Comparative overview: Shari’a-compliant investing, responsible investment, ESG and sustainable/impact investing
Shari’a screening and responsible investment (RI)
Many investors may have heard of responsible investment (RI), ESG and sustainable or impact investing. Even so, many of them may not have explored what exactly these terms mean. The assumption is often made that adopting RI, ESG or impact investing requires entering new markets or an overhaul of their investment strategy – not realizing that they may (at least partially) already have done this through their existing investment approach and policies. This tends to especially be the case among Muslim investors who already have guidelines in place to ensure that their investments are Shari’a compliant. The following figures compare Shari’a screening to RI.
Figure 1. A comparison between Shari’a-compliant and traditional responsible investment (RI)
Differentiators of Islamic finance
The main difference between Islamic finance and conventional finance lies in the balance sheet assessment process and the exclusion on investing in conventional financial products and services. As the Shari’a contains explicit guidelines on what types of activities and transactions are permissible or impermissible in Islam, most Muslim investors will firstly and primarily be concerned with compliance in these areas. This entails, for instance:
Assessment of capital structure: financial ratio screens are applied to represent the prohibition on excess, uncertainty (gharar) and speculation/gambling (maysir), as explained in the paragraph below.
Income purification: any dividend or income acquired from impermissible activities is paid to charity. This applies in the case that a diversified portfolio or corporation passes as Shari’a compliant according to existing screens, but a small portion of its business is engaged in impermissible activities. Any income from this small portion is to be donated to charity.
Governance: Shari’a compliance is typically overseen by Shari’a (supervisory) boards, consisting of Islamic (legal) scholars who review, determine and certify products/services/transactions to be Shari’a-compliant or non-Shari’a-compliant. Shari’a boards exist on the organizational, national (e.g. National Shari’a Board – Indonesian Council of Ulama) and international levels (e.g. Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)).
Ethical basis for financial ratio screens
In some areas, Shari’a screening arguably treads beyond conventional RI through its additional exclusion on conventional finance and addition of capital structure assessment. These screens can be traced back to ethical principles:
Total debt/asset ratio < 33%: avoidance of excess and uncertainty involved in investing in over-leveraged firms
Account receivables < 45%: avoidance of excess and uncertainty involved in investing in over-leveraged firms
Conventional financial products/services and riba (interest): avoidance of conducting exploitative transactions
Significant overlap with areas for improvement
The ethical and social considerations that form the basis of Shari’a screening clearly overlaps with the conscientiousness that RI promotes and requires among investors. In fact, Shari’a-compliant investing is generally considered a form of SRI (socially responsible investing). There is, however, room for improvement when it comes to environmental considerations. Negative screens based on environmental considerations are, however, relatively less common among Muslim (faith-based) or Shari’a-compliant investors. Indeed, this may be because environmental considerations have not been explicitly imposed on financial industry participants by existing Shari’a guidelines. However, regional regulatory trends and rising global awareness and demand for environmentally sustainable products will ultimately require that the Islamic financial industry “greens” itself. Whether this will be achieved through a parallel, “secular” regulatory framework (e.g. minimum standards based on country or regional policy) or an Islamic jurisprudential framework that incorporates environmental welfare into Islamic law or ethics is still to be seen. One thing is, however, undeniable – Islamic scholars and Shari’a advisory boards have the potential to play an important and valuable role in this shift. Throughout the past half century, Islamic legal scholars and infrastructures (such as Shari’a advisory boards) have been instrumental in ensuring that the prohibition on interest-based finance is adhered to and maintained within the Islamic financial industry. In a similar manner, existing infrastructures can ensure that “greener” or more (socially and environmentally) responsible financial practices become a lasting industry practice.
Shari’a-compliant investing and ESG investing
ESG takes RI one step further. While RI incorporates exclusions and policies that are meant to avoid causing social and environmental harm, ESG includes additional tools for actively monitoring, managing and minimizing (the risk of causing) harm. This is done through, for instance, voting at shareholder meetings and engaging with portfolio companies or managers on ethical, social and environmental issues.
Engagement
Engagement is an integral part of ESG investing. It is based on the recognition that positive change cannot only be achieved by divesting or avoiding harm. Rather, change also requires harm-doers to change – especially when it concerns large companies that dominate a certain sector or market. As such, to engage with investees on important ethical, social and environmental issues (through, for instance, (proxy) voting), is to make an effort toward minimizing harm and creating positive change. Once engagement does not deliver sufficient results within a given timeframe, or there is insufficient prospect for an investee to change its ways, an investor should consider divesting.
Figure 2. A comparison between Shari’a-compliant and conventional investment approaches
Areas for alignment
While Islamic finance has some overlap with conventional RI – in terms of tools/policies as well as ethical foundations – ESG integration, shareholder engagement and active ownership are still relatively rare. As previously mentioned, there is particularly room for improvement when it comes to incorporating environmental considerations into sourcing, screening, selection and risk management processes.
Having said that, ESG integration should not be particularly hard to do or to sell among Muslim investors. The concept of avoiding environmental harm is aligned with, and even encouraged, in Islamic teachings and tradition as well as. Shari’a. Furthermore, active ownership is inherent to Islamic economic philosophy, which promotes shareholder engagement and partnerships (through, for instance, a preference for equity investments). It furthermore discourages passivity and earning profits in a manner that causes injustice onto others. Not only must income be gained from halal activities – it must also be tayyeb (good).
In order to move from a “halal” approach to a “tayyeb” approach, Muslim investors will need to:
Apply ESG integration and screens to the existing universe of Shari’a-compliant investment opportunities
Assess the impact this will have on deal flow and financial return
Shari’a-compliant investing and sustainable/impact investing
Impact investing takes RI and ESG even further and has been increasingly growing over the past decade. The Global Impact Investing Network (GIIN) defines impact investing as follows:
“Impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.”[1]
The GIIN goes on to describe:
“Impact investments can be made in both emerging and developed markets, and target a range of returns from below market to market rate, depending on investors' strategic goals.
The growing impact investment market provides capital to address the world’s most pressing challenges in sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services including housing, healthcare, and education.”[2]
Some arguments for impact investing include:
The world has reached a point where merely avoiding harm is no longer sufficient to prevent the dire consequences of existential challenges (such as climate change, environmental degradation and growing inequality) from manifesting
It is possible to do without compromising financial returns, and offers a viable, alternative economic philosophy resulting in a more sustainable financial system
There is a real, financial risk associated with continuing to allow sustainability challenges remain unaddressed and conducting “business as usual” (e.g. rising sea levels caused by climate change will pose risk to assets in real estate, and impoverishment caused by environmental degradation will make humanitarian conflicts more frequent and likely to occur)
In order to do impact investing, the tools, policies and processes for RI and ESG must first be in place. These are subsequently built upon by defining which problems an investor wants to contribute to solving, what impacts or positive change to target, adding positive screens and implementing impact measurement and monitoring processes. The figure below gives a brief overview of what tools are typically in place in an impact investment strategy compared to other approaches to investing.
For a Shari’a-compliant investment strategy, moving into impact investing will typically first require ESG integration.
Figure 3. A comparison between Shari’a-compliant and conventional investment, including impact investing
Common assumptions and obstacles to industry growth
Investors who have not yet fully explored the option of impact investing often harbor a number of reservations. These typically include (mis)perceptions such as:
Impact investing requires an overhaul of existing investment strategies in terms of, for instance, sourcing, due diligence and selection
Impact investments are necessarily concessionary or philanthropic
There is not sufficient deal flow
Often, these beliefs unnecessarily hamper the growth of the impact investment industry. Various institutional asset owners and asset managers, such as Church Commissioners for England, Dutch pension fund PGGM, and even traditional houses the likes of Bain Capital have started to adopt impact strategies and committed to promoting and growing the impact investment industry. While it is true that the market of institutional quality impact investments is still relatively nascent, growth requires sufficient demand for impact investing from investors. Given the increasingly supportive regulatory environment and that there is hardly a way around the fact that a solutions-oriented approach to finance is necessary (for the planet and humanity’s survival, and hence, the sustainability of financial returns), the impact investing movement is currently experiencing tail wind, and is anticipated to experience more tail wind in the future.
Nonetheless, some obstacles still need to be overcome in order for a larger-scale shift from traditional finance, RI or ESG into impact investing. The table below briefly lists a few common examples and what is necessary to overcome them.
Figure 4. Obstacles to move into Shari’a-compliant impact investing versus conventional impact investing
Differentiators of Islamic finance
The above-listed obstacles are discussed in another post. However, there are a few differentiators worth mentioning, which set Shari’a-compliant impact investing apart from conventional impact investing. These include:
Governance: the governance structure and auditing and compliance processes will differ for Shari’a-compliant investors. The extent to which these will be different may depend on whether the impact investing movement will be driven from within the Islamic finance industry or from external markets and regulatory trends. In the case of the latter, the issue of Shari’a compliance may be addressed on a case-by-case basis – i.e. an investor would have to review whether a prospective investee that markets itself as impact in the conventional financial market is Shari’a-compliant (in terms of not only the usual Shari’a screens applied, but also in terms of whether its impact goals are aligned with the Shari’a). In this case, there would be no impact investing, but merely a more elaborate form of Shari’a-compliant, responsible investment, and investors would arguably once again be playing “catch-up” with conventional finance.
If, however, impact investing, along with its requirement of “intentionality”, is going to come from within the Islamic financial industry, the jurisprudential basis and framework for this will need to be addressed. This requires answering questions such as:
What would be the Islamic basis for impact investing?
How should “impact” be defined or how can/should “impact” be viewed through an Islamic lens? In other words, what is desirable and what do “sustainability”, “development” mean in Islam?
How can one ensure that impact targets as well as the intention behind impact investing is aligned with the Shari’a?
How do existing impact frameworks or goals (such as the Sustainable Development Goals) fit in Islamic philosophy and the Shari’a?
Questions such as these will ultimately shape an Shari’a-complaint investor’s impact investment framework.
Impact measurement: impact is measured against an investor’s impact goals and impact framework. As such, for the Shari’a-compliant investor, this will be shaped by the answers to the aforementioned questions.
Cultural awareness: Most Shari’a-compliant investors are based in Muslim majority regions. As such, the demand for impact investing relies on the demand and cultural awareness for impact and sustainable development in these regions or among senior leadership figure heads at Islamic investing institutions. So far, the focus of the Islamic financial industry has largely been on Shari’a compliance and negative screening. Relative to institutional investors as well as the general public in the Global North, the cultural awareness for sustainable development still needs to be substantially raised.
Deal flow: it is true that Shari’a-compliant investors have more filters to apply in sourcing and selecting their potential investees. It is fair to ask whether there are enough institutional quality impact investment opportunities that are also Shari’a compliant. This should, however, not be a deterrent. As long as demand does not grow, neither will supply. Investors can start contributing towards growing the Shari’a-compliant sustainable/ESG and impact investment market by, for instance, engaging with their fiduciary intermediaries (e.g. banks, advisors and managers) to express their demand and push the industry toward creating sustainable and impact investment products.
[1] The Global Impact Investing Network (GIIN). What is impact investing? Available at: https://thegiin.org/impact-investing/need-to-know/ (Accessed: September 28, 2021).
[2] Ibid.
Further readings
Global Impact Investing Network (GIIN). What is impact investing? Available at: https://thegiin.org/impact-investing/need-to-know/ (Accessed: September 28, 2021)
CFA Institute and Principles for Responsible Investment (PRI). (2019). ESG Integration and Islamic Finance: Complementary Investment Approaches. Available at: https://www.unpri.org/download?ac=957 (Accessed: September 30, 2021)
