A Switch to Natural Gas Raises Exposure To Coal-Related Contract Damages
The lure of low natural gas prices is undeniable. As companies choose (or are compelled) to reduce coal consumption in favor of gas, however, they are well-advised to examine the many potential legal and economic minefields that may lurk in coal supply and coal transportation contracts. Of particular importance is the cost of satisfying coal supply and coal transportation contract damages that may apply for missing annual minimum volumes.
Most coal supply and coal transportation contracts are priced on the assumption that the consumer will purchase and transport an annual minimum volume of coal. Theoretically, the shipper enjoys the benefits of a “volume discount” on prices, and the railroad and/or coal supplier benefit from assured volume sales and profits. To protect the economic value of these volume-based arrangements, most contracts have built-in damages provisions that will compensate the supplier or carrier if the shipper falls short of its annual minimum volumes.
Liquidated damages are the most common form of damages remedy found in coal supply and transportation contracts. A typical liquidated damages clause obligates the shipper/purchaser to pay a fixed amount or a percentage of the price for each shortfall ton. In making decisions regarding a switch to greater reliance on natural gas, costs associated with coal volume shortfalls often are assumed in a straightforward fashion. For example, assume that a shipper is obligated to pay $5.00 per ton for each shortfall ton. If the shipper is obligated to purchase and ship 1,000,000 tons of coal, but the shipper decides to purchase and ship only 800,000 tons due to gas displacement, the shipper could figure it owes $1,000,000 to both the railroad and the mine. Simple enough? . . . not quite.
Liquidated damages provisions can hold hidden traps. The most problematic hazard is the belief that liquidated damages clauses are the last-and-final word on damages calculations. This is not always the case.
Liquidated damages clauses generally are intended to apply when a shipper misses a targeted annual minimum volume despite its good faith efforts to meet the minimum. Depending on the language of the contract, a shipper’s deliberate decision to burn natural gas instead of coal may fall outside of the scope of the liquidated damages provision. When that happens, the aggrieved party may opt to seek actual damages, which could be much greater than liquidated damages.
It is imperative that a shipper analyze the legal prospects of different measures of actual damages that might be awarded, and that it calculate such amounts in advance, if possible. For example, actual damages under a rail transportation contract might include consideration of the railroad’s profit margin using different costing systems and approaches. The results of such analyses can differ by several dollars per ton, which could reduce substantially or even negate the value of switching to natural gas.
Liquidated damages clauses also can lull the unsuspecting into assuming that the contract itself is secure. Depending on the language and the severity of the shortfall, a carrier or coal supplier might opt to seek actual damages and terminate the contract, arguing that the shortfall represents a “material” breach that excuses it from performance under the contract.
Reducing coal volumes to allow for increased natural gas use is a consequential decision. Advance research now can prevent unwelcome surprises down the road.