ISLAMIC FINANCE: NEW OPTIONS FOR

INFRASTRUCTURE PROJECTS?

Kamran M. Khan
Infrastructure Department
East Asia and the Pacific Region
The World Bank
Islamic Finance: New Options for Infrastructure Projects?

Development Agency Perspective on Islamic Finance

Islamic Finance Instruments

Islamic Finance Transaction Structures

Role of Development Agencies

Infrastructure Finance in developing countries
is about more than infrastructure development
• Correcting Sector Policies: Financing of infrastructure has
proven to be a good incentive for correcting sector policies

• Channeling Investment (Institutional): Infrastructure investments

are an ideal vehicle for investors to take long-term country risk

• Mobilizing Local Investment (Retail): Local investment in

infrastructure can improve transparency/asset management

• Improving Infrastructure Investment Efficiency: Increase in non-

budget, private sector, investment often tends to accompany
improvements in planning and management of infrastructure

• Developing Critical Infrastructure: The link between poverty,

growth and infrastructure supports investment in infrastructure
Donors can achieve limited leverage in the fast-growing
economies by financing physical infrastructure

Donors are Small Players in the Fast-Growing East Asia

Aid (% of GDP and % of investment, 2003)

Mongolia

Cambodia

Vietnam
Aid (% of investment)
Philippines
Aid (% of GDP)
Indonesia
For the region as a whole,
East Asia & Pacific aid is only a small portion
of infrastructure needs
Malay sia

China

Estimated regional infrastructure needs (percentage of GDP) – 6.2 %

Thailand

-10 0 10 20 30 40 50 60

Source: World Development Indicators, 2004

Infrastructure finance systems provide models for
channeling savings into infrastructure development

• Sound investment mechanisms with track records

• Supporting legal framework
• Established norms and standards

• Consistent and reliable regulatory framework

• Interconnectivity with the financial markets

• Identifiable infrastructure investments (assets)

• Broad-based investor appeal which responds to the civic and

investment psyche of the people
Islamic Finance presents a unique opportunity
to improve the infrastructure finance systems

• Islamic Finance can entice a large population in

investment activities

• The need to have investments directly tied to specific,

non-financial assets lends itself to infrastructure finance
• Implications on infrastructure planning
• Implications on management of infrastructure assets

• Establishment of transaction structures which are

relatively easier for the local population to accept
Islamic Finance: New Options for Infrastructure Projects?

Development Agency Perspective on Islamic Finance

Islamic Finance Instruments

Islamic Finance Transaction Structures

Role of Development Agencies

Islamic Finance instruments are recognized by the
relevant markets … and they are continuing to evolve

• Profit-sharing Instruments
– “Mudarabah” profit-sharing with risk-sharing assignment
– “Musharakah” equity partnership

• Debt-based Instruments
– “Murabahah” trade with markup or cost-plus sale
– “Bai`bithaman ajil” deferred payment sale
– “Bai`al-salam” advance purchase
– “Istisna`” purchase order

• Leasing Instruments: Ijarah

• Insurance Products: Takaful

Profit-sharing instruments in Islamic Finance

• Mudharabah
– Contract between two parties to finance a business venture
– The parties are a “rab el-mal” (investor) who provides the capital,
and a “mudarib” (entrepreneur) who operates the venture
– If the venture is profitable, the profit is distributed based on a
pre-agreed ratio. The investor takes the market risk and the
entrepreneur takes the operational risk

• Musharakah
– An equity partnership arrangement in which all the parties
contribute investment to finance a business venture
– Profit of the venture is distributed based on a pre-agreed ratio,
while the loss is shared on the basis of equity participation
Islamic Finance has various non-equity based
instruments (substitutes for conventional debt)

• Murabahah
– Sale and purchase contract for the financing of an asset where cost and profit
margin (mark-up) are known and agreed by all parties involved
– The settlement for the purchase can be affected either on a deferred lump
sum basis or on an installment basis, and is specified in the agreement
• Bai`bithaman ajil
– Contract that refers to the sale and purchase transaction for the financing of
assets on a deferred and installment basis with a pre-agreed payment period
– The sale price includes a profit margin
• Bai`al-salam advance purchase
– Contract where the payment is made in cash upon signing but the delivery of
the asset purchased is deferred to a pre-determined date
• Istisna purchase order
– Buyer places an order to purchase an asset to be delivered on a future date
– Buyer will require the seller to build and/or deliver the asset in the future
according to the specifications in the sale and purchase contract
– Both parties to the contract will decide on the sale and purchase prices and
the settlement is arranged based on the schedule of works
Sukuk replace the conventional bonds in
Islamic Finance

• Sukuk
– Bonds that are backed by real, non-financial assets

– Offers proportionate ownership in the underlying asset, which

is leased to the client to yield the return

– Tradable in a Shari’ah-compliant secondary market

– Shari’ah prohibits the trading of ST instruments other than at

face value or from drawing on inter-bank money markets
Islamic Finance leasing instruments are well-
recognized in the relevant markets

• Ijarah
– A manfaah (usufructuary) type of contract where the lessor (owner)
leases out an asset or equipment to his client at an agreed rental fee
and pre-determined lease period upon the aqad (contract)

• Ijarah Thumma Bai

– A contract which begins with an Ijarah contract for the purpose of
leasing the lessor’s asset to the lessee

– At the end of the lease period, the lessee purchases the asset at an
agreed price from the lessor by executing the purchase (Bai`) contract
Islamic Finance also offers insurance products

• General Takaful Islamic general insurance (based on

the principle of “ta’ awun” or mutual assistance)

• Family Takaful Islamic life insurance

• Retakaful Coverage Islamic reinsurance

Islamic Finance: New Options for Infrastructure Projects?

Development Agency Perspective on Islamic Finance

Islamic Finance Instruments

Islamic Finance Transaction Structures

Role of Development Agencies

Islamic Project Financing is primarily based on
Istisna and Ijara

Istisna (Procurement Contract)

• The common structure for construction project is a combination of Istisna
(Procurement or Construction Contract) followed by Ijara (Lease Contract).
• Since the project assets have to be constructed by the EPC contractor or
supplier, the investors fund the construction of project assets through the
Istisna arrangement directly with the Client or Project Company

Forward Ijara (Lease)

• Simultaneously with the Istisna, the investors enter into a Ijara (a Forward
Lease) with the Client or Project Company for a period equal to the tenor of
the investment facility
• The investment facility is funded through the Istisna and the repayment of
the investment facility flows under the Ijara
• At the maturity of the Ijara period, the assets revert back to the Client or
Project Company and all other arrangement are terminated
Typical Islamic Construction Finance
involving a combination of Istisna and Ijara

Investors 1. Investors provide the Project funding to the

Investment Agent

Client enters into a

Construction Contract 2. Investment Agent appoints Client
(e.g., EPC) with a as a Contractor under an Istisna
Contractor to construct (Procurement) contract
the Project
Investment 7. Investment Agent distributes the semi-annual
Client lease rentals to the Investors
Agent
3. Client delivers the Project
Assets as per the Project schedule

4. Investment Agent 5. Investment 6. Client pays semi-annual lease rentals

disbursers the Facility as per Agent leases the
the Project payment schedule Project Assets to
Client

Independent
Contractor Client
(Lessee)

Source: ABN-AMBRO Bank

USD1.5 B Sohar Project
(USD260 M Islamic Tranche)
 Transaction Summary

Lessor/Owner SPC incorporated in Bermuda

Lessee/Obligor Sohar Aluminium Company LLC. (“Sohar”) and the sponsors ADWEA,
ALCAN, Oman Oil Co
Leased Asset Gas & Steam Turbines, Transmissions, Heat Recovery Steam
Generators, Reverse Osmosis Plant
Facility Size US$260 million Islamic facility
Facility Structure Istisna and Forward Ijarah
Pricing L+45bps (during construction) and up to L+95bps (at end of 15 years)
Tenor 15 years
MLAs Arab Bank, ABN AMRO Bank, Citibank and SMBC
Security Standard security package and Completion Guarantee provided by the
Sponsors
Islamic
11 Conventional Banks
Participants
Source: ABN-AMBRO Bank
Istisna (Construction) & Ijara (Forward Lease)

Investors provide the

Investors funding to Sohar SPC
1. Sohar SPC appoints
Co and will acquire the
Sohar Aluminium Co. as
beneficial interest in the
a Contractor under an
Assets through the
Istisna contract and pays
Investment Agency
the Consideration
Sohar Agreement
Aluminium Sohar Aluminium
Sohar SPC Co.
Co. enters Co. LLC
2. Sohar Aluminium
into a
Co delivers the Assets
Construction 4. Sohar Aluminium Co.
(ie the project assets) as
Contract pays semi-annual lease
per the schedule
with a rentals: (i) Advance Rental
Contractor to Payment (during the Istisna
3. Sohar SPC
construct the construction period only);
forward leases the
Assets and (ii) Rental Payment
Independent Assets to Sohar
(after construction and
Contractor Aluminium Co. Sohar Aluminium
delivery of the Works)
Co. LLC (as Lessee)

Source: ABN-AMBRO Bank

Guarantees + Investment Agency Agreement

Completion Guarantors
2. The three Guarantors
provide Completion
ADWEA ALCAN Oman Oil Co Guarantees
1. Sohar SPC Co. is
appointed by the
Investors in the
Investment Agency
Agreement to
implement and enforce
each of the Completion
Sohar SPC
Guarantees
Co.

Source: ABN-AMBRO Bank

Sohar Aluminium
Co
 USD4.5 B Dolphin Project
(USD1 B Islamic Tranche)
Dolphin Energy bridge financing (Phase II)

• $3.45 billion 4 years

bridge financing for
the Dolphin Gas
Project (Phase II)

• Closed Sep. 2005,

Operational Q4 2006

• First cross-border
pipeline project in the
Gulf

• $1 billion Islamic
tranche with risk
equivalent to the
commercial tranches
 Transaction Summary

Lessor/Owner GIB as Facility Agent for the Investors

Lessee/Obligor Dolphin Energy Limited (“DEL”) and the Sponsors Mubadala
Development Company (“Mubadala”), Total S.A. (“Total”), and
Occidental Petroleum Corporation (“Oxy”)
Leased Asset Gas pipeline between Abu Dhabi and Qatar
Facility Size US$1.0 billion Islamic facility
Facility Structure Istisna and Ijarah (Bridge Financing Facilities)
Pricing L+35bps (first two years) and L+45bps (last two years)
Tenor 4 years
MLAs ABN AMRO Bank, BNP Paribas, Citibank, Dubai Islamic Bank, and
Gulf International Bank
Security Standard security package (oil pipelines) and Completion Guarantee
provided by the Sponsors
Islamic
1 Islamic Bank and 14 Conventional Banks
Participants Source: ABN-AMBRO Bank
Dolphin Energy Istisna (advance lease) structure

• Dolphin entered an agreement to construct the project on behalf

of the investors and also signed a forward lease agreement with
the investors to lease the assets when they are built

• Islamic component of the deal is economically equivalent to the

commercial tranche and is based on a floating (3 month Libor-
plus) rate rather than fixed payments

• First Sharia compliant deal to offer an advanced rental payment

that is linked to a floating rather than a fixed rate
Istisna + Ijara Financing

Financiers Financiers provide the

Project funding to the
1. Security Agent Facility Agent &
appoints Dolphin to Facility Agent
complete the Works distributes the semi-
under an Istisna contract annual lease rentals to
Dolphin the Financiers
enters into an
EPC contract Dolphin Facility Agent
with an EPC 3. Dolphin delivers the
Contractor to completed Works as
construct the per the Project
Works schedule Dolphin pays semi-annual
2. Facility Agent 4. Facility
lease rentals
disbursers the Agent leases
Facility as per the the completed
Project payment Works to
EPC Contractor schedule Dolphin
Dolphin
(Lessee)
Source: ABN-AMBRO Bank
Other Notable Transaction Models
Mudaraba bonds are suitable for public utilities
and other clients with identifiable cash flows
1. Arranger invests 2. The Mudaraba Bonds stipulate that
capital in Client and the Client the net profit of asset-based venture is
Client issues investment shared between the Client and the
certificates (Mudaraba Arranger per annum on an established
Bonds) with a defined ratio (e.g., 90:10). This arrangement
face value continue for an agreed period. At the end
Mudarabah of agreed period, the Client will buy
Bonds
back the Mudaraba Bonds at par value

Primary
Arranger Mudaraba
Bonds
Subscribers

trading

Secondary
Market
Source: ABN-AMBRO Bank
Malaysia global sukuk offers possibilities for
municipal bond applications

• $600 m sukuk. Issued in 2002, due 2007

• Proceeds utilized to finance the development of 4 land parcels

(2 hospitals, GoM living headquarters and GoM office complex)
• SPV bought the land parcels from the GoM
• Parcels are then leased back to the GoM
• Semi annual lease payments (LIBOR+.95%), guaranteed by GoM
• Upon termination, GoM will buy back the property at face value

• Rated Baa2 Moodys, BBB S&P

Government of
SPV Malaysia (GoM)
5 years Ijara lease
$600 m Libor + .95%

Investors
Islamic Finance: New Options for Infrastructure Projects?

Development Agency Perspective on Islamic Finance

Islamic Finance Instruments

Islamic Finance Transaction Structures

Role of Development Agencies

Development agency engagements in Islamic
Finance can have multiple objectives
• Islamic Finance as a product type
– Focus on supporting Islamic Finance transactions
– Governments mandating Islamic Finance components in projects
– Int’l banks driving Islamic Project Finance as arrangers/investors

• Islamic Finance markets as a source of capital

– Attracting Islamic Finance (capital) to client countries
– Directly raising capital in the Islamic Finance markets

• Islamic Banking
– Financial sector stability
– Corporate governance, disclosure and accountability
– Establishment of appropriate regulatory framework
Support to the emerging Islamic Finance
institutions should be the critical starting point
• Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI) (1991)
– 18 financial accounting standards, 4 auditing standards, 4 governance
standards, 2 codes of ethics, Statement on the purpose and calculation
of capital adequacy ratios for Islamic banks + 13 Shariah standards
• Liquidity Management Centre (LMC) (2002)
– Facilitates the pooling of assets and securitization through issuance of
tradable Sukuks for Islamic institutions to invest their surplus liquidity
• International Islamic Financial Markets (IIFM)(2001)
– Facilitates the establishment of a cooperative framework among the
265+ Islamic banks and financial institutions
• Islamic Financial Services Board (IFSB)(2002)
– Association of central banks, monetary authorities, securities and
exchange commissions, and other regulatory/supervisory authorities
• International Islamic Rating Agency (IIRA)(2002)
– Rates, evaluates, provides independent assessments and opinions on
the likelihood of any future loss by Islamic financial institutions
• Islamic Development Bank
– Charter includes development of Islamic Finance
Financing transactions with Islamic Finance
structures is challenging, but possible
• Direct borrowings in the Islamic Finance markets
– World Bank, IFC, IDB, others
• Participation in Islamic Project Finance
– Guarantees are likely to be the tool for initial engagements
– Sale and lease-back structures offer promise for utility financing
• Establishing transaction models to attract Islamic Finance
– Significant challenges related to local capacity in client countries
– Standards, norms and industry practices
– Harmonizing internal project preparation requirements
– Perceived geographic constraints on Islamic Finance investments
• Financial market stability
– Consumer finance driving the risk, not Islamic project finance
– Guidance on regulatory frameworks is a critical industry need
– Very potent risk-reward equation vis-à-vis Islamic microfinance
Islamic Finance: New Options for Infrastructure Projects?

The End