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2020: the year sustainable Islamic finance scales?

Islamic finance has enormous potential to align investors with crucial funding of the Sustainable Development Goals in the Arab region, argue Eric Usher and Dr. Daouda Ndiaye

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The Islamic finance sector is booming. From a market of just $200bn in 2003, the sector is expected to grow to over $4trn in assets by 2030. Much of these funds originate in the majority Islamic countries in the Arab region, yet the investments are global in scope and impact. 

As Islamic finance continues to expand in the next decade across regions and asset classes, there is a unique window of opportunity to align elements of these investments with the UN Sustainable Development Goals (SDGs). 

All permissible Islamic financial products generally share four main features: they are asset-backed, ethical, share risks equitably and are subject to good governance. These characteristics mean that Islamic finance is well suited to alignment with the SDGs.

Islamic finance is defined by the implementation of principles of shariah, Islamic law derived from the Quran, the hadith and other founding elements of Islam. Islamic finance transactions must adhere to religiously permissible investment categories (halāl) and abstain from prohibited investment themes (harām). 

Halāl encompasses everything that is good for the community and does not cause harm, whereas the term harām encompasses everything that may lead to harm and have negative impacts on the community. All permissible Islamic financial products generally share four main features: they are asset-backed, ethical, share risks equitably and are subject to good governance. These characteristics mean that Islamic finance is well suited to alignment with the SDGs.

All Islamic finance products are contract-based, making them a natural fit for institutional investors committed to positive impact. Islamic finance contracts and associated structured products aim to reduce the risk of asymmetric information and moral hazard and guarantee investment terms are protected in conformity with Islamic legal principles. 

Islamic contracts fall into three broad categories: trade-oriented transactions (debt-like instruments), equity (profit-and-loss-sharing) and support contracts. Each of these categories creates an opportunity for new sustainability-oriented products. With the UN Secretary General’s Decade of Action on the SDGs now underway, it is time to leverage the stability and availability of Islamic finance to achieve more.

Globally, Malaysia, Saudi Arabia and Luxembourg lead the Islamic finance and fund product industry, with the UK a growing player across key Islamic finance asset classes. Sovereign wealth funds, pension funds, and high net worth individuals in the Arab region will all be key players in the shift towards more sustainable SDG-aligned Islamic finance. 

Within the international development bank community, the Islamic Development Bank Group (IsDB), with 57 member countries, is the only lender fully compliant with Islamic financing principles. The IsDB Group’s Sustainable Finance Framework, published in November 2019 provides a model for other multilateral banks seeking to align Islamic finance with the SDGs across their lending portfolios.

One of the most promising areas for Islamic finance to synchronise with the SDGs is on climate action. As green Islamic finance instruments become more widely available, Organization of Islamic Cooperation (OIC) countries could become an exporter of SDG-aligned investment products across markets, supporting positive change in the most climate stressed parts of the world. 

Sovereign wealth funds, pension funds, and high net worth individuals in the Arab region will all be key players in the shift towards more sustainable SDG-aligned Islamic finance.

The Global Islamic Finance and Impact Investing Platform (GIFIIP) Green Sukuk Initiative has already piloted domestic green sukuk in Jordan. Indonesia has already issued the world’s first sovereign green bond, and more Islamic countries are lining up to take advantage of a booming green sukuk market and demand for these fixed income instruments.

Islamic finance has enormous potential to align investment with SDG financing for the Arab region and globally. Global investors are well placed to support the trend towards sustainable Islamic finance by learning more about the system and creating new products and deal flow to support growing capital allocations towards the SDGs.

How to align Islamic finance with SDGs in the 2020s

Islam’s promotion of social trust, cooperation and solidarity means that Islamic finance products are well suited to SDG impact. In order to be successful as a channel for SDG financing, Islamic financial institutions should focus on opportunity areas in 2020 to:

  1. Align towards global standards for impact measurement and reporting in line with Islamic finance principles. 

The GIFIIP has begun to do this and seeks to position impact investing as a core enabler of SDG implementation. This year, policymakers, asset managers, and local investors in the Arab region must come together to ensure SDG impact metrics and reporting are agreed upon that are both sharia compliant and  in line with international standards. This will be required to open up global investment opportunities and co-investing financial structures to scale SDG impact.

  1. Boost SDG deal-sourcing and matchmaking for global Islamic finance players. 

In order for the trillions of dollars managed as Islamic finance to better support the SDGs, leaders must develop a range of shariah-compliant impact investing tools and financial instruments that are attractive for large investors. In addition, there is a related need to improve the access of impact enterprises to Islamic funding. In April 2018, IsDB launched a $500m Transform Fund, to provide seed money for start-ups and SMEs, but many more such funds and structures will be required to deploy more Islamic finance in support of SDG themes.

  1. Make SDG-compliant Zakāt investments the norm. 

Zakāt is a 2.5 percent mandatory welfare tax, payable by all Muslims who have wealth above nisab, a threshold or exemption limit. It is a cash contribution to the poor that encourages cooperation, fair dealings, transparency and spending on others. Annual Zakat contributions amount to around $1trn across the Islamic world, representing an important source of SDG finance. In Indonesia, the UNDP has already partnered with the national Zakat collection body, BAZNAs, to channel Zakat funds to local SDG projects. These include renewable energy projects in underserved communities. In Palestine, Zakat funds support SMEs through Islamic microfinance structures.

  1. Create a deal flow of pro-poor initiatives to attract investment from the public and private sector stakeholders. 

Resource mobilisation initiatives need to be conducted to target pro-poor initiatives that work. This is especially important for impact investment funds where the definition of ‘success’ on the basis of the theory of change, the indicators that will be measured and how the data will be collected need to be clearly defined and agreed. This will require the development of tools, including GHG accounting or climate risks screening tools, which could support the measurement of SDG13 impact indicators, for instance. IsDB need to develop a pipeline of SDG projects especially, pro-poor programmes where the success indicators can be easily determined and measured. 

  1. Differentiate and communicate how Islamic finance principles and values are key success factors.

SDG projects can be financed by Islamic finance or conventional finance. So why should it be structured in a Shariah compliant manner? If IsDB would like to mobilise resources beyond the Muslim demographic, it should be able to differentiate and communicate how mobilising funds through shariah compliant structures is a key success factor. For example, under the Youth Employment Support (YES) programme, IsDB pioneered venture capital financing (Restricted Mudaraba) for micro and small businesses operated by youth. Through risk-sharing, the Restricted Mudaraba financing facilitated financing to youth micro and small businesses. 

  1. Comply and fulfil Shariah – achieving the SDGs through economic empowerment for poverty alleviation and reduction of climate vulnerability. 

Through the scaling of the ‘smart microfinance’ concept, a new generation of Islamic finance institutions could not only provide a range of products to accompany vulnerable communities in SDG-aligned projects through economic empowerment, but will also ensure these communities are adequately equipped and empowered by strengthening their technical and managerial capacities, identifying and addressing climate risks in their activities, accessing markets, building partnerships, etc. In Tunisia, IsDB has invested in Zitouna Tamkeen, a unique microfinance institution with an innovative approach to achieve socio-economic impact objectives by funding economic empowerment projects with high potential value chains and calibrating the intervention points in order to reach the greatest number of beneficiaries. The same approach may be used to build resilience at the local level and address climate vulnerabilities through customized projects. To build on this successful experience and scale it up to reach more communities in its member countries, IsDB has established a dedicated Department of Economic Empowerment. 

7. Normalise Islamic Finance, which is still currently viewed as an unconventional source of funding in many developing economies in the Muslim World, in addition to low levels of awareness and knowledge of its principles. This calls for the development of innovative Islamic finance products and services that target specific SDG needs and development plans in countries including those related to climate action and the environment, which will help scale-up for the use of Islamic Finance and raising awareness on the principles of Islamic banking.  



Eric Usher is Head of the UN Environment Programme’s Finance Initiative, and Dr Daouda Ndiaye is Lead Climate Adaptation Specialist at the Climate Change Division of the  Islamic Development Bank

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