S&P’s Michael Wilkins: Sukuk and Securitisation: More Green Shoots in the Market

The diversification of the green finance market and the rise of green Islamic finance.

The global and political drive to address climate change is stronger than ever. With ambitions heightening in 2018, S&P Global Ratings expects further diversification in the green finance market. Alongside a rise in traditional green bonds (30% market growth is predicted this year) we anticipate more first-time issuers exploring new financing vehicles – and across a wider spectrum of geographies.
Notably, green securitisation and green sukuk (Islamic green bonds) are two instruments enabling the advancement of green finance outside Europe, which remains the primary region for labeled green bond issuance. While North America leads the green securitisation market, Southeast Asia has hosted all five green sukuk issued to date, beginning in July 2017. Both nascent financing trends – securitisation and sukuk – would broaden the green finance market’s investor base and may contribute to achieving climate goals while funding local infrastructure needs.

Securitisation in the U.S.
Green lending and green securitisation have been on the rise – reaching a record US$36 billion of issuance in 2017. This was largely driven by U.S. issuer Fannie Mae’s US$25 billion mortgage-backed security (MBS) program, which serves to improve the energy and water performance of U.S. residential properties. In terms of water, the U.S. has significant infrastructure needs: US$630 billion of investment is required through to 2033, according to the U.S. Environmental Protection Agency. Green structured products – financial products whose underlying collateral or assets are green or those that reinvest their proceeds in green technologies – may help to finance these needs, along with a variety of financing tools.
The U.S. will likely continue to lead the green securitisation market in 2018, supported by existing state and government programs as well as positive momentum in collateralised loan obligations and mortgage backed security issuance. The development of green financial products, in our view, reflects how the market is approaching new business opportunities arising within the green space. Moreover, new green securitisation may also address the increasing retail demand for green investments, while leveraging the return potential of often-diverse and small-scale low-carbon projects, such as energy efficiency initiatives.
While today the green structured green products market is mostly centred on the U.S. market, we nonetheless see growth potential for green lending across a broader range of geographies. This includes emerging and developing markets. A rising number of green securitisations is among the key trends to watch out for this year.

Sukuk in the Southeast
Another green financing instrument coming into its own is the green sakk – more commonly known by its plural form, green sukuk. The Climate Bonds Initiative (CBI) defines green sukuk as Islamic finance investments that are not only Sharia-compliant but also address Sharia concern for protecting the environment. Proceeds generally are used to finance construction, to refinance construction debt, or to service government-granted green subsidies – for renewable energy or other climate-related initiatives.
Perhaps the most famous principle of Islamic finance is the prohibition of Riba. Depending on the school of thought, Riba can be defined as interest or excessive and exploitative rates of interest.Sharia doesn’t consider money to be an asset in its own right because it is not tangible. Islamic law thereby prohibits the act of earning a return on capital due to the simple passing of time. Green sukuk, however, are compliant with this and all other principles of Islamic finance, the ultimate goal of which is to create a sustainable, equitable, and socially responsible financial system.
The investor base for these kinds of financings is growing fast. Sukuk issuance volume increased significantly to $97.9 billion in 2017, with issuance from GCC countries driving the growth of the overall market. So financings for environmental projects that align with the principles of Islamic finance could diversify the investor base of the green finance market as a whole.
The first green sukuk was issued in July 2017. Tadau Energy, a unit of China-owned Edra Power Holdings, issued a Malaysian ringgit (MYR) 250 million (c.US$ 63 million) green infrastructure sukuk. The bond, known as Green SRI Sukuk Tadau, will finance a large-scale solar project of 50 megawatts (MW) in, Sabah, Malaysia.
Since then, a further four green sukuk have been issued, including the Republic of Indonesia’s US$1.25 billion sovereign issuance, the first sovereign green bond to be issued by an Asian state. The other sukuk came from Mudajaya Group Berhad (Sinar Kamiri) and Quantum Solar Park (Semenanjung Sdn Bhd). These entities raised MYR 245 million and MYR 1 billion respectively for large-scale solar photovoltaic projects, which together will add capacity of nearly 100 MW to the Malaysian grid. The fourth, Permodalan Nasional Berhad, raised MYR 2 billion of debt under the green sukuk framework for an 83-storey green building office tower. This could only be the beginning: the emergence of more renewable energy and other green projects in the Southeast Asia region may prompt further green sukuk issuance this year.

Potential grows in the GCC
Furthermore, green sukuk could support infrastructure projects in other regions, such as in the Gulf Corporation Council (GCC), where infrastructure costs are high. Projects in the region require approximately US$120-150 billion before 2019. Green sukuk may provide a boost to the infrastructure sukuk market in the medium to long term.
There is no natural GCC investor market for green finance. So, in order to tap into two distinct liquidity pools, we suspect that GCC issuers may combine green and vanilla sukuk features. In turn, this will likely attract a more diversified investor base – as is typical for green financings – which may also lower the cost of funding. The issue of pricing is topical, and there has been enough anecdotal evidence that green bonds price tighter than non-green counterparts. Notably, we think that a number of the utilities we rate in the GCC could consider green issuance; yet they would most likely also expect to obtain pricing at least equivalent to a conventional issuance before proceeding.
The nascent green sukuk along with additional green securitisation issuance, may lead to further diversification of the green finance market in 2018. Led by the traditional labelled green bond – which remains the bellwether of green finance – issuers will hope that new financing vehicles may help address climate change while meeting infrastructure and energy needs.

Michael Wilkins is Head of Sustainable Finance at Standard & Poor’s.