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Growing risks in the European energy market

Richard Power, head of energy disputes at law firm Berwin Leighton Paisner looks at the key causes of disruption to the fast-changing European energy market, and the legal risks involved

Europe's energy market is today arguably in a more precarious state than the (literally) dark days of the mid-1970s. International conflict, carbon reduction targets, increased use of renewables and political upheaval all pose threats to the security of Europe’s energy supplies, particularly natural gas. 

Europe is highly dependent on Russian energy supplies, importing about 30% of its gas and 35% of its crude oil needs from Russia. Western Europe is better insulated from supply shocks than many Eastern European states, which remain almost entirely dependent on Russian gas supplies.

The civil war in Ukraine is a grave threat to continued gas and oil supplies from Russia. Most obviously, Russia has in the past shut off gas supplies to Ukraine itself, resulting in international arbitrations worth many millions of dollars. However, the threat to supply is much wider. Around 50% of EU-bound Russian gas is delivered via pipelines which cross Ukrainian territory. If these are damaged or destroyed, or supply is otherwise cut off, the EU would feel the effects quickly. 

Furthermore, Russia’s alleged involvement in the civil war, its annexation of Crimea and the downing of flight MH17, which may have been carried out by pro-Russian separatists, prompted the EU and US to impose targeted sanctions on Russia. The obvious targets for those sanctions are Russia’s oil and gas exports, and although the EU has not yet dared to go that far, it may be forced to do so in the future.

Moreover, sanctions imposed by nations not directly dependent on Russian oil and gas – the US, for example – might force private, EU-based firms with a presence in the US to cease dealing with Russian suppliers. Elsewhere, instability and violence following the Arab Spring of 2011 poses a threat to continued oil and gas supplies from a number of countries across the Middle East and North Africa. This year, a number of oil refineries and export facilities in Libya have been shut in, while in June militants from the Islamic State captured the Baiji oil refinery in Iraq, and advanced on the country’s semi-autonomous Kurdistan region, a potential source of oil and gas supplies to Turkey and the EU.

An unstable North Africa and the widening conflict in Syria and Iraq are both likely to see oil and gas supply contracts suspended or terminated, giving rise to claims for compensation. 

War, sanctions, civil unrest and insurrection often fall within force majeure clauses which excuse non-delivery from the affected party, but whether the event relied upon in a particular case falls within the contractual definition of force majeure is a common source of disagreement. Often one party tries to use the interruption of supply as an excuse to terminate the contract, while the other party will insist that the contract is merely suspended for the duration of the force majeure event.

Opportunity or threat?

Given these risks, the EU – and in particular Germany, Poland and other Eastern European states – is moving to wean itself off Russian gas. This raises two obvious issues: how to extricate oneself from long-term gas supply contracts, some of which tie in parties for 10 years or more; and which sources of gas can be used as an alternative?  

The former problem is an obvious source of potential disputes for wrongful termination claims, but the latter presents a more subtle threat. One of the main potential alternative sources of gas is the US’ considerable shale-gas reserves, large-scale exports of which, as liquefied natural gas (LNG), are scheduled to come on line in the next couple of years. 

However, Europe is not alone in wanting to import LNG. China has a large requirement for LNG to fuel its expanding economy, Japan remains the world’s largest importer of the super-cooled gas since the 2011 Fukushima disaster; South Korea is a close second. Will burgeoning European demand lead to a price war? Will cargoes be diverted from regular customers to meet demand in higher-priced markets, as happened after Fukushima? At least some of this seems likely, especially if conflicts in Eastern Europe, North Africa and the Middle East choke supply.  

Chain reaction

The EU’s plan to create a single energy market and its efforts to reduce carbon dioxide emissions offers a stark example of the law of unintended consequences. As an incentive to switch to cleaner energy generation, governments, particularly Germany, have subsidised solar and wind power generation. However, renewable energy has high capital cost, but virtually no marginal cost of production, and so the subsidies have distorted the market by reducing up-front capital costs and allowing wind and solar to undercut coal and gas power stations, making thermal generation borderline uneconomical. Consequently, some gas and coal-fired power stations have been taken offline temporarily, or even decommissioned, and investment in new fossil fuel-reliant power stations has fallen.  

Renewable energy is intermittent – it only works effectively when the wind blows or the sun shines. Extremely windy and sunny conditions can lead to oversupply, meaning curtailments to constrained power grids. At the other extreme, adverse weather can lead to the market being undersupplied, raising the spectre of blackouts despite there being too much overall capacity from all energy sources. A single energy market may exacerbate the problem because of the potential for high cross-border demand at times of low production. 

Apart from the scope for disputes which arise out of power-cuts – claims against power generation companies for lost production, for example – downward price pressure from oversupply has a knock-on effect on spot prices for natural gas. A glut of power supply to the grid means spot gas prices often diverge considerably from oil-indexed prices in long-term gas supply contracts, making the latter uneconomical. That, in turn, has led to a recent increase in the number of price review arbitrations.

In the UK, compliance with EU directives has led to the shutdown of carbon-intensive coal- and gas-fired power stations before new nuclear generation facilities have been brought on line, meaning that the UK’s power generation capacity is close to critical limits. It is not inconceivable that a cold winter after 2015 would lead to blackouts, and compensation claims. In order to protect against this, the UK government pays a retainer to certain generation companies to provide back-up capacity. 

Whether such arrangements will be challenged as illegal state aid remains to be seen. What, then, can be done to minimise these myriad risks? At a strategic level, European governments are taking steps to protect against oil, gas and electricity shortages. The EU has 30% more gas in storage now than this time last year. European Energy Commissioner Guenther Oettinger recently told reporters: “We have a Plan B for the worst-case scenario. But we don’t expect to need it.” The EU and the UK government are both aware of the structural problems in their respective markets and are addressing these, albeit slowly. 

Power cuts

However, it is possible – perhaps even likely – that at least one of the situations canvassed could result in disruption. In these circumstances, it is important for the management of the energy companies affected to retain a clear head, consider the relevant contracts closely and carefully with their in-house counsel, and if faced with a termination or force majeure situation, to seek external legal advice before taking action. If a contractual breach, suspension or termination is handled well from the start, the situation – like any emergency – can be managed and, with skill, even turned to the company’s advantage, perhaps by renegotiating a burdensome deal. Conversely, if action is taken hastily or a bad situation is left to fester, companies can become embroiled in a dispute which takes millions of dollars and a number of years to resolve.

The European energy sector is facing many challenges, perhaps more than it has wrestled with in a generation. The probability is that in the short term, at least some of the sector’s participants may face claims for compensation of one sort or another, either through national courts or via arbitration. They may also face becoming embroiled in challenges to executive and regulatory decisions which affect their business. Taking effective steps now to minimise and contain risk is vital. Never before has the saying “a stich in time saves nine” been more appropriate.

Richard Power, head of energy disputes at law firm Berwin Leighton Paisner

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