The Middle East and North Africa (MENA) region has recently seen a surge of interest in developing renewable energy, in particular solar energy projects. Led by Morocco and Jordan which have successfully implemented numerous projects, the region is looking to considerably increase the proportion of electricity generated from solar energy. This includes the ambitious 9.5 gigawatts (GW) of renewable energy Saudi Arabia hopes to install as part of its Vision 2030 program, the further development in Dubai following the success of the Sheikh Makhtoum Solar Park which, when complete, will have a total capacity of 1,000 MW. In Egypt, the government hopes to procure 2,000 MW of solar energy through its feed-in-tariff program and hopes to confirm a second round of the program.
Waste-to-energy projects are also expected to be developed in the region and will form a key part of the integrated waste management strategy. Already in the UAE, there have been two publicly announced projects (in Dubai and the Northern Emirates) and others in Sharjah and Abu Dhabi are expected. In Saudi Arabia, there is an interest in developing such projects including in the Royal Commission of Yanbu.
In almost all cases, the projects are procured on an independent power project (IPP) model. As further described in the next section, under this model, a government entity enters into a long term, typically 20 25 year, power purchase agreement (PPA) with a private sector entity to purchase power at a fixed price from the project.
Typically, the private sector will enter into project financing arrangements with lenders (commercial banks, multi-lateral agencies, export credit agencies, etc.) whereby the lenders are repaid from the revenue stream generated by the project.
In recent years, a number of factors have led to Islamic financing gaining ground in the project financing market in the MENA region. They include:*the establishment of new Islamic banks ( g., Alinma in Saudi Arabia and Abu Dhabi Islamic Bank and Dubai Islamic Bank in the UAE);
*the development of more creative Islamic finance structures which can utilize a projects underlying assets;
*the increasing number of conventional banks that are now willing to lend on an Islamic finance basis;
*the willingness of credit export agencies to work with Islamic financing structures and co-lenders; and
*the preference of some private sector sponsors to procure finance on an Islamic finance basis ( e.g., the USD 2 billion financing of an industrial gases unit in Jazan, Saudi Arabia concluded in 2015). Islamic finance is certain to be deployed in the renewable energy sector as well. Familiarity with such structures is crucial for lenders to gain a meaningful share in the renewable energy project finance market. For sponsors, the ability to finance projects on an Islamic finance basis allows them to access a considerably greater number of financing sources. Moreover, sponsors in the high growth markets of the Middle East and Southeast Asia often encourage Islamic finance.
In the following sections, we first provide a short overview of the traditional project finance structure as applicable to a renewable energy project. While we use the case of solar projects, the principles are applicable to any renewable energy project, including waste-to-energy, geothermal and wind project. We then describe some of the principles of Islamic finance and elaborate in detail on the most commonly used Islamic finance structures in project financings, the combination of a procurement facility and a forward lease arrangement, referred to as the Istisna-Ijara structure and the Tawarooq structure.
Conventional Project Financing
In a conventional project financing, the private sector sponsor (or sponsors) would create a special purpose vehicle (or company) (SPV) to build, own, operate and maintain the project. This SPV would enter into the PPA with the purchaser of electricity (typically a government entity if the project is to be connected to the grid system) as well as the contracts relating to the solar panel supply, civil works and other construction (collectively, the EPC Arrangements) and contracts for the operation and maintenance of the project (the O&M Agreement).
Financing for the project would be typically provided through a combination of debt and equity. Factors such as the country where the project is located, the reliability of the technology being employed for the project and the credit worthiness of the counterparty to the PPA will impact the ratio of debt to the total project costs the riskier the project, the lower this ratio would be. However, in nearly all cases, the sponsor(s) can expect to be required to contribute at least 10-15% of the equity for the project. The factors noted above will also determine whether the lenders will require all of the equity to be contributed before or pro-rata with the debt. Finally, the lenders will typically require the sponsor(s) to commit to providing further equity in the event the total costs of the project are greater than initially expected.
The obligation to repay the debt is an obligation of the SPV and not of the sponsor(s). As such, the lenders will also be provided with a security package to secure the repayment of the debt. This will include:
*a security interest over the equity interests in the SPV (pledged by the sponsor(s));
*assets comprising the project;
*the land rights of the SPV;
*any bank accounts of the SPV (the SPV will be restricted from maintaining any bank account not expressly permitted by the lenders); and
*any contracts entered into by the project company. It should be noted that the ability to provide and/or perfect all or part of the security may be limited by the laws of the jurisdiction in which the project is located.
The lenders will also enter into direct agreements with counterparties to the principal agreements of the SPV including the counter-parties to the PPA, the EPC Arrangements, the O&M Contract and any land lease (unless the land on which the project is constructed is owned by the SPV). These direct agreements will give the lenders certain rights in the event of a default by the SPV under the applicable contract, require information to be provided directly to the lenders of certain material events and direct the applicable counterparty to remit any payments owed to the SPV to one of the accounts over which the lenders have a security interest.
Recognizing that the lenders sole recourse is to the assets of the SPV and there is no creditworthy guarantee standing behind such obligations, the SPV is also subject to considerable restrictive and affirmative covenants under the financing agreements. These include restrictions on sale of assets, restrictions on incurring any debt or providing security over assets of the SPV, requirements to maintain insurance (and use of any insurance proceeds) and interest rate hedges, requirements to provide frequent reports on construction and operation, etc.
In some circumstances, again depending on the risk profile of the project, the lenders may agree to allow the project company to incur debt to cover the equity contribution commitment of the sponsor(s). However, such debt will always be deeply subordinated in right of payment to the senior lenders and the senior lenders will typically require it to be paid off at the time the project achieves commercial operations and starts selling electricity under the PPA.
The following figure represents the key contractual arrangements for a solar project developed on a conventional project finance basis.
Principles of Islamic Financing
An overview of certain basic principles of Islamic financing is helpful in understanding the structures that can be employed for a project financing that is also compliant with Islamic finance requirements.
A defining element of all Islamic finance structures is that no interest ( riba) can be charged. Rather, the financier charges a mark-up or shares in the profits of the venture. This can be achieved in by the following:
*entering into sales and purchase transactions;
*entering into leasing arrangements; or
*participating in equity investments. In addition, there are some general principles that must also be adhered to, which are discussed below.
Interest and Unjust Enrichment
Returns to financiers should generally be linked with the profits of an enterprise and derived from the commercial risk taken by the financier. Islamic law principles encourage financiers to become partners in the enterprise they finance and not act as pure creditors. Fixed return on investment, therefore, cannot be guaranteed.
The existence of uncertainty ( gharar) in a contract is prohibited; transactions where the price, time of delivery or subject matter are not determined in advance may not be compliant with Shariaahprinciples.
Transactions should be free from speculation or gambling ( maisir); this prohibition does not usually extend to general commercial speculation as seen in most transactions, but the aim is to prevent speculation which may be considered gambling.
Finally, investments relating to prohibited activities and products drugs, pork, alcohol, gambling, etc. are not permitted.
The Istisna-Ijara Structure
While a number of Islamic finance structures can be used to finance renewable energy projects, the most common, and the one most international lenders have become comfortable with, is referred to as the Istisna-Ijara structure. This is essentially a combination of an Istisna (procurement) and Ijara (forward lease) structures.
An Istisna is a contract for sale whereby one party undertakes to manufacture a specific asset according to agreed specifications and deliver the asset by an agreed time for an agreed price.
To implement the structure, a special purpose vehicle (the Owner) is established by the financiers and acts as the purchaser of certain agreed upon assets. The SPV acts as the procurer on behalf of the Owner under a procurement agreement. Under the procurement agreement, the SPV agrees to procure assets on behalf of the Owner by a certain date. The procurement agreement operates for the construction phase of the project; and on delivery of the assets, title to and possession of the assets passes to the Owner. The assets to be procured comprise the assets required for the development of the project in the case of a solar energy project, these would include the solar panels, the substation, the civil works required for the project and any other items needed for the completion of the project.
The use of the Owner entity to act on behalf of the financiers is a fundamental part of this structure. This benefits both the financiers and the SPV. The financiers are protected from the risks associated with the ownership of the assets, for example, environmental liability. For the SPV, the assets are isolated from the risk of insolvency of a financier since the assets are not held directly by the financiers.
The financiers agree to pay the project company an amount no greater than the total project cost for the procurement of such assets. This amount would be the amount equal to the total principal amount of the loans advanced in a conventional project financing described above. These payments are made as phase payments corresponding to drawdowns under the conventional project finance structure. Accordingly, under the procurement agreement, phase payments are made with the same conditions to drawdown as under the conventional loan facilities.
Some features of a conventional project financing are replicated in this structure, these include a reduction of facilities whereby the SPV can alter the specifications of the assets and thereby reduce the total amount payable by the financiers. In addition, if the cost of constructing the assets is greater than the maximum amount committed by the financiers, the SPV (and in turn the sponsor(s)) must pay the excess and the financiers have no obligation under the procurement agreement with respect to the excess.
In addition to its liability for any cost overruns, the project company is required to pay liquidated damages to the Owner (which the Owner uses to repay the financiers) if:
*the assets are delivered behind schedule;
*the assets are non-conforming; or
*the procurement agreement or Istisna is terminated before the project is completed. Because the financiers are repaid from lease payments and lease payments can only be made once the assets are constructed and operational, the liquidated damages provision enables the financiers to receive monies equivalent to:
*the lease payments they would have received had the lease transaction commenced as scheduled (in case of a delay); or
*all amounts paid by the Owner (and in turn the financiers) to the SPV to procure the assets (in the case of non-conforming assets or termination of the procurement agreement). The SPV, as lessee, and the Owner, as lessor, will also enter into a forward lease agreement such that, once the project is complete, it is leased to the SPV. The forward lease agreement operates during the operational phase and expires on the date corresponding to the final maturity of the debt facilities under a conventional project financing.
The lease payments to be made by the SPV under the lease agreement comprise of the following components:
*Fixed element equivalent to principal on the conventional facilities; and
*Variable element generally on the basis of a reference rate ( g., LIBOR, SAIBOR, etc.) plus a fixed fee (equivalent to the applicable margin under a conventional facility). Voluntary prepayments are addressed through a sale undertaking entered into by the Owner and the SPV. This undertaking mimics the typical voluntary prepayment provisions of a conventional debt facility allows the SPV to take ownership of the assets by paying off the remaining amount of the facilities.
Similarly, the SPV and the Owner are typically also parties to a purchase undertaking that requires the SPV to purchase the assets under certain circumstances. While these circumstances are deal specific, a mandatory purchase upon the occurrence of an event of default under the facilities is quite common and equates to the acceleration of debt upon the occurrence of an event of default under conventional facilities.
Under Islamic finance principles, unlike in conventional operating leases, the Owner (in its capacity as lessor) is responsible for all major maintenance and insurance while the SPV (as lessee) is responsible for all ordinary maintenance. To limit the Owners liability and ensure that third parties do not have any claims on the Owner or its assets, the SPV and the Owner enter into a service agency agreement under which the SPV is appointed as agent of the Owner for the purpose of carrying out the major maintenance and procuring the insurance. Should the SPV fail to effect any repairs or replacements, or obtain the insurance, the Owner may do so and will be indemnified by the SPV for all amounts paid or costs incurred by the Owner. Payments due from the Owner to the SPV under this agreement are netted out of the lease payments due from the SPV to the Owner.
The treatment of the assets at the end of the term of the lease varies by jurisdiction and the view of the applicable Shariaah committee of the financiers. In some cases, ownership passes automatically (or expressly as a gift) to the SPV and in others, a predetermined price has to be paid by the SPV to acquire the assets. This price can be included in the repayment profile to ensure that the total amount paid by the SPV would equal the amount it would have paid under a conventional facility.
Other Islamic Finance Structures
An alternative but similar structure often implemented in project financings is known as the Wakala-Ijara Mawsufah Fi Al Dhimmah structure or Wakala-Ijara structure. In such a financing, the SPV is employed as the Owners agent or Wakil in accordance with a WakalaAgreement. While largely the same as the Istisna arrangement described above, being an agency agreement, the contractual relationship between the Islamic finance institutions and the borrower is different. Otherwise, the two structures are similar.
In some instances, a Murabaha structure can also be used. A Murabaha is a cost-plus financing which involves the purchase of an asset by the financial institution (which could be an Islamic financial institution) and the immediate resale of the asset to the borrower on deferred payment terms at cost, plus an agreed profit. This structure can be used to finance the acquisition of existing assets and also for equity bridge loans ( i.e., when the equity contribution obligation of the sponsor(s) is satisfied via the SPV entering into a debt facility).
The total purchase price of the asset is generally paid in instalments over an agreed period of time. Although the Murabaha structure has the advantage of placing title to the property in the hands of the borrower, prepayment restrictions and pricing constraints have limited the use of this structure.
One of the most popular forms of Shariaah compliant financing is the use of working capital or commodity Murabahas ( Tawarooq). Amounts are lent to the SPV through the use of separate Murabahas for the acquisition by the lender (acting as the agent of the SPV) of amounts of commodity equal in value to the principal amount required, the immediate resale to the SPV at the purchase price of such commodity, plus an agreed return, and the immediate resale to the original seller of the commodity (normally for the price at which the original seller sold the commodity to the lender, plus a small transaction fee, which is passed on to the SPV). The profit portion owed to the lender is then in addition to the amounts lent to the SPV for the construction and/or operation of the project. While this form of Islamic financing is widely utilized, particularly in Saudi Arabia, it has been criticized by certain Islamic financial institutions, and borrowers in the GCC region are increasingly opting for other forms of Shariaah -compliant financing.
We also note a growing interest of energy projects in the GCC region to being partially or completely financed through the use of Sukuk. Sukuk holders have undivided beneficial ownership interests in the asset underlying the Sukuk. Sukuks are arguably analogous to US Trust Certificates and provide holders regular payments that are often benchmarked to LIBOR. It is now possible to obtain rated Sukuk, and a number of Sukuk in the region are redeemable in the event the SPV floats its shares within a certain number of years from the issuance of the Sukuk. The assets from which the Sukuk holders share in the risk return profile must be Shariah-compliant. Sukuk tranches in project financings of energy projects are widely expected to grow in popularity over the next few years in the GCC, particularly as some lenders lack the liquidity for some of the planned mega projects.
While there are other Islamic finance structure practiced in the market including Musharaka (joint venture) the Istisna-Ijara (and for some lending institutions, the Wakala-Ijara) and the Tawarooq are the most commonly employed and allow lenders to mirror conventional financing principles effectively.
Two other areas deserve mention when considering Islamic finance structure for renewable energy projects. These are intercreditor issues and governing law issues.
This arises when the financing for a project is procured through a combination of conventional and Islamic facilities. As the Islamic financiers are the (indirect) owners of the assets, this structurally puts an Islamic financier in a better position than a conventional lender, who is usually only a beneficiary of security granted to a collateral agent. These issues need to be addressed in an intercreditor agreement which sets out the decision-making process in connection with the enforcement of security and the mechanics for the sharing of enforcement proceeds.
There are no universally accepted principles of Islamic financing as there are four schools ( maddhabs) of Islamic law and the details differ from jurisdiction to jurisdiction and, indeed, from lender to lender (for instance, some lenders in Saudi Arabia only consider Wakala-Ijara structure to be compliant with Islamic law and not Isitsna-Ijara). As such, normally the agreements would provide that only the Shariaah board of the applicable lender can opine on whether or not agreements are Shariaah -compliant. Once deemed to be Shariaah compliant, the contracts should be subject to a legal system which would enforce them as agreed between the parties and not conduct a de-novo Islamic law review on them. Specifying English Law or New York Law, without reference to Shariaah, to be the governing law of the agreements achieves this objective.
Future of Islamic Finance in Renewable Project Financing
For reasons outlined at the start of this paper, the use of Islamic financing structures in the renewable energy space is expected to grow. Further, given the fact that some of these have now been considerably standardized (and projects financed with such arrangements are in operation), it is our view that more and more projects will utilize Islamic finance facilities. With the assistance of qualified advisors the identification of an appropriate financing structure for a project and its implementation can be achieved quickly and efficiently.