Building Blocks

Islamic Finance and its use in Infrastructure

“Islamic Finance” is a broad term used to describe financial transactions that comply with Islamic principles and ethics. An industry worth around two trillion dollars, many find the terms and modes of finance confusing and exotic. Our aim here is to de-mystify many of the financial structures used across the globe for funding Infrastructure Projects.

Why Islamic Finance?

The main purpose of Islamic Finance is to create an ethical framework for financial transactions. This means both the assets and financial structures must abide by ethical standards. The assets themselves cannot relate to Islamically prohibited activities such as alcohol, gambling, pornography etc. Similarly, the financial structures themselves must be free from speculation, profiteering and uncertainty with a long-term goal of moving to a framework of risk-sharing and profit-based returns for financial investors. 

What does this mean for Infrastructure Finance?

Infrastructure projects are generally free from the speculation and uncertainty of large financial markets, and the assets themselves are largely wholesome and for the benefit of the people, making them a prime candidate for the usage of Islamic Finance. On the other hand, being long term financing projects with a long-term payback period and unpredictable future cash flows, they present challenges for the usual risk and profit structures traditionally preferred in Islamic Finance.

 What are the financial structures used for Infrastructure projects? 

Most Infrastructure projects have complex financial structures but are largely financed through a mix of equity and debt, the latter being largely loans from banks with a smaller portion of bond capital financing. Islamic ethics prohibits the use of interest or making individuals agree to contracts where the final payment is unknown and contingent on factors beyond their control. The goal is to prevent individuals taking on large financial risks that  could financially destabilise them with unrepayable debt. Rather, Islam encourages risk to be shared amongst all the participants in the contract and the profits divided accordingly.

For Infrastructure Projects, a number of financial structures are used, all of which contain four major players: 

1) The sponsors - These are the initiators or promotors of the project. They may be one or more government or private entities. They may or may not provide equity financing for the project.  

1) The Financier(s), who provide the balance of funds not provided by the sponsors for the development or purchase of the project usually on a fixed income basis using any of the structures detailed below

2) The EPC (Engineering, Procurement and Construction contractor), which is responsible for the construction and engineering of the project3) The SPV (Special Purpose Vehicle) or the project company is an entity set up by the sponsors which manages the project and all the assets on their behalf. The SPV is also the middleman between the financiers and the EPC. 

This mode of finance contains two contracts which work in tandem with each other and together constitute most Islamic Infrastructure financing agreements.

1)  A construction/procurement agreement: The financiers make an agreement with the SPV to initiate an infrastructure project, providing them the funds in return for possession of the title deeds of the project. These funds are given in stage payments. The SPV, in turn, approaches the EPC to start construction of the project in return for stage payments as well.

 2) A specified leasing agreement: The financiers enter into a lease agreement with the SPV, thereby taking the role of lessor and lessee respectively. Here, the SPV pays rental payments to the Financers for the benefit of using the asset with the cost of each payment being dependent on several factors such as phase of project, market conditions and other economic variables. The purpose of these payments being to service the advanced funds offered by the financers in the procurement agreement before the operational phase begins and then being in exchange for the revenue the asset makes. When the leasing period ends, and the financiers have made their required returns, the assets can be handed to the SPV.

This mode of finance also contains two transaction which work in tandem with each other in a fashion very similar to the Construction-Leasing structure. It is less commonly used globally but has a larger presence in Saudi Arabia:

1) An agency agreement: The financiers appoint the SPV as its agent to purchase or procure the assets that will be constructed by the EPC and finances this using stage payments with a total fixed amount. The SPV is only an agent in this scenario and all the risks and liabilities of the project are dealt directly between the financiers and the EPC. 

2) A Specified Leasing agreement: This agreement is similar to the Ijara component within the Istisna’-Ijara agreement. However, sometimes in this structure the rental payments are fixed ex ante, whereas in the Istisna’-Ijara model, the rental payments can vary depending on economic factors. 

The difference between the usage of Istisna’ and Wakala centres around the level of risk of the project and whether it is feasible for the EPC to  manage the risk associated with the project (as happens in the Wakala agreement) or whether this is untenable and needs to be transferred to the SPV (as in the Istisna’ structure). 

This is similar to a normal Construction-Leasing structure yet differs in the ownership of the assets. In previous structures the assets were held entirely by the financiers, however in this structure they possess only a specific number of shares.  The project company procures the construction of the infrastructure project, yet the shares of the final asset are distributed amongst equity holders including the Islamic Financers. The project company also enter into leasing agreement with the Islamic Financers for the returns of their share of the project. At the completion of the project the company may purchase the assets back from the Islamic Financers. This kind of agreement is normally used for non-PPP structures where the title deeds of the assets are held by a larger group of individuals.