Infrastructure investment is suitable to be financed through an Islamic financing scheme.
Infrastructure is an asset and an infrastructure project does not contain any activities that are prohibited in shariah. Therefore, it is aligned with Islamic financing principles. This section presents an overview of the combination of Islamic financing and infrastructure project financing, which is hereafter referred to as Islamic project financing.
Several research studies on Islamic project financing were undertaken in the late 1990s. Khan (1997) proposed an alternative Islamic structure for project finance deals in power plant projects. Western project finance models were analysed in the light of Islamic financial principles by suggesting how the Western model may be modified with a view to develop an integrated Islamic project finance model. The Islamic law allows financial innovation and contractual agreements to create the model. With the integrated model, a structure could be developed whereby Islamic and Western financiers could participate in infrastructure projects without compromising any religious principles or financial interests. Wilson (1998) also found that private sector enterprises were becoming involved in infrastructure projects because governments rarely financed major projects. Within the istisna scheme, it was proved that projects can be financed when the interest was diminished. Zarqa (1997) stated that istisna can be applied in both explicitly income-generating public infrastructure projects and non-income generating projects.
Ebrahim (1999) proposed an integrated model of Islamic and Western project financing which was more focused on synthesising mudaraba security. Mudaraba security is a combination of the murabaha facility and call option. In this approach, a methodology was proposed to derive the profit sharing ratio endogenously. Using mathematical derivation, Ebrahim synthesised the future value of a project opposed to the incremental payoffs in the mudaraba scheme. However, the study only interpreted and modelled Islamic project financing instruments from the perspective of a conventional banker.
A co-financed structure which was a combination of Islamic and Western sponsor financing was implemented successfully in the Equate Petrochemical project in Kuwait (Esty, 2000). The project used ijara, istisna and murabaha structures. Since then, there have been several more co-financed deals in infrastructure projects, such as the Kuala
Lumpur Light Rail Transit 2 project, Thuraya Space Telecommunications project in the United Arab Emirates, Shuaiba power plant project in Kuwait, the Tarsus-Adana-Gaziantep and Mersin motorway projects in Turkey, and the Kuala Lumpur International Airport. However, the number of projects which have used co-financed structures is not large. There are still factors that need to be considered such as improving the stakeholders’ understanding of Islamic finance.
Shariah-compliant collateral security and project financing structures have been described as a critical factor in the availability of enforcement entities and paradigms in project financing (McMillen, 2001). McMillen (2001) highlighted that, in this process, a shariah board will examine the investment structure and documentation to approve an Islamic investment, to ensure that every transaction acknowledges the cultural, moral, ethical and religious principles.
Figure 2.3 describes a basic ijara financing structure which is used in an extensive range of project transactions, such as real estate projects, petrochemical projects and electricity projects, and can be used in any type of infrastructure project.
Figure 2.3: Ijara financing model
The funding company is the special purpose vehicle for the project financing transaction and will own the project asset. The bank will provide a loan agreement to the funding company for project construction. The shariah investors embed capital contributions in the project company. The funding company will lease the project asset to the project company in accordance with the ijara scheme. The understanding to purchase (known as the put option in conventional terms) allows the project company to purchase the assets from the funding company and then use the funds to make payments
Understanding to purchase (put option) Understanding to sell (call option)
Managing contractor agreement Lease (Ijara) Bank
Funding
Company Project
Company
Off-takers/
Tenants Loan agreement
Other loan documents
Sales agreements Occupational tenant leases
Source: Adapted from McMillen (2007)
under the mandatory prepayment provision. The understanding to sell (known as the call option) allows the funding company to sell the assets to the project company and use the funds to make the payment under the voluntary prepayment provision.
Based on a study of several infrastructure projects that incorporated Islamic project finance, Camacho (2005) concluded that innovative ways to gain capital in infrastructure projects included: combining Islamic and Western finance, creating new structures of financing, or finding other ways to mitigate risks. Camacho also pointed out that there were institutional problems which can increase the financial cost of Islamic project financing. Therefore, Camacho recommended that a scheme should use the adl (trustee), a uniform Islamic finance body and well established accounting practices.
Government guarantees are less necessary when the profit sharing is high and the sponsor’s own capital is large. However, government financial guarantees are still necessary to increase the creditworthiness and to raise the debt capacity of the project (Hassan & Soumaré, 2006).
As project finance and Islamic financing are now converging, a huge amount of capital is being invested in industrial, real estate and infrastructure projects. This convergence makes Islamic financing structures of immediate and long-term consequence to all project participants (McMillen, 2007).
Alexander (2011) explicates potential sources of problems when projects with an Islamic scheme attempt to suit Western financing. First, there is a lack of a cohesive regulatory body, which in this context is a shariah board. There is uncertainty regarding the shariah boards’ decisions which can sometimes appear to be unpredictable and subjective. Although a board will consider similar transactions, there is no guarantee the decision will be the same. This happens because a fatwa is only valid for one specific case. Therefore, shariah boards also hold the most significant decision-making role in project endorsement. Second, the requirement in shariah compliance that the lender should bear the project risk may cause risk enhancement from the Western lenders’
perspective.
Infrastructure projects, which are considered as an investment, can generate revenue, which can be identified and analysed in the project feasibility study. In its form as a profit-loss sharing scheme, Islamic financing is suitable to be implemented in infrastructure projects. To identify the losses, there should be project risk identification, and then the risk should be minimised or dispensed. Most infrastructure project risks arise from the complexity of financing, taxation, documentation or technical details.
From the perspective of project sponsors, public and private investment is fundamental in project financing, and a project can be viable if a reliable, long-term revenue stream can be determined. Therefore, the risks related to the revenue and market might be low or negligible within the infrastructure project (Grimsey & Lewis, 2002).