Climate change stands as one of the most critical challenges of our era, demanding united efforts and creative solutions. As the world confronts its escalating risks, the urgency to develop innovative and inclusive financial systems has never been greater.

Islamic finance, known for its global reach and its focus on supporting the real economy and sustainable initiatives, presents a distinctive approach to climate finance by aligning ethical investment principles with sustainable development goals.

According to the Islamic Finance Development Report 2024 issued by the London Stock Exchange Group, more than 1,981 institutions now offer Islamic financial services, managing assets worth $4.9 trillion, with a presence spanning 120 countries. Islamic climate finance is gaining recognition as an effective tool in the global effort to address and adapt to the challenges of climate change.

Both the Kyoto Protocol and the Paris Agreement emphasise the need for financial support from wealthier nations to assist those who are less resourced and more vulnerable to climate challenges.

Shariah-compliant finance aligns with the sustainable development principles, making it as a natural partner in combating climate change

The Climate Finance Report 2023 by Climate Policy Initiative highlights that average annual climate finance flows approached $1.3tr in 2022. In fiscal year 2023, the World Bank Group contributed a record $38.6 billion to climate finance. Looking ahead, the annual demand for climate finance is projected to increase significantly, reaching an estimated $9tr by 2030.

Climate finance is essential primarily for mitigation efforts aimed at reducing the emission of heat-trapping greenhouse gases into the atmosphere. Significant investments are needed to lower emissions, particularly in sectors like energy, transportation, and infrastructure.

Equally important, climate finance supports adaptation measures in industries such as agriculture, water management, waste management, and others. These efforts require substantial funding to address the adverse effects of climate change and minimise its impacts.

Islamic finance is rooted in principles drawn from Islamic commercial law, which prohibits practices such as interest-based transactions, speculation, toxic assets, and gambling. It offers an alternative to conventional finance by promoting risk-sharing, asset-backed trade, rent-based models, and equity investments that focus on profit and loss sharing. This ethical framework encourages stability, transparency, and social responsibility, aligning with the values of social justice while avoiding engagement with unethical or harmful industries.

Islamic finance relies on core instruments such as Sukuk (an Islamic alternative to bonds), Musharakah (equity-based partnerships), Mudarabah (profit-sharing arrangements), trade and rental-based financing, and Waqf (endowments). These tools are structured to uphold fairness, transparency, and social responsibility in financial transactions.

In the realm of climate finance, the principles of Islamic finance align seamlessly with the objectives of sustainable development, positioning it as a natural partner in combating climate change. By prioritising ethical investments and social responsibility, Islamic finance can direct funds toward initiatives that deliver economic returns while creating positive environmental and social outcomes.

Green Sukuk is a Shariah-compliant financial instrument specifically developed to fund environmentally sustainable projects. These can include renewable energy initiatives, energy efficiency improvements, and sustainable infrastructure developments.

The first Green Sukuk was launched by Malaysia in 2017, valued at $58 million, to support solar energy projects. This innovation was soon adopted by other countries, including Indonesia, the United Arab Emirates, Turkey, and Saudi Arabia. In 2023, Saudi Electric Company issued a $1.2bn Green Sukuk for a renewable energy project, while Indonesia issued a $1.0bn Green Sukuk with a focus on a Green and Blue sustainable project.

Islamic finance naturally aligns with the principles of Socially Responsible Investing (SRI), which focuses on making investments that not only generate financial returns but also have a positive impact on society and the environment. Islamic financial institutions can enhance their commitment to SRI by prioritising investments in green technologies, renewable energy, and companies with strong environmental, social, and governance (ESG) practices.

Furthermore, Waqf, a traditional Islamic endowment, can be used to fund environmental projects. By utilising the concept of Green Waqf for environmental protection, Islamic finance can play a key role in preserving natural resources and biodiversity for future generations.

The potential for growth in Islamic climate finance is vast. As awareness of sustainable development increases and the principles of Islamic finance align with climate action, more countries and financial institutions are expected to enter the market. The global demand for green and sustainable investments is likely to drive further innovation and growth in this sector.

However, to fully realise its potential, Islamic climate finance faces several challenges, including raising awareness and educating stakeholders, developing a clear and consistent regulatory framework, fostering partnerships to advance market development, encouraging innovation to create new financial instruments that attract impact investors seeking both financial returns and measurable environmental benefits.

By aligning financial practices with ethical principles and sustainable development goals, Islamic finance can play a pivotal role in supporting the transition to a low-carbon economy, helping to build a more sustainable and equitable future for all.

Ahmed Ali Siddiqui is the Founding Director of the IBA Centre for Excellence in Islamic Finance aasiddiqui@iba.edu.pk

Published in Dawn, The Business and Finance Weekly, December 2nd, 2024