Malaysia brings Islamic finance and ESG together
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Malaysia brings Islamic finance and ESG together

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There has always been great overlap between Shariah-compliant finance and ESG principles. Malaysia is trying to harness the potential that arises from this confluence.

Islamic finance veterans like to point out that environmental, social and governance principles have a lot in common with the standards Shariah-compliant finance has imposed since antiquity.

“A lot of things that within Islamic finance were clearly forbidden are now core concepts of ESG,” says Raja Teh Maimunah, managing director of wholesale banking at AmBank Group, and a former CEO of two separate Islamic banks.

“The intersection between ESG and Islamic finance is like a merging between a philosophy that has been around for 1,600 years and something that seems to be sexy today: realizing that those things were bad for societies.”

You encounter a few emotions around this situation among Shariah practitioners: perhaps a touch of hubris at the rest of the world having caught up with their way of thinking; perhaps a little irritation, that the whole idea has only become mainstream when given a different name and branding. But the sharpest minds in the industry see a huge opportunity in the considerable crossover between Islamic and ESG themes.

“Islamic finance and ESG investing share similar principles of being a good steward to society and the environment through prevention of harm and attainment of benefits,” says Nor Shamsiah Mohd Yunus, the ninth governor of Bank Negara Malaysia, the country’s central bank. “With many similarities, it is inspiring to see Islamic finance making significant headway and contributions in the ESG space in recent years.”

Nor Rejina Rahim, managing director at Nomura Asset Management Malaysia, has been country head for Nomura’s Islamic asset management operations for 15 years, as well as for conventional assets, and has seen a great deal of growth – but believes there ought to be much more.

The Shariah-compliant asset management industry accounted for $120 billion at the end of 2019, dwarfed by the overall global asset management industry that stood then at $89 trillion and is now thought to be well over $100 trillion.

“To me, there is a lot of potential, and this is something I’ve been talking to regulators about: the fact that we should be trying to market Islamic finance to a wider audience than just Muslim investors,” Rahim says. “There’s a lot of similarities between ESG and the universal values of Shariah.”

Common characteristics

The common ground between the two ideals is firstly around exclusion.

Islamic finance has always banned investment in gaming, alcohol, weapons, tobacco, human trafficking and pornography, for example, all of which are also excluded from ESG principles.

Moreover, both systems share this idea of responsible stewardship, with an underlying sense of social justice and inclusion.

Islamic finance requires that it support activities that benefit society, without unjust gains, and with an equal sharing of risk and reward.

Other characteristics of the two approaches spring from separate wells but arrive at a similar outcome. So, for example, Islamic finance prohibits interest, and ESG does not, so Shariah-compliant investment must exclude conventional banks, which is not a consideration for any ESG portfolio.

But the reason Islamic asset management prohibits interest is because of the idea that money can’t just turn into more money without serving some productive purpose related to a real underlying asset in the economy, and that risk and reward are shared.

In practice, this principle tends to find its way into ESG: a bank that makes its money from a socially inclusive business model is more likely to appeal to an ethical investor than one that does so chiefly through, say, speculation in derivatives trading.

I’m glad we could use ESG to propagate the whole concept of things that are important in Islamic finance
Raja Teh Maimunah, AmBank Group

Raja Teh runs both the Islamic and non-Islamic wholesale book at AmBank, and sometimes applies Islamic principles in the conventional book if she thinks it makes sense to do so. An example is derivatives.

Derivatives aren’t banned outright in Shariah, but they can’t be traded. They can be used for a practical and productive purpose like hedging, which is what they were invented for.

Raja Teh imposes the same principle in the conventional book on the grounds that it is a better way to behave and a better way to run a business.

There is a feeling in the Shariah world that they work harder on validation and rigour than do those in conventional banking seeking the ESG investment dollar.

“I think a lot of people at the senior level in banking are engaging in it is because it’s flavour of the month,” says Arsalaan 'Oz' Ahmed, chief executive of Al Rajhi Bank Malaysia.

Those people still need to understand the tough decisions that will be required in making sure capital has a positive social and environmental impact, he says.

“You have to do the hard yards, and make tough decisions even when you launch a product,” he says.

Islamic banks go through a Shariah process to make sure something is compliant, he points out; banks should probably go through a similar ESG process to make sure their products are equally compliant.

“If you do that, you might find you are told something you may not like but need to know and need to change," Ahmed says. “Are you ready for those hard yards? I would say Islamic banks are doing some of those hard yards, because ESG naturally aligns to the principles of Islamic finance.”

Principled integration

Three years ago, governor Nor Shamsiah gave her first international interview to Euromoney, in order to talk about something called Values-Based Intermediation (VBI).

The idea of this was that Islamic finance had developed a tendency to get stuck on semantics, on creating cleverly structured ways of getting Shariah finance to just mirror the conventional system, rather than focusing on the real impact Islamic finance ought to be having on society and the economy.

At Bank Negara Malaysia, Nor Shamsiah naturally thinks a great deal has been done.

“We have made progress,” she says. “Today, the Islamic financial industry is integrating VBI principles in institutional conduct and practices, as well as in offering value-based solutions that align with the UN Sustainable Development Goals and ESG.”

Regulatory support plays a pivotal role in the development of Malaysia’s SRI ecosystem
Nor Shamsiah Mohd Yunus, Bank Negara Malaysia

She says a total of RM9.2 billion-worth ($2.2 billion) of VBI-aligned financing was channelled by Islamic banks to 235,000 accounts in 2020, with 95.6% of it – RM8.8 billion – catering for green finance. One in every three Islamic banking institution’s deposits and investment accounts are VBI-aligned, she says, worth RM36.8 billion, and the impact can be seen from small and medium-sized enterprise financing to renewable energy.

Nor Shamsiah argues that VBI has an impact beyond Shariah.

“The Islamic finance industry is also playing its part in reshaping the characteristics and behaviour of the nation’s financial system,” she says.

She argues that Islamic banking subsidiaries of conventional banks “are also steering the sustainability agenda at the broader financial group.”

The idea of VBI was not just a nebulous sense of purpose, but a carefully structured methodology. There is a VBI Community of Practitioners who have been entrusted with developing documents to guide the adoption of VBI, the most recent of which is a sectoral guide to complement the Climate Change and Principle-based Taxonomy.

The group has published three of these guides to date – palm oil, renewable energy and energy efficiency – and will follow up with manufacturing, construction and infrastructure, and oil and gas by the end of the year.

Common ground

Another framework has been developed for takaful, the Islamic equivalent of insurance. Nor Shamsiah argues a clear social rationale here.

“The alignment between the underlying thrust of VBI with the Principles of Sustainable Insurance opens the door for greater collaboration between the insurance and takaful operators and global practitioners to address the distinctive needs of the economy and society,” she says. “Some notable examples are affordable coverage for lower-income groups against adverse life events and farming communities against adverse weather conditions.”

For Ahmed, VBI represents something important and committed.

“In Islamic finance, the intention is more sincere, I still believe that,” he says. “I see that sincerity through the Value-Based Intermediation Community of Practitioners: a group of bankers – who are competitors – working together to try to come to common ground on things.”

Among that group, he considers Bank Islam and Bank Muamalat, both Malaysian Islamic banks, as leaders on social capital products.

“Some of the positives are around the close collaboration,” he says. “There have been products that have come out combining social capital with financial services, led by the Islamic sector, which have come out of us coming together to share best practice.”

But there are areas where VBI has not been a success, he says: “The bit I would say is not working as well was that the scoring methodology stopped.

“I felt there was something really good in being able to give people a feel of where they were and put a little peer pressure on.”

Whatever the practical outcomes, the adoption of VBI chimes with the global trend of investing with society and climate change in mind. There’s an opportunity here.

“Value-based intermediation looks at social and climate, and it is more pertinent to have them together, especially in emerging markets,” says Ahmed. “If people are hungry, they don’t care about the environment.”

In 2015, the UN came up with a list of exclusions that were similar to those from Islamic finance 1,400 years ago
Arsalaan 'Oz' Ahmed, Al Rajhi Bank Malaysia

Bank Negara Malaysia says that the sustainability metric has gained momentum among both domestic and foreign investors into Malaysia. The bank says investment approvals in green technology projects have grown 15-fold in the past decade to 439 projects with a total investment of RM4.36 billion in 2019.

Malaysia is a signatory to the Paris Agreement, and Nor Shamsiah sees a sign of the government’s commitment to SDG responsibilities with its issuance of the world’s first dollar SDG sovereign sukuk in April 2021. The deal was covered more than four times over and has since served as a benchmark for other Malaysian corporate issuers.

Ahmed recalls doing a UN SDG sukuk issuance, the first of its kind, as the chief executive of the issuing bank. He was at a roadshow giving a presentation to investors, using a slide highlighting the UN SDGs the proceeds of the sukuk would support, which also showed a list of excluded sectors.

An investor asked if those exclusions were because it was a sukuk.

“I said: no, it’s from the SDG framework,” Ahmed says. “In 2015, the UN came up with a list of exclusions that were similar to those from Islamic finance 1,400 years ago. Back then it was just called ‘finance’.”

This brings us back to an overlap that is clearly useful for Islamic finance but also somewhat frustrating, given that Shariah-compliant finance has been offering much of what the ESG sector requires for many years.

“Has anyone ever said: 'If I invest in an Islamic organization, I will be 80% aligned with UN SDGs'?” asks Ahmed rhetorically. “I don’t think so.”

Still, there’s not much use in being petulant about it; it is an opportunity, better late than never. Practitioners today feel they just have to keep reminding the world that Islamic finance has something to offer in the broader ESG world.

“I’m glad we could use ESG to propagate the whole concept of things that are important in Islamic finance which we couldn’t quite sell to the rest of the world before,” Raja Teh says.

The point now is to keep that momentum going so as to demonstrate Shariah’s relevance to ESG challenges.

“As we try to solve social and environmental issues, we will naturally have to think about Islamic financing principles,” says Ahmed.

Much of what we aspire to do today, he says, is already enshrined in Islamic finance: zakat, fundamentally, is a tax on wealth in order to circulate it in the economy. Financing transactions need to be rooted in the real economy.

Sadaqa speaks to issues not just of charity but what we could use today in social blended finance.

“Climate change projects are really long and investors get paid nothing for the first two years,” he says. “Islamic finance acknowledges that model: it allows for some capital that does not require a financial return to be infused into the economy to make sure the rest of the capital that does require a financial return can do so.”


Malaysia has by far the most sophisticated Islamic capital market in the world. It has set every first that matters over the years and continues to be the place where innovative techniques are tried out first.

It has achieved this partly because of a clear agreement between the government, the central bank and the Securities Commission, as well as stock exchange Bursa Malaysia and the big private-sector practitioners, that being a leader in Islamic finance is something the country wants.

Raja Teh, who is formerly the chief executive of Aminvestment Bank and of Hong Leong Islamic Bank, as well as being the former global head of Islamic markets at Bursa Malaysia, runs both the Islamic and conventional capital markets side of the business at AmBank, and says the far bigger book is Islamic origination.

It is striking, though, that the Islamic markets have not yet been a hotbed for development of green or sustainability-linked sukuk, perhaps because investors feel that the very fact of them being sukuk gives them an element of ESG already.

Attempting to build more green sukuk “is still challenging,” says Raja Teh. “The drive towards green assets has been a bit slow. But we’re continuously trying to push.”

Foreigners have not been huge buyers into green sukuk because it is primarily a ringgit market, she says, which in turn is driven by the sheer scale of onshore liquid funds such as the enormously powerful Employees Provident Fund (EPF). (The EPF declined an interview this time, but its leaders have spoken to us on Shariah/ESG themes many times before.)

Sustainability-linked bonds, catching on elsewhere, have not yet been a big fixture in Islamic finance, she says.

It is not for lack of clarity.

“Regulatory support plays a pivotal role in the development of Malaysia’s sustainable, responsible investing (SRI) ecosystem, particularly in the SRI-related Islamic capital market,” says Nor Shamsiah.

The Securities Commission introduced an SRI sukuk framework back in 2014, and some landmarks have followed, notably Khazanah’s sukuk ihsan and the world’s first green SRI sukuk in 2017.

Since then, the SRI Sukuk Roadmap followed in 2019, while grants were introduced to defray the cost of SRI issuance in order to encourage more momentum.

It is not as if ESG sukuk are totally absent: Bank Negara, using the definition 'SRI sukuk', says there has been RM7.25 billion worth of issuance in Malaysia to date. Globally, it’s certainly catching on: there were four ESG sukuk issues in the first half of 2021, raising $4.05 billion between them, one of them from Malaysia.

But there does seem to be scope for more.

“Demand for ESG investments will certainly soar post-pandemic, including Shariah-sensitive investors,” Nor Shamsiah says. “I am confident that this momentum will continue to grow, fuelled by booming green infrastructure and private projects as envisaged in the CMP3.”

CMP3 is the Capital Market Masterplan 3, released by the Securities Commission in September. The Securities Commission declined an interview for this article, instead pointing us towards public announcements. Part of the masterplan, these documents say, involves focusing on greater market transparency and investor protection, which includes disclosures.

This fits in with a plan for Bank Negara Malaysia itself to demand the mandatory disclosure of TCFD [Task Force on Climate-related Financial Disclosures) information by banks, insurers and takaful operators by the end of the year.


Malaysia is big on masterplans like this, and there is another over-arching one that is relevant: the 12th Malaysia Plan. This, too, includes sustainability-related reforms and initiatives, geared towards helping the Malaysian government’s stated ambition to become net zero by 2050.

Equally important is a new Climate Change and Principle-based Taxonomy (CCPT) launched through the Joint Committee on Climate Change, which is driven by Bank Negara, the Securities Commission and other stakeholders.

“Both the 12th Malaysian Plan and the Capital Markets Masterplan 3 talk about inclusivity, which can be achieved by marrying Islamic finance and sustainability,” says Nor Rejina. “The government-linked companies and the EPF are pushing the sustainable agenda, and if you’ve got those major names embracing it, it’s just a matter of time before the rest of the capital markets will as well.”

There are other reasons it has been harder for green sukuk to take off here.

“In Malaysia, it’s tricky because we’ve got a major issue with palm oil,” says Nor Rejina. “And a lot of our other major listed companies are in highways, which are also not very green. But the fact that we have a new and rigorous climate change taxonomy that all major financial institutions have to adhere to by July 2022 is going to be a major game changer.”

We can’t just say: ‘OK, let’s do away with palm oil or coal’. We don’t have the necessary infrastructure
Nor Rejina Rahim, Nomura Asset Management Malaysia

The palm oil issue is a thorn in the side of Malaysia when it comes to ESG. Palm oil plantations are big employers in the country. In 2020, Malaysia accounted for 25.8% of the world’s palm oil production and 34.3 % of its exports, according to the Malaysian Palm Oil Council; as of December 2020, 17.9% of the country’s entire total land area, or 5.9 million hectares, was planted with palm oil. There are over half a million plantation workers in Malaysia, according to the International Labour Organisation; the vast majority are migrant workers.

It has never been feasible for Malaysia to just flick a switch and turn off that part of the economy and the labour force that drives it, and it is a considerable irritation to Malaysians when Western investors suggest that it is.

“There has been a number of foreign banks saying: we are not going to bankroll palm oil,” says Raja Teh. “As a Malaysian bank, we cannot say that, it is crucial to our economy. Our role is instead to say: we will continue to bankroll you, but you will have to be certified,” on a range of sustainable metrics.

And if a palm oil company is unable to be completely certified to an ideal standard?

“That’s just an example,” says Raja Teh. “It could be anything that touches the environment. But we’re all learning.”

Nor Rejina takes a similar view from the investor perspective, and believes the CCPT will help.

“That taxonomy is very much looking at the idea of transition risks,” she says. “Because in this part of the world, we can’t just say: 'OK, let’s do away with palm oil or coal'. We don’t have the necessary infrastructure.

“But we can say to a company: we want you to make things a lot better for your migrant workers. There is a whole ecosystem that supports sustainability.”

This suggests there ought to be a market for sustainability-linked issuance: not green bonds, exactly, but those whose coupon is predicated upon tangible and verifiable improvements in a company’s climate or social impact. There should be potential for this to be applied to palm oil, provided improvements – on labour welfare, for example – can be verified with suitable rigour.

Specific sukuk

More broadly around the world, there is an expectation of more ESG-specific sukuk. S&P Global Ratings addresses the issue in its Islamic Finance Outlook for 2022, published in October.

“We may see more frequent issuance of dedicated social Islamic finance instruments and green sukuk as the industry realizes and leverages its alignment with ESG values,” the outlook says. “The aftermath of the pandemic and the agenda for core countries’ energy transition could create opportunities to expand these products.

“We expect adoption will remain slow, however, given the additional complexity related to these instruments and core Islamic finance countries’ slow implementation of policies to manage the energy transition.”

Nor Rejina notes a modest level of development in ESG funds for Muslims in Malaysia and across the Islamic world.

“Muslim investors don’t have a lot of choice for ESG options within the Islamic space itself,” she says.

But she does see some evidence of this changing: “Some of the major asset managers are already embracing this and have created funds that are not just Shariah, and not just sustainability, but a marriage of the two.

“From a performance point of view, we are seeing a lot better results if we marry the two.”

Fundamentally, though, a true marriage of Islamic finance and ESG is going to require some changes in the way that Islamic practitioners approach their work.

“In the Islamic finance world, practitioners are still very much focused on a negative and exclusionary sort of screening,” Nor Rejina says. “That’s got to change. A lot of what we have been working on is around active engagement with our investee companies.

“It is very clear that you cannot have a one-size-fits-all [approach]. Shariah has tried to standardize a lot of things, which is why you go through that negative screening approach. But the potential is much greater if the sustainability agenda is imputed in that. And that goes back to the spiritual teachings of the Quran.”

Islamic banking and loan moratoria

Islamic finance was not spared by the Covid-19 pandemic. The slowdown of economies, restriction of movement and the forced closure of businesses were just as problematic for Islamic banks as conventional ones.

In fact, in some ways it was worse.

“When a loan moratorium occurs, what happens is that we allow people to stop paying for a period of time, and we shift it to pay later,” explains Arsalaan 'Oz' Ahmed, chief executive of Al Rajhi Bank Malaysia.

During that time, in the conventional system, there is an accumulation of compounded interest. All things being equal, because of the shift in time of the payment, a technical loss, called a modification loss, occurs due to banks losing the opportunity to reinvest that money in something else.

“Compounding of interest adjusts for all of that,” Ahmed says. “But what it means is that people may be paying back a lot more, and it is not just the tenor that is being extended. The amount can be astronomical. Look at the impact on a home financing: it’s gigantic how much people are getting impacted.”

Without that compounding of interest, he says, a bank will have an accounting loss in the year that it happened, but write it back in future years. Islamic finance can’t compound interest, so typically one cannot adjust for this loss without renegotiating with customers.

Ahmed was troubled by the impact that compounding in the conventional world was going to have on ordinary people.

“What does this technical point mean to Joe on the street?" he says. "It means they are even more indebted. With everything that’s happened in Covid, someone has to look and say: 'People who have taken financing are going to be in even deeper trouble and we’re not going to see the full impact of this for years to come'.”

Permanent reality

During the first Malaysian loan and financing moratorium, he advocated to conventional banks not to compound interest. Ahmed’s former employer, HSBC, agreed, and then others followed.

Conventional banks were able to take this one-off hit for that moratorium, he says, but for Islamic banks that’s a permanent reality.

“There is a limit to what Islamic banks could do from a principles perspective during Covid because of the system we exist in that is primarily geared to manage conventional banks,” he says.

“It would be horrible to think we don’t collectively learn from what happened. We are in a pandemic, we want to help people, but if we as banks get impacted by this financial accounting piece that will impact our financial stability, therefore limiting what we can do to support customers, particularly in extraordinary situations.”

So, what should be learned?

“I think it is around understanding whether the time value of money is a relevant concept to adopt when something like this happens,” Ahmed says. "There should be an ability for people to freeze that accounting treatment without the penalization of anyone in the system.”

Regulators could have stepped in as required, he says, but probably not without potentially impacting the sovereign ratings.

“This goes to show the magnitude of the learnings from the principles of Islamic banking that can be applied on a global level,” he says.


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