Changes to the ICMA’s green, social and sustainability (GSS) bonds framework could inhibit issuance of GSS sukuk and the development of green capital market assets in Islamic markets. Developments from within sukuk markets provide a way for sustainability-linked sukuk to help fill the gap.
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ICMA releases new guidance to ensure green assets are not double-counted, but in doing so hits upon a point of ambiguity relating to green sukuk
Depending on how the guidance is applied, it could substantially increase the review process for labelled sukuk compared to similar labelled bonds
For green, asset-light issuers, sustainability-linked instruments can complement labelled GSS bonds to create additional green assets and benefit from regulatory frameworks such as the one recently issued by Malaysia’s Securities Commission
The proposed guidance is written with securitization and covered bonds in mind, but broadly speaking, it may create challenges for sukuk issuers depending on how it is interpreted, because many sukuk use securitization-like structures. Currently, sukuk are subject to very limited additional requirements compared to GSS bonds, a sensible situation where most function as unsecured obligations issued to finance specific green-qualifying activities.
Taking green bonds and sukuk as an example, ICMA’s Guidance Handbook released in January 2022 only included a clarification that green issuers should explain how their issuance contributed ‘to environmental objectives by exclusively applying the proceeds to finance or re-finance eligible Green Projects’. In the context of general-purpose, unsecured financing, that is the economic outcome of most sukuk issuance, although it abstracts from their underlying structures.
One ambiguity in the application of GSS bond standards & guidelines from ICMA and other similar frameworks is how well the rules apply to the unique structural aspects of sukuk. For example, plain vanilla ijara sukuk link a sale-and-leaseback transaction with application of the proceeds by the originator often for different purposes than investing in the underlying leased asset. The ICMA green bond principles would require explanation of how the proceeds of the sukuk are to be used exclusively for eligible Green Projects.
The ambiguity in the green bond standard in this situation is determining how to apply ICMA guidance on ‘Green Project eligibility’ in different situations. For example, if the issuing SPV raises a green sukuk, in the narrowest sense, the Green Project eligibility would be considered for the asset it is buying (the ijara asset). However, it’s unlikely that this narrow view would prevail when the review system for green bonds focuses primarily on the ultimate use of proceeds, which would be the spending by the originator and not the issuing SPV (not to mention hybrid sukuk that combine tangible leasing assets with commodity-based financing to allow for increased issuance size).
The recent clarification in the ICMA’s guidance on securitizations provides additional definition that could broaden the applicability of the secured GSS bond standards to include sukuk. It specifically includes both ‘issuer’ and ‘originator’ and explains how those terms are being broadly applied to include many forms of bonds. Importantly for sukuk, it includes an explicit note that ‘synthetic bonds are not excluded from the definition’, which would indicate a broad definition of what a ‘secured GSS bond’ is for the purpose of determining applicability of the guidance.
The principal criteria are that:
assets should not be counted twice by multiple different instruments in a single transaction, and
all use of proceeds follow the Green, Social or Sustainability Framework established by the issuer.
Having expanded the scope of review of different component transactions within securitization and securitization-like transactions, the guidance would seem to substantially increase the elements for review associated with green (and social and sustainability) sukuk beyond the use of proceeds assessment that all GSS bonds and sukuk are subject to.
One impact this could have on GSS sukuk issuers would be to require a wider review of ‘green eligibility’ to include underlying assets (including for commodity-based financing). It would also restrict the ability of issuers that finance one asset using a green sukuk from using a non-green asset in the process on the grounds that doing so would lead to application of proceeds outside of what is defined by the green (or social or sustainability) framework.
It could also create a higher bar for issuance of follow-on green sukuk other than for refinancing if each transaction used to structure the green sukuk needs to use distinct green assets. The effect of both of these changes would be to complicate green sukuk issuance and to limit the ability of issuers, especially in countries where green-eligible assets are in scarcer supply. One of the ways that these limitations are mitigated is through non-labelled issuance such as sustainability-linked sukuk, where Malaysia’s Securities Commission has just provided a new framework.
Sustainability-linked issuance is more flexible than labelled GSS sukuk is currently, and especially in how it would be if covered under the new ICMA guidance on securitizations. This can help facilitate broader issuance and creation of the green (and social or sustainability) assets for future GSS sukuk issuance. In the process, however, some of the challenges relating to issuer and investor incentives created by the financial impact of meeting or failing to meet specified KPIs will need to be mitigated.
Coming away from an initial review of the new ICMA guidance on green securitizations, it is clear there may need to be more clarification about what elements of a sukuk transaction need to be reviewed for ‘green’ (or social or sustainability) eligibility for a labeled GSS sukuk. It is important, as ICMA is trying to do, to reduce the degree of double-counting of green assets in the labelled bond market.
However, at the same time, it is important to find the right balance between fixed requirements about green eligibility and greater flexibility with added transparency to keep the labelled GSS bond market open to sukuk issuers. The ambiguity added from the new ICMA guidance should be a call to action for stakeholders in Islamic capital markets to help resolve it.
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