Malaysia shows the way for ESG sukuk issuance

Malaysia’s strength in Islamic finance has always stemmed from the fact that its regulator, central bank and financial services players have presented a united front, constantly refining the industry to improve it. It is much easier to get things done when everyone is pulling in the same direction.

This can be seen in the progress of codes and regulation in the environmental, social and governance (ESG), as well as the Shariah sphere. The country's Securities Commission issued an ESG market framework in 2014, guidelines on ESG funds in 2017, and then established a socially responsible investment (SRI) sukuk and bond grant scheme in 2018, allowing issuers to offset the external review costs of issuance, a scheme that was expanded in August 2022.

“It’s a very conducive environment for issuance,” says Raja Amir Shah Raja Azwa, chief executive of HSBC Amanah in Kuala Lumpur.

The last few months have brought new key measures, most importantly the launch of an SRI-linked sukuk framework in June 2022, and the launch of the first ESG Islamic repurchasing agreement in Malaysia in the same month.

The sukuk framework is designed “to facilitate companies to issue SRI-linked sukuk to support their transition towards low-carbon activities,” the Securities Commission says.

Tan Ai Chin, managing director and head of investment banking at OCBC Bank (Malaysia), views the sukuk framework as “timely: it will serve as a fresh catalyst for a more diversified type of ESG sukuk issuance in Malaysia.”

She compares it to the sustainability-linked bond principles issued by the International Capital Markets Association (Icma), in that the framework provides the flexibility for issuance proceeds to be used for general corporate purposes “instead of being restricted to only a finite list of eligible green or social projects under the existing SRI sukuk.”

As is the case in sustainability-linked bonds elsewhere in the world, SRI-linked sukuks under the new framework have a potential profit-rate adjustment linked to a predefined list of sustainability indicators or performance targets linked to the ESG agenda of a company. That might be a commitment to renewable generation, for example, or to reduce carbon emissions by a defined amount.

These efforts come alongside a strong conviction at Bank Negara Malaysia, the central bank, to develop what it calls "values-based intermediation", which envisages a more meaningful and directly impactful Islamic finance industry. In essence, this means emphasizing the ESG elements that already exist in Shariah financing.

Given the supportive ecosystem, it’s little surprise that Malaysia has been home to many landmarks in Islamic ESG. The very first green sukuk was issued here, by Tadau Energy in 2017; 2021 brought the world’s first US dollar sovereign sustainability sukuk, from the government of Malaysia, a $1.3 billion dual-tranche deal featuring a $800 million sustainability 10-year sukuk.

There is also a clear market to sell to. On the buy side, of the 43 SRI funds offered in Malaysia as of December 31, 2021, 16 of them are Islamic funds, according to the Securities Commission.

“On the local front, we have seen PNB, EPF, KWAP and Khazanah taking several measures to evidence their commitment towards the sustainability agenda,” says Tan at OCBC, referring to four key state pension and sovereign wealth institutions in Malaysia.

This includes establishing internal sustainability frameworks to chart a clear transition pathway to zero portfolio emissions by 2050, and “setting up specific investment mandates into green and sustainable assets to support the capital required for the country’s transition journey,” says Tan.

But we should be careful of overstating the scale of the buyer base. Malaysia is not Europe in ESG terms.

Amir notes: “Lots of international investors have a mandate to buy a certain proportion of ESG issuances for their portfolios. In Malaysia, that’s still up and coming: there are some who are signatories to the UN PRI [Principles for Responsible Investment], but not a whole stream of them.”

And, while there is clear cross-over between the Shariah and ESG camps, Amir points out that the two are not the same.

“While there is convergence, there is also a discrepancy,” he says. “For example, in the past you could finance a coal-fired power plant on a Shariah-compliant basis, but not through ESG. The lens of climate is becoming more prevalent.”

He also argues that any issuer that has decided to take the Shariah-compliant route might as well go further and make an issue resonant with ESG investors.

Issuing sukuk is not straightforward for reasons to do with compliance, documentation and differences in standards between Asia and the Middle East.

“But once an issuer has identified these challenges and is willing to go ahead," Amir says, "it makes sense to issue an ESG instrument, as it gives access to a whole new pool of investors and profiling of the overall transaction.”

Without question, Malaysia leads the ESG sukuk field locally. Some RM8.3 billion ($1.8 billion) of SRI sukuk had been issued by December 31, 2021, according to data compiled for Euromoney by the Securities Commission; OCBC puts the figure at RM12 billion since the launch of the SRI Sukuk Framework in 2014.

According to Fitch, Malaysia hosts the highest number of active ESG sukuk globally, with 172 out of the 192 active ESG sukuk instruments in the world at the end of the second quarter of 2022, or 91.1% of all ESG sukuk issuances. Most are in local currency, which is distinctive.

But these are still not huge sums relative to their potential and there is a sense that more can be done.

Big issuers are doing their bit. Cagamas, Malaysia’s national mortgage corporation, has cumulatively issued RM1.69 billion of sustainability related bonds and sukuk across 11 deals in total since its inaugural sustainability issuance in 2020. Not all of these are sukuk, but those that are have included landmarks: in October 2020, it launched Malaysia’s first sustainability SRI sukuk for affordable housing, at RM100 million.

“The proceeds from the issuances are fully allocated to eligible assets,” says Asyraf Mokti in treasury and markets at Cagamas. “For example, for affordable housing, employment generation, renewable energy, as well as sustainable water and waste management.”

As with many nascent markets, issuance is a bit lop-sided.

“SRI sukuk issuance in Malaysia is still very much driven by green-labelled sukuk catering for specific projects within common industries, mainly renewable energy and green buildings,” says Tan at OCBC Bank. “While these industries are undeniably important to curb carbon emissions,” particularly in Malaysia where carbon emissions per capita are among the highest in Asean, “focus should also be given to other sectors within the ESG value chain to facilitate the country’s transition towards a low-carbon economy.”

Tan finds it interesting that, other than the Ihsan sukuk issued by Khazanah back in 2015 to improve the accessibility of quality education in government schools, “we have yet to see any other social-impact sukuk issued by other corporates to date. There are several issues with significant impact to the larger social communities such as food security and the wellbeing of certain communities living below the poverty line, which have become more critical after what the world experienced during the pandemic.”

She believes social sukuk should be feasible with sufficient effort from stakeholders.

Tan also points out that in Malaysia, ESG issuance still has to prove itself from a return perspective: “One of the key challenges for ESG sukuk issuers is to convince investors to prioritize the sustainability agenda over targeted investment returns as part of the investment decision-making process.

“Notwithstanding increasing investor demand for ESG sukuk, it is still not visibly evidenced that such appetite has translated into a more competitive yield by investors compared to plain-vanilla sukuk issuances.”

An important transaction that helped demonstrate the sophistication involved in Shariah sukuk was a RM1 billion five-year sustainability linked sukuk for Yinson Holdings, a crude oil and gas player active in the floating production storage and offloading (FPSO) sector.

In this deal, sole led by HSBC Amanah, the issuer is subjected to a series of sustainability performance targets, such as increasing renewable energy generation and reducing carbon intensity, and the profit rate of the security increases if those hurdles are not met by 2025.

“That transaction required additional investor engagement to the market on the product features, given it was the first of its kind,” says Amir. “They’d never seen sustainability linked deals before,” nor characteristic features such as step-up or step-down coupons, or carbon credits, “so we needed to make it easy and provide education to the market about how this product worked.”

Bankers had learned from past experience that step-downs in coupons or principle amounts, upon achievement of key performance indicators, were more challenging to distribute, because they feel like they are penalizing the investor in an unpredictable fashion.

“That was difficult for investors to stomach,” says Amir.

The preferred model was instead to do a step-up if KPIs are not met.

This meshes with Tan’s experience at OCBC, who says it “is a challenge to gauge the level of acceptance by investors towards SRI-linked sukuk, given the profit-rate ratcheting feature, especially if it involves potential reduction in the sukuk profit rate in the event the agreed sustainability targets are achieved.”

Globally, she says, there have been few sustainability linked bonds issued with a coupon step-down or discount feature, and the same is true in Malaysia, “given the price uncertainties which could affect the tradability of such bonds, and this is something investors would want to avoid.”

Setting KPIs for an oil-and-gas services company like Yinson also required careful consideration, but the deal was helped by the fact that “the company already had a credible transition plan in place,” Amir says. “We didn’t need to sit down with them and tell them they needed to have a transition story: they already had it.”

Bankers feel there is potential in ESG sukuk. Tan says OCBC “remains buoyant” on a potential uptick in issuance by local corporates, while HSBC Amanah thinks it is important that issuers aren’t just launching because they’ve been told to by a regulator.

Jared Jimbau, associate in debt capital markets at HSBC Malaysia, says: “Initially, momentum started from the top, with the government setting the pace and leading by example. But now we’re hearing stakeholder voices being heard, so the dynamics are both top-down and bottom-up, converging in the middle, creating the momentum for growth.”