Peter Godwin, Sophie Lenox and Azlin Ahmad
With increasing awareness and concern about climate change and socially responsible financing, there is a continuing trend in the Islamic financing market for the issuances of green sukuk. Closely resembling green bonds, the emergence of the green sukuk is a natural evolution in Islamic financing. Islamic financing, which is by nature based on ethical principles, already incorporates many socially responsible elements as part of its aims and intrinsic values. The popularity of the green sukuk also naturally synchronises with the increasing demand for environmental and social governance (ESG, of which green financing is a component), an ideology which is being embraced by many industries across the world.
This article sets out some of the areas of attention from a legal viewpoint that both investors and issuers should take note of in formulating a green sukuk.
Lack of standardisation
There is currently no universal definition of a green sukuk. The green bonds and green financing framework have historically consisted of a multitude of market-driven and regulatory regimes. Malaysia’s sustainable finance ecosystem benefits from a set of guidelines particularly in the debt capital markets space. These include the Sustainable and Responsible Investment Sukuk framework (2016), the ASEAN Green Bonds Standards (2017), the ASEAN Social Bond Standards (2018) and the ASEAN Sustainability Bond Standards (2018). The ASEAN standards are generally more stringent as they encourage more frequent reporting and greater transparency regarding the credentials of external reviewers and use of proceeds. Ongoing compliance of the above frameworks is largely self-regulated.
The definition of green financing in general is fluid, with each jurisdiction refining it by way of regulation and self-governance. At its core, the green sukuk is largely similar to a normal sukuk. The differentiating factor is that the green sukuk proceeds can only be used to fund environmentally sustainable projects.
Differing views exist on the finer details on what constitutes the “greenness” of a sukuk, including (i) what constitutes a green project, (ii) the percentage of proceeds which should be used to fund green projects, and (iii) the extent of ongoing supervision post sukuk issuance.
Differing standards in the green market lead to regulatory arbitrage. Governance gaps can be exploited by firms to engage in “greenwashing”, which poses a threat to the stability and legitimacy of the green sukuk market. Differing standards also result in market fragmentation, making it more difficult for the entire market to attract a single large investor base, as investors will have differing demands or requirements on the “greenness” of the sukuk. Given the diverse projects in which a green sukuk may be utilised (for example, the construction of a green building opposed to the construction of a solar plant), it is time for the industry to issue sector specific guidelines to aid both investor and issuer.
Due diligence and risk factors
Pending tighter regulations on both regional and local levels, a sukuk which is labelled “green” may not necessarily satisfy the environmental investment criteria of every investor. Notably, most green bonds and sukuk in the market focus on the sukuk‘s green credentials and green labelling at the issuance stage. In addition to the customary due diligence accompanying private debt issuances, an investor requiring an enhanced level of greenness should consider conducting a more comprehensive due diligence on the issuer to determine the satisfaction of its green mandate. More focus should be placed on the ways in which the issuer handles ESG issues. Points to consider include supply chain risks and the net impact of the green project on environmental sustainability. Any issues of concern should also be described as risk factors in the disclosure document.
Ongoing monitoring post-issuance
Once the sukuk has been issued, the responsibility for monitoring its adherence to green standards normally falls on the issuing entity and not the investor. Post-issuance compliance is a largely self-governed area. At present, the compliance of the green objective post-issuance and throughout the sukuk tenure, as with other green bonds, is normally limited to annual reporting on the allocation of proceeds. Second opinions are also limited to their issuance date only and therefore are not tools to monitor ongoing compliance.
In terms of legal documentation, it is rare that objective adherence to green standards is embedded as a contractual term to the extent that it is linked directly to an event of default, as this is not the intention of the issuer or the investor. One should consider the implications of entrenching detailed green obligations into the sukuk documentation lest it imposes additional obligations that the issuer is neither willing nor able to undertake.
The way forward?
Presently, the incorporation of ESG elements in a sukuk has minimal legal impact on the legal documentation. The issuing documents may refer to the green bond principles being relied upon, but care is usually taken to avoid creating onerous contractual obligations on the issuer based on green principles alone. There are valid reasons for this including the extent to which the investors would like to ensure that the project being financed remains viable from the green aspect relative to their financial expectations in the performance of the sukuk.
In April 2021, the United Nations Environment Programme Finance Initiative published guidelines for climate target setting for banks. Among the core principles are the setting and public disclosure of long term and immediate targets under the Paris Agreement, baseline and reporting requirements and decarbonisation targets. These principle will be subject to implementation by the signatory banks and with an eighteen month deadline for implementation, its effects are yet to be seen. The same way that the growth of Islamic finance in general continues to transform in order to adapt to increasingly sophisticated market needs, the same parallel evolution is expected in the green sukuk space.
Herbert Smith Freehills LLP is licensed to operate as a Qualified Foreign Law Firm in Malaysia. Where advice on Malaysian law is required, we will refer the matter to and work with licensed Malaysian law practices where necessary.