In recent years, the European gas market has experienced a `perfect storm': an increasingly liberalised market has seen an increase in gas supply (resulting from, amongst other things, the "shale gas revolution" in the US) and, in some sectors at least, declining demand (largely as a consequence of the prevailing economic climate, the increasing availability of renewable/ alternative sources of energy and the increasing competitiveness of coal).
The consequent pressure on prices in the market, and the ongoing oil, gas and natural resources global pricing crisis has placed strain on long-term gas supply contracts to continental Europe under which the price of gas is typically (or at least often has been) set by reference to an oil-linked formula.
In order to weather the storm, purchasers of gas have sought to take advantage of contractual price review mechanisms about which there have been a number of disputes. There has been an increase in the number of arbitrations on these issues and a number of multi-million euro arbitral awards have been made. Even a minor change in the contract price can have a significant financial impact on buyers and sellers due to the large gas volumes involved. That trend has been focused on the European market but is expected to be a global trend in coming years.
In this article we draw on our experience of the issues that commonly arise in gas pricing arbitrations and reflect on both how parties can protect their position once a price review is triggered and on how they can increase their prospects of success in the battle which can ensue.
Price review clauses in long term gas supply contracts generally allow an adjustment of the contract price if circumstances beyond the parties' control (commonly known as "trigger events") change significantly compared to the underlying assumption in the prevailing price provisions. The consequence of such change is that the price formula no longer reflects the value of gas in the relevant market. In this respect, gas price review disputes are different to other commercial disputes in the sense that there are no allegations of breach or failure to fulfil a contractual obligation.
Price review requests tend to be challenged on two main grounds: (i) that they are formally invalid; and/or (ii) that they are substantively invalid (i.e. cannot be justified). The requesting party can strengthen its position by considering the following before pulling the "trigger":
- A request should adhere strictly to the form specified by the contract, particularly as regards timing and content. In that regard parties should:
- Ensure that the request is brought within specified time limits. The contract may permit requests only after a certain amount of time has passed since the last request was made or concluded, or after certain limitation periods have passed. It may also be important to consider whether there are any unresolved requests which may prevent or immensely complicate a new request being made.
- Consider the content of a request. The contract may require the extent of the price adjustment sought to be specified at the outset and reasons to be given to justify the request. If the contract is unclear as to, for example, the extent of the reasoning required, reference can legitimately be made to the parties' prior practice, although requesting parties are advised, where they are able to do so, to err on the side of caution.
- Leave some room to manoeuvre. Although specific contractual requirements must be adhered to, parties should give themselves room to manoeuvre by making clear that the reasons underpinning the request are not comprehensive (and by reserving the right to offer further justification) and that the extent of the price adjustment requested is subject to further "refinement".
- A request should also comply with any substantive requirements set out in the contract. This will require:
- Thorough analysis of the substantive reasons given in advance of making the request. Checks must be made to ensure that the reasons given warrant a price review (both as a matter of fact, in the sense that they show that relevant market conditions have changed, and by reference to what the contract requires in order for a price review to be justified).
- Avoiding informal discussions as to the substance of a prospective request. Unless there is material commercial advantage in doing so, informal discussions and materials exchanged during those discussions can prove to be both embarrassing and difficult to explain before a Tribunal if it can be shown that they contradict a position subsequently adopted. However, many contracts do request a negotiation period to be observed before the parties can resort to the dispute resolution mechanism generally arbitration set forth in the contract. Accordingly, if such discussions do take place, parties should ensure that they are expressly "without prejudice" i.e. that they cannot be referred to or relied upon by the parties in any subsequent litigation or arbitration proceedings and/or that a careful record of what was discussed is kept in an effort to avoid inconsistent positions being taken at a later stage.
- Endeavouring to maintain consistency. Requesting parties have fallen foul of their own inconsistent actions where their price formulas with third parties were amended in a manner inconsistent with the change under review between the parties. Strategic planning and clear internal communications are crucial, as is ensuring that the same team of people are working on all related matters (or at least that all people working on price reviews are aware of the other reviews underway which may potentially be relevant).
PULLING THE TRIGGER
In order to trigger a price review the requesting party usually has to identify one or more "significant changes". What constitutes a "significant change" (and whether the changes relied upon are significant) is often a key question in a dispute. Significant changes are commonly required:
- to be of non-transient effect. The requesting party may have to establish that the impact of the alleged change was permanent or, at the very least, long lasting (i.e. a forwardlooking analysis). Widely cited examples of permanent change in European gas markets is the decoupling of oil indexed gas prices (which has traditionally been the reference point in long term gas supply contracts) with spot gas prices and the liberalisation of gas markets in the EU.
- to have occurred during the relevant Reference Period (i.e. a backward-looking analysis). The relevant reference period will often be the period between the effective date of the last price review request and the date of the new request (the "Reference Period"). It is important to distinguish between cause and effect whilst a legislative change to liberalise a national gas market may have occurred prior to the Reference Period, it may nevertheless be a significant change if its effect is felt within the Reference Period. Conversely, a change within the Reference Period may not be considered significant if its impact is not felt until after the Reference Period.
- to have had an effect on a specific market or sector. The contract is likely to specify a market on which the significant change must have had effect. As will be apparent, changes in the European gas market as a whole may differ significantly from the changes that are occurring in a national gas market. For example, increasing liquidity in European gas markets as a whole may not be material in a national context where the market remains relatively illiquid.
- to have an impact on the value of gas in the relevant market. A change that has no meaningful impact on the value of gas in the relevant market unless such impact is reflected in the current price formula will not be deemed to be significant for the purpose of a gas price review exercise.
A range of data may be relied upon by the requesting party in asserting that a "significant change" has occurred. Receiving parties may dispute the use of certain data in an attempt to thwart the request. In particular, parties often disagree as regards:
- whether data must be taken from within the relevant Reference Period or whether data which becomes available after the Reference Period can also be relied upon;
- whether gas prices negotiated but in respect of which deliveries have not yet commenced (for example, contract prices which are negotiated with downstream buyers that are in the six month commercial campaign which takes place prior to deliveries being made) can be used; and
- whether trends in supply and demand should be based only on actual data or whether such data should be adjusted to take account of seasonal fluctuations, an issue likely to depend upon the picture being portrayed, including the sectors relied upon, the data available and the extent to which seasonally adjusted data can be applied to all sectors which are under consideration.
WHAT MAKES FOR A SUCCESSFUL GAS PRICING DISPUTE STRATEGY?
Gas pricing disputes are an increasingly prevalent feature of the European gas market, and can have a direct and significant impact on the economic fortunes of a gas company. In these circumstances, the importance of succeeding in such disputes is beyond doubt.
CONTINUING THE FIGHT
The way in which parties conduct themselves once a request has been made can also have a significant impact on the outcome of any dispute.
PURSUING THE BATTLE PLAN
Once made, requests should be pursued. Failing to take steps in the process may allow the receiving party to argue that the request has been abandoned. It may also allow that party to bring a request of its own seeking an adjustment in the opposite direction.
Records of agreements or meetings to discuss the request will form an important part of the evidence before a tribunal, particularly where the parties decide to extend the process or keep it on hold. That is a material consideration for both receiving and requesting parties.
ROUNDING UP THE TROOPS
Early involvement of lawyers can often assist parties making or receiving price review requests. A full alignment between the legal and the commercial teams is a must.
Experienced gas sector disputes lawyers will be able to give valuable insight when drafting price review clauses, drafting requests or responses to requests, and with the conduct of any dispute which follows, particularly from a strategic perspective.
Early reference to appropriate experts is also likely to assist, particularly with the formulation of reasons and justifications underpinning price review requests. Not surprisingly, in these disputes the legal submissions largely track the expert evidence. However, care must be taken when selecting an expert:
- The expert must be appropriately qualified having experience of the relevant market in which the parties operate. A generalist without specific experience may be vulnerable under cross examination at any arbitration hearing.
- More than one expert may be required. Whilst a gas market focused economist may be able to assist with analysis of the appropriate price adjustment and the justification for it, an expert with direct (and ideally extensive) industry experience of price review in the gas sector can be invaluable in establishing an entitlement to a price review and in assisting the Tribunal to understand how these clauses operate.
- The expert must be independent and impartial from the party appointing him. A "hired gun" who gives the analysis required by his client without proper consideration of its validity or of the merit of the alternative position will be exposed under cross examination at any hearing.
- Extensive due diligence on the proposed experts should be carried out at the outset beware the expert who has previously and publicly advocated an opinion contrary to that which he is now prepared to stand behind on your behalf.
- Experts should be subject to strict confidentiality provisions to ensure that the terms of the contract, the negotiation process and any arbitration proceedings and/or awards remain confidential.
Parties should keep records not just of the decision to make a request and/or pursue or abandon it, but also of all meetings, telephone conversations and face-to-face discussions about the request. Employees should be advised to preserve potential evidence in the event that the request falls to be decided by a tribunal documentary evidence will always be more persuasive than oral testimony which is unsupported by documentary evidence.
A WAR OF WORDS
The request, and any position taken in relation to it, should be stated clearly in writing. Parties should dispute positions they do not agree with in writing and should not allow points to go unchallenged doing so could result in subsequent suggestions that they had tacitly agreed with the other party or waived their rights to dispute at a later date. However, given the weight that could be afforded to documentary evidence in the event that arbitration proceedings are commenced, parties should be careful what they commit to writing and bear in mind that it could be used as evidence against it in the future.
WINNING THE BATTLE
Given the increasing prevalence of gas pricing arbitrations and their significant value it is imperative that parties do all that they can to protect their position before a dispute ends up subject to a Tribunal's determination. Pre-request preparation is, as will be apparent from the above, of fundamental importance. A well prepared and fully substantiated request that has been tried and tested in advance of submission
will be less susceptible to challenge. Post request conduct can also materially impact the outcome of any arbitration and so parties are advised to think carefully, strategise effectively and involve their lawyers wherever possible. A well planned and supported request will ultimately have better prospects of success should the parties find themselves in the heat of a gas pricing dispute.
Gas pricing disputes (and indeed energy sector pricing disputes generally) are of particular importance in a difficult market. The right to bring, and the ability to advance effectively, a request for a price review (or indeed to resist such a request) may have `make or break' significance for an energy company under financial pressure. Similarly a right to litigate or arbitrate may be the most valuable asset which our clients have. For those reasons an understanding of this type of energy dispute (and the firm's capability to handle it) is of value to all of the firm's energy clients.
Our ability and long track record of successfully handling these disputes is complementary to the broader energy sector practice, be it from the perspective of drafting a price review clause as part of a transaction, or advising on the value of commercial disputes in the context of a restructuring. Disputes expertise can be used as an integral part of an effective crossdiscipline, cross jurisdiction, energy sector offering.