Damages in Gas and Electricity Arbitrations

Introduction

The nature of damage in the electricity and gas sectors can be quite disparate depending on the part of the value chain in which the dispute has arisen. Damage can relate to competitive parts of the value chain, such as generation or supply. It can also relate to regulated activities such as transmission, distribution or support for generation from renewable energy sources. It would be too wide-ranging to try to cover the full breadth of these in electricity and gas disputes so we focus in this chapter on the estimation of damage relating to competitive parts of the value chain.

As with many, if not all, other sectors, damage in electricity and gas supply most commonly arises through breach of contract. If a party has entered into a contractual obligation to supply electricity or gas that it does not fulfil, the buyer under the contractual arrangement may incur damage. Similarly, the seller may incur damage under a contractual arrangement if the buyer refuses to fulfil its obligation to accept delivery and pay the agreed price. Reasons for the non-fulfilment may be manifold, ranging from a ‘simple’ unwillingness (for example, owing to commercial reasons) to technical issues (for example, resulting from delays in constructing a power plant that was supposed to generate electricity to be sold under a contract).

Damage may also arise as a result of expropriation of an asset by government or state authority, for example, the unreasonable withdrawal of a power plant’s operating licence.

Breaches of competition law may also give rise to damage. A party may have held a dominant position in the relevant market (either as a single firm or jointly with other market players), which allowed it to impose conditions that it would not have been able to impose had it been subject to the constraints of effective competition. An abuse of a dominant position may take the form of unfair prices or trading conditions that causes damage to the counterparty. Although these types of claims are most commonly dealt with through national courts, they have also arisen in arbitration (but are not the focus of this chapter).

The specific nature of the electricity and gas sectors creates a high propensity for disputes to arise and significant complexity in estimating the damage. In particular, the sectors are characterised by the following:

  • Long-duration contracts: The generation of electricity and the production and delivery of gas both typically require the construction of long-lived dedicated infrastructure (for example, a power plant or long-distance gas pipeline). Given the large up-front and sunk investments, investors will often seek to secure their investments with long-term (sales) contracts, which can lead to similar long-term contracts further down the value chain. Long-duration contracts mean that any persistent breach of contract obligations may create significant damage. Similarly, long asset lives mean that expropriation of an asset or the underperformance of an asset may create significant damage. Long-lived assets and long-duration contracts also potentially increase the complexity of estimating damage, if it means the value of gas or electricity must be projected many years into the future.
  • Limited ability to store electricity (and gas):[2] This leads to the value of electricity potentially varying substantially over time, further complicating the estimation of damage. Electricity is difficult and expensive to store. Even with the limited storage technologies that exist (for example, pumped storage and batteries), the supply of electricity from all sources (including storage) needs to be balanced second by second with the demand for electricity. Since the demand for electricity varies over time, the value of electricity also varies significantly over time. This variation in demand also means that contractual arrangements for electricity (or gas) delivery often include some specificity or the time profile of volumes or the flexibility that either party may exercise as to the volume to be delivered during a particular period. These special arrangements in supply contracts need to be taken into account when calculating damage.

So, how does one go about estimating damage, assuming some breach of contract or expropriation has occurred?

The broad framework for estimating damage in the electricity and gas sectors is the same as for other sectors. Damage equals the difference in value between the factual and ‘but for’ cases. Within this framework, damage estimation typically entails at least four steps, which we use as the structure for the remainder of this chapter:

  • establishing the factual case;
  • establishing the ‘but for’, or counterfactual, case;
  • determining the correct perspective for the damage estimation (ex ante or ex post); and
  • valuing the damages.

Computing the present value of these damages to arrive at the amount to be compensated is typically the fifth and final step (which we do not cover in this chapter as the discounting issues involved are not specific to gas and electricity).

The factual case

As in any damage estimation, the starting point is to establish the factual case. This is not always as simple as looking at actual developments following the breach.

Generally, it is necessary to exclude from the damage calculation the effects that are unrelated to the breach. Depending on the situation, it may also be appropriate to exclude effects that could have been avoided if the harmed party had taken appropriate and reasonable mitigating measures. In the case of a long-term contract, with damage extending into the future, the factual case may also need to be projected into the future.

How the factual case is established in practice depends on the perspective for the damage estimation (i.e., ex post or ex ante – see below).

The counterfactual case

The ‘but for’ or counterfactual is the situation in which the parties would have found themselves if it were not for the breach of contract or expropriation.

Sometimes the counterfactual can be relatively straightforward to establish. In the case of non-delivery under a contract, the counterfactual may be that a pre-specified volume of deliveries would have taken place during a pre-specified period at a pre-specified price. In the case of an unfair contractual term, such as an excessive price, the counterfactual may simply be the ‘fair’ price, with everything else being constant.

In most cases, establishing the counterfactual may be more complex. For instance, what would have been the volume and timing of deliveries in a contract if the buyer or seller had optionality over delivery volumes? If an electricity generation asset had been available six months earlier but for a delay in construction, how would this have affected market prices and, therefore, the value of electricity sold on the market? How would those changes to market prices have affected the value of other assets in the harmed party’s portfolio?

Suppose a gas trading and retail supply company purchased the bulk of its gas needs through a single long-term contract. The seller terminates the contract in breach of its obligations and the supplier markedly reduces the scale of its retail operations. Aside from the disputed contract, the counterfactual could be a larger company with, for example, higher staff and accommodation costs, greater credit requirements and more retail customers.

Some of these complexities are more likely to arise in less competitive markets or if the asset in question is sufficiently large to affect market prices. With a competitive market, a new player’s entry (or lack of entry) would be expected to have an immaterial effect on the market price. Similarly, the delayed delivery of a small generation asset (relative to the size of the market) is likely to have an immaterial effect on the price.

Ex post versus ex ante perspective

There are two conceptual approaches to estimating the loss of value caused by an infringement or breach: the use of ex ante information and the use of ex post information.

  • The ex ante approach uses only information available essentially at or prior to the breach to estimate the value destroyed by the breach.[3]
  • The ex post approach uses information that becomes available after the breach – thus, the latest available information – to estimate the value destroyed by the breach. This approach can be applied with respect to both past damage and future damage.

A combination of the two conceptual approaches may also be used; for example, ex post information could be used to estimate damage from the time of breach until the present, and ex ante information could be used to value the damage that is expected to arise in the future. The legal framework will dictate which approach should be used or whether there is any option to use either.

Given the nature of electricity and gas markets, with prices that vary over time, taking an ex ante view or an ex post view can result in materially different damage estimates. The option to choose after the fact between the two approaches, so as to arrive at the highest or lowest valuation of damage, is a valuable option that neither party to a dispute would have had at the time of the breach.

Ex ante view

With an ex ante perspective, the basic principle is that the damage should be the change in value caused by the breach or infringement, typically measured at the time of that breach or infringement. When an asset is expropriated, the measure of damage is the fair market value of the asset at that time (or, strictly, before knowledge of the breach).

The application of the ex ante perspective typically requires the breach to be traceable to a specific point in time – this may either be the point of the breach or the point in time at which the damaged party became aware of the breach or underperformance.

Electricity and gas are traded, and in most markets the majority of electricity and gas is contracted for, well in advance of delivery. If companies can value electricity and gas well enough to buy and sell in forward contracts, it would normally be possible to value electricity and gas for the purposes of a damage calculation in an ex ante format. For example, when a power purchase contract is breached by the seller, creating an open position for the buyer (who had already resold the electricity they expect to receive), the buyer would close that open position through forward trades when it becomes aware of the breach. So all, or a large part of, the damage of future non-delivery under the breached contract may already become obvious at that point in time through the additional hedging costs incurred.

In some cases, there may be no option but to use ex ante information. Future damage cannot be analysed ex post without waiting until it is no longer in the future, and so, in some circumstances, the ex ante view revealing the lost value at the time of the breach (or award) may be the only practical approach. Some electricity and gas contracts have termination clauses that work in this way, with provisions for compensating the parties based on the (future) value lost as a result of termination (since it would be impractical to wait until the contract would have reached its full term – potentially many years later – to calculate termination payments ex post).

Ex post perspective

Depending on the case and legal framework, some damage may be more amenable to ex post calculation. For example, a continuous infringement, such as excessive prices, may only be detected retrospectively, so damage may be best estimated ex post as the difference between the actual excessive price and the counter­factual of what would have been a fair price. Assuming the abusive behaviour, once detected, does not extend into the future, an ex ante approach may not be required.

Similarly, non-performance under a contract may continue for a lengthy period, but the duration of non-performance may not be known at the time it first occurs. In this case, it might be more practical to compare ex post the counter­factual of what should have happened with what actually did happen, albeit ex ante approaches may still be available.[4]

The use of ex post information does not always provide an unambiguous answer that removes all uncertainty associated with the damage calculation. For example, when there is a traded market for gas and electricity, should ‘actual’ prices be derived from prices for contracts for delivery the next day, delivery the next month or delivery the next year? What time profile of deliveries should be applied following the breach if the contract provided for optionality over delivery volumes?

Additional complexities associated with calculating damages

In simple terms, the damage incurred as a consequence of a breach of contract, expropriation or competition infringement is the difference in value between the factual and the counterfactual cases (using either ex ante or ex post – or a combination of ex ante and ex post – valuation).

The simplest approach to calculating damages, theoretically, is to observe the effect of the breach on the change in market value of the harmed firm (if this is possible). However, even when possible, this is not straightforward, since the value of the firm may have begun to change prior to the breach if expectations of the breach emerged in the preceding days, weeks or months. In addition, unrelated events may have affected the market value of the company contemporaneously with the information about the breach becoming known. Adjusting the change in market value of the firm to exclude the effect of wider changes to a market or utilities more generally may help.

In some sectors, it is possible to observe around the time of a breach the value of transactions for similar assets and to use those values to estimate the effect of the breach on value. In electricity and gas, assets tend to be unique in the sense that there is no precise replica of a gas field or power station, and a trading or retail supply company has its own set of contracts and customers. This may make it difficult to find sufficiently comparable transactions.

To calculate damage, one would most likely need to revert to an alternative approach: estimating the change in value over time owing to the breach. To simplify the discussion, we describe this approach in terms of the early termination of a long-running contract to deliver gas or electricity to the wholesale market. However, many of the same principles can be applied to other situations, such as delayed power station commissioning, expropriation or excessive pricing.

The value of the contract at termination is the difference between the expected present values of two future streams: (1) the anticipated market value of the electricity or gas that would have been delivered under the contract and (2) the amounts expected to be payable under the contract. If the contract had endured, the buyer could have expected to earn this difference as a profit; the loss in expected profit following termination constitutes the damage. In cases like this, the market value of the commodity delivered would typically be estimated ex ante, at termination based on expected prices. However, an ex post perspective might also be taken, depending on the legal framework. To the extent that termination caused a material change to other costs (e.g., additional procurement costs to replace the power or avoided fuel costs in not generating), these should be taken into account. In practice, this may lead to a number of challenges.

First, consider the counterfactual. As the value of gas and electricity can vary substantially over time, it is necessary to understand the time profile of when the electricity or gas under the contract would have been delivered. It is then necessary to establish the price that would have been paid to receive those deliveries, the payments for the deliveries and when the payments would have been made under the contract. This information can normally be derived and, if necessary, projected into the future, based on the contractual terms.

Next, consider the factual setting. It is necessary to estimate the market price for gas or electricity that was not delivered and needs to be replaced to close an open sales position. Again, this analysis would need to use the same profile of deliveries as for the counterfactual[5] and would need to consider what the market value (buy price) of the deliveries would have been and when payments for the replacement gas or electricity would be made. Other terms in the contract, such as delivery options and delivery location, should also be valued relative to standard market products.

The appropriate ‘factual’ case may not be what is observed to have actually happened for two reasons. First, the wronged party typically would be expected to mitigate damage reasonably (e.g., by closing an open position as described above in forward markets instead of relying on spot markets – for simplicity, here we assume that closing the open position would have been ex ante the best option for mitigating damage or consistent with the damaged parties’ pre-existing trading strategy). If the damaged party failed to do so, there may be a difference between the appropriate ‘factual’ and the observed actual. Second, in the case of a long-term contract, the factual case must be projected into the future, meaning that it cannot be observed.

Estimating the market price for replacement gas or electricity in practice is also more complex than implied here. Delivery contracts have specific profiles or terms that may deviate from standard traded products for which market prices are observable. A comparator analysis draws on the market prices of similar traded products, if available. If not available, the way in which the market works may be sufficiently well understood that the market can be simulated to estimate market prices, and hence estimate damage. We focus on the comparator approach first and later return briefly to the modelling approach.

Comparator approach

The more common approach used when estimating damage in the electricity and gas sectors is some form of comparator approach.

Often, ‘perfect’ comparators, which could be used directly to provide a market price for replacement gas or electricity, do not exist because contracts with the precise specifications of the long-term contract in question are not traded regularly. Even when traded, the price at which they are traded is often not observable by the parties to the dispute. Therefore, the closest possible, but still imperfect, comparators are normally used, adjusting for differences between the terms of the contract in question and those of comparator products.

To make appropriate adjustments, it helps to consider the essential characteristics of electricity or gas contracts. A contract for the delivery of electricity or gas to the wholesale market would typically entail the following components:[6]

  • Delivery of the commodity: This is just the delivery of electricity or gas, usually the essence of a supply agreement, and can be thought of as the delivery of a uniform volume during each hour or day of a given period (e.g., a calendar year) of a standard traded product.
  • Shape: Typically, a commodity contract provides for a volume that, although fixed in advance, may vary by delivery period; for example, more gas is delivered in winter than in summer and more electricity is delivered during the day than at night. A contract that provides for greater volumes to be delivered when the market-wide demand for the commodity is higher is typically more valuable than a contract with a uniform delivery profile.
  • Flexibility: Until some point in time prior to delivery, the contract may provide the buyer or seller with the option to nominate the delivery volume within certain limits. For example, the buyer in a gas supply contract may be able to take gas within a year, opting for any volume between minimum and maximum annual contract quantities. This type of flexibility is valuable to the party with the option and may reduce value for the other party.
  • Location: Delivery of electricity or gas under the contract may take place at a specific network location. This would need to be compared with the delivery location of the comparator product and, if they differed, an adjustment made for the cost of transportation.
  • Payment terms: The terms of payment under the contract and under the comparator product may constitute a value to one or other of the parties. For example, if payment for delivery in one month is due in the middle of the next, the seller is providing the invoice amount as working capital to the buyer for an average period of one month.
  • Other terms: The contract and comparator products may include other terms that need to be valued, such as the quality of gas delivered (although complex price terms may do this automatically), credit support and exposure to force majeure.

Valuing many components of a contract can be complex. However, the task can be made easier in two ways. First, since we are using a comparator approach, we are only interested in the differences between the terms of the contract and the terms of the comparator product.[7] Second, the vast bulk of the value is likely to sit with only a few of the components. If the less critical components cannot be valued, it may not have a material effect on the overall damage estimate.

We discuss potential methods of valuing each of the components below. The approaches used to value each component in electricity and gas markets are similar, in principle, to those used when determining the value or price of a contract in the first place, or during price reviews of long-term energy contracts.

Commodity

The value of commodity electricity or gas at the wholesale level may best be reflected by the price at which it is traded. Exchanges, brokers and price-reporting firms make available market prices for standard contract products; for example, a calendar year product for gas or electricity that entails the delivery of a fixed volume of gas or electricity for every hour or day of a specified year, a quarterly product that entails the delivery of a fixed volume for every hour or day of a specified quarter. With the ex ante approach, the market price available at or before the breach is relevant for contracts for delivery in the period contemporaneous with delivery under the disputed contract. If the market price is not available in the relevant jurisdiction, one could potentially use market prices for other jurisdictions or at other points in the value chain within the same jurisdiction (e.g., regulated wholesale prices, published import prices or even final retail prices, with appropriate adjustments to reflect the expected difference between retail and wholesale prices).[8]

Gas and electricity are regionally traded commodities (and in the case of gas, globally traded to some extent). This means market prices for other jurisdictions could provide useful information about the price in the relevant jurisdiction. An adjustment for transportation cost differentials may be required (see below).

If the market price in the relevant jurisdiction is not available for products for delivery sufficiently far into the future, it may be necessary to look to the market price in alternative jurisdictions for products for delivery further into the future.

Shape

Delivering gas or electricity according to a specific profile, as opposed to a standardised product, may mean the gas or electricity delivered by the contract under dispute has greater or lesser value than the market price for the closest standard traded product.

For gas and electricity, shape could be valued by temporal differences in the market price for shorter duration products; for example, the price of gas in winter versus the price of gas in summer, or the price of electricity during the day versus the price of electricity during the night. These shorter-duration products are normally traded only a relatively short period into the future. For this reason, information about temporal prices for historic delivery periods, or delivery periods only a short time into the future, may be required to overlay onto the price for future delivery of the commodity electricity or gas (with any adjustments for how inter-temporal price shape may change from one year to the next).

In addition, for gas, shape can be provided by gas storage facilities. If relevant to a given case, and assuming no shortage of storage, the cost of gas storage (e.g., as obtained from published storage tariffs) could be used to value shape or set limits on the value of shape.

Flexibility

An option for a buyer or seller to vary the shape of deliveries can be valued in several ways. In the case of gas, some of the option value may be reflected in tariffs for using storage facilities, since storage facilities would usually offer optionality over the timing and quantity of injections and withdrawals. Otherwise, flexibility in the case of gas may be valued approximately, using standard option valuation techniques when markets are sufficiently liquid. Options in both gas and electricity can be valued through market simulation.

If applying an approach using ex post information on market prices, ideally one would consider how, in practice, the option could have been used, given the time constraints on its exercise. Assuming the perfect exercise of an option based on ex post information when that information would not have been available when the option had to be exercised may provide some guidance on its value, but may overstate the full value to the buyer (or its cost to the seller).

Transport costs

The value of transport services included in a contract could potentially be based on published transport tariffs, taking into account the effect of, for example, network congestion, and import and export levies. Transport costs might be incurred or avoided relative to the delivery point of the product to which the observed market price relates. For gas, this could be between the source of gas and the observed market, and between the source of gas and the point of delivery of interest. For electricity or gas, it could be the transportation cost incurred or avoided in moving from one jurisdiction to another.

Payment terms

Payment terms in the contract under dispute can be valued relative to the payment terms of the product to which the observed market price relates. This may mean a saving or an increase in costs. The timing and quantum of advance and ‘wash-up’ payments may also need to be taken into account.

Simulation

In the absence of appropriate comparator market prices with which to value the gas or electricity delivered under the contract in dispute, a market simulation model can be used. There are many approaches to simulating market outcomes. Without market prices, the most common approach would be to develop what is often called a fundamental model of the market and then simulate the interaction of supply and demand and the price-setting process.

Considering the power sector, this approach, simplified, might be based on the following.

Power stations can be thought of as being stacked from the lowest to the highest short-run marginal cost. Power stations with lower marginal costs run in preference to those with higher marginal costs. The available generation is compared with demand in the hour. For that hour, the point at which the demand curve intersects with the supply curve, derived from the plant stack of available generation in the hour, determines the market price for the hour, and which power stations produce electricity and which do not. The (hourly) market price is set by the power station that is the most expensive still required to meet demand – the market price may be set equal to the marginal cost of the marginal power station or some function of the marginal cost. This simulation can be repeated for every hour of the year, or for a sample of representative hours, with varying demand, varying generation availability and varying short-run marginal costs (reflecting, for example, changing gas and coal prices). In the long run, power stations will close and, particularly if demand is increasing, new power stations will be built. Simulation models can simulate new entry and exit decisions, such that, as prices rise and it becomes profitable to enter, new entry occurs.

Needless to say, these types of models – although conceptually simple – are complex and require many inputs. The complexity will increase with the presence of interconnected markets, imperfect markets with large players, and markets whereby policy decisions have an important influence on outcomes.

Conclusion

Estimating damage relating to supply in the electricity and gas sectors has many similarities to estimating damage elsewhere. However, the characteristics of electricity and gas mean the estimation may be more challenging owing to the often long duration of contracts and the potentially large changes in value over time.

A number of techniques are available that would typically allow damage to be estimated using an ex ante, ex post or hybrid approach, as legally appropriate. Although the estimation is often complex, approaches can be applied to simplify the task, including using comparator analysis and focusing on those aspects that are most material to the overall damage estimate.


Notes

[1] Wynne Jones and Christoph Riechmann are directors and Matthew Roberts and Stefan Lochner are associate directors at Frontier Economics Ltd.

[2] Although gas can physically be stored in greater quantities, there are capacity limitations on how much can be stored and made available in different time frames. Unlike other commodities, such as coal, storing gas also requires dedicated infrastructure, which is costly to build and significantly limits for how long it makes economic sense to store gas.

[3] This is a simplified view that ignores some practical considerations; for example, negligence by maintenance contractors may constitute a breach of their legal duty. However, the negligence may not be observable, and hence affect behaviour or cause damage, until later. Even then, consider an example where such negligence at a power plant leads to a fire that disables the plant. Although the cause of the fire may have been prior negligence, the extent of damage or the amount of time needed before the plant can reopen may not be assessable until some time after the fire. Arguably, the best interpretation of an ex ante approach in such circumstances is to value the loss as soon as it becomes identifiable and can be managed by the harmed party.

[4] For example, even in circumstances in which the parties face uncertainty about the likely duration of the damaging effects of a breach, the damaged party may nevertheless have formed some expectations on the likely duration. As in the example cited earlier, this could, for example, have been reflected in forward hedging to close the open position created by the breach (an expected resumption of deliveries under the contract implies a reduced period with an open position following the breach). It is also possible that new information is revealed over time about the expected duration of damaging effects, in which case it may still be possible to base an ex ante valuation on updated breach-related information as and when it becomes available.

[5] In some cases, this may be more complex if the market price itself might have been affected by the contract termination. If the injured party has to replace the gas or electricity owing to the need to meet contractual commitments to others, it is the buy price of replacing the commodity in the post breach market that is relevant. However, if the breach simply caused the injured party to sell less, it is the sell price in the hypothetical market without breach that is relevant. Determining which position applies requires examination of the contract position of the injured party.

[6] It is also possible that two or more of the individual components interact in such a way that their combined value differs from the sum of their individual values.

[7] Note, a term that differs may require consideration of terms in common if it is to be valued.

[8] Electricity has inputs to production that are other commodities. Market prices for these other commodities that are underlying drivers of the price of electricity in the relevant jurisdiction may also provide useful information. For example, market prices for gas, coal and carbon dioxide permits (in jurisdictions where these apply) may provide useful information in estimating future electricity prices.

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