T h e Wo r l d ’ s L e a d i n g I s l a m i c F i n a n c e N e ws P rov i d e r

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Much has been writt en about the correlation between Shariah compliant fi nance and socially responsible investing (SRI) in terms of their ethical and moral foundations; but so far the two sectors have seen litt le crossover despite obvious similarities in terms of their goals, methods and expectations. However, a groundbreaking new product pioneered in the UK is seeing its profi le grow rapidly in popularity – and could perhaps represent a new avenue for Islamic investment to assist in socially responsible projects without compromising on fi nancial return.

Social impact bonds (SIBs, or ‘pay for success’ bonds) are essentially fi xed income products that act like public-private partnerships, allowing private investors to purchase government (or government-related entity)-issued bonds for the purpose of funding social schemes – as an alternative to public funding or raising taxes. The funds are used for a specifi c social purpose which, if successful, then repays the original investors with returns based on the savings accrued as a result.

A pioneering instrumentThe structure was pioneered in the UK town of Peterborough in 2010, with the UK Ministry of Justice selling GBP5 million (US$8.42 million) of social impact bonds to social investors including charitable trusts, banks and philanthropists to fund a pilot rehabilitation scheme for young off enders. If the rate of reoff ending was signifi cantly reduced, investors could receive up to GBP8 million (US$13.47 million) aft er six years – a return of 7.5%. Although as of April this year no money had been paid out to investors, the program is

reported to have been a success with a fall in reoff ending of around 11% over three years; and the fi rst payment should be made to investors this summer following an independent assessment of performance. Following this success, the government just this month announced a further investment of GBP31 million (US$52.2 million) in SIBs to improve the job prospects of the 14-24 age group and get young homeless people into sustainable employment.

These types of bonds have also been used in multiple instances across the US, where they are growing in popularity as alternative avenues to state funding that guarantee returns (or they don’t pay out). In summer 2012 the fi rst example was launched in New York City targeting juvenile recidivism, funded by a US$9.6 million investment from Goldman Sachs which was guaranteed by a US$7.2 million grant from Bloomberg Philanthropies. Since then New York State, Massachusett s and Salt Lake City have all issued SIBs with a trend towards increasing sophistication as structures evolve and institutional investors take on more of the risk. As of April 2014 a further 12 US states were also considering pay-for-success schemes; and in the 2014 US budget proposal the 'Pay for Success' scheme was allocated almost US$500 million along with a further US$300 million

to set up a Treasury Department fund to incentivize state and local governments to develop SIBs.

Islamic opportunitiesSo what opportunity does this

hold for Islamic fi nance? The UK, with its stated ambition

of developing itself as a center for Islamic fi nance,

Social impact bonds: A new tool for Islamic finance?

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Volume 11 Issue 19IFN Rapids .........................................................2Islamic Finance news .........................................6Shariah Pronouncement .................................15ICD Exclusive Report: ICD and Tabung Haji join eff orts to enhance mobilization of savings in ICD member countries .......................................16IFN Reports: Sukuk race: Luxembourg lags behind; Scotland: A new hub for Islamic fi nance?; The Cambodian conundrum; A new addition to Oman’s Takaful market; GreenTech upbeat on prospects for a green bank despite uncertain demand; Dubai goes green: New collaboration marks a focus on environmental investment; ...............................18Special Reports: Czech Republic: Opening the door to Islamic fi nance in the heart of Europe ...26Case Study: Dubai Government’s US$750 million Sukuk issuance ..............................................................28

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continued on page 3

3© 14th May 2014

COVER STORY

has already recognized the potential that SIBs hold for the industry. “SIBs are an area of interest for us at the Islamic Finance Council UK, and an integral part of our proposal to set up a Scott ish Ethical Hub to create synergies between ethical and Islamic fi nance,” confi rmed Mujtaba Khalid, a senior associate with the Islamic Finance Council UK and specialist researcher into Islamic social investing, to Islamic Finance news. “We have already been in talks with persons involved in the UK's SIB off erings.”

Not only is there an obvious match between socially responsible and Shariah compliant investing, but the idea of using Islamic fi xed income products such as Sukuk as a means to connect the two sectors is becoming increasingly popular. For example Malaysia, which introduced an Environmental, Social and Governance Index in its Budget 2014 last October, also announced an SRI Sukuk initiative to encourage “sustainable and responsible” investments. In March of this year the Securities Commission

of Malaysia (SCM) confi rmed that a framework for socially responsible Sukuk was in the process of being fi nalized and would be launched by the third quarter of 2014. “The SRI Sukuk is the Islamic capital market’s response to the rising trend of green bonds and social impact bonds that have been introduced globally to fi nance a wide range of sustainable activities such as those addressing the needs of the country like infrastructure and small businesses,” said Dr Nik Ramlah Mahmood, the deputy CEO of the SCM.

Development opportunitiesAnd while Malaysia hopes to leverage its deep pool of institutional liquidity to capture the Shariah compliant SRI market and become a global center for sustainable investment, considerable

continued on page 4

Social impact bonds: A new tool for Islamic fi nance? Continued from page 1

As conventional social impact bonds develop their structure is becoming ever more sophisticated, with institutional investors increasingly willing to take on risk as their precedent becomes more established and a track record of success is visible. But what of Shariah compliant SIBs – how might these be structured?

Mujtaba Khalid of the Islamic Finance Council UK suggests that an Islamic SIB could be set up using a Jualah contract, or ‘reward’ structure; which is an accepted structure deemed permissible by the Maliki, Shafi ’e and Hanbali schools.

A Jualah structure is a contract of service based on the successful completion of a diffi cult task. One party (the off eror, or Ja’il) off ers specifi c compensation to anyone (worker, or Amil) in return for achieving a specifi c task, target or result within a (not necessarily predetermined) period of time.

Jualah is not in principle a binding Shariah contract, as the Ja’il can

rescind the off er before the work starts. However, once work has started the contract becomes binding on the off eror (i.e., once an SIB program has started, a Shariah compliant Juarah SIB would become binding on the issuing authority or government). Notably, once work has started the Juarah contract is also binding on the Amil, or provider, as long as he undertakes not to revoke the contract within a specifi ed period. Once work has commenced, the property of the off eror is transferred to the possession of the Amil – but not the ownership. This means that the Amil acts as a trustee rather than as a guarantor of the property, and is thus not liable for any loss or damage except as a result of his own negligence, misconduct or violation of specifi ed conditions.

The key diff erence between Jualah and Ijarah is that in a Jualah contract, the reward is dependent upon the success of the specifi ed task. Jualah can also be a public off er meaning that whoever delivers the work fi rst can claim the reward (while in Ijarah the tenant or Amil must be specifi ed in advance),

which means that a Jualah contract can be put out to public tender.

“A government can give a range of social linked projects that it wants completed – e.g. a power plant or a hospital - and link them to tax rebate. Companies would have the option to choose a project that they believe they can effi ciently implement,” explained Mujtaba to Islamic Finance news.

As a simple example, a government may give an open tender for a US$20 million power plant under a Jualah SIB. A fi rm may owe $20 million in taxes. This fi rm can take on the project and the project may end up costing the fi rm US$18 million but it can ask for a US$20 million tax rebate provided that the plant meets all the required specifi cations.

The advantages for SIB application are clear, and with such a structure already in place and approved by most Shariah scholars, it seems as if an SIB could simply be the next logical step along the road towards sustainable social investment.

Not only is there an

obvious match between socially responsible and Shariah compliant investing, but the idea of using Islamic fixed income products such as Sukuk as a means to connect the two sectors is becoming increasingly popular

SIB — proposed Shariah structure

4© 14th May 2014

COVER STORY

potential also exists for these instruments in Muslim markets across the globe.

In regions such as the GCC where there are high levels of infrastructure demand, SIBs can also be used to enable the private sector to access public opportunities in an ethical manner while still off ering a compelling fi nancial return. In developing countries such as Pakistan or Bangladesh where taxation is low and state funds are strained, the public-private partnership element can off er a new avenue of sustainable funding for social investment in key areas such as housing, education, healthcare and water; while avoiding further international borrowing and decreasing dependence on overseas aid.

“Personally I believe that the real potential for SIBs is in developing countries, and Islamic fi nance can play a pivotal role in this,” agreed Mujtaba. “Pakistan as a case study can benefi t from SIBs as the government is looking to promote Islamic fi nance and is in need of capital to deal with an energy shortage. To tackle ineffi cient and corrupt contractors, the government can make use of SIBs.”

This could in fact be an invaluable tool to help improve private sector service in developing nations that struggle with corruption, as the investor/provider does not receive their return unless the program achieves deliverable success. “As tax collection in Pakistan is low and what ends up in the government's coff ers is even lower, SIBs can also help the government balance infl ows and outfl ows,” pointed out Mujtaba.

A long-awaited bridgeBut not only do SIBs off er an ideal opportunity for Islamic social investment – they also off er the elusive prospect of a link between the Islamic and conventional fi nancial markets. The World Bank last year released a research report entitled ‘How socially responsible investing can help bridge the gap between Islamic and conventional fi nancial markets’ which highlighted that while a lack of Shariah compliant fi xed income products is inhibiting the

growth of the Islamic capital markets, the same is also true for the SRI market: “Therefore, the development of socially responsible Sukuk could benefi t both markets simultaneously, expanding the universe of Sukuk issuers and Sukuk buyers while at the same providing the SRI community with a new kind of ethical fi xed income instrument.”

According to Michael Bennett , the head of derivatives and structured fi nance at the World Bank: “Sukuk are appropriate for

SRI investors because they provide… a high degree of certainty that their money will be used for a specifi c purpose. In order to comply with the underlying

Shariah principles, the funds raised through the issue of a Sukuk must

be applied to investment in identifi able assets or ventures.

Therefore, if a Sukuk is structured to provide funds to a specifi ed development project that is appealing to SRI investors, such as a renewable energy project or a low-cost housing program, there is litt le chance the investors’ money will be diverted and used for another purpose.”

Speaking to Islamic Finance news, Bennett confi rmed that: “The rapid growth of the Sukuk market is a testament to the power of investor demand. If those investors now start to focus more on the use of proceeds, and demand products where the proceeds are used to fund clearly defi ned environmental and social development programs, the market for green Sukuk and social impact Sukuk should be extremely robust."

Fixed income gapIt is notable that up until now, the development of the SRI market has largely been on the equity side with limited progress in the fi xed income space. “This lack of investment opportunities has meant that SRI fi xed income investors oft en have been forced to choose between having a well-diversifi ed portfolio and having a portfolio that meets all of their SRI criteria,” said Bennett . “Since Sukuk [are] most similar to a conventional fi xed income security, the development of SRI-oriented Sukuk could help fi ll in this fi xed income gap in the SRI market.”

There is certainly a gap in the Islamic market for such products. The conventional sector is very familiar with social development bonds to channel investment towards emerging economies – the fi rst being pioneered by the World Bank as far back as 1947. However, although the IDB plays a vital role in OIC development and has launched a number of signifi cant Sukuk programs, beyond this there are very few Shariah compliant products which off er investors access to socially responsible or development activities – and even for the IDB Sukuk, it is arguable how many buyers of its bonds do so on ethical grounds, as opposed to their desire to hold highly sought-aft er ‘AAA’-rated Shariah compliant paper.

Impact investors“We believe the lack of supply of such products is largely a result of a lack

Social impact bonds: A new tool for Islamic fi nance? Continued from page 3

In developing countries

such as Pakistan or Bangladesh where taxation is low and state funds are strained, the public-private partnership element can offer a new avenue of sustainable funding for social investment in key areas while avoiding further international borrowing and decreasing dependence on overseas aid

continued on page 4

5© 14th May 2014

COVER STORY

of clearly expressed demand from investors,” said Bennett together with his co-author Zamir Iqbal, the lead investment offi cer with the quantitative strategies, risk and analytics department in the Treasury of the World Bank.

“As long as the Islamic fi nance market remains driven principally by the concept of negative screening, such demand will remain latent. What is required for such products to develop is for Shariah compliant investors to make the same transition as conventional SRI investors and begin to demand products that allow them to affi rmatively express their beliefs. In other words, what is needed is for Islamic investors to become proactive ‘impact investors’.”

Perhaps social impact bonds could be the fi nal link needed to connect the twin sectors of Shariah compliant and socially responsible investing – yoking

them together to drive faster in harness than either could progress alone. — LM

Social impact bonds: A new tool for Islamic fi nance? Continued from page 4

What is required

for such products to develop is for Shariah compliant investors to make the same transition as conventional SRI investors and begin to demand products that allow them to affirmatively express their beliefs

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