What is the role of Islamic financing in terms of funding energy transition projects, particularly renewable energy? What are Islamic development finance institutions doing in this critical arena? Here is a briefing on the outlook and state of play in the Islamic development finance market, with a particular focus on Asia
A shared sense of social responsibility is embedded in both sustainable financing and Islamic finance, and there is a real symbiosis between the two areas. Islamic financing is estimated to exceed US$4 trillion by 2030, and a union of Islamic financing and sustainability could mark a key advancement in helping finance the global energy transition. Islamic finance should offer excellent potential regarding how non-interest-bearing structures could be used as tools for key transition energy issues, such as retiring old fossil fuel plants. However, combining the two streams of financing is not as easy as it would appear on the surface.
The similarities between Islamic and sustainable financing are plentiful. They are both subsets of the global financial market with ethical principles that require finance to be used in a very specific way. Islamic finance lawyers point out that protecting the environment in any context is enshrined in the principles of Shariah law.
In terms of financing projects, Islamic finance lends itself naturally to the energy transition as it has evolved to be entirely asset-based. In the past, finding a Shariah-compliant asset to tack onto financing was always a challenge for financiers and led them to develop creative structures. Now, energy transition projects abound that are centred around an asset that perfectly fit the requirements of Shariah.
Sustainable project finance – investor opportunities
There are certainly investor pools that could be engaged for sustainable project finance. For instance, in Indonesia, waqf and pilgrimage funds are pools of capital that currently represent IDR2180 trillion (US$146 billion) and IDR163 trillion (US$10 billion), respectively. The pilgrimage funds present an attractive option as they are largely invested in low-risk, short and long term government bonds. Their perpetuity principle makes them ideal for long term projects – although asset-based waqf and Sukuk have more freedom regarding value and risk.
Nonetheless, while these capital pools are promising, the Environment, Social and Governance (ESG) and green Sukuk market are certainly where investor appetite is picking up. According to Fitch Ratings, outstanding ESG Sukuk increased by 11.2% to US$19.3 billion in Q2 2022 from the previous quarter. That was a faster rate of growth than for the total Sukuk market. Notable deals in 2022 included Riyad Bank’s first sustainability linked AT1 US$750 million Sukuk and Infracorp’s issuance of Bahrain’s first green Sukuk at US$900 million.
Most significantly, Indonesia returned to the market in 2022 to raise US$3.25 billion in its largest global Sukuk offering, which included the world’s largest ever green tranche. This Sukuk received significant demand, tightening the coupon by an average of 37.5 basis points to 4.4% on the US$1.75 billion five-year tranche and 4.7% on the US$1.5 billion green 10-year tranche.
The Indonesian green Sukuk was targeted at the international market, with only 10% of its investors coming from the domestic market. The government specifically targeted the potential investment from the wider Muslim world and used the route of green and Shariah-compliant instruments to help deepen relationships.
This is one of the key reasons green Sukuk represents an attractive prospect for promulgating sustainable financing – it allows the largest Islamic investor base to invest in Shariah-compliant, sustainable products. According to Fitch Ratings, Sukuk is the preferred format in many cores Islamic finance markets, equalling 75.5% of outstanding hard-currency ESG-debt at Q2 2022 in the GCC region, 90.7% in Saudi Arabia, and 100% in Bahrain.
Progress remains slow
While Islamic finance ESG wheels are starting to turn and demands from funds that are traditional investors in Islamic finance for ESG compliant products is certainly rising, progress does remain slow. Hard-currency Sukuk have typically been oversubscribed, including green Sukuk, and undoubtedly investor interest in ESG products is growing. The marriage of sustainability and Sukuk in Indonesia’s 10-year green tranche helped make it oversubscribed by more than 4.8 times.
Yet whether badging the products’ sustainable’ adds to (or even detracts from) Sukuk demand is complicated by the numbers. In some cases, ESG Sukuk achieved a lower yield at issuance than their non-ESG counterparts, but only slightly. It is difficult to tell because, despite increased interest, ESG Sukuk still represents only 2.6% of the global outstanding total.
Demand from the Middle East for sustainable products may be behind the curve because it took some issuers time to offer ESG-related products. In part, this has been a result of differing standards imposed by regulators and a lack of politically driven incentives such as the green taxonomy framework established by the EU. Nonetheless, some say that this gives the region the advantage of learning from some of the early mistakes elsewhere that have led to accusations of ‘greenwashing’.
Project by project or looking wider?
One of the challenges for using waqf assets has been that issuers may need to be looking wider than simply on a single project basis. There is an argument that looking at innovation and looking to use underlying assets to issue financing instruments for sustainable projects on a broader basis can help.
While demand is slowly rising, there are still issues with supply. A mixture of nascent market infrastructures, underdeveloped local guidelines, and taxonomy – a persistent, global issue for ESG – shortages in qualified human capital, and regulatory constraints make for an unready global market. This is especially true of project financing. Analysts argue that while Islamic finance on its own fits from an ethical and moral perspective, getting an Islamic finance deal done in terms of the standardisation of documents and structures needed takes longer. That includes getting agreement from banks, other stakeholders, and then the final sign of a fatwa, if needed. As a result, seeing infrastructure fully financed by Islamic finance remains rare in the Middle East.
That is on top of policy issues depending on the jurisdiction and different expectations as to what security is required and whether financing will need government sovereign backing. Commercial disparities between Islamic and other parties can delay agreements and coordinating these in emerging markets are complex. Risk considerations such as these are where Shariah-compliant insurance institutions such as ICIEC could be ready to step in and help.
ICIEC is a signatory to the Principles for Responsible Insurance and is also the only Shariah-compliant multilateral insurer. This means that sustainable investment, climate action and finance, and Green Finance are at the core of ICIEC’s due diligence process, and ICIEC can link all new business and other queries with SDG and climate action indicators.
Lessons from the Malaysian experience
Malaysia is a market leader in Islamic ESG, as Fitch Ratings has highlighted. Malaysia created an ESG framework in 2014. Malaysian firm Tadau Energy issued the world’s first green Sukuk in 2017, and the Securities Commission issued guidelines on SRI funds in the same year. Unlike other core markets, the majority of its green Sukuk is in local currency, supported by the SRI Sukuk and Bond grant scheme that offsets up to 90% of the external review costs per issuance. This developed ecosystem is a long stretch from others and, as a result, Malaysia houses 91% of global ESG Sukuk issuances (175 of 192 as of Q2 2022).
Indeed, most new projects are financed by Sukuk rather than by conventional bonds. This is helping energy transition projects. For instance, for Large Scale Solar (LSS), a competitive bidding programme was used to drive down the cost of energy for large scale solar PV plants, where many of these projects have been financed by Sukuk.
Malaysia’s dominance of the Shariah-compliant ESG market also displays that, in practical terms, the preconditions for success are to have an ESG framework at the corporate level in place, with policies, procedures, and methodology for measuring targets. This is important before borrowing or investing in an ESG-compliant way can be considered.
The preconditions necessary for success
There is a lot to do before Islamic investors can and will get behind financing sustainable projects on a large scale. There are processes and regulatory frameworks that need development, and their absence will continue to curb accelerated progress.
On the demand side, interest in ESG Sukuk is growing – but the majority of Sukuk investors are still a distance away from actively seeking impactful projects. However, there are opportunities cropping up for higher impact infrastructure projects. One example to watch is the MoU signed between IsDB and PT Sarana Multi Infrastruktur (PT SMI), a special mission vehicle (SMV) of Indonesia’s Ministry of Finance and country ETM platform manager and collaborator on the Just Energy Transition Partnership (JETP) Investment and Policy Plan.
The agreement will support a partnership for the provision of a line of financing and co-financing for Energy Transition, Renewable Energy, and the Development of PPP-supported infrastructure initiatives. If this MoU were to lead to Sukuk being issued by IsDB for the ETM and JETP, it would mark a significant pathfinder for the wider market.
