gif Project financing
as well as the performance of the project. It simply means that because lenders can- not rely on sponsors’ other available assets, they have to be actively involved in the project company to some extent. This non-recourse characteristic converts the role of financiers from passive investors to active ones. This is due to the repayments of finance directly to the cash flow generated by the project per- formance. Such a characteristic of project fi- nancing corresponds to one of the most well known principles of Islamic Finance: profit and loss sharing (PLS). According to the PLS principle, neither project sponsors nor bor- rowers shall bear all the project risks; these risks shall be shared amongst the various contracting parties including contractors, op- erators, financiers and so on. Project financ- ing facilitates financing of the project in such a way that all potential profits and losses of the project could be easily shared amongst all involved parties. The straightforward risk allocation methodology of a project financing structure is one of the significant and basic features also present in Islamic jurisprudence. The more transpar- ent the risk allocation is, the more Shariah-compliant the financing structure is Thus Islamic finance can honour its objectives and principles more successfully through the use of project finance than through corpo- rate finance. The only potential point of controversy is the cost of project finance. The complexity of structur- ing, the time-consuming process and the indirect credit support of project financing means it’s higher in cost than corporate financing. However, several benefits of project finance result in a lower overall level of cost. These offsetting benefits include:
• Higher level of tax shield • Reduction of agency costs • Tighter corporate governance
Shariah-compliant project financ-
ing: Basic and synthetic models
Let’s now distinguish which Islamic financial instruments are appropriate to project financ- ing. First of all, it should be mentioned that all financial instruments known as Shariah-com- pliant can be used to some extent in project fi- nance. However, since the construction phase is the main and preliminary stage in making a project company functioning and operational, it’s necessary to ascertain those Islamic fi- nancial instruments which are the most prac- tical and realistic in this regard. We should ultimately aim to employ Shariah-compliant financial instruments that are mainly in line with construction financing. Therefore, we will now determine which Islamic finance instru- ments are suitable for each stage of the con- struction phase. According to the terminology of project management, we have three main
a) Engineering stage-Seeking optimum value b) Procurement stage-Achieving sustainability c) Construction stage-Executing the project
We will now elaborate on the features of each stage and the appropriate Islamic financial in- struments:
a) Engineering-Seeking optimum value
During the engineering stage, the contractor will usually be responsible for the prepara- tion of the Front-End Engineering and Design (FEED), as well as completion of detailed en- gineering in accordance with normal industry and good engineering practices. Since the nature of engineering is similar to service ac- tivities, financiers can use an Ujrah or Ju’alah contract in order to provide the funds needed
funds. Consequently, financiers can afford money by means of Murabaha (credit sale with pre-agreed profit margin), Muajjal (credit sale with deferred payment) or even Ijarah Al- eiqtina’a (lease purchase contract for fixed rent). For example, Islamic Financial Institu- tions can become involved in project financing by using Ijarah in a manner through which fin- anciers purchase required equipments from the producing company. They then deliver them to the project company under the Ijarah contract in order to procure all necessary ma- terials. The contract outlines repayment terms regarding the delivered equipment, as well as transfer of ownership following expiration of the Ijarah .
c) Construction-Executing the project
Figure 1 categorizes Shari’ah-compliant financial instruments briefly based on the development of the project company:
Module
Engineering Procurement Construction EPC, EPC LSTK
Shari’ah-compliant financial instru- ments
1. Ujrah 2. Ju’alah
3. Murabaha 4. Muajjal
5. Ijarah Al-eiqtina’a
6. Initial Istisna’a and Secondary Istisna’a 7. Istisna’a and installment sale (Murabaha) 8. Istisna’a and Ijarah Muntahia Bittamleek
9. Istisna’a and MOU aiming at Ijarah 10. Istisna’a and Ijarah Fi-Themmah 11. Musharakah
12. Diminishing Musharakah 13. Musharakah and Murabaha
Figure 1: Shari’ah-compliant financial instruments applicable in project financing.
in this stage. For example, the financier and project company enter into the initial Ju’alah based on which the financier undertakes to complete the FEED and detailed engineering . This is against a fixed fee paid by the project company to the financier in pre-agreed instal- ments. Simultaneously the financier enters into a secondary Ju’alah with a third party that has the engineering background required to do the engineering works. The fee payable un- der the secondary Ju’alah is lower than that paid under the initial Ju’alah so that a profit margin is made for the financier. Some Islamic jurisprudents authorize the secondary Ju’alah to be also concluded between financier and project company but in an opposite direction.
b) Procurement-Achieving sustainability
During this stage, the project company shall provide all equipments and materials speci- fied in the engineering stage. At this stage, as most of the required equipments are usually available in the market, all Shariah-compliant instruments related to credit sale or forward
At the construction stage, a project such as a power station or petro- chemical plant shall be constructed based on engineering documents and procured equipments. For this stage, the most convenient and fea- sible instrument is an Istisna’a con- tract whereby financiers place an order to manufacture or construct an industrial plant against interim or progress payments to be paid when- ever each milestone of the plant is constructed. Like Ju’alah, at this stage we have two Istisna’a contracts, one of which is between the project company and the Islamic financial institution. The other is between the IFI and the construction contractor. The secondary Istisna’a shall mirror the terms and conditions of the first one, except for the inclusion of some other clauses guaranteeing enough profitability for the financier. Based on some Islamic jurisprudential viewpoints, it’s permissible to draft
two Istisna’a contracts in such a way that the price of the secondary Istisna’a will be lower than the initial one. The main problem with such a structure is that during the construc- tion phase, the project company cannot pay any progress payments in accordance with the secondary Istisna’a contract. Such a dilemma can be solved through modifications to the initial Istisna’a clauses, allowing the progress payments to be paid by the project company after a grace period in which the plant is set up. Alternatively, the initial Istisna’a could be replaced by an Ijarah, which is similar to a conventional lease purchase contract. As a re- sult, as soon as the contractor completes con- struction of the plant in accordance with the Istisna’a contract between financiers and the construction contractor, it will be handed over to the project company based on Ijarah with purchase option. Based on this, the financier irrevocably and unconditionally undertakes to transfer the title of plant to the project com- pany immediately after the last instalments are made by project company. The financing plan for this stage could be also structured as
Construction phase
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