The rise in responsible investment is irrefutable. Its development has spanned decades from the 1970s when strong voices for responsible corporate practices began to influence the global discourse, to the launch of the first socially responsible mutual fund in the US in 1971, to 1997 when the Kyoto Protocol convened world leaders to set goals on addressing global warming1. Today, new investments in sustainable funds reached a record high in 2020 at US$51 billion (more than double the previous record set in 20192) and at the time of writing, the world is eagerly awaiting concrete commitments, actions and accountability from the financial sector at the 2021 United Nations Climate Change Conference or more commonly referred to as COP26.
As part of the Principles for Responsible Investment (PRI)’s contribution to this thought leadership report, we will explore where we construe positive, growing areas of overlap between responsible investment and Islamic finance, how investors that follow the principles of Islamic finance or Shariah law are represented in our signatory base, the state of the market and how further convergence can benefit real-world impacts. While the PRI has not developed a house view on nor expertise in Islamic finance, we draw upon insights from our own observations and signatory activities to explore this area.
The PRI defines responsible investment as a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership3. Examples of ESG issues and subsequent investment risk factors include climate change and pollution (E), modern slavery and working conditions (S), and corruption and tax strategies (G). Responsible investment can be approached by considering ESG issues when building a portfolio (ESG incorporation) or improving real-world outcomes (known as active ownership or stewardship).
The PRI is the world’s leading proponent for responsible investment. Launched in 2005 by a 20-person investor group, there are now over 4,500 signatories (categorized as asset owner, investment manager or service provider) to the six principles with a combined signatory assets under management (AuM) of more than US$120 trillion — over half of the world’s investable capital. The six aspirational principles range from incorporating ESG issues into investment analysis to seeking appropriate disclosure on ESG issues from invested entities. Discussions with signatories have firmly progressed from ‘why’ to ‘how’ since the PRI’s inception and we have supported them on their journeys accordingly. This is mirrored by increased action on climate change, building awareness of social issues as accelerated by the COVID-19 pandemic and a growing focus on real-world outcomes. Policy and regulatory pressures have similarly mandated accelerated responsible investment considerations and there is an increasing call for reliable company ESG data and disclosures across the industry.
The relationship between responsible investment and Islamic finance
Islamic finance can be defined as a way to manage money which keeps within the moral principles of Islam. Like the responsible investment industry, the Islamic finance industry is rapidly expanding with a total of US$2.88 trillion in assets by the end of 2019 and expected growth to US$3.69 trillion by 20244.
At its core, we can infer that there are some powerful areas of overlap between responsible investment and Islamic finance.
Both approaches look to promote certain social ‘goods’ and look to align broader objectives with financial returns while avoiding harm to the people or the planet (avoiding or decreasing ‘negative outcomes’). The clearest overlap lies in the use of similar processes around screening or excluding certain activities. The exclusion of certain sectors which is fundamental to Islamic finance ranges from alcohol to gambling and weaponry as these are considered unethical and injurious according to Shariah. This practice is aligned to the screening approach which many ESG investors take5. Exclusionary screening — including Shariah screens or UN norms-based screens — is not a requirement of PRI membership6 but remains a common approach to responsible investment. Among the PRI’s signatory base, most listed equity and fixed income investors use some form of positive, negative or norms-based screening as part of their holistic investment process or for specific funds7. For those who completed the PRI’s reporting ‘Listed Equity’ module in 20218, 57% used screening as a stand-alone strategy. Within screening practices, negative screening is the most popular (as reported by 482 signatories compared with 389 signatories for positive screening) — directly reflective of the screening process used in Islamic finance. We can see similar trends for fixed income, with the actual number of signatories applying ESG screens growing over the years and negative screening as the most common approach.
Differences do exist
Differences between responsible investment and Islamic finance naturally exist. While responsible investment places a strong emphasis on active ownership and engaging with companies on ESG issues, within Islamic finance this practice is perhaps not as widespread (although “there are no issues from a Shariah compliance perspective to steer a company to further improve Shariah compliance or economic performance”9). Islamic finance avoids investments in companies with excessive leverage while this is not typically made explicit in responsible investment. Responsible investment is a holistic approach that aims to include any material ESG factor. A report by Thomson Reuters and the Responsible Finance Institute suggests that “Islamic finance has only ideologically incorporated rather than practically incorporated environmental issues in investment … The financial institutions that set the ‘just’ and ‘unjust’ Shariah lines for Islamic finance have prohibited negative actions, but also need to focus on encouraging good practices10“. This, it elaborates, could be achieved by encouraging positive ESG screening.
Thinking about E, S and G coverage specifically, it has been suggested by S&P Global Ratings that the similarities between Islamic finance and responsible investment are more visible in the ‘E’ and ‘G’ space, owing to the presence of green Sukuk and the additional layer of governance required in Islamic finance, while the ‘S’ factor has historically been less visible. Specifically, “while the underlying principles are socially focused and several instruments already exist, they have not been leveraged in modern Islamic finance in a transparent, systematic manner … At present, there are limited public disclosures on how Islamic banks or issuers of Sukuk are dealing with social issues ”11.
The state of the market: Regulations and policies abound
The PRI has a regulation database which documents existing and evolving sustainable finance policies around the world12 . Of the policies identified by PRI, 96% have been developed since 2000. This pace is only increasing — the PRI has identified 159 new or revised policy instruments so far in 2021, more than the whole of 2020. Looking at countries in the OIC, the UAE has seen the introduction of the ESG Disclosure Guidance for Listed Companies and the Guiding Principles for Sustainable Finance, which aim to “facilitate the UAE’s transition to a more sustainable and diversified economy, in part through mitigating the risks of reduced global demand for oil, as well as addressing the physical and financial risks of climate change”. In Malaysia, we have seen the introduction of the Sustainable and Responsible Investment Roadmap for the Malaysian Capital Market. Meanwhile, the Nigerian Sustainable Banking Principles were introduced in 2012 and the Egyptian Code of Corporate Governance was updated in 2016. In Indonesia, the Financial Services Authority published the Roadmap for Sustainable Financing in December 2014. These — among many others — act as strong vehicles to leverage the powerful role of Islamic finance as we collectively work toward positive sustainability outcomes.
In addition to the number of regulations, there has been growth in the number of existing and potential green taxonomies worldwide, including the EU Taxonomy, South Africa’s Green Finance Taxonomy as well as the UK’s Green Taxonomy. The Shariyah Review Bureau is “studying the EU green taxonomy and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) to inform the development of a new ESG offering aimed at Islamic financial institutions”13. This is seen as the first initiative with Islamic finance which will directly examine how the EU Taxonomy can be applied when considering Islamic law. The Malaysian central bank launched a risk assessment framework in 2018 which integrates Shariah principles, TCFD standards and ESG criteria, following on from the Sustainable and Responsible Investment Sukuk Framework in 2014. The IsDB, meanwhile, has released a Sustainable Finance Framework which “aims to boost commitment towards sustainability through the potential issuance of Sukuk to finance sustainable investments”.
A surge in sustainability-minded products
In September 2021, it was announced that a Tier 2 sustainability Sukuk facility was 12 times oversubscribed14, with an orderbook in excess of US$4 billion. Several green Sukuk (in which issuers use the proceeds to finance investments in renewable energy, environmental assets, transition or infrastructure projects) have been issued, including the US$600 million green Sukuk issued by Majid Al Futtaim in 2019. The amount is still minimal compared with the global green bond market that saw US$168 billion of issuances in 2018, but it is growing. Refinitiv data showed that ESG Sukuk issuance reached a record value of US$4.6 billion in 2020. Green Sukuk allow issuers to access not only the pool of conventional investors interested in green projects, but also Islamic investors15. Overall, it has been argued that green Sukuk structures “can facilitate green investment since the Islamic community already has a large experience of dealing with energy project financing and might subsequently be more comfortable when dealing with non-carbon-based green energy financing16”.
In the sovereign wealth fund space, the Public Investment Fund (Saudi Arabia) has “hired five international banks as members of an environmental, governance and social (ESG) panel for its medium-term capital-raising strategy”17. Meanwhile, Khazanah Nasional, a PRI signatory, is due to issue its first social impact bond18.
The COVID-19 pandemic has perhaps been a ‘catalyst’ for the surge in sustainable Sukuk and investment funds. It has been predicted that the “global economic slowdown caused by the pandemic will lead to greater numbers of social instruments being launched by Islamic financial institutions to tackle issues such as mass unemployment19… With the growth of sustainable and ESG investments across various Islamic finance asset classes, this strategic alignment will unlock new long-term investment trajectories and trends for Islamic finance and ESG investors, while enabling Islamic financial institutions to discover new business opportunities”.
The PRI’s OIC signatories
Aligned with the aforementioned convergence, we have also seen an uptick in the number of signatories to the PRI which are based in OIC countries, some of whom are partially or fully mandated to invest in a Shariah compliant manner. Some of our first signatories in OIC countries included KEHATI – the Indonesian Biodiversity Foundation (Indonesia), Hawkamah Institute (the UAE) and Access Bank (Nigeria). As of October 2021, the PRI has 52 signatories which have their headquarters in an OIC country (with a combined AuM of US$419 billion), compared with 37 in 2020. These numbers can be construed as symptomatic of a growing convergence — or at the very least interest — between ESG investing and Islamic finance.
Every year, PRI signatories are required to complete our internally developed reporting framework to demonstrate their responsible investment activities. Signatories complete a series of organizational and asset-class level modules and are scored accordingly. The completion of our reporting framework by a growing number of Islamic investors will allow us to gain more insight into current practices, offer tailored support and enable us to showcase particular Islamic finance characteristics which may be considered leading practice for the broader responsible investment industry. In addition, completing the reporting framework is a valuable in-house learning tool for signatories and allows for peer comparison.
In order to provide a glimpse of how our own signatories — as direct investors and practitioners — view the interplay between responsible investment and Islamic finance, we have showcased three case studies.
We are living in a climate crisis and many individuals globally are exposed to modern slavery practices, growing inequality and a lack of basic human rights. While public bodies have traditionally been viewed as the key levers to solving these crises, the past few years have confirmed the role which the financial sector must play to close the funding gap required to meet the UN Sustainable Development Goals — estimated at US$2.5–3 trillion annually in developing countries alone20. Not only is invested capital key to creating and enabling solutions to these challenges, but investing with ESG considerations is now strongly evidenced to correlate with positive financial returns21. As such, as the inflow of capital into responsible investment products proliferates, it seems natural that Islamic investors can play a leading role due to their fundamental, unquestionable and preexisting alignment to many responsible investment principles and criteria. Ultimately, Islamic finance can only “broaden its investor portfolio by connecting those overlapping core values to access the large amount of (responsible investment) funds available in global markets22”.
We continue to see growing interest from Islamic finance investors in the PRI and hope to welcome many more to our signatory base. In addition to aligning to an internationally-recognized set of principles and demonstrating a commitment to responsible investment, the PRI can offer asset-class specific guidance and toolkits, access to the PRI’s collaboration platform (learn, engage and collaborate with companies, policymakers, academics and investors), annual reporting which demonstrates responsible investment development, events and tailored support through access to experts across numerous responsible investment topics.
2 Sustainable investments hit record highs in 2020 (cnbc.com)
3 What is responsible investment? | Introductory guide | PRI (unpri.org)
4 How To Integrate Islamic Finance With ESG Goals? (halaltimes.com)
5 Malaysia brings Islamic finance and ESG together | Euromoney
6 The PRI is, however, expecting that investors undertake due diligence as defined in UN norms (i.e. UNGPs) to manage human rights risks and impacts. This will become a requirement via the PRI’s reporting framework over the coming years.
7 How To Integrate Islamic Finance With ESG Goals? (halaltimes.com)
8 Listed equity snapshot 2017 – 2020 | PRI reporting data | PRI (unpri.org)
9 Islamic-Finance_09.20_2020-09-14-164738.pdf (gibam.com)
10 ESG and Islamic Finance collaboration could be major revenue boost for sustainable investment: report (responsible-investor.com)
11 Islamic Finance And ESG The Missing ‘S’ | S&P Global (spglobal.com)
12 Regulation database | Policy | PRI (unpri.org)
13 Efforts underway to adapt EU green taxonomy and TCFD for Islamic finance (responsible-investor.com)
14 Ground-breaking sustainability Tier 2 sukuk 12-times oversubscribed – Environmental Finance (environmental-finance.com)
15 Islamic Finance And ESG The Missing ‘S’ | S&P Global (spglobal.com)
16 ESG and Islamic Finance collaboration could be major revenue boost for sustainable investment: report (responsible-investor.com)
17 Saudi Arabia’s PIF hires banks to advise on ESG -IFR | Reuters
18 Khazanah to launch Malaysia’s first social impact bond | Reuters
20 UN Secretary-General’s Strategy for Financing the 2030 Agenda – United Nations Sustainable Development
21 ESG factors and equity returns – a review of recent industry research | Blogs | PRI (unpri.org)
22 Socially-Responsible-Investing-An-Opportunity-for-Islamic-Finance.pdf (islamicfinance.com)