This blog was co-authored by Kristin January, Trainee Associate
Islamic finance has shown to be systemically important in many jurisdictions and is growing in the wider regions of the Middle East, Asia and Africa. Recent discussions focusing around the favourable prospects of green Sukuk are another growth driver for Islamic Finance.
COP-27 highlighted the massive investment required to tackle climate change in emerging markets (EM) including those in the Middle East and Africa (MEA). The location of the host country Egypt in the Northeast corner of Africa brought renewed focus to the region. According to estimates by Bloomberg, global investments managed on environment, social and governance (ESG) principles are expected to reach $53-trillion by 2025.
Islamic finance, with its ethical underpinning in the Maqasid al-Shari’ah (objectives of Shari’ah), has a significant head-start on conventional finance in aligning itself to ethical standards such as the UN Sustainable Development Goals (UN SDGs), although it has not yet capitalised on this advantage sufficiently. Issuers such as the governments of Indonesia and Malaysia and the Islamic Development Bank have produced green Sukuk frameworks and issued green Sukuk in the market with success, demonstrating that the technical requirements can be satisfied by issuers wishing to engage the wider market.
Islamic Banking refers to a method of banking based on Islamic Law (Shari’ah) which prohibits interest-based banking and encourages risk and reward sharing based banking. Islamic Banking is based on four main principles:
- the prohibition of interest;
- ethics by prohibiting investment in unlawful businesses;
- transparency; and
- an equitable sharing of risk and reward primarily through the use of profit and loss sharing contracts.
The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines Sukuk as “certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects or special investment activity”. An important difference between Sukuk and a conventional bond is that the Sukuk entitles the holder to a pro rata share of the income generated by the Sukuk asset. A conventional bond, by contrast, entitles the holder to principal plus interest and makes the holder a creditor with a claim against the issuer’s asset. Sukuk are the main instruments in the Islamic capital markets used by corporations and government institutions to raise capital directly from the public. Islamic banks use Sukuk capital instruments to raise economic and regulatory capital.
So why is Sukuk a good fit for green investment and what role could it play in the future? For one, to finance sustainable infrastructure through green Sukuk can further broaden this market as well as help acquaint the conventional financial world and Islamic financial world. Both environmentally sustainable investors and Sukuk investors aim to use their money in ways that comply with set out values and beliefs. Green Sukuk funding and environmentally sustainable infrastructure projects, such as the construction of renewable or clean energy projects, could appeal to both Sukuk investors and conventional environment-focused investors, as Sukuk by design is structured on a specific pool of assets.
For the first time, the Climate Bonds Initiative has analysed the shape and size of the MEA GSS+ debt market (green, social, sustainability and sustainability-linked market). Climate Bonds had recorded USD33.2bn of thematic debt originating from the region. While growth over the last four years has been steady, cumulative volumes are less than 1% of the global GSS+ market, indicating vast potential for growth. Governments can play a leading role, and to date, sovereign GSS bonds have originated from four nations in the region. Overall, green is the leading theme taking 56% of the cumulative volumes.
Perhaps the most important aspect of this engagement will be in communicating the congruence of the ethical dimension of Islamic Finance with broader sustainable finance, which can be done through explicitly linking the ethical dimension of Islamic Finance with widely recognised standards such as the UN SDGs, and engaging with other market standards such as ESG ratings by external organisations.
While SA businesses can become more attractive for foreign investors by effectively implementing ESG in business strategy, organisations need to demonstrate to investors how their actions go beyond ESG risk management. The Sanlam ESG Barometer is the first report of its kind in SA, it will provide an assessment of the activities initiated by JSE-listed companies to improve environmental and social outcomes in society. The Sanlam ESG Barometer will assess how South African companies are changing their businesses to deliver improved ESG outcomes. This will highlight to investors the opportunities for their capital to support “ESG additionality” – adding to the stock of ESG good in the world, rather than merely screening out firms.