Sustainable sukuk issuance on the rise

Sustainable sukuk issuances stood out as a bright spot in an otherwise tepid year for Islamic finance in 2023, with issuers in the UAE in particular seeking to burnish their environmental credentials in the run up to COP28 in Dubai.

Accounting for less than $500mn as recently as 2017, sustainable sukuk issuances grew by 16 per cent during 2023 to $10.8bn last year, compared with an overall fall of 6 per cent for all sukuk issuances, according to data from S&P Ratings.

Such sustainable issuances are set to rise further this year, boosted by the decarbonisation strategies of governments and corporates in key Islamic finance markets such as the UAE, Indonesia and Saudi Arabia.

Furthermore, with a perceived overlap between Islamic finance and environmental, social and governance concerns in mainstream finance, an opportunity also exists for sustainable sukuk’s issuers to tap into liquidity pools from outside Islamic finance’s heartlands, experts believe, even as concerns over standardisation remain.

Islamic finance’s green wave

The sustained growth in sustainable sukuk over the past seven years comes as little surprise, given the “natural alignment” between ethical forms of finance and the principles of Islamic finance, says Omar Shaikh, managing director of the Global Ethical Finance Initiative.

“Sustainable issuance in the mainstream market makes up approximately 1.5 per cent of total issuance, whereas sustainable sukuk is closer to just over 6 per cent of the total sukuk market,” Shaikh tells The Banker.

Green sukuk accounted for 63 per cent of sustainable sukuk issuance in 2023, consistent with Islamic countries’ energy and climate transition agendas, says Mohamed Damak, managing director and global head of Islamic finance at S&P Global Ratings.

The predominance of green financing is in line with the conventional bond market, with green bonds accounting for more than 60 per cent of ESG-labelled issuances last year, according to Crédit Agricole.

UAE issuers were responsible for 40 per cent of sustainable issuances during the year, followed by Malaysia (25 per cent) and Saudi Arabia (20 per cent), according to S&P data. With issuances boosted in the run up to COP28, issuers also benefited from an exemption of sukuk registration fees introduced by UAE regulators last year.

Companies were the predominant issuers of sustainable sukuk in 2023 (responsible for 49 per cent of issuances), followed by banks (36 per cent) and sovereigns (15 per cent). Banks have become increasingly active issuers of sovereign sukuk in the past two years, a trend set to continue as they bid to diversify their investor base, according to Damak.

Longer term, digital sukuk could spur the sector further by offering a quicker and cheaper way for issuers to tap into Islamic finance markets, he tells The Banker.

“The value proposition of digital sukuk is really about shifting to a process where sukuk issuance becomes a matter of logging into a platform or an application, selecting a legal document and plugging in the underlying assets,” says Damak. “Investors would quickly know that the company is trying to issue sukuk and if interested, they could participate.”

Standardisation anxieties

Such a shift would require the harmonisation of legal documents and a standardised interpretation of Sharia across geographies, says Damak.

The overlap between islamic finance and ESG finance presents a large opportunity for sustainable sukuk issuers to tap into global liquidity pools, according to Shaikh, particularly in the “global north’s agnostic liquidity pools, which are seeking emerging market returns to be deployed in the global south and in an ESG manner”.

If global issuers can position investment in sukuk as green or sustainable, it will further enhance the market opportunity and expand the customer base for Islamic finance, he says.

Yet, such efforts — and the sukuk industry — may face longer-term headwinds from proposed new standards under consideration.

The Accounting and Auditing Organisation for Islamic Financial Institutions, in late 2023, published its exposure draft of Sharia standard 62 on sukuk, with industry feedback invited until March 3 this year.

If adopted, Sharia standard 62 would require that the ownership and risk related to the underlying assets are transferred to sukuk holders. This could weaken sukuk sponsors’ contractual obligations if repayments become dependent on the performance of the underlying assets, their market value, or the sukuk holder potentially selling assets to third parties, S&P Global analysis suggests.

If conventional fixed income investors in turn avoid the sukuk market, pricing dynamics of such transactions may change to offset potential additional risks.

“At this stage, it is hard to tell whether Sharia standard 62 will be revised and how countries that adopted AAOIFI standards may react to the potential disruption of their sukuk markets,” says Damak.

If approved, the implementation of standard 62 may be deferred some years, which could spur sukuk issuance ahead of the standard’s adoption. As such, while sustainable sukuk issuance is expected to continue surging this year, medium-term levels of issuance are less predictable, S&P Global analysis suggests.

The drop in overall sukuk issuances last year to $168.4bn from $179.4bn the previous year came amid tighter liquidity conditions in Saudi Arabia’s banking system and Indonesia’s lower fiscal deficit, according to S&P. The trend also reflected a decline in the volume of local currency-denominated sukuk issuance, which dropped 16.8 per cent year on year, offset in part by an increase in foreign currency-denominated issuances in Saudi Arabia and the UAE.

In the meantime, financing needs in core Islamic finance markets remain high, with sukuk issuance set to reach $170bn this year, according to S&P projections.