A Natural Role for ESG in Islamic Finance
There is growing awareness among global investors of the synergy between ESG (environmental, social and governance) investing and Islamic finance, contributing to the rising appetite for Shariah-compliant investments as investors look for greater portfolio diversification and an alternative to more traditional ESG investments.
Islamic finance and ESG investing are complementary investment approaches sharing significant common ground, such as being a good steward to the society and the environment. Both offer products that appeal to Muslim and non-Muslim investors alike, and hold strong practices and policies that each can learn from the other.
The fundamental teachings of Shariah in finance can be summarized in three broad ways:
- Prohibition of interest – The ban on interest-based borrowing or lending in a financial transaction means capital cannot be borrowed or lent on interest.
- Type of contracts – Shariah provides guidelines on acceptable and permissible forms of entering into contractual agreements. For example, certain conventional financial contracts such as forwards and futures are deemed not to be in accordance with the guidelines of Shariah. Similarly, contracts on notional amounts, treating currencies as asset classes, purchase and sale of risk and options, are viewed as non Shariah-compliant. Contracts are based on principles of risk sharing, avoidance of excessive uncertainty, and real asset-backed or asset-based transactions.
- Restrictions on activities that are not in the public interest – These guidelines are set to preserve life and honor humankind. In line with this, Islamic financial institutions do not deal with any entity nor transact in areas that intersect with the restricted activities. These include participating in betting and gambling, along with its restrictions on alcohol, drugs, weapons and industries or activities that have a negative impact on societies.
In line with these practices, societal values are at the forefront with Islamic finance, just as they are with ESG investing. In addition, Shariah restrictions on activities or industries that are not in the public interest are consistent with the negative screening that forms part of the ESG approach.
Beyond these evident socially focused similarities between ESG investing and Islamic finance, there is also convergence in environmental objectives. For example, green Sukuks, a Shariah-compliant financial instrument similar to a bond, are designed to finance sustainable, climate-resilient and environmentally friendly projects, generating returns in line with Shariah principles. In terms of governance, Islamic institutions are automatically subject to an additional layer of oversight compared with their conventional counterparts as they are being regulated by Shariah boards that are responsible for providing guidance and issuing opinions on whether a product or service conforms to Shariah principles.
With growing consensus that the objectives of generating returns and prioritizing global social welfare are not mutually exclusive, investors are exploring Islamic finance to complement their ESG investments for enhanced overall risk-adjusted returns and greater portfolio diversification while building more sustainable economies.