This post is part of an occasional series highlighting a project finance article or news item from the past. It is often interesting and thought provoking to look back on these items with the perspective of months, years or decades of further experience.

With this installment, we turn to an article written by Richard Keenan, a partner in Chadbourne's project finance group. It was first published in the February 2010 issue of the Project Finance NewsWire.

Islamic finance is expected to make up 30% of the total project finance market in the Gulf Co-operation Council, or GCC, countries by 2012, compared to just over 12.5% in 2006, according to the latest estimates.

However, growth in Islamic finance as a percentage of the total market continues to be constrained by certain obstacles. A significant proportion of Islamic finance that has been provided in connection with project financings in the GCC countries has been supplied through the “Islamic windows” of conventional banks rather than by Islamic finance institutions.

This article summarizes some of the Islamic finance structures typically implemented in project financings and looks at some of the challenges that have faced and still face the continued growth of Islamic finance in the project finance sector and how some of these challenges may be overcome.

The relationship between Islamic finance institutions and their customers is not the same as the conventional creditor and debtor relationship, but rather one involving the sharing in financial risks and rewards. Islamic finance is also principally asset-based and, in line with Shari’a principles of risk sharing, Islamic lenders bear some of the risks associated with ownership of the relevant assets. Applying these principles to project finance is difficult.
It is worthwhile describing briefly how an Islamic finance tranche is typically structured in a project finance transaction.

The most frequently used structures in the project finance sector in the Middle East are the Istisna’a-Ijara structure, which is sometimes generally referred to as a “procurement” structure, and the Wakala-Ijara structure.

An Istisna’a-Ijara structure incorporates an Istisna’a contract that applies to the construction phase of a project, and an Ijara contract is put in place for the operations phase.
An Istisna’a is a contract for sale whereby one party undertakes to manufacture a specific asset according to agreed specifications and deliver the asset by an agreed time for an agreed price.

If a traditional Istisna’a contractual arrangement was applied to a project financing, the financiers would enter into a contract directly with the contractors engaged to construct the project’s assets. To avoid the Islamic lenders being exposed to significant construction risk and the credit and performance risk of contractors, most project financings use a parallel structure where the borrower undertakes under an Istisna’a contract to procure the manufacture, delivery and construction of the relevant plant and equipment from the manufacturer. In parallel with the Istisna’a contract, the borrower enters into a construction contract with the construction contractor incorporating a pass through of the terms and conditions of the Istisna’a contract.The Islamic financiers make phased payments to the borrower, akin to draws under any conventional finance facility during the construction phase of a project. Some scholars have permitted the use of a forward lease arrangement, known as an Ijara Mawsufah Fi Al Thimma, whereby advance rental payments are paid by the borrower during the term of the Istisna’a. These advance rental payments are typically sized to cover the Islamic financier’s funding costs, together with a profit margin, and are often effected by a deeming provision whereby certain phase payments equal to advance rental payments are deemed to have been paid by the Islamic financiers to the borrower.
The use of forward lease arrangements is often permitted by scholars only on the proviso that if the borrower never has the benefit of a lease of the assets under the Ijara (for example, due to a failure to deliver the assets), any such advance rental payments must be reimbursed to the borrower. To avoid such an unacceptable outcome from the point of view of the Islamic financiers, if the Istisna’a is terminated prior to project completion, the borrower is obliged to pay liquidated damages for failing to deliver the assets equal to the aggregate advance rental payments paid by the borrower.

Title to the relevant assets typically passes to the Islamic financiers automatically upon transfer of title under the EPC or construction contract.

If the borrower fails to deliver the assets, the remedies available to the Islamic financiers are more or less the same as the remedies conventional banks rely on in the same scenario. The Islamic financiers are entitled to accelerate the repayment obligations of the borrower and to terminate the Istisna’a. The borrower is typically obliged to reimburse to the Islamic financiers the aggregate of phase payments it has received prior to enforcement and is often also obliged to pay liquidated damages as described above.

The Ijara contract typically comes into effect upon project completion. An Ijara, in simple terms, is a lease contract where a lessor purchases an asset and rents it to the lessee for a specific period of time at an agreed rental.

The leased asset must have a usufruct, or a legal right to use and derive profit or benefit from the asset. In order to be Shari’a compliant, an Ijara must be transparent, detailed and the terms agreed prior to execution. The lessor under an Ijara must maintain legal and beneficial ownership of the asset and bear responsibility for risks associated with ownership of the asset, meaning there must be a link between an Islamic lender’s ability to earn profits and the assumption of risk.

In the context of Islamic finance, the form of Ijara typically used is known as an Ijara-wa-iqtina’a; it includes a promise by the Islamic lenders as lessor to transfer the ownership of the leased asset to the borrower, as lessee, either at the end of the lease period or in stages during the term of the Ijara.

This form of Ijara is essentially the Islamic equivalent of a conventional equipment lease contract. Ownership of the assets is delivered to the Islamic financiers upon project completion pursuant to the Istisna’a contract and thereafter the Islamic lenders lease the assets to the borrower in consideration for rental payments that are sized to cover the capital cost of the equipment plus a profit margin.

The Istisna’a-Ijara documentation typically incorporates purchase and sale undertaking arrangements following termination or expiry of the lease. The Islamic lenders usually undertake to sell all or part of the assets to the borrower in the event of a partial or full cancellation or prepayment of the Islamic facility and following the discharge by the borrower of all outstanding payments owed to the Islamic financiers. After an event of a default by the borrower, the Islamic financiers normally have the benefit of a purchase undertaking from the borrower. This is a form of acceleration of the Islamic facility — the borrower in these circumstances is obliged to purchase the leased assets for a purchase price equal to the aggregate of amounts outstanding under the Islamic tranche. The documentation normally stipulates that title to the assets does not pass to the borrower until the amounts owed to the Islamic financiers have been discharged in full.

Obligations that would ordinarily fall to the Islamic lenders as owner and lessor of the assets, such as care and maintenance of the assets and responsibility for procurement of insurance, are normally performed by the borrower on behalf of the Islamic lenders pursuant to the terms of a service agency agreement. The amounts payable to the borrower in consideration for the performance of these obligations are normally recouped by the Islamic financiers as part of the rental payments payable by the borrower after delivery of the asset.
The Islamic financiers’ rights to take any enforcement action in relation to the assets is governed by the terms of an intercreditor agreement between the Islamic lenders and the conventional financiers.

A typical Istisna’a-Ijara structure is illustrated in the following diagram:

1 Construction phase (Istisna’a) — the borrower procures construction of project assets and then transfers title to assets to Islamic financiers. As consideration, Islamic financiers makes phased payments to the borrower (equivalent to loan advances).

2 Operations phase (Ijara) — Islamic financiers lease project assets to the borrower. Borrower makes lease payments (equivalent to debt service).

An alternative but similar structure often implemented in project financings involving an Islamic tranche is what is known as the Wakala-Ijara Mawsufah Fi Al Dhimmah structure or “Wakala-Ijara structure.”

This structure was used in connection with the Marafiq and Shuaibah IWPPs in Saudi Arabia.

Under this structure, the borrower is employed as the Islamic lenders’ agent or “Wakil” in accordance with the terms of an agency agreement known as a Wakala agreement. The Wakala agreement more or less fulfills the same function as an Istisna’a agreement in the other structure, although being an agency agreement, the contractual relationship between the Islamic finance institutions and the borrower is different. The borrower procures the design, engineering, construction, testing, commissioning and delivery of the assets identified in the Wakala agreement as the agent for the Islamic lenders.

The Istisna’a-Ijara and Wakala-Ijara structures are otherwise similar. They both incorporate an Ijara agreement for the operations phase and a service agency agreement pursuant to which the borrower performs certain obligations with respect to maintenance of the assets and procurement of insurance. The documentation involved in a Wakala-Ijara structure does not include separate purchase and sale agreements; however, the same rights and obligations of the parties with respect to transfer of assets at the end of the term or in the event of early termination are embodied in the documents.

What, then, have been some of the challenges affecting the integration of Islamic finance in the project finance sector?

A significant problem has been the difficulty that many Islamic financiers have had until recently competing with conventional lenders in terms of price and tenor.
Before the onset of the financial crisis in 2008, the pricing of project financings hit all-time lows and at these levels, project finance was not a particularly attractive proposition for many Islamic financial institutions. Pricing coupled with the length of tenors conventional lenders were able to commit to (up to 15 years in the oil and gas sector and over 20 years in connection with power and water transactions) made it very difficult for Islamic financiers to compete. Islamic financial institutions tend to focus more on retail banking and rely more on deposits as a source of liquidity rather than the longer-term bond market tapped by conventional banks.

A second obstacle for some Islamic financiers has been the risks associated with project finance.

A lot of time and effort have gone into the development of Islamic finance structures such as the Istisna’a-Ijara model in order to try to mitigate or eliminate risks to Islamic lenders. However, the remaining risks still make participation in these transactions prohibitive for many Islamic financiers.

As the legal owner of the project assets, Islamic financiers have exposure to third-party liabilities including environmental risk. Other obligations imposed on the Islamic lenders as owners of project assets include responsibilities relating to insurance and operation and maintenance of the assets. Under a typical Istisna’a-Ijara structure, these obligations are normally performed by the borrower on behalf of the Islamic lenders under a service agency agreement, and the borrower in its capacity as the service agent is liable for any loss or damage suffered by the Islamic financiers as a result of any failure to perform these obligations. However, notwithstanding the considerable effort that has gone into developing structures that transfer these risks to the borrower, the Islamic financiers still bear significant responsibility and risk as owners of the assets. The lenders often remain responsible for any capital improvements that are required and, although procurement of insurance is normally delegated to the borrower, the bottom line is that the Islamic financiers, as owners of the assets, bear the risk of availability of insurance and any vitiation by the borrower of its obligations with respect to the project insurance policies. Borrower indemnities to cover insurance shortfalls are of little value if the plant sustains serious damage or incurs significant third-party liability.

Add to these risks the standard risks that are always the concern of any project lender such as counterparty, technology and market risk and you end up with a risk profile that is too onerous for many Islamic financiers to take or results in the pricing of Islamic finance at levels that make it uncompetitive with conventional bank pricing.

A third impediment is, in the eyes of some Islamic finance experts and scholars, an incompatibility of some of the structures that have been developed with the principles of Shari’a.

Financial advisors, lawyers, Islamic financial institutions and their Sharia’a committees have spent a lot of time grappling with how to structure Islamic project finance in order to integrate Islamic finance with conventional finance. The end result of this has been the development of a somewhat cumbersome and document-heavy structure that in many respects mimics conventional financing (at least in terms of risk allocation).

What does the future hold for Islamic finance in the project finance sector, and how might some of the challenges faced by the sector be overcome?

In terms of pricing, the gap in margins between conventional and Islamic finance has more or less closed for the time being in the aftermath of the 2008 crisis in the international credit markets. However, the cost of borrowing from conventional banks is unlikely to remain as high as current levels in the medium to long term, and a pricing gap between conventional and Islamic finance will inevitably emerge again.

Looking ahead, there probably needs to be a greater recognition that Islamic finance and conventional finance are two different disciplines and that there will be price disparities between the two types of financing.

The disparity between pricing of conventional and Islamic finance is one of the drivers that has led to development of structures designed to put Islamic banks in more or less the same position as conventional lenders in terms of risk allocation. However, rather than implementing these structures or trying to “squeeze a square peg into a round hole,” as some commentators have put it, perhaps the way forward is to embrace more fully the principles of Shari’a underpinning Islamic finance. This could lead to the development of Islamic finance structures where the Islamic financial institutions play a more active role in discharging their responsibilities as owner of project assets rather than passing these onto to the borrower or third parties. In turn, this could lead to a greater willingness in the market to accept that the risk profile of Islamic finance justifies higher compensation.
There is an ongoing debate among experts and commentators as to whether the fundamentals of Islamic project finance need to be re-examined and new structures put in place.

It is no secret that the Islamic project finance market has been dominated by the “Islamic windows” of conventional banks. In fact the proportion of funding by purely Islamic finance institutions in the project sector is comparatively small. The one exception to this is Saudi Arabia where the Shari’a compliant finance institutions, meaning those Saudi financial institutions that do not offer conventional forms of finance — such as Alinma, Islamic Development Bank, Al Rajhi and National Commercial Bank — have made and continue to make a very significant contribution to the funding of project-financed transactions in the Kingdom. For example, of the US$1.5 billion loaned by Saudi banks in connection with the Rabigh IPP that achieved financial close in June 2009, 65% was contributed by Alinma, Al Rajhi and National Commercial Bank. The fact that Islamic finance structures such as the Wakala-Ijara structure have been accepted by Islamic financial institutions such as Alinma, Al Rajhi and National Commercial Bank and have withstood the rigorous scrutiny of their Shari’a committees has to be seen as a strong endorsement of these structures in terms of compliance with Shari’a principles. The outlook for Islamic project finance in Saudi Arabia is strong.

There undoubtedly needs to be a greater degree of consistency among the Shari’a committees of Islamic finance institutions regarding Shari’a compliance. The fact that you can have one particular Islamic finance structure or specific aspect of a structure approved by the Shari’a committee of one particular Islamic finance institution but not another is not helping the growth of this industry. A more standardized approach must be adopted not only to overcome a prevailing perception that the viability of Islamic finance continues to be hampered by uncertainty in terms of Shari’a compliance, but also in order to reduce the time and cost involved in executing Islamic project finance transactions.

The myriad legal documentation required to structure an Islamic finance tranche makes these transactions more expensive and more time consuming to execute compared to a conventional financing. Some recent initiatives have helped with market standardization. They include the growing list of industry standards published by the Accounting and Auditing Organization for Islamic Finance Institutions and Bahrain’s International Islamic Finance Market. However, more work and collaboration between Islamic finance institutions and their respective Shari’a committees is required.

There may also be a greater role to play for those governments of the GCC keen to foster Islamic finance within their countries. Some of the risks assumed by Islamic finance institutions could be mitigated by different forms of government protection. One example is a backstop against insurance risk. If, as owners of project assets, Islamic financiers are obliged to insure the assets, governments might offer backstop insurance protection to mitigate the risk of insurance not being available. This type of protection has already been provided by governments in favor of sponsors in relation to project financings in certain jurisdictions in the GCC, including Saudi Arabia and Abu Dhabi.

The enforceability of insurance provisions has been questioned by some Shari’a scholars on the basis that a contract of insurance has been associated with gambling, an activity proscribed by the Shari’a. Making the government the insurer of last resort could spur development of takaful (Islamic insurance) industries within GCC countries.
Government sponsors could also provide some degree of protection, third party or environmental risk through an indemnity or statutory relief.

There are also often tax implications for Islamic financiers with which governments of the relevant countries could assist. The ownership of project assets by the Islamic finance institutions and the contractual arrangements that they are party to often raise tax concerns for both sponsors and lenders. From the Islamic financiers’ point of view, taxes may be imposed in connection with the physical location of the asset or nature of the contractual arrangements — lease payments for example in some jurisdictions may be subject to withholding tax. From the borrower’s point of view, these structures can also be disadvantageous. Interest payments under conventional loans can be claimed as a tax deduction in many jurisdictions, whereas lease payments may not attract the same tax relief and, if withholding tax is levied on such payments, this liability is most likely to be passed onto the borrower through tax gross-up provisions. Governments in many of the GCC jurisdictions could do more to ensure that Islamic financiers and sponsors of projects that involve Islamic tranches are not any worse off from a taxation point of view than they would be if they were participating in a conventional financing.

Islamic finance is undoubtedly more suited to certain type of projects than others. Islamic finance lends itself more to projects that incorporate a discrete set of assets that can be owned by the Islamic financiers without too much potential intrusion on the enjoyment of such rights by conventional banks under intercreditor arrangements. Furthermore, to qualify for an Ijara contract, the assets owned by the Islamic financiers must be separable and have an economic value as stand-alone assets.

However, this can be a difficult proposition for plants that are made up of integrated equipment. While certain assets forming part of a plant may be capable of being “ring fenced” from the rest of the plant, such assets, if valued as individual items of equipment, may not reflect their true value in terms of their importance to the overall operation of the plant.

Finally, there is the issue of tenor. As with pricing, the competitive advantage in favor of conventional banks in terms of tenor they can offer has been to some extent eroded in the aftermath of the credit crisis, but it is difficult to gauge any advantage in the current market. Over the last 12 months, conventional banks have struggled to commit to tenors of more than eight to 10 years. This has resulted in the emergence of the “mini-perm” structure that was adopted, for example, in connection with the Al Dur IWPP in Bahrain. However, there are examples of project financings that have closed in the last 12 months where tenors of 20 years or more have been achieved. The Rabigh IPP in Saudi Arabia and Shuweihat 2 in Abu Dhabi are two examples.

It is difficult for many Islamic financial institutions to commit to tenors beyond seven to eight years. Some bankers have for this reason considered Islamic finance better suited for bridge financing. The market for equity bridge finance in the Middle East has contracted significantly over the last 18 months. Prior to the credit crisis in 2008, it had become more or less standard market practice for sponsors of project financings in the power and water sector in the Middle East to fund their equity contributions initially through an equity bridge loan. At the height of the market in 2006 and 2007, EBL tenors were as long seven years often not expiring until three or four years into the operation phase of a project. Depending on pricing, Islamic finance would in many in ways be ideally suited to equity bridge financing and if the market for this form of finance recovers, it may be worthwhile for sponsors, lenders and their advisors to try to attract Islamic finance institutions into this market.