The last 22 months since the outbreak of COVID-19 that started in China which rapidly evolved into a global-wide pandemic have seen unprecedented disruption, in ways no work of fiction could have envisioned. In 2020 where we thought we had seen the height of the pandemic, Islamic finance and the general financial markets stayed largely resilient despite the global economic shocks.
In Malaysia in particular, 2020 proved to be a surprisingly good year for the capital markets with Shariah compliant solutions growing at double the pace of the total assets under management (AuM)1 and contributing greatly to the overall growth. Malaysia also remains the most developed market for Islamic finance as per the IDC–Refinitiv Islamic Finance Development Report 2020.
Islamic finance has grown to a sizeable US$3 trillion industry but pales in comparison with the global financial services market of US$20 trillion2. Drilling down to the investment management industry, Shariah compliant assets are still trailing at about US$120 billion in 20193 while the global asset management industry is a monster at almost 775 times the size at US$93 trillion and growing another 11% to US$103 trillion as at the end of 20204.
The last few years have seen a pickup in demand for sustainable investments, with growth rates of 15% in the past two years (2018–20) for a total AuM value of over US$35 trillion5 with growth expected to pick up further since the advent of the COVID-19 pandemic has shown the world that a global-wide pandemic’s ramifications can be a lot more damaging than any of us had pictured or anticipated.
Despite Islamic finance’s many similarities and values with sustainable investments, it is surprising that the product proliferation has not taken up in a big away despite the opportunity presented by the pandemic. The time is ripe for a reset in Islamic finance to move beyond being seen as merely an exclusionary value-based investment approach and embrace its spiritual ideals.
Islamic finance is not merely a value-based investment approach that excludes interest-bearing instruments, gambling and alcohol. There are clear references of humankind’s duty toward the environment found in multiple verses in the Quran such as Surah Ta-Ha (20), verses 53–54 where it clearly states that Allah has created the earth where all nature is one and one must use nature intelligently and not abuse it. Social justice is another important element of the Quran addressing the treatment of orphans and women fairly and embracing diversity as God made it clear in Surah Al-Hujurat (49), verse 13 that God made us into males and females and made us into different tribes so that we learn to know about each other.
Within this paper, we will be using sustainable and responsible investment (SRI) as an overarching term to encompass both environmental, social and governance (ESG) as well as Islamic or Shariah compliant investments (see Figure 1). The 2000s onwards have seen considerable growth in the Shariah space yet the division of Islamic assets is very much focused on banking assets and Sukuk which are still very much within the domain of the institutional and bankable. Socially-conscious products like Waqf are still a very insignificant contributor to the overall Islamic assets.
What are the universal values of Shariah compliant investments?
There are essentially five main principles:
1) Support for activities that benefit society
2) Prohibition of activities and practices that promote unjust gains, thus prohibition against interest-bearing instruments
3) Sharing of risk and rewards on an equitable basis
4) Transparency of contract and sanctity of the contract, and
5) Prohibition of activities harmful to the individual and society such as alcohol, gambling, weapons and pork.
The Quran’s teachings further support moderation and balance to contain human excesses and the main themes found within the Quran are equity, balance and responsibility. These values are also the same to be found within ESG and SRI. The only major difference would be the fact that Shariah investments, in their current form, are still largely exclusionary-based rather than embracing a more holistic viewpoint that the Quran and the religion require of followers.
Looking at the compound annual growth rate (CAGR) numbers available, it does appear that Islamic compliant funds trail somewhat to ESG and SRI funds. Inversely, that also means that the potential for growth of Islamic compliant products is equally as good as that of SRI and ESG, if Islamic compliant funds can pivot, and show that they also meet the requirements of sustainability in general and not just be seen merely as a value-based investment.
The overlap between ESG principles and Shariah compliant finance has long been remarked upon. Given the clear overlaps, convergence would be timely and act as the trigger for Shariah investments to move into the mainstream, especially in areas that can address social economic issues. A recent example was seen when the Malaysian government issued the retail Sukuk Prihatin to help the underserved weather the COVID-19 pandemic economic impact; it was oversubscribed by 33%.
|Figure 2: Quick comparison of the three main themes Items SRI ESG integration Islamic finance Themes Sustainable and responsible Environmental, social and governance Shariah compliant Screening Both negative and positive Both negative and positive Negative Main markets Global Global Middle East and Southeast Asia Asset under management 6 Global funds: 2016: US$23 trillion 2020: US$35 trillion Four-year CAGR: 11.5% Global funds: 2016: US$10 trillion 2020: US$25 trillion Four-year CAGR: 24.9% Malaysian funds: 2016: RM150 billion (US$36.14 billion) 2020: RM217 billion (US$52.28 billion) Four-year CAGR: 9.7% Global funds: 2016: US$97 billion 2019: US$120 billion Three-year CAGR: 7.4%
|Figure 3: Main differences between Islamic and ESG investing Description 11 Islamic ESG Certified by Shariah boards Yes No Strict assessment of capital structure (ie interest, debt ratio) Yes No Screening of environmental issue using a specific standard No Yes Active ownership practices (ie active engagement with investee companies) No Yes Significant difference between the benchmarks, country and sector allocations Exclusion of the traditional financial sector, high leverage companies and non-permissible business. Relatively smaller investment universe. Relatively bigger investment universe. Asset size and geographic concentration Smaller size than ESG. Most of it in commercial banking and concentrated in the Middle East and Malaysia. Bigger asset size than Islamic. Most of it is traced to asset managers and asset owners. Mainly in the western regions.
One of the key issues in being a practitioner of both SRI and Shariah compliant products would be how does one address the crossover in terms of products and investors?
Global ESG assets surpassed US$35 trillion in 2020 and are on track to exceed US$50 trillion by 2025, denoting one-third of the US$140 trillion in projected total AuM globally 7. The pandemic and race to net-zero emissions helped send interest into orbit, with the surge reshaping the financial industry. If these numbers are any indication, then the total addressable market for Shariah compliant investments should not be limited to merely the 1.8 billion Muslims globally.
The Schroders 2019 Global Investor Study provides support for the possibility that the current offerings within the Shariah compliant space are not sufficient to meet investors’ investment needs and thus move into SRI or ESG. The study finds that 66% of Asian respondents to this survey said they would always consider sustainability factors when selecting an investment product, higher than the 57% globally who agreed with this statement. An even higher percentage felt this way in Indonesia (76%). The figure for the UAE was also above average, at 62% (individual country-level data not available for other predominantly Muslim countries). Furthermore, Middle Eastern and Asian respondents also felt more strongly than their global peers that climate change will impact their investments. With the obvious overlap between SRI and Shariah compliant investments, the potentiality of growing the Islamic investor base should be explored.
The Malaysian fund management industry’s AuM are RM905 billion (US$218.03 billion) in size with a lot of the growth seen in the industry AuM contributed by the Islamic side which had a 20% growth in 2020 as compared with 10% of the total AuM 8. If Shariah compliant funds are already attracting better growth, layering it with a social agenda should attract and expand the current investor base.
The Malaysian government, in trying to future-proof its government-linked investment institutions, earlier came out with the PERKUKUH 9 initiative which is a medium-term strategic plan that focuses on good governance, social inclusivity and environmental sustainability. With a coordinated and focused plan, we personally believe that both the demand and supply of SRI-friendly products will rise in the next few years, changing corporate behavior for the better as well as increasing the breadth and depth of the capital markets.
A recent survey by MAMBU that appeared in an IFN report mentioned that in a survey of 2,000 Muslim youths, 70% required online presence and 80% insisted on accessibility. Digital convenience is the obvious way to go but the Muslim world is also the one which is poorer with less access to banking convenience and poorer digital infrastructure. However, sometimes less is more. Indonesia with a less developed banking infrastructure has used mobile penetration in ways that has profited the general population as can be seen from one of their homegrown unicorns, Gojek.
The Indonesia start-up ecosystem sets a great example of the need to look at utilizing digitization and the e-commerce market to do better and be more inclusive to all segments of society. The rise of digitization and the ease of access through mobile phones are giving rise to new opportunities within the global markets. Brighter spots in the Islamic world arising from technology can be particularly seen in markets such as Indonesia which has over 11 unicorns currently 10. E-commerce in Indonesia encompasses everything from Halal food, clothes and Wudhu-friendly makeup to banking and investments which are all available from its e-commerce sites. Other more structured and regulated markets like Malaysia can take a leaf from Indonesia’s book in terms of its flexible approach in dealing with the rise of digital adoption by the masses.
What are the most significant differences between the two approaches, from a fund management perspective?
Sustainable funds generally employ some level of exclusions in determining the investable universe. Common exclusions in the US include gambling, alcohol, pornography, civilian weapons manufacturing, tobacco and fossil fuels. Some of these screens, such as gambling, alcohol and pornography, are more common in funds labeled ‘socially responsible’, ‘faith-based’ or ‘values-based’ investing strategies. Values-based investing strategies are typically aligned with a specific set of morals or ethics, such as Catholic funds or Shariah compliant funds. 12
Despite the similarities with SRI and ESG, we are not seeing demand for Shariah compliant funds growing as strongly as SRI and ESG as per the CAGR numbers seen in Figure 2. We have observed that despite the consistent stronghold of Islamic finance, Islamic finance in its present form has not been able to break into the global mainstream and remains sidelined to just a few Muslim countries. Its attractiveness as an alternative to conventional investments, compared with that for SRI compliant investments has been poor despite the rise in awareness of social inequity, climate change in the last few years due to the rise of social media and ease of access to information. This paper is by no means exhaustive and can only superficially examine the reasons why the expansion of Islamic finance into going back to its spiritual roots is timely and crucial.
Islamic finance with its religious roots dating back over 1,443 years ago has to be innovative to successfully compete in the modern world. Its equitable base of social equity, respect for nature and holistic view of the market economy has not been fully explored by existing practitioners. Islamic finance has not positioned itself to move beyond growing the Sukuk market and Islamic banking. Growth with regards to Islamic investments is still difficult as the investment universe remains narrow. It would be a waste if the growing focus on climate change, social inequality and racial diversity, themes so strongly found in the Quran, is not taken advantage of to make the world a better place for all.
Malaysia, which is a global leader in Islamic finance, is pivoting toward SRI and its central bank has just recently released a climate change taxonomy that will see the Malaysian financial markets comply from July 2022. The capital market taxonomy by the Malaysian capital market regulator, the Securities Commission (SC) is expected to also be released later this year. The SC’s recently launched Capital Markets Master Plan 3 which will cover the years 2021 to 2025 aims to utilize SRI and Islamic finance pillars as a means to draw more capital to sustainable businesses to achieve its main objective of accelerating economic growth through a sustainable and inclusive manner.
One of the greatest arguments for merging the concepts of SRI and Shariah compliant investments would be with regards to stronger long term performance. Performance is and will always remain an important element for any investor. The question that needs to be asked is if ESG and Shariah compliant investments can actually deliver greater performance impact together.
An analysis of the 6,554 companies in Refinitiv’s EIKON global database shows an average 5.9% higher ESG score for Shariah compliant companies. Companies in the real economy get a bigger ESG lift from Shariah compliance screening 13. This study by Refinitiv clearly shows that the potential for a broadening of product development would possibly entice back those investors whose sustainability agenda was not previously met. SEDCO in Saudi does Prudent Ethical Investing which marries ESG and Shariah. Islamic finance is expected to grow to US$4 trillion in 2030.
Suggestions for Islamic fund management to embrace SRI as part of Shariah should not be dismissed easily as it is clear that the financial screenings of Shariah helps in screening for better financially managed companies while SRI and ESG work in dealing with the megatrends affecting the world such as tech and disruption, climate crisis and pandemics as well as geopolitics. Investors will typically tend to veer toward the agnostic and focus on returns, so from a product development side, the performance element cannot be ignored. However, education and awareness must also come into play to educate the end investor on long term performance which is much more sustainable ecologically rather than short-term performance that is purely driven by greed and profits which is not sustainable nor ecological. Compensation of the capital markets should similarly be aligned to longer-term sustainability. Only once all these elements come together shall we see a stronger demand for truly sustainable products in their truest form.
If we were to examine Shariah compliant investments from the much-talked-about 17 UN Sustainable Development Goals (SDGs) point of view, Islamic finance has massive potential to address the ‘S’ element strongly within the ESG framework, and within the 17 SDGs themselves, Islamic finance has the potential to address most of them through financing, banking and investing in businesses and initiatives.
Addressing the ‘E’ element in ESG: Everyone is talking about climate change
The recent Intergovernmental Panel on Climate Change (IPCC) report’s warning of 1.5 degrees of global warming in the next 20 years and the 26th UN Climate Change Conference of the Parties or COP26 in Glasgow have put the topic of climate change at the forefront of all major media of late.
The flagship standard for SRI, the Principles for Responsible Investment, now has over 2,000 signatories responsible for over US$80 trillion in assets. SRI is complementary with many shared principles of Shariah such as being a good steward to society and the environment while Islamic economic thought is heavily based on the concepts of fairness and justice. As a result, the Islamic economic system is largely value-driven and fits within the principles of sustainability. 14
The COVID-19 pandemic has shown cracks in our society and socially-inclusive policies are made more pertinent than ever now. Islamic finance transactions should promote equality, social justice, inclusivity and economic prosperity. And above all, Islamic finance must demonstrate accountability and transparency.
The Malaysian central bank, Bank Negara Malaysia, recently issued a Climate Change and Principle-based Taxonomy (CCPT). The CCPT recognizes the impact and importance of identifying and managing climate risks. More than 50 natural disasters have occurred in the past 20 years which resulted in financial losses of more than RM8 billion (US$1.93 billion) and affected the lives and livelihoods of over three million people in Malaysia through displacements, injuries and death.
If climate- and environmental-related risks are not recognized and managed, they may lead to substantial financial consequences not just for businesses and households but also financial institutions which provide financing or investment to those exposed to such risks.
There is a US$115 trillion opportunity for energy transition by 203015. David Attenborough, the famous environmentalist, in a recent documentary on climate change had a map which shows how the planet would look like in 2050 and scenes from the movie Dune comes to mind where most of humankind will be climate change refugees if action is not taken to address the warnings in the IPCC report. With the certainty of the planet getting warmer, so will other risks like pandemics rise.
There seems to be a rising number of news reports coming out globally on zero pledges. But the whole ecosystem to support such zero pledges is still not yet there, particularly in the less developed world. There is little talk on a zero-carbon supply chain for example and thus why more collaborative and collective work by all, especially in expanding Islamic finance, to consider the wider concepts of SRI needs to be done and done now.
Elon Musk had mentioned earlier this year about allowing Bitcoin to pay for his Tesla cars which caused Bitcoin to shoot up and yet had to retract this later given the pressure he faced when criticised about the rise in crypto mining which is bad for the environment. So how do we move from here as SRI investors while being Shariah compliant? A common rhetoric we have noticed is that it is not possible to do ‘E’ without the ‘S’ and ‘G’. We truly believe the answer lies in how SEDCO in Jeddah has done it through its approach of Prudent Ethical Investing and we hope more influential institutional investors will similarly embrace such a merger of ideas for the betterment of all.
For those not convinced that the expansion of Shariah investments should be so diversified, we need to remember that inequality of wealth is a common trigger for wars and revolution as can be seen through the history of mankind. China’s recent pullback on its major tech giants is Premier Xi Jinping’s mission to redistribute wealth for all or what he has termed as “common prosperity for all”. This message echoes the socialist and populist regimes rising due to inequality in Europe in the early 20th century. We are already seeing the culling of certain ethnic groups globally and with technology and social media, the speed of unease will gather momentum very fast if the financial and capital markets do not address the idea of sustainability for the greater good. The idea of a circular economy needs to be embraced by all stakeholders and cannot just be within the purview of the government and regulators.
It is important to ensure that the evolution of Islamic finance is something that brings value and not just a rubber stamping exercise as can now be seen in the ESG space where one of the biggest proponents of green investing, Deutsche Bank’s investment management arm DWS, has been accused of greenwashing. A recent study by Master Action actually puts DWS in the top four for ESG.
Investors and consumers alike are a lot more aware of what is going on in the world, thus the term ‘stakeholders’ is no longer limited to shareholders, clients and vendors. The stakeholder economy is a lot more holistic and in order for Islamic finance and its Shariah compliant investments to remain relevant and compelling for the sustainable future, the time to pivot toward SRI is now.