Blog Section

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.

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 [2015]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.