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FEATURE: The role of Islamic financial services in climate resilience and adaptation

Margherita Calderone and Lena Weingartner introduce the potential of Sharia-compliant financial products to reach a new consumer base – and in so doing, boost families’ and communities’ climate resilience.

The UN Climate Summit in September 2019 will present a significant opportunity to transform the international response on climate change resilience and adaptation. It will also provide a key space to promote innovative sources of finance and financial instruments to support climate adaptation and resilience. While there is a growing consensus recognising that financial inclusion has manifold benefits, including enhancing financial stability and building resilience, there also needs to be a realisation that, if the international pledge to foster financial inclusion and support resilience is serious, Islamic financial products must be supported to ensure that Muslim populations are not excluded from the formal financial system.

ODI and Islamic Relief Worldwide (IRW) have launched a briefing note – Investing in financial inclusion for climate resilience and adaptation: The role of Islamic financial services – which aims to feed into the Climate Summit by examining the opportunities for investing in Sharia-compliant financial products.  The publication is based on an extensive literature review and the research team’s participation in a roundtable in February 2019 on the role of how Islamic financial services can drive greater financial inclusion and so support climate resilience and adaptation.

Basic principles of an Islamic financial system

Islamic financial systems have the following characteristics:

  • Prohibition of interest and speculative behaviour. An Islamic financial system discourages hoarding and prohibits transactions featuring extreme uncertainties, gambling and risks.
  • Risk-sharing. Because interest is prohibited, suppliers of funds become investors instead of creditors. The provider of financial capital and the beneficiary share risks in return for shares of the profits (and losses).
  • Asset-based transactions. As a result of the previous principles, the system promotes the ‘materiality’ aspect, which requires linking financing directly with the underlying asset so that financing activity is clearly identified with ‘real’ sector activity.
  • Sanctity of contracts and preservation of property rights. Islam anchors socio-economic relations in contracts and encourages individuals to comply with their contract terms (Iqbal et al. 2013).

Why scaling up Islamic finance could fuel climate adaptation and resilience

Financial inclusion rates tend to be low in Muslim-majority countries: more needs to be done to develop financial services and instruments that are tailored to the context. The trend is promising, though:

In recent years Islamic finance has moved from a market niche to a rapidly growing industry. According to the National Bureau of Asian Research, the Islamic finance market globally grew by between 10% and 15% annually from 2000 to 2012, and Sharia-compliant assets rose by more than 160% between 2009 and 2011. In 2016, the industry held about $1.6 trillion in banking assets (concentrated in the Gulf Cooperation Council (GCC) countries (Daly and Frikha, 2016).

The Islamic finance sector is attracting increasing interest from both Muslim and non-Muslim countries, and Sharia-compliant institutions now include banks (fully Islamic institutions and institutions with Islamic subsidiaries), Islamic investment banks and finance and insurance companies.

There is evidence that the application of Islamic finance principles makes a difference to inclusion of households, groups and Small and Medium Sized Enterprises in climate change adaptation and mitigation activities, too.

For instance– although instruments so far are underutilised, the recent emergence of green sukuks and the increasing use of zakat waqf in funding climate action exemplify this potential. Sukuk is a green Islamic bond where the proceeds are used to fund a specific environmentally sustainable project such as green infrastructure. Zakat is one of the pillars of Islam. It prescribes a spiritual duty to give a set percentage of one’s wealth to charity. Waqf involves donating an asset – usually land or buildings – for religious or charitable purposes.

What is more, when it comes to reducing the risks of extreme weather events, takaful [an Islamic alternative on conventional insurance] products are slowly but steadily emerging as a central part of the Sharia-compliant family of financial services, helping to meet insurance needs in ways that are consistent with local norms. Re-takaful is a Sharia-compliant form of reinsurance. A project piloted by Islamic Relief Worldwide in Bangladesh demonstrated that low-cost Islamic risk financing can open up opportunities to scale up insurance against extreme weather events among low-income individuals. Takaful has high potential and can possibly cover various climate-related risks at the micro and meso level.

However, in Islamic finance and beyond, more needs to be done to channel climate finance where it is needed most. To address this, there is a need to identify new approaches for investing in financial inclusion for resilience and adaptation at the micro and meso level through Islamic finance. In particular, there appears to be a ‘missing middle’ of intermediaries and aggregators that would be able to absorb and channel larger investments, for instance by the Islamic Development Bank, at a more disaggregated level.

Recommendations for scaling up

In scaling-up Islamic financial services, more effort is needed to identify new tools and complement grant funding with different financing approaches. Greater experimentation in product delivery could help in driving down costs, while further product development could contribute to wider acceptance of Sharia-compliant financial services as instruments of financial inclusion and resilience.

There is also a need to further develop relationships and partnerships to connect private and public actors, as well as linking Islamic finance players and donors with mainstream climate resilience and disaster risk management.

Read more

Read the full briefing note: Investing in financial inclusion for climate resilience and adaptation: The role of Islamic financial services


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