What Is a Take-or-Pay Contract?
A take-or-pay contract is an agreement between a buyer and seller, in writing, that requires the buyer to pay even if the seller fails to provide the item.4 min read
A take-or-pay contract is an agreement between a buyer and seller, in writing, that requires the buyer to pay even if the seller fails to provide the item or service. Typically, the buyer is not obligated to pay the full amount, but the intention is to protect the seller in case the buyer decides to refuse the good or service at the time of delivery.
This is also referred to as the “killing clause.” These agreements are usually signed by companies when their suppliers require them to purchase a certain amount of items by a specific date, and a fine is imposed if they do not. In this type of agreement, the seller is protected from potential loss of money from the production of the item that the buyer was supposed to purchase.
Why Take-or-Pay Is Used
Take-or-pay provisions in a contract are intended to facilitate predictable results from a financial perspective, particularly when debt is involved. If a supplier requires a loan to finance the production of a buyer's order, the lender may be unwilling to offer the funds needed without a take-or-pay provision in the contract. This provision ensures that the supplier will be able to pay the loan as anticipated.
The energy sector makes frequent use of take-or-pay provisions because supplying energy requires a large overhead investment in natural gas, crude oil, or other resources. Without this means of assurance that they will have some return on their investment, they would have no incentive to spend capital up front for production.
Due to the unpredictability of energy markets, where the price may fluctuate due to demand vs. supply, the sellers rely on take-or-pay contracts to ensure their revenue is secure and constant. For suppliers of energy who use pipelines, oil, or natural gas to produce electricity, the huge expenditure of overhead requires some assurance that they will receive income as expected over the long term.
There are three factors that explain the need for take-or-pay clauses in energy supplier contracts:
- Energy projects require high expenditures of capital.
- Energy projects take place over long periods, potentially 20 to 30 years, and usually require loans to finance them. Therefore, they need to make sure their investments are recovered, and they can pay the lender for the amount borrowed plus accruing interest.
- With a take-or-pay provision, the buyer has no choice but to accept delivery of the minimum quantity or pay for the difference between what was agreed upon and what is accepted.
Why Long-Term Contracts Are Used
Major projects with returns on investment that take long periods use long-term contracts to assure the lender that payments will be made on a predictable, reliable basis. A long-term contract is typically one with a 20- to 30-year duration.
This is what a take-or-pay long-term contract does for the parties:
- Protects the seller's stream of revenue.
- Convinces the bank to approve financing for the project.
- Facilitates decision-making and planning, particularly with regard to budgets.
- Minimizes risk to the seller by transferring some of it to the buyer.
- Assists in mitigating other expenses, some of which are unforeseen and unpredictable.
- Eliminates competition for the term of the contract.
- Creates less of an impact on the credit-worthiness of the seller.
Risks of Take-or-Pay Contracts
Because take-or-pay contracts are long-term agreements, they are vulnerable to unforeseen events that were not covered in the contract. Such external events include political circumstances, commercial developments, geological occurrences, etc. When one of these takes place, the contract may no longer be practical or viable for one or both parties. In this situation, one of the parties may terminate or withdraw from the contract.
However, maintaining the contract often has benefits for both parties, even if an unforeseen event should occur. It's better for both parties to be reasonable and cooperative, maintaining a good reputation within the industry and among the business community. Therefore, most companies, governments, and other entities will allow for renegotiation when external events cause disruption.
Take-or-pay contracts typically include clauses that define under which circumstances they will be renegotiated. These include the following:
- Force majeure clause, also called “act of God,” which must state a requirement for notice to be given, the types of situations that would constitute force majeure, and the effect of the event on both parties' obligations.
- Price clause, which protects both parties against unforeseen fluctuations in market prices. This includes the price escalation clause and price reopener clause.
- Review clause, which subjects a long-term contract to regular renegotiation every few years.
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