It is clear from our research that Shariah compliance screening can do much to improve environmental, social and governance (ESG) performance.
ESG scores from Refinitiv’s EIKON database of over 5,000 non-financial companies suggest a direct correlation between Shariah compliance and higher ESG scores.
Shariah-compliant companies — to which Islamic financial institutions will direct capital — have ESG scores that are on average 6% higher than for those excluded by the Shariah screening process. For non-financial companies, the difference rises to 10%. ESG scores for Shariah-compliant companies ranged from 3.0% higher for governance to 7.3% and 7.0%, respectively, for environmental and social issues.
Still, while screening for Shariah compliance can help identify many ESG issues, there are shortfalls in certain areas and geographies that can leave financial institutions exposed to unnecessary risk, particularly in emerging and frontier markets. It is possible that in emerging markets there is greater complementarity between Shariah and ESG screening methods, which would minimise the difference in scores, although Shariah screening in these markets does seem to positively impact social quality in relation to workplace issues and human rights.
Recommendations and insights
Our research suggests that even if Shariah and ESG screening show some correlation, combining the two could improve overall risk-adjusted returns. This may occur whether the investment is in the form of equity held in listed companies or in the financing provided by an Islamic bank. Other recommendations include:
- Islamic banks should acknowledge that ESG issues have financial relevance to their financing operations.
- Islamic banks should assess the indirect ESG risks that affect their own financial performance, which are frequently not priced into the cost of financing they provide.
- Islamic asset managers should conduct further practical assessment about the degree to which their exclusion of Shariah-compliant financing may benefit more from additional ESG screening in markets where the leverage screens are less restrictive as a result of greater availability of Islamic financing
- Central banks and other regulators should assess the degree to which specific types of ESG risks that are relevant to the economic sectors typically financed by Islamic banks are addressed in the prudential and supervisory requirements relating to both project-level financial risk but also systemic risk within less diverse economies.
- Researchers in industry and academia should analyse the degree to which ESG risks of bank financing obligors creates different financial outcomes in markets with a large degree of Islamic bank activities
- Researchers in industry and academia should study empirically to determine the degrees to which ESG and Shariah compliance are complementary across a wider range of asset classes and markets
Environmental and social risk exposures
Most Islamic banks operate within their home markets so the indirect environmental and social exposure to these markets will be reflected in the companies they deal with. This would suggest that a greater focus on ESG-specific screening on top of Shariah screening would minimise the risks from such exposure. The research shows there may be value for Islamic banks that screen for environmentally risky projects, which they can either reject or raise the financing costs for.
We have found that the most common risks across the 11 markets with the largest Islamic finance industries are emissions to air & water, the management of waste and the effects of site contamination, as well as workplace safety & health. These risks are particularly prevalent for Islamic banks that are financing utilities, manufacturing, healthcare, mining/oil & gas, and primary agriculture.
If a bank is not taking active measures to integrate these risks into the financing process, it is taking on additional risk while receiving no compensation for doing so. As more research demonstrates the importance of ESG risks to financial return, financial institutions are becoming increasingly aware of how these risks affect their potential profitability, portfolio risk levels and return on capital.
It is imperative that an Islamic bank that has become aware of ESG risks that will have a financial impact first addresses these concerns with employees at all levels to create buy-in to the changes that will need to be made. Change will take time, but improving ESG risk management will not only benefit the bottom line, but will allow the bank to stand out from its peers and discover new business opportunities.
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