On ensuring stable natural gas supplies in China and Japan

Semenovich Kristina Sergeevna PhD in Law Director of the Center for Energy Law of St. Petersburg State University (St. Petersburg State University) 199034, Russia, gorod Sankt-Peterburg, g. Saint Petersburg, ul. Universitetskaya Naberezhnaya, D., 7-9 enlcenter@spbu.ru

Gao Yui Postgraduate student, Department of Commercial Law, St. Petersburg State University 199034, Russia, gorod Sankt-Peterburg, g. Saint Petersburg, ul. Universitetskaya Naberezhnaya, D., 7-9 gaoyu321324@gmail.com Other publications by this author

Since 2016, China and Japan, as well as other countries, have begun to fulfill the goals of the Paris Agreement of 12.12.2015 on achieving carbon neutrality, implementing an energy transition involving the development of "new energy" based on clean, carbon-free, intelligent and efficient energy ^{[1, 2]}. Natural gas, as well as energy derived from renewable energy sources, are gradually displacing oil from international energy markets. For example, according to the Energy Strategy of Russia for the period up to 2035, approved by the Decree of the Government of the Russian Federation dated 06/09/2020 No. 1523-r, among the largest economies in the world, the fuel and energy balance of the Russian Federation is one of the most environmentally friendly (low-carbon) - more than a third of the generation of electric energy accounts for nuclear power, hydropower and other renewable energy sources, about half is for natural gas ^[3]. It is natural gas that will play an important role in ensuring international energy security and transforming the structure of energy demand ^{[4, p. 29]}.

According to the International Energy Agency (IEA), in 2021, global consumption of natural gas increased by 4.6% ^[5]. European gas prices increased by almost 600%, which led to a crisis of natural gas supplies to the EU ^[6]. China's dependence on foreign natural gas has increased to more than 40%, the share of LNG supplies has increased from 13% in 2015 to 28% in 2020 ^[7]. China has become the world's largest importer of LNG. China and Japan, which are the world's largest emitters of greenhouse gases, face the task of achieving carbon neutrality by 2050, to solve which it is necessary to accelerate the internal transition from hydrocarbon consumption to renewable energy and new environmentally friendly energy sources.

To ensure the stability and security of oil and gas supplies, China and Japan have taken appropriate political decisions: they have carried out market reforms in the energy sectors, taken measures to encourage the signing of short-term and spot contracts for the purchase and sale of natural gas, approved procedures for reviewing prices in long-term contracts for the purchase and sale of natural gas.

1. Measures to ensure the safety and stability of natural gas supplies in China and Japan

In 2014, the Chinese government approved the "general concept of national security", which for the first time raised resource and environmental security to the strategic level of the country's national security in the Law of the People's Republic of China "On National Security" ^{[1, 8]}. In the same year, the Government of Japan in the "basic energy plan" recognized ensuring the security of energy supply as a strategic goal of energy ^[9].

Since 1949, China has gone through three stages of changing the order of oil and gas supplies: (1) since 1949, oil and gas imports to China have been heavily dependent on oil and gas supplies from the USSR; (2) since 1978, China's offshore and onshore oil and gas fields have been developed jointly with other countries, mainly through the attraction of foreign capital, the creation of joint ventures or on the basis of production sharing agreements; (3) in the XXI century, cooperation in the field of energy was organized within the framework of the "One Belt, One Road" project in order to connect the two largest world centers of energy exporters - the Middle East and the main oil-producing countries of the former Soviet Union (Russia, Turkmenistan and Kazakhstan), in order to provide China with a stable energy supply ^[10]. In Japan, the mechanism for importing natural gas depends on the government's implementation of a policy of subsidizing the extraction of foreign resources and the use of other financial support measures. All concluded contracts are mainly aimed at the purchase of LNG delivered by sea.

China and Japan have gradually moved from simply buying natural gas abroad to participating in financing the development of foreign oil and gas companies, joint field development projects, which strengthens their positions in the global energy market ^[11]. Nevertheless, China and Japan practically cannot influence the pricing policy in the field of natural gas supplies ^{[12, p. 4]}.

2. Reform of the domestic natural gas market in China and Japan

In order to ensure the security and stability of natural gas supplies, the Governments of China and Japan have also initiated reforms of the domestic natural gas market.

Since 2017, the Chinese government has embarked on a comprehensive reform of the oil and gas system, which provides for: ensuring stable and reliable oil and gas supplies, ensuring national energy security, as well as creating a competitive oil and gas market in the country^[13]. In 2019, the Chinese government not only lifted restrictions on foreign investment in oil exploration and production, but also actively encouraged private and foreign investors to finance shale gas exploration and production, as well as the construction of natural gas warehouses and receiving stations to provide domestic sources of natural gas supplies ^[14]. There was a complete opening of the oil and gas industry of China for external investment ^[15]. Three major state-owned vertically integrated oil and gas companies were separated, an independent PipeChina was created for the transportation of oil and gas, whose infrastructure can be used under contracts by all participants in the energy market.

The Law of Japan "On Natural Gas Utilities" ^[16] provides that all consumers can freely choose resource-supplying companies. In 2017, the Japanese government established a requirement to open LNG terminals to third parties. There has been a complete liberalization of the competitive market of Japanese natural gas terminals ^[17].

Natural gas marketization reforms in China and Japan have the following common features?

(1). Governments encourage diversification of energy import channels and transportation methods. Obtaining control over foreign natural gas fields is considered as an important means of ensuring the security of natural gas supplies ^{[18, p. 19, 19]}.

(2). In order to make efficient use of the natural gas transportation and storage infrastructure, market participants are allowed to freely use national natural gas transportation and storage systems (third party access).

(3). Natural gas trading centers (natural gas hub) are being created, reflecting the domestic spot price of natural gas. For example, the Shanghai Oil and Natural Gas Trading Center in China, whose activities are aimed at obtaining fair and reasonable prices for imported oil and gas ^{[20, 21, p. 141]}.

Similar natural gas marketization reforms have taken place in the European market. Since 2009, the European Union has carried out the third reform of the liberalization of the natural gas market (in particular, the European regulatory authorities forcibly opened third parties' access to natural gas transportation and distribution assets and promoted the separation of vertically integrated companies - the sphere of transportation is separated from the sphere of production and sale of natural gas). In addition, three more successful gas hubs in Europe (NBP in the United Kingdom, TTF in the Netherlands and NCG in Germany) have strengthened the position of European buyers in the international natural gas market.

3. Portfolio of long-term, short-term, spot contracts

Thanks to the success of the shale revolution in the United States in 2017, the United States turned from an importer of natural gas into the largest exporter. In the natural gas fields of traditional LNG exporting countries such as Australia and Qatar, production has increased, the total volume of global LNG trade has increased and the liquidity of the LNG spot market has increased. A number of LNG sellers began to use portfolio models. Such models relate to multinational assets, which include resources for the extraction, transportation of LNG, as well as long-term, short-term and spot contracts ^{[22, p. 2]}.

Portfolio players can effectively manage sets of contracts with various pricing mechanisms indexed by Henry Hub, TTF, JKM regional spot indexes or linked to oil quotes^[23]. The operator of portfolio players can meet the diverse needs of gas buyers by coordinating each link of the entire gas supply chain.

Compared to a long-term contract, the portfolio model has the following advantages: from the flexibility of LNG transportation (FOB or DES) to the coordination of transport vessels as needed (chartered vessels, guided vessels, spot charters, etc.); from the choice of various storage methods (LNG tanks or floating storage) to the use of own receiving terminals or lease of other parties for regasification ^{[24, p. 4-9]}. At the same time, a long-term contract has a number of serious drawbacks: in the process of executing long-term contracts, prices calculated in accordance with the established price formula deviate greatly from market prices. For example, a long-term agreement signed by Japan is linked to the JCC (Japan Crude Oil Cocktail) spot oil price index. The price set by JCC is much higher than the spot market price and cannot reflect the actual supply-demand ratio and the actual price of natural gas.

Until 2020, the price of LNG in spot and short-term contracts was significantly lower than the price of natural gas in long-term contracts, which led to massive refusals of concluded long-term contracts. Prior to the separation and liquidation of the monopoly pipeline transportation business of China's three largest state-owned oil and gas companies (CNPC, SINOPEC and CNOOC), if the price of natural gas increased along with the price of oil in long-term contracts signed by these three companies, the difference was shifted to domestic consumers. After the establishment of the national independent natural gas pipeline company PipeChina in 2019, long-term contracts dominated by portfolio players began to fully compete with spot and short-term contracts ^[25].

The places where natural gas is extracted and consumed under long-term contracts are geographically close. For example, the contract for the purchase and sale of Russian gas along the Eastern route (the Power of Siberia gas pipeline) has been concluded for a period of 30 years and involves the supply to China 38 billion cubic meters. m of gas per year.  Transportation of natural gas through pipelines is not only characterized by low transport costs, but also assumes stable supplies. Despite the fact that short-term or spot contracts have the advantages of flexibility in terms of demand, transportation costs are high in them, and price fluctuations are relatively large.

4. Review of contract prices in arbitration

State regulation of prices (tariffs) in the fuel and energy complex is one of the main mechanisms for implementing energy policy and is aimed at achieving an optimal combination of economic interests of consumers and subjects of natural monopolies ^[26].

The prices of short-term and spot contracts often differ greatly from the prices of long-term contracts, so Chinese and Japanese buyers began to demand a revision of the prices of previously concluded long-term contracts, as well as the inclusion in long-term contracts of provisions on the possibility of price revision in arbitration (a price review with binding arbitration) ^{[27, p. 437]}.  A similar situation occurred in Europe in 2009 after the third reform of the natural gas market.

If a long-term contract does not contain relevant provisions on the revision of prices, the legal relations of the parties become unstable. The clause of the price revision agreement plays the role of a "ballast stone" during its entire validity period. After the reforms of the energy markets, each long-term contract concluded by the Chinese or Japanese side contains a clause on the procedure for reviewing the price - negotiations, which also specifies the formula for calculating the price. If the parties to the contract do not come to a new agreement on the revision of the price, the dispute is referred to the arbitration court.

A long-term contract usually includes conflict of laws rules, such as: applicable law on the merits of disputes, applicable law on the validity of an arbitration agreement, arbitration procedural law, etc. In addition, the parties usually have high requirements for confidentiality, enforceability of the decision and the level of professionalism of the arbitrator. International Commercial Arbitration is often chosen to resolve price disputes.

Arbitration clauses on price revision contain two important elements: 1) the trigger mechanism and 2) the scope of changes authorized by the arbitration court ^{[28, p. 37-39]}.

Basically, two ways of determining the provisions on the trigger mechanism prevail. The first one contains three elements: a) the circumstances are beyond the control of the contracting party; b) the circumstances lead to significant changes in the buyer's market; c) in order to adapt to this significant market change, it is necessary to revise the formula for calculating the price. The second one contains four elements: a) a change in the economic situation during the execution of the contract; b) this change is obvious; c) this change occurs in the buyer's country or market; d) the change is beyond the control of the contracting parties ^{[29, p. 487]}. The first, three-element method mainly focuses on finding a causal relationship between the elements. The second, four-element method is to study each element separately.

When the price is revised, the amount in dispute is usually very large, billions of dollars are often at stake, while a change in the contract price by just a few cents leads to an increase in costs by several million dollars during the term of the contract or until the next price revision ^{[30, p. 131]}. The scope of the powers of the arbitration court in the matter of price revision may be limited to a partial revision (revision of a specific article) or to allow a revision of all the conditions for determining the price. As part of the partial review, the arbitration court is trying to restore the balance between the rights and obligations (economic interests) of the contracting parties that existed before the dispute was referred to the arbitration court. During the revision of all the provisions of the contract regulating the price, on the contrary, the balance of rights and obligations (economic interests) the parties reached at the conclusion of the contract are not taken into account by the court, a new price calculation is made based on the current situation ^{[31, p. 146]}.

It is obvious that when approving a new settlement, the terms of the contract undergo significant changes that may violate the original economic interests of the parties, which may lead to evasion from the execution of the arbitration court's decision by one or both parties to the dispute ^{[28, p. 39]}. Arbitration clauses with the power to partially change the terms prevail. For example, in the case of RWE v. Gazprom Export in 2013, the ICC arbitration partially satisfied RWE's requirement to adjust the contract price formula by removing the reference to the oil price and replacing the reference to spot gas prices^[32].

Meanwhile, the price formula is the central point of the entire contract, and its change will entail a change in other terms of the contract: conditions related to the supply of gas (take or pay / take or pay, flexibility of supply, over-delivery, etc.), rights and obligations of the parties and others.

In the case of GNA v. Atlantic LNG Co. of Trinidad Tobago, article 8.5 of the long-term contract for the sale of natural gas provided: (b) When reviewing the contract price, the Parties should take into account the levels and trends of prices for LNG and natural gas supplies and take into account all the characteristics of such supplies (including, but not limited to quality, quantity, possibility of interruption, flexibility of supply and delivery time); (c) The contract price revised in accordance with this article shall take into account, in particular, all relevant operations, services and risks at import points for processing and marketing of natural gas in all market segments.

In this case, the Atlantic seller, through arbitration, demanded an increase in contract prices to take into account the cost of natural gas in the New England market. The Arbitration Court divided the original single market price into two different prices, that is, for the price in Spain: the original price formula was preserved, and its components were revised. And for the New England price, a "New England market adjustment" has been added. Both sides of the dispute objected to the decision of the arbitration court.

When appealing, the Plaintiff Atlantic referred to the excess of the arbitration powers, expressed in the imposition of a pricing scheme, distortion of the original transaction and in fact a complete change in contractual relations.

It is established that both parties in the arbitration clause actually granted the arbitration court the right to review the price: if the prerequisites for initiating a review of the price are met, the arbitrator has the right to make a fair and impartial result at his discretion. There were no restrictions on the application of the double price structure by the arbitration court, the court literally interpreted the text of the contract ^{[33, p. 2-6]}.

According to experts, previously all revisions of LNG prices in Asia took place during "negotiations at the pre-arbitration stage" ^{[34, p. 18]}. Prior to the reforms of the natural gas market, long-term contracts concluded by the Chinese and Japanese sides indicated the need for "appropriate", "reasonable", "fair", "price adjustments", or "a combination of these or similar thresholds". The provisions of the trigger mechanism of price changes also rarely contained such items as "significant changes in the economic environment of a particular market"^[34]. In addition, Chinese and Japanese buyers of natural gas were mainly companies with close ties with the government, so the parties were more inclined to negotiate and agree on the settlement of price issues than to submit the dispute to arbitration ^{[35, 36, p. 31]}.

Now the new long-term contracts being concluded include an arbitration clause on the revision of prices and contain clearer conditions for the revision. In fact, the arbitration proceedings on the revision of prices contributed to the transition from a formula for calculating prices linked to the oil price index to a pricing mechanism based on various indices of natural gas hubs.  In the European natural gas market, according to experts, up to 50% of long-term contracts have been revised taking into account the prices of European centers (hubs) natural gas trading ^[37]. China and Japan also accelerated the process of abandoning the traditional natural gas pricing mechanism tied to oil prices and turned to developing a new mechanism based on hub pricing ^{[38, p. 109]}.

While competition in the natural gas trading centers of China and Japan, unlike the British NBP hub, is in the process of formation, when concluding a new or revising a previous long-term contract, Chinese and Japanese buyers with international suppliers are recommended to use a price formula calculated based on the price index of developing shopping centers, spot price and JCC, in order to avoid excessive fluctuations in natural gas prices ^{[39, p. 6, 40]}. At the same time, it is a long-term contract that is a tool that allows ensuring reliable and uninterrupted supplies of natural gas to China and Japan, despite changing economic, epidemiological, and climatic conditions.