Shifting Title and Risk: Islamic Project Finance with Western Partners

Abstract

Project finance exemplifies modern globalized business transactions in that a single project can bring together numerous participants from across the world, and in that sense it is a truly international undertaking. A general definition of project financing would be “the financing of an economic unit in which the lenders look initially to the cash flows from operation of that economic unit for repayment of the project loan and to those cash flows and other assets comprising the economic unit as collateral for the loan.” Project finance is commonly used to finance large-scale infrastructure projects such as toll roads, power plants, airports, and desalination plants, as well as natural resource exploitation projects such as hydroelectric dams, mining projects, oil and gas assets, and paper mills. These types of projects often require larger amounts of capital than one company alone can raise, or entail greater amounts of risk than one company alone can bear. Thus, project finance enables companies to pool capital and spread risk. Moreover, because the project is its own economic unit, the project is “off-balance sheet” from the vantage point of the participating companies, thus further insulating them from the project’s liabilities. Also, governments will sometimes look to project finance to undertake projects that would be difficult for the government to finance through its own resources, or because the government and host country lack the expertise to domestically construct and operate the project. In sum, project financing is common in both the public and the private sector, and has been since the mid 1970’s.

Indeed, there are very few countries and economic systems in the world where project finance techniques have not been used to undertake the construction and operation of a project. Countries in which Islam is the predominant religion (the Islamic world) and financiers from such countries have perhaps been the most recent entrants to the world of project finance. As such, project financing in and from the Islamic world picked up steam only in the last ten years. This late arrival is due in large part to conflicts between many fundamental principles of Western project financing and certain Islamic principles. Despite these obstacles, growth in project finance in the Islamic world is due in large part to surges in the price of oil and the resulting pools of excess cash that governments in the Islamic world have accumulated and invested in infrastructure.

This note will survey Islamic finance and banking to show that the main consideration for structuring Shari´ah-compliant project financing is to ensure that the Islamic financier retains title in the project’s operating assets. Structuring projects to accommodate this requirement allows for traditional Western financing to cooperate in project financing with Islamic financing, and overcomes most Shari´ah prohibitions. Such not only facilitates the participation of Western interests in projects in the Islamic world, but also allows for the participation of Shari´ah-compliant financing in countries outside of the Middle East, including the United States. To proceed, Part I of this note will provide a general background to Shari´ah, its economic principles, and its application to project finance. Part II will address potential problem areas that are idiosyncratic to participation in Islamic project finance, including the need for the Islamic participants to retain title in the underlying project assets. Part III will describe Islamic financing tools and how those tools have been applied to project finance to facilitate title retention and deal with the some of the other potential problem areas. Part IV will examine some past project financings with both Islamic and Western participants that used Islamic financing tools in order to demonstrate how allowing for some form of retention of title on the part of the Islamic participants helps assure Shari´ah compliance. Finally, the note will conclude by reemphasizing that the chief concern in projects with both Islamic and Western partners is facilitating the retention of title in some or all of the project assets for the Islamic financiers, and discussing how project finance could grow and benefit from potential new sources of wealth and resources in the Islamic world. In the end, it is important to acknowledge the unique nature of Islamic project finance, and that learning how to facilitate the retention of title for the Islamic financier makes it possible to overcome most of the Shari´ah restrictions as well as many of the potential problem areas associated with Islamic project finance.

Keywords: Islam, Shari´ah, Shari´ah-compliant, Islamic law, finance, project finance, title, risk, international law

JEL Classification: F15, F10, F20, F21, F23, F30, F36, G10, G15, G19, G20, G24, G30, G31, G32, G39, K33, L14, L60, L70