1

Islamic microfinance products to provide

renewable energy products to off-grid areas


Blake Goud
1



Abstract
This paper presents a template for a musharaka- (profit-and-loss sharing partnership) based
Islamic microfinance product to provide affordable access to off-grid renewable energy in areas
where it is not available and where the grid is not likely to extend, with a specific goal of
targeting people living in poverty who currently rely on more costly/dirty sources of energy.
People living in poverty already spend a substantial amount of their income on electricity, which
does not account for the cost of adverse health effects of emissions from diesel generators,
kerosene lanterns and wood-fueled stoves. Some estimates suggest that indoor air pollution,
largely from these sources, causes around 100,000 deaths per month globally.
The development Islamic microfinance would be advanced by developing individual- and
community-based financing of renewable energy and clean lighting. For larger-scale products,
this paper proposes community-owned renewable energy generation (wind, solar, biogas or
micro-hydro) financed using a (profit-and-loss sharing) musharaka model that can provide
employment as well as access to electricity in areas where the grid does not reach. For
household-level projects (like solar panels), financing would also use a musharaka structure,
while smaller renewable energy products (like solar lights) would use a ROSCA methodology.
Keywords: Islamic finance, energy finance, microfinance

1
Mr. Goud is the Principal of Sharing Risk. Contact information: blake@sharingrisk.org, (503) 419-8139.
The author would like to thank Saif Ahmed, Managing Partner, Zamzam Capital LLP (Islamic
investments) and Infinity Consultants (Islamic training & development) based out of India, Karen Hunt-
Ahmed, President of the Chicago Islamic Microfinance Project and Joanna Goud for comments on draft
versions of this paper. Errors are the sole responsibility of the author.
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Introduction
Both the Millenium Development Goals and the Makkah Declaration include a focus on
poverty alleviation and an awareness of the need for greater environmental protection. Neither is
viewed as a focus for the Islamic finance industry, if one looks at how the industry operates in
practice. While there has been some development of Islamic microfinance, it has generally
followed the practice of providing Shariah-compliant alternatives to conventional microfinance,
and has not focused on the development of renewable energy, cleaner lighting solutions and a
substitute for dirty cooking fuels that contribute to greater environmental preservation but also
can significantly reduce rates of respiratory illness.
Within the OIC countries, there is a significant need for more programs to reduce poverty
and provide broader access to clean, affordable sources of energy. For the 35 countries for
which there is data in the CIA World Factbook (representing 1,353 million out of the 1,532
million people living in OIC countries), only four countries have poverty rates under 10% and 14
have poverty rates above 40%. World Bank data on access to electricity in 34 OIC countries
(representing 1,304 million out of the 1,532 million people in the OIC countries), the average
(population-weighted) rate of electrification is 63%, although the rate is dramatically lower in the
17 countries with the lowest rate, where the average is just 50%.
Islamic microfinance could be further developed through individual- and community-
based financing of renewable energy. This approach would fit well within Islamic finance,
where there is a tangible asset to develop the financing mechanism. This paper proposes a
musharaka version of a financing product for household- and community-sized renewable energy
projects and a rotating savings and credit association (ROSCA) model for financing of smaller
renewable energy technologies like solar lighting.
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The first section provides a review of the literature relating to Islamic microfinance and
conventional energy microfinance. This is followed by a section describing the potential non-
monetary benefits that renewable energy products financed by Islamic microfinance could
provide. The third, fourth and fifth sections of the paper cover the application of ROSCA for
small products, a household-level musharaka-based microfinance product, and a community-
level musharaka-based microfinance, respectively. The sixth section suggests a sukuk structure
that the MFI could use to expand its financing capacity. The seventh section provides a
conclusion.
Literature review
The history of microfinance is well known, beginning in the 1960s and 1970s with the
Grameen Bank in Bangladesh and ACCION in Venezuela. Islamic microfinance is much
younger, having formally developed after the Islamic finance industry grew into prominence in
the 1990s. A CGAP study by Karim et al (2008) found that Islamic microfinance served just
380,000 clients, compared with 77 million for conventional microfinance institutions. A more
recent CGAP study by El-Zoghbi and Tarazi (2013) found that Islamic microfinance reached
over 1.2 million as of 2011, which translates to annualized growth of 50% per year, albeit from a
very small base.
The development of microfinance products specifically targeting energy financing make
up a very small portion of total microfinance lending and so the available research on this area of
microfinance is similarly limited. A report prepared by the SEEP Foundation (Morris et al 2007;
Hilman et al 2007) on energy microfinance was unable to find any microfinance institutions
(MFIs) in Latin America and the Caribbean for field research, although it did identify some MFIs
that had energy lending programs. The reason for the lack of many MFIs with energy lending in
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Latin America can be ascribed to the population they serve, which is primarily middle income
and located in urban areas where there is more limited potential for energy products to develop a
sizable market.
Instead, the report focused on institutions in Africa and South Asia, where microfinance
has a large and varied markets and found significant differences in the products applied to the
energy market. Financing was provided for many different types of systems from household-
level solar and community-sized micro-hydro systems in Sri Lanka to smaller solar lanterns and
clean cookstoves in India to biogas plants in Nepal. Another study (Center for Financial
Inclusion 2011) focused on the mass distribution of solar lanterns in Uganda, Mali and Tanzania.
The diversity of systems being financed represented the diversity of environments in
which they would operate, based on the local community need and the future prospects for grid
connection. Larger systems (household- and community-sized) were found to work best in areas
where the grid is unlikely to extend since the MFIs often need to negotiate buy-back
arrangements with vendors in the case of an unplanned extension of the grid, which often occurs,
in many cases based on political, not economic, consideration. The cost to the MFIs and vendors
can be substantial where the buy-back arrangement occurs, and this may not be feasible when the
system removal rate is high.
Since there is no known Islamic microfinance program specifically focused on energy
financing, the literature on conventional energy microfinance provides a basis for the analysis in
this paper. However, because this paper aims at providing a model for Islamic microfinance that
is not replicating the interest-based model used by the conventional microfinance institutions, it
is not likely to be fruitful to review in detail the financial structures used, so only a few
observations will be provided.
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The key features of the energy microfinance product is that clients are required to make a
down payment of roughly 10-20% of the cost of the system for most of the MFIs surveyed by the
SEEP report and repayment occurs over a period between 2 and 5 years. In the case of the
community-sized micro-hydro projects installed by SEEDS in Sri Lanka, the community has the
option of contributing cash and/or in kind services in the installation of the system. Some of the
MFIs providing energy-related loans require the clients to open savings accounts with the MFIs
or to have already successfully repaid at least one or two microloans from the MFI. However,
each MFIs programs and requirements are different, and the model outlined in this paper will
draw upon the experiences of the MFIs described above (primarily with regards to anticipated
length of financing and down payment requirements) but putting this type of product into
application will have to be modified to suit the needs of the MFI and the conditions of the
community, as well as the specific renewable energy products used, cost of installation and
ability of the local community to contribute cash and/or labor to the installation of the systems.
Non-monetary benefits from renewable energy microfinance projects
The development of microfinance is focused primarily on increasing the monetary
income of people living in poverty. Data on the success of achieving this goal are mixed.
1
This
is due to many factors that lead clients of microfinance institutions to receive financing. While
microfinance is usually thought to entail the financing of microbusinesses to allow the
entrepreneurs to expand their earnings potential, there are many cases where microfinance is
provided to meet consumption needs, to repay other loans, and to make improvements to the
borrowers home and so looking at purely monetary returns from microfinance requires a large
degree of effort to distinguish financing taken to expand earnings potential from the financing
provided to meet clients other financial needs.
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This paper aims to develop a system to provide financing to clientshouseholds and
communitiesto address non-monetary costs that face them as a result of their current energy
sources. For starters, the use of non-renewable energy sources has direct marginal costs, whether
this is the cost of purchasing diesel for a generator, kerosene for lanterns, or the opportunity cost
of time spent gathering firewood for cooking. In contrast, renewable energy generally has a
higher fixed cost for the system, but low or negligible marginal costs for electricity generation.
The direct marginal cost of non-renewable energy is the easiest to measure, and the benefit from
avoiding these costs are included in the hypothetical example provided later in the paper. The
indirect costs of non-renewable energy and the indirect benefits from switching to renewable
energy are more difficult to measure and so any measurement of direct costs only is likely to
understate the true benefit from renewable energy financed with Islamic microfinance.
In addition to the positive marginal costs for non-renewable energy generation, there are
additional costs in the form of uncertainty about the future trajectory of these costs. The price of
kerosene and diesel is in large part driven by the movement of the price of oil in the world
commodity markets, which has varied significantly in recent years and is unlikely to be stable in
the future, as well as government subsidies which may decline in the future as the costs for
subsidies rises with world energy prices.
In addition, there are other costs to non-renewable energy that are more difficult to
measure in the context of analyzing the total benefit from switching from non-renewable to
renewable sources of energy. For example, diesel generators and kerosene lanterns generate
emissions which are harmful when inhaled and cause respiratory ailments that diminish an
individuals earning potential and impose additional healthcare costs, as well as causing
premature death. Indoor air pollution is estimated to cause 100,000 additional deaths per month
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globally.
2
In addition to these costs, kerosene lanterns are vulnerable to being knocked over,
which can start fires that may cause significant damage, injury and death.
Although it is difficult to measure the non-monetary benefits from Islamic microfinance
that provides an alternative to non-renewable sources of energy, these benefits are tangible. Any
assessment of any large-scale effort to facilitate renewable energy microfinancing (whether
conventional or Islamic) should be aware that the monetary benefitwhile importantis only
one source by which the financing generates benefits.
ROSCA for small systems
The most basic need that can be addressed from renewable energy is lighting. There are
many systems that provide lighting and most of these are cheap solar powered lights. The
development in the solar market have made these products very cheap alternatives to kerosene
lanterns. Lanterns are widely used but are more expensive as the price of kerosene rises, they
present a fire risk, and their emissions cause negative health effects (Center for Financial
Inclusion 2011: 5).
Many of the solar lighting systems produced in East Asia cost between $10 and $100 to
purchase, making them affordable for many more households that are targeted by MFIs (Center
for Financial Inclusion 2011: 6). However, in areas served by the grid, MFIs can serve as
distribution centers to reach a wide share of the population. These MFIs and community groups
will have to do more than just sell the units in order to get widespread take-up of solar lights as
alternatives to kerosene. They will also have to be involved in financing the purchases.
There is a role for both MFIs and community groups in this process, and each can
provide value. In order to reach cost effective scale, many MFIs operate across a wide
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geographic area that may include many villages where the electricity grid is either not available
at all, or is not reliable (to the extent where people have backup lighting to cope with an absence
of electricity). Community groups on the other handwhether organized within the local masjid
or outside of ittend to be focused on a specific village or localized area that includes several
villages.
The MFIs and community groups should collaborate to use MFIs as a vehicle to join
together several community groups to gain the ability to bargain effectively for lower prices from
suppliers. This will provide the opportunity for the MFI to buy and resell systems to several
community groups and make a profit for coordinating the purchase while still providing systems
at a lower cost than if they were bought directly from the supplier and each must pay retail price,
as well as the cost of shipping.
The community groups shouldbefore buying the systems from the MFIfind local
demand for the systems and organize groups of community members into a rotating savings and
credit association (ROSCA) to finance the purchase of the systems. ROSCAs are a widespread
form of self-organized microfinance that operate worldwide, and have been institutionalized in
India as regulated Chit Funds.
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ROSCAs work by organizing groups of several people who contribute a set amount each
period to the group, with each member receiving all of the contributions each period, less a fee
paid to organizer of the ROSCA. As a result, the ROSCA operates essentially as an informal
qard al-hasan fund where all members make loans to the group every month and the fund makes
a qard loan to an individual member, in this case for the purchase of a solar lighting system. The
financing cost will vary from member to member based on the delay in receiving financing, but
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even the highest cost (for the last member to receive financing) will be lower in most cases than
the interest cost from a conventional loan.
The ROSCA structure allows the purchase to be made in smaller installments, making
them more affordable for each ROSCA member than if they had to pay the entire cost up front.
The ROSCA organizer earns a fee for the service they provide in collecting donations and
distributing the ROSCA funds for the purchase of the solar lighting system. The ROSCA
structure has already been applied in a Shariah-compliant framework.
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An extension to the ROSCA framework to maximize the cost savings from buying bulk is
if the ROSCA itself can receive a qard al-hasan loan from an external group that is promoting
the deployment of renewable energy technology to low-income communities. This outside
group provides a loan to the ROSCA which uses the funds to buy the full number of systems for
the ROSCA group and distributes the systems one-by-one as the funds are collected from the
customers. When these funds are collected, the qard al-hasan loan is repaid to the external
group, which can then use these funds to finance other ROSCAs.
Household Mudaraba/Musharaka
The key for developing an Islamic microfinance product for renewable energy is using
the underlying characteristics of the available products to the maximum advantage by providing
differentiation from conventional microfinance and benefiting clients. For example,
microfinance institutions are attracted to energy lending because there is a much larger potential
market than for microbusiness financing. Everyone has energy needs, while only some people
have the desire and ability to start microbusinesses. In addition, the energy loan products were
developed in a way to capture the self-repaying nature of energy financing through the energy
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savings they enable. For example, some MFIs have linked the loan product with a savings
account where clients deposit their energy savings, which are held both as a form of savings for
the client, as well as to provide greater security for the MFI.
The structure of energy loans linked with savings accounts is not the focus of this paper
in part due to doubts about whether linking a deposit product to a loan would be accepted as
Shariah-compliant. It instead serves as an example of how product innovation was necessary to
create the energy lending model, which will be further expanded into the Islamic microfinance
sector below using a musharaka product. This paper focuses on musharaka as a preferable
product for the situations outlined, but more undifferentiated products like murabaha may also
be used to fill out the product portfolio for Islamic MFIs offering energy microfinance.
The product is designed for a family with existing electricity demand that is unfulfilled
by the grid (met instead by a diesel generator) in a region that is not likely to be reached by the
grid during the life of the system. Competition from the grid, particularly if the electricity were
offered at subsidized rates through the grid would make the system uncompetitive.
5
The typical
consumer will have a diesel generator that powers the homes existing demand for electricity
which can be replaced or augmented by a renewable energy system.
For the reasons mentioned above, the primary financing rationale in this scenario is to
replace non-renewable electricity generation with renewable energy. Another primary concern is
the health and cost of non-renewable energy. The goal is to make obsolete the current source of
electricity, so the financing should have as little up-front cost as possible. By displacing an
existing system, it already involves a (non-cash) loss of the investment in the current generator,
which is a sunk cost. The structure that involves the least cost would be a mudaraba, since the
up-front cost will be covered by the MFI and the client makes payments for the use of electricity,
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whether it is used on-site or connected through a micro-grid and sold to another community
member.
The downside to using a mudaraba is that it may provide a disincentive for the client to
perform routine maintenance on the system to maximize its working life since they are paying
for only the current production of electricity and do not have a direct investment in the system
which would be lost if the system reaches a premature end of its useful life. There is also not an
intuitive way to calculate the value of the system for the MFI to gradually sell it to the client
under the mudaraba system. The clients interest is as the manager (mudarib) whose role is
limited between deciding to consume or to sell the electricity generated by the system in a given
period, which does not end up aligning the incentives of the client and the MFI.
Furthermore, there are potential Shariah issues relating to a diminishing mudaraba.
Vogel and Hayes (138-139) break the issues into three parts. A diminishing mudarbaha
purports to be a binding future sale of mudaraba ownership, which is not valid, it incorporates
the concept of transfer [] at a price of par, or may represent a binding agreement to enter
into a series of diminishing mudarbaha, each liquidated by a conjectural final accounting,
distributing final profits, and each followed obligatorily by a new partnership with a reduced
capital contribution from the bank [which may create an invalid] agreement to enter into a
mudaraba into the future. Despite these issues, the OIC Academy upheld the contract.
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Although the OIC Academy approved a diminishing mudaraba, the structural challenges
present the question of what to do when the first profit payment is made and the mudaraba is
reconstituted with a lower contribution from the bank. If the partnership creates greater value
than the initial profit payment, then the reduced capital contribution from the bank will be lower
than the value of the partnership, leading to a capital contribution (in kind) by the client and
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recharacterizing the contract as a musharaka. As a result of this structural challenge and the
incentive problem noted above, it is more intuitive to begin with a diminishing musharaka. This
is supported in the large scale Islamic finance where diminishing musharaka is far more
common.
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A musharaka, by contrast, will align the incentives of the client and the MFI, as well as
providing a tried and tested methodology for gradually selling the activity being financed in a
way that spreads the purchase out to make it affordable for low-income clients. The down
payment associated with the musharaka financing should not be onerous, recognizing in
particular non-cash loss that the client realizes with the obsolescence of their existing electricity
generating source. However, it should be set at a level that is significant to the client (i.e.
significant if it were lost due to lack of maintenance on the renewable energy system). This will
provide the incentive for the client to protect the value of the investment, particularly if there is a
warrantee for the product that covers the cost of the service, and just requires the client to ask for
service.
Unlike the mudaraba, the process by which the MFI can exit the investment using the
musharaka structure is a relatively simple modification to a well-tested product (declining
musharaka) used elsewhere in Islamic finance. The contract for the system would include a
purchase undertaking where the client purchases a portion of the system, either fixed in percent
(with cost per 1% varying) or a fixed dollar amount (with the percentage acquired varying).
Alternatively, the cost of electricity could be set at a higher level so that the profit share accruing
to the client is used to effect a gradual buy-out of the MFIs share in the musharaka.
The key to this declining musharaka (musharaka mutanaqisah) product will be
determining the pricing and valuation method that will be consistently applied throughout the
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financing in a way that offers competitive value compared with the existing source of electricity.
In the pricing model suggested for this product, the key assumption is near zero marginal cost of
generation for the renewable source versus a fixed (non-zero) marginal cost of generation that is
increasing over time. As a result, the end cost per period can be competitive with the non-
renewable alternative, while providing a revenue stream for the project (through the payments
for usage) which can be used to set the valuation of the entire system in the purchase
undertaking.
Take the following hypothetical example of a renewable energy system that costs $7,500
and has a 5 year useful life.
8
The system requires maintenance of 1% of the system cost
annually, and the client is required to put down a 10% down payment ($750). The client requires
400kWh per month. The system valuation method (a multiple of revenue using the previous
months revenue) and the cost of electricity are set based on expectations of the return to the MFI
and the length of time before the financing is completed. The cost per kWh will increase each
month according to an annualized rate of electricity price inflation (in this example, it is set at
5%). For the example, the revenue multiple is set to 1.25 and the cost of renewable electricity is
set to $0.60 per kWh.
Table 1: Hypothetical example of an individual musharaka financing

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The above example is purely hypothetical and assumes a constant level of generation as
well as maintenance costs. If this were an operational financing arrangement, the generation and
maintenance would vary, and this would affect the length of time during which the buyout would
be completed as well as the returns to both client and MFI because valuation at which the buyout
of the MFI are conducted are based on actual performance and are not fixed ex ante. This results
in risk sharing between the MFI and the client in a different way from how a conventional
amortizing loan would work, where the payments would be due without regard to the
performance of the system.
The use of a renewable system to replace a non-renewable (e.g. diesel) system does not
necessarily have to have a lower cost per kWh in order to provide a benefit to the client because
the renewable system has a near zero marginal cost of electricity while the non-renewable source
has does not. Therefore, when viewing whether the product offers a benefit to the client, it is not
enough to measure the cost of financing the system.
The net benefit or cost to the client will include the cost of the renewable source as well
as the avoided cost of not paying the marginal cost of energy for the non-renewable system.
During the buyout period, these factors partially offset. However, when the buyout is complete,
the monthly cost is nearly eliminated (maintenance cost would remain), though the avoided cost
(a benefit) will remain. In the example above, if the cost of electricity from the non-renewable
source is $0.20 per kWh, then the avoided cost from the 22 months after the buyout is complete
(assuming a 5-year system life) will more than offset the additional cost of the system during the
buyout period. The average cost of electricity is expensive compared to what most grid-provided
electricity consumers see on their monthly bills, but that is because costs rapidly escalate as
generating capacity moves from large to small.
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There may be some situations where the MFI can use a mudaraba structure. However,
there are few situations in which the mudaraba structure will be able to overcome the adverse
selection and moral hazard problems inherent in the contractual structure even before addressing
the challenges associated with the diminishing feature of the contract. It may be possible to use
if the MFI is otherwise involved with the community members to ensure the willingness and
ability of the specific clients to pay for the electricity generated and that the proper upkeep is
performed on the systems to the manufacturers specific recommendations. The costs for
providing such intensive additional work in what are likely to be smaller villages that are
completely off the grid will probably not be common, so the mudaraba product is likely to be
rarely used.
The financing to be provided under the mudaraba or musharaka investment will be for a
complete system necessary to generate electricity which can be used to power lights, television,
radio; anything that requires electricity to operate. The system size will depend on the typical
electricity demand, and will therefore vary across countries, but the individual financing size will
be focused on a system large enough to power the entire house with the possibility for some
excess generation which can be sold to a village-level micro-grid, if one is available, although
the financing analysis by the MFI will likely proceed on the assumption that all power generated
by the system will be by the household. The model will remain the same, with additional cost,
but also greater adaptability for situations where electricity generation and demand occur at non-
overlapping times, where batteries are necessary.
The selection of renewable energy system will be of primary concern because allowing
many different systemswhether wind, solar, biomass or otherwill accommodate different
environments where one or the other of the systems may be inadequate. For example, some
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regions where there is a steady flow of wind will benefit from wind power, while others with
more variable wind resource that fluctuates from no wind to heavy wind will not likely benefit
from wind power.
Even where the resource is the same, the average level of electricity consumption may
favor one source of electricity generation over another because of the relative efficiency of
generation for a particular capacity. It may in some cases, become infeasible to do finance
household-level generating capacity using a particular power source, but be feasible for a
community-level project. Flexibility will be key because a lack of adaptability across regions
will leave the implementing MFI with only a hammer and cause each varied situation to become
viewed as a nail.
The MFIs will be involved in the selection of the technology offered, but there will need
to be some source of expert input that determines the conditions under which different
technologies are installed. This will provide a way to avoid installing generating capacity that is
inappropriate for the sites where electricity demand exists (e.g. installing wind power in an area
with a poor wind resource). Because the systems are intended to provide small levels of
generating capacity, it is imperative that sites be selected properly, but also that the site selection
costs are minimized, to control the cost to the client and keep the economics of the system
viable. The levelized cost of energy (LCOE) from a particular source of energy has to be
affordable for the low income clients that the MFI deals with. Providing financing for systems
with a high LCOE will be counterproductive because it will not be affordable for the targeted
clients of the MFI.
Community renewable energy systems
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Most of the conventional microfinancing for energy has focused on individual household
needs to replace expensive and dirty kerosene and diesel generating system, and the methods
described above provide a way to develop Shariah-compliant alternatives to this market, but the
area where Islamic financeparticularly mudaraba and musharaka financing can be effective
is on community-wide systems. However, these types of financing projects require more
complex design to address the specific incentive challenges facing profit-and-loss sharing
systems where there are more than two parties (household and MFI or ROSCA) involved.
The same trade-offs as described above relating to mudaraba and musharaka will apply to
community systems but the challenge of maintenance needs and associated costs are magnified
so a musharaka is preferable. A community system requires effective management organization
to collect sufficient revenue to perform regular maintenance in order to keep systems
functioning. There is a free rider problem that will need to be addressed because the efforts of
one member to ensure maintenance is conducted will provide a benefit to the other members of
the group. In the absence of division of responsibilitiesand perhaps paying board members of
the community electricity cooperative for their timeeach individual may not find it
economically advantageous to ensure that maintenance is performed on the system, to the
detriment of all community members and the MFI.
A community system will require several things to be effective. Firstly, the system has to
be purchased and installed. Secondly, it will need a distribution system to supply electricity to
the community members participating in the electricity cooperative. Thirdly, it will need to have
a dedicated organization responsible for maintaining the system and for collecting the payments
for electricity used. Finally, it will need to have an organization to finance the entire venture.
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The chart below shows the structure of micro-hydro financing projects financed by the
Sarvodaya Economic Enterprise Development Services (SEEDS) in Sri Lanka.
The community organizes and electricity cooperative society (Consumer Society in the
diagram, or ECS) who recruits a developer in conjunction with SEEDS. The development is
financed through a grant from the Renewable Energy for Rural Economic Development
(RERED), a program initiated by the government of Sri Lanka with assistance from the World
Bank and the Global Environmental Facility (GEF), a public facility financed by the World
Bank, UN Environmental Program and UN Development Program. Projects are submitted to the
local authorities for approval by a developer working with SEEDS and the local community.
Once approval is granted, the community contributes in kindlabor and materialsto
the installation by the developer of the project of the village hydro project which is financed by
donors and SEEDS, and refinanced by RERED to free up funds for SEEDS to finance other
projects. Once the installation is completed, the community purchases electricity from the ECS
which provide funds to repay the loan from SEEDS which are passed through to RERED under
the refinancing agreement (with SEEDS operating as the collection agent for RERED).
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Figure 1 Structure diagram of SEEDS energy microfinance

Source: Hilman et al 2007, p. 50
The structure above is similar in many respects to how the musharaka community energy
project will work (see below), but there are some key distinctions that require breaking down the
proposed structure into discrete phases: 1) approval, development and commissioning of project;
2) co-ownership phase; 3) community ownership.
During the first phase, the community establishes an electricity cooperative society
(ECS), as a separate entity to represent the community in the project. A project-level entity is
also established to act as the musharaka entity through which the financing of the project is
directed, and which is the entity that arranges for the construction of the project. The musharaka
entity is established with a qard al-hassan loan from the MFI to fund the project assessment. If
the project is not feasible, the loan will be forgiven and the musharaka entity dissolved. If it
moves forward, the initial profits to the musharaka will be used to retire the qard loan.
20


Figure 2 Structure diagram for community musharaka project

The musharaka entity will fund the developers request for approval from the relevant
authorities, including obtaining any permits that are required. The planning process will include
determining the cost of installation of the generating capacity as well as distribution network to
connect the renewable energy source to the ECS members homes and businesses. Information
collected during the planning process will determine the community demand for electricity and
ability to pay for electricity. This information can be used to determine the optimal systems that
will generate electricity at the time of day when demand is high and at a cost that matches the
communitys ability to pay.
Once the project is fully permitted, the musharaka will be funded by the MFI and the
community. The community can fund their contribution in cash or in kind (materials and labor).
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Once the musharaka is fully funded the initial profit sharing ratio will be established, and the
terms of the valuation metrics used for buy-out will be determined.
10
The musharaka entity will
then contract with the developer under an istisna agreement to construct the facility with
payment from the musharaka entity payable on the delivery of the system when the musharaka
entity will be able to generate revenue from selling electricity to the ECS.
The profit-sharing ratio should be determined in a way that provides for buyout of the
MFI with a competitive level of profit given the estimated time required for the buyout. The
market survey for electricity demand and the communitys ability to pay should be estimated in a
way that anticipates the potential for delay in the buyout process from unexpected events. The
cost through a musharaka may end up being more or less expensive financing than an interest-
based loan because losses caused by lower demand for electricity or lower generation than
anticipated will be shared between the community and the MFI. The contracts will not use a
musharaka structure with the payoff structure of a conventional loan; the returns accruing to the
MFI will be determined entirely by the performance of the musharaka entity.
Once the project is operationalfor both generating and distribution capabilitiesand
funded by the contributions from the MFI and ECS, it will begin selling electricity to the ECS,
which will sell the electricity to community members. Depending on the structure of the initial
contributions by the ECS members (cash or in kind) the ECS can provide meters bought by the
musharaka entity (if ECS members contribute cash) or charge the members for the meters (if
ECS members provide labor, or for members not initially involved in the projects)
11
.
The ECS, which is run by the community, will be responsible for collecting payments
from members and it will use these payments to pay for the electricity generated by the
renewable energy generation. If it so chooses, the ECS may use existing non-renewable
22

generating capacity or batteries (potentially financed by the MFI under separate financing
arrangements) to provide continuity of service to the community. Any other services will be
controlled entirely by the ECS and will not be part of the musharaka agreement. The ECS may
choose to use these sources of revenue to pay for the electricity usage from the musharaka-
financed renewable generating capacity to avoid default.
12

Under normal circumstances, the electricity used by the ECS members will be billed to
those members by the ECS and the collected revenue will be paid to the musharaka entity,
generating a revenue stream for the musharaka entity. The musharaka entitywhich will be
jointly managed by the ECS and the MFIwill be responsible for all the operations and
maintenance of the system (both generation and distribution). It will be required to maintain
insurance on the system for catastrophic events (preferable takaful). The premiums paid for the
takaful coverage will be deducted from the musharaka entitys profits.
The financial results of the musharaka entity will be calculated on a regular basis
13
and
based on these results, the profits will be divided according to the profit-sharing ratio. The
profits accruing to the MFI will be distributed to such and the profits accruing to the ECS will be
paid to the MFI in exchange for a share of ownership of the musharaka entity as determined by
the diminishing musharaka agreement, which will set a multiple of either revenues or profits to
value the musharaka entity. After the buyout each period, the relevant profit-sharing ratios will
be reset according to the new ownership.
If there is a loss, there will be no distribution to either the MFI or the ESG (to be used to
buyout the MFIs share in the musharaka entity). For isolated (one-off) cases, it will lead to no
change in the ownership structure. However, for more persistent losses, the buyouts will cease
and each party will face losses in the value of their musharaka assets. The musharaka agreement
23

will have to include terms for how persistent losses are handled. For instance, any party that
contributes cash to the musharaka entity could be granted shares based on a valuation that uses a
revenue multiple (to avoid the problems of valuing a loss-making musharaka entity).
This process will repeat until the musharaka entity is entirely owned by the EC at which
point the musharaka agreement will terminate.
14
There should, however, also be in place an
agreement how the ECS surplus profit are used. These could include distributions to ECS
members (in cash or as rebates against electricity charges), use in social programs in the
community, or they could be put into a fund to be used to finance replacement electricity
generating and distribution equipment.
Accessing Islamic Capital Markets
The products described above are meant to be financially sustainable. An MFI offering
these products will have to be seeded with equity or donor capital in order to build to a
sustainable scale, using the profits from these products to cover its operating expenses. For
several reasons, the MFI may wish to tap external sources of financing. For example, it may
wish to access additional capital to grow its operations beyond the level its own capital can
finance. In order to do so, it will be beneficial for the MFI to offer a sukuk to raise funding. The
MFI will face questions about whether accessing capital markets fits within the social mission of
supporting its low-income clients and whether the benefits are fairly shared. It will be important
in designing the sukuk that the interests of the clients are placed on at least equal footing with the
investors and that the investors profits and its ability to recoup any losses are not allowed to
occur at the expense of clients. If the sukuk is designed in a way that favors investors over
clients, it would fail to meet the primary economic objectives of microfinance, as well as
24

creating a negative image of the MFI in the eyes of donors who provide seed capital to establish
the MFI.
The most desirable structure for the MFI is a wakala-istithmaar sukuk, which will provide
an opportunity for the MFI to continue to generate some earnings from servicing the portfolio
while retaining less risk. This should be designed to be a fully amortizing sukuk to limit the
requirements for the MFI to manage the later redemption or refinancing of outstanding sukuk.
Presuming that the information on the status of the underlying portfolio is fully disclosed to
investors and updated with the assistance of an independent third party, the amortizing feature
will be beneficial to investors by providing early warning to problems with the MFIs portfolio.
Figure 3 Structure diagram for walaka-istithmar sukuk

The development of the MFI sukuk will provide an alternative asset class for sukuk
investors that may provide a higher yield than other sukuk, but will also carry additional risks
because it is fully amortizing and the investors will not have recourse against the MFI unless it
25

can prove that the representations regarding the portfolio involved fraud on the part of the MFI
or fraud on the part of the underlying clients that the MFI should have been aware of.
In addition, the sukuk investors will provide financing for institutions which generate
social benefit to MFI clients who have been left out of the growth in Islamic banking for the
most part, as well as promoting an environmentally sustainable business that can be used by the
investors to demonstrate their corporate social responsibility (if they are institutional investors).
This sukuk structure may also appeal to conventional investors not focused on the Shariah-
compliance, but who see benefit from developing a non-interest based form of microfinance and
those who are interested in providing to a MFI that specifically targets reducing reliance on non-
renewable sources of energy.
The ability of an Islamic MFI to attract sukuk investors will be dependent on many
factors, not all of which will be in the control of the MFI. These sukuk structures will contain
more risk relative to the profit they can provide to investors in order to avoid incentivizing the
MFI to place the goal of being profitable above the goal of providing a valuable service to low-
income clients (for example, by targeting financing to better off communities where returns will
be higher). Additionally, an MFI seeking this type of financing will be operating in emerging or
frontier markets where there are additional risks and a smaller subset of the investment
community compared to other areas in the fixed income markets. Execution risks will be borne
by investors, further limiting the number of potential investors. However, the amortizing nature
of the sukuk could provide a benefit within an environment where currently low interest rates are
expected to rise, because the sukuk will provide both profit and principal payments which can be
reinvested in potentially higher yielding investments (limited reinvestment risk).

26

Conclusion
The development of Islamic energy microfinance should represent a unique area for the
Islamic finance industry, as well as the conventional microfinance industry. The musharaka
financing contract described in this paper conforms both to what is commonly believed to be the
more authentic form of Islamic finance because it shares both profit and loss.
15
It is also more
well suited in the case of energy financingwhere there is a relatively predictable and
measurable set of cash flows generatedthan in other areas of microfinance where it will be
faced with much more costly measurement to determine the profits to which the profit-sharing
ratio will be applied.
This paper has also attempted to provide a way for an Islamic MFI to tap the capital
markets in a way that passes much of the underlying risk from the products onto the investors in
a way that limits the MFIs exposure to large payments due upon maturity of the sukuk,
preferring instead to have the sukuk fully amortize where the profits and losses are passed
straight from the projects to the investors with the MFI earning a fee for originating and
servicing the projects on behalf of the investors in the sukuk.
The key moving forward will be for an MFI to step in and take the lessons relating to the
logistics of negotiating MOUs with energy product providers from other MFIs providing energy
microfinance and combine it with the musharaka financing structure outlined in this paper to
demonstrate if this model works better in practice than the conventional MFI energy lending
programs. If so, this structure could provide a useful for MFIs who offer energy microlending,
whether they are Islamic or not.
27

References
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Energy Links Project. CFI Publication No. 13.
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Implementation of the OIC Ten-Year Programme of Action, Jeddah, KSA: OIC.
El-Zoghbi, Mayada and Michael Tarazi. 2013. Trends in Shariah-compliant financial
inclusion. CGAP Focus Note No. 84.
Hevener, Christy Chung. 2006. Alternative Financial Vehicles: Rotating Savings and Credit
Associations (ROSCAs). Federal Reserve Bank of Philadelphia Community Affairs
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development/publications/discussion-papers/discussionpaper-ROSCAs.pdf
Hilman, Helianti, Jyoti Gidwani, Ellen Morris, Prem Sagar Subedi and Sonali Chowdhary. 2007.
Using Microfinance to Expand Access to Energy Services: The Emerging Experiences in Asia of
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Development Services (SEEDS), Dirdhan Utthan Bank Limited (NUBL), and AMRET.
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Karim, Nimrah, Michael Tarazi and Xavier Reille. 2008. Islamic microfinance: An emerging
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Morris, Ellen, Jacob Winiecki, Sonali Chowdhary and Kristen Cortiglia. 2007. Using
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28



Endnotes

1
Westover (2008).
2
Morris et al (2007, 11).
3
Hevener (2006).
4
Urs (2012).
5
This problem was encountered in Sri Lanka by the MFI SEEDS, where there were unplanned
grid extensions. As a result, the group offered a buy-back arrangement with the vendors in the
event of grid extension. The solution is not always feasible where removal rates are high
(Hilman et al. 2007).
6
Decision 5 (d4/08/88), fourth session (1988), Fiqh Academy Journal 4:2161, 2164 as cited in
Vogel & Hayes (1998: 139, note 18).
7
Wilson (2012: 184) writes that mudaraba and musharaka investments are inherently illiquid,
although the former can be progressively retired if there is a diminishing mudaraba contract.
Given the significantly higher frequency of use of diminishing musharaka and the Shariah
issues noted above, it is unclear how a diminishing mudaraba would be preferable.
8
The hypothetical example is much larger than a single household in a developing economy
would require, but is presented because it has similar economics to systems familiar to the author
for which reliable data could be obtained.
9
Additionally, there is no calculation of the benefit from avoiding the detrimental affects of non-
renewable systems, such as reduced incidence of lung ailments.
10
It is important to note that the valuation metrics (e.g. revenue, cash flow and profit multiples)
will be decided once the full capital contributions are determined. There should be disclosure by
the MFI at the outset of planning discussions of the typical terms accepted by the MFI for
valuation metrics and anticipated buy out period.
11
The ECS will likely have first adopters who participate in the initial funding as well as
community members who join the ECS later. Those that join the ECS after it is operational will
need to be connected to the micro-grid and have meters installed. While they should pay for
meters up front, it is unclear whether it is preferable to charge them up front for connectivity into
the grid, or just build in additional per-kWh costs to their service to, over time, pay for that cost.
It is the authors view that a per-kWh charge is preferable to encourage wider community
adoption of the service.
12
While the service is operated under a profit-and-loss sharing contract, the sales agreement by
which the musharaka entity sells electricity to the ECS will require payment for electricity used.
If the ECS does not pay for the electricity that is used by the grid, there will be remedies for the
musharaka entity including the cessation of service or sale of the generating and distribution
capacity owned by the musharaka entity in order to terminate the musharaka.
13
Quarterly or semi-annually would be preferable but annually would suffice for long-lasting
systems to reduce costs to the musharaka entity.
14
In case of persistent losses and no party is willing to inject additional capital into the
musharaka entity, the assets can be liquidated and the proceeds distributed according to the last
calculated profit sharing ratio.
15
El-Zoghbi and Tarazi (2013).