Global Islamic finance sector moves towards incorporating ESG concerns

Islamic finance industry looking for growth in new areas.

London: Global Islamic finance industry observers are predicting significant growth in Sharia-compliant environmental and social governance (ESG) investment, as the demand for institutions to ethically deploy funds, along with an awareness of climate change and social justice, expands.

According to research conducted by Maybank Islamic Berhad, the Islamic banking arm of Malaysia’s Maybank Group, and IslamicMarkets.com, a UK-based financial intelligence and investing platform, more than a third (36%) of Islamic finance professionals expect “dramatic growth” in combined ESG/Sharia compliance funds over the next two years.

The research, published in a report called Driving Sustainable Impact Through Islamic Finance in March this year also showed 73% of those surveyed believe the Islamic finance market has yet to meet the demand for ESG investment strategies.

They add there is ample room for new Sharia-compliant ESG products. The Maybank findings also indicated the majority of these new funds could be bought by non-Muslim investors whose appetite for ESG investments will potentially outstrip Islamic investors given the comparatively larger non-Muslim finance market.

These investors are also unconcerned about whether the key ESG component is Sharia compliant.

Research by Refinitiv, an American-British global provider of financial market data owned by the London Stock Exchange (LSE), also published in March, claims 2021 was a particularly busy year for the launch of Sharia-compliant funds with an ESG focus.

Refinitiv points to the establishment of new funds in Saudi Arabia (SEDCO Capital), Switzerland (Lombard Odier) and Malaysia (Pheim Global ESG Islamic Fund – PPGEIF) as examples of some of the most recent launches.

The group identifies Saudi Arabia as the global hotspot for Sharia-compliant capital aimed at ESG. The kingdom’s favoured approach to ethical investment has been to issue ESG-focused sukuk (Sharia-compliant bond-like instruments used in Islamic finance).

Refinitiv’s data shows in the first two months of 2022, the kingdom issued ESG sukuk totalling $1.5 billion, more than any other country. The Refinitiv league table names next largest sukuk issuers were Indonesia, Malaysia and the United Arab Emirates (UAE) as the next largest sukuk issuers.

Muhammed-Shahid Ebrahim, a professor of finance at Durham University’s Business School in the UK, said part of the reason the Islamic finance market was playing catch-up with ESG-focused investment opportunities was that “financial literacy” in the Muslim community had not been historically widespread to support growth in Sharia-compliant ESG investments.

Unlike the non-Muslim finance industry, partly driven towards ethical investments by retail investors, individual shareholders and pension fund members, the appeal of ESG-focused investments in the Islamic finance market has been mostly limited to institutional and sophisticated investors.

“ESG-focused assets use a general value system instead of a religious value system. An average Muslim consumer is keener on an investment approved by religious scholars than one based on general values,” Ebrahim explained, adding a lack of development of theory in Islamic finance had similarly restricted the expansion.

Despite this partial hesitancy of the Islamic finance market to embrace ESG investing, according to some experts, incorporating ESG principles into Islamic finance was a natural fit. A central pillar of Islamic finance is to screen Sharia-compliant products to avoid industries deemed unlawful (haram) under Islamic guidance and law. This includes tobacco, alcohol, weapons and gambling – areas theoretically also prohibited in ESG investing.

Amanjit Fagura, a Dubai-based partner at US-headquartered international law firm Morgan Lewis, says because ESG-focused and Islamic investments are guided by principles of morality, transparency, and fairness, it was possible for an investment to be simultaneously Sharia and ESG compliant.

However, the two concepts do not always overlay each other perfectly. Fagura cited investment into a highly leveraged solar energy project.

“(This) may be a sound ESG investment, but would not be Sharia-compliant due to the prohibition on riba (earning interest on loans),” she said.

Improving access

Fagura acknowledges there is currently a lack of access to investment opportunities that explicitly satisfy both sets of values, but this is changing as financial institutions respond to market demand.

“While green investments that tick the boxes of ESG and Sharia compliance may currently be limited, the rise in innovative structured solutions that allow for exposure to certain ESG investments not otherwise Sharia compliant are increasingly being used by family offices, regional banks and institutional investors,” Fagura said, noting this could further bridge the gap between Islamic finance and ESG investing.

A 2019 report published jointly by the World Bank and Securities Commission Malaysia suggests such innovative structures could include sukuk designed exclusively to manage green projects, mortgage-backed securities that could act as a new asset class to bridge sustainability and profit; waqf (a special philanthropic deed that involves donating a fixed asset to produce a financial return or provide a benefit) and zakat (an annual obligation to donate a proportion of wealth to charitable causes) funds structured into broader financing purposes that give impacts on social and environmental dimensions.

Another solution to the access issue could be developing Islamic fintech that promises to bring retail investing to Muslim consumers who have hitherto lacked the opportunity to participate in financial markets.

Bashir Yusuf Ahmed, founder and CEO of eTijar, a Nigerian Sharia-compliant fintech platform providing Islamic investment and saving services to Muslims and non-Muslims, expects young Islamic consumers to be attracted by the prospect of making direct ethical choices about their investments.

eTijar screens for Sharia-compliant investments and mutual funds to offer its users, allowing customers to build their portfolios using its platform and earn profit rather than interest.

“For the general ethical user, (our screening process means) they know we are playing by ESG rules and not dealing with anything that conflicts with (Islamic) principles and beliefs,” Yusuf explained.

However, he admits there is work to do to persuade potential investors to choose ethical investments.

“Some people think when you talk about halal or ethical (investing), this means there is no return on investment, but in fact there is the possibility of very good returns. Some of the industries or companies that qualify (as ESG investments) are dividend-paying entities,” said Yusuf.

Ebrahim thinks breaking down cultural barriers and better financial education would allow Muslims to make informed and participate more in financial markets while broadening the appeal of Islamic finance to the wider market.

“The integration of the Muslims with the rest of the society can lead to the development of ESG Sharia funds. There are issues in the Islamic scripture and traditions … not understood or applied by the religious scholars or political Islamists. If these issues are understood in their proper context, it will expand the scope of ESG Sharia funds and attract non-Muslims,” he added.

Standardisation

An issue repeatedly cited as a barrier to the growth of ESG investing in Islamic finance is the lack of agreed standards for what constitutes an ESG investment and how that maps across to Sharia principles.

According to the Maybank report, 72% of recipients felt introducing a global standard for ESG and Sharia would boost the demand for ESG investment opportunities among Islamic investors. However, immediate progress in this area was not anticipated.

“Respondents are concerned about the lack of a global standard for ESG and Sharia,” it said, with 55% of respondents believing the launch of a global standard was two years or more away.

While global ESG standards were under development by bodies including the newly established International Sustainability Standards Board (ISSB) that incorporate work developed by the older Sustainability Accounting Standards Board (SASB), there was no current move to link these standards to Sharia rules.

Meanwhile, standards were being set in individual markets, presenting the challenge of harmonisation. A joint 2019 report by the United Nations-supported Principles for Responsible Investment (PRI) and the CFA Institute, a US-based finance education organisation, stock exchanges are developing reporting guidance and listing standards for ESG that impact Islamic finance.

According to the report titled ESG and Islamic Finance: Complementary Investment Approaches, this standardisation method has been followed by the Dubai Financial Market (DFM), a Sharia-compliant exchange. In 2019 it updated its DFM Shari’a Standards to cater to investors’ growing interest in sustainability and a green economy and in 2020 launched its own ESG Index.

In principle, until more comprehensive regulation is approved, especially internationally, anything can be marketed as an ESG/Sharia investment and it was up to investors to decide if they agreed – a situation that makes some Muslim investors uncomfortable.

Fagura said, “Investors will likely conduct their due diligence on any Sharia-compliant opportunities claiming to be ESG investments to ensure such investments do comply with their investment aims and are not misled by greenwashing”.

Some national regulators are taking steps to tackle this issue by personally vetting ESG claims. Securities Commission Malaysia launched the FTSE4Good Bursa Malaysia Sharia index in July 2021 that measures the companies demonstrating strong ESG practices.

It seems likely Sharia-compliant and ESG investing are destined to remain separate approaches for the time being, but will increasingly converge as market factors and financial and technological innovations break common ground.

Ebrahim said the Islamic finance industry had a long way to go before seeing “a truly Islamic financial architecture” that could comfortably accommodate ESG investing.

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