The post-pandemic social and economic recovery has witnessed the integration of ESG investment within Islamic Finance, based on Islamic law or Sharia. Islamic finance prohibits charging or paying interest (Riba), gambling (Maisir), contracts with excessive risk and uncertainty (Gharar), pornography, and investments in tobacco, drugs, alcohol, and pork products. The prohibition also extends to speculative-type businesses and firms that deal in products or services regarded as unethical or haram.
Islamic finance relies on the principles of risk and profit sharing, where parties in the contracts share profit and loss and risks linked to the transactions. It is also perceived as a more stable alternative to the conventional banking system and investors are captivated by the domain due to its ethical appeal. As Islamic finance harmonizes Sharia principles, the former is faith-based and dependent on tried-and-tested principles.
Islamic finance strives for the sustainability and security of investments that align with Islamic values. Meanwhile, ESG includes environmental and social scores and governance components, such as human rights, diversity, equity and inclusion, labor standards, carbon emissions, political lobbying and transparency.
Confluence of Islamic Investments and ESG Investing
The convergence of ESG with Islamic finance has garnered immense headlines as stakeholders vie to align their portfolios with the ethical mandates of Islamic law and boost financial goals. In a similar vein, studies are afoot to help ESG enhance Islamic finance. In May 2024, the UK faith investment group-led global coalition rolled out a platform to validate the ESG credentials of Sharia funds. Investment products listed on ISIP (Islamic Sustainable Investing Platform) are likely to be benchmarked against ESG frameworks, including the Principles for Responsible Investment (PRI).
Tenets of Islamic Finance are akin to ESG investing; there is a connection between 17 Sustainable Development Goals (SDGs) and the objectives of Sharia as they strive to address environmental, social and economic effects and foster a sustainable world. The UN Agenda 2030 guidelines exhort that the Islamic transaction principle looks to create a shared sustainable future for customers, workers, community and shareholders.
Both ESG and Islamic finance emphasize similar elements. For instance, ESG investing seeks negative screening to exclude companies whose activities are not in line with the investment mandate—divesting from the tobacco industry, alluding to a similarity with Islamic finance. Meanwhile, positive screening is conducted to sift top-performing businesses that comply with ethical business practices and sell environmentally friendly products and services.
How Do Middle East Giants Navigate Sustainability?
The incorporation of ESG into Islamic finance institutions has gained momentum across the Middle East. The sukuk (the Islamic version of bonds) has amassed immense popularity in the global financial market as it pushes for diverse investment options, catering to non-Islamic investors, too. Sharia-compliant sukuk emphasizes ethical investments; it encourages responsible investments in sustainable agriculture and renewable energy projects and promotes SDGs. The prevalence of sukuk in Islamic finance suggests it can underpin the financial market across GCC countries and a few South Asian countries. According to the Global Islamic Fintech Report 2023/24, Islamic fintech transaction volume could touch USD 306 billion by 2027. The projection is far from surprising as Saudi Arabia, UAE, Indonesia, Malaysia and the UK are at the helm of the Islamic fintech ecosystem.
Saudi Arabia
Saudi Arabia has emerged as a hotspot on the back of a robust Islamic finance ecosystem and favorable regulatory frameworks. Moody’s Ratings asserts that Saudi Arabia spearheads GCC in sustainable sukuk issuance with 42%, followed by the UAE at 33%. Predominantly, in H1 2024, GCC contributed 82% to global sustainable sukuk issuance.
The country is home to one of the largest Islamic banks in the world, Al Rajhi Bank; its approach to ESG is underpinned by Sharia-led Islamic finance. The bank has 0% financing exposure to alcohol and gambling and tobacco, while 5 Independent directors out of 11 Board members (ESG Report 2023) underpin the bank’s governance portfolio. In May 2024, Al Rajhi Bank succeeded in providing the first sustainable additional capital (AT1) sukuk denominated in USD 1 billion.
UAE
The UAE celebrated 2023 as the “Year of Sustainability”; in 2022, it became the first country in the Middle East to set a Net Zero goal for 2050. The Middle East giant has been at the forefront of the Islamic finance and banking sector. The Islamic Finance Development Indicator Report 2023 placed the UAE as the 4th largest Islamic finance market globally. Besides, the Central Bank of the UAE (CBUAE) exhorted in its UAE Islamic Finance Report 2023 that the Islamic banking sector contributed 23% of total banking assets in the UAE in 2022.
In what has come as a huge boost for ESG-conscious investors, the Emirates News Agency noted that ESG sukuk (as of Q3 2024) accounted for approximately 15.6% of the UAE’s overall sukuk issuance. The West Asian country also houses a 47% share of the GCC’s ESG sukuk market. These trends encourage Islamic financial institutions to inject funds into sustainable finance in line with Sharia principles and take bold steps to combat climate change.
Snippets on Regulations
Saudi Arabia: The Sharia Law regulates and governs the Islamic financial market. The Saudi Central Bank (SAMA) is the main regulatory body that makes policies and regulations for the Islamic financial market in the country and ensures that banking practices are in line with Islamic teachings while keeping up with the modern financial needs of the region.
UAE: The Central Bank of United Arab Emirates (CBUAE) regulates Islamic banking and financial sectors. It is headed by the Higher Shari’ah Authority (HSA), established under Federal Decree Law No. (14) of 2018. The law also regulates the issuance and redemption of Sukuk instruments and other Sharia Law-compliant financial instruments.
Bottlenecks in Sharia-compliant Investing
Although governments have furthered investments in Islamic banking, Sharia-compliant investing is not aloof from questions and challenges. Lack of awareness, for instance, is one of the major roadblocks in fostering Islamic banking. Add to it the dearth of standardization—various jurisdictions interpret Sharia differently—that can dissuade investors from counting on Islamic finance. Different interpretations have also led to inconsistencies in evaluation and screening. Moreover, investors are grappling with the limited availability of ESG and Sharia data.
Roadmap
Islamic finance has made strides in the ESG market with Sharia-compliant investments and the integration of sustainability in operations and strategies. A purpose-driven Middle East calls for a strategic alliance between ESG and Islamic finance to promote responsible business and unlock long-term investment trends and opportunities for Islamic financial investors and institutions.
Islamic fintech is expected to present itself as an ethical and truly inclusive landscape as non-Muslim countries discern Islamic finance. Stakeholders can encourage standardization, investments in ESG and Sharia data and increased transparency in ESG and Sharia reporting. They are likely to focus on busting myths that Sharia-compliant investing is only for Muslims. For the record, Singapore was one of the earliest non-Muslim countries to adopt Islamic finance, followed by the UK and Hong Kong.
