Hidayathullah Baig, First Energy Bank, Bahrain

Economic growth in the Middle East has created a need for more power projects. Funding for these schemes in the past has been standard but Islamic finance is now increasingly backing them. Hidayathullah Baig of First Energy Bank explains how it works.

The day may not be too far off when all power projects in the countries of the Gulf Cooperation Council (GCC) are financed under rules laid down by Islamic law, or Shariah.

For several reasons the growing market for the Islamic financing of power projects in the region is likely to receive a boost. First, sponsors of power projects in the nations of the GCC want to enhance the reputation of independent power projects (IPPs) and independent water & power projects (IWPPs) among Islamic investors and are willing to achieve this through the use of Shariah-based financing. Second, GCC governments are encouraging this form of banking and, third, the risk appetite of Islamic banks is growing.

Islamic project financing has successfully backed almost all the recent schemes in an IPP/IWPP programme the GCC launched to open the sector to private investment. So what sets Shariah financing apart from traditional forms?

The Al Hidd IWPP in Bahrain under construction in 2007

In the latter case debt for capital-intensive projects such as IPPs and IWPPs is backed by the assets of the project and serviced by the revenue they generate. Although both forms of project financing are based on real assets, the traditional form depends more heavily on the cash-flow stream the project provides. Islamic finance relies more on the ownership of the project assets.

While the structures of the two types of financing are different the underlying economics tends to be similar, for example in terms of the pricing, tenor and repayment profile, although not necessarily so in every case. It is these similarities that have made Islamic finance a new source of funding for the capital intensive IPP and IWPP projects.

Various modes of Islamic financing can back power and water projects. These include:

  • the Murabaha, which is based on deferred payment;
  • Istisna, or construction financing;
  • Ijara, or leasing;
  • Mushraka, or partnership.

Ijara is the method widely used for long-term schemes like IPPs and IWPPs. As these projects have two distinct phases – the construction phase and the operations phase – a different mode is usually employed to suit the specific character of each. For example, Istisna tends to back the construction phase while Ijara tends to back the operations phase.

Islamic banks can earn lease rentals as soon as the assets are delivered at the end of the construction period or from the date of the beginning of the operations phase, as the leasing kicks in from then. Since the Islamic financing arrangements are required to be finalized for both the phases before financial close, Ijara is structured as a forward leasing arrangement, known as Ijara Mawsufah Fi Al Dhimmah.

The Al Hidd IWPP in Bahrain

Under a different structure, called Istisna-Ijara Mawsufah Fi Al Dhimmah, the Islamic banks identify a particular asset in the project for financing, for example a generator or boiler. Under this agreement the Islamic banks appoint the project company, or borrower, as the “contractor” for procurement of that particular asset. The project company then enters into back-to-back construction contracts with construction contractors for procurement of the asset. At the same time, the Islamic banks agree to lease these assets to the project company under a forward lease agreement. The assets are delivered after the construction period.

Although Istisna-Ijara Mawsufah Fi Al Dhimmah is used mainly in IWPPs in the region, in some countries it has found no favour with the Shariah boards of some banks, particularly in Saudi Arabia. Shariah scholars stress the need to avoid unduly complex contractual structures to avoid any element of excessive uncertainty. According to some of them, a combination of Istisna and Ijara is not permissible as it is akin to two contracts in one; the two contracts seem to be interdependent and interrelated.

To overcome this issue some Islamic financing employs an alternative structure called Wakala-Ijara Mawsufah Fi Al Dhimmah. Here the Islamic banks appoint the project company as their Wakil (agent) to procure the assets. The project company enters into the construction contract with contractors to procure and construct the assets as an agent of the Islamic banks, not for its own account. Saudi Arabia has found this arrangement acceptable and all IWPPs in that country have used this structure.


Multiple Islamic tranches


Recent project finance transactions have used multiple Islamic tranches to accommodate the requirements of different Shariah boards. The first of these was the $5.50 billion Ma’aden Phospate Company’s mining project in Saudi Arabia, which includes the construction of power and desalination plants. Here Istisna-Ijara Mawsufah Fi Al Dhimmah and Wakala-Ijara Mawsufah Fi Al Dhimmah are in operation. A recent example in the IWPP sector is the Al Dur project in Bahrain in 2009.

The Islamic banks receive advance rentals during the construction period for leasing the assets in the future. The advance rentals are to be fixed and agreed upon at the time of execution of the forward leasing agreement under Wakala-Ijara Mawsufah Fi Al Dhimmah, whereas under the Istisna- Ijara Mawsufah Fi Al Dhimmah the advance rentals are linked to a benchmark index.

During the lease period, the Islamic banks as lessors receive periodic lease rentals which are structured on a floating rate basis. The lease rental comprises two components.

The first is fixed and is the principal repayment. The second is variable, reflects the return to the Islamic banks and comprises a benchmark index like LIBOR – a reference rate based on the interest rates at which banks borrow money from other banks in the London wholesale money market – plus the margin.

Islamic banks have to maintain and insure the projects assets because they are their owners. However, the banks transfer responsibility for maintaining and insuring them to the project company under an agreement in which the project company acts as a service agent. For this, the Islamic banks must make periodic payments to the service agent.

As asset owners, the Islamic banks are entitled to compensation under the lease agreement. The periodic payments made to the service agent for maintenance and insurance are recovered by increasing the fixed component of the lease rental.

On expiry of the lease period, the title to the assets is passed on to the project company, either by way of a gift or by a nominal payment.


GCC’s IPP/IWPP programme


The most recent of projects in the GCC’s IPP/IWPP programme was Al Dur IWPP, in Bahrain, in which in 2009 First Energy Bank invested $50 million for a nine per cent stake. The Al Manah Power Project in Oman was the first IPP in the GCC region.

Over 20 IPP/IWPP projects have been implemented in UAE, Saudi Arabia, Oman, Qatar and Bahrain and many more will be in the near future. The table above shows some of the IPP and IWPP projects in the GCC region.


Future of Islamic financing for IPPs and IWPPs


Given the huge capital cost requirements and long-term nature of IPPs and IWPPs, there is immense potential and opportunity for Islamic project finance to develop. However, the lack of capacity among Islamic banks to fund such projects hinders the development of the Islamic project finance market.

Participants in Islamic financing are not just Islamic banks. Conventional banks have also participated in Islamic tranches, either through their Islamic windows or directly, as most of the commercial terms tend to be the same compared with tranches in traditional project finance.

It is possible that IPP/IWPP projects could be financed fully by Islamic financing, with the participation of both the Islamic banks and conventional banks. However, it seems that the project sponsors are reluctant to push for a full Islamic financing package, given the state of the market.

With signs of economic recovering and signs of liquidity problems in the bank market easing, hopes are rising for a revival of the project finance market. With the emergence of the market for sukuk, which are fixed interest rate bonds that meet the requirements of Shariah, the possibility of issuance of project finance sukuk in the region has also increased. It is definite that Islamic project finance will continue to play a major role in the infrastructural development in the GCC region.

Although traditional project financing has previously dominated the IPP/IWPP financing market, Islamic project financing has become an essential part of financing these projects in recent years.

Over the past 5-6 years, all the IPPs and IWPPs in the region have had Islamic tranches ranging from 20-50 per cent of the overall financing of the projects.

Be it the desire of the project sponsors to maximize Islamic financing or to tap the liquidity of the Islamic banks, Islamic project financing has come to stay in the development of IPPs and IWPPs. MEE


Key features of IPP/IWPP programmes in the GCC region



  • Implementation of the project as a build-own-operate scheme by the private sector, with or without partnership, with the off-taker or government entity in the project company;
  • Successful bidder selected on the basis of lowest tariff for electricity and water;
  • Energy conversion or tolling arrangement sees fuel supplied free of cost for conversion into electricity;
  • Power purchase agreement/power and water purchase agreement (PPA)/(PWPA) for off-take of electricity or desalinated water by government utility;
  • Tenor of PPA/PWPA ranging between 15 and 25 years;
  • In many cases the payment obligations under the PPA/PWPA are guaranteed by the government;
  • Financed 70-75 per cent by debt and 25-30 per cent by equity;
  • Debt financing by export credit agencies, international, regional and local commercial banks, and Islamic banks;
  • Tenor of commercial and Islamic financing ranges from 15 to 25 years, unavailable in the current market.



Case Study: Al Dur IWPP


In 2009 a consortium comprising GDF Suez of France and Gulf Investment Corporation of Kuwait won the contract to develop the 218 000 m3/day water desalination and 1234 MW power project in Bahrain. The construction cost of the project is estimated at $2.1 billion. Operation of the first unit is expected to begin in July 2010, full operations in July 2011.

The PWPA tenor is 25 years. Funding is from debt and equity in a ratio of 75:25. The $1700 million financing for the project had multiple financing sources, including export credit agencies, commercial financing and Islamic financing. This is the first IWPP transaction with multiple Islamic tranches. The Islamic financing of $300 million comprised Istisna-Ijara Mawsufah Fi Al Dhimmah and Wakala- Ijara Mawsufah Fi Al Dhimmah.

The project successfully achieved financial close in July 2009 in an adverse market. As long-term liquidity had vanished, the project had to settle with tenors of eight years, with a balloon of 80 per cent for the commercial and Islamic tranches. This financing structure has been termed “mini-perm”.

The key documents for the Istisna-Ijara Mawsufah Fi Al Dhimmah tranche are the Istisna agreement, the forward lease agreement and the service agency agreement.

For the Wakala-Ijara Mawsufah Fi Al Dhimmah tranche these are the Wakala agreement, the forward lease agreement and the service agency agreement.

Under the forward lease agreement, the actual lease begins only from the date of delivery of the assets and the passing of the title of the assets to the Islamic banks.


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