Chris Kidd Head of Shipbuilding and Offshore Construction, Joint Head of Energy & Infrastructure, Partner
Take or pay: does a breach of capacity obligation cause loss?
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British Gas Trading Limited v Shell UK Limited, Esso Exploration & Production UK Limited  EWCA Civ 2349
The recent Court of Appeal ruling in British Gas Trading Limited v Shell UK Limited, Esso Exploration & Production UK Limited  EWCA Civ 2349concerned a “take or pay” arrangement, in which the buyers, British Gas, were only entitled to nominal damagesdespite Shell’s breach of their capacity obligations as sellers.
This case is another reminder, following our recent podcast on Apache v Euroil, that the Court may look at two separate but related agreements to construe a provision in one of them.
Under “take or pay” arrangements the seller agrees to maintain supply of an agreed volume of a commodity, and the buyer commits to either:
- Take delivery and pay the price of the agreed volume over a given period; or
- Reject delivery but pay a minimum price to the seller.
Such terms are popular in long-term energy supply contracts where buyers and sellers wish to share a degree of the risk in the movement of price and demand.
In this case, Shell and British Gas entered into an agreement (the Principal Agreement) for the supply of natural gas from 1988 until at least 2025. This Principal Agreement included a “take or pay” provision, under which the Shell agreed to:
- Supply daily quantities of natural gas to British Gas; and
- Constantly maintain certain delivery capacity at the gas field reservoirs.
British Gas agreed to either take delivery or, in the event they could not take delivery, pay for a minimum amount of gas every year.
The quantity of gas British Gas were required to take every year was calculated by reference to a percentage of the total daily quantity of the Reservoirs (the “TRDQ”). The TRDQ also determined the delivery capacity rates which Shell were obliged to maintain.
The parties anticipated that the TRDQ would change over the life of the contract, so they agreed that, after a certain stage of production, Shell would be entitled, but would not have, to reduce the TRDQ if they thought that production levels could not be maintained. Needless to say, any reduction in the TRDQ would reduce the quantity of the gas which British Gas were required to take.
Separately, British Gas and Shell were parties to a different agreement (the Separate Agreement) entered into with other producers. Under this agreement, Shell were required to lend gas produced from the Reservoirs to other producers on the basis that those producers would repay the lent gas to Shell.
Production volumes at the Reservoirs declined over time and Shell subsequently served variation notices reducing the TRDQ. However, after 2009 Shell were able to meet their supply obligations without having to reduce the TRDQ by using a significant balance of gas that was owed by other producers under the Separate Agreement.
British Gas complained, not of a failure by Shell to deliver the nominated volumes, but of their failure to maintain capacity to deliver gas at the agreed rates from the Reservoirs.
In fact, British Gas complained, because the market price of gas had for some time fallen below the price agreed under the Principal Agreement with Shell. They contended that Shell ought to have reduced the TDRQ which would have had the effect of reducing the amounts that they were obliged to take and pay for above market price.
The British Gas claim was based upon three arguments:
1) When determining Shell’s capacity obligations the gas owed by other producers under the Separate Agreement should not be taken into account.
The High Court rejected this proposition, so British Gas appealed.
The Court of Appeal interpreted the language of Shell’s capacity obligation clause, and then tested this construction against the terms of the two agreements. It also considered the “commercial common sense” invoked by Shell. It was however doubted this would have much of a role to play in the interpretation of detailed and complex contracts.
The Court of Appeal found that Shell’s capacity obligation was concerned with gas provided from the Reservoirs alone, so gas owed by other producers should not be taken into account for the purpose of determining whether Shell had maintained their delivery capacity.
2) Shell were under an implied duty to exercise their entitlement to reduce the TRDQ in good faith.
This was rejected by the High Court. British Gas appealed but their application was also rejected.
3) The assessment of damages.
The British Gas case was that in order for Shell to avoid being in breach of their capacity obligation, they would have served variation notices reducing the TRDQ, which, in turn, would have reduced the amounts that British Gas were obliged to pay for under the Principal Agreement. It therefore claimed the difference between the price of gas which it could have purchased on the market and the price which it actually paid to Shell (which was estimated at over £61 million).
However, the Court rejected British Gas’ arguments emphasising that damages should be assessed on the basis that the party in breach had performed its obligations (that is, if Shell maintained delivery capacity throughout the duration of the Principal Agreement). On this basis, Shell would have provided the same gas volumes, so British Gas suffered no loss.
The Court of Appeal’s approach on interpretation of the Shell’s capacity obligation serves as a reminder of how important the agreed language in complex contracts can be.
On the assessment of damages, the Court’s conclusion that British Gas suffered no loss despite Shell’s breach, could be “surprising” and seemed to run contrary to the “conventional expectation that parties who break contracts should face consequences”. However, this was reached on a proper application of law on what was described as an “unusual” agreement “giving one party the prerogative to set the parameters of an obligation that binds both parties”.