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ESG Finance and Islamic Finance | K&L Gates LLP

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[co-author: Dominic Hewitt]

This memo originally appeared on Practical Law. It examines how Islamic finance adopts environmental, social and governance (ESG) standards to produce hybrid Sharia-compliant ESG products. In particular, it defines the main characteristics of green sukuk.

Scope of this note

Financial institutions are increasingly interested in the environmental and social impact of their investments and business practices, and investors, banks and companies compliant with Islamic law or Sharia are no exception. Finance related to ESG and sustainability has become one of the fastest growing sectors. Likewise, we have also witnessed the enormous growth of Islamic-compliant finance which has channeled trillions of dollars into investment projects and financing under Islamic principles.

This note examines how Shariah-compliant financial transactions can be combined with ESG principles to create green, social and sustainability-related Islamic financial instruments and examines the particular issues that might arise when combining these two different regimes, even if they overlap. It explores the outline of each type of financing and looks for the similarities and disparities between them.

Sharia-Compliant ESG Finance

Islamic finance and ESG finance are based on fundamental principles of ethics and morality; therefore, it can be expected that there is significant overlap between the financial instruments provided by each form of financing. Of course, there are similarities.

Islamic law does not have an exhaustive list of what finance is and is not Sharia compliant. However, there are a number of principles that will guide a potential investor seeking to comply with Islamic principles.

These include:

  • Riba: Under Islamic law, interest-backed transactions are prohibited because the risk and reward of any transaction must be shared between the parties, rather than there being a disparity.
  • Butir: All forms of speculation or gambling are prohibited under Sharia principles. Therefore, financial institutions cannot be involved in transactions where ownership of the asset depends on an uncertain future event.
  • Gharar: Islamic finance prohibits participation in contracts involving excessive risk or uncertainty. Therefore, short selling and other derivative transactions are prohibited.
  • Sharing of profits or losses: When parties enter into contracts, the profits, losses and risks associated with the transaction are shared, which means that neither party can bear all the advantages or disadvantages of a transaction.
  • Societal benefit: The investment should also have social and ethical benefit to society at large beyond mere return. However, this principle has (in the opinion of some commentators) been weakened in recent years, because the overall impact of, for example, a construction project on workers or the environment has not been sufficiently factored into some otherwise Shariah-compliant transactions.
  • Material purpose: This means that there must be an underlying tangibility in the transaction.

Many of these ethical and religious constraints, particularly the emphasis on risk sharing; prohibition of speculation, gambling and excessive risk; and the requirement of a societal benefit, facilitate the integration of Shariah-compliant transactions into the social and sustainability aspects of ESG.

Strict disclosure of product use and external regulation by expert Islamic law advice means rules governing Shariah-compliant transactions are strict enough to ensure they don’t pretend to be what they don’t. are not. However, there are ways they differ due to their structure and requirements. For a potential investor looking for ESG compliance combined with financing in line with Islamic principles, green sukuks are the only model of this type of financing that has so far gained traction.

Islamic finance has developed a practice of negative screening, excluding certain sectors, industries or financing structures. ESG finance has adopted a more positive selection framework, through which improving ESG performance is a key objective of structures.

As practiced in an Islamic financial transaction, ESG transactions will use external experts to judge the compliance of a proposed transaction, as maintaining oversight is a crucial part of the governance side of any ESG transaction. This element of governance is easily achieved through Islamic finance as good governance has been placed as a key part of any transaction to ensure that all principles are adhered to. Islamic financial institutions have achieved this by using Sharia advisors and scholars who will sit and advise with as much weight as the board in decision-making. This can be used as an easy model for adapting to ESG, as employing ESG advisors and creating oversight committees that can review and oversee all transactions will ensure adherence to ESG principles. Arguably, Sharia councils have traditionally been involved at the instigation of a transaction rather than playing a permanent role. In these cases, a change of approach would be needed to involve academics in an ongoing monitoring role.

On the other hand, Islamic finance and ESG requirements, although similar, present two different sets of rules for a transaction to follow. Islamic finance will ensure compliance with Sharia principles, which certainly contributes to a good overall ESG position. Nevertheless, ESG rules will push the societal benefit of a transaction further because while Islamic finance says that any transaction must be accompanied by a societal benefit, ESG says where, when and how this benefit must be achieved. Some Islamic scholars will also need training on ESG financial standards in order to be able to validate their achievement.

ESG finance rules and Sharia principles lend themselves to the now stylized financing of green sukuk. It is a combination of traditional Islamic sukuk financing with the green requirements of green project financing. This form of financing allows the parties to predefine all aspects of the transaction, guaranteeing certainty and allowing Riba to be avoided, while also allowing the full scope of the project to be understood and therefore allowing itself to be properly analyzed. in the style of ESG Rules.

Gulf states like Saudi Arabia and the United Arab Emirates (UAE) have announced ambitious plans to increase their clean energy production over the next decade. These projects will require vast sums of funding and the green sukuk may well provide the best route for these projects to be undertaken. As the world looks to COP 27 in Egypt and COP 28 in the United Arab Emirates for the next round of global solutions to the climate crisis, the spotlight will be on the Middle East and the wider Islamic world. Green sukuk and the intersection between Islamic finance and ESG can provide the very thing needed to move this region to the forefront of global sustainable investing.

To date, green sukuks have been the dominant financing structures that have sought to combine Shariah and ESG principles.

Green Sukuk

Generally, green sukuk adhere to the same green principles as green bonds. They are issued in the same way as a non-green sukuk but with the following additional elements:

  • Green frame: Green frameworks generally align with recognized standards, such as the Green Bond Principles published by the International Capital Market Association, and include four components: the use of products, the project evaluation and selection process, the product management and reporting.
  • Second opinion: An independent review of the green framework of the proposed green sukuk issuance is generally required. This is to confirm alignment with components of the relevant standards. This can be given by the Shariah board or another board made up of ESG experts.
  • Impact report: Reports on the progress of projects and underlying assets are considered a key element.

Green sukuk issuances that have taken place have been underpinned by existing global standards and aligned with a framework established or adopted by the issuer. These include the sustainable finance framework introduced by the Islamic Development Bank (IDB), the first AAA-rated institution to issue green sukuk. These additional requirements are in addition to those involved in issuing sukuk. Although additional requirements have financial implications, market demand for green sukuk indicates that there is a significant market for such instruments.

The Sustainable Finance Framework contains a commitment to the United Nations Sustainable Development Goals (SDGs) and the IsDB states that it strives to integrate ESG criteria into its investment process.

With the first issuances of green sukuk and sustainable sukuk in 2019 and 2020 respectively, the IsDB has been involved in the evolution of Islamic capital markets, raising the profile of sukuk as financial instruments that can contribute to a sustainable recovery after the COVID-19 pandemic. This was exemplified by the IDB’s Sustainability Sukuk. The proceeds were exclusively earmarked for IDB projects under “SDG-3: Good Health and Wellbeing” and “SDG-8: Decent Work and Economic Growth”.

Further development of green sukuk may require dedicated, Islamic-compliant ESG guidelines and risk management frameworks. An example in conventional markets is the Equator Principles. These principles form a risk management framework adopted by financial institutions to identify, assess and manage environmental and social risks in projects.

The challenge of climate change and the growth of the Islamic finance industry, as well as the increase in socially responsible investing, could position green sukuk as a key instrument to finance clean energy and infrastructure projects. resilient as well as short-term energy efficiency projects. Expanding a green sukuk market could promote environmentally friendly projects and help Islamic finance achieve its moral goals.

Funding of Sharia-compliant ESG projects more generally

Islamic compliant structures other than sukuk can be used for project financing. There is currently not much evidence that these other techniques are used without green sukuk packaging in an explicitly ESG context (e.g. to finance eco-friendly energy projects, social housing or development projects) . However, they may very well occur without the ESG badge being explicitly applied to them. Islamic finance is used to combining with conventional financing techniques to finance projects. There is no reason why such combinations with ESG principles and techniques should not evolve and succeed.