The Court of Appeal has handed British Gas (as Buyer) partial victory in its dispute with Shell and Esso (as Sellers), in relation to North Sea gas deliveries under long term supply contracts. The Buyer argued that the Sellers were in breach of contract for factoring in gas ‘borrowed’ from other suppliers when delivering gas to the Buyer. The Court of Appeal agreed but found that the Buyer had not suffered any loss as a result of the arrangement.
This is another case (following the recent High Court decision in Apache North Sea Ltd v Euroil Exploration Ltd  EWCA Civ 1397) where when construing the terms of a contract, the court looked at both the contract itself and also other related agreements before reaching a conclusion. It also raised an interesting issue on the correct basis to award damages which meant that despite prevailing on the construction of the contracts, the Buyer was not entitled to damages.
The appeal related to a decision of Persey J on two preliminary issues.
- The first issue concerned the construction of the Sellers’ obligation to provide and maintain capacity to deliver natural gas from the Sole Pit Reservoirs and whether it is permissible, to take account of gas from other reservoirs to which the Sellers have access (the Construction Issue).
- The second issue concerned the assessment of damages for breach of the capacity obligation (the Damages Issue).
This was an appeal by the Buyer on the Construction Issue and a cross appeal by the Sellers on the Damages Issue.
The Buyer entered into two agreements on materially identical terms (so far as the appeal was concerned) (the Principal Agreements) with the Sellers, for the supply of daily quantities of gas from the Sole Pit Reservoirs. The Principal Agreements provided for a minimum amount of gas which the Buyer must either take delivery of or pay for (the Delivery Capacity) and are due to run until at least 2025. Clause 6.4(1) of the Principal Agreements requires the Sellers to consistently maintain the Delivery Capacity.
The quantity of gas which the Buyer is required to take is dependent on the variable “Total Reservoirs Daily Quantity” (TRDQ). Following the initial period, the Sellers have the right to serve Variation Notices to reduce the TRDQ and subsequently the Delivery Capacity, unless such notice is challenged by the Buyer.
The Buyer, the Sellers and other natural gas producers are also party to a separate agreement known as “the Shell Bacton 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. The STACA also provides for the lending and borrowing of natural gas between different producers, the purpose of which is to enable a “User Group” which would otherwise be unable to perform its delivery obligations, to do so. Under the STACA, there is currently a significant volume of gas owed to the Sellers.
The Buyer did not complain of a failure by the Sellers to deliver the amounts of gas properly nominated. Rather they complained that the Sellers were in breach of an obligation to provide and maintain capacity to deliver natural gas from the Sole Pit Reservoirs at a specified rate. This was because for some years the market price of gas has fallen below the price payable under the Principal Agreements and the Buyer could have purchased cheaper gas elsewhere if they were not obliged to take (or pay) under the Principal Agreements. The Buyer contended that in order to comply with the capacity obligation, in circumstances where the production volumes of the Sole Pit Reservoirs were in decline, the Sellers ought to have taken steps to reduce the daily quantities of gas that the Buyer was obliged to nominate for delivery under the Principal Agreements, by serving Variation Notices to reduce the TRDQ. Instead, the Sellers maintained the capacity by ‘borrowing’ gas from other reservoirs. There were three key elements to the claim:
a) The Sellers’ Delivery Capacity obligation relates only to the Sole Pit Reservoirs. Any natural gas owed to the Sellers from other reservoirs cannot be taken into consideration.
b) That a term was to be implied into the Principal Agreements, whereby the Sellers’ right to serve (or not serve) a Variation Notice to reduce the TRDQ must be exercised honestly and in good faith and not arbitrarily, capriciously or irrationally.
c) That damages for breach of the capacity obligation should be awarded on the basis that the TRDQ and subsequently the Delivery Capacity would have been reduced and the Buyer would have been able to purchase natural gas from other sources at the reduced market price.
At first instance, Persey J rejected (a) and (b) and the Buyer’s claim was dismissed. Notwithstanding that the Damages Issue did not require determination, the judge found in favour of the Buyer. The Buyer was granted permission to appeal on (a) but not (b) and the Sellers cross-appealed on (c).
The construction issue
The judge at first instance considered that when viewed in isolation, the words “from the Reservoirs” in clause 6.4(1) were capable of being construed as applying only to those molecules delivered from the Sole Pit Reservoirs but that when that construction was tested against the relevant provisions of the Principal Agreements and the STACA, that construction did not hold.
The Court of Appeal identified five key points:
- This is an obligation to provide and maintain a certain capacity to deliver gas, i.e. a capacity obligation, not a delivery obligation. The fact that what is actually delivered to the Buyer is commingled gas from various reservoirs is therefore only of limited relevance.
- The capacity which the Sellers are obliged to maintain is defined as “Delivery Capacity”. It was therefore relevant to consider how the term was used in other provisions. The expectation was that the term would be used consistently throughout the Principal Agreements.
- The rate at which the Seller must be able to deliver gas is the DCQ, which is half of the TRDQ in force on any particular day. There is therefore a link between the capacity obligation and the TRDQ.
- The capacity obligation is qualified by clause 6.8 which allows the Sellers to reduce the TRDQ to repair and modify the Sole Pit facilities where that work will affect the Sellers’ “ability to supply Natural Gas under this Agreement”. The Court did not find that this was conclusive, but that it was an indication that clause 6.4(1) was concerned with the physical capacity of the Reservoirs.
- The obligation is to maintain a capacity to deliver gas “from the Reservoirs” at a specified rate. The plain meaning of the clause therefore is that it is concerned only with the gas from the Sole Pit reservoirs and not gas from other sources.
An interesting issue that arose in relation to the Construction Issue was whether the meaning of clause 6.4(1) should be determined by reference to the contractual provisions and background facts at the time the Principal Agreements were first agreed in December 1988 or when later amendments were made, even where those amendments did not change the wording of the original clause. The Buyer argued the former relying on case law and Lewison on the Interpretation of Contracts that it is unlikely that the parties would have wished to alter the meaning of the clause without actually altering its words. The Sellers argued that when a contract is amended, its terms (including those which were not altered) must be constructed in light of the background circumstances existing at the time of the amendments, with the consequence of this being that the meaning of even unaltered clauses may be changed by the amendments. Unfortunately the Court of Appeal found that it was unnecessary to determine this issue for the purpose of the appeal, as whatever date was chosen would make little or no difference to the Construction Issue.
The Court of Appeal found that the words of clause 6.4(1) provide strong support for the construction put forward by the Buyer. It then went on to consider:
- the other relevant provisions of the Principal Agreements to determine whether they confirmed or undermined this conclusion and concluded that reading the Principal Agreements as a whole supported the Buyer’s construction of clause 6.4(1) and confirmed the provisional view formed based on the language of clause 6.4(1) itself.
- there was nothing in the STACA to call into question the Buyer’s construction of clause 6.4(1) of the Principal Agreements.
- the Sellers invoked commercial common sense, submitting that it made no sense to ignore gas which is available to them, particularly in circumstances where such gas can only be used for the purpose of delivery to the Buyer under the Principal Agreements. However, the Court did not consider that this had much of a role to play in the construction of detailed and expertly drafted contracts such as those in issue here.
For all these reasons, it was held that for the purpose of deciding whether the Sellers had maintained the necessary Delivery Capacity in accordance with clause 6.4(1), it was not permissible to take account of gas from other reservoirs which was owed to the Sellers by other gas producers, in repayment of gas from the Sole Pit Reservoirs; therefore the appeal was allowed.
Assessment of damages
On the damages issue, the Buyer’s case was that, in order to avoid being in breach of the capacity obligation, the Sellers would have served one or more Variation Notices reducing the TRDQ, which would have had the effect of reducing the quantities which the Buyer was required to take and pay for under the Principal Agreements. It claimed damages (amounting to over £61 million up to the end of the 2017/18 Contract Year) consisting of the difference between the price of gas which it could have purchased on the market 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 reduced.
The Court held that the general common law principle that damages should be assessed on the basis that the party in breach had fulfilled their contractual obligations should apply and that this is not the same as saying that damages should be assessed as if the party in breach had taken steps to avoid being in breach of contract in the first place. The Sellers’ obligation was to maintain a Delivery Capacity of 130% of the TRDQ. The Sellers were not under a contractual obligation to serve a Variation Notice to reduce the TRDQ and damages could not be assessed on the basis that they were. The relevant counterfactual for the purpose of assessing damages is that the Sellers would have maintained the applicable Delivery Capacity and therefore the Buyer had suffered no loss.
The approach taken by the Court of Appeal on the Construction Issue was to construe the words of the clause and then test that construction against the terms of the Principal Agreements as a whole and then against the STACA. Whilst business common sense was considered, the Court found that it was only of limited relevance in detailed and expertly drafted contracts of this kind. This serves as a reminder that parties to contracts should not assume that an interpretation which accords most with business common sense will necessarily prevail.
Lord Justice Peter Jackson observed that this was a Pyrrhic victory for the Buyer and that might be a surprising outcome as it runs contrary to the expectation that parties who break contracts should face consequences, even more so where that party had the power to vary the obligation to avoid the breach. However, the Court reached its view by application of the terms of the contracts finding that the obligation was to maintain capacity and damages must be assessed on the basis that that capacity would have been maintained and therefore the Buyer would have been obliged to take (or pay) for the gas at the contract price. Whilst these were clearly bespoke contracts, and the facts were specific, buyers in long term commodity agreements may wish to revisit their take or pay obligations to ensure that they are not unexpectedly exposed.