ESG-linked sukuk, or Islamic bonds, are emerging as significant funding tools in Muslim-majority countries, with growing support from supranationals, sovereigns and government-related entities. In 2022, the volume of outstanding ESG sukuk expanded by 11.2% quarter-on-quarter to reach $19.3bn, with $4.3bn issued in H122. Fitch now rates more than 80% of the hard-currency ESG sukuk market, with 97.4% of issues rated as investment-grade.
The issuance of green and sustainable sukuk in many Organisation of Islamic Cooperation (OIC) countries, including in the Gulf Cooperation Council (GCC) nations, helps to fund programmes addressing ESG risks in those locations, such as water scarcity, climate change, and governance reform. Regulators in many of these markets are also rising to the challenge, with some launching tax and cost incentives for ESG sukuk and bond issuers. Others are establishing ESG sukukand bond frameworks to create common standards for issuing ESG debt, among other initiatives.
Notably, the ESG sukuk segment is showing an upward trajectory despite the volatilities in the debt capital market caused by Russia’s conflict with Ukraine, increasing interest rates, rising oil prices, and inflation.
One catalyst behind the segment’s rise is the commonalities between Islamic finance and ESG principles, with both focusing on responsible finance. Similar to ESG, Islamic finance has principles built into its foundation that concentrate on avoiding harmful practices rather than looking solely at bottom-line profits. As an example, Islamic finance prohibits income from activities such as alcohol production, tobacco, gambling, pornography, and illegal arms trading. However, they differ because Islamic products must be structured in such a way that complies with Shariah (Islamic canonical law), in addition to Islamic products prescribing how proceeds are used.
ESG sukuk could be an attractive proposition for issuers because the demand generally outweighs supply, and could enhance their reputation because this activity signals to investors, regulators, customers, and other stakeholders that an issuer is focused on environmental issues.
We have also seen cases of ESG sukuk attracting a wider pool of investors from outside core markets. For example, European and US investors collectively funded 52% of Indonesia’s 30-year green sukuk tranche issued in 2021, while they collectively funded only 17% of the five-year non-green sukuk tranche.
Issuers are also taking advantage of rising international demand for green and sustainable debt products with more than $1tr. issued in 2021, 92.8% higher than in 2020. Sukuk, rather than conventional bonds, remains the preferred format for ESG-linked debt in many core markets because it attracts a large Islamic investor base. In the GCC region, for example, 75.7% of outstanding hard-currency ESG debt at end-2Q22 was in sukuk, with the remaining in the bond format.
Nevertheless, there are a number of challenges to overcome if the ESG sukuk market is to develop to its full potential. These include a shortage of domestic ESG-focused investors and issuers, regulatory constraints, underdeveloped local guidelines and taxonomy, complex issuance process, a shortage of qualified human capital, and a nascent market infrastructure. This is unlike regions such as the US, Europe and China, where the segment is more developed.
Barriers also remain in the conventional ESG debt markets. These include a lack of commonly accepted green and sustainability standards and definitions, issues in ESG data comparability across issuers, and scepticism and legal risks surrounding greenwashing
The pricing advantage of issuing green and sustainable sukuk is also not yet evident, with pricing swinging in both directions. While there are cases of issuers obtaining a coupon discount known as a ‘greenium’ on the launch of ESG sukuk, compared with a similar non-ESG instrument by the same issuer, there are also cases of ESG sukuk issuers paying a higher coupon. Any pricing advantage could also be offset by higher issuance costs linked to ESG-related governance and Shariah-compliance. Uncertainty also looms if the presence of green or sustainable labelling gives sukuk a significant demand boost.
However, the long-term growth potential of the segment remains high, as ESG sukuk makes up only 2.6% of the total sukuk market. We expect this to rise to 5% in the next five years on the back of sustained international investor demand and government initiatives that promote sustainability and economic diversification.