The Islamic finance industry is expanding rapidly. The industry witnessed double-digit growth of 14 percent with a total of US$2.88 trillion in assets by the end of 2019. Global Islamic finance assets are expected to hit $3.69 trillion in 2024, according to the 2020 Islamic Finance Development Report released by Refinitiv and the Islamic Corporation for the Development of the Private Sector.
As the industry continues to grow in the coming years, there is a unique opportunity for Islamic finance and environmental, social, and governance (ESG) to converge and drive sustainable investment globally. Islamic finance and ESG investing are complementary capital-raising and investment approaches with many shared underlying principles.
Islamic finance calls for justice, empowerment of all stakeholders, ethical practices, and social responsibility – notions that are at the heart of sustainability efforts and initiatives. In recent years, the Islamic finance industry has witnessed the launch of several initiatives and the creation of innovative structures that align with sustainability and ESG efforts.
In Indonesia, the Financial Services Authority (OJK) published a Roadmap for Sustainable Financing in December 2014. The Ministry of Finance issued a green Sukuk in February 2018, becoming the first Asian country to do so. Similarly in Malaysia, the Securities Commission Malaysia introduced the Sustainable and Responsible Investment Sukuk Framework in 2014.
This was followed by the issuance of the first social impact Sukuk by its sovereign wealth fund, Khazanah Nasional Berhad. In 2017, Bank Negara Malaysia issued the Value-Based Intermediation (VBI) Strategy Paper. Two years later, Malaysia’s Islamic fund manager, BIMB, signed the UN-supported Principles for Responsible Investment (UNPRI) to incorporate ESG into investments.
Given the high degree of complementarity between Islamic and ESG investing, this has allowed Islamic investment managers globally to tap a wider investor base, including socially responsible investors outside Islamic jurisdictions who are seeking to diversify their holdings.
Factors Behind Islamic Finance & ESG Investing
Several factors are driving the increased alignment between Islamic finance and ESG in recent years. They are listed below.
- Regulators are increasingly requiring banks in general and Islamic banks, in particular, to consider and report on the ESG impact of their activities. Sharia-sensitive investors are also focusing on both sharia compliance and the ESG impact of their investments, especially in the wake of the pandemic.
- Both Islamic finance and ESG investing principles require avoiding investments in business activities such as tobacco, alcohol, weapons, and gambling. These businesses are considered illegal, and unethical according to the basic tenets of Shariah. They are also considered injurious to society in more than one way. So, they do not meet the criteria set by ESG investing principles either.
- Islamic finance requires positive screening of the business activities Islamic financial institutions are engaged in. According to the principle, Islamic banks need to consider that not only is an initiative sharia-compliant but that it is also socially or environmentally responsible.
- Research from Refinitiv’s EIKON database covering over 6,500 publicly listed companies shows that there is a strong correlation between sharia compliance screening and stronger ESG performance. Refinitiv’s Islamic Finance ESG Outlook 2019 report found that sharia-compliant companies have ESG scores that are on average 6 percent higher than for those excluded by the sharia screening process.
The research suggests that combining Sharia and ESG screening could improve overall risk-adjusted returns. The COVID-19 pandemic has been a catalyst for the resurgence of sustainable Sukuk and investment funds. Refinitiv data showed that ESG Sukuk issuance reached a record value of $4.6 billion in 2020, boosted by large sustainable issuances during the year. Meanwhile, the sharia-compliant fund’s space has been undergoing a shift towards sustainable investment, with Islamic sustainability funds amounting to $542 million by the end of 2020.
Sustainability Sukuk is expected to drive ESG Sukuk and Islamic funds growth in 2021, as the recovery from the economic fallout from COVID-19 continues to be the prime focus for governments and corporates. ESG Sukuk issued in the first quarter amounted to over $2.5 billion, over half of the total ESG Sukuk issuance in 2020. Islamic ESG funds also continued to build momentum, and grew to a value of $756 million in the first quarter of 2021, following the launch of several Islamic SRI funds in Malaysia and Indonesia.
More sharia-ESG funds are likely to be launched in coming years, in line with the growing issuance of green and sustainable Sukuk. In addition, 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 unemployment. 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.
