CEO of the Responsible Finance & Investment Foundation
There is a growing recognition that Sustainable Development Goals (SDGs) are not just compatible with Shariah, but are aligned in terms of shared objectives. This alignment has had relatively little traction until recently because there has not been much done to contextualize the SDGs as being an important objective for Islamic finance to work to achieve. Daud Vicary Abdullah wrote recently that many scholars are “content to be in ‘factory fatwa’ mode”, perhaps the result of a desire by the financial sector to prioritize efficiency of process over reflection motivated by the challenging economic times we live in.
Depending on the perspective one takes, it is possible to blame any separate party throughout the Islamic finance value chain for the limited focus on the SDGs but this blame is misplaced. Bankers prioritizing profit over values, Shariah scholars influenced by the banks they work for to quickly approve products, customers and shareholders focusing on the immediate costs and not the longer-term benefits. In order to overcome the obstacles, some lessons from the conventional side of the responsible finance industry is instructive.
The end of a consumer-driven movement
Initially, socially responsible investment was a grass-roots movement led by people unwilling to finance certain activities and not concerned about the financial implications of their decision. This approach looked at the black and white of investments and avoided those that fell into the former category. This is arguably the end of where consumers acted as the driving force for responsible finance.
The shift in who is driving the responsible investment market towards financial professionals and those who invest on behalf of others is not a sign that has been diluted or co-opted. It is a sign that there is a market demand for it (responsible finance has increased due to greater preference by younger people for responsible finance) coupled with greater knowledge about the consequences of responsible investment on financial returns.
Financial benefit from responsible finance
The professionalization of responsible finance has led to an increased body of research with different techniques, covering different time periods, sectors and geographical regions. Three seminal papers looking at the body of literature from Deutsche Bank Climate Change Advisors, Arabesque and Deutsche Asset Management put the evidence together and, using different methodologies, came away with the same conclusion: responsible finance works. These were
1) Mark Fulton, Bruce Kahn and Camilla Sharples. “Sustainable Investing: Establishing Long-term Value and Performance”, DB Climate Change Advisors (June 2012)
2) Gordon Clark, Andreas Feiner and Michael Viehs. “From the Stockholder to the Stakeholder: How Sustainability can Drive Financial Outperformance”, Arabesque Partners & University of Oxford (March 2015)
3) Gunnar Friede, Timo Busch & Alexander Bassen. “ESG and financial performance: Aggregated evidence from more than 2000 empirical studies,” Journal of Sustainable Finance & Investment (December 2015)
In particular, the research confirms that companies with better environmental, social and governance (ESG) practices deliver better operational performance and better returns to their equity shareholders. Emerging areas of research by Barclays has shown promising implications also from the role of ESG on fixed income returns, although the research posits that the link is indirect (ESG acts as a proxy for management quality) as noted by Albert Descleé, Jay Hyman, Lev Dynkin and Simon Polbennikov in their report “Sustainable Investing and Bond Returns” released by Barclays Investment Bank.
Building on strong foundations
Nonetheless, there is a pattern buried in the growth trajectory of responsible investment that is important in returning to the question of how to turn the focus of Islamic finance towards the SDGs. The initial stage of growth was grass-roots driven, powered by the passion of people to integrate their beliefs in their financial decisions with relatively little regard of the financial implications. Rather than being a flash in the pan, the consumer preference for values-based finance has been mainstreamed with a rising recognition of its importance in financial decisions.
For Islamic finance, this has been the core audience to which the industry speaks. Although there is criticism of the way in which they are served (in terms of Shariah authenticity, value for money and continuing financial exclusion), there has been an irreversible recognition that there is a market for financial institutions to cater to Muslims by offering a Shariah compliant product.
Moving out the curve
Like the growth of ESG in responsible investment, the growth of sukuk in Islamic finance is an institutionalization of the market as traditional players in the global financial world recognized an opportunity and took full advantage of it. As evidence of the importance of financial professionals in legitimizing Islamic finance, most sukuk are not available to a retail investor base and the market has not developed a robust way for retail investors to access it.
Sukuk remain the province of institutional investors but does not have the intellectual backing that ESG has to demonstrate empirically why it represents a financial benefit versus plain vanilla bonds. But financial instruments replicating fixed income can only serve one purpose and have become reliant upon a single volatile source of liquidity to backstop the demand that supports their financial viability. This is a weakness for Islamic finance if it wants to demonstrate a compelling, durable value proposition based on compatibility with and an ability to extend the responsible investment proposition.
Connecting the dots
There is this idea of diversifying funding sources through sukuk issuance, social impact sukuk that connect to Islamic concepts such as awqaf or humanitarian funding via capital markets instruments. However, the challenge has remained how to connect proven practices (from a financial perspective) like ESG integration which plays out over a long time horizon with the concept of the maqasid which also encourages long-term development over short-term profits that come at the expense of future generations.
One way to do it is to push Islamic financial institutions from a perspective that they are (for-profit) financial institutions first and Shariah compliant second. This is likely to be controversial because it can be seen to degrade their ethical foundations within Shariah but if it is effective it will increase their ethical contribution and enhance the influence the stature of the Shariah Supervisory Boards.
Specifically, this approach recommends using an ESG framework, subject to Shariah compatibility, as a starting point because it has a well-demonstrated ability, as noted above, to contribute to beneficial financial performance. It also provides a starting point that fits into the existing Shariah governance system whereby boards can be convinced to adopt an ESG approach (starting as risk management) and the Shariah board can review and approve a specific methodology for consideration.
This provides a way to improve Islamic financial institutions performance, particularly in relation to the environmental and social impact of what they are financing. It is a very good start but it does not craft a distinctive add-on value for Islamic finance that is necessary for its mainstreaming outside of environments where it has a significant core (Muslim) consumer base. Even within the core consumer base, there will be missed opportunities by not offering something distinctive.
Creating a distinctive value proposition for Islamic finance
In order to make the next step from doing ‘Shariah compliant ESG’ towards a distinct value proposition that is ‘Shariah based’, it is still necessary to develop a business case that can satisfy both the Shariah board and the board of directors. The impetus for developing what social impact to focus on should come from Islamic financial institutions’ consumers, from its employees, from its Shariah board (and national Shariah boards) as well as from other relevant stakeholders.
This will ensure that the objectives are determined primarily based on the objectives of society and the economy and not solely based on what is profit-maximizing, especially in the short-term. However, in order to effectively integrate these objectives into the financial sector’s operations, they should have their support anchored both in how they contribute to the broader objectives of Islam, and also how they can provide a solid footing for the long-term financial interests of the financial institutions themselves.