Islamic finance and sustainable development

By Professor Habib Ahmed, November 2021

Professor Habib Ahmed investigates how Islamic finance practices can contribute to UN sustainability goals.

The Sustainable Development Goals (SDGs) were launched by the United Nations in 2015 as a plan of action for people, planet, prosperity, peace and partnership. The funding needed to achieve the ambitious SDGs is huge, and the shortfall in financing for developing countries is estimated to be as much as US$3 trillion annually. Although most of this is expected to come from governmental sources, the financial sector also has an important role to play to help fill the gap and give both industry and indeed society a realistic chance of meeting this challenge.

With the total values of the global bond market outstanding and equity market capitalisations being $123.5 trillion and $105.8 trillion respectively (compared with total banking assets of $155.4 trillion), the capital markets can certainly be tapped to raise funds for sustainable development.

Sustainable investments in the capital markets of developed economies have grown significantly, reaching 35.9% of the total assets under management in 2020. Such increases in sustainable investment are facilitated by guidelines issued by various international organisations on green, social and sustainable finance. For example, the International Capital Markets Association (ICMA) has published principles for green and social bonds - the Sustainability Bond Guidelines - that combine green and social elements. Similarly, organisations such as CICERO provide independent assessments of securities' compliance with the green and sustainability bond frameworks.

But more can certainly be done, and additional financial support can be found in Islamic financing. Since the ethical and social values of Islamic finance are aligned with SDG-related issues, Islamic finance could potentially play a very important role in helping countries and industries meet the 2030 goals set by the UN.

Islamic capital markets and sustainable finance

The principles of Islamic commercial law tie financing to real activities and introduce risk-sharing modes of financing. Since interest-based financing is prohibited, Islamic financial instruments are structured as sale-based, leasing, partnership and agency contracts. Accordingly, the bonds are structured as in 'sukuk', which are defined as investment certificates representing shares and rights in tangible assets, usufructs and services, equity of a given project or equity of a special investment activity. The total outstanding sukuk in December 2020 was $648 billion, with $174.6 billion issued in 2020.

Although most of the sukuk issued before 2015 did not consider sustainability-related issues, numerous social, green and sustainable sukuk have been issued more recently. Examples of those that did include the International Finance Facility for Immunisation (IFFIm) Vaccine Sukuk, issued in 2014 to raise $500 million to finance child immunisation and strengthen health systems in some of the world's poorest countries; and the 100 million Malaysian Ringgit (MYR) Khazanah SRI Sukuk, launched in 2015 to improve accessibility to quality education in public schools in Malaysia. Several energy companies have also issued green sukuk to finance initiatives such as solar plants.

At a global level, the Islamic Development Bank (IsDB) initiated a $1.5 billion Sustainability Sukuk in June 2020 and then issued a second, worth $2.5 billion, in March 2021 through the securitisation of its existing assets. The funds raised have been used to finance sustainability-focused projects in its 57 member countries and to help them recover from the adverse economic impacts of Covid-19.

Innovative instruments for promoting sustainable development

Beyond the traditional social, green and sustainable sukuk, some innovative Islamic capital market instruments have been used to raise funds for social and sustainable development. An interesting example is the retail Cash Waqf Linked Sukuk (CWLS) issued by the Indonesian government after the onset of Covid-19 in 2020. With a two-year tenor and paying an annual return of 5.5%, CWLS is based on the concept of Islamic charitable endowments (waqf) that are created to advance specific social causes. The purchasers of the sukuk donate funds either temporarily or permanently that are then used for projects such as public markets, hospitals, schools, etc. While in the case of a temporary waqf the donated amounts are returned to the donors upon maturity of the sukuk, in a permanent waqf the principal amount is reused for other social and public projects. The returns on these investments are also distributed to social programmes in areas such as education and health, and used to finance micro-, small- and medium-sized enterprises.

The retail feature of CWLS also enables individuals to purchase the sukuk as it is priced at IDR (Indonesian Rupiah) 1 million (equivalent to $68) for one unit. Because of this, a total of IDR 14.91 billion (equivalent to $1.07 million) was raised during October-November 2020 from 1,041 donors.

Another innovative capital market product used to raise funds for microfinance institutions is the Smart Sukuk issued by Blossom Finance in Indonesia. Using a fintech-based model has enabled sukuks to be issued in small denominations at low costs, which facilitates small- and medium-sized enterprises to access finance. Using an Ethereum-based blockchain framework, the ownership of sukuk is represented by tokens issued in local currency. The token uses industry-standard protocol ERC20, which allows them to be traded globally on public crypto-currency exchanges. The funds raised from investors are then provided to local microfinance institutions for financing microenterprises that generate revenue. Investors take on a partnership contract, whereby Blossom Finance keeps 20% of any profits as its share.

While the principles of Islamic finance are aligned with the SDGs, the industry's contribution to sustainable development is still modest. Further contributions to the SDGs would not only require increasing the quantity of financing, but also changing its quality by embedding environmental, social and governance (ESG) issues into financial decision-making. This would mean coming up with innovative financing models and strategies that can facilitate the generation of resources from many different sources and employing them in a sustainable manner.

More information on Professor Ahmed's research interests.