Three senior figures from the Islamic finance industry discuss how sharia-compliant project finance has fared in 2013 after a stellar decade, and look at its prospects – with a particular focus on sukuk – for 2014 and beyond.

The panel

Mansoor Durrani, senior vice-president and head of project finance at the National Commercial Bank, Saudi Arabia

Faisal Qadri, director, project and export finance, HSBC Saudi Arabia 

Badlisyah Abdul Ghani, executive director and chief executive officer, CIMB Islamic Bank, Malaysia 

Q: The Islamic project finance market has grown significantly over the past decade. While the past couple of years have proven to be more challenging, there was renewed optimism for 2013, with a strong pipeline of deals expected. Did the market’s performance meet your expectations? 

Mansoor Durrani: Islamic project finance is essentially a Middle Eastern phenomenon, though there have been a few, scattered, Islamically structured deals outside of the region. 

Both the number and size of the deals are a reflection of the economic activity in a market that is fairly robust in the Middle East region in general, and the Gulf Co-operation Council [GCC] and Saudi Arabia in particular. At the same time, Islamically structured project financing is increasing, not just within the largest market of Saudi Arabia, but also beyond.

In 2013, a couple of large Islamic project finance deals were delayed in Saudi Arabia. But they are expected to close either towards the end of this year or early 2014. The overall deal pipeline looks reasonably healthy. With an increased global need for infrastructure expenditure, the demand for Islamic project finance is expected to grow.

Faisal Qadri: The performance of Islamic project finance within the GCC region remained more subdued compared to that of the overall project finance market. A key illustration of this was the overall size of the Islamic commercial bank facility that was utilised in the largest project financing transaction to close in the region in 2013 – the $20bn Sadara Chemical Company greenfield joint venture between Saudi Aramco and Dow Chemical – compared with the size of the Islamic tranche used in the largest project in 2012.

Moreover, Saudi Arabia continues to lead the Islamic project financing market, with limited deal flow within the rest of the GCC and Middle East and north Africa (Mena) region.

While there were some notable achievements for the industry during 2013, including the largest ever sukuk project of $2bn for a greenfield project and fully sharia-compliant financing of the Polysilicon Technology Company renewables project, 2012 was clearly a more eventful year with groundbreaking Islamic project financing transactions, such as the multi-project company financing of the Acrylates Complex and the build, transfer and operate financing of Madinah Airport.

Badlisyah Abdul Ghani: Islamic project finance has performed well and gained prominence over the years through conventional project financing. It can be said that project finance helped build the corporate sukuk market when it first started in 1990 in Malaysia.

Post-2000, we have seen sukuk issuances based on Islamic project finance blossom globally, led by Malaysia with issuances made by the likes of Sejingkat Power Corporation in 2000, Sarawak Power Generation in 2000, Projek Lebuhraya Utara-Selatan in 2002, New Pantai Expressway in 2003, Ranhill Powertron in 2005, Plus SPV in 2006 and Pengurusan Air SPV in 2009.

Malaysia, being the world’s largest sukuk market, has had a great year for Islamic project financing. We have already seen issuances made by Telekom Malaysia, JatiCakerawala, Teknologi Tenaga Perlis Consortium, Segari Energy Ventures, Malakoff Power and Tanjung Bin Power, to name a but few, and there are a few more in the pipeline.

The rest of the world joined the fray in undertaking sukuk-based Islamic project financing in the past two to three years. This year, in Saudi Arabia, we saw Saudi Electricity Global Sukuk Company issue a $2bn sukuk, which is helping to pave the way for more such issuances in the GCC in the future. With greater infrastructure development needs in both Malaysia and the GCC, we expect a vibrant Islamic project finance pipeline in 2013 and onwards.

Q: The origins of Islamic funding in project financing transactions trace back to the early 1990s, with the $1.8bn Hub River power project in Pakistan which involved a $92m Islamic tranche. However, 2006 saw the first wholly Islamic project financing, Saudi Arabia’s $526m Al-Waha petrochemical project, and there have been others since. Do you expect to see an increasing shift towards projects that are solely funded by Islamic money?

MD: A lot has happened globally since Hub River in Pakistan and Al-Waha in Saudi Arabia. Over the past few years, almost every single project has had an Islamic tranche embedded in the overall financing. And the size of these tranches has progressively increased. There are a number of multi-billion-dollar mega-projects that have been co-financed, due to their sheer size, by a number of export credit agencies such as Export-Import Bank of the United States or Japan Bank for International Cooperation. Even these institutions have been comfortable in participating side-by-side with Islamic banks.

Additionally, the entire commercial tranche in the $2.5bn Rabigh independent power project in 2009 was Islamically structured, while the $1.1bn Madinah International Airport in 2012 was mainly financed Islamically. We played the lead role in structuring and financing both these landmark projects in the Saudi market.

FQ: The growth experienced in Islamic project financing within the Mena region can clearly be divided into two distinct phases. Phase one comprises the pre-financial crisis period that started in the early 1990s and culminated in 2008. In this phase, Islamic project financing volumes grew as a result of increased overall economic activity, the desire of private sector sponsors to promote their projects as sharia-compliant investments, and an increased push from government-related entities to align themselves to the preferences of the people.

The sponsors’ preferences and considerable funding competition led to regional and international conventional banks participating in Islamic financing tranches alongside conventional financing. Post-financial crisis, however, marks a new era for Islamic project financing, where growth is led by local conventional and pure Islamic banks. Due to balance sheet constraints, the appetite of regional and international banks to participate in project financing in general, and Islamic financing in particular, has reduced significantly. The ability of sponsors to fund their projects purely from Islamic financing tranches therefore currently remains limited and is dependent on their ability to attract funding from their local banks.

Large-scale greenfield projects, especially those requiring funding in excess of $1.5bn to $2bn, depend on additional financing sources, especially from governmental agencies and export credit agencies. While these organisations have shown interest in participating in Islamic financing tranches prior to the financial crisis, their relative importance in the funding mix has meant that project sponsors now have limited leverage in encouraging such organisations to participate in and support Islamic financing tranches.

BG: There is no reason why project financing cannot be done wholly Islamically since it can attract both conventional financiers as well as fully fledged Islamic financiers. Malaysia has been executing fully sharia-compliant deals since the 1990s. This is easy to do in Malaysia because of the effective legislative, regulatory, legal and sharia-compliant frameworks that exists in the country for Islamic finance.

The construction of the iconic Kuala Lumpur International Airport in the early 1990s was fully funded by way of sukuk issuance, and when it was issued it attracted a tighter pricing for the issuer than it would have achieved if it had issued a conventional bond. In terms of capacity to support large project financings, we do not see any limitation for Islamic finance to do this if it has the right market infrastructure, such as that currently available in Malaysia.

Perhaps the most notable and best example where a project was fully Islamically funded was the RM34.35bn [$10.81bn] Plus Berhad IMTN sukuk programme in 2012. It was the single largest sukuk issuance executed in one go anywhere in the world to date. We don’t expect this to abate in Malaysia and we foresee the same trend becoming more prevalent in other parts of the world.

Q: While the use of sukuk in project financings has been fairly limited to date, it is expected that a growing number of project companies will look to raise capital, in whole or part, by tapping the sukuk market. Do you agree with this outlook and how quickly do you expect it to happen?

MD: I have been far less bullish, on record, than some of my colleagues in the market. Looking at the limited trajectory in sukuk closed in Saudi Arabia and also within the GCC, unfortunately, my views have been proven correct.

The points that drive my pessimism, in the near term are, first, for project bonds to take off, we need a deeply liquid debt capital market that we don’t currently have, and second, the subscribers of these bonds should either be large pension funds/insurance companies or retail investors – currently bank treasuries are subscribing and therefore this is not 'new money' or 'additional pools of capital' that most of us are looking for. Finally, retail investors are getting far higher returns in investing in either equities or real estate, so there is very little incentive for them to diversity into sukuk or project bonds.

FQ: The SR3.75bn [$1bn] Satorp sukuk in 2011 and the SR7.5bn Sadara sukuk in April 2013 should be considered as important stepping stones for the industry in its efforts to diversify sources of funding and attract non-banking financial investors. However, these issues are unlikely to open the floodgates for project companies looking to raise additional capital by tapping the sukuk markets. As long as the local and regional banks remain liquid and willing to fill in the long-term financing gap at acceptable pricing, sponsors have had little incentive to put in the additional effort required to tap debt capital markets.

Moreover, recent case studies have not been able to demonstrate the ability of such project sukuks to tap significant ‘new money’ into their transactions. This is mainly because willing and capable non-banking investors are fairly limited in number and remain local in their investment approach. As project financing from banks becomes more constrained due to their compliance with Basel III regulations, the industry will develop funding solutions that tap into the limited recourse financing expertise of banks and the long-term investment horizon of its natural investors, such as pension and infrastructure funds and insurance companies.

Such meaningful collaborations usually take time and remain a challenge for the overall project finance industry. A key growth area for project sukuk in the near term is the refinancing of existing projects that have achieved completion and have demonstrated consistently stable operations.

BG: While the Islamic finance market remains small overall compared with the conventional finance industry, we should not discount the growth at which projects funded by sukuk have increased.

We have already highlighted how Islamic project finance has been integral in the development of the sukuk market in Malaysia, so I don’t think it’s fair to say that Islamic project financing by way of sukuk is limited. The only reason why we have not seen the same developments in other jurisdictions yet is because the market infrastructure is not ready. However, with Saudi Arabia rolling out the same market infrastructure as can be found in Malaysia, we are seeing more and more sukuk being used to finance projects there.

If other jurisdictions implement what Malaysia (a full tax regime) and Saudi Arabia (zero or limited tax regime) already have, then the outlook for sukuk in project financing is going to be very positive. However, I doubt that this will be seen any time soon as each jurisdiction must carry out their own different processes to put in place the right sukuk market infrastructure.

Q: In terms of products used to help mitigate risks associated with Islamic project financing, do you expect to see more emphasis being placed on obtaining takaful in the future?  

MD: 'Fully Islamic' has been an explicitly stated goal of both Islamic scholars and banks. Pragmatism demanded that they should begin with whatever is feasible and quickly achievable. To help manage expectations, we must bear in mind that the current bandwidth and sophistication of product offerings of conventional banks evolved over a period of three or four centuries. The Islamic finance industry is less than 40 years old. I am not implying we will have to wait that long for Islamic banks to offer 'total solutions', but scaling up in size and sophistication will require time.

Both Islamic banks and scholars are working together to achieve this objective. Consequently, we have now reached a point where large financings and hedgings are being done Islamically. While Islamic insurance [takaful] is also growing gradually, they still have some distance to cover in order to be able to underwrite the risks of large projects. For instance, many Islamic insurance companies do not have the required balance sheet size, risk assessment/management capabilities and the much-needed ratings from international rating agencies.

FQ: Islamic scholars have always promoted increased utilisation of sharia-compliant risk management solutions and have consistently incorporated such requirements into the Islamic financing documentation. However, the utilisation of such Islamic solutions is subject to commercial viability and left at the full discretion of the project sponsors. There have therefore been a number of instances where projects have been fully funded by Islamic financing tranches but chosen to utilise conventional hedging and insurance solutions. The main reason is the lack of commercial incentive for project sponsors, as well as a monitoring mechanism that tests the efforts made by these sponsors in maximising the utilisation of Islamic risk management solutions.

Moreover, large Islamic banks have focused on providing financing rather than hedging solutions, leaving little incentive for project sponsors to maximise competition by including Islamic banks in the hedging mix. The situation is more acute, however, with the takaful industry, which is limited in scale and therefore remains focused on meeting the requirements of retail investors, rather than multi-billion dollar, world-scale projects. The takaful industry therefore needs to increase its product offering and capacity to underwrite risk in order to become a commercially viable alternative to conventional insurance products for sponsors of large-scale projects.  

BG: One of the reasons why certain Islamic project financings are covered by conventional insurance is because some decades, back when issuers were looking for insurance, takaful was in a nascent stage, so they opted to use conventional insurance. Now that takaful is more developed, ideally conventional insurance that expires should be renewed with a takaful policy. However, this may cause the project to incur more costs due to the necessary administrative and documentation processes to replace the insurance coverage. Therefore, takaful has been perceived as more expensive.

Nonetheless, as new issuers enter the market to finance projects, either through local or cross-border flows, we envisage better prospects for takaful to cover or mitigate risk for Islamic project finance, as now takaful operators are more established and more ready to support large infrastructure projects at competitive rates.

Of course, this is subject to the takaful operator being able to provide the same kind of risk mitigating coverage and services. The ability of takaful to support project finance deals depends again on industry infrastructure being available in particular jurisdictions, including the availability of re-takaful providers. If takaful cannot cater, Islamic scholars still permit the issuer to opt for conventional insurance on a [public interest] basis, as additional project costs may translate to more costs to the country and the people. So the timeframe in seeing greater use of takaful in project finance deals will differ in different jurisdictions.

Q: What do you see as the greatest opportunities and challenges facing the future development of the Islamic project finance market?

MD: Opportunities will surely grow, across the board, when the overall demand for Islamic financing grows. The challenges centred around deal structuring, taxation and regulation will also grow as we move out of rather 'plain vanilla' GCC markets into more mature economies.

One case in point, for example, is how to structure build, transfer and operate projects in the infrastructure sector, as Islamic financing is all asset-based. We came up with an innovative solution for Madinah Airport in Saudi Arabia. But when we tried to replicate that structure for a large highway project in Turkey, we faced both taxation and regulatory challenges. We are currently working on possible solutions. Every opportunity brings along some challenges but we are prepared to face and overcome those challenges.

FQ: The demand for Islamic project financing is likely to increase significantly with increased political and economic stability and the expansion of Islamic banking into new markets in the Mena region and countries such as Turkey, Indonesia and Pakistan. Structuring export credit agencies financing and funding from governmental agencies on a sharia-compliant basis will be key to achieving fully sharia-compliant funding for large-scale projects. Meanwhile, strong government sponsorship will be key to the development of Islamic debt capital markets as demonstrated by the success of the Malaysian project sukuk industry.

The key challenge for Islamic project financing, however, remains the establishment of Islamic pension and endowment funds that would have the relevant scale, expertise and mandate to invest in project sukuk. Similarly, the industry is yet to see the emergence of pan-regional Islamic banks that would have the ability to participate in project financing on a cross-border basis and become a significant source of new money for project sponsors.

BG: The greatest opportunities for Islamic project finance is upon us today as we go through a reform of the global financial market to allow for wider and more stable financial access globally. As long as there is a need for infrastructure development in any particular country, there will be opportunities for Islamic project finance – the demand side is clear. And as long as there is facilitation of the Islamic finance industry through proper legislation, regulation, legal and sharia frameworks in a particular country then there will be opportunities for Islamic project finance.

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