Malaysia’s strength in Islamic finance has always stemmed from the fact that its regulator, central bank and financial services players have presented a united front, constantly refining the industry to improve it. It is much easier to get things done when everyone is pulling in the same direction.
This can be seen in the progress of codes and regulation in the environmental, social and governance (ESG), as well as the Shariah sphere. The country's Securities Commission issued an ESG market framework in 2014, guidelines on ESG funds in 2017, and then established a socially responsible investment (SRI) sukuk and bond grant scheme in 2018, allowing issuers to offset the external review costs of issuance, a scheme that was expanded in August 2022.
“It’s a very conducive environment for issuance,” says Raja Amir Shah Raja Azwa, chief executive of HSBC Amanah in Kuala Lumpur.
The last few months have brought new key measures, most importantly the launch of an SRI-linked sukuk framework in June 2022, and the launch of the first ESG Islamic repurchasing agreement in Malaysia in the same month.
The sukuk framework is designed “to facilitate companies to issue SRI-linked sukuk to support their transition towards low-carbon activities,” the Securities Commission says.
Tan Ai Chin, managing director and head of investment banking at OCBC Bank (Malaysia), views the sukuk framework as “timely: it will serve as a fresh catalyst for a more diversified type of ESG sukuk issuance in Malaysia.”
She compares it to the sustainability-linked bond principles issued by the International Capital Market Association (Icma), in that the framework provides the flexibility for issuance proceeds to be used for general corporate purposes “instead of being restricted to only a finite list of eligible green or social projects under the existing SRI sukuk.”
As is the case in sustainability-linked bonds elsewhere in the world, SRI-linked sukuks under the new framework have a potential profit-rate adjustment linked to a predefined list of sustainability indicators or performance targets linked to the ESG agenda of a company. That might be a commitment to renewable generation, for example, or to reduce carbon emissions by a defined amount.
These efforts come alongside a strong conviction at Bank Negara Malaysia, the central bank, to develop what it calls "values-based intermediation", which envisages a more meaningful and directly impactful Islamic finance industry. In essence, this means emphasizing the ESG elements that already exist in Shariah financing.
Landmarks
Given the supportive ecosystem, it’s little surprise that Malaysia has been home to many landmarks in Islamic ESG. The very first green sukuk was issued here, by Tadau Energy in 2017; 2021 brought the world’s first US dollar sovereign sustainability sukuk, from the government of Malaysia, a $1.3 billion dual-tranche deal featuring a $800 million sustainability 10-year sukuk.
There is also a clear market to sell to. On the buy side, of the 43 SRI funds offered in Malaysia as of December 31, 2021, 16 of them are Islamic funds, according to the Securities Commission.
“On the local front, we have seen PNB, EPF, KWAP and Khazanah taking several measures to evidence their commitment towards the sustainability agenda,” says Tan at OCBC, referring to four key state pension and sovereign wealth institutions in Malaysia.
Lots of international investors have a mandate to buy a certain proportion of ESG issuances for their portfolios. In Malaysia, that’s still up and coming
This includes establishing internal sustainability frameworks to chart a clear transition pathway to zero portfolio emissions by 2050, and “setting up specific investment mandates into green and sustainable assets to support the capital required for the country’s transition journey,” says Tan.
But we should be careful of overstating the scale of the buyer base. Malaysia is not Europe in ESG terms.
Amir notes: “Lots of international investors have a mandate to buy a certain proportion of ESG issuances for their portfolios. In Malaysia, that’s still up and coming: there are some who are signatories to the UN PRI [Principles for Responsible Investment], but not a whole stream of them.”
And, while there is clear cross-over between the Shariah and ESG camps, Amir points out that the two are not the same.
“While there is convergence, there is also a discrepancy,” he says. “For example, in the past you could finance a coal-fired power plant on a Shariah-compliant basis, but not through ESG. The lens of climate is becoming more prevalent.”
He also argues that any issuer that has decided to take the Shariah-compliant route might as well go further and make an issue resonant with ESG investors.
Issuing sukuk is not straightforward for reasons to do with compliance, documentation and differences in standards between Asia and the Middle East.
“But once an issuer has identified these challenges and is willing to go ahead," Amir says, "it makes sense to issue an ESG instrument, as it gives access to a whole new pool of investors and profiling of the overall transaction.”
More to be done
Without question, Malaysia leads the ESG sukuk field locally. Some RM8.3 billion ($1.8 billion) of SRI sukuk had been issued by December 31, 2021, according to data compiled for Euromoney by the Securities Commission; OCBC puts the figure at RM12 billion since the launch of the SRI Sukuk Framework in 2014.
According to Fitch, Malaysia hosts the highest number of active ESG sukuk globally, with 172 out of the 192 active ESG sukuk instruments in the world at the end of the second quarter of 2022, or 91.1% of all ESG sukuk issuances. Most are in local currency, which is distinctive.
But these are still not huge sums relative to their potential and there is a sense that more can be done.
Big issuers are doing their bit. Cagamas, Malaysia’s national mortgage corporation, has cumulatively issued RM1.69 billion of sustainability related bonds and sukuk across 11 deals in total since its inaugural sustainability issuance in 2020. Not all of these are sukuk, but those that are have included landmarks: in October 2020, it launched Malaysia’s first sustainability SRI sukuk for affordable housing, at RM100 million.
“The proceeds from the issuances are fully allocated to eligible assets,” says Asyraf Mokti in treasury and markets at Cagamas. “For example, for affordable housing, employment generation, renewable energy, as well as sustainable water and waste management.”
As with many nascent markets, issuance is a bit lop-sided.
“SRI sukuk issuance in Malaysia is still very much driven by green-labelled sukuk catering for specific projects within common industries, mainly renewable energy and green buildings,” says Tan at OCBC Bank. “While these industries are undeniably important to curb carbon emissions,” particularly in Malaysia where carbon emissions per capita are among the highest in Asean, “focus should also be given to other sectors within the ESG value chain to facilitate the country’s transition towards a low-carbon economy.”
One of the key challenges for ESG sukuk issuers is to convince investors to prioritize the sustainability agenda over targeted investment returns as part of the investment decision-making process
Tan finds it interesting that, other than the Ihsan sukuk issued by Khazanah back in 2015 to improve the accessibility of quality education in government schools, “we have yet to see any other social-impact sukuk issued by other corporates to date. There are several issues with significant impact to the larger social communities such as food security and the wellbeing of certain communities living below the poverty line, which have become more critical after what the world experienced during the pandemic.”
She believes social sukuk should be feasible with sufficient effort from stakeholders.
Tan also points out that in Malaysia, ESG issuance still has to prove itself from a return perspective: “One of the key challenges for ESG sukuk issuers is to convince investors to prioritize the sustainability agenda over targeted investment returns as part of the investment decision-making process.
“Notwithstanding increasing investor demand for ESG sukuk, it is still not visibly evidenced that such appetite has translated into a more competitive yield by investors compared to plain-vanilla sukuk issuances.”
An important transaction that helped demonstrate the sophistication involved in Shariah sukuk was a RM1 billion five-year sustainability linked sukuk for Yinson Holdings, a crude oil and gas player active in the floating production storage and offloading (FPSO) sector.
In this deal, sole led by HSBC Amanah, the issuer is subjected to a series of sustainability performance targets, such as increasing renewable energy generation and reducing carbon intensity, and the profit rate of the security increases if those hurdles are not met by 2025.
“That transaction required additional investor engagement to the market on the product features, given it was the first of its kind,” says Amir. “They’d never seen sustainability linked deals before,” nor characteristic features such as step-up or step-down coupons, or carbon credits, “so we needed to make it easy and provide education to the market about how this product worked.”
Bankers had learned from past experience that step-downs in coupons or principle amounts, upon achievement of key performance indicators, were more challenging to distribute, because they feel like they are penalizing the investor in an unpredictable fashion.
“That was difficult for investors to stomach,” says Amir.
The preferred model was instead to do a step-up if KPIs are not met.
This meshes with Tan’s experience at OCBC, who says it “is a challenge to gauge the level of acceptance by investors towards SRI-linked sukuk, given the profit-rate ratcheting feature, especially if it involves potential reduction in the sukuk profit rate in the event the agreed sustainability targets are achieved.”
Globally, she says, there have been few sustainability linked bonds issued with a coupon step-down or discount feature, and the same is true in Malaysia, “given the price uncertainties which could affect the tradability of such bonds, and this is something investors would want to avoid.”
Setting KPIs for an oil-and-gas services company like Yinson also required careful consideration, but the deal was helped by the fact that “the company already had a credible transition plan in place,” Amir says. “We didn’t need to sit down with them and tell them they needed to have a transition story: they already had it.”
Bankers feel there is potential in ESG sukuk. Tan says OCBC “remains buoyant” on a potential uptick in issuance by local corporates, while HSBC Amanah thinks it is important that issuers aren’t just launching because they’ve been told to by a regulator.
Jared Jimbau, associate in debt capital markets at HSBC Malaysia, says: “Initially, momentum started from the top, with the government setting the pace and leading by example. But now we’re hearing stakeholder voices being heard, so the dynamics are both top-down and bottom-up, converging in the middle, creating the momentum for growth.”
From firsts to frameworks: the future of ESG sukuk issuance
This year was meant to be a good one for sustainable Islamic finance, which should be a larger part of the sustainable finance universe than it is. The conventional sustainable bond market still dwarfs its Islamic counterpart, reaching $428 billion in the first six month of the year, compared with just $4.3 billion of environmental, social and governance (ESG) sukuk.
S&P Global projected 10% to 12% growth in this sector in its 2022 outlook and anticipated more frequent issuance of ESG sukuk as the industry benefitted from its alignment with ESG values. Indeed, the sustainable sukuk market grew to 2.6% of total Islamic bond issuance by the end of the second quarter, and outstanding ESG sukuk expanded by 11.2% quarter on quarter, to reach $19.3 billion, according to Fitch Ratings.
In the Middle East and North Africa, big regional names such as Riyad Bank and Saudi National Bank (SNB) joined the list of ESG sukuk issuers and have issued deals worth $750 million.
Relative to the European and developed market, ESG financing in the GCC region is still at an early stage in terms of market volumes on the supply side
Khaled Darwish, HSBC
Geopolitical developments have, however, impacted the sector. Firstly, as oil prices have risen due to the global energy crisis, the financing needs of core Islamic markets in the Middle East have fallen. This has hit the deal pipeline, but for HSBC’s head of MENA debt capital markets, Khaled Darwish, heightened market volatility, along with inflationary pressures and uncertainties around global monetary policies throughout 2022, have also played their part.
“Relative to the European and developed market, ESG financing in the GCC region is still at an early stage in terms of market volumes on the supply side,” he says, adding nevertheless that the ESG market in the region has seen promising growth in the past few years.
The bank has acted as bookrunner on a number of breakthrough deals, including Riyad Bank’s $750 million additional tier-1 sustainability sukuk issuance, and Saudi National Banks’ $750 million ESG sukuk.
But there has been a noticeable decrease in the volume of conventional financing products with an ESG focus in the GCC.
“We’re probably at 50% less than what we had last year,” says Darwish.
Funding climate adaptation
Muslim-majority countries are, nevertheless, rapidly catching up with international sustainability standards. And they have a very real imperative to do so.
“In terms of actual exposure to drought, floods, extreme temperatures and water scarcity, many OIC [Organisation of Islamic Cooperation] countries are topping the charts,” points out Fitch Ratings' global head of Islamic finance, Bashar Al Natoor.
The Islamic Development Bank (IsDB) estimates that the financing gap for OIC countries to achieve their UN Sustainable Development Goals is between $700 billion and $1 trillion. The bank raised $1.6 billion via a public sukuk issuance in April, the proceeds of which will be used to finance projects in member countries under the IsDB development mandate.
Many financial institutions are becoming more aware of the [environmental] risks, and we expect this funding gap to be addressed by sukuk issuance
Bashar Al Natoor, Fitch Ratings
That mandate includes anything from sustainable agriculture and water infrastructure to poverty alleviation and education. It is founded on Shariah principles but is very much aligned with global ideals of sustainable finance.
“Many financial institutions are becoming more aware of the [environmental] risks, and we expect this funding gap to be addressed by sukuk issuance,” says Al Natoor.
On the investor side, limited domestic appetite means that issuers are keen to attract foreign capital to diversify their investor base and generate additional green assets. Adding sustainable conditions to the use of proceeds of an Islamic bond makes the structure more palatable to conventional investors, without excluding local stakeholders.
There is a sense that some domestic investors feel Shariah compliance is social contribution enough. Many argue that Islamic finance was practising ESG long before that became a buzzword because of the exclusion criteria and the philosophy to avoid harm and attain benefits.
Perhaps partly for this reason, Fitch notes that there are limited domestic or regional ESG-dedicated investors and issuers in core Islamic finance markets, and that “Shariah-sensitive investors in these regions largely outnumber ESG-sensitive investors.” Anzal Mohammed, capital markets partner at Allen & Overy, points out that ESG sukuk issuance attracts a broad buyer base.
“Issuers prefer to access as many investors as possible," he says, "and a sustainable sukuk will attract both conventional and Islamic investors. From a commercial and credit perspective, if structured appropriately, they are on par with conventional bonds.”
Regulatory standardization
For Mohammed, the smaller number of institutions able to issue a Shariah-compliant bond brings benefits of its own.
“Sukuk tend to capture a solid investment base because there is scarcity of issuance,” he points out. "In comparison to bonds, sukuk tend to be more oversubscribed due to the captive Islamic investor base."
But even in Islamic markets, issuers recognise the legal complexity of sukuk – which has typically lacked the appropriate standardization and regulation to encourage foreign investment – compared with conventional bonds.
Things are, however, changing. Initiatives such as Saudi Arabia’s Vision 2030 and the UAE Green Agenda 2030 will drive standardization, but the expansion of sustainability frameworks goes beyond this. In March this year, the Qatar Financial Centre published its sustainable sukuk and bonds framework, and in June, Uzbekistan’s ministry of finance announced a concept note for the development of a national sukuk regulatory framework, for both green and vanilla issuance.
As more of these frameworks are developed, local investors must build up their in-house expertise for issuance to pick up. At the moment, the buy-side capacity is not there.
“What would help further support this growth is an emergence of regional ESG-dedicated funds and portfolios that would increase the demand for and liquidity of ESG issuances,” says Darwish at HSBC.
International ESG and socially responsible investment (SRI) funds will tend to ask for ambitious and specific key performance indicators from corporate issuers. Sustainability linked structures are still too sophisticated for many regional corporates that are used to the more straightforward use-of-proceeds option. For corporates to commit to sustainability linked KPIs, they need to be further along the road in terms of data collection and measurement.
The practice is becoming more common on the debt side, however. Sustainability linked loans (SLL) are becoming more popular in the region; the most recent deal was Dubai-based retail property conglomerate Landmark Group in April this year, and Majid Al Futtaim’s $1.5 billion deal last August.
“We expect the growth momentum in the regional ESG market to accelerate in the coming years, in terms of supply and in the evolution of issuance structures to include social issuances as well as sustainability-linked bonds with well-defined KPIs” says Darwish. Bankers point to other promising examples of recent corporate ESG sukuk issuance. Etihad Airways signed onto Citi’s Abu Dhabi Global Market deposit solution in July of this year, having issued an inaugural transition sukuk back in 2020.
Middle Eastern sovereigns are also increasingly present in the global sustainability debate. With COP27 and COP28 taking place in Egypt and the UAE respectively, Islamic finance will surely play a big role in funding the climate transition. What remains to be seen is if the sustainable finance frameworks at the sovereign level can provide answers to the difficult questions that corporates face before they can start issuing.
Marianne Gros
