Take-or-pay contracts: Lessons from Brazil and Bolivia

Michael Giberson

Yesterday’s post on the Gazprom take-or-pay contract dispute mentions a now classic article by Scott Masten and Keith Crocker, “Efficient adaptation in long-term contracts: Take-or-pay provisions for natural gas” (American Economic Review, 1985).  You may wonder if there is newer work on take-or-pay contracting potentially relevant to the case of Gazprom and its customers.  The short answer: Yes.

The February 2009 volume of Energy Policy includes Jean-Michel Glachant and Michelle Hallack, “Take-or-pay contract robustness: A three step story told by the Brazil–Bolivia gas case.”

Glachant and Hallack examine the manner in which two take-or-pay contracts used to align incentives and share risks among gas consumers in Brazil, a gas pipeline company in Brazil, and gas producers in Bolivia. The situation:

Brazil desired an energy source that is less expensive than its domestic resources and is relatively clean. Bolivia, in turn, has the potential to produce vast quantities of natural gas, but little domestic demand. These two countries thus have the capacity to develop both the upstream and the downstream of a strong gas market. However, connecting this upstream and downstream requires the construction of nearly 3000 km of pipeline.

The authors find the alignment of incentives changes over the term of the contract, distinguishing in their analysis between the ex ante phase (before construction begins), initial trading phase (infrastructure in place, but use below capacity), and a mature phase (capacity fully used, expansion would be expensive).  In the third phase, with investment costs largely sunk and throughput at its maximum, all adjustment is via transfer price within the limits of the contract. Here the incentives of producer and consumer become directly opposed.

When in 2006 international natural gas costs rose, Bolivia sought to renegotiate the price in the contract and threatened to cut off supplies to Brazil.  Glachant and Hallack observe that lacking an independent third party arbitrator, Brazil and Bolivia resolved the conflict by means of a diplomatic summit between the presidents of the two countries.  They sum up:

During the first and second phases of the contract lifecycle, ToP clauses and complementary “netback prices” are sufficient to align the interests of the partners and hasten the development of trade. The fundamental safeguards here come from self-enforcement, with bilateral hostages, risk sharing, and appropriate incentives. However, during the final, mature period of the contract cycle there is a change to the strength and consistency of the bilateral “self-enforcement” mechanisms—be they hostages, the initial allocation of risks, or the initial alignment of incentives. The changes operating at the end of the cycle give rise to conflicts of interest between the upstream and the downstream of the industry. They enhance the importance of the existence of an independent third party to support the long-term application of the initial ToP contract.