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The Kapuni Judgment - One Year On
presented by E Welson and M Verbiest, Simpson Grierson, PO Box 2402, Wellington,
at the 1998 New Zealand Petroleum Conference
Abstract
The energy industry is characterised by long term contracts, often with take or pay requirements and output requirements. The Kapuni Contract is one such contract. Entered into in 1967, the commercial environment in which that contract was ultimately challenged in the Courts was significantly different to that at the time it was entered into. While long term contracts are not, by themselves, inherently anti-competitive, the substantive test in section 27 of the Commerce Act 1986 has continuing application and requires that they be judged in the context of circumstances applying at any given time. The paper discusses why Justice Barker determined that the Kapuni Contract brought the defendants within section 27 and reviews that analysis in the context of the commercial environment one year on.
Introduction
The Judgment of the High Court in the Kapuni Decision is a land mark judgment, for a number of reasons.
It is perhaps most significant because this was the first time that a court exercised the powers in section 89(2) of the Commerce Act 1986 to vary a contract which it had found to be anti-competitive.
At issue was a contract for the sale of natural gas from the Kapuni Field signed in July 1967 between the then developers of the Kapuni Field, Shell, BP and Todd and the New Zealand Government.
At the time the litigation was commenced, the parties to the Kapuni Contract were Shell and Todd as the sellers (BP had sold out its interest) and Kapuni Gas Contracts Limited (KGCL), a wholly owned subsidiary of Fletcher Challenge Limited, as the purchaser of the gas. In 1970 the Crown assigned its interests to what was the then government owned Natural Gas Corporation (NGC). NGC was subsequently privatised and in turn assigned its rights as buyer to KGCL. NGC however remained liable to Shell/Todd for performance of the contract and, under a series of contracts with KGCL, was responsible for managing KGCL's interests under the Kapuni Contract and other related contracts.
A Brief History
To understand the issues before the Court and the significance of the decision, it is useful to understand some of the background to the contract.
The Kapuni Field
The Kapuni Field was discovered in 1959 and is a gas condensate field. This was the first discovery of its kind in New Zealand's history and a natural gas industry as such did not at that time exist. The field was originally thought to have proven gas reserves of around 263 PJ with probable reserves of 395 PJ. Delivery of gas commenced on 31 May 1970.
In June 1972 there was a re-determination of the original recoverable reserves, increasing the reserves to 485 PJ. A further informal re-determination in 1977 put the reserves at 749 PJ. At the time of the Kapuni hearing reserves were estimated at 908 PJ, of which about 400 PJ remained in the field - well above the initial proven reserves.
The Kapuni Contract
All condensate was retained by Shell/BP/Todd and the untreated gas was sold to the Crown. Annual Contract Quantities totalling approximately 264 PJ were fixed over a 25 year primary period from the date of first delivery, with a requirement that if the contract continued beyond the 25th year Annual Contract Quantities were to be determined by mutual agreement but could never be less than the Annual Contract Quantity for the 25th year.
Significant take or pay obligations totalling approximately 253 PJ, or 96% of the field over the initial 25 year period, were assumed by the Crown.
All gas in the field was dedicated to performance of the contract. That obligation, however, was expressed to be "subject to the other provisions" of the contract.
The Litigation
The parties came before the Court in 1996. Shell/Todd were plaintiffs. KGCL and NGC the defendants.
There were two central issues argued before the Court. The first issue concerned interpretation of the contract. In particular, the provision which dedicated all gas in the field to the performance of the contract. The second issue was a claim by Shell/Todd that, in the event the contract was still on foot, it was anti-competitive and breached sections 27 and 36 of the Commerce Act 1986. Various forms of relief under that Act were sought by both parties.
Contract Claim
Shell/Todd's basic contention was that the contract had come to an end when the total Annual Contract Quantities of gas had been supplied, shortly after the end of the initial 25 year period. This is somewhat of an over simplification of a series of related arguments on the appropriate interpretation of the contract. The outcome, however, was that the Court held that the contract dedicated the Kapuni Field to the contract beyond the initial 25 year period and for the life of the field.
Commerce Act Claim
Having addressed the contractual issues in favour of the buyers, the Court considered Shell/Todd's further claim that the contract was anti-competitive and contravened sections 27 and 36 of the Commerce Act 1986.
Section 27
Section 27 of the Commerce Act prohibits contracts, arrangements or understandings which have the purpose, effect or likely effect, of substantially lessening competition. Subsection 4 provides that such a provision in a contract is unenforceable.
There are a number of key elements in any section 27 analysis. The first, and most critical, is to define the relevant market. The next step is to consider the impact of the contract and whether there is, or is likely to be, a substantial lessening of competition.
Shell/Todd contended that the Kapuni Contract breached section 27 because NGC and KGCL, separately and together, had broad interests in the gas industry. They argued that to allow them to have the sole benefit of the Kapuni Contract would, given their involvement with the gas industry and with each other, have the likely effect of substantially lessening competition in the market for gas.
The Court agreed that NGC and KGCL had to be considered together in the market context. "...because KGCL's business is operated by NGC and because NGC is liable equally under the contract as the assignor to KGCL, it would be artificial to consider the defendants individually. Any assessment of KGCL's market power cannot be made without acknowledging both the heavy involvement of its parent [Fletcher Challenge Limited] in the gas industry as well as the numerous links between KGCL and NGC".
When considering what was the appropriate market, the Court endorsed the approach of the Australian High Court in Queensland Wire Industries Pty Limited v BHP Co Limited (1989) 167 CLR, 177 to the effect that defining the market and evaluating the degree of power in that market are part of the same process. Following a lengthy and detailed overview of the state of the gas industry in New Zealand as it was in 1996 the Court concluded that there were two relevant markets - a wholesale market and a retail market for natural gas. It also identified a separate market for transmission of gas.
The Court found that the constraints from other fuels were limited and that in the wholesale market there was no evidence of NGC being constrained by other gas sellers such as Contact Energy or Methanex - at least at the particular time the Court heard evidence. Arguments based on potential entry were not accepted by the Court. The Court concluded that NGC was the only effective wholesaler of gas and therefore was dominant in the wholesale market and that it also had a substantial degree of market power in the retail market.
The Court then moved on to consider the likely effect of a continuation of the Kapuni contract, possibly for another 15-20 years and whether, in giving effect to that contract, NGC and KGCL would have such market power that they would be able to behave without regard to actual or potential competitors. As part of this analysis the Court regarded the dedication of the Kapuni Field to the contract as being in the nature of a long term "output" or "requirements" contract and, in that context, considered various decisions in Australia and the United States. While on the one hand the Court accepted that long term output contracts have inherent anti-competitive features, it also recognised that there are economic justifications by way of pro-competitive effects, such as benefits for new entrants to a market where large capital investment is required and for existing participants in a market where economies of scale may result from such contracts.
However, the only issue to be determined under section 27 is the primary test for illegality - whether the contract has or is likely to have the effect of substantially lessening competition. The general view up until this time had been that section 27 did not allow for consideration of any public benefits. Nevertheless, the Court identified what it saw as a trend for efficiencies to be considered in terms of their pro-competitive effects and concluded that it should, when considering the competitive impact of the Kapuni Contract, have regard to any efficiencies which were pro-competitive.
As its starting point the Court reviewed the approach taken under the United States anti-trust laws, where the United States Courts consider the potential benefits of such contracts and take into account the resulting efficiency gains when judging the terms of a requirements contract in relation to the substantiality of the foreclosure of competition.
It went on to consider the approach of the Australian Competition and Consumer Commission ("ACCC") to long term supply contracts, generally in the context of authorisations. The ACCC has recently recognised that requirements contracts may have pro-competitive benefits arising from efficiencies separately from other public benefit attributes. This approach is also reflected in the ACCC's merger guidelines, which make it clear that efficiencies should also be taken into account in assessing competition.
The Court reviewed in detail the ACCC's decision in the matter of Australian Gas Light Company, a review by the ACCC of an authorisation granted in December 1981 of an agreement between the Australian Gas Light Company and the Cooper Basin producers of natural gas. While having regard to the benefits arising from long term supply contracts, which it recognised as "a means of addressing the risks associated with the high costs of exploration, production and transmission in developing markets", the ACCC nonetheless held that the benefits of the particular contract under consideration, which at that stage, had run for 25 years, were "now outweighed by their anti-competitive effects in restricting the entry of a third party producer to the New South Wales markets".
In its own analysis of the effect of the Kapuni Contract on competition the Court accepted economic evidence highlighting the efficiencies and desirability of certainty for gas explorers and producers when they enter long term contracts and that exploration will slow down if long term contracts can be broken once the capital cost of the field and any pipeline transmission networks have been recovered.
However, on balance, it concluded that the exploration and efficiency arguments were insufficient to overcome the foreclosure of competition which arose from what it described as "NGC's unconstrained market power". Here was an exclusive dealing contract which had run for 29 years, which could easily last for another 20 years and which tied up the whole of the only significant onshore gas field in New Zealand in the hands of the dominant wholesaler.
Section 36
Although the Shell/Todd claim proceeded under both section 27 and section 36, there appears to have been very little evidence in relation to section 36. Section 36 prohibits the use of a dominant position for the purpose of restricting a persons entry into a market or preventing or deterring a person from engaging in competitive conduct. The Court found that neither of the requirements of purpose or use of power was made out. It expressly rejected Shell/Todd's argument that NGC's actions to enforce its perceived contractual rights were sufficient to meet the purpose requirement.
Remedies
Section 89(2) of the Commerce Act gives a broad remedial discretion to the Court to make orders by way of variation or cancellation of a contract or to require restitution or payment of compensation.
Shell/Todd sought to have the whole contract set aside while NGC argued for limited variation and put forward a tender process or sale back for the quantities of gas awarded to Shell/Todd. NGC countered Shell/Todd's submission to have the contract set aside with arguments that to do so would be an expropriation without compensation.
The Court observed that the issue of compensation was not one that seemed to have been addressed in previous competition cases. It adopted the view that the word compensation suggested a legitimate entitlement to property which property had subsequently been taken away. The impact of section 27 however was to make NGC's entitlement unenforceable. Compensation was inappropriate in those circumstances.
What the Court chose to do was to vary the contract "in a manner which provides as reasonable a competitive outcome as is possible in such a small market". It decided that the anti-competitive aspects could be eliminated by allowing Shell/Todd to retain up to one half of the remaining gas in the field from 1 April 1997.
This was fleshed out with some details by way of further variation of the Kapuni Contract providing for determination of the price to be paid by NGC for its share and of annual quantities. The judgment also formalised an undertaking offered by Shell/Todd not to sell gas into the petrochemical industry or for electricity generation other than cogeneration projects, and a further undertaking by NGC/KGCL to make its CO2 removal plant available to Shell/Todd, should it require, at a reasonable price.
This is the first time that the Court has exercised its discretion under section 89(2) to vary a contract found to be unenforceable. The discretion to vary is very wide. The only limitation on the Court's discretion is not to replace one anti-competitive provision with another. Here, the Court appears to have been driven by a desire to open up the wholesale gas market to competition and a belief that if Shell/Todd were to retain part of the Kapuni Field, they would have a greater incentive to prove up more reserves which, on the evidence before the Court, seemed likely to exist.
One Year On
At the time the Kapuni Judgment was handed down it was almost universally hailed as introducing competition into the wholesale gas market. Certainly that was the Court's expressed intention. Has this happened?
I don't pretend to be an expert on the finer details of the gas market as it stands in 1998. I leave that to other speakers. What follows is a lawyer's view.
Having defined two separate markets - the wholesale market and a retail market, the Court seemingly proceeded to exclude Shell/Todd from a large chunk of the wholesale market. Shell/Todd are excluded from selling Kapuni gas into the petrochemical and electricity generation markets. The various gas utilities would appear to now all be effectively supplied. Since the judgment was handed down NGC has finalised contracts with TransAlta and Enerco as well as other reticulated utilities. Enerco has also contracted with Contact Energy for supply. Although query whether the gas utilities have all taken their full requirement and may still want to purchase top up quantities from someone else.
Of significance is one of the "questions of detail" addressed in the supplementary Kapuni Judgement. The issue that arose was utilisation of annual quantities. Was there an ability for either party to "bank" gas, for example, pending Maui gas becoming scarce? The Court pointed out that "the whole purpose of the judgment is to encourage competition in the wholesale market". It therefore determined that both parties must utilise their respective annual quantities. At the same time it recognised that it was impractical to assume that Shell/Todd would be able to develop a market share for its gas overnight and provided a "break-in" period of three years during which Shell/Todd would not be required to use all of their annual quantities.
Obviously, the amounts fixed by way of annual quantities are critical. Evidence led at the Kapuni hearing suggested that the Kapuni Field was capable of delivering about 25 PJ for the next 13 years, declining to less than 10 PJ per annum after 18 years. Alternatively it could produce about 32 PJ per annum for about nine years declining to less than 10 PJ per annum after 16 years. On these figures it is likely that Shell/Todd could have available to it for sale anywhere between 11 PJ to 16 PJ per annum. It seems that these quantities may have been fixed at 16 PJ.
Once the three year grace period has expired Shell/Todd must sell all of its annual quantity or lose the benefit of half of it back to NGC (assuming that NGC uses the whole of its annual quantity, which seems likely given its current contractual commitments for Kapuni gas).
Evidence was led at the hearing about potential purchasers from Shell/Todd. The most significant was a contract already entered into in 1995 to supply Kapuni gas to Kiwi Co-op Diary Co Ltd for 10 years with a minimum requirement to supply 2.6 PJ per annum. Other potential customers were suggested to be Lactose New Zealand Limited at 0.55 PJ per annum and Taranaki By-Products Ltd, described as "a relatively small consumer".
Although Shell/Todd have another two years to develop a market for Kapuni gas, it is difficult to see where 16 PJ per annum can be sold in the wholesale market other than for new cogeneration projects or back to NGC. The only other option and probably a more realistic one is sale into the reticulated gas market through the open access régime.
I leave you with the following thought: is it possible that rather than opening up competition in the wholesale gas market, the impact of the Kapuni Judgment will be most felt in the retail gas market with increased competition for large industrial consumers. Ironically, many of the local utilities with whom Shell/Todd are most likely to be competing for customers will have signed up long term supply agreements with NGC, presumably with some form of take or pay commitment.
Authors
Elisabeth Welson is a Senior Associate at Simpson Grierson. She practices in the energy sector and advises on competition issues generally. Her energy practice includes gas, electricity and oil at all levels in those markets. Matters on which she has advised, include advising Enerco New Zealand in respect of gas supply contracts and issues, acting for the Crown on the establishment of Contact Energy Limited and the acquisition of assets from ECNZ, including ECNZ's Maui gas supply contract and related arrangements and advising Transpower on a range of issues. She has practised law in both Australia and New Zealand.
Mark Verbiest is a Partner at Simpson Grierson. His practice in the energy sector ranges over 15 years and includes advising Enerco New Zealand in respect of gas supply contracts and issues and also strategy industry issues, acting for the Crown on the split of Transpower New Zealand Limited from ECNZ, acting for the Crown on the establishment of Contact Energy Limited and the acquisition of assets from ECNZ, including ECNZ's Maui gas supply contract, advising Transpower on a range of issues including the establishment of the wholesale market, establishing the Brierley led AsiaPower joint venture, establishing utility investor Infratil and advising numerous other parties on supply contracts and the like. Mark has also had previous petroleum exploration farm-in experience.
