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The Guide to Construction Arbitration - Second Edition

Energy Sector Construction Disputes

Disputes in the energy sector present a range of challenges for stakeholders in the industry, which can be particularly acute given their inherent complexity and the financial (and frequently, political) consequences of delay and disruption in production. Such complexity is often compounded by the highly regulated environment in which these projects are developed.

Notable recent examples include the 1.6GW Olkiluoto 3 nuclear plant dispute, which has been described as 'one of Europe's longest-running and most bitter corporate disputes', and the disputes arising from the cancellation of the South Stream project to pipe Russian gas to Europe. Both of these projects, while significant in terms of the sums in dispute, also bring with them increased degrees of financial pressure and political tension.

In addition to the typical construction issues – delay, disruption, workmanship and design liability – energy construction disputes also often feature attendant disputes arising out of either the integrated nature of such projects or the nature of the materials involved. The owner of a delayed power plant project, for example, is likely to face penalties under its offtake arrangements for delayed power production. Furthermore, defective work, particularly in offshore and undersea operations, may bring with them the potential for regulatory and environmental consequences.

Such disputes are also complicated by the high likelihood of the project being financed (whether on a sole-recourse or 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 raises the stakes in this area.

Typical projects

Energy sector disputes are typically linked with common themes of complex and sometimes new technology, low tolerance of defects and high thresholds for contractual and regulatory compliance. Projects in the energy sector, as one would imagine, 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 nuclear power projects, but also more sustainable options such as hydroelectric and 'energy from waste' plants);
  • 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
  • solar and wind farms.

Given the variety of types of projects, each present their own individual technical challenges. However, given the scale of some of the projects, they often involve other unique challenges such as those crossing international borders, or involving construction in harsh conditions such as in remote areas or offshore. The regulated and political environment coupled with changes in technology also provide additional challenges. In the United Kingdom, for example, the energy from waste industry has successfully contributed to reduction in the amount of biodegradable household waste sent to landfill over the past 20 years or so. However, cuts to local funding as well as increased environmental pressure, particularly given the debates over incineration versus gasification, may indicate a slowdown in the industry.

The key players: the significance of the state

Although the contractors, engineering, procurement and construction (EPC) managers and material suppliers often stem from the same organisations regardless of whether the project is the energy sector or not, those sitting 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 impacted with the dynamic that comes as a result 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 progress or resulting in unexpected changes of direction and scope, which is particularly so given the long-running nature of energy projects generally.

Profit and energy generation are generally the key motivators for new projects. Accordingly, owners are faced with the challenge of trying to design and build in an environment where the justification for doing so very quickly evaporates, in this instance, with a change in a commodities index. In a world of US$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.

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. While this can be particularly so with projects undertaken in developing nations, it is also applicable in first world developments, particularly where margins are tight. This approach can sometimes ignore the consequences of the real world dynamics of how construction decisions are taken during the course of a project, 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 focused 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 build, operate, own, transfer or build, operate, transfer basis 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. The inevitable tension between the desire to build something that will last and the desire to not depress short-term profits is inherent in these kinds of projects.

Contractors are, however, more astute then ever as to their contractual and legal rights, particularly in emerging and developing markets. Indeed, contractors are becoming more sophisticated with their understanding of local laws and how such laws may impact or drive their ability to make claims against an owner. For example, the rise of claims for 'equitable rebalancing' is becoming more prevalent in these markets and presents particular concerns for owners who typically operate in common law jurisdictions. Furthermore, the nature of large energy projects means that contractors, designers, subcontractors and suppliers more often than not come from varying nationalities and backgrounds, which brings an added legal and social complexity to the working environment.

The propensity for claims beyond typical construction disputes

Disputes in energy construction projects typically give rise to many of the same types of claims that other construction projects encounter. The differentiating factor of energy construction disputes is that such disputes can often have knock-on consequences that can be significantly greater than the basic problem of the project not being delivered as specified.

Taking an 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. As an additional consequence, 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.

The likely issues that could arise from this scenario 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.

While this is an overly dramatic example, it serves as a demonstration of the scope of potential disputes given the interlinking nature of the development of an energy facility with the wider energy market, key stakeholders and environment.

Technology drives the energy industry

It comes as no surprise that developments in technology drive changes in the energy industry. Developments in power production from coal to nuclear, for example, show how technology and energy production process have changed in recent decades. These processes, however, bring about issues as to how technology is managed in construction contracts. Owners and contractors are, quite rightly, concerned about valuable rights in process and production technology, particularly where competing states are involved. For example, the new Hinkley Point C Nuclear Plant planned for the United Kingdom brings together two competing state nuclear entities to develop nuclear infrastructure in a third state. How technology will be managed in this relationship is something that we can only watch as time progresses and will, no doubt, be closely guarded.

While there are technological developments in energy processing itself, developments in other ancillary fields also change the way energy is sourced. For example, the increase in battery technology, particularly in the automotive industry as well as in the potential for long-term power storage, has driven growth in sourcing and processing of minerals such as lithium and cobalt. Some commentators see that electrification and storage is the beginning of an era away from the traditional fossil fuels and as such, demand for such minerals could represent the 'new oil'.

The importance and reliance on new and developing technology means that disputes over design responsibility, often a key feature in large energy disputes, becomes ever-more complex. Furthermore, when determining design responsibility, it is more often than not that the experts who are constructing the facility are the only available experts who can determine the causative reasons for fault, making the search for an independent view on liability troublesome. This, coupled with the closely guarded and the commercially sensitive nature of technology development, makes these kinds of disputes novel.

Issues beyond employer–contractor disputes

Construction disputes in the energy sector can also be at the mercy of international and domestic 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 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 US$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.

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.

Taking this example slightly further, even a new governing political party in a nation can bring about significant change. For example, the widespread adoption of fracking in the United States has opened the potential for billions of barrels of oil and trillions of cubic feet of natural gas to production, and is likely to have significant impact on the global energy sector in the upcoming years. This will undoubtedly impact the incumbent OPEC producers such as Saudi Arabia and other significant producers like Russia. While many will claim this as a political and policy change victory resulting from the change from the Obama to the Trump administration, some analysts consider that the growth in US production is not driven by policy, but by other factors such as increased demand from China and India, and the likely increase for demand in petrochemicals used in plastic. Future trade relations between Europe (and the United Kingdom) with the United States, therefore, also presents potentially a new era moving away from heavy dependency on Russia for oil and natural gas.

Construction and energy specialists in dispute resolution

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.2 As ever, market reputation 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 obviously key, but a common problem for the most sought after and desirable candidates.

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 cherry, and, as observed by Lord Justice Longmore in Sun Life,3 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 of the cherry

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 the England courts that 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, as well as identifying the high threshold in establishing a serious irregularity, reflecting the reluctance of the courts to interfere with the conduct of arbitration. Indeed, the courts have 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 courts 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 4 and Raytheon II.5 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.

Summary

Energy sector disputes are the pinnacle of construction and engineering disputes in terms of complexity, commerciality and political intervention and persuasion. Generally when energy construction projects go wrong, there is the potential for massive, headline-grabbing disputes that need to be approached with specialist knowledge of the industry, the players and the political environment. 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.


Footnotes

1 Scott Stiegler is a senior associate and James L Loftis is a partner at Vinson & Elkins LLP.

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

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

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

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