The Rising State of Sustainable Finance — Challenges and Opportunities

According to Fitch Ratings, the size of the Islamic finance sector may have already exceeded US$3 trillion. While the size of the sustainable Islamic finance sector remains a fraction of that, it is rising. Nevertheless, it would seem that the growing importance of sustainability, in particular climate change-related issues, is giving back some importance to Islamic finance in particular in the Middle East. As the Middle East continues to seek distinguishing itself from the rest of the world through sustainability, Islamic finance could easily enable that. 

Indeed, the ability to structure a sustainable Islamic finance deal as seen in capital market transactions (Sukuk specifically) has enabled expanding the pool of funding to borrowers. These types of bonds attract three pools of investors: Islamic finance investors, sustainability investors and those simply looking for the underlying credit risk.

Islamic capital market instruments, specifically Sukuk, remain the fastest-growing segment. However, one segment to watch is Islamic fintech which has grown exponentially in both Asia and the Middle East with various digital and fintech products becoming Shariah-approved such as crowdfunding, Buy Now Pay Later products, blockchain-based products and cryptocurrency.

Review of 2022 
The biggest markets for Islamic finance continue to be centered in the Middle East, Saudi Arabia and the UAE, as well as East Asia, in Malaysia and Indonesia. The growth of Islamic finance products in both markets continued in 2022, although it may have started to slow down after the second half due to, among other reasons, the geopolitical and economic issues which started impacting the world.

Other factors have contributed to this deceleration including the fact that the Central Bank of the UAE adopted the AAOIFI standard demanding stricter adherence to the percentage of underlying assets required to enable the transferability of Sukuk. On the sustainability side, the slow growth of available projects for financing has restricted the market. That may change as MENA approaches both COP27 Egypt [2022 United Nations Climate Change Conference] and COP28 UAE [2023 United Nations Climate Change Conference], heightening awareness and interest in the region and increasing transition plans and net-zero commitments.

Preview of 2023 
Growth challenges going forward depend, in part, on areas not specifically related to Islamic finance such as the global economy and the availability of sustainable projects that can be financed, including December 2022 the development of sustainability frameworks and taxonomies that would accelerate this process.

But there are other challenges from within the industry itself, namely the lack of standardization of documents across the markets and, more importantly, the differences in Shariah interpretation between Asia and the Middle East for the purposes of finance structures. This difference means that it will always be difficult for the global market to expand rapidly.

The ability of the Asian Islamic finance market to use Murabahah/Tawarruq structures provides flexibility and more product possibilities. Yet that structure not being acceptable in the Middle East means that, when embarking on global issuances as in the example of Indonesia’s Sukuk, a more Middle Eastern-accepted structure requiring minimum physical assets would be needed. This is potentially restricting issuances.

Conclusion
Despite these stumbling blocks, there are several factors that send encouraging signals for the year ahead, providing international capital markets recover. The world requires massive amounts of financing to achieve their climate and SDG commitments. The Middle East alone requires around US$2 trillion.
 
Given that 90% of sustainability bonds that came out of Saudi Arabia have taken the form of Sukuk, it is expected that Saudi Arabia will be tapping into Islamic finance to fund its sustainability-related expansion. Saudi Arabia also has set a target of becoming the global Islamic finance center in its Vision 2030. 

Similarly, in Asia, in 2020, Malaysia’s Securities Commission has identified socially responsible Islamic investment as part of its continued leadership in the Islamic capital market space. In furtherance of that vision, Malaysia today is home to 91% of all ESG Sukuk issuances and has issued in June 2022 the SRI Sukuk Framework to further support that vision and facilitate further issuances by corporates. 

With the two key markets standing behind it, the only way for sustainable Islamic finance is moving up. 

Written by: Luma Saqqaf, CEO of Ajyal Sustainability Consulting
Source: The Rising State of Sustainable Finance — Challenges and Opportunities (December 2022).  IFN Annual Guide 2023 (pp. 67)

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