Applying two principles of Islamic finance to create meaningful ESG initiatives

This article was originally published in the September issue of Butterworths Journal of International Banking and Financial Law and is reproduced with permission from the publisher.

Environmental, social and governance matters are a burgeoning issue on the agenda for businesses, governments and individuals alike. Companies are under increasing pressure to shift their focus from maximising profits and shareholder value to maximising value for all stakeholders. This can seem an impossible task. But there are powerful lessons to be learnt by applying the principles of Islamic finance to ESG initiatives.

Islamic finance

Islamic finance is a financial system based on being beneficial to society and humanity by avoiding potentially harmful and exploitative practices and behaviours. It seeks to do this in two main ways:

1. It prohibits the collection and payment of interest, to avoid unjust and unequal exchanges between parties.
2. It prohibits investments in certain types of businesses and industries deemed unethical or harmful to society, and those considered speculative or uncertain.

Islamic finance, therefore, inherently seeks to promote ethical and sustainable decision-making and investments.

Role of Shariah scholars

Unique to Islamic finance is the role of Shariah scholars, who play a critical governance role: supervising, regulating and verifying that a product or transaction is Shariah-compliant. The need for Shariah board “sign-off” is an important and objective safety valve that ensures short-term commercial interests do not override longer-term considerations.

A practical illustration of this is the refinancing of a large international airport in the Middle East in the early 2000s. The airport was predominantly financed through an Islamic finance structure. Given the strict prohibition on financing tobacco and alcohol, however, the scholars would not permit any part of the funding to be used for the airport’s duty-free zone. The tax-free zone was therefore expressly excluded from the Islamic financing and separately financed by others.

This additional layer of governance is similar to the positive and negative “screening” approach adopted in socially responsible investing. The screening prohibits investments in certain types of industries and considers the wider social impact of any investment. Funds adopting this approach have generally yielded higher financial returns in the long term.

There is a strong case for businesses to incorporate an additional layer of governance (e.g. an internal ESG board) that ensures decisions at all levels of the business comply with ESG principles.

Collaboration

Islamic finance prohibits exploitative practices and proactively encourages enterprise through profit and loss sharing between parties. In Musharakah financing, a financier can contribute cash to a joint venture and, in return, may receive back the initial investment plus a share of the profits.

In an interest-based system, the key metric for providing financing is often the creditworthiness of a borrower. In contrast, a number of Islamic finance structures focus on the viability and likely productivity of the underlying project. This helps ensure all parties have a vested interest in preserving and enhancing the brand, reputation and value of the underlying asset. It also encourages collaboration between parties, and is intended to promote social solidarity and cohesion through mutual cooperation.

A good example is the 2018 Indonesian sovereign five-year sukuk issuance, which raised USD1.25bn to fund a solar power plant at Tambolaka airport and a 727 km railway connecting Karata and Surabaya. The investment offered a return significantly higher than US treasury bonds, and so was attractive to Islamic, mainstream (“non-green”) and ESG investors.

ESG issues cannot be addressed by businesses, governments or individuals acting alone; they require multi-stakeholder partnerships. Parties – particularly financial institutions – are more likely to be incentivised to support the development of sustainable practices, innovative ideas and behaviours, and long-term investments, if they have a self-interest in the project.

Perhaps that is why we’re seeing an increase in demand for ESG funds. Universal and impact investors are seeking investment opportunities that yield long-term results and are less likely to trigger the adverse PR consequences associated with businesses that – knowingly or otherwise – adopt unsustainable or exploitative practices.

Conclusion

We can do more than apply Islamic finance principles to create meaningful ESG initiatives; we can combine the two. Proponents of Islamic finance argue its role and that of ESG are intertwined, dating back almost 1,500 years. As demand and focus on ESG increases, there are invaluable lessons that businesses, governments and individuals can learn from Islamic finance and apply to new opportunities:

• Be purpose-driven and have clear values promoting long-term welfare and interests.
• Adopt a strong governance structure (akin to the Shariah screening board) that ensures decision-making is consistent with ESG principles.
• Encourage and develop a culture of interdependence and collaboration with stakeholders, which should help develop more sustainable behaviours and practices.