At the heart of Islamic law (Shari’a law) lies the spirit of the pursuit of excellence, known as ‘tahsinyat’. Islamic finance is ethical finance that is governed by Islamic law. From a financing perspective, excellence is in the social benefit of the investment project. The values of Islamic finance are deeply rooted in ethical, environmental and social excellence.
The central economic tenant of Islam is to develop a prosperous, just and egalitarian economic and social structure in which all members of society irrespective of their beliefs and religious affiliations could maximise their intellectual capacity, preserve and promote their wealth, and actively contribute to the economic and social development of society. Economic development and growth, along with social justice, are the foundational elements of an Islamic economic system. With these principles at its core, it is surprising that socially responsible investment is a relatively new development in Islamic finance.
ETHICS AND SOCIAL RETURNS
Islamic finance and socially responsible investment (SRI) have been two of the most rapidly growing areas of finance over the last two decades. During this period, they have each grown at rates that far exceed that of the financial markets as a whole. A recent report by the World Bank believes that a SRI Shari’a-compliant product can bridge the gap between conventional and Islamic finance. The World Bank report cites that some have estimated that the total volume of assets held by explicitly SRI investors now exceeds US$3 trillion, having increased by more than 30% since 2005. SRI has grown at a comparable rate in Europe, with estimates that Euros 5 trillion of assets in Europe are subject to some kind of socially responsible mandate.
The common ground for both Islamic finance and SRI investments is that Islamic and SRI investors have compatible ethics and a desire for the promotion of social welfare activities. Although both types of investors seek to achieve a strong return on their investments, they take into account not only the pure economic return, but also the social returns the society receives from their money being used in compliance with their beliefs.
According to the World Bank, Islamic finance and SRI share another similarity as well. To date, they both have been focused, within the capital markets sphere, more on equity than on fixed-income investments. The fundamental principles behind Islamic finance, such as an emphasis on equitable sharing of risks and the prohibition of interest-based financing, are most easily compatible with investing in equities. Likewise, SRI traditionally has been a strategy applied mainly to equity investing through the application of various types of portfolio screening techniques. As a result, financial intermediaries have found it easier and more straightforward to create Shari’a-compliant and SRI equity products than fixed-income ones.
With equity products having been well-established, practitioners of both Islamic finance and SRI are increasingly turning their attention to developing the fixed-income side of the capital markets. This convergence of interest in fixed income creates a clear opportunity. Given their similar histories and similar focus on ethics, it should be possible to create fixed-income products that meet the needs and demands of both types of investors. Such products could then become a useful bridge to connect the conventional and Islamic markets.
SRI SUKUK
The Securities Commission Malaysia recently took the initiative to incorporate SRI into its regulatory framework. This is as a result of successful green bonds that have been issued by the likes of the World Bank and the discussion about issuance of green Islamic bonds, known as sukuk. This is in recognition that the industry is beginning to recognise the importance of SRI investment and the future development of Islamic finance. So what are the requirements of a SRI sukuk? A sukuk issuer must ensure that proceeds raised from the issuance of the SRI sukuk are utilised for the purpose of funding permitted SRI projects. The Securities Commission Malaysia has identified eligible SRI projects as follows:
- Natural resources projects which relate to:
- Sustainable land use;
- Sustainable forestry and agriculture;
- Biodiversity conservation;
- Remediation and redevelopment of polluted or contaminated sites;
- Water infrastructure, treatment and recycling; or
- Sustainable waste management projects,
- Renewable energy and energy efficiency – projects relating to-
- New or existing renewable energy (solar, wind, hydro, biomass, geothermal and tidal);
- Efficient power generation and transmission systems;
or
Energy efficiency which results in the reduction of greenhouse gas emissions or energy consumption per unit output,
Community and economic development – projects relating to:
- Public hospital/medical services;
- Public educational services;
- Community services;
- Urban revitalisation;
- Sustainable building projects; or
- affordable housing; or
- Waqf (benevolent fund) properties/assets – any projects that undertake the development of such properties/ assets.
From the above list it is clear that the scope for SRI sukuk is huge and can range from local authority infrastructure projects, green energy projects to large-scale immunisation programmes. The sukuk would normally be structured so that it is asset-backed.
TRAIL BLAZER IN SRI
Last year, the Malaysian sovereign wealth fund, Khazanah Nasional, launched the first ringgit-denominated sustainable and responsible investment sukuk to raise funds for its Trust Schools Programme. The proceeds of the issuance will be channelled to Yayasan AMIR, a non-profit organisation initiated by Khazanah in 2010, to manage its cash flow for the deployment of the Trust Schools Programme for schools identified in 2015. The first issuance will be used to roll out 20 schools under the programme in three different states. The sovereign wealth fund raised RM100 million (US$27 million) from a seven-year sukuk.
Investors buying into this bond will need to be committed to the school project as the sukuk uses a “pay for success structure” that will reduce returns if certain key performance indicators (KPIs) are met. The sukuk’s prospectus states that the social impact of this “Pay for Success” structure is measured using a set of pre-determined KPIs, which will be measured over a 5-year observation timeframe.
If at maturity, the KPIs are met, the sukuk holders will forego a pre-agreed percentage of the nominal amount due under the SRI sukuk as part of their social obligation in recognising the positive social impact generated by the Trust Schools Programme. On the other hand, if the KPIs are not met, the sukuk holders will be entitled to the nominal amount due under the SRI Sukuk in full. This is an example of an innovative use of Islamic finance to attract private investment for a socially responsible investment project.
OVERCOMING CHALLENGES
The challenge for the SRI sukuk sector is to bridge the gap between the conventional market and the Islamic one. The feature of prohibition of interest can itself attract non-Muslim investors who are opposed to excessive use of debt and leverage. Shari’a-compliant investors can be viewed as a unique subset of the SRI community. According to the World Bank, what is required is for Shari’a-compliant investors to make the same transition as conventional SRI investors and begin to demand products that allow them to affirmatively express their beliefs. In other words, what is needed is for Islamic investors to become proactive “impact investors.” This means rather than screen products for Shari’a compliance, they need to demand products that go beyond mimicking conventional products that meet basic religious scripture requirements.
Another challenge is for Islamic finance to attract non-Muslim investor. I am of the opinion that heavy Arabic terminology is an obstacle. The replacement of the Arabic and religious labels with universal ethical financing vocabulary will make Islamic finance appeal to a wider audience. Once conventional SRI investors understand sukuk and realise the potential of socially responsible sukuk as a new fixed-income alternative for their portfolios, the number of issues of this type should increase dramatically, thus enabling the bridging between SRI and Islamic finance. In the light of the above, Shari’a financing of infrastructure projects can make a valuable contribution to development. The funding of the health sector, schools, and affordable housing projects all are examples of socially responsible investment projects that can be structured in a Shari’a-compliant way in order to attract much-needed investment into these important public sectors. Such an innovative approach would make the SRI sukuk to be one of the first to be issued in the world. Thus making those involved in the sukuk’s issuance pioneers in the field of socially responsible investments.
