Pakistan can access a new investor base that may also be more resilient.

The growing impetus for socially responsible investing that seeks to align the personal preferences of investors with environmentally friendly, ethical investing has found a potent outlet in green bonds and most recently sukuk.

These instruments seek to invest proceeds in a variety of green causes that range from cultivating sources of renewable energy, reducing the carbon footprint, sustainable transport, waste management and construction of green buildings.

The linkage with Islamic finance creates products that are ethical on two fronts — abjuring usury and investing proceeds in the real economy to create a better environment. Thus green sukuk represent a powerful alignment of the financial and moral imperatives that govern Islamic finance.

Unsurprisingly, green bonds have experienced exponential growth over the past decade with total issuance reaching $155 billion in 2017 from barely $1bn in 2007. Whilst initially championed by municipalities and multilateral development banks, issuance is now driven by private sector financial institutions and corporates which comprised more than half of the issuance in 2017.

On the demand side, pension funds looking to offset climate risks in their portfolios have been one of the earliest investors and have been followed by prominent private sector asset managers like BlackRock who have set up dedicated green bond funds.

Issuance also tends to attract new investors amongst asset managers, insurers and pension funds and therefore enables significant funding diversification for the issuer.

There is also evidence that green bonds may perform better than their plain vanilla counterparts due to the relative scarcity of the product and by attracting a sustainability-focused investor base, exert downward pressure on the borrower’s yield curve.

Given the relatively nascent asset class, a fundamental issue concerning the investment of proceeds and in defining the constituents of ‘green’ investments remains.

The World Bank has helped specify eligibility criteria for projects financed by green bonds and on developing a system of ringfencing proceeds to ensure that they are deployed appropriately. Additionally, the Bank has worked with sovereign governments to delineate reporting and compliance processes that provide investors with greater assurance on use of proceeds.

However, more needs to be done to address the issue of ‘greenwashing’ to ensure that proceeds are not misappropriated especially since some recent sovereign issuers such as Poland and Indonesia are heavily reliant on coal for their energy production.

In an effort to achieve greater standardisation in defining green investments (which must sound all too familiar for sukuk investors), 13 banks drew up a shared set of principles governing different categories of bonds in 2014.

By 2017, over 130 of the world’s largest banks and asset managers had signed up to the Green Bond Principles which define what counts as ‘green’, stipulate reporting requirements and recommend the use of external reviewers.

Whilst ‘certification’ of the use of proceeds initially rested with the World Bank’s environmental department when the institution led issuance, the development of the market has enabled the emergence of various bodies focused on certification.

The Climate Bonds Initiative (CBI), an NGO, specialised environmental consultancies, large external auditors have all developed the requisite expertise whilst major rating agencies have also launched green evaluation services.

Ultimately, the market will benefit from a more uniform approach to environmental assessment and the development of a ratings like system that clearly communicates the green compliance of every offering.

The World Bank has worked with sovereigns in bringing them to market, particularly in relation to the green sukuk issued by Malaysia and most recently by Indonesia.

The biggest catalyst for issuance has usually come from regulators that are encouraged to conduct detailed knowledge sharing sessions with potential issuers and investors and offer various incentives that are typically tax based to encourage issuance.

Issuance of green bonds and sukuk is likely to experience continued exponential growth with issuers from China and India increasingly prominent amongst emerging markets. With the opening of the market to sukuk investors, it is likely that issuance from the Middle East will also follow.

Pakistan has every opportunity to join this group and benefit from genuine funding diversification by tapping into a new investor base that may also be more resilient given the current scarcity of supply.

Much as sukuk have been utilised to access new markets and stimulate the domestic Islamic finance industry, green sukuk can signal a commitment to the environment and be used to initiate green legislation for projects financed by various ministries.

—The writer is the head of Islamic Solutions, Merchant Banking Group, at Bank Alfalah

Published in Dawn, The Business and Finance Weekly, April 2nd, 2018