Take-or-Pay Clauses in Gas Supply Agreements and their legal evaluation

Take-or-pay provisions are now fairly common in long-term off take and supply agreements in the energy sector, a notable example being gas supply agreements. In essence, take-or-pay provisions provide that a buyer must pay for specified quantities of energy (gas, for example) from a seller, even if the buyer is unwilling or unable to take such quantities. At the most basic level, take-or-pay clauses require the buyer either to purchase and take delivery of certain quantities of gas, or to pay for the gas regardless of whether it takes delivery.

The aim of these provisions is to ensure that the seller will receive a guaranteed stream of revenue under the agreement, irrespective of the quantities actually taken by the buyer. They often operate where the supplier has had to undertake substantial debt and capital commitments in order for the project to get off the ground in the first place.

Although take-or-pay clauses are widely used, the rules applicable to such clauses, under most national laws, are not fully settled. The concern frequently expressed is whether these provisions constitute a form of penalty which a court or arbitral tribunal should not enforce.

This article is intended to shed light on some of the uncertainties surrounding the legal treatment of take-or-pay clauses, by presenting an overview of the practice of take-or-pay conditions in gas supply contracts and reviewing how these clauses are interpreted and enforced.

Take-or-Pay Clauses in Practice

 a. Take-or-Pay Conditions as a Risk Allocation Mechanism in Long-term Contracts

A defining characteristic of projects in the energy sector is that they frequently require significant upfront capital investments on the part of producers for the exploration, design and construction of the facilities.

This opens the door to what some economists refer to as the “hold up problem”: certain buyers may have an incentive to take advantage of the investments made by the seller (which strengthen the buyer’s bargaining position, since these investments have little value for other uses) to thereby increase their share of the profits generated by the relationship. To help deal with this problem, buyers and sellers enter into long-term contracts, which are intended to guarantee a stream of revenue to the seller on pre-determined terms.

In simple terms, the quid pro quo involved in these arrangements involves an assumption of different risks. In order to be able to market the gas the buyer seeks accommodation and protection through price flexibility, ensuring that the price it pays still allows it to market the gas in its chosen market. This can be provided by price indexation, and – where circumstances warrant – a reopening of the price formula itself. Hence, the seller assumes a degree of price risk over the life of the contract.

Sellers, on the other hand, having committed substantial sums into the project – often backed by banks whose sole recourse is the project itself – require assurances as to ongoing income. Hence, they ask buyers to take supply risk through the imposition of “take or pay” clauses. The aim is thus to ensure that the seller will receive at least a minimum level revenue stream defined at the outset of the contract.

b. Take-or-Pay as Collateral in Project Financing

As can be readily seen, in addition to being risk allocation mechanisms, take-or-pay conditions may also operate as indirect guarantees in the context of project finance, where the only recourse open to the banks may be the project itself. In such cases, a constant revenue stream is generally a condition sine qua non of the project’s feasibility, and hence financing.

This unconditional payment obligation means that take-or-pay contracts may be characterized as a form of guarantee, reportable as such on financial reports. Similarly, buyers may have to seek the approval of their own lenders before entering into agreements subject to a take-or-pay condition.

Take-or-Pay Conditions under EU Law

Take-or-pay conditions fall within the ambit of EU regulation of the gas sector, which currently takes the form of the Third Gas Directive and the application of general EU competition law to the gas/electricity industry.

The EU adopted Directive No. 2009/73/EC (the “Third Gas Directive”) in 2009, as a replacement for Directive No. 2003/55/ EC (the “Second Gas Directive”) in 2003 itself preceded by Directive No. 98/30/EC (the “First Gas Directive”) in 1998. These three directives are intended to set out the basic rules governing the gas market within the EU, by establishing common rules for the distribution, transmission, supply and storage of natural gas.

One of the key principles of the Third Gas Directive is third party access to gas transport systems. This principle, set out under Article 32 of the Third Gas Directive, provides, in essence, that the owner of the grid must allow any supplier nondiscriminatory access to its gas transmission and distribution system.

The Second Gas Directive does not directly address take-or-pay conditions. However, take-or-pay clauses are listed as one of the possible justifications for derogation from third party access. In this context, Article 48(1) of the Third Gas Directive provides that a party to a gas undertaking may request a derogation from third party access under Article 32 of the Third Gas Directive, in case it is subject to serious economic and financial difficulties as a result of its take-or-pay obligations. All of this suggests that take-or-pay obligations are in principle valid, so far as EU legislators are concerned.

Another angle from which take-or-pay conditions may be tackled is EU competition law, notably Articles 101 and 102 TFEU. Article 101 TFEU prohibits agreements or other concerted practices which restrict or distort competition within the Common Market. Article 102 TFEU prohibits abuse by undertakings of a dominant position within the Common Market. Both Articles 101 and 102 TFEU are directly effective provisions of EU law, thus enforceable in the national legal orders.

Take-or-pay conditions, as part of long-term gas supply contracts, may fall within the ambit of the European Commission policies regarding market foreclosure and/or restriction of competition in the Common Market. The main rule applied by the commission for gas supply contracts was defined in the 2007 Distrigas decision: Long-term gas supply contracts are not per se prohibited, but their impact must be appreciated on an individual ad hoc basis, in order to determine whether they restrict competition to an unacceptable extent.

Column Εditors: «Metaxas & Associates Law Firm – Attorneys At Law» (www.metaxaslaw.gr)