Sharia-compliant ESG Investment and Inclusion of Islamic Finance

Overview

Sharia investment also known as Islamic finance or Halal investing refers to the field which encourages businesses and individuals to raise capital on the principles of Sharia or Islamic law. These principles prohibit investments in certain sectors such as gambling, tobacco, alcohol, and companies that produce products or services considered harmful or unethical. The concept of Islamic finance is based on certain moral factors and is based on risk sharing where investors are advised to share profit and loss and advised to avoid riba (Interest) and gharar (deception). Due to this principles-based approach of Sharia-compliant investment, they are also considered to be comparable to other socially responsible funds within the environment, social, and governance (ESG) spectrum.

Similarities Between ESG Investing and Islamic Investments

ESG investments and Islamic investments share similarities as both these categories prioritize ethical considerations, long-term sustainability, and take a long-term view of investing. ESG investments aim to improve a company’s long-term sustainability, while Islamic investing suggests prioritizing investments, which are expected to provide long-term economic as well as social benefits, give weightage to governance, and it is considered an integral part of the action plan to achieve long-term stability for a business or investment opportunity. However, both these investment principles hold varied perspectives on governance. While ESG investments prioritize corporate transparency and accountability to enhance success, Islamic investments suggest players in the market follow intangible values such as honesty, integrity, and accountability while investing.

Another important similarity between ESG and Islamic investments is that both concepts were drawn on the foundation of creating an overall positive social impact. On one hand, where ESG investments seek to improve a company's environmental and social performance, on the other hand, Islamic investment suggests keeping social responsibility and philanthropy at the core of investing. Hence, both these investment fields use screening processes based on the above-mentioned values to exclude certain types of companies or investment opportunities. For instance, ESG investors may exclude companies involved in tobacco, weapons, or fossil fuels, while Islamic investors may exclude companies involved in operations prohibited by Islamic law such as alcohol, or interest-based financing. Hence, both ESG and Islamic investments prioritize ethical considerations, social responsibility, good governance, and a long-term view of investing. However, there are some differences in the specific criteria used to evaluate these investments with ESG focusing more on environmental and social issues, while Islamic investments follow the principles of Sharia law.

Country level insights

The Sukuk or the Islamic bond market and the Islamic banking market are the two important aspects of the Islamic finance market which make it complete. Sharia Law-compliant finance market or the Islamic finance market is prevalent across GCC countries and some South Asian counties. Out of all the countries in these regions, Saudi Arabia, Malaysia, and UAE are the top three countries in the Islamic finance market mainly because of the popularity of Islamic banking in these countries.

Saudi Arabia

The share of Islamic banking in Saudi Arabia has increased by 2% (year on year) from 82% in 2020 to 84% in 2021. Further, the country hosts one of the largest Islamic banks in the world, Al Rajhi Bank. This bank has concluded a 3-year dual tranche of Sustainable Commodities Murabaha of USD 1 billion in 2022, which is considered one of the largest Sharia-compliant transactions in the Middle East Region that also complies with ESG practices. The funds from the proceedings were reported to be focused on increasing the bank’s liquidity levels, creating an impact on the bank’s overall activity. 

Malaysia

In Malaysia, the share of Islamic Banking was 36.6% of the total banking in the country as of 2020. Further, as of the second quarter of 2022, Malaysia hosts the greatest number of active Sukuk instruments (Islamic equity bonds) compliant with ESG practices, out of 192 Sukuk issuances on a global scale the country hosts 172 sukuk instruments, issuing around 91% of the total sukuk instruments in the world, making the country a leader in the Sukuk instrument market.

UAE

In UAE, the share of Islamic Banking was 22% that of the total banking in the country as of 2020. One of the leading Islamic banks in UAE, the Dubai Islamic Bank raised USD 1 billion in February 2023, by issuing Sustainable Sukuks, which will be focused on the bank’s sustainable strategy along with supporting the UAE’s sustainability agenda and 2050 Net Zero target.

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Country-wise Regulations across the Top Three Countries

Saudi Arabia

In Saudi Arabia, the main law that regulates and governs the Islamic financial market is the Sharia Law, apart from which there are no legislations that regulate and govern the Islamic financial market in the country. The Saudi Central Bank is the main regulatory body that makes policies and regulations for the Islamic financial market domestically in the country. In 2021, this body issued Sharia Governance Rules, which mandate that financial institutions comply with Sharia Law for all transactions with customers, and establish responsibilities on the financial institutions for management and supervision of financial transactions.

Malaysia

The main legislation that governs and regulates the Islamic financial market is the Islamic Financial Services Act 2013, which complies with Sharia Law principles of finance. The Central Bank of Malaysia is the main statutory body that regulates the Islamic financial market by enforcing the law of 2013 domestically, by mandating that financial institutions comply with this law. The Capital Market and Services Act of 2007 governs the terms and conditions, issuance, and redemption of Sukuk instruments in the Islamic financial market of Malaysia and mandates intermediaries and financial institutions to comply with the act.

UAE

In UAE the main statutory body that regulates Islamic banking and financial sectors is the Central Bank of United Arab Emirates (CBUAE), headed by the Higher Shari’ah Authority, which was established under the Federal Decree Law no. 14 of 2018. This Authority supervises and makes regulations for Islamic financial institutions as per the standards of Sharia Law. Further, this law also regulates the issuance and redemption of Sukuk instruments and other Sharia Law compliance financial instruments, and the law enables the CBUAE to supervise and monitor the Islamic financial market.

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Challenges in Sharia-compliant Investing

While Sharia-compliant investments share some similarities with ESG investing, there also exist some unique challenges that investors face when trying to incorporate ESG factors into their Sharia-compliant investment portfolios. On one hand, the ESG investment approach is goal-based and demands evidence to verify the investment or business opportunity, whereas, Islamic funding lacks codification and only works on the intent of an investor. Additionally, ESG is a holistic approach that drives the investment practices of an institution and provides an integrated meaning, but Islamic finance is a stand-alone practice. Furthermore, Sharia investment guidelines are not standardized globally, and the same is true for ESG guidelines. The lack of standardization in Sharia investment guidelines and ESG guidelines creates confusion and inconsistency in the application of Islamic financing along with ESG principles, making it difficult for investors to evaluate the compliance of investment products.

Summary

Although Sharia Law-compliant investments have some differences compared to ESG investment practices, Islamic financial laws made by the GCC and South Asian countries offer long-term sustainable social benefits for investors.