Financial Risk Management Instruments for Renewable Energy Projects - The Islamic Finance...

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


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


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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