Take or Pay Clause in Energy Contracts
What is a take or pay clause in an energy contract?
If you haven’t heard the term before, the short and sweet explanation is that a take-or-pay clause is a contractual provision where a buyer agrees to pay for the minimum amount of a product or service upfront. Moreover, the agreement will be honored regardless of whether the buyer actually uses the minimum amount of the item in question.
We’re talking specifically about energy in this circumstance, but take-or-pay clauses are used in contracts across a range of industries. In the energy sector, these clauses are commonly found in liquefied natural gas (‘LNG’), sale and purchase agreements (‘SPAs’), natural gas SPAs, power purchase agreements, and other long-term purchase or supply arrangements. Similar ‘send-or-pay’ clauses are found in gas transportation agreements.
By requiring the buyer to make payments regardless of how much of the good or service is used, take-or-pay clauses seek to guarantee the seller a consistent stream of revenue, which has become more important than ever in today’s changing business landscape.
The effect of COVID-19 on energy suppliers
The energy industry is buzzing about consumption, or—more to the point—the lack thereof. This is a key area of concern for most business energy suppliers in the U.K, many of whom overbought energy at the beginning of a contract and need to sell the remainder back to the market.
Historically, when the market rose and a supplier overestimated the amount of energy they would need, they were able to sell the remaining volume at a profitable position. The market was strong enough to allow suppliers to cover the cost of the original transaction while making a small profit on the resale.
The difference between then and now is that the COVID-19 lockdown closed businesses, both temporarily and permanently, all over the world. This led to a significant decline in energy demand. The result? Many suppliers were left with too much supply and not enough demand. It’s a tough situation, to say the least.
No one could have predicted COVID-19, or the lockdowns that would prove to be detrimental to so many businesses and industries. Through a type of domino effect, we find ourselves in awkward situations as either well-intentioned customers or well-intentioned suppliers where there is simply not enough demand for energy.
So what does this mean? In short: energy suppliers need to find a way of recouping their losses.
Take or pay clause in flexible energy contracts
The most straightforward way that suppliers can protect themselves against this type of market dilemma is by instating a take or pay clause in their energy supply contracts. This clause guarantees suppliers some level of certainty and security, despite the risk they’re taking when they enter into a contract with the buyer.
To put all of this into context, here’s some food for thought: a business enters into a supply contract with Supplier A, then secures something like a million kW hours for annual usage. By the end of the fiscal year, that business has used 500,000 kW hours—only half of what they’d thought. Suppliers who have the safety net of a take or pay clause will still end up being compensated for a minimum of something like 70%, and a maximum of 130%.
Now, you might be thinking: why is there a maximum threshold? Surely the more energy I use, the better it is for a supplier.
Here’s the thing: that’s not really the case. If you use too much energy, the supplier won’t have hedged correctly for your energy portfolio; thus, if you consumed 1.5 million kW hours during the year, they’ll need to buy the surplus energy—and the market is now in a different place than when you both signed the contract.
All of this is precisely why the take or pay clause exists. It’s not in every contract; some suppliers do not have take or pay clauses. In these cases, you may find that you’ll pay a premium for not having a take or pay clause, but what you’re really paying for is a fully de-risked contract.
If you have a take-or-pay clause in your energy contract
Let’s assume that you’re in the majority of U.K. customers who have a take or pay clause in their energy contract. I think the best approach is to evaluate what your energy consumption has been during the lockdown, determine the amount of time you have left in your energy contract, and try to anticipate your business’s needs going forward. All of this will prove tremendously helpful to your supplier. At the end of the day, it is truly in the best interests of all parties to establish free and open communication, which will mitigate losses for both buyer and seller.
What are suppliers currently doing to solve volume discrepancies?
The solution to volume discrepancies depends a lot on the individual supplier’s business model. There are some suppliers that have been able to remain calm in the face of these major issues that COVID-19 has presented, either because their circumstances have been lucky or because they’ve got a diverse enough portfolio to withstand such turmoil. Others may want to have a conversation in the event of a major supply discrepancy that deviates from their agreement with you.
Don’t judge the supplier for knocking on your door if there is an issue with volume tolerance. Instead, working openly with your supplier towards a resolution will be in the best interest of all involved. It’s possible that suppliers may use such meetings as leverage to secure a contract renewal, which could prove to be an advantageous option for both parties.
That said, a word of forewarning: some suppliers may demand either a payment from the buyer, or an extension of their contract for continued business to recoup losses. While both of these are valid options, it would be better if the supplier revealed exactly what the exposure is, in pounds value, at that given moment. In this same vein, they should also be willing to share the number of kW hours compared to the agreed-upon rate.
Alternatively, it may be beneficial to go back to the drawing board for your energy renewal, since the market is in a lower place. It may work out in your favor to go with another supplier, take the hit, and possibly achieve a better financial result. It’s important, however, that you check the market against any punitive charges you’ll receive for a lack of energy consumption. Doing so will give you peace of mind that you’re making the best decision for your business.
Ultimately, every supplier has a different approach when it comes to the idea of take or pay. As the market and current events continue to shift, suppliers will need to respond in the interest of their companies to secure profitable business; however, these decisions don’t have to be made at the expense of your business’s interests. A business energy consultant can guide you through this process.
If you have any questions about take or pay clauses, or your energy contract, COVID-19, and its effect on your current contractual obligations, please contact us or call us on 0203 068 0000