Pyrrhic Victory in Take or Pay Dispute Under Long-term Gas Supply Agreements: a Breach of Contract, but No Damages
A Court of Appeal decision in December 2020 has provided further guidance on the interpretation of long-term gas supply agreements, particularly in relation to take or pay clauses. It also offers a salutary reminder of the importance of being able to link the damages claimed to the specific breach of contract. British Gas (as Buyer) successfully obtained judgment confirming a breach of contract by Shell and Esso (as Sellers), but in an unsatisfactory outcome failed to prove its GBP 60-million claim for damages.
In 1988 Shell and Esso agreed to two identical long-term contracts (the Principal Agreements) for the sale to British Gas of natural gas from the Sole Pit Reservoirs in the North Sea, which are due to run until 2025. Included in the Principal Agreements are “take or pay” provisions which are based on the “Total Reservoirs Daily Quantity” (TRDQ). The TRDQ changed in the initial period of the contracts but then remained constant. However, the TRDQ could be reduced by the Sellers issuing a variation notice if they believed they would no longer be able to meet the TRDQ. Importantly for this case, the Sellers had no obligation to reduce the TRDQ, only the right to do so.
Conversely, the Sellers were obliged to maintain a delivery capacity “from the Reservoirs” of 130% of the TRDQ (clause 6.4(1) of the Principal Agreements). Acting together, the ability to issue a variation notice reducing the TRDQ and the capacity obligation ought to have ensured that the Sellers reduced the TRDQ in the event that there was insufficient supply from the Reservoirs, thereby reducing the Buyers’ take or pay obligation.
However, the parties, along with other natural gas producers, are also parties to a separate agreement known as the “Sub-Terminal Allocation Commingling and Attribution Agreement” (the STACA). Under the STACA, gas produced from various reservoirs is delivered and processed at the Shell Sub-Terminal at Bacton. After processing, the commingled gas is then delivered to different users, including the Buyer. STACA also required gas to be lent and borrowed between entities on the basis that it will be repaid as soon as reasonably practicable.
The Sellers had issued a number of variation notices reducing the TRDQ due to the steadily declining production volumes of the Sole Pit Reservoirs but had not issued any further notices since 2009 despite the production volumes continuing to decline. The Sellers maintained that they were able to take account of gas owed to them from other reservoirs under STACA and that they were therefore not in breach of their capacity obligation. British Gas, on the other hand, argued that the obligation to deliver gas “from the Reservoirs” meant that only gas from the Sole Pit Reservoirs was to be counted. Accordingly, British Gas argued that the Sellers were in breach of their capacity obligation.
The motivation, of course, for the dispute was that British Gas considered it was paying more for the gas supplied under the Principal Agreements than it would have paid for equivalent volumes on the open market.
The particular key issues argued by British Gas in the first instance proceedings were:
- The sellers’ capacity obligation in clause 6.4(1) of the Principal Agreements required the sellers to maintain the capacity to deliver the required contractual quantities from the Reservoirs themselves, taking no account of gas which was owed to them in repayment of gas lent under STACA;
- A term was to be implied into the Principal Agreements whereby the sellers’ right to serve (or not to serve) a variation notice to reduce the TRDQ had to be exercised honestly and in good faith (a “Braganza” term1); and
- Damages payable consisted of the difference between the market price of gas and the price which it actually paid to the Sellers for gas which it would not have been required to take if the TRDQ had been appropriately reduced by variation notices.2
The High Court rejected issues (1) and (2), holding that as British Gas received the gas from a commingled stream there was no reason to distinguish between gas produced contemporaneously from the Sole Pit Reservoirs and repaid gas which is representative of the historical production of the reservoirs. British Gas was granted permission to appeal the judge’s decision on issue (1), but not (2). Although issue (3) did not require determination, the judge held that he would have determined it in the buyers’ favour, citing the decision of the Court of Appeal in Durham Tees Valley Airport Ltd v BMIBaby Ltd,3 where the Court held that, when assessing damages, it should be estimated how the contract would have been performed if it had continued. The Sellers cross-appealed the judge’s decision on issue (3).
The Judgment of the Court of Appeal
The Court of Appeal allowed the appeal on issue (1). Applying the test for the interpretation of commercial contracts set out in Arnold v Britton4, the Court closely considered the language of the contract, including clause 6.4(1). In particular, the Court considered the obligation to “maintain the capacity to deliver gas from the Reservoirs,”5 and found that “the unavoidable fact is that gas which is repaid to the Sellers in repayment of Sole Pit gas previously lent by them is not gas ‘from the Reservoirs.’”6
The Court gave little weight to the Sellers’ arguments as to “commercial common sense”, with Lord Justice Males expressing doubt as to the relevance of this as a factor in the construction of detailed and expertly drafted contracts.
However, in what was described by Peter Jackson LJ as “[running] contrary to the conventional expectation that parties who breach contracts should face consequences,”7 the Court also allowed the Sellers cross-appeal on issue (3). Since the purpose of damages is to put the innocent party in the position, it would have been had the contract been performed, and since the Sellers only had the right, not the obligation, to issue notices reducing the TRDQ, the Court essentially concluded that if the contract had been performed then the Sellers would have maintained their capacity obligation using gas “from the Reservoirs” (rather than from other sources). In that scenario, British Gas would have been obliged to pay for the gas, just as it did, in fact, do. Accordingly, British Gas had suffered no loss.
The Court found that it was not required to assume that the Sellers would have taken steps (reducing the TRDQ) to avoid being in breach of contract. Clearly, the conclusion would have been different if the Sellers had had an obligation to reduce the TRDQ. In that context, it is disappointing that permission to appeal was not granted on issue (2), particularly given the ongoing discussion in recent cases regarding the implication of Braganza terms. In particular, this issue has arisen recently in the context of long-term contracts in the energy sector (see, for example, our previous note on TAQA v RockRose here). It may have been helpful if the Court of Appeal had considered this issue in the context of agreements such as those at issue in this case.
The judgment provides further confirmation of the approach the courts will take to the interpretation of commercial contracts concluded between sophisticated and properly advised parties. Importantly, following the direction of travel set by Arnold v Britton, in such circumstances the wording of the contract itself is unlikely to be displaced by arguments as to commercial common sense.
It also provides an example of the requirement to link the damages claimed to the particular breach of contract, and the position the claimant would have been in had that particular breach not occurred. Since, here, the breach was one of capacity, had the Sellers’ not breached that capacity obligation (i.e. had they been able to deliver the required capacity “from the Reservoirs”), the Buyer would have been obliged to purchase the take or pay volume of gas at the contractual price. Since the Buyer had purchased that volume of gas at that contractual price, no loss arose. The situation would have been different had the Sellers failed to meet its capacity obligation with any gas and as a result the Buyer had been forced to purchase gas in the market at a higher price. However, here the contractual price was higher than the market price, and the real issue was that the Buyer wanted the take or pay amount reduced so that it could buy alternative gas at a cheaper rate. Although it is counter-intuitive that a party in breach of contract can escape payment of damages, the particular drafting of the relevant clauses and the refusal of the High Court to imply a term limiting the Sellers’ discretion, meant that applying standard principles of damages resulted in what Lady Justice Andrews described as a Pyrrhic victory.
Adam Fenby, a Trainee at our London Office, contributed to this article.
1 See Braganza v BP Shipping and another  UKSC 2017
2 British Gas Trading Ltd v Shell Gas Trading Ltd and Esso Exploration & Productions UK Ltd  EWHC 3943 (Comm)  9 WLUK 485
3  EWCA Civ 485,  1 All ER (Comm) 731
4  UKSC 36,  AC 1619
5 N1 [Paragraph 50]
7 Ibid [Paragraph 102]
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.