Islamic finance should tread cautiously as momentum for ESG-aligned reaches fever pitch

Pitfalls can trip up the unwary.

Blake Goud has been the CEO of the London-based RFI Foundation since the organisation’s incorporation in 2015. The RFI Foundation works to promote responsible finance in Islamic markets and Islamic finance, and to support its members' adoption of responsible finance practices and their integration into the global responsible finance industry.

The powerful desire for Islamic finance to embrace environmental, social and governance (ESG) development is gaining traction, given this sector’s close association to the United Nations Sustainable Development Goals (SDGs).

Those goals have a commonality with the higher objectives of Sharia and obviously Islamic finance should find opportunities to connect within this sphere of growing investor interest, but it must remain mindful.

Islamic finance knows from first-hand experience that mainstream interest can be a double-edged sword. I have seen the process unfold largely for the better over the past 15 years, but there are countless pitfalls accompanying rapid growth.

It brings with it a growing need for industry frameworks to promote institutionalisation and standards. Islamic finance has an advantage over ESG as these organisations have been developing for two to three decades – far longer than most within ESG and responsible finance.

While the ESG market has grown rapidly, with the 2020 Global Sustainable Investment Alliance data indicating it now accounts for $25.2 trillion in assets for ESG integration, it has been fragmented.

ESG integration means different things to different investors, asset managers and asset owners and there is a diverse variation in its actual practice of ESG integration.

Some investors view it as a simple binary screen where a single data provider’s ranking includes or excludes an investment based on where it falls relative to its peers. Others focus purely on financially material ESG issues and their risks and opportunities when developing forecasts for companies’ financial performance. Still more view ESG screens as merely a way to divide between green and not green sectors without regarding social and governance concerns.

Flexibility has some merit

This flexibility makes sense from one perspective: it represents an overarching term referencing various investment approaches and ESG issues and now encompasses different, sometimes contradictory, ideas while capturing a fast-growing share of financial assets.

Given assets grew 143% between 2016 and 2020, the space has become too attractive to ignore for those seeking opportunities to grab on to its coattails.

Regulators now react to the initial opportunism that accompanied this growth with crackdowns on blatant greenwashing where statements promoting financial products outpace their ability to follow through. Meanwhile, the patchwork of guidelines and standards are being consolidated through standards from the International Sustainability Standards Board (ISSB) as companies and investors make disclose their ESG.

Banks are waiting on the implementation of the Basel Committee on Banking Supervision’s principles on effective management and supervision of climate-related financial risks. This is new ground for ESG as, until now, standards have been varied and voluntary, lacking anything resembling a global baseline.

Islamic finance has a long history of industry infrastructure organisations

By contrast, Islamic finance has a much longer history of industry organisations collaborating to define the principles for a thriving financial sector built around interest-based finance. The adversity Islamic finance faced growing up in this financial system means it has a stronger architecture to evolve a global baseline, despite diverse opinions and practices.

Consequently, it is easier to understate the challenges and risks from a rush for Islamic finance to adopt ESG. Much of what is labelled ESG is described as originating from “socially conscious investors’ actions”, but equally described as “focusing solely on financially material considerations relevant to all investors”.

Sometimes the combination of ethically- and financially-motivated ESG investors can be reconciled, but at others, the definitions’ fuzziness and market applicability given the wide, potentially contradictory approaches, become fuel for greenwashing.

Greenwashing is a short-term motivated action for windfall gains at the expense of credibility. It emerges from the conflation of the ethical motivations of some ESG investors with the financial outcomes intended by others who use ESG integration. A greenwasher claims both ethical and financial motivations but is unable to fully deliver on either.

It thrives where an idea catches mass appeal, but before regulators and standard setters can lay the groundwork for a global baseline to reduce the asymmetry of information between the financial sector and market.

In delivering on ethical and financial objectives, Islamic finance is different. It has a consistent, coherent rationale for ESG integration on ethical grounds and provides well-developed financial screening practices that can complement ESG integration.

However, because Islamic finance promises to unite ESG’s ethical and financial benefits, it risks being perceived as another greenwashing potential unless each element is distinctly articulated. If Islamic finance is aligned with ESG, it must prove it can deliver the following elements in different situations:

• What actions are motivated by extra-financial (ethical) requirements where Sharia compliance requires them, regardless of the short-term costs?

• What actions are motivated by financial risk mitigation or opportunity seeking where ESG integration overlays Sharia compliance screening?

• What elements of responsible finance go beyond the ethical requirements for compliance and pursue extra-financial objectives such as Maqasid-aligned impact to promote balance in planetary systems or social harmony and well-being?

• What elements from Sharia screening, designed for ethical compliance purposes, can complement ESG integration’s financial outcomes?

Each characteristic is found where Islamic finance and ESG intersect, but they are distinct features typically present in different Islamic financial services. It is not immediately obvious to most people what is meant when the two are discussed together.

Sometimes the conflation of ethical and financial objectives in Islamic finance can be mistaken for short-term opportunism. Maintaining clear, consistent and transparent definitions about Sharia compliance, improved financial outcomes or striving for an extra-financial impact will avoid the ESG-associated risks.

It will preserve the biggest advantage Islamic finance has within responsible finance of being guided by consistent, long-term oriented principles and objectives.

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