Long-Term Electricity Supply Contracts
(1)
Dept. of Accounting and Commercial Law, Hanken School of Economics, Vaasa, Finland
8.1 General Remarks
Electricity supply contracts can be (1) standardised, mainly short-term, and traded in an organised way; or (2) not standardised, rather long-term, and agreed bilaterally. Standardised contracts are more likely to be traded on an exchange or a regulated marketplace. They can be simple contracts traded in the spot market (Sect. 4.5). Standardised contracts are used even in the market for balance energy and control reserves (Sect. 4.10). In this case, trading or auctions are organised by the TSO. Contracts that are not standardised can have a longer duration. OTC contracts can be relatively simple bilateral long-term contracts or more complex structured contracts.1
This chapter focuses on long-term electricity supply contracts in the OTC market. Spot contracts and contracts for the provision of control reserves are discussed in Chap. 4. Balancing contracts are discussed even in Chap. 9.
The topics discussed in this chapter include: the use of long-term supply contracts as part of the business model of the firm (Sect. 8.2); the role of physical electricity derivatives governed by master trading agreements (Sect. 8.3); the general provisions of the EFET General Agreement (Sect. 8.4); the particular objectives of the firm in long-term electricity supply contracts and the ways to reach them (Sect. 8.5); and reliance on the preferential treatment of electricity generation from renewable sources (RES-E) as an alternative to long-term supply contracts (Sect. 8.6). In this section, we will briefly discuss the nature of long-term electricity supply contracts, the reasons for their use, the ways to regulate them, and other general issues.
The Nature of Long-Term Electricity Supply Contracts
The liberalisation of markets and the emergence of physical and financial exchanges brought electricity contracts closer to traditional commodity contracts.2 However, electricity supply contracts are really contracts for the provision of services (Sect. 2.7). Their services nature is clearer to see when the duration of the contract is long, because the customary complexity of long-term contracts makes it necessary for the parties to regulate the modalities of their respective obligations in greater detail.
Many Reasons to Use Long-Term Contracts
The business model of the electricity producer and the choice between long-term and short-term contracts depend on the structure of the market.5 Unbundling therefore plays a particularly important role. The purpose of long-term contracts depends on the prevailing competition model.
Their purpose is not limited to security of supply in unbundled and liberalised markets. Security of supply can be ensured even by other means. Structurally, security of supply is increased by the existence of a competitive wholesale market, the existence of efficient marketplaces, market coupling, the entry of new suppliers, the integration of new power plants to the electricity network, and so forth. At transaction level, parties can use various products to increase security of supply.
There can, therefore, be even other reasons to use long-term contracts: (1) All long-term contracts provide a way to manage risks. (2) Electricity producers can use long-term supply contracts to ensure security of consumption, that is, the existence of buyers for their generation. One may call this locking in consumers. The preferential treatment of RES-E means that some electricity producers may enjoy security of consumption under mandatory provisions of law without long-term supply contracts (Sect. 8.6). The preferential treatment of RES-E is having a major impact on the business model of electricity producers. (3) Long-term supply contracts can be used to reduce the price risk. Because of unbundling, previously integrated electricity firms and new market entrants must now rely more on electricity supply contracts for their profits.6 While spot prices tend to be volatile,7 long-term contracts can help to reduce dependence on electricity exchanges and spot markets and to fix a sufficient profit margin. (4) Long-term contracts can be used by distributors to increase their own security of supply. The unbundling of electricity generation and distribution has also increased the number of distributors that compete for upstream contracts in the wholesale market. Electricity distributors need an optimal portfolio of purchase contracts to ensure security of supply.—Like electricity producers, distributors also need to manage price volatility. Sometimes they complement long-term supply contracts with the ownership of shares in electricity generating companies.8 (5) Particular long-term supply contract structures can be created to accommodate the diverging needs of electricity producers and their customers.9 (6) Particular long-term supply contracts can facilitate the provision of control reserves (Sect. 4.10) and balance energy (Chap. 9).
Risk Mitigation
There are thus many reasons for electricity producers to use long-term supply contracts. One of the traditional reasons is risk mitigation.
First, the use of long-term contracts enables electricity firms to hedge price and quantity.10 It is a way to mitigate risks caused by the extreme price volatility of spot markets11 and helps large electricity consumers and distributors to ensure security of supply in a relatively simple way.12
Second, long-term contracts help to manage opportunistic behaviour13 in electricity markets. The risk of opportunistic behaviour can be high because of the high sunk costs and asset specificity of energy investments.14 For instance, an electricity producer can face a hold-up problem where its power plant is dependent on one large end consumer.
Funding
There are also funding reasons. Long-term contracts are customarily used in corporate finance. Long-term supply contracts are an essential part of the contractual structure of many large-scale energy investments.15 They can be necessary, because the risk exposure of investors influences the access of the electricity firm to funding and the firm’s funding costs. Long-term contracts are a means to reduce exposure to various risks.
Long-term supply contracts are particularly important in project finance in which the project is “ring-fenced” and the project company’s cash flow is used as collateral.16 A long pay-back period can be supported by long-term take-or-pay contracts. Generally, project finance can be a suitable way to finance energy projects because of high up-front financing costs, the long operational phase, the long-term duration of the supply contracts, and the take-or-pay provisions used in the contracts.17
The availability of long-term supply contracts makes it easier to invest in high fixed-cost generation technology that customarily is employed in the generation of base load and balance energy. Therefore, they can increase the mix of generation technologies and contribute to a reduction in marginal costs.18
Regulation
For many reasons, long-term supply contracts are less regulated compared with many other contracts in the wholesale electricity market.
Bilateral and long-term supply contracts are not contracts traded on an exchange or in a multilateral system.19 They do not require the participation of intermediaries for the matching of bids or the participation of a central counterparty.
These contracts are not based on external rules adopted by the operator of a trading venue.20 Consequently, these contracts are not subject to mandatory clearing. In contrast, some simple OTC supply contracts that are based on the rules of a multilateral system can be subject to mandatory clearing because of the broad definition of “regulated markets” for the purposes of MiFID II.21 In principle, simple OTC supply contracts could also fall within the scope of the clearing obligation under EMIR provided that they are declared subject to the clearing obligation.22
Bilateral supply contracts do not fall within the scope of the MiFID regime as they are neither traded on a regulated market nor regarded as “financial instruments” (Sect. 4.8.2).
However, there are competition law constraints on the use of long-term contracts and take-or-pay clauses (Sect. 8.2.5).
Standardisation
Although bilateral supply contracts are not standardised under the rules of the market, other factors have contributed to the convergence of their terms.
Obviously, bilateral supply contracts fall within the scope of the regulatory regime for physical electricity markets. The parties must comply with the rules of the TSO for access to the grid and the use of transmission capacity. The rules of the TSO should be non-discriminatory under the Third Electricity Directive.
Moreover, it is customary to use master agreements that lay down the terms of many supply contracts. In principle, a master agreement can be negotiated bilaterally between the parties. In practice, however, it is customary to use model agreements such as the EFET General Agreement Concerning the Delivery and Acceptance of Electricity. Such model agreements are also known as master trading agreements. They have become the preferred and customary documentary support for the vast majority of wholesale trading of energy products in Europe’s electricity and natural gas markets.23
Contract Terms
The contract terms must necessarily address the issues that are characteristic of electricity supply contracts (Sect. 2.5). The EFET General Agreement gives many examples of how the characteristic issues can be regulated in the supply contract. Other contract terms depend on the particular contract type and the circumstances of the case. The long-term nature of the contract relationship is reflected in the contract terms.
Contract Types
Long-term bilateral contracts for the physical supply of electricity in the wholesale market can be divided into particular contract types.
One can broadly distinguish between electricity futures/forwards (Sects. 8.2.3 and 11.2), individually negotiated long-term contracts, and more complex structured contracts. Structured contracts range from tolling contracts to load-serving total supply contracts (load-serving full-requirement contracts).24
The contract can also cover one transaction or many similar transactions that the parties repeat during a long contract period (repeat transactions). In repeat transactions, the parties can use a master agreement that lays down the detailed terms of all transactions, and shorter contracts that confirm the core commercial terms of each transaction.
Risks
Structured contracts and other long-term contracts enable electricity producers and other wholesale market participants to transfer risks over a long contract period. On the other hand, this increases exposure to other risks because of the very nature of long-term contracts25 and the particular characteristics of long-term electricity supply contracts.
The exposure of the electricity producer to counterparty risk can be increased by the high upfront investment in generation installations (and sometimes even in transmission installations). It is also increased by limitations on the transferability of the contract. There must be limitations on the transferability of the contract because of: physical constraints (electricity cannot be supplied without grid access and transmission capacity); the fact that the contract requires timely compliance with detailed modalities of a technical nature; and the high upfront investment.
Transparency and Liquidity
Bilateral and individually negotiated long-term contracts are not as transparent as exchange-traded contracts. Neither are they designed to increase the liquidity of the market. On the other hand, volumes sold using these contracts may subsequently be traded in the wholesale marketplace. This can contribute to liquidity.26
Business Model
The firm can choose from a pool of contract types for the long-term supply of electricity. Contract types are used in the context of business models. The choice of the contract type and the contractual framework are influenced by the business model of the firm.
8.2 Business Models
8.2.1 General Remarks
Electricity producers choose business models for the long-term supply of electricity. Their customers choose business models for the long-term purchase of electricity. Each firm’s business model depends on the overall market structure (Sect. 2.3). The choice of the business model also depends on other reasons such as costs, risks, funding, and legal aspects.27
The electricity producer’s business models for the power plant range from market-based models (exchanges or auctions) to the use of various kinds of structured transactions. The availability of a large variety of business models would also increase incentives to invest in a wide range of generation technologies depending on the preferences of the electricity producer.
Main Components
At a very high level of generality, the customary business models focus on three main components: the power plant, the operator of the plant, and the allocation of cash flow and risk.
First, the power plant is at the core of the business model. It can serve as the starting point because of physical laws and the balance requirement (electricity consumption must be balanced with electricity generation at all times). The power plant can here be defined as the place where one combines: (a) energy source inputs (such as fossil fuel, nuclear fuel, wind, flowing water, or other); (b) the generation of electrical energy from the inputs; (c) the search for electricity consumers that will balance their own electricity consumption or distribution with electricity supplied from the plant; (d) capital investment; and (e) funding.
Second, the power plant must be operated by a party. In a simple transaction, the commercial risks linked to the operation of a power plant are generally borne by the owner of the plant.28 There are nevertheless other alternatives. The power plant can be operated by the electricity producer, the purchaser, or a third party. By whom the power plant is operated depends on the electricity producer’s business model.
All generation capacity is not used. Whether the right to operate the plant and change energy source inputs into electricity will be exercised depends on electricity prices and the marginal production costs at the plant. The value of the right to operate the plant thus depends on production costs and electricity prices and the likelihood of future electricity prices exceeding marginal production costs.29
Third, like in all transactions, the parties can allocate cash flow and risk and manage agency relationships in different ways.30 In particular, there are different ways to allocate: revenue from the supply of electricity; costs of electricity generation; and the risk of production shortfalls and other risks.
Risk Allocation, Price, and Limits of the Firm
The choice of the business model influences both risk allocation between the parties and the price. When choosing the business model, one of the most fundamental questions relates to the limits of the firm (the “make or buy” decision) and the scope of vertical integration. They thus influence both risk allocation and the price.
At one end of the scale you can find individual contracts between very independent firms (“buy”, not “make”). Trading between independent firms could of course be facilitated by market-based solutions (auctions). Alternatively, the electricity producer could replace the use of market-based solutions by structured contracts to fix the price and transfer risk to the buyer. The firm is exposed to higher counterparty risk in long-term contracts.
At the other end of the scale there is vertical integration (“make”, not “buy”). Where the electricity producer and the buyer are parts of the same firm, the firm manages risk internally without being exposed to counterparty risk.
There is also an area between these two extremes. The flora of legal tools and practices is very rich in this area. (a) The buyer may use an outsource provider to generate its electricity—or a functional equivalent of electricity—and have authority over the production process. The buyer can thus use various forms and degrees of vertical integration (Sect. 8.2.4). (b) The power plant may be operated by different parties and cash flow and risk may be allocated in different ways (Sect. 8.2.3). (c) Risk may be ring-fenced by using incorporated legal entities. Separate legal entities can be used both within the same firm and in dealings between different firms. For example, a vertically integrated firm may, for financial and risk management reasons, use a separate legal entity as buyer to allocate certain risks and costs to the separate legal entity within the limits of the same firm.31 (d) Share ownership (Sect. 8.2.2) is one of the customary ways to align the parties’ interests and manage principal-agency relationships. When the electricity producer is a major shareholder of the buyer, the exposure of the electricity producer to counterparty risk is reduced.
8.2.2 Excursion: Block-Ownership
Ownership of shares can influence price and risk. For instance, industrial firms may transfer their generation assets to specialised electricity producers in return for shares and rights to purchase electricity at special prices.32 Alternatively, large suppliers or end consumers can participate in a consortium that invests in new generation capacity to ensure security of supply and special prices.
The share ownership structure of the electricity producer can influence the price. The price of electricity is likely to be the lowest when the buyer is a major shareholder (or a similar stakeholder) of the electricity producer.33 This is likely to be in the interests of that particular shareholder, but it can also be in the interests of the electricity producer.
From the perspective of the firm, shareholders have a function.34 Selling electricity to a shareholder at a lower price is neither good nor bad as such. Depending on the circumstances of the firm, it may be in the long-term interests of the firm to sell electricity at a low price to a major shareholder or any shareholder.
Block-ownership can influence the relationship between the electricity producer and the customer in two main ways. Block-ownership can be used for aligning interests indirectly or directly.
Indirectly, a shareholder/customer may be entitled to a share of the electricity producers profits as a residual claimant. Although block-ownership can align interests indirectly, mere block-ownership is not sufficient to align the interests of the parties.
Generally, a shareholder does not want to pay overprice for electricity as the company’s profits would be shared by other shareholders. A major shareholder is more likely to pay less for electricity as these private benefits are not shared by other shareholders. A shareholder may try to use its legal or de facto rights to ensure that the price is low.
On one hand, the customer has an investment risk where the customer is a shareholder of the electricity producer. A shareholder will bear its indirect share of the risk of production shortfalls and the commercial success of the electricity producer in general, although its risk is limited by the limited liability of shareholders. If the customer has paid a large enough sum for the electricity producer’s shares, the customer may have an incentive to purchase electricity supplied by the electricity producer and to pay a sufficient price for electricity supplies.
On the other hand, the customer’s direct benefits in the form of lower prices can outweigh its indirect share, in its capacity as shareholder, of the electricity producer’s direct loss.35 Fortunately for the electricity producer, a single block-holder may not be able to force the electricity producer to offer better terms because of constraints on shareholders’ powers under the applicable provisions of company law and the allocation of power in the company. The firm is protected by the company’s board that has a legal duty to act in the interests of the company (the firm).36
More fundamentally, block-ownership can change the whole business model of the electricity producer. Where the electricity producer is a closed company whose shares are held by a small number of customers, the rates are customarily based on the production costs of the electricity producer rather than on market prices. The electricity producer is dependent on its few shareholders, and its shareholders rely on the electricity producer for security of supply and low prices.
The Finnish Mankala model provides an example. The Mankala model is based on two decisions of the Finnish Supreme Administrative Court.37 The Mankala model means that the production is purchased by a small number of wholesale customers that are shareholders. The purpose of the Mankala company is to produce electricity for the joint shareholders at the lowest possible cost.38
8.2.3 The Business Models of the Electricity Producer: Basic Business Models
The electricity producer can choose from a pool of six basic business models for the power plant: (1) a merchant power plant39; (2) long-term supply contracts; (3) a PPA power plant (based on a Power Purchase Agreement); (4) a tolling contract40; (5) a share of production41; and (6) a virtual share of capacity.42
Merchant Power Plant
A merchant power plant is a stand-alone generator which sells all its production on short-term markets at a fixed price and without long-term contracts. Merchant generators are the canonical business model in economics,43 but they were rare in the EU when the basic market model was complete vertical integration and “virtually unheard of prior to 1980” in the US.44
Two things are characteristic of merchant power plants: the mechanism for finding electricity consumers and the mechanism for raising funds.
When an electricity producer owns a merchant power plant, it relies on the spot or futures marketplace for its income. A merchant power plant does not have pre-identified customers.
As the electricity generated by a merchant power plant is not reserved for any pre-identified customers, customers will not participate in the construction, operation, or maintenance of the plant. Investment in a merchant power plant is funded by other parties.
The electricity producer is exposed to increased market risk. A merchant power plant cannot make a profit (and survive) unless the market price is higher than the merchant plant’s indirect and direct production costs. Because electricity generation is capital intensive and investments are made up front, funding costs and investors’ perceived risk exposure are an issue. Variation in the price of fuel is important as a factor influencing direct production costs. Moreover, the electricity producer is exposed to the risk that its power plant is not dispatched.
Investments in merchant power plants are heavily influenced by EU law. On one hand, the unbundling of electricity markets is designed to increase the number of merchant power plants. On the other, the 2020 targets of the EU influence market prices, dispatching, and the allocation of investment.
EU law fosters investment in RES-E and distributed generation. Installations that use renewable energy sources or waste or produce combined heat and power have priority access to the grid.45 Moreover, the market price depends on the regulation of feed-in tariffs. Feed-in tariffs are the main support mechanism applied by the EU Member States to increase the share of energy generated from renewable energy sources.
Futures
Physical electricity futures lead to the physical supply of electricity. Physical electricity futures are relatively simple contracts and can thus be exchange-traded.
ICE Endex. For instance, “Dutch Power Baseload Futures” can be traded on ICE Endex in continuous trading. These futures are contracts for “physical delivery of power to/from the Dutch high voltage grid”.
The trading period is “up to 59 consecutive month contracts”, “up to 9 consecutive quarters”, or “up to 4 consecutive years”.
ICE Clear Europe (ICEU) acts as central counterparty to all trades. There is an Initial Margin. There are Daily Margins and there can be Variation Margins. Open contracts are marked-to-market daily.
Delivery is made “equally each hour throughout the delivery period from 00:00 (CET) on the first day of the month until 24:00 (CET) on the last day of the month”. Matching nominations must be made by the buyer and the seller and ICEU to TenneT before 13:00 (CET) on each day prior to the commencement of the delivery period.
“German Power Base Load Futures” are a similar product of ICE Endex. They are contracts for “physical delivery of power to and from the high voltage grid in the TSO zones where ICE Clear Europe is a [balance responsible party] and specified by the trading participant by means of the relevant designation form”. Again, matching nominations must be made to TenneT before the delivery of power.
EEX. Futures traded on EEX provide a further example. The maturities of these contracts can vary depending on the area. The manner of settlement depends on the contract. There is “physical delivery” for Dutch or Belgian Power Futures, “cash settlement or physical fulfilment” for French Power Futures, and “cash settlement” for Italian Power Futures.
Physical futures can be distinguished from financial electricity futures. The difference in terminology is discussed more closely in the context of financial contracts (Sect. 11.2).
Long-Term Supply Contracts
The opposite of the business model of a merchant power plants is the use of long-term supply contracts. They can be used to hedge price and volumetric risks and to reduce transaction costs. Long-term supply contracts can be bulk power contracts not limited to any power plant or contracts limited to a certain plant (such as PPA power plants). Of the two, bulk contracts provide more flexibility to the electricity producer that may select the lowest cost source of supply.46
Types
There are various kinds of long-term supply contracts that are bulk contracts. (a) The most basic form is an electricity forward contract with a fixed volume. Electricity forward contracts are contracts for the supply and off-take of a fixed amount of electricity at a pre-specified contract price (the forward price) at certain time in the future (maturity or expiration time).47 (b) Alternatively, the contracts can be load-serving contracts or schedules designed to match the pre-estimated load. (c) The electricity producer and the customer can even use more complex long-term supply contracts with a flexible volume. (d) The duration of the contract and exit can be regulated in various ways. Like in forward contracts, the duration of the contract can be limited in time and expire on a certain date. Alternatively, the contract can provide for termination on notice (see Sect. 8.4.6). (e) Like in all long-term contracts, it is particularly important to regulate the price (Sect. 8.5.6) because circumstances are bound to change over time.
Terms
Long-term supply contracts must address the issues that are characteristic of all physical electricity supply contracts (Sect. 2.5) and the flexibility, price, and exit issues that are customarily addressed in all long-term contracts.48 These issues are discussed collectively for all electricity supply contracts (Sects. 8.4.8 and 8.5).
The EFET General Agreement Concerning the Delivery and Acceptance of Electricity is an example of how these issues can be regulated by the parties (see Sect. 8.4). Moreover, where more complex long-term contracts are negotiated individually because of customer requirements, their terms must reflect the commercial objectives of the customer.
The main rule in contract practice is that a long-term contract for the physical supply of electricity is not freely transferable because of physical constraints and high exposure to counterparty risk. This is regardless of the fact that the transferability of claims belongs to the basic ways to manage both the agency relationship between two contract parties and risk and is the legal default rule.
A major difference between contracts traded on regulated markets (exchange-traded contracts) and contracts traded outside regulated markets relates to collateral and margining. Each exchange has rules on collateral and margining and there are also daily margin calls (Sect. 4.6.2). Outside regulated markets, parties agree on collateral requirements bilaterally49 and do not need to apply daily margin calls (see Sects. 8.4 and 8.5).
PPA Power Plant
Long-term supply contracts can be bulk contracts without any designated power plant or, like power purchase agreements, limited to a certain power plant (PPA power plant).50 Power purchase agreements are particular kinds of contracts used in long-term projects.51 The business model of the electricity producer is then the PPA power plant.
PPA power plants raise the same two core issues as merchant power plants. Electricity consumers are found in a particular way, and there is a particular way for raising funds. A PPA power plant has just one or a small number of pre-identified customers whose purchases ensure the commercial viability of the project.
A power purchase agreement means a long-term contract between (a) an electricity producer that generates electricity in a certain new facility for sale (the seller) and (b) an electricity consumer that intends to purchase electricity generated in that facility for balancing its electricity consumption (the buyer).
The buyer is customarily a distributor (a utility or a wholesaler). The buyer may want to combine purchases under a number of PPAs with spot purchases and sales to achieve a close match with the volume of electricity required to service wholesale or retail contracts.52 The purchase of electricity generated in a certain facility rather than any electricity supplied by the electricity producer can be a way to increase security of supply, meet renewable-energy portfolio standards, or obtain tax credits.53
A power purchase agreement regulates two main issues: action that is necessary before the reliable commercial operation of the facility can be started (there can be a construction period, a testing period, and an agreed completion date); and the supply of electricity from the facility.
These two issues can be illustrated with a sample power purchase agreement used by the United States Department of Energy represented by Bonneville Power Administration (BPA).
The two parties to the contract are BPA and the seller. The characteristic terms of the contract reflect the intentions of the parties set out in the preamble of the contract: (a) BPA is authorised to acquire sufficient capacity and energy from power production facilities to meet the electric power requirements placed on BPA by its regional customers; (b) the seller desires to construct, own, and operate a power generation plant; (c) the seller desires to sell to BPA all (or a portion) of the energy output generated by the facility; and (d) BPA desires to buy it from the seller.
The seller undertakes to “construct, operate, and maintain the Facility”.54 The Completion Date plays an important role. The production facilities must be operational by the Completion Date.55 Beginning on the Completion Date, the seller undertakes to supply to BPA the entire energy output from the Facility, and BPA undertakes to buy it.56
It is characteristic of power purchase agreements that the buyer undertakes to purchase all or most of the electricity generated in the facility.
When Electricité de France (EDF) and Zweckverband Oberschwäbische Elektrizitätswerke (OEW) acquired joint control of Energie Baden-Württemberg AG (EnBW), power purchase agreements were mentioned in the competition law commitments undertaken by EDF.57 EDF had already signed Power Purchase Agreements with French co-generators promising to buy all their electricity production over a 12-year-period. EDF undertook to make available to competitors access to in total 6,000 MW generation capacities located in France, 5,000 MW in the form of virtual power plants (VPP) and 1,000 MW in the form of back to back agreements to existing co-generation power purchase agreements.
Power purchase contracts can be relevant even when the basic market model is complete vertical integration. In this case, the owner of the transmission system may have weak incentives to build transmission infrastructure to be used mainly by other electricity producers. It may have better incentives to build the necessary transmission infrastructure and connect the plant to the grid if the whole output is sold to it. These kinds of “output contracts” were used in the gas market before the liberalisation of the market.58
The power purchase agreement also sets out the price. Combined with the long duration of the contract, these terms can reduce the electricity producer’s market risk and give it incentives to invest.
Because of the long-term nature of power purchase agreements, the parties need to regulate what will happen on termination of the contract. There are several alternatives: the parties may renew the contract with different terms; the contract may expire and the electricity producer may be free to sell electricity to any buyer; the buyer may have an option to purchase the generating equipment; or the buyer may request that the equipment be removed.
Power purchase agreement can influence the availability and cost of funding. Generally, the existence of a long-term power purchase agreement can make it easier for the plant’s owner to raise external funding for the construction project. If project finance is used, the assets and revenue streams of the project company will be “ring-fenced”. Cash flow from the power purchase agreement ensures that project finance debt can be repaid. The power purchase agreement will then be the core component of the legal framework of the asset-backed funding transaction.
A Tolling Contract
Like a power purchase agreement, a tolling contract is a contract between the owner of a power plant and an electricity buyer. The most characteristic difference between power purchase agreements and tolling contracts relates to control of the plant.
The term tolling means the control of an asset without ownership and the associated development or operation costs. According to the terms of a tolling contract, the customer determines when electricity is to be produced and how much electricity should be produced at any given time. A tolling contract thus gives the buyer the right either (a) to operate and control the scheduling of the power plant or (b) to simply take the output electricity.
A tolling contract transfers electricity price risk from the owner of the plant to the customer. The owner of the plant retains the operational risk.
The owner of the plant could be remunerated in alternative ways. (a) The plant’s owner should in any case be paid enough to cover its fixed costs regardless of the production level. The buyer therefore agrees to pay an upfront fee for the right to operate and control the scheduling of the power plant. The size of the fixed fee depends even on the other terms of the contract. (b) Where the buyer pays a price for the electricity that it takes, the amount of the fixed fee could be reduced if the customer undertakes to purchase minimum volumes. The customer may therefore be prepared to accept a take-or-pay clause.59 (c) Alternatively, the customer could pay a fixed fee over the life of the contract in exchange for the right to supply fuel and market the power output from the plant.
As a tolling contract gives the customer the right to control the plant’s output, tolling contracts are sometimes initiated by the customer. (a) For instance, tolling contracts could be used by an energy merchant with strong marketing skills and little interest in the operation of the plant (Sect. 2.3.4). (b) A tolling contract could be the result of financial engineering and outsourcing where an industrial firm sells its electricity generation assets to an electricity company but wants to retain control. (c) Tolling contracts may also interest fuel suppliers. For instance, a fuel supplier may prefer to pay a fee for the option to convert fuel into electricity rather than sell the fuel. Converting fuel into electricity might yield a higher return at some point in time.
There are often contractual limitations on how the buyer may operate the power plant or take the output electricity. For instance, the buyer may have a right to take the output electricity during pre-specified time periods only and subject to other constraints.62
Tolling-type agreements tend to be relatively short in duration (i.e., months).63
A Share of Production
The owner of a power plant can grant the buyer rights to a share of the production of the power plant (Kraftwerksscheibe). Contracts for a share of production, or a virtual share of capacity, are customarily long-term contracts for the physical delivery of electricity combined with a take-or-pay clause.64 A contract for a share of production can also be cemented by the ownership of a block of shares.
A contract for a share of production, or a virtual share of capacity, can be used in two ways. It can be used for balancing the customer’s own electricity consumption. Alternatively, the customer can sell the electricity to a third party.65
The parties are free to agree on the allocation of risks and costs. (a) As the volume is expressed as a share of electricity production, the starting point is that the buyer bears the risk of production shortfalls. The owner of the power plant may nevertheless guarantee the supply of electricity up to a certain fixed maximum volume in the event of unplanned production shortfalls. (b) As the buyer of a share of production is a separate legal entity that is not the owner of the power plant, the buyer is not responsible for the costs of the power plant. However, the buyer may assume responsibility for part of the costs. This can reduce the price.66 (c) Moreover, the buyer undertakes take-or-pay obligations.
These contracts enable the buyer to reduce its funding needs. From the perspective of the buyer, the owner of the power plant is its “asset investor” in the sense that the buyer of a share of production can use the assets of the plant owner without having to invest in the assets itself and without having to raise funding from debt investors or shareholders for the plant.67 On the other hand, it is particularly important to manage exit in these kinds of contracts, because the buyer may still need to use the assets or similar assets in its operations after the expiry of the contract.
There are various ways to regulate the rights of the buyer on termination of the contract. The duration of the contract can be limited in time and expire on a certain date. Alternatively, the contract can be valid for an indefinite period (golden end clause), or the contract can give the buyer an option for a longer contract period after the first expiry date (optional golden end clause).68
A Virtual Power Plant
Instead of a share of production, the electricity producer may offer to sell a virtual share of capacity (virtuelle Kraftwerksscheibe). In Europe, it is known as the virtual power plant (VPP).
A VPP contract gives a right to part of the producer’s generation capacity. It can give a right to draw electricity from a plant or a pool of plants under the terms of the contract. The capacity can also relate to base load or peak load. There are thus base-load virtual power plants and peak-load virtual power plants.69
A VPP contract can resemble financial market option contracts.70 A VPP contract is then sold or auctioned at a price that gives the right to draw energy at the predetermined energy price. These prices can be regarded as the option premium and the predetermined strike price.71 Where VPPs are auctioned, the set period is customarily a month, a quarter, or a year.72
A VPP contract can also contain a take-or-pay clause. The buyer may then consume its share of the production capacity or sell it on the market.
A VPP contract customarily provides that buyers must give one day’s advance notice if they wish to exercise the VPP. In effect, such a clause means that the contract cannot be used in the real-time market for balancing power.
A VPP contract brings benefits to both parties. (a) For the buyer, the VPP contract increases security of supply. The buyer does not bear the risk of production shortfalls in VPP contracts (whereas the buyer would bear this risk in a contract for a share of production). The allocation of this risk to the electricity producer can increase the price that the buyer is prepared to pay.73 (b) The seller benefits from flexibility because the contract is not tied to any particular plant. The volumes are not constrained by actual plant configuration. (c) Moreover, a virtual power plant can also consist of the microinstallations of a group of end consumers that use smart metering. Smart metering and a VPP help microgenerators to sell their production in the market, and the operator of the VPP to buy that surplus generation for resale in the wholesale market.
Generally, the use of virtual power plants is likely to increase in the future. This trend is connected with the increased decentralisation of power generation, in particular the increased generation of electricity from wind and other renewable sources, microgeneration by small end consumers, and major own generation by large industrial end consumers. On one hand, electricity suppliers can use virtual power plants as a mechanism to buy this new supply of energy and sell it in the market. On the other, electricity suppliers will be exposed to increasing competition by their own customers that have an incentive to increase the share of their own electricity generation when electricity costs are high (because of high retail electricity prices and the size of the L-component of transmission costs).74 Customers’ incentives to compete with their electricity suppliers are even greater if they have a chance to benefit from high feed-in tariffs for RES-E75 or energy prices are high.
Next Kraftwerke has created a virtual power plant which interconnects different types of RES-E units. A biogas plant or a CHP unit can generate power when the wind is not blowing or the sun is not shining.
The establishment of virtual power plants can increase competition and improve the functioning of the market.76 Virtual capacity auctions have been used in European markets to increase the liquidity of the forward market. There are cases of the use of virtual capacity auctions as part of the competition law commitments undertaken by electricity producers such as EDF and DONG Energy.
EDF. In EDF/EnBW, EDF undertook to make available to competitors access to in total 6,000 MW generation capacities located in France, 5,000 MW in the form of virtual power plants (VPP) and 1,000 MW in the form of back-to-back agreements to existing co-generation power purchase agreements.77
The VPP contracts were awarded through an open, non-discriminatory public auction.78 Both base-load and peak-load VPP were offered simultaneously, but separately. The VPP contracts were concluded with the successful bidders.
The VPP contracts were for 3 months, 6 months, 1 year, 2 years, and 3 years.79 Over the duration of the contract, the buyer had the right to call upon EDF at any time to request delivery up to the agreed generation capacity (x MW).80
The price consisted of two components, the capacity price and the energy price. The successful bidder paid the capacity price for x MW of generation capacity.81 The buyer also paid the energy price for the electricity consumed.82
DONG Energy. The VPP auctions of DONG Energy A/S, a Danish company, were based on competition law commitments given by the parties to the Danish Competition Council when it approved the merger between Elsam A/S (now DONG Energy) and NESA A/S on 24 March 2004. An important condition for the approval of the merger was that Elsam sells by action 600 MW electricity generation capacity in an infinite period through Virtual Power Plants. Generation capacity was sold at 35 VPP auctions from 22 November 2005 until 6 May 2014. On 28 May 2014, the Danish Competition Council abolished the commitment as market conditions had improved significantly and there was strong competitive pressure on DONG Energy.
DONG Energy auctioned the rights to a portion of its production capacity. It offered capacity options of three different durations (3 months, 12 months, and 36 months). The VPP auctions took place on a quarterly basis.
VPP power was physically delivered to the high voltage grid in the Danish DK1 price area. The price consisted of the option price and the energy price. Whereas the option price and the allocation of capacity were determined by auction, the energy price of exercising the option to produce electricity was set in advance. It was based on DONG Energy’s most effective central power plant in the DK1 price area and remained fixed throughout the duration of each individual product.
DONG Energy cooperated with a number of parties to facilitate the auctions. There was a party that was responsible for the implementation of the VPP auctions and acted as the auction administrator (Deloitte). The technical infrastructure for the auctions was provided by Nord Pool. Where the winning bidder wanted to exercise the option, it must nominate deliveries to a nomination aggregator that also informed DONG Energy of the aggregated hourly deliveries of power. The entity responsible for the physical delivery of electricity was DONG Energy Power A/S, a company in the DONG Energy group.
Access to the auctions was restricted. To participate in the auctions, a party: must have in place all agreements required by the relevant TSO; must have been approved by the Danish Competition Authority; and must comply with the eligibility criteria set out in the Auction and Credit Rules.
Bidders were also required to establish three types of credit support at different stages of the auctions: bid security (all bidders prior to each quarterly auction); option security (winning bidders following each quarterly auction); and energy security (winning bidders prior to the delivery of power).
Load-Serving Contracts
Load-serving contracts are customary supply contracts designed to match the changing consumption needs of the buyer. There are various kinds of load-serving contracts.
Contracts for the Supply of Base Load or Peak Load
In the wholesale market, individually negotiated load-serving contracts customarily are contracts for the supply of base load, peak load, or weekend base load. For instance, energy intensive industries need access to base load at a low cost.
Peak-load-serving contracts can be categorised based on the delivery period during a day. One can distinguish between forwards on peak electricity, off-peak electricity (the remaining period during a day), and “around-the-clock” electricity (24 h/day).83
Load-Serving Total Supply Contracts
Load-serving contracts with final customers can also be total supply contracts (load-serving full-requirement contracts). Total supply contracts belong to structured contracts. All contracts between the utility and the end consumer used to be total supply contracts under the vertically integrated market model.85
In wholesale markets, load-serving total supply contracts reflect the customary preferences of large electricity consumers that may want to: maximise the flexibility of the volume term so it matches their actual consumption; and pay a fixed rate per unit of energy for the actual consumption quantity regardless of the quantity being high or low.86
Load-serving total supply contracts are contracts for the supply of the actual consumption quantity. They could also be defined as call options with the fixed price for each billing period as the strike price of the option.87
Load-serving total supply contracts can be complemented by elements of forward contracts, in particular where an industrial customer has a predictable load or a load that can be up- or down-regulated with relative ease. For instance, the supply contract could lay down an exact load profile at a fixed energy price. The contract could also set another price for the difference between the agreed volume and the actual volume. In effect, the load-serving total supply contract would then consist of (a) a forward contract for volumes that match the agreed load profile (the energy price paid by the buyer); (b) a call option for the difference when actual consumption exceeds the agreed volume (the energy price paid by the buyer); and (c) a put option for the difference when the agreed volume exceeds the actual volume (the energy price paid by the seller).88
Load-serving total supply contracts can also be limited to a certain percentage of the buyer’s total demand, or cover the buyer’s residual needs.89 The free quota not covered by the contract can be defined in relative terms or fixed as a certain amount of power (MW) or energy (MWh).90 The buyer pays the market price for volumes not covered by the total supply contract.91
The parties customarily agree that the buyer may purchase certain standard products from a third party or the supplier. The contract could give the buyer the right to purchase forwards covering, say, 30 % or 50 % of the load.92 In this case, the buyer agrees to inform the supplier of purchases from a third party within a certain period.93
Another alternative is to use the spot market price for part of the volume covered by the load-serving total supply contract. This can also be an option.94
Functional Equivalents
There can be functional equivalents of long-term contracts for the supply of electricity. For instance, instead of burning fuel and turning steam to electricity, the owner of the plant may prefer to sell the steam to a buyer that either turns it into electricity or uses it in its own production process. These kinds of functional equivalents are discussed in the following section.
8.2.4 End Consumer’s Alternatives to Vertical Integration
Like all firms, an end consumer takes “make or buy” decisions. (a) It may prefer to generate its own electricity (“make”) for various reasons. For instance, an end consumer whose production process is energy-intensive may need to increase security of supply and reduce its exposure to price risk by self-generation. (b) There are alternatives to such vertical integration. The end consumer may purchase electricity (“buy”). (c) As there are various degrees of control of the plant, an end consumer may achieve some of the advantages of vertical integration through block-ownership (Sect. 8.2.2) or contracting (Sect. 8.2.3). From a legal perspective, vertical integration is less complicated than its functional alternatives (such as business outsourcing).95
The German market provides examples of models designed to replace the purchase of electricity with the customer’s own generation or the purchase of other goods or services.
In Germany, EEG 2012 required end consumers to pay a fee for RES-E (EEG-Umlage, EEG surcharge)96 but exempted industrial firms to the extent that they consumed electricity from their own generation (industrieller Eigenverbrauch, Eigenverbrauchsprivileg).97
Like EEG 2012 that it replaces, EEG 2014 provides for an EEG surcharge98 and reductions from the EEG-surcharge. The reductions apply to energy-intensive users in certain sectors99 and to certain self-generators (Eigenerzeuger).100 The consumption of electricity from self-generation is fostered even by other regulation.101
To circumvent the EEG 2012 rules, some consumers tried to use purchase models that replaced the purchase of electricity with: (a) self-generation; (b) the purchase of products used for energy storage; or (c) the purchase of services. These models (which might not be recognised under the EEG but show what could be done) include the following102:
Tolling, rental, PPA (das Pachtmodell). In this two-party contract, the generation installation is owned by one party but operated by another party. There are two main alternatives. (a) The installation can be owned by a third party and operated by the consumer that bears the commercial risk (tolling contract). (b) The installation could also be owned by the consumer and operated by a third party that bears the commercial risk (rental). Such rental contracts resemble power purchase agreements (PPA) but are rarely used in Germany.103
Co-ownership (das Betreibergemeinschafts-/Betriebsführungsmodell). This contract means that the generation installation is owned by many consumers but operated by a third party. Each consumer takes its share of production and bears its share of the commercial risk.
Co-rental, a share of production (das Scheibenpachtmodell). Alternatively, the installation can be owned by a third party but operated by many consumers. Each consumer takes its share of production and bears its share of the commercial risk.
Steam or compressed air contracts (Dampf-/Druckluftcontracting). The generation installation is in this case both owned and operated by a third party that supplies steam or compressed air to the customer.
Service contracts or “light contracts” (Lichtcontracting). The generation installation is again owned and operated by a third party. In addition, that party undertakes to supply and to take care of the operation and maintenance (O&M) of technical facilities (such as lightning, air conditioning, elevators, escalators) that typically consume plenty of energy. The customer pays for the services provided by the third party.
Outsourcing (Lohncontracting). The generation installation is owned by a third party that operates it according to the instructions of the customer. The customer supplies fuel free of charge. The owner/operator turns the fuel into power or heat. The customer pays the owner/operator for this service rather than for electricity or heat.104
8.2.5 Long-Term Supply Contracts and Competition Law
There is a large variety of long-term supply contracts and they can have different effects on the market.105 Some long-term supply contracts are deemed to restrict competition under Article 101(1) TFEU (Sects. 3.6.3 and 5.2).106 On the other hand, long-term supply contracts can also produce efficiency gains. In particular, they enable both parties to manage risks.107 The question is where to draw the line.
Legal risk is reduced by the Block Exemption Regulation for vertical agreements and the Commission’s Guidelines on Vertical Restraints.108 The main rule is that vertical agreements do not restrict competition as such.
Under some circumstances, however, long-term downstream contracts with a high commitment level can lock in consumers, increase barriers of entry, and reduce competition.109 As the purpose of long-term contracts and their effect on competition depend on the prevailing market model (Sect. 8.1), the answer may depend on (a) the market model, (b) the market share of the supplier or the buyer, and (c) other contract terms.
For instance, off-take obligations are often made stronger by a take-or-pay clause or an excess charge applied when the customer’s actual consumption differs from the forecast.110 Moreover, the existence of long-term contracts with a high commitment level can limit market access and reduce competition more where the electricity producer has a dominant position in the market.
Long-term contracts can be regarded as more restrictive in unbundled and liberalised markets and in the light of the competition-enhancing goals of the electricity directives.111 This could increase legal risk for firms. Long-term contracts might not be assessed according to the old doctrines, and traditional rules might be applied in new ways in markets that are in the process of being liberalised.112
Eighty Percent, Single Branding
According to existing competition law, any long-term electricity supply contract can give rise to de facto exclusivity of supply where the customer’s off-take obligation is fixed at values close to the customer’s estimated total consumption. An obligation to purchase more than 80 % of the buyer’s total purchases from only one supplier is regarded as a non-compete obligation.113 Such long-term agreements are regarded as single branding agreements.114
Block Exemption
On the other hand, vertical restraints contained in vertical agreements are exempted under the Block Exemption Regulation for vertical agreements.115 The block exemption applies provided that neither the supplier nor the buyer has a market share that exceeds 30 % of the relevant market.116
The main rule is that the exemption covers even non-compete obligations. The exemption does not apply to “any direct or indirect non-compete obligation, the duration of which is indefinite or exceeds five years”.117
Single branding is thus exempted by the Block Exemption Regulation where the supplier’s and buyer’s market shares do not exceed 30 % and the duration of the non-compete obligation is 5 years or less.118
Test
The parties may be able to obtain an individual exemption under Article 101(3) TFEU for clauses that do not benefit from the Block Exemption Regulation. There is a test.
In the past, hardly any distinction was made between electricity and gas related cases in Commission practice.119 The maximum duration of permitted long-term supply contracts was some 15 years.120 Why the Commission drew the line here was unclear.
The Commission permitted such contract periods in the Electricidade de Portugal/Pego project case121 (the Commission regarded 15 years as a legitimate maximum duration for both financing and investment), in the REN/Turbogas case122 (the Commission accepted a 15-year duration while it also insisted on removal of the right of first refusal by the Portuguese transmission operator and inclusion of third-party access as condition for supporting this duration),123 and in the Electrabel case (the Commission accepted a duration of 14 years, reduced from the original 20–30 year duration and with a gradual fade-out for the volume of power supplied).124
The earlier lack of sufficient reasoning changed after the judgment of the CJEU in European Night Services.125 According to the CJEU, the duration of an exemption granted under Article 101(3) TFEU must be sufficient to enable the beneficiaries to achieve the benefits justifying the exemption.
In European Night Services, the benefits could not be achieved without considerable investment. For this reason, the CJEU stated that “the length of time required to ensure a proper return on that investment is necessarily an essential factor to be taken into account when determining the duration of an exemption”.126 In other words, proper return on investment should be the starting-point in assessing the acceptable duration where the long contract term is motivated by investment reasons.
In 2007, the Commission opened proceedings against EDF (France)131 and Electrabel (Belgium)132 because of concerns that, by virtue of their scope of application, duration and nature, the use of long-term electricity supply contracts significantly limited the possibilities of other undertakings to conclude contracts for the supply of electricity to large industrial customers as the main or secondary supplier.133 The Commission applied the same principles as in the Distrigaz case (Belgium).134
The Commission identified five elements to be considered when determining whether long-term contracts are to be considered illegal under competition rules: the market position of the supplier; the share of the customer’s demand tied under the contracts; the duration of the contracts; the overall share of the market covered by contracts containing such ties; and efficiencies.
The Commission thus did not primarily focus on imposing any fixed maximum contract duration. Instead, it introduced a model according to which a certain part of the overall demand in the market must be subject to competition.135
In the E.On/Ruhrgas case,136 the German Bundeskartellamt (BKA) ordered the dominant German gas operator to stop writing long-term supply contracts with distributors that: (a) cover more than 80 % of total annual demand for more than 2 years; or (b) cover more than 50 % of its customers’ total annual demand for more than 4 years. The BKA gave some long-term supply contracts the green light: (a) For contracts covering more than 80 % of the requirements, a maximum term of up to 2 years was accepted. (b) Where the gas supply contracts covered 50 to 80 % of total customer requirements, the contracts could not exceed a term of 4 years.137
The nature of the customer is one of the factors that may play a role. For example, different maximum contract durations were allowed for contracts with different customers such as resellers, large industrial users, and electricity producers in E.ON Ruhrgas and Distrigaz. 138
Take-or-Pay Clauses
There are particular competition law constraints on the use of take-or-pay clauses (Sect. 8.5.3).
8.3 Introduction to Master Trading Agreements
Bilateral long-term electricity supply contracts and other OTC contracts are often governed by master trading agreements. The use of master trading agreements can reduce transaction costs (as parties share the same legal platform) and operational costs (as the firm may use the same platform other market participants use, the same platform for many transactions of the same kind, and the same platform for different kinds of transactions).139
In Europe, the most important master trading agreement for electricity supply contracts is the EFET General Agreement Concerning the Delivery and Acceptance of Electricity (the EFET General Agreement). The UK power market has its own Grid Trade Master Agreement (GTMA). For the EU ETS, the International Emissions Trading Association (IETA) has published the Emissions Trading Master Agreement (that provides an alternative to the use of modified versions of the EFET General Agreement or the ISDA Master Agreement).140 In the US, the most important master trading agreement is the Master Power Purchase and Sale Agreement of Edison Electric Institute (the EEI Agreement).
The most important master trading agreement for OTC trading in derivatives is the ISDA Master Agreement. It has served as a model even for electricity master trading agreements.
History
The roots of master trading agreements for the European gas and electricity markets lie in the US gas market of the late 1980s and early 1990s.141
Before the liberalisation of the US gas market, US contract documents were long and detailed because of large contract volumes, long contract periods, and the customary drafting practices applied in common law countries.142
The gradual liberalisation of the gas market meant that smaller and smaller volumes could be sold and resold. Trades in the new market were being transacted principally by telephone, and mark-to-market accounting was applied to trading positions. The liberalisation of the gas market gave rise to new risks such as: credit risk; performance or settlement risk; carrier default risk; price risk; contract risk; and new categories of regulatory risk. Consequently, the traditional individually negotiated sales contracts had to be replaced by standardised general terms and conditions.143
The general terms and conditions used by market participants tended to be fairly similar.144 However, each transaction was still regarded as a separate transaction and the parties had to agree on the use of general terms and conditions separately for each transaction.
This led to the emergence of master trading agreements.145 Each company used its own master trading agreements first. Consequently, the first agreements were biased. A party could use one master trading agreement as a seller and another when it was a buyer.
These agreements were replaced by a single master trading agreement to be used by sellers and buyers.146
The early master trading agreements were not very sophisticated. The vast majority of them contained little or no language intended to mitigate counterparty insolvency and related credit risk. The first standardised natural gas trading agreement, the Gas Industry Standards Board Agreement, contained no early termination, close-out netting or similar clauses for the mitigation of credit-based risks.147
The EEI Agreement
When the US electricity market was liberalised, the benefits of an industry standard were recognised.148 The master trading agreements employed in the electricity market were similar to the master trading agreements for gas but more sophisticated.
The dominant master trading agreement in the US electricity wholesale market is the EEI Agreement.149 In addition, the master trading agreements of Western Systems Power Pool (WSPP) and the Electric Reliability Council of Texas (ERCOT) are used in particular geographic markets (the Western System Power Pool and Texas, respectively).150
The EFET General Agreement
US experiences influenced and speeded up the process of developing standardised master trading agreements for the European electricity market.151
In the UK power market, GTMA is the standard set of terms for the majority of electricity forward trades.152 The cross-border nature of the European power markets required a contractual platform that could be used in cross-border transactions.153 In 2000, the European Federation of Energy Traders (EFET) released the first version of the EFET General Agreement. The EFET General Agreement is drafted with the German market and cross-border transactions in mind. The EFET General Agreement is the most important contractual platform for trading physical electricity across Continental Europe.154
The EFET General Agreement was developed with the intention of facilitating cross-border trade in wholesale power in Europe’s interconnected electricity markets. For this reason, the rights and obligations of electricity buyers and sellers under the EFET General Agreement must be sufficiently general and generic, and the EFET General Agreement must be enforceable in different European countries.155
8.4 The EFET General Agreement
8.4.1 General Remarks
The EFET General Agreement, the GTMA, and the EEI Agreement resemble the ISDA Master Agreement in many respects. The ISDA Master Agreement has served as a model even for electricity master trading agreements.
There are nevertheless some fundamental differences between the ISDA Master Agreement and the other agreements. While master agreements for derivatives or swap contracts provide for financial settlement, master trading agreements for electricity supply contacts must even regulate issues that are characteristic of all electricity supply agreements that are settled physically (Sects. 2.5, 8.4.8 and 8.5). Moreover, the Emissions Trading Master Agreement is designed for the EU ETS.
There are also some differences between the EFET General Agreement and the EEI Agreement. The most fundamental differences relate to the nature of the contract and the governing law. While the EFET General Agreement is an agreement designed for cross-border trading and governed by the law of a civil law country, the EEI Agreement is designed to be used inside the US that is a common law country.156
In the following, we will study the contents of the EFET General Agreement and compare it with the EEI Agreement and the ISDA Master Agreement.
8.4.2 Scope
The scope of the EFET General Agreement is defined in relation to transactions—future or present—and in relation to the governing law.
Future Transactions
Like all master trading agreements, the EFET General Agreement applies to all future transactions between the parties157 (and may even be applied to existing transactions depending on the Election Sheet158). The terms of the EFET General Agreement are thus incorporated into the contracts that the parties will enter into.159 The EEI Agreement works in the same way.160
As the parties have agreed on the unchanging terms in advance, it is enough for them to focus on the key commercial terms of each transaction. This reduces transaction costs and saves time. There would be increased transaction costs if the parties derogated from the terms of the EFET General Agreement.161
Governing Law
The agreed terms are complemented by the governing law. The terms of the contractual relationship consist of the mandatory provisions of the governing law, the agreed terms, and the dispositive provisions of the governing law. One can also distinguish between the law governing the master trading agreement and the law that governs the individual contracts made under it.
It would bring benefits to choose the law of one country as a platform for many similar contracts.162 Interpretation risk would be reduced if all contract law disputes were resolved in the same manner irrespective of the location of the parties. Moreover, it would reduce transaction costs and facilitate international (global, European-wide) contract management.163
The EFET General Agreement is governed by German law according to its default choice of law clause. The application of the CISG is expressly excluded reflecting the fact that the sale of electricity falls within the scope of sale of goods law in Germany (Sect. 2.7.2).164 The choice of law clause can only cover contractual matters.165 For instance, it does not cover insolvency.166
Whether individual contracts made under the EFET General Agreement are governed by German law is a matter of interpretation. The wording of the choice of law clause does not explicitly cover individual contracts. On the other hand, the terms of the EFET General Agreement are incorporated into each individual contract (“single agreement”, Sect. 8.4.4).167
The EEI Agreement is governed by the law of New York.168 The choice of law clause does not address the issue of the law governing individual agreements.
Terms, Appendices
The terms of the EFET General Agreement are general in nature. They may need to be adapted to consider legal requirements in the different countries in which the terms are applied. For this reason, the EFET General Agreement is complemented by appendices developed by the EFET.169 The same technique is used in the EEI Agreement.170
8.4.3 Conclusion of Individual Contracts
The purpose of standard trading agreements is to make it easier to conclude individual contracts and to reduce transaction costs. The basic documentation for an individual transaction consists of the EFET General Agreement, an Election Sheet (known as the Schedule in the ISDA Master Agreement) adapting the EFET General Agreement to the particular circumstances of the parties (with standardised terms for the customisation of the EFET General Agreement and additional provisions), and a confirmation.
Short Confirmation
Because of the existence of the EFET General Agreement and the Election Sheet that set out the largest part of the legal framework, the confirmation can be short and limited to the core commercial terms of the transaction.
There are also Long Form Confirmations, also known as Single Trade Agreements. They repeat all terms customarily found in the master trading agreement and confirmations. Long Form Confirmations are used where a party trades with a counterparty before a master trading agreement is signed or in the rare circumstances where a transaction is not to be subject to any master trading agreement.171 Long Form Confirmations are coupled with higher legal risk.172
Form and Representation
According to the governing law, the default rule is that contracts can be concluded in any form of communication. This main rule is applied even in the EFET General Agreement.173
As contracts can be deemed to have been concluded even orally, it is important for the parties to limit the number of people that may represent them and identify the authorised representatives. The EFET General Agreement permits the parties to list the persons that may represent them.174
Interpretation
The contractual relationship consists of many documents. One may ask what their mutual ranking is in the event of inconsistencies. The main rule is that the specific prevails over the general (generalia specialibus non derogant). There is a particular term in the EFET General Agreement to this effect. The terms of the individual contract prevail for the purposes of the individual contract, and the provisions of the Election Sheet prevail over the other provisions of the EFET General Agreement.175
8.4.4 The Single Agreement Concept
The EFET General Agreement is not just an “umbrella” agreement. Like other master trading agreements, the EFET General Agreement defines itself and the multiple transactions covered by it as a single agreement.176 They are thus intended to be part of a single and legally inseparable contractual relationship.177 The same concept is used in the EEI Agreement.178
The single agreement concept is important in the event of default and in the insolvency of a party. In combination with close-out netting, it is designed to reduce the risk of cherry-picking.179
8.4.5 Payments, Netting, Tax, Collateral
As regards payments, the main rule under the EFET General Agreement is monthly invoicing180 and monthly payments.181 Invoicing and payments are based on scheduled contract quantities in accordance with all applicable delivery schedules for the respective month.182
Option premiums are an exception to the main rule. They are invoiced as agreed between the parties and due and payable on the agreed premium payment date.183
The EFET General Agreement regulates questions of default interest and disputed amounts. The interest rate is specified in the Election Sheet.184 There is a provision on disputed amounts. The parties may choose one of two alternatives in the Election Sheet: (a) pay now, litigate later; or (b) pay the undisputed sum.185
Netting
The parties may also agree to use payment netting in the Election Sheet. Payment netting means that the party owing the greater aggregate amount pays the net amount where each of two parties is required to pay one or more amounts in the same currency under one or more individual contracts on any day.186
The parties can extend the scope of netting by the EFET Cross Product Payment Netting Agreement. In this case, netting applies to individual contracts based on different master agreements. The EFET Cross Product Payment Netting Agreement is drafted with the EFET Power Agreement, the EFET Gas Agreement, the GTMA, the ZBT Terms (Zeebrugge Hub Natural Gas Trading Terms and Conditions 2004), and the NBP Master (the Short Term Flat NBP Trading Terms and Conditions 1997) in mind but could in principle be chosen to cover even other master agreements such as the 2002 ISDA Master Agreement.187
Tax
Both parties have a qualified contractual duty to minimise taxes.188 In addition, the EFET General Agreement lays down other duties relating to tax. (a) The EFET General Agreement is neutral as far as value added tax (VAT) is concerned. Where VAT is payable, the buyer must pay to the seller an amount equal to the VAT.189 (b) Generally, the delivery point is used to divide tax liability between the buyer and the seller.190 (c) The parties may elect to use a tax grossing-up clause that supports the duty to make payments free of any withholding of or deduction for tax.191
Collateral and Other Credit Enhancements
The parties are free to agree on collateral and other credit enhancements192 in bilateral trading and customarily do so. In electricity trading, collateral often consists of guarantees (parent company guarantees, bank guarantees, or demand guarantees).193
The EFET General Agreement addresses the question of collateral and other credit enhancements in various ways. While the parties are free to agree on credit enhancements in advance, the EFET General Agreement gives a party the right to ask for better collateral in the event of material adverse change:
The parties may agree on “guarantees and credit support”.194
Whether they have agreed or not, a party may require “performance assurance” when it believes that a material adverse change has occurred.195
To illustrate, there is a material adverse change: when the agreed credit rating is downgraded196; when a performance assurance or an agreed credit support document expires or fails197; or when “in the reasonable and good faith opinion” of the party the ability of the other party to perform its obligations is materially impaired.198
8.4.6 Contract Period, Assignment, Changed Circumstances, Termination, Close-Out Netting
The long-term nature of the EFET General Agreement and the electricity supply contracts that fall within its scope is reflected in the contents of the EFET General Agreement in many ways. It has influenced clauses on: the contract period; changed circumstances; the termination of individual supply contracts and/or the EFET General Agreement; and close-out netting. In spite of the single agreement principle, one can distinguish between the EFET General Agreement and individual contracts for these purposes.
The Contract Period
The EFET General Agreement is in force for an indefinite period. It may be terminated in two ways: by notice to expire after a termination period (Ordinary Termination); or for a material reason to expire immediately (Termination for Material Reason).199
As regards individual contracts, the contract period (total supply period) is chosen by the parties. The total supply period is part of the schedule.200
In case of Ordinary Termination, the notice period is 30 days. The expiry of the EFET General Agreement will not affect individual contracts concluded before the expiry date. The General Agreement remains binding on the parties until the parties have performed their obligations under the terms of individual contracts concluded before the expiry date.201
Assignment
Transferability is one of the customary ways to mitigate counterparty risk in long-term contracts. However, transferability is limited in long-term electricity supply contracts (Sect. 8.2.3).
The EFET General Agreement addresses transferability in several ways. (a) The main rule is a prohibition. A party may not assign its “rights and obligations” to a third party without the prior written consent of the other party. A prohibition is necessary in the light of the fact that the trading relationship requires the ability to settle individual contracts physically and is based on mutual assessment of counterparty risk. A party’s counterparty risk could be increased by the assignment. The assignee’s creditworthiness could be worse, and there could be less room for netting after an assignment because netting requires the existence of mutual claims. (b) However, the prohibition does not apply with its full force. It is diluted because a party must not unreasonably delay, refuse, or withhold its consent.204 (c) Moreover, the parties may agree in the Election Sheet that a party may assign its rights and obligations to an affiliate with the same or better creditworthiness.205 One may ask whether the parties should choose this alternative in the light of the problems.206 (d) Whether the assignment is permitted depends, among others, on the representations and warranties that a party must comply with.207
While the EFET General Agreement regulates the assignment of “rights and obligations”, it remains open whether the EFET General Agreement addresses the assignment of individual rights or obligations and not just the assignment of the whole agreement. According to German law (the governing law), a party may not assign its obligations without the consent of the other party but may assign its rights. The EFET General Agreement for gas regulated the assignment and transfer of the whole agreement.
Changed Circumstances
All long-term contracts tend to address the problem of changed circumstances. The EFET General Agreement provides for various mechanisms for this purpose.
In the event of a material adverse change208 in respect of one party, the other party is entitled to require a “performance assurance”, that is, a form of credit enhancement.209
Where the contract price is based on a variable reference price (and is a floating price rather than a fixed price),210 the market disruption clause provides for an alternative settlement price as a fallback mechanism in the event of market disruption.211
There is also an optional tax crossing-up clause.212
The EFET General Agreement contains the customary force majeure clause. The particular characteristics of electricity supply agreements have been addressed in three ways.
First, a party is released from its duty to perform its obligations for so long as and to the extent that the force majeure event prevents their performance. In other words, the duty to perform is not just suspended.213 As there is no breach of contract in this case, the other party has no right to compensation for damage. On the other hand, the other party is released from its corresponding acceptance and payment or delivery obligations.214 The EEI Agreement contains similar force majeure provisions.215
Second, it is not required in the EFET General Agreement that the impediment was unforeseeable or that the party would not have been able to consider the occurrence of the impediment at the time of the conclusion of the contract.216 In electricity markets, the impediments tend to be foreseeable. Force majeure is therefore defined as “an occurrence beyond the reasonable control” of a party “which it could not reasonably have avoided or overcome” and “which makes it impossible” for the party to perform its delivery or acceptance obligations.
There is a difference between the broader definition of force majeure events under the EFET General Agreement and the slightly narrower definition used in the EEI Agreement. According to the wording of the EEI Agreement, an event or circumstance that was anticipated when the transaction was agreed on by the parties cannot be invoked as a force majeure event.217
Third, some important examples of force majeure events have been expressly mentioned in the EFET General Agreement. They relate to the system operator.218