KARACHI:
Climate change is one of the most pressing issues of our time, requiring collective action and innovative solutions. As the global community grapples with the growing threat of climate change, the need for innovative and inclusive financial mechanisms becomes increasingly urgent.
Islamic finance, with its global appeal and unique characteristic to support real economy and sustainable initiatives, offers a unique approach to climate finance, blending ethical investing with sustainable development goals. As per the Islamic Finance Development Report 2023, over 1871 institutions are offering Islamic finance with an assets base of $4.5 trillion and the global footprint can now be seen in 120 countries. Islamic climate finance is also emerging as a powerful tool in the worldwide effort to mitigate and adapt to climate change.
Climate finance often refers to local, national, or transnational financing drawn from public, private, and alternative sources of funding that seeks to support mitigation and adaptation actions that will address climate change. The Kyoto Protocol and the Paris Agreement also call for financial assistance from Parties with more financial resources to those that are less endowed and more vulnerable.
According to the Climate Finance Report 2023 by Climate Policy Initiative, average annual climate finance flows reached close to $1.3 trillion in 2022. The World Bank Group alone delivered a record $38.6 billion in climate finance in fiscal year 2023. The annual need for climate finance is expected to rise dramatically over the next decades estimated at $9 trillion annually by 2030.
Climate finance is needed mainly for mitigation actions that are required to reduce the flow of heat-trapping greenhouse gases into the atmosphere, large-scale investments are required to significantly reduce emissions, especially in the area of energy, transportation, and infrastructure. Secondly, climate finance is equally important for adaptation efforts in areas like industry, agriculture, water, and waste management, as significant financial resources are needed to adapt to the adverse effects and reduce the impacts of a changing climate.
At its core, Islamic finance is based on principles derived from Islamic commercial law, which prohibits activities such as interest-based transactions, speculation, toxic assets, and gambling. Islamic finance serves as an alternative to conventional financial practices by promoting risk-sharing, asset-backed trade transactions, rent-based modes, and equity investment that emphasise profit and loss sharing. This ethical framework fosters stability, transparency, and social responsibility, aligning with broader societal values and social justice while shying away from unethical and anti-social industries.
The core instruments of Islamic finance include Sukuk (Islamic alternative to bonds), Musharakah (equity-based partnership), Mudarabah (profit-sharing), trade and rental-based financing, and Waqf (endowment). These instruments are designed to ensure that financial transactions are conducted in a manner that is fair, transparent, and socially responsible.
In the context of climate finance, these principles align closely with the goals of sustainable development, making Islamic finance a natural partner in the fight against climate change. By emphasising ethical investments and social responsibility, Islamic finance can channel funds into projects that not only generate economic returns but also have a positive environmental and social impact.
The following are key areas where Islamic finance can contribute to climate action:
Green Sukuk: Green Sukuk is a Shariah-compliant financial instrument designed to raise funds for environmentally sustainable projects. These include renewable energy, energy efficiency, sustainable infrastructure projects, etc. The first Green Sukuk was issued by Malaysia in 2017 valued at $58 million for solar projects, followed by Indonesia, United Arab Emirates, Turkey, and Saudi Arabia. In 2018, Indonesia issued a $1.25 billion Green Sukuk to finance renewable energy projects, including geothermal and solar power plants.
Socially Responsible Investing (SRI): Islamic finance is inherently aligned with the principles of Socially Responsible Investing (SRI). SRI involves choosing investments that not only yield financial returns but also contribute positively to society and the environment. Islamic financial institutions can further promote and integrate SRI principles into their portfolios by prioritising investments in green technologies, renewable energy, and companies with strong environmental, social, and governance (ESG) practices.
Waqf for Environmental Protection: Waqf, an Islamic endowment, can be utilised to support environmental projects. Historically, Waqf has been used to fund public goods such as schools, hospitals, and water wells. Today, Waqf can be directed towards climate-related initiatives, such as reforestation, conservation, and sustainable agriculture. By leveraging Waqf for environmental protection, Islamic finance can contribute to the preservation of natural resources and biodiversity.
Risk-sharing Mechanisms: Islamic finance emphasises risk-sharing between parties, which can be particularly valuable in financing climate adaptation projects. For example, Musharakah and Mudarabah-based partnerships can be used to fund climate-resilient infrastructure in vulnerable regions. By sharing the risks and rewards, Islamic finance can attract green, social, and ethical investors to innovative projects and infrastructure development, clean energy ventures, and much more, thereby facilitating greater investment in climate adaptation.
On the institutional level IsDB, Jeddah is actively working to support climate finance initiatives in the Muslim countries. In 2019, the IsDB issued a $1.1 billion Green Sukuk, the largest ever by a supranational entity, to finance projects in renewable energy, clean transportation, and sustainable water management.
Asian Development Bank is also actively supporting Islamic finance and issued a detailed report titled Unlocking Islamic Climate Finance in Nov 2022. The report recommends four specific channels for sector development: (i) greening Islamic capital markets, (ii) greening Islamic social finance, (iii) mobilising Islamic project finance for green infrastructure, and (iv) developing green banking services for the unbanked to support financial inclusion.
The potential for growth in Islamic climate finance is immense. With the increasing awareness of the need for sustainable development and the alignment of Islamic finance principles with climate action, more countries and financial institutions are likely to enter the market.
Despite its potential, Islamic climate finance faces a few challenges that need to be addressed to fully realise its impact. These include a) awareness and education among stakeholders b) the development of a clear and consistent regulatory framework c) linkage and partnerships for market development d) innovation for new financial instruments to attract impact investors seeking both financial returns and measurable environmental benefits.
THE WRITER IS THE DIRECTOR OF IBA CENTRE FOR EXCELLENCE IN ISLAMIC FINANCE
