As the novel coronavirus (COVID-19) continues to spread, we are helping our clients navigate the potential consequences to energy markets and attendant legal risks. The following are five misconceptions of which we’d like you and your team to be aware.
1. The COVID-19 pandemic is a force majeure event that will excuse nonperformance under my energy contract.
Not every contract provides for a force majeure excuse from liabilities associated with nonperformance, and the availability of common law or statutory defenses will depend on the applicable governing law. While force majeure evolved from common law doctrines such as frustration of purpose, impossibility and impracticability, it is now largely a contract-based risk allocation device. In each instance, you’ll need to review the applicable contract to determine whether it includes a force majeure provision and, if so, whether it captures the COVID-19 outbreak and/or related effects on the relevant performance obligations. Where the COVID-19 outbreak does not itself appear to fall within the scope of force majeure (either explicitly or under a catch-all provision), consider the treatment of other events related to the outbreak. The effects of the virus in the energy market are likely to range widely and may include manufacturing and supply chain disruptions, decreased demand for energy products, labor shortages, and governmental restrictions and mandates (such as quarantine) imposed to contain the outbreak. Force majeure defenses will be most effective where direct causation by the occurrence of a covered event of a party’s inability to perform can be established.
2. Force majeure provisions are uniform among energy contracts.
There is not an industry standard for the application of force majeure in energy contracts. The force majeure provisions in our clients’ energy contracts are frequently similar in form — providing a general definition of force majeure, followed by a list of events included and excluded from that definition — but we see a great deal of variation in the scope of inclusions and exclusions across contracts. For example, while we think of pipeline tariffs and statements of operating conditions as highly standardized, in a review sample we found only about half to explicitly identify “epidemic” as a force majeure event. The force majeure provisions in bespoke, long-term power purchase agreements frequently reflect heavy negotiation. Further, while there is a variety of standard master agreements commonly used for energy trading (for example, the International Swaps and Derivatives Association (ISDA) 2002 Master Agreement, Edison Electric Institute (EEI) Master Power Purchase & Sale Agreement and North American Energy Standards Board (NAESB) Base Contract for Sale and Purchase of Natural Gas), their force majeure provisions may be (and frequently are) adjusted by contracting parties. The upshot is, you’ll need to closely evaluate each contract to determine whether the COVID-19 outbreak may trigger force majeure claims thereunder.
3. Unavailability of a supplier, transportation path or purchaser is a force majeure event under my energy purchase/sale agreement.
The COVID-19 outbreak may affect an energy contract by resulting in the loss or unavailability of a party’s preferred source of supply, method of transport to or from the point of sale or preferred market in which to resell the subject energy product. In most instances, these circumstances will not be sufficient to support a force majeure defense. A number of cases with respect to natural gas purchase and sale transactions have indicated that the preferred source of supply, transportation path or market, as applicable, must be expressly stated in the contract for its loss or unavailability to constitute a force majeure event. If not expressly stated, the affected party is expected to find an alternative means of performance.1 Further, many energy contracts expressly exclude market disruptions from the definition of force majeure. The EEI Master Agreement, ISDA Power Annex, NAESB Base Contract and ISDA North American Gas Annex each explicitly states that force majeure may not be based on the loss of buyer’s markets or the loss or failure of seller’s supply, unless expressly stated otherwise in the terms of a specific transaction confirmation (e.g., a unit-contingent sale).
4. If the COVID-19 outbreak partially restricts a party’s performance, performance of some energy contracts may be prioritized over others.
If the COVID-19 outbreak limits, but does not entirely interrupt, a party’s ability to perform your obligations under a number of contracts, the party may be inclined to allocate its performance to higher-priority counterparties or contracts. However, performing under some contracts raises the risk of damaging a force majeure defense against liability for nonperformance under the others. First, as with other elements of force majeure, a review of the contract’s terms is required. Natural gas supply contracts, in particular, commonly include provisions requiring pro-rata allocation of supply in instances where capacity is curtailed at a particular delivery point. A contract or regulatory scheme may also require that certain customers be given preference. Even in the absence of such a provision or requirement, note that force majeure excuses are predicated on the idea that the force majeure event “prevented” performance of the claiming party’s obligations — they do not excuse a claiming party’s choice not to perform. Look to applicable law to determine whether any standards have been established regarding allocation of performance during the pendency of a force majeure event. In the aforementioned natural gas supply contract context, some courts have looked for a “fair and reasonable” allocation of capacity between firm gas customers.2 Section 2-615 Uniform Commercial Code also provides a “fair and reasonable” standard for allocation of product by a seller whose performance has been made impracticable by a “failure of presupposed conditions.”
5. Force majeure events excuse payment obligations.
Natural gas contracts may allow suspension of performance but not suspension of payments. For example, pipeline tariffs and Statements of Operating Conditions (SOCs) often state that force majeure excuses performance obligations except the obligation to make payments. Tariff and SOC rules frequently provide that if a pipeline declares force majeure, the shipper gets credits for demand or reservation charges paid by the shipper — but when a shipper declares force majeure, the payment obligation will not be suspended. This may lead to a “game of chicken” where each party waits in hope that their counterparty will declare force majeure before they do.
We would not typically expect payment obligations under cash-settled energy derivative transactions to be excused by force majeure events. Under the ISDA Master Agreement, for example, we would not expect parties’ ability to render payments electronically (as is generally the case) to be disrupted by the COVID-19 outbreak. Government mandates responsive to the COVID-19 outbreak may cause an unscheduled bank holiday or an exchange, price, source or settlement disruption, but standard ISDA documentation includes a panoply of fallback provisions to adjust or terminate trades in most such circumstances (for example, in the ISDA Commodity Definitions), and force majeure may be invoked under the ISDA Master Agreement only after giving effect to such fallback provisions.