Practical Limitations of Liquidated Damages in Complex Oil and Gas Projects

Liquidated damages (LDs) sit at the heart of risk allocation discussions in complex oil and gas projects worldwide. In long‑term, high‑value contracts such as EPC contracts, they are a hallmark feature, intended to convert defined risks (such as delay and underperformance) into pre‑agreed financial certainty between the parties. This can be a significant factor for parties, particularly in an oil and gas context where even relatively minor delays, non-performance and underperformance can have severe cost implications. However, LDs should not be viewed in isolation as a complete cure for default, and it is important to appreciate some of their practical limitations that can often be overlooked.

Legal Risk vs Operational Risk

At first glance, the benefit provided by LDs is clear, with the non-defaulting party being compensated for the occurrence of a defined risk (delay and performance risks perhaps being the most frequently encountered):

• Delay LDs: Party A fails to complete works by an agreed date, which triggers compensation payable to Party B (usually at an agreed rate per day).

• Performance LDs: Party A fails to meet pre-agreed performance levels, which triggers compensation payable to Party B (usually at an agreed rate or amount).

However, while LDs can be effective in addressing legal risks, questions arise as to their effectiveness in remedying the broader operational picture when a default occurs. If we consider delay LDs by way of example, although the innocent party will receive compensation in the event of a delay, the LDs will not, in isolation, result in accelerated delivery thereafter, or enable the innocent party to recover any lost operational time. In addition to this, LDs will often be capped (usually at a certain percentage rate of the contract price), further limiting their effectiveness in truly remedying defaults, as the innocent party’s remedy is spent once the cap is reached. Operational risk is therefore left largely untouched by LDs, and careful consideration should be given as to how they are supplemented contractually to mitigate that risk.

Contractual Mechanisms for Addressing Operational Risk

The financial certainty provided by LDs should not come at the cost of long-term operational performance. When considering operational risk in this context, it is useful to think of LDs as the mechanism that puts a price on failure, but to consider supplemental contractual mechanisms as the conduit for addressing the failure. Effectively drafted contracts will ensure that LDs are captured as the starting point, and not the end point.

Common mechanisms to address operational risk include:

• Performance correction obligations.
• Step-in rights or escalation procedures.
• Termination rights once the LDs cap is reached.

It is also common practice to see LDs described as the “sole and exclusive” remedy available to the non-defaulting party, when the event triggering the LDs occurs. Careful drafting is therefore required to ensure that appropriate carve-outs are included, so as not to inadvertently undermine or exclude supplemental contractual mechanisms intended to address operational risk.

Concluding Remarks

As LDs are not treated uniformly across jurisdictions (for example, under UAE law as compared with English law), their effectiveness depends not only on drafting, but also on the governing law and dispute resolution framework through which they are enforced.

When deployed as part of a wider risk allocation framework, they can be critical in the mitigation of defined project risks, particularly in an oil and gas context. They should not be viewed as a complete cure, but rather as a key contractual trigger providing a limited remedy for failure, to be supplemented by additional operational obligations and remedies.