As the 26th United Nations Climate Change Conference of the Parties (COP26) drew to a close in mid-November of this year, UN Secretary General Antonio Guterres warned: “Our fragile planet is hanging by a thread. We are still knocking on the door of climate catastrophe.” i While the Glasgow Climate Pact took important steps forward, he hastened there was still much to be achieved. His points included an end to fossil fuel subsidies, a phase-out of coal, a price on carbon, building the resilience of vulnerable communities against the impacts of climate change and delivering the long-promised climate finance commitment to support developing countries. Even with this list, he noted with a hint of optimism that while global leaders “did not achieve these goals at [COP26] … we have some building blocks for progress.” ii
Among those building blocks are the commitments made by the financial services sector. COP26 saw the first-ever Finance Day held on Day 3, in prime position after the two-day World Leaders Summit. The engagement of the financial sector was at a level not seen previously, leading some even to refer to this as the Finance COP. Among the discussions on Finance Day, and the days that followed, was the growing need for transition finance. While not a new topic, the two weeks of COP26 advanced that discussion to focus not only on the necessity of financing the transition, but of financing a just transition. Financing a just transition is not solely about decarbonizing the economy, it is about innovating for a lower carbon future without creating severe economic impact, particularly to the developing world.
Therefore, the focus now has evolved to mobilizing funding to limit climate change and promote the shift to a lower carbon future in a way that is sustainable and positive for all communities. This presents a very unique opportunity for the Islamic capital markets (ICMs). Islamic finance is a proxy and an entry point to the ‘Global South’ which is disproportionally vulnerable to climate change and significantly impacted by decarbonization. The global finance community, and in particular the ICMs, now have the opportunity, and perhaps even the responsibility, to help accelerate the transition to a less carbon-intensive economy and become stewards of the said change.
The case for transition financing
Before COP26, estimates suggested that an annual US$6.9 trillion in infrastructure investment and between US$1.6 trillion and US$3.8 trillion for the energy transition were required to meet the Paris Agreement targets. With new goals surrounding the Glasgow Climate Pact, these amounts will have only increased. As there are not sufficient public funds to meet these needs, private capital is vital and this presents a considerable prospect for engagement by the ICMs.
Environmental, social and governance (ESG)-focused capital market activities are often synonymous with portfolio divestment from heavy emitting sectors such as oil and gas, cement, steel, shipping, aviation and mining. However, many of these currently high-emission sectors are sectors the real economy will still need decades from now and viable low- or no-carbon alternatives do not yet exist at the scale required, if at all. Some sectors face significant hurdles to achieve decarbonization whether they be economic, technological or rooted in other considerations. Other sectors may not be able to completely decarbonize but still must be included in the global economic transition. Furthermore, divestment by ESG-principled investors effectively abandons control to those who may not share the same concerns and who may not exert their influence in the furtherance of a sustainable agenda. Equally, by refusing to provide financing to these areas, the capital markets leave them without the necessary resources to transition. Divestment does not result in lower emissions.
This is particularly true for the emerging markets. Currently, there is a substantial gap in emerging market transition finance because emerging market investing is inherently carbon-intensive, as many of these economies are still heavily dependent on coal. In fact, investing in emerging markets can increase portfolio emissions by 10%. Carbon targets and other divestment policies, while well intentioned, often serve to drive capital away from areas which need it most.
Therefore, on the path from COP26, the focus should shift to engagement with these industries globally to build outcome-led partnerships focusing on decarbonizing the real economy. If the finance is mobilized to support the transition, investing in new technologies and, where possible, retooling to accommodate renewables, the financial sector and in particular the ICMs can enable increased momentum to convert intent into action.
Developing a responsible transition Sukuk market
One structure by which to achieve a lower carbon economy is the growing area of transition bonds and Sukuk. Transition bonds and Sukuk, as opposed to green bonds and Sukuk, provide financing to high-emitting sectors and projects that would not be eligible for green certification but yet are still necessary to implement the changes required to meet the Paris Agreement targets. To date, there have been fewer than 20 transition bonds and even fewer transition Sukuk, but it seems momentum may be growing.
In 2020, the Islamic finance sector saw the first-ever transition Sukuk by Abu Dhabi’s Etihad Airways, which raised US$600 million for investment in sustainable aviation and carbon reduction targets. In March 2021, the IsDB raised US$2.5 billion with its sustainability Sukuk, the proceeds of which will be allocated to eligible projects under the IsDB’s Sustainable Finance Framework, which incorporates supporting the transition to a green economy as one of the three main pillars of its climate change policy.
The market has also seen increased commitment to transition funding in the MENA region. For example, in September 2021, APICORP announced it is considering the issuance of transition Sukuk as part of its green bond framework. Additionally, Saudi Arabia’s Public Investment Fund (PIF) has stated that it would look to “gradually move toward turning down investments that lack their own sustainability plans”.iii In the meantime, the PIF has been investing in the transition, boosting its stake in ACWA Power International which focuses on renewable energy sources and investing in electrical vehicle manufacturer Lucid. iv
Meanwhile in Malaysia, the instruments issued under the government of Malaysia’s Sustainable Development Goals Sukuk Framework in April 2021 have allocated the use of proceeds to activities which are expected to facilitate the transition to a low-carbon economy. v These areas include: clean transportation, sustainable management of living natural resources, renewable energy and green buildings (among others).
Standing alongside investors and corporates, financial institutions are also supporting clients in this work. Standard Chartered’s recently introduced Sustainable Trade Finance Proposition in the UAE helps industries transition and reduce carbon emissions by offering financing that recognizes their efforts to lessen their carbon footprints. HSBC has made a similar commitment and in early 2021 announced the formation of a dedicated Sustainable and Transition Finance team in the Middle East, North Africa and Turkey which will help institutions, corporates and individuals to transition to a more sustainable future.vi
There is growing interest and unlimited potential for the ICMs in this area. Stakeholder collaboration (including multilaterals, sovereigns and both regional and global financial institutions) across the ICMs will be needed to ensure the industry mobilizes the necessary capital as efficiently as possible to those companies with a legitimate dedication to the transition. Effective leadership from within the ICMs will be imperative to ensure effective standards are put in place, and compliance with those standards is monitored.
In its recent white paper, Climate Bonds Initiative (CBI) posited what might constitute a certification regime for ‘transition bond’ or ‘transition Sukuk’. Under this new label, companies would be held to account based on “five hallmarks of a credibly transitioning company, ie a company whose transition is rapid and robust enough to align with … the Paris Agreement.” vii
These key elements would be the focus and requirement of the certification assessment to achieve the ‘transition’ label. Specifically, the CBI’s hallmarks include: (1) Paris-aligned targets; (2) Robust plans to reduce emissions; (3) Implementation action; (4) Internal monitoring; and (5) External reporting. The proposal, while complementing existing ESG frameworks and methodologies, goes beyond them to “avoid transition labelling”. The CBI acknowledges that “different industries will have greater or lesser potential to reduce emissions/increase sequestration over time, meaning that the end goals and speed of transition will vary substantially by sector”; however, the requirement for all would be to reduce emissions to the greatest extent possible, as quickly as possible.
Whether the ICMs look to adopt this framework, or develop their own, the key governance elements must reflect a company’s “willingness and ability to deliver on its decarbonization targets” as well as provide the necessary granularity “to ensure that those targets are ambitious and in line with climate goals”. viii Governance and accountability will be key to ensuring a meaningful transition, requiring transparency not only of targets met, but targets missed. Projects must be analyzed not only from an investment perspective but also from an efficiency perspective, to avoid needlessly repeating structures that do not produce optimal results. Transition financing must address Scope 1, 2 and 3 emissions and short-, medium- and long-term targets must be set. The ICMs need to work together to agree methodologies and governance structures to be able to get to work to address these considerations and enable the transition. However, while Islamic financial institutions and investors wait for policy guidance on how the ICMs should best proceed, they should begin to take action now to build governance systems to embed sustainability considerations and build internal capacity to address these growing market demands.
In his closing media statement, COP26 President Alok Sharma gave the world a call to action that “the hard work starts now.” After two years of preparation, and two weeks of negotiations, the global community has written down the commitments that will see it through to the next COP. Now, after catching its collective breath, the global financial community needs to work together to put that into reality. It is no longer about goals and aspirations; it is about actions.
However, actions require resources. The global financial community, and in particular the ICMs, must focus on mobilizing resources to meet these goals. The ICMs have a responsibility to meet this call to action, to continue to mobilize funding for green, blue and sustainability projects and begin to formalize their plans to dedicate resources to facilitating the transition required. The next two COPs are in the MENA region: 2022 in Egypt and 2023 in the UAE . In Glasgow, on the sidelines of COP26, Islamic finance stakeholders including the IsDB, Indonesia’s Ministry of Finance and Her Majesty’s Treasury in the UK announced their formation of a high-level working group to promote green and other sustainable Sukuk. The three-year initiative will ensure that the developing ICM contribution is highlighted at the annual COP summits in 2022 and 2023, promoting acceleration and elevation in the volume of green and sustainable Sukuk issued to help countries deliver against their climate-related targets. As the global community prepares for these events, the ICMs will be center stage and must grasp that key opportunity to differentiate the potential and the scale of contribution by Islamic finance and the ICMs.