A number of Islamic project finance transactions have successfully closed over the last three years, attracting interest from the regional project finance market, not least for the structural innovation that each of these transactions has introduced. But the contribution these deals have made to the development of Islamic finance overall has been overshadowed by the high-profile sukuk offerings that seem to dominate the headlines.

Upon closer examination, a number of parallels can be drawn between Islamic project financing techniques and some of the sukuk structures in the market. One parallel is evident in the use of musharaka (partnership) principles. However, what distinguishes the Islamic project finance market from sukuk is that a lot of these transactions are multi-sourced financings, requiring the Islamic tranche to be integrated within a wider, in most cases pari passu, financing arrangement.

One of the more obvious examples of Islamic project finance leading the way is shown by the impressive penetration of Islamic project finance into markets such as Saudi Arabia, where the uncertainty surrounding the legal and regulatory framework had historically made structuring efforts more difficult.

The right balance

Islamic project finance deals such as the petrochemicals project for Al-Waha and the Rabigh refinery, petrochemical and IWSPP upgrade show how crucial structural innovation is, not only to drive the Islamic finance industry forward but also to ensure that the right balance is achieved between the shariah requirements and commercial needs.

One such structural development has been the use of co-ownership arrangements based on the principle of shirkat ul milk (seen on the Al-Waha petrochemical project), under which the banks and the sponsors agree to invest in, and co-own, certain identifiable physical assets of a project. The attraction of this arrangement lies in its simplicity; the injection of the equity into a project is a natural fit within these arrangements, with the basis upon which the co-owners will make contributions being agreed upfront (including the order in which these contributions are made). For greenfield projects, these co-ownership arrangements can tie in closely with basic istisna'a (construction) or procurement contracts, which dovetail with the sponsors' more detailed arrangements with contractors who have the requisite expertise to complete a project. In a brownfield project, it would be necessary to identify existing assets that are suitable for a co-ownership structure – not always an easy task.

Islamic project finance has helped to confirm the importance of the forward leasing product (ijara mawsufah fi al dimmah). This structure enables financiers to receive advance rental payments (the equivalent of interest payments) during the construction phase. Certain shariah scholars continue to express reservations over its use, but forward leasing has been increasingly used in a number of project structures (particularly those in Saudi Arabia), with the common provisos that: (i) advance rentals are taken into account (as rental that has already been paid) when actual leasing begins; and (ii) advance rentals can be refunded in full if the assets are not delivered for leasing. Some of the more recent deals have added a further limb to contemplate the equivalent of a commitment fee within the advance rentals, providing more flexibility and a parallel return to participants in the Islamic tranche.

By contrast, the market has taken a tougher stance on additional costs (such as increased costs and mandatory costs) and other potential exposures for financiers. Recent projects have seen these costs wrapped up as part of the rental calculation, marking a retreat from the position taken on earlier projects (where structures had contemplated the financiers making a separate claim for these amounts through the indemnity provisions). The drawback is that, to avoid uncertainty (one of the prohibitions under shariah), the rental calculation always looks to costs incurred in and quantifiable for an earlier period: that is, an increased cost incurred during any rental period would form a component of the rental for the next rental period. This delays the financier's ability to claim these amounts and means that any costs incurred in the last rental period cannot be claimed through this approach. A similar stance has been taken by certain financial institutions who provide revolving commodity murabaha facilities, where these institutions have elected to remove standalone indemnities, preferring these additional costs to form a part of the deferred sale price for subsequent murabaha trades.

Total loss positions

One area subject to consistent scrutiny on ijara (lease) deals is the treatment of the leasing arrangements where underlying assets suffer a total loss: if these assets are destroyed, are damaged beyond repair or are lost through some other means (for example, nationalization or expropriation), it is a fundamental shariah requirement that any leasing arrangements in relation to those assets are terminated with immediate effect – and that any purchase undertaking mechanisms contemplated in respect of those assets also fall away.

Without the service arrangements typically found on lease-based transactions, financiers would not be able to claim outstandings from the project company. These service arrangements have developed so that financiers no longer rely solely on insurances (which the project company, acting as service agent, would be obliged to procure) but are now able to crystallize a claim against the project company for all outstandings on the basis that the project company has either failed to discharge strict obligations under the service arrangements or agreed to provide an indemnity to the Islamic financiers in exchange for insurances being assigned in its favour. These arrangements also sometimes require the project company to provide replacement assets so that the leasing arrangements can continue and the financing remains in place.

Service arrangements do not offer a flawless solution. For example, the strict-obligations approach is not without its critics: given that insurance proceeds are likely to be the main source of cash flow in a total loss situation, some would argue that it is artificial and unnecessary to draft service arrangements so that the project company would always default after a total loss event. This view increasingly appears to be shared by certain scholars.

One method of ensuring a default under these service arrangements is for the project company to undertake to procure a payout under the insurances within a fixed time. From the Islamic financiers' perspective, if a total loss has occurred on a multi-sourced financing, a short time to crystallize the claim is important. Without this, and on a strict legal analysis, there would not be any amount outstanding from the project company until the insurances have paid out and the shortfall (which the project company is typically required to make good) has been quantified. In the meantime, the other financiers could accelerate, without the Islamic tranche having any claim against the project company. Take also nationalization or expropriation where insurance cover is unlikely; again, it is difficult to see how the Islamic financiers could recover their monies from the project company without imposing strict obligations on the project company under the service arrangements. With such diverging views on total loss, extra care needs to be taken when negotiating service arrangements to ensure that the Islamic financiers' position is not prejudiced.

Banking the risk profile

On any project that includes Islamic funds, an analysis of the risks associated with asset ownership (or, as in Al-Waha, co-ownership) is a big part of the Islamic structuring process. Of concern to the financiers are potential third party and/or environmental liabilities that could arise during the construction or the operating phase. The risk of any liability materializing is reduced because the project company will be in control of the assets. However, it is important from the Islamic financiers' perspective to ensure that indemnity coverage in the documentation goes further towards ensuring that the financiers are not in a worse position than they would be on a conventional financing. Transactors now also want to avoid situations where the project company acts (or could be construed to act) as an agent of the Islamic financiers: the most obvious example of this is under the service arrangements, where the project company is appointed and described as an independent service contractor as opposed to a service agent – a distinction that often affords the Islamic financiers a stronger footing under local laws, especially when enforcing indemnities against the project company.

Scholarly scrutiny

Product innovation entails more extensive dialogue with the shariah scholars to ensure the shariah integrity of each product. This puts an additional demand on the scholars' time. With the subtle change that the shariah approval process is undergoing, with scholars now expressing a preference to be involved at all stages of a transaction, the implications for the Islamic project finance industry are clear: if consideration is not given to getting the approach right in dealing with and progressing through the shariah process, it might impact on the success of the deal.

Dedicated support for the shariah process from an early stage is essential to ensure that the transactors start and remain on the front foot with the scholars to optimize the chances of achieving close within reasonable time frames. Financial institutions have addressed this by having dedicated shariah coordination departments that manage the shariah aspects of transactions, easing the burden on their scholars. The process is also helped by lawyers who understand exactly how the requirements of shariah vary for each financial institution. When progressing through the shariah implications of complex intercreditor and common terms arrangements, lawyers who enjoy good working relationships with the scholars can be a valuable resource.

The increase in dialogue and scrutiny is not limited to Islamic project finance: as far as the sukuk market is concerned, greater scrutiny of structures has led certain scholars to question certain aspects of the sukuk-al-musharaka structure. Sukuk-al-musharaka is probably the most popular sukuk structure (based largely on the flexibility that it provides in terms of the underlying asset base) so it will be interesting to monitor what effect this will have on the sukuk market.

Broadening the horizon

Although the GCC countries will continue to experience most of the deal-flow in this area, this will change as the globalization of Islamic finance continues. Positive steps in countries outside the GCC, such as those changes recently announced by the UK Treasury, illustrate that many view Islamic funding as an increasingly key contributor to the economies of the world's leading financial centres and not just in the developing world.

Some have even suggested that London will become the centre for Islamic finance – a proposition that might hold true for listing of sukuk and retail product development. But it is difficult to see Islamic tranches becoming a regular feature in the European projects market. As well as the challenging tax and regulatory hurdles that Islamic structures face in funding project development in Europe, there remains a knowledge gap among some of the main players and certain preconceptions about Islamic structures that present a challenge in the European context.

Despite these difficulties, a number of financial institutions and corporates in countries such as Germany, Russia, Kazakhstan, China, Japan and Hong Kong are looking to implement Islamic financing structures. Renewed and serious intent is also being shown by some of the north African countries. A desire to attract some of the sizeable outward investment being made by the GCC countries has played a role in this.

A wholly Islamic future?

Further development of takaful (insurance) products and Islamic hedging products will have an influence on Islamic project financing. If these products are able to compete with their conventional counterparts, project sponsors will have more options available when looking at insurance requirements and hedging strategies.

The demand for Islamic funding from the energy and infrastructure sector in the Middle East looks likely to continue to outstrip the Islamic funds banks can mobilize, increasing the size and frequency of Islamic tranches on multi-sourced project financings and wholly Islamically funded projects.

Given the strides the industry has made so far, it will not be long before scholars start demanding an all-encompassing approach to Islamic project financing, where not just the financing but also insurance and hedging strategies need to be structured in a shariah-compliant way.

Author biographies

Nadim Khan Herbert Smith Nadim is a finance lawyer who specializes in banking and Islamic finance. Nadim has been based in the Middle East for over six years and has advised on a number of the leading Islamic financing transactions in the region as well as advising on the structuring and development of a number of first of their kind Islamic products. Credentials include advising the arrangers of the $500mililon financing of the Al-Waha petrochemical plant in Saudi Arabia (Middle East Islamic Deal of the year 2006, Project Finance Magazine), and advising the arrangers on the Islamic tranche of QatarGas II LNG, a multi-sourced $3.5 billion financing for the Qatar-based offshore production and liquefaction facilities. Paul McViety Herbert Smith A senior associate in the finance division of the Dubai office, Paul has been involved in a number of high-profile projects in Europe and the Middle East, including advising the arranging banks on the $500 million financing the Al-Waha petrochemicals project in Saudi Arabia (Middle East Islamic Deal of the year 2006, Project Finance Magazine), The Bahrain Petroleum Company's low sulphur diesel production project and the Qatargas II LNG Project.