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Client Update: LNG destination clauses under scrutiny by Japanese competition regulator

7 September 2016

In brief: Part of the Japanese Ministry of Economy, Trade and Industry's strategy for LNG market development, which aims to achieve stability in LNG supply and lower prices, is to 'abolish or relax' destination clauses with the view that this would lead to lower prices through increased reselling and arbitrage selling. Japan's Fair Trade Commission has since launched an investigation into whether destination clauses impede fair competition and contravene Japanese competition law. Certain types of destination restrictions have long been held to infringe EU competition law. Partner Ted Hill (view CV), Managing Associate Robert Walker (view CV) and Associate Sophie Matthiesson consider the implications of this investigation in light of the approach taken in the EU. 

How will this affect you?

  • Japan's competition regulator, the Japan Fair Trade Commission (JFTC) is currently investigating whether destination clauses in LNG contracts impede fair competition and contravene Japanese competition law. Should the JFTC conclude that it has jurisdiction in respect of these arrangements and that they contravene Japanese competition law, LNG contracts may need to be revisited.
  • In the EU, destination clauses that prevent the onward sale of LNG within the EU have been held to infringe EU competition law. Alternative mechanisms, such as profit-sharing mechanisms (PSMs) have been permitted where the LNG is sold on a delivery ex ship (DES) basis.
  • The strictness with which the European Commission has approached destination clauses has in part been driven by the concern that restrictions on the onward sale of LNG within the EU undermine the European single market. Given this overlay, while the JFTC is likely to have regard to the EU decisions, any direct analogy is limited.  

The JFTC's investigation

In Asia, the traditional market model for LNG has been long-term contracts into defined markets linked to the crude oil price. Japan is the world's largest buyer of LNG and has been looking at ways to improve market liquidity, particularly in light of the current glut in LNG supply.

In its strategy for LNG market development published in May this year, the Japanese Ministry of Economy, Trade and Industry (METI) flagged destination clauses as a hindrance to the evolution of a freely traded LNG market:

In order to develop a flexible and liquid LNG market, these restrictions need to be eliminated to the greatest extent possible to increase the number of market players as well as trade volumes and frequencies to a level exceeding a certain critical mass.

 

METI has encouraged other large LNG consuming countries to relax or abolish the use of destination clauses in their jurisdictions (including, Korea, China, and India).

Subsequent to the announcement of METI's strategy, in July this year, the JFTC is reported to have launched an investigation into whether destination clauses impede free competition and contravene Japanese competition law. The investigation is at an early stage; however, reports suggest that the JFTC's findings could be announced later this year.

The position in Europe

In the EU, destination clauses that prevent onward sales within the EU are considered 'hardcore' restrictions of competition and prohibited under the EU competition rules.

The European Commission has taken a hard-line approach to destination clauses, treating them as object-based infringements of EU competition law, meaning that there is no need to demonstrate an anti-competitive effect on the market. This is on the basis that the clauses have the effect of partitioning the single market, which is considered to be a serious violation of EU competition law. Between 2002-05, the European Commission closed a number of its investigations following commitments by the gas producers to remove destination clauses and not introduce them in any new contracts.1

However, the European Commission has shown more flexibility in relation to alternative mechanisms, such as PSMs. In doing so, the European Commission has distinguished between DES, FOB (free on board) and CIF (cost insurance and freight) arrangements. Where title and risk is transferred to the buyer before the LNG is delivered to the EU, such as in an FOB or CIF arrangement, the European Commission has concluded that the buyer should be free to determine the ultimate destination for the gas within Europe. PSMs in FOB or CIF arrangements are therefore viewed as infringing EU competition law. By contrast, the European Commission has permitted PSMs where the seller retains title and risk until delivery, such as under DES arrangements.

For example, in 2007, the European Commission investigated the Algerian gas supplier, Sonatrac.2 To resolve this investigation, the European Commission reached a common understanding with the Algerian Government under which:

  • absolute territorial restrictions would be removed from Sonatrach agreements; and
  • PSMs were only permitted for DES contracts, meaning Sonatrach was required to transform its FOB and CIF agreements into DES arrangements in order to maintain the PSMs.

PSMs themselves can raise competition law issues in so far as they may involve the sharing of competitively sensitive information between competitors. Parties may need to ensure that mechanisms are put in place to avoid the sharing of sensitive information and appoint a third party auditor to ensure compliance with the PSM.

While the JFTC is likely to consider the EU experience, the extent to which it is directly applicable to Japan is limited. One of the drivers behind the strictness of the European Commission's approach to destination restrictions is the view that they undermine the European single market. This consideration does not apply to the Japanese context. It remains to be seen how the JFTC will seek to characterise any competition law concerns.

What will this mean for Australian exporters?

Australia is a significant exporter of LNG and, therefore, if the JFTC asserts jurisdiction and orders the removal of destination clauses, a large number of LNG contracts may need to be revisited, at least in respect of this aspect of the contracts. As LNG capacity is forecast to outstrip local demand in Japan for the foreseeable future, differences in the price of LNG across Asia may create arbitrage opportunities for Japanese importers and a secondary re-sale market for LNG supply.

Footnotes
  1. European Commission, press release IP/02/1084, 'Commission successfully settles GFU case with Norwegian gas producers', 17 July 2002; press release IP/02/1869, 'Commission settles investigation into territorial sales restrictions with Nigerian gas company NLNG', 12 December 2002; press release IP/03/1345, 'Commission reaches breakthrough with Gazprom and ENI on territorial restriction clauses', 6 October 2003; press release IP/05/195, 'Commission secures improvements to gas supply contracts between OMV and Gazprom', 17 February 2005; press release IP/05/710, 'Commission secures changes to gas supply contracts between E.ON Ruhrgas and Gazprom', 10 June 2005.
  2. European Commission, press release IP/07/1074, 'Commission and Algeria reach agreement on territorial restrictions and alternative clauses in gas supply contracts', 11 July 2007. 

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