Take-or-Pay Contracts in Liberalized Markets

hether gas is bought, sold, and trans- W ported by a pipeline or as LNG, the typical contractual arrangements will be long-term and will include take-or-pay commitments. Where traditionally monopoly markets are liberalizing (for whatever reason) there will often be a tension between long-term contracts put in place to reflect the monopoly model and the development of competition and markets, par- ticularly in distribution and supply. However these issues have been addressed, there are probably two ever-present general questions: “For whose benefit are liberalization measures introduced and pursued?” and “Who will bear the costs that arise in the transition from mo- nopoly structures to liberalized markets?”

Traditionally, oil and gas were both traded on long-term contracts with long-term pricing. Oil has moved to become spot-priced even if the sale and purchase arrangements are long- term. Gas has traditionally been seen as differ- ent from oil. However, the example of liberal- ized markets has shown that gas too can come to be traded at short-term or spot prices. Long- term gas contracts tend to have fixed or ascertainable quantities and may provide for sale or purchase on an exclusive basis. There will often be fixed pricing under which an initially agreed price is adjusted from time to time by reference to the movements in the prices of competing fuels.

These arrangements will come under pres- sure in those jurisdictions where there is a drive for liberalization of monopoly markets. The move to liberalization tends to be driven by politicians, regulators, or both-and markets will

Paul Griffin is head of energy and project finance for the law firm Cadwalader, Wickersham & Taft, London.

often develop in gas supply and, separately, in gas transportation and related services (such as storage). Additionally, these developments may happen particularly quickly in circumstances (such as in Britain) where the electricity sector is liberalized at the same time as the gas sector.

If downstream markets are liberalized with- out regard to the structure upstream, then it is almost inevitable that a discontinuity will de- velop between the two. For example, it may be that the former monopoly business is continu- ing to buy gas under long-term take-or-pay contracts with fixed initial prices adjusted by reference to oil, coal, and electricity. Such a situation will be likely to leave the former monopoly at a disadvantage.

If downstream markets are liberalized without regard to the

structure upstream, then it is almost inevitable that a

discontinuity will develop.. . The former monopoly’s problems are exac-

erbated in circumstances of oversupply and regulatory intervention where gas market prices are likely to be falling at a time when its purchase prices under long-term take-or-pay contracts are not. Particularly notable in these circumstances is that among those undertakings that are best placed to attack the former monopoly’s markets (and that may be encour- aged by the regulator to do so) are the major oil producers. Additionally, these companies will often have the benefit of the long-term take-or- pay commitments from the former monopoly.

Nature of Take-or-Pay Commitment Essentially, under a take-or-pay commit-

ment the producer takes the production risk and the buyer takes the market risk. This market risk will often be reflected by tying the price of gas

a NATURAL GAS MAY 1999 0 1999 John Wiley & Sons, Inc.

to the price of competing fuels with the aim of gas remaining competitive against whichever fuel is competing with it. In the absence of gas- to-gas competition, it is competing fuels with which gas is intended to remain competitive.

Often, the producer will have no alternatives for disposal of its gas and the producer will be seeking a secure outlet as well as secure cash flows. The buyer will agree to take certain quantities of gas or, if the buyer does not take the gas, then in any case the buyer must pay for it. This basic take-or-pay commitment will usually be supported by rights to recover gas paid for, but not taken, together with other flexibility mecha- nisms to enable the buyer to balance the uncer- tainties of supply and demand over time. The buyer will be unwilling to provide the security of a take-or-pay commitment lightly and will usu- ally be in a position to have back-to-back cover by means of take-or-pay sales contracts or a monopoly market into which to sell the gas.

This classic take-or-pay bargain will usually be adjusted by reference to nonperformance by the producer or the buyer. Typically, the mini- mum bill that would ordinarily apply will be reducible in the event that the seller does not deliver natural gas nominated for delivery, whether this nondelivery arises by reason of default or by circumstances that are defined to constitute force majeure. For the buyer, there will usually be a reduction in the event that the buyer is unable to take gas by reason of force majeure, but not in the event of default.

This basic take-or-pay commitment will be supported by greater or lesser flexibility for the buyer. Typically, if the buyer has paid for gas it has not taken during a particular period, then the buyer will gain a contractual right to take an equivalent quantity of gas without charge or at a reduced price in the future. This recovery of take- or-pay gas will usually be conditional upon the buyer taking the minimum quantity in the relevant period. The take-or-pay provision will sometimes be supported by a carry-forward mechanism developed for the benefit of the buyer. Under this mechanism, if the buyer takes more gas than the minimum bill in a particular period, then the excess is available to it to reduce what would otherwise be the minimum quantity in relation to a future period. There are many variations on these themes and it is not unusual for commercial limits to be applied to these arrangements whether by limiting the time or the quantities by reference to which these rights can be exercised.

If a buyer does take less than the minimum quantity in a period, then that will usually trigger an obligation to pay for the shortfall. The price at which this shortfall is to be paid for is, again, a matter for negotiation. It will sometimes be the usual contract price or it may be more or less than that. Under the simple model, if recovery of gas previously paid for takes place, then this make up will be recovered free of charge. However, again, there are many variations.

Legal Analysis of Take or Pay The courts of most common-law jurisdictions

are familiar with the concept of a take-or-pay contract and it is generally seen as an “obligation in the alternative.” The buyer’s obligation can be fulfilled either by taking the gas or by paying for it if the gas is not taken. There will often be no obligation at all to take gas. Usually, take-or-pay contracts tend to find their way into court when the price under the contract is different from the price at which the buyer is then buying gas or is different from the price in the market if a market has developed. The courts have shown them- selves to be alert to this point.

. . . tend to find their way into court when the price under the contract is different from the

price at which the buyer is then buying - - -

The courts have dealt with a number of arguments concerning the enforceability of take- or-pay contracts in relation to gas and also in relation to other products and services. One of the most enduring arguments is that the take-or- pay provision is a “penalty” or is otherwise not enforceable as it is unconscionable. This argu- ment has not fared well with findings that a take- or-pay payment is typically not a payment made in the event of a breach of contract and that an inability or failure to take gas is in any case not conclusive. The argument is that the take-or-pay commitment is an obligation in the alternative and is equally performable either by taking or, if not, then by paying.

In addition to challenging the enforceability of the take-or-pay provision, it may be that a buyer fails to make a take-or-pay payment otherwise due. In these circumstances the pro- ducer will have an election to make. On the one hand, the producer may choose to sue for the debt and not question the continued validity of the contract. Alternatively, the producer may

MAY 1999 NATURAL GAS 0 1999 John Wiley & Sons, Inc.

9

claim that the nonpayment is a repudiation of the long-term contract, entitling the producer to bring it to an end. In these latter circumstances, the producer would claim for the capitalized value of the remaining contract term, less the value of that gas in the market. This analysis presumes the existence of another market.

One other point to touch on is the account- ing treatment of take-or-pay payments. In many jurisdictions (including the United States and the United Kingdom) take-or-pay payments cannot be brought into profit and loss but are treated as balance sheet items. Thus, although it can be said that take-or-pay guarantees a cash flow for the producers, this cash flow cannot necessarily be treated in the same way as money paid and received for gas sold. This accounting treatment is also likely to result in different tax treatment for take-or-pay payments.

Liberalization of Markets The traditional model of gas industries is of

a vertically integrated business having mo- nopoly powers. This will often take the form of a business that has rights to produce or pur- chase gas (or both), to transport gas, to store gas, and to distribute gas to end-users. How- ever, many nations have now embarked on changes to this traditional model, although the reasons for this course vary. The restructuring and liberalization of the industry can take a number of forms but will often include a disin- tegration of the functions of gas businesses. The trading of gas can be seen as a separate function from its transportation-and this can be seen as a separate function from, say, the storage of gas. Typically, contestable elements of the gas chain are identified and steps are taken to create markets where markets can be created.

As markets are created and competition begins to develop, there is a need to address the continued market power of the former mo- nopoly. Many states will have an existing com- petition law, although it may not be well-suited to the requirements of the task, and specific regulatory bodies may also come to be created. Even if one were to leave aside the role of a regulator in the development of competition, there will often be a requirement for a regula- tory body where monopoly remains despite the liberalization of the market. The accepted theory is that transportation systems will tend to be natural monopolies and that regulation is neces- sary, if only to act as a proxy for competition.

Throughout this process, one of the most important elements is the gaining of access to facilities. If new entrants are to compete with the incumbent business, buy gas from producers or wholesalers, and supply to end-users, then the new entrants will almost certainly need access to the existing facilities and particularly pipe- lines. The duplication of existing facilities is likely to be uneconomic and the creation of new facilities may be beyond the business of the new entrant. Whether this access can be achieved and, if so, on what terms, will be one of the crucial questions to resolve.

The success of measures aimed at achieving market liberalization will turn on a number of factors and, depending on the circumstances, may include the will of politicians or regulators to see liberalization take place and, perhaps, an oversupply of gas.

Experiences in the United States There are more cases from the courts of the

United States than anywhere else. The example of the United States during the late 1980s can be seen to some extent as an example of more general application. The developments in the United States were overseen by the Federal Energy Regulatory Commission (FERC), which was working with the benefit of a considerable oversupply of gas, or “gas bubble.” In 1984, Order 380 relieved the local distribution compa- nies of their take-or-pay commitments to the pipelines but did not relieve the pipelines of their take-or-pay commitments to the producers.

In 1985, Order 436 continued the process of liberalization and provided for the pipeline com- panies to open their pipelines to third-party business by transporting natural gas for others. This period saw considerable activity in the law courts with pipeline companies seeking to avoid take-or-pay commitments to producers. Addi- tionally, the period saw pipeline companies seeking to renegotiate take-or-pay contracts with producers. Subsequent orders enabled pipeline companies to recover from their customers a proportion of the costs incurred in renegotiating and restructuring their take-or-pay contracts.

These regulatory actions left many of the pipeline companies in commercial difficulty and some in such difficulty that they contemplated liquidation as a result of the take-or-pay commit- ments owed to producers. In these circumstances and in the absence of satisfactory regulatory intervention to ease the position, a number of

10 NATURAL GAS MAY 1999 0 1999 John Wiley & Sons, Inc.

pipeline companies pursued legal remedies in the law courts. There were many challenges and many grounds of challenge. The more usual grounds for challenge included the following: Challenges based on force majeure clauses nec- essarily turned on the particular words used in the force majeure provisions, but were largely unsuccessful. Arguments based on penalties were largely unsuccessful with the take-or-pay com- mitment generally identified as not giving rise to a payment on breach. Arguments were made that there had been a frustration of the original purpose of the parties and the contracts, but the courts found that this test was not fulfilled where the contract was merely more onerous than might have been expected. Arguments in mistake fared no better with the court finding that errors of prediction were not sufficient to found an action for mutual mistake.

Most contracts were renegotiated against the background of litigation and the prospect of the failure of the purchaser. In these circum- stances the take-or-pay contract would have come to an end, leaving the producer to sell gas at the (lower) market price with an incentive for the producer to reduce the price from the then- contract price but still keep it above the then- market price.

Experiences in Britain Until the early 1980s, Britain had a fairly

traditional monopoly model for its gas sector. British Gas Corporation was effectively the monopoly buyer, transporter, and supplier of gas. These monopolies were matched by obli- gations to supply. Prices were adjusted over time by reference to movements in inflation and the prices of competing fuels.

New legislation in 1982 and again at the time of the privatization of British Gas PLC in 1986 created a procompetitive market structure un- der which the monopolies were relaxed or removed. However, competition did not de- velop. There was no immediately available gas, nor were there willing buyers and sellers. In 1988, British Gas was referred to the competi- tion authorities in relatiqn to an alleged abuse of its dominant position in the nascent market for gas supply. The alleged abuse was that British Gas as a gas supplier was discriminating be- tween different purchasers on the basis of whether those purchasers had dual-firing capa- bility. There was a finding of abuse and this gave rise to political and regulatory powers that

provided the impetus for considerable changes in the gas market over the period until the mid- 1990s. In 1995, the legal structure was revised by the passing of a new Gas Act. In many ways it put the legal structure in a form consistent with the way in which the markets had developed and provided for the formal separation of a system for the shipping of gas, supply of gas, transportation of gas, and storage of gas. . . . put the legal structure in a form consistent with the way in which the markets had developed.. . The new markets developed quickly from

the late 1980s and early 1990s when major gas supplies were first made to purchasers other than British Gas. These major purchases were made primarily for the purposes of power generation. The day-to-day imbalances inher- ent in seeking to match gas production with electricity generation soon gave rise to gas that was available for short-term trading. The mar- kets have developed to the stage where gas is now traded bilaterally and on the International Petroleum Exchange in London with the price of gas moving independently of oil prices and the prices of other competing fuels.

As part of the United Kingdom, Britain is within the European Union (EU), which is seek- ing to institute measures to liberalize the energy market across Europe. The EU has recently made progress on this by achieving agreement on directives concerning liberalization in the elec- tricity market and the gas market. However, there are many member states and each will tend to take a different view on the implementation of the requirements of these directives and issues of security of supply, public service, and the impor- tance of the respective gas and electricity indus- tries. Also, there are many powerful vested interests within member states that may see few benefits in liberalization.

In the meantime, what has happened to the long-term fEed-price contracts that many would say were responsible for underpinning the devel- opment of the industry? These contracts include not only the contracts of British Gas from the 1960s, 1970s, and 1980s, but also the contracts of other purchasers in the late 1980s and early 1990s.

Market Restructuring and Contract Reformation in Britain

Broadly, the present position in Britain is of a competitive market in the supply of gas in all

MAY 1999 NATURAL GAS 0 1999 John Wiley & Sons, Inc.

11

sectors, even domestic. However, the upstream market remains characterized by long-term take- or-pay contracts at inflexible prices that move by reference to factors such as general inflation and oil prices. Most gas that is delivered by producers to wholesalers remains sold under contracts that are long-term and inflexible. Many of these are above or well above current market prices. Gas is now freely traded and there are a number of publications that give information on market prices in addition to International Petro- leum Exchange (IPE) prices, but some say that the volumes traded in this way remain small and that there is still insufficient transparency or real liquidity in this market.

Most gas that is delivered by producers to wholesalers

remains sold under contracts that are long-term and

inflexible.

The nature of the renegotiations has taken a similar form to that in the United States. Producers have sought to rely on the existing contractual arrangements and to refer to ideals such as the “sanctity of contract.” Buyers have tended to point to the fundamental change of circumstances that has taken place by regula- tory and political acts beyond the control or prediction of those buyers. Negotiations have taken place and are continuing to take place against a number of backgrounds, one of which is litigation in the courts. Where the gas industry was once characterized by a strong preference to resolve disputes by negotiation, the commer- cial tensions caused by the liberalization process have meant that companies are now prepared, in some cases as their first step, to resolve disputes via the courts, arbitration, or expert determination.

The nature of the renegotiations has taken a similar form to that

in the United States.

Where renegotiations have taken place and the terms have been made public, it can be seen that there have been deferrals of purchase commitments and reductions of prices. Often, these advantages to the buyer will have been obtained as a result of current money payments or the trading of other assets.

Conclusions In those cases that have so far come before

them, the common-law courts in the United

States and Britain have taken a fairly clear view on the enforceability of long-term take-or-pay commitments. However, each case is different and judgments will turn on the particular facts and circumstances of each case. Additionally, similar contracts seem not yet to have been tested to the same extent in civil law jurisdic- tions. It may be that civil law jurisdictions would adopt different approaches to reopening long- term take-or-pay commitments by reference to the purpose or intention of the parties and the changes of circumstances over time.

- . . may be that civil law jurisdictions would adopt different approaches to

reopening long-term take-or-pay commitments - . .

Where contract reformation has taken place, it has largely taken place by negotiation, al- though there are some states where the difficul- ties experienced in the United States and Britain have been borne in mind at the outset and the liberalized or restructured regime has sought to avoid the problems encountered elsewhere. Even in these cases, it will be necessary to address the question of where the costs of restructuring are to fall, and there is no easy answer to this.

Looking forward a little, the United King- dom has already seen the introduction of com- petition into certain sectors of the electricity supply industry. Competition in electricity sup- ply is scheduled to be applicable to all consum- ers this year. In many countries gas is a fuel for electricity generation and what has taken place in the gas markets may provide lessons for electricity markets.

. . . signed up to long-term take- or-pay gas contracts at prices that would now be seen to be well above the market price.

For example, the independent power projects that were concluded in the early 1990s during the so-called dash for gas in Britain signed up to long-term take-or-pay gas contracts at prices that would now be seen to be well above the market price. Thus far it has been possible to pass these high prices through to electricity consumers in monopoly markets. However, the introduction of competition into electricity sup- ply will make it difficult to do this. H

12 NATURAL GAS MAY 1999 0 1999 John Wiley & Sons, Inc.