Crossroads: where sharia financing meets ESG

Social responsibility and ethics have been central to two of the most significant global finance trends in the past decade, though the crossover between the two remains minimal.

Environmental, social and corporate governance (ESG) investing has grown from a niche concern to a $30,000bn industry, with factors including increased sensitivity over poor corporate governance and growing alarm over climate change prompting the world’s largest asset managers – including giants such as BlackRock and Japan’s Government Pension Investment Fund – to actively monitor investments based on ESG scores.

In parallel with the rising profile of ESG concerns, the ascent of the modern Islamic finance sector has been a particularly noteworthy trend in Muslim-majority countries and beyond for the past 30 years, providing a widening range of sharia-compliant financial services and financing tools.

Such instruments are underpinned by principles that include: transparency; a prohibition on speculation and interest-bearing instruments; the need to benefit society; and an exclusion of goods and services seen as detrimental to society, such as alcohol and gambling.

Overlapping aims

While the approaches taken by ESG and sharia investors have often differed, there has been a growing recognition in the past decade of the overlap between the two disciplines.

“Sustainability, fairness and equity, we can all agree, are at the heart of [ESG investing] principles,” Bandar Hajjar, president of the Saudi-based Islamic Development Bank, told The Banker.

“These values could not be any closer to the principles of sharia-compliant investing, which are enshrined in the basic tenets of sharia (Islamic law) that include protection of the environment, prohibition of economic and social injustice, accountability at every level of organisation and promotion of sustainability for future generations. These are grounded in the spirit of Islam to ensure social cohesion, co-operation and solidarity.”

The crossover between the two approaches is not just theoretical, with sharia-compliant investments scoring higher than conventional instruments on various ESG criteria. Research from Schroders conducted in 2019 found that the Dow Jones Islamic Market World Index performed much better than the conventional market on a number of sustainability criteria, with carbon dioxide emissions per million dollars of revenue 34% lower than the score for MSCI’s All Country World Index.

Much of this performance is accidental rather than the result of deliberate investment policies, Schroders found, with sharia-investors having low exposure to the carbon-intensive utilities sector.

Yet the past three years, in particular, have seen a more deliberate crossover between Islamic finance and ESG investing – green sukuk, or sharia-compliant bonds, being the most obvious trend. Furthermore, the massive financial relief packages unveiled by Muslim states during the coronavirus pandemic has raised the prospect of expanding activities within the social area.

Despite such moves however, the approach taken by Islamic finance practitioners differs in subtle yet significant ways from conventional ESG peers, which restricts the overlap between the two.

“There are differences between sharia and ESG investing but one can learn from the other,” says Richad Soundardjee, group chief regional officer at Société Générale in the Middle East. “From the sustainable finance side, the emphasis is the positive impact of the project. For the Islamic finance side, the starting point is the prohibitions, so sharia boards will often first look at whether the transaction involves anything that is haram [forbidden]. So there’s a need for each discipline to learn from one another.”

Sustainable bonds

Of the three core elements of ESG, investment in environmental projects has been the area embraced most enthusiastically by the Islamic finance community, and the one that offers the largest growth potential in the years ahead. This mirrors the dramatic growth of the conventional green financing sector, as growing concerns over climate change have fuelled a dramatic rise in renewable energy and other major green projects.

Ten years on from the issuance of the world’s first green bond by the World Bank, the global green bond and green loan issuance market reached an adjusted $257.7bn in 2019, a year-on-year increase of 51%, according to the Climate Bonds Initiative (CBI), with demand for such instruments only set to increase.

In a survey of treasurers published by the CBI in April, 98% of respondents said that their green bond issuances had attracted new investors, while 88% of respondents said they intended to issue more green bonds. Green sukuk, by contrast, remain a relatively recent addition to the green bonds and loan market, accounting for just $3.1bn in 2019. This underscores the market’s enormous growth potential.

“Early entrants in the corporate green sukuk space have proven that it is one of the solutions for financing green projects such as solar parks and low-carbon buildings,” says the Islamic Development Bank’s Mr Hajjar. “However, supply is still limited. Their corporate peers who value sustainability would do well to walk this path and cater to the demand of ESG and sharia-oriented investors.”

The world’s first green sukuk was issued in June 2017 in Malaysia – the world’s most developed Islamic finance market – when Tadau Energy raised RM250m ($59m) for the financing of a solar power plant in the eastern state of Sabah. The government of Indonesia followed suit the following year, raising $1.25bn in the world’s first sovereign green sukuk, followed by a $750m issuance in 2019.

In May 2019, Dubai-based real estate firm Majid Al Futtaim raised $600m in the first green sukuk of the Gulf Co-operation Council (GCC) region, with the issue six times oversubscribed. It followed up with another issue in October. Then in November 2019, the Islamic Development Bank issued the world’s first AAA-rated green sukuk, raising €1bn.

Mr Hajjar says: “The issuance was successfully executed on the basis of our ground-breaking sustainable finance framework, with the use of proceeds being exclusively allocated to projects for renewable energy, clean transportation, energy efficiency, pollution prevention and control, environmentally sustainable management of natural living resources and land use, and sustainable water and wastewater management across our 57 member countries.”

Environmental concerns

While the economic impact of Covid-19 is expected to put a damper on green sukuk issuance in 2020, renewable energy, particularly within the GCC, is set to be a significant driver for the green sukuk as economies recover, according to Mohamed Damak, senior director and sector lead for financial institutions in the Middle East and Africa at S&P Global.

“Green [energy] and sukuk work perfectly together, as environmental principles are in line with the underlying principles of sharia, namely to preserve life,” he says. “Governments in the GCC are working on significant renewable energy projects in a bid to transition to green energy, so there will certainly be some that will be funded by sukuk.”

While the opportunities for green sukuk are clear, issuers have often been slow to make the link between Islamic finance and environmental concerns explicit.

“If you look at the Islamic finance space and how sharia boards vet different transactions, so far we only seen green shoots of a specific focus on the environment,” says Mr Soundardjee. “It’s not explicitly part of the investment criteria, but the link is very easy to make, given that there is the objective of taking care of the environment and humanity.”

The Islamic finance community’s slowness to embrace such principles – despite the obvious overlap between the two disciplines – means it risks missing out on wider interest in ESG investment principles, not least among Muslim investors.

In a global survey of investors carried out by Schroders in 2019, 66% of Asian respondents said they would always consider sustainability factors when selecting an investment product, a higher proportion than the 57% globally who agreed with this statement. An even higher percentage (76%) felt this way in predominantly Muslim Indonesia, with the figure for the United Arab Emirates (UAE) also above average at 62%.

“The lack of an explicit focus on sustainability within the majority of sharia equity funds could be pushing investors who are motivated by ESG considerations to the traditional sustainability arena, as opposed to the sharia arena,” the asset management firm said in a research report published in November 2019.

There have been signs of a mindshift towards sustainable finance within the GCC in recent months, however. “Climate change is a reality that we can no longer ignore,” Farouk Bastaki, managing director of Kuwait’s sovereign wealth fund, the Kuwait Investment Authority, said in a speech to the Arab Bankers Association of North America in October. “All of us share the same planet. We share the responsibility to protect it for our future generations.”

Legal changes

In January 2020, financial regulators in the UAE announced the country’s first guidelines on sustainable finance that “take into consideration sharia law requirements, principles and guidelines”.

UAE-base Adil Hussain, global head of Islamic finance at international law firm Clyde & Co, says the guidelines are a positive step, but that authorities needed to do more to persuade financiers to adopt them, which would in turn build momentum for ESG financing in the region and beyond.

“It’s one thing to have guiding principles, but it would be a big step to actually put such guidelines into the laws and regulations,” he says. “Once there’s an uptick in [ESG] investing in the UAE and the wider region, and institutions begin to get comfortable and build portfolios, then they can look for similar investments beyond the region – in Africa and other parts of the world.”

S&P’s Mr Damak expects green sukuk issuance “to take a back seat” in 2020 due to the impact of coronavirus on GCC economies, with overall sukuk issuance for the year expected to fall to $100bn from $162bn in 2019.

Extending to social impacts

Yet the pandemic may be a catalyst for the greater use of Islamic finance in the social impact area, as governments in the Muslim world seek to provide economic support to citizens most affected by the lockdown measures.

“The connection between the principles of Islamic finance and ESG investment were always evident in the environmental and the governance space, but less obvious in the social space,” says Mr Damak. “Now the pandemic has raised the possibility of putting a number of Islamic finance instruments to work in the social development space as well.”

In a report published in mid-June, S&P Global highlighted four Islamic finance tools as being helpful for Islamic countries, banks and corporations to navigate the current situation: qard hassan (interest-free loan), zakat (social tax), waqf (charitable endowment) and social sukuk. Of the four, social sukuk may be particularly significant, in that they could be used not only to help support education and healthcare systems during the coronavirus crisis, but also to attract both Islamic and mainstream ESG investors, says Mr Damak.

The Islamic Development Bank has taken the initiative in this regard, raising $1.5bn in mid-March with its first ever sustainability sukuk. Demand for the issuance was sufficiently high for the bank to tighten the pricing to mid-swap plus 55 basis points (bps), compared with the initial price thought of 70bps. It was the lowest ever profit rate the bank has achieved for a US dollar public sukuk; 53% of the issue was distributed to investors in the Middle East and North Africa, 37% to Asia, 8% to Europe, and 2% to others including US offshore investors.

“With the success of this transaction, I also call upon the Islamic finance industry to promote sustainable and social sukuk as alternate asset classes that have the potential to counter the multi-fold impact of the Covid-19 coronavirus,” Mr Hajjar said in a statement.

SDGs a common strand?

Beyond the use of Islamic finance tools to help societies with the impact of coronavirus, the overlap with broader social impact projects favoured by the ESG investors remains less clear cut than with environmental projects.

“Social impact can mean something very different in different contexts,” says Société Générale’s Mr Soundardjee. “There’s a lot of overlap in terms of values, but again the approaches taken are often quite different.”

Of the many ways to measure social impact, the UN’s Sustainable Development Goals (SDGs) provide perhaps the most tangible example that can be used as the basis for social development within both the ESG and Islamic finance space, he says. “It’s a very comprehensive approach that has been agreed by 192 countries, that has been broken down into 17 separate goals, that are very specific and allow governments to build an agenda around them.”

Projects that empower women could be among the earliest projects to receive such support, he says. “I think everyone agrees that the world would be a much better place when women are more empowered. So you could definitely see, for example, projects that finance education for girls receiving such investment.”

The $1.5bn raised by the Islamic Development Bank’s sustainability sukuk will be deployed by social projects that fall under the UN’s SDGs on ‘Good health and wellbeing’, and ‘Decent work and economic growth’, the bank said.