This article looks at the similarities between environmental, social and governance (ESG) investing and Islamic investment, and secondly how specific ESG-oriented projects can satisfy many of the principles that underpin Islamic investing. It will also examine the growing area of private debt and how Shariah compliant investment vehicles can be created to satisfy prohibitions on interest-based transactions.
We also use a case study of a new approach to the financing of small biogas projects within the UK rural economy, using an Islamic fund structure.
Common values
Islamic finance and ESG investing hold many values in common, including for the investor to be a good steward to the environment and society. Social justice and inclusion are important factors for both. The level of overlap is hard to estimate and will differ from institution to institution. But Islamic-based investments will tend to line up with 80% of the UN Sustainable Development Goals as a general rule of thumb. 1
Both investment approaches require a level of screening to be applied to the underlying investments. For active portfolio management, eg equities, this demands an additional layer of due diligence be applied to all investments in a portfolio.
At the more convenient end of the scale is the screening-out of companies in specific sectors, eg arms, alcohol, fossil fuels, etc. Both approaches maintain a high level of scrutiny which fund managers must also be aware of when developing products.
There is obviously an overlap between activities banned under Shariah investing (Haram) and those screened from ESG portfolios. This is most consistent in areas where the investor is seeking to achieve wider social benefits or avoid damage to the environment. Passive screening by both approaches immediately eliminates many companies from a possible portfolio, for example, companies specifically involved in environment-harming activity or with very poor records of social governance.
Islamic finance structures are already well-established and draw on centuries of legal corpus, whereas ESG investment criteria represent a fast-evolving landscape with newer levels of regulatory oversight and reporting being applied.
The two can be complementary, however: environmental issues are consistent with the fundamental principles of Shariah. But like the wider ESG investing community, Islamic investors are pursuing a more active ownership agenda than previously.
We are already seeing progress in this area, for instance in the green Sukuk market. Organizations like the Clean Energy Business Council (MENA) and Climate Bonds Initiative have been working on the groundwork for Sukuk that are issued specifically to support the green energy transition. Green Sukuk are being designed to invest in renewable energy and other environmental assets and address the Shariah concern for protecting the environment and being a good steward of the planet.
Eligible assets for green Sukuk, as outlined by the Climate Bonds Standards certification, include solar parks, wind energy, renewable transmission and infrastructure, and significantly, biogas plants, of which there are more below.
The first green Sukuk facility was launched more than four years ago and led a strong program of issuance to finance environmentally-friendly energy projects around the world. These products combine the best of both worlds, the structure of a Sukuk facility with clearly defined goals of the proceeds.
This market is already relying on green bond standards to provide that additional layer of responsible investing, and it is here that we have seen the start of that synergy between Islamic and ESG investment.
The evolution of private debt
Private debt has grown impressively over the period since the ‘Great Financial Crisis’ in 2008. Some of the key drivers behind it include the retreat of commercial banks from active lending in the SME sector, and the low yields from government bonds. The yield picture for government debt remains very depressed, and with global inflation picking up quickly, investors are searching for consistent yields from other quarters.
The private debt sector was valued at around US$575 billion in 2016 and expanded to close to US$900 billion by the end of 2020. According to research data group Preqin, it is projected to grow 11.4% annually to US$1.46 trillion by the end of 2025. It is becoming a much more diverse and mature part of the overall asset management sector.
The private lending market has created a body of specialist fund managers who have been active in the SME market in various countries, developing the knowledge base, in-house expertise and network of contacts required to source deals and manage large loan books. This has led to a premium being placed on their expertise by larger fund managers, banks and investors.
Importantly, the market also provides investors with access to the economics of a very significant slice of the global economy — private SMEs. These are companies defined as having fewer than 250 employees, and a turnover of less than EUR50 million (US$57.96 million). In the UK alone, they account for 99.9% of the business population, over 60% of the jobs, and over half of the total turnover. 2
ESG investing is becoming a factor in the work of direct lending funds as well. While the strategy manages business loans rather than equity investments, this necessitates that top-down screening criteria are applied first of all (eg fund managers can still screen out SMEs with activities in specific sectors).
Close analysis of an SME is part and parcel of the secured lending process and an important factor in the ongoing risk management of private debt portfolios. When applying an additional ESG screen or indeed Shariah criteria, these additional requirements can be readily factored into the process by a sophisticated private debt fund manager.
Impact investing is gaining ground
Impact investing is, however, becoming an area of more interest to investors. This includes lending strategies that are specifically focused on businesses and/or infrastructure projects with strong environmental and/or social characteristics. This can be applied to the private debt market, with the creation of funds that target lending at very specific areas of the economy.
The financing required for the creation of global clean energy infrastructure is going to be enormous. While some of this will be satisfied by governments, much of it will have to come from private capital sources.
With energy prices trending ever higher at the moment, well-financed projects that help to generate or distribute green energy, and reduce carbon emissions, will be at a premium. Private financing of such projects ticks the box for many ESG investors, as the capital is targeted specifically at projects involved in the shift to a zero-carbon emissions economy.
This is a long-term goal for many investors. It brings with it additional social benefits that can be more immediate, for example, the creation of new jobs in the green energy sector, and the provision of cheaper, cleaner energy to households and communities. This is important for those investors looking for social benefits beyond climate/environmental gains.
Taking for example the financing of biogas installations in the UK, such projects bring jobs to rural communities, create a source of clean gas and electricity and also help to process farm waste into fertilizer. The social benefits are considerable.
According to the UK Anaerobic Digestion & Bioresources Association (ADBA), biogas could deliver 30% of the UK’s current carbon budget shortfall, and lead to the creation of 60,000 green energy industry jobs in the next 10 years. It has the potential to generate over GBP5 billion (US$6.82 billion)-worth of private sector investment and support the UK agricultural industry.
“There are over 140 million tonnes of readily available organic wastes still being left undigested in the UK every year,” said Charlotte Morton, the chief executive of ADBA. “Left untreated, they release methane — a potent greenhouse gas — directly into the atmosphere, which contributes to climate change and causes human health issues. Recycling these through anaerobic digestion instead means that these emissions are captured and the organic wastes turned into valuable bioresources, such as a storable, flexible green gas (biogas), a rich-in-nutrient bio-fertilizer (digestate), bioCO2 as well as other valuable bio-products.” 3
An associate technology to biogas is carbon capture, which helps to ensure that no excess carbon is released into the atmosphere from the breakdown of waste. The efficient management of gases from farming processes is becoming an important, indeed necessary, part of the on-farm energy tech equation and requires finance.
It is also worth mentioning here the changing landscape in terms of commercial banking in the UK. Many businesses historically turned to high street banks for funding, but this has changed considerably in the UK since the financial crisis. Banks are closing their high street branches and retreating from SME lending, concentrating on easier-to-process areas like mortgages and credit card lending.
This has created problems for agricultural businesses that require funding for energy infrastructure projects like biogas plants. These have the scope to provide farms and rural communities with cheaper electricity, but to get there needs considerable project financing. Private debt funds are helping to fill that vacuum and have provided these projects with considerable financial support and on-site consulting services, helping them to continue to operate profitably during the coronavirus pandemic disruption.
Shariah banking and impact investing
Much impact investing can include long lead times, but environmental projects that can assist with the battle against climate change can meet the Islamic principles of Zakat, financing transactions which have a strong real economy component. Islamic finance models recognize this element of real economy investment.
Shariah investing is partly defined by a prohibition on Riba (interest-based transactions), but Islamic banking represents over 60% of the global Islamic finance market 4 and is a potential source of very useful capital when it comes to financing the green energy revolution.
The Murabahah and Ijarah contracts provide a strong foundation for more advanced debt-based contracts within financing. In 2017, 10% of Islamic fund assets were invested in Sukuk-based strategies, compared with 42% in equity funds. 5 When combined with the appetite in the Islamic world for making impact investments to help save the climate, this represents a massive force for good.
Shariah screens are applied to ensure that sources of income originate from Halal sources or are purified if the source of income is considered to be non-compliant. They differ from ESG screens in that they require assessment of capital structure and also require certification from Shariah boards/scholars. They can be effectively applied alongside ESG screens.
Private lending in the SME context necessarily requires a secured lending process, especially where an energy project is being financed (eg a large biogas/anaerobic digestion installation, which can require upwards of GBP10 million (US$13.63 million) in financing). This generates an interest-bearing income scheme which, in the Shariah context, requires a scholar-approved purification scheme.
Prestige Funds has created a dedicated Islamic fund that is focused specifically on the biogas opportunity in the UK. This requires a portfolio of biogas projects that can be approved by a Fatwa issued by an Islamic scholar in Saudi Arabia. It has required an already existing fund be reconstructed from the ground up and carefully analyzed to ensure that it meets the requirements of Shariah investors.
Part of the process is the dedicated screening of the waste sources used within the project. This requires ongoing screening of new opportunities by the fund manager as well as monitoring of the operations of the existing plants the fund is financing. In the case of Prestige, we employ a large team of experts in biogas in the UK who carry out regular due diligence and monitoring of the projects we support.
Projects to be included in the fund are screened to ensure they can be incorporated into a Shariah strategy. The movement of money between the fund and the firm which carries out the lending and due diligence activity is subject to a Murabahah transaction. The exchanges between the various parties to a transaction are governed by a clearly defined 12-step process that is the subject of its own Fatwa.
It has been important from the start that the scholars we have been dealing with are fully informed of the entire process, including how the anaerobic digestion plants work to provide energy and digestate which can be used on farms. Our lending partners had to ensure that there would be no lending to companies and farms that are active in the pig farming business.
Key observations
We have been managing funds in the private debt market since 2008 and have been witness to the evolution of a strong ESG component within our activity, ie lending to biogas and other on-farm clean energy projects. These have demonstrated that they can play an important strategic role in the battle to bring the UK’s carbon emissions to net zero.
From our distribution relationships within the Islamic world, it became clear to us that there was a demand for an Islamic product which could sit alongside our other funds and satisfy the requirements of Shariah law. It has required an additional layer of reporting and supervision, but that is work that we anticipate will also be required now by ESG reporting demands.
We also wanted to ensure that the reporting/supervision costs of an Islamic product would not result in a higher fee profile for that fund.
Many fund managers are already facing a higher level of reporting and fielding more questions about ESG from investors; we have been able to leverage existing investment in the technology we use to oversee the credit risk on our portfolios and to also ensure ESG and Islamic oversight requirements are seamlessly incorporated. The complexity of an operation that oversees thousands of corporate loans is up to that task.
We are already seeing a considerable overlap between the demands of ESG investors and those following an Islamic mandate. In many cases, the values and goals that underpin these approaches are very similar.
What is also interesting is the development of an ESG-specific strain within Islamic finance structures. Despite the commonality between ESG and Islamic finance, there is also an appetite on the part of Islamic investors for products that also embed strong climate-related themes within them, while also being Shariah compliant. 6
We are seeing activity within the Islamic finance market this year which supports this thesis, eg recent sustainable debt sales like the US$2.5 billion sustainability Sukuk launched by IsDB in March 2021.
Islamic finance has a strong social inclusion component which we are also now seeing in ESG investing. Projects should be seen to be putting money to work to achieve the greater good. This goes beyond pure environmental characteristics to include social impact. This is one of the main pillars of ESG investing and has been at the core of Islamic finance for centuries.
Ultimately, we will see more synergies between these two worlds in the near future. There is already discussion within the Islamic banking world about value-based intermediation 7 and the need by investors to act within the spirit of these objectives. There is a similar discussion within ESG investment: moving forward from simply screening and actually also focusing on positive outcomes will benefit both the planet and society.