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The Guide to Construction Arbitration

Construction Disputes in the Energy Sector

The energy sector is replete with major, complicated infrastructure and construction projects. In addition to the technical challenges they present, and the scope of the projects, the energy sector couples these pressures with extreme price sensitivity and interlocking deadlines. Accordingly, it should be no surprise that construction disputes are rife in this area, and often come with significant attendant publicity, given their political importance and the vast sums invested.

By way of example, when Finnish power producer TVO and construction consortium Areva-Siemens went to arbitration in a bid to resolve an ongoing €3.5 billion Finnish nuclear dispute over construction delays to the 1.6GW Olkiluoto 3 nuclear plant, it was widely reported, even in the mainstream press. There are, of course, bigger disputes in the world from time to time, but not many. This dispute has been live for eight years at the time of writing.

In addition to the normal issues (for construction arbitrations) of delay and defects (frequently relating to subterranean and subsea works, and thus difficult to rectify and remedy), energy construction disputes often also feature attendant disputes arising out of either the integrated nature of such projects or the nature of the materials involved. By way of example, the owner of a late-running power plant project is likely to face penalties under its offtake arrangements if power production is delayed - can these penalties be passed on to the delinquent contractor? If an oil pipeline suffers defects in its construction, who is responsible for the resulting environmental contamination? Is the contractor responsible just for the costs of remedying the defect, or is it on the hook for the wider damage caused - including potential loss of reputation of the employer?

Such disputes are also complicated by the high likelihood of the project being financed (whether on a sole-recourse/project finance basis or otherwise) and the involvement consortiums of owners (energy projects often being both on such a scale and so risky that even the biggest oil major is reluctant to go it alone). Evolving technologies (particularly in the renewables sector), frequently harsh environments, and political pressure to deliver projects and avoid environmental damage also ramp up the stakes in this area.

The projects

The construction projects that arise in the energy sector are many and varied - but most are linked by the common themes of high technology and low tolerance of errors. Examples range from the large civil engineering projects for dam building (in support of hydro-electric projects) to the high-tech installation of fields of solar arrays. Typical construction projects in the energy sector include:

  • laying pipeline (buried sub-surface, sunk in hundreds of metres of water, and across land, including pristine wildernesses) - see, for example, the South Stream cross-Black sea pipeline;
  • constructing power transmission infrastructure (see, for example, Peru's cross-Andes high-voltage transmission network);
  • power plants (ranging from traditional coal through to the huge nuclear power projects);
  • refineries;
  • LNG liquidation and regasification facilities;
  • port facilities for the loading and unloading of oil and LNG;
  • offshore platforms and supporting facilities (storage tanks, processing facilities, pipes, etc.); and
  • wind farms.

Each present their own unique challenges, particularly those crossing international borders, or involving construction in ultra-harsh conditions (spare a thought for those trying to construct facilities in the North Sea, offshore Alaska or off the Falkland Islands), and each have given rise to disputes - either because the projects have not been delivered on time or on budget (or both), or because they do not work as designed, or where the design itself was fundamentally flawed (for example, one dispute in the Philippines concerned a co-generation facility that was meant to harmoniously produce electricity, water and CO₂, but, in fact, due to a design failing, the production of electricity positively impeded the production of the other two products). As such matters almost inevitably give rise to substantial losses, they also inevitably give rise to disputes and, given the cross-border nature of such investments, this almost as equally inevitably means arbitrations.

The players

Although the contractors, EPC managers and material suppliers are often the same regardless of whether the project is the energy sector or not (although most of the large engineering consultants do have specialist sub-teams, focusing on power, pipelines or the like), those siting on the owner's side of the table can be different from in many other construction projects.

In relation to large projects (for instance, the Kashagan development in Kazakhstan, featuring the building of multiple offshore facilitates and the construction of a sub-surface 92 kilometre offtake pipe), frequently there is no one sole owner but rather a consortium of owners. There may or may not be an operating company, but even if such a company does exist, it will still be infected with the dynamic that comes of having to answer to multiple masters, who often have competing agendas, or at least differing stakes depending on their level of investment and the number of roles they may be taking in the overall project. This can lead to added levels of bureaucracy, slowing down projects (particularly when matters start to go wrong, and would benefit most from decisiveness) or resulting in unexpected changes of direction. Even the most stable consortium will come under pressure to break ranks and point fingers when multibillion dollar projects encounter significant overruns of time or money.

Inevitably, energy sector projects are designed in some fashion to exploit energy sources for a profit. Accordingly the owner is faced with the challenge of trying to design and build in an environment where the justification for doing so can evaporate with a change in a commodities index. In a world of $100-barrel oil, projects can afford grand designs, ‘nice- to-haves', multiple levels of redundancy and the use of the very best materials. However, a collapse in the oil price can lead to an entirely different dynamic, causing owners to seek to engage in ‘value engineering', or to vary the timing (either by accelerating or delaying) in order to catch an anticipated market upcycle or to get out of capital costs as quickly as possible. This can radically alter the dynamic between owner and employer, changing a successful project relationship to one under extreme pressure. As a general matter, though, the goal is to achieve maximum efficiency for the least possible cost - a particular factor in the world of upstream oil and gas developments where the capital costs of construction are often recovered out of oil production, lessening the profits available for distribution to both the investors and the host states. Recent years have shown strong trends towards ever more interventionist host states in this regard, with projects being audited to ensure that no ‘gold plating' is occurring, often by unleashing audit bodies designed to root out corruption and checking for black and white compliance with procurement regimes. This approach comes at the expense of specialist understanding of the real world dynamics of how construction decisions are taken, or what normal industry practice is in the energy sector (with its belt and braces approach to safety and reliability, and the constant conflict between using ex-patriot expertise and complying with ‘local content' requirements).

The eye of the state is frequently not only focussed on initial cost recovery, but contradictorily also on ensuring that the facilities represent a good bargain for it. Whether in the area of upstream oil and gas development (where facilities are typically used by the international investor for 20 or 25 years and are then handed over to the host state for the remainder of the field life at no cost to the state) or in the construction of power plants on a ‘BOOT' or ‘BOT' basis (‘build, operate, own, transfer' or ‘build, operate, transfer') where it is normal for the owner to have a certain number of years to earn an operating tariff before handing the power generation facility over to the state, the state party wants to ensure that it is getting value for its money. Will the facilities still be in good working condition decades after they are first commissioned? Will it get a return on its investment when the investor is out of the way and it can, hopefully, enter a pure profit phase? A tension is created by between the desire to build something that will last, and the desire to not depress short-term profits.

Indeed, in some projects, the owner is the state or a state entity and not a commercial actor. This can lead to headaches for the contractor, with day-to-day decision making delegated to committees or requiring multiple levels of approval. In some countries, direct state involvement may also dramatically limit the contractor's ability to protect its own contractual rights. If the state, or a major state entity, is sued, then it will frequently black-ball the contractor - meaning that an arbitration claim has to be very financially significant before it is worth giving up the opportunity to operate in country at all in the future.

Claims like ripples in a pond

Problems in energy construction projects give rise to many of the same claims that other construction projects do - however, these claims often spiral and have knock-on consequences that can be significantly greater than the basic problem of the project not being delivered as specified.

Let us take a hypothetical example: a consortium of companies is working together to develop an oil and gas field. In addition to specialist drilling works, they require the construction of numerous processing and initial storage facilities, along with the means to move the product to their markets. The consortium agrees that it will construct a pipeline to a local refinery company and enters into a crude oil supply agreement with the refiner (who then will on-sale refined products to its own customers). At the same time it is decided that the associated gas produced with the oil will be sold to a local power station, which in turn enters into a power purchase agreement with the government, with a guaranteed level of dispatch.

The consortium hires a major EPC contractor, who in turn hires multiple subcontractors. The project is delivered late. Still worse, when the oil pipeline is commissioned it is found to be leaking due to defective welding, causing significant environmental damage. It has to be immediately shut in pending repairs. Given the limited storage tanks on site, this quickly has the effect of suspending oil and gas production for several weeks.

Clearly in this scenario the employer consortium has a claim against the EPC contractor (and likely the EPC contractor against its sub-contractors) under the classic headings of delay and defective work. At the least, they would be entitled to the inevitably specified liquidated damages for delay and for the costs of remedying the defective work. However, do such standard remedies even begin to properly compensate the employer consortium in the circumstances?

Almost certainly not.

The likely issues arising in the circumstances will include:

  • the levying of environmental fines for contamination by the host state on the consortium;
  • potential public interest litigation by concerned environmentalists seeking to block further work on the projects;
  • claims from the refiner against the consortium, who has lost substantial profits as it has been unable to produce refined products while the pipeline is shut in for repair, a particular issue where commodities prices are falling;
  • claims by the power producer, who has had fines imposed under its own contract with the state for failing to dispatch enough power as it did not have enough gas to burn;
  • the consortium's own lost profits in not being able to sell the hydrocarbons they would otherwise have produced;
  • potential moves by the host state to revoke the consortium's right to continue to develop the hydrocarbon resources at all (which in turn might lead to a bilateral investment treaty claim by the investors against the state); and
  • claims within the consortium about whether the lead consortium member selected the right EPC contractor and managed it properly.

Can all, or any, of these additional losses that the consortium faces be passed through to the delinquent contractor?

It's all about the boiler (plate)

At this point, all eyes should hopefully turn to two clauses in the EPC contract: the liquidated damages provisions, and the waiver of consequential loss provisions. This, of course, assumes that such clauses exist in the EPC agreement at all, though all the major international industry forms tend to have such provisions in one form or another. Bespoke contracts (or those which have been subject to heavy one-sided negotiation (e.g., because the employer is a very dominant state entity)) may lack such clauses; the contractor may therefore face very significant exposure, depending on the default rules that apply at law (whatever that law may be, per the contract).

As is discussed elsewhere in this book, general practice in construction contracts is for the remedy for delayed completion to be in the form of liquidated damages. This common sense device means that an employer does not have to prove actual loss; thus the contractor is incentivised to hit the target date. However, often in the energy sector, when a situation such as our hypothetical one arises, the liquidated damages do not begin to reflect the scale of loss the employer actually suffers. The question then becomes whether the liquidated damages clause is intended as an exclusive remedy, such as to shield the contractor from greater exposure. Is the liquidated damages provision both a floor and a ceiling, or merely a floor? The devil will be in the detail, but the financial consequences are likely large enough to guarantee arbitration where there is any scope for doubt.

As to the wider claims, the focus will be on the consequential loss exclusion clause. General practice in standard form industry contracts is to include exclusions for lost profits and other more remote measures of damage. How tightly these exclusions are drafted will be a significant issue in circumstances such as in our example. This question will need to be examined in light of the governing law of the contract. English law has, until recently, always read such clauses narrowly. However, the recent Court of Appeal decision in Transocean v. Providence[2] suggests a new approach of seeking to give such exclusions their literal meaning - which may have the impact of giving contractors significantly wider protection than may have been understood when the contract was being negotiated. Equally, problems often arise when the industry standard form contracts (which are largely drafted to work under English law) are instead governed by a law from the civil law world. Literal (and some time last minute) transpositions often forget that common law concepts such as ‘direct' and ‘indirect' loss do not translate well (or at all) into many civil law systems - leaving significant uncertainty as to what was intended. The result? Almost certain arbitration.

Issues wider than owners and contractors

Construction disputes in the energy sector can also be at the mercy of international politics, owing to the importance of natural resources to sovereign and other international actors. One reason is that determining the entitlement to natural resources often requires the involvement of international law, since many reserves lie in areas to which claims are disputed - this is particularly the case for offshore assets - including production facilities and pipelines. By way of example, in August 2014, Somalia filed an application seeking an International Court of Justice (ICJ) ruling based on the United Nations Convention on the Law of the Sea. The question was essentially whether the maritime border should follow the land border (as Somalia wanted) or simply cut east. At stake are 64,000 square kilometres of what are currently Kenya's territorial waters, including part of the Lamu oil exploration basin. The oil exploration blocks were leased to Total and Eni, which Somalia contests contravenes Somali Law No. 37, which defines Mogadishu's continental shelf and territorial seas at 200 nautical miles. In response to Somalia's actions, Kenya voluntarily halted its (or rather Total and Eni's) oil exploration in the disputed part of the Indian Ocean as an ‘expression of its good faith', according to Professor Muigai, Kenya's Attorney-General. But where does that leave the international oil companies and the facilities they are developing?

As already noted, construction projects in the energy sector are also distinguished from general construction projects by their sheer scale and scope, which invariably warrants international cooperation. Pipe-laying, for example, often requires passage through multiple nations or seas. When a project is contemplated, the initiating country may have a choice of routes through different states - a decision with a considerable effect on international relations.

For example, Uganda has been planning a $4 billion oil pipeline that would connect landlocked Uganda to foreign markets. Both Kenya and Tanzania had been lobbying for the pipeline to cross their territory, with Kenya pushing for the Lamu pipeline, which would go through its oil-rich Turkana region, while Tanzania was competing with the Kabaale-Tanga port route. In October 2015, Uganda and Tanzania signed an agreement to explore the possibility of building a crude oil pipeline between the two countries, while Kenya believed it had already agreed a deal with Kampala, thus setting the stage for fierce competition between the countries.

Uganda has ultimately elected to export its planned crude oil production via a pipeline through Tanzania and estimates that it could have reserves of around 6.5 billion barrels of oil in place, with recoverable oil estimated at 1.8-2.2 billion barrels, and 0.5 trillion cubic feet of gas. Major investments will be made, and significant construction projects will be entered into on the basis of this sort of investment, but there are instances (particularly in the Black Sea) of such decisions being subsequently reversed.

Clearly the presence of energy construction projects is of great importance to national leaders, owing to the international recognition and associated foreign investment. It is, therefore, important to see construction projects in the energy sector against the backdrop of turbulent international relations, since such projects may assume a pivotal role in the maintenance, progression or deterioration of relations between sovereign actors - a factor out of the control of the contractor, and which may also be outside of the influence of the employer, unless investments have been carefully structured to give access to protection under a bilateral or multilateral investment treaty (such as the Energy Charter Treaty), which may give access to a remedy via an international tribunal.

Additionally, recognition of the reliance on, and significance attributed to, natural resources can present other complications for construction projects in the energy sector. Indeed, the energy sector itself is an obvious target when there is disagreement among nations. Construction projects in the energy sector may, therefore, be subject to a greater risk of complications since the energy sector may be ‘taken hostage', as a means of trying to coerce another nation to adopt, or cease, a particular course of action.

For example, it is no secret that the relations between Russia and the European Union have deteriorated in recent years. In particular, the destabilisation of eastern Ukraine has resulted in sanctions against Russia, many of which are directed against its energy sector, upon which it is largely reliant. As a commodity holding so much financial and political clout, the ability to deal with natural resources freely is not guaranteed, as these sanctions demonstrate. It is clear, therefore, that construction projects in the energy sector are among some of the riskiest in the world as a result of the often unpredictable moves of various international and national actors, whether as a result of unclear territorial boundaries, battles over securing a project on national territory, or use of the energy sector as a pawn in international disagreements.

Even in circumstances where all is smooth between the investor and the host state, there is the additional problem that such projects are a ready subject of hostile action by terrorist groups - either those seeking to make an environmental point, or those engaged in hostile actions to press an agenda with the host state. The gas pipelines in Pakistan's Balochistan region remain subject to regular attack. Those seeking to complete infrastructure and refinery projects in Iraq face the hostilities of ISIS and other terrorist threats. Such matters give rise to both practical problems in terms of security, but also to legal ones - insurance claims abound, as do claims on ‘knock for knock' indemnities - and, of course, there are perennial questions regarding at what point a country or regime becomes so unstable that force majeure conditions may be satisfied (a question increasingly asked in the energy sector in Libya, for example).

Fighting the good fight

As to the conduct of these disputes themselves, many of the same issues arise as in any construction arbitration. It is clearly desirable (depending, perhaps, on the strength of your case) to find arbitrators who have experience in both construction and energy matters. Potential sources of information on such individuals include the Permanent Court of Arbitration (who maintains lists of experienced energy arbitrators and energy expert witnesses) and the International Center for Dispute Resolution's ‘Energy Arbitrator List', which is freely available online.[3] As ever, word of mouth also remains an invaluable resource. In addition to experience, (long-term) availability will be a factor worth particular consideration. Energy construction disputes are typically highly document-heavy, involve multiple sub-issues and often are resolved over the course of years rather than months. Good availability, running far into the future, is key.

The multiplicity of parties and multiple related disputes (with interlocking contracts) also gives rise to the issue of whether or not consolidation of disputes is possible, or indeed even desirable. While always a case-specific question, anecdotal evidence suggests that despite ever greater access to consolidation mechanisms via the latest editions of the various institutional rules, parties in this sphere often prefer to keep each step in the dispute chain separate. This can, and does, of course lead to the danger and reality of inconsistent results and contractual gaps. However, there often appears to be a preference for preserving a second bite at the apple, and, as observed by Lord Justice Longmore in Sun Life,[4] such a result is an inevitable and inbuilt feature of arbitration.

Given the political and environmental dimensions of these cases, energy construction disputes can also see attempts by third parties to intervene. This is particularly the case where arbitrations are being fought in the World Bank's ICSID mechanism, where there are trends to permit both greater visibility in what is normally a confidential world as well as active intervention by way of amicus curiae briefing and interjection. At best, such interventions delay awards and increase cost. At worst, they take otherwise private disputes in different directions from those which either of the original parties would intend or desire.

Second bites at the apple

Among the reasons why arbitration is popular in energy disputes is the perceived finality of the process - typically, appeals are not permitted unless something can be shown to have gone fundamentally wrong with the arbitration process itself. ‘Wrong' results are tolerated as part of the process, in favour of avoiding multiple levels of appeal and dragging cases on still longer. This narrow approach has been re-enforced in England by the judges of the Commercial Court, who have typically heard applications to challenge arbitration awards rendered in England, and who have respected the pro-arbitration, anti-interventionist approach envisioned by the drafters of the Arbitration Act 1996. Indeed, the Court has gone so far as to now punish attempts to reopen the merits of arbitrations with awards of indemnity costs, which has had a cooling effect on attempts to encourage the Court to reverse awards. However, a recent high-profile case has shown that in construction cases that door is less closed.

In a 2015 decision of the English Technology & Construction Court, the UK government managed to achieve what came suspiciously close to such a reversal, in the cases of Raytheon I[5] and Raytheon II.[6] Although couched to fall within the scope of the existing procedural unfairness grounds of challenge, the decision of Mr Justice Akenhead came (in the eyes of many commentators) very close to a reversal on merits grounds. The decision was appealed, although a settlement was reached before the appeal was heard. The question remains though as to whether the judges of the TCC will be more willing as a general matter to second-guess arbitral tribunals in matters that fall within their ambit. This may well offer those involved in disputes in the energy sector an opportunity to fight on where previously they would have conceded defeat.

Covering the bases

Construction disputes in the energy sector involve the marriage of three specialist worlds - construction, energy and arbitration. Each has its own argot, secret signs and world views. Inevitably this leads to traps for the unwary and potential unexpected exposure. Generally when energy construction projects go wrong, there is the potential for massive, headline-grabbing arbitrations that need to be approached with knowledge of all three industries. More than anything, however, there must be an awareness that nothing happens in isolation. Every design error, or badly welded joint, risks leading to a cascade of claims. The allocation of the risk of such claims as between employer and contractor, and contractor and subcontractor, will be key to the issue of who is dragged into the fight, and who will be left carrying the can - and that is before the impact of third-party interventions from states, public interest groups and other concerned parties is felt.

Notes


[1]    Mark Beeley is a partner at Vinson & Elkins RLLP. Thanks are expressed to Ms Antonia George and Mr Craig Rischmiller for their assistance in the preparation of this chapter.

[2]    Transocean Drilling UK Ltd v. Providence Resources PLC [2016] EWCA Civ 372.

[4]    Sun Life Assurance Co of Canada & Ors v. Lincoln National Life Insurance Co [2004] EWCA Civ 1660.

[5]    Secretary of State for the Home Department v. Raytheon Systems Limited [2014] EWHC 4375 (TCC).

[6]    Secretary of State for the Home Department v. Raytheon Systems Limited [2015] EWHC 311 (TCC).

Practical insight from experts on the ground