Turning the taps off? Arbitration and the European gas crisis

Introduction

Since Russia invaded Ukraine, energy prices in Europe have soared. Europe is heavily reliant on Russian gas and alternative sources of gas are not viable in the short term. Unlike oil, gas cannot be easily diverted – it is either transported by pipelines or liquefied, which requires dedicated liquefaction and regasification facilities. The price of natural gas has increased by approximately 400 percent since September 2021.

Despite European governments intervening to mitigate the effects of the war and related sanctions on energy markets, the scale of the crisis as Europe enters winter is likely to mount. Against this backdrop, suppliers and buyers alike will be reviewing their contracts, looking for sanctions relief, early exits, price reviews and considering whether they could get a better deal elsewhere.

The Rouble Decree

On March 31, 2022, Vladimir Putin enacted a Presidential Decree (the Decree) under which Russian gas sold to ‘unfriendly’ countries (including the UK and EU member states) would have to be paid for in Roubles to counteract the impact of international sanctions levied against Russia. Under the mechanism set out in the Decree, buyers must first transfer funds to a Gazprombank account. This sets in motion a process whereby Gazprombank purchases Roubles and credits them to a second buyer account, and then to the seller’s account. Under the Decree, the buyer’s payment obligation is only deemed to have been fulfilled when this process is complete.

The response of buyers to the Decree has varied across Europe but, for those who refused to comply, Gazprom was quick to turn off supplies earlier this year. We also saw Gazprom shut off the Nord Stream 1 pipeline for ten days in July 2022. This was followed, in early September 2022, by a further shutdown with no end date in sight at the time of writing. Additionally, even when open, the pipeline has been operating at greatly reduced capacity (less than 20 percent at times) since the introduction of Western sanctions against Russia.

Gas supply agreements (GSAs) usually specify that prices must be paid in either US Dollars or Euros. The buyer’s payment obligation will be deemed fulfilled as soon as the relevant payment is made into the contractually-specified bank account. The Decree has therefore unilaterally changed the provisions in numerous GSAs.

These changes raise various issues. First, because payment obligations are only deemed fulfilled at the end of a complex conversion process handled by Gazprombank, exposure for buyers is significantly increased whilst this is effected – which can take days. The effect of the Decree is that buyers essentially transfer control over making payment to a third party.

Secondly, the European Commission has suggested that compliance with the Decree could be in breach of EU sanctions because: (i) it would put foreign currency in the hands of Russian entities for an undefined period, and (ii) the conversion process is “entirely in the hands of the Russian authorities”.

Buyers are having to decide what their commercial objectives are and how to respond: do they wish to continue buying Russian gas or do they wish to exit or suspend arrangements? If they accept the terms of the Decree and formally amend their GSAs, they risk being in breach of EU sanctions. Alternatively, if they reject the Decree’s terms as an invalid and unilateral amendment, they risk having their gas supplies disrupted, further exacerbating the Europe energy crisis.

A potential middle ground was proposed by the European Commission, which stated that buyers are permitted to use the Decree mechanism so long as they expressly state that they consider their payment obligations to be fulfilled when they transfer the contract price to Gazprombank. While this may be an attractive option for some buyers, it is unclear whether this approach would be acceptable to the Russian authorities.

What does the contract say?

The actions that parties to GSAs can take in response to the current gas crisis will depend on the terms of their contracts, including: sanctions clauses; force majeure and change in law provisions; price review clauses; and, the governing law and dispute resolution mechanisms. With non-performance being seen on both the buy and sell side in this crisis, parties are scrutinising risk and liability allocation in their contracts.

During the July 2022 interruption, many buyers received letters from Gazprom declaring force majeure in relation to GSAs, citing ‘extraordinary’ circumstances. Force majeure claims (or claims for sanctions relief) are also being made by buyers wishing to extricate Russian GSAs. Whether these claims will be effective in suspending liability will depend on the express terms of the contract. Force majeure however, generally involves two broad elements:

1. an event / circumstance prevents one party from performing its obligations. It is not sufficient for the event / circumstance to have merely made performance more difficult or expensive; and
2. the event in question is unforeseen and outside the control of the relevant party.

GSAs also usually define specific events which will fall within the scope of force majeure. While the prospects for success for a buyer seeking to dispute a force majeure claim will largely depend on the construction of the force majeure clause in the contract, a seller would likely struggle to succeed in arguing that sanctions qualify as a force majeure event if the seller itself is the sanctioned entity.

Non-Russia linked GSAs are also impacted by the turmoil, with prices negotiated pre-invasion now out of step with market. Long term GSAs (still common in Europe) generally include price review clauses permitting the parties to revisit the pricing formula if market conditions change (or on a periodic basis).

Dispute resolution

In the face of non-supply from Gazprom, buyers could seek specific performance. However, this outcome may be of limited value due to ongoing doubts surrounding enforceability. More likely, we will see buyers seeking damages for breach of contract. Whilst GSAs will often include a cap on the total amount of recoverable damages, this is the more attractive option; a buyer is more likely to be able to enforce an award of damages as gas sellers are likely to have assets in other jurisdictions outside Russia.

GSAs usually contain arbitration dispute resolution clauses, with the ICC and SCC being the most commonly chosen institutions. However, this is not a swift route to resolution, with this type of complex arbitration usually taking at least 12 months and often considerably longer between the request for arbitration being issued and the tribunal issuing an award.

A potential solution to this issue which is offered by various institutions (including the ICC and SCC) to parties that require urgent measures to be taken, would be to apply for an emergency arbitration. If permission is granted by the relevant institution, an arbitrator can issue an emergency order or award within a considerably shorter timeframe. That said, whilst speed is attractive, enforcement of emergency orders may not be straightforward.

Conclusion

As we enter the European winter with the war in Ukraine ongoing, the terms of GSAs are going to be tested, with drafting being scrutinised and challenged across a whole raft of provisions – sanctions, force majeure, variation, change in law, price review, termination, governing law and jurisdiction. Inevitably the fall out of this crisis will be legal disputes, most of which we would expect to see determined in international arbitration.