Exploring the Intersection and Distinctions: ESG vs. Islamic Finance Investing

According to the United Nations Agenda 2030 guidelines, the Islamic transaction (muamalat) principle aims to create a shared sustainable future for workers, customers, shareholders, and the community. Similarly, the Sustainable Development Goals (SDGs) are designed to unite all nations in the fight against all forms of poverty, inequality, and climate change, as well as to advance human rights and good corporate governance.

There are clear interlinkages between the 17 SDGs and the maqasid-al-Shariah (objectives of Shariah) in that they look to advance global sustainability and resilience, as well as to create a better community and address economic, social, and environmental effects. There are many commonalities between sustainable or responsible investing and Islamic finance; for example, avoiding injury is a core concept they both adhere to. But does this overlap mean these two financial disciplines might converge, as some have suggested? It is a fascinating idea because it might allow Islamic finance companies access to a sizable and quickly expanding worldwide market if Islamic finance products could be easily certified as “ESG compliant”.

Islamic Finance (IF) tenets resemble those of responsible investing, also known as Environmental, Social, and Governance (ESG) investing, in many ways. In theory, IF products like Shariah-compliant Sukuk bonds or "Waqf" (also known as endowment) funds could enter the portfolios of ESG-hungry investors worldwide thanks to a market convergence, giving Islamic banking institutions a growing share of what is expected to become one of the largest, and possibly the dominant, investment sectors of the future. That such a confluence has not yet occurred does not preclude its possibility. 
But first, it may be necessary for IF experts and ESG investors to acknowledge both the contrasts and the commonalities between the two investment philosophies. They must recognize that these are still distinct markets where certification, the range of indicators, and underlying mindsets have not yet converged.

Some Core Differences

The prohibition on interest, security lending, and short selling is well-known in Shariah-based investing, except for Shariah-compliant securities borrowing and lending. This exception is significant as it allows for liquidity and risk management within Islamic financial practices, aligning with Shariah principles while providing flexibility in investment strategies. In this framework, transactions are structured to avoid the payment or receipt of interest and ensure that the securities involved are Shariah-compliant. Additionally, there are stringent restrictions in dealing with businesses related to specific sectors and products, such as cigarettes, alcohol and breweries, guns and munitions, and non-halal products.

Like responsible investors, Shariah investors often employ a harmful screening method, avoiding sectors on their exclusions list, thereby adhering to ethical and religious guidelines.

ESG investment involves a combination of positive and negative screening approaches to make informed decisions. Positive screening is used to identify top-performing businesses that set an example by selling environmentally friendly products and adhering to ethical business practices. Negative screening, conversely, is used to exclude companies that engage in activities that are harmful to the environment or society. These two screening methods, amongst others, form the core of ESG research, which delves into intricate and multifaceted issues. This in-depth analysis encompasses various factors, from environmental sustainability and social responsibility to corporate governance and ethical conduct. By evaluating these complex, interrelated issues, ESG research aims to identify investments that are not only financially sound but also sustainable and socially responsible, thereby reducing risks and enhancing long-term profitability.

Industry Developments

The shift towards sustainable and Shariah-compliant investments in the ASEAN region, particularly in Malaysia, is underscored by the robust growth in Islamic sustainability funds and Socially Responsible Investing (SRI). By the end of 2020, Islamic sustainability funds amounted to $542 million. Further emphasizing this trend, as of December 2021, there were 34 SRI funds in Malaysia with a combined net asset value of RM5 billion. This growing interest aligns with a global recognition of the overlap between Environmental, Social, and Governance (ESG) investing and Islamic finance, fuelling the appetite for Shariah-compliant investments as a means for greater portfolio diversification and an alternative to more traditional ESG investments. The global Islamic finance industry, with total assets of US$3.06 trillion, is set to significantly contribute towards funding the UN Sustainable Development Goals.

In 2021, Malaysia emerged as a leader in Shariah-compliant assets in the Asia Pacific, constituting 92% of the overall Islamic assets under management (AUM) in the region and 23% of Malaysia's total mutual fund AUM. The growth of ASEAN sustainable bonds and sukuk, increased investment focus on sectors like energy, green buildings, and transportation, and the growing issuance of sustainability-themed products have further propelled this market. 
To ensure Shariah-compliant investing, two layers of screening are typically applied: business activity (sector screening) and financial screening. Sector-based Shariah exclusions include revenues from sales of alcohol, pork, tobacco, gambling, pornography, conventional financial services, conventional insurance, and trading of gold and silver on a deferred cash basis.

Bursa Malaysia, in collaboration with FTSE Russell, has introduced several indices in response to these market dynamics. The FTSE4Good Bursa Malaysia Shariah Index (F4GBMS), launched in July 2021, tracks Shariah-compliant constituents of the F4GBM Index, supporting investors in making ESG investments in Malaysian listed companies and encouraging best practice disclosure for a lower carbon and more sustainable economy. Other indices include the FTSE Bursa Malaysia EMAS Shariah Index, a broad benchmark for Shariah-compliant investors; the FTSE Bursa Malaysia Hijrah Shariah Index, comprising companies in the FBM EMAS Index that meets international Shariah screening requirements; and the FTSE Bursa Malaysia Top 100 ESG Low Carbon Select Shariah Index, consisting of all Shariah-compliant constituents of the FTSE Bursa Malaysia Top 100 ESG Low Carbon Select Index.

The FTSE Bursa Malaysia Index series, covering all stock sizes in the market, offers a comprehensive range of indices for creating various investment products such as ETFs, derivatives, structured products, and index-tracking funds. The F4GBM Index measures the performance of publicly listed companies (PLCs) with strong ESG practices, requiring an FTSE Russell ESG Rating of 2.9 or higher and additional screens against involvement in tobacco, weapons, or controversy. 
The F4GBMS index, which comprises 77 constituents as of June 2023, undergoes a semi-annual review in June and December. This index recognizes publicly listed companies that have taken steps to improve their ESG practices and disclosures and cater to the growing appetite for Sharia-compliant investment tools in the region.

Data indicates a significant shift in investor appetite for sustainable and Shariah-compliant investments in Malaysia. The convergence between ESG and Islamic investing has led to a new dimension for local fund managers, who can now embed Shariah principles into an ESG index with the F4GBMS. As a result, fund managers can develop new investment products comprising portfolios of Shariah-compliant equities guided by sustainable investing principles.

Apart from the F4GBMS, Bursa Malaysia offers other Shariah-compliant indices, highlighting its commitment to meeting the market's needs and expanding its index offerings. These include the FTSE Bursa Malaysia EMAS Shariah Index, FTSE Bursa Malaysia Hijrah Shariah Index, and FTSE Bursa Malaysia Top 100 Low Carbon Select Shariah Index. These indices provide investors with additional options to align their investments with Shariah principles and sustainable practices.

The Maybank Global Sustainable Equity-i Fund, the first actively managed Shariah-compliant ESG fund that invests in both Shariah-compliant and sustainable businesses in the global markets, was recently introduced by Maybank Asset Management Sdn Bhd (MAM Malaysia) in response to these trends. The fund's investment adviser is Schroders Investment Management (Singapore) Ltd.

Although the fund is not the first in Malaysia to integrate Shariah-compliant investing with ESG considerations, it is one of the few actively managed funds that does so.

Measuring Shariah-Compliant Investing and ESG for a More Coordinated Effort

Islamic finance employs standards including shared compensation, reliance on legitimate underlying assets, avoidance of “pure financial transactions,” accountability, transparency, and the exclusion of particular goods and services. It is a technique intended to guarantee the security and sustainability of the investment by accepted Islamic values. It can be viewed as an all-investor-recognizable, long-term, low-volatility risk reduction technique. A wide range of impact measurements used in ESG investing has a similar focus on long-term risk reduction and is also intended to minimize harm. The ESG approach, however, is more comprehensive and includes social scores such as gender and diversity, human rights, labor standards, and environmental scores to measure and control carbon emissions, pollution, waste, and biodiversity.

ESG's governance component includes political lobbying, pay, supervision and responsibility, and transparency. The ESG investment proposition does not yet have a universal definition or "taxonomy." However, recognized standards are emerging (such as the Global Reporting Initiative (GRI) standards or the EU's Taxonomy Regulation). There is a contender that almost offers a complete framework for ESG investments: the International Sustainability Standards Board (ISSB). However, it is important to note that although the ISSB is a significant advancement, there is still a long way to go before a comprehensive and universally accepted standard can be achieved.

The intersection of IF and ESG investing is increasingly apparent, as both domains share a fundamental commitment to ethical and responsible investing. Both IF and ESG investing prioritize financially viable investments that align with broader moral, environmental, and social values. Islamic Finance, with its strict adherence to Shariah principles, inherently incorporates elements of ethical investing by avoiding investments in activities harmful to society and the environment, such as those involving alcohol, tobacco, and gambling. Similarly, ESG investing focuses on companies that demonstrate strong performance in environmental stewardship, social responsibility, and ethical governance.

Despite these similarities, there are distinct theoretical and practical differences between IF and ESG investing. Islamic Finance is rooted in religious doctrine and has specific prohibitions, such as the ban on interest (riba) and excessive uncertainty (gharar). At the same time, ESG investing is more secular and focuses broadly on sustainability and ethical impact. To bridge these two worlds effectively, finance professionals must understand these nuances. By doing so, they can develop a comprehensive ESG/IF investment proposition that leverages the strengths of both approaches. This synergy can offer a powerful and appealing option for investors seeking financial returns while adhering to high ethical and sustainable standards. Thus, the convergence of IF and ESG investing presents a unique opportunity to cater to a growing market of investors who seek to align their financial goals with their values.