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How would you describe investor appetite for ESG sukuk? What types of investors are driving this
demand?

Within the realm of the global sukuk market, we have seen a rapid rise in ESG sukuk issuance, with a widely reported $4.4 billion issued in H1 2022, bringing total outstanding ESG sukuk to $21.3 billion, according to Refinitiv data. Demand for ESG sukuk is growing substantially as more investors begin to integrate sustainability and impact investing criteria into their investment decision-making processes. This growth also stems from a strong push by the investor community to promote sustainability-related investments through collaborative, investor-led organisations such as the UN-supported PRI or Net Zero Asset Managers initiative.

It is also interesting to note that we are seeing investors pushing boundaries by investing across multiple tenors. As an example, the Indonesian government issued the world’s first sovereign green sukuk in 2018, with a 5-year tenor. It then extended the maturity curve with a 30-year green sukuk in 2021 and a 10-year tranche in June 2022.

The green sukuk tranche has consistently provided investor profile diversification for the Indonesian government, with 35.6% of the green tranche for the 2022 sukuk issuance allocated to green or SRI investors.

In the case of the Malaysian government’s sustainability sukuk issuance in 2021 – the world’s first sovereign sustainability sukuk – the transaction was able to attract a new set of investors (i.e. investors with ESG mandates) to participate in the 10-year tranche.

Against the backdrop of robust demand coming from high-quality, real-money accounts with ESG mandates, we see not only sovereign issuers capturing these pockets of demand, but corporate issuers are also seizing this opportunity. Saudi National Bank’s ‘sustainability’ sukuk issued in January 2022 saw around 19% of the final issue size allocated to accounts with an ESG mandate.

In terms of the type of investors driving demand for ESG sukuk, traditional Islamic investors still play a key role with anchor orders, although a large portion of these investors may not currently have an ESG investment mandate. Their interest has been more focused on the Shariah compliance of the instrument, rather than focusing on the sukuk’s ESG credentials. Having said that, the sukuk market has witnessed a new pool of liquidity driven by investors with dedicated ESG desks, based largely out of Europe, who may not have previously showed interest in traditional sukuk issuances.

However, with the increased awareness of ESG, we can expect investors to be more informed on the importance of ESG-linked investments and the impact they will have in moving towards a better economy.

How does the structuring process for ESG sukuk differ from traditional sukuk? What are the areas for improvement in this process?

There are four broad categories of ESG sukuk in the market: green, social, sustainability (a combination of green and social objectives), and sustainability-linked. Across all categories, the structuring process would entail an additional layer of workstreams involving the issuer’s commitment to sustainable finance. The first step is to develop a sustainability sukuk framework that is aligned with international standards such as the ICMA Green Bond Principles.

In establishing the framework, it is important to ensure alignment with the following four core components:

  • Utilisation of proceeds: sukuk proceeds must be used exclusively to finance or refinance expenditures related to eligible green or sustainability projects
  • Project evaluation and selection: a clear tagging process to identify expenditures related to eligible green projects
  • Management of proceeds: identify whether there are any designated accounts to capture such proceeds and the processes for allocation of the proceeds
  • Reporting: publish an annual report on the progress of the identified eligible projects, the amount of proceeds allocated and an impact analysis where an independent third party would be appointed to provide assurance

Issuers would then be encouraged to appoint an SPO provider for an independent assessment of the accuracy and integrity of the sustainability framework, which adds credibility.

For sustainability-linked instruments, profit payments are linked to an issuer’s performance against company-wide ESG KPIs. There is a need to identify the relevant ESG metrics as KPIs, which should be relevant, core and material to the issuer’s overall business, measurable or quantifiable on a consistent methodological basis, and externally verifiable.

As an example, Yinson Holdings issued the world’s first sustainability-linked sukuk with a profit stepup in 2021. This was an innovative structure with a tiered profit step-up against three sustainability performance targets.

Market players must work together on encouraging greater transparency in order to address concerns around greenwashing. All sukuk transactions must be asset-based to be Shariah-compliant. In the current ESG sukuk market, issuers tend to have two separate sets of assets: underlying assets to be used under the sukuk structure; and ESG assets identified as eligible projects.

Although the underlying assets under the sukuk structure are not limited to ESG assets, issuers may want to work towards utilising the ESG assets as the underlying assets for the sukuk structure for efficiency purposes.

In reality, it can be challenging to find assets that meet both criteria. However, the Malaysian government’s sustainability sukuk in 2021 successfully identified such assets by employing vouchers under public infrastructure projects as its tangible assets under the sukuk structure, and it utilised the same public infrastructure projects as the ESG government assets identified under eligible projects as per the framework.

With sustainability-linked sukuk, the biggest challenge lies in defining an ambitious KPI (e.g., emissions reduction targets). A one-size-fits-all approach does not work, in our view. We need to recognise that each sector’s pathway to Net Zero will be different, depending on technological constraints and the starting carbon footprint. Hence, a sector-specific approach is needed, where companies ought to be assessed against a sector-specific benchmark.

Is the pricing of ESG sukuk in the primary market more favourable compared to traditional sukuk?
Could we observe ‘greeniums’ for these sukuk?

The greenium measures the spread of ESG-labelled sukuk to non-ESG-labelled sukuk from the same issuer of the same seniority and maturity.

In 2020, Cagamas, the National Mortgage Corporation of Malaysia, priced a 3-year ASEAN sustainability SRI sukuk (SRI sukuk) and a plain-vanilla Islamic Medium-Term Note (IMTN) in the local market on the same day. There was a lower yield recorded (2 basis points) on the SRI Sukuk compared to the IMTN. However, it is worth highlighting that ESG sukuk transactions may be able to garner a larger order book, driven by the wider pool of ESG-focused investors.

As such, issuers can achieve a higher price compression during the book-building process, subject to market conditions. Although the pricing advantage is uncertain at this juncture due to the limited comparables in the sukuk market, we can view greeniums as the ‘price’ of cutting financed emissions.


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