Sustainable Investing: What's the difference between ESG, SRI and Islamic Investing? | Karyawan
Sustainable Investing: What's the difference between ESG, SRI and Islamic Investing?
Dr Hazik Mohamed
25 Oct 2023
9 min read
Returns are no longer the only factor to consider when investing. Investors increasingly want companies that are as committed to making the world a better place as they are to making money.
Investment deals today are being viewed from a broader perspective. It used to be that financial performance, annual returns, and capital appreciation were the only factors used to determine the profitability of an investment, but that has changed over time. Many funds and strategies exist today to facilitate this movement as more investors want to use their money positively impact society. In this context, we find terms such as socially responsible investing (SRI), environmental, social, and governance investing (ESG investing), and impact investing.
BY DEFINITION
Funds and strategies that incorporate ethical considerations into their investment processes have risen in popularity due to the increasing demand. In the investment industry, terms such as ESG, SRI and impact investing are often used interchangeably, assuming that they all refer to the same thing. There are, however, subtle differences between these terms. It is important to understand the differences between these three investment trends in order to formulate an investment portfolio that will suit your needs.
Corporate social responsibility (CSR) investing aims to limit a company’s negative impact on society or to benefit it at the same time (or both). To better inform investors, the Sustainability Accounting Standards Board (SASB) aims top>standardise the ways companies report on ESG criteria based on the sector and industry in which they operate. The conversion of a data centre from fossil fuel to renewable energy is an example of an ESG investment, as it provides cost and environmental benefits at the same time.
References
1.U.S. Forum for Sustainable and Responsible Investment, The US SIF Foundation’s Biennial 'Trends Report' Finds That Sustainable Investing Assets Reach US$17.1 Trillion. Available at: https://www.ussif.org/blog_home.asp?Display=155/
In SRI, investments are screened to eliminate companies whose values conflict with those of the investor. SRI was established by John Wesley, the founder of the Methodist movement, urging his followers not to invest in stocks based on sins such as alcohol, tobacco, weapons, or gambling. Nowadays, fossil fuel producers and firearms manufacturers are often excluded from SRI. An SRI approach is one of the most basic (and often least expensive) forms of values-based investing.
Islamic finance is based on a system of standards based on moral and ethical values. Among the goals of Islamic finance are improving living conditions and well-being, promoting social equity, and preventing unfair trade practices. As a result, usury (interest or riba) was prohibited and replaced by a system in which profits and risks are shared. For investments to be deemed Islamic or Shariah-compliant, they are subjected to two screening processes:
> Financial Screening – certain financial ratios are examined according to certain threshold values, e.g. for debt and income from debt securities (The Accounting and Auditing Organization for Islamic Financial Institutions uses 30%; Thomson-Reuters uses 33% threshold)
> Sector Screening – screen out stocks of companies associated with businesses that contravene the Shariah, such as alcohol, casino/gambling, pork, other vices.
There is another category called impact investing which refers to private funds, while SRI and ESG investing involve publicly traded assets. Impact investing is meant for investors who want to know how their money is being used for a particular cause, and its direct impact, unlike ESG, Islamic and SRI funds which are more broadly diversified.
HOWTHEYOVERLAPAND HOW THEY DIFFER
It is entirely possible for financial services to qualify as ESG, Islamic, and SRI. In developed countries, however, most SRI. In developed countries, however, most SRI products do not meet Islamic criteria since they do not comply with Islamic prohibitions. There is no rule that prohibits the SRI universe from lending money at interest or trading risk. As an example, a green bank may warrant high marks as a sustainable bank but would not qualify as Islamic due to its interest-based transactions.
The offering of Islamic financial services may be relatively easy for financial institutions familiar with ESG considerations, since responsible and Shariah values are clearly aligned, and both approaches have a strong ethical foundation.
There are many commonalities among these companies, including a commitment to human rights and the environment as well as long-term sustainability and success. By creating a responsible screen, much of the heavy lifting had already been done for assembling a Shariah-compliant fund.
A research report3 on Islamic finance and ESG considerations states that ESG scores from more than 5,000 non-financial companies suggest a direct correlation between Shariah compliance and higher ESG scores. ESG scores for Shariah-compliant companies are on average 6% higher than for companies that are not subject to the Shariah screening process. The difference increases to 10% for non-financial companies. In terms of ESG performance, Shariah-compliant companies scored higher on governance issues by 3.0% and on environmental and social concerns by 7.3% and 7.0%, respectively.
SEARCHINGFORECONOMIC VALUE AND MORAL VALUES IN INVESTING
There are various reasons why investors consider ESG issues. It is possible that some people view them solely as economic opportunities and risks. Other people may view ESG issues not just as risks and opportunities, but also as moral issues. In the assessment of a values-based system, investors usually mean very similar things by economic value, but they mean very different things by moral values.
Morally motivated individuals may not wish to participate in actions that are objectionable, or they may seek to make a positive impact on society or the environment. For example, investing in tobacco may be unacceptable to an individual investor or a health-related charity, irrespective of its economics. Others may not be concerned about these issues. Investing in the tobacco industry may be economically attractive to them, and they may consider ESG factors simply to complement their impact on society or conventional financial analysis.
By taking into account ESG issues, investors can help bring positive change for society and the environment, whether they are motivated primarily by economic value or moral values. A company's employees and vendors could benefit from improved health and safety practices if investors concerned about potential losses from health and safety risks engage in discussions with the company about changing its practices.
Islamic finance was born out of economic thought governed by Shariah principles, and largely a subset of a wider-scoped Islamic economics. It tends to criticise the free market versions of capitalism. Using an Islamic worldview, it seeks to identify ways and means to arrive at a more just economic order, one with less inequality and more stability than the present one through risk-sharing, social justice and personal accountability. Figure 2 depicts the steady growth of this demand in the last decade.
Though SRI investing has its roots in Abrahamic faiths, it has become increasingly secular over the years. Several factors have contributed to this change, including the secularisation of Western Europe, which is the heartland of modern SRI investing. Changing social values have also contributed to the secularisation of SRI investments, which may differ greatly from the values espoused by classic SRI investments. Climate change and gender diversity are among the issues receiving more attention now than slavery, war, and apartheid. In contrast, Islamic finance remains deeply religious, focusing on exclusionary screening of "sin" industries and on just financial transactions and commercial exchange as the principles of its economics. There are significant cultural differences between Islamic finance and SRI investing, as evidenced by the differing vocabularies and underlying priorities used in their respective narratives.
When compared to SRI investments, Islamic financial services exhibit a greater level of consistency across countries. Globally, Islamic equity funds employ similar exclusionary screening requirements regarding the purpose of the business and the capital structure of the company. There is a wide range of values in the SRI space, and exclusionary screening based on capital structure is not commonplace.
COMPARING PERFORMANCE
A substantial amount of attention has been paid to financial performance in research on environmental, social, and governance issues. It is essential to determine whether ESG investing, SRI, or Islamic finance compromises financial performance when compared with conventional investments. Some investors expect this compromise pointing out that excluding assets based on moral values will reduce the investment universe, which could lead to assuming more risk or earning lower returns. They contend that anything beyond a pure economic perspective, such as a desire to make a positive difference to society and the environment, can adversely affect performance.
FIGURE 3: COMPARATIVE PERFORMANCE OF DOW JONES INDEX (CONVENTIONAL VS ESG VS ISLAMIC) FOR A 10-YEAR PERIOD BETWEEN 2014-2023 (Q1)
CONCLUSION
Investing in ESG factors, SRI and Islamic finance aims to meet the financial needs of customers, achieve financial success, as well as deliver better outcomes for society and the environment. SRI investments predate modern Islamic
finance and were developed in the most advanced economies, therefore, it is not surprising that they are setting standards for ESG considerations. Islamic finance was born of Islamic economics, which seeks a more just and stable economic system, one with a financial system that supports real and sustainable economic growth. Therefore, Islamic finance providers are expected to uphold Islamic prohibitions and take into account environmental, social, and governance considerations voluntarily. Islamic finance would provide a systematic and substantive advantage to ESG considerations in order to enhance its value proposition to global investors (that includes all religions and
cultures) since it is strongly linked to more sustainable investment methods with positive social and environmental outcomes.
Dr Hazik Mohamed is a multi-skilled professional, whose focus is on business growth strategies for start-ups, tech-related research, and various consulting projects. His past corporate clients include the ASEAN Secretariat, national finance offices, and the United Nations Capital Development Fund. He is also the author of three internationally published books: Belief and Rule-Compliance (Academic Press, 2018), Blockchain, Fintech and Islamic Finance (De Gruyter, 2019) and Beyond Fintech (World Scientific, 2021).
About the Author
Dr Hazik Mohamed is a multi-skilled professional, whose focus is on business growth strategies for start-ups, tech-related research, and various consulting projects. His past corporate clients include the ASEAN Secretariat, national finance offices, and the United Nations Capital Development Fund. He is also the author of three internationally published books: Belief and Rule-Compliance (Academic Press, 2018), Blockchain, Fintech and Islamic Finance (De Gruyter, 2019) and Beyond Fintech (World Scientific, 2021).
