Islamic Finance & Environmental Sustainability

Blake Goud

Islamic finance has the potential to contribute to the work being done by UN Environment and the World Bank to identify a roadmap to create a sustainable financial system.  The new roadmap, undertaken as part of the UNEP Inquiry into the Design of a Sustainable Financial System initiative, has at its core the idea that the financial system should “shape real wealth to serve the long-term needs of a sustainable and inclusive economy along all dimensions relevant to achieving those needs, including economic, social and environmental issues”. 

Immediately, the challenge becomes about how Islamic finance addresses these issues in practice as well as in theory, and how the dialogue can be taken forward.  In this area, there is some help provided in the roadmap recently released by UNEP Inquiry in the form of short- and medium-term initiatives proposed, where the degree of alignment can start to be translated into some practical steps for Islamic finance to tackle. 

Green Assets

One of the short-term objectives relevant to Islamic financial institutions is that they should work to understand the degree to which they have significant green assets on their balance sheet already.  This is not a unique need for Islamic finance, but it supports a broader effort in sustainable finance to have better tracking of green assets which is useful for understanding the current environmental footprint of the loans and investments made by the financial sector. 

In addition to making headway to measure environmental impact so that it can be better managed, this would open up several specific new sources of financing to the Islamic financial industry.  In particular, a better catalog of the volume of green assets would allow Islamic financial institutions to generate green sukuk backed by a specific portfolio of green assets.

To date, the green sukuk that have been issued are single project sukuk which have financed solar farm construction, and will soon also finance a green building construction in Malaysia.  Shortly after the first green sukuk was issued, Juniza Zahari, Director of Debt & Capital Markets at Affin Hwang Investment Bank pointed at the prospect for future smaller solar projects of between 10 MW and 30 MW that would rely on the loans market but which could be financed via green sukuk issued by financial institutions. 

The same mechanism that could allow smaller renewable energy projects to receive financing in the loans market with refinancing through green sukuk issuance could be usable for other green projects financed by Islamic banks.  The critical need to facilitate the issuance of green sukuk backed by projects other than new projects specifically chosen to be used to back a green sukuk is data on the inventory of green projects that already exist on Islamic banks’ balance sheets.  The development of the ASEAN Green Bond Standard will help this development by providing greater clarity on what ‘green’ means with specific reference to sukuk. 

A Sustainable System

Over the medium-term, as the data becomes more widely collected within each individual Islamic financial institution, there are other opportunities for the industry to contribute to a sustainable financial system.  One way will be to continue to encourage ‘transformational transactions’.  One example of such a transaction is the series of institutionally placed social impact sukuk and recent retail social impact sukuk from Khazanah. 

These social impact sukuk use a pay-for-performance model similar to social impact bonds and target a specific social outcome (in the case of Khazanah, they were designed to support education).  For Islamic finance to contribute to these types of transformational transactions, there need to be an increased number of issuers.  The development of an SRI Sukuk Framework and Khazanah’s use of it to issue social impact sukuk will help.  So will the emerging experience with issuers tapping the green sukuk sector in Malaysia which will build the technical capacity for at least one specific type of SRI Sukuk. 

Another area that will build upon the measurement of green assets held on Islamic banks’ balance sheets will be to introduce regulatory encouragement or requirements for Islamic financial institutions to tag their green assets internally and report aggregate numbers.  Similar policies are suggested by UNEP Inquiry, but if Islamic financial institutions are proactive in recognizing the value of driving forward sustainable financial institutions, they could lead the way in markets where they make up a sizeable share of total banking sector assets. 

The recommendations described up until this point hew closely to the recommendations from the UNEP Inquiry Roadmap and little or no modification is needed to the recommendations that were made to the financial sector as a whole.  The limitations of simply taking recommendations from the mainstream financial sector and applying them to Islamic finance are clear at this point.  Although competing head-to-head with conventional finance, as Islamic finance must do, requires some replication to offer products that meet customer expectations, it doesn’t help Islamic finance differentiate itself. 

The solution to this challenge has been the idea of moving from ‘Shari’ah compliant’ to ‘Shari’ah based’ but the characteristics of what is both ‘Shari’ah based’ and competitive in the market has proved elusive.  The area of sustainable finance, and the characteristics which are used to define what a sustainable financial system means opens up new ground that Islamic finance should seize. 

Shaping Real Wealth

Returning to the beginning of the article, a sustainable financial system is one in which financial institutions’ activities “shape real wealth to serve the long-term needs of a sustainable and inclusive economy”.  Environmental sustainability through compiling data on green assets in banks, supporting green sukuk and other transformational transactions and helping Islamic finance take the lead with regulators on systemic reporting about environmental impact is part of creating a sustainable financial system, but fail to get the bigger picture. 

The financial sector must focus on environmental sustainability though a focus in this area is just a necessary condition; it is not sufficient.  At the core of a sustainable and inclusive economy is the idea of fairness and justice.  It is an idea that people will be provided with opportunities and treated fairly regardless of their status in society, something which requires fairness both at the macroeconomic level, in governments but importantly also in their economic activity with others.

Financial institutions do not have an ability to control the macroeconomy or governments, but they do have a role in bringing fairness at the transactional level and in Islamic finance, this is put forward as a point of emphasis.  If one were to look at how Islamic finance differs in its current practice from conventional finance, the focus on transactional fairness, transparency and a concern for avoiding unjust practices would be at the top of the list. 

The focus on fairness, transparency, and justice that Islamic finance encourages contributes to sustainability too.  Paired with environmental sustainability, it offers Islamic finance a way to become recognized as one of the ‘market-led initiatives’ that the UNEP Inquiry Roadmap says should be encouraged to drive sustainability into day-to-day operations within the financial sector. 

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