Responsible finance encompasses everything from socially responsible investing (SRI), environmental, social and governance (ESG) and Islamic finance. Despite the growth of all segments of responsible finance, the evolution of our knowledge about how the different sectors interact in practice remains limited. In part, this is because although many objectives are shared, definitions are at varying stages of development.
What we have learned through intensive research is that it is not enough to just find the highest ESG-scoring investments and overlay it with a screen for Shariah compliance. The interaction between Shariah screening and ESG is more complicated. We find ways that promote better outcomes from combining the two than using them independently.
At the core to understanding responsible finance is understanding that the integration of ESG information into investment practices is not merely a compliance exercise. There is no set threshold for what constitutes compliant or non-compliance on the ESG spectrum. There is an institutionalization push underway in responsible investment to make actions by investors integrating ESG into their investment decisions more credible, but it is still unlikely to create clear thresholds.
The drive for national taxonomies and global standards like those proposed to be created by the International Sustainability Standards Board under the IFRS Foundation will help to provide some certainty about what we mean by ‘ESG’. It mirrors the efforts taken over the past 20–30 years in Islamic finance to define a ‘common ground’ approach to Islamic finance as described by the standards issued by AAOIFI and IFSB.
The institutionalization gap between Islamic finance and ESG has stymied rigorous comparisons about the value of each and how they might work together in practice. One of the first efforts was undertaken when RFI was established in 2015 to show that the objectives shared between Islamic finance and responsible finance had more similarities than differences. We lined up the exclusionary screens of ethical and responsible investment against Islamic investment screens providing a side-by-side1 lineup of the exclusionary screens common to the two.
We found similarities in some market practice relating to common exclusions against weapons, nuclear power and tobacco. Other sectoral screens were found in SRI, responsible finance or Islamic finance but were not found in the market practice of the whole responsible finance sector. For example, SRI screens that investors use that are focused on excluding genetically modified organisms which do not overlap with Shariah screens.
For many years, this has been the filter through which responsible finance and Islamic finance are viewed through — a shared set of negative screens with a few that differ between the two. One of the steps to clarify whether this ‘exclusionary’ approach was the element of the commonality and the financial value added or subtracted in responsible finance came in 2017 with research by SEDCO Capital. Rather than qualitatively lining up the negative screens of SRI and Islamic finance and seeing what was the same and what was different, it looked into the financial results of these ethical screens.2
SEDCO’s analytical focus zeroed in on one often overlooked element of Islamic finance that goes beyond the issue of negative screening to avoid investing in prohibited businesses: the financial ratio screens. These screens are incorporated into Islamic finance primarily as a proxy for avoiding companies that are likely to have significant interest income or expense, although the most common exclusions that result are for companies with excessive debt.
The result of SEDCO’s analysis focusing on this question of excessive debt was that the financial ratio screens in Islamic investing come out as more of a ‘positive’ screen than a ‘negative’ screen in both objectives and financial returns, and these results are linked. The positive objective that the financial ratio screens bring to the analysis is that it narrows the available investment universe so that they are more ‘prudent’.
By adding positive screens, the slightly negative returns of the SRI screens (just the sectoral exclusions) are more than offset by the positive impact of more prudent screens, particularly during periods of financial stress like the global financial crisis. This leads to a question about whether other features of responsible finance — ESG — can have a similar impact on returns, making Shariah compliant ESG investing more appealing than conventionally screened ESG funds.
To explore this question, the RFI Foundation undertook a rigorous examination of the data together with the International Centre for Education in Islamic Finance or INCEIF, expanding the time period to both validate some of the results from SEDCO Capital, and extending the analysis to reflect a more comprehensive look at ESG. We find that ESG benefits companies in emerging markets, while Shariah screens provide more value in developed markets. The impact of combining the two screens is both more complex and more informative.
The financial impact of better ESG performance is much stronger in emerging markets than in developed markets. This in part reflects the nature of most ESG data as being more focused on the policies of companies and not always effective at measuring impacts, when viewed in tandem with a more limited ESG benefit in developed markets.
This could indicate that ESG scores as they are currently collected for emerging market issuers are better at gauging how well companies aspire toward best-in-class ESG policies. They could also act as a proxy for these companies being better governed. We find less of a difference between Shariah compliant and non-compliant company performance regardless of ESG scores in emerging markets.
As we mentioned, in most developed markets, better ESG-scoring companies underperformed lower ESG-scoring companies, but at each level of ESG score quartile, Shariah compliant companies outperformed similar scoring companies. This result is consistent with the ‘policy’-focused approach to ESG scores.
Many ESG issues are legislated in developed markets with more rigorous enforcement than in emerging markets, which may result in a narrower gap between leaders and laggards in a particular sector and country. If there is less of a gap in ESG practices between leaders and laggards, it becomes harder to find any systematic financial benefit from improving ESG practices.
One explanation would be that best-in-class ESG screens are already factored into current prices, so buying higher ESG-scoring companies will be pursuing already fully valued (or overvalued) companies. Although this matches up with what some critics of ESG suggest, it does not fully explain the persistence of this finding across a long time frame with data going back to 2001, well before ESG became commonplace. A more compelling explanation is that, although we analyzed sources of risks in several different ways, there remain ESG-related risks that are not reflected fully in ESG scores.
For example, if an ESG score omitted some environmental or social risks, or this information was lost in the process of aggregating ESG data into a composite score, the higher returns we identify could be compensation for bearing additional ESG risk not picked up by the aggregated score. If this is the case, it offers significant opportunity for the use of the Shariah screens in responsible investment that extends some of the results uncovered by SEDCO.
Our findings suggest that the ‘prudent’ features of Islamic investing could help investors benefit from investing and engaging with lower ESG-scoring companies. In contrast, investors who simply overlay a best-in-class ESG screen with a Shariah screen may be sacrificing potential returns in exchange for lowering their ESG risk exposures (measured by the score). For investors willing to take on additional ESG risks, they can use Shariah screens to provide a ‘margin of safety’ while they work with investees to lower their overall ESG risk profile.
This raises a fundamental question about how to look at these results in terms of what responsible investment strategies will look like in the future. As the world’s standards on ESG data are harmonized, there will be more consistency and comparability of ESG information (although its quality may improve only with a lag and after greater assurances are introduced).
As countries pursue taxonomies to define what is ‘green’ or ‘sustainable’ within their economies and financial markets, the way they set out these definitions will also affect how investors evaluate ESG data. To dig into one possible scenario, although there is no data yet to test the hypothesis in our research, countries which adopt a ‘bright-line’ taxonomy may find that the expected return for unsustainable companies rises while expected returns fall for green companies.
This could occur because ‘green’ companies find it easy to raise funding and maintain a stable investor base. They are included in indices that track ‘green’ companies that passive investors use to find the best-in-class ESG companies. The access to finance based on backward-looking ESG information or sustainability data about their products does not necessarily indicate higher returns for investors. We found this to be true in developed markets even in the absence of rigorous taxonomies.
By contrast, lower ESG-scoring companies that are labeled as ‘unsustainable’ tempt investors with higher returns in part because they are underinvested by ESG best-in-class investors. On average, these higher returns may persist, but the companies will be less resilient in part because of their less dependable access to finance.
Investors could see this as an opportunity to pursue higher returns by investing in and engaging with lower-scoring companies, with a Shariah screening overlay to provide a margin of safety for investors, while they engage to uplift the companies into the ‘green’ universe, lowering risk and broadening their access to a wider investor base.
However, in bright-line taxonomies, there is a sharper cliff between green and unsustainable companies. This may put more focus on improving companies near to the dividing line and reducing the value of improving lower ESG-scoring companies. Lower ESG-scoring companies that will not likely become qualified as ‘green’ are unlikely to get the uplift in investor appetite if they cannot cross the ‘think green line’.
In contrast, in places that use what Mark Carney dubbed the ‘fifty shades of green’ taxonomy approaches (such as countries covered by the ASEAN Taxonomy including Malaysia and Singapore), the value of improving lower-scoring companies even if they do not end up becoming green may translate into higher returns for investors. What our research shows is that in these cases, there may be higher returns available through Shariah compliant screening of lower ESG-scoring companies to improve returns during the process of engagement to improve ESG characteristics.
Recognizing these nuances in ESG screening rules and taxonomies can help responsible investors to improve their process by considering Shariah screening. By taking a more active approach to pursue potentially riskier companies with lower ESG scores, Islamic investors can take advantage of the prudent characteristics of the Shariah screening process and engage with companies. The Shariah screens will help to increase the margin of safety against adverse realized ESG risks while the engagement can reduce their prevalence and significance.
As ESG data standards improve comparability across different types of data and narrow differing requirements across different markets, aggregate scores between companies may provide more forward-looking information about potential risks and returns. Until then, there is value to be had in looking at empirical data to understand how to link ESG and Shariah screens and engagement together, and to find new opportunities beyond the ones discussed above.