In February 2018, almost three and a half years after the Request for Arbitration was issued, an award was rendered in one of the most high value arbitrations this past year.
The over 1,000-page award in SCC Arbitration No. V2014/129, which was published on Naftogaz’ website a few months ago, concerned a dispute under a long-term gas transportation agreement between Naftogaz and Gazprom, for the transit of gas from Russia and Belarus, through Ukraine, into Europe.
The award found that, notwithstanding the absence of a typical ‘ship-or-pay’, or ‘send-or-pay’, clause an obligation on Gazprom to deliver minimum annual volumes of gas entitled Naftogaz to damages when Gazprom under-delivered against those minimum volumes. The award also confirmed that Naftogaz was not entitled to revise the price payable by Gazprom for transit under the relevant contract, because, amongst other things, it had not satisfied the conditions set out in the price revision clause.
Although the outcome of this case was very fact-specific, it provides a useful reminder of the need for clear and careful drafting surrounding minimum quantities obligations and the consequences of breaching those obligations.
The Ukrainian Gas Transmission System is a complex of pipelines used for the transmission of natural gas from ‘entry points’ in Russia and Belarus, through Ukraine, to ‘exit points’ at the borders between Ukraine and Romania, Hungary, Slovakia, Poland and Moldova. The system is now operated by Ukrtransgaz, a subsidiary of Naftogaz (Ukraine’s largest oil and gas producer).
In 2009, Naftogaz and Gazprom (one of the world’s largest gas extracting company, majority owned by the Government of Russia) entered into a long-term agreement for the use of the Ukrainian Gas Transmission System to transit very significant volumes of natural gas through Ukraine into Europe (the “Transit Contract”). At one time during the 11-year term of the Transit Contract, gas transmitted under it covered approximately 50-60% of Russian natural gas exports to Europe, making Ukraine (in the arbitral tribunal’s words) “the most important transit country in the world”.
A number of disputes arose between Naftogaz and Gazprom in relation to the Transit Contract and in 2014, Naftogaz commenced arbitration (in accordance with the SCC Rules and subject to the procedural laws of Sweden, as required by the Transit Contract). Amongst other things, Naftogaz sought to argue that:
- The volumes of gas Gazprom was delivering each year for transit was lower than the minimum volumes agreed under the Transit Contract, and Naftogaz was entitled to damages for this underdelivery; and
- The price for transit set out in the Transit Contract should be revised upwards, pursuant to either (i) a price revision clause in the Transit Contract, (ii) an invalidity clause triggered because the pricing provisions are not consistent with Ukrainian law (which had recently undergone a natural gas market sector reform to comply with Ukraine’s commitment to follow the EU’s 3rd Energy Package Directives for the natural gas market) or EU law, or (iii) the application of the Swedish Contracts Act.
The arbitral tribunal accepted Naftogaz’ claim for underdeliveries, and rejected its claim for revision of the price. The reasoning provided by the arbitral tribunal is summarised below.
(1) Claim for Underdeliveries
Relevant Contractual Provisions
The Transit Contract applied the substantive laws of Sweden.
Under Article 2 of the Transit Contract, Naftogaz agreed to perform the relevant transit services “subject to the volumes and terms set out in Article 3”. Article 3, in turn, stated the following:
- Article 3.1 stated that “From 2009 to 2019 inclusive, [Gazprom] shall transfer to [Naftogaz] the Natural Gas for transit to European countries in the volume of at least 110 (one hundred ten) billion m3 [except for the year 2009 for which Article 3.1.1 provided a different transit volume] on an annual basis…and [Naftogaz] shall ensure its acceptance and further transit through the territory of Ukraine…” (Article 3.1)
- Article 3.2 stated that after 2009, annual gas volumes shall be specified in supplements, or addenda, to the Transit Contract. It then stated that “In case of the Parties’ failure to execute such Supplement prior to the commencement of the relevant Contractual Year, the volumes of the Gas transit in the relevant year shall be determined based on the aggregate obligations to supply minimum annual quantities of Gas under the Contracts of [Gazprom] with the European buyers which receive the Gas transited through the gas transportation system of Ukraine. In that case such minimum annual obligations under the contracts of [Gazprom] have to be confirmed by the auditor.” Naftogaz and Gazprom agreed volumes for the years 2010-2015 in addenda to the Transit Contract, but failed to agree volumes in the other years.
The Transit Contract did not contain what is typically referred to as a ‘ship-or-pay’, or ‘send-or-pay’, provision (essentially, a provision providing for payments based on reservation of capacity); Naftogaz proposed such a clause as part of contract negotiations, but Gazprom rejected it. However, the Transit Contract did contain a general liability provision: Article 10.1 required one party that failed to perform any of its obligations under the Transit Contract to “reimburse the other party for any proven damages caused by such failure to perform”.
Underdeliveries from 2009 - 2015
The volumes of gas actually delivered in this time period were less than those set out in the Transit Contract and relevant agreed supplements. Naftogaz argued that this was in breach of Article 3.1, which obliged Gazprom to transit certain minimum volumes, and that Gazprom was required to compensate Naftogaz for damages caused by such breach pursuant to Article 10.1.
Gazprom, on the other hand, relied on the evidence of a witness who stated that the volume was intended as “no more than a forecast”, to ensure that sufficient capacity to meet Gazprom’s anticipated transit needs was available in Naftogaz’ system. It pointed to Article 3.2 to argue that the volume of gas to be transited under the Transit Contract was “inextricably” linked to the needs of Gazprom’s European customers, and that, for this reason, the volume specified in Article 3.1 could not have been intended as a commitment of Gazprom to transit a minimum volume. In any event, Gazprom argued that the absence of a ship-or-pay (or send-or-pay) clause in the Transit Agreement shows an intent to agree not to undertake financial liability for underdeliveries, notwithstanding the words in Article 10.1.
On the basis that “testimony was mostly contradictory and generally followed the interest of the party who called the witness”, the arbitral tribunal considered it impossible to decide this issue on the basis of such testimony. It therefore sought to interpret the relevant contractual provisions in accordance with the “plain and ordinary meaning of the words used”. Doing so, it agreed with Naftogaz, concluding that:
- The words of Article 3.1 are straightforward in creating a binding minimum obligation of transit volumes. Relevant to the arbitral tribunal’s reasoning was the second sentence of Article 3.1, which required Naftogaz to ensure transit of the relevant gas through Ukraine. The arbitral tribunal found that this effectively amounted to a legal obligation on Naftogaz to transit the minimum volume specified in Article 3.1 (unless otherwise agreed in subsequent addenda), which meant Naftogaz had to reserve transit capacity for Gazprom in that volume to comply with its obligation. On Gazprom’s interpretation of Article 3.1, Naftogaz would have had to reserve capacity for Gazprom without being paid for the capacity that Gazprom would not use, and without the possibility to sell such unused capacity to anyone else. The arbitral tribunal considered that this was not likely to be correct.
- In relation to liability for breach of Article 3.1, Article 10.1 “says what it says, whatever Gazprom now states were its intentions”. Therefore, Gazprom must compensate Naftogaz for proven damages caused by such breach.
Underdeliveries from 2016 - 2017
No supplements were agreed regarding volumes of gas to be delivered in the years 2016 and 2017. Gazprom argued that by a letter dated 30 December 2016, it informed Naftogaz of the results of an audit undertaken pursuant to Article 3.2, which determined the relevant volumes of gas for these two years. This represented a reduction of the annual volume according to Article 3.1.
Gazprom argued that Article 3.2 did not require Naftogaz to verify the auditor’s report, nor did it specify a deadline for issuing the report or set out a procedure for challenging the report. It therefore did not matter for the purpose of Article 3.2 that Gazprom’s letter amending the volumes in 2016 and 2017 was only issued on 30 December 2016, and that Naftogaz was not provided with an opportunity to verify it before the commencement of contract years 2016 and 2017.
Naftogaz argued that although not expressly stated, the procedure in Article 3.2 is subject to an “obvious time limit”. It is implied that any request for revision to the 110 billion m3 annual transit volume must be received by Naftogaz sufficiently ahead of a delivery year to allow Naftogaz to consider the request and adapt to Gazprom’s export needs, and, in the case of non-agreement, to verify the audit report before the start of the delivery year in question. On that basis, the letter was issued too late to set the delivery volumes for the years 2016 and 2017.
In agreeing with Naftogaz, the arbitral tribunal focused on the “purpose of the system established by Article 3.2”, which is that Gazprom quantifies its needs for gas transit in the Ukrainian Gas Transmission System before the delivery year, so that Naftogaz has a chance to mitigate its losses (e.g. by offering capacity to other shippers). The arbitral tribunal considered that Gazprom’s position did not accord well with this purpose. Without going into detail, the tribunal also considered it relevant that Naftogaz had presented evidence that cast doubt on the accuracy of the volumes set out in Gazprom’s letter for contract year 2017.
(2) Claim for replacement / revision of price
Relevant Contractual Provisions
Article 8.1 of the Transit Contract set out the formula for calculating the ‘tariff’ (price) Gazprom was to pay Naftogaz for performing transit services.
The Transit Contract also contained, at Article 8.7, the following provision for revising the tariff:
“In case of a significant change in 2010 and subsequent years of the terms for the determination of transit tariffs in the European gas market as compared to what the Parties had reason to expect at the conclusion of this Contract, and if the price for transit services specified in Clause 8.1 of this Contract does not correspond to the level of transit tariffs in the European gas market, each Party is entitled to apply to the other Party with a request for revision of the price for transit services.”
Further, Article 8.7 provided that any such request for a price revision shall be made in writing, and be properly substantiated, and that if the parties failed to agree on a price revision within a specified time period, the dispute could be referred to arbitration.
Article 13.2 was what may be referred to as an “invalidity” clause. Pursuant to this article, “If any of the provisions of the present Contract becomes legally invalid pursuant to the applicable legislation or ineffective, this shall not effect the validity of other provisions hereof. If any of the provisions of the present Contract becomes invalid or ineffective, the Parties shall agree to replace such invalid or ineffective provision with a new provision that would have the economic effect as close as possible to that of the invalid or ineffective provision.”
Replacement of tariff due to incompatibility with competition and energy law
Naftogaz claimed that Ukrainian and/or EU competition law and related energy law should apply to this dispute. Further, a number of provisions in the Transit Contract, including the tariff, are contrary to such law and therefore invalid. It argued that, pursuant to Article 13.2, these provisions should be replaced in a manner that would result in Gazprom having to make significant further payments. Specifically and by way of example:
- Naftogaz argued that EU competition law applied to the Transit Contract, including Articles 101 and 102 of the Treaty on the Functioning of the European Union (which prohibit agreements that have as their object or effect the restriction, prevention or distortion of competition within the EU, and prohibit abuse of a dominant position within the EU). Naftogaz sought to rely on the application of the ‘qualified effects doctrine’. The arbitral tribunal confirmed that this doctrine applies if Naftogaz can show “not only that there is a negative effect on competition within the EU, but further that this negative effect is “immediate”, “substantial”, and “foreseeable”. The arbitral tribunal considered that, as a matter of fact, Naftogaz did not show this. Reference to the laws of an EU state was not enough; it must be shown that competition within the EU is affected in an immediate, substantial, and foreseeable manner. As Naftogaz did not show this, the qualified effects doctrine did not apply and, consequently, EU competition law did not apply.
- Naftogaz also sought to argue that Ukrainian competition and energy law applied to the Transit Contract through article 7(1) of the Rome Convention. (Naftogaz argued that certain provisions of Ukrainian competition law mirror Articles 101 and 102 of the Treaty on the Functioning of the European Union (see above) with respect to competition in Ukraine.) The arbitral tribunal disagreed with Naftogaz, on the basis that the parties expressly chose Swedish law both as the governing law of the Transit Contract and as the procedural law of the arbitration. It found that Article 7(1) of the Rome Convention does not allow for foreign states’ public law to be applied to Swedish arbitral tribunals, apart from cases where the opposite follows from Sweden’s international obligations.
In relation to these claims, the arbitral tribunal emphasised that “it is not the role of the Tribunal to implement desirable reforms to meet energy policy targets or requirements according to Ukrainian legislation.” Instead, this is within the competence of the Ukrainian authorities.
Revision to tariff pursuant to Article 8.7 of the Transit Contract
Alternatively to its claim for replacement of the tariff due to non-compliance with competition and energy law (see above), Naftogaz claimed for invalidity and replacement of the tariff pursuant to the price revision clause at Article 8.7 of the Transit Contract.
Naftogaz issued a letter to Gazprom in June 2009, which referred to a reduction in transit volumes during the first five months of 2009 and stated that this is less than the volumes provided for in the transit contract. Further, the letter states that the decline in volumes “leads to a substantial decline in the revenues of [Naftogaz] from the provision of transit services and carries a threat of significant unplanned financial deficit for the Company in 2010 and subsequent years”, and “provides a basis for its revision in accordance with clause 8.7 of the Contract”.
Naftogaz argued that this constituted a valid request for price revision pursuant to Article 8.7, and provided the arbitral tribunal with a number of grounds for revision. Gazprom disagreed on the basis that Article 8.7 required any request to be properly substantiated, and the letter did not contain such substantiation. Further, it argued that the grounds for revision stated by Naftogaz in the letter are not the same as those advanced in the present arbitration.
The arbitral tribunal considered that Article 8.7 contains within its words two conditions:
- First, there must have been a significant change in 2010 and subsequent years of the terms for determination of transit tariffs in the European gas market as compared to what Naftogaz and Gazprom had reason to expect at the conclusion of the Transit Contract.
- Second, the price for transit services as provided for in Article 8.1 of the Transit Contract does not correspond to the level of transit tariffs in the European gas market.
The June 2009 letter from Naftogaz made no mention of either of these conditions. While the arbitral tribunal acknowledged that a request does not need to set out all relevant facts and legal arguments and the exact revision requested in order to satisfy the conditions of Article 8.7, it considered that “there must nevertheless be a minimum reflection of what Article 8.7 requires that has to be satisfied”.
The arbitral tribunal decided that on the facts there was no such “minimum reflection”, and, therefore, no valid request was made pursuant to Article 8.7.
Having rejected the claim on procedural grounds, the arbitral tribunal did not consider the grounds argued by Naftogaz for revising the tariff pursuant to Article 8.7.
Revision to tariff pursuant to Section 36 of the Swedish Contracts Act.
Alternatively to its claim for replacement of the tariff due to non-compliance with competition and energy law, and to its claim for invalidity and replacement of the tariff pursuant to Article 8.7 of the Transit Contract (see above), Naftogaz also claimed for invalidity and replacement of the tariff pursuant to section 36 of the Swedish Contracts Act.
In short, section 36 of the Swedish Contracts Act allows courts to set aside or modify contractual terms or contracts in their entirety on the basis of ‘unconscionability’. It has been established in Swedish law that although the section is primarily applied in disputes between consumers and commercial entities, it can also be applicable in relationships with commercial parties.
Naftogaz argued, amongst other things, that it had an inferior bargaining position when the Contract was entered into, that Gazprom abused / leveraged its dominant position, that the tariff deviated from standards in the gas transit market, and that the decline in volumes of gas delivered each year rendered the tariff unconscionable, so as to trigger section 36 of the Swedish Contracts Act.
The arbitral tribunal decided that there is “not sufficient evidence” that section 36 of the Swedish Contracts Act should apply. First, it could not be concluded that Naftogaz was in an “inferior position” during negotiations prior to execution of the Transit Contract. While Ukraine was reliant on Russia for gas supplies, Russia was also reliant on Ukraine for transit through Ukraine into Europe. Secondly, the arbitral tribunal considered that there was no “obvious deviation from generally accepted principles of competition” so as to render the tariff unconscionable. In this context, there is not sufficient evidence to displace the fundamental Swedish contract law principles of pacta sunt servanda (“agreements must be kept”) and rigor commerciallis (“freedom of contract”).
The arbitral tribunal awarded Naftogaz approximately USD 3.9 billion (plus interest) in damages for Gazprom’s under-delivery of volumes of gas. This figure represented Naftogaz lost profits, i.e. the amount of fees that Gazprom would have paid if it had transited the minimum volumes that the Transit Contract obliged Gazprom to transit, less the revenues that Naftogaz had in fact received under the Transit Contract, less all costs that Naftogaz had saved as a result of the underdeliveries. The costs saved included: costs associated with the volume of fuel gas saved and the cost of royalties (i.e. tax) saved.
Set-off against these damages were:
- The approximately USD 2 billion amount owed to Gazprom pursuant to a separate arbitration between Gazprom and Naftogaz. This separate arbitration concerned the price payable by Naftogaz for natural gas received from Gazprom under a gas sales contract executed on the same day as the Transit Contract. Further to an arbitral award issued on 22 December 2017, this price was revised downward from 27 April 2014.
- The amount of transit tariff overpaid by Gazprom as a result of the price revision under the gas sales contract. (One element of the transit tariff formula is the price payable by Naftogaz for natural gas received from Gazprom under the above gas sales contract). The parties agreed in the present arbitration that, pursuant to the operation of the transit tariff formula, the downward revision to the price for gas in the gas sales contract resulted in a downward adjustment to the transit tariff payable in the Transit Contract, meaning Gazprom had made overpayments totalling USD 44 million (plus interest).
This award demonstrates alternative ways in which parties to transportation contracts may protect themselves contractually in the event that minimum volumes are provided for transit.
Ship-or-pay (or send-or-pay) provisions, which require a shipper to either use the transportation service to which a contract relates, or pay for it anyway, are a familiar feature in many energy-sector transportation contracts. These provisions provide an operator with a pre-agreed “income stream” forming part of the operator’s financing arrangements. In English law, failure to pay such an income stream will likely be construed as a “debt” (i.e. a definite sum of money fixed by an agreement as payable by one party in return for the performance of a specified obligation by the other party). See Ashley and Holland, Enforceability of take-or-pay provisions in English law contracts – revisited (21013) 31(2) J.E.R.L. 205. As such it will provide a clear specified sum due regardless of volumes delivered.
In the present case, the relevant transportation contract did not include a ship-or-pay’ (or send-or-pay) provision. However, as Gazprom’s actions amounted to a breach, Naftogaz was nonetheless entitled to compensation in the form of damages for loss of profits, resulting from Gazprom’s failure to comply with a contractual obligation to deliver minimum annual volumes of gas. However, the measure of damages would be loss of profits – which would ordinarily be less than a sum due under a ship-or-pay’ / ‘send-or-pay clause as profit would be merely one element of the sum due under such a provision.
Whilst, this award may give some comfort to operators of pipelines whose contracts do not contain a send-or-pay provision, such operators should be alive to the differences between making a claim for payment of a debt (e.g. pursuant to a ship-or-pay provision) and making a claim for damages for breach of contract (as Naftogaz did in the present arbitration). These differences will vary depending on the relevant applicable law. For example, in relation to English law contracts:
“rules on damages do not apply to a claim for a debt, e.g. the claimant who claims payment of a debt need not prove anything more than his performance or the occurrence of the event or condition on which the sum becomes payable; there is no need for him to prove any actual loss suffered by him as a result of the defendant’s failure to pay; the whole concept of the remoteness of damage is therefore irrelevant; the law on penalties does not apply to the agreed sum; the claimant’s duty to mitigate his loss does not generally apply; and the claimant will usually be able to seek summary judgment.”
In the present arbitration, the fact that Naftogaz’ claim was for damages for loss of profits, and not a debt claim for payment for services rendered, meant that, for example, the arbitral tribunal considered Naftogaz’ duty to mitigate its losses, and also meant that VAT was not payable.
Governing Law and Changes in Law
In addition, this is the latest in a series of cases concerning modifications to contractually agreed tariffs in long-term gas transportation agreements. (See, for example, PT Transportasi Gas Indonesia v Conocophillips (Grissik) Ltd & Anor  EWHC 2834 (Comm), a UK commercial court decision upholding an arbitral award regarding the tariff regime set out in an agreement for the transportation of gas through the Grissik-Singapore pipeline, stretching through Indonesia. See, also, the recent decision by the Supreme Court of Norway in relation to Gassled, the owner of the system of pipelines that transports gas from the North Sea and Norwegian Sea to Norway, the UK and Central Europe. In this case, the court held that the Norwegian Ministry of Petroleum and Energy was entitled to reduce the tariffs Gassled was able to charge to shippers for new bookings.)
The present award is another reminder of the significance of the law chosen to govern a contract. If the Transit Contract had applied the substantive laws of, for example, Ukraine, then it is likely that the arbitral tribunal would have found that Ukrainian competition law applied. Where there is freedom to agree the governing law of a contract, parties should think carefully about which law to adopt in order to best preserve their respective positions.
As the Transit Contract applied Swedish law, the arbitral tribunal was apprehensive about invalidating or amending provisions of the Transit Contract pursuant to Ukrainian or EU law, remarking that this is the “task of the regulator”. It remains to be seen what, if any, regulatory reform is implemented in Ukraine before the expiry of the Transit Contract at the end of this year, and what, if any, impact this might have on the provisions of the Transit Contract.
Meanwhile, in a press release dated July 2018, Naftogaz confirmed that in the months following receipt of the award, it has followed the proper process for requesting a tariff revision pursuant to Article 8.7 of the Transit Contract, and has subsequently re-referred the matter to arbitration when agreement could not be reached with Gazprom. Naftogaz has preliminarily estimated the value of its fresh tariff revision claim at approximately USD 12 billion, excluding interest.
Mr. Tore Wiwen-Nilsson (Chair), Mr. Jens Rostock-Jensen, and Mr. Johan Munck
 The Transit Contract was written in Russian. The translations provided in this article are those referred to by the arbitral tribunal in its award.
 See Amoco (UK) Exploration Company v Teesside Gas Transportation Limited and another  UKHL 18
 Chitty on Contracts, 33rd Ed, 2018, Vol 1 at para 26-009.