Green Finance Instruments, FinTech, and Investment Strategies: Sustainable Portfolio Management in the Post-COVID Era 3031290305, 9783031290305

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Sustainable Finance

Nader Naifar Ahmed Elsayed   Editors

Green Finance Instruments, FinTech, and Investment Strategies Sustainable Portfolio Management in the Post-COVID Era

Sustainable Finance Series Editors Karen Wendt, CEO. Eccos Impact GmbH, President of SwissFinTechLadies, President Sustainable-Finance, Cham, Zug, Switzerland Margarethe Rammerstorfer, Professor for Energy Finance and Investments, Institute for Finance, Banking and Insurance WU, Vienna, Austria

Sustainable Finance is a concise and authoritative reference series linking research and practice. It provides reliable concepts and research findings in the ever growing field of sustainable investing and finance, SDG economics and Leadership with the declared commitment to present the theories, methods, tools and investment approaches that can fulfil the United Nations Sustainable Development Goals and the Paris Agreement COP 21/22 alongside with de-risking assets and creating triple purpose solutions that ensure the parity of profit, people and planet through choice architecture passion and performance. The series addresses market failure, systemic risk and reinvents portfolio theory, portfolio engineering as well as behavioural finance, financial mediation, product innovation, shared values, community building, business strategy and innovation, exponential tech and creation of social capital. Sustainable Finance and SDG Economics series helps to understand keynotes on international guidelines, guiding accounting and accountability principles, prototyping new developments in triple bottom line investing, cost benefit analysis, integrated financial first plus impact first concepts and impact measurement. Going beyond adjacent fields (like accounting, marketing, strategy, risk management) it integrates the concept of psychology, innovation, exponential tech, choice architecture, alternative economics, blue economy shared values, professions of the future, leadership, human and community development, team culture, impact, quantitative and qualitative measurement, Harvard Negotiation, mediation and complementary currency design using exponential tech and ledger technology. Books in the series contain latest findings from research, concepts for implementation, as well as best practices and case studies for the finance industry.

Nader Naifar • Ahmed Elsayed Editors

Green Finance Instruments, FinTech, and Investment Strategies Sustainable Portfolio Management in the Post-COVID Era

Editors Nader Naifar Department of Finance and Investment Imam Mohammad Ibn Saud Islamic University (IMSIU) Riyadh, Saudi Arabia

Ahmed Elsayed Department of Economics and Finance United Arab Emirates University Al Ain, United Arab Emirates

ISSN 2522-8285 ISSN 2522-8293 (electronic) Sustainable Finance ISBN 978-3-031-29030-5 ISBN 978-3-031-29031-2 (eBook) https://doi.org/10.1007/978-3-031-29031-2 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Preface

In a post-COVID-19 pandemic era, a sustainable financial system is getting more attention, and policymakers are now moving into investment and financing decisions based on sustainable development. According to the European Commission, “Sustainable finance refers to taking environmental, social, and governance (ESG) considerations into account when making investment decisions in the financial sector, leading to more long-term investments in sustainable economic activities and projects.” Sustainable finance contributes to achieving sustainable recovery from the impacts of the COVID-19 pandemic. Green finance is vital in mobilizing financial resources and hedging against environmental risk to achieve a financially sustainable system. Moreover, green financial instruments provide alternatives for investors and regulators for portfolio management and risk minimization. Over the last few years, financial technology (FinTech) has been considered one of the most topical areas in the global financial services industry. The development of distributed ledger technology, big data, smart contract, peer-to-peer lending platforms, biometrics, and new digital has motivated innovation in the financial services industry and the development of new financing and investment strategies. The marriage of sustainability with Fintech helps policymakers to achieve ESG considerations when making investment and financing decisions. This book, “Green Finance Instruments, Fintech, and Investment Strategies: An Analysis of Sustainable Portfolio Management in the Post-COVID-19 Era,” is a collection of the recent development in green finance and Fintech, and their impact on achieving sustainable finance, investment strategy making, and portfolio management. This book provides appropriate theoretical frameworks and the latest empirical research studies in green finance, Fintech, and sustainable portfolio management. It is written for academics, professionals, policymakers, regulators, and investors who

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want to deeply understand the impact of green finance and FinTech on future investment and financing strategies in a post-COVID-19 pandemic. Riyadh, Saudi Arabia Al Ain, United Arab Emirates

Nader Naifar Ahmed Elsayed

Acknowledgments

To my father and my mother, my wife and my children, and to all my friends and colleagues, Thank you for your support!

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Contents

Part I

Green Finance, Sustainability, and Investment Strategies

Multicriteria Decision Analysis for Sustainable Green Financing in Energy Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . K. S. Sastry Musti

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The Development of the Global Green Finance Market: The Role of Banks and Non-banking Institutional Investors . . . . . . . . . . . . . . . . . Liudmila Filipava and Fakhri Murshudli

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Corporate Social Responsibility and Bank Credit Ratings . . . . . . . . . . . Laura Baselga-Pascual, Nebojsa Dimic, and Emilia Vähämaa The Impact of Banking on Sustainable Financial Practices Toward an Equitable Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hazik Mohamed Ethical and Socially Responsible Investments in the Islamic Banking Firms: Heart, Mind, and Money: Religious Believes and Financial Decision-Making in the Participatory Financing Contracts:Charitable Donation Announcement Effect on Agents’ Level of Effort and Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Anas El Melki and Hejra Ben Salah Saidi

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Malaysia’s Sustainable Banking Regulatory Framework: Value-Based Intermediation and Climate Change Principle-Based Taxonomy . . . . . . 125 Zuraida Rastam Shahrom and Sherin Kunhibava Part II

The Impact of Fintech and Investment Sustainability

The Impact of the Digital Economy Paradigm on Investment Sustainability in Oman . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 Faris Alshubiri ix

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The Sandbox in Saudi Arabia: A Regulatory Approach and Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191 Amal Khairy Amin Mohamed Risk Factors in Cryptocurrency Investments and Feasible Solutions to Mitigate Them . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211 Harsh Jain, Shourya Rohilla, Dhairya Vakharia, Neeraj Gangani, and Shalini Wadhwa The Examination of Shariah Compliance of Equity Crowdfunding Companies in Indonesia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237 Ahmad Hidayatullah and Burhan Uluyol Fintech and Banking: An Indian Perspective . . . . . . . . . . . . . . . . . . . . . 261 Amarpreet Singh Virdi and Akansha Mer Green Finance and Fintech: Toward a More Sustainable Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283 Sunanda Vincent Jaiwant and Joseph Varghese Kureethara

About the Editors

Nader Naifar is a Professor of Finance at the College of Economics and Administrative Sciences at Imam Mohammad Ibn Saudi Islamic University (IMSIU), Riyadh, KSA. He teaches graduate and undergraduate courses on Finance in Ph.D. Finance program, MBA, EMBA, and Bachelor of Finance (BF) programs.His current research focuses on, but is not limited to, FinTech, Financial Economics; Sustainability; Islamic Finance; Sukuk Markets; Green Finance; Default risk; Global crisis; Contagion; Climate Finance, and Energy markets. Nader Naifar has authored and co-authored multiple papers published in reputable international journals and has been a guest editor for several international journals.

Ahmed Elsayed is an Associate Professor of Economics and Finance at United Arab Emirates University. He is a core member of the Ethical Finance, Accountability and Governance (EEFAG) center, a Research Fellow of the SDGs Network, the Economic Research Forum, and the Institute for Middle Eastern and Islamic Studies, among other institutions. Furthermore, he is a Senior Fellow of the Higher Education Academy and an Associate Editor of the Research in International Business and Finance and the Heliyon Business and Economics journals. His current research focuses on, but is not limited to, FinTech and Cryptocurrency, Sustainable Finance and

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Financial Development, Financial Market Integration, Financial Networks, and Islamic Banking and Finance. Ahmed Hamed Elsayed has authored and co-authored multiple papers published in reputable international journals and has been a guest editor for several international journals.

Part I

Green Finance, Sustainability, and Investment Strategies

Multicriteria Decision Analysis for Sustainable Green Financing in Energy Sector K. S. Sastry Musti

1 Introduction Meeting the ever-growing energy demand has remained a major challenge to many countries. While developed nations strive to achieve energy adequacy, developing countries are trying to strike a balance between energy demand and supply. Capacity addition in the energy sector is financially intense and even requires careful analysis due to several risks involved. The major risk at the global level is the negative impact of energy production and utilization on the environment. Many studies have pointed to the need of combating the global warming, and energy sector is one of major contributors. Concerted efforts are in place at all levels to reduce the global warming by encouraging the use of environmentally friendly energy options. Green financing in general is aimed at increasing the use of renewable energies and reducing the use of fossil fuels. However, in the world of financing, needs of the fund seekers initiate the dynamics of the well-known supply and demand game. Adequate energy production and distribution are essential for social and economic growth of any nation, and the study of financing in energy sector is always interesting. Due to the contemporary climate policies and technological advances, green financing has become an excellent landscape for researchers. Energy markets are decentralized in many countries and thus electricity supply industry (ESI) more or less consists of independent verticals (Lingyan et al., 2022; Liu et al., 2020). The major ones are the generation companies (GenCos), transmission companies (TransCos), and distribution companies (DisCos). Though there are several advantages of such decentralization, the major objective is to improve technical and operational efficiencies of the individual verticals and also to encourage private investment in the energy sector (Jin et al., 2021; Managi et al., 2022). Financing in energy sector can be a complex landscape to understand. Several K. S. Sastry Musti (✉) Namibia University of Science and Technology, Windhoek, Namibia © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 N. Naifar, A. Elsayed (eds.), Green Finance Instruments, FinTech, and Investment Strategies, Sustainable Finance, https://doi.org/10.1007/978-3-031-29031-2_1

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factors including, but not limited to policy frameworks, technical, social, and financial aspects influence the state of ESI. It is usual to operate the sector with a lot of debt and debt financing. Let us examine the South African ESI, as it serves as good example for the scope of this chapter as there is a significant gap between demand and supply and also investments into the ESI have been differed over the years. As of now, global policies and South African national outlook do not entirely favor the coal-based energy production. This points to the need of considering the green financing avenues. According to a 2019 report (DPE, 2019), Eskom has a long-term debt exceeding R441 billions (approx USD29 billions). Its financial ratios clearly indicate that the financial debt and other challenges have been growing over several years. In 2019, Eskom has reported an annual loss in excess of R20 billion, and several municipalities were not able to collect the bills from the consumers (DPE, 2019; Sastry, 2007). According to the GreenPeace study, generation companies are the worst hit financially as South African generation companies reported heavy losses over successive financial years, 2018 and 2019 (GreenPeace, 2019). At the same time, it is interesting to note that distribution companies have shown profits, and transmission companies have done slightly better when compared to generation companies. Added to this, the GreenPeace report clearly indicates that reasons for such financial conditions of the organizations cannot be explained without information. This clearly shows that cash flows have not been as expected and payment delays and defaults have occurred. Hence, there are several conflicting and supporting aspects to the green financing for ESI do exist. Stakeholders have their own interests, and value chain gets influenced by several aspects. Energy projects are financially intense due to inherent nature of essential needs and high value chain engineering and social ecosystems. Most capacity addition projects are typically planned over 20 or 25 or even 30-year horizon. Global trends in climate policies explicitly encourage the of renewable energy technologies (RETs) to reduce overall greenhouse gas emissions. However, capacity addition in any segment be it using RETs and/or with fossil fuels takes considerable planning, resources, and time (Dziugaite-Tumeniene et al., 2017; Sastry Musti et al., 2021). For instance, the overall costs of RETs in the solar segment are very low; however, solar firms need a lot of land to produce the same amount of energy when compared to a thermal power plant. However, the average time to establish a solar power plant is far lower when compared to a thermal plant. Similarly, it usually takes 10–15 years to establish a hydropower plant and requires significant amount of land as well. Fossil fuel-based energy production also requires a lot of water for cooling and other operations (Li and Huang, 2020; Sastry et al., 2013). Utilization of land for establishing the power plants results in displacing a large number of people and in some cases removal of forests. Thus, a conflict can be seen between the energy generation for national needs and social and environmental interests. At the same time, a lot of capital is required for establishing power infrastructure, and it is common to seek loans for major international lending houses and/or through private investors (Chen and Ma, 2021). However, most international funding agencies are now obligated to provide funding for capacity addition projects and other energyrelated initiatives that are environmentally friendly (He et al., 2019; Azhgaliyeva

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et al., 2020). This results in a constraint that opposes the use of fossil fuels, though some countries may have the natural resources. In other words, there is a nexus between resources and needs that needs to be resolved through careful planning (Chang & Starcher, 2019; Sastry Musti & Van der Merwe, 2022). As of now, no research work has completely addressed the complexity and challenges in green financing to energy projects. Thus, in the first instance, all the factors related to ESI development need to be identified. Further, interdependencies and conflicting aspects between those factors need to be identified as well. To address these gaps, this chapter focuses on green financing in energy sector through elaborate discussions on technical and financial aspects. For this, the chapter first takes up discussion related to some selected, yet key needs, challenges, and risks in ESI. Challenges in the decision-making processing will be illustrated. Then it deals with the possible opportunities and the application of multicriteria decision methods (MCDM) for making informed decisions specifically in the areas of capacity addition and risk evaluation.

2 Literature Review International climate policies, increasing awareness, and even falling prices of RETs have prompted various nations to take up the path toward clean energy. United Kingdom has taken a decision to close a few older nuclear power stations as part of its clean energy initiatives. In its 2019 report, Eskom, the South African utility recommended the decommissioning of its oldest coal-fired power stations (GreenPeace, 2019). However, such initiatives need to be backed up with newer energy production facilities that are environmentally friendly and also capable of meeting the energy needs of the nation. Energy projects are financially intense and thus require huge amounts of capital investments and of course timely and smoother flow of funds to maintain the infrastructure. Since energy is related to different areas such as economic development, social obligations, and industrial development, research on the financial aspects is interesting. In fact, energy financing is a very vast area and indeed complex various areas exist due to the logistics, supply chain, market design, complexities conflicting, and interrelated aspects (Carfora et al., 2021; Chen et al., 2019; Dutta et al., 2020). Some utilities have openly reported the challenges related to managing the energy sector through comprehensive analysis, specifically pointing to the poor financial conditions, reducing revenues and losses over successive years (DPE, 2019). Replacing the old, fossil fuel-based plants with eco-friendly energy systems are quite challenging due to several reasons. Thus, combating the global warming requires appropriate policy decisions at the highest level and then resolving various technical and logistical complexities to push the green initiatives forward. With the recent developments in renewables and environmental conditions, several countries are more inclined to add capacity in solar PV, wind, and other renewable segments. However, such resources are dependent on local conditions and

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have several technological challenges in delivering the energy to the end consumer. Naturally, green financing is now becoming the norm due to changing policies and frameworks in most countries. The major reasons behind this are the availability of funding for green initiatives, falling costs of RETs, and proven track record of smart grid technologies in cost savings and reduction of greenhouse gas emissions. Thus, green financing can be sought in different areas—building new RE power plants, development of smart grids, and/or transformation of legacy networks (Trinasolar, 2022). Financing such long-term green energy projects that too in large sums requires a lot of information and careful planning (Musti, 2021; Sastry Musti et al., 2021; Shiljkut and Rajakovic, 2015). Though there are several factors, actions, and stakeholders that influence energy financing, a few of them are outlined below. From the above discussion, on the policy front, major aspects are ability of the ESI to uptake energy mix, support for smart grids, fair market conditions for IPPs, appropriate policies for cost sharing based on their geo-location, fine turning of policies related to Demand Side Management (DSM), Energy Efficiency (EE) and Circular Economy (CE). On the operational front, independent variables also need to be understood well. They include aggregated demand response of the system, energy injected by the prosumers, consumer-initiated saving strategies, consumer migration (due to the lack of employment and/or cost of living), power thefts, and nonpayment of bills (Sastry, 2007). Figure 1 shows all of these in perspective to provide a graphical illustration of major issues that will be taken up in this chapter for discussion. Risk evaluation is most important and central for any financing model. The classical financing landscape uses the well-known credit score approach as it is the single parameter on which both financiers and loan seekers keep a close watch.

Fig. 1 A schematic representation of a typical ESI with various actors, verticals, stakeholders, and actions

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Financiers would want their customers to have a healthy credit score as it represents their repaying abilities. Also, financiers do expect a comprehensive and genuine framework for the evaluation of credit score. Once the loan is granted, the financiers would expect a free flow of information about the changing financial standing and assured cash flows. In other words, financiers would want to understand the risks before lending and try to establish and maintain the cash flows toward timely servicing of the loan. Now the customers try hard to secure the loans to meet their financial needs and generally try to maintain healthy credit scores to demonstrate their good financial standing. At the same time, finance companies that almost act as a bridge (or agents) between the financiers and the recipients will advise both parties on various aspects—specifically the financiers on possible risks and terms and conditions to the customers. And then, collateral arrangements have their own role as permitted by the applicable legal framework. Green financing is no different from the other forms of financing; however, the analysis related to risks involved, challenges and opportunities to the stakeholders is of significant interest (Azhgaliyeva et al., 2020; Hauwanga & Musti, 2022). However, the evaluation of risks involved in energy financing can be quite broad subject. Risks can be associated with different aspects such as the national-level framework, current financial standing of the stakeholders, abilities to make profits, abilities to payback, technological choices in selecting the RETs, and resource availabilities (Hashemizadeh et al., 2021; He et al., 2019; Musti & Kapali, 2021; Şerban et al., 2016). For example, if the national policy is not favoring the use of RETs, then there may not be any scope at all for green financing. Similarly, if the national policy provides significant levels of encouragement and financial incentives for DSM, EE and CE, then consumers resort to reduce (or even avoid) the use of electricity and even may shift to other energy options such as roof-top solar and/or water heating systems (Goddin, 2020; Musti, 2020a, 2020b). This directly results in reduced incomes to the utilities. However, CE, DSM, and even energy efficiency (EE) initiatives are key elements of green initiatives, though they act in opposition to the interests of the green financiers. Typically, governments and regulators strive toward least cost capacity addition to cut financial burden. However, aspects such as availability of resources for energy production, continuous load growth, expansion of societies, changing policies due to leadership changes will affect overall costs of energy projects. Though green financing goes well with least cost planning strategies, earning models are subject to several conditions as narrated above. Among the different energy resources, solar photovoltaic (PV) is an attractive option for electric power producers when selecting the most suitable RET to implement (Pitra & Musti, 2021; Dall et al., 2019). This is because of its unique relationship to system integration, its decreasing cost, performance improvements, and its huge unexploited resource potential. Thus, capacity addition in the solar PV segment has gone up for obvious reasons. In many cases, excess amounts of solar energy during peak hours can result in negative loading conditions due to the fact that supply is far greater than the load itself. And this leads to the formation of duck curve phenomena. Under this condition, energy from RE plants is curtailed and thus resulting in loss of revenues to the IPPs. Least-cost

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planning is always subjected to resolving the resource nexus, and thus, decision making in picking the RETs is always complex as it is not entirely mathematical. Risk assessment also involves several parameters that are cannot be measured directly. MCDM tools provide an excellent avenue to deal with such complex settings. Ekholm et al. (2014) have proposed MCDM methods to resolve climate policy issues. Sastry Musti and Van der Merwe (2022) developed a simple MS-Excel tool for selecting the energy mix. However, there is no simple MCDM tool at present available to undertake risk evaluation. This chapter makes an attempt to address this very gap. DSM strategies encourage energy savings; installation of small-scale roof-top PV systems with or without storage and solar water heaters. Regulators recommend liberal financial incentives to the consumers who follow the DSM guidelines. Thus, most modern consumers are transforming themselves into prosumers, and this results in decrease in the energy consumption and this in turn results in revenue loss to the utility. Thus, DSM nearly acts in opposition to load growth, and thus, green financing strategies need to consider current DSM policies, demand response in general, and also prospects for load growth. Due to environmental concerns and steep reduction in the capital and levelized costs, renewable energies are popular choice for capacity expansion. Utilities in most countries are allowing independent producers to participate in their energy markets, more specifically in the solar-pv and wind segments. Increasing penetration of solar-pv and wind has resulted in duck curve phenomena, and many utilities have reported the technical and financial challenges associated with duck curve phenomena. Typically, the off-taker will curtail the solar-pv in-feed and continue to utilize base load plants. This poses significant risks to the operations of IPPs. This aspect is now seen as major financial threat, and this predominantly affects green financiers. Energy market design greatly influences the wheeling and other infrastructure usage charges Freytag (2020). Location of IPP, mode of loss allocation in the network, and availability of single buyer will also influence the revenues of IPPs (Liao et al., 2011; Hauwanga & Musti, 2022). Thus, investors and financiers need to analyze present energy market designs, wheeling charges, and prospects of finding a nearby single buyer to ensure financial inflows and revenues. Apart from the above, several other challenges that are specific to a country’s socioeconomic conditions do exist. Some of them include, but not limited to (1) absence of required frameworks for green finance or finance to clean energies, (2) lack of internal data/information systems, which may result in inaccurate estimations for setting national investment policy, (3) absence of regulatory and legal framework directly related to green finance, (4) lack of proper framework for energy transition toward clean energies that might result in poor green project selection and management, (5) information asymmetry at the capital markets, and (6) lack of analytical tools and expertise in identification and assessment of green projects’ risks. Further, there may be a few hard factors that can influence green projects. They include cheaper and guaranteed energy imports from neighboring countries, lack of resources (such as land, water, etc.) that may prevent capacity addition in large quantities, especially in the cases of small island countries and/or land locked countries.

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From the above, it can be seen that green financing is gaining lot of prominence. However, there are several factors that have to be carefully considered in order to ensure sustainable project progress and stable financial outlook. There are several interdependent, cross-dependent, and mutually conflicting aspects that need to be studied carefully and resolved through a structured fashion. Understanding and analyzing the risks and applying the multicriteria decision methods to some of the problems can provide successful pathways to reap the benefits of green financing opportunities in energy sector. In this context, this chapter has the following objectives: • Qualitative and quantitative treatment of various factors related to green financing • Challenges, risks, and opportunities for green financing. • Application of MCDM for green capacity addition and risk evaluation

3 Identification of Needs, Challenges, and Risks in ESI Energy need of the nation is the key most driver for sustained investments into the ESI. To effectively manage the ESI, different stakeholders have different needs. There are challenges and so are the risks. The subsections below discuss some of the key needs, challenges, and risks.

3.1

Load Following Power Production

Knowing the varying load in real time and then adjusting the generation levels is an operational requirement. Thus, load information is a need for the utilities. For this, meters in different locations measure the key parameters and send to the central facilities so that generation can be adjusted if possible. The conventional, fossil fuel-based generation and load consumption patterns are changing rapidly due to various reasons, but mostly due to the advent of smart infrastructure being put in the place, in the immediate past. And this is true for many countries even now, where little or no renewable energies are used. Typical (legacy) generation and load profile are shown in Fig. 2. The hatched region indicates the power generated and/or supplied to the feeder at a constant level of 780 kW throughout the day. Load is varying according to the consumption patterns of the consumers on the feeders. It can be seen that load consumption is not constant over any given day. The hatched region indicates the energy that is supplied, but not consumed. Which means, utility did not earn any revenue for this energy that is supplied, but not sold. This means revenues for a significant part of the energy are “lost.” A few points should be noted here. (1) Generation levels are normally in mega-watts, and this example has used kW only for illustration purposes and this means quantity and

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Varying Load and Energy Unsold 1000 900 800

Unsold, unutilized energy

700 600

Peak load

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Based load

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Fig. 2 Daily load profile and energy supplied by a base load plant

costs of energy lost can be very high. (2) Load profile can be visualized typically for a specific consumer, or for a feeder or even for an area such as a building or even a city. (3) Load profile can be visualized for a day or for a month (with average values) or for a year based on requirements. (4) Then consumption over the weekends and holidays differ significantly from that of weekdays due to obvious reasons. (5) The example uses a case of 11 kV power distribution feeder with a limited number of consumers (peak load: 780 kW) in a small area. (6) Generation sources, especially fossil-fuel based, base load generation facilities are from power distribution areas where the end consumers are located. This means, there will be power loss over the transmission lines while transporting the energy, which generally varies, but can be safely assumed as 10% by taking the mix of high power and lower power distribution lines into consideration. (7) One important aspect about fossil fuel-based generation is that every plant normally will have different generator units and plant engineers do control the overall energy plant output based on the load forecast and power dispatch information that is available to them. At the hindsight, it may appear as though it is possible to reduce the unsold energy by switching off a part of generation when not required. However, such a case is not possible as thermal power plants cannot be switched off and on frequently due to ramp-up and ramp-down constraints. Even otherwise, such switching on/off requires a lot of real-time information and extensive computation. From the above, it can be seen that nonrenewable energy plants such as coal, nuclear and natural gas are normally used to supply the base load. These are baseload plants that typically result in a significant amount of unutilized energy and also contribute to greenhouse gas emissions. With the advent of smart grids and RETs, it is possible to mitigate some of the problems. Now, let us examine the case of smart grids with appropriate control technology. Smart grids have the ability to incorporate

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Fig. 3 Energy mix with base load and solar plants

RETs such as solar and wind energies at various points in the power grid. Let us consider a simple example of formulating an energy mix solution to a town with a peak load of 390 MW at 13h00 (or 1PM) during the day and has a base load of 150 MW. Let us say a few more MWs of energy (say, 495 MW) is required to cater to the power losses during the peak time. If the energy pool is designed in such a way that only a coal-based power plant with a base generation of 495 MW, then a significant amount of energy (except during the peak loading) will stay unutilized and thus remains unpaid for. Such planning is not effective and not economical. Since peak, in this illustration occurs as mid noon as in most cases, it is desirable to consider building a solar farm as solar energy is available during those hours. It is important to consider system losses and reserve energy. While system losses (transmission, transformation, and other losses) generally go up to 9–12% depending on various aspects, the reserve energy is generally planned at 10–15%. This means base generation should be around 150 MW (of load) + 41 MW (losses plus reserve) = 195 MW. This can be considered as 200 MW approximately. At the peak, the generation should be 390 MW (peak load) + 105 MW (losses plus reserve) = 495 MW approximately. Now an appropriate energy mix needs to be simulated for this scenario. There are many takeaways here. First, energy outputs of base load plant and the solar energy plants are now mixed to realize the energy mix. Second, variations of both energy and the load are now looking similar as shown in Fig. 3. This is what is called load following energy production, as the pattern of overall energy production closely matches with that of the load. Third, a portion of the load, specifically the load during the peak hours, is now met by cheaper and environmentally friendly solar energy. Lastly, solar plants are located closer to the grid when compared to base load plants and this means, transmission lines losses are reduced as overall

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flows are now less. Energy mix has several other advantages as well. It supports localized IPPs and thus investor friendly. It also agrees well with the circular economy principles. However, it should be noted that this is only a simplified illustration to illustrate the energy mix. In reality, several different costs and technical aspects need to be considered. Given the intermittency nature of the solar energy, utilities need to monitor the quality of the power delivered by the solar segment. In fact, regulator usually sets the technical standards within which the IPPs need to operate.

3.2

Duck Curve

Conventional power plants contribute highly to the emission of greenhouse gases to the atmosphere. In order to change this paradigm, power utilities are encouraged to meet the electrical power demand by generating electricity from both conventional and renewable energy technologies (RETs). Since costs of RETs have decreased drastically in the recent past, a great deal of investments is being made in solar segment (Chen and Ma, 2021; Giones et al., 2019). In many cases, excess amounts of solar energy during peak hours can result in negative loading conditions due to the fact that supply is far greater than the load itself. And this leads to the formation of duck curve phenomena. This phenomenon is generally illustrated using a typical plot of load and generation over a day and a pattern that is similar to a duck can be seen (Pitra & Musti, 2021). Figure 4 shows a typical formation of duck curve condition as result of varying solar PV penetrations over 4 years. In other words, the duck curve phenomenon occurs when solar energy in higher quantities is integrated into the power grid. This results in excess generation that cannot be delivered during peak hours and a part of the load that cannot be supplied during off-peak hours. Over the day, solar energy starts ramping up as the sun rises in the morning, reaches its peak around mid-afternoon, and starts dropping as the sun sets in the late afternoon. This declining power output in the late afternoon is usually accompanied by a rising load, demanding an immediate supply of peaking power from fossil fuelbased power plants or any other possible sources. Thus, the addition of high penetration of PV to the power grid increases operational complexity and in fact results in contrasting conditions of lower load demand during mid noon and higher load demand in the evening hours (Dall et al., 2019). The net load, that is, the difference between electricity demand and the portion supplied by PV power, is what is referred to as the duck curve. System operators have two options—shutting down either conventional, fossil fuel based (usually thermal) power plants, or the environmentally friendly solar PV plants. However, this problem of negative load is only for a few hours, about 3–4 h. It is not really possible to shutdown thermal power plants due to ramping up and down problems. Obviously, this results in the curtailment of solar PV for obvious reasons. It should be noted that, in most cases, the energy supplied by privately owned solar PV plants. The energy from these plants is sold typically through well-structured power purchase agreements that may not provide

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Fig. 4 Duck curve phenomenon over the years with different levels of PV generation

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flexibility to utility engineers in dealing with operating conditions. The problem becomes much more complex if there are more IPPs with small capacities, engineers need to have an approved process for applying the curtailment to certain plants, and/or for taking a plant offline from the grid, etc. Thus, it can be seen that the addition of excess solar energy than needed is the root cause of the problem.

3.3

Location of IPP

In most developing countries, energy markets are open to private investment through well-defined market structure, policies, and power-purchase agreements. This naturally results in a number of private investors operating simultaneously and thus modern smart grids are typically energized by different IPPs with different RETs at various locations. The power plants owned by IPPs are connected to the grid through a metered point, or the PCC. Cash flows depend on the energy flows, which will be measured by the meters at the PCC (Hauwanga & Musti, 2022). Numerous technical challenges such as possible system faults and power quality issues are associated with integrating the varying nature of solar PV and wind resources. System faults need to be cleared by fast acting protection schemes that can isolate the power plant from the grid to avoid possible damages on either side. Both PV and wind power plants are known to produce harmonics and thus poor power quality can render up to 15–20% of their energy useless. To deal with such difficulties, policy frameworks specify the technical standards within which the IPPs are expected to operate. Thus, the IPPs are expected to invest into appropriate quality control infrastructure, real-time monitoring systems, and skilled engineers to meet the set standards. Revenues for IPPs depend largely on the energy supplied, but intermittency and seasons play their role in limiting the energy output. Importantly, it is the responsibility of either local or federal governments to acquire the land and issue lease-based ownership or land use licenses to the IPPs. However, bit lots of land either for PV and/or wind can be provided outside urban areas, thus plants owned by IPPs are far from the urban power grids. Power transmission lines need to be run from the plant to the urban grid, and somewhere in between a substation needs to be built, where the PCC is situated. For this, right of way for the power corridor and also the land for the substation needs to be acquired. Costs of such procurement and infrastructure development need to be factored into the revenue estimates and risk assessments. In fact, PCC is the point where the power from the independent power producer is transferred or sold over to the grid given that it meets the quality requirements. Hauwanga and Musti (2022) stated that the PCC is “the point in the electrical system where the ownership changes from the electric utility to the customer The distances between IPP to the PCC and PCC to the grid are often ignored in risk assessment.” Another aspect is that usually 8–12% power is lost in transmission losses. These losses are significant, and in fact increase with capacity addition through distributed generation. Losses depend on the lengths of the transmission lines. It is important that the financial value of the losses needs to be

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determined and then allocated to various stakeholders through the avenues provided by the market design (Hauwanga & Musti, 2022). Further, financial costs involve several parameters such as market models, cash flow structures, energy flows, and losses, as the utility wants to absorb the losses in the section from PCC to the grid. Revenues and other cost parameters are dependent on the distances involved, as the power losses occur in in both the sections. If the distance between the power plant and the PCC is more, then power loss in that section will be more (than the power loss in the section owned by the utility) and naturally the IPP needs to absorb the same. Thus, IPPs need a lot of information before they think of investing so that informed decisions can be made (Giones et al., 2019; Hauwanga & Musti, 2022). It is here, the government and the regulator play a vital role to see that all the required information is provided for understanding the overall financial implications. From the above, it can be seen that IPPs do need a lot of system data and information before making their investment. Trinasolar (2022) clearly indicated the importance of accurate data and information for various aspects of ESI management—in developing energy policies, market design, costs and cash-flow mechanisms, financial incentives, and penalties for various operating scenarios etc. Otherwise, IPPs can be subjected to significant financial and legal risks. However, there are other factors that also exist that can contribute to the risk, such as the location of PCC (Hauwanga & Musti, 2022).

3.4

Policy Framework and Possible Contradicting Aspects

There are other factors as well that can potentially contribute to duck curve phenomenon or the net negative load. Some of them include solar PV installations in domestic, commercial, and industrial consumer segment. In other words, when regular consumers turn into prosumers, load seen by the supplier goes down and thus forcing the utility engineers to adjust the generation levels to suit the operating conditions (Goddin, 2020; Musti, 2020b). This reduced load is the direct result of a greater number of consumers turning into prosumers in a bid to cut down their own energy bills by installing solar panels in their respective premises. It is important to examine the reasons for increased number of prosumers and the overall possible circularity in energy usage (Musti, 2020b). First state policies and incentives to the citizens for using solar energy production, second, the higher energy prices, and third frequent power shutdowns due to lack of adequate energy from the supply side. Not just solar panels, even the addition of solar water heaters also results in significant reduction in energy consumption and thus net load seen by the utility goes down (Musti & Kapali, 2021; Şerban et al., 2016; Musti, 2020b). While it is not possible to restrict the citizens in their choices for energy use, the utility certainly needs to know the overall load, its trend over the day. The load curve is the typical starting point that describes the overall demand. It is for this reason, energy audits must be conducted to undertake physical verifications of consumer apparatus, importantly solar PV panels and solar water heaters at the consumer premises to

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provide the much-desired estimates for the overall load (Şerban et al., 2016). Such information needs to be kept in a centralized facility so that different stakeholders can use it to adjust their individual energy outputs in a transparent with manner (IEEE Innovation, 2022b)

3.5

Energy Market Design and Operating Conditions

Most ESIs in the world are decentralized into different, independently operating verticals—mainly as GenCos, TransCos, and DisCos. This results in resolving many issues related to operating efficiencies, obscurity of information, and even the details related to value chain. Value chain in ESI is mainly related to energy flows and cash flows. Figure 5 illustrates that energy is generated by the GenCos, it is then sent to TransCos, which then is sent to DisCos for distributing it to the consumers. Now, consumers pay for the energy consumed to the DisCos, who will in turn pay to the TransCos and then finally GenCos get paid. In the overall value chain, the energy flows occur from GenCos to the consumers, whereas the cash flows occur in the opposite direction. Typically, consumers pay at the end of the calendar month, but meter readings will be considered during a set of specific dates, let say from 15th to 15th of successive months. TransCos might get their payments in bulk, may be once in a quarter or so. Similar arrangements may exist for GenCos to get paid. Issues related to nonpayments and delays can lead to breaks in the value chain for obvious reasons. However, it should be noted that the technical standards for energy flows and financial obligations for the cash flows will be set by the regulator. Enforcing the set procedures in ESI is always a challenge just as in other sectors. This can happen due to prevailing political, social, or economic conditions. It should be noted that the value chain system illustrated in the figure is a simple model and in reality, the ESI structure can be quite complicated. Government has the direct responsibility to set up a level-playing field so that financial risks are reduced for stakeholders and the

Fig. 5 ESI verticals, energy flows, and cash flows

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verticals. The job of the regulator is to enforce the set protocols and policies to ensure the value system operates effectively.

4 Opportunities with Smart Grids From the above sections, it is clear that advances in smart grids can provide several opportunities. For instance, MCDM can be used to evaluate risk and energy mix can be used to follow the load. However, timely switching on/off of the loads and energy sources is possible only with real-time monitoring and control. Conventional grids cannot achieve such a monitoring and control. However, by using smart grids, it is possible to accomplish real-time monitoring and control, and thus load following feature. Smart grids support several state-of-the art technological options such as integrating a diverse energy portfolio and consumers using the power networks that centrally monitored and controlled in real time. Apart from this, smart grids can potentially result in wide ranging benefits. In an article titled, “3 Real-Life Examples of the Positive Impact of Smart Grid Data Analysis,” IEEE Innovation (2022a) states that The Boston Consulting Group found that an energy retailer was able to boost its gross margins by more than 20% by creating detailed customer profiles using multiple sources of data to guide pricing increases, targeting those likely to pay and avoiding those at high risk of churn. Florida Power and Light was able to use grid data to monitor the status of their grid and operations (particularly from their smart meters) to gain $30 million in operational savings. Norway has reached the epitome of clean energy, with over 96% of electricity produced from hydropower, and a goal of selling no fossil fuel-powered cars by 2025. The country is on its way to being the first fully renewable energy-powered nation and is reaping significant benefits like more efficient energy generation, new jobs in the renewables sector, improved consumer choice in energy, and reduced carbon footprint.

However, a majority of the power transmission and distribution networks are more or less existing and functioning across the globe, though several more networks are expected to be added. The smart grid control technologies can be easily adopted while developing the newer networks. On the other hand, the major challenge is to transform the existing legacy networks into modern versions so that they can be part of smart grids. Smart grids essentially operate on the information that is collected from the meters in various places in real time. A lot of computational and digital storage infrastructure is required for effective management. Thus, existing networks require transformation in two ways—removal of obsolete infrastructure and addition of state-of-the-art infrastructure. Such a transformation is imperative to realize the benefits such as those indicated above. Cost of such transformations can be prohibitively expensive given the vastness and geographical spread of the power networks. The major question is how to secure green financing for modernization of the legacy

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networks. However, this challenge can be considered as an opportunity if the energy policy can be modified to incorporate in smart grids and timely transformation of the legacy grids into smarter versions. Such a policy shift naturally attracts international funding agencies, as it would help the utility to make higher revenues and profits.

4.1

Application of Multicriteria Decision Methods

Application of MCDMs to various aspects of energy systems is of significant interest. MCDM tools have become a standard choice where participating variables are dissimilar from one another (Sastry Musti & Van der Merwe, 2022). In this section, the tool developed by Musti (2021) is used to apply standard MCDM methods to the problems of energy mix and risk evaluation. It should be noted that problem formulation can be different ways with different variables with varying degree of impact. The tool itself is versatile as it allows the users to change the variables and weights.

4.2

Energy Mix

As of now, different renewable energies are available and each of them having their own costs, advantages, and disadvantages. Social, economic, and environmental impacts of renewable energies are always of significant interest to contemporary researchers. In the modern era, demand response needs to be understood well for planning the energy mix (Musti, 2020a; Sastry Musti et al., 2020). And proportions in energy mix invariably depend on merits of different energy resources. Just as any other example, choosing a renewable energy for a specific purpose also involves both measurable and nonmeasurable attributes or criteria in the decision-making process. Naturally, several researchers have applied MCDA methods to renewable energy selection. This case study considers few of the well-known attributes— levelized costs of production per megawatt hour, land usage in acres, environmental friendliness, and capabilities of load following. Realistic values for these parameters have been chosen from reputed references. Both the attributes energy production costs and land usage values are measurable. Costs of energy production and land usage values are obtained from standard data repositories (Sastry Musti & Van der Merwe, 2022). Then the rest of the two attributes are nonmeasurable directly. Hence, numerical values on a scale of 1–10 are given to both environmental friendliness and load following capabilities, based on the known information. Few points should be noted beforehand. This only a simple, entry level example on selecting a renewable energy resource, as the emphasis is more on using MS-Excel tool and applying the MCDA techniques. In a real-world setting, there will be several different expenses in energy systems from generation point to the end use. Costs of energies vary from place to

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Table 1 Default input data for renewable energy selection Solar PV Wind Coal Natural gas Nuclear

Total cost 88 91 112 152 136

Land required 44 71 13 14 15

Env. friend. 10 9 2 3 2

Load follow 2 4 9 9 9

Table 2 Overall rankings of renewable energies from different MCDM Rank 1 2 3 4 5

Weighted sum Solar PV Wind Natural gas Coal Nuclear

Weighted product Solar PV Wind Natural gas Nuclear Coal

WASPAS Solar PV Wind Natural gas Nuclear Coal

Topsis Solar PV Wind Coal Nuclear Natural gas

Table 3 Input data with high weighting for load following capabilities Solar PV Wind Coal Natural gas Nuclear

Cost 87 90 110 150 135

Land usage 43.5 70.64 12.21 12.41 12.71

Env. friend. 8 8 1 3 2

Load following 3 3 8 10 9

place due to local environmental conditions, sages to staff and even cost of construction etc. (Sastry Musti & Van der Merwe, 2022). Values of the input parameters used for the selection of energy type are shown in Table 1. With the above data set, all the MCDA methods should be independently executed and the corresponding output shows that solar PV which has the least cost ($87) is ranked as the best one by all methods, and there are other reasons as well including high rating given in Env. Friend. category. Solar PV which has the weightage (a beneficial criteria) is ranked as the best one by all methods and overall rankings are shown in Table 2. Now let us consider that cost is not a prominent attribute, but load following ability is more important, and that the cost and land usage may not be very critical. This may be justified in a location where critical, industrial, and commercial loads exist. To try this option, changes are made in such way that the attribute for the Load follow is now increased to 0.5 and the rest are reduced, while ensuring the sum of the weights of all the attributes is one. Since the tool is user-friendly, it is possible to change the data on the cover sheet and then carryout the computations in all the rests of the sheets. The changed inputs and the corresponding outputs are shown in Tables 3 and 4.

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Table 4 Overall ranking with high weighting for load following capabilities Rank 1 2 3 4 5

Weighted sum Natural gas Nuclear Coal Solar PV Wind

Weighted product Natural gas Nuclear Coal Solar PV Wind

WASPAS Natural gas Nuclear Coal Solar PV Wind

TOPSIS Coal Solar PV Nuclear Natural gas Wind

And the corresponding output shows that all the methods identified natural gas (also known as the gas peaker) as the best, except the TOPSIS which picked the coal as the best. It also ranked natural gas and wind at the bottom, though weights are in favor of Env. Friend attribute. As explained earlier, it is the way TOPSIS carries out the computations based on Euclidian distances that are different from the rest of the methods, and thus the results will be different from the rest. As explained earlier, this is an example to demonstrate the distinctive features of different methods and also to attest the fact that all the methods do not give same results, though same input data sets are used.

4.3

Risk Evaluation

Just as any other financing models, investors would like to study various risks involved and especially want to understand the prospects for handsome and timely returns. Since there are several stakeholders with different interests and requirements, decision making can be very difficult to ascertain such prospects. Thus, this problem warrants the application of MCDM. For this, the entire ESI can be divided into five (5) different verticals—viz., GenCos, TransCos, DisCos, combination of these three verticals, and then finally the anciallary services. Possibilities for investment in four verticals are already discussed earlier. Ancillary services in the ESI are critical in the modern day context as specialized services such as reactive power injection, voltage control, and energy storage provisions can be offered by independent firms. Almost all ESIs encourage private firms that specialize in ancillary services to cut costs in procuring specialized equipment and to employ skilled engineers. Now the green investor has options to invest in any of the three verticals and also in the combination of these three and then also in investing into exiting ancillary service firms. Similarly, let us consider four major categories, viz., profits made, current state of the technology in terms of smart readiness, existing environmental policy, and current level of solar penetration for evaluating the risk. Higher profits indicate financial stability and urge to take the loan is lower. Thus, this parameter is set as nonbeneficial one. In other words, if a vertical is making high profits, then it may not need the loan in the first place. There may be several reasons for lower profits such as failures in value chain system and current policies, and these can be possibly

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Table 5 Input data with high weighting for risk evaluation for investments into various verticals Ben 1/Non Ben 0 Weightage Investment area GenCos TransCos DisCos Combined Ancillary Services

0 0.3 Profits 5 25 55 65 75

1 0.2 Smart ready 10 15 20 30 60

1 0.4 Env Policy 9 6 4 5 8

0 0.1 Solar part 2 3 5 6 9

Table 6 Overall ranking with high weighting for policy and smart technologies Rank 1 2 3 4 5

Weighted sum GenCos Ancillary Services TransCos Combined DisCos

Weighted product GenCos TransCos Ancillary Services Combined DisCos

WASPAS GenCos Ancillary Services TransCos Combined DisCos

Topsis GenCos TransCos DisCos Combined Anciliary Services

changed through mediation and consolations. Higher smart readiness indicates the higher technological strength, and thus higher prospects for servicing the loan. This is set as a beneficial parameter, which means higher the value, better prospects in servicing the loan in a timely manner. Similarly, the environmental policy parameter is set to a beneficial one. Higher the value means, the current policy supports green initiative and the market is ready for uptake of green energy. Lastly, the variable solar part indicates the current level of solar energy penetration. Higher the value means, the ESI already has a lot of solar energy thus solar segment may have been saturated. At this point, adding more solar energy does not yield good returns due to duck curve phenomenon as explained earlier. Thus, this is set as a nonbeneficial parameter. Now, assume that the ESI has the values as shown in Table 5. Using the MCDM tool, it is possible to resolve the decision-making problem into a hierarchy of preference for green investing. Weightages have been considered as explained in the earlier illustration. Since high green policy is critical for investments, it is given higher weightage. After applying the MCDM, the tool gives the following output as shown in Table 6. It can be seen that a good financial standing and smart readiness aspects generally favor green investors. It should be noted that this is a simple example and is not a comprehensive solution. The aim here in this chapter is to provide a basis and foundation for using MCDM to various problems in the area of green financing.

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5 Discussion Globally and locally several ESI players exist. They include international committees that monitor climate changes carbon emissions and major greenhouse-gas contributing nations. Policies of some developed nations on climate change can also be significant players. International monetary funding organizations, other lenders, and Banks also have their role in influencing recipient Nations also Anita the implementation process of climate policies. Technology investors and developers and other stakeholders also some of the key players. State governments themselves are key players in their respective energy supply industries. Utilities and regulator have their own role to play, though utilities are mostly controlled by the regulator within a well-defined policy framework. Lastly but not the least, the consumers are also key players as they are the ones who pay for the energy that they consume. Table 7 summarizes some of the needs, requirements, and challenges of various actors and stakeholders in any modern day ESI. The above sections and illustrations show the use of MCDM to resolve several conflicting and interdependent issues. Due to the given complexity, the above example and MCDM approaches need to expand appropriately and thus there are several opportunities for further work to develop new algorithms and risk assessment. Most of the parameters and aspects from above sections, in fact, vary dynamically. Such variations impact energy flows and cash flows in different ways. Further works should also consider these parameters in a dynamic sense, let us month-wise or annually etc., and carryout investigations.

6 Conclusion Green financing is becoming more and more popular in energy sector. This chapter presented a few key issues in terms of needs, challenges, and risks in ESI. Then opportunities in terms of using smart grids, determining a suitable energy mix and need for policies, have been discussed. Applicability of MCDM is demonstrated using a MS-Excel tool for risk assessment of energy projects for green financing. Adopting the global green initiative at the national level is now becoming an imperative to every nation as part of benign fight again the unwanted climate changes. The chapter clearly points to the need to establish a national level green energy policy at the national level, use of energy mix, and smart grids for the green cause. Importantly, a well-defined framework for green energy policy is essential to ensure sustainable operation of ESI and adequate opportunities to the green financiers.

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Table 7 Summary of needs and requirements of various actors and stakeholders of ESI Actors and stakeholders Agencies monitoring climate change, developed nations, and policy-making organizations

Funding agencies and banks

ESI Technologies

Investors and developers

State and federal governments

Utilities

Consumers

Needs, requirements, and challenges International agencies and some developed nations tend to monitor the climate change is very closely and work toward reducing greenhouse gases. Such players usually bring pressures on state governments specifically at the top leadership positions. Such efforts are generally channeled through international-level climate agreements and meetings International our cross-border funding agencies to put various restrictions in their energy financing frameworks as they themselves are influenced by committees that monitor climate changes. This means that funding for fossil fuel-based energy production may not be favored. This intern can result in lesser availability of baseload energy production in respective ESIs Recent technological advances and developments by and large have resulted in cheaper environmentally friendly renewable energy technologies. For instance, the levelized costs of solar and wind energies have been reduced drastically over the years. However, the random nature and intermittency of such resources pose significant challenges in utilizing the energy produced Investors and developers in energy supply industry do expect returns on their investments. Investor-friendly energy markets benign policy frameworks to ensure returns and timely payments from the consumers or some of the factors aspects that investors anticipate. Importantly, they expect the ESI to utilize and operate on energy mix (and not just one form of energy source) Both state and federal governments expect funding agencies and banks to provide loans with low interest rates and longer durations for repayment. Developing and underdeveloped nations expect the developed nations to provide them with the niche technologies required for integrating intermittent renewable energy sources, at affordable prices Utilities would expect policy support to build and develop base load plants to meet varying load conditions in a safe and reliable manner. They also expect the regulator to understand their financial budgetary requirements in managing their own operations, as capex and opex in ESI can be cost intense Consumers expect reliable and cheaper energy supply

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Lingyan, M., Zhao, Z., Malik, H. A., Razzaq, A., An, H., & Hassan, M. (2022). Asymmetric impact of fiscal decentralization and environmental innovation on carbon emissions: Evidence from highly decentralized countries. Energy and Environment, 33(4), 752–782. Liu, R., He, L., Liang, X., Yang, X., & Xia, Y. (2020). Is there any difference in the impact of economic policy uncertainty on the investment of traditional and renewable energy enterprises? A comparative study based on regulatory effects. Journal of Cleaner Production, 255, 120102. https://doi.org/10.1016/j.jclepro.2020.120102 Managi, S., Broadstock, D., & Wurgler, J. (2022). Green and climate finance: Challenges and opportunities. International Review of Financial Analysis, 79. https://doi.org/10.1016/j.irfa. 2021.101962 Musti, K. S. S. (2020a). Quantification of demand response in smart grids. IEEE International Conference INDISCON (pp. 278–282). https://doi.org/10.1109/INDISCON50162.2020.00063 Musti, K. S. S. (2020b). Circular economy in energizing smart cities. In Handbook of research on entrepreneurship development and opportunities in circular economy (pp. 251–269). IGI Global. https://doi.org/10.4018/978-1-7998-5116-5.ch013 Musti, K. S. S. (2021). MS-excel tool for MCDA methods. Mendeley Data. Retrieved from https:// data.mendeley.com/datasets/zjckp3b259/1. https://doi.org/10.17632/zjckp3b259.1 Musti, K. S., & Kapali, D. (2021). Digital transformation of SMEs in the energy sector to survive in a post-COVID-19 era. In N. Baporikar (Ed.), Handbook of research on strategies and interventions to mitigate COVID-19 impact on SMEs (pp. 186–207). https://doi.org/10.4018/978-17998-7436-2.ch009 Pitra, G. M., & Musti, K. S. S. (2021). Duck curve with renewable energies and storage technologies. In 13th International Conference on Computational Intelligence and Communication Networks (CICN) (pp. 66–71). https://doi.org/10.1109/CICN51697.2021.9574671 Sastry, M. K. S. (2007). Integrated outage management system: An effective solution for power utilities to address customer grievances. International Journal of Electronic Customer Relationship Management, 1(1), 30–40. https://doi.org/10.1504/IJECRM.2007.014424 Sastry Musti, K. S., & Van der Merwe, M. (2022). A novel MS excel tool for multi-criteria decision analysis in energy systems. IGI-Global. https://doi.org/10.4018/978-1-6684-4012-4.ch003 Sastry Musti, K. S., Iileka, H., & Shidhika, F. (2020). Industry 4.0 based enterprise information system for demand-side management and energy efficiency. In Novel approaches to information systems design. https://doi.org/10.4018/978-1-7998-2975-1.ch007 Sastry Musti, K. S., Paulus, G., & Katende, J. (2021). A novel framework for energy audit based on crowdsourcing principles. In Crowdfunding in the public sector (pp. 167–186). Springer. https:// doi.org/10.1007/978-3-030-77841-5_11. isbn:978-3-030-77841-5. Sastry, M. K., Bridge, J., Brown, A., & Williams, R. (2013, February). Biomass briquettes: A sustainable and environment Friendly energy option for the Caribbean. In Fifth International Symposium on Energy, Puerto Rico energy Center-Laccei Puerto Rico. Şerban, A., Bărbuţă-Mişu, N., Ciucescu, N., Paraschiv, S., & Paraschiv, S. (2016). Economic and environmental analysis of investing in solar water heating systems. Sustainability, 8, 1286. https://doi.org/10.3390/su8121286 Shiljkut, V., & Rajaković, N. (2015). Demand response capacity estimation in various supply areas. Energy, 92. https://doi.org/10.1016/j.energy.2015.05.007 Trinasolar. (2022). With microgrids poised for major growth, here’s what IPPs and EPC and developer firms must know. Retrieved July 2022, from https://www.trinasolar.com/us/resources/ blog/microgrids-poised-growth

The Development of the Global Green Finance Market: The Role of Banks and Non-banking Institutional Investors Liudmila Filipava

and Fakhri Murshudli

1 Introduction The popularization of “green” ideas contributes to the globalization of green finance (Nedopil et al., 2021), causing the compliance of the financial institutions’ activities with the principles and Goals of Sustainable Development (SDGs). Since the main contribution to green investment, including renewable energy and other low-carbon projects, is provided by bank lending, the banking sector plays a significant role. According to Runyon (2016), bank lending accounts for 70% of debt and 50% of total sustainable financing. The Green Banking system includes actors at the international level within the framework of the Global Alliance for Banking on Values (GABV). Commitment to environmental issues is now a part of the overall banking strategy and corporate governance, from environmental audits to including ESG factors in risk management (WWF, 2014). Bank’s interest in green finance, among other reasons, is explained by the possibility of obtaining reputational benefits and competitive advantages in the market (UNEP, 2015a), especially in new green sectors of the economy. The Global Green Finance (GGF) market currently sees the rapid growth of numerous informal private alliances and initiatives. For example, the Sustainable Banking and Finance Network (SBFN) brings together banking regulators and banking associations of private financial institutions. Other examples include the Sustainable Stock Exchanges Initiative (SSE), the Financial Centers for Sustainability Network (FC4S), the Sustainable Insurance Forum (SIF), the Principles for L. Filipava (✉) Belarusian State University, Minsk, Belarus e-mail: fi[email protected] F. Murshudli Azerbaijan State University of Economics, Baku, Azerbaijan e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 N. Naifar, A. Elsayed (eds.), Green Finance Instruments, FinTech, and Investment Strategies, Sustainable Finance, https://doi.org/10.1007/978-3-031-29031-2_2

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Sustainable Insurance (PSI) Initiative, the Sustainable Insurance Initiative (PRI), and the Principles for Responsible Investment (PRI). The concept of blended finance, involving the attraction of private sector capital to achieve the SDGs, is becoming increasingly relevant. This approach can also be used to mobilize capital from smalland medium-sized investors through the use of digital finance. In order to achieve this, at the annual World Economic Forum in Davos (2007), the Green Digital Finance Alliance (GDFA) was launched, which, together with UNEP, implemented investment attraction mechanisms to finance low-carbon industries. However, the implementation of long-term green projects in emerging countries is limited by the insufficient development of appropriate green financial mechanisms and instruments. At the same time, the transition to a global low-carbon sustainable economic model in low- and middle-income countries provides for the financing of USD1.6 trillion annually (WB, 2019). Achieving this would require the banking sector’s active participation and the attraction of entrepreneurial capital. Therefore, the purpose of this study is to consider current trends in the GGF market to develop a financial mechanism based on a green fund establishment with the subsequent securitization of its assets through the issuance of green bonds and the attraction of private capital to the projects that meet the principles of the green economy.

2 Understanding Sustainable and Green Economy: Literature Review 2.1

Green Economy as an Integral Part of Sustainable Development

In the scientific community, there is often a divergence of views on the term “sustainable development.” Many scholars interpret it in the context of economic growth based on an increase in GDP. Likewise, the global economy requires a harmonious and balanced development of three components: economic, social, and environmental. Thus, achieving long-term sustainable economic growth is impossible without considering social and environmental factors (Agenda 21, 1992). The concept of sustainable development was initially introduced in the report “Our Common Future,” prepared by the UN World Commission on Environment and Development in 1987. According to the G. H. Brundtland definition, sustainable development meets the needs of the present, but does not compromise the ability of future generations to meet their own needs [quoted by UN (1987)]

This term was recognized by numerous countries at the United Nations Conference on Environment and Development in 1992 as part of the process of adopting the Framework Convention on Climate Change (UNFCCC). The convention’s purpose is to implement the concept of global sustainable development by countries. As a result of globalization and the growth of the TNC’s influence, the primary vector of

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Table 1 The green economy forms Green economy Low carbon The efficient use of energy resources Widespread use of renewable energy sources The minimization of the use of traditional hydrocarbons —

Bioeconomy

Cyclic economy

Blue economy

— The extension of the life cycle of the resources (products) used The efficient use of waste

Sustainable agriculture

Source: Compiled by the authors

the concept shifts from the national level to the corporate one, as evidenced by the growing number of private initiatives in the sphere of sustainable development and green investment. The world community adopted the 2030 Agenda in 2015 (UN, 2015), which includes 17 global Sustainable Development Goals. The new SDGs are consistent with international law, consider national characteristics, opportunities, and priorities, are comprehensive, and ensure a balance between all three components of sustainable development: economic, social, and environmental. Achieving the sustainability goals is expected to contribute to the transition to a new economic model—a green economy model (Grabowska et al., 2022). Indeed, the transition from a traditional economic growth model to a “green” one is becoming a worldwide trend. A green economy is a tool for achieving sustainable development, aiming to increase people’s well-being while reducing environmental risks (UNEP, 2015b). As already mentioned, the foundations for a green economy were laid within sustainable development in the late 1980s. The term “green economy” was first mentioned in ‘Plan for a Green Economy’ (Pearce et al., 1989), highlighting the need for economic support of the environmental policy. In subsequent works, researchers touched upon issues such as climate change, ozone layer depletion, deforestation in tropical regions, etc. (UNDESA, 2012). Since the mid-2000s, within the framework of implementing the global strategy for sustainability, new models of the GE have become widespread: low-carbon, bioeconomy, and blue economy (European Commission, 2018, 2020, 2022). Although these concepts are often considered identical (since the principle of environmental orientation can be found in all models), they have specific differences. The general and characteristic directions of developing modern GE forms are shown in Table 1. The low-carbon economy strives to reduce greenhouse gas emissions into the atmosphere to stabilize the climate system (Solomon et al., 2007). Low-carbon development is primarily associated with improving energy efficiency, such as minimizing traditional hydrocarbons, primarily coal (Flavin, 2008), and using renewable energy sources. The bio-economy involves transitioning to a new

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technological paradigm based on energy efficiency and biotechnology, involving renewable biological raw materials to produce energy. Bioeconomics is also associated with sustainable agriculture, organic food production, and the efficient use of waste. A circular (cyclic or closed-loop) economy involves reusing materials and resources, their regeneration, restoration, and optimization to preserve the environment. The circular economy is based on resource efficiency and the producer’s responsibility to reduce the environmental footprint of manufactured products (Stahel & MacArthur, 2019). The blue economy was first formulated in 2009 by Gunter Pauli (2010). It enables society to obtain value from the oceans and coastal regions whilst respecting their long-term ability to regenerate and endure such activities through implementing sustainable practices (The EU Blue Economy Report, 2022). New hybrid forms, such as the circular bio-economy, are also emerging. Thereby, the green economy: – is democratic and strives for the rule of law based on the principles of equality, responsibility, transparency, stability, and intergenerational justice (UNEP, 2011); – is a means of achieving sustainable development (Bobylev, 2017), which assumes the assessment of not only economic but also social indicators (poverty reduction, ensuring the population’s well-being, social protection, and essential services access) (Lindenberg, 2014) as a result of the implementation of resource and energy efficiency policies; – strives to protect biodiversity and ecosystems. The fundamental principles of a green economy (i.e. peaking, climate neutrality, voluntary cooperation, adaptation, transparency, and a global “stocktake”) are laid down in the Paris Agreement (UN Framework Convention on Climate Change). Furthermore, the goals, objectives, and requirements for participants are designed to last until the end of the twenty-first century (UNFCCC, 2015). The cooperation of the G20 countries has reached a significant level within the G20 Climate Finance Study Group framework and the Task Force on Climaterelated Financial Disclosures (TCFD). Furthermore, the informal green associations in the corporate and financial sectors are represented by mutual obligation platforms, joint industry initiatives, and lobby groups. Their priority areas of activity are developing dialogue and cooperation in green finance, assisting effective financial instruments used to stimulate climate-friendly projects, and mobilizing private investment to accelerate the global “green” transformation (Table 2). The central idea of global cooperation is the search for solutions to international (regional, national) climatic and environmental problems through the tools of the global financial market and the “greening” of the world financial system.

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Table 2 Informal green initiatives Initiative Mutual Obligations Platforms

Joint Industry Initiatives

Lobby groups

Corporate sector Primary purposes: harmful emissions reduction, energy efficiency, renewable (alternative) energy sources for the own needs use, hydrofluorocarbons (HFCs) reduction Initiatives: Science-Based Targets Initiative, RE100 Initiative, WWF’s Climate Savers, Oil and Gas Climate Initiative, Consumer Goods Forum’s, Sustainable Refrigeration Resolution, Refrigerants Naturally! Primary purposes: the development of industry transition roadmaps (ITRs) to limit global warming to 2 °C, support the transformation to the low-carbon emitting technologies (LCET), implementation of the public–private partnerships (PPPs) environmental protection projects Initiatives: International Air Transport Association’s 2020 and 2050 Emission Targets, Cement Sustainability Initiative, International Road Transport Unions, 30 by 30 Resolution, Lighten Initiative, Tropical Forest Alliance 2020, Consumer Goods Forums, Zero Net Deforestation, World Business Council for Sustainable Development (WBCSD) Low Carbon Technology Partnership Initiative (LCT Pi) Primary purposes: the development of an international framework agreement (IFA) and policies to achieve SDGs Initiatives: We Mean Business Coalition’s International Policy Support Statements, CEO Climate Leaders Statement, World Bank Carbon Pricing Leaders Coalition, Caring for Climate Business Leadership Platform, Ceres Business for Innovation Climate and Energy Policy (BICEP), The Prince of Wales’s Corporate Leaders Group

Source: Compiled by the authors

Financial sector Primary purposes: investment portfolio decarbonization, carbon footprint measurement, the development of tools for climate and carbon risks’ analysis when making investment decisions Initiatives: Climate Wise Principles, Investor Platform for Climate Actions, RiSE, Montreal Carbon Pledge, CDP’s Carbon Action Initiative, Principles for Responsible Investment (PRI) Primary purposes: the distribution of green bonds to stimulate investments in low-carbon projects, reports publication containing environmental data Initiatives: Portfolio Decarbonization Coalition. Banking Environment Initiative’s Soft Commodities Compact, Low Carbon Investment Registry, Climate Bonds Initiative, Green Bonds Principles1101 in a 100 Initiative, Ceres’ Investor Network on Climate Risk (INCR), Ceres’ Shareholder Initiative on Climate and Sustainability (SICS)

Primary purposes: the development and implementation of norms and standards for the low-carbon projects finance Initiatives: Global Investor Coalition on Climate Change, Institutional Investment Group on Climate Change, 2 Degrees Investing Initiative, Climate Wise, Investor Working group on Climate Corporate Lobbying

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Conceptual Approaches to the Definition of Green Finance

Sustainable finance is an integrated approach that combines different strategies to improve the social, economic, and environmental indicators of the financial system. Green finance appears to be a part of the strategic agenda for sustainable finance. In modern practice, there are two main approaches to the definition of green finance. In the broadest sense, this is an investment in the development and implementation of (1) programs in balanced environmental management (for example, water resources management, soil protection, and biodiversity conservation) (Daily & Ellison, 2003; Makower & Pike, 2008); (2) ecological projects (in particular, to reduce greenhouse gas emissions and adapt to climate change (climate finance) (UNEP, 2011); (3) and industries focused on measures to improve processing, recycling of resources and support for renewable energy (low-carbon finance). This approach is implemented within a closed-loop economy at the macro level, which provides for the repeated use of resources through their regeneration, restoration, and optimization while preserving natural environments. The narrow approach (Krugman, 2010; Lindenberg, 2014; Mazzucato & Perez, 2014) implies the implementation of environmentally friendly investments and low-carbon technologies, projects, industries, and enterprises based on appropriate financial tools and products used in making decisions on loans, monitoring, and risk management. The term “green finance” was initially proposed in 1992 by the American economist Richard Sandor and was envisaged mainly as an investment for climate change (Sandor, 2012). Over time, this term started to be used with a narrower meaning, implying projects and programs to ensure mitigation and adaptation to climate change. Currently, there are concepts of sustainable investment, low-carbon finance, circularity finance, impact finance, and ESG finance. Responsible investment has become widespread, which involves considering environmental, social, and managerial factors. It aims to bring economic and social/environmental benefits, referred to as targeted social investment (or impact investing). In 2006, the Responsible Investment Association (RIA), with the support of the UN, developed six basic Principles for Responsible Investment (PRI, 2018). These Principles are voluntary initiatives in which companies consider environmental and social projects in their investment strategy. In today’s conditions, “brown” (“gray” or “dirty”) investments appear to be opposed to “green” ones. A comparative analysis of “green” and “brown” financing is presented in Table 3. Green finance usually involves a different verification stage for compliance with “green” requirements and standards and the provision of appropriate reporting. Therefore, the term “brown financing” is used in the context of projects implemented in “traditional” spheres of social and economic infrastructure without a claim to environmental friendliness. Meanwhile, international organizations refused to identify priority sectors or activities that fall under the definition of “green,” noting the multidisciplinary nature of green financing.

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Table 3 Comparative analysis of “green” and “brown” finance Criteria Sectors of the economy (or types of activities)

‘Brown’ finance Economic and social infrastructure

Sources of financing

Traditional credit and financial instruments Banks and non-banking financial institutions, TNCs, etc. Economic and/or social efficiency Investment and industry risks

Participants

Project selection criteria Features of project implementation

‘Green’ finance Renewable energy, water supply, and sewerage, organic agriculture, sustainable forest management, waste disposal, pollutant elimination “Green” financial instruments (green loans and bonds) Green banks, WB, RDBs, etc.

Environmental friendliness Investment and industry risks, additional verification tools for environmental compliance

Source: Compiled by the authors

3 The Current Trends in the Global Green Finance Market 3.1

Green Economy Financing Instruments

The following instruments have become widespread in the GGF market: green (sustainable, climatic, and collateralized) bonds, green (eco-) loans, and weather derivatives. These financial instruments are not fundamentally new from a technical perspective, but they are distinguished by the environmental component. Green bonds (GBs) are used to finance projects that meet the criterion of environmental friendliness [projects in energy saving, energy efficiency, renewable energy, etc. (UNEP, 2016)]. Most GBs are subject to special labeling requirements, and the issuer or an independent appraiser can perform the labeling. According to the International Financing Corporation (IFС) definition, a green bond is a bond that meets the following criteria: (1) attracted capital must be directed to the green projects’ implementation, (2) investments must be assessed for compliance with eco-principles, (3) the funds attracted by the issuer are exclusively targeted, and (4) information on the funds spending is transparent and should be published annually (IFC, 2020). The priority areas of the GBs are energy efficiency (38%), sustainable low-carbon transport (16%), water resources (14%), adaptation to climate change (6%), and forestry and agriculture (2%). This is because countries primarily issue GBs to invest in water supply and sanitation. This trend is typical for developed countries (USA and France). Within the described terminology, the broadest definition of green or so-called climate-aligned bonds (CABs) was proposed by the Climate Bonds Initiative (CBI) to designate financial instruments for low-carbon and climate-resilient infrastructure development. The World Bank also defines GBs, as implementing a program to finance environmentally sustainable growth in emerging countries.

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Green bonds were issued for the first time by the European Investment Bank (EIB) in 2007, called climate awareness bonds (CABs). The issue had a volume of USD600 million and received an AAA rating (European Commission, 2016). The bonds were intended to finance renewable energy projects. In 2008, the IBRD issued bonds labeled as “green.” The World Bank applied environmental criteria, and an independent assessment carried out by experts from the University of Oslo to select appropriate projects. The funds from the placement of GBs in the amount of SEK 2.85 billion were used to finance agricultural, waste processing, and forest management projects (WB, 2015). The need for standardization and labeling of green bonds arose from the necessity to identify their specifics in the financial market. Until recently, the lack of investor interest in green financial instruments was caused not only by profitability requirements but also by the lack of recognized standards and an efficient international mechanism to control the cash flows. The initial stage in the GB standardization can be considered the adoption of the Wind Criteria (or Wind Sector Eligibility Criteria) of the Climate Bonds Standard, developed by the CBI in 2011. Furthermore, CBI has approved four industry standards (version 2.0) for wind and solar energy, low-carbon public transport, and energy-efficient buildings. Version 2.0 also includes a description of the certification process, requirements for issuers, and the GBs industry standards. The principles of green bonds were improved simultaneously (CBI, 2018a). In 2014, the International Capital Market Association (ICMA) released the Green Bonds Principals (GBPs), which are similar to the CBI Standards but address broader issues. The GBPs provide guidelines for issuers to disclose information about the upcoming GB issue, allowing investors and stakeholders to assess the key characteristics and make strategic investment decisions. The Principles involve: (1) the target orientation of investments as a result of the GBs placement, (2) green projects’ selection and evaluation, (3) funds management, (4) reporting (ICMA, 2021). The certification of securities provides for disclosing information on the expenditure of emission funds, which is important for two reasons. First, it guarantees the investor that his funds will be spent on climatic purposes. Secondly, public authorities have the opportunity to support the GB market. Marking is carried out based on international rules and procedures in the Green Bond Principles (GBP) and the Climate Bond Standard (CBS) adopted by international organizations. At the same time, the European Green Bond Standard (EUGBS) certification is being developed, which is expected to become mandatory in EU countries. Green bond ratings are assigned to both individual issues and entire securities programs. Moody’s international rating agency has developed a methodology for the GB assessment (GBA) based on the issuer’s compliance with the principles of targeted use of funds, project management, and reporting. The GBA uses the climate bonds initiative (CBI) criteria and The International Organization of Securities Commissions (IOSCO). If a company wants to receive a CBI certificate after the GB issue, it should apply to CBI accreditation experts. These institutions include international consulting and audit companies, certification agencies (such as ERM Certification and Verification Services, Kestrel Verifiers, and TÜV NORD CERT),

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and responsible investment consulting companies (such as Sustainalytics and Vigeo Eiris). However, the listed standards are voluntary and are only partially accepted in the ratings (Standard & Poor’s estimates their share at 5%). One of the problems in the international GBs market is the lack of unified tools for their verification. The dynamics of the GB market can be best presented in the CBI statistical reviews. The continued acceleration of green issuance drove it to over half a trillion (USD517.4 billion) in 2021. The annual figure is the highest since the market inception and maintains the trend of 10 consecutive years of growth (CBI, 2021a). The current growth trajectory could result in the first annual green trillion in the year ahead—a goal first set by the Conference of Parties (COP22) in 2016. The early achievement of this milestone this decade serves as a key indicator that capital is being shifted at scale towards climate solutions as the world races the clock (CBI, 2022). Different estimates of the GB’s annual issuance are given by world experts, but it still provides a useful reference point for comparing current investment levels. Sean Kidney, CEO of Climate Bonds, has nominated annual green bond issuance of USD5 trillion by 2025 as the next global milestone governments, policymakers, and investors need to reach as the necessary contribution to the climate goals achievements (CBI, 2022). According to estimates from the IMF and International Energy Agency (IEA), achieving net-zero carbon emissions by 2050 will require additional global investments in the range of 0.6–1% of annual global GDP over the next two decades, amounting to a cumulative USD12–20 trillion (IMF, 2021a, 2021b, p. 60; IEA, 2021). In the Reuters poll of economists in Europe, Asia, and the Americas (September–October 2021), there was substantial divergence in the scale of dollar estimates for the cumulative investment needed, reflecting the differing methodologies used by economists. The median view provided was that the total value was USD44 trillion. Oxford Economics experts, however, estimated that the cumulative amount of investments required in alternative energy and other sectors would reach almost USD140 trillion by 2050, the highest estimate obtained in the survey (CBI, 2022). As for the issuers, in 2021, 54% of the issue volumes were provided by the United States, Germany, China, and France (CBI, 2021b). Moreover, the first two countries continue to hold the lead, and this trend appears to be ongoing. China has also become one of the leading countries where the issuance of GBs is based on the refinancing of green loans. In 2021, China moved up one position to take third place from France, the fourth-largest emitter of greens in the previous year. Major Chinese banks, including the Industrial and Commercial Bank of China (ICBC), place large volumes of GBs in the domestic market and the world’s financial centers. Currently, more than three-quarters of the GB issue is provided by RDBs and TNCs. The leadership in the Top 10 Climate Bond Certified Issuers in 2021 belongs to Chinese banks (China Development Bank and ICBC), Société du Grand Paris (France), Queensland Treasury Corp (Australia), and ABN AMRO Bank NV (Netherlands). Other notable issuers include Norwegian financial group DNB ASA, the Republic of Chile, Australian bank Westpac, National state railway holding of Italy Ferrovie dello Stato (FS) Italiane, and Indian renewable energy company ReNew Power (Table 4).

36 Table 4 Top 10 climate bonds certified issuers in 2021

L. Filipava and F. Murshudli Issuer name China Development Bank Société du Grand Paris ICBC Queensland Treasury Corp ABN AMRO Bank NV DNB ASA Republic of Chile Westpac FS Italiane ReNew Power

Certified in 2021 (USD billion) 7.4 5.8 4.2 2.2 2.2 1.8 1.2 1.2 1.2 1.0

Source: CBI (2022)

Twenty-one sovereign GBs were priced in 2021, including a GBP 10 billion (USD13.7 billion) UK Gilt, the largest single debut sovereign green bond to date. A smaller GBP 6 billion (USD8.25 billion) deal followed later in the year in the United Kingdom, placing it among the top largest sovereign GB issuers in the world (CBI, 2022). The German state-owned development bank Kreditanstalt für Wiederaufbau (KfW) and the financial conglomerate Fannie Mae were the leading green issuers of the year, with a total volume of USD13.6 billion and 13.4 billion, respectively. Major Chinese banks continue to adhere to the practice of issuing multiple GBs aligned with the CBS. In 2016, the Bank of China, together with the China Development Bank (CDB) and the Chinese Bank of Communications (BoCom), announced the issuance of 1 billion euros in foreign currency-denominated GBs (with an initial target of 2.25 billion euros) to finance Belt and Road Initiative (BRI) projects (CBI, 2018b). The investors became European and Middle Eastern banks. Several prominent certified climate bonds (CCBs) originated in China in 2021. Industrial and commercial bank of china (ICBC), the world’s largest bank, returned to the market with another GBP 2.3 billion CCB (USD3.2 billion), with the use of proceeds certified in accordance with the Version 2.0 Standard. The state-led CDB raised USD7.4 billion in three deals, with funds used for ecological protection and green development along China’s Yellow River Basin. Consequently, the CDB was the largest certified climate bond issuer in 2021. The CDB issuance puts them ahead of French transport operator Société Du Grand Paris (SGP) for 2021. SGP was an early adopter of the Programmatic Certification process and is the all-time largest Certified green debt issuer, funding a decade-long upgrade of the Paris rail network, one of the largest infrastructure projects in Europe. By the end of December 2021, overall certified issuance was expected to reach USD210 billion, helping to establish green market investment standards and harmonized definitions in multiple jurisdictions in both developed and emerging economies (CBI, 2022). Municipal bonds appeared in 2012 in France (Île-de-France region), then in Sweden (Gutenberg), the USA (New York), South Africa (Cape Town), and China (Wuhan, Hong Kong). In 2018, Indonesia issued the first sovereign Islamic green bonds (also known as green Sukuk). In 2017, the United States issued sovereign

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bonds worth USD18.5 billion, accounting for 60% of subsovereign issues worldwide (EU countries—USD8.8 billion; Canada—USD2 billion, United States— USD1 billion, Australia—USD962 million) (CBI, 2018a). There has been an increase in sovereign debt levels by emerging countries (Nigeria, Fiji, and Indonesia), mainly due to the slowdown of the developed countries’ emission volumes. One of the significant obstacles to green project financing is the small size of projects, which makes it economically inefficient to issue and invest in bonds. It leads to the implementation of mechanisms for aggregating collateral assets (cash claims, loans, leasing, and mortgages) and the issuance of securitized green bonds. There are two types: GBs secured by a separate pool of assets (asset-backed securities, ABS), and covered GBs secured by nonsegregated assets. Unlike general (or “standard”) green bonds, ABS bonds bear the risk of default on the investor. In the event of default, the right of recourse refers to the pool of green (and not only) assets that act as collateral. Unlike ABS bonds, covered green bonds are backed by a nonsegregated pool of assets. If default occurs, investors can turn their claims to the issuer and to the collateralized assets, which serve as an additional guarantee to repay the debt. These bonds are issued only by banks. Green credit (GC) is the essential instrument for green financing. The main contribution to green investment comes from direct bank loans, which account for about two-thirds of debt and half of the total funding. In just 1 year, 104 US banks issued loans for renewable energy projects. In 2014, 12 banks provided loans in excess of USD1 billion; in 2015, this number increased to 20. Environmental lending, a variation of national debt conversion into ecological investments, is frequently implemented among developed countries. Currently, more than 30 countries have become beneficiaries of this instrument (OECD, 2016). For instance, the United States signed an environmental agreement with Poland of over USD370 million. The term green (eco-) loans refer to environmental projects and companies. Regional development banks typically offer preferential interest rates for ecological projects, such as preferential mortgages for energy-efficient buildings. Сarbon finance for adaptation to climate change is actively implemented in the following directions (UNFCCC, 1998): – emissions trading, when the state or its economic entities sell (buy) quotas for greenhouse gas emissions on the national, regional, or international markets (Art. 17); – joint projects to reduce greenhouse gas emissions [СО2 Joint implementation (JI)] (Art. 12); – clean development mechanisms (CDMs) to reduce greenhouse gas emissions implemented in one of the emerging countries that have signed the Framework Convention on Climate Change (UNFCCC) (Art. 6). Weather derivatives are financial products that help manage the risk of losses caused by changes in climatic conditions. Weather derivatives entered the market in the mid-1990s. According to data from Chicago Mercantile Exchange, the volume of the corresponding transactions for 2002–2016 exceeded USD1 billion

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(Jacque, 2015). At the same time, despite the growth of the GB market, less than 1% of the global bond market is labeled as “green,” that is, this segment is still relatively small. Green indices and ratings are spreading, assigned to international companies that adhere to the SDGs and European Standards & Guidelines (ESG). In 2012, the United Nations Environment Program (UNEP) published A New Angle on Sovereign Credit Risk Analysis, which addresses environmental considerations in the sovereign credit assessment process. Standard & Poor corporate credit ratings consider factors such as global warming, carbon emissions, and clean energy (UNEP, 2012). The leading green stock indices include the S&P Global Clean Energy Index, the Nasdaq Clean Edge Green Energy Index (CELS), and the FTSE Japan Green Chip 35. Additionally, there are multiple specialized indices, such as the DB x-trackers Carbon Index (DB) and the S&P Carbon Effective Index. There is also an iPath Global Carbon ETN offered by Barclays Bank PLC.

3.2

The Main Participants in the Global Green Finance Market

Today, the GGF market is characterized by the growing interest of private financial institutions in “greening” issues. With the increasing influence of TNCs, the primary vector of sustainable development and green investments began to shift from the national level to the corporate one. Many institutional investors have reaffirmed their commitment to the principles of socially responsible investment (SRI). Thus, to date, more than 400 of the largest companies have refused to invest in traditional energy sources (Porfir’ev, 2016). Since 1999, the UN Global Compact has been in operation—the world’s largest international voluntary initiative, aimed at promoting sustainable economic growth and increasing the level of corporate citizenship (UN, 2018). The initiative supports companies in implementing social and environmental projects. More than 13,000 companies and organizations have already signed up for the US Global Compact. Investment banks are also showing interest in the green finance market. Moreover, the transition to a low-carbon economic model will require significant financial resources from the banking sector (IFC, 2016). Within the framework of ensuring a positive environmental and social effect and stimulating the implementation of sustainable development principles, there is a process of the largest banks integration, e.g., the Sustainable Banking and Finance Network (SBFN) and the Institute of International Finance (IIF). The Network of Central Banks and Supervisors for Greening the Financial System (NGFS), formed in 2017, aims to ensure the implementation of measures necessary to achieve the goals of the Paris Agreement. Currently, NGFS unites 18 members, including the Central Banks of Germany (Deutsche Bundesbank), Great Britain (Bank of England), Finland (Bank of Finland), France (Banque de France), Mexico (Banco de México), the Netherlands

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(De Nederlandsche Bank), China (Peoples Bank of China), Singapore (Monetary Authority of Singapore), as well as the Swedish Financial Supervision Authority (Finansinspektionen). As part of the United Nations Environment Program Financial Initiative (UNEP FI), a roadmap for banks and institutional investors has been drafted to create an enabling environment for “green” banking development. The Sustainable Banking Network also plays an active role in this direction. Formed in 2012 as an informal group uniting banking regulators and associations interested in developing environmentally sustainable practices and initiatives, the Network currently includes representatives from 20 countries across four different continents. The role of insurance companies in the GGB market is also increasing. The Environmental Liability Act (Umwelthaftungsgesetz) passed by the German government in 1990 requires compulsory insurance for 96 sectors of the economy. The Association of British Insurers coordinates the launch of similar insurance services by British insurance companies, which cover cleaning costs and fines, property damage and losses, and legal and medical expenses if a pollution incident occurs. In 2004, the European Union adopted the Directive on Environmental Liability (EUR-lex, 2004), which significantly contributed to developing green insurance services. Several global financial centers, including London (Green Finance Initiative), Luxembourg (Luxembourg Green Exchange), and Paris (Finance for Tomorrow Initiative), have shown a particular interest in environmental programs. Other stock exchanges, including those in Dublin, Milan, Stockholm, and Frankfurt, are also launching sustainable finance initiatives. Cooperation between major financial centers is expected to facilitate the exchange of best practices and ensure the convergence of crucial principles and dimensions toward sustainable development. Climate change and the development of low-carbon finance are given priority. Projects attract significant interest from both the state and private investors. For instance, the EU countries subsidize the implementation of alternative energy projects that reduce greenhouse gas emissions and adapt to climate change—renewable portfolio standard (RPS), which imposes special quotas and network tariffs (feed-intariffs). In 2008, the European Commission also launched the international Covenant of Mayors for Climate and Energy initiative. Their efforts are focused on supporting local authorities in achieving environmental goals (IPCC, 2018). The Covenant of Mayors offers local authorities an opportunity to build sustainable economies in ecological and social aspects, with the aim of reducing carbon dioxide (CO2) emissions. Nine joint anti-crisis initiatives were initiated by the UN in 2008, including the Global Green New Deal (GGND). The GGND formulated recommendations in public investment and designed important policy reforms to initiate the transformation to a green economy, employment growth, and tackle poverty. The role of nonprofit organizations in disseminating green business practices is increasing. The Climate Bonds Initiative (CBI), Mission 2020, The Climate Group, Carbon Disclosure Project (CDP), Citizens Climate Lobby (CCL), and Natural Resources Defense (NRD) were involved in the launch of the Green Bond Pledge

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(GBP) in March 2018. Participants of this initiative commit to financing infrastructure projects through GBs. The Coalition for Environmentally Responsible Economies (CERES) is an informal association that aims to mobilize investors and business communities to introduce environmental practices into business relationships, promote renewable energy programs, and develop reports on climate change and global warming.

4 Recommendations for the Green Fund Establishment In most emerging economies, the green finance market is still in its infancy, and traditional lending mechanisms are often used to achieve SDGs. The implementation of green projects is supported by funds from the budget or development institutions. Another concern is the lack of guaranteed payment flows from budgetary organizations or local authorities. This issue is typically addressed in practice by establishing specialized “green” funds, including individual legal entities, with the prospect of their subsequent capitalization (Fig. 1). The primary sources of its financing can be budgetary resources (direct and indirect investments of the state and utilities), credit instruments of international organizations (i.e., technical assistance), and carbon tax. Therefore, the share of financing from international development institutions in the establishment of national “green” banks (funds) can range from 20 to 80%

Financed from carbon tax, budget, technical assistance, etc.

Project 1

FUND Project 2

Project 3

FUND after seruritization

Project N

Private capital

Fig. 1 Financial model based on the Green Fund establishment. Source: compiled by the authors

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(Kazakhstan and Kyrgyzstan, respectively), from federal governments from 10 to 80% (Uganda and Zambia), and from private capital from 10 to 30% (Kenya, Kyrgyzstan, and Mongolia). Furthermore, private financial organizations that provide capital on a grant basis (for example, as part of crowdfunding, voluntary contributions, etc.) may also be able to be attracted. After its formation, the fund is expected to securitize its assets by issuing green bonds, thereby attracting additional private capital. Following this, the fund will be able to finance investment projects that meet financial, social, and environmental criteria. The environmental criteria should be developed considering the type of economic activity, with consideration for the closed-loop economy principles and adaptation to climate change (i.e., the efficient use of resources, environmental protection, pollution prevention, prevention of emergencies, etc.). For instance, for water treatment and sanitation projects, such criteria would include water retention on the soil surface, storage of water for subsequent distribution or delayed use, changing water characteristics by specific standards, flood protection, droughtresistant structures, rainwater use, etc. The criteria are detailed in the European Union Taxonomy Technical Report (European Commission, 2019). The Green Fund is also expected to play an essential role in promoting public– private partnerships (PPPs) by developing standards for tracking climate-related investments and assessing their environmental and social impacts. To accomplish this, incentives can be provided to redirect private investment to green projects (so-called adaptation of financial instruments to the SDGs). The National Infrastructure Strategy (NIS) implementation should be intensified to support economic transformation, including support for small- and medium-sized enterprises, business incubators, initiatives, and cooperation in industry, financial alternatives to improve energy efficiency, and renewable energy sources. With the introduction of new financial mechanisms and instruments in developing a green economy, the leading role is traditionally assigned to the state. The need is to acquire a regulatory legal, and methodological framework for regulating “green” project financing issues, primarily the standardization of green bonds. It is planned to develop guidelines and standards for green projects and investment performance indicators, which will guarantee the interests of both government agencies and private investors.

5 Conclusions and Directions for Further Research 5.1

Concluding Remarks

Until now, there has not been a single, unified approach to the definition of green finance. It creates difficulties in risk management and monitoring of the implementation of green projects, as well as in ensuring proper control, accounting, reporting, and an adequate assessment of their socioeconomic efficiency. According to global practice, implementing green projects involves circling particular financial instruments (green bonds and credits).

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The typical participants in the green finance market are investment banks, insurance companies, international corporations, stock exchanges, and global financial centers. However, European financial centers (including London—the Green Finance initiative, Luxembourg–the Green Exchange, and Paris—the Finance for Tomorrow initiative) and informal green associations in corporate and financial sectors (mutual obligations platforms, joint industry initiatives, and lobby groups) are the most significant interest in sustainable development issues. Simultaneously, factors such as the lack of widespread practice of using financial instruments in the implementation of environmental projects, the small number of currently used green financing instruments, and the presence of numerous restrictions on their use, including the lack of a unified system for verification and certification of green bonds, currently significantly hinder the widespread use of green financial instruments. The development of green financing provides special funds with subsequent capitalization based on financial instruments, such as green bonds. It should also be noted the need for state support for environmental projects by providing financial incentives and fiscal preferences, guarantees at the government level, and the attraction of external financial resources. Specific measures should include the development of an appropriate legal and methodological framework, as well as guidelines and standards for implementing green projects.

5.2

Further Research

Modern research on green finance issues affects not only the interests of countries but also regional economic unions, such as the European Green Deal, and multilateral initiatives, such as the Belt and Road Initiative. Cities have also created their own initiatives, such as the Cities Investment Facility (CIF)—UN-Habitat). Further research into the role of financial market participants will be related to such promising areas of green economy development as decentralization, digitalization, and decarbonization. For the purposes of the decentralization program (Costa, 2021), the concept of a smart city involves the following: (1) housing and public utilities: smart metering of utilities, municipal energy management, an automated monitoring system for the technical condition of buildings (including noise, temperature, fire and gas safety systems), automated decision-making systems; (2) urban transport: intelligent public transportation systems, intelligent parking management system for urban areas, traffic violation automated photo and video recording system, safe and comfortable waiting areas; (3) urban environment: energy-efficient street lighting, public Wi-Fi hotspots; and (4) urban governance: digital participatory platforms, emergency public alert system, intelligent platform for monitoring fire extinguishers. The expected outcome of the City Climate Finance Gap Fund (Gap Fund), EBRD, CDP Matchmaker, EIT Climate-KIC, The Cities Investment Facility—UN-Habitat, and other investment initiatives is to fill the City’s climate finance gap.

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Research in the field of financing tools for the platform economy and the Internet of Things is promising in the direction of digitalization. As part of a decarbonization strategy, areas of research such as carbon taxes, emissions trading, and a carbon border adjustment mechanism should be mentioned. It is essential to evaluate new instruments of foreign trade policy, considering decarbonization on a global scale. The complementarity of digital and environmental finance instruments requires separate consideration.

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Corporate Social Responsibility and Bank Credit Ratings Laura Baselga-Pascual, Nebojsa Dimic, and Emilia Vähämaa

1 Introduction Corporate social responsibility (CSR) has gained significant attention in recent years and its importance is highlighted during turbulent times, such as the COVID-19 pandemic, the energy crisis, and the ongoing general widespread global political instability, including the war in Ukraine. These recent events have caused unexpected challenges for companies and, consequently, demonstrate the relevance of understanding the importance and influence of corporate social responsibility in the companies’ operations and performance which is supported by earlier research. El Ghoul et al. (2021) report that firms with good environmental, social, and governance (ESG) performance can attract a broader investor base. Moreover, Riedl and Smeets (2017) suggest that investors are willing to sacrifice some financial gains for holdings in socially responsible investments. However, reportedly, CSR may also enhance shareholder value (see e.g., Deng et al., 2013; Nguyen et al., 2020; Aouadi & Marsat, 2018; Capelle-Blancard & Petit, 2019). Finally, many studies

This paper was written when Emilia Vähämaa was a Visiting Scholar at Harvard University’s Weatherhead Center for International Affairs. L. Baselga-Pascual University of Deusto, Donostia, Gipuzkoa, Spain e-mail: [email protected] N. Dimic University of Vaasa, Vaasa, Finland e-mail: nebojsa.dimic@uwasa.fi E. Vähämaa (✉) Department of Finance and Economics, Hanken School of Economics, Vaasa, Finland Harvard University, Cambridge, MA, USA e-mail: evahamaa@hanken.fi © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 N. Naifar, A. Elsayed (eds.), Green Finance Instruments, FinTech, and Investment Strategies, Sustainable Finance, https://doi.org/10.1007/978-3-031-29031-2_3

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show that high-quality CSR often lowers a firm’s expected risk (see e.g., Albuquerque et al., 2019; Chava, 2014; Hong & Kacperczyk, 2009; Hoepner et al., 2018; Reber et al., 2022). CSR is the backbone of corporate reputation, and it is also widely accepted as one of the key components in impacting the success of a company. In addition to financial advantages, CSR may also provide strategic gains to companies in the form of competitive advantages. Because banking is largely based on trust, it can be argued that the role of CSR is particularly important in the financial industry. A recent stream of literature focuses on corporate social responsibility in the banking industry. Grougiou et al. (2014) document that banks engaging in earnings management practices are also actively involved in CSR but, interestingly, the reverse relationship is not significant. García-Sánchez et al. (2018) report that banks with more independent directors and more female members on their boards incline toward socially responsible behavior. Recent papers argue that the real benefits of CSR are manifested in intangibles, such as reputation, relationships with stakeholders, and trust, that are not considered in traditional profitability measures (Attig et al., 2013; Lins et al., 2017). Furthermore, Dallas (2004) argues that credit-rating agencies consider CSR-related information in their decision making. Although CSR has attracted significant interest from investors and other interest groups, its impact is still unclear in the banking industry where trust is even more crucial than in many other economic sectors. The importance of CSR in banking is further highlighted by the recent turmoil in the global political environment. We contribute to the existing literature by examining whether socially responsible behavior in the banking industry is associated with better credit ratings. In contrast to prior work, this is the first paper to investigate the impact of corporate social responsibility on credit ratings, particularly in the banking industry. We motivate that studying CSR and credit ratings in the banking sector is particularly relevant and interesting since, due to a different set of contextual circumstances, banks have completely different priorities regarding CSR engagement than other sectors or industries. Specifically, for example, Castelo (2013) argues that banks are mainly focused on anti-money laundering, bribery, and corruption issues, together with environmental aspects of CSR. We contribute to the existing literature by demonstrating a significant and positive association between credit ratings and high-quality CSR activities in the banking industry. This reported relationship is especially driven by the diversity and employee relations dimensions of CSR. Our results may have important implications for bank supervisors, regulators, depositors, and other stakeholders of financial institutions, as we highlight the relevance of effective CSR policies in the solvency of the financial industry.

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2 Related Literature and Hypothesis The responsibility of companies toward society is a longstanding debate. In particular, during the two recent decades, we have witnessed a surge of academic interest in CSR. Two contradicting theories regarding the relationship between CSR policies and firm value were developed in the academic literature by the end of the twentieth century. Interestingly, early work on CSR in corporate decision-making argues that the only corporate responsibility of a company is to maximize the shareholders’ wealth (Friedman, 1970). The underperformance hypothesis (Friedman, 1970) states that CSR policies require firms to consume resources, thus negatively affecting the firm value. Friedman (1970) reasons that companies should use all available resources to engage in activities designed to increase profits while engaging in open and free competition and without any deception or fraud. Furthermore, Friedman (1970) argues that it is the government’s mission to set the rules and maintain regulations to ascertain that other stakeholders’ interests are taken into the account. On the contrary, Freeman (1984) suggests that besides focusing on the shareholders, companies should also cherish their relationship with all stakeholders (such as customers, suppliers, communities, etc.) that are affected by their operations. This opposing view is the so-called Stakeholders’ Theory, which argues that CSR policies promote long-term relationships with stakeholders that would result in a reduction of costs and, therefore, an increase in firm value (Freeman, 1984). Therefore, it is important that companies take all stakeholders into account when making corporate decisions. The Stakeholder Theory teachings have prevailed in recent decades as the desired way of doing business. Jensen (2002) further suggests that doing business while taking care of stakeholders’ needs ultimately increases the shareholders’ wealth as well. Finally, it is highly unlikely that a company can be successful and profitable in a long term without taking good care of its employees, making sustainable products, and preserving the environment for future generations. The importance of CSR has been growing significantly during the recent decades as more and more companies are paying attention to responsible behavior and to the impact their operations make (Deng et al., 2013). Nevertheless, the motivation behind companies’ efforts toward CSR is an open debate. Legislative requirements and the political system are among the most important reasons behind the responsible behavior of companies (Ioannou & Serafeim, 2012; Becchetti et al., 2012). In particular, one of the directives by the European Union in 2016 was mandatory reporting on environmental, social, and diversity information by large companies in the EU. Furthermore, the growing impact of CSR has been backed strongly by investors and society. Above all, the growth of responsible investing by both institutional and retail investors has pressured companies to operate more responsibly (Sparkes & Cowton, 2004). For example, the United Nations (UN) initiative on principles of responsible investments (PRI) established in 2015 encourages investors to follow ESG disclosures and use socially responsible investments to better manage their risks. UN’s PRIs are currently having 4902 signatories worldwide with an

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estimated total of assets under management of USD121.3 trillion (Principles of Responsible Investments Annual Report, 2022). Further, external pressure from society shapes the companies’ behavior toward being more sustainable. Particularly, an unethical company faces challenges to attract investors, customers, and good employees (Fombrun, 1996). Moreover, an environmental-, social-, or governance-related incidents can potentially hurt the company financially and damage its reputation and relationship with network partners (Sullivan et al., 2007). Finally, the responsible activities of a company can potentially lead to better financial performance as well. Companies operating sustainably and responsibly can create a competitive advantage that is especially profitable in the long run (Deng et al., 2013; Jeong et al., 2018). Empirical literature focused on the financial industry is relatively scarce, although it provides some evidence indicating that social responsibility is related to the value and risk of financial institutions. In particular, studies from Simpson and Kohers (2002), Chih et al. (2010), Wu and Shen (2013), and di Tommaso and Thorton (2020) find contradicting results when assessing the effect of CSR practices on firm value and risk. Simpson and Kohers (2002) use a sample of commercial banks in the United States and find a positive relationship between social and financial performance. Likewise, Wu and Shen (2013) find a positive relationship between CSR and financial performance in terms of return on assets and return on equity after analyzing a large international sample of banks. Nevertheless, they further find the opposite relationship when focusing on nonperforming loans. The work of di Tommaso and Thorton (2020) provides the opposite results. They focus on European banks, showing high ESG scores to be related to a lower value in terms of Tobin’s Q, the book value of capital and equity process; but also, to lower risk measured by Z-score, credit default swap spreads, and nonperforming loans. Chih et al. (2010) focus on an international sample of financial firms listed on the Dow Jones World Index and the Dow Jones Sustainability Indices, finding no significant relationship between financial and CSR performance. However, they find that firms in countries with stronger investor rights engage in less CSR activities and that bank regulation positively affects CSR policies. The relationship between CSR practices and credit ratings in the financial industry has not been examined. The closest related literature to our work is nonbanking firm studies by Attig et al. (2013), Bae et al. (2008), Jiraporn et al. (2014), and Li et al. (2020). Attig et al. (2013) find that credit rating agencies tend to provide higher ratings to firms with good social performance. They further show that the individual components of CSR that are related to stakeholder management (i.e., community relations, diversity, employee relations, environmental performance, and product characteristics) exert a greater impact on creditworthiness. Jiraporn et al. (2014) use a sample of US firms from 1995 to 2007 and show a positive and statistically significant relationship between socially responsible firms and their credit ratings. Bae et al. (2008) and Li et al. (2020) examine the impact of CSR activities and credit ratings on loan spreads. Focusing on a US sample of syndicated loans from 1991 to 2008, Bae et al. (2008) find that CSR strengths affect loan pricing after controlling

Corporate Social Responsibility and Bank Credit Ratings

51

for credit ratings. Likewise, Li et al. (2020) show a significant impact of CSR, credit ratings, and green certification on yield spreads using data on Chinese green bonds. Given the empirical findings of previous studies focused on nonfinancial firms, the preliminary evidence on banking-related CSR policies and risk, and Freeman’s (1984) Stakeholder theory, we posit the following hypothesis: H1: There is a positive and significant relationship between CSR quality and the credit rating of financial institutions.

3 Data and Methodology 3.1

Sample and Variables

The data consist of large publicly listed banks in the United States. The financial data are gathered from Bloomberg, and the CSR data are from KLD. Our data cover fiscal years 2000–2016. Thus, both the financial crisis and periods of more normal market conditions are covered. The total sample consists of 486 bank-year observations and 59 individual banks. Following Shen et al. (2012) and Attig et al. (2013), we proxy the bank credit ratings (Rating) by S&P long-term ratings (i.e.: ratings on obligations with an original maturity of 365 days and more). The bank credit ratings are coded as 16 ordinal values so that the highest rating in our sample (AA+) equals 16 and the lowest (CCC+) equals 1. We measure CSR for each bank as the cumulative score of six dimensions of the ESG ratings retrieved from the MSCI KLD database. The MSCI KLD database provides data on the following CSR dimensions: Environment, Community, Human Rrights, Employee Relations, Diversity, and Product.1 The final value for each dimension is calculated as the sum of the strengths minus the sum of the concerns scores for that particular category. Our control variables consist of the following set of ratios that are commonly used in the banking literature and are shown to affect credit ratings: profitability (ROA), equity to total assets (Capital), the cost-to-income ratio (Efficiency), nonperforming loans (NPL Ratio), and capital structure, measured as Loan to Assets Finally, we control for the bank size by the natural logarithm of total assets (Size).

1

Following Lins et al. (2017), we do not include the dimension Corporate governance in our tests because governance is generally not part of a firm’s CSR remit.

52

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Descriptive Analysis

According to our descriptive statistics reported in Table 1, the average and median Rating is BBB+. Regarding our main explanatory variables, CSR is the most volatile variable, ranging from 21 to a minimum of 2. Concerning the CSR components, Employee Relations presents the highest average (4.08), which might be due to many ESG efforts in the banking industry being focused on employee policies. Regarding bank-specific controls, we can note from the average bank size that the sample consists of large institutions. This is explained by our sample selection of public banks. The mean capital ratio is 10.26% which indicates that, in general, U.S. public banks are well capitalized. The average efficiency ratio is above 50, which implies suboptimal values. As we are focusing on commercial banks, the proportion of loans to total assets is above 60%, while the nonperforming loans ratio is around 1.45% on average. The correlation matrix depicts that there is a positive correlation between all CSR components and the credit rating, except for the CSR component Product, which has a negative and significant correlation (-0.37) with the credit rating. Moreover, also most of the CSR components have positive and significant correlations with one another (see Table 2).

Table 1 Descriptive statistics Variables/stat Rating CSR-Score Community Diversity Employee Relations Environment Human Rights Product ROA Capital Efficiency NPL-Ratio Size Loan to Assets

Mean 10.22 8.97 1.78 3.01 4.08 3.93 2.29 3.40 0.90 10.26 61.70 1.45 10.67 61.01

Median 10 9 2 3 4 4 2 4 1.00 9.97 61.58 0.80 10.40 65.58

S.D. 2.39 3.24 0.91 1.55 1.53 1.21 0.67 1.10 0.95 2.75 28.20 1.76 1.39 16.14

Max. 16 21 5 9 10 9 4 6 4.43 32.80 165.21 13.32 14.76 96.17

Min. 1 2 0 0 1 1 0 -1 -6.54 4.21 0 0 8.38 4.64

This table provides the mean, median, standard deviation, maximum and minimum values of each variable

Rating 1 0.2822* (0.00) 0.3025* (0.00) 0.3769* (0.00) 0.1526* (0.0003) 0.1485* (0.0004) 0.0378 (0.3729) -0.3695* (0.00)

0.5628* (0.00) 0.5036* (0.00) 0.7036* (0.00) 0.6857* (0.00) 0.4709* (0.00) 0.0427 (0.3145)

1

CSR-Score

0.3237* (0.00) 0.2410* (0.00) 0.3932* (0.00) 0.4014* (0.00) -0.1292* (0.0022)

1

Community

0.067 (0.1143) 0.1329* (0.0017) 0.0086 (0.8398) -0.5195* (0.00)

1

Diversity

0.3929* (0.00) 0.2329* (0.00) 0.0097 (0.8199)

1

Employee Relations

0.6625* (0.00) 0.1583* (0.0002)

1

Environment

0.2218* (0.00)

1

Human Rights

1

Product

This table provides the pairwise correlations between the credit rating and the CSR score and CSR components: Environment, Community Human Rights, Employee Relations, diversity, and product *Denotes statistical significance at the 0.1 level

Product

Human Rights

Environment

Employee Relations

Diversity

Community

Rating CSR-Score

Table 2 Correlation matrix

Corporate Social Responsibility and Bank Credit Ratings 53

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4 Results and Discussion We employ the following regression for examining the relationship between bank credit ratings and CSR: RATINGj,

t

= βðCSR scoresÞj,

þ ϕðYear dummiesÞj,

t

þ εj,

t t

þ γ ðBank specific controlsÞj,

t

ð1Þ

where Ratingj, t denotes the S&P long-term credit rating converted to an ordinal scale from 16 (AA+) to 1 (CCC+) of bank j at year t. CSR scores present the main explanatory variables in our study, comprising CSR score and CSR dimensions, including Environment, Community, Human Rights, Employee Relations, Environment, Diversity, and Product. The set of bank-specific control variables includes proxies from size (Size), profitability (ROA), capitalization (Capital), efficiency (Efficiency), impaired loans (NPL Ratio), and capital structure (Loan to Assets). We control for the time-fixed effects by including dummy variables for fiscal years. Given the nature of our dependent variable, to avoid biased coefficient estimates, we employ ordered response models, similar to Shen et al. (2012) and Attig et al. (2013). Our regression results are reported in Table 3. According to our results, most of the CSR components and the total CSR score have a significant impact on the credit ratings, thereby supporting our bivariate results. In particular, the coefficient for CSR-Score is positive and highly significant in Model 1, thereby indicating that high-quality CSR is associated with good credit ratings in the banking industry. These results provide empirical evidence supporting the Stakeholder view (Freeman, 1984) in the banking sector. In Models 2–7, the CSR components for community, diversity, and employee relations have positive and statistically significant coefficients in line with Attig et al. (2013). Our results are further aligned with a strand of literature focused on financial institutions that links board gender diversity to lower credit risk (e.g., Palvia et al., 2015; Amore & Garofalo, 2016; Andries et al., 2017; Kinateder et al., 2021). Moreover, good employee relations are also linked to lower cost of debt and higher credit ratings (Bauer et al., 2009). Unexpectedly, the coefficient for the product dimension of CSR is negative and statistically significant (Model 7). However, in a similar vein, Esteban-Sanchez et al. (2017) find a negative relationship between the product responsibility dimension and the financial performance of banks. The authors suggest that their findings may be explained by banks moving toward a more relational business model to meet the real needs of their customers. In Model 8, we combine all CSR components and find that the strongest positive impact on banks’ credit ratings is driven by the diversity and employee relations components of banks’ CSR activities. Both diversity and employee relations components of CSR are considered “progressive” social thinking positions—as opposed to “traditional” social thinking (McGuire et al., 2012). Thus, “progressive” banks that cherish diversity in their culture by preventing discrimination in the workplace have higher credit ratings than “traditional” banks. Furthermore, banks that cherish the relationship with unions,

Lntotassets

NPL Ratio

Efficiency

Capital

ROA

Product

Human Rights

Environment

Employee Relations

Diversity

Community

CSR-Score

0.12 (0.12) -0.15*** (0.03) -0.01 (0.01) -0.48*** (0.05) 0.58*** (0.05)

(1) 0.06*** (0.02)

0.13 (0.12) -0.15*** (0.00) 0.00 (0.03) -0.46*** (0.05) 0.62*** (0.05)

0.12** (0.05)

(2)

0.12 (0.12) -0.15*** (0.03) 0.00 (0.01) -0.46*** (0.05) 0.58*** (0.05)

0.13*** (0.04)

(3)

0.13 (0.13) -0.15*** (0.03) 0.00 (0.00) -0.48*** (0.05) 0.60*** (0.05)

0.09** (0.04)

(4)

Table 3 Ordered probit results of CSR qualitative issue areas on credit ratings

0.13 (0.12) -0.15*** (0.03) 0.00 (0.00) -0.47*** (0.05) 0.63*** (0.05)

0.04 (0.04)

(5)

0.13 (0.12) -0.15*** (0.03) 0.00 (0.00) -0.47*** (0.05) 0.64*** (0.04)

0.09 (0.07)

(6)

-0.11* (0.06) 0.14 (0.12) -0.15*** (0.03) 0.00 (0.00) -0.46*** (0.05) 0.60*** (0.05)

(7)

(continued)

0.09 (0.06) 0.11*** (0.04) 0.08* (0.04) 0.00 (0.06) 0.05 (0.10) -0.11* (0.07) 0.12 (0.12) -0.16*** (0.03) 0.00 (0.01) -0.47*** (0.05) 0.51*** (0.06)

(8)

Corporate Social Responsibility and Bank Credit Ratings 55

(1) -0.01*** (0.00) Yes 486 24.78

(2) -0.01*** (0.00) Yes 486 24.44

(3) -0.01*** (0.00) Yes 486 24.71

(4) -0.01*** (0.00) Yes 486 24.53

(5) -0.01*** (0.00) Yes 486 24.31

(6) -0.01*** (0.00) Yes 486 24.32

(7) -0.01*** (0.00) Yes 486 24.43

(8) -0.01*** (0.00) Yes 486 25.23

This table reports the coefficients and robust standard errors (in parentheses) for eight ordered probit models. The dependent variable is the S&P long-term credit rating converted to an ordinal scale from 16 (AA+) to 1 (CCC+). Capital is the equity to total assets ratio, Efficiency is the cost-to-income ratio, NPL Ratio is the impaired loans to gross loans ratio, Size is the natural logarithm of total assets and Loantoassets is the ratio of loans over total assets ***, **, and * denote statistical significance at the 0.01, 0.05, and 0.10 levels, respectively

Year dummies Observations Pseudo R2

Loan to Assets

Table 3 (continued)

56 L. Baselga-Pascual et al.

Corporate Social Responsibility and Bank Credit Ratings

57

implement various no-layoff policies, and therefore perform well in the employee relations dimension of CSR, also benefit in the form of higher credit ratings. As a robustness check, logit-ordered models confirm the previous findings of a positive relationship between the credit ratings and CSR activities of banks. These results reported in Table 4 indicate that diversity and employee relations components are mainly responsible for the positive and significant association between credit ratings and bank CSR. To overcome endogeneity, we run additional tests (not tabulated) providing similar results when using the lagged explanatory variables. We further examine the robustness of our results by testing alternative models as well as both ordered probit and logit regressions. We also regroup our dependent variable into four categories by giving a value of 4 to banks with credit ratings of at least AA-; a value of 3 is given to those entities ranging from A+ to A-; institutions with credit ratings between BBB+ and BB- are assigned a value of 2 and, finally, we place banks with credit ratings of B+ or lower into category 1. The results of both ordered probit and logit regressions support the reported findings. Our results provide further evidence on the positive relationship between CSR policies and credit quality supporting results from Attig et al. (2013) for nonfinancial firms. We find a positive and highly significant correlation between CSR and credit ratings and also between most CSR components, diversity and employee relations being the components with the strongest coefficients. This finding is in line with Esteban-Sanchez et al. (2017) who state that shareholders and employees could be the most relevant stakeholders in the banking industry. Our results further support those from Bauer et al. (2009) for nonfinancial firms, showing a positive correlation between employee relations and credit ratings, and provide additional empirical evidence to the banking strand of literature that links board gender diversity to lower credit risk (e.g.: Palvia et al., 2015; Amore & Garofalo, 2016; Andries et al., 2017; Kinateder et al., 2021).

5 Conclusions During recent decades, attention to CSR policies has increased significantly. Regulators are issuing legislation to promote socially responsible practices, backed by a genuine interest from both investors and society (Sparkes & Cowton, 2004). The banking sector has demonstrated dubious ethical standards in recent years. Some examples are the placement of investment products without taking into account the customer’s risk profile, or the granting of mortgages to high-risk customers, among others. These practices have been linked, to a certain extent, to the financial crisis of 2008, from which strong regulation has been developed (e.g.: Basel III Accord, MiFID II, etc.). Given the role of the financial industry in the previous crisis and the plausible arrival of a new crisis in the coming years because of the current macroeconomic situation of high inflation and low expected growth, it is of interest to analyze corporate social responsibility in the banking industry.

Size

NPL Ratio

Efficiency

Capital

ROA

Product

Human Rights

Environment

Employee Relations

Diversity

Community

CSR-Score

0.36* (0.20) -0.27*** (0.07) -0.01 (0.01) -0.92*** (0.12) 1.05*** (0.09)

(1) 0.11*** (0.03)

0.41** (0.19) -0.28*** (0.07) 0.00 (0.01) -0.88*** (0.10) 1.13*** (0.09)

0.17* (0.10)

(2)

0.39** (0.19) -0.28*** (0.06) 0.00 (0.01) -0.88*** (0.11) 1.05*** (0.10)

0.23*** (0.08)

(3)

Table 4 Ordered logit results of CSR components on credit ratings

0.41** (0.19) -0.27*** (0.06) 0.00 (0.01) -0.92*** (0.10) 1.09*** (0.09)

0.19*** (0.07)

(4)

0.42** (0.19) -0.28*** (0.07) 0.00 (0.01) -0.89*** (0.10) 1.14*** (0.09)

0.07 (0.07)

(5)

0.42** (0.19) -0.28*** (0.07) 0.00 (0.01) -0.88*** (0.10) 1.17*** (0.09)

0.18 (0.13)

(6)

-0.15 (0.12) 0.44** (0.18) -0.28*** (0.06) 0.00 (0.01) -0.87*** (0.10) 1.12*** (0.09)

(7)

0.09 (0.11) 0.11** (0.04) 0.08* (0.04) 0.01* (0.06) 0.05 (0.10) -0.11* (0.07) 0.12 (0.12) -0.16*** (0.03) 0.00 (0.01) -0.47*** (0.05) 0.51*** (0.06)

(8)

58 L. Baselga-Pascual et al.

-0.02*** (0.01) Yes 486 24.93

-0.02*** (0.01) Yes 486 24.43

-0.02*** (0.01) Yes 486 24.71

-0.02** (0.01) Yes 486 24.68

-0.02*** (0.01) Yes 486 24.36

-0.02*** (0.01) Yes 486 24.39

-0.02*** (0.01) Yes 486 24.41

-0.01*** (0.00) Yes 486 25.29

This table reports the coefficients and robust standard errors (in parentheses) for eight ordered logit models. The dependent variable is the S&P long-term credit rating converted to an ordinal scale from 16 (AA+) to 1 (CCC+). Capital is the Equity to total assets ratio, Efficiency is the cost-to-income ratio, NPL Ratio is the impaired loans to gross loans ratio, Size is the natural logarithm of total assets, and Loan to Assets is the ratio of loans over total assets ***, **, and * denote statistical significance at the 0.01, 0.05, and 0.10 levels, respectively

Year f.e. Observations Pseudo R2

Loan to Assets

Corporate Social Responsibility and Bank Credit Ratings 59

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Consequently, we examine whether a positive relationship exists between CSR quality and the credit rating of financial institutions. Our study contributes to the banking literature by examining whether socially responsible behavior in the banking industry is associated with better credit ratings. This paper is the first study that analyses the relationship between CSR and credit ratings in financial institutions. Additionally, we contribute to the literature by providing further empirical support to the Stakeholder view (Freeman, 1984). More specifically, our work is in line with Attig et al. (2013) and Jiraporn et al. (2014) showing a positive and significant relationship between CSR activities and debt credit ratings. Moreover, our findings indicate that a higher quality in the CSR elements that promote bank responsibility toward its community, diversity, and employee relations tend to increase the bank’s creditworthiness. However, we document that the product dimension of CSR seems to have a negative association with credit ratings. Consequently, we provide empirical support to the body of banking literature that relates female representation in the governing organs of the firm to lower credit risk (e.g.: Palvia et al., 2015; Amore & Garofalo, 2016; Andries et al., 2017; Kinateder et al., 2021). With regard to employee relations, our results support those from Bauer et al. (2009), whose work documents that firms with stronger employee relations enjoy a lower cost of debt and higher credit ratings. In general, we provide support to nonbanking literature (e.g.: Attig et al., 2013; Bae et al. 2008; Jiraporn et al., 2014; Li et al., 2020) documenting the positive effect of CSR activities in the creditworthiness of firms, showing CSR as a value relevant element in the company that promotes credit quality of responsible firms. As a limitation of this study, we recognize that endogeneity problems may arise from omitted variables and reverse causality between some variables. To address these limitations and to further improve the robustness of the results, we test for additional regression models and use an alternative dependent variable. Our results remain unchanged after these additional analyses. Our results may have important implications for bank supervisors, regulators, depositors, and other stakeholders of financial institutions, as we highlight the benefits of effective CSR policies in the solvency of the financial industry. Looking ahead, future research could focus on the resilience of banking institutions in the imminent upcoming economic crisis given the current high inflation and interest rates. Moreover, it is important to examine the role of CSR policies and new banking regulations in coping with these challenging macroeconomic conditions. Declaration of Interest Baselga-Pascual wishes to thank the financial support from BANEF Research Group funded by the Andalusian Government (SEJ-555) and from ICES Research Group funded by the Basque Government. Dimic acknowledges the financial support of OP Financial Group Research Foundation (number 20210174). Vähämaa acknowledges the financial support of the Emil Aaltonen Foundation, the Finnish Savings Banks Research Foundation, the Foundation for the Advancement of Finnish Securities Markets, the Foundation for Economic Education, the Marcus Wallenberg Foundation, the Niilo Helander Foundation, and the OP Financial Group Research Foundation. The funding sources had no involvement in or impact on the study design, the writing of the report, or the decision to submit the article for publication.

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Funding This work was supported by the Emil Aaltonen Foundation, the Finnish Savings Banks Research Foundation, the Foundation for the Advancement of Finnish Securities Markets, the Foundation for Economic Education, the Marcus Wallenberg Foundation, the Niilo Helander Foundation, and the OP Financial Group Research Foundation. The funding sources had no involvement in or impact on the study design, the writing of the report, or the decision to submit the article for publication.

Appendix: MSCI KLD Dimensions of CSR The table describes the dimensions of the MSCI KLD database’s ESG ratings and the criteria for their strengths and concerns. The MSCI KLD database gives 1 point for each strength criteria a company meets and deducts 1 point for each concern. Dimension Community

Human Rights

Employee Relations

Environment

Diversity

Product

Strengths Charitable giving Innovative giving Non-US charitable giving Support for housing Support for education Indigenous people’s relations Volunteer programs Indigenous people’s relations Labour rights Positive record in South Africa Union relations No-layoff policy Cash profit sharing Employee involvement Retirement benefits Health and safety Beneficial products and services Pollution prevention Recycling Clean energy Communications Property, plant and equipment Management systems CEO diversity Promotion diversity Board of Director Work/Life benefits Women and minority contracting Employment of the disabled Gay and lesbian policies Quality R&D/Innovation Benefits to the economically disadvantaged

Concerns Investment controversies Negative economic impact Indigenous people’s relations Tax disputes

Labour rights Indigenous people’s relations Controversies in South Africa Union relations Health and safety Workforce reductions Retirement benefits concerns

Hazardous waste Regulatory problems Ozone depletion chemicals Substantial emissions Agricultural chemicals Climate change Controversies Non-representation

Product safety Marketing/Contracting Antitrust

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The Impact of Banking on Sustainable Financial Practices Toward an Equitable Economy Hazik Mohamed

1 Why Sustainable Actions Are Crucial? The planet struggles against unprecedented assaults from resource depletion and species extinction to pollution overload and toxic surplus. The problem is exacerbated by population explosions, industrial growth, technological manipulation, and military proliferation never before seen by humans. Many reports suggest that the basic elements that sustain life—clean air, water, and arable land—are in danger. The solution, on the other hand, is more elusive and complex. For sure, crisis has economic, political, and social implications. Muslims are called to actively establish justice and forbid injustice wherever and whenever possible. There is a famous hadith on this topic recorded from the Prophet (may Allah bless him and grant him peace), in which he said: The likeness of those who uphold the limits laid down by Allah and those who transgress them is like that of a group of people who draw lots on a boat [as to who will go where] and some of them get the upper deck and some of them get the lower. When the people on the lower deck want to get water, they have to pass by those who are above them, so they say, “Let’s make a hole in our part of the boat and then we won’t be inconveniencing those above us.” If the others let them do this, they will all perish; but if they stop them, they will not only save themselves, but save everyone. [Sahih Bukhari]

Sustainability is the concept of developing goods services and products that meet our present needs without compromising the future needs of future generations. Sustainability recognizes that the environment is not a limitless resource. The environment and its resources should be utilized responsibly and protected for the planet for mankind and for all living things.

H. Mohamed (✉) Stellar Consulting Group, Singapore, Singapore e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 N. Naifar, A. Elsayed (eds.), Green Finance Instruments, FinTech, and Investment Strategies, Sustainable Finance, https://doi.org/10.1007/978-3-031-29031-2_4

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Sustainability is not just about the environment, as it also affects economic development and social responsibility. For instance, the Earth’s carrying capacity, ecosystem sustainability, occupation patterns, behavior patterns, and many others affect the decisions we make to ensure that we are able to manage the finite resources of this world we have for all mankind. A sustainable society conserves the natural environment for future generations, promotes social justice for all, and enhances their quality of life. The benefits of sustainability include a better quality of life, a healthy ecosystem, and the preservation of natural resources for future generations. A truly Islamic or sustainable organization takes into account all aspects, from manufacturing to logistics to customer service, as a holistic approach to sustainability. The benefits of going green and being sustainable exceed the short-term benefits a company can gain from an environmental focus. The Islamic teachings on land management hold great promise for protecting fragile ecosystems by valuing sacred precincts and setting aside land for the common good. Similarly, Islamic reflections on garden metaphors and water images provide fertile ground for rethinking human relationships with the natural world. In Islam, humans play an essential role as trustees of creation. In this paper, we explore the reasons behind unsustainable development and behaviors. In order to do so, we uncover causes and consequences of the behaviors that have resulted in unsustainable outcomes. The widespread economic, environmental, social, and governance problems that we experience every day are prima facie evidence of injustice, selfish, narrow-minded agenda, and unIslamic practices. We highlight and elaborate on five of them. Next, we detail how banks and other financial institutions can provide investments in ESG-friendly equities and debt, with an aim to help individuals and businesses achieve long-term socially responsible objectives. We analyze nine types of sustainable financing instruments that comprise bonds, equities, mutual funds, ETFs, renewable energy credits, green mortgages, green credit cards, and governmental and multilateral credit guarantees. We then provide a case analysis on several sustainable and climate-based financing programs for the agriculture sector in Indonesia. Lastly, we conclude with the emphasis on Green Bond Principles that have been laid out to align to the best industry practice and uphold consistent performance for intended outcomes.

2 Economic Impact of Climate Change Every economic agent (households, businesses, and governments) will be affected by climate change, regardless of sector or location. Nonlinear correlations and escalation of risks are likely to lead to tipping points. Other structural changes do not have the same, wideranging, and diverse impacts that climate change will have (NGFS, 2019).

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While the exact results and timeframe are unknown, there is a very high probability that the grey rhinos of physical and transition risks will manifest at some point (NGFS, 2019). Currently, there are no technologies that can reverse climate change caused by greenhouse gas concentrations in the atmosphere. The climate change impact on our planet will be irreversible above a certain threshold, although uncertainties remain about the exact severity and timeframe (IPCC, 2014). Actions taken today will determine the nature and scope of future impacts, which require a credible and forward-looking policy approach. In this regard, governments, central banks and supervisors, firms, households, and financial market participants need to act and work together in a coordinated manner (NGFS, 2019). To visualize the impact of climate change, the following examples illustrate the financial losses brought on by its devastation: • Estimated $8 trillion in financial losses across 15 US cities because of rising sea levels and extreme weather events (BlackRock, 2019). • Direct and indirect losses in the value of global private sector financial assets caused by more destructive floods, droughts, and severe storms (NGFS, 2020) can be exponentially worse per degree of global warming: – estimated $4.2 trillion loss with 4 °C warming – estimated $7 trillion loss with 5 °C warming – estimated $13.8 trillion loss with 6 °C warming • As a result of the most destructive and deadliest wildfires in California, Pacific Gas and Electricity declared bankruptcy in January 2019, having difficulty paying the legal costs associated with the numerous lawsuits (NYT, 2019). • There has been a heatwave in Europe, which has caused the Rhine River, a major shipping route across Europe, to have low water levels. Due to the low water level, industrial production had been restricted due to the high transportation cost of raw materials (CNBC, 2019). • In the ASEAN region, a 4.8 °C scenario is expected to cause losses in combined GDP of 6.7% by 2100. • Worldwide, natural disasters and catastrophes (excluding technological and biological hazards) have doubled since 1980 (UNODRR, 2019). • Approximately $121 billion remains uninsured out of the $175 billion total disaster-related losses in 2016. Over the past 25 years, the global protection gap has increased by about 20% (EESI, 2021; Swiss Re, 2017).

3 Sustainability Encompasses More than Climate Change Aside from climate change and aggravated natural disasters like earthquakes, hurricanes, drought and flooding, the causes of our collective problems extend beyond the ecology and the environment. Our behaviors and the way we govern ourselves

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account for the unsustainable outcomes that we have created for ourselves. The widespread social ills that we experience every day are prima facie evidence of injustice, greed, narrow-minded agenda, and self-centered egotistical desires. To elaborate, the following are some discussions to shed light on negative behaviors that need to be overcome and prevented for sustainability to flourish. 1. Sustained Control of Power A disproportionate amount of political power is centralized and remain in the hands of a few in many developing countries for a long time. The concept of centralized systems of governance differs from decentralized ones in that one major party and a small group of politicians within a concentrated region are in charge of making decisions throughout the country instead of a network of political representatives. Making decisions and developing plans can be difficult as a result. In such circumstances, politicians are making decisions concerning unfamiliar places, lacking adequate knowledge about the context to design policies and programs that are effective and appropriate. Such circumstances violate the principles of consultation and cooperation. Consultation reduces ambiguity, improves clarity, and helps to coordinate efforts toward achieving common goals. A sustainable governing system should be led by a leader that abides by the Rule of Law, and established upon an allegiance by the majority of citizens (i.e. democratically elected and chosen), and acts on behalf of the country in managing its affairs. The evolution of sustainable development brings it closer to the Islamic interpretation based on Shariah, especially in regard to its alignment with the Islamic concepts of khilafah (vicegerent) and istimar al-ard (development of the earth). However, the duty of sustainable development will always fall upon governmental organizations and multilateral institutions to base upon scientific information in order to utilize technical expertise for solutions and garner public and private involvement for sustainability. 2. Corruption Centralization of power is often accompanied by corruption because leadership is not accountable to the people they are supposed to serve. Corrupt leaders exploit funds that could otherwise be used to fund development projects. They ensure their followers’ loyalty by providing them with services. There are inefficiencies and injustices created by this precedent. If nepotism and bribery spreads throughout a society, it will undoubtedly cause it to be corrupt and doomed for destruction. Good talented people will be deprived of opportunities to contribute, and unqualified people will occupy positions of power and make decisions that will only keep them there without regard for the greater good and what is just for the society at large. Like a tree that does not survive in an unhospitable environment, prosperity and real wealth cannot grow in a tainted environment with weeds that suck up nutrients from the soil and cutoff food supply to other plants in the garden. 3. Poor and Ineffective Policies

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Poor countries often face development hurdles due to a lack of uniform, basic infrastructure, which includes roads, bridges, power, and communication. The movement of goods and people cannot be done efficiently and quickly without these basic infrastructures. There may have been diverted resources for development to the benefit of certain individuals and groups instead of being redirected to where they can be equitably distributed. The various levels of corruption that we mentioned previously are closely related to this injustice of underdevelopment. Muslim countries are increasingly advocating the use of Shariah heritage in managing their environmental resources, but there is a disappointing proliferation of ineffective, weak implementing agencies. It also suggests that most Muslim countries are less prepared than other nations to achieve sustainable development, whether or not they revitalize their Islamic cultural heritage due to poor or misguided developmental policies. They face not only severe environmental obstacles today but also deep political obstacles. Absent policies and poor political support for greening initiatives are at the heart of the ecological destruction and resource depletion in the Muslim world. 4. Social Inequality Cultural ideas about the relative worth of different genders, races, ethnic groups, and social classes contribute to social inequality, which is deeply engrained throughout the world. According to attributed inequality, individuals are placed in different social categories at birth, sometimes based on their faith, ethnicity, or race. The apartheid laws of South Africa established a binary caste system that determined the level of opportunity for individuals from different races based on their skin color. Even though national and tribal divisions unite people who belong to the same country or tribe, they separate them from other human groups. In one country, people consider their fellow countrymen to be brothers, yet regard others as foreigners and view them as if they were objects or property to be exploited. It would be more beneficial to eliminate nationalistic and tribal divisions, as they can split humanity, and instead establish morality which has equal value to all that everyone is naturally inclined to as a rallying point for humanity. 5. Conflicts and Warfare Armed conflict diverts scarce resources away from fighting poverty and inequality to maintaining a military, thus further entrenching insufficiency. Take, for example, the invasion of Ukraine. As of March 2022, an estimated $100 billion worth of infrastructure damage1 (and rising) is wrecking decades of economic progress. The cost of war could exceed trillions of dollars2 before a truce can be declared. The US alone has drawn down $150 billion worth of

1 Ukraine war: $100 billion in infrastructure damage, and counting. https://news.un.org/en/ story/2022/03/1114022 2 The War In Afghanistan Cost America $300 Million Per Day For 20 Years, With Big Bills Yet To Come. https://www.forbes.com/sites/hanktucker/2021/08/16/the-war-in-afghanistan-cost-america300-million-per-day-for-20-years-with-big-bills-yet-to-come/?sh=1bb0e2687f8d

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military equipment and passed a $40 billion dollar aid package in May 2022. The G7 and EU had already committed 27 billion euros ($29 billion) as of April 2022. For Russia, the daily cost of this war for them exceeds $20 billion3 for every day the conflict drags on as estimated by one study. Such is the irony just as COVID19 pandemic was subsiding and the world was beginning to open up after more than 2 years of lockdown for perhaps a recovery from the gloom of the pandemic. The world’s resources and expertise would have been better allocated toward rebuilding a stalled economy, fortifying infrastructure, investing in new technologies and improving lives instead. The global public has become increasingly concerned about environmental degradation after sustained efforts by various groups that are not limited to the UN SDG and corporate ESG programs over the last few decades. Different cultures, nations, religions, and social classes are participating and supporting them. However, the effects of environmental degradation disproportionately affect the poor. Natural resources often provide the poor with the essentials for maintaining their households, such as drinking water, firewood, and wild plants for consumption and medicine, in developing countries. Agriculture and gathering resources are essential to meeting the needs of the poor. Consequently, contamination of drinking water and depletion of natural resources directly threaten the livelihoods of those who depend on them.

4 Types of Sustainable Financing and Investments Typically, green or sustainable financing attempt to tackle (through incentives or other ways) these three main areas: carbon emissions, carbon sequestration, and recycling. Emission trading and emissions taxes are two ways of reducing carbon dioxide emissions. Carbon emission reductions can also be achieved through changes in technology, processes, or work rules. In carbon sequestration, CO2 is prevented from being released into the atmosphere. As we know, green finance involves recycling materials rather than throwing them away and helps people reduce their energy consumption. Green finance is any type of financing that reduces the carbon footprint of companies and consumers without ruining the economy. There are several types of green finance, and their types are continually evolving due to the different needs of each person. Since green projects are generally capital intensive, if there was no dedicated funding for development, the vast majority of new projects would not be funded. Sustainable financial instruments include carbon markets, green bonds, and sustainable development bonds, as well as renewable energy, electric vehicles, and infrastructure, water conservation, waste management, and recycling initiatives. 3 Daily cost of Ukraine war likely to exceed $20B for Russia: Study. https://www.aa.com.tr/en/ russia-ukraine-crisis/daily-cost-of-ukraine-war-likely-to-exceed-20b-for-russia-study/2522706

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Our reliance on fossil fuels is reduced when we use green finance. Businesses that adopt environmentally friendly business practices benefit from increased revenue, brand loyalty, and improved reputation, which goes beyond financial returns. The types of green finance relating to water conservation, for example, the ability to cut costs and create new cost savings where once there was only dry land for companies already located in drought-prone regions. In addition to green financing, a company can adopt renewable energy sources and emission reduction technologies to reduce carbon emissions. Today, green financing has no limits. Banks and other financial institutions seeking to be socially responsible can provide investments in ESG-friendly equities and debt, with an aim to help individuals and businesses achieve long-term objectives. 1. Privately Placed Green Sukuk Governments and businesses that can issue bonds may also issue green sukuk. In addition, a bank can raise long-term funds using green sukuk. To qualify as a green private placement, an issuer must agree to use the proceeds of the issuance that provide clear benefits to the environment with the assessment and (if necessary) quantification of the project’s benefits determined by the issuer. Green bonds can be indirectly purchased through exchange-traded funds and mutual funds, such as the Calvert Green Bond Fund and the iShares Global Green Bond ETF. Based on the level of risk, collateral, and stability of the underlying assets, an investor could make 1–5% on their investment. A green sukuk is the most notable and prominent green finance instrument because their issuers commit to use sukuk proceeds to fund climate-friendly projects. A consortium of investment banks pioneered the Green Bond Principles in 2014 after establishing a voluntary best practice guideline. Currently, the GBP are overseen by the International Capital Markets Association (ICMA). Voluntary Process Guidelines for green bonds are published annually by the ICMA. These guidelines can also be used to direct green sukuk issuances. 2. Renewable and Sustainable Equity The number of sustainable funds has been rising rapidly in recent years. There are 3435 sustainable mutual funds and 552 sustainable exchange-traded funds in the sustainable fund universe, with AUMs of $1.56 trillion and $174 billion, respectively (UNCTAD, 2021). Around two-thirds of sustainable funds are equity funds, where fixed income and mixed allocation funds make up the remainder. Most of the funds are based in developed countries (usually Europe) and target countries in the developed world. The number of sustainable funds in developing and transition economies is about 5%, and their assets account for less than 3% of the total (UNCTAD, 2021). Having a sustainable tilt in their portfolios did not systematically harm the funds’ returns, according to the UNCTAD analysis. In terms of financial performance, sustainable funds performed almost as well as their benchmarks over a 3-year period. Sustainability-related factors including environmental, social, and governance (ESG) factors will be considered in the Renewable and Sustainable Equity fund

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with the objective of achieving positive long-term capital appreciation over a full market cycle. Homeowners and businesses can use this type of financing. Solar power is the most common type. Tax credits or cash for the electricity can be generated from solar panels when they are installed in houses. Its advantage is that it is reliable and guaranteed for 20 years. Solar panels will likely be installed with the money received from the financing. 3. Green Mutual Funds Several types of investment vehicles are devoted to promoting socially and environmentally sustainable business practices and policies, including mutual funds. Sustainable funds like these usually invest in green transportation, alternative energy, and sustainable living companies. Unlike regular mutual funds, green finance invests in environmentally friendly companies and the goods and services they provide. Investment decision makers in conventional mutual funds rarely consider the environment, so green investments are becoming increasingly popular. A group of investors began to focus their attention and resources on businesses that made better use of the environment than more traditional firms after major events like the Exxon Valdez oil spill and protracted logging rights fights in the U.S. northwest. Many investors saw these companies not only as operating in a more ethical manner but also as having a competitive advantage over companies that were unable to reduce the impact they had on the environment. Those who saw renewable energy sources as part of a sustainable society felt they had an ethical obligation to invest in technologies and businesses that could contribute. Green funds and socially responsible investing (SRI) may not yet consistently produce higher returns for investors based on performance, but they do represent a proactive step toward environmental consciousness, something that many investors value highly. 4. Solar Sukuk The goal of solar sukuk is to increase the development of renewable energy technologies such as solar power at a lower cost by providing a low repayment financing tool without interest. Green energy credits, rather than cash, must be used to buy this type of green finance. Based on the history of the company and the sukuk it offers, business owners can receive between 2 and 4% returns from their investment. As solar bonds are issued to help U.S. homeowners finance the purchase of rooftop solar panels to power their homes, investment firms are buying record amounts. Sales of solar bonds reached $2 billion in the first half of the year, almost double what they were in the same period in 2019 and 2020, according to deal tracker Finsight.com. Solar bonds are taking off in the United States, and solar sukuk will likely appeal to investors seeking alternative green investments who are looking for environmentally conscious, interest-free, Shariah-compliant regular-payment investments. In the conventional solar bond market, companies such as GoodLeap LLC, Sunnova Energy, and Solar Mosaic offer packaged loans to

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homeowners for the purchase of rooftop solar panels. A number of fund managers, including Blackstone Group and BlackRock, purchase the bonds and include them in investors’ portfolios. 5. Green Mortgages Green mortgages are loans that are specifically aimed at green buildings. Borrowers who can demonstrate that their home meets certain environmental standards can apply for a green mortgage by banks or mortgage lenders. It is possible for a borrower to upgrade an existing building’s sustainability rating or purchase a new home with a sustainability rating. Green buildings (and their occupants) are typically less costly to operate due to lower utility bills, thus making them a lower risk investment for banks. This means that borrowers are better positioned to pay off loans, thus lowering the likelihood of default, as banks refer to it. A green building usually has a higher value called “green value” in markets where brown properties are becoming increasingly unattractive, that is, equivalent properties without any green credentials. As mortgage repayment terms are often 25 or 30 years, both of these impacts are expected to increase over time. In order to minimize risks associated with its loans, a lender should maximize green value and avoid future brown discounts. In addition, lending more to green buildings than to brown ones may also be justifiable on the basis of a lower loan-to-value ratio. Most European buildings that will be in use in 2050 are already constructed, which consumes a lot of energy. For the Paris Agreement to achieve its climate change targets, energy efficiency renovation rates should be increased from 1 to 3% per year. By offering a green mortgage, the private sector can provide additional funding for renovations, promoting green buildings to a broader range of stakeholders—the mortgage banks. Furthermore, the building owner is made aware to the issue of energy efficiency and sustainability at a crucial time in the building’s life when renovation decisions may need to be made. An analysis by the UK’s Energy Saving Trust indicates that renovations are mainly undertaken in the first year after purchase. A bank will either lower the loan repayment rate or increase the loan amount to borrowers as an incentive to buy or renovate a green building. These types of green finance are typically only available to homeowners with existing traditional loans. Renewable energy sources like solar panels can save them money, and they can acquire green financing to do so. In addition to paying off standard loans early, some borrowers may also be eligible for 0% loan repayment green loans. 6. Green Credit Cards Green Credit Card users earn points by purchasing eco-friendly products, utilizing public transportation, making paperless transactions, and using less electricity, water, and gas. Users can convert the points into cash or donate them to environmental organizations. In addition to discounts for electric car charging, the Green Credit Card also offers discounts for recycled automobile parts. Further, it is a key driver of eco-innovation and shifts the economy into a low-carbon one, as it cultivates a market for low-carbon products. Green Credit

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Cards is the world’s first nationwide initiative that rewards eco-friendly behavior using a credit card platform. For every dollar spent with Waste Management, the company earns additional rewards for green financing through green credit cards. A Green Credit Card can be viewed as a Big Data tool that helps monitor and manage greenhouse gas emissions associated with the consumption of goods and services. By using one credit card, it is possible to monitor numerous aspects of the residential sector, such as product types/usage, transportation, as well as energy consumption. With participating corporations, credit card holders can receive rewards for purchasing eco-friendly products and services. Using a credit card can also be a cost-effective way of getting around town, reducing utility bills (such as electric, water, and gas consumption), and facilitating paperless transactions. Points are converted to cash, which is then added to the credit card system, where they can be redeemed for cash later or used as desired. With the Green “Point of Sales” System, retailers can automatically recognize green products by scanning barcodes and reward consumers when they use their Green Credit Cards to buy eco-friendly products. The Green Credit Card can direct people’s consumption patterns toward a sustainable lifestyle and reduce carbon emissions. Green Credit Cards can also be effective in bridging the information gap and reducing the cost barrier associated with eco-friendly consumption. The emissions of about 1 million tons of CO2 can be reduced by purchasing 10 types of eco-friendly products, which can be offered as reward points. These products can be combined to generate savings of 1.5–24% from reward redemptions. Furthermore, using the database, the Green Credit Card program can encourage manufacturers to produce low-carbon products and plan for future developments that are greener and circular. 7. Green Stocks Companies that invest in alternative energy sources are considered green stocks. This category includes wind power stocks, solar power stocks, geothermal power stocks, and wave power stocks. As alternatives to fossil fuels, green stocks appeal conceptually and emotionally. With climate change, businesses and other institutions are forced to think about ways to reduce their carbon footprint. There are many companies signing power purchase agreements (PPAs) with electricity providers and other generators specifically to purchase renewable energy. Some are pursuing projects directly to develop renewable sources of energy. As solar panels, wind turbines, and batteries for energy storage become more affordable, many are doing this to become more socially responsible global citizens. This makes the sector more attractive to investors. Global renewable energy capacity is expected to grow by more than 60% from current levels by 2026 and represent nearly 95% of worldwide power capacity growth at that time. The future belongs to renewable energy, and it could prove to be a terrific investment for the long term. Across the globe, there is a deep and apparently enduring shift toward sustainability, with the United States, China, and Europe all moving in the same direction. According to the American Cities Climate Challenge,

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U.S. municipalities and provinces boosted the extent of their renewable energy pacts by more than threefold from 2015 to 2020. In addition, the internal combustion engine might be about to give way to battery electric vehicles. At the beginning of 2020, 17 countries set themselves a goal of having completely zero-emission vehicles or phasing out internal combustion engine vehicles by 2050, according to the International Energy Agency. Moreover, a study by KPMG found that over the next decade, the top 10 automakers will invest $200 billion in electric vehicles (EVs), which is more than what the United States spent on the Apollo moon landing over 13 years ago. 8. Renewable Energy Credits Renewable energy credits (RECs) represent energy produced from renewable sources, such as solar or wind. Renewable energy certificates are not the same as buying electricity. Rather, RECs are attributes of renewable electricity that are clean. A renewable energy credit is a tradable, nontangible commodity that proves that a one megawatt-hour (MWh) of electricity was generated using a renewable energy source before being connected to the power grid. There are many different sources of electricity entering the grid, including natural gas, solar, wind, and nuclear power. Consequently, it is not possible to determine the exact source of your electricity. With RECs, you can solve this problem. Renewable energy certificates (RECs) transfer ownership of the renewable aspect of the energy. By using renewable energy credits coupled with electricity from the grid, renewable energy is generated on your behalf. An REC is produced when one MWh of electricity is produced from renewable power and released to the energy network. A wind power facility that makes five megawatt hours of electricity has five credits to sell or retain. By purchasing these credits, you are purchasing the “renewable” part of wind farm electricity, and you can claim five megawatts of the electricity you use from renewable sources. RECs cannot be repurchased after they have been sold. There is a unique number assigned to every renewable energy credit, which includes information such as where it was produced, the kind of renewable energy it comes from, and the date from which it was created. REC exchanges are tracked and recorded. There are two types of REC purchasers: voluntary and compliance. The majority of voluntary credit buyers strive to reduce their greenhouse gas emissions. Renewable energy credits can be purchased for many reasons. As a company, they might have emissions goals they would like to achieve, or they might be curious about where their electricity comes from. Whole Foods and Starbucks, for example, are voluntary REC buyers. Individuals can purchase renewable energy if they wish, as well as homeowners. A compliance buyer is an electric utility that is required to produce a certain percentage of its electricity from renewable resources. Several states have regulations that set requirements for the use of renewable energy called renewable portfolio standards (RPS). Utility companies must submit renewable credits as evidence that they source a certain amount of their electricity from renewable

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sources under these laws. When they are not able to generate enough RECs, the utility must purchase them. 9. Credit Guarantees and Financing Subsidies For most financial institutions in emerging and developing economies, green segments remain a new frontier. Financing green projects faces a number of challenges, including the risk appetite of lenders and borrowers’ lack of awareness. In addition, it is challenged by insufficient policy and regulatory guidance, as well as poor economic efficiency (projects that produce social returns but provide insufficient private returns). To improve the bankability of smaller green projects, capital can be directed into the project pipeline using a blended finance approach, incorporating coverage for risks and enhancement of credit. By providing credit guarantees, green issuers can obtain funding for longer term debt and reduce currency and maturity mismatches in their local capital markets. Among the unique characteristics of green credit guarantee schemes is its ability to support access to finance as well as target green economic outcomes. By combining these two seemingly mutually exclusive goals, national policy goals can be addressed efficiently without compromising on the green agenda. Thus, the green market can grow and remain stable with such financial assurances. The following case analysis illustrates an example of how loan subsidies can help micro and small enterprises as they are generally excluded from being able to issue green bonds or are excluded from investments by mutual funds or ETFs which generally look for larger forms of investments.

4.1

Case Analysis: Innovative Green Financing Programs for the Agriculture Sector in Indonesia

In Indonesia, the government has implemented several sustainable and climatebased financing programs for the agriculture sector, namely the Credit for Food Security and Energy or Kredit Ketahanan Pangan dan Energi (KKPE) program and the People’s Business Credit or Kredit Usaha Rakyat (KUR) program. In the first phase between 2007 and 2014, cooperatives and MSMEs (micro, small and medium enterprises) were provided with credit guarantees by KUR. After 2014, KUR subsidized loans with loan repayment rates up to 13% provided by partner commercial banks. A slightly different approach is taken by KKPE in terms of loan repayment rates and how it targets MSMEs under farmer groups and cooperatives.

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Background

It is estimated that 55.3% of all Indonesia’s farmers own land less than 0.5 ha. A lack of capital is the major problem in running their farming business for small farmers with low education, limited skills, and limited capital. Through various types of agricultural financing programs from the Ministry of Agriculture, the government has provided various incentives to improve access to capital, including green capital, particularly for small farmers. These are arranged by the Coordinating Ministry of Economic Affairs (BJBE) with collaborations with public and commercial banks along with cooperatives. Indonesian Financing Program Tools and Credit Facilities for Micro and Small Enterprises 1. KUR—Kredit Usaha Rakyat (People’s Business Credit) Like KKPE, KUR is a low-interest loan for working capital, but it targets a wider audience, including small and micro entrepreneurs, apart from farmers. KUR is designed to improve access to credit and financing for farmers and MSMEs in order to support agricultural growth (food crops, horticulture, plantation, and livestock), green practices, reduce poverty, and expand employment opportunities in agriculture. The KUR targets are MSMEs in upstream agriculture, i.e., those engaged in farm equipment, agriculture machinery, horticulture, forestry and livestock production, and in downstream agriculture, which are those involved in processing and production. 2. KKPE—Kredit Ketahanan Pangan dan Energi (Credit for Food Security and Energy) To help farmers and farmer groups implement Food Security and Development Programs for biofuel raw material plants, KKPE provides investment credits and working capital loans. By developing biofuel raw material plants, KKPE believes it can improve sustainability implementation in agriculture and energy by providing investment credit and working capital at affordable loan repayment rates. Governments provide lower loan repayment subsidies under this scheme than commercial rates. As long as the executing banks extend these credits, they may be accessed by these groups.

4.3

Measures and Actions

Under these schemes, no collaterals are required for KUR micro, and small enterprises who are borrowing up to IDR 100 million, according to the Coordinating Ministry of Economic Affairs (BJBE). For the KKPE scheme, the credit extended is a maximum of IDR 25 million for individual and IDR 500 million for group applications. The government-subsidized

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Fig. 1 Loan rate subsidy and credit guarantee by government toward commercial loans to farmers

Loan

Banks

Farmers/ cooperatives

loan repayment subsidies

Government

repayment rate offered is 8% per annum for each loan. For loans above IDR 100 million, some collateral may be required (Fig. 1). For the KUR scheme, the credit extended is a maximum of IDR 25 million for individual and IDR 500 million for group application. The government-subsidized loan repayment rate offered is 7% per annum for each loan, but the tenure is restricted to 3–5 years. During COVID-19, no loan repayment rate was applied (0%) for a period until December 2020. Also, these loans are often accompanied by a credit guarantee by the government.

4.4

Results and Impact

As a result, there has been greater collaboration between various entities that include public and private banks, other financial institutions, and cooperatives. These loans also do not require collateral which is one of the major impediments for MSME’s access to credit due to their size, lack of credit history, and informal structure. The credit guarantees also help the micro-enterprises without any collateral or credit history to obtain capital for their agriculture livelihood and implement sustainable practices. Various KUR clusters have been developed (and continue to be developed) while reaching out to the MSMEs. The portion of the credit for MSMEs has been gradually increasing: IDR 190 trillion in 2021, IDR 285 trillion in 2022, and a projected IDR 350 trillion for 2023.4 More micro-loans have been disbursed because of these measures and programs. This is in line with the central bank’s target of 30% bank credit allocation for MSMEs, which is less than 20% as of early 2022.

4

Improving cluster KUR (Microcredit Program Kredit Usaha Rakyat) to accelerate credit absorption from the perspective of Teten Masduki, Minister of Cooperatives and MSMEs. https://east.vc/ perspectives/teten-masduki/

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5 Practical Steps to Sustainable Green Finance Issuance To improve the issue of sustainable financial instruments, four key elements must be followed according to the Green Bond Principles: • Use of Proceeds: Amounts raised by the bond/financial instrument issuance are exclusively used to finance eligible projects or activities. The categories of green and social projects must be specified. • Project Evaluation and Selection Process: Develop an evaluation process and selection criteria for eligible projects. • Management of Proceeds: Allotted funds go into a designated account or are otherwise tracked accordingly. • Reporting: The annual reporting provides information about the key elements of the financial instrument, like amounts allocated, amounts used, amounts not used, and the expected impact of the projects. It is considered best industry practice to obtain external reviews of selected projects’ sustainability credentials and compliance with guidelines and frameworks. There are several types of external reviews available for climate bonds, including assurance reports, second-party opinions, ratings, and verification reports. • Compliance with the guideline or standard is confirmed by an independent third party in an assurance report. • An issuer’s green/social/sustainable bond framework is audited by a third party to confirm compliance with standards and to analyze projects that meet the criteria. • An independent rating agency evaluates the green/social/sustainable bonds. • The use of proceeds from certified green bonds or MSME financing is verified by a third party, confirming compliance with both the bonds standards and sector criteria before and after issuance.

6 Conclusion Despite sustainability problems being more complex than the aggregation of social irresponsibility, they cannot be solved by movements acting alone and simply combining disparate solutions. To achieve far-reaching and long-lasting change, sustainable development geared toward an equitable global economy will need to encompass the ecological environment, economics and employment, equity and equality. Not only do our economic systems need to be adapted to include social solutions, but we should also weigh their objectives inwardly against our own individual behaviors. Sustainable plans should include policies that are aimed at reaching the younger demographic, as consumer behavior is engrained at a young age. It is vital that the sustainable financial initiatives toward an equitable economy are implemented using a successful public/private partnership business model, where government policy is

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to encourage eco-friendly consumption and production practices. Furthermore, eco-friendly products and products from eco-friendly distributors result in reduced nonindustrial greenhouse gas emissions.

References Blackrock. (2019). Getting physical: Scenario analysis for assessing climate-related risks. Retrieved from https://www.blackrock.com/us/individual/literature/whitepaper/bii-physical-cli mate-risks-april-2019.pdf CNBC. (2019). Low water levels in the river Rhine could create havoc for Germany’s economy. EESI. (2021). Fact sheet: Strengthening financial resilience to climate change. IPCC. (2014). Mitigation of climate change. Chapter 10: Industry. Retrieved from https://www. ipcc.ch/site/assets/uploads/2018/02/ipcc_wg3_ar5_chapter10.pdf New York Times (NYT). (2019). California’s largest utility says its bankrupt. Here’s what you need to know. NGFS. (2019). First comprehensive report: A call for action: Climate change as a Source of Financial Risk. NGFS. (2020). Overview of environmental risk analysis by financial institutions. Retrieved from https://www.ngfs.net/sites/default/files/medias/documents/overview_of_environmental_risk_ analysis_by_financial_institutions.pdf Swiss Re. (2017). Natural catastrophes and man-made disasters in 2016. UN Conference on Trade and Development (UNCTAD). (2021). The rise of the sustainable fund market and its role in financing sustainable development. United Nations. UN Office for Disaster Risk Reduction (UNODRR). (2019). The human cost of disasters.

Ethical and Socially Responsible Investments in the Islamic Banking Firms: Heart, Mind, and Money: Religious Believes and Financial Decision-Making in the Participatory Financing Contracts: Charitable Donation Announcement Effect on Agents’ Level of Effort and Commitment Anas El Melki

and Hejra Ben Salah Saidi

―There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud. (Friedman, 1970) A standard definition of CSR (CSR: stands for Corporate Social Responsibility) is that it is about sacrificing profits in the social interest. For there to be a sacrifice, the firm must go beyond its legal and contractual obligations, on a voluntary basis. CSR embraces a wide range of behaviors, such as being employee friendly, environment friendly, mindful of ethics, respectful of communities where the firm’s plants are located, and even investor friendly. (Bénabou & Tirole, 2009, p. 2)

1 Introduction The concept of ethical and socially responsible investments has grown over time continually and rapidly but it still remaining relatively little known and little experienced. At best, this knowledge remains limited to assimilating ethical and socially responsible investments to giving charity with efforts in supporting civic initiatives in the areas of community projects, health and social services, education, and the cultural and the artistic events.

A. El Melki (✉) · H. Ben Salah Saidi Higher Institute of Business Administration Gafsa University Tunisia, Gafsa, Tunisia e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 N. Naifar, A. Elsayed (eds.), Green Finance Instruments, FinTech, and Investment Strategies, Sustainable Finance, https://doi.org/10.1007/978-3-031-29031-2_5

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What drives the agent to perform well in the contractual relationship and afford effort levels that maximize the common welfare? And what can do the Islamic financial institutions as policymakers to enhance smart and optimal decisions? Key drivers of the increasing interest in the ethical and socially responsible investments (E.S.R.I) have been the globalization of trade, market, and stakeholders pressures, a rise in the strategic relevance of stakeholder connections, as well as competitive advantages, knowledge, and brand reputation due to the presence of digital communication power, as well as an increase in the size and influence of businesses. Working across value systems formed by many different cultures and religious traditions has become more and more necessary as a result of globalization. Social responsibility can be considered as an incentive mechanism in the Islamic financing contracts offered by the Islamic banks in their financial intermediation model. The social responsibility can be found in both the mandatory (ZAKAT) and voluntary (SADAQAH, WAQF, QARD AL-HASSAN) forms as practiced over centuries in Muslim society are considered. As Zakat is a component of a larger religious belief system, it calls for voluntary compliance with the Day of Judgment’s account and the performance of commitments with a certain level of accountability. There’s also an increasing attention in the banking industry to invest money on corporate social responsibility (C.S.R) initiatives, try to have C.S.R departments, and make their charitable work transparent through public annual reports, we questioned about the Islamic banking firm, does it do the same and for what purposes? The motivation for this paper is mainly to bring some answers to these aspects and others. The incentive behind the choice of this research question is the rise in volume of investment in the ethical and socially responsible programs and activities around the world, by making pro-social activities public through ethical and socially responsible (E.S.R) reports and communication support and network. These investments, do they imply doing well? Or paying to do good for social causes, or just to appear good in the public perception? The motivation of this paper fits into the effort of contribution to the financial experiment investigation of interactions between the prosocial and ethical behavior with reference to Blount (1995), Offerman (2002), Charness and Levine (2007) and Falk et al. (2005). Irlenbusch and Sliwka (2005) and try to understand experimentally and theoretically whether and why principals’ charitable giving has a positive effect on agents’ effort. We investigate why and under what conditions donation announcement decision by a principal can have an effect on the agent’s motivation to exert effort that is beneficial for the common welfare? Through an experiment with a principal-agent setup, a principle (the Islamic banking firm) first determines whether or not to contribute a predetermined amount to a charity, and then the agent (funded partner) decides on his degree of effort. This allows us to analyze how the principal’s donation decisions impact the funded participant’s engagement. Numerous studies have looked into the connection between financial performance and participation in (E.S.R) Investments. While some researchers—(McGuire et al., 1988; Karagiorgos, 2010; Simpson & Kohers, 2002)—found a positive association between these two factors, other researchers—(Vance, 1975; Lopez

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et al., 2007; Makni et al., 2009)—found a negative correlation. While other academics contend there is absolutely no connection (Peng & Yang, 2014; Nelling & Webb, 2009). Although some of the above-mentioned researches and others in this theme, the impact is ambiguous especially in an Islamic financial context with reference to different categories of (E.S.R) Investments. Most Islamic banks operate within their home markets so the indirect environmental and social exposure to these markets will be reflected globally in the situation of the companies they deal with. Islamic banking firms were launched with leading principles of enhancing social justice through financial intermediation, with an emphasis on avoiding harm and optimizing benefits for the surrounding community, by not financing sectors that may impact negatively the society on the long run. Modern Islamic finance and E.S.R.I as well as Environmental Social and Governance (E.S.G) investing are emerging approaches with many shared principles, with many more similarities than differences. Both are regarded as ethical to a certain extent and provide investors, both Muslims and non-Muslims, with products. Each has effective procedures and policies from which the other can benefit. Islam does not view E.S.R.I as being weird or unrelated to Islam because its foundation is Islamic Law (SHARI’AH). With the use of negative screening by many ethical investors, some of their common behaviors also apply to traditional investing products. Although the justification for these decisions may not come from the same place (religion/ethics), both Islamic and the E.S.R.I procedures aim to prevent from funding organizations that are viewed as harmful. Decision making and the consequences of our actions are not just a religious issue, they are a part of all aspects of our lives. What makes investments be considered as ethical is finally based on different set of contextual factors and motivational triggers. Islamic banking firms do not only care about the types of activities they finance, but also how these activities are financed. With this in mind, the purposes of this paper is to describe, explain, and explore the ethical and socially responsible investments decision of the Islamic banking firms in the financing participatory contracts (Mudaraba and Musharaka), and how the religious believes influence the decision making and what balance can be found between the heart, mind, and money. With reference to pro-social behavior, this paper shed light, experimentally and theoretically, on the question of whether or not and why principals’ charitable giving has, or not a tremendous effect on agents’ level of efforts decision. We analyze, through a principal-agent experiment game, the effects of Donation Announcement Decision (D.A.D) on agent’s motivation.In this game, the principle (here the Islamic bank: the fund provider) can incentivize the agent by setting a minimum performance requirement before the agent (entrepreneur) decides on effort level to be afforded. Even though most agents are willing to improve their performance in response to the principal’s D.A.D, our findings suggest that effort affects performance and profit improvement. Overall, D.A.D has a non-monotonic effect on the principal’s payout. When asked regarding their emotional reactions to D.A.D, most agents who respond positively say they see it as a symbol of trust and a boost to

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their choice autonomy and gives them pride about their indirect social responsibility of their business and increase the belonging feelings and the esteem needs, the desire for reputation or respect from others (Maslow), as well as the reward in the hereafter. What is the Islamic standpoint on the ethical investment and social responsibility? How the Islamic banking firms subscribe to an ethical investment and social responsibility program? What are their responsibilities, social duties or obligations and toward any stakeholders, i.e., the responsibility of giving ZAKAH and SADAQAH? What is the stakeholder agencies level of understanding of the ethical funding and social accountability of the Islamic banks? The paper is organized as follows: the first section provides an overview of the concept of ethical and socially responsible Investments E.S.R.I, optimality and happiness. The second section introduces the E.S.R.I and economic performance, Doing well and doing Right. This section presents an experimental analysis of how the agent perceives the donation announcement decision (D.A.D) of the principal and how this affects the agent’s behavior through their effort levels and commitment. The third section examines the organizational motivations, religious affiliations, and ethical character: motivation and incentives. The fourth section treats and analysis the Islamic approach of ethical and socially responsible investments: Compulsory and voluntary basis Donations Islamic Religiosity vs. Optimality Behavior and Rationality in decision making.

2 Ethical and Socially Responsible Investments, Optimality and Happiness Numerous research, such as those by Al-Khatib et al. (1999) and Dusuki and Abdullah (2007), has revealed that religion is one of the deciding factors when a stakeholder decides to work with an Islamic bank or another (2006). Although ethical and socially responsible investments (hereafter referred to as ESRI) do not have a standardized and universally accepted definition, it can be analyzed as a win–win business commitment for the different stakeholders environment, for social justice and equity, for employees and shareholders, and for the brand and profitability and its sustainability. E.S.R.I is a set of philosophical conducts forming different systems approach to business with a focus on developing credible and win–win partnerships with the different stakeholders going from investing into human capital development to enhancing local community development projects, by considering public expectations and following generally accepted ethical values within business processes, and improving constantly added value by high-quality offer in the market (products and services) to increase in final shareholders’ wealth. We can distinguish two sides of the human social behavior a selfish and selfless. Humans are different by nature, and they differ also by their social preferences: a tendency for helping and collaborating with others. Historically, the economic theory has recognized the narrow self-interests of people and the rationality hypothesis, but it is now commonly acknowledged that

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this assumption is frequently outdated (Fehr & Schmidt, 1999; Charness & Rabin, 2002; Gintis et al., 2003; Falk & Fischbacher, 2006; Thaler, 2015; Bowles, 2016). Similar to this, during and after the emergence of the behavioral finance, the presumption that people act rationally in pursuing their goals is frequently disproven due to deeply ingrained cognitive biases and restrictions on human cognitive abilities: “bounded rationality” (Simon, 1982; Gigerenzer & Selten, 2002; Kahneman, 2003). In the cultural, religious, and social norms and its impact of one’s own free will views on charitable giving, we find the study of Vohs and Schooler (2008) that suggests when people’s faith in free will is challenged, they are more likely to commit fraud for their own financial advantage. This study by employing an online experiment to look at the effect of free will belief on donation behavior, and this study extends the literature on self-serving bias to free will beliefs and altruistic behaviors. Alain Cohn et al. (2014) examine how knowledge and culture can affect ethical behavior in the banking industry. This study expands on the idea that employees’ dishonest and unethical behavior can be influenced by the professional culture in the banking sector. The study of Trope and Liberman (2010) advances the idea that making decisions for other people involves a greater degree of psychological and social distance, which leads to more abstract and detached thinking. Also it examines how people’s decision-making processes are affected by ambiguity, or the lack of knowledge about potential rewards and likelihoods.

2.1

Ethical Reminders Strategy

This strategy is based on the idea that individuals have short-term memory are prone to forgetting their best intentions and may not always consider the interests of others while making crucial decisions. Reminders have been used effectively in the field to encourage behaviors like blood donation (Stutzer et al., 2011; Vuletić, 2015), as well as elections voting (Dale & Strauss, 2009). E.S.R.I stand at the nexus of business and society. Several factors that have contributed to the E.S.R. The globalization of trade, market, and stakeholder pressures, the growing size and influence of corporations, the realignment of government regulatory pressure, and the rise in strategic importance of stakeholder relationships and competitive advantages, knowledge, and brand reputation with the presence of digital communication power are all things that I have been affected by. Working across value systems influenced by many different cultures and religious traditions has become more difficult as a result of globalization, according to Wajdi Dusuki (2008). The link between C.S.R and financial performance has been a topic of significant dispute. Regarding the provision of CSR, two related questions have been presented in their work (McWilliams & Siegel, 2001):

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1. Is there a performance difference between corporations and businesses that are socially conscious and those who are not? 2. How much should a business spend on CSR? The concept of ethical and socially responsible investments has grown over time continually and rapidly, but it still remaining relatively little known and little experienced. This understanding is limited, at best, be the use of charitable giving and attempts to support civic and community projects, health and social services, education, the arts, and other cultural endeavors. In a highly competitive environment, the use of charitable giving has been named “Strategic Charity” to bring legitimacy to profit making (Hemphill, 1999, p. 57). In this strategic vision, the goals of ethical and socially responsible investment programs and company organizations with sponsorship that are directly or indirectly tied to commercial objectives have given rise to corporate community investment. According to Elkington’s (1997) triple bottom line theory, corporate social responsibility (CSR) refers to a company’s duty to take into account the interests of its customers, employees, shareholders, communities, and the environment in all facets of its operations. Beyond what is required by law, this commitment is generally applicable, and not only trade-offs between profits and improving the lives of people and the health of the planet but also doing things differently. CSR can take the form of economic responsibility, law, ethics, and compassion, according to Carroll (1999). The key to corporate responsibility, according to Carroll (1999), is economic responsibility, which is followed by legal and ethical responsibility and charity as the final pillar of the pyramid (Carroll, 1999, p. 264). Dashrud (2006) reviewed 37 definitions that are frequently used by researchers to define CSR. He came to the conclusion of the existence of five dimensions (the environmental dimension, social dimension, economic dimension, and charitable dimension) frequently used to define C.S.R. A great part of people’s motivation comes from their own specific goals that depend on their interactions with other people around them. In seeking our objective we worry about how other’s beliefs choices and actions can affect our practices (choices, actions derived from our beliefs) and the opportunities behind this to learn from the actions of others, which makes herding behavior a source of social learning. At this level, we can talk about social (communities groups) influences. Normative influences can shape the identity level, when a person is under social pressure and norms to conform to other’s choices. Then the identities determine our social preference and in final our identity is the result of the social influences from groups, communities around us. Behavior can be impacted by individual beliefs (especially religious ones), and or by identity salience (Weaver & Agle, 2002). The study of financial economics integrates more and more the morality and rules for moral behavior: religious philosophers have been always dealing with economic topic Adam Smith, Keynes, Marx. . . The religious philosophers were concerned with reconstructing the moral basis of economic and financial life. The new market economy created a moral problem for the new man of the early modern period.

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From an Islamic perspective individuals and society are not separated: “[H]elp one another to do what is right and good; do not help one another towards sin and hostility” Quran, Surah Al-Ma’idah 5:2. The responsible finance integrate the Islamic finance as they are ethical in nature and pursuing the goal of improving the society well-being and thus the living conditions of the individuals by establishing social equality and preventing injustice in economic exchange relations. The classical and neo-classical economic view of men “Homo-Economicus” (Max Weber, 1992, p. 16) consider the economic agent as a machine that acts rationally such it’s setup in its basic parameters, assuming a given level of information, he would always choose the option that maximizes its gain and his own advantages including even committing an immoral action such as lying, betraying and other immoral acts (Meyer et al., 1992) especially when the context allows, in situations of lack of laws rules and regulations (sanctions and monitoring). With the Homo-Ethico-economicus, the same is true with the difference in redefining “Gain” and widening this concept to integrate the doing good for other people. Even it seems to reduce one’s own objective benefits, it increases, then his happiness instead. Socially oriented and altruistically motivated Muslim man whose primary objective is to achieve Happiness (Anas & Hejra, 2020). Economic agents tend to optimize their choices and the more they become aware of the substantially better possibilities of choice set, the more they tend to optimize their choices and then converge toward equilibrium. In this way of thinking we can relax the assumption made often by economists that people act independently of others and furthermore other’s actions can be source of additional information to incorporate it in part, in our way of acting. But the deviation from what is appearing to be optimal and logical choices can be explained as a self-awareness and intentions to realize a compliance between the beliefs and practices [exp: the conventional banking financing services although its less expensive than the Islamic one (economy of scale), some clients do choose the more expensive one because it is licit and compliant with their beliefs]. In this case, the choice is not necessarily appearing optimal for nonbelievers but rather satisfactory for believers as bounded rationality (Simon, 1982). Furthermore, the irrationality may appear also when the economic agents want to cooperate to help others (pro-social behavior: donating). An important assumption underpinning this paradigm is that the economic agents, who are seeking Happiness in this worldly life and in the Hereafter, which constitutes a strong motivation, and an incentive of the spiritual rewards enhancing altruistic behavior and social responsibility toward others. The concept of Happiness exceeds significantly the classical concept of utility in the conventional economics in a variety of ways. The Happiness finds its roots not only in the pure self-satisfaction goals, but more importantly, the realization of social interest as being in compliance with Allah Guidance. Also it is different from multiple utility conception advocated by some moral philosophers and economists, such as Etzioni (1988) and Sen (1987), still the Happiness encompasses not only the worldly plain but also extends to life of the after world.

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Strategic vs. Nonstrategic Donation

The ultimate objective of the banking firms, whether Islamic or conventional, is to maximize its value and thus its profits earnings. The Islamic banking company is expected to work on enhancing community welfare or at the very least to ensure that its operations do not have a harmful effect on it. The fundamental question that comes from practical observation is: for more than 40 years ago of its real existence, to what extend the Islamic banking firms have succeeded the implementation of a just and equitable distribution of wealth? Or the only distinguishing feature of these banks being that their transactions and contracts only comply with Islamic law in the financial intermediation process? Obviously the Islamic banking firms need to be competitive and profitable not charitable organizations aiming solely social development objectives. This requires a shift in the strategic perspective of Islamic banking organizations, forcing them to economically include social development goals into their portfolio of assets. In order to realize such strategies, many Islamic banks have begun to report different ethical and socially responsible (ESR) investments within their activities to signal their engagement in the social welfare dimension and then be able through the digital communication tools to build a brand and develop a competitive advantage without losing insights the financial benefits. A strategic vision of the social responsibilities needs to be analyzed with reference to the normative deontological understanding. It helps homogenize the opinion of the different stakeholders in the Islamic banking firm context, usually governed by solely profits and gains which alone cannot improve the well-being of the society. The strategic vision of the social responsibilities can be established with reference to the normative and positive dimensions of human being individually and in interaction with the society based on the happiness achievement goals. The ultimate objective of Islamic investing is to achieve success, Happiness “AL FALAH” and the well being in this world and the hereafter through efficiency and effectiveness but also with fair dealing and economic justice. Islamic investment can be analyzed under the umbrella of socially responsible investment (SRI). Sustainable, responsible, and impact investing is an investment discipline that considers environmental, social, and corporate governance criteria to generate long-term competitive financial returns and positive societal impact. Ethical and socially responsible investments means that when investments are analyzed, selected, and chosen, criteria of a financial, environmental, ethical, and social nature must be met.

3 Ethical and Socially Responsible Investments and Economic Performance, Doing Well and Doing Right The debate around the concept of ethical investment and social responsibility continues to grow, both in academic and practical terms, and has become an important variable in fixing the level of company’s performance.

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There are a number of CSR models, but the CSR pyramid model is the most well known. It presents a company’s social responsibilities as including financial, ethical, legal, and philanthropic obligations (Carroll, 1991 as cited in McDonald & RundleThiele, 2008). With reference to the stakeholder theory the satisfaction of all stakeholders enhances the image and reputation of the company, thus help improving the financial performance (Freeman, 1984; Donaldson & Preston, 1995). Other models conclude the inexistence of a relationship between the ethical investment and social responsibility and the financial performance. This neutrality of the relationship is explained by the compensation between the costs and benefits of the ethical investment and social responsibility (McWilliams & Siegel, 2001) and by the complexity of the relationship between the ethical investment and social responsibility and financial performance.

3.1

Social Responsibility as an Incentive Mechanism in the Islamic Financing Contracts: Happiness in Helping Other

Different recent studies have analyzed the link between the social incentives on employees’ performance: Imas (2014), Charness et al. (2014), Koppel and Regner (2014), Cassar (2015), and Tonin and Vlassopoulos (2014), they concluded that the social incentives enhance productivity whatever was the form of the donation and its size. An experimental gift-exchange game’s agents’ effort and CSR are examined by Koppel and Regner (2014). In their experiment, the agent’s effort and the principal’s decision regarding the wage and portion of earnings donated to a charity are made concurrently. They discover that agents’ efforts rise in direct proportion to the amount of profit principals contribute to charity. Similar to how Cassar (2015) demonstrates that a principal’s piece-rate present inspires agents, encouraging them to exert more effort in a gift-exchange game. Based on these studies (Benabou & Tirole, 2003; Falk et al., 2000, 2003; Fehr & Gachter, 2002; Fehr & Rockenbach, 2003; Plant & Ryan, 1985). We seek to study the behavioral elements that cause the correlation between the principal’s charity contributions (the Islamic banking firm) and the agents (the entrepreneurs) effort. Note that in this scenario, the agent’s efforts choice and eventual gift size can be influenced by the charity donation objectives. Therefore, the purpose of our scenario is to investigate how the principal’s philanthropic deed may alter their relationship, improving the indirect social incentives for the agent to increase charitable giving through his efforts. Having no idea of the potential counter-response from the agent can lead the Islamic banking firm as a principal to expect that the level of effort decided by the agent and thus their payoffs might depend on the intention of donation announced to

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the different stakeholders and in particular the agent and can be considered as strategic concerns. In this section, we analyze how the agent perceives the Donation Announcement Decision (D.A.D.) of the principal and how this affects the agent’s behavior through their effort level and commitment. We run interviews1 with CEO’s of the 20 SMEs financed by the Islamic bank Zitouna they confirmed that when helping other by charity donation and when they are willing to pay Zakat, they will be helped by God [Barakah (Allah’s blessings)] and they will perform better and afford high level of effort.

3.2

Experimental Design

How may the religious belief in the hereafter reward and helping others impact altruism behavior? The participants in an online experiment were chosen based on their appartenance to the Islamic religion and we suppose they are motivated by religious beliefs that represent the main drivers of being customers of the Islamic financial institutions. Religion belongings are more strongly associated with societal norms that encourage assisting the needy with prosocial conduct. Numerous studies have demonstrated a relationship between religious affiliation and larger charity donations (Bekkers & Wiepking, 2011), a greater tendency to volunteer for the underprivileged and seniors (Ahn et al., 2011), and higher charitable donations in dictator games, in which participants are given a certain amount of money and can choose how much they want to give to another participant (Nadelhoffer et al., 2014). The fact that these findings are applicable to western nations where Christianity is the predominant religion should be acknowledged.

See Appendix. Interviews were run with the Zitouna bank Gafsa branch “Tunisia” during the period first quarterly 2022. Although in the annual report of the Zitouna Islamic bank there’s no clear information about the mandatory donation (zakat) and or voluntary one (SADAQAH, WAQF, QARD AL-HASSAN) but it adopts a social corporate responsibility and it is clearly mentioned and communicated in their website: https://www.banquezitouna.com/fr/rse: Vision: An ethical and socially responsible bank. Assignment As a leading banking institution in Islamic Finance in Tunisia, Banque Zitouna is committed to playing a decisive role on the economic, social and environmental levels to promote the anchoring of sustainable development in Tunisia. Banque Zitouna, as part of its 2020–2024 CSR strategy, works for the sustainability of its activities, operational excellence and commitment to building a sustainable future in Tunisia. Goals This strategy will be genuinely integrated into the various businesses and processes of the bank and will enable: Total commitment to responsible and sustainable finance; consolidation of a healthy social climate by relying on team cohesion as a powerful lever; supporting national efforts in the areas of employability, public health, quality of education and the fight against poverty and regional disparity; strengthening the bank’s identity and sharing values with all stakeholders. See Appendix for further details. 1

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There exist other evidences that point to the varying effects of individuals’ religious affiliation on social behavior. Experimental lab and field research, Duhaime (2015), Mazar et al. (2008), and Shariff and Norenzayan (2007), offer causal evidence in favor of the hypothesis that religious primes can encourage honesty and prosocial conduct. Participants are involved in a series of binary dictator games types where they can choose how much effort they afford to increase the payoffs and then the charity donations that help low-income individuals. In each decision-making alternative, participants have to select from two distributions, one of which is more favorable to the charity. In this principal-agent experiment game, we analyze the effects of Donation Announcement Decision (D.A.D) on agent’s motivation. In this game, the principle (here the Islamic bank: the fund provider) can incentivize the agent by setting a minimum performance requirement before the agent (entrepreneur) decides on effort level to be afforded. Even though most agents are willing to improve their performance in response to the principal’s D.A.D, our findings suggest that effort impacts performance and profit improvement. Overall, D. A.D has a nonmonotonic effect on the principal’s payout. When asked regarding their emotional reactions to D.A.D, most agents who respond positively say they see it as a symbol of trust and a boost to their choice autonomy. According to the agency hypothesis, a conflict of interest could taint the principal–agent relationships. Therefore, principals often use incentive schemas to reach the common welfare. We conducted an experiment with the Islamic banking firm as the principal that can decide either to donate or not, and the agent will be informed about this decision which can affect the agents’ willingness to provide additional and higher effort and then act in the common welfare of the two partners. We implement an experiment with a game set of principal (the Islamic bank) and 20 agents (20 entrepreneurs2 seeking funds to finance their projects). The game had two levels and was only played once.

2 We run an interview with the CEO of the 20 SMEs, “this find its justification in the article reference” Koppel, H., Regner, T.: Corporate Social Responsibility in the work place. Experimental Economics 17, 347–370 (2014). https://doi.org/10.1007/s10683-013-9372-x Experimental protocol: pp. 356

In their paper the experiment started only after all participants had answered all control questions correctly. In each session, 30 participants were subdivided in two equally large groups—workers and firms—to play the game for 15 periods. Participants knew that they would not be matched with a participant twice. Caution should be exercised when generalizing our results. Since our analyze has been conducted in a small sample of agents (CEO of the 20 SMEs) and only one principal (only one islamic bank branch), this might not adequately capture existing impact of Donation Announcement Decision by a principal can have an effect on the agent’s motivation to exert effort that is beneficial for common welfare and may reflect to great extend a sample perception. Our results are in line with those of Koppel and Regner (2014), but in a different context as they found that, on average, workers react positively to CSR. They reciprocate not only higher wages but

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We present a simplified framework in which the Islamic banking firm (principal) is associated in contractual engagement (through participatory financing contract: partner in musharaka or mudaraba 3) with the entrepreneur in sake of funds (agent).

also investments in CSR with increased effort. Matching mission preferences motivate workers to exert more effort, independently of the extent of CSR investment. With respect to the positive effect of CSR activity on firms’ profits in our paper, it is worth noting that the results reflect mostly a sample perception. Previous studies have shown that CSR can be beneficial, if this has positive effects on the decisions of consumers or investors. Gafsa context: The study area where the bank branch is implemented is in the southwestern of Tunisia Gafsa displays the lowest level of interest in entrepreneurship and the existing entreprneurs and potential ones are most risk averse. In this governorate exists also the Companie des Phosphates de Gafsa (CPG) Established in 1896 is one of the world’s top 5 producers of phosphates and is Tunsia’s largest export-oriented extractive industry? Young entrepreneurs operate in a closed environment with very little exchange with the outside world and limited contact between peers or other entrepreneurs. The existing financial products are not flexible they require collateral and are centralized in the Capital Tunis with no room to adapt products to local conditions and markets. 3 Participatory financing contract nature and characteristic and objectives can be found in a large and abundant literature of the Islamic finance. We chose to refer to Samir Alamad Financial and Accounting Principles in Islamic Finance. ISBN 978-3-030-16298-6 ISBN 978-3-030-16299-3 (eBook) https://doi.org/10.1007/978-3-030-16299-3 © Springer Nature Switzerland AG 2019. The financial participatory contracts musharaka and mudaraba with profit and loss sharing (PLS) arrangements between capital providers and entrepreneurial partners should be superior to conventional finance in several respects. Musharaka and mudaraba partnerships are considered as the Islamic alternative to conventional finance based on interest rate mechanism. (Musharaka) Partnership Contracts Musharaka is a contractual partnership between two or more parties whereby each partner contributes with a specific amount of money. The capital must be contributed by all partners: Capital can be in the form of monetary assets or in the form of tangible assets. In Musharaka, all partners have equal right to take part in its management. All partners maintain assets of Musharaka on trust basis. Therefore, no one is liable, except in the case of misconduct, negligence or breach of contract. A partner cannot guarantee the capital of another partner except when one provides a personal guarantee to cover cases of misconduct, negligence or breach of contract. A third party can also provide a guarantee to the capital of the partners. (e) Profit Distribution: Profit is to be distributed among the partners according to the partnership agreement and losses are to be borne by the partners in accordance with the contribution of each partner to the Musharaka capital. The profit sharing ratio must be agreed upon at the time of effecting the contract, it can be one other than the capital contribution ratio, but cannot be a predetermined lump sum or a percentage of capital. Mudaraba (Venture Capital): Silent Partnership: Mudaraba is a trust-based contract, it’s a form of partnership in profit whereby one party provides capital (rab-al-maal) and another, management skill or labour (mudarib). According to AAOIFI standard No. 13, for practical purposes, mudaraba can be seen as a special case of musharaka, although the Shariah background is somewhat different. In general, a mudaraba is a musharaka to which one party provides only capital (but no labor: here the Islamic banking firm) and the other party provides only labour (managerial skills, but no capital: here the entrepreneur agent). The capital provider (investor: the Islamic bank) is called rab al-maal, the manager of the partnership (agent entrepreneur) is called mudarib.

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Each player of the 20 participants was matched, in the role of Agent A with a responsible of the Islamic banking firm as the role of principal B (the principal). The objective is to analyze how sensitive the agents level of commitment and efforts they are ready to perform, and thus the project outcome and payoff, to the intentional, distributional, and warm glow as social incentives. In the first stage of the experience, and prior to the level of agent’s effort provided, the Islamic banking firm (principal) decides whether to donate or not through [mandatory (ZAKAT) and or voluntary (SADAQAH, WAQF, QARD AL-HASSAN)] to a charity in form of ethical and socially responsible investments programs or not. The agent was told about the donation decision and the planned programs in the game’s second stage (nature, size, type: number of household helped; the number of small businesses built through the donations that allow people to switch from scarcity to self support) through published reports and social media accounts on the planned E.S.R.I programs to be implemented of the Islamic banking firm (principal), and in the light of this information level, decides on his effort as it can incentivize him with a sense of pride of helping others and increase the belonging feelings and the esteem needs, the desire for reputation or respect from others. Almost all the CEO’s of the SMEs interviewed (18 out of 20) are pro-social and agree to proceed to optimum effort and commitment level throughout the announcement of charitable giving donation and believe that it has a value raising of the overroll result and thus give them incentives to perform their projects with higher level of effort and engagement. The nature (size: impact; intention; announcement; belief) of the donation affects behavior of the financed entrepreneur. He or She is, by increasing his effort, and thus realizing higher return, participating in financing the donation. It allows him (her) to communicate about the indirect social responsibility of its business and gives him pride to be part of the achievement and increase the belonging feelings and the esteem needs, the desire for reputation or respect from others (Maslow), as well as the reward in the hereafter. There is a performance-contingent incentives, meaning that higher level of efforts increases the expected revenue of the financed project and thus increases the principal’s and the agent’s payoffs simultaneously as each one of them takes a percentage (profits or losses sharing ratio) of that revenue. When the Islamic banking firm (the principal) decides on the donation especially the mandatory (ZAKAT) 2.5% of the assets value possessed during the year, and informs their stakeholders about these activities, this can impact the agents’ effort by a certain specific “buy in”4 that may make the agent feels that he contributes in part to financing the donation when affording higher effort to the project and realizing good deeds. In another hand, distributional concerns (profits or losses sharing ratio level) can enhance an encouraging response to donation as donations raise the intensity of

4

Note that we here extend the notion of “warm glow” proposed by Andreoni (1990).

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effort of the agent in participatory financing contract and improve payoffs of the partners. Agents seeking financing from the Islamic banking firm are supposed to be fully motivated by religious drivers and looking principally for the compliance of their beliefs and practices so they are warm glow. In the beginning of the experiment, we first suppose that the Islamic banking firm is wealthier than the agent and most of the time risk neutral as it employs the funds of depositors and is free to choose whether or not to engage in ethical and socially responsible investments programs through [mandatory (zakat) and voluntary (SADAQAH, WAQF, QARD AL-HASSAN)] and can inform the agent to push him to afford the higher effort level. We change the size of donation from the only mandatory (zakat) to the voluntary (SADAQAH, WAQF, QARD AL-HASSAN). Expands in donation size can have a favorable impact on efforts due to the fact that a greater donation increases the scope of “buy in” and influences the amount of effort. The agent’s behavior is characterized with a constructive effort response to a donation intention. Raising the principal’s share of gains (wealth) can aid in decreasing the agent’s efforts if distributional considerations are important, as larger efforts in this situation would raise unfairness even more. By interviewing principals who are ignorant that agents make a subsequent effort decision and agents who know that principals were aware when they made the choice, we examine how possible strategic incentives, following a contribution, affect agents’ degree of effort. Donations in these sets may represent the principal’s prosocial preferences in their “pure” signal form. Regarding the importance of charitable intents and reciprocal altruism, the contribution of giving is not particularly significant when donations are selected in an exogenous manner. Globally, efforts decrease (slightly) when nothing is donated and increase after a donation in the nonintentional conditions (the voluntary donation: sadaqah, waqf, and qard al-hassan): in form of strategic orientations through ethical and socially responsible investments programs within their activities to signal their engagement in the social welfare dimension and be able then through the digital communication tools to build a brand and develop a competitive advantage without losing insights the financial benefits. We notice that 18 out of the 20 entrepreneurs (agents) tend to put forth notably more effort when they are aware of the principal’s intention to give. We find that higher marginal donations do not generate higher marginal effort levels than those observed after medium and low marginal donations. Reciprocal altruism is a strong way through which we can observe how prosocial principal’s behavior can affect agents’ efforts levels. When the Islamic banking firm proceeds deliberately to mandatory donation (zakat), this reveals in part first the value of the firm as a signal to the different stakeholders and second the agents

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decide to choose significantly higher levels of effort taking into account that for sure that the principal is naturally wealthier than the agent. The agent tends to reduce his effort level when he or she feels that it increases the principal’s wealth without bringing an additional part of his gains.

4 Illustrative Model Analyze In a world with perfect and costless information, the bank would stipulate precisely in a contract all the actions which the agent partner should undertake (level of effort which might affect the project revenue and thus the level of profitability and payoff). As the Islamic banking firm cannot make sure that it has chosen the good agent even when gathering the required level of information before signing the contract and cannot observe the level of effort and/or the outcome of the funded investment (revenue streams; the respect level of the contractual terms that guarantee the common economic welfare of the partners of the project), an informational problem and thus incentive mechanism design are possible to take place. The Islamic banking firm the principal can use the donation information as contractual design mechanism. Monitoring the agent’s actions, if it is possible to implement (with reasonable costs), can offer additional information to use in developing the contractual terms. In this case, a first-best solution (implying optimal risk sharing) is possible by using a forcing contract that takes actions against opportunistic behavior. However, the bank is not able to directly control all the actions of the agent; therefore, it will use a set of screening tools in a manner to induce the agent to take actions and perform level of effort which are in the interest of the Islamic bank as to attract low or reasonable risk agent profile. In a simplified principal-agent set, where the Islamic banking firm (principal) decides whether or not to donate a fixed amount to a charity with an informed agent about the bank decision (partner in the participatory financing contract), the agent chooses then his effort level and commitment in the light of the bank decision. We suppose that the entrepreneur (agent) can choose between three levels of effort related to the donation intentions of the bank partner: week, medium, or high associated to three payoff functions. It is not always easy for the Islamic banking firm to identify “Good Agent” partners in the participatory contracts and to do so it requires using a variety of screening devices:

4.1

Donation Intention

In fact the Islamic banking firm may not know perfectly (exactly) the entrepreneur characteristics related to the effort level nor his behavior post contractual and commitment to the project, but knows that he/she is sensible to the donation decision

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Fig. 1 Level of effort, incentive and profit

of the Islamic bank whether mandatory (ZAKAT) to the voluntary (SADAQAH, WAQF, QARD AL-HASSAN). Also, do the social responsibility and the intention of the Islamic banking firm to donate or not has a role in the incentives schemas of the agent and build condition of his decision in choosing the level of effort that he is willing to provide? The profits or losses sharing ratio (P.L.S.R) is a screening tool: those who are willing to accept low P.L.S.R may on average be worse risky; they are willing to accept low P.L.S.R because they perceive their probability as low profitability. As the P.L.S.R decreases, the average riskiness of those agent increase and thus increasing possibility lowering the final bank’s payoff. As the terms of the contract may change, the behavior of the agent client is likely to change. For instance, increasing (decreasing) the P.L.S.R and decreasing the time of ownership of the shares of the business company (the profitability of the business). We will show that lower P.L.S.R induce agent to undertake (they will perform) projects with lower profitability (lower probability of success) and lower level of efforts and thus higher risk. For these reasons, the expected return of the project and thus the part of the Islamic bank from the project revenue may increase less rapidly than the P.L.S.R and beyond a point may actually decrease (Fig. 1). The P.L.S.R at which the expected return to the Islamic banking firm is maximized, we refer to as the optimal P.L.S.R*. Both the demand and supply of funds are function of the P.L.S.R and interest rate (in a dual banking system). Under this contract, the remuneration of the entrepreneur takes the form of a predetermined percentage of total expected income of the project. This remuneration scheme offers no incentive for the contract or to provide the level of effort required to maximize profit. We analyze the incentive schema that may offer the intention of donation of the principal when the agent knows that and what is its impact on his level of effort. Thus, the effort provided by the contractor is equal to his share of marginal revenue instead of the total marginal revenue of effort.

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By constructing a simple model, the incentive problems associated with Mudaraba contract will be discussed in the following: Under the financing participatory “Mudaraba”, the Contractor receives, 1- PLSR ðeÞ  PðeÞ whereas the banking firm receives PLSR  PðeÞ: With PðeÞ: net expected profit with three level of realization: π(e = LL) = π 1: LL: Low Level: when the Islamic bank has not the intention to donate π(e = ML) = π 2: ML: Medium Level when the Islamic bank inform about its intention to donate π(e = HL) = π 3: HL: High Level when the Islamic bank inform about its intention to donate as strategic orientation. The entrepreneur can choose the level of effort (e) that he will afford and the Islamic banking firm cannot force him nor control the chosen level of effort. The Islamic banking firm makes decision related to the donation and announce it and communicate about its Ethical and socially responsible investments programs and send signs to the entrepreneur and hopes that he chooses a higher level of effort that the Islamic banking firm can only observe through the outcome of his effort which is reflected to the final net profit. The net profit depends exclusively on the level of effort provided by the contractor Agent: PLSR = f(e). PLSR(e) is an increasing function of the effort with decreasing marginal rate. The more the effort is provided by the contractor Agent, the higher the level of profit will increase. The function PLSR(e) is continuously differentiable and strictly increasing concave. The entrepreneur is risk neutral. If not, if he was risk-averse he will choose fixed revenue (for example a salary: wage). This assumption implies that the utility function of the entrepreneur depends on what he will receive as income and what it will provide such effort level. The production analysis is in the given certainty case, thus there is a positive relationship between effort and output. Our analysis focuses on the level of effort and not on the risk sharing. π 0 ðeÞ ≥ 0 π 00 ðeÞ ≤ 0 π ðe= 0Þ = 0

ð1Þ

From the time that the contractor signs the contract and agrees with the bank on the profit sharing rate, his concerns will be to maximize his utility function by keeping the level of effort provided (e): Maxð1- PLSR ðeÞÞ π ðeÞ - ae ð eÞ

with (1 - PLSR(e)) π(e) the part of the contractor in the net gain π(e).

ð2Þ

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a = the marginal disutility of effort is assumed to be constant. The utility maximization of the entrepreneur is provided by the first order conditions: ð1- PLSR ðeÞÞπ 0 ðeÞ - a = 0 , π 0 ðeÞ =

a ð1 - PLSR ðeÞÞ

ð3Þ

The Islamic bank is also interested in its share of income; its problem is the following: MaxðPLSR ðeÞÞ π ðeÞ ð eÞ

ð4Þ

This gives the first order condition: ðPLSR ðeÞÞπ 0 ðeÞ = 0 , π 0 ðeÞ = 0

ð5Þ

However, the socially optimal level is maximized when the rate of marginal revenue equalizes the marginal cost (disutility costs): Max π ðeÞ - ae

ð6Þ

π 0 ð eÞ - a = 0 , π 0 ð eÞ = a

ð7Þ

ðeÞ

this gives,

This implies that the entrepreneur maximizes his utility by equalizing the marginal cost of disutility to its marginal revenue that can have a social dimension too. This means that the contractual agreement will not automatically provide the optimum level of effort to achieve the socially optimal level of income. This can be illustrated in the following figure. Agency problems and information asymmetry are not supposed to occur in a context of Islamic finance which is based on moral and religious beliefs of different stakeholders,5 each of them treats others with sincerity and loyalty, love for them what he/she likes for her/his self. The realization of these moral and religious convictions will minimize transaction costs. But the problem is that the ethical and religious values are not always present, even their applications and understandings are not homogeneous.

5 Stakeholders should not necessarily be Muslims. The fact that non-Muslim do not share the same faith as the Muslim, this does not mean that a Muslim must be despicable with them, on the contrary, it must behave fairly towards the both by the word and by the Act. Equity is the basis of various reports with non-Muslims.

Ethical and Socially Responsible Investments in the Islamic Banking Firms:. . .

4.2

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Musharaka (Equity: Participation in a Joint Venture or Joint Ownership)

Musharaka (active partnership) is a financial contract between two parties (or more) to fund a project which its payoffs (losses or profits) will be distributed in proportion to respective capital contributions. This contract is based on the morality of the client, the relationship of trust and profitability of the project or activity funded. The key to sharing profits or losses is determined at the time of signing the contract. Thus, the P.L.S.R can beset either on the basis of negotiation and mutual consent (thesis Hanafi and Hanbali School6), or based on the setting of each contracting party (Maliki school thesis and Shafi’ie7). In a Musharaka arrangement, the Islamic bank and the contractor both contribute in different degrees in the capital needed to start a business. The capital contribution maybe made either by cash contribution and/or in kind. This contract gives each partner the right to administer the affairs of society, and the right to participate in the profits or losses in proportion to their contributions. The Contracting Parties shall jointly assume the risks. Musharaka can be performed by the Islamic banks in the sense client/depositors-Islamic bank or in the sense Islamic bank-customer (contractor).First, as part of customer relationship depositorIslamic bank which is governed by a contract musharaka, the customer participates in the outcome of the Islamic bank and receives a portion based on the amount it has advanced. Moreover, the relationship between Islamic bank and customer Contractor, and is governed by a contract type musharaka, focuses on financial investment projects considered cost-effective and compatible with the principles of Islamic finance. The funds require dare subject to a contribution of the two contracting parties will be integral incase of loss and share profits if the outcome of this investment is a gain. Diminishing Participation in the Capital of Firm According to AAOIFI8 standards, Diminishing Musharakah has been defined as “the partnership in which one of the partners undertakes that it will purchase the shares of the other party/parties in installments/is periods to ensure that the project that is the subject matter of the partnership is transferred to the party that demands the financing”. In a diminishing Musharakah, the bank’s interest share decreases by the payments received from the client, and the bank’s share of the profit is calculated on the basis of the outstanding interest share. The client enters into an agreement with the bank for joint ownership of property in a known investment share of each partner. 6

There are four main Islamic schools of law making authority to determine what is or what not Sharia compliant is. The Hanafi and Hanbali schools are rather conservative they prevail in the Middle East countries mainly golf. 7 The school Shafi’ie prevails in Southeast Asian countries and the Maliki School prevails in North Africa. These two schools are quite liberal. 8 Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI): http://aaoifi. com/

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Afterward, the client pays the rent to the bank for using its share. The bank can only rent this property according to the level of its investment share. The bank cannot obligate the client to purchase its share. The bank’s shares will be divided into a certain number of units, and the client will purchase these units from time to time at an agreed period. The customer purchases these units and the client increases his investment shares and reduces the amount of rent gradually until the client becomes the sole owner of the property.

4.3

Modeling of Diminishing Participation and Acquisition of Capital by the Entrepreneur at the End of the Period

Let C be the capital needed to undertake the project, CE = B: contribution of the entrepreneur to Capital CIB= K = N * B contribution of the Islamic bank to Capital. With N: coefficient of proportionality of K with respect to B, N > 1. C = CE þ C IB ; whereC = ðN þ 1ÞB

ð8Þ

We consider the profit reinvestment hypothesis with two cases: 1. The project generates regular income on an annual basis. 2. The project generates a variable income from one year to another. First Case9 Let P1 = P2 = P 3 = . . . = Pn = P. The profit of each period: year. And let us assume that the portion of the profit going to the entrepreneur is proportional to his share in the capital. First year: the part of the capital held by the entrepreneur “Agent” is: C E1 = B Part of the profit available to the entrepreneur PC E1 PB P R1 = C = BðNþ1Þ = ðNþ1Þ. Second year: the part of the capital held by the entrepreneur is:

9

ð9Þ “Agent”:

Boualem Bendjilali & Tariqullah Khan Economics Of Diminishing Musharakah [Research Paper No: 31] First edition 1995 1416H Islamic Research and Training Institute, Islamic Development Bank. Jeddah-Saudi Arabia.

Ethical and Socially Responsible Investments in the Islamic Banking Firms:. . .

C E2 = B þ

P P =B 1 þ Nþ1 ðN þ 1ÞB

101

ð10Þ

Part of the profit available to the entrepreneur “Agent”: R2 = NPþ1  ð1 þ ðN þP1ÞBÞ. Third year: the part of the capital held by the entrepreneur is: CE3 = B 1 þ

P P P þ = 1þ Nþ1 ðN þ 1ÞB ðN þ 1ÞB

= Bþ

P Nþ1

=B 1 þ

1þ

P ðN þ 1ÞB

P ðN þ 1ÞB

ð11Þ

2

2

P P  ð1 þ ðNþ1ÞB Þ . Part of the profit available to the entrepreneur “Agent”: R3 = Nþ1 Generally speaking we can write: the part of the profit available to the contractor at the period j is written in the following form:

Rj =

P P  1þ Nþ1 ðN þ 1ÞB

j-1

ð12Þ

We assume that the entrepreneur’s share of the total profit is fully reinvested in the project in the form of acquisition of part of the capital materialized in the shares of its partner namely the bank. We note CEj - 1 the contribution of the entrepreneur to the capital at period d-1 and Rj - 1 the contractor’s share of the profit that will be reinvested in period j. The total contribution of the entrepreneur to the capital C in the period j: CEj = C Ej - 1 þ Rj - 1 C Ej - 1 = C Ej - 2 þ Rj - 2 Making: C En = CE1 þ

n-1

Rj

ð13Þ

j-1

with CE1 = B. As the entrepreneur’s share of total profit increases and the bank’s share decreases each year, this indicates a change in the ownership structure. When the project is wholly owned by the contractor at the lifetime of the project, its share of the profit will equal the entire profit generated by the project. In other words we will have the following equality:

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Rj = P

P 1 þ ðNþ1 ÞB

P Nþ1

j-1

=1

P

, 1þ

P ð N þ 1Þ B

, ðj- 1Þ log 1 þ ðj- 1Þ =

j-1

=N þ 1

P = logðN þ 1Þ ð N þ 1Þ B logðN þ 1Þ P log 1 þ ðNþ1 ÞB

ð14Þ

Equation (14) provides information on the time required for the contractor to be the owner of the entire project. In other words, when P increases the time required for the project to belong entirely to the entrepreneur “Agent” decreases. Deriving (14) on P: ∂ðj - 1Þ =∂P1

logðN þ 1Þ P log 1 þ ðNþ1 ÞB

2



1 P þ B ð N þ 1Þ

ð15Þ

The negative sign of Eq. (15) illustrates the inverse relationship between period j and profit level P. Second Case10 The project yields a variable income from 1 year to another. Is P1 ≠ P2 ≠ P3 ≠ . . .Pj. . . . ≠ Pn the profit of the period: year. And let us assume that the part of the profit going to the entrepreneur is proportional to his share in the capital. First year: the part of the capital held by the entrepreneur is: CE1 = B. Part of the profit available to the entrepreneur “Agent”: R1 =

P1 Nþ1

Second year: the part of the capital held by the entrepreneur is: C E2 = B þ

P1 P1 =B 1 þ Nþ1 ðN þ 1ÞB

Part of the profit available to the entrepreneur “Agent”:

10

Extension of the first case.

ð16Þ

Ethical and Socially Responsible Investments in the Islamic Banking Firms:. . .

R2 =

P1 P2  1þ Nþ1 ðN þ 1ÞB

103

ð17Þ

Third year: the part of the capital held by the entrepreneur is: P2 P1 P1 þ  1þ ðN þ 1ÞB Nþ1 ðN þ 1ÞB P2 P1 P1 þ  1þ =B 1 þ ðN þ 1ÞB BðN þ 1Þ ðN þ 1ÞB P1 P2 =B 1 þ 1þ ðN þ 1ÞB BðN þ 1Þ

CE3 = B 1 þ

ð18Þ

Part of the profit available to the entrepreneur “Agent”: R3 =

P3 Nþ1

1þ

P1 ðN þ 1ÞB

1þ

P2 BðN þ 1Þ

Fourth year: the part of the capital held by the entrepreneur is: C E4 = B  R4 =

P4 Nþ1

1þ

1þ 1þ

P1 ðN þ 1ÞB

P1 ðN þ 1ÞB

P1 ð N þ 1Þ B

1þ 1þ

1þ

P2 BðN þ 1Þ

þ

P3 Nþ1

P2 BðN þ 1Þ

P2 BðN þ 1Þ

1þ

P3 ð N þ 1Þ B

ð19Þ

Generally speaking we can write: the part of the profit available to the entrepreneur “Agent” at the period j is written in the following form: Rj =

Pj Nþ1

j-1

1þ i-1

Pi ðN þ 1ÞB

ð20Þ

We assume that the entrepreneur’s share of the total profit is fully reinvested in acquiring new parts of the capital by holding additional the shares from the Islamic bank. We note CEj - 1 the contribution of the entrepreneur to the capital at period j-1 and Rj - 1 the contractor’s share of the profit that will be reinvested in period j. The total contribution of the entrepreneur to the capital C in the period j: CEj = C Ej - 1 þ Rj - 1

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C Ej - 1 = C Ej - 2 þ Rj - 2 Making: C En = CE1 þ

n-1

ð21Þ

Rj j-1

with CE1 = B. When the project is wholly owned by the entrepreneur “Agent” at the time of the project, its share of the profit will equal the entire profit generated by the project. In other words we will have the following equality:

Rj = P

Pj Nþ1

j-1 i-1

Pj

j-1

1þ

, i-1

Pi 1 þ ðNþ1 ÞB

=1

Pi =N þ 1 ðN þ 1ÞB

ð22Þ

Of what precedes, the part of the profit coming back to the entrepreneur is increasing with the participatory capital owned: the key of profit or losses distribution, this encourages him to increase his level of effort and therefore his level of productivity and profit in order to have the full capital under the diminishing musharakah contract. This can be considered as an incentive mechanism to solve the agency problems encountered during participatory contracts musharakah by involving the entrepreneur in the project via the share of capital.

4.4

Bargaining Power and Renegotiation Effects in Contractual Design

In the case of pay for performance contracts (venture capital financing and PLS in the Islamic financing context), the bargaining power is a crucial variable in the process of designing the contracts. The bargaining power can essentially be useful when determining the PLS ratio in the Mudaraba or Musharaka contracts and the period covering these agreements. The payoff related to the entrepreneur’s actions and effort (complete vs. incomplete and symmetric vs. asymmetric). With the cooperation coalition game (Nash, 1953) between the fund providers with the entrepreneur, they can discuss their situation and agree on a joint plan when the outcome of the financed project is uncertain. It’s also relevant to think about contracting and bargaining in a situation of informational asymmetry (adverse selection, Hazard Moral) and the conflict of interest: all these problems have been

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developed in the contractual approach of the firm: Coase (1973), Jensen and Meckling (1976), Fama and Jensen (1983) and are still valid for the Islamic financial context. A-Bargaining Tools The following tools can have effect on the contract type, placement, and investment modes, the right to set contracts conditions taking into account the agency cost consideration and the strategic aspects: • • • • • • • • • •

Leverage: parts in the capital: Musharaka or Mudaraba Previous successful experiences Managerial power and teams Rival fund providers for the brilliant project ideas Corporate control and property rights Renegotiation in the loss cases Size of the firm and its capital structure Competition in banking and venture capital markets Transaction costs Symmetrically or not parties are informed

Smaller firms (growth cycle: when the firm is new) hardly have any access to funds from traditional financial institutions as they have few assets and being riskier would prefer the PLS mode of financing to share their risk. The Islamic banks can use the PLS ratio to distinguish good (bad) investment and high (low) risk. The question to be asked is the level of information (expected return yield estimated by the entrepreneur and how the Islamic bank can evaluate it) gathered by the Islamic banks is enough and relevant? The Islamic bank can mention in the contractual term the fact that it has the right to undertake auditing process in case its share is less than expected, and in order to incentive the agent to perform effort needed to succeed the project and to behave in a manner to increase their mutual welfare. When the auditing process is implanted its costs are supported by the agent to dissuade the agent to behave dishonestly. The renegotiation in the PLS contracts can help to influence the way agent acts and behaves. The principal can induce the agent take set of desirable actions and thus improve the common welfare and risk sharing. In the property rights approach as developed by Grossman and Hart (1986), Hart and Moore (1990), and Hart (1995), the ownership structure leads to the residual control rights. In the PLS contracts allocation of the right to tale decision in case not mentioned prior in the contract to the principal (Islamic Bank) or the agent (entrepreneur) can play the role of incentives (Hart et al., 1997; Laffont & Martimort, 2002).

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5 Organizational Motivations, Religious Affiliations, and Ethical Character: Motivation and Incentives In the neoclassical economics framework, economic agents are supposed to be solely motivated by economic and monetary drivers (Homoeconomicus). In a behavioral financial framework, other motivations can influence the decision making rather than monetary rational ones. Havighurst (2009) described the negative impact of introducing payments for blood donation: “payment undermined social values and dampened people’s willingness to donate.” Human behavior and trade-off between selfishness, egoism and versus pro-social help, cooperation, and altruism.

5.1

Extrinsic Versus Intrinsic Motivation

Allport (1950) distinguishes two religiosity factors motivations on the individual level,—extrinsic and intrinsic motivations. The intrinsic motivation is founded on intrinsic religious objectives (e.g., religious satisfaction itself person lives his religion). Extrinsic incentives are utilitarian motivations, such as the desire for money gain that may underlie religious action. Usually intrinsic and extrinsic motivation can be mixed, and individuals, when accomplishing a specific task tend to privilege one of them (Aydemir & Egilmez, 2010). While the extrinsic incentive can strengthen a person’s commitment to religion in relation to a particular social or professional aim, the intrinsic motivation can strengthen a person’s commitment to religion exclusively for its spiritual goals (Vitell, 2009; Donahue, 1985). Because religious convictions and rules are treated as ends in themselves by personal believers, their internal motivation is more likely to translate into behavior. Extrinsically motivated people are more willing to deviate from the demands of their religion (i.e., people who view religion as a tool for obtaining other rewards). Bénabou and Tirole (2006) use the concepts of intrinsic and extrinsic motivation to explain pro-social behavior. An increasing emphasis has been put on the value systems and personnel beliefs in the business and financial fields through various paper research (Badaracco, 1997; Ciulla, 1998; Kaptein, 2005; Sims & Brinkmann, 2002; Treviño et al., 2000). These motivations in business, personal belief, and value systems are often rooted to the religious (Abeng, 1997; Fort, 1996, 1998; Frederick, 1995; Fry, 2003; Mitroff & Denton, 1999; Tsalikis & Fritzsche, 1989). The religion still very important for its adherents as a source of motivation (Weaver & Agle, 2002). Toward a certain social pressures and social norms that push the individual to show his characteristics to seek reputation and self-respect when he or she exhibit prosocial behavior. Bénabou and Tirole (2006) built a model of choice based on

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three motivations (drivers): intrinsic motivation, extrinsic motivation, and reputation building (self-image value of pro-social choices: Esteem-driven demands are the first in a hierarchy of ego-driven needs that starts with esteem. Self-respect (the conviction that you are valuable and deserving of dignity) and self-esteem are the foundational components of respect (confidence in your potential for personal growth and accomplishments). Maslow makes it clear that there are two different kinds of selfesteem: esteem, which is based on the respect and approval of others, and esteem, which is based on your own evaluation of yourself. This later form of self-esteem gives rise to self-assurance and independence. Ariely et al. (2009) studied the intrinsic motivation specifically personal preferences for giving, extrinsic motivation and image motivation. In the behavioral game theory, models are built by incorporating social preference (in contrast to self interest) and tying them to the social motivations. Several experimental studies of games showed that people do not always play games in a selfish manner (Camerer, 2003). Berg et al. (1995) studied the trust and tried to bring answers whether or not trust is a primitive response. They note an experimental problem with trust game, where the participants may want to impress experimenters with their generosity. So they introduced features allowing them to contribute anonymously using envelops or boxes. So the experimenter cannot know whether they have been generous or not? Social norms determine in part: work effort, consumption choices, common pool resources, public good. Some other models focused on the emotional satisfaction procured by giving. Andreoni’s (1990) model of warm glow giving, explaining the fact that utility increases with the act of giving (volunteering and work) (Sauer et al., 2014). Generosity may represent types of specific investment in our visibility and positioning of self image on social capital. Contextual factors can condition religious affiliation and social expectations of its presence. Islam has a significant impact on a person’s values, morality, and ethical behavior as well as their decision-making process, from the first stage of recognizing a certain issue as such to the last stage of implementing a particular answer. That impact consequently influences organizational behavior, as was noted.

5.2

Choice Constraints

Utility theory as specified by neoclassical, advances choice constraints as being solely monetary constraints (prices, income, wealth) behavioral framework add a variety of non monetary constraints such as

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• Overload choice • Overload information • Self satisfaction In the Islamic financial context: • • • •

compliance of beliefs and practices: previous experiments Time constraints (few time to choose) Time frame: within which they should make their decisions Optimality with respects to believes

5.3

Interactions Between Cognitive and Emotional Dimensions Can Lead to Certain Balance: With Reference to the Cognitive Balance Theory

The cognitive dissonance: Heider analyzed the congruence between expectations and outcomes through cognitive balance theory. People usually act in a manner to balance the state of psychology as they seek consistent patterns. People tend, most of the time, to reinterpret events and available information (and previous experiments) and address a normative vision to the world (how the world is/and should be). When they realize they have behaved not in compliance with their believes, this creates cognitive dissonance and believes bias. Akerlof and Dickens applied to an economic model psychological dimension about cognitive dissonance based on three essentials preferences: • People have preferences not only over states of the world but also over theirs believe about states of the world • People have some control over their believes • Believes persist over time The cost/gain of the belief is perceived with association of the welfare mistake (lesson learned) made because of the belief. In other words, costs (in various forms) that are transferred to society will result in higher gains for commercial companies. The ZAKAH institution, which is a wealth tax that mandates charitable contributions for certain groups in society, makes it easier to take care of everyone in society. The wealthy are just trustees of their riches, not the genuine proprietors, according to Islamic business principles. They are required to spend their wealth in accordance with the provisions of the trust, one of which is meeting the needs of the underprivileged.

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109

Persistence in Believes: Readjustment by Learning

Camerer (2003) emphasizes on the fact that economic theory gives slight attention (if not none) to the question of learning and suppose that people are strictly rational when information is perfect and available making them able to proceed to correct choice that is easily identifiable and when information changes they will move from one equilibrium to the next one. Camerer and Weigelt observed the importance of learning in experimental game, and it should lead to prediction possibilities by accumulating stock value learning which can be assimilated in the quantitative context as time-dependent functions of strategies known as attractions.

5.5

Believes and Learning

It’s supposed that believes are not directly observable, but in the set of practices they can be interpreted. Cheung and Friedman built their empirical learning rules in which different stakeholders interact and exchange feedback on their actions, outcomes and believe. The process is iterative: • • • •

Believes interact with decision rules to generate actions Actions interact with payoff functions to generate income Outcomes interact with learning rules to generate beliefs Identity social learning and herding behavioral in decision making

When it comes to showing a certain type or level of beliefs, people can follow others and imitate or not a specified groups rather than acting independently based on their own attitude. Keynes (1936–1937) proposed that when faced with a situation of uncertainty in which we simply do not know what the future holds, people have a tendency to use simplifying techniques, such as imitating the actions of those who are thought to have better decision-making abilities or simply extrapolating past behavior into the future.

5.6

Contextualizing Rationality in Decision Making: The Bounded Rationality Approach

When contextualizing rationality in the decision-making context, we take into account the norms that are associated to the overall decision-making environment, in general and those specific to the decision maker itself. Simon, Todd and Gigerenzer, placed human action in the decision-making environment of individual or organization, allow them to talk about rationality.

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Also Simon specified that rationality requires that the decision maker should be a goal oriented and have his own reasons behind his actions. But this does not deny the decision-makers’ cognitive constraints, especially those related to their awareness of important information. Bounded rationality approach can bring explanations when decisions appear to be odd or irrational, and what seen to be irrational choices is quit rational for decision makers given their environmental characteristics constraints, capabilities, and opportunities. Akherlof and Karanton through what they developed in the identity economics framework, an individual is behaving to maximize his utility taking into account his desire to fit into the groups or community by respecting their norms, social values. Social practices and norms have significant influence on individual decisions. The use of social comparisons can alter decisions. Social environment and the prevailing social norms Herd behavior in decision making finds its explanation in three main causes. Free riding in information acquisition, simply because the decision maker imagines that others (to follow) know better how decision should be made. Seeking protection by doing as others do: safety, reducing blames, judgments, risks from being outlier: regret avoidance. Conform to group norms: adherence. Ignorance plays a role in fastening the herd behavior. Many decisions are often made by processes that may be unclear for us. When dealing with decision making, we deal with the real world and its ill structured and nonspecified definition of problems that include uncertainty, ambiguity, self-perception, noneasy probabilistic formulation, and not easy fit with the standard rational (optimization) models paradigms (Von Newman Morgenstein on the expected utility 1944). Distinguishing between compliance to a moral code and responding to social preferences: Social preference trade-off self-interest against the greater good, while compliance to a moral code is a constraint that admits no trade-off. The constraint depends on the content (scope) of the particular moral code and that varies by context even in simple group’s communities or societies. Social purpose of a moral code, and why codes vary so much in terms of which behavior they encourage or discourage new markets (Islamic finance). Cognitive limitations, habits, and poor information, have been advanced as justifications for the suboptimal behavior. The reality is most of the time agents are assumed to have limited information about the environment they evolve into, about other resources availability and accessibility (price, type), and about the detailed behavior of other agents with whom they interact, limited foresight. From the adaptive point of view: good decision making requires integration of many relevant data, motivations with the knowledge concerning potential consequences of the resulting action. Individual preferences and beliefs develop an ability to predict the behavior of others to access and predict various states such as opinions, intentions, goals, whether are explicitly stated or implicitly, they shape and influence

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choices decisions and emphasize with them to be able to able to take decision. A possible link can be established between the perceived Islamic banking firm ethical investment and social responsibility and its reputation and the satisfaction of its different stakeholders.

6 The Islamic Approach of Ethical and Socially Responsible Investments: Compulsory and Voluntary Basis Donations 6.1

Religious Affiliations and Individual Level Decision Making and Organizational Behavior

Decision making and behavior in the individual level are not easy to analyze and model and have been studied largely in the empirical research works. Rest and Jones four stages; the first is called ethical sensitivity. Second stage is prescriptive reasoning that results in identifying the ideal solution to a particular ethical dilemma. The third stage is ethical motivation that involves one’s formulation of ethical intention of whether to comply or not with the ethical judgment made previously. The fourth stage—that supposedly should resolve the ethical dilemma and is a function of the individual’s ethical character. Ethical and socially responsible investments, with reference to David Crowther, need to be sustainable and implemented with accountability and transparency.

6.2

Principles of Corporate Social Responsibility and Zakat Mechanism

The social responsibility can be found in both the mandatory (zakat) and voluntary (SADAQAH, WAQF, QARD AL-HASSAN) forms as practiced over centuries in Muslim society are considered. The concept of zakat, or charitable giving, is one of the Islamic five religious pillars and the Quranic incitation principals that are related to the financial context. This is meant to be an active response to helping those in need. However, the inclusion of Zakat in SHARIAH principles does not necessarily impact investments. Since the allocation of such donation is most of the time not well planned and gathered: it is performed individually and the amounts are not pooled and transformed to help poor beneficiary to get out of poverty and be able to give zakat in the coming years. Social responsibility principles, is not something very new, it has been rooted in religious scriptures. With reference to Islam, the social responsibility principles were embedded for more than 1400 years. Zakat is the Third Pillar of Islam. It is the obligatory giving of one’s wealth proportion to donations as charity. It is a worship

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and of self-purification which extends the charitable gifts given out of kindness or generosity, to the systematic giving of 2.5% of one’s wealth each year to benefit the deprived. It is a very unique system that helps redistribution of wealth and has as principal objective to allow poor to meet their basics needs and offer them economic possibilities to rescue them by empowering them to get out of poverty and be able to give zakat in the coming years in order to reduce the gap of the societal division and unequal distribution of wealth and in final to improve the economic growth toward a better and just society. With reference to Adnan and Bakar (2009), organizations that are paying the Zakat are performing ethical and socially responsible investments and supporting philanthropic aims. Zakat as a mechanism allows the practice of ethical and socially responsible investments with the ultimate goal which is to generate the social welfare in society. There are prerequisite criteria specified by the Islamic law for who are eligible to benefit from Zakat donation, ensuring help reaches the needy and is given by people who can do so. Islam encourages Muslims to give generously on a voluntary basis.

6.3

Normative Specifications of the Zakat: Rationale Religious Obligation

The compulsory Zakat donation is strict in term of its implementation when it comes to the amount and the intervals at which it should be paid; there is also conditions eligibility of its beneficiaries. The first and fundamental specification of the Zakat models relates to the rationales of Zakat, as a religious obligation and part of a greater belief system with an individual responsibility and also in organizations level (companies, firms, etc.) with the shareholders through their wealth in the companies may also be paid as percentage of their property and revenue. A second specification of the Zakat lies in who is the socially responsible actor and accountable for doing it. Priority to the Closest vs. Society as a Whole: the place of responsibility. The principle of zakat is a principle of proximity where the benefactor starts with the needy in his immediate surroundings and then gradually moves outwards within the limits of his/her resources. The first group is the destitute: those with no source of income, who cannot support themselves or their family. The second group is the poor, individuals whose income cannot provide them with their basic needs such as food, clothes, and others on monthly or yearly basis. The third group is those who are employing working on collecting Zakat. The fourth group is individuals who have embraced newly the religion of Islam and lack economic support. The fifth group includes slaves or captives, so that they can free themselves. The sixth group includes individuals who are in high massive debts and cannot pay them on their actual rhythm and cannot afford their basic needs.

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The seventh group includes travelers “strangers” who are stranded and have no money to continue their journey. The final group includes those who are striving to work in the path of Islam.

6.4

Incentives to Perform Zakat

Publicity: “Pleasing God” or Marketing Business Tool and Accountability: Day of Judgment vs. Voluntary Compliance: There is no consensus among Islamic jurists scholars on the question of publicity in paying the Zakat in open or privately, whereas ethical and socially responsible investments are all about brand value. Firms are believed to report on their ethical and socially responsible investments activities and are also glad to reap publicity benefits from it. The Zakat model is more critical of public donations because it sheds doubt on the benefactor’s intention (Niyya). Anonymous giving has the additional advantage of protecting the identity of the recipient to avoid reproach and doubt about the latter’s need and reduce the feeling of shame. As Zakat is part of a greater belief religious system that requires performing obligations with a level of accountability and sanctions in the Day of Judgment with a voluntary compliance.

6.5

The Equilibrium of Islamic Financial Framework: Islamic Religiosity vs. Optimality Behavior and Rationality Assumption

As Adam Smith has stated in The Theory of Moral Sentiments “The great source of both the misery and disorders of human life, seems to arise from over-rating the difference between one permanent situation and another. Avarice over-rates the difference between poverty and riches: ambition, that between a private and a public station: vain-glory, that between obscurity and extensive reputation.” In the Islamic financial framework, the equilibrium is very important as it is mentioned in the holy Quran as the “Middle Nation” that state is reached with a certain balance between collective and individual goals. The concept of rationality is also present in the Islamic financial framework; agents have incentives and continuous commitment to consider other stakeholders interests in their transactions. From a theoretical point of view in the Islamic financial framework, trust is supposed to be the cornerstone of all transactions that need to be fair and equitable. The two parties involved in the contractual agreement must act with good intention in order to avoid exploitation in the exchange transaction and improve their mutual

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welfare. Explicit trust provides the economic glue that enables social financial cohesion. In fact, the contractor loves to his partner that which he loves for himself. On the authority of Anas bin Malik (may Allah be pleased with him)—the servant of the Messenger of Allah (peace and blessings of Allah be upon him)—that the Prophet (peace and blessings of Allah be upon him) said: “None of you will believe until you love for your brother what you love for yourself.” Related by Bukhari and Muslim. Even Muslims may, sometimes and somewhere, not comply with values and beliefs. And they may also behave in different manners depending on engaging in different social situations and relations each with its own unique set of role expectations and this after valuing them when occupying multiple social positions (Enzle & Anderson, 1993). This can find its justifications in part, in the symbolic interaction theory (Mead & Schubert, 1934). This is true in the context of the Islamic finance as the Islamic finance is not merely reserved to Muslims, and also among Muslims there could be who is not behaving in accordance with the Islamic teachings all the time, or tends to be selfish or bounded rational entrepreneur, or with intrinsic material motivations, may get in PLS contractual relationship with the Islamic bank and thus hams the common welfare of the contractual partners. The Islamic financial guidance and rules provide a framework by which stakeholders, and the nature and extent of their rights, may be designed. It traces and clarifies the concepts of profit and shapes motivations and efforts to earn it with an emphasis on the consciousness of responsibilities to others and not only of one’s own rights. Many industry stakeholders appreciate this, for they look to Islamic financial institutions to behave consistently with Islam and engage in transactions with built-in preservation of social values. The normative vision of the Islamic financial micro approach of the firm put a great emphasize on ethical and the religious dimensions as the economic dimension still shaping in great part the individuals’ decisions that seek to reconcile self-interest motives with the social interest. Religiosity or religious affiliations are strongly correlated with general financial decisions and also specifically with S.R.I and socially controversial investing, although the empirical results are not completely consistent (e.g. Borgers et al., 2015). The degree of adherence to the religious principles and teachings and its impact on the economic behavior (financial markets) and the sustainable behavior Cui et al. have been studied in different contexts (Hilary & Hui, 2009; Renneboog & Spaenjers, 2012). According to Natale and Doran (2012), the development of pro-social and pro-ethical behavior like the fair trade movement is also strongly supported by religious groups. Andorfer (2013) shows that individual religiosity has strong positive effects on fair trade consumption in Germany. The impact pertinence of feelings of warm glow, social pressure, signaling aspects, or environmental values on the general contribution to public goods or specific contributions to charities has been studied by several researchers (e.g., Harbaugh, 1998; Ariely et al., 2009).

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7 Conclusion The concept of ethical and socially responsible investments has grown over time continually and rapidly but it still remaining relatively little known and little experienced in the Islamic financial context. At best, this knowledge remains limited to considering ethical and socially responsible investments to giving charity with efforts in assisting education, arts and culture activities, health and social services, and civic and community projects. Social responsibility can play an incentive role in the Islamic participatory financing contracts as it increase the intention to donate when realizing the expected level of income or more. Social responsibility principles are not something very new, it has been rooted in religious scriptures in both the mandatory (zakat) and voluntary (SADAQAH, WAQF, QARD AL-HASSAN) forms as practiced over centuries in Muslim society are considered. As the ultimate objective of Islamic investing is to achieve success and happiness (the well-being in this world and the hereafter) not only through efficiency and effectiveness but also with fair dealing and economic justice. The normative and positive dimensions of human being individually and in interaction with the society based on the happiness achievement goals help in designing a strategic vision of the social responsibilities that can be established. As the Islamic banking firm aim to finance projects that help in the development, reducing poverty and unemployment rates across. Ethical and socially responsible investments programs implemented by the Islamic banking firms should be derived from the bank’s business activity by making impact in the communities. In order to do this, the Sharia Board of the Islamic banking firm has a role to play in establishing pertinent sustainable policies to ethical and socially responsible investments and helping in designing programs under this umbrella in order to ensure that all the bank’s activities comply with Sharia. In their strategic vision, the Islamic banking firms to be successful in this aspects have to show through their action plan that the concept of ethical and socially responsible investments is not limited to giving donations or organizing social events or sponsoring, but it includes all activities (economic, social, and environmental) that support the objectives of Sharia by working to advance the welfare of society, preserving the environment, and making a profit in accordance with Sharia. Ethical and socially responsible investments could have significant impact and can even constitute paradigm shift in the sustainability of the Islamic banking industry, as it is expected to influence on management, products and services, community and environment. Therefore, banks as well as other corporations are asked to engage actively in ethical and socially responsible activities to insure their sustainable development. Ethical socially responsible investments can present competitive advantages and build a good image and reputation (Garriga & Melé, 2004). Stakeholders may also have positive perceptions of the organization brand value and reputation: any benefit

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and advantage realized from performing ethical and socially responsible activities (Siwar & Hossain, 2009, p. 290). Ethical and socially responsible activities can be perceived as an indirect marketing strategy to promote the bank by advancing its image and reputation and increase awareness across its operational environment and bridge collaborative ways between bank and society and stakeholders could advance increasing loyalty and become more confident in associating with the bank to reduce the energy consumption, and also reduces waste and it fulfils SHARI’AH requirement which makes it virtuous according to Islamic teaching. The advantage of being ethical is that it could ensure sustainability, builds trust and loyalty; and lastly it brings about positive behaviors (Mousa, 2007, p. 44). In supporting this, Kitson and Campbell (1996, p. 6) emphasize that the survival of business is not merely concerned with profit, but it should comply to legal regulations and society’s moral values as well. We conducted an experiment with the Islamic banking firm as the principal that can decide either to donate or not, and the agent who will be informed about this decision which will affect the agents’ willingness to provide additional and higher effort and then act in the common welfare of the two partners. We analyze the effects of Donation Announcement Decision (D.A.D) on agent’s motivation. How may the religious belief in the hereafter reward and helping others impact altruism behavior? Participants have been involved in a series of sort of binary dictator games where they can choose how much effort to afford to increase the payoffs and then the charity donations that helps low-income individuals in developing nations or to themselves. In each decision-making alternative, participants have to select from two distributions, one of which is more favorable to the charity. We find that 18 out of the 20 entrepreneurs (agents) tend to afford significantly higher efforts when they know about principal’s intention to donate. We find that higher marginal donations do not generate higher marginal effort levels than those observed after medium and low marginal donations. Reciprocal altruism is a strong way through which we can observe how prosocial principal’s behavior can affects agents’ efforts levels. When the Islamic banking firm proceeds deliberately to mandatory donation (zakat), this reveals in part first the value of the firm as a signal to the different stakeholders and second the agents decide to choose significantly higher levels of efforts taking into account that for sure that the principal is naturally wealthier than the agent. The agent tends to reduce his effort level when he or she feels that it increases the principal’s wealth without bringing an additional part of his gains. Islamic banking firms need to make more efforts on the disclose all their ethical and socially responsible investments programs through a special report and social media accounts, thereby encouraging other businesses to fulfill their obligations toward society rather than for the purpose of marketing. A balance between individualism and collectivism, that is to say equilibrium between the interest of the individual and the interest of the society.

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Caution should be exercised when generalizing our results. Since our analysis has been conducted in a small sample of agents (CEO of the 20 SMEs) and only one principal (only one Islamic bank branch), this might not adequately capture existing impact of Donation Announcement Decision but for sure can have an effect on the agent’s motivation to exert effort that is beneficial for common welfare and may reflect to great extend a sample perception. Our results are in line with those of Koppel and Regner (2014) but in a different context as they found that, on average, workers react positively to CSR. They reciprocate not only higher wages but also investments in CSR with increased effort. Matching mission preferences motivate workers to exert more effort, independently of the extent of CSR investment. With respect to the positive effect of CSR activity on firms’ profits in our paper, it is worth noting that the results reflect a sample perception. Previous studies have shown that CSR can be beneficial, if this has positive effects on the decisions of consumers or investors, respectively.

Appendix: Experimental Instructions This survey should take 30 min (average) to complete. Please note that your participation in this experiment is voluntary, and you are free to end the experiment at any time. By clicking the “Consent and enter survey” button below, you are consenting to the following terms: Your participation in this experiment is voluntary. We do not anticipate that participating in this experiment will result in any risks or direct benefit to you. However, your inputs may lead to recommendations that will benefit this study and, thereby, future decision making in the Islamic financial framework. The experiment is set up in a way that will require you to provide an answer to each and every question in order to continue (no skipping of questions). Data from this survey will be stored by the authors. Any responses you provide will only be used in the sake of this study in an anonymized aggregated way for quantitative data or the qualitative analysis from open-ended responses with all personal identifying information removed. The following instructions for participant’s potential entrepreneur “agents” (20 entrepreneurs CEO of SME’s to be funded by the Islamic bank: Zitouna Bank Gafsa Branch Tunisia). These instructions are explained to the participants and we asked them if something still unclear we can re-explain it for them in order to have a common understanding. [Instructions Participants] Welcome in our experiment! The answer to the question is individually without talking or interacting with other participants and phones and other devices are not allowed which may disturb the experiment.

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Each player of the 20 participants will be matched, in the role of Agent A with the responsible of the Islamic banking firm as the role of principal B (the principal). The question of sensitivity of the agent’s level of commitment and efforts to the intentional, distributional, and warm glow as social incentives. In the first stage of the experience, and prior to the level of agent’s effort provided, he will be informed about the intention of. The Islamic banking firm (principal) not to donate, through [mandatory (zakat) and or voluntary (SADAQAH, WAQF, QARD AL-HASSAN)] to a charity in form of Ethical and socially responsible investments programs or not. And we ask him what level of effort he will be ready to afford: What level of effort. LL: Low Level: when the Islamic bank has not the intention to donate: π(e = LL) = π 1 ML: Medium Level: when the Islamic bank inform about its first intention to donate: π(e = ML) = π 2 HL: High Level: when the Islamic bank inform about its intention to donate as strategic orientation: π(e = HL) = π 3 In the second stage of the game, the agent was informed about the donation decision (nature, size, type: number of household helped; the number of small businesses built through the donations that allow people to switch from scarcity to self support), and the traditions of the Islamic bank he will tread within the donations through published reports and social media accounts on the implemented ethical and socially responsible investments programs of the Islamic banking firm (principal). Will this enhance his decision on his effort as it allows him (her) to communicate about the indirect social responsibility of its business and gives him pride to be part of the achievement and increase the belonging feelings and the esteem needs, the desire for reputation or respect from others (Maslow). We will also ask if there is a performance-contingent incentives, meaning that higher level of efforts increases the expected revenue of the financed project and thus increases the principal’s and the agent’s payoffs simultaneously as each one of them takes a percentage (profits or losses sharing ratio) of that revenue. To make the participants committed and interested to give fair answers, they will have invitation to lunch and will be afforded during the experiment coffee water and snacks independently of the decisions made in the experiment.

References Abeng, T. (1997). Business ethics in Islamic context: Perspectives of a Muslim business leader. Business Ethics Quarterly, 7, 47–54. Adnan, M. A., & Bakar, N. B. A. (2009). Accounting treatment for corporate zakat: A critical review. International Journal of Islamic and Middle Eastern Finance and Management, 2(1), 32–45.

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Malaysia’s Sustainable Banking Regulatory Framework: Value-Based Intermediation and Climate Change Principle-Based Taxonomy Zuraida Rastam Shahrom and Sherin Kunhibava

1 Introduction The United Nations’ Sustainable Development Goals (SDG) integrates economic development, social inclusion and environment sustainability to shift the world to a more sustainable and resilient path so that by 2030 everyone can enjoy peace and prosperity. UN estimates that $5 trillion to $7 trillion per year between 2015 and 2030 is needed to achieve the SDG globally.1 The total investment needs in developing countries are estimated between $3.3 and $4.5 trillion per year, mainly for basic infrastructure, food security, climate change mitigation and adaptation, health and education.2 According to the United Nations Conference on Trade and Development (UNCTAD), public sector funding alone is insufficient to meet demands across all SDG-related sectors, and there is an annual funding shortfall of $2.5 trillion.3 The private sector can fill this gap through the financing of and investment in sustainable development projects and businesses. FIs can support such investments through lending and innovative financial instruments to mobilize capital for sustainable development projects and companies with sustainable practices. Central banks and regulatory authorities can steer FIs in this direction through policies and regulatory frameworks that require FIs to consider environmental and social aspects in their operations, business strategies and offerings.

1

UNCTAD (2014). UNCTAD (2014). 3 UNCTAD (2014). 2

Z. R. Shahrom (✉) · S. Kunhibava Faculty of Law, Universiti Malaya, Malaysia e-mail: [email protected]; [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 N. Naifar, A. Elsayed (eds.), Green Finance Instruments, FinTech, and Investment Strategies, Sustainable Finance, https://doi.org/10.1007/978-3-031-29031-2_6

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In Malaysia, the regulatory framework that can steer the FIs under the purview of Bank Negara Malaysia4 (BNM) towards supporting sustainable development began with the issuance of the Strategy Paper on VBI by BNM on 12 March 2018.5 It aims to re-orient Islamic finance business models towards realizing the objectives of Shariah that generate positive and sustainable impact on the economy, community and environment through IBIs’ practices, processes, offerings and conduct.6 The Strategy Paper on VBI defines VBI and articulates approaches and strategies to advance VBI as a means to strengthen the roles and impacts of IBIs towards a sustainable financial ecosystem. VBI adoption by IBIs is voluntary. BNM envisioned a two-pronged approach in facilitating VBI adoption by IBIs, that is, by creating an enabling environment through regulatory guidance and enhancing transparency to trigger intended stakeholder activism.7 To create an enabling environment for VBI adoption through regulatory guidance, BNM produced a set of guidance documents on translating VBI into real banking practices and offerings. The three guidance documents are (1) the Implementation Guide for VBI8; (2) the VBI Scorecard, Consultative Document9 and (3) the VBI Financing and Investment Impact Assessment Framework (VBIAF) Guidance Document.10 In addition, to support the implementation of VBIAF, several VBIAF Sectoral Guides have also been issued.11 The Implementation Guide for VBI guides practical VBI banking practices, outlines the phases of VBI implementation, and deliberates on key challenges alongside pragmatic solutions.12 The VBI Scorecard allows IBIs to conduct a self-assessment of the effectiveness and achievements of the IBIs’ strategies in

4

Bank Negara Malaysia is the central bank for Malaysia established under the Central Bank of Malaysia Act 2009 (Act 701). Its primary functions are provided under section 5 of the Central Bank of Malaysia Act 2009 which includes to regulate and supervise financial institutions which are subject to the laws enforced by the central bank. 5 BNM (2018a). The Strategy Paper was developed by BNM in collaboration with founding members of the VBI Community of Practitioners (COP) comprising Bank Islam Malaysia Berhad, Bank Muamalat Malaysia Berhad, Agrobank, CIMB Islamic Bank Berhad and HSBC Amanah Malaysia Berhad. 6 BNM (2018b). 7 BNM (2018c). 8 BNM (2018d). 9 BNM (2019a). 10 BNM (2019b). 11 These are developed by the VBIAF Sectoral Guide Working Group which is spearheaded by the VBI Community of Practitioners (CoP), which comprises 12 members of the Association of Islamic Banking and Financial Institutions Malaysia (AIBIM), which are Agrobank, Alliance Islamic Bank Berhad, AmBank Islamic Berhad, Bank Islam Malaysia Berhad, Bank Muamalat Malaysia Berhad, CIMB Islamic Bank Berhad, HSBC Amanah Malaysia Berhad, Maybank Islamic Berhad, OCBC Al-Amin Bank Berhad, Public Islamic Bank Berhad, RHB Islamic Bank Berhad and Standard Chartered Saadiq Berhad. 12 BNM (2018d).

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implementing VBI.13 The VBI Scorecard Consultative Document briefly elaborates on the key aspects of a VBI Scorecard. The VBIAF guidance document facilitates the implementation of an impact-based risk assessment and management system14 to assess the financing and investment activities of IBIs so that these activities are in line with their VBI commitment.15 The VBIAF Sectoral Guides, which support the implementation of the VBIAF, serve as an in-depth impact-based risk management toolkit to facilitate IBIs to make financing or investment decisions in selected sectors based on an environmental, social and governance (ESG) risk score. It is also intended to provide transparency to customers and investors on the IBIs’ ESG considerations in coming to its final financing and investment decision. The VBIAF Sectoral Guides that are issued are VBIAF Sectoral Guides on Palm Oil; Renewable Energy and Energy Efficiency; Oil and Gas; Manufacturing and Construction and Infrastructure.16 The Strategy Paper on VBI, the three guidance documents and the VBIAF Sectoral Guides together form the regulatory framework for VBI. In addition to this, BNM also issued the Climate Change Principle-based Taxonomy (CCPT),17 which specifically addresses climate change issues. The CCPT provides a robust and consistent assessment and classification of economic activities and the overall business of a customer of FIs in Malaysia based on how they impact the climate. It complements the VBIAF in that whilst VBIAF incorporated ESG assessment to positively impact the environment in general, the CCPT addresses a specific environmental issue: climate change. In addition, the VBI and its guidance documents are voluntary for IBIs, whereas the CCPT applies to IBIs and conventional banks and is also for voluntary adoption by these FIs. This chapter examines the VBI articulated in the Strategy Paper and the guidance documents mentioned above. It seeks to understand how adopting the VBI, VBIAF and the VBI Scorecard can change the offering, practices and operations of IBIs to add value to the economy, environment and community. This study considers that the VBI and its guidance documents is BNM’s first regulatory framework governing IBIs that emphasizes creating value to the economy, environment and community.

13

BNM (2019a). Impact-based risk assessment and management considers not merely the financial impact of the financing or investment but extends to the impact on wider stakeholders, for example, the community and environment based on the broader goal of sustainable and resilient future. This is elaborated further in the subsequent paragraphs of this Chapter. 15 BNM (2019b). 16 The first cohort of the VBIAF Sectoral Guides on Palm Oil, Renewable Energy and Energy Efficiency was issued on 31 March 2021 and the second cohort of the VBIAF Sectoral Guides on Oil and Gas, Construction and Infrastructure, as well as Manufacturing sector was issued on 22 March 2022. See https://www.mifc.com/-/vbiaf-working-group-release-sectoral-guides-on-oilgas-construction-infrastructure-and-manufacturing 17 The CCPT was issued by BNM and came into effect on 30 April 2021. The CCPT is available at https://www.bnm.gov.my/documents/20124/938039/Climate+Change+and+Principle-based+Tax onomy.pdf 14

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The regulatory framework on VBI has been said to be similar to other ESG frameworks; however, its distinction lies in that it is premised on achieving the objectives of Shariah. Therefore, most discussions on the regulatory framework of VBI focused on the VBI and Shariah principles embedded in the VBI, with limited discussions on the guidance documents.18 This chapter, however, takes a different perspective by examining the regulatory framework of VBI holistically through the examination of the Strategy Paper on VBI and all its guidance documents. This approach aims to add to the body of knowledge on VBI by providing understanding of the correlation between the VBI as articulated in the Strategy Paper, the VBIAF and the VBI Scorecard. It also aims to demonstrate how adopting the regulatory framework of VBI can assist IBIs in adding value to the economy, environment and community. In addition to the above, this chapter also examines the CCPT, which supports sustainable development, particularly SDG 13.19 The CCPT is fairly new as it was issued by Bank Negara Malaysia in 2021. The CCPT is distinctive from existing taxonomies because it assesses both the economic activity as well as the overall business activities of the customer and how these impact the climate. In light of this, a study of CCPT’s General Principles and classification system would be advantageous to understand its application by FIs in Malaysia and its implication for businesses seeking financing from these FIs. This is especially so where current literature on the CCPT is mostly limited to an overview of the CCPT.20

2 VBI 2.1

VBI Under the Strategy Paper

BNM acknowledges that finance has a role to play in helping governments achieve the 17 SDGs, and there is an increasing expectation for the financial sector to deliver a greater impact on the economy and society.21 It stated that the call to action for sustainable finance to support the SDGs could not be ignored, particularly for Islamic finance.22 BNM stated that Malaysia already has a well-developed and regulated Islamic finance industry.23 The Islamic Financial Services Act 2013

18 Hassan and Mohamad Nor (2019a), Alwi et al. (2021, p. 173), Khan (2021), and Mahyudin and Rosman (2020, p. 34). 19 Goal 13 of the SDG is to take urgent action to combat climate change and its impacts. 20 Pfaff et al. (2021) and Tandon (2021). 21 BNM (2018e). 22 BNM (2018e). 23 BNM (2018e).

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provides for the regulation and supervision of IBIs, and the 14 Shariah Standards24 set clear Shariah parameters to facilitate innovation beyond credit-based products. BNM believes that the way forward to propel Islamic finance to its next level of growth should be by giving equal weight to both economic value creation and upholding ethical values.25 Thus, it embarked on VBI, a holistic approach for IBIs to deliver the intended outcome of Shariah that generates a positive and sustainable impact on the economy, community and environment. The initial position of IBIs was to offer Islamic financial products and services to customers that demand Shariah-compliant financial services.26 Thus, the focus was ensuring that the product structures, features, and operational aspects comply with Shariah’s requirements. Adopting the VBI moves beyond compliance to Shariah to also creating value for shareholders of the IBIs and its financial consumers, and others within the society and the economy at large.27 VBI as articulated in the Strategy Paper, “aims to deliver the intended outcomes of Shariah through practices, conduct and offerings that generate positive and sustainable impact to the economy, community and environment, consistent with the shareholders’ sustainable returns and long-term interests.”28 There are three components that can be observed from this definition. Firstly, it is clear that the end objective of the VBI is the “intended outcomes of Shariah”. The “intended outcome of Shariah”29 as explained in the Strategy Paper, focuses on the enhancement of the well-being of the people through the preservation of wealth, faith, lives, posterity and intellect.30 Primarily, its purpose is to achieve benefits for all human beings. As mentioned by the Governor of BNM in her

24 Shariah Standards outline the principles, pillars and conditions of specific Shariah contracts to ensure end-to-end compliance with Shariah rulings in the structuring of Islamic financial products and services. The Standards have mandatory provisions and guidelines denoted by “S” in the Standards and provisions as guidance which may consist of statements or information, intended to promote common understanding and advice or recommendations that are encouraged to be adopted. These are denoted by “G” in the Standards. The 14 Shariah Standards are Istisna, Rahn, Bai’ al-Sarf, Wa’d, Wakaiah, Wadiah, Tawarruq, Qard, Musyarakah, Murabahah, Mudarabah, Kafalah, Ijarah, Hibah. See https://www.bnm.gov.my/banking-islamic-banking 25 BNM (2017). 26 BNM, Strategy Paper on VBI at page 9. 27 BNM, Strategy Paper on VBI. 28 BNM, Strategy Paper on VBI, at page 12. 29 This is also referred to as value proposition of Shariah in the Strategy Paper and guiding documents of VBI. 30 These outcomes correspond to Imam Al-Ghazali’s five Maqasid al-Shariah. Imam Al-Ghazali (Abū Ḥāmid Muḥammad ibn Muḥammad al-Ghazālī c. 1058–1111) was one of the most prominent and influential philosophers, theologians and jurists of Islam. He explains the meaning of Maqasid as “The very objective of the Shariah is to promote the well-being of the people, which lies in safeguarding their faith (din), their lives (nafs), their intellect (aql), their posterity (nasl) and their wealth (mal). Whatever ensures the safeguarding of these five serves the public interest and is desirable, and whatever hurts them is against public interest, and its removal is desirable” (Al-Ghazali, 1973).

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Keynote Address at the Global Islamic Finance Forum 2018, “The business models of Islamic financial institutions should be guided by the overarching objectives of Shariah (Maqasid Shariah)—which are to preserve and advance the common interest of society at large, by preventing harm and maximizing benefits.”31 An example of this can be in the form of facilitating entrepreneurial activities and channelling funds towards productive sectors of the economy that create value for the economy, community and environment. Secondly, to achieve the “intended outcome of Shariah”, IBIs are expected to adopt practices and conduct; and provide offerings that generate positive and sustainable impacts on the economy, community and environment. Thus, the components of VBI include sustaining the planet, that is, the environment, the economy and the people. Sustainability in the VBI is produced by “practices, conduct and offerings” of the IBIs, which generates “positive and sustainable impact to the economy, community and environment” to achieve the objectives of Shariah. By adopting this triple bottom line approach,32 the VBI shares similarities with ethical finance,33 ESG34 and socially/sustainable responsible investment (SRI).35 However, the distinguishing factor in VBI is the underpinning Shariah principle.

31

BNM (2018e). The triple bottom line theory expands business success metrics to include contributions to environmental health, social well-being, and not just economy. These bottom line categories are often referred to as the three “P’s”: people, planet, and prosperity. See Global Alliance Banking for Values at https://www.gabv.org/the-impact/the-scorecard/triple-bottom-line 33 Ethical finance is commonly used to describe finance which takes into account not only financial returns but also ESG factors (Mascu, 2013). In an article which examines the business potential of ethical banking and green banking, respondents interviewed in the research understand ethical banking as relating to business ethics that require one to refrain from misusing power and position in discharging banking duties (Tan et al., 2013). 34 ESG investment is investment that considers environmental, social and governance factors apart from financial factors in the investment decision-making. Companies that adhere to ESG standards make an active effort to limit a negative impact on the society and environment or to deliver benefits to society and environment or both. Multiple issues fit into the categories of ESG. These can include climate change, carbon emission reduction, water pollution and water scarcity for the environment dimension; gender and diversity inclusion, hygiene and security, community for the social dimension; and logistics and defined process for running a business such as Board of Directors and its makeup; and decision making practices for the governance dimension. Diligent Insights, What is Environmental, Social and Corporate Governance (ESG)? An ESG Guide, retrieved from https:// insights.diligent.com/esg/. It has been argued that ESG is a term utilized largely from the institutional investors which are uncomfortable with terms like “socially” and “responsible” (Kinder & Domini, 1997). 35 SRI from the sustainability perspective entails environment, social and corporate governance screening for investments. Under SRI investors consider both the financial and non-financial criteria in their investment analysis. The core philosophy behind SRI is that environmental and social considerations are relevant factors in investment decision-making and should therefore be considered by responsible investors (Wagemans et al., 2013; Martini, 2021). SRI has been described in various terms. In Malaysia SRI refers to Social Responsible Investment (Ministry of Finance, 2013) and Sustainable and Responsible Investment (Securities Commission Malaysia, 2019). Other terms used to describe SRI are Sustainable, Responsible and Impactful Investments (Mujahid & Adawiah, 2015), Socially Responsible Investment (Bennet & Iqbal, 2013). 32

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Thirdly, the definition ends with the sentence “consistent with the shareholders’ sustainable returns and long-term interests”.36 This means that in addition to the intended outcome of Shariah and sustainability of the planet, benefits to the community and economic growth, what is equally important under the VBI is the growth and sustainability of the IBIs and, consequently, the Islamic finance industry. In a descriptive study, Hassan and Nor37 explored the Shariah principles embodied in the VBI. It concluded that the VBI is an intermediary that functions to deliver the intended outcomes of Shariah. The VBI is expected to enable greater achievement of the Shariah objectives. The researchers concluded that, in general, the VBI is expected to deliver justice, establish values and standards and enhance social responsibility, and specifically under the VBI, wealth preservation is achieved through wealth distribution, circulation and protection of ownership. The views of Hassan and Nor are in line with the definition of VBI articulated in the Strategy Paper, as discussed above. Going a step further, based on a qualitative investigation, Mahadi et al.38 explored the implementation of VBI from the Shariah perspective and the impacts of VBI activities in Islamic banks. The study revealed that some local Islamic banks39 have already carried out initiatives towards sustainability and achieving the objectives of Shariah through their product offering before the introduction of VBI by BNM. Therefore, the researchers were of the view that the introduction of VBI by BNM is “a wake-up call for the Islamic financial services industry to give more serious efforts in using Islamic social finance and its instruments in the financial market”.40 Similarly, Sharifah Faigah Syed Alwi et al.41 in their study, which investigated whether Islamic banks had truly been achieving the objective of Shariah in their banking operations before the introduction of VBI, found that IBIs had developed their products and services to achieve the objectives of Shariah even before BNM introduced the VBI.42 However, notwithstanding this finding, they believed that The original definition read “An intermediation function that aims to deliver the intended outcomes of Shariah through practices, conduct and offerings that generate positive and sustainable impact to the economy, community and environment, without compromising the financial returns to shareholders.”. Following the public consultations, it was amended to the current definition as in the Strategy Paper. This is in consideration of views that creation of values to other stakeholders through business activities will, to a certain extent, have an impact on short-term financial returns. See BNM (2018f). 37 Hassan and Mohamad Nor (2019b). 38 Mahadi et al. (2019). 39 One example is Agrobank which collaborated with BERNAS in launching an initiative to improve the productivity of paddy and farmers’ standards of living by providing a working capital worth RM50 million to farmers with BERNAS providing free technical advice and consultation to the farmers. The bank also introduced tawaruq based financing facility as financial assistance to farmers with their Paddy-I Tawaruq product. 40 Mahadi et al. (2019, p. 83). 41 Alwi et al. (2021). 42 Examples of the banks studies by the researchers are Bank Islam Malaysia Berhad, Maybank Islamic Berhad and Agrobank. All these IBs have products that protects both life and intellect. 36

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before the implementation of VBI, IBIs were at a disadvantage as there were no proper framework or guidelines in the implementation of achieving the objectives of Shariah into their banking operations other than the banks’ own understanding of the objectives of Shariah.43 From the findings of the researchers above it is clear that IBIs have a central role in financial intermediary to deliver Islamic finance products and services which can create positive and sustainable impacts on the economy, environment and society. The VBI premised on the four underpinning thrusts, its enhanced disclosure and scorecard, and its impact-based risk assessment and management system known as VBIAF establishes a framework and guidance to IBIs in implementing the objectives of Shariah and consequently directing the IBIs to support sustainable development. The VBI’s four underpinning thrusts, its enhanced disclosure and scorecard, and the VBIAF will be discussed in detail in the following paragraphs of this chapter. The researchers in the article entitled Leading towards impactful Islamic social justice: Malaysian experience with the Value-Based Intermediation Approach,44 emphasized that by adopting VBI the role of financial intermediary of Islamic financial institutions (IFIs) must always be consistent and meet the objectives of Shariah. The researchers argue that IFIs may adopt the 17 goals of SDGs as part of VBI, as long as the SDGs are consistent with the objectives of Shariah and is incompliance with Shariah. As mentioned earlier in this chapter, the SDG consists of 17 goals to end poverty, promote socioeconomic justice and address climate and environmental degradation. The end objective of the VBI, which is the intended outcome of Shariah, focuses on the enhancement of the well-being of the people through the preservation of wealth, faith, lives, posterity and intellect. Whatever ensures the safeguarding of these five serves the public interest and is desirable, and whatever that may adversely affect them is against the public interest, and its removal is desirable.45 VBI emphasizes minimization and prevention of negative impact on the people and environment arising from Islamic banking industry’s practices, conduct and offerings.46 Whilst it is acknowledged that the SDGs are open to multifaceted interpretation, it is argued that the aims of SDGs have similarities and are aligned with the objectives of Shariah, whereby both seek a better and sustainable future for the betterment of humanity. This is supported by the study and findings in the report by Fares and Younes entitled Islamic Finance: Shariah and the SDGs,47 which concluded that most of the SDGs are in line with the objectives of Shariah and there is a strong link between the two as both are considered to achieve various socioeconomic justice and increase in human well-being. INCEIF, in its report entitled Harnessing VBI: The Role of Development Financial Institutions,48

43

Alwi et al. (2021, p. 186). Mahadi et al. (2019). 45 Al-Ghazali, Abu Hamid as quoted in Hashim Kamali (1998). 46 BNM, Strategy Paper on VBI at p. 12. 47 Fares and Younes (2021). 48 INCIEF (2019). 44

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which studied the role of selected Development Financial Institutions with regards to their appetite for VBI practices, was also of the view that there is a proximity between the objectives of Shariah and what the SDGs seek to do. The SDGs, which display equal concern for people and the planet, converge with Shariah’s objectives to develop humans spiritually and intellectually and prohibit the deliberate devastation of resources and extravagances.49 Human beings should utilize the resources of the planet as trustees, protecting the well-being of all and protecting the environment, maintaining the balance of life and the earth.50 This alignment of SDGs to the objectives of Shariah was also clearly reflected in the mapping between the two done by Kasbani.51 The VBI is, therefore, a significant step by the regulator to encourage the Islamic finance industry, in particular the IBIs, towards sustainable practices that support sustainable development.

2.2

The Voluntary Nature of VBI for IBIs

Malaysia has a dual banking industry where Islamic and conventional banks operate side by side. The enactment of the Islamic Banking Act 198352 enabled the establishment of Malaysia’s first full-fledged Islamic bank, that is, Bank Islam Malaysia Berhad. Islamic banking and finance in Malaysia have seen rapid advances since then, and some studies have recorded initiatives by IBIs to fulfil the objectives of Shariah.53 Nonetheless, the Islamic banking and finance industry has been criticized for focusing on the legal compliance aspects of its product and services, such as the prohibition of riba and gharar54 whilst neglecting other aspects of the objectives of Islamic finance.55 The practice of Islamic finance was said to be predominantly prohibition-driven industry, for instance, using negative screening criteria to decide only on the Shariah validity of any investment.56 There was a lack of use of positive screening to channel investments towards positive social and environmental goals.57 Participants of the workshop held by SOAS, University of London on “Responsible Investment, VBI and the Future of Islamic Finance” were of the view that this observation is affirmed by the fact that many of the constituents of the FTSE Shariah

49

INCIEF (2019, p. 17). ibid. 51 Kasbani (2018). 52 The Islamic Banking Act was approved by the Parliament and the Senate at the end of 1982 and was gazetted in 1983. 53 Mahadi et al. (2019) and Alwi et al. (2021). 54 Transactions which involve excessive risk, that is transactions where a significant element of uncertainty exists. 55 Baker (2019) and Al-Mubarak and Osmani (2010). 56 Baker (2019). 57 Mohamad and Borhan (2017). 50

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All Share Index are not part of the FTSE4Good Index.58 There is a lack of emphasis on the other objectives of Islamic finance such as Shariah’s ethical and social objectives. Rusni Hassan et al. agree by stating that despite the great success stories of the growth of IBIs, many criticisms have been levied on IBIs for their inactive participation in contributing to societal well-being, even though this actually is included as one of the objectives of Shariah.59 Despite the objective of Shariah framework, which promises social justice and welfare, Islamic finance is said to have minimal social impact. Apart from the Shariah compliance standards, the social impact of the industry is offering little difference as there are only a few Islamic finance products and services that cater to the marginalized sector of society.60 Asutay et al.,61 study which measured the social performance of Islamic banking and finance industry according to the objectives of Shariah framework,62 found an unimpressive overall performance at country level by the industry, with lack of achievements in social and environmental responsibilities.63 To encourage more IFIs to go beyond Shariah compliance and increase more positive impact on society, BNM, in collaboration with the IFIs, developed the VBI. This is clear from the Strategy Paper on VBI which states “VBI promotes a more holistic observation of Shariah beyond Shariah compliance, that is, ensuring Islamic banking offerings and practices not only comply with Shariah requirements but also achieve the intended outcome of Shariah.”64 VBI is said to be the “vehicle to transform the industry, from one focused on profits and Shariah compliance to one that is also focused on positive impact.”65 It is expected to “bring various stakeholders together to advance the sustainability agenda, encouraging IFIs to assess how they create value and impact, particularly in response to changing economic, social and environmental conditions.”66 The legislation that established the first Islamic bank in Malaysia, the Islamic Banking Act 1983 defined Islamic banking business as ‘banking business whose aims and operations do not involve any element which is not approved by the Religion of Islam’.67 This legislation has been repealed by the Islamic Financial Services Act 2013 (IFSA), and s.28(1) of the IFSA provides that IFIs must ensure

58

Baker (2019, p. 19). Hassan et al. (2018a). 60 Mohamad et al. (2015). 61 Asutay and Harningtyas (2015). 62 The study utilizes the information disclosure in annual reports of Islamic banks over 5 years period: 2008–2012. 13 Islamic banks from 6 countries are chosen, which includes 3 Islamic banks in Malaysia which are Bank Islam Malaysia Berhad, RHB Islamic Bank Berhad, Hong Leong Islamic Bank. 63 Asutay and Harningtyas (2015). 64 BNM, Strategy Paper on VBI, page 12. 65 Zahid (2019). 66 BNM, Strategy Paper on VBI, page 12. 67 S.2 Islamic Banking Act 1983. 59

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that their aims and operations, business, affairs and activities are aligned to and in compliance with Shariah principles.68 Shariah compliance under the IFSA is supported by a two-tier governance structure that operates at the industry and institutional levels. At the industry level, the Shariah Advisory Council of BNM is the highest authority in the ascertainment of Islamic law for IFIs.69 At the institutional level each IFI has a Shariah committee to advice the management and board on Shariah compliance of the IFIs’ business, affairs and activities. Thus, the Islamic finance legal framework in Malaysia, from its inception, has been focused on compliance with Shariah. On the other hand, the VBI initiative has a different emphasis from the IFSA. Its approach is impact driven by requiring IBIs to fulfil the objectives of Shariah through having products, services and practices that deliver positive and sustainable impact on the economy, community and environment. Thus, it would require IBIs to undertake not just an assessment of Shariah compliance but also on whether its products, services and practices deliver positive outcomes to the economy, community and environment. It is argued that the different emphasis of the VBI initiative from the legal framework, can only allow for the VBI initiative to be voluntary on IFIs until a policy decision is made to amend the legal framework accordingly. Propelling the IFIs to their next level of growth is also a basis for why the VBI is proposed to IFIs. Although Islamic finance has evolved and grown with good progress in Malaysia, BNM felt that there was a need to propel Islamic finance to the next level of growth.70 The Strategy Paper specifically mentioned that the market share of total Islamic banking assets in Malaysia increased by 7.1% from 2010 to 28% in 2016. However, there was a decline in its annual growth rate from 24.2% in 2011 to 8.2% in 2016, and this signals that the Islamic financial industry needs to explore new opportunities for sustained growth.71 The next level of growth for the Islamic finance industry is the adoption of the VBI, which focuses on the 3Ps, namely, people, planet and profit. This is clear from BNM’s Deputy Governor’s address at the VBI Dialogue, where he stated that from the regulator’s view, to propel the Islamic finance industry to its next level of growth is for Islamic finance to give equal weight to both economic value creation and upholding ethical values and VBI is the holistic approach for the industry players to deliver the intended outcomes of Shariah that generate positive and sustainable impact to the economy, community and environment.72

68 S. 28(1) IFSA provides “An institution shall at all times ensure that its aims and operations, business, affairs and activities are in compliance with Shariah.” 69 S. 51 of the Central Bank of Malaysia Act 2009. 70 Bank Negara Malaysia (2017). 71 BNM, Strategy Paper on VBI, page 9. 72 Bank Negara Malaysia (2017).

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Strategies Towards VBI

BNM’s Strategy Paper laid down six strategies for the adoption and implementation of the VBI. The six strategies are: 1. Realigning the focus of Islamic banking industry towards creating greater socioeconomic impact through the VBI; 2. Defining the underpinning thrusts of VBI as a basis of collective action of the IBIs and its stakeholders; 3. Showcasing by BNM of successful examples of IBIs that have adopted the VBI to nurture potential VBI adopters; 4. Enhanced disclosure by IBIs on their intent in adopting VBI; 5. Introduction of the VBI Scorecard as a self-assessment tool for IBIs to measure their institution performance in implementing the VBI. 6. Development of effective network by the establishment of Community of Practitioners (COP) and strategic collaboration with relevant key partners and stakeholders. This chapter will focus on strategies 1, 2, 4 and 5 as these are the strategies that IBIs have to undertake if they are adopting VBI.73

2.3.1

Strategy 1

The first strategy is for the Islamic banking industry to adopt the VBI that is articulated under the Strategy Paper as a common vision for the industry.74 Banks are profit maximizers. A bank’s shareholders are claimants for its profits, and it is in their interest to maximize this profit.75 However, the envisioned financial landscape arising from the adoption of VBI will not be driven by short-term benefits to shareholders of the IBIs in the form of mere profits. The adoption of VBI focuses on long-term benefits with wider objectives, that is, generating profits and creating a positive impact on the people, planet and economy. The adoption of VBI therefore involves changing of mindsets on how value is being viewed by the IBIs and the Islamic finance industry. Thus, to be successful, the VBI must be accepted as a common vision by the Islamic finance industry.

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Strategies 3 and 6 are mainly to be implemented by the regulator. BNM, Strategy Paper on VBI, page 12. 75 Bikker and Bos (2005). 74

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Strategy 2

The second strategy is for IBIs together with the industry’s key stakeholders76 to mutually define the underpinning thrusts of VBI, which will create values and be the basis of collective action for the IBIs and the industry. The four underpinning thrusts of VBI identified under the Strategy Paper as preliminary guidance are: (i) (ii) (iii) (iv)

Entrepreneurial mindset; Community empowerment; Good self-governance; and Best conduct.

(i) Entrepreneurial mindset 77 Under the thrust of an entrepreneurial mindset IBIs are expected to have greater involvement in facilitating entrepreneurial activities. IBIs are to do this by providing a comprehensive set of products and services which support businesses and entrepreneurs. This includes financing and proactive support, such as advisory, market infrastructure and business network.78 The proactive support is provided to ensure that the business and entrepreneurs become successful. An example of such a comprehensive product and service can be seen in Agrobank’s Integrated Value-chain Financing Approach, as elaborated in the Implementation Guide for VBI.79 The financing model supports the whole chain of production relating to agriculture. The model finances the supply for the production,80 the agricultural production,81 trading and logistics,82 processing and manufacturing,83 up to assisting in identifying market distribution. The provision of the products and services can also be tailored to assist specific SDGs, for example schemes such as energy-efficient financing that helps businesses to reduce energy costs and manage their environmental footprint by providing financial solutions for energy-efficient equipment.84 The energy-efficient financing scheme may also include non-financial services

76

Based on the Strategy Paper, key stakeholders may refer to knowledge providers, advisory and thought leadership such as INCEIF and ICLIF, government bodies such as MOF and EPU, institutional investors, business ventures and customers. A public consultation on the Strategy Paper was also carried out where responses were received from financial institutions, talent institutions, consultants and individuals both local and international. 77 BNM, Strategy Paper on VBI, page 21. 78 BNM, Strategy Paper on VBI, page 21. 79 BNM, Implementation Guide on VBI, pages 21 and 22. 80 For example, financing product for seedlings preparation, nursery and fertilisers, land preparation. 81 For example, financing product for cultivation and harvesting. 82 For example, financing product for transportation, storage, building renovation. 83 For example, financing product for processing machine. 84 The Westpac Energy Efficient Financing scheme, BNM, Implementation Guide on VBI, page 23.

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where customers can choose to receive specialist advice to assist in designing energy-efficient projects.85 It is envisaged that this will not only create an opportunity for IBIs to develop and produce innovative products and services but also to better understand the challenges that businesses and entrepreneurs face apart from credit issues.86 The thrust of an entrepreneurial mindset will create a competitive edge for IBIs. It will also steer IBIs to add positive value to the economy, people and environment supporting sustainable development, particularly SDGs 1,87 8,88 989 and 12.90 (ii) Community empowerment 91 Under the thrust of community empowerment, IBIs are expected to empower communities by providing financial solutions that create positive socioeconomic impact.92 Balancing between commercial and social considerations is core to navigating IBIs strategic decisions. Through the thrust of community empowerment, the opportunity for IBIs to give back to society is created beyond corporate social responsibility activities.93 The Strategy Paper elaborates that this can be achieved through development, funding and implementation of effective solutions for issues faced by the communities which aim to create positive impact on the communities.94 Therefore, to integrate the thrust of community empowerment into their business, IBIs will first need to understand the challenges and needs of the community in which they operate. IBIs will then need to develop and introduce products and services that can assist and benefit the community. Similar to the thrust of entrepreneurial mindset, this will create a competitive edge for IBIs. In addition, consistent with the end objective of VBI, this positively impacts the community and can support the achievement of SDG 195 and 8.96

85

The Westpact Energy Efficient Financing scheme, BNM, Implementation Guide on VBI, page 23. 86 BNM, Strategy Paper on VBI, page 21. 87 Goal 1 is on ending poverty in all its forms everywhere. 88 Goal 8 is on promoting sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all. 89 Goal 9 is on building resilient infrastructure, promote inclusive and sustainable industrialization and foster innovation. 90 Goal 12 is on ensuring sustainable consumption and production patterns. 91 BNM, Strategy Paper on VBI, page 22. 92 BNM, Strategy Paper on VBI, page 22. 93 It is said to be beyond corporate social responsibility because under the VBI, it is one of the underlying thrust of VBI and IBIs are required to prepare an implementation plan and measurable key performance indicators on their initiatives to implement this underlying thrust. 94 BNM, Strategy Paper on VBI, page 22. 95 SDG 1 is to end poverty in all its forms everywhere. 96 SDG 8 is to promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all.

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Where the thrust of entrepreneurial mindset and community development focused on businesses, entrepreneurship and the community, respectively, the remaining underpinning thrusts of VBI, which are good self-governance and best conduct, involve the internal operations of the IBIs themselves. (iii) Good self-governance 97 The thrust of good self-governance focuses on the IBIs’ governance. There are two components to this thrust. The first component is inclusive governance which requires IBIs to proactively engage their stakeholders in key decisionmaking process. IBIs are expected to engage not only their shareholders but also extended stakeholders. 98 The Strategy Paper did not elaborate specifically on who these extended stakeholders are but states that this includes the IBIs’ customers and investors.99 The rational for this holistic engagement is to provide IBIs with better perspectives, insights and expectations that will determine or influence the outcome of their business plans.100 The Implementation Guide for VBI went further to state that the rationale of conducting proactive engagement with multi-stakeholders is to leverage on technical competencies, skills and infrastructure that are critical but not owned by the IBIs and to attract, engage and retain the right human resource for VBI.101 Based on this understanding, the engagement may also be undertaken with non-government organizations, the government, regulators and industry experts depending on the circumstances. The second component of this thrust is self-governance. It entails IBIs to inculcate a culture of self-discipline within its operations and practices.102 The Implementation Guide for VBI elaborated that the inculcation of a culture of self-discipline should begin from the Board of Directors and senior management of the IBIs.103 They are to perform appropriately, according to what is specified by Shariah, in all situations, including where no prevalent regulation is set in place. This behaviour should cascade down to the IBIs’ operations and reflected in its offerings.104 By embracing the culture of self-discipline, there should be greater accountability and integrity of the IBIs driven by a common moral outlook for the ultimate good instead of primarily based on regulations. IBIs should develop a framework and transparent disclosure of the roles, responsibilities and accountability of those involved in the implementation of

97

BNM, Strategy Paper on VBI, page 23. BNM, Strategy Paper on VBI, page 23. 99 BNM, Strategy Paper on VBI, page 23. 100 BNM, Strategy Paper on VBI. 101 BNM, Implementation Guide on VBI, at page 30. 102 BNM, Strategy Paper on VBI, page 13. 103 BNM, Implementation Guide on VBI, page 10. 104 BNM, Implementation Guide on VBI, page 10. 98

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the VBI.105 This is to reinforce the approach that the culture of self-discipline must begin from the top and to incentivise leaders to take greater ownership in inculcating a positive culture in the IBIs. In a conceptual study undertaken by Ahmad Yani Ismail,106 which highlighted the issues and challenges faced by the industry players in realizing the initiative of VBI, the researchers were of the view that for the VBI initiative to be successfully implemented, IBIs’ shareholders need to change their mindset from merely profit maximization and compliance towards creating a long-term value for the economy, people and environment. This entails not only the banks’ shareholders, but all of the Islamic banking workforce to be aware and have sufficient knowledge about the VBI and the SDGs. They were of the view that relevant education concerning the SDGs and VBI initiatives should be undertaken. Similarly, the statement of commitment of GIFF 2018107 stated that one of the immediate action plans for VBI is for the bank staff to be trained with the right DNA print. There is a real need for capacity building right from the bank’s board of directors to the management committee and the frontlines. Participants of GIFF 2018 were of the view that it is important for shareholders, senior management as well as investors coming on board to embrace wholly the sustainable policies. It is submitted that awareness, knowledge and capacity building on the SDGs and VBI are important in realizing the initiative of the VBI, since this can assist in creating within the IBIs a culture that embraces the value propositions of VBI. Once, this culture is cultivated within the IBIs, it is expected that the IBIs would proactively act in line with the value propositions of VBI with minimal regulatory intervention as envisaged under the underpinning thrust of VBI on self-governance. (iv) Best conduct108 The Strategy Paper states that this thrust refers to the IBIs’ treatment towards its stakeholders, that is, its customers, employees, public and investors.109 This thrust requires IBIs to adopt practices that improve the IBIs’ offerings, processes and treatments toward their stakeholders to enhance their satisfaction. An example that demonstrates the best conduct, according to the Strategy Paper is safeguarding the rights of stakeholders through fair and transparent

105

BNM has issued a discussion paper on Responsibility Mapping in February 2018. It focused on the role of individuals holding leadership positions in financial institutions to promote actions and decisions in areas under their purview that are consistent with good governance and sound risk management. See BNM (2019c) Responsibility Mapping Exposure Draft document BNM/RH/ED 028-13 retrieved from https://www.bnm.gov.my/documents/20124/52006/ed_responsibility+map ping_dec2019.pdf/73187c28-8465-fdd2-7fcf-0ddefa2e8bb2?t=1578645662143 106 Ismail et al. (2020). 107 Masryef Management House (2016). 108 BNM, Strategy Paper on VBI, page 24. 109 BNM, Strategy Paper on VBI, page 24, footnote 13.

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disclosure for all transactions and decisions by the IBIs. This is important to avoid any misunderstanding by the stakeholders, which can lead to disputes. It is clear from the above that integration of the four underpinning thrust by IBIs into their practices, conduct, offerings and operations can give IBIs its own branding and distinctiveness by providing wholesome finance services which are not only Shariah-compliant but also fulfil the objectives of Shariah. The underlying thrust of entrepreneurial mindset and community empowerment adopted by IBIs will positively impact businesses, entrepreneurs and the community. Under these two underlying thrusts, IBIs are expected to consider not only profitability and Shariah compliance but how their products and offerings can facilitate and support businesses and entrepreneurs and provide solutions to empower the community. The underlying thrust of good selfgovernance and best conduct on the other hand emphasizes on improving the way in which IBIs conduct their business by requiring consultations with stakeholders when making key decisions and disclosure of all important information to them. The requirement to consult stakeholders can assist IBIs to make decisions which are consistent with its Shariah proposition to do good by generating positive impact to the economy, environment and community and not do harm as propagated under the VBI. Transparency will also provide oversight that IBIs conform to the VBI’s aspiration. Thus, both these underpinning thrusts will assist IBIs in supporting sustainable development through VBI. 2.3.3

Strategy 4

As mentioned earlier in the introduction to this chapter, BNM envisioned a two-pronged approach in facilitating VBI adoption by IBIs, that is, by creating an enabling environment through regulatory guidance and by enhancing the quality of transparency to trigger intended stakeholder activism. Under the VBI framework, enhancing the quality of transparency takes the form of strategy 4, that is, enhanced disclosure of the IBIs’ intention to adopt VBI.110 This is where IBIs are expected to make disclosures through the Corporate Value-Intent (CVI) followed by disclosure of any additional information or data that goes beyond the CVI.111 (i) CVI The CVI is the minimum transparency expected of IBI that decides to adopt the VBI.112 Under the CVI, IBIs are to disclose their intent to adopt the VBI by establishing and declaring the IBIs’ specific intent and commitment. This is referred to as “value-intent” under the Implementation Guide for VBI.113 It is 110

BNM, Strategy Paper on VBI, page 28. BNM, Strategy Paper on VBI, page 28. 112 BNK, Strategy Paper on VBI, page 28. 113 BNM, Implementation Guide on VBI, page 8. 111

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akin to a mission statement. The Implementation Guide for VBI further elaborates that this intent and commitment must be premised on Shariah’s intended outcome, which is to prevent harm and enable all to attain benefits.114 In achieving this intent and commitment in the CVI, IBIs may adopt initiatives such as the Equator Principles that consider environmental and social risks in project finance and the UN Principles for Responsible Investment that considers ESG impacts in investment appraisals as long as these initiatives are not inconsistent with Shariah.115 Besides the disclosure of the value-intent, IBIs are also expected to formulate implementation strategies to support the CVI, which must be integrated with the IBI’s business focus and operations.116 Each implementation strategy must be accompanied by measurable KPIs. IBI must assess the impact of these implementation strategies, identify any implementation gaps and challenges and review their current business strategies and performance to facilitate the smooth implementation of these strategies. This assessment on the progression of the implementation strategy are to be disclosed by the IBIs to its stakeholders. It is referred to as “impact reporting” under the Implementation Guide for VBI.117 Thus, under the CVI two disclosures will be made by the IBIs, that is, its “value-intent” and the “impact reporting”. The Strategy Paper did not elaborate on the manner of disclosure for impact reporting. However, the Implementation Guide for VBI provided guidance to IBIs that impact-driven performance reporting covers both financial and non-financial aspects and is aimed at facilitating stakeholders’ understanding of the IBIs’ contribution beyond numerical reporting.118 It can take the form of an Integrated Reporting, Sustainability

For example, Maybank Islamic Bank Berhad’s sustainability statement 2020 states “In our pursuit to become a Global leader in Islamic Finance, our growth has been premised upon delivering a sustainable and value-driven financial solution, not only to our customer, but also to the communities and environment we operate in. The premise reflects the intrinsic values of Islamic finance that aims to nurture and preserve the following five essentials as articulated by the Maqasid al Shariah—Faith, Life, Progeny, Intellect, Wealth. In striving to achieve this, our commitment unfolds into the following promises: 114

•

We place trust and trustworthiness as an essential attribute in our business relationships and in fulfilling our obligations to Humanise Financial Services • We constantly undertake responsive measures in the prevention, eradication and mitigation of harm against the environment • We continuously promote the creation of sustainable economic, social and environmental value.”

Retrieve from https://www.maybank.com/iwov-resources/pdf/islamic/about-us/MIB_Sustain ability-Statement2020.pdf on 20 October 2021. 115 BNM, Implementation Guide on VBI, page 9. 116 BNM, Implementation Guide on VBI, page 9. 117 BNM, Implementation Guide on VBI, page 9. 118 BNM, Implementation Guide on VBI, page 24.

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Report, a dedicated VBI report or a section in the IBIs’ Financial Report accessible vide the IBIs’ website.119 (ii) Additional information or data beyond the CVI. In addition to the CVI, IBIs may also disclose additional information or data beyond the CVI.120 The Strategy Paper did not elaborate on the examples of this additional information or data. However, based on the Implementation Guide for VBI, an example of this additional information may include information or insights into real sectors that the IBI serves, such as the sector, products and services offered and the sector’s recent issues and updates relating to the VBI implementation.121 2.3.4

Strategy 5

Under strategy 5, IBIs that adopt the VBI must also undertake a self-assessment of the institution’s overall performance in advancing the VBI agenda. The selfassessment takes the form of a VBI Scorecard.122 It is envisaged in the future that IBIs will disclose their VBI score and the information they submitted for the VBI Scorecard assessment.123 This will then be another form of enhanced quality transparency by IBIs. 1. Assessment Under the VBI Scorecard The assessment under the VBI Scorecard is based on two components124 as follows: (a) Assessment of performance (outcomes) of IBIs from the aspect of: (i) financial sustainability, (ii) level of support to the real economy; and (iii) value creation for the economy, community and development; (b) Assessment of existing and future efforts of IBIs in developing and executing relevant action plans to deliver the commitment on VBI agenda.

Assessment of Performance (Outcomes) 1. Assessment of performance (outcome) from the financial sustainability aspect125

119

BNM, Implementation Guide on VBI. BNM, Strategy Paper on VBI, page 28. 121 BNM, Implementation Guide on VBI, page 25. 122 The VBI Scorecard is developed by Bank Negara Malaysia in collaboration with the IBIs (led by members of the COP) and the Global Alliance for Banking on Values. 123 BNM, VBI Scorecard Consultative Document, page 15. 124 BNM, VBI Scorecard Consultative Document, page 5. 125 BNM, VBI Scorecard Consultative Document, page 7. 120

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To be able to generate a positive impact on the economy, community and environment, as well as profits for shareholders, IBIs need to be resilient and have long-term capabilities and capacities to do so. Assessment of IBIs’ performance in relation to financial sustainability focuses on the IBIs’ resilience, capabilities and capacities by evaluating IBIs’ (a) (b) (c) (d)

profitability: return of assets; capital strength: equity to total assets; asset quality: impairment ratio; and liquidity position: client funding to total assets ratio.

2. Assessment of performance (outcome) on the extent IBIs’ intermediation activities support the real economy.126 This assessment involves the evaluation of the proportion of total financial intermediation that directly supports the overall economy and community at large and the level of income generated from such financial intermediation activities. The assessment focuses on the purpose of the transaction. 3. Assessment of performance (outcome) from the aspect of value creation for wider stakeholders. 127 This assessment evaluates to what extent the IBIs’ financial intermediation has created positive and sustainable impacts on the economy, community and environment in delivering the Shariah intentions consistent with the VBI aspirations. The evaluation focuses on the following: (a) proportion of total intermediation that has created positive and sustainable impacts on the economy, community and environment; (b) the efforts of the IBIs in identifying, measuring and monitoring positive and negative impacts of the proposed transaction; (c) for transactions that result in negative impacts, the availability of effective mitigation that manage the negative impacts; (d) the degree of consistency between the actual impacts of intermediation activities with the IBIs’ CVI. For purposes of this assessment, the VBI Scorecard explores the use of references issued by local or international authorities such as SDGs by the UN and the environmental and social risk by industry sector from the International Finance Corporation (IFC). Assessment on Efforts of IBIs in Developing and Executing Relevant Action Plans to Deliver the Commitment on VBI Agenda128 This assessment evaluates the IBIs’ efforts in integrating the key under pinning thrusts of VBI within the overall banking operations and its offerings. The evaluation

126

BNM, VBI Scorecard Consultative Document, page 8. BNM, VBI Scorecard Consultative Document, page 10. 128 BNM, VBI Scorecard Consultative Document, page 12. 127

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also covers future plans of the IBIs such as products and projects in the pipeline. Among others, IBIs need to provide information on how the Board of Directors and senior management are actively promoting VBI internally and externally; the current institutional infrastructure support to VBI and commitment from key shareholders; features of banking products and services that demonstrate key underpinning thrust of VBI; adoption of best practices relating to products and services which create better value to customers; risk management framework that identifies positive impacts and addresses negative impacts arising from proposed transactions; and measures on performance reporting. 2. Score and Disclosure The score of the VBI Scorecard reflects an IBI’s progression in advancing the VBI agenda. The score ranges as follows: (a) Initiating. This score is given where there are evidence based on the assessments above that there is transparent commitment and visible advocacy of VBI adoption. (b) Emerging. This score is given where there are evidence based on the assessments above that the IBI’s banking practices, products and services demonstrate principles of VBI. (c) Engaged. This score is given where there are evidence based on the assessment above that active stakeholder activism has been triggered. (d) Established. This is the highest score and is given where there are evidence based on the assessment above that there is the total change in the IBI’s overall banking business operation, culture and behaviour, proactive behaviour by industry players and active stakeholders activism.129 The VBI Scorecard assessment is to be carried out annually.130 IBIs will adopt the VBI Scorecard in two phases which are Phase 1 where the VBI Scorecard is used internally as a management tool to assist in planning process and self-assessment of performance and progression in implementing VBI; followed by Phase 2, where it is envisaged that the data and information captured in the VBI Scorecard will be made available to the public to allow for wider stakeholders to analyse and compare performance of the IBIs.131 In the workshop on Convergence of Islamic and Sustainable Finance organized by SOAS,132 several participants were of the view that the imposition of the scorecard could lead to a similar phenomenon to ‘greenwashing’ where a product or service is claimed to be more sustainable than it really is. Some participants also felt that the scorecard is superfluous as investors were said to look to indexes when

129

BNM, VBI Scorecard Consultative Document, page 14. BNM, VBI Scorecard Consultative Document, page 15. 131 BNM, VBI Scorecard Consultative Document, page 4. The implementation of Phase 2 will be determined by BNM and members of the COP, depending on the level of readiness among the industry players as well as feedback from other stakeholders. 132 Baker (2019). 130

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making decisions about where to invest. They were of the view that IFIs would gain increased consumer and investor faith in their sustainability if they were to try and join indexes such as the FTSE Shariah Index and the FTSE4GOOD Index or organizations such as the European Federation of Ethical and Alternative Banks. Mahyudin et al.133 in their article that discussed issues, trends and challenges for Islamic banks in Malaysia towards satisfying various stakeholders’ needs through the implementation of VBI, raised two challenges with regard to the scorecard. The first challenge is the identification of relevant indicators. They were of the view that choosing an appropriate performance indicator for Islamic banks is crucial to differentiate the true essence of Islamic banks from their conventional counterpart. This is supported by Ghayad,134 who argued that a different method should be introduced to measure the performance of an Islamic bank as the level of objectives is divergent from a conventional bank. The second challenge is the Islamic bank’s readiness to disclose sufficient information for public assessment. Disclosing information in the public report requires more work and involves more cost to the banks. As mentioned earlier, IBIs will implement the scorecard by way of phased-in adoption. In Phase 1, the scorecard will only be for internal use. Thus, it is more of a management tool for the IBIs for their VBI implementation as it captures the commitment, implementation strategy and KPIs of the IBIs in advancing the VBI strategy. It is envisaged that in Phase 2, the scorecard will be available to the investors. The scorecard details how and to what extent VBI has been integrated into the IBIs. Thus, it is argued that the scorecard provides an alternative or additional source investors can refer to when making investment decisions. Nonetheless, it is agreed that relevant indicators will have to be established to measure the performance and efforts of the IBI as the VBI initiative is different from its conventional counterpart due to the Shariah perspective. It is also agreed that the assessment under the scorecard will require a trained VBI team together with new information to be gathered and may incur additional costs on the IBIs. Thus, the VBI Implementation Guide provides that the adoption of VBI by IBIs is dependent on the level of willingness of the IBIs and their state of readiness.135

3 VBIAF 3.1

Introduction

The adoption of VBI extends Islamic finance from Shariah compliance to delivering the intended outcome of Shariah through practices, conduct and offerings that generate positive and sustainable impact on the wider stakeholders, that is, the society, environment and economy at large. Thus, IBIs have to review their current

133

Mahyudin and Rosman (2020). Ghayad (2008). 135 BNM, Implementation Guide on VBI, page 5. 134

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risk assessment and management system so that it aligns with this commitment.136 In light of this, BNM recommends IBIs to adopt the VBIAF which is a risk assessment and management system that integrates ESG considerations in the provision of financing and related advisory services and investment activities to generate a positive and sustainable impact on the economy, community and environment. To facilitate and guide IBIs to adopt the VBIAF, BNM issued a guidance document on VBIAF on 1 November 2019. Whilst VBI only formally applies to IBIs, BNM has stated that the VBIAF framework has universal application for FIs seeking to reflect ESG considerations in their governance, business strategy and operations, reporting and risk management systems.137 Based on the guidance document, a VBIAF should: (i) Be built on principles that guide the IBI’s operationalization of the VBI commitment as described in its CVI.138 The set of principles identified by the guidance document is attainment of benefit and prevention of harm,139 integration of Shariah in the IBIs’ business strategy and operational design,140 fairness and transparency141 and constructive and inclusive collaboration of stakeholders.142 (ii) Be supported by an enhanced governance process.143 (iii) Expands credit risk management practices to include impact-based risk management.144

3.2

Enhanced Governance Process

The guidance document elaborates that the best governance practices would include enhanced accountability on the Board of Directors of the VBI commitment145;

136

The Implementation Guide to VBI at page 16 elaborates that one of the example of best practices to enhance the risk management system is having an Environment and Social Risk Management which integrates environment and social impact assessment throughout the cycle of risk management. 137 CCPT, para 4.1, page 6. 138 BNM, VBIAF Guidance document, page 4. 139 Under this principle any financing or investment activities are to be evaluated by the benefit and harm that can arise from the financing and investment activities. The IBIs are to identify their approach on how this is to be evaluated. The VBIAF guidance document states that IBIs should be guided by its CVI, national strategic interest and national sustainable development goals. IBIs should also aspire to meet the goals and objectives of international standards such as the SDGs, the Paris Agreement, the UN Business and Human Rights Framework and other UN agreements. 140 BNM, VBIAF Guidance document, page 8. 141 BNM, VBIAF Guidance document, page 9. 142 BNM, VBIAF Guidance document, page 11. 143 BNM, VBIAF Guidance document, page 13. 144 BNM, VBIAF Guidance document, page 21. 145 BNM, VBIAF Guidance document, page 13.

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integration of Shariah governance146; integration of VBI responsibilities and strategies across all relevant functions of the IBIs’ financing and investment activities, that is, risk management, compliance and audit147; and a culture of selfgovernance.148 In the workshop Convergence of Islamic and Sustainable Finance,149 organized by SOAS, in terms of individual IFIs, participants felt that the VBI process should be separate from the Shariah audit process carried out by the Shariah Supervisory Boards150 notwithstanding that VBI is premised on the objectives of Shariah. They felt that it is the responsibility of the management to ensure that products categorized as Shariah-compliant by the Shariah Supervisory Boards are used in a sustainable manner. They felt that VBI concerns should not prompt the Shariah Supervisory Boards to disallow a transaction that otherwise complied with Shariah. The participant felt that the Shariah Supervisory Boards should not be leading the internal assessment as they were of this view that VBI assessments necessarily include the assessment of different sources of data than Shariah scholars are used to, ranging from environmental impact assessments to labour and human rights reports. Thus, a two-tier system was envisaged, the first tier on the Shariah compliance of the product or transaction determined by the Shariah Supervisory Boards, followed by the second tier assessment in which a committee assesses VBI elements with the necessary expertise. In the report by ISRA151 and UKIFC,152 Shariah scholars discussed their views and perceptions on the role that needs to be played by Shariah scholars in implementing the SDGs. There were two divergent views whereby a number of

146

BNM, VBIAF Guidance document, page 8. BNM, VBIAF Guidance document, page 16. 148 BNM, VBIAF Guidance document, page 19. 149 Baker (2019). 150 The Accounting and Auditing Organization of Islamic Financial Institution (AAOIFI) under its Governance Standard for IFI No. 1 on Shariah Supervisory Board (Appointment, Composition and Report) effective from 1 January 1999 defines the Shariah Supervisory Board as “an independent body of specialized jurist in fiqh al mualamat (Islamic commercial jurisprudence) that is entrusted with the duty of directing, reviewing and supervising the activities of the IFI in order to ensure that they are in compliance with Islamic Shariah rules and principles.” It is acknowledged that for Shariah compliance some jurisdiction, for example Malaysia adopts a two tiered governance structure whilst others may have a single tier governance structure. In the context of the discussion in the workshop by SOAS, the Shariah Supervisory Board refers to the role of the Shariah Committee in the IB and not the Shariah Advisory Council. 151 International Shariah Research Academy for Islamic Finance (ISRA) was established in 2008 by BNM as an Islamic finance and Shariah-related research institution. It is recognized globally as a leading global premier research academy in the Islamic finance industry. See https://www.isra.my 152 Islamic Finance Council UK (UKIFC) launched in 2005 is a specialise, not-for-profit, advisory and development body focused on promoting and enhancing the global Islamic finance industry. See https://www.ukifc.com/about/story/; Fares Djafri and Younes Soualhi (October, 2021) Islamic Finance: Shariah and the SDGs Thought leadership series Part 4. Report produced by ISRA and UKIFC. 147

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Shariah scholars felt that the role of Shariah scholars should not be limited to the approval of the Shariah compliance of the product but should instead extend to include assessment on the sustainability values of the product. Scholars should come up with new innovative products that are not only Shariah-compliant and profitable to IBIs but would help society to achieve and reach sustainability goals. Other interviewees noted that Shariah scholars are not privileged to make such business decisions at the IBIs, and the business decision-making should rest with the Board of Directors. They are of the view that Shariah scholars can play a complementary role but not a primary role in the assessment. They may be involved in the ongoing review of the product or transaction, but it is not the sole role of the Shariah committee to decide whether a product or transaction supports sustainable development. On the other hand, according to Hasan et al.153 the Shariah committee must be involved in the initiative of VBI. The Shariah committee’s role should not be constrained to ensuring Shariah compliance but should be engaged in determining the direction of the bank, including its product offerings and be involved in oversight functions to ensure that the strategies and direction of IBIs achieve the objectives of Shariah. It was opined that Shariah committee has the authority to issue decisions related to VBI and to persuade management to execute the VBI initiatives throughout the IBIs’ operations, management and product offerings. The Shariah committee should consider beyond Shariah compliance of riba, gharar and maysir but consider VBI parameters when screening and approving products. Besides proposing and pushing management for VBI initiatives, the researchers were also of the view that the Shariah committee should be directly involved in the discussion or brainstorming session with management on VBI initiatives and given a chance to lead certain VBI projects. The committee should also have a role in monitoring the VBI initiative in the IBI and leading awareness and education programmes related to VBI for employees of IBIs. The VBI seeks to deliver the objectives of Shariah. It seeks to do this through practices, conduct and offerings that generate positive and sustainable impact to the economy, community and environment. Therefore, in adopting the VBI initiative an IBI has to ensure two things, that is, its practices, conduct and offerings are not only Shariah-compliant but also generate positive and sustainable impact to the economy, community and environment to achieve the ultimate aim of VBI which is the objectives of Shariah. Section 30(1) of the IFSA provides, “A licensed person shall establish a Shariah committee for purposes of advising the licensed person in ensuring its business, affairs and activities comply with Shariah.” As such, the Shariah committee must be involved in the initiatives of VBI, namely, to advise the IBI on the elements of compliance to Shariah, of the IBIs’ practices, conduct and offerings. This would be in line with the objectives of the establishment of a Shariah committee as provided under s.30(1) of the IFSA.

153

Hassan et al. (2018b).

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To ensure that its practices, conduct and offerings generate positive and sustainable impact to the economy, community and environment to achieve the objectives of Shariah the risk assessment by the IBIs must extend beyond credit risk and Shariah non-compliance risk. It has to include an impact-based assessment. The impact-based assessment is in the form of the VBIAF. The guidance document on VBIAF stated that one of the key principles to the design of VBIAF is the integration of Shariah,154 and this entails an integration of Shariah which extends beyond a compliance approach to affect real change in behaviour and culture of the IFI towards embracing the VBI strategy.155 It goes on to state that the design of policies and procedures and capacity development should aim to enable a Shariah mindset which focuses on impact rather than a Shariah checklist.156 The guidance document on VBIAF also states that the VBI strategy necessitates a more involved Shariah governance even at the development of the IFIs’ business and risk strategies.157 This is emphasized by the guidance document imposed on the board to determine the roles and responsibilities of the Shariah governance functions in respect of the VBIAF.158 The guidance document goes on to state that IFIs need to consider the most effective governance setup that ensures timely and appropriate information on Shariah perspective is obtained during the formulation of the business and risk strategies.159 It also stated that when implementing the VBIAF, IFIs need to coordinate responses from credit risk, including impact-based criteria and Shariah perspectives for decision-making purposes.160 An example given is when the IBI is assessing whether a product or offering is a daruriyyat, hajiyyat or tahsiniyyat.161 Therefore, these requirements in the guidance document reflect that the Shariah committee is to be involved in the VBIAF. BNM has issued the Shariah Governance Framework 2010, which is superseded by the Shariah Governance Policy Document 2019, to strengthen the structures and processes adopted by IBIs to ensure compliance with Shariah principles. It sets out the oversight accountabilities of the board, Shariah committee and other key organs involved in ensuring the execution of Shariah compliance. S.30(1) of the IFSA

154

BNM, VBIAF Guidance document, paragraph 9, page 8. BNM, VBIAF Guidance document, paragraph 10, page 8. 156 BNM, VBIAF Guidance document, paragraph 11, page 8. 157 BNM, VBIAF Guidance document, paragraph 26, page 15. 158 BNM, VBIAF Guidance document, paragraph 26, page 15. 159 BNM, VBIAF Guidance document, paragraph 27, page 15. 160 BNM, VBIAF Guidance document, paragraph 28, page 15. 161 The objectives of Shariah are divided into two main categories which are the general objectives and specific objectives. The general objectives are further divided into three sub-categories which are the daruriyyah, hajiyyah and tahsiniyyah. Daruriyyah is defined as interests of lives which people essentially depend upon. If they are ignored, then coherence and order cannot be established, and chaos and disorder will prevail in this world and loss in the hereafter. Hjiyyah are interest that supplement the essential interest. It refers to interests if neglected leads to hardship but not to total disruption of the normal order of life. Tahsiniyyah refers to interests whose realization leads to refinement and perfection in the customs and conduct of people at all levels of achievement. 155

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mandates the Shariah committee to advice the IBIs on Shariah compliance with respect to its business, affairs and activities. It is clear that the focus of the governance framework, policy document and IFSA is on Shariah compliance. As such, it is submitted that the Shariah committee’s involvement in the VBI and the VBIAF must be within the mandate that is provided to it under section 30(1) of the IFSA and parameters of the governance framework and policy document. Bearing in mind that the Shariah committee’s mandate under s.30(1) of the IFSA is advising on Shariah compliance, it is argued that direct involvement in impact-based risk identification, measurement, management and mitigation is beyond the mandate of the Shariah committee as provided by the IFSA. Furthermore, it will involve the analysis of data which the Shariah committee may not be familiar with. It is also questionable whether the Shariah committee should have a part or the extent of involvement the Shariah committee should have, in the integration of Shariah which focuses on impact and beyond a compliance approach. The gap between expectations in the VBI and VBIAF and the mandate of the Shariah committee under the IFSA has to be addressed to assists IBIs to determine the roles and responsibilities of the Shariah committee in VBI and VBIAF.

3.3

Impact-Based Risk Management

In line with the principle of attainment of benefit and prevention of harm, impactbased risk management considers the implication of the financing and investment activities funded by the IBIs based on its CVI and the broader goal of a sustainable and resilient future. For example, IBIs is expected to assess the negative and positive impacts of their financing and investment activities on the environment and the community. In adopting impact-based risk management, an IBI needs to establish the following: (i) A comprehensive approach to identify and categorize negative and positive impacts of the IBIs’ financing or investment activities (Impact-based risk identification);162 (ii) An approach for a complete and accurate understanding and measurement of the risk associated with the financing and investment activities (Impact-based risk measurement);163 (iii) A comprehensive impact-based risk management and mitigation strategy;164 and (iv) A robust impact-based risk monitoring and reporting.165

162

BNM, VBIAF Guidance document, page 24. BNM, VBIAF Guidance document, page 31. 164 BNM, VBIAF Guidance document, page 36. 165 BNM, VBIAF Guidance document, page 38. 163

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Impact-Based Risk Identification

Impact-based risk identification allows the IBI to identify the negative impacts of a financing or investment activity which requires mitigation and determine the appropriate risk management tool to mitigate the negative impact.166 For example, the positive impact of an IBI’s customer running a business of palm oil cultivation and manufacturing is that it is an important contributor towards export earnings, job creation and alleviation of poverty among rural communities in Malaysia. On the other hand, if the customer does not manage its business properly it can result in biodiversity loss, deforestation or illegal logging. Thus, IBIs must assess the positive and negative impacts of the financing or investment activities that the IBI intent to undertake with the customer in relation to the customer’s business activities. For purposes of identifying and categorizing the impact of a financing or investment activity, the guidance document on VBIAF provides that IBIs should: • Develop tools and methodologies to understand if a customer in a particular industry is at risk of causing negative impacts.167 The IBI must consider real and not perceived impact risk. In order to do this IBIs may establish a key impactbased risk category.168 To illustrate, reference is made to the VBIAF Sectoral Guide: Palm Oil169 which provides the key impact-based risk categories in the palm oil sector in Malaysia. The key impact-based risk is categorized based on the ESG risk aspect. For the environmental (E) category, one of the potential risks identified is biodiversity loss and deforestation. This risk can arise from unsustainable production practices and encroachment into forest reserves. For the social (S) category, one of the potential risk identified is risk relating to labour rights and working conditions. This risk can arise from prosecution or fines for poor working and living conditions. For the governance (G) category, one of the potential risk identified is risk relating to governance mechanism. This risk can be transmitted from lack of strategic planning on sustainability. The guidance document on VBIAF also provides some examples of regulations and standards (local and international) that the IBI can utilize to identify material negative impacts170 to assess whether a client is at risk of causing those negative impacts. To illustrate, the Environmental Quality (Prescribed Activities) 166

BNM, VBIAF Guidance document, page 24. BNM, VBIAF Guidance document, page 25. 168 BNM, VBIAF Guidance document, page 25, footnote 52. 169 VBIAF, Sectoral Guide: Palm Oil issued on 31 March 2021. 170 Some international standard examples are the International Finance Corporation (IFC) Performance Standards and the World Bank Group Environmental, Health and Safety (EHS) Guidelines. The EHS Guidelines contain the performance levels and measures that are normally acceptable to the World Bank Group. The World Bank Group requires borrowers/clients to apply the relevant levels or measures of the EHS Guidelines. When host country regulations differ from the levels and measures presented in the EHS Guidelines, projects will be required to achieve whichever is more stringent. See https://www.ifc.org/wps/wcm/connect/topics_ext_content/ifc_external_corporate_ site/sustainability-at-ifc/policies-standards/ehs-guidelines 167

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(Environmental Impact Assessment) Order 2015 specifies a list of activities requiring an environmental impact assessment (EIA) to be conducted. Where financing is to be given to a client undertaking any of the activities listed in the Environmental Quality (Prescribed Activities) (Environmental Impact Assessment) Order 2015, the IBI can be guided by the EIA in assessing the positive and negative impact of the specific activity. • Develop sector and issue-specific policies to clearly state the IBI’s requirements for a customer’s performance. The sector and issue-specific policies are to contain requirements consistent with national policies/agenda/regulations,171 including where possible, referencing international standards,172 best practice frameworks and robust independent certification and verification. • Identify during the customer onboarding process gaps in the customer’s performance against the IBI’s sector and issue-specific policies. • Develop an exclusion list of sectors in which the IBI should not finance or invest.173 Where the non-financing or non-investing in that sector can cause a severe negative impact on the economy of the country, the IBI should consider mitigation strategies to assist the customer in transitioning towards sustainable practices.

3.3.2

Impact-Based Risk Measurement

Following the impact-based risk identification, IBI then must develop a mechanism to measure the impact-based risk and assign a risk level or score to the customer. This involves assessing the customer’s ability to meet the requirements of the IBI’s sector and issue-specific policies mentioned above. The customer is assessed by examining its present commitment, capacity and track record. The assessment is to be made at the customer level174 and transaction level.175 Based on the results of both assessments the customer can be scored as unacceptable risk, high risk, medium risk and low risk.176 Low-risk customers can be automatically approved,

171

For example, the National Policy on Biological Diversity, Employment Act 1955 and its regulations, Child and Young Persons (Employment) Act 1966 and its regulations. 172 For example, the Paris Agreement. 173 For example, activities that can cause biodiversity loss or pollution. 174 A customer may have limited management procedures to mitigate E&S impacts, limited reporting on E&S performance and has a poor track record. This customer may be categories as “High Risk”. 175 For example, the VBIAF Sector Guide: Palm Oil at page 20 illustrates that a transaction that has not obtained a valid land term and planning permission can be categorized as “Unacceptable/High Risk” whereas a transaction with credible evidence of preliminary approval/in progress status from relevant authorities can be categorized as “Moderate Risk”. Where there are valid documents from relevant authorities, the transaction is categorized as “Low Risk”. 176 BNM, VBIAF Guidance document, Table 8 and 9 at pages 33 and 34.

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medium-risk customers can be approved with conditions and high-risk customers should be escalated to senior levels for approval with conditions.177 The guidance document elaborates that IBIs may rely on independent, third-party certification standards to measure impact.178

3.3.3

Impact-Based Risk Management and Mitigation

IBIs must also develop a comprehensive set of impact-based risk management and mitigation strategies that is effective in minimizing financial and reputational impacts on the IBI.179 Based on the risk level or score assigned to the customer, the IBI identifies conditions for approval, covenants that the client needs to abide by and may include penalties in the case of non-compliance.180 The guiding document on VBIAF also states that the IBIs needs to develop a robust customer-nurturing strategy to effectively assist the customer in adopting and enhancing its sustainability practices and deter the customer from failing to comply with the IBI’s impactbased terms and conditions.181 IBIs are also to have an effective exit mechanism if the customer fails to meet the conditions, abide by the covenant or adhere to remedial action plans within the customer’s control.182

3.3.4

Impact-Based Risk Monitoring and Reporting

Finally, IBIs should establish a robust monitoring and reporting process to identify changes in impact-based risk and to ensure timely escalation to the Board of Directors and senior management.183 Impact-based risk monitoring involves the IBI monitoring the customer’s impactbased risk periodically as part of periodic financing or investment reviews, when previously agreed remedial action is due, or/and when there are material changes to the transaction. IBI may also establish an appropriate complaint mechanism in relation to IBI’s customers and the process that the IBI will take to address the complaint.184

177

BNM, VBIAF Guidance document, paragraph 54, page 34. For example, in palm oil certification issued by the Malaysian Standards Palm Oil and Roundtable on Sustainable Palm Oil. See Guidance document on VBIAF at page 35. 179 BNM, VBIAF Guidance document, page 36 180 BNM, VBIAF Guidance document, page 37. 181 BNM, VBIAF Guidance document, page 37. 182 BNM, VBIAF Guidance document, page 37. 183 BNM, VBIAF Guidance document, page 38. 184 BNM, VBIAF Guidance document, page 38. 178

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Impact-based risk reporting involves disclosure by the IBI to internal and external parties on information such as the following185: • Details of the IBI’s governance framework and impact on business strategies; • Description of key impact-based risks affecting the IBI; • Information about processes that incorporate impact-based risk requirements into customer acceptance decisions, customer engagement and monitoring processes; • At portfolio level strategy and reporting, transparency on: – Processes for periodical review of portfolio exposures to climate-related risks and other environmental and social issues; – Strategy to manage the environment and social risk to align with national and international standards, best practices on sustainability and supporting science base targets where applicable; – Aggregated customer/transaction-level assessment results; – Impact achieved by the IBI’s activities, projects and programmes. As can be seen above, the VBIAF provides a framework for IBIs to incorporate ESG considerations in the provision of financing and related advisory and investment activities. It involves a considerable change in the manner IBIs approach risk management as under the VBIAF IBIs are not merely assessing credit risk or Shariah non-compliance risk but how their financing and investment activities impact the economy, community and environment. In addition, IBIs have a deeper involvement in creating a positive impact on the environment and community as they are expected to nurture their customers towards sustainable practices. Thus, it is understandable that BNM makes the VBIAF voluntary for IBIs. Since the risk appetite, capacity and capabilities of each IBIs differ, the implementation of the VBIAF would also depend on the respective technical, operational and financial VBI implementation strategy of individual IBIs.186 IBIs have also to consider if any contractual obligation needs to be amended or terminated arising from the implementation of VBIAF to achieve VBI goals and whether this can be addressed by adopting a phased approach187 or prospective application188 of the VBIAF.

185

BNM, VBIAF Guidance document, page 40. BNM, VBIAF guidance document, page 3. 187 BNM, VBIAF guidance document page 4 explains from the portfolio perspective, phased approach means initial application of the VBIAF to specific portfolio of the IBIs’ financing, related advisory services and investment. The opposite of phased approach is the comprehensive approach which means VBIAF is applied across all the IBIs portfolio. 188 BNM, VBIAF guidance document page 4 explains from the customer perspective, a prospective application means application of the VBIAF to customers’ new financing and investment only as opposed to a retrospective application where VBIAF is applied to all existing and new customers’ financing and investment. 186

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4 Climate Change and Principle-Based Taxonomy (CCPT)189 4.1

Introduction

The adoption of VBI changes the focus of IBIs from short-term benefits to long-term benefits with wider objectives, that is, generating profits and creating a positive impact on the people, planet (environment) and economy. Consistent with this change, IBIs will have to review their risk assessment and management system to adjust to this commitment. VBIAF is the recommended approach by BNM. Whilst VBIAF lays the foundation for ESG consideration in the provision of financial services to generate a positive and sustainable impact on the economy, community and environment in the broad sense, the CCPT addresses a specific issue affecting the environment: climate change. The CCPT provides a robust and consistent assessment of FI’s financing, investment and structuring of capital market transactions (economic activities) to determine how these economic activities impact the climate. 190 The CCPT is applicable to all FIs supervised by BNM, including IBIs.191 Whilst the risk assessment and management under VBIAF is focused on ensuring that financing and investment activities of IBIs are directed towards projects and businesses that do not cause a negative impact on the environment and society, the assessment and classification of the economic activities under the CCPT assist FIs to channel capital and funds to businesses and projects that address climate change. Thus, the CCPT complements the VBIAF and is aligned with VBI’s commitment to the intended outcome of Shariah that generates positive and sustainable impact on the economy, community and environment. The CCPT has five guiding principles. The first two guiding principles are climate change mitigation (GP1) and climate change adaptation (GP2). GP1 and GP2 assess the economic activity.192 The assessment on no significant harm to the environment (GP3) and GP5 on prohibitive activities assessment, assess both the economic activity and the overall business of the customer. GP4 assess the remedial efforts of the customer.193

189

The CCPT was issued by BNM and came into effect on 30 April 2021. CCPT, paragraph 7.1, page 12. 191 CCPT, page 6. 192 CCPT, paragraph 7.2, page 12. 193 CCPT, page 12. 190

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GPs GP1: Climate Change Mitigation

The objective of GP1 is to reduce or prevent emission of greenhouse gas (GHG) into the atmosphere. Under GP1, the economic activity is assessed on whether it makes a substantial contribution to avoid GHG emissions, reduce GHG emissions or enable others to avoid or reduce GHG emissions.194 The CPPT explains that “substantial contribution” means that the positive impact of the activities should not be negligible and must be material enough to avoid potential greenwashing.195 Although the CCPT provides this guidance, it is noted that what is negligible or otherwise and what is material enough to avoid potential greenwashing is left to be determined by the FIs. The economic activity must also not cause significant negative impact on the broader environment. Similarly, what amounts to significant negative impact on the broader environment is left to the FIs to determine. To guide the FIs, examples of economic activities that are regarded as contributing to climate change mitigation are provided in the CCPT.

4.2.2

GP2: Climate Change Adaptation

The objective of GP2 is to increase resilience to withstand the adverse physical impact196 of current and future climate change.197 An economic activity meets this objective if the economic activity positively contributes to a reduction in material physical risk arising from climate change, is sustainable and does not negatively impact other adaptation efforts or cause harm to the broader environment and community and have a climate change adaptation outcomes that can be clearly defined, observable, measurable and monitored over time against a set of pre-determined indicators.198 To guide the FIs, the CCPT does not provide a quantitative threshold but gives examples of assessment criteria. The type of assessment criteria can be demonstrated from the following example: where a customer proposes a project to improve drainage to reduce flooding, the assessment criteria on whether the financing of this project (economic activity) meets GP2 can be first, whether the purpose of the economic activity can reduce the physical damage to a 194

CCPT, page 12. CCPT, footnote 16 at page 12. The guidance document on VBIAF at page 40 footnote 77 explains that “An entity is considered to be involved in “greenwashing” when it partakes in practices that are intended to create an impression that would result in the entity receiving a more than favourable perception about its environmental impact.” 196 Physical impact of climate change or physical risk of climate change is explained under the CCPT as risk arises from acute and chronic climate-related events that damage property, reduce productivity and disrupt trade. 197 CCPT, paragraph 7.7, page 14. 198 CCPT, paragraph 7.9, page 14. 195

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community or society arising from frequent flooding and second, whether the economic activity will not cause harm to the broader environment. Since the threshold and assessment criteria for GP1 and GP2 are left to the FIs, this will require FIs to develop a comprehensive guideline to implement the assessment. Apart from the threshold and assessment criteria to be applied, the guideline will also need to address matters such as the type of information required from the customer to enable the FI to make the assessment, the time period for assessment and approval.

4.2.3

GP3: No Significant Harm to the Environment

Under this guiding principle, apart from the economic activity, the customer’s overall business is assessed to ensure that it does not cause unintended harm to the broader environment.199 The economic activity and overall business of the customer must support the environmental objectives under the Environmental Quality Act 1974 and National Policy on the Environment 2002.200 The objective of GP3 will be met where the economic activity and the overall business prevents, reduces and controls pollution in air, water and land; protects healthy ecosystems and biodiversity; and uses energy, water and other natural resources in a sustainable and efficient manner.201 Similarly, here FIs will have to establish the assessment criteria which can guide the FIs to determine whether the environmental objectives mentioned above are met by the economic activity and the overall business of the customer.

4.2.4

GP4: Remedial Measures to Transition

Under this principle, FIs are expected to encourage, facilitate and take into account the remedial efforts and improvement measures that their customers take to ensure their economic activities and overall business are aligned with a low-carbon and climate-resilient economy.202 By this principle, FIs can support their customers to align their operations and overall business to support climate change management and/or adaptation. To implement GP4, FIs will first have to establish their minimum requirement on climate change objectives for their customers to fulfil. Second, because FIs are to consider the remedial efforts and improvement measures their customers make, FIs will have to have a set of criteria to assess the suitability and strength of the remedial efforts of their customers which do not meet the minimum requirement imposed by the FIs.

199

CCPT, paragraph 7.12, page 16. CCPT, paragraph 7.12, page16. 201 CCPT, paragraph 7.13, page 16. 202 CCPT, paragraph 7.17, page 18. 200

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GP5: Prohibited Activities

Under GP5, FIs are expected to verify and ensure that the economic activities are not illegal and do not contravene environmental laws.203 FIs should also ascertain if the businesses are engaged in activities that are in contravention of national human rights and labour laws in line with VBIAF.204 Thus, under GP5, the FI assesses both the economic activity and the overall business customer. Under GP5, there must also be avenues that allow the FIs to take necessary actions against their customers if they are found to be involved in any illegal activities after financing is approved.205 This is possible by way of written statements or compliance clauses signed by customers in a Letter of Undertaking or any other form of facility agreement with a covenant they will not undertake any illegal activities or activities which contravene environmental laws, national human rights and labour laws.206 The CCPT allows for FIs to rely on third-party verifications and recognized certification by local agencies, national authorities or international accreditation bodies and sustainability reporting standards or external rating agencies to assist them in assessing the customer on GP1 to GP5.207 However, FIs are to apply informed judgement on whether such certification standards meet the climate and environmental objectives under GP1 to GP5 as the certification may have different scopes and emphasis. The CCPT stipulates that at the onset, the FI assesses the economic activity and the overall business based on GP5. Following the assessment of GP5, the economic activity is then assessed on GP1 and GP2, followed by an assessment of the economic activity and overall business of the customer on GP3. Where there is significant harm on the broader environment (GP3) caused by the economic activity or overall business, the customer is then assessed on its remedial efforts under GP4. From the assessment conducted, the economic activity is classified under the categories of climate supporting (C1), climate transitioning (C2 and C3) or watchlist (C4 and C5).

4.3

Classification of Economic Activities

Economic activity will be classified as climate supporting (C1) where the economic activity contributes to climate change mitigation and/or climate change adaptation and the economic activity and overall business do not cause significant harm to the broader environment.208

203

CCPT, paragraph 7.21, page 20. CCPT, paragraph 7.23, page 20. 205 CCPT, paragraph 7.24, page 21. 206 CCPT, paragraph 7.24, page 21. 207 CCPT, paragraph 8, page 21. 208 CCPT, paragraph 9.4, page 24. 204

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Where the economic activity contributes to climate change mitigation and/or climate change adaptation but the overall business of the customer causes significant harm to the broader environment, then the customer is assessed on whether its business has taken remedial measures to promote transition to low-carbon and sustainable practices and reduce the harmful practices. Where the business has taken remedial measures, then it is classified as transitioning (C2).209 If the business has not taken remedial measures, then it is placed under watchlist (C4).210 An economic activity that does not contribute to climate change mitigation and/or climate change adaptation or both and the economic activity and overall business of the customer causes significant harm to the environment; however, remedial efforts to reduce the harmful practices are taken by the customer falls under transitioning (C3).211 Where the business do not display any commitment to remedy and reduce the harmful practices, it falls under watchlist (C5).212 From the above, businesses that implements remedial actions are regarded as transitioning to sustainable practices, whereas business that does not make any effort on remedial actions are placed under the watch list. It is observed that under the CCPT an economic activity that does not contribute to climate change mitigation and/or climate change adaptation and the economic activity and the overall business does not cause significant harm to the broader environment does not fall under any classification. Thus, it is unclear how the FIs should deal with this type of economic activity. It is noted that the taxonomy looks at both the economic activity and the customer’s overall business in the classification process. These criteria of the CCPT are said to be unique amongst existing taxonomies in the world.213 The positive environmental impact, whether there is a contribution to climate change adaptation and/or mitigation, is determined at the economic activities level. The negative impact, that is, whether there is significant harm to the broader environment, is determined by both economic activity and the overall business level of the customer. Where there is a negative impact, FI are to assess whether the customer has taken any remedial action to address the negative impact. In addition, the CCPT urges FIs to engage customers classified as “watchlist” to develop action plans to address the negative impact. The CCPT states that FIs may provide incentives to their customers to transition to sustainable practices.214 For customers who fail to demonstrate any effort of remedial actions or are not committed to implement remedial efforts, FIs may consider measures to penalize the customer through more stringent lending

209

CCPT, paragraph 9.5, page 24. CCPT, paragraph 9.6, page 24. 211 CCPT, paragraph 9.5, page 24. 212 CCPT, paragraph 9.6, page 24. 213 Pfaff et al. (2021). 214 CCPT, paragraphs 9.6 and 9.7, page 24. 210

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terms or even exiting the business with the customer.215 Therefore, the CCPT not only facilitates and promote the channelling of funds by FIs to activities and business that address climate change and support the environmental objective. It also encourages businesses to adopt a sustainable approach by including climate and environmental considerations into business strategies and developing remedial action plans in the event business operations cause significant harm to the climate or broader environment.

5 Summary and Recommendations Focus on SDGs has gained substantial momentum in countries around the world, including Malaysia. It is acknowledged that FIs have an important role in relation to sustainable development as they can, through their operations and financial services, exercise considerable influence on businesses to support sustainable development. In line with this, BNM issued the Strategy Paper on VBI, supported by the guidance documents: the Implementation Guide for VBI, the VBIAF guidance document, and the VBI Scorecard. VBIAF Sectoral Guides were also issued as guidance to implement VBIAF for specific sectors. To address a specific SDG, which is climate change, BNM issued the CCPT to complement the VBIAF guidance document. The VBI, its guidance documents and CCPT lays the foundation for IBI and FI, seeking ways to positively impact the economy, community and environment in support of sustainable development. The adoption of the sustainable banking regulatory framework of VBI and CCPT is voluntary on IBIs and FIs, respectively. It is found from this research that from its inception, the Islamic finance legal framework in Malaysia has been focused on compliance with Shariah. On the other hand, the VBI initiative has a different emphasis from the legal framework. Its approach is impact driven by requiring IBIs to fulfil the objectives of Shariah through having products, services and practices that deliver positive and sustainable impact to the economy, community and environment. This chapter argues that the different emphasis of the VBI initiative from the legal framework can only allow for the VBI initiative to be voluntary on IBI until a policy decision is made to amend the legal framework accordingly. It has been demonstrated earlier in the chapter that the sustainable banking regulatory framework changes the approach of IBIs and FIs in their operations and business strategies. The focus of IBIs and FIs is no longer solely directed to short and long-term benefits in the form of profits. IBIs and FIs are realigning their focus towards positively impacting the economy, community and the environment and considering climate change. To embed the sustainable banking regulatory framework into IBIs’ and FIs’ operations and business strategy, some factors need to be considered as follows:

215

CCPT, paragraph 9.7, page 24.

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• Strategic vision and mission of the IBIs and FIs The strategic vision and mission of the IBIs and FIs need to change to incorporate sustainability and climate considerations to institutionalize the mindset of those within the institution. This is also to give an indication to the stakeholders, including IBIs’ and FIs’ customers, of the institutions’ direction and what is expected from them. As mentioned earlier in this chapter, one of the strategies to facilitate the adoption of VBI is for IBIs to declare their intent and commitment to adopt VBI. Similarly, FIs that decide to adopt the CCPT should also make it clear in their strategic vision and mission that climate considerations are incorporated into their business strategy. • Governance structure The role of the board in relation to the implementation of VBI and climate change oversight must be clearly articulated. Dedicated committees to oversee and drive the implementation of sustainable and climate change initiatives should also be established with a clear reporting line. There should also be clear roles, responsibilities and KPIs for these specific committees. As highlighted earlier in this chapter, various views were put forward on the role of Shariah committee in the IBI relating to the implementation of the VBI and VBIAF. Some researchers argue that the Shariah committee should be directly involved in the implementation of the VBI, whereas others feel that the Shariah committee should be left to focus on Shariah compliance. Several researchers were of the view that the Shariah committee may play a complimentary role to the implementation of VBI. The VBIAF guidance document states a more involved Shariah governance is required in VBIAF. It is noted that s. 30(1) IFSA mandates the Shariah committee to advise the IBI on Shariah compliance concerning its business, affairs and activities. The gap between the expectations of VBI and VBIAF and the mandate of the Shariah committee under the IFSA will have to be addressed to facilitate IBIs to determine the role of their Shariah committee, if any, in implementation of the VBI and VBIAF. • Risk management With the adoption of VBI and CCPT, the current risk management framework of IBIs and FIs will have to be realigned with the VBI and CCPT commitment. IBIs and FIs will have to integrate climate-related risk consideration and impactbased risk assessment and management into their risk management framework. For example, following the adoption of the VBI by Bank Islam Malaysia in 2017, Bank Islam developed its framework to manage ESG risk,216 and when it adopted the CCPT, it extended its risk management framework to include climate risk.217 The Board Risk Committee and Management Risk Control Committee of Bank

216

Bank Islam Integrated Annual Report 2021, Advancing Prosperity for All, p. 108 retrieved from https://www.bimbholdings.com/investor-relations/corporate-financial-reports/annual-reports 217 Bank Islam Integrated Annual Report 2021, Advancing Prosperity for All, p. 37 retrieved from https://www.bimbholdings.com/investor-relations/corporate-financial-reports/annual-reports

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Islam provides oversight and strategic direction on sustainable risk, including climate-related risks.218 • Capacity building For VBI to be integrated across all relevant functions of the IBI, there must be initiatives to build the capacity of the board and all employees of the IBI. Similarly, for the implementation of the CCPT, there should be capacity building for all levels in the FI to increase awareness and build competencies. The VBIAF requires an IBI to consider the implication of its financing and investment activities towards its stakeholder based on the IBI’s CVI to provide a positive impact to the environment and community and the broader goal of sustainability. A FI that adopts the CCPT will assess whether the economic activity and overall business of its customer considers climate change mitigation or adaptation or is transitioning towards sustainable practices in its operations. This would mean businesses seeking financing or investment must consider how their business impacts the community, the climate and the broader environment. Businesses seeking finance or investment should consider the following: • They should aligning their business strategy to incorporate climate and environmental considerations and establish action plans to incorporate these considerations into their business strategy. They should develop policies on sustainable practices which are aligned with national standards, international agreements and best practice frameworks on sustainability. The business should have a governance structure for oversight of environment, social and climate-related risks and opportunities. • They should develop an approach to identify and assess any negative impact arising from their business activities and projects towards the community, the climate and broader environment in which they operate and establish remedial action plans to address the negative impacts. • They should diligently perform periodic assessment of their business activities and operations to ensure that they do not contribute to negative impacts on the community, the climate and broader environment. This assessment should also be extended to their supply chains. As can be seen from the discussion in this chapter the adoption of VBI by IBIs and the CCPT by FIs can encourage their customers to transition towards sustainable practices in their business and operations. Thus, it is important for the largest number possible of IBIs and FIs to adopt the regulatory framework, especially in light of the voluntary nature of the regulatory framework. This chapter concluded with some recommendations regarding the integration of the regulatory framework into the IBIs and FIs business and operations. Further studies to explore how IBIs and FIs integrate the regulatory framework into their business strategy and operations will 218

Bank Islam Integrated Annual Report 2021, Advancing Prosperity for All, pp. 108 and 196 retrieved from https://www.bimbholdings.com/investor-relations/corporate-financial-reports/ annual-reports

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be beneficial to assist and encourage other IBIs and FIs intending to adopt the regulatory framework. This current study was conducted purely based on review of literature and documents available on the internet. Thus, fieldwork research is encouraged to understand the various measures taken by IBIs and FIs in integrating the regulatory framework into their business strategy and operation, the challenges they face and how the challenges are addressed. It would also be beneficial for a study to be conducted on whether the VBI and CCPT have changed how businesses seeking financing and investment conduct their business and operations. The proposed study can be an indication of the impact the VBI and CCPT have in encouraging businesses to adopt and transition to sustainable practices.

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Mahadi, N. F., Zain, N. R. M., & Ali, E. R. A. E. (2019). Leading towards impactful Islamic social finance: Malaysian experience with the value-based intermediation approach. Al-Shajarah: Journal of Islamic Thought and Civilization of the International Islamic University Malaysia (IIUM) (Special Issue: Islamic Banking and Finance), 69–87. Mahyudin, W. A., & Rosman, R. (2020). Value-based intermediation and realisation of Maqasid Al-Shariah: Issues and challenges for islamic banks in Malaysia. Advanced International Journal of Banking, Accounting and Finance, 5(2), 34–44. Martini, A. (2021). Socially responsible investing: from the ethical origins to the sustainable development framework of the European Union. Environment, Development and Sustainability. https://doi.org/10.1007/s10668-021-01375-3 Mascu, S. (2013). Ethical banks: An alternative in the financial crisis (pp. 1680–1684). Economic Sciences Series X, Ovidius University Annals. Masryef Management House. (2016). Value-Based Intermediation (VBI): A new norm for Islamic finance. In Global Islamic finance forum 2018. Association of Islamic Banking and Masryef Management House. 2016–2017. https://www.masryef.com/uploads/brochure/79ed10341 78d9206037b86235066e1d8.pdf Ministry of Finance. (2013). The 2014 budget. Government of Malaysia. Retrieved from https:// www.mof.gov.my/portal/arkib/budget/2014/bs14.pdf Mohamad, S., & Borhan, N. A. (2017). Islamic finance and social sustainability: Parameters for developing a model for social impact measurement. Malaysian Journal of Sustainable Environment, 3(2), 81. Mohamad, S., Lehner, O. M., & Khorshid, A. (2015). A case for an Islamic social impact bond. SSRN Electronic Journal, 2, 65–74. Mujahid, S. & Adawiah, E. A. (2015). Sustainable and responsible investment (SRI): Trends and prospects. Kuala Lumpur islamic finance forum 2015. Retrieved from https://www. researchgate.net/publication/303985122_Sustainable_and_Responsible_Investment_SRI_ Trends_and_Prospects Pfaff, N., Altun, O., & Jia, Y. (2021) Overview and recommendations for sustainable finance taxonomies. International Capital Market Association. Retrieved from https://www.icmagroup. org/assets/documents/Sustainable-finance/ICMA-Overview-and-Recommendations-for-Sustain able-Finance-Taxonomies-May-2021-180521.pdf Securities Commission Malaysia. (2019). Sustainable and responsible investment sukuk framework: An overview. Retrieved from https://www.sc.com.my/api/documentms/download.ashx? id=84491531-2b7e-4362-bafb-83bb33b07416 Tan, H. B., Ang, P. M., Chung, R. H. K., & Pek, C. K. (2013). Green and ethical banking: Demand and supply perspective from banker’s corporations and head of household in Malaysia. Journal of the Institute of Bankers Malaysia, 12–17. Tandon, A. (2021). Transition finance: Investigating the state of play—A stocktake of emerging approaches and financial instruments. Environment Working Paper 179. Organisation for Economic Co-operation and Development. Retrieved from https://www.oecd.org/ officialdocuments/publicdisplaydocumentpdf/?cote=ENV/WKP(2021)11&docLanguage=En UNCTAD. (2014). World investment report. Investing in the SDGs: An action plan. United Nations. Wagemans, F. A. J., van Koppen, C. S. A. K., & Mol, A. P. J. (2013). The effectiveness of socially responsible investment: a review. Journal of Integrative Environmental Sciences, 10(3-4), 235–252. https://doi.org/10.1080/1943815X.2013.844169 Zahid, A. Z. M. (2019). Adnan Zaylani Mohamad Zahid: Sustainability and the challenges ahead. Kuala Lumpur.

Part II

The Impact of Fintech and Investment Sustainability

The Impact of the Digital Economy Paradigm on Investment Sustainability in Oman Faris Alshubiri

1 Introduction The digital economy refers to Internet-based technologies for producing goods and services that have spread widely in recent years (Afonasova et al., 2019). The reach of the digital economy can play a prominent role in increasing competitiveness in all economic sectors (Pan et al., 2022). In addition, it may provide valuable opportunities for entrepreneurs and access to foreign markets for breaking into global electronic value chains. Further, it gives a chance to address social problems and achieve economic development (Gozgor & Lau, 2021). However, the digital economy comes with numerous challenges as a result of the global digital divide, which may result in negative social effects and lead to complex Internet issues that decision-makers must address (Kim, 2020). The digital economy is gaining significance in emerging economies, especially in the field of investment, because it can transform international monetary operations for multinational companies and the impact of foreign companies on host countries, which affects investment policies (Fang et al., 2021). The digital economy is also affected by both emerging and developed countries at the global level in building a connected infrastructure, strengthening digital companies and supporting digital transformation (Williams, 2021). Information technology (IT) has been a prominent factor in the growth of production, reflecting the significant role of the digital economy at the global level and the disruption of the symbiotic relationship between information and communication technology (ICT) and international production (Dahlman et al., 2016). The digital economy provides multinational companies with far-reaching opportunities

F. Alshubiri (✉) Department of Finance and Economics, College of Commerce and Business Administration, Dhofar University, Salalah, Oman e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 N. Naifar, A. Elsayed (eds.), Green Finance Instruments, FinTech, and Investment Strategies, Sustainable Finance, https://doi.org/10.1007/978-3-031-29031-2_7

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to re-engineer processes and access local and global markets, and it redefines governance methods in global production networks (Hofman et al., 2016). Multinational companies rely on the ICT infrastructure and encompass a variety of business models, including online platforms, e-commerce and digital content companies (Duan et al., 2020). Digital and technical multinational companies, in average international production, have limited assets to access foreign markets, while multinational companies feature in greater numbers in foreign markets. The statistics indicate that multinational technology companies’ sales abroad exceed 74%, with 42% of their assets outside their country of origin in 2019 (EU-GCC, 2021). Thus, the greater the density of the Internet in the operating models of multinational companies, the greater the separation between foreign revenue and material assets. Therefore, we note that the economic impact of digital multinational companies on host countries is less clear in terms of material investments and job creation, although their investments have a clear indirect role in the production process and contribute in some way to digital development (EU-GCC, 2021). The headquarters of digital multinational companies are concentrated in a few countries that are characterised by their ability to operate at the global level with limited foreign investment, which may reflect the prevailing trend towards foreign direct investment (FDI), which has led to the democratisation of FDI abroad (Bukht & Heeks, 2017). The current trend is the concentration of digital multinational corporations in large home countries (Sun et al., 2021). The digital economy is not limited to the ICT sector and digital companies (Vu, 2011). Rather, it can be said that the greatest economic impact comes from the digitisation of various processes and supply chains across all global economies. Digitisation can affect any supply chain, including production, procurement and coordination, through the network of logistics units and customer relations (Zhai et al., 2021). Further, it can be a clear guide for the future transformation processes of all multinational organisations, as the trend towards more forms of hidden assets of international production and patterns has led to alternative governance (Sun et al., 2021). Multinational companies that adopt digitalisation in production can change the form of international production in various ways, as different scenarios affect international production trends, including production that is more centralised or more distributed, and the types of activities in international production may differ between countries (Fang et al., 2021). For example, duplex digital production sites and 3D printing may lead to smaller investments in countries, and conversely, massive technologies and the mass customisation of data may lead to fewer and larger production sites (Zhai et al., 2021). Digital technologies are increasing the speed of service operations, which may activate the activities of multinational companies affiliated with the service (Sun et al., 2021). At the same time, the greater importance of technology and intellectual property can lead to value creation and the resettlement of some outsourcing activities. In addition, a lack of mediation resulting from digitisation has led to the loss of some sectors in host countries (Zhai et al., 2021). Countries are trying to accelerate the adoption of the digital economy at the macroeconomic level, and the

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greatest value of development may be in the digitalisation of companies in non-digital sectors (Vu, 2011). Encouraging investment in ICT extends to all companies, as do business linkages and participation in global value chains (Zhai et al., 2021). Digital adoption by companies requires investment in Internet access, as well as the use of computers, and several factors have an impact on investment decisions, including policies related to the digital economy in all sectors affected by regulations in most companies, such as data protection and privacy (Dahlman et al., 2016). Tax tariffs on equipment, as well as on Internet use, also affect the actual final cost of ICT adoption (Appiah-Otoo & Song, 2020). However, developing skills and partnerships with multinational companies to reduce costs and optimising these partnerships enabled local companies to interact digitally with multinational companies and access electronic value chains (AppiahOtoo & Song, 2020). The growing interest in promoting balance in building an investment environment to enhance investment in digital development may require policymakers to address public concerns and to require continuous policy updates related to data, privacy and intellectual property protection, as well as attention to cultural values and consumer protection (Dahlman et al., 2016). Policymakers must also address the negative social and economic effects (Appiah-Otoo & Song, 2020). Therefore, governments must find a balanced approach that accommodates all interests and the interests of investors in the private sector (Fang et al., 2021). Therefore, given the important role of investment at the local and international levels in the development of the digital economy and its likely positive impact in digital economics on international production, this chapter aimed to bridge the research gap by highlighting the role of and taking an organised and proactive approach towards investment issues in the digital field in development strategies, where digital development is an integral part of investment policies, which are integrated into digital development strategies. Based on the current literature, the relationship between the digital economy and economic development is still ambiguous, necessitating further research. Few studies were found that examined the impact of the digital economy on economic growth. Therefore, this chapter examined the digital economy and the extent of its contribution to investments, its impact on infrastructure and its impact on the structure of industries, contributing to the building of investment opportunities that mitigate economic losses and stimulate digital industries. The increasing global competition around the adoption of technology for economic activities, the competition between world and GCC countries in particular, and an increase in the number of agreements of global trade agreements have made it necessary for the Sultanate of Oman to update its economy so that it is in line with other developed economies. As such, Oman is increasing the transparency and strength of the resources used to build its economy and rapidly implementing information and communication technology to ensure that the entire system is attractive to the business sector and investors. Furthermore, the Sultanate of Oman has begun implementing electronic initiatives that aim to achieve tangible business results in the Middle East. These practices have given Oman a strong impetus to attract foreign investment.

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To address challenges of digitisation, countries should keep pace with regional and global changes and try to exploit investment opportunities to stimulate economic growth and improve the level of social welfare at the global level. The most important aspect of Oman Vision 2040 is its focus on the long-term and how cornerstones of national development, such as comprehensive sustainable development, can be leveraged to achieve social, cultural, economic and political integration and face crises that may arise in the next two decades. It also prioritises seizing global and regional opportunities and enhancing competitiveness by focusing on the civil society, private and public sectors and directing relations between them to ensure effective economic management. To achieve such goals, the Omani economy began in last years to diversify its investments, implement many tourism and industrial projects, and exploit the country’s unique environment, supporting innovation, health systems and natural resources. Oman Vision 2040 is also focused on enhancing governance, oversight of national priorities, the optimal use of resources and trust and transparency among the various economic sectors to promote economic growth. These issues have been reinforced through workshops to diagnose economic trends and achieve these goals. There were several motivations for writing the current chapter. First, this is one of the first chapters to explore the relationship between the digital economy paradigm and investment sustainability in Oman, and insights from this study can enhance digital economy development and sustainable investment development. Second, this chapter aims to fill the research gap related to the digital economy paradigm in the GCC region, which can devote more funds to digital development and technological innovation than other countries by drawing on its vast oil and gas resources. Third, the chapter meets the needs of practitioners and policymakers in Oman. Specifically, businesses and governments in countries need to facilitate rapid, effective communication as well as efficient data storage, retrieval and processing. Fourth, the criteria for attracting foreign investment are the extent of political stability and the level of technology available to facilitate various commercial operations. Therefore, the state must diagnose the technological situation and the extent of willingness to engage in foreign investments. The remainder of this paper is organised as follows. After the introduction, the literature review section is presented in Sect. 2. Then, Sect. 3 provides the methodology, followed by the empirical results in Sect. 4. Section 5 presents the discussion, and finally, the conclusion and policy implications are provided in Sect. 6.

2 Literature Review Many technologies that we use constitute digital technologies, such as the Internet, big data, 5G, applications of artificial intelligence (AI), as well as used technologies in different industries, bringing the countries under the concept of the digital economy (Afonasova et al., 2019). The digital economy works to maximise the structure of the industry and increase jobs through ICT and AI applications (Shi

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et al., 2021). In particular, the digital economy plays a prominent role in mitigating economic losses and stimulating the industrial revolution, especially during the COVID-19 period (Gozgor & Lau, 2021), which brought many economic shocks and transformed the global economy through a major competitive revolution that affected production and the supply chain and that negatively impacted financial markets (Zhai et al., 2021; Duan et al., 2020). In addition to decision-makers’ employees, the social movement, which reduced economic activity, was reduced (Sun et al., 2021). Conversely, the digital economy, with its advantages, used high technologies and economic integration between industries to create opportunities for digital transformation between industries (Zhai et al., 2021). In addition, global economic governance, which appeared during COVID-19, led to an increase in the speed of digital transformation, which is assessed in this chapter by examining the model of the digital economy on investments through the high use of technology (Vu, 2011; Hofman et al., 2016; Appiah-Otoo & Song, 2020), leading to economic development. However, in current studies, there are no coherent implications about the impact of the digital economy on the local economy, though some researchers have indicated that the digital economy can affect improvements in the efficiency of many factors, including the invested capital and the skill of workers, which contribute to increasing economic growth (Dahlman et al., 2016; Pan et al., 2022). Further, the digital economy is an indicator for developing countries, contributing to stimulating economic growth and positively impacting employment and the structure of the industry, as well as investments (Pan et al., 2022). Conversely, other studies indicated that the cost of ICT is high and weakens the infrastructure of developing countries (Aker & Mbiti, 2010). Therefore, the implications of the digital economy are vague and difficult to measure. However, after the COVID-19 crisis, it was proven that the digital economy stimulated the demand for online services, which created opportunities to create digital industries (Kim, 2020; Fang et al., 2021). Furthermore, these electronic services eased the movement of individuals, reduced the risk of disease transmission and contributed to economic stability. In recent years, the digital economy has become a new economic form after the agricultural and industrial economies (Pan et al., 2022). Tapscott and McQueen (1996), who identified the first appearance of the digital economy, clarified that the age in the AI network is not evidence of technology, but the interaction of the individuals’ network with technology is the most important factor, meaning the interaction and integration of digitals with the technology network, making the digital economy permanent in economic and social activities. Mesenbourg (2001) pointed out that the digital economy consists of three components: the structure of electronic business, e-commerce and e-business. Carlsson (2004) pointed out that the digital economy is defined as a continuous dynamic process in the economy, rather than the fixed efficiency of the business. In recent years, Williams (2021) and Bukht and Heeks (2017) pointed out that the digital economy is broader than a digital sector, constituting the integration of various economic activities within the business network.

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For example, the Organisation for Economic Cooperation and Development (OECD) indicated that the digital economy constitutes a digital transformation of social and economic development and that all traditional industries are considered a digital process within the digital economy network (OECD, 2014). The G20 Digital Economy Development and Cooperation Initiative further indicated that the digital economy is composed of broad economic activities that use digital and knowledge technology as a key to production and a modern network of information, which is important in the effective use of ICT, which leads to maximising the economic structure (G20, 2016). In previous studies, the digital economy was considered a key to promoting economic growth in both developing and developed countries (Cheng et al., 2021; Pradhan et al., 2019). The digital economy has contributed to a positive impact on increasing investors’ capital and the productivity of workers to obtain high-quality services at low prices (Dahlman et al., 2016). Seo et al. (2009) pointed to the development of an accumulative model to examine the positive impact between ICT investments and economic growth, and they found that productivity decreases with a decrease in investment technology. Vu (2011) pointed out that ICT increases technological innovation output, improves decision-making quality and reduces production costs (Brynjolfsson & Yang, 1996). With the increasing speed of digital technology, many researchers have focused on the role of the digital economy in consumer surpluses and the supply chain of electronic commerce (Swaminathan & Tayur, 2003). Banga (2020) pointed out that the digital economy has played a large, positive role during COVID-19, and it has maintained control over the added value of various production processes and economic and investment development. During COVID19, many digital services accelerated the transition from traditional to digital industries, which boosted economic growth (Ganichev & Koshovets, 2021). Jiang (2020) pointed out that digital technology is not only a response to short-term investment strategies but also the establishment of long-term technology. Studies have reinforced (Albiman & Sulong, 2017; Nchofoung & Asongu, 2022) that the digital economy is a determinant of economic growth, especially in the absence of economic transformation. Although COVID-19 contributed to maintaining the adoption and acceleration of technology, this process remains uncertain, as we can see from the results of COVID-19, as it strengthened regional economies in certain sectors and vice versa in other sectors (Amankwah-Amoah et al., 2021). Accordingly, this chapter contributes to bridging the research gap in defining the digital economy and its indicators and impact on investments, especially in the State of Oman, which is rich in oil wealth and which can accelerate the building of the digital economy system in the country, in addition to the distinction of the various economic sectors and their impact on building digital infrastructure and enhancing e-government services.

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3 Methodology The methodology explains the main model and variables included in the chapter.

3.1

Main Econometric Model

This chapter examines the digital economy and investments in Oman. The annual time-series data used for this study covered a period of 36 years, from 1985 to 2020. All variables in this chapter were collected from the World Development Indicators (World Bank, 2022). The digital economy paradigm, measured by three proxies empowering society, technological, economic growth and infrastructure, are considered indicators for measuring digital economy (G20 DETF—Measurement of the Digital Economy, 2018). Three proxies were used to measure the digital economy as follows: empowering society, which was measured by mobile cellular subscriptions (LOGMCS); technological, economic growth, which was measured by medium- and high-tech exports (% manufactured exports; LOGMTHE); and infrastructure, which was measured by fixed telephone subscriptions (LOGFTS). The dependent variable used was the portfolio of investment, which expresses transactions in equity securities and debt securities in Oman. For more robustness, the chapter used four control variables: gross capital formation (% of GDP; LOGGCF), real interest rate (%; RIR), interest inflation and GDP deflator (annual %; ING) and GDP growth (annual %; GDPG) (Myovella et al., 2020; Bahrini & Qaffas, 2019; Ongo et al., 2014; Benzell & Brynjolfsson, 2019; Watanabe et al., 2018). The current results highlight the important role of the digital economy in Oman, leading to an enhanced wealth of economic policies showing this situation is similar to that in other GCC countries. The chapter model emerged as described in the following equation: PINi,

t

= β0 þ β0 IVi,

t

þ β0 control varaiblesi,

t

þ εi,

t

where PINi, t is the portfolio investment (PIN) proxy, which measures the PIN of countryIat time t as the dependent variable. The IVi, t are the three digital economy proxies, and the control variablesi, t are LOGGCF, GDPG, RIR and ING. The main econometric model of the chapter was used to test the hypothesis and increase the chapter’s robustness, and many diagnostic tests were used. The chapter used descriptive statistics, a correlation matrix and a unit root test for the augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) tests; the bounds cointegration test; and the long- and short-run ARDL error correction model (ECM). In addition, the chapter used diagnostic tests, including serial correlation, stability tests using cumulative sum (CUSUM) and CUSUM of squares and normality and heteroskedasticity tests. The unit root tests for Phillips and Perron (1988) and Dickey and Fuller (1979) were used to check the stationarity of every variable.

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The ARDL model, which was used in this chapter’s model analysis, utilised a standard least squares regression with lags of both independent and dependent variables as regressors (Greene, 2008). The ARDL model was used to check the cointegration between economic variables (Pesaran & Shin, 1999; Pesaran et al., 2001). The econometric of cointegration, which reflects the susceptibility of the variables to move together, was employed to reflect the existence of long-run dynamic equilibrium in the econometric model (Emeka & Kelvin, 2016). The ARDL model was selected because the variables under study were non-stationary and integrated in the same order. Furthermore, the ARDL model can be used for cointegration analysis to determine whether the variables are stationary at its level, integrated of order one, or a mixture of both (Pesaran & Shin, 1999; Pesaran et al., 2001). In addition, a single equation framework can support a sufficient number of lags while the data are directed through the ARDL model. (Harvey, 1981). Moreover, according to Haug (2002), the ARDL approach is ideal for studies with small sample sizes. To estimate the long-run relationship between the digital economy and PIN, the chapter used a bound methodology to show the cointegration status (Pesaran et al., 2001). Furthermore, the appropriate lag criteria for the Akaike information criterion (AIC) were used in the chapter model, which was integrated into the first difference, allowing the use of the ARDL model in the short and long runs. Next, the main formula in this chapter was the ARDL bounds test, as shown in the following equations: e1

ΔPINemt = β0 þ

e2

β1i ΔPINemt - 1 þ p=1

e3

þ

e4

β3i ΔLOGMTHEemt–1 þ p=1

e7

β6i ΔLOGGCFemt–1 þ p=1

e5

β4i ΔLOGMCSemt–1 þ p=1

e6

þ

β2i ΔLOGFTSemt–1 p=1

e8

β7i ΔRIRemt–1 þ p=1

β5i ΔGDPGemt–1 p=1

β8i ΔINGemt–1 p=1

þ δ0 BMTRt–i þ δ1 LOGFTSt–i þ δ2 LOGMTHEt–i þ δ3 LOGMCSt–i þ δ4 GDPGt - i þ δ5 LOGGCFt–i þ δ6 RIRt–i þ δ7 INGt–i þ μt The above formula is organised at the first difference. The above main equation used the first difference by adding Δ, and μt is the residual term of the bound tests. H0 = ų0 = ų1 = ų2 = ų3 = ų = 4ų5 = ų6 = ų7 = ų8 = 0, = ų2 = ų3 = ų = 4ų5 = ų6 = ų7 = ų8 = 0, and there is no cointegration if the value of the F-test is below the upper-bound value and vice versa. Furthermore, if the Fvalue is between the upper and lower values, the result is considered inconclusive. The ECM was used to estimate the short-run relationships using the following formula:

The Impact of the Digital Economy Paradigm on Investment Sustainability. . . e1

ΔPINemt = β0 þ

e2

β1i ΔPINemt–1 þ p=1

β2i ΔLOGFTSemt - 1 p=1

e3

þ

e4

e5

β3i ΔLOGMTHEemt - 1 þ p=1

β4i ΔLOGMCSemt–1 þ p=1

e6

þ

177

e7

β6i ΔLOGGCFemt–1 þ þ p=1

e8

β6i ΔRIRemt–1 þ þ p=1

β5i ΔGDPGemt–1 p=1

β6i ΔINGemt–1 p=1

þ η1 ECTt–i þ μt where η1–η6 refer to the speed of adjustment as a lagged error correction ECTt - i. This value should be negative and significant.

4 Empirical Results This section is split into six subsections to interpret how the chapter hypotheses were tested.

4.1

Descriptive Statistics

The variables covering the period 1985–2020 in Oman are presented in Table 1, and they include the mean, median, maximum and minimum values for the main model. They also show that the p-value was more than the 5% significance level for all variables, which means the variables were normally distributed except for PIN and RIR.

4.2

Correlation Matrix

The correlation matrix is presented in Table 2 to show the relations among the independent variables to confirm no multicollinearity issue between the ‘predictor and response’ as two variables. All variable matrices between the digital economy and investment are presented, and the findings show the correlation strengths between most of the variables ranged from very weak to moderate, and these results are consistent with economic theory. This theory supports economic phenomena and interprets the behaviour of economics. Furthermore, the theory establishes ideas and principles regarding the functions of different sectors of economies based on their role in economic development. Furthermore, the results show the significance level

Mean Median Maximum Minimum Std. dev. Skewness Kurtosis Jarque–Bera Probability Sum Sum Sq. Dev. Observations

LOGFTS 5.490 5.458 5.872 5.295 0.157 0.868 2.806 3.183 0.203 137.2 0.597 36

Table 1 Descriptive statistics

LOGMTHE 1.599 1.604 1.809 1.318 0.133 -0.077 2.120 0.830 0.660 39.99 0.427 36

LOGMCS 6.130 6.507 6.841 4.176 0.781 -0.984 2.820 4.070 0.130 153.2 14.65 36

PIN -8.75E+08 -1.28E+08 1.67E+09 -6.80E+09 2.10E+09 -1.872 5.503 21.13 0.000 -2.19E+10 1.05E+20 36

GDPG 3.038 2.658 9.045 -2.668 3.095 -0.013 2.261 0.568 0.752 75.95 229.9 36

LOGGCF 1.374 1.385 1.562 1.136 0.106 -0.322 2.653 0.559 0.756 34.37 0.273 36

RIR 3.436 -0.826 43.34 -20.12 13.97 1.178 4.313 7.579 0.022 85.91 4690.3 36

ING 4.630 7.415 33.75 -25.12 13.14 -0.246 3.141 0.273 0.872 115.7 4145.3 36

178 F. Alshubiri

LOGFTS 1.000 – -0.575 0.002 0.754 0.000 -0.635 0.000 -0.261 0.207 0.336 0.100 -0.025 0.903 -0.215 0.301

1,000 – -0.652 0.000 0.275 0.183 0.080 0.702 -0.502 0.010 0.418 0.037 -0.282 0.171

LOGMTHE

1.000 – -0.364 0.073 0.012 0.953 0.536 0.005 -0.062 0.767 -0.061 0.769

LOGMCS

Note: This table presents the correlation coefficients of the eight variables Source: World Development Indicators (2022)

ING

RIR

LOGGCF

GDPG

PIN

LOGMCS

LOGMTHE

Correlation LOGFTS

Table 2 Correlation matrix

1.000 – 0.192 0.3561 -0.197 0.344 -0.060 0.773 0.160 0.442

PIN

1.000 – 0.158 0.450 0.189 0.365 -0.022 0.915

GDPG

1.000 – 0.145 0.488 -0.113 0.588

LOGGCF

1.000 – -0.935 0.000

RIR

1.000 –

ING

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F. Alshubiri

between two variables, most of which were significant. For example, the correlation between LOGMTHE and LOGFTS was negative (-0.575), while it was positive between LOGMCS and LOGFTS (0.754) and negative between LOGMTHE and LOGMCS (-0.652).

4.3

Unit Root Test

Table 3 presents the findings of the unit root ADF test (Dickey & Fuller, 1979) and the PP test (Phillips & Perron, 1988). According to the ADF test, if a series is considered a unit root process, then the lagged level of the series will not provide certain information in expected changes, and the null hypothesis will not be rejected. In contrast, if the model of study has no unit root, then the variables of the model will be stationary and exhibit reversion to the mean, and the null hypothesis of a unit root will be rejected. Following the same argument as the ADF test, the PP test addresses the issue that the process generates data but has a higher order of endogenous autocorrelation, invalidating the ADF test. Furthermore, the PP test provides a non-parametric correction to the t-test statistic. Thus, the PP test is robust due to the absence of autocorrelation and heteroscedasticity in the process of the test equation. The results show no unit root test for all variables at the first difference as the ARDL applied in this stage, confirming that all variables were stationary; most of the variables were at level I (0), and all the variables were stationary at the first difference and confirmed the integrated of order one, I (1).

4.4

Diagnostic Tests

The main issue of diagnostic tests was heteroskedasticity, and serial correlations in the data are presented in Table 4. The findings show no problems in this table, as the chi-square value for the Breusch–Pagan–Godfrey (BPG) test and the BreuschGodfrey serial correlation Lagrange multiplier (LM) test were above 0.05 (0.994 and 0.471), respectively. The normality was confirmed in Table 5, as the J–B test result was 5.36, and the probability value was 0.0683. Furthermore, the results showed the stability in the ARDL model based on the CUSUM of recursive residuals and the CUSUM of recursive residual squares. Therefore, the results were not spurious.

4.5

Long-Run ARDL Results

After confirming the existence of cointegration between variables, the long-run estimates of the ARDL model are presented in Table 6. The result of the bounds

The signifcant level 1%

Intercept

Intercept

Intercept

Intercept

LOGFTS LOGMTHE ADF (Level) -2.078 -1.705 PP (Level) -1.451 -3.770*** ADF (first difference) -7.058*** -8.050*** PP (first difference) -9.086*** -6.996***

Table 3 The unit root tests PIN -2.127 -2.127 -5.152*** -5.297***

LOGMCS -2.078 -3.770*** -8.050*** -6.996***

-11.47***

-10.50***

-5.494***

-5.492***

GDPG

-6.039***

-5.459***

-2.548

-2.567

LOGGCF

-16.56***

-7.819***

-6.322***

-6.315***

RIR

-16.72***

-8.124***

-6.300***

-6.310***

ING

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Table 4 Serial correlation and heteroskedasticity test Breusch–Godfrey serial correlation LM test F-statistic 2.73E-05 Obs*R-squared 4.09E-05 Heteroskedasticity test: Breusch–Pagan–Godfrey F-statistic 0.867451 Obs*R-squared 6.602514 Scaled explained SS 7.040775

Prob. F(2, 15) Prob. Chi-Square (2)

0.9959 0.9949

Prob. F(15,17) Prob. Chi-Square (15) Prob. Chi-Square (15)

0.5517 0.4714 0.4246

Table 5 Normality test and Ramsey RESET test for misspecification Test of normality Test of Ramsey RESET Test of Stability

J–B test (Sig. value) Ho: Residuals are normal t-value 1.572615 F-value 2.473119 CUSUM CUSUM Square

5.36 (0.0683) 16 (1, 16)

0.1354 0.1354 Stable Stable

Table 6 Long-run ARDL and bounds test results Var. LOGFTS1 LOGMTHE1 LOGMCS1 GDPG1 LOGGCF1 RIR1 ING1 C F-bounds test Test statistic F-statistic k

Coeff. 1.26E+10 1.54E+09 9.33E+09 -51,218,599 -9.46E+09 -2.08E+08 -2.79E+08 -1.19E+09 Value 3.935562 7

Std. error 1.01E+10 1.80E+09 2.86E+09 63,798,055 3.95E+09 96,544,450 1.02E+08 4.42E+08

t-value 1.249111 0.858664 3.260277 -0.802824 -2.395022 -2.152718 -2.733435 -2.696619

Signif. (%) I(0) 10 1.92 5 2.17 2.5 2.43 1 2.73 Denote: ARDL (4, 1, 1, 1, 1, 1, 1, 1), Case 2: Restricted Constant and No Trend

Sig. 0.4298 0.5483 0.1895 0.5694 0.2518 0.2768 0.2233 0.2261 I(1) 2.89 3.21 3.51 3.9

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test was 3.93, above the upper value, which means there is cointegration between digital economy and investment. Meanwhile, the long-run results showed no significant value between variables, as model 2 used a restricted constant and no trend. Furthermore, the results show the AIC (for the top-20 ARDL models) for the lowest ARDL model (4, 1, 1, 1, 1, 1, 1, 1), as it was selected. Furthermore, the coefficients of variables explain that values equal to or greater than 1 (≥1) and less than 10 (