Environmental, Social, and Governance Investing: A Bridge to Shari’a-Compliant Investments in the GCC?

February 01, 2022

A version of this article first appeared in New Private Markets

It has been reported that some asset managers in the Gulf Cooperation Council (GCC) expect stronger inflows amid growing demand for environmental, social, and governance (ESG) and Islamic-compliant investments.[1] The rise in the global popularity of ESG investing presents a unique opportunity to investors, asset managers, and banks in the GCC to offer more “green” Islamic investment products to attract and obtain investment from a broader pool of potential investors that seek to invest in an ESG-compliant manner. Additionally, while “green” investments that tick the boxes of ESG and Shari’a compliance may currently be limited, the rise in innovative structured solutions that allow for exposure to certain ESG investments that would otherwise not be Shari’a compliant are increasingly being used by family offices, regional banks, and institutional investors and could bridge the gap further.

With the GCC’s significant pool of liquidity and the global popularity of ESG investing, the coming years could see an increase in ESG- and Shari’a-compliant products as envisaged by asset managers in the region. However, it should be noted that there is currently no standard that needs to be met before an investment can be labeled or described as ESG-compliant, hence investors will likely conduct their own due diligence on any Shari’a-compliant opportunities claiming to be ESG investments to ensure that such investments do in fact comply with their investment aims and they are not misled by “greenwashing.” Nonetheless, given that the market for Shari’a-compliant ESG investment is still relatively nascent, there is significant potential for growth.

Further, with the appetite for ESG investments increasing in the GCC and with investors and managers becoming more mindful of the opportunity for growth associated with ESG investing, there may be a rise in Shari’a-compliant offerings that align with ESG principles. In this article, we explore both themes and the potential synergies between the two.

Back to Basics: What Is ESG?

ESG investing as per the CFA Institute[i] is an approach to managing assets involving investors explicitly acknowledging such factors in their investment decisions.

There are several ways for investors to engage in ESG investing, including active investing, which involves active engagement through using their voting powers to persuade the entities they have control over to invest solely in ESG-friendly activities and to operate in a manner consistent with ESG policies and trends; and screening, which involves refraining from investing in companies or with asset managers that invest in non-ESG–friendly activities (for example, those engaged with tobacco, gambling, alcohol, or arms sales).

As widely publicized, investor demand for ESG investments has increased significantly in recent years,[ii] resulting in investment managers building sustainability efforts into their investment practices. Further, initiatives such as the Net Zero Asset Managers Initiative,[iii] which brings together an international group of asset managers committed to supporting the goal of net-zero greenhouse gas emissions by 2050 or sooner, are building on this paradigm shift to ESG investing across the globe.

Back to Basics: Islamic-Compliant Investments

Compliance with Shari’a or Islamic law and the principles of Islam rests on certain morals and human and social factors, including guiding principles whereby, for example, wealth must be generated from legitimate trade and asset-based investments; therefore, the concept of using money to make money is forbidden. Lending money with the intention to receive interest (Riba), contracts with excessive uncertainty (Gharar), and certain activities that are deemed harmful (Haram) are also forbidden.

While Shari’a principles are not codified, they guide how an investment needs to be structured to be considered Shari’a compliant or whether an investment can be made at all. Such investments are also dependent on the Shari’a board or advisor that has been appointed to oversee the investment at hand and without whom an investment would not be deemed “compliant.” 

The main areas of Islamic investments include Islamic banking, Islamic funds, Takaful or Islamic insurance, and the sukuk market. While these can all contribute to sustainable development goals, there has been a marked increase in the sukuk and asset management sectors, with a great interest in the development of “Green Sukuk” and Shari’a-compliant structured solutions for investments with conventional asset managers. Such investments have increased in recent years and give some credence to the notion that the coming years will continue to see growth in the GCC, which continues to be one of the largest Islamic financing jurisdictions in the world.

Similarities Between ESG Investing and Islamic Investments in the GCC?

In short, ESG investing and Islamic investments can unite given that they are both concepts guided by principles of morality, transparency, and fairness, hence it is possible for an investment to be both Shari’a and ESG compliant. For example, an ESG investor may screen and eliminate companies that are involved in gambling or alcohol on the basis that such companies do not create a positive social and environmental impact, and similarly a Shari’a-compliant investor would do the same on the basis that such activities are contrary to the principles of Islam (Haram).

However, notwithstanding certain similarities between ESG investing and Islamic investing, it should be noted that it is possible for an investment to qualify as an ESG investment but not be Shari’a compliant and vice versa. For example, an investment in a solar farm project that is highly leveraged may be a sound ESG investment but would not be Shari’a compliant due to the prohibition on Riba. Similarly, a Shari’a-compliant sale-leaseback financing for a coal-powered power plant would likely be Shari’a compliant but would not be appropriate as an ESG investment. Thus, there are limitations on the synergies that can be achieved in this space. With that said, it is worth noting that the relevance and growth of ESG principles in investments more generally has captured the attention of the global business community, particularly during the pandemic years, and the GCC has also taken heed of this. Similarly, Shari’a-compliant investing has also continued to grow, and the markets have witnessed the development of innovative Shari’a-compliant structures that align with ESG principles.

For example, in March 2021 the Islamic Development Bank in the Kingdom of Saudi Arabia issued its US$2.5 billion sustainability sukuk. The addition of a sustainability component to a sukuk offering attracted socially responsible investors who were outside the traditional sukuk fixed-income investor space and encouraged them to seek to diversify their holdings and participate in such offerings. Another clear example of this approach that aligns Islamic investing and sustainability is Kuveyt Türk Katilim Bankasi, a leading Turkish bank majority owned by Kuwait Finance House, which issued US$350 million of fixed-rate resettable sustainability Tier 2 certificates due 2031, and which listed on the Irish stock exchange. These certificates were at the time the world’s first regulatory capital Tier 2 ESG- and Islamic-compliant trust certificates.

Other examples demonstrating the increase in ESG- and Shari’a-compliant investing and policymaking in the GCC include the Dubai Islamic Economy Development Centre, Dubai International Financial Centre, and Dubai Financial Market creating a new focus group in 2020 composed of relevant experts in capital markets and environmental protection with a responsibility for developing “Sustainable Sukuk Standards.” Also, at the G20 Climate Solutions Forum, the Islamic Development Bank made an ambitious commitment that by 2025 at least 35% of its operations will be directed to climate finance, and First Abu Dhabi Bank, which is the largest bank in the United Arab Emirates by assets, issued a Green bond for CHF 200 million in 2021 with a tenor of five years and participated in the US$1.3 trillion Green Sukuk issuance by Saudi Electricity Company. Similarly, international banks have made progress on ESG investing, including Standard Chartered Bank issuing the first Green Islamic loan in the Middle East to DP World in 2018, and Majid Al Futtaim’s listing in May 2019. This was the Middle East’s first benchmark corporate Green Sukuk, valued at US$600 million and with a tenor of 10 years to mark its long-term commitment to support the transition to a low-carbon economy; and in May 2021 signing its inaugural US$1.5 billion (AED 5.51 billion) sustainability-linked loan, a financial instrument secured primarily on ESG-related performance.

What Does the Future Hold?

The strides in ESG investing in recent years exemplifies the prominence that ESG is taking in investment decisions globally as well as regionally, and will continue to take, as we develop a generation that places more value on ESG than its predecessors may have done. Additionally, Shari’a-compliant investments continue to grow despite the challenges faced of late in the global economy.

Nevertheless, as outlined above, the concepts of ESG and Shari’a compliance do not always align and, as such, the types of potential investments available in the GCC and wider afield may be limited, until additional structures and products are developed and/or relaxation takes place in Shari’a compliance tolerance levels themselves. 

Paralegal Samia Mechernene also contributed to this article.