Oil and Gas: Protecting LNG project and feed-gas supply from State interference

International

A recent award rendered by a tribunal acting under the auspices of ICSID, the World Bank’s arbitration institution, in Union Fenosa Gas S.A. v Arab Republic of Egypt, provides further guidance for companies in the energy sector to ensure that selected contracting structures take advantage of favourable protections under applicable international investment agreements, such as bilateral or multilateral investment protection treaties. The ruling clarifies the benefits of contractual structuring that ensures: (i) that the investment falls within the scope of an applicable investment protection treaty; and (ii) the receipt of express undertakings from the host State so as to protect contractual obligations against State interference.

In this case, a letter of undertaking from the Egyptian Government, procured pursuant to a gas sales agreement to which the government was not party, ensured that Union Fenosa Gas S.A. was entitled to compensation when Egypt promulgated policies that required the gas seller to discriminate against providing gas to LNG exporters in favour of domestic consumption. As the actions of the State undermined the economic viability of the LNG project, the undertaking received from the State under the project documentation turned out to be critical.

Facts

The Claimant (“Union Fenosa”) (which has now been acquired by another company), was a Spanish company carrying out the liquefaction, shipping, regasification and commercialisation of natural gas. Between 2002 and 2005, an LNG plant in Damietta, Egypt, was constructed by SEGAS, a special purpose entity to which Union Fenosa (80%) as well as Egyptian state-entities EGAS (10%) and the Egyptian General Petroleum Company (“EGPC”) (10%) were shareholders.

Pursuant to a Sales Purchase Agreement (“SPA”) concluded in 2000, EGPC (as later novated to EGAS) was to supply the natural gas for the plant for a period of at least 25 years. The feed-gas to be supplied under the SPA was an important element in the viability of the Damietta project.

Under the SPA, EGPC agreed to obtain from the Egyptian authorities an undertaking not to interfere with the buyer’s rights under the SPA:

EGPC undertakes to procure that the Egyptian authorities undertake not to interfere with the rights of the Buyer under this Agreement, and not to dictate or promulgate any act or regulation which could directly or indirectly affect the rights of the Buyer under this Agreement, or affect the capacity of the Buyer to perform its obligations under this Agreement, even in the case of a N[atural] G[as] shortage in Egypt, save for Force Majeure as defined in this Agreement.

EGPC shall also assist and actively collaborate with Buyer to obtain any authorization and/or legal, administrative or governmental benefit to the Buyer for the Project and/or construction of the Complex.”

In a letter dated 5 August 2000 (“5 August Letter”), the First Under-Secretary of the Egyptian Ministry of Petroleum wrote to Union Fenosa confirming:

On behalf of the Ministry of Petroleum I have the pleasure to inform you that the Egyptian Government official [sic.] endorsed the natural gas Sales and Purchase Agreement  signed August 1st , 2000 between UFACEX and EGPC […]”

In the event, EGAS failed to meet its feed-gas supply obligations under the SPA. Between 2006 and 2012, its annual gas supply ranged between 84% and 61% of the contractually agreed quantity. This shortfall was caused by:

  1. Egypt’s long-standing policies of encouraging and subsidising domestic gas and electricity use, together with a failure to encourage the discovery of gas reserves.  As foreseen by Wood Mackenzie in 2007, this resulted in a “supply-demand gap”. The logical result was the curtailment of gas to the Damietta project.
  2. Subsequently, the Government of Egypt decided to discriminate between users of gas.  As part of this discrimination, the Egyptian Government directed EGAS to limit and eventually halt supplies under the SPA. The purpose of this discrimination was the give priority to domestic users. 

Spain-Egypt BIT

Article 4(1) of the Spain-Egypt BIT requires Egypt “to guarantee in its territory fair and equitable treatment of investments made by investors of the other party” (“FET Standard”).

Decision on the merits

The ICSID Tribunal found that Egypt had breached the BIT’s FET standard. However, it did so on grounds more narrowly than those asserted by Union Fenosa.

The ICSID Tribunal was content to apply under Article 4(1) the customary international law standard of, inter alia, prohibiting conduct which is unjust, arbitrary, unfair, discriminatory or in violation of due process, including conduct that frustrates the investor’s “legitimate expectations”.

As to the scope of “legitimate expectations”, the ICSID Tribunal adopted the approach set out in Philip Morris v Uruguay (2016) that: “It clearly emerges from the analysis of the FET standard by investment tribunals that legitimate expectations depend on specific undertakings and representations made by the host State to induce investors to make an investment”.

The ICSID Tribunal decided that the 5 August Letter was an important element in the project being sanctioned and that the investment would not have gone beyond the signing of the SPA without it. That said, the 5 August Letter did not amount to a government guarantee of the terms of the SPA. In the ICSID Tribunal’s view, the effect of the 5 August Letter was to preclude Egypt from: (i) interfering with the rights of the buyer under the SPA; (ii) dictating or promulgating any act or regulation that could directly or indirectly affect the rights of the buyer under the SPA; and (iii) affecting the rights of the buyer to perform its obligations under the SPA (subject to Force Majeure). In other words, Egypt was prohibited from acting contrary to the scope of the undertaking set out in the SPA that the 5 August Letter implicitly provided.

The Egyptian Government’s decision to cut and curtail gas supply under the SPA was, by its nature and purpose, a sovereign act. Further, it was an act that sought to discriminate against non-domestic users of gas, and the Damietta Plant, specifically.  In doing so, the Egyptian Government interfered with the legitimate expectations generated by the 5 August Letter.

The ICSID Tribunal emphasised that the 5 August Letter was the “decisive tipping factor” in finding that Egypt had breached the BIT’s FET standard. In the absence of such undertaking, the ICSID Tribunal expressly stated that Union Fenosa would not have established a treaty violation. 

Union Fenosa was awarded slightly over US$2 billion in damages.

Comment

This case provides important confirmation that pursuing an investment treaty claim against a host State can be considered as distinct from seeking relief against the state-entity under the relevant contract.  Further, pursuing both claims in parallel will not necessarily amount to an abuse of process.

However, the case also emphasises that the nature of a contract claim and a claim based on an international investment agreement are different. In the event that an investor claims under an investment protection treaty that its legitimate expectations have been violated by State action, in breach of a fair and equitable treatment standard, it normally will need to be in a position to point to specific undertakings or representations made by the State upon which it relied in making the investment. However, it must be noted that other tribunals sitting in investment treaty cases have observed that commitments can be “specific” in two respects: as to their addressee (including when directed at a class of investors) and as to their object and purpose. Thus, under international law a host State may make a binding commitment to foreign investors through its legislation, although general legislative representations to an undefined class of investors will not typically engender legitimate expectations protected under investment law. Nevertheless, a host State’s right to regulate is circumscribed by its international law obligations and, in finding a balance between the stability and flexibility of a legislative framework for the purpose of the FET standard, tribunals may consider the nature and extent of any subsequent legislative changes.

In the absence of a ‘stand-alone’ State guarantee, the investor in this case succeeded because its contractual structuring ensured:

  1. There was a relevant investment protection treaty under which the party to the SPA could seek protection from State actions;
  2. Although the Egyptian State was not party to the SPA, the seller (which was owned by the State) was contractually obliged to seek State undertakings concerning the State’s actions concerning performance of the SPA; and
  3. In the absence of the undertaking being given, the investor would be entitled to ‘walk-away’ from the SPA. 

For drafters of long-term gas sales agreements and associated project documentation concerning the construction of liquefaction facilities, the lesson seems clear: it may not be enough to purely rely on the existence of an investment protection treaty to protect the gas supply that is needed to make the investment work against government interference. A representation or undertaking may be needed from the State. Further, the scope of any protection afforded against government interference under an investment treaty might only extend so far as the specific undertakings or assurances given. Insofar as such representations and/or undertakings can be procured expressly and/or in writing, this decision confirms that such written undertakings will greatly assist the investor to evidence its ‘legitimate expectations’ for the purpose of establishing a breach of the fair and equitable treatment standard. As such, the structure of the project documentation is likely to benefit from a requirement for specific written undertakings and/or assurances from the relevant government ministry.

References:

Union Fenosa Gas S.A. v Arab Republic of Egypt (ICSID Case No .ARB/14/4), Award dated 31 August 2018.