Islamic finance is creating opportunities to provide leadership in responsible finance

The Islamic finance market has demonstrated impressive growth in recent decades, with several waves of growth propelled by different global trends. There has been increasing convergence with the development of responsible finance that has occurred over the decade since the agreement on the Sustainable Development Goals and the Paris Climate, which was a principal objective of the RFI Foundation when it was established in 2015.

One success of Islamic finance in adopting responsible finance has been demonstrating the operational compatibility of ESG screening alongside the core mandate for Shariah compliance. A new position paper from the Malaysian International Islamic Financial Centre (MIFC) Leadership Council provides a vision for the next phase of growth and development of Islamic finance. This is one of several initiatives to more firmly establish responsible finance in its core.

The position paper, which was released during the Global Forum on Islamic Economics & Finance (GFIEF), recognizes that more needs to be done to establish sustainability and responsible finance as embedded within Islamic finance, not merely something that operates alongside of it. This approach is also reflected in the work around the Tayyib Secretariat, which announced an Islamic Sustainable Investing Platform during GFIEF.

The position paper’s set of 10 key focus areas and 18 initial MIFC Leadership Council (MLC) impact projects cuts across a wide range of opportunity for commercial Islamic finance, Islamic social finance, and areas in-between the two such as Islamic microfinance. From the work that RFI has been engaged with currently, three topics stand out among the 10 key interlinked focus areas: climate and biodiversity; digital innovation and technology; and the role of takaful.

First and foremost, the financial, economic and social risks related to the climate crisis and increasing risks to biodiversity and natural capital raise questions beyond the purely economic. Across markets in which Islamic finance has a large presence, there will in general be higher costs relating to mitigation and adaptation compared with the historical benefits for those economies from the activities that caused the current crisis.

The slow and uneven flow of climate finance from the largest emitting countries to those most impacted by climate change demonstrates the lack of a clear solution. Despite the formidable size of the conventional financial system, it has not found the solution to deliver climate justice and equity. One element absent from the conventional system is the systematic prioritization of equity and justice that Islamic finance strives for.

An additional element that should factor into Islamic finance more seamlessly is integrating consideration of humanity’s stewardship role in relation to the natural environment. Islamic finance operates within the same backdrop of economics where environmental and social externalities are not priced. This dynamic has made it challenging to systematically address failures in social and environmental stewardship. But global trends on climate, Just Transition, and the global biodiversity framework are elevating a search for solutions to issues where the conventional financial system doesn’t have a good answer.

With the backdrop of the global challenges, and an emerging focus on the ways that Islamic finance is well-suited to offer solutions, there are some practical challenges also considered in the MLC’s Key Focus Areas that require further effort. Even an ideal solution to the challenges requires implementation in a highly uncertain world, and with substantial information gaps.

Adding climate, nature and ESG to that existing complexity and uncertainty expands the scope of the problem at the same time as the crises of breaching planetary boundaries potentially upends traditional methods of risk mitigation such as insurance. It is difficult to fully quantify the long-term losses that will come if temperature rise approaches 3˚  C when compared to an outcome if it is held under 2˚  C or better still is limited to 1.5˚  C. Estimates of damage are assumed to be large even excluding social and humanitarian impacts that are excluded from economic models.

A conventional approach to these issues would require significant investment in technology to collect the data needed for analyzing the distributions of risks and losses in order to adequately price insurance where it is even possible under these conditions. The investment in expanding insurance access may result in more data being gathered than is necessary to mitigate the risks, because of the nature of conventional insurance in maximizing its own returns.

In conditions of historically normal levels of uncertainty, there may be economic grounds for operating insurance using a model built on underwriting precision and profit maximization. However, when the degree of uncertainty rises to more extreme levels like what will prevail under different climate scenarios, there may be efficiency gains from greater mutualization such as that offered by takaful.

Rather than premiums being set as low as possible, subject to some level of prudential risk, it may make sense both in terms of climate mitigation and efficiency for premiums to be set on a more precautionary basis knowing that policyholders will share in the gains if they are too conservative while giving a greater leeway for more adverse outcomes to occur without threatening financial stability.

A more precautionary approach would also have the side benefit of reducing the economic value of surplus data collection that is primarily valuable only to underwriting. It could result in freeing up more of the data-related investment for use in mitigation of harm to natural systems, assessment of negative social impacts, and measures to improve the participatory elements that are necessary for a Just Transition.

There has always been a strong ground for Islamic finance to play a more active and leading role in addressing global needs to address concerns such as the climate and nature crisis. What has taken time since agreement around global goals for sustainable development and restoring balance in planetary systems has been to demonstrate compatibility of climate and ESG approaches with Islamic finance. By conclusively demonstrating this compatibility, Islamic finance has also illuminated opportunities for the sector to lean into its concern for equity and justice and provide solutions as the momentum of interest in responsible finance produces opportunities to feasibly put them into action.