Arab pension funds are increasing their focus on ESG, and could benefit even more from recognizing its alignment with Islamic finance

• The Arab Monetary Fund and UNDP have jointly surveyed Arab pension funds and found rising understanding of ESG and a willingness to explore, strategize and plan to implement more
• Existing ESG integration is dominated by negative screening and thematic approaches, with much more limited work on systematic integration
• Given the prominence of the Arab world in the global Islamic finance industry, and the findings of research by RFI Foundation on the integration of ESG and Shariah screens, there are currently under-explored opportunities to improve outcomes for beneficiaries

UNDP and the Arab Monetary Fund recently released the results of a survey of a limited sample of pension funds in Arab countries, which looked at the progression of their adoption of ESG integration and focus on the Sustainable Development Goals. The survey was ‘limited’ in the sense of covering only public-sector rather than private pensions, which may have a wider range of progress in integrating ESG into their investments.

1. Three things jumped out from the survey results:Arab pension funds generally classify their progress as either being only at the stage of ‘knowledge and understanding’ or having robustly integrated ESG into their investment process. There are few in the in-between stage of developing strategy, conducting engagement with stakeholders, and developing a plan for ESG integration;
2. Far and away the most common approach reported is negative screening, followed by thematic investments with social, governance or SDG-related themes. More common approaches such as ESG integration and corporate engagement or thematic investments with an environmental focus are less common;
3. Among those with the most developed ESG integration, there remains very limited work on climate risk management. This is out of sync with expectations that the most common future driver for ESG integration by pension funds is that it presents a material financial risk requiring assessment and management.

The growth of ESG knowledge and understanding, and openness to work more on the topic, is a positive sign for these Arab pension funds. However, the maturity matrix used is just a rudimentary tool excluding, for example, the wide variation between the maturities of ESG integration. There are also significant hurdles to get from one end to the other of the maturity spectrum, and much work to do to get there.

However, the positive growth in awareness of the importance of ESG and responsible finance more broadly is complicated by a few more discontinuities than one might expect as responsible finance develops across the Arab world. For example, there is relatively limited reference to Islamic finance, despite the Arab world holding a large proportion of the world’s Islamic finance assets.

Some of the overlap between ESG integration and Islamic finance may be subsumed to some degree by the report’s classification of investment practices under the heading ‘negative screening’. However, that would leave the question of why so few pension funds report using ESG integration compared to thematic approaches.

For comparison’s sake, the Global Sustainable Investment Alliance’s 2020 Trends Report cataloguing responsible finance assets found that ESG integration was the most common approach ($25 trillion), more than 50% higher than for negative screening ($15 trillion), and much greater than the size of investment assets using thematic strategies ($1.9 trillion).

Developments in responsible investment among Arab pension funds are moving in the right direction. The large share of fund members who may prefer or already be covered by Shariah-compliance screening of their pension fund investments may add additional considerations for how ESG integration is conducted, as well as provide avenues for improving returns as the ESG integration implementation progresses.

The RFI Foundation’s recently released research found that ESG integration within a Shariah-compliant universe may have different results depending on the region where the investments are made. Within emerging markets, the ESG screening process generally delivers the best results and there is little performance difference between Shariah-compliant and non-compliant outcomes (there’s no systemic cost from Shariah screening).

In developed markets, there is more limited gradation for traditional ESG metrics between companies, and more investors already factoring in ESG risks into their investments, which limits the upside available from crowding into the best-in-class ESG assets. In these markets, however, we found evidence that the Shariah screens provide a good filtering mechanism within lower ESG scoring companies that may carry both higher ESG risk and prospect of returns if they sufficiently mitigate their ESG risks (where engagement by institutional investors can have an impact).

This would suggest that as Arab pension funds move across the maturity spectrum for ESG integration, there should be a specific consideration about how any Shariah screens applied might interact with the ESG integration approach being used. Furthermore, and especially for pension funds already integrating ESG that don’t apply formal Shariah screening, it would be useful to consider how some of the screens could complement existing ESG screening practices.

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