Islamic Finance & ESG: A Natural Synergy
Introduction
In the world of finance, sustainability is no longer a choice–it’s a necessity, and an urgent one at that. In response to growing concerns about climate change, financial inequality and ethical investing, two powerful movements are reshaping the industry: sustainability-driven ESG (Environmental, Social and Governance) investing and ethics-focused Islamic finance (IF), both experiencing rapid growth. However, despite their commonalities, IF and ESG investing often operate in parallel rather than in collaboration, limiting their potential synergies in driving sustainable and ethical financial practices.
Now, a looming crisis casts a shadow over global sustainability efforts–a staggering financing gap. According to the UN Trade & Development 2024 report, the world is severely off track to achieve the SDGs by 2030, particularly SDG 13, climate action. Avoiding the impending climate catastrophe requires large-scale investment efforts to support transitions. Various efforts have been made to quantify the financing gaps, revealing that it is significant, particularly in developing countries, with estimates ranging between $2.5 trillion and $4 trillion annually. While ESG investments are on the rise, much of the financing fails to reach developing nations, which contribute only a fraction of emissions.
Islamic finance, with over $4 trillion in assets (expected to grow to over $6 trillion in 2027), and a strong presence in developing economies could help shrink the funding gap.
What is Islamic Finance?
Unlike conventional finance, which often thrives on interest-based lending, short-term profits and speculation, IF is an ethics-focused approach operating on a set of Shariah (Islamic law) principles that promote:
Risk-sharing, not risk-shifting – IF prohibits riba (interest) as it allows one party (lenders) to benefit at the expense of another (borrowers), exacerbating the wealth gap and financial distress. Instead, it promotes partnerships where both parties share profits and losses (as in Mudarabah and Musharakah contracts).
Investments that do not harm society – Like how ESG investing avoids industries and companies that harm the planet and violate human rights (though ESG screening) , IF uses negative screening to eliminate investments in unethical sectors such as alcohol, weapons manufacturing, gambling and exploitative labour (Shariah screening).
Certainty – Excessive uncertainty (gharar) is prohibited as like interest, it can lead to exploitation and disproportionate gains. Additionally, similar to ESG, IF requires transparency and accountability.
Social justice and financial inclusion – Similar to ESG, IF is both profit-driven and impact-driven as IF inherently favours businesses that contribute positively to society. Beyond investment, built-in societal welfare mechanisms such as Zakat (mandatory almsgiving) redistribute wealth, but unlike traditional philanthropy, these welfare mechanisms are institutionalised within the financial system.
At its core, IF aims to create wealth ethically and distribute it fairly, ensuring that money serves the greater good by benefiting both people and the planet–not simply maximising profits at the expense of large external costs, much like ESG investing.
Interestingly, despite similarities between IF and ESG, IF remains largely absent from ESG discussions. Regulatory challenges, lack of integration, and lack of awareness have disconnected the two.
However, that is starting to change.
Could Islamic Finance help close the SDG funding gap?
As ESG considerations become more commonplace, and climate risks escalate, Islamic Finance has increasingly integrated sustainable financial instruments. This integration, coupled with IF’s stronghold in emerging markets, could mobilise ethical capital toward climate resilience and social good.
Green Sukuk, Islamic microfinance, and Zakat are a few instruments IF offers that could help fund sustainable projects in developing countries. In practice, however, limitations arise when mobilising these effectively and at scale.
Green Sukuk – One of the most promising innovations in IF, targeting SDG 13 head on, is the Green Sukuk, an interest free bond that generates returns without infringing on principles of Shariah. Like a Green Bond, it is designed to finance environmentally sustainable projects.
Malaysia’s Success Story
On July 27th, 2017, the first Green Sukuk was issued, raising $59 million to finance a solar photovoltaic plant in Sabah. This milestone set a precedent, inspiring others to follow suit. Several other Malaysian producers followed using larger Green Sukuk issuances, stimulating a global surge in Islamic green finance.
Green Sukuk has immense potential to fund large-scale sustainable projects and bridge the funding gap, however, challenges remain. Green Sukuk issuance is still concentrated in a handful of Muslim-majority nations, while many other developing countries where climate finance is most urgently needed have yet to issue their own. As a relatively new financial instrument, Green Sukuk is still in its early stages, making its expansion a promising avenue for growth.
Islamic Microfinance
Financial exclusion is one of the greatest barriers to sustainable development in developing economies. IF, with its emphasis on financial inclusion, offers a compelling alternative to conventional lending. Islamic microfinance institutions in developing economies such as Pakistan, Bangladesh, and Sudan, provide interest-free loans (Qard Hassan) and profit-sharing arrangements (Mudarabah) to small businesses and entrepreneurs. This directly addresses SDG 1 (No Poverty) and SDG 8 (Decent Work and Economic Growth).
Bangladesh’s Success Story
The Rural Development Scheme (RDS) initiated by Islami Bank Bangladesh Limited (IBBL) has expanded from an Islamic microfinance program covering 4 villages to a nationally recognised model that serves underserved communities, particularly rural women and small-scale farmers.
Islamic microfinance aligns closely with ESG goals by promoting sustainable economic development and financial inclusion. While it is growing, it has yet to become a mainstream financing option globally. Another limitation may be the concerns over loan repayment, as Islamic microfinance operates with little to no collateral. However, the rapid expansion of Islamic microfinance in Bangladesh and an impressive 99% repayment rate, proves that it can be ethical, financially sustainable and can increase in scale.
Zakat – Zakat holds immense potential in addressing the SDG funding gap as it is one of the largest forms of wealth redistribution. With global Zakat contributions estimated between $200 billion and $1 trillion annually, it could play a significant role in targeting poverty, hunger, and inequality. In order for this to materialise, Zakat must be integrated into formal financial systems (rather than being distributed informally). Steps are being taken to bring this into effect, as seen by the UNDP’s partnership with Zakat organisations.
The Path Forward
IF holds enormous untapped potential in driving sustainable development. With Shariah-compliant companies consistently scoring higher on ESG metrics, outperforming non-compliant firms by 7% in the environment and social metrics and 10% overall in non-financial sectors, the ethical nature of IF is made clear. To materialise the integration of ESG and IF, IF must move from the margins of sustainable finance into the mainstream. This requires scaling up Green Sukuk in developing nations, establishing an ESG-IF regulatory framework, formalising Zakat, and raising global awareness of IF’s role in sustainability.
Advancements have been made.
At COP28, the spotlight turned to the pivotal role of IF in advancing sustainable development.
The Unlocking Islamic Finance Summit ran in parallel, and explored the synergy between IF and ESG principles. This event also marked the launch of Project Tayyib, an approach that builds on the Shariah-compliant model of IF by integrating an approach inspired by Tayyib (wholesomeness, or purity). Focus areas include, but are not limited to, developing ESG-linked products, and formally aligning IF with ESG and impact investing. Meanwhile, the Global Islamic Finance SDG Taskforce (a collaboration between the Islamic Finance Council UK and HM Treasury) continues to disseminate information on and promote SDG adoption in IF. Another advancement is the increasing issuance of ESG Sukuks. Fitch ratings highlights that ESG Sukuk issuance is surging and is emerging as a crucial SDG funding tool in developing economies, boasting a 99% investment-grade status.
Islamic Finance could be a transformative force in sustainable investment. The question now is: Will IF’s potential to bridge the funding gap, and its synergy with ESG, be embraced — or will it largely remain an untapped force?
References
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Fitch Ratings. (2024). ESG Sukuk Growth to be Sustained in 4Q24-2025: Large EM Share. Available at: https://www.fitchratings.com/research/islamic-finance/esg-sukuk-growth-to-be-sustained-in-4q24-2025-large-em-share-30-10-2024.
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