Contractual compensation scheme in long-term gas supply agreement excludes common law remedies

Underdeliveries of gas under a long-term gas supply contract can have significant adverse consequences for the buyer, whether that is a wholesaler, a large industrial end-user, or a power producer.  Those buyers who re-sell gas risk not only forgoing their profits but may also be subject to penalties (or damages claims) from their customers.  Faced with a shortfall in delivery by its gas supplier, the buyer will typically source the gas on the traded markets (hubs) on relatively short notice, quite possibly at a higher price, and often without the daily flexibility built into many long-term supply contracts. 

It is therefore not surprising that it is common practice for long-term gas sales agreements to contain contractual mechanisms for dealing with the consequences of underdeliveries of gas by the seller.  One of the usual mechanisms used in pipeline contracts characterises the shortfall amount of gas as "Default Gas" (or "Shortfall Gas", "Shortfall Quantity", "Deficient Quantity", etc). The buyer is then entitled to take the Default Gas at a discount to the contractual price.  The range of discounts varies widely, and more modern contracts modulate the discount depending on the amount or duration of the shortfall and the period of the year in which the entitlement to Default Gas arises.  In clauses with seasonal variations, the discounts will be higher in winter months to reflect the higher cost of obtaining gas at traded markets in those months. 

There are many causes of underdeliveries.  They can include a deliberate decision by the seller not to supply the gas, a failure by the seller to maintain, or make available, the necessary production and/or transport infrastructure, a non-negligent accident or a natural cause. Some contractual shortfall mechanisms specify the specific cause(s) of underdelivery that will trigger the provision, but many are silent on this point.  In other words, the remedy (discount on Default Gas) is the same regardless of the cause of underdelivery (save for force majeure, which is rarely invoked). 

The contractual alternative to a discount mechanism is to require the seller to compensate the buyer for either: (i) the costs of procuring gas from an alternative source; or (ii) the lost profits and any liability incurred by the buyer for not re-selling the gas to its customers.  As one can appreciate, these alternative mechanisms are more difficult to operate in practice and can lead to disputes (over what may be relatively small amounts of money in the context of the contract).  This is all the more so if the agreement is silent on the consequences of underdelivery, in which case common-law remedies apply. 

Following a period of underdeliveries, Scottish Power claims Default Gas and damages

The agreements in question were a series of long-term gas sale and purchase contracts entered into by Scottish Power UK Plc (Scottish Power) and the respondent natural gas-selling companies. The underdelivery mechanism was a typical Default Gas provision.  The price for Default Gas was 70% of the contract price.  The agreements also specified (at Article 16.6) that the buyer's entitlement to Default Gas "in respect of underdeliveries" replaced the buyer's common-law remedies "howsoever arising … in respect of underdeliveries by the Seller". 

In addition to gas delivery obligations, the agreements included an obligation on the sellers to provide, maintain and operate the production and transport infrastructure necessary to deliver the contracted gas to Scottish Power (Article 7.1). This kind of clause is common in North Sea agreements, but a parallel obligation often does not feature in contracts for gas from other production fields, eg in Russia or Norway. 

But Default Gas regime is comprehensive

The sellers admitted breach of Article 7.1, but asserted that the Default Gas mechanism provided a complete code of compensation for all losses related to underdeliveries. 

Christopher Clarke LJ, giving the leading judgment in the Court of Appeal, held that the compensation mechanism in the Agreements was intended to be comprehensive. While the wording "in respect of underdeliveries" was in principle capable of a narrower interpretation, that interpretation would require "a degree of legal finesse which commercial men are unlikely to have contemplated" (para. 22).  This broad interpretation was also supported by the wide wording of Article 16.6, which covered all remedies "howsoever arising". 

Common law rights can be replaced

Scottish Power's case also relied on the rule that when interpreting a contract it should be presumed that parties to the agreement did not intend to deprive themselves of common-law rights absent clear language excluding or limiting such rights (the "Gilbert-Ash¹ presumption").  Christopher Clarke LJ clarified that the strength of the presumption will depend on the degree of derogation from common-law rights.  Here, the compensation mechanism was not a pure exclusion clause.  Common-law rights were replaced by a different contractual remedy, which in some circumstances could have been more valuable than damages.  In the circumstances, given the language of the agreements and also the parties' experience and sophistication, the presumption was overturned. 

Comment

From a contract law perspective, this decision follows existing authority and should be uncontroversial.  The judgment is nevertheless important for the energy sector, as it provides a welcome clarification and endorsement of what has long been the contractual practice of market participants. 

It is notable that the decision gives comfort to the wider energy sector.  Most energy-related contracts are agreed at arm's length by parties that are sophisticated, commercially minded, and have an understanding of the market and industry.  They are intended to set out a comprehensive framework for the parties' relationship, reflecting the allocation of risks between them.  It is therefore not unusual for these contracts to replace common-law remedies with comprehensive contractual compensation codes.  Even in the narrower gas sales context, underdeliveries provisions are just one example of such mechanisms.  Other commonly seen mechanisms address the consequences of overdeliveries, the provision of gas of deficient quality, or the buyer's failure to take the minimum daily, quarterly or yearly amounts of gas. 

The Court of Appeal's decision delivers a clear signal that such contractual mechanisms, provided they are agreed by parties with similar bargaining strength and are not unreasonable exclusion clauses, will be upheld by the English courts.  English law continues to be a safe choice for parties in the energy sector.

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Further information

This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication. For more information please contact Amy Edwards at amy.edwards@allenovery.com.​