financial risk management instruments for renewable energy projects - the islamic finance...
TRANSCRIPT
Executive Master in Energy Management 2011/12
Financial Risk Management
Instruments for Renewable Energy
Projects
The Islamic Finance Alternative
Georges Khoury
September 10, 2012
Financial Risk Management Instruments for Renewable Energy Projects – The Islamic Finance Alternative
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Table of Contents
Executive Summary .............................................................................................................. 3
Introduction ........................................................................................................................... 5
The UNEP Report ................................................................................................................. 5
Renewable Energy Project Risks ....................................................................................... 6
Risk Management Product # 1 – Insurance ....................................................................... 7
Other Risk Management Instruments ................................................................................ 9
Risk Management Products – The Way Forward ..............................................................12
A Primer on Islamic Finance .................................................................................................12
The building blocks of Islamic Finance .............................................................................12
Islamic Risk Management – Takaful is the new # 1 ..............................................................15
Basic Structure of Takaful .................................................................................................15
Models of Takaful .............................................................................................................16
Takaful and Conventional Insurance Compared ...............................................................18
Using Takaful to Manage Risks of Renewable Energy Projects ........................................19
Other Risk Management Instruments – Are there Islamic Equivalents? ................................21
Risk Management Products – Could the Way Forward be Shari’ah Compliant? ...................25
Conclusion ...........................................................................................................................26
References ...........................................................................................................................27
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Executive Summary
In 2004, the United Nations Environment Program published a Scoping Study on Financial
Risk Management Instruments for Renewable Energy Projects. Their objective was to
present renewable energy projects (Direct solar, Wind, Wave, Tidal, Geothermal and
Biomass) and the challenges posed by coming up with the right financing for them.
The state of technology, though more mastered in some forms of projects than others, still
gives rise to operational risks, described in the report.
The most prominent risk management instrument used to mitigate the operational risks, as
well as the financial risk, remains traditional insurance coverage. A survey, conducted in
2011, confirms this fact, seven years after the original report.
After introducing traditional insurance policies applicable to specific project risks, the report
goes on to present financial instruments ranging from weather derivatives to International
Financial Institutions’ guarantees and grants.
The report finally lays out potential future development in the field, the most important of
which being the integration of revenue streams from carbon emission trade with the existing
income streams of renewable energy projects.
The objective of this study is to introduce financial instruments compliant with Islamic laws,
that could serve as alternative to the traditional products.
To be compliant with Islamic law, Shari’ah, financial products need to steer clear of riba
(interest), gharar (uncertainty) and maisir/qimar (gambling). Shari’ah scholars have
developed a large portfolio of financial / banking contracts that could be combined to achieve
whatever traditional finance does. These contracts include mudarabah (profit and loss
sharing agreement between financier and business), musharakah (permanent equity
investment for a fixed duration), murabaha (cost plus agreement), salam (prepayment for
purchase of goods), ijarah (leasing), istisna’a (agreement to manufacture an item at a future
date) and wakalah (agency agreement).
The counterpart to traditional insurance is Islamic takaful, whereby the insured parties
contribute donations to a takaful fund, managed by a takaful operator; the fund would pay for
the eventual claim. In addition, the underwriting surplus or deficit usually is shared among the
policyholders. Takaful can follow many models: pure wakalah (where the takaful operator
receives a fixed fee and the proceeds of the funds are shared by the insured parties), pure
mudarabah (where the takaful operator shares the proceeds of the fund), a combination
wakalah / mudarabah (where there is also sharing of the proceeds but the whole model is
frowned upon) and the wakf model (where the amounts paid by the insured are split into
donations and investments and only investment proceeds are shared among the insured and
the takaful operator).
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Irrespective of the model followed by the takaful contract, all traditional insurance policies
can be replicated in a Shari’ah compliant fashion. The caveat is to be as precise as possible
in underwriting policies by defining the risks, the trigger mechanisms and by limiting
uncertainties through affixing coverage ceilings and assigning fixed values to contingencies
(loss of profit, loss of time, etc.).
In a similar fashion, takaful policies can be used as basis for other financial products used to
mitigate renewable energy risks. Any derivative product (swaps, options, CDO’s, etc.) are
prohibited by Shari’ah, due to the excessive risk they carry and to the fact they have no fixed
underlying assets. Apart from that, and as long as all terms are carefully spelled out, Islamic
finance instruments are more than adequate in mitigating risks.
For the future proposal of combining carbon trading with renewable energy finance, Islamic
products can be developed by forming pools of carbon emission credits that could be used in
a pre-specified, pre-scheduled fashion by the renewable project sponsors, in full compliance
with Shari’ah tenets.
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Introduction
In 2006, the Sustainable Energy Finance Initiative (SEFI) of United Nations Environment
Program published a study entitled “Scoping Study on Financial Risk Management
Instruments for Renewable Energy Projects”. The study ran through the various renewable
energy sources and identified financial risks associated with their implementation; it then
presented a detailed account of the financial instruments that could be used to mitigate said
risks.
The objective of this brief study is to take the discussion one step further, towards the Islamic
finance way. Though Islamic finance instruments are not as developed as traditional ones,
there are still equivalencies to be made.
I see this as hardly an academic exercise: Islamic finance is on the rise (“Islamic finance is
on the way to reach a global volume of 1.1 trillion US dollars in 2012, representing an
compound annual growth of 20 per cent since 2006”1) and renewable energy projects lend
themselves perfectly to this form of finance, thanks to their being a Halal (permissible)
investment that benefit the greater good. In addition, a vast number of these renewable
energy projects are needed in Islamic majority countries, where access to electricity is still
underdeveloped (Indonesia, Bangladesh, Pakistan, Afghanistan, Iraq, Yemen, Nigeria, etc.).
This study will first introduce the UNEP report then present the financial instruments it
advocates, along with a description of the equivalent / nearest Islamic financial instrument.
The scope is not to exhaust the subject but to offer a framework stepping stone for future
studies that will address each instrument on its own and give it its due in analysis,
background and prospects.
The UNEP Report
The report starts by enumerating the renewable energy sources it considers. These are (all
terms are as used in the report):
Direct solar: photovoltaics, solar thermal power generation, solar water heaters
Wind: large scale power generation, small scale power generation; pumps
Wave: numerous designs
Tidal: barrage, tidal stream
Geothermal: hot dry rock, hydrothermal, geopressed, magma (only hydrothermal
currently viable)
1 Study by Ernst and Young, The Financial Express, Dhaka, August 27 2012
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Biomass: combustion, gasification, pyrolysis, digestion, for biofuels, heat and
electricity.
The study goes on to list the various forms of finance that might be used for renewable
energy projects (private finance, grants, risk capital, mezzanine finance, corporate finance,
project finance, participation finance, risk finance/insurance structures, consumer finance
and third-party finance). The implied preference is, justifiably, for project finance.
Renewable Energy Project Risks
Then comes a section I consider to be of paramount importance for whoever is thinking
about venturing into renewable energy projects: a breakdown by technology of the type of
associated operational risk. The table is reproduced here, although technological advances
have already mitigated some of the risks listed.
RET type Key risk issues Risk management considerations
Geothermal Drilling expense and associated risk
(e.g. blow out)
Exploration risk (e.g. unexpected
temperature and flow rate)
Critical component failures such as
pump breakdowns
Long lead times (e.g. planning
permission).
Limited experience of operators and certain
aspects of technology in different locations.
Limited resource measurement data.
Planning approvals can be difficult.
‘Stimulation technology’ is still unproven but can
reduce exploration risk.
Large PV Component breakdowns (e.g. short-
circuits)
Weather damage
Theft/vandalism.
Performance guarantee available (e.g. up to 25
years).
Standard components, with easy substitution.
Maintenance can be neglected (especially in
developing countries).
Solar thermal Prototypical/technology risks as
project size increases and
combines with other RETs e.g.
solar towers.
Good operating history and loss record (since
1984).
Maintenance can be neglected (especially in
developing countries).
Small
hydropower
Flooding
Seasonal/annual resource
variability
Prolonged breakdowns due to
offsite monitoring (long response
time) and lack of spare parts.
Long-term proven technology with low
operational risks and maintenance expenses.
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RET type Key risk issues Risk management considerations
Wind power Long lead times and up-front costs
(e.g. planning permission and
construction costs)
Critical component failures (e.g.
gear train/ box, bearings, blades
etc.)
Wind resource variability
Offshore cable laying.
Make and model of turbines. Manufacturing
warranties from component suppliers.
Good wind resource data.
Loss control e.g. firefighting can be difficult
offshore due to height/location.
Development of best practice procedures.
Biomass
power
Fuel supply availability/variability
Resource price variability
Environmental liabilities associated
with fuel handling and storage.
Long-term contracts can solve the resource
problems.
Fuel handling costs.
Emission controls.
Biogas power Resource risk (e.g. reduction of gas
quantity and quality due to changes
in organic feedstock)
Planning opposition associated with
odor problems.
Strict safety procedures are needed as are loss
controls such as firefighting equipment and
services.
High rate of wear and tear.
Tidal/wave
power
Survivability in harsh marine
environments (mooring systems
etc.)
Various designs and concepts but
with no clear winner at present
Prototypical/technology risks
Small scale and long lead times.
Mostly prototypical and technology
demonstration projects.
Good resource measurement data.
Table 1 - taken from “Scoping Study on Financial Risk Management Instruments for Renewable Energy Projects”
Risk Management Product # 1 – Insurance
The report then introduces one of the most important risk management products, insurance.
First comes traditional insurance, the Islamic counterpart of which being Takaful (described
in detail in future sections).
The report lists these traditional insurance policies, in the following table:
Risk transfer
product
Basic triggering
mechanisms
Scope of insurance/
risks addressed
Coverage issues/ underwriting
concerns
Construction All
Risks (CAR)/
Erection All
Risks
Physical loss of and/or
physical damage during
the construction phase of
a project.
All risks of physical loss
or damage and third
party liabilities including
all contractor’s work.
Losses associated with cable
laying such as snagging can be
significant for offshore wind
projects.
Quality control provisions for
contractors.
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Risk transfer
product
Basic triggering
mechanisms
Scope of insurance/
risks addressed
Coverage issues/ underwriting
concerns
Delay in Start
Up (DSU)/
Advance Loss of
Profit (ALOP)
Physical loss of and/or
physical damage during
the construction phase of
a project causing a delay
to project handover.
Loss of revenue as a
result of the delay
triggered by perils
insured under the CAR
policy.
Cable laying risk.
Loss of transformer.
Lead times for replacement of
major items.
Offshore wind weather windows
and availability of vessels.
Operating All
Risks/ Physical
Damage
Sudden and unforeseen
physical loss or physical
damage to the plant /
assets during the
operational phase of a
project.
‘All-risks’ package. Explosion/fire concerns for
biogas, geothermal.
Increase in fire losses for wind.
Lightning.
Quality control and maintenance
procedures.
Machinery
Breakdown (MB)
Sudden and accidental
mechanical and electrical
breakdown necessitating
repair or replacement.
Defects in material,
design construction,
erection or assembly.
Concern over errors in design,
defective materials or
workmanship for all RETs.
Turbine technology risk.
Scope and period of equipment
warranties.
Wear and tear (excluded from
MB).
Business
Interruption
Sudden and unforeseen
physical loss or physical
damage to the
plant/assets during the
operational phase of a
project causing an
interruption.
Loss of revenue as a
result of an interruption
in business caused by
perils insured under the
Operating All Risks
policy.
Cable/transformer losses
represent large potential BI
scenarios.
Lead times for replacement of
major items.
Offshore wind weather windows
and availability of vessels.
Supplier/customer exposure (e.g.
biomass resource supply).
Operators Extra
Expense
(Geothermal)
Sudden, accidental
uncontrolled and
continuous flow from the
well which cannot be
controlled.
All expenses
associated with
controlling the well,
redrilling/ seepage and
pollution.
Some geothermal projects
require relatively large loss limits.
Exploration risk excluded.
Well depths, competencies of
drilling contractors.
General/Third-
Party Liability
Liability imposed by law,
and/or Express
Contractual Liability, for
Bodily Injury or Property
Damage.
Includes coverage for
hull and machinery,
charters liability, cargo
etc.
Concern over third-party
liabilities issues associated with
toxic and fire/explosive perils.
Table 2 - taken from “Scoping Study on Financial Risk Management Instruments for Renewable Energy Projects”
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The following figure, taken from the report, illustrates the risk transfer heat map for existing
insurance products:
Figure 1- taken from “Scoping Study on Financial Risk Management Instruments for Renewable Energy Projects”
Other Risk Management Instruments
The report goes on to present more financial risk management instruments, such as:
alternative risk transfer (ART) products
special purpose underwriting vehicles (SPUV)
weather derivatives
credit derivatives
political risk insurance
risk mitigation and credit enhancement products provided by Multilateral Financial
Institutions (MFIs), Export Credit Agencies (ECAs) and Official Bilateral Insurers
(OBIs).
The Islamic alternative exist or can be developed for the above, except in the area of
derivatives, which incorporate an element of “gharar” (the uncertainty or hazard caused by
lack of clarity regarding the subject matter or the price in a contract or exchange) and are
therefore prohibited under Shari’ah principles.
The following table summarizes the instruments introduced in the report:
Risk
mitigation
product
Nature Basic mechanism Risks addressed Key RET
application
issues
Weather
insurance/
weather
derivatives
Hybrid of re-
insurance
and indexed
derivatives
Contracts and traded/ OTC
derivatives including weather-linked
financing (e.g. temperature, wind,
and precipitation). Risks transferred
from project owners/sponsors to
insurance and capital markets.
Volumetric
resource risks that
adversely affect
earnings.
Requires
accurate and
robust data
streams from
satellites etc.
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Risk
mitigation
product
Nature Basic mechanism Risks addressed Key RET
application
issues
Double-trigger
products
(integrated risk
management)
Alternative
Risk
Transfer
(ART)
Contracts or structures provided by
re-insurers covering, for example,
business interruption risks caused
by a first trigger such as
unforeseen operational problems
that create a contingent event (e.g.
a spike in electricity price).
Clearly defined
contingent risks
which adversely
impact revenues.
Complex and
relationship-
intensive.
Requires
accurate and
robust trigger
definition.
Contingent
Capital
Risk finance
(synthetic
debt and
equity)
Insurance policy that can take the
form of hybrid securities, debt or
preference shares provided by (re)
insurer to support and/or replace
capital that the insured would
otherwise be forced to obtain in the
open market at punitive rates.
Any contingent
event that
suddenly
damages the
capital structure of
a project or
enterprise.
Complex and
relationship-
intensive. Can
be used in SPUV
development.
Finite
Structure
Risk finance Multi-year, limited liability contracts
with premium calculated on
likelihood of loss and impact.
‘Timing risk’ that
losses occur
faster than
expected.
Complex and
relationship-
intensive. Often
relies on strong
credit profile.
Alternative
Securitization
Structures
Various
types of
asset-
backed
securities
(‘synthetic
reinsurance’)
Smoothes out volatility of events
that adversely impact
earnings/cash flows. Potential to
spread high cash-flow impact
losses over time. Securitized risk
finance instruments including
Insurance Linked Securities (CAT
Bonds)/Collateralized Debt
Obligations issued with several
‘tranches’ of credit/risk exposure.
Creates a risk transfer and
financing conduit based on credit
differentials.
Bundling of credit
default, liability,
trade credit risk
together. CAT
bonds address
risks associated
with natural
catastrophes.
Pooling of
energy, weather
related or
emerging market
and resource
supply risks.
SPUV potential.
Captives or
other pooling/
mutualization
structures
Risk finance
or ART
Self-insurance program whereby a
firm sets up its own insurance
company to manage its retained
risks at a more efficient cost than
transfer to a 3rd party. Pooling
through ‘mutual’ or ‘Protected Cell’
structures can further diversify risks
amongst similar enterprises.
Property/casualty
insurance. Can be
adapted to include
financial risks.
Mutualization/
pooling
mechanisms
often require
homogeneous
risk. Initial
capitalization
requirements.
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Risk
mitigation
product
Nature Basic mechanism Risks addressed Key RET
application
issues
TGC or
emissions
reduction
delivery
guarantees
Insurance Products provided by insurers
and re-insurers to guarantee
future delivery of ‘credits’ or,
money to purchase credits in spot
markets to fulfill contractual
requirements. Risks transferred
from project owner/investors to
insurers.
Risks associated
with delivery of
TGCs or
emissions
reductions,
including
performance
related and
political risks.
Sound
legal/regulatory
framework
required. Long-
term policy
support
mechanism for
RE needed.
GEF
Contingent
Finance
Mechanisms
Grant, loan,
guarantee
Contingent grant, performance
grant, contingent/ concessional
loans, partial credit guarantees,
investment funds and reserve
funds provided by GEF in
conjunction with Implementing
Agencies. Transfers some
financial project risk.
Desirable but
high-risk projects
benefit from soft
funding.
Process delivery
is slow and
appears
complex. Limited
resources.
Guarantee
funds
Guarantee
(credit
enhancement)
Professionally managed funds
that use donor capital to leverage
commercial lending. Examples
include the Emerging Africa
Infrastructure Fund and
GuarantCo.
Political and credit
risks in emerging
markets.
Designed for
large
infrastructure
projects but have
wider
applications.
Guarantees
from MFIs
Guarantee
(credit
enhancement)
Partial Risk Guarantee (covers
creditor/ equity investors) and
Partial Credit Guarantee (covers
creditors) by World Bank Group
and the Regional Development
Banks. Flexible structures that do
not require sovereign counter-
guarantees are preferred.
Specific political
risks (e.g.
sovereign risks
arising from a
government
default on
contractual
obligations) and
credit default.
There are ad hoc
applications of
PCGs for RE
project finance.
Credit
enhancements in
any form help
transact RE
deals.
Export Credit
Guarantees
Guarantee,
export credit,
insurance
Guarantees, export credits,
insurance provided by bilateral
Export Credit Agencies (ECGD
etc.) and Official Bilateral Insurers
(OPIC etc.).
Commercial and
political risks
involved in private
sector
trade/investment
abroad.
Most ECAs/OBIs
have limited RET
experience.
Need more data
for underwriting.
Table 3- taken from “Scoping Study on Financial Risk Management Instruments for Renewable Energy Projects”
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Risk Management Products – The Way Forward
The report then concludes with the way forward to mitigate risks in financing renewable
energy projects, namely integrating renewable energy project finance with carbon finance. By
linking renewable energy and carbon cash flow to debt payments, the project developer can
increase net margins on electricity revenue, and enhance the average DSCR for the project.
This can result in one of two things. It either allows the project to be financed because it
increases the required DSCR past the predetermined threshold set by the lender, or it
decreases the amount of equity investment required for the project – thereby increasing
ROE.
A Primer on Islamic Finance
While this brief is not the place to explain all nuances of Islamic finance, it is useful to get a
quick idea of the tenants of this system.
The Islamic system of finance is based on the Shari’ah principles laid down in the Qur’an and
the Sunnah of the Prophet Muhammad. Shari’ah secondary sources are based on Ijtihad, the
Islamic scholars’ thinking, predicated on Ijma’a (consensus of the Prophet’s Companions)
and Qiyas (analogy of current conditions to those presented by the Qur’an and the Sunnah).
Islamic finance is regulated by Shari’ah boards with no central authority, which sometimes
creates confusion about what is allowed (Halal) or not, in matter of instruments.
The basic tenets are however not subject to discussion.
The concepts that Shari’ah explicitly prohibits are:
Riba: originally interpreted as usury, but usually extended to cover any commercial
interest
Gharar: uncertainty or hazard caused by lack of clarity regarding the subject matter
or the price in a contract or exchange
Maisir / Qimar: gambling and wagering.
The building blocks of Islamic Finance
The prohibition of interest has sparked the creation of specific instruments to facilitate
commerce in an Islamic system:
Mudarabah: this is a partnership arrangement in which one party provides capital to
the partnership while the other party provides business skills. The Islamic principle of
profit and loss sharing (PLS) applies here: any loss is borne by the financier, while
any profit is shared by the partners according to a pre-agreed ratio
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Musharakah: this is another PLS arrangement, which may take the form of a
permanent equity investment, a partnership in a specific project having a fixed
duration or a diminishing partnership (the bank’s share is reimbursed over time by
the company acquiring funds), especially for housing and other fixed asset financing
that could be leased
Murabaha / Mu’ajjal: this is akin to a cost plus arrangement. The bank in this case
would acquire goods upon a customer’s demand or otherwise and sell them on credit
at a profit margin. It results in debt covering the cost plus a profit margin. This debt
has to be paid back irrespective of profit or loss to the customer
Salam: this involves providing funds against the forward purchase of precisely
defined goods with prepayments
Ijarah: this is leasing an asset and receiving rentals. As long as the asset is on lease,
the lessor owns the asset and the risk and reward of its ownership.
Istisna’a: this is engaging a person that could also be a financing agent to
manufacture or construct and supply an item at some future date for an explicit sum
on periodic payment. The agent contracts with a manufacturer to produce the
commodity and the customers make payments to cover the production price and the
profit margin
Wakalah: this is an agency agreement.
The above building blocks can be combined to achieve results similar to contracts / products
used in conventional finance.
An example of project finance using the basic Islamic contracts would be the financing of an
Independent Power Plant (IPP).
This is illustrated as follows:
Figure 2 - Taken from “Islamic Project
Finance”
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This operation involves the application of four different Islamic contracts: mudarabah,
istisna’a, salam, and wakalah.
In this model, there are 4 main participants:
the syndicate of lenders led by the agent
the SPV set up by the agent
the power producer
the power purchaser (the utility).
The agent leading the syndicate of lenders enters into a credit agreement with the SPV; this
transaction can be based on mudarabah, where the lenders will act like sleeping investors
(Rabbul-mal) entrusting money to the SPV (manager or mudarib). The SPV is to trade with
the money in an agreed manner and then return to the investors the principals and the pre-
agreed share of the profits, keeping for himself what remains of the profits.
The SPV as a manager then enters into a production payment contract with the producer
whereby the SPV finances the project by making an advanced payment to the producer
against a promise under an agreed schedule for the future delivery of electricity; this a bai’
salam (a salam sale).
The producer enters into a power purchase agreement with the utility. This transaction is
basically an istisna’a contract which gives an order to manufacture a definite article with
agreement to pay a definite price for that article when it is completed.
The difference between istisna’a and salam is that under salam, the price must be paid in
advance, while in istisna’a, the payment is flexible, to be paid only when the article is ready
for delivery.
It is important to note that a valid istisna’a contract should be defined in its minutest details;
therefore, the power purchase agreement should be very comprehensive including the
description of the physical infrastructure, specifications of the required electricity, a
description of the fuel and all other technical quantitative and qualitative details of the project.
This document should also include risk allocation, the dispute resolution mechanism, and the
financial and operational obligations of the producer and the utility.
The SPV mandates the producer through a wakalah (an agency contract) to sell electricity to
the utility. This sale will be split into 2 components:
the production payment electricity which will be sold on behalf of and for the account
of the SPV
the subject electricity which represents the share of the producer to be sold to the
utility on the same basis.
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All the revenue from the sale of production payment electricity from the utility will be
transferred to the SPV after the deduction of the producer’s fixed O&M costs, fixed fuel costs,
insurance costs and return on equity investment.
Islamic Risk Management – Takaful is the new # 1
Conventional insurance is based on an exchange of premium payments now for future
indemnities in case of specified events. Such an exchange (sale) contract would not be valid
under Shari'ah law due to the uncertainty (gharar) of the value of the future indemnities. It
also bears elements of riba (interest) and maisir (gambling).
However, Shari'ah scholars accept uncertainty in contracts for one-sided transfers (tabarru')
such as endowments or donations. Therefore, they base takaful schemes as the Islamic
alternative to insurance on the concept of “donations” (voluntary individual contributions) to a
risk pool (the takaful fund) out of which indemnities are paid to other contributors, on the
basis of mutual help and sacrifice.
These donations are however “conditional”, a concept in conformity with Shari'ah. Takaful
participants’ donations are predicated on the condition that they will receive compensation
from the pool for specified types of losses suffered by them.
Basic Structure of Takaful
Takaful participants are individuals (or institutions) who enter into a Shari'ah compliant
scheme of mutual risk cover. Although somewhat similar to conventional mutual insurance,
the Islamic solidarity arrangements differ by being initiated and managed by takaful
operators, which are commercial corporations (joint stock companies).
The takaful business (risk cover and investment) is executed in takaful undertakings with a
hybrid structure, consisting of:
a commercial management company, the takaful operator
and a separate risk fund or underwriting pool, the participants' takaful fund.
A Takaful operator serves as a trustee or a manager on the basis of Wakalah or Mudarabah
to operate the business. The operator and the partners who take any policy contribute to the
Takaful fund. Claims are paid from the Takaful fund and the underwriting surplus or deficit is
shared by the participants. The underwriting surplus or deficit belongs to the policyholders/
partners, while distribution of profit arising from the business depends upon the basis of
Wakalah or Mudarabah.
In the case of general Takaful (i.e. non-life), the whole contribution is considered a donation
for protection and the participants relinquish their ownership right in favor of the Takaful fund,
and the underwriting surplus or underwriting loss belongs to the participants.
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There is a provision of Qard al Hasan (virtuous loan, meaning a loan with the stipulation to
return the principal sum in the future without any increase) by the takaful operator to the fund
if claims at any time exceed the amount available in it and the reserves are insufficient to
meet the shortfall.
On the same bases of Tabarru‘, Waqf and Mudarabah, takaful operators can arrange re-
Takaful, for which they pay an agreed-upon contribution from the Takaful fund to a re-takaful
operator, which, in return, helps the Takaful companies in case of losses.
Models of Takaful
Shari’ah scholars have suggested from time to time various models of takaful, like that of
wakalah, mudarabah, waqf (endowment) or wakalah with waqf.
In a pure Wakalah model, the takaful operator acts as a wakil (agent) for the
participants and gets a fee in the form of an agreed percentage of the participants’
donations; and the whole underwriting surplus or underwriting loss and the
investment profit/loss belongs to the policyholders or the participants. The wakalah
fee is to cover all management expenses of business. The fee rate is fixed annually in
advance in consultation with the Shari’ah committee of the operator. In order to give
incentive, a part of the underwriting surplus is also given to the operator, depending
upon the level of performance. However, underwriting loss, if any, has to be borne
only by the participants. The operator simply provides Qard al Hasan.
Under a pure mudarabah model, the participants and the operator enter into a
mudarabah contract for cooperative sharing of losses of the members and sharing
the profits, if any. The profit, which is taken to mean return on investments plus any
underwriting surplus (as in the case of conventional insurance), is distributed
according to the mutually agreed ratio between the participants and the company.
The Shari’ah committee of the takaful operator approves the sharing ratio for each
year in advance. Most of the expenses are charged to the shareholders. An issue in
this model is that the amount donated as Tabarru’ cannot simultaneously become
capital for the mudarabah relationship. Moreover, the Takaful operator gets the
underwriting surplus, but does not bear the underwriting loss. Therefore, Shari’ah
scholars have raised serious objections to this model
In some cases, a model involving the combination of mudarabah and wakalah has
been adopted. Under the combined model, the sharing of profit between participants
and operators is an entitlement embedded in the contract, i.e. the underwriting
surplus and the investment profit both are shared. There is, however, a structural
issue in the way such profit/ surplus is determined. The issue is that, under
mudarabah, the operator, as the mudarib, cannot charge its management expenses
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from the takaful fund separate from its share as mudarib, whereas under wakalah, the
operator, being the agent of the participants, can take its management fees from the
fund as per pre-agreed terms. Furthermore, the operator does not bear the
underwriting loss. Therefore, it also smacks of trouble from the Shari’ah angle
In the Waqf model, introduced in recent years, the shareholders create a waqf fund
(takaful fund) through an initial donation to extend help to those who want cover
against catastrophes or financial losses. More than one takaful fund can be formed
for different classes of service. Contributions of the participants, appropriate to the
risk of the participants/assets, are divided into two parts: one as donation to the
takaful fund and the other for investment on the basis of mudarabah. The donation
part always remains with the waqf. Operational costs like re-takaful, claims, etc. are
met from the fund. The underwriting surplus or loss belongs to the fund, which can be
distributed to the beneficiaries of the waqf, kept as a reserve or reinvested to the
benefit of the waqf. There is no obligation to distribute the surplus. Rules for
management fees, distribution of profit, creation of reserves, the procedure, extent or
limit of compensation to the policyholders are decided beforehand. In the case of
need, shareholders give Qard al Hasan to the fund. For investment purposes, a
mudarabah contract takes place between the takaful fund and the company working
as mudarib. The investment part is invested by the company on a mudarabah basis
and is redeemed to the policyholder on a Net Asset Value basis at maturity of the
policy. The investment profit is shared between the company and the fund. As per the
contents of the policies, the company distributes the profit among the beneficiaries.
It is evident from the above that takaful, while gaining ground, is still a work in progress.
Scholars still find matter to criticize the presented models:
1. Mudarabah Model: In this model, amounts paid by the participants and the
investment incomes are used to pay the claims, re-takaful costs and other claims-
related expenses from the general takaful fund. Normally, the shareholders meet all
management and marketing-related expenses from their share and any remaining
amount is their net profit. However, in some cases, the companies charge
management expenses from the takaful fund, which is against the rules of
mudarabah. Some part of any underwriting surplus is also given to the operator,
depending upon his performance.
More fundamentally, the donations forming the base of takaful cannot be used as the
capital for mudarabah. In addition, profit-sharing cannot be applied here, as saring in
any underwriting surplus would render the takaful contract essentially the same as
conventional insurance, in which the shareholders become the risk-takers. The basic
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premise of takaful is that the operator should not take any risk, which he would were
he a mudarib.
Furthermore, in mudarabah, invested capital has to be returned along with the profit,
if any; and if there is a loss, that has to be subtracted from the capital. In non-life
takaful, the paid premiums are not returned.
Also, the requirement to provide qard al hasan (in case of a deficit) in a mudarabah
contract is against the whole concept of mudarabah, which is a profit-sharing
contract.
2. Wakalah and Wakalah–Mudarabah Models: the same objections as the pure
mudarabah models can be levied. In this case, the problem arises when the takaful
operator is given a part of the underwriting surplus in addition to the operating fee as
a performance incentive. Sharing of surplus should be among the pool members of
the fund.
In addition, the risk premium should be separately defined and related to the risk; this
should be the same for similar risks, regardless of who the client is. For large clients,
the company should reduce the operator’s fees and not the risk premium rates.
Takaful and Conventional Insurance Compared
Takaful and conventional insurance are different with respect to the objectives, structure,
investment policies and returns. In conventional insurance, risk is transferred to one party –
the company– and the prohibited factors of riba, gharar and gambling are involved. The
policyholders have to pay the premiums against unknown risks in the case of general
insurance. In Takaful, the participants or the group members relinquish their ownership right
of the amount of the donation and then the waqf fund bears the losses to any of them and
the members share the underwriting surplus or loss. The takaful operators manage the
business and share the investment profit with the policyholders.
Although there still remains some uncertainty, it is within the group itself, all members have
jointly contributed to help those among them who incur any loss and share the remainder, if
any. This is why the model of takaful in which underwriting surplus or loss fully belongs to the
participants is considered to be the best model as per the latest research. Uncertainty is
further minimized by recourse to reserves and access to qard al hasan to the takaful fund
from the shareholders in case of need.
The risk premium in the conventional system is commercially driven, motivated by the desire
for maximum profit for the shareholders; while in takaful, its adequacy is the main
consideration and the profit element is subject to the rules of equity, justice and ethics.
Losses in terms of underwriting or on investment, if any, are first absorbed by the reserves,
then from the interest-free loans from shareholders and then by a general increase in pricing
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by the company. Hence, the takaful system has a built-in mechanism to counter any
overpricing policies of the insurance companies, because whatever the amount of premium,
the surplus goes back to the participants in proportion to their contributions.
The distinction between conventional insurance and Takaful business is more visible with
respect to investment of funds. While insurance companies invest their funds, among others,
in interest-based avenues and without any regard to the concepts of Halal and Haram,
takaful operators undertake only Shari’ah-compliant business and the profits are distributed
in accordance with the pre-agreed formula/basis in the takaful agreement.
Using Takaful to Manage Risks of Renewable Energy Projects
Let us revisit Table 2 that listed types of insurance policies that are usually applicable in
renewable energy projects.
Our objective is to make sure that a takaful product can be used to cover the same risks:
1- Insurance Policy: Construction All Risks (CAR)/ Erection All Risks
Triggering mechanisms: physical loss of and/or physical damage during the
construction phase of a project
Scope of insurance/ risks addressed: all risks of physical loss or damage and
third party liabilities including all contractor’s work
Takaful applicability: takaful is applicable to cover this risk. The contractor
could contribute to a takaful fund that would cover any claim. As discussed,
this process might prove more economical to the contractor, when the sharing
of eventual underwriting surplus is factored in
2- Insurance Policy: Delay in Start Up (DSU)/ Advance Loss of Profit (ALOP)
Triggering mechanisms: physical loss of and/or physical damage during the
construction phase of a project causing a delay to project handover
Scope of insurance/ risks addressed: loss of revenue as a result of the delay
triggered by perils insured under the CAR policy
Takaful applicability: This case is a bit trickier because it involves an additional
element of gharar (uncertainty) – how to determine the extent of revenue
loss? The workaround would be to predetermine the expected revenue and
link it to a time measurement (e.g. 100k USD / week). This would also
presuppose the existence of another contract (a combination bai’ salam /
istisna’a, equivalent to a power purchase agreement) that would specify the
compensation expected, and therefore liable to be lost
3- Insurance Policy: Operating All Risks/ Physical Damage
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Triggering mechanisms: sudden and unforeseen physical loss or physical
damage to the plant / assets during the operational phase of a project
Scope of insurance/ risks addressed: ‘all-risks’ package
Takaful applicability: takaful is applicable in this case, as long as all the costs
liable to be claimed are predefined. The same principles of prudence /
insurable interest as conventional insurance are to be exercised
4- Insurance Policy: Machinery Breakdown (MB)
Triggering mechanisms: sudden and accidental mechanical and electrical
breakdown necessitating repair or replacement
Scope of insurance/ risks addressed: defects in material, design construction,
erection or assembly
Takaful applicability: takaful should be applicable with no issues, provided that
the contractor can prove that the material used is of standard / high quality (in
this case defects are justifiable statistically) and the design follows best
practices of similar projects
5- Insurance Policy: Business Interruption
Triggering mechanisms: sudden and unforeseen physical loss or physical
damage to the plant/assets during the operational phase of a project causing
an interruption
Scope of insurance/ risks addressed: loss of revenue as a result of an
interruption in business caused by perils insured under the Operating All Risks
policy
Takaful applicability: the same concerns raised by the applicability of takaful in
Delay in Start Up / Advance Loss of Profit policies exist here. This should not
be insurmountable however, as long as all costs / revenue streams are
predefined and mutually agreed
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6- Insurance Policy: Operators Extra Expense (Geothermal)
Triggering mechanisms: sudden, accidental uncontrolled and continuous flow
from the well which cannot be controlled
Scope of insurance/ risks addressed: all expenses associated with controlling
the well, redrilling/ seepage and pollution
Takaful applicability: takaful is fully applicable, with the usual caveat of all
costs being preapproved. In the case of pollution though, since no one can
predict the full extent of the damage (direct or collateral), a claim ceiling is to
be agreed upon, based on analogous installation conditions
7- Insurance Policy: General/Third-Party Liability
Triggering mechanisms: liability imposed by law, and/or express contractual
liability, for bodily injury or property damage
Scope of insurance/ risks addressed: includes coverage for hull and
machinery, charters liability, cargo etc.
Takaful applicability: the same concerns of unquantifiable liability affect the
takaful contract. A priced schedule of all equipment / property involved should
be mutually agreed upon before entering into the takaful contract.
Although the takaful market is growing rapidly (takaful premiums of approximately USD 1.7bn
were written in 2007, and it is estimated that the global takaful market could reach USD 7bn
by 20152), it is hard at this moment to construct a similar heatmap as Figure 1.
The growth of the takaful and retakaful market gives reason to hope these instruments will
find their way into renewable energy project finance.
Other Risk Management Instruments – Are there Islamic Equivalents?
It is time to revisit Table 3 to see whether Islamic products can be found to replace
conventional risk management instruments in the renewable energy project finance domain.
1- Risk mitigation product: Weather insurance/ weather derivatives
Nature: Hybrid of re-insurance and indexed derivatives
Basic mechanism: Contracts and traded/ OTC derivatives including weather-linked
financing (e.g. temperature, wind, and precipitation). Risks transferred from project
owners/sponsors to insurance and capital markets.
2 Source: Swiss Re Retakaful website (http://www.swissre.com/reinsurance/insurers/retakaful/)
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Risks addressed: Volumetric resource risks that adversely affect earnings.
Islamic equivalent: as this product is basically a derivative (swap, call, put, etc.), no
Islamic equivalent exists. There have been a lot of attempts to create Islamic
derivatives but they all stumble when the basic tenets of Islamic finance are weighed
in:
o Options: Shari’ah principles specify that the delivery of an asset / commodity
has to be given and taken pursuant to the sale contracts without regard to
movement in prices. As option contracts confer the right but not the obligation to
enter into an underlying contract of exchange at or before a specified future
date, they are fundamentally non-Shari’ah compliant
o Swaps: as these mostly deal with interest rates, they are obviously excluded
from Islamic finance conversations
2- Risk mitigation product: Double-trigger products (integrated risk management)
Nature: Alternative Risk Transfer (ART)
Basic mechanism: Contracts or structures provided by re-insurers covering, for
example, business interruption risks caused by a first trigger such as unforeseen
operational problems that create a contingent event (e.g. a spike in electricity price).
Islamic equivalent: while the first trigger is taken care of via a traditional takaful
contract, the trick resides with the second trigger; as the contingency usually implies
uncertainty, gharar rapidly rears its head. The workaround is, as usual, to be a
specific as possible in determining baselines / offsets from these baselines prior to
entering the contract
3- Risk mitigation product: Contingent Capital
Nature: Risk finance (synthetic debt and equity)
Basic mechanism: Insurance policy that can take the form of hybrid securities, debt
or preference shares provided by (re) insurer to support and/or replace capital that
the insured would otherwise be forced to obtain in the open market at punitive rates.
Risks addressed: Any contingent event that suddenly damages the capital structure
of a project or enterprise.
Islamic equivalent: The derivative (option) element of this product makes it
incompatible with Shari’ah principles, and therefore no Islamic equivalent exists
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4- Risk mitigation product: Finite Structure
Nature: Risk finance
Basic mechanism: Multi-year, limited liability contracts with premium calculated on
likelihood of loss and impact.
Risks addressed: ‘Timing risk’ that losses occur faster than expected.
Islamic equivalent: the element of uncertainty involved excludes an Islamic finance
equivalent; this is especially true since finite risk products are basically swaps and
options
5- Risk mitigation product: Alternative Securitization Structures
Nature: Various types of asset-backed securities (‘synthetic reinsurance’)
Basic mechanism: Smoothes out volatility of events that adversely impact
earnings/cash flows. Potential to spread high cash-flow impact losses over time.
Securitized risk finance instruments including Insurance Linked Securities (CAT
Bonds)/Collateralized Debt Obligations issued with several ‘tranches’ of credit/risk
exposure. Creates a risk transfer and financing conduit based on credit differentials.
Risks addressed: Bundling of credit default, liability, trade credit risk together. CAT
bonds address risks associated with natural catastrophes.
Islamic equivalent: the extreme level of uncertainty linked to these structures means,
again, their non-suitability to be Shari’ah approved products
6- Risk mitigation product: Captives or other pooling/ mutualization structures
Nature: Risk finance or ART
Basic mechanism: Self-insurance program whereby a firm sets up its own insurance
company to manage its retained risks at a more efficient cost than transfer to a 3rd
party. Pooling through ‘mutual’ or ‘Protected Cell’ structures can further diversify
risks amongst similar enterprises.
Risks addressed: Property/casualty insurance. Can be adapted to include financial
risks.
Islamic equivalent: the takaful contract presupposes the legal split between the
contributors to the takaful fund and its operator. There could however be a way to
have a fully owned entity of the firm to act as takaful operator; such schemes have
been going on in Malaysia since 2010
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7- Risk mitigation product: TGC or emissions reduction delivery guarantees
Nature: Insurance
Basic mechanism: Products provided by insurers and re-insurers to guarantee future
delivery of ‘credits’ or, money to purchase credits in spot markets to fulfill contractual
requirements. Risks transferred from project owner/investors to insurers.
Risks addressed: Risks associated with delivery of TGCs or emissions reductions,
including performance related and political risks.
Islamic equivalent: as the number and value of carbon credits cannot be determined
in advance, there is an element of uncertainty that prevents a legitimate takaful
contract
8- Risk mitigation product: GEF Contingent Finance Mechanisms
Nature: Grant, loan, guarantee
Basic mechanism: Contingent grant, performance grant, contingent/ concessional
loans, partial credit guarantees, investment funds and reserve funds provided by
GEF in conjunction with Implementing Agencies. Transfers some financial project
risk.
Risks addressed: Desirable but high-risk projects benefit from soft funding.
Islamic equivalent: as this is basically a grant by GEF, Islamic finance has little to do
9- Risk mitigation product: Guarantee funds
Nature: Guarantee (credit enhancement)
Basic mechanism: Professionally managed funds that use donor capital to leverage
commercial lending. Examples include the Emerging Africa Infrastructure Fund and
GuarantCo.
Risks addressed: Political and credit risks in emerging markets.
Islamic equivalent: to be Shari’ah compliant, the fund needs to invest only in Halal
activities (no alcohol, no gambling, no weapon trading, etc.)
10- Risk mitigation product: Guarantees from MFIs
Nature: Guarantee (credit enhancement)
Basic mechanism: Partial Risk Guarantee (covers creditor/ equity investors) and
Partial Credit Guarantee (covers creditors) by World Bank Group and the Regional
Development Banks. Flexible structures that do not require sovereign counter-
guarantees are preferred.
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Risks addressed: Specific political risks (e.g. sovereign risks arising from a
government default on contractual obligations) and credit default.
Islamic equivalent: The Islamic Corporation for Insurance of Investments and Export
Credits (ICIEC) is a member of the Islamic Development Bank Group. The ICIEC
provides insurance products for investments and export credits
11- Risk mitigation product: Export Credit Guarantees
Nature: Guarantee, export credit, insurance
Basic mechanism: Guarantees, export credits, insurance provided by bilateral Export
Credit Agencies (ECGD etc.) and Official Bilateral Insurers (OPIC etc.).
Risks addressed: Commercial and political risks involved in private sector
trade/investment abroad.
Islamic equivalent: again, The Islamic Corporation for Insurance of Investments and
Export Credits (ICIEC) can help in this regard.
Risk Management Products – Could the Way Forward be Shari’ah Compliant?
As previously introduced, the UNEP report speculates that the future of renewable energy
project finance lies in integrating the cash inflow streams generated by carbon trade with the
cash inflows inherent to the project (take-offs, etc.).
While the conventional carbon trade market has no equivalent Islamic counterpart, it would
be safe to argue that an Islamic framework can be found to enable carbon credit trade. The
elements of this framework would be:
Vetting the carbon traders, be it the carbon emitters or the carbon reducers; this
would make sure that they are not otherwise engaged in Haram activities (alcohol,
gambling, weapon trading, etc.). Should these traders be part of conglomerates who
do have interests in Haram activities, suitable ring-fencing would be in order
Quantifying the carbon credits; for Islamic contracts to be valid (especially salam type
ones), the exact quantity of the commodity (here tons of CO2) must be known, in
addition to its trade value. A practical way of insuring sufficient numbers of credits are
available at the required date is to form a fund / pool of such credit and have the
renewable energy project sponsors trade with the pool at a suitable date
Insuring all financial operations linked to integrating project finance and carbon
trading adhere to the Islamic underlying contracts, i.e. banning any interest
generating activity not backed by physical asset transactions, especially of the swap /
option type.
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Conclusion
However modest the objective of this study has been, the outcome has proven that Islamic
finance is flexible enough to create worthwhile risk management instruments. And this, to
boot, in projects notoriously hard to sell, as renewable energy projects have tended to be.
Furthermore, this study has steered clear of Sukuk or Islamic bonds, one of the fastest
growing Shari’ah approved products; this is due to the fact the base UNEP report made no
mention of bonds. However, one can easily make the case for renewable energy project
sponsors to issue Sukuk to widen their finance base; the underlying asset in this case would
be their real estate or their machinery components.
As the demand for renewable energy project grows, there will form a critical mass that will
have a virtuous cycle effect of reducing costs, either thanks to better technologies or to a
broader financial base. Islamic finance, while also a work in progress, has to take part in this
field. Apart from the obvious “greater good” aspect preached by Islam, the special nature of
these projects will also have a beneficial effect on the development of the Islamic financial
instruments themselves.
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