Sustainable Finance and the Goal of Net Zero: what can Islamic finance bring to the table?

The past year has brought a renewed focus on sustainability, both nationally and globally with countries pushing to reduce their reliance on carbon fuel sources and hit their net zero targets. The US Inflation Reduction Act, which is celebrating its first anniversary, has resulted in huge subsidies for renewable and sustainable energy in the US. It has also worried many in the UK renewables sector, particularly given the EU and China’s response by introducing their own green investment policies. How will the UK respond, particularly given the Government’s change of course away from its green commitments?

Whether guided by government or driven by private investment, sustainable finance is playing a key role in working towards net zero. However, it is still in its infancy. We are consistently seeing new initiatives, taskforces, legislation and regulations emerge – it’s new and confusing. How should the financial sector deal with this change?

When looking at sustainability, investors may wish to take inspiration from Islamic finance. This relatively niche area of finance has already adopted key principles of sustainability and has methods that might make the implementation process smoother. At its core are set principles based on Sharia law. These principles dictate what type of investments financiers can fund and how they can generate income. We have set out three principles of Islamic Finance which can help your investments become more sustainable.

Ethical Investments

The first principle is that all finance must be ethical. Under Sharia law, this means it must be for the benefit of society and have an ethical purpose.

Various regulatory bodies, such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Finance Services Board (IFSB), provide standards on ethical investments. Whilst these organisations resemble regulatory bodies that already exist for sustainable finance, Islamic finance takes it one step further. Each transaction has to be approved by a Sharia committee to ensure that the transaction is ethical. If it is compliant, the committee will issue a pronouncement or opinion. Transactions that do not have this sign-off cannot go ahead.

UK banks are implementing sustainable boards. However, they are usually high level, with the focus being on the business rather than scrutinising individual transactions. Case-by-case compliance assessments could lower the risk of issues failing to be identified, with more certainty that the transaction will not be exposed to future sanctions.

This is not to say that the Sharia system is beyond criticism. Many point to the increased complexity of the transaction as a major drawback, due to its impact on time and costs. However, with the increasing scrutiny, perhaps the “burden” is worth bearing.

Sharing and Managing Risk

The second principle is that neither party should be unfairly exploited by the other. Under Sharia law, charging interest (making money from money) is considered exploitation of the customer which is strictly forbidden.

Islamic banks instead make profit from the returns of a successful investment. As returns are not assured, the financier will have to invest in ventures it believes will be successful. This exposes them to higher commercial risk than under conventional finance.

In conventional finance, charging interest provides lenders with confidence, as they are guaranteed payment of the interest and the repayment of the loaned capital. If the borrower defaults, the outstanding amount owed (both interest and capital) will be recovered by the lender enforcing its security. The lender in this case is heavily focused on the borrower’s financial viability to make repayment. The borrower therefore carries a bigger risk whereas, in Islamic finance the risk and desire for a successful investment is shared between the parties.

Sharia principles can also impact what assets an Islamic bank can take security over. This can lead to a smaller set of assets over which to take security when compared to conventional finance. In these circumstances, the Islamic banks have to assess loans more carefully, as they have less to recover from in the event of enforcement.

Unlike financial risks, climate risk is shared by everyone. Islamic finance’s principle of sharing and managing risk could offer a framework for sharing climate risk. Used effectively, this principle could create sensible and sustainable lending, unlike the kind that ultimately led to the 2008 financial crash.

Long-term Planning

The final principle is to focus on the long-term viability of transactions.

Focusing on a customer’s financial viability can create a short-term outlook. The key criterion becomes the customer’s ability to repay, without thinking of the greater impact of the project, both good and bad.

When focusing on long-term viability, the role of the financier is akin to a co-investor, under which the financial viability of the customer and the impact of the project can be equally weighted. This encourages both parties to focus on the long-term impacts of the transaction, which will now include environmental and social impacts.

Comment

With the drive towards Net Zero becoming increasingly urgent, Islamic finance’s attitude to ethics, sharing risk and long-term focus on project viability can offer examples of what a sustainable model for the entire finance industry could look like.

If your business requires advice, please do not hesitate to contact us…