There are parallels between Shariah and ESG principles, such as being a good steward to society and the environment. Having such overlapping and complementary principles has led to their natural pairing and a growing traction for ESG Shariah solutions around the globe. However, there is something that may be unexpected about these indices: even though they do not offer it by design, some ESG Shariah solutions can offer a strong temperature alignment. One such example is the S&P Pan Arab Composite ESG Shariah Capped Index (Custom).

This index is designed to measure the performance of the 40 companies with the highest-ranking ESG scores (as measured by the Corporate Sustainability Assessment [CSA] conducted by S&P Global Sustainable1), from 60 of the largest (by float-adjusted market capitalization) constituents of its benchmark, the S&P Pan Arab Composite Shariah Index.¹

Based on its design, the S&P Pan Arab Composite ESG Shariah Capped Index (Custom) achieved an ESG score improvement of 3.94 against its benchmark, as of June 28, 2024. This is based on an aggregate score, however, and drilling further down into the underlying criteria for the environmental, social and governance pillars can give additional granularity on the index’s ESG performance. We identified three criteria, one for each pillar, for which most companies were assigned a score. The Environmental Policy & Management criterion in the “E” pillar refers to the management of an organization’s environmental programs in a comprehensive, systematic, planned and documented manner. Human Capital Development in the “S” pillar can make up a significant part of a company’s intangible assets, and for many industries, human capital development is one of the most financially material sustainability factors. On the other hand, the Business Ethics criterion evaluates the Codes of Conduct, their implementation and the transparent reporting on breaches, as well as corruption & bribery cases and anti-competitive practices. Exhibit 1 summarizes the change in ESG criteria for a given calendar year for the S&P Pan Arab Composite ESG Shariah Capped Index (Custom).

The S&P Pan Arab Composite ESG Shariah Capped Index (Custom) achieved a consistent improvement in each of the ESG criteria over the two years since its inception. The improvement of 12.0 in Human Capital Development criterion in the “S” pillar in 2023 particularly stands out.  Environmental Policy & Management was improved by 5.7 in 2022 since the index’s inception, followed by 2.8 in 2023. Business Ethics had a materially higher improvement in 2023, with 3.9 compared to only 0.1 in 2022.

Now, let’s put that unexpected trait of some ESG Shariah indices, which is not offered by their design, under the spotlight—i.e., a strong temperature alignment. The S&P Pan Arab Composite ESG Shariah Capped Index (Custom) is not explicitly designed to target improved temperature alignment (a transition pathway assessment that examines the adequacy of emission reduction over time to meet a 2°C carbon budget). However, as of June 28, 2024, it achieved a 1.5°C alignment and was 9% under its 2°C carbon budget, versus the S&P Pan Arab Composite Shariah, its benchmark, which was 7% over budget and was 3°C aligned.² Furthermore, the S&P Pan Arab Composite ESG Shariah Capped Index (Custom) improved the carbon intensity³ and fossil fuel reserves⁴ by 45% and 51%, respectively, against its benchmark.

Given the superior sustainability profile that the index exhibited, we calculated its weighted average impact ratio, which is the index-weighted total direct and indirect external costs as a percentage of revenues. The external cost is an estimate of the value of a service based on the cost of damage that results from its loss. It is based on the assumption that the cost of maintaining an environmental benefit is a reasonable estimate of its value. Exhibit 2 illustrates the environmental footprint of the index from a sectoral perspective and compares it against its benchmark.

The S&P Pan Arab Composite ESG Shariah Capped Index (Custom) achieved an impact ratio improvement of 41.07% versus its benchmark. The largest contribution came from Utilities, which had an allocation effect of 35%. The Utilities sector is 4°C aligned and, together with Energy, is one of the main detractors from the carbon budget. The index was, on average, 2.86% underweight in Utilities since its inception. This contributed positively to its relative impact ratio performance.

Going beyond the ESG score improvement that is implied in its index construction, the S&P Pan Arab Composite ESG Shariah Capped Index (Custom) achieved a strong sustainability profile, even though its design does not offer it. It would be interesting to see if this observation continues, as it might help to shed more light on the parallels between Shariah and ESG principles.

¹ For more information, please see the S&P Custom Indices Methodology.

² In a previous analysis, we had a similar observation for another broad ESG index.

³ Based on weighted average carbon intensity (metric tons of CO₂e/USD million revenues) using direct plus first tier indirect emissions.

⁴ Fossil fuel reserves: The carbon footprint that could be generated if the proven and probable fossil fuel reserves owned by index constituents were burned per USD 1 million invested.

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