Out-Law Analysis 6 min. read
20 Feb 2023, 5:25 pm
The transition from fossil fuels to cleaner forms of energy is fundamental to the drive to decarbonise the global economy amidst the impacts of climate change. However, the pivot towards cleaner technologies carries with it a greater risk of dispute across several business activities.
The increased risk of disputes arising from the energy transition was emphasised by findings from a major energy arbitration study undertaken by Queen Mary University of London (QMUL) in partnership with Pinsent Masons (50-page / 20MB PDF), which considered in part how the transition to cleaner sources of energy might impact the disputes landscape.
Respondents, which included parties to energy-related arbitrations, disputes practitioners, arbitrators, academics, experts and arbitral institutions, believe disputes associated with the move away from fossil fuels will increase in the next five years. They cited changes arising from state regulation, new infrastructure, decommissioning and the shift to renewables and other new technology as among the most likely drivers of energy transition-related disputes. Other dispute drivers, such as price volatility, the phasing out of fossil fuel projects and changes relating to energy supply and security, were mentioned too.
The study suggests that the nature of disputes precipitated by the energy shift are likely to be wide ranging and arise out of a variety of activities which involve different participants. The type of risk posed by the transition will depend upon the business activity, ownership, funding and investment activity, geographical location, and the sector in which the business operates.
For oil and gas companies, for example, the energy transition entails the repurposing or retiring of infrastructure assets that in many cases have been operated for several decades – infrastructure used for drilling and extraction, distribution and processing, for instance, will all require decommissioning. Commercial relationships that have endured generations concerning the operation of shared infrastructure will need to be unravelled, bringing with it the risk of disputes.
One consultant who participated in the QMUL and Pinsent Masons study predicted that a variety of commercial disputes will arise from what he described as the “daisy-chain” of relationships which compromise the complex oil & gas projects. The term refers to the interconnectedness of relationships and infrastructure used in oil and gas production and how when some supporting infrastructure is decommissioned it can leave dependent assets stranded.
There is widespread recognition of the need for a gradual shift to cleaner sources of energy and that there will remain an important role for oil and gas production in the global energy mix in the short-to-medium term.
However, facing growing pressures from funders, some large oil and gas companies have already taken strategic decisions to move out of existing fields – including in the UK Continental Shelf and Gulf of Mexico – and have handed responsibility for managing the remaining infrastructure to smaller operators. We expect that these smaller operators will seek to sweat the assets using fewer resources for as long as it is viable to do so. Cost pressures and a lack of fresh investment at these sites poses a real risk of disputes.
Supply chain availability issues are a common cause for delay which can indirectly lead to disputes arising from associated issues like budget overspend, funding issues and pricing pressures
The pace of change and the nature of the transition in any business or region will vary. Market pressures and regulatory drivers are different across the globe. Therefore, there are differing views in the market about just how quickly it will take to pivot away from fossil fuels. Of course, this is an iterative process with no fixed end point. The global energy market is evolving to produce a mixed and ultimately balanced combination of energy sources. This systematic market shift will continue for decades.
Many respondents to the QMUL and Pinsent Masons study said they think the fallout from Russia’s war in Ukraine will delay the global energy transition. In its energy outlook for 2023 (53-page / 2.2MB PDF), however, bp said it expects the effects of the war to accelerate the energy transition, based on the “increased importance placed on energy security” and the associated drive to “shift away from imported fossil fuels towards locally produced non-fossil fuels”.
What is clear is that the war in Ukraine has had an impact on global prices for fossil fuels and that sustained high oil and gas prices make it more likely that existing fields will be operated for longer.
In seeking to decouple their country’s energy security from their reliance on sourcing fossil fuels from Russia, many western governments have outlined plans to increase domestic low carbon energy generation capacity. Therefore, renewable sources of energy are expected to make an increasing and accelerated contribution to the energy mix of countries in the short to medium term.
However, the race to scale up renewables capacity will provide an environment for greater disputes. Several factors will contribute to the risk of dispute. Pressure on planning and building consenting, the competition between renewable technologies, limitations within the supply chain, untested technology, competition over funding and state aid, accelerated building programmes, disputes between JV partners and grid capacity and connection issues.
There is a finite number of suppliers and contractors capable of delivering major new renewable energy projects. We expect to see competition for their services and the products they supply – from wind turbines to solar cells – increase. Supply chain availability issues are a common cause for delay which can indirectly lead to disputes arising from associated issues like budget overspend, funding issues and pricing pressures.
For renewable projects in remote greenfield locations specifically, another cause of dispute could be delay arising from the difficulties in getting the assets connected to the electricity grid.
As large incumbents in the energy market seek to repurpose assets and diversify their own product and service offerings, as carbon capture, use and storage (CCUS) and hydrogen solutions emerge, for instance, many are partnering with so-called ‘cleantech’ providers via joint venture (JV) arrangements.
JVs are a popular mechanism for bringing businesses with different strengths together to innovate and commercialise solutions at scale, but as many respondents to the QMUL and Pinsent Masons study recognise, JV activity can give rise to disputes.
With any JV, choosing the right partner is important to avoid frictions arising. In oil and gas, the investment and profit profiles of incumbents are typically measured in decades, while technology providers have a short-term outlook. These differences in commercial expectation will need to be managed to avoid frustration and dispute.
There are inherent risks associated with any new technology. Disputes arise from design development and patent conflicts, performance requirements, defects, operation and maintenance, interface issues with other infrastructure and technology. This means that when negotiating terms, prospective JV partners will want to carefully consider risk allocation in respect of performance, defects and warranties.
On the one hand, large energy businesses may wish to push the bulk of the risk onto the technology provider that developed the underlying solution, but often it will be the energy business that has more financial clout and which is better able to stand behind risk. As was the case in the European biomass market a few years ago, failing to get the balance of risk right can put small technology providers at risk of liquidation which in turn puts JV-led projects at jeopardy.
As requirements are updated and new standards set, and as environmental, social and corporate governance (ESG) issues become more important factors in investor decision-making, so businesses should expect greater scrutiny of their practices – shareholder activism and climate-related litigation is on the rise.
Policy and regulation, flowing from international commitments made by governments, will continue to drive and shape the energy market and determine where funding is channelled. However, changes to state policy and financial incentives over time has and will continue to lead to significant disputes between foreign investors and state organisations. Many of these large energy investment disputes are resolved in investor-state arbitration.
The ability to avoid local courts for resolving disputes and the ease with which arbitral awards can be enforced were identified in the QMUL and Pinsent Masons study as core advantages of investor-state arbitration. However, respondents to the study also said they expect the planned modernisation of the Energy Charter Treaty (ECT) to have bearing on the suitability of arbitration for resolving energy transition-related disputes in future.
The ECT is a multilateral treaty with contracting parties including countries in Europe, Asia and the Middle East. It has applied since 1998. It protects energy investors against unreasonable or discriminatory conduct by states. In June 2022, members of the ECT reached an agreement in principle which will modernise the treaty, among other things, to reflect international renewable energy and net zero emissions targets, but some countries have already left the treaty, others have announced plans to do so, and the European Commission is reported to have recommended an EU-wide withdrawal.
What is clear is that investor-state disputes relating to the energy transition will almost certainly grow in future as governments update policy and regulation to deliver on decarbonisation commitments and the changes impact on the viability of foreign investments. We expect international arbitration to remain the most popular means by which those disputes are resolved.
You can watch a recording of Mark Harris and colleagues from Pinsent Masons examining the energy transition from a disputes perspective during an event last year.
20 Jan 2023