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Arbitration and Pricing Mechanisms in International Gas sale contracts
International contracts for the sale of gas by producers to transport and distribution utilities typically deal with enormous volumes of gas - volumes which may represent a significant proportion of the available resources of the producer or indeed of the producer's country, and likewise of the anticipated requirements of the distributor. Contracts of this significance need, from the point of view of both parties, to run for many years and to be negotiated several years in advance of their commencement.
This article examines some of the considerations relating to arbitration and pricing mechanisms which producers and distributors need to keep in mind during the negotiation and performance of long-term gas sale contracts.
The aim of pricing mechanisms in gas sale contracts is to strike a fair balance between the parties' interests. This equilibrium must be carefully defined in the contract if, in the event of a price dispute, an arbitral tribunal is to understand the contractual equilibrium and thereby make a fair decision in relation to the dispute.
The contractual balance
For the producer, the sale contract is often the raison d'être for the large investments which must be made over a long period in order to develop the gas resource from which the contractual volumes are to be obtained, and the commercial soundness of the sale contract will certainly need to be established to the satisfaction of any institution from which it is hoped to obtain debt financing for this development.
For the distributor, the existence of a commitment to purchase a large volume of gas will significantly alter its perception of its available overall gas supplies, and will need to be taken into account in developing an integrated distribution and marketing strategy. Transportation and storage facilities may need to be extended, and marketing policies will have to be directed over a substantial period to ensure that a sufficient consumer demand exists in order to resell the contractually purchased gas when it becomes available.
The pricing mechanism - a result of delicate negotiations
In the context of a contract which is likely to endure for decades rather than years, the pricing provisions assume a delicate role, and can be even more difficult to negotiate and to administer successfully than in the case of a transaction for a shorter term.
It would normally be unthinkable to agree on a fixed price per kilowatt-hour (or per cubic metre of gas) for the duration of the contract. The behaviour of world energy markets over the last twenty years has demonstrated that any price agreed upon prior to, say, 1990 would today be regarded as hopelessly unrealistic. It is, therefore, common for the parties to agree upon a "basket" of other fuels or energy forms which they may regard as major natural competitors of gas. The contractual price for gas will initially be set at a base price agreed upon at the date of signature and will subsequently vary in proportion to the movement in the prices of the competing fuels making up the agreed "basket".
The experience of our clients shows that negotiating such an indexation formula is not easy. Indeed, the aim of the pricing mechanism is to create a balance between the very differing interests of the buyer and the seller in the long term, so that the risks are shared equitably.
In determining what the major competitors of gas are, the seller and buyer may start from very different viewpoints. The buyer will principally be concerned with competition in its own end-user market - the alternative energy forms available to household, commercial and industrial consumers of various profiles. The seller may take a more global view. In our experience there is an emerging, although by no means universal, trend towards reflecting the buyer's competitive situation, to the exclusion of that of the seller, in the negotiation of indexation formulae.
Opening a Pandora's box
Even if the parties agree that the contractual price formula should reflect the value of gas in the buyer's end-user market, there will still be other pending questions. How, for example, is one to distinguish the market consisting of all the existing users of gas - who have already invested in the necessary plant and may arguably be regarded as "captive customers" - from the larger market consisting of existing users of other fuels, who may be induced to switch to gas when renewing their plant, and new energy users who may not be loyal to any particular fuel? A gas distributor will naturally be able to obtain a different resale price, and be concerned with different competitive pressures, if it is primarily interested in the first group of customers rather than the second. If potential new customers are also to be considered, should the distributor be satisfied with obtaining enough new customers to replace the disappearance of existing ones, or may it reasonably expect a degree of market growth? Again, in a period of liberalisation of energy markets across Europe, to what extent should competition from competing alternative gas supplies be taken into account when assessing the value of gas in the buyer's end-user market?
If the parties are able to resolve their differing points of view in relation to all these questions, as well as any differences in perception of the nature of the buyer's end-user market, they may agree on a "basket" of competing fuels which, in their respectively agreed proportions, are taken to represent the state of competition in the buyer's end-user market at the date of signature of the contract. The contractual indexation provision, however, is unlikely by itself to be satisfactory to both parties in the long term. This is due both to the certainty that there will be changes in the nature of the competition posed by alternative fuels, and the possibility of changes in other factors (the buyer's transport, distribution and storage costs, government taxation, etc).
Long-term corrective clauses
In light of these difficulties, the parties may commonly agree on a long-term corrective clause in addition to the day-to-day indexation clause. The corrective clause may be drafted so as to compensate for changes of a given nature; such a clause might begin:
"[I]f the value of gas in the buyer's end-user market should change compared to what is reflected in the indexation clause…"
or so as to preserve a given state of affairs, for example:
"[T]he price payable hereunder shall at all times enable the buyer to resell the gas competitively in its end-user market."
In our experience, in some cases, these approaches are used in combination with each other.
Typically, the corrective clause will not have a continuous effect but will operate at specified intervals (for example, at every third anniversary from the signing of the contract). The clause may provide for the parties to negotiate in an attempt to agree upon whether the specified changes have occurred or the specified state of affairs has ceased to exist, and in what way the indexation clause should be amended in consequence. The right to claim an adjustment is open to either party if it can demonstrate that the price is no longer appropriate in the light of current market conditions. The aim of the resultant negotiations is to achieve a new pricing provision which will be satisfactory to both parties for the next contractual interval. If the parties fail to agree a new price, the dispute may, under most corrective clauses, be referred to an arbitral tribunal, which will then decide, in light of the existing pricing mechanism and the alleged economic changes, which position is correct.
Such corrective clauses possess a number of advantages and disadvantages. On one hand, they permit the adjustment of the pricing provisions over time and protect both sides against the risk of large financial losses over the long term. On the other hand, their initial negotiation can prove extremely complex; competent advice at an early stage can be of great assistance in this respect.
Negotiation and arbitration
In view of the magnitude of the amounts at stake and the possible impact on the parties' continuing relationship, a decision to initiate arbitration proceedings is not taken lightly. Although arbitration may start to be considered after a few unsuccessful negotiating sessions, the parties frequently continue to meet on numerous occasions and, in conjunction with their legal and economic advisers, analyse each other's respective arguments and negotiating positions in ever-increasing detail. Such continuing analysis and negotiation often result in a decision to settle the claim for correction, either prior to the initiation of arbitration proceedings, or when such proceedings have been commenced but are still in some distance from their conclusion.
In choosing a legal advisor, a party to a gas sale contract should look for a practitioner who has significant experience in both the negotiation of such contracts and relevant arbitration proceedings. This two-sided experience will be of great benefit both in connection with the negotiation and drafting of the contract and in connection with any arbitration proceedings which may arise from it.
