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ICMA sustainable sukuk guidance brings flexibility and risks for issuers with limited green assets
The International Capital Markets Association (ICMA), Islamic Development Bank (IsDB) and LSEG have released guidance on sustainable sukuk, reflecting the growing contribution of Islamic capital markets to the wider sustainable fixed-income market.
Through the first quarter of this year, sustainability-labelled sukuk have been dominated by core Islamic finance jurisdictions including Malaysia, Indonesia, the UAE, Saudi Arabia and the IsDB, but the new guidance has been purposely developed for issuers coming from either sukuk or green bond markets to issue green, social, sustainable, transition or blue sukuk.
One of the areas on which the guidance is silent is the ESG/sustainability evaluation of the underlying asset, which is a structural difference between sukuk and bonds. The absence of guidance on ESG/sustainability screening of the underlying asset similar to what is required for the ultimate use-of-proceeds presents an area of risk that could be mitigated with clearer disclosure.
Even as it represents a risk to the sustainable credentials of the transaction if the asset's sustainability profile differs from investor expectations, it could be easily addressed with additional disclosure. This would mitigate the risks while providing flexibility for green and social sukuk where lack of green assets would otherwise create a barrier to issuers, especially in markets where a substantial share of financial assets are held by Shari'ah sensitive investors and financial institutions.
The transition teething process often means two steps forward and one step backwards
The development of frameworks and supporting policies to guide more finance towards the green transition (both into green projects and to enable energy transition in line with global Net Zero 2050) is a positive, but there remains uncertainty about which policies will be effective and which will be counterproductive. In addition to the policy uncertainty, there is also substantial doubt about whether the financial system as a whole – comprised of regulators, management and staff at financial institutions, investors, capital markets (domestic and international) and ratings agencies – is able to row in the same direction at the same time.
One recent example of the pitfalls that lie close to the surface under the structures being built to transform the financial and non-financial corporate sectors was when the Science Based Targets Initiative (SBTi) outlined a proposed change to its net zero targets that would allow companies to use carbon credits to abate Scope 3 emissions, which quickly sparked a significant backlash.
At issue is where to draw the line about responsibility for emissions within a value chain. One argument in favor of allowing offsets for Scope 3 emissions is that they are generally outside of a company’s control, and the requirement for offsets retains a financial incentive to do more than disclose Scope 3 emissions. The mechanism of carbon credits provides a way to direct finance towards projects that could reduce global emissions.
The challenge – which ties into the process of experimentation in the way financial systems are being adapted – is that although companies don’t usually have operational control of their Scope 3 emissions, it could still influence their behavior in sub-optimal ways.
Banks in the GCC region are tackling climate transition risk, but it remains a ‘work-in-progress’
Standard & Poor’s Ratings has this week addressed frequently asked questions about climate transition risk facing banks in the Gulf Cooperation Council (GCC) countries, describing banks’ efforts in measuring the risk to date as a ‘work-in-progress’. On financed emissions, like those covered by RFI Foundation’s financed emissions database, S&P highlighted that “banks' difficulties with measuring scope 3 emissions come up regularly in our discussions”. This is understandable because emissions measurement is an almost universal challenge for banks globally.
This context of data gaps was a motivating factor for the way RFI undertook its financed emissions work, which is catalogued in an open-access database with five years of data covering banks and financial markets in the six GCC countries and five other OIC markets. The financial sector plays a key role in financing the transition and will need substantial new capabilities beyond what they have now to understand the many types of climate transition risk they face from the activities they finance.
How transition finance could eclipse sustainability-linked financing
One of the consequential outcomes of COP 28 was the agreement to transition away from fossil fuels in order to reach the global climate goals of limiting warming to 1.5˚ C, which requires reaching Net Zero by 2050. After COP 28 ended there has been a widespread effort to determine the best way to achieve that transition, for which finance plays a key role.
IMF report examines climate & stranded asset risks facing banks in MENA and Central Asia
A research paper written by an IMF team examines the readiness, risk and opportunities for the financial sector in the Middle East & North Africa (MENA) and Central Asia and identifies some areas that need particular focus. The evaluation of the region’s preparedness for the climate transition starts by looking at the sources of physical climate risk, transition risk, and the risk related to stranded assets on the region as a whole, including some that have been identified by financial sector supervisors and central bank Financial Stability Reports.
Emerging markets need to be able to absorb much more climate finance than they do today
Following the COP 28 climate summit in Dubai, there will need to be a redoubled effort to drive finance in the direction of alignment with the transition. International private climate finance in particular will need to rise by 15 times from current levels. One of the major challenges in driving this growth is that it often relies on data to guide and assess whether financing flows are moving consistently with the Paris Agreement or inconsistently with these global objectives.