Where the buyer is obliged to pay for gas not taken pursuant to the take-or-pay obligation (‘make-up gas’), the buyer will usually be entitled to nominate and receive those quantities of make-up gas at a subsequent time during the term of the GSA.
Having already paid for the gas, the buyer may be entitled to receive make-up gas quantities at no additional charge, although some GSAs may provide for certain adjustment payments to be made at the time the buyer takes the make-up gas to account for differences in price and/or calorific value between when the take-or-pay obligation was incurred and when the make-up gas is actually taken.
The seller will not wish for the buyer to have unrestricted make-up rights and will usually seek to impose limitations on the buyer’s ability to recoup make-up gas, including:
• Time limit: because make-up rights give rise to an element of cash-flow uncertainty for the seller, the seller will generally wish for the buyer to exercise its make-up rights within a reasonable period of time following the accrual of such rights, failing which the make-up rights shall be deemed to have been forfeited by the buyer. The forfeiture of make-up rights by the buyer will also result in a significant commercial benefit for the seller as it would have received payment for gas which it never had to supply to the buyer. Accordingly, it is in the seller’s interest to ensure that the time period within which the buyer is to exercise make-up gas rights is as short as possible.25
• Make-up gas threshold: to ensure that the buyer’s make-up gas rights do not significantly erode the seller’s cash-flow position, the seller may argue that the buyer shall only be entitled to recoup make-up gas once it has nominated and taken a minimum quantity of gas (eg, the daily contract quantity or the daily equivalent of the take-or-pay quantity). If the buyer accepts such a
23 A seller may also argue that carry-forward rights introduce an element of cash-flow uncertainty for the seller and therefore undermine the principal purpose of the take-or-pay obligation.
24 Limitations on carry-forward rights commonly seen in long-term GSAs include: (i) carry-forward credits accruing only in respect of gas quantities taken by the buyer over and above the applicable contract quantity (eg, either the daily contract quantity or the annual contract quantity), rather than the take-or-pay quantity; (ii) the buyer being obliged to exercise carry-forward rights against future take-take-or-pay obligations within a specified period of time following the carry-forward credits accruing, where time limits on exercising carry-forward rights typically seen in long-term GSAs typically range between two and five years; and (iii) to prevent the buyer from accruing carry-forward credits over an extended period and applying those credits on a one-off basis causing disruption to the seller‘s cash flow, the buyer’s right to exercise carry-forward credits may be subject to an annual volumetric cap. For example, the GSA may provide that the buyer is not entitled to utilise carry-forward credits exceeding 5% of the adjusted annual contract quantity in any given year.
25 By way of guidance, in long-term GSAs time limits on exercising make-up gas rights often range between two and five years.
limitation, it will need to be careful to ensure that there is adequate scope and flexibility with the quantities provisions to enable the buyer to exercise its make-up gas rights in an effective manner.
• Annual cap: to prevent the buyer from ‘stockpiling’ make-up gas rights over an extended period and exercising those rights on a one-off basis causing a significant disruption to the seller’s cash flow, the buyer’s right to nominate make-up gas may be subject to an annual cap.26
The GSA will also need to prescribe what is to occur in relation to outstanding make-up gas existing upon expiry or termination of the GSA. The seller may argue that such outstanding make-up gas should be extinguished, whereas the buyer will argue that it should be entitled to receive the benefit or value of such accrued make-up gas rights notwithstanding the expiry or termination of the GSA. The GSA may therefore provide for (i) a term extension to enable any outstanding make-up gas to be delivered by the seller to the buyer, (ii) outstanding make-up gas to be monetised and paid to the buyer,27or (iii) the seller to discharge the outstanding make-up gas by delivering to the buyer alternative fuel equivalent in value to the unrecovered make-up gas.28
8. Shortfall
Where the seller has failed to deliver a properly nominated quantity29of gas to the buyer and the seller’s failure is not otherwise excused under the GSA, the seller will usually be liable to the buyer in respect of that shortfall quantity of gas (with the quantities of gas not delivered being referred to as ‘shortfall gas’).
8.1 Remedies
Most GSAs will provide for an express remedy in favour of the buyer for shortfall gas rather than leaving occurrences of shortfall to be addressed under the general dispute resolution provisions in the GSA (which would be administratively burdensome, time consuming and costly for both parties). In broad terms, a GSA will usually prescribe either an actual loss remedy or liquidated damages in respect of shortfall gas.
An actual loss remedy will generally oblige the seller to compensate the buyer for the buyer’s actual and direct loss incurred as a result of the seller’s shortfall, subject to certain limits on the liability of the seller. To be entitled to compensation under an actual-loss shortfall gas remedy, the buyer will usually be obliged to provide the
26 For example, the GSA may provide that in any contract year the buyer is not entitled to receive a quantity of make-up gas in excess of 5% of the annual contract quantity.
27 This will usually involve the seller refunding the buyer the earlier amounts paid by the buyer in respect of the take-or-pay obligation.
28 Other make-up gas issues that the parties may also wish to clarify in the GSA include whether the seller’s failure to deliver up gas should give rise to shortfall gas liabilities, and how excess gas and make-up gas nominations are to be reconciled. The GSA should also make clear whether carry-forward credits should accrue in relation to make-up gas nominated by the buyer (usually this is not the case). The GSA will also usually stipulate that make-up gas is to be taken on a first-in-first-out basis.
29 An under-delivery of gas by the seller will only constitute shortfall to the extent that it relates to a properly nominated quantity of gas, and the buyer will usually not be entitled to be compensated under the applicable shortfall gas remedy in respect of under-deliveries relating to gas quantities that were not properly nominated by the buyer in accordance with the nominations regime.
seller with reasonable evidence of the buyer’s loss to substantiate its claim for compensation. While an actual-loss remedy has the benefit of matching the compensation payable by the seller with the buyer’s actual-loss, actual loss shortfall gas remedies tend not to be favoured by parties to a GSA due to the burden associated with the buyer having to demonstrate and quantify its actual loss on each occasion of shortfall and the potential uncertainty surrounding the extent of seller’s liability and the success of the buyer’s claim.
A shortfall gas liquidated damages remedy, on the other hand, provides the parties with a greater degree of certainty, both in terms of the level of compensation afforded to the buyer and the extent of the seller’s liability for non-performance. Shortfall gas liquidated damages are typically formulated on the basis of a price discount (‘shortfall gas price discount’) applying to a quantity of gas equivalent to the shortfall gas quantity to be delivered by the seller to the buyer at a subsequent point during the term (typically in the following month). To ensure that the remedy is upheld as liquidated damages, the GSA will normally prescribe that the shortfall gas price discount constitutes a genuine pre-estimate of the buyer’s loss arising from the shortfall and that the buyer waives any defence as to the validity of such liquidated damages on the grounds that such liquidated damages are void as a penalty.30
A buyer will wish for a seller’s liability for shortfall gas to crystallise as frequently as possible (eg, on a daily basis) to ensure that the remedy is sufficiently robust to discourage the seller from not performing, whereas the seller will prefer that liability for shortfall be assessed over a longer period (eg, on a monthly basis) to afford the seller with greater flexibility to even out under-deliveries and minimise its shortfall gas liabilities.
Unless the seller’s failure to deliver gas falls within one of the recognised exceptions (discussed below) the seller’s liability under the shortfall gas liquidated damages remedy will usually be absolute, so that the seller will be obliged to compensate the buyer without the buyer having to demonstrate actual loss.31
To prevent the buyer from challenging the adequacy of the shortfall gas remedy and/or bringing an alternative claim, as well as ensuring that the shortfall gas remedy operates as an effective cap on the seller’s liability for non-performance, the seller should always ensure that the GSA provides that the shortfall gas remedy constitutes the buyer’s sole and exclusive remedy in respect of the seller’s non-performance, and for the buyer to indemnify the seller in respect of any claims brought against the seller in respect of such non-performance (including in respect of claims brought by third parties, including the buyer’s end-users).
30 Such provisions are common to GSAs governed by English law. Although the shortfall gas price discount will typically be expressed as being a genuine pre-estimate of the buyer’s loss arising as a consequence of shortfall, the discount will often be arrived at purely as a matter of commercial negotiation, with each party seeking to achieve the best commercial outcome (ie, the lowest possible price discount in the case of the seller, and the highest possible price discount in the case of the buyer).
31 A buyer may argue that where shortfall occurs as a result of the seller’s wilful misconduct (eg, where the seller knowingly shortfalls the buyer to sell such gas to another customer on more favourable economic terms), then the shortfall gas remedy should not apply and the buyer should be entitled to bring a claim against the seller for its actual loss, meaning the seller would not have the benefit of the limitation on liability afforded by the shortfall gas remedy.