Over the last few years energy prices have been subject to significant volatility. This left the parties to long-term energy contracts that use price formulae incorporating oil price indices either smiling or grimacing. The solution such contracts often adopt to lessen the smile and lighten the frown is a price review clause. We are getting many enquiries from parties who want to trigger price reviews. However, we often find that their price review clauses do not prove as easy to operate as they imagined they would when they agreed the clause, usually in rather less volatile times for energy prices. This has left us thinking: is there a better (or fairer) way to adjust the commercial risk in long-term energy contracts? This article examines some pitfalls in price review clauses and explores possibilities for addressing these.
A typical price review clause
When parties agree a price, and a price formula enabling that price to change over time, they do so given their current market understanding and expectations about how that market may develop going forward. Usually the starting (or base) price will reflect the current market value of the product. The parties will hope the agreed price formula will track the value of the product going forward. Nonetheless, the relationship between the price produced by the price formula and the market value of the product inevitably fluctuates. Prudent parties will factor this into the commercial value-sharing the price formula represents. However, no matter how prudent the parties, the relationship between price and value and the agreed value-sharing encapsulated in the price formula may break down. The idea behind price review clauses is to deal with circumstances where this breakdown occurs.
A typical price review clause may say something like:
“If a circumstance beyond the control of either party results in a significant change in the energy market of the buyer compared to such energy market on [date], then either party may give notice for a price review.
If the parties fail to agree a revised price formula within 90 days after giving notice for a price review, the price formula shall be reviewed by arbitration. In any such arbitration the arbitrators shall review the price formula and shall decide whether it needs to be revised to reflect, as at the review date, the relevant significant change(s) in the energy market of the buyer which affect the value of [the product] in the end user market of the buyer as such value can directly or indirectly be obtained by a prudent and efficient buyer.
Any revised price formula determined by the arbitrators shall enable the buyer to market [the product] economically delivered under this Agreement in the energy market of the buyer in competition with other competing sources of energy in the end user market of the buyer, assuming always the buyer acts as a prudent and efficient energy company.”
This clause breaks down into three parts:
deciding the revised price formula; and
the “market economically” test.
Each part raises issues about how the parties expect a price review to happen when they negotiate their contract.
The “trigger”: “significant changes”
The first half of the “trigger” is straightforward. It looks for an event which a party could not prevent, i.e. it avoids self-induced price reviews. It is then the effect of this event that triggers a price review. The event has to cause “a significant change in the energy market of the buyer”. This immediately raises two questions:
- what is “the energy market of the buyer”?
- what amounts to a “significant change” in that market?
In turn, these questions spawn others. How is the energy market defined territorially? Does the energy market of the buyer include only those sectors of the market in which the buyer takes part directly or all forms of energy in a territory? Does the energy market include both the market upstream and downstream of the sector in which the buyer operates? The price review clause could tackle each of these questions by using a more precise definition of the relevant energy market.
The concept of “significant change” is vague. Are there any qualifications or limits on what can amount to a significant change? For example, does it only comprise unexpected changes? Or do only fundamental changes to the structure of the energy market qualify? Can only a change in energy prices ever amount to a significant change? And what precisely is (and is not) “significant”?
These questions not only lend themselves to opposing arguments by lawyers; they also need detailed expert evidence from economists delving into areas such as market definition and the nature and extent of such changes. Immediately, we have a recipe for complex and expensive disputes.
One solution may be to have a more sophisticated price formula. The hope is that a sophisticated formula will enable the price it produces to reflect more closely the market value of the product in all circumstances. Then no one will have to trigger a price review. The simplest price formula is a straight line, i.e. a base price plus part of the change in a comparable product’s price index. Knowing the expected price range within which the comparable product is likely to trade should enable the parties to share value properly provided that the index price stays within that range. However, outside the expected trading range the value-share may start to break down. This may suggest using a price formula with a series of straight-line formulae with inflexion points, or an S-curve formula. Such a formula “expects” the index price to remain in the central price band most of the time, but addresses situations where the index price moves outside its expected range into upper or lower price bands.
A “banding” (or “grid”) approach to price formulae could deal with all extreme and unexpected cases. However, given our experience of how difficult parties find it to negotiate and agree even a simple straight-line price formula, it may prove an impractical solution. “Banding” also fails to tackle a problem inherent in any price formula. The parties will have agreed it (and their value-sharing arrangement) based on an “expected” range of index prices.
What happens when the “expected” range changes, as almost inevitably it will over time? If this happens, the value-sharing arrangement starts to break down. Should the parties be tied to the upper (or lower) band formula, even though they may have thought it would have to deal with unexpected and temporary changes in the index price? Further, what if the movement in the index price is so extreme that even the upper (or lower) band formula fails to reflect the agreed temporary valuesharing arrangement in a world of “unexpected” prices?
These questions may suggest placing a “floor” or “cap” on the operation of the lower and upper band formulae. For example, a price review will be triggered if the index price:
- goes above X or below Y; or
- stays in the upper (or lower) band for more than X months.
Of course, these approaches move away from any form of evaluative trigger (“significant change”) towards an automatic trigger. This may suggest parties should do away with the trigger altogether. If the practical problem the parties want to deal with is a dislocation between the price produced by the price formula and the market value of the product over time, why not simply accept this? So, why not fix the price formula in time, i.e. every X years the parties will either:
- agree to continue the existing price formula for another X years;
- agree a revised price formula to apply for the next X years; or
- have a revised price formula decided by arbitration.
One problem with this approach is it fails to address sudden, unexpected changes in the market, say, one year into an X-year price deal. The suffering party would have to wait until year X for a price review. However, how does that differ from a shorter-term energy contract at a fixed price? Perhaps some form of risk management or hedging may be a better commercial solution to this problem than a vague “trigger” for a complex, timeconsuming and costly price review?
Deciding the revised price formula
The next step in the price review clauses we see is that “significant change” must affect the value of the product in the end user market of the buyer. This is a question of causation and should not raise many issues. However, there is another issue of market definition. What is the “end user market of the buyer”? The obvious answer is those people who finally consume the product. However, where the buyer is a trading company that re-sells the product to distributors that sell the product to final consumers, arguments may be raised about whether it should mean the distributors to whom the buyer sells the product. Although the words “end user” seem clear, perhaps some “for the avoidance of doubt” language could close down this argument.
Having shown a causal link between the significant change and the value of the product in the end user market, the price review clauses we see broadly use two different approaches to deciding the revised price formula:
- valuing each “change” as at the review date and altering the existing price formula to reflect the change in the end user value of the product caused by each change; or
- re-valuing the product as at the review date and producing a new price formula that reflects the market value of the product.
In drafting or in logical terms there may be little to choose between these approaches. However, from a practical perspective, the latter may be preferable simply because it is easier to place a value on a product than it is on a change. Further, if there are multiple and overlapping changes, arbitrators may find it difficult to place any precise value on any of those changes individually even though it is clear those changes combined have affected the end user value of the product. This may lead the arbitrators to adopt a holistic approach to valuation even if a strict interpretation of the price review clauses suggests valuing each change individually.
The “market economically” test
The final part of the price review clause checks that any revised price formula allows the buyer to market the product economically. This implies comparing the prices the proposed revised price formula produces to the prices of competing energy products in the end user market. Arguments often arise about what are the competing products. Further, does the buyer have to be able to market the product economically across the end user market as a whole, or within each sector of the end user market in which the product competes with other sources of energy? The clause could clarify both of these issues. However, “fixing” the competing energy sources in each sector of the end user market (i.e. stating the competing product) may risk the clause not working properly if the energy sources which compete with the product change over time.
Even more importantly, what does “market economically” mean? Does one look at the actual buyer or a hypothetical buyer? Does the buyer have to be able to sell the product in the “end user market” at a profit? Or does the buyer only have to be able to sell the product competitively against other energy products, regardless of profit? Again, some clarification may help.
The reference to “a prudent and efficient” buyer suggests the cross-check is objective, rather than focusing on the actual buyer. However, even this leaves open the issue of profitability. It might be argued that there is no presumption that the product has to be sold for a profit in the end user market. If the end user market is especially competitive, even a prudent and efficient buyer may face having to forgo a profit. Another view is that the “prudent and efficient” test assumes the buyer should receive a reasonable rate of return on its working capital employed in buying and selling the product. Some reference in the clause to one of these approaches could lend further clarity. However, again changes in the end user market could risk the clause becoming difficult to work.
Price review clauses offer the parties to long-term energy contracts protection against being tied to a price which fails to reflect the agreed sharing of the value of the product. However, parties remain reluctant to make this plain in their contracts, presumably because they hope they will be on the “smiling” side of the deal. Perhaps greater transparency in drafting price review clauses would, in the long run, lead to parties reaching better deals and avoiding complex and costly disputes.