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Focus: Flooding generates more debate on consequential loss exclusion

14 October 2013

In brief: A recent decision of the Western Australian Supreme Court arising out of a flooding incident at a remote power station near Lake Argyle, WA, has shone a bright light on the law on consequential loss in the wake of the previous authority that had informed this area of law. Partner Michael Hollingdale and Senior Associate Nicholas Gallina report on the case.  

How does it affect you?

    • This decision1 indicates that:
      • courts will approach the interpretation of consequential loss exclusion clauses from the starting point of construing the clause according to its natural and ordinary meaning in light of the contract as a whole;
      • courts may be less inclined to approach the interpretation of these clauses in a way that is constrained by reference to the second limb of the rule in Hadley v Baxendale2 or by reference to the 'normal measure of damages' espoused in Peerless3; and
      • the law on consequential loss remains unsettled.
    • As a result, care needs to be taken when drafting clauses purporting to exclude liability for consequential loss.
    • Best practice is to aim for drafting that specifies, without reference to terms such as 'consequential loss' or 'indirect loss', those losses intended to be recoverable and those that are not. 

The facts

Under a power purchase agreement made in 1994 (the PPA), Pacific Hydro Group Two Pty Ltd agreed to construct the Ord Hydro Power Station adjacent to Lake Argyle, near Kununurra in northern Western Australia, and then sell the power station's electricity to the Regional Power Corporation (the Corporation).

As the result of a flooding incident that occurred in 2006, the power station became inoperative for two months.4 The Corporation claimed approximately $4 million in damages for breach of contract for its cost of hiring diesel generators and purchasing fuel to generate replacement electricity.5  

Pacific Hydro argued that the Corporation's economic loss was in the nature of consequential or indirect loss, and so was excluded by clause 26.1 of the PPA. This clause stated: 'Neither [party] shall be liable to the other party in contract, tort, warranty, strict liability, or any other legal theory for any indirect, consequential, incidental, punitive or exemplary damages or loss of profits.'6  

The Corporation's arguments were:

  • In 1994, it was well understood and well accepted (among the lawyers and legal draftsmen involved with the PPA) that consequential loss was to be determined by reference to the second limb of the rule in Hadley v Baxendale. The first limb refers to damages that 'may fairly and reasonably be considered' as 'arising naturally, ie, according to the usual course of things, from such breach'. The second limb of the rule in Hadley v Baxendale refers to damages that 'may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it'.7  
  • While the law in Australia on consequential loss may have altered since 1994, the accepted meaning of consequential loss at the time the PPA was entered into should apply to the construction of clause 26.1 of the PPA.8  
  • In 1994, a reasonable person in Pacific Hydro's position could have foreseen that the damages the Corporation claimed as a result of the 2006 flooding incident would be likely to arise in the ordinary course of things from a breach of the PPA.
  • Clause 16.3 of the PPA, which affords the Corporation the right to generate its own electricity to cover any shortfall in supply by the power station, supported this position.9  
  • On this basis, the Corporation's losses fell within the first limb of the rule in Hadley v Baxendale and were therefore recoverable under the PPA.10   

Pacific Hydro relied on Peerless to support its position that the Corporation's losses were consequential or indirect losses and therefore excluded by clause 26.1 of the PPA. In Peerless, Justice Nettle of the Victorian Supreme Court of Appeal stated: '[I]n my view, ordinary reasonable business persons would naturally conceive of 'consequential loss' in a contract as everything beyond the normal measure of damages'11 (emphasis added).

Pacific Hydro submitted that ordinary reasonable parties in the positions of Pacific Hydro and the Corporation would surely have viewed the expenses that the Corporation incurred to hire replacement generators, and purchase fuel to operate them, as falling outside a range of any 'normal measure of damages'.12  

The decision

Justice Kenneth Martin approached the construction of clause 26.1 by referring to Darlington Futures Ltd v Delco Australia Pty Ltd13 in which the High Court established that the meaning of an exclusion or limitation clause was to be 'determined by construing the clause according to its natural and ordinary meaning, read in light of the contract as a whole.'14 His Honour said 'Both parties would accept that the proper approach nowadays towards interpreting an exclusion or limitation clause was settled by the High Court in Darlington...'.15  

His Honour noted that the proper approach to construing clause 26.1 is to start with the words of that provision, rather than with a fettering predisposition to construing 'consequential' or 'indirect' loss 'as only embracing a head of loss that falls under the second limb of the rule in Hadley v Baxendale.'16 His Honour also noted that it was inappropriate to adopt a predisposition to ascertaining the meaning of 'consequential' or 'indirect' loss by reference to the 'normal measure of damages' referred to in Peerless.

Justice Martin referred, with approval, to the view of Professor Carter that approaching the construction of 'consequential' or 'indirect' loss by reference to the second limb of Hadley v Baxendale, or by reference to the 'normal measure of damages' espoused in Peerless, is artificial. His Honour described as compelling Professor Carter's view that both these approaches 'are wrong because they approach the expression 'consequential loss' from particular legal perspectives rather than a commercial perspective which will vary from case to case'.17  

Commenting on Peerless more broadly, Justice Martin stated that the decision does not explain why, as Justice Nettle's judgment suggests, 'profits lost or expenses incurred through breach' must invariably fall outside the scope of a 'normal measure of damages'.18  

His Honour concluded that, on the proper construction of clause 26.1, the losses the Corporation claimed were direct losses and so their recovery was not excluded by clause 26.1. His Honour based this conclusion on several PPA provisions, including:19  

  • clause 16, which made it clear that the PPA envisaged a long-term commercial relationship achieved by establishing a take and pay regime for electricity, was founded on stated assumptions as to 'Reliable Operation';
  • clause 16.3, by which the parties recognised that the Corporation 'may need to generate its own electricity to make up [a] shortfall or obtain the shortfall from another source';
  • clause 16.4, which showed that electricity supply was being provided in circumstances where the Corporation may have to maintain a 'reliable supply of electricity to its customers during the period that Reliable Operation is lost'; and
  • PPA provisions, which acknowledged the public character of the Corporation's statutory responsibilities as a supplier of electricity to the people of the Kimberley region of Western Australia, recognised that the Corporation's obligations run deeper than returning profits.

Justice Martin's view was that the PPA parties were sophisticated commercial entities which, against the background of the well-understood requirement for the Corporation to continue to supply its customers with electricity if the power station failed, could be taken to have likely appreciated that such a failure would require the Corporation to take steps to replace the lost electrical supply.20 His Honour stated that 'it is inconceivable...that [the] parties did not appreciate all these future potentialities in 1994'.

He went on to state that the power station's failure to deliver the promised levels of energy was not simply a case of the Corporation suffering loss of profit (the recovery of which was excluded by clause 26.1). Rather, the failure rendered the Corporation unable to meet its public obligations to supply electricity to its customers, and indicated that placing the Corporation in a position where it could not meet this responsibility 'cannot simply be dismissed as being an indirect outcome of a PPA non-supply breach.'21 

Conclusion

In its decision, the court interpreted 'consequential loss' or 'indirect loss' according to its ordinary and natural meaning in the context of the PPA. The contract included obligations on one party, Pacific Hydro, to perform its PPA obligations so that the other party, the Corporation, could in turn perform its obligations under other arrangements. 

The decision serves as yet another reminder to parties seeking certainty about whether liability for certain types of loss will be excluded. They need to ensure their exclusion clauses are drafted to specifically identify those losses.

Footnotes
  1. Regional Power Corporation v Pacific Hydro Group Two Pty Ltd [No 2] [2013] WASC 356.
  2. Hadley v Baxendale (1854) 9 Exch 341.
  3. Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd [2008] VSCA 26.
  4. Regional Power Corporation v Pacific Hydro Group Two Pty Ltd [No 2] [2013] WASC 356 at [8]. 
  5. Ibid at [15] and [16]. 
  6. Ibid at [49], [50], [51] and [76]. 
  7. Hadley v Baxendale
  8. Regional Power Corporation v Pacific Hydro Group Two Pty Ltd [No 2] [2013] WASC 356 at [53] - [56]. 
  9. Ibid at [62] and [63]. 
  10. Ibid at [64]. 
  11. Ibid at [72]. 
  12. Ibid at [74]. 
  13. Darlington Futures Ltd v Delco Australia Pty Ltd [1986] HCA 82. 
  14. Regional Power Corporation v Pacific Hydro Group Two Pty Ltd [No 2] [2013] WASC 356 at [68], [89] and [97]. 
  15. Ibid at [68].
  16. Ibid at [89]. 
  17. Ibid at [94]. 
  18. Ibid at [92]. 
  19. Ibid at [101], [102], [103] and [104].
  20. Ibid at [106]. 
  21. Ibid at [107].

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