Launch Partners

Tuesday, January 31, 2023

Launch Partners

Islamic sustainable finance has an opportunity to focus on the ‘real economy’ dimension of climate-related financial risks

With climate talks and the G20 both being hosted in Islamic markets this year, Islamic sustainable finance has a unique opportunity to extend the connection of Islamic finance as an integral part of the broader responsible finance market, according to BLAKE GOUD, CEO of RFI Foundation. Indonesia hosted the G20 and Egypt hosted COP27 [2022 United Nations Climate Change Conference] in 2022 and the UAE will host COP28 in 2023.

There has always been an opening for Islamic finance to thrive on the back of rising concerns for ESG issues, especially relating to climate change. Now that the forum for discussions around these topics is moving into Islamic markets themselves, Islamic sustainable finance needs to do more to seize this opportunity. The opportunity is amplified by regulators signaling their interest in climate-related risks.

For Islamic sustainable finance, the response to climate change starts with understanding where the risks are concentrated, but it should not end there. Islamic finance should look deeper than just the direct high-emission exposures in its own balance sheet and focus on everything it facilitates in the real economy which will be impacted by climate-related risks materializing. A focus on finance as a means to support the real economy rather than an end in itself will prove to become a valuable asset as climate-related risks become more embedded in regulation.

As a starting point, when a bank, investor or financial institution looks to define its risk from climate change or any other risk, it is reasonable to start by defining a threshold for when a risk factor becomes significant and then quantifying how and what types of exposures exist beyond that threshold. With climate change, this often takes the form of analyzing the sectors or customers receiving financing whose direct business exceeds a specific emission threshold.

However, this type of methodology is not very useful in fully appreciating the dynamic nature of climate-related risks, especially transition-related risks. The actions that would naturally follow from identifying the highest emission sectors would be to reduce the risks, often by exiting funding over time to reduce the exposure to the risk being managed. That will make a financial institution’s metrics for financed emissions fall over time, which could benefit it directly, but on its own it will be an ineffective step for creating change within the real economy.

High-emission sectors account for a relatively small share of the total financing of banks. The share of ‘green’ financing for alternatives within those sectors is an even smaller share of their financing assets. By limiting most of their response to climate-related risks to these few sectors, and ignoring the interlinkages between high-emitting sectors and other sectors in the economy, financial institutions’ power to fund the climate transition is limited unnecessarily.

One concern that may arise for financial institutions that recognize the real-economy linkages between high-emitting sectors and other sectors throughout a financial institution’s assets is how to analyze the problem. Data is already scarce in most Islamic markets, and it can be difficult to get precise counterparty-level data on the direct emissions of high-emission sectors, let alone full value chain emission data.

That often leads to financial institution myopia toward climate risk focused only on the highest emitting sectors that are pulled to the top of the list for measurement purposes. However, for Islamic sustainable finance to step ahead, it should return to the focus on the real economy and recognize that even though precise data may be lacking, it can use the data that is available to improve the breadth of response to climate-related risks and commit to improving its approach progressively over time.

There are two reasons why this can be justified in practice. First, the Basel Committee on Banking Supervision has stated and reiterated that recognition of the data issue will lead to evolving practices. Most recently, in an FAQ on its earlier ‘Principles of Effective Risk Management and Supervision of Climate-Related Financial Risks’, the Basel Committee stated that “the responses explicitly acknowledge data limitations and recognise practices will evolve iteratively over time [and they intend] to allow for flexibility while also encouraging banks to continuously develop their measurement and mitigation of climate-related financial risks”.

Second, both the International Sustainability Standards Board (ISSB) draft Climate Standard and the Partnership for Carbon Accounting Financials (PCAF) set disclosure expectations that are broader than just direct emissions. For the ISSB draft standard, the ‘financed emissions’ disclosure requirement follows the GHG Protocol, which includes only customers’ indirect emissions from purchased heat and electricity (customer Scope 2 emissions).

PCAF is broader in its expectation and, in addition to customer Scope 3 emissions, also incorporates in a phased-in way disclosures by financial institutions of customer Scope 3 emissions as well. Although those customer indirect (Scope 3) emissions are limited to only the customer’s value-chain emissions from high-emission sectors, disclosure will expand over time. By 2026, PCAF signatories may be required to report financed emissions inclusive of all customer Scope 3 emissions.

Amid the concerns about data quality, there is a reasonable question about whether this expanded analysis as well as disclosure is feasible to expect. RFI Foundation has been researching the question about whether existing bottom-up data on financed emissions, and links between high-emission and other sectors, can be supplemented with top-down estimates across Islamic markets.

RFI’s findings so far are that ‘order of magnitude’ estimates can complement bottom-up data available, and we have released reports summarizing findings relating to six Islamic markets and our work continues. But the importance should not be lost across Islamic markets, including Islamic financial institutions. The message from regulators and disclosure standard-setters is to extend focus on the entirety of the real economy and not just on portfolio metrics related to high-emission sectors only. That will require measurement and mitigation of climate-related impacts across their whole balance sheet and Islamic sustainable finance should view that as an opportunity.

Prior to joining RFI, Blake was the community leader for the Thomson Reuters Islamic Finance Gateway from 2012 to 2015.Blake has more than a 15 years of experience researching Islamic finance and working in a compliance and investment officer role in the finance industry. His published research covers a variety of topics in Islamic finance relating to ESG, social finance, climate-related risks, fintech and public finance. He received his Bachelor of Arts degree in economics from Reed College in 2003.

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