Energy Sector Construction Disputes

Disputes in the energy sector present a range of challenges for stakeholders in the industry. Such challenges can be particularly significant given the inherent complexity of disputes in the sector 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.

Construction and energy sector disputes undeniably dominate international arbitration both in number and value, with the highest value arbitral awards arising from arbitrations in these fields. This is perhaps unsurprising, given the protections around enforceability of arbitral awards, coupled with the inevitable geographical split between owner, contractors, suppliers and the like. The successful resolution of energy disputes, as indeed with the successful completion of energy projects themselves, rely heavily on the expertise of the parties involved. The ability of parties to select arbitral tribunal members with relevant and specific experience is a key piece of the puzzle in achieving a successful resolution.

Construction disputes arising within the energy sector often result from many of the common issues that arise in large construction projects more generally, including claims relating to time and delay, defect, quality and performance, and payment and variation disputes. However, given the large-scale and often long-running nature of many energy sector projects, as well as the highly technical nature and huge costs associated with their infrastructure elements, more complex disputes typically tend to follow. This is often not helped by the complex contracting frameworks that are often involved, and the associated payment and risk/reward-sharing structures. Add to this the level of political pressure that often follows large energy projects, and it is easy to see how construction disputes within the energy sector bring about a ‘perfect storm’.

In addition to the typical construction issues, energy sector construction disputes also regularly feature attendant disputes arising out of either the integrated nature of such projects or the nature of the end product. The owner of a delayed power plant project, for example, will doubtless face penalties under its offtake arrangements for delayed power production. Furthermore, defective work, particularly in offshore and undersea operations, is likely to carry the real risk of regulatory and environmental consequences for the owner.

Energy sector construction disputes are further complicated by the likelihood of the project being financed (whether on a sole-recourse or project finance basis, or otherwise) and the frequency with which the owners in such projects are consortia (energy projects often being both on such a scale, and carrying such significant risk, 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 all serve to raise the stakes higher still.

Ultimately, in addition to the complexity, scale and nature of the asset being developed, construction disputes in the energy sector are heavily driven by the number of players in the dispute. In general, the more significant and complex the asset, the greater the number of interested parties, and consequently the higher the likelihood that any dispute arising out of the construction of the asset will become multifaceted.

The nature of typical disputes

Energy sector construction 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. As one would imagine, projects in the energy sector include:

• laying of pipeline (buried subsurface, sunk beneath hundreds of metres of water, and across land with vast variances in its natural features);
• construction of power transmission infrastructure;
• construction of power plants (ranging from traditional coal to nuclear power projects, but also more sustainable options, such as hydroelectric and ‘energy from waste’ plants);
• construction of refineries;
• construction of liquefied natural gas (LNG) liquidation and regasification facilities;
• development of port facilities for the loading and unloading of oil and LNG;
• construction of offshore platforms and supporting facilities (storage tanks, processing facilities, pipes, etc.); and
• development of solar and wind farms.

Each of these types of project presents its own individual technical challenges. Given their scale, many involve additional challenges, such as those crossing international borders or involving construction in inhospitable environments; for example, in remote areas or offshore.

The regulated and political environment, coupled with development in technology, expand the breadth of the challenges further still. In the United Kingdom, for example, the energy from waste industry has successfully contributed to a reduction in the amount of biodegradable household waste sent to landfill over the past 20 years or so. Energy from waste, however, is not truly a source of renewable energy in the same way as solar or wind. The ease with which household waste can be treated through these facilities has also had an impact on recycling rates. Incinerating otherwise recyclable materials to generate electricity discourages efforts to preserve resources and potentially even creates a disincentive to generate less waste. It is no surprise, then, that there are links between the pressure to utilise these facilities and reduced recycling rates.

Energy sector construction disputes – beyond the ordinary

There is no ‘one size fits all’ approach to the development of an energy-producing asset. Like any large project, there is a natural life cycle to energy projects – typically, feasibility and initial design development, procurement, design and engineering, construction, commissioning and start-up, and operation and maintenance. Each of these phases contributes to the complexity of the project and, indeed, these various stages will doubtless overlap and have interrelating features.

Feasibility and initial design development

In the early stages of an energy project, feasibility is the primary focus. This is usually a careful balancing act of various factors, covering the usual array of issues, such as cost, time, risk and reward. No two energy projects are the same, and each project will require its own decision-making analysis. This analysis is primarily aimed at understanding the commercial aspects of the project in the context of the current and future market.

Added to this is the close consideration of regulatory, social and political factors. This may cover the development of assets in particular areas because of government incentives, or the identification of new technology that may give a party an added edge in exploiting an energy development. These factors can be more easily influenced by external factors, such as changes in government or policies or changes in the development of competing technology.

Invariably in larger disputes, fingers will be pointed at early representations and decisions that were made based on those early representations. This period in the project, and the way the parties behave, can be highly influential in the ultimate execution of the project. This is particularly so when there are drivers that push a project forward when it may otherwise have been considered unviable on a purely commercial basis, adding a further layer of sensitivity in any subsequent dispute.

Procurement strategy

Another influence on the nature of later disputes is the procurement model adopted. The choice of the delivery model is a risk management exercise in itself, involving a balancing of various factors, including, for example:

• the complexity of the engineering contemplated for the project;
• the control an owner wishes to retain (particularly in relation to design);
• time constraints;
• the experience, resources and capability of the owner;
• the experience and capability of designers and contractors, particularly where new or patented technology is involved;
• the physical size of the project;
• the geographical location of the project;
• the indicative cost of the project;
• the owner’s appetite for risk; and
• the requirements of any financiers.

There are advantages and disadvantages associated with each of the differing models, and the decisions made during this period will impact on subsequent disputes. For example, traditional disputes arising from quality and variations are more likely to arise in lump sum contracting arrangements, whereas more complex disputes are likely to arise around risk/reward models and cost overruns where there are more complex pricing arrangements and more owner influence in decision-making.

Design and engineering

The design and engineering of an energy project can be a highly complex area. In large energy projects, it is commonplace for there to be a detailed front-end engineering design phase prior to an investment decision being made. The primary purpose of this stage is for a basic engineering design to be developed, from which an indicative cost package can be prepared to allow an owner to make a decision on investment. This phase, however, can be fertile ground from which points that feature heavily in subsequent construction disputes may be harvested.

Decisions made during the design stage have perhaps the most impact, positive or negative, on the later progress of the project. Typically, designers will define the functional requirements: how the facility is to perform and under what operating conditions. From this point, generally the design is developed, materials and components are selected, operator requirements are integrated and other factors, such as design life, are taken into consideration. In parallel, detailed costing scenarios are developed to ensure the design of the facility will fit with the owner’s costing and financing arrangements. Most technical challenges are identified and managed during this stage.

It is not uncommon for the eventual contractor (usually an engineering, procurement and construction contractor) to work hand in hand with the owner to develop and refine the front-end engineering design. While this has the advantage of collaboration, the contractor’s interests are not always aligned with the owner’s. For example, contractors may be forced to adopt working methodologies they would not select if the choice were entirely their own, probably as a result of pricing pressure, brought to bear to ensure the project can be completed within certain cost constraints. Depending on the pricing methodology for the construction works, these issues tend to simmer, bubbling to the surface at a later stage.

Construction

One hallmark of construction disputes in the energy sector is the duration of the construction, with time periods typically being measured in years. The scale of these projects alone brings inherent complexity in supply chain, access, logistics and workforce management. Challenges will also arise if projects are being undertaken in inhospitable locations, such as offshore or in remote or developing regions.

As touched on above, construction disputes are almost invariably founded on the balance in the contracting framework. Timely performance is often a central cause, and likely to lead to significant financial consequences. Like most traditional construction disputes, claims that stem from delay or disruption include, on the one hand, increased build costs, exposure to liquidated damages or reductions in any contractual incentive regimes, and on the other, claims arising from losses to production, breach of ancillary agreements and those relating to the financing arrangements. Given the importance of energy projects, disputes are also likely to bring with them the added pressure of government influence and publicity.

In addition to timely performance, the cost of performing the works, and changes thereto, is another key root for disputes. There is no fixed approach to payment in construction contracts, which can range from a lump-sum turnkey approach right through to a hybrid of payment methods over different stages of the performance of the work. Of course, payment is closely associated with risk allocation, and just because a contracting arrangement is traditional or straightforward does not mean that disputes will not arise. Indeed, disputes arising from traditional lump-sum contracts have the same propensity to arise as those in which the parties have carefully allocated risk and reward between them.

Environmental concerns during the construction phase are also commonplace, and can be problematic for owners and contractors alike. Taking wind farms as an example, these represent a new source of impact and disturbance for birds. This can manifest itself as a direct impact from bird strikes to more subtle impacts, such as changes in breeding and migration patterns. Depending on how and when these issues arise, both parties could face delays and claims for additional costs, as well as possible sanctions.

Commissioning and start-up and operation and maintenance

Following construction is the critical phase of commissioning and start-up. It is during this phase that risks associated with materials, workmanship and quality tend to arise. The range of risks that can arise span those that relate to snagging and other contractual non-conformances (such as in respect of materials and workmanship), right through to ‘failure’ scenarios, where the asset fails to meet performance level requirements, for example. Needless to say, the consequences of such a range of issues can be equally broad in scope. Even if a plant passes the start-up steps, quality-related issues can still arise during the operation and maintenance phase.

The key players: the significance of the state

Many of the instantly recognisable global entities (whether or not they specialise in the energy sector) will appear as contractors, construction managers and material suppliers in construction projects within the energy sector. Often, those sitting on the owner’s side of the table are not such familiar faces – there are relatively few owners with multiple truly large-scale energy projects on their ledger.

Profit and energy generation are generally the key motivators for new projects. Owners are faced with the challenge of trying to design and build in an environment where the justification for doing so can evaporate at the drop of a hat if, for example, there is movement 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, volatility 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) to catch an anticipated market upturn, or to get out of capital costs as quickly as possible. This can radically alter the dynamic between owner and contractor, shifting a successful project relationship towards one that is operating 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. This often occurs when audit bodies, designed to root out corruption and check for black-and-white compliance with procurement regimes, are unleashed. One may be forgiven for assuming that this applies more to projects undertaken in developing nations, but it is also applicable in first world developments, particularly where margins are tight. It should be noted, however, that this approach can sometimes ignore 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 expatriate expertise and complying with ‘local content’ requirements).

Perhaps unsurprisingly against this backdrop, contractors are more astute than ever as to their contractual and legal rights, particularly in emerging and developing markets. Indeed, contractors are becoming ever more sophisticated in their understanding of local laws and how such laws may impact or drive their ability to make claims against an owner. Claims for ‘equitable rebalancing’ are becoming more prevalent in these markets and present particular concerns for owners who typically operate in common law jurisdictions. The nature of large energy projects dictates that contractors, designers, subcontractors and suppliers, more often than not, consist of a diverse range of nationalities and backgrounds, bringing an added legal and social complexity to the working environment.

The energy transition – paving the way for future construction

The energy transition is the shift from a system reliant on fossil fuels (oil, gas and coal) to one that is primarily supported by clean, renewable sources of electricity. The aim of the energy transition is to reduce energy-related carbon dioxide emissions to limit climate change.

The International Renewable Energy Agency (IRENA) recently reported that, despite clear evidence of human-caused climate change, widespread support for the Paris Agreement and the prevalence of clean, economical and sustainable energy options, energy-related carbon dioxide emissions increased 1.3 per cent annually, on average, between 2014 and 2019.^[2] Notably, while emissions declined 7 per cent during 2020 as a result of the global coronavirus pandemic, IRENA feels that a rebound is very likely.

IRENA considers that the driving force in the energy transition is the combination of increasing the use of low-cost renewable power technologies and the wider adoption of electricity to power end-use applications in transport and heat.^[3] For the construction industry, this means growth in not only the development of energy-producing assets, transmission and distribution networks and storage, but also the development or conversion of infrastructure assets.

Technology drives the energy industry

It comes as no surprise that developments in technology are the driver behind changes in the energy industry. Developments in power production from coal to nuclear, for example, show how technology and energy production processes have changed in recent decades. These processes, however, bring about issues of their own as to how technology is managed in construction contracts. Owners and contractors are also, quite rightly, concerned about valuable rights in process and production technology, particularly where competing states are involved.

As well as 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 the 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 of, and reliance upon, new and developing technology means that disputes over design responsibility, often a key feature in large energy disputes, become ever more complex. When determining design responsibility, the experts who are constructing the facility are often the only available experts who can determine the causative reasons for fault, rendering the search for an independent view on liability troublesome. This, coupled with the closely guarded and commercially sensitive nature of developments in technology, sets this type of dispute apart.

Issues beyond employer–contractor disputes

Construction disputes in the energy sector can also be at the mercy of international and domestic politics, primarily as a by-product of the importance of natural resources to sovereign and other international actors. Determining entitlement to natural resources often requires recourse to international law, as many reserves lie in areas to which claims of ownership are disputed. This is particularly true of offshore assets, including production facilities and pipelines.

As noted above, construction projects in the energy sector are also distinguished from general construction projects by their sheer scale and scope, which invariably warrant 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 that may be guided by existing international relations, and with the potential to have a considerable effect on future international relations.

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, as 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 that may also be outside of the influence of the owner, 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 provide access to a remedy via an international tribunal.

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 as the energy sector may be ‘held hostage’, as a means of trying to coerce another nation to adopt, or cease, a particular course of action.

Investor–state disputes in the energy construction sector

During the past decade, there has been an increase in disputes on investments, and more specifically on investments in renewable energy. Because of global or regional policy initiatives, there has been an increase in national legislative and regulatory reform aimed at promoting and boosting the development of renewable energies in certain countries. The regulatory framework created by these countries was generally based on premiums and feed-in tariff schemes. A notable example of the pressures caused by these schemes is Spain.

Spain saw an opportunity to become a world leader in the production of clean energy. During the early 2000s, it promoted a favourable legislative framework for the investment and production of renewable energy, mainly with the entry into force of Royal Decree 661/2007, of 25 May 2007, which regulated the activity of electricity production under a special regime. This Decree introduced a series of highly favourable remuneration measures that attracted foreign investment.

Problems arose shortly after the Decree came into force, through the realisation that the tariff deficit was too generous in the wake of the global financial crisis. This triggered a series of new regulatory measures between 2010 and 2014 that led to a decrease in the advantageous conditions for investors. The enactment of Royal Decree 413/2014 and Order IET/1045/2014 in 2014 established a new regulatory framework applicable to existing and new projects, which completely abrogated the 2007 regime. For investors, the changes have significantly impacted the short- and long-term value of the assets being developed.

As a result, more than 40 arbitrations have been requested against Spain, claiming compensation of billions of euros based mainly on the breach of the fair and equitable treatment standard and legitimate expectations of the investors.

It is widely accepted that the investor’s legitimate expectations rely on the fair and equitable treatment standard (i.e., a fair and equitable treatment of their investments by host states). These expectations can rely either on particular commitments addressed specifically to an investor via a stabilisation clause in a specific agreement or contract or on the regulatory framework favourable to granting benefits and advantages to investments.

The key issue to consider in these disputes is how much of the investors’ legitimate expectations can rely on a legal and regulatory framework in a given time, taking into account that any state is entitled in its sovereignty to reform this framework to accord with variable economical and sociopolitical circumstances.

Obviously, on one side, a state cannot be limited to legislate and regulate the country on behalf of the public interest. As the tribunal in the Masdar arbitration stated, ‘a limitation of the State’s legislative power can only be derived from constitutional principles in the internal legal order and possibly rules of jus cogens in the international legal order’.^[4] On the other, the investors would have legitimate expectations of the regulatory framework with the confidence that, if amended, their legitimate interests would be taken into account.

Therefore, tribunals are required to assess whether the host state, when making amendments to regulations, has taken into account not only the public interest and the specific political and economic circumstances, but also the investor’s legitimate expectations. As the tribunal in Eiser stated, ‘the question presented here is to what extent treaty protections, and in particular, the obligation to accord investors fair and equitable treatment under the [Energy Charter Treaty], may be engaged and give rise to a right to compensation as a result of the exercise of a State’s acknowledged right to regulate’.^[5]

There must be a proportionality between public and private interests. If the state fails to do so and disregards the legitimate interests of the investors, the investors will be entitled to the payment of a compensation based on the breach of the fair and equitable treatment standard by the host state. Notwithstanding the foregoing, there is no globally accepted method to assess the correctness of the host state’s actions other than the agreement that these actions must be reasonable and proportionate. The ‘proportionality’ and ‘reasonableness’ must be measured by each tribunal differently, on a case-by-case basis, taking into account all the factual evidence for every situation. It is thus the case that demands based on the same regulatory reforms can lead to different outcomes.^[6] At least in the Spanish scenario, what the cases reveal is that, to assess the proportionality and reasonableness of the state’s measures fairly, tribunals ought to consider several factors: the legislative framework, together with other assurances provided by the host state; the political and economic situation in which the investor decided to invest; whether there is a radical change of the regulatory framework that causes serious damage to the investor’s legitimate interests, and why; and whether the investor took all the steps that any prudent investor would have taken when deciding on the investment and its risks.

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 the 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 (which maintains lists of experienced energy arbitrators and energy expert witnesses) and the International Centre for Dispute Resolution’s Energy Arbitrators List, which is freely available online.^[7] As ever, market reputation remains an invaluable resource. In addition to experience, 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.

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 International Centre for Settlement of Investment Disputes 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 that 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 reinforced in the English courts that have typically heard applications to challenge arbitration awards rendered in England, and that 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, by way of adverse awards of indemnity costs, those parties seeking to reopen the merits of arbitrations, which has had a cooling effect on attempts to encourage the courts to reverse awards. However, English authority has shown that in construction cases that door is not always closed.

In a 2015 decision of the English Technology and Construction Court, the UK government managed to achieve what came suspiciously close to such a reversal, in the cases of Raytheon I^[8] and Raytheon II.^[9] 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. 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 Technology and Construction Court 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, political intervention and persuasion. Generally, when energy sector 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 the owner and contractor, and as between the 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