It’s all about governance!
In any discussion on oil & gas matters, the focus is on the need for robust but competitive legislative and fiscal regimes, efficient regulators, experienced industry participants and contracts which allocate risk efficiently and minimise transaction costs.
I am off to Lagos, Nigeria, in November which got me thinking.
Recent and ongoing developments in Nigeria are a reminder that while these are all important, they all fall down in the absence of good governance.
Nigeria’s new President, Muhammadu Buhari, is trying to deal with government and institutional corruption and renegotiate Production Sharing Contracts (PSCs) and joint venture agreements with the oil majors, yet there are a number of other issues which must be addressed. They all have a common theme; the importance of good governance, whether the renegotiation of the PSCs, the Nigerian National Petroleum Corporation (NNPC), the oil & gas industry’s regulatory bodies, the control the scale of oil theft, or the award of discretionary PSCs.
What is the basis for the renegotiation of the PCSs with the oil majors?
PSCs commonly provide for `stabilisation` or ‘freezing’ i.e. contractual mechanisms to preserve benefit of specific economic and legal conditions which the parties considered to be appropriate at the time they entered into the PSC. The aim is to insulate the contractual relationship from any material adverse effect or change. The freezing or stabilization clauses may not be a guarantee against the bona fide State’s exercise of sovereign authority in the public interest but they can form the basis for compensation.
More modern clauses aim at protecting the economic equilibrium of the contract, rather than freezing the existing fiscal frameworks. They provide for a re-balancing (renegotiation) of the benefits of the contract in the event of a unilateral action by the host government e.g. an increase in fiscal obligations that adversely affects the foreign investor may trigger a provision that other parts of the fiscal regime must be adjusted.
There are various forms of balancing provisions. For example:
- Stipulated economic balancing which provides for automatic amendment in a specified way (e.g. by way of readjustment of the profit petroleum split. The Ecuadorian Model PSC provides:
In the case of modification to the tax regime, including the creation of new taxes, or labor participation, or its interpretation, that have consequences on the economics of the Contract, a corresponding factor will be included in the production share percentages to absorb the increase or decrease in the tax burden or in the labor participation of the previously indicated contractor. The correction factor will be calculated between the parties and approved by the Ministry of Energy and Mines.
- Non-specified economic balancing which, while providing for automatic amendment, does not provide for a specified amendment and does not require the agreement of the parties for such an amendment. The PSC between the State Oil Company of Azerbaijan and Kura Valley Development and Socar Oil (an affiliate of the State Oil Company) provided:
In the event that any Government Authority invokes and present or future law, treaty, intergovernmental agreement, decree or administrative order which contravenes the provisions of this Agreement or adversely or positively affects the rights or interests of the Contractor hereunder…the terms of this Agreement shall be adjusted to re-establish the economic equilibrium of the Parties, and if the rights or interests of the Contractor have been adversely affected, then SOCAR shall indemnify the Contractor…
- Negotiated economic balancing which requires the parties to negotiate amendments to the PSC. The current Indian Model PSC provides:
If any change in or to any Indian law, rule or regulation imposed by any central, state or local authority dealing with income tax or any other corporate tax, export/import tax, customs duty or tax imposed on petroleum or dependent upon the value of petroleum results in a material change to the economic benefits accruing to any of the Parties after the Effective Date, the Parties…shall consult promptly to make necessary revisions and adjustments to the Contract in order to maintain such expected economic benefits to each of the Parties as of the Effective Date.
See Tade Ovewunmi, Renegotiation and Stabilisation of International Oil and Gas Contracts http://www.slideshare.net/TadeOyewunmi/renegotiation-and-stabilisation-of-international-oil-and-gas-contracts.
They can be categorised in other ways. For example:
- Full Freezing Clauses which freeze both fiscal and non-fiscal law with respect to investment for the duration of the project.
- Limited Freezing Clauses which freeze a more limited set of legislative actions.
- Full Economic Equilibrium Clauses protect against the financial implications of all changes of law, by requiring compensation or adjustments to the deal to compensate the investor when any changes occur.
- Limited Economic Equilibrium Clauses which protect against financial implications of some limited set of changes in law or after specified costs are incurred. They require compensation or adjustments to the deal to compensate the investor only when the covered changes occur.
- Full Hybrid Clauses which protect against the financial implications of all changes of law, by requiring compensation or adjustments to the deal, including exemptions from new laws, to compensate the investor when any changes occur
- Limited Hybrid Clauses which protect against financial implications of some limited set of changes in law or after specified costs are incurred. They require compensation or adjustments to the deal, including exemptions from new laws, to compensate investor only when the covered changes occur.
In the case of the Nigerian PSCs subject to renogiatation, entered into in the early 1990s, one understands they have three re-balancing clauses such as (i) re-examination of the fiscal terms, if oil prices reach US$20, (ii) a re-examination and re-negotiation of the fiscal terms for more equity in favour of the government, should there be discoveries above 500 million barrels and (iii) an overall review of the PSC after 15 years. They reflected the circumstances then prevailing, but by 1997, most PSC major contractors operated fields with reserves exceeding 500million Barrels and by 2001, oil prices had surged far ahead of $20 per barrel and now, more than 15 years have expired. Hence, the current round of renegotiation undertaken by Nigeria’s new President, Muhammadu Buhari. However, what are the parties’ respective BATNAs (the parties’ respective best alternative to a negotiated outcome)? One assumes that each, the Nigerian government via NNPC and the oil major PSC contractors, have access to international arbitration in the absence of a negotiated outcome.
The re-balancing clauses have been effective in terms of allowing allowing a renegotiation and perhaps an improved position for the NNPC and the Nigerian government, but success is dependent on the good governance of the NNPC.
The NNPC is the lowest ranked National Oil Company on Transparency International’s transparency ranking, with a score of zero; and, it seems, for good reason. President Buhari has commenced a programme of reform to transform the NNPC into an effective organization and control corruption.
Reform of the NNPC, the oil & gas industry’s regulatory bodies, the control the scale of oil theft, or the award of discretionary PSCs and progress on the consideration of the Petroleum Bill to reform the legislative regime for the industry are the key matters which Nigeria’s new President, Muhammadu Buhari must address and good governance is key. The renegotiation of the legacy PSCs as contemplated by the re-balancing clauses is just one aspect; while important, it is modest in the face of these other matters and the need for good governance.
I try to blog on energy project contracts, in particular, petroleum contracts, power contracts or electricity contracts; in fact, any project contracts for oil and gas, electricity and other energy projects.
This blog was initiated by a recent Energy News article on how Greenpeace New Zealand says its solar petition is gathering support: see http://www.energynews.co.nz/news-story/29182/greenpeace-says-solar-petition-gaining-support which mentioned New Zealand lines company Unison’s new distribution pricing aimed at providing consumers with ‘clearer price signals on the real costs and benefits of new technologies like solar PV, batteries and electric vehicles so that they can be applied efficiently and their costs met fairly’. Unison is quoted as noting that the electricity distribution sector ‘… is very engaged right now in discussions about how we can evolve from legacy pricing approaches to make sure consumers can make the most of emerging technologies – for example, access to cheap night rates for charging electric vehicles’.
This is just one example of how incumbent participants, not just in the electricity distribution sector, but the electricity as a whole (and other industries) are coping with emerging technologies.
The Energy News article followed, almost immediately, two articles published on line by McKinsey & Company one on an ‘Incumbents Guide to Digital Disruption’: http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/an-incumbents-guide-to-digital-disruption , and the other reporting on a podcast on ‘How Incumbents become Digital Disruptors’: http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/how-incumbents-become-digital-disruptors?cid=digistrat-eml-alt-mip-mck-oth-1606.
I was struck how their comments were relevant to incumbents like Unison.
McKinsey talk about the four key stages.
Stage one: Signals amidst the noise
They say that at this first stage of disruption, incumbents feel barely any impact on their core businesses except in the distant periphery. In short, they don’t “need” to act. Furthermore, it can be difficult to work out which trends to ignore and which to react to.
It seem to me that Unison and others have clearly seen the signals amidst the noise.
Stage two: Change takes hold
At this stage, the trend is clear. The core technological and economic drivers have been validated. Incumbents must commit to new initiatives. They say ‘the idea is to act before one has to.’
They acknowledge how hard it is for an incumbent’s leaders to commit to experimental ventures. They note that few boards and investors can handle pain when the near-term need is debatable. Incumbents have existing revenue streams to protect and to safeguard against stranded assets—start-ups only have upside to capture. Additionally, management teams are more comfortable developing strategies for businesses they know and are reluctant to enter or adopt new initiatives.
Unison has committed to a new imitative and others to investment new ventures e.g. Vector’s relationship with Tesla Energy to bring the Powerwall battery to New Zealand to complement solar energy management systems and provide a backup power supply
Stage three: The inevitable transformation
By now, the future is pounding on the door. The new model has proved superior to the old, at least for some critical mass of adopters, and the industry is in motion toward it. At this stage of disruption, to accelerate its own transformation, the incumbent’s challenge lies in aggressively shifting resources to the new self-competing ventures it nurtured in stage two. Think of it as treating new businesses like venture-capital investments that only pay off if they scale rapidly, while the old ones are subject to a private-equity-style workout.
The top decision makers, who usually come from the biggest business divisions, resist having their still-profitable (though more sluggishly growing) division starved of resources in favor of unproven new initiatives. Hence, incumbents often under invests in new initiatives and the legacy operations continue to receive the lion’s share of resources instead. By this time, the very forces causing pressure in the core make the business even less willing and able to address those forces. The reflex to conserve resources kicks in just when the incumbent most needs to aggressively reallocate and invest.
Incumbents must embark on a courageous reallocation of resources from the old to the new.
When incumbents lack the capability to build new businesses, they must look to acquire them instead. Here the challenge is to time acquisitions somewhere between where the business model is proved but valuations have yet to become too high at the time when the incumbent is a “natural best owner” of the new businesses it acquires.
Stage four: Adapting to the new normal
In this late stage, the disruption has reached a point when the incumbent has no choice but to accept reality: the industry has fundamentally changed; their earnings are caving in, and they find themselves poorly positioned to take a strong market position.
The McKinsey identification of the cycle of stages for how incumbents must commit as disruption takes hold as the industry transforms, while hardly revolutionary, is a timely reminder as to how incumbents must react to disruptive technologies and seek to become disruptors themselves.
As the New Zealand Energy News reported on 7 September 2015, the Smart Grid Forum has issued its full year report to the New Zealand Minister of Energy.
The report can be found at http://www.mbie.govt.nz/info-services/sectors-industries/energy/electricity-market/nz-smart-grid-forum/publications/first-year-report-to-minister-june-2015.pdf/view.
The Smart Grid Forum report notes that based on ‘High Uptake of New Technology’ scenario modelling which explores the impact of sustained cost reduction of photovoltaics and battery storage technologies, the costs fall to below the cost of mainframe generation net of transport and distribution within the next 10 years and we may see around 2.5 GW of photovoltaics is installed in New Zealand by 2050. The impact on the electricity sector of this and other emerging ‘disruptive’ technologies is a hot topic and has been the subject of a lot of discussion.
But what of the Smart Grid Forum report? Did it fail to address head on two related elephants in the room?
The report is a good overview of the issues arising from the emerging smart grid technologies and the work of the Smart Grid Forum to date. It is a good and interesting read with useful links to the important background papers.
The report concluded:
‘This paper has considered both the challenges of coordination to achieve the opportunities from adoption of emerging technologies and maintaining quality, reliability and security risks in the face of these technologies. They are overlapping issues, but in both cases the Forum has found no evidence of a problem that would justify rethinking the legal framework of existing governance arrangements at this point. But there is a need to be vigilant and the practical difficulties in transition should not be underestimated.’ (page 18 of the report with emphasis added).
I assume this based on the Electricity Authority’s position: ‘the governance arrangements in New Zealand are perfectly designed to allow whole systems thinking to be applied across the whole electricity system without the need for legislative changes.
Specifically, the Electricity Authority has the remit, the tools and is legislatively obliged to ensure that the advent and growth of new technologies such as distributed generation and electric vehicles does not undermine the reliability of the electricity system.’ (page 18 of the report).
The report went on to make various recommendations, in essence, that a service be established to inform consumers of the new smart technologies and changing commercial arrangements, there be a permanent body to advise on emerging risks to the electricity system, and that Forum’s work continue (the recommendations are set out in pages 21 and 22 of the report).
However, I think the Smart Group Forum failed to adequately address two related elephants in the room warrant and push for some change in the implementation of the framework of governance.
First elephant in the room – the significant risk of adverse impact on private, consumer and taxpayer capital at risk. The report (to mind surprisingly) does not specifically refer to the risk of serious adverse impact of the disruptive technologies on asset values and shareholder value, or put another way, the risk of serious adverse impact on private and public capital at risk. Sure, the report arguably does so by implication, for example, by referring to the need to monitor regulatory incentives given the regulation of EDBs to ensure that they are not encouraged to over invest in long lived assets which may become stranded (pager 11 of the report) and that regulated pricing methodologies may be a commercial barrier to the introduction of the new technologies (page 14 of the report). Maybe it is so obvious, it goes without saying, that electricity industry participants, whether they be Transpower, EDBs, generators or retailers, face the prospect of stranded d assets and private, community and taxpayer funded shareholders face massive adverse impacts on shareholder value.
Finance Minister Bill English touched on the point at Commerce Commission’s July 2015 two day workshop when he commented on the challenges facing EDBs. He is reported as having warned that a lot of community value stood to be lost if customer and council owned networks did not act fast enough (to, I suggest, divest or seize new revenue opportunities) and challenged delegates to consider whether community ownership of lines businesses really makes sense.
The potential loss of revenue and shareholder value has been foreseen for some time (e.g. see Disruptive Challenges, 2103, Edison Electric Institute at http://www.eei.org/ourissues/finance/documents/disruptivechallenges.pdfs) and is now an international experience. NRG Energy (a major US electricity utility with generation capacity of 50,000 megawatts) CEO David Crane spoke of the paradigm shift occurring in the utility market and his company’s new investment in solar to preserve shareholder value:
“Our industry is in the early but unmistakable stage of a technology-driven disruption of historic proportion. This disruption ultimately is going to end in a radically transformed energy industry where the winners are going to be those who offer their customers, whether they be commercial, industrial or individual customers, a seamless energy solution that is safer, cleaner, more reliable, more convenient and increasingly wireless.” See http://www.theenergycollective.com/energydeborah/2215426/dg-solar-how-utilities-can-create-shareholder-value.
Given the potential impact on capital at risk across the industry, perhaps something more than reliance on the Electricity Authority’s position was warranted.
The second and related elephant in the room – the risk of regulatory capture i.e. the Electricity Authority may suffer the risk that instead of regulating or leading innovation on behalf of consumers, it regulates or innovates on behalf of the incumbents, and the risk of incumbents stalling innovation to protect revenue and asset values.
On paper the governance framework may be adequate; but is something more desirable?
The Authority members do not represent the interests of any particular group and act independently. Members are recommended for appointment on the basis of ensuring a spread of experience and capability relating to the electricity industry, consumer issues and business generally.
“No member of the Authority, when acting as a member, may represent, or promote the interests or views of, any organization or any particular industry participant or group of industry participants.” :New Zealand Electricity Industry Act 2010 s 20(1) and (2).
Pursuant to the Act, the Authority has established the Security and Reliability Council (to provide independent advice to the Authority on performance of the electricity system and the system operator and reliability of supply) and other Advisory Groups, for example, the, Retail Advisory Working Group and Wholesale Advisory Working Group, and can appoint other ad hoc advisory and technical groups. They play an important role.
They are governed by Charters and Terms of Reference to give independent advice, independent chairs must be appointed by the Authority board, and Advisory Group members are to be appointed by the board because of their ‘strategic, commercial, and regulatory knowledge and experience, their knowledge and experience across the relevant component of the electricity supply chain, and for their balanced representation of alternative views’ (e.g. clause 7 of the RAG Charter). Advisory Group members are required by the Charters to be ‘…mindful that…they have been appointed to act in their personal capacity and not as representatives of organisations and that the Act requires them to provide independent advice as a group, even though they may not be independent persons’ (e.g. clause 10 of the RAG Charter).
All good stuff.
In practice, as per the Charters, the Advisory groups have independent chairs and members selected from incumbent participants in the electricity industry. Yes; there are some exceptions to this.
But how can one be assured that the Advisory Groups will in practice be charged with providing independent advice to the Authority as to how it might regulate or innovate in the face of disruptive new smart grid technologies?
Once so charged, can one not help but note that the Advisory Groups are comprised of representatives of the incumbent participants who face the very risks posed by those disruptive technologies, namely, reduced revenue, stranded assets and an adverse impact on shareholder values?
I am not, of course, questioning the integrity of the Authority or Advisory Group members; but is there, or, is there not, on the face of it, a risk of Advisory Groups not being charged with the responsibility of providing advice in a timely manner and, if so charged, incumbents’ representatives stalling innovation to protect revenue and asset values?
On the face of it, there is.
I think the Smart Grid Forum missed the opportunity to address head on the related elephants in the room i.e. the foreseeable revenue and asset value implications for the established industry incumbents, and the risk to the role the Advisory Groups can play (in providing independent advice) by having those Groups ‘manned’ by established industry incumbents.
It was open for the Forum to address these related elephants and push the Authority to demonstrably engage the Advisory Groups with a greater representation from the disruptive technologies.
The Smart Grid Forum did say ‘… Technologies and equipment supplied from outside the electricity industry which have the potential to interact with electricity systems are likely to be an increasing feature of the electricity industry. This will require increased communication and cooperation with other industries’ (page 13 of the report).
But to my mind, this is simply obvious and, indeed, an understatement. Solar, battery storage, electric vehicle, telecommunication and digital technologies are already part of the electricity industry, they already interact with the electricity system and they will definitely be (on the Smart Grid Forum’s own analysis) an increasing part of the electricity industry.
The Smart Grid Forum is doing good work and it is, of course, easy to snipe from the side-lines. I look forward to the outputs from its continuing work.
My next blog items will look at some of the legal issues that might arise; in the first instance, are changes to the governance framework desirable?
My previous blog concluded with the note that a contractual obligation to ‘negotiate in good faith’ was worthy of discussion,
A contractual provision which requires the parties to ‘…negotiate in good faith…’ is common. For example, a Joint operating agreement often provides:
“Balancing agreement: The parties recognise that, in the event of individual disposition of natural gas, imbalances may arise with the result being that a party will temporarily have disposed of more than its participating interest share of the production of natural gas. Accordingly, if natural gas is to be produced from an exploitation area, the parties shall, in good faith, and no later than the date on which the development plan for natural gas production is approved by the operating committee, negotiate and conclude the terms of a balancing agreement to cover the disposition of natural gas produced under the permit, regardless of whether all of the parties have entered into a sales agreement.”
A clause or requirement for parties to negotiate is used because contracts do not cover all contingencies and therefore require a mechanism for preserving the contract in the event of unexpected contingencies and negotiation is a cost effective method for forming and preserving a contract. In other words, the obligation is commonly used in incomplete contracts (in the economic sense) where it is inefficient for the parties to agree on how all risks that may materialise should be allocated; instead, they use obligations of this kind to promote an agreed outcome if and when the risk does materialise.
We need to distinguish this from the question whether in exercising or performing their obligations, the parties to the contract must do so in ‘good faith’. New Zealand courts are unlikely to incorporate an obligation of good faith into all contracts generally. This conclusion was particularly applicable to those commercial contracts where the parties have extensively spelt out their obligations and where a good faith requirement would not fit comfortably with those detailed express terms e.g. Archibald Barr Motor Company Ltd v ATECO Automotive New Zealand Ltd (High Court, Auckland, CIV 2007-404-5797, 26 October 2007), at .
However, the obligation is implied by law into some contracts and the negotiation of those contracts, for example, contracts governing:
- Fiduciary relationships.
It has been established that aspects of the obligation are:
- Fair Dealing
How does one perform the obligation where it is expressly imposed by the contract?
A clause or requirement for parties to negotiate “in good faith” would at the very least require performance of the obligations associated with a duty to consult. A good definition of what consultation involves is given by the New Zealand Court of Appeal in the leading New Zealand case on the issue, Wellington International Airport v Air New Zealand  1 NZLR 671.The Court set out the requirements of consultation as: the statement of a proposal not yet fully decided upon, listening to what other have to say, considering their responses and then deciding what will be done. Essentially, then, a person with a consultation right must be given the opportunity to be heard, listened to and taken seriously.
The proposed merger eventually failed to close and negotiations over the definitive licence agreement stalled as SIGA proposed economic terms significantly more favourable to it than those set forth in the licence agreement term sheet. For example, SIGA proposed to increase the upfront payment to be received by SIGA from $6 million to $100 million, and the milestone payments to be paid by PharmAthene increased from $10 million to $235 million. The Delaware Supreme Court affirmed the Chancery Court’s conclusion that SIGA Technologies breached its contractual obligation to negotiate the licence agreement in good faith. Since the court found that the parties would have reached an agreement but for SIGA Technologies’ bad-faith negotiations, the plaintiff was entitled to recover contract expectation damages. This case serves to remind that an agreement to negotiate in good faith should not be entered into lightly, and that it may be risky to unilaterally depart from the key agreed principles during a negotiation if the agreement includes a binding good faith negotiation obligation.
The obligation to negotiate in good faith can be upheld by the Courts where it is possible to for the Court to define what the parties were to achieve. Put another way, in New Zealand, where the objective and the steps needing to be taken to attain it are able to be prescribed by the Court, a best endeavours or reasonable endeavours or ‘good faith’ obligation will be enforceable: Fletcher Challenge Energy Ltd v ECNZ Ltd  2 NZLR 43. An example can be found in SIGA Technologies, Inc v PharmAthene, Inc [CA 2617 (Del May 24 2013] the Delaware Supreme Court found that a contractual obligation to negotiate in good faith is enforceable. In late 2005 SIGA Technologies, Inc and PharmAthene, Inc began discussing a possible merger, but SIGA Technologies insisted that the parties negotiate a licence agreement first, given its immediate need for cash. After extensive negotiations over a “non-binding” licence agreement term sheet, PharmAthene gave SIGA a bridge loan and the parties ultimately executed a merger agreement in June 2006. The bridge loan and merger agreement both provided that in the event of failure of the merger, the parties would “negotiate in good faith with the intention of executing” a licence agreement reflecting the contents of the negotiated, non-binding term sheet.
Under the Native Title Act 1993 (Cth of Australia), before a Government body can do certain acts that may affect native title, for example, grant a mining lease, is required to undertake negotiations with the affected native title holder or claimant and the grantee party. The object of these negotiations is to obtain agreement on the conditions pursuant to which the act may take place. The Native Title Act 1993 (Cth) requires the Government party to conduct these negotiations in ‘good faith’, a responsibility that is not imposed on the native title party or grantee party. Chief Justice Carr listed a number of factors to be considered in determining whether or not the Government party had negotiated in good faith, including whether there was:
- Unreasonable delay in initiating communications in the first instance;
- Failure to make proposals in the first place;
- Failure to respond to reasonable requests for relevant information within a reasonable time;
- Stalling of negotiations by unexplained delays in responding to correspondence or telephone calls;
- Sending of negotiators without authority to do more than argue or listen;
- Adopting a rigid non-negotiable position; and
- Refusal to sign a written agreement in respect of the negotiation process or otherwise.
The Judge did acknowledge that the duty to negotiate in good faith does not impose on the Government party an obligation to:
- Accept the other side’s position; or
- Insist that a negotiated agreement is reached.
Fundamentally, however, a clause or requirement for parties to negotiate “in good faith” is problematic because:
- The meaning of “good faith” is difficult to define, but it may, at the very least, impose a duty to disclose all relevant facts;
- It can erode traditional negotiating powers; and
- It could give rise to remedies which the parties did not foresee e.g. damages (or possibly punitive damages) if it is held to include a duty to disclose all material facts or information and such facts or information were deliberately withheld.
When drafting a good faith clause parties should consider: Why are they providing for “good faith” negotiations? Is there alternative wording which better serves the interests of the parties under the contract e.g. the use of “reasonable endeavours”.
Many contracts oblige the parties to undertake ‘amicable discussion’ or ‘negotiations in good faith’ and the like to resolve matters. The obligation is commonly used in incomplete contracts (in the economic sense) where it is inefficient for the parties to agree on how all risks that may materialise should be allocated; instead, they use obligations of this kind to promote an agreed outcome if and when the risk does materialise. It is also commonly used in the context of a multi-tiered dispute resolution procedure where obligations of this kind are the first step of the procedure. The obligations may or may not be enforceable, depending on the circumstances.
Whether or not such obligations are enforceable has commercial consequences e.g. an efficient means to promote an agreed allocation of risks and thereby secure both a flexible and durable contract, or, an efficient means of dispute resolution may fail.
The point has been highlighted by an English High Court case Emirates Trading Agency LCC v Prime Mineral Exports Ltd 1 WLR 1145 in which a ‘friendly discussions’ obligation in an iron ore purchase agreement was held to be enforceable. The long term iron ore purchase agreement provided:
‘In case of any dispute…the parties shall first seek to resolve the dispute…by friendly discussion … If no solution can be arrived at between the Parties for a continuous period of 4 (four) weeks then the non-defaulting party can invoke the arbitration clause and refer the dispute to arbitration.’
Prime claimed a failure to take and pay by Emirates, some meetings took place to discuss the dispute but Prime went ahead and commenced arbitration proceedings. Emirates argued that the arbitration tribunal had no jurisdiction but the tribunal disagreed. Emirates applied to the High Court for an order that the tribunal lacked jurisdiction to determine the claim brought by Prime. It argued that a condition precedent had to be satisfied before the dispute could be referred to arbitration i.e. ‘friendly discussions’ (which implied negotiating in good faith) for a continuous period of 4 weeks, and that this condition had not been met.
Prime argued that the ‘friendly discussion’ obligation was an agreement to negotiate and, therefore, unenforceable.
The High Court held that the obligation was an enforceable condition precedent to arbitration as it was complete, certain and the obligation to negotiate had an identifiable standard, namely, a fair, honest and genuine discussion aimed at resolving a dispute. As a matter of policy the enforcement of such a clause was in the public interest as commercial managers expect the court to enforce obligations which have been freely undertaken and which have an objective of avoiding expensive and time consuming arbitrations.
Commercial managers should note the ‘boiler plate’ of dispute resolution clauses and obligations to negotiate in good faith. A typical joint operating agreement for oil & gas or mineral exploration or production and many sale and purchase agreements will have a dispute resolution provisions requiring a notice of dispute, amicable discussions or good faith negotiations by the parties’ respective contract representatives, failing agreement, amicable discussions or good faith negotiations by the parties respective CEOs, failing agreement, mediation and, ultimately, court proceedings or arbitration. In practice this multi-tiered procedure is ignored in order to cut to the chase and get legal proceedings underway, but be aware, this may be stopped by the other party as the contract will often mean what is says.
You have to consider the commercial merits of what the contract says; do you want the multi-tiered procedure? If so, ensure there are time limits and an ability to commence proceedings in certain cases notwithstanding the procedure e.g. to meet a statutory limitation period. If not, make sure you have the right to commence legal proceedings as when you may wish.
In the case of obligations to negotiate ‘in good faith’; do you want negotiation restrained by good faith obligations or not? The detail of this deserves its own blog item!
This item follows on from my Nigerian experience.
I have since read a report entitled Powering Africa by McKinsey & Company http://www.mckinseay.com/insights/energy_resouces_materials/powering_africa?cid= which summarises their report Brighter Africa: The growth potential of the sub-Sarahan electricity sector, which highlights the challenges facing the sub-Saharan African power sector.
Fulfilment of the economic and social promise of the region depends on the ability of governments and investors to develop the available power capacity.
Sub-Saharan Africa has 1% of the world’s population but 48% share of the world population without access to electricity. Over 600 million people in this region lack access to electricity.
The numbers referred to the report are immense.
McKinsey project that sub-Saharan Africa will consume nearly 1,000 terawatt hours by 2014 (as much as India and Latin America combined as at 2010) but even then will only achieve an electrification rate of 70% to 80%.
How will this be supplied?
In sub-Saharan Africa there is currently 1.2 terawatts of capacity but potential sources of supply to meet projected consumption in 2014 are solar (8% rising to 30% between 2030 and 2040)), gas (40%) and the balance from coal, hydro, geothermal and wind. This would require about US$490 billion of capital for new generation capacity plus US$234 billion for transmission and distribution capacity.
The investment opportunities will be immense but ‘game changers’ are required to achieve efficient investment and incentivise the necessary investment.
The ‘game changers’ that are required are:
- regional integration for gas, solar, wind and transmission and as power pools
- aggressive promotion of renewables
- national governments having to focus on the financial capability of the sector e.g. ensuring electricity tariffs reflect the cost of electricity, costs are transparent and least cost investments are undertaken
- national governments creating an environment that will attract a range of funding mechanisms, especially private sector funding, which, in turn, will require consistent legal regimes, consistent private (contract) law to permit efficient risk allocation, and (in turn), the participation of credible offtakers and international financial institutions
- the political will to achieve the foregoing with good governance and eye on the long term.
Nigeria has stated down this route having reformed its power sector and embarking on the privatisation programme (as I have previously described). Given the election of the former General Muhammadu Buhari as President of Nigeria being a peaceful transfer of power in an African country with biggest population, it will be interesting to see if Nigeria, at least, can show the necessary political will and good governance to provide leadership and show how one can power Africa.
I have recently returned from a week in Lagos, Nigeria.
It was an experience I will not forget in a hurry; in fact, there is no chance of that. I am scheduled to go back and my thirst for Nigerian adventures has not been quenched.
The purpose of this item is share some thoughts rising from the Nigerian electricity industry where there is massive load shedding and black outs, minimum of 20 per day.
This brought home to me again that countries must have regulatory regimes and institutional structures where there is an incentive for investors to invest; if not, the economy goes backwards. However, in some countries this is not easily done.
The electricity industry in Nigeria has been run by state owned monopolies but Nigeria is now going through what is now a traditional reform route – splitting the monopoly functions (transmission and distribution) from the competitive functions (generation and retail), creating new entities in the competitive markets and privatising them (if not everything) in order to promote efficiency. They truly need to do this because the monopolies have simply failed to invest and have, in effect, protected consumers from the true cost of supply of electricity. Like all infrastructure in Nigeria, the electricity infrastructure has been run down through lack of maintenance, upgrades and new production capacity.
In recent years the Nigerian Federal Government has made efforts to reform the industry by removing the monopoly held by the vertically integrated monopoly and unbundling it into separate generating companies, distribution companies and a transmission company and establishing a framework for the privatization. They are halfway down the track with the finishing line being a competitive wholesale market with system operation and market operation being the responsibility of the transmission company (Transmission Company of Nigeria) and retail competition.
While I was there, one of the two local networks serving the major commercial city area, Lagos, was calling for bids for embedded generation capacity. In Nigeria, local networks are both distributors and retailers; they also have ‘standalone’ retailers. The generators cannot be retailers. This local network, which has just been recently privatized, has a capacity of 700MW and a potential consumer demand of 700MW plus but could only access 200MW production off the transmission grid. Even then the production capacity was plagued by gas feedstock supply interruptions due to terrorism and vandalism on the gas pipeline supply system. Not only is there massive load shedding but numerous regular black outs. The result, of course, is consumer back up generation by those who can afford it, and ‘energy poverty’ by those who cannot (61% of Nigerians live on US$1.00 per day). Those who talk about energy poverty in New Zealand (and here I do not mean to demean their point) should go to Nigeria and elsewhere to see what it is really like. The local network was calling for bids for its first stage of embedded generation and by the time I left, it had received 41 private sector bids (of course the quality of them is unknown to the likes of me).
One focus of my visit was the role of Power Purchase Agreements (PPAs) in the context of the reform process. Pending the commencement of the wholesale marked, PPAs will remain supreme.eg. the Lagos local network owner/retailer will take all the production from embedded generation via PPAs. Once the wholesale market is in place, they will see the development of merchant power producers and, hopefully, a sufficiently deep and liquid hedges market.
Some observations from a New Zealand perspective.
On top of all the reforms is price regulation of both the monopoly functions (transmission and distribution) and the competitive functions (generation and retail). Presumably, this is to control the price shock to those consumers in Nigeria who can afford to pay for electricity and the time over which will they see the true price of electricity. A demanding environment for the private sector investor attracted by the privatization programme and for the Federal Government which has now recognised that there must be an incentive to invest.
Nigeria has faith in controlling market power through regulation not state-ownership. The plan is to privatise everything that moves, both the monopoly functions (transmission and distribution lines) and the competitive functions (generation and retail). Why can’t we in New Zealand? Once our price-quality regime for lines companies is bedded in; is there any reason for state-ownership of Transpower; especially if the system operator function is embedded in a stand-alone SOE?
The PPP model is standard for investment in new infrastructure. The Nigerian transmission grid has a capacity of less than 6000 MW and about US$3.7 billion is required by the government to increase transmission capacity to 20,000 MW by 2016. The Transmission Company of Nigeria, with management outsourced to Canada’s Manitoba Hydro International, is to upgrade the country’s transmission capacity to 20,000 MW in conjunction with Chinese firm, Xian Electric Engineering, funded by the China Exim Bank up to US$500 million and the proceeds of the government’s privatization programme. The use of the PPP model and the proceeds of privatization, and the acceptance of offshore management and Chinese funding, in infrastructure development is something we can note here in New Zealand.
Drilling contracts: risk allocation and some economics
The New Zealand Minister of Energy Resources, Simon Bridges, noted at the recent New Zealand Petroleum Summit, this summer’s petroleum exploration programme is expected to be the largest on record with 13 exploration wells drilled offshore and 27 onshore.
This highlights the role that drilling contracts play in petroleum upstream operations. A key feature of these contracts is that the risk allocation and insurance arrangements are counter intuitive to the un-initiated.
Naturally, drilling contracts will vary with market conditions where in tight rig markets the rig rates are high and contractors are able to negotiate favourable terms. Conversely, in soft rig markets with low rates, the employer operators are able to negotiate more favourable contract terms. Needless to say, in New Zealand, we usually face tight market conditions with rig acquisition being difficult and the need to have rig sharing agreements whereby a number of operators take turns to utilise one rig for successive exploration programmes.
However, whatever the state of the market, a drilling contract has to provide for a clear contractual risk allocation which enables each party to assess the risk exposure it will absorb or insure at least cost. A key feature is that risks are allocated to the contracting parties without cause. While it may seem counter intuitive to protect and indemnify a party guilty of negligence or misconduct, it creates a line of demarcation for risk assessment and insurance. This clear demarcation avoids the transaction costs of determining cause and fault and the need to resort to litigation in the event of disputes. It also avoids both contracting parties insuring against the same risk because liability turns on fault rather than the event itself.
For example, it is customary for the contractor to assume liability for rig and associated contractor equipment loss or damage and for the operator to assume liability for its property and well related risks, including pollution, well damage or loss and reservoir damage. This is called the “knock for knock” principle so as to ensure that the respective parties can insure (or self insure) their own assets against damage or loss and thereby be prepared to accept the risks associated with drilling operations.
An exception for this is damage or loss to in-hole and subsea equipment incurred while working on a day work basis. This is because a contractor’s insurance may exclude or limit cover for such equipment and therefore the drilling contract will usually provide that the operator has the responsibility to compensate the contractor for in-hole and subsea equipment damaged or lost, such to be offset by any insurance proceeds recovered by the contractor. Some contracts create an exceptions for gross negligence and wilful misconduct and there has been an increased push for this post the 2010 Macondo well blowout but this can defeat the efficiency purpose of the ‘knock for knock’ approach.
The clear allocation of risk under this “knock for knock” approach and the few exceptions safeguards against the risk of the parties assuming the same risks for each other’s equipment and thereby doubling up on insurance cost reduces transaction costs and give more certainty to the risk profile of a company’s profile and, therefore, implicitly, its economic capital. This is another example of how efficiency considerations drive the allocation of risk in contracts.
The single buyer model: what is it?
As the debate here in New Zealand, on the Labour and Green’s power policy reform proposals in relation to the electricity wholesale market, rages on, my blog items on Farmin Agreements seem irrelevant. So, I thought I would contribute to the debate by pointing out that some views may be based on a misunderstanding as to what is proposed by Labour and the Greens which is, in turn, driven by the lack of detail as to exactly what they propose.
The latest contribution to the debate that I have read comes from TrustPower chief executive Vince Hawksworth. In an article on Energy News, 21 June 2013 entitled Single-buyer model risks halting project development – Hawksworth, he is reported as having told the Electricity Engineers’ Association conference in Auckland that creating a single-buyer for the generation market would turn development into a “lottery” and could stall the consenting of new projects.
His point (as reported) was that since the creation of the market wholesale prices had been volatile but they had been sufficient for business to invest more than $2 billion on new generation, much of it new renewables. The country also has an extensive list of consented projects that can be developed as needed.
But he says generators are unlikely to go to the expense of consenting new developments under a single-buyer model. TrustPower, which has invested $620 million in New Zealand since the market’s creation, could not justify seeking consents for new projects if their timing was to be decided by a state regulator.
“You don’t want to buy a lottery ticket for when it gets built” he is reported as having said.
To my mind what he says makes perfectly good sense. However, I do not think that this is what is proposed by Labour and the Greens single buyer model.
I am not advocating the Labour and Greens proposals; I am just making the point that there may be some confusion as to what is proposed which is driven by lack of detail.
The Green’s discussion paper Empowering New Zealand says ‘NZ Power will be a ‘single buyer’ – all generation will be sold to it and will onsell to electricity retailers and major users… NZ Power will make long-term contracts with generators and use its market power to negotiate much lower wholesale prices…’ and ‘NZ Power will lock in most of electricity supply it needs by auctioning long-term contracts with generators.’
The Labour party policy document Energising New Zealand says ‘We will establish NZ Power – a new independent Crown entity – to have a central role in the planning and operation of the electricity system, taking a holistic approach’ and that ‘NZ Power will have the ultimate government responsibility for energy sector planning. It will be required to determine future investment needs for generation and seek competitive proposals for the construction of new plant and equipment’.
This tells me that Greens and Labour propose that NZ Power will decide when new generation plant is required and, therefore, will seek competitive proposals for the consenting and construction of new generation as per its planning and not that of the generators. Hence, a competitive proposal would comprise the generator’s proposal for consenting, construction and operation of the new generation plant on a time scale commensurate with NZ Power’s planning which, if successful, would be secured by a long term contract. Therefore, any consenting undertaken by the generator would not be undertaken without a contract with NZ Power in place; there would be a contract in place which provided for consenting, construction and operation with the security of a contracted revenue flow from NZ Power with an implicit Government guarantee. This is not expressed in the Green and Labour discussion and policy documents but, to mind, it is plainly implicit as, otherwise, an advantage of the single buyer model is not obtained. The UK Energy Research Centre in its paper Electricity Market Design for a Low-carbon Future, October 2010, said ‘…the guaranteed income stream associated [with] a single buyer model would improve investor confidence and reduce the cost of capital’.
However, this may be outweighed by other factors. For example, the concentration of planning and the timing of new generation in NZ Power as the single buyer and central planner may magnify the consequences of planning or forecast error, as happened in the 1990s; over investment might be expected – the incentive to avoid any security of supply failure, in turn leading to less innovative and more conservative planning; and, finally, NZ Power might be expected to be not so good as a competitive wholesale market in sustaining pressure on operational costs. These were the factors which have influenced the decision making of previous Governments.