July 19, 2013

The not so sacred contracts

Recent decisions over energy contracts have reopened the fundamental debate between Pact sunt servando and Rebus Sic Stantibus.

In recent weeks, we’ve seen some interesting arguments and disputes over energy pricing. The most prominent case, of course, was the government’s decision to accept the Rangarajan Committee formula for fixing the price of natural gas for a period of 5 years from April 1, 2014. Reliance, which is supposed to be the major beneficiary, is actually sulking that it cannot bring in more investments without a stable policy. This is a fair point. When it won the bid in 2000 under the New Exploration Licensing Policy (NELP) the company had believed that it would have the freedom to decide the pricing of gas based on market dynamics. In 2000, the price of gas was around $2.5/MMBTU but by the time Reliance could operationalise its fields, the international price went up by 4 times or more. Based on the principle of high-rewards for high-risks (Reliance had sunk more than$10 billion despite the high geological risks), Reliance believed that the benefit of the upside should have accrued to them. But the government brought in the logic of “gas belongs to the nation” and decided to interfere with the pricing mechanism, ignoring what the contract had spelt out.


A few months back, Tata Power and Adani had approached the regulator for enhancement in price of electricity to be supplied from their Ultra-Mega Power Plants, on the ground that new export duties levied by the Indonesian Government had led to high increase in landed cost of coal, making it impossible for them to honour the fixed-price PPA that had been signed with a 20-year tenure. The regulator permitted the enhancement, overruling protests from discoms that the contract did not provide for any change in price and that any burden arising out of changed circumstances was to be borne entirely by seller.

In a tit-for-tat, Gujarat Urja Vikas Nigam Ltd (GUVNL) which had signed PPAs with solar-power developers for 1000 MW of capacity, has approached the regulator with a plea to reduce tariff from the agreed Rs 12.54 per Kwh (25-year average) to Rs 9 per Kwh. GUVNL’s argument is that the contractual tariff was based on the then prevailing perception that the project cost would be around Rs 16.50 crores per MW. However, it says, the project developers have invested only Rs 11-12 crores per MW, adding, “if private players like Tata and Adani can approach the regulator and even the Prime Minister to prevent their thermal plants from making losses, the government of Gujarat too has a right to renegotiate its solar power purchase agreements”. Ironically, it was the Gujarat Government that had proposed the tariff in the first place; it was not arrived at by a competitive bidding process.

Probably inspired by these developments, GAIL has asked Petronet to re-negotiate a gas deal which the latter had signed with an Australian company for long-term supply of gas from their Gorgon field at a price linked to oil prices. With oil price at $100 a barrel, the gas price from this field will be $14.5 per MMBTU and the landed cost at Kochi after transportation would be close to $17/MMBTU. This agreement was signed when the oil price (and therefore the gas price) was on an upward trajectory and GAIL/Petronet had judged it prudent to secure the gas supplies at that cost. But then, with US gas price (as indicated by the Henry Hub) hovering now at a much lower level and European gas price showing signs of cooling down too, GAIL is emboldened to re-open the contract. The only justification GAIL provides is that the renegotiation is necessary due to “changing pricing scenario worldwide”.

So, are contracts no longer held as sacred? Can one of the parties renege on, or threaten to dishonour contracts that they had willingly entered into? Can changed circumstances be cited as the reason for doing so? If, after signing a fixed-price contract, the production costs increase, can the seller throw up his hands and claim it is no longer viable for him to deliver as promised? Or, if the market prices slump, can the buyer insist on renegotiating prices to a lower level citing “changing pricing scenario”. Where does this leave a project like Gorgon with its high capital costs and which would have been rendered bankable only because of a long-term assurance of offtake at a good price?

Sanctity of contracts (Pact sunt servando) is a fundamental principle in law and rightly so. Two parties who have entered into a firm-price contract on their own volition and by exercising their own judgement must respect the terms agreed, regardless of changing circumstances. Otherwise, the very essence of an agreement is lost. Most arbitrators and regulators have supported this view.

On the other hand, the concept of changed circumstances (Rebus Sic Stantibus) was mentioned even in the Vienna Convention on contracts for international sale of goods, albeit intended only for “exceptional cases”. Economic hardship of seller or buyer was not allowed as a ground for invoking this principle. However, there are legal systems that recognise that the future is uncertain and with increased inter-connectedness even a distant event can rapidly disturb and completely alter the circumstances that were taken for granted when the contract was signed. Some national laws allow more leniencies on this ground.

Lawyers all over the world have made a fortune by taking on either of these positions (“sanctity of contract” vs. “unforeseeable, changed circumstances leading to frustration of purpose”) for their clients and will continue to do so. We can expect more litigation and arbitration proceedings in the future.

With the energy market in a constant state of flux and with such extreme unpredictability, it will become increasingly difficult to sign or enforce fixed-price, long-term contracts, as one of the parties can, sooner or later, cite “changed circumstances”. Long-term, feed-in tariff for renewable energy will not be sustainable, and market pricing based on a robust RPO/REC mechanism will have to take over. For LNG, long-term contracts are still the norm, but this only ensures security of supplies for the buyer and commitment of steady offtake for the seller; the price will vary based on an agreed index or formula (as in the case of Gorgon). With gas price showing signs of getting delinked from oil price, a spot market for gas based on its own supply/demand equation may soon be the reality. India will have to get used to the dynamics of this volatile market. Raising debt for projects, which don’t have long-term purchase agreements, is impossible in India today. However the risk perception will change gradually, if the market inspires confidence.

Insulating the ultimate consumer from the vagaries of energy pricing will be tough. The burden or benefit of price changes will simply have to be passed on to ultimate consumers through such free-market mechanisms. This will give rise to a more vibrant, derivatives market where the seller and the buyer (at least the distributor or retailer) may be able to hedge part of the risks. If political compulsions make it necessary to protect the interests of economically weaker sections of society, it must be done offline (eg. cash subsidies), without causing market distortions.

Photo: falling_angel

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