Working Group (HLWG) on Green and Sustainability Sukuk, which includes the London Stock Exchange Group, the Indonesian and UK finance ministries and the Islamic Development Bank.

Sukuk bonds comply with Shariah law, pay no interest and do not involve speculation. Instead, bondholders become, in effect, partners with the issuer and part-owners of the issuer’s assets.

The total outstanding on sukuk bonds is estimated at US$749.6 billion, according to Fitch Ratings, of which just US$19.3 billion represents ESG bonds.

This year has seen a continued uptick in activity, with global green and sustainability sukuk issuance totalling US$4.4 billion during the first half of 2022, following a record annual issuance of US$6.1 billion last year.

“The growth of green and sustainability sukuk will enable more countries and companies to access finance in a manner consistent with their faith and values. As sukuk are linked to assets that may be eligible for green and social projects, they will become vital tools to fund the UN SDGs,” said Shrey Kohli, Director, Head of Debt Capital Markets, London Stock Exchange, and Chair of the HLWG on Green and Sustainability Sukuk.

Future growth potential in Gulf

The working group noted that there was an opportunity for growth in Islamic green investment due to the rising demand for ESG investments from institutional investors as they progressively integrate ESG criteria in their investment mandates.

“The current supply of ESG debt issuance falls short of this demand, presenting a huge opportunity for green and sustainability sukuk to bridge the gap.”

But it added: “Demand for green and sustainability sukuk has been driven mainly by investors with ESG-centric investment mandates rather than Shariah compliance-focused investors, which has resulted in slower adoption of ESG principles across most OIC [Organisation of Islamic Co-operation] jurisdictions.”

This means green and sustainability sukuk are still at a “nascent phase”, it said. The report also noted a shortage of certifiable green projects, particularly in oil-reliant GCC [Gulf Co-operation Council] economies. “Yet as these countries transition to running more sustainable economies, there will be more growth potential for these types of sukuk,” it added.

While Indonesia and GCC are the leading jurisdictions in terms of issuance (with 53% of the total) much current demand comes from the developed world. “There is growing demand for green and sustainability sukuk from investors in Western markets such as the US and Europe, where ESG priorities are becoming increasingly widespread,” the report said.

“Combined with regular demand from Shariah-compliant investors, this will broaden the investor base for green and sustainability sukuk.”

Extra layer of governance

A number of Islamic financial jurisdictions are developing plans to further support growth of their sustainable investment markets, with Malaysia and Indonesia among the most active.

While most green and sustainability sukuk already comply with one of the International Capital Market Association (ICMA) principles, the report highlighted the need for “common regional and international standards” as one of the key pre-requisites of future growth. It also recommended capacity building measures to enhance the wider ecosystem and initiatives to expand the investor base.

The working group includes representatives from the Islamic Finance Council UK, which promotes the role of Islamic finance in delivering positive social outcomes, and the Global Ethical Finance Initiative, which is focused on organising and co-ordinating programmes to “promote finance for positive change”.

The report noted that both ESG investing and Islamic finance share many principles, and listed four key areas where the two systems could complement each other. The first was that sukuk provides an extra layer of governance through Shariah law, ensuring proceeds are channelled to projects that satisfy both ESG and Shariah standards.

The second was that those who may otherwise have not engaged with financial services for religious or other reasons could be included with sukuk ESG.

Rapid growth of interest

Third, the involvement of Islamic finance can “attract new sources of funding that remain untapped by conventional green and sustainable finance”.

Finally, Islamic finance can be a “rock of stability” during financial crisis, as a result of its avoidance of speculation and, because of its asset-backed nature, its “close linkages to the real economy”.

In September, finance platform said that the expected strong growth in ESG sukuk “will require greater standardisation and regulation”.

In August, Fitch Ratings reported: “ESG-linked sukuk is likely to persist as a key issuance theme in core Islamic-finance jurisdictions amid government initiatives that promote sustainability and economic diversification, along with rising investor demand and awareness.”

But it listed challenges including a complex issuance process and regulatory constraints as well as a shortage of domestic ESG-focused investors and issuers.

For western investors, the growth in interest in sukuk finance has been rapid since then-UK Chancellor George Osborne issued the first sovereign sukuk bond outside the Islamic world in 2014.

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