Green sukuk growth could follow the trajectory of green bonds

• Sovereign, multilateral and corporate issuers have shown the broad applicability of green sukuk to address climate change
• The range of projects financed by green sukuk remains limited mostly to renewable energy and green buildings, but will expand as the market matures
• The governance characteristics built into sukuk structures, combined with a sustainability focus, could create a new type of ESG instrument

The green sukuk market may still be new, but it has evolved far enough to be able to assess where it is in terms of its development, which the World Bank has done in a recent report. The report found some liquidity challenges associated with the smaller project-based issuers that confound a clearer understanding of the cost of financing green versus vanilla sukuk. However, as the market matures with the development of green taxonomies, its characteristics are likely to converge with the mainstream green bond market.

One distinguishing factor that the World Bank noted throughout their report was that the market has so far remained limited in size and issuer diversity. There is a concentration on a few issuer profiles, largely project-based renewable energy, in Malaysia, where most issuance has originated. Other issuers have brought larger green sukuk to market including the Islamic Development Bank’s euro-denominated issuance targeting green investors, Indonesia’s annual dollar-denominated global sukuk and rupiah-denominated retail green sukuk, and two green sukuk issued by Majid al-Futtaim in the UAE.

The profile of the issuers to date has been largely either sovereign and supranational or in the project-based renewable energy or green building sectors. The World Bank concluded that “it runs the risk of overly associating green sukuk with renewable energy and green real estate to the detriment of other sectors. Green sukuk could be used to finance a much wider range of projects, beyond renewable energy and green real estate.”

These projects include:

• waste management
• resilient infrastructure and the built environment
• greater efficiency in transportation and clean transportation
• energy-efficient building construction and energy efficiency projects
• reforestation and avoidance of deforestation
• protection against extreme events
• agriculture and sustainable land use
• forests and ecological resources
• pollution prevention and control, and
• biodiversity conservation

One of the impediments to issuance has been the costs associated with developing a green framework. But in Malaysia the government has followed the lead set by other countries, to put in place incentives to reduce the cost of issuance through a government rebate of 90% of the costs. The other objection for issuance has been that it is less cost effective to issue green sukuk in comparison to vanilla sukuk. The World Bank found some evidence for this, but the weight of the evidence — higher spreads on green sukuk than for similarly rated vanilla sukuk — is limited in explanatory power for future issuers.

Most of the green sukuk are focused in narrow sectors, primary renewable energy development, and the issuance volume for each is small. This means an equally likely explanation for the spread premium is a liquidity premium. The market for green bonds has grown rapidly and as global investors have become more sophisticated in their understanding of sukuk issuance, there will be a diminishing divergence between green bonds and sukuk, if sufficient volumes are issued.

There are two considerations that could affect the development of green sukuk in the future, one positive and one potentially negative but easily mitigated. These relate to the Shariah review process for a sukuk, which focuses on the structure of the sukuk in relation to the issuer or obligor. The green bond review on the other hand is concentrated on the use of proceeds raised in a relatively narrow framing.

This would provide an opportunity for the ‘governance’ reviews conducted by the Shariah advisors to include evaluating whether the bigger picture relating to the sukuk structure, including its use of commodities, aligns with the issuer’s sustainable finance framework. This could include evaluating whether any commodities sourced in the structuring process align with sustainable sourcing guidelines.

Some of this may lie outside of traditional Shariah advisory firms’ competency, but it should be covered within their mandate to understand the connection between the issuer’s business and the sukuk structuring and issuance process. Unlike a conventional bond where the issuance process generally requires more limited structuring, there would be an opportunity for Shariah advisors to engage and get specialized input from the second-party opinion giver that the issuer will already have engaged in the transaction.

These additional reviews could complicate or add cost to green sukuk issuance (the potential negative which can be easily mitigated). For example, there are other ways to offset costs such as attaching green finance frameworks to existing issuance programs. On a net basis, the cost impact could be a wash but they would still create value for investors and be supportive of market development. Some of the existing incentive programs in place could also be adjusted to specifically encourage larger issuances. This would bring maturity to the market, although it may still be difficult if issuers lack an easy way to identify green assets.

If regular issuers of (vanilla) sukuk are able to increase their pipeline and green sukuk open a new opportunity to fund a more diverse range of green assets, it could help to promote development of a liquid green sukuk market. One forthcoming issuer that would benefit the market would be Cagamas, which has received an environmental benefit rating for a sustainability sukuk under an existing RM 60 billion program.

Other issuers that would be likely to bring assets showing a range of ‘green’ and ‘social’ alignment would be financial institutions as they start tagging assets in countries like Malaysia where a climate taxonomy is under development. With the combination of ‘green’ and ‘social’ impact plus the governance screenings that are conducted for sukuk, this could be seen as a new form of an “ESG Sukuk”.

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