What Is Environmental, Social, and Corporate Governance ESG Investing in Islamic Finance?

6 min read
26/03/21 1:53 AM

Socially and environmentally responsible investing is neither naïve nor rash. Recently, ethical investors worldwide have been keen to try investment practices grounded in ESG. ESG refers to environmental, social, and corporate governance.

ESG holds particular appeal for Islamic finance institutions and their Muslim clients. It allows them to invest in shariah-compliant ways. That way, they put their money toward charitable and other beneficial causes.

We’ll examine this ongoing move toward a unified investment practice. How might it affect financial markets, and what does that mean for those who follow Islam and those who do not?

What Is ESG, and How Does Social and Corporate Governance Work?

ESG investment principles originated in a UN initiative led by former Secretary-General Kofi Annan in 2006. Click here to read the full document outlining the Principles for Responsible Investment (PRI).

PRI lists actions to which signatories representing the global investment industries have committed. Thousands of asset owners, investment managers, and service providers have signed.

Some of the very recent signatories include the following companies and organizations:

  • Nasdaq
  • MassMutual
  • Roc Partners
  • Kersten Saudi Arabia
  • UNIQA Insurance Group AG
  • New Ireland Assurance Company plc
  • Shanghai Greenment Environmental Technology Co., Ltd.
  • And many others

The resulting ESG Principles became public in April 2006 at the New York Stock Exchange. Much credit goes to a 20-person investor group drawn from institutions in 12 countries.

ESG Principles

Today, ESG criteria help us better predict the future financial performance of companies. Thus, the term connects to sustainable, socially responsible, and mission-related investing.

ESG criteria are a popular way for investors to assess companies in which they are considering making investments.

Socially conscious investors might screen potential investment options. This includes a company’s social and corporate governance and includes criteria like:

  • Environmental stewardship
  • Management structure
  • Management-employee relations
  • Ethical supply chain management
  • How they treat the global communities where they operate

In other words, ESG criteria help future-minded investors find companies with values that align with their own.

They might seek assurance that companies avoid conflicts of interest in selecting board members. They might also refrain from making political contributions in exchange for special treatment. And they will avoid illegal business practices.

ESG-Supporting Organizations and Businesses

The United Nations Global Compact is a non-binding pact. It encourages businesses globally to adopt sustainable and socially responsible policies. And they must report on how they implemented those goals.

“At the UN Global Compact, we aim to mobilize a global movement of sustainable companies and stakeholders to create the world we want. That’s our vision.”

The Compact supports companies that conduct business responsibly. Their strategies and operations should adhere to the stated principles on:

  • Human rights
  • Labour
  • Environment
  • And anti-corruption

The UN Global Compact also supports those taking strategic action toward broader societal goals. For example, the UN Sustainable Development Goals (2016) stress collaboration and innovation.

It might surprise you to see some familiar names on the Investor’s Business Daily list of the top 50 stocks that uphold ESG values. Here are a few examples:

  • Home Depot
  • Salesforce.com
  • Adobe
  • iRobot
  • Intuit
  • Microsoft
  • Nvidia
  • Kimberly-Clark
  • Hanesbrands
  • T. Rowe Price Group

“Why is there so much support for the ESG values?” you might wonder. It’s simple for two reasons. First, there are no moral grounds that can’t be accommodated. Second, the comparative lack of revenue from the investments is no longer much of an issue.

The Motley Fool explains that companies with excellent management tend to perform well on ESG criteria. They do well in other areas, too, by reducing environmental, social, and governance risks.

Empirical evidence supports the idea that ESG-focused companies are run well. And they can produce financial results comparable or superior to their non-ESG-focused peers. ESG also reduces investment risk overall.

Now, let’s find out exactly how and why ESG and Islamic investment approaches have begun to overlap or merge.

How Does ESG Work With Islam and Islamic Finance?

ESG and shariah-compliant investing have similar goals. Each promotes responsible financial stewardship and societal value creation. Still, investors have tended to view the two strategies as distinct and separate.

This is beginning to change, though. The Islamic asset management industry wants to unite sustainable, responsible, and Islamic investing. Their goal is to complement conventional investment strategies.

How ESG Might Conflict with the Tenets of Islam

Still, there are obstacles to contend with when merging disparate value systems. This is the case with those grounded in both Islamic and non-Islamic faith values. Or those lacking a formal faith.

One pronounced disparity involves Islamic concerns with practices considered “riba”. Riba refers to usury or unequal exchanges and has a strong bearing on stock investment decisions. Riba is considered a sin (haram) in the Islamic faith.

Riba maintains the unfair distinction between poverty and wealth. The poor carry ongoing debt. Yet, the wealthy use their existing debt to build even greater wealth. Loans should be charitable and thus halal (permissible).

Being halal is to be shariah-compliant. Thus, Islamic investment approaches differ from ESG norms for non-Muslims. Shariah forbids any form of riba, along with such practices as:

  • Selling or promoting alcohol
  • Selling pork products
  • Facilitating gambling
  • Promoting illegal activities
  • Promoting pornography
  • Manufacturing weapons

How do Muslims know whether their stock investments are halal, not haram? They check the above criteria. They should not invest in businesses with interest-based income or those that borrow on interest.

Muslim investors should ask about interest-bearing debt. They should avoid funds with assets that can readily produce cash (liquidity). And they should use Islamic financial apps to screen stocks.

Socially and environmentally-minded investors might reject some of the practices as observant Muslims. But, few would go to the same lengths to scrutinize for compliance with shariah.

Some thorny points of difference exist when promoting ESG-friendly stocks or funds to Muslim investors. These securities draw most non-Muslim investors through gains and dividends. These are riba for Muslims.

Muslims can remove investment options that are not sharia-compliant even if they are part of ESG-approved funds. The process is called exclusionary screening, and it takes certain assets out of an investment universe or specific plan.

The Status of ESG and Islamic Finance Today

Most Middle East and other Muslim-majority countries shut down during the pandemic. So businesses are only now returning to their “as usual” state. But there’s a lot of catching up to do.

The next few paragraphs capture the thoughts of some Muslim financial experts.

Bandar Hajjar

Hajjar is the President of the Islamic Development Bank. Writing only months before the onset of the COVID-19 pandemic, he made a recommendation. Hajjar wanted to promote the Islamic finance industry for its development leadership.

He argued that Islamic investment institutions Have an important role. That role is to bridge the financing gap for the UN’s Sustainable Development Goals. Thus, they can set a path toward a “reinvigorated, more accountable financial system”.

Usman Hayat

Hayat is CEO of the Audit Oversight Board, Pakistan’s independent regulator of audit firms. He also authored a report published in December 2019 titled SRI Investing, Islamic Finance: 2 Sides of Same Coin.

The report said that “There is an ethical bridge between Islamic finance and SRI investing. It is built upon a shared concern about society and the environment as well as a historical connection”.

Certain financial services providers have begun to create offerings that follow Islamic prohibitions. At the same time, they take into account ESG considerations.

Shahariah Shaharudin

Shahariah Shaharudin is President of asset management firm Saturna Sdn Bhd. According to her, the pandemic has helped both ESG and shariah-compliant funds. They performed well during the market downturn.

She says that “Our portfolios are more defensive, so they provide downside protection during stressful times. Since most ESG and shariah investors are long-term and value investors, these funds do comparatively well over time”.

All three point to the idea of shariah-compliant investing. They see it putting observant Muslims at the forefront of future financial frameworks. These frameworks will move beyond individual wants and toward societal and environmental needs.

Into the Future

Islamic finance and ESG investing are complementary capital-raising and investment strategies. And they have several shared principles, such as responsible social and environmental stewardship.

These closely-related positions on 21st-century investing will only grow more collaborative and beneficial. Muslims will continue to dispel negative stereotypes associated with their religion and way of life.

They will become social and environmental leaders.

Despite many differences, Jews, Muslims, and Christians worship the same God and have for many hundreds of years. Although their respective values differ, they received roughly the same proclamations long ago.

Faith + Giving = Social Benefit

Is capital-raising more of a challenge to Islamic finance because of Shariah? Based on what we’ve said here, It seems the answer is not likely. Muslims feel called upon by Islam to build capital for charitable purposes.

Nothing keeps Muslims and non-Muslims from investing their earnings in the same financial instruments. And while not restricted by Shariah, non-Muslim investors still invest in charitable initiatives.

Contact us to learn more about how we support environmental, social, and corporate governance (ESG) investing.