UK: Financial Security for Decommissioning Costs in the UK North Sea

Last Updated: 7 May 2003

by John C. LaMaster, Managing Partner and Christopher Prior, Partner Vinson & Elkins, London

As the UK North Sea matures, new entrants in particular, smaller independent companies seek to explore and develop existing acreage. Consequently, the UK government, acting through the Department of Trade and Industry (DTI), has become increasingly aware of the need to minimise the risk of licensees failing to meet the decommissioning costs associated with such assets.

Since 1967, several hundred fixed and floating platforms have been installed on the UK continental shelf (UKCS). Many of these platforms will be decommissioned between 2004 and 2020. In addition, there is over 5,000 kilometres of major sub-sea pipeline on the UKCS.

Early estimates for the future cost of decommissioning the platforms and associated pipelines varied at approximately 5-9 billion Great Britain pounds (GBP). The original construction plans for platforms often budgeted 7 to 12 per cent of construction cost as the cost of decommissioning. Recent experience in decommissioning suggests that these estimates were too optimistic and the actual costs may be far higher. For example, it was recently reported that the GBP 150 million decommissioning costs for Phillips Maureen platform were more than 100 per cent above the original estimate.

The UK government is bound by Oil Spill Preparedness and Response (OSPAR) decision 98/3 on the disposal of disused offshore installations. This decision, effective 9 February 1999, imposes significant restraints on the disposal at sea of offshore installations and any parts thereof. In a nutshell, the decision prohibits the dumping and leaving of disused installations in place at sea. This prohibition is subject to certain derogations in the case of concrete installations, concrete anchor bases and the footings of large steel installations for example, those weighing more than 10,000 tonnes and put in place prior to 9 February 1999. Other disused installations can be left in place only when exceptional and unforeseen circumstances can be demonstrated.

Clearly, a balance has to be reached between the freedom of large companies to transfer mature assets to smaller independent companies a trend actively encouraged as allowing the continuing exploitation of the UK North Sea and maximising economic recovery and the DTIs desire to ensure that satisfactory security packages are in place to avoid the risk of companies defaulting in the meeting of inevitable decommissioning costs.

Effects of the Petroleum Act 1998

The decommissioning of offshore oil and gas installations and pipelines is regulated under Part IV of the UK Petroleum Act 1998 (the Petroleum Act). The Petroleum Act is supplemented by the DTI Guidance Notes for Industry Decommissioning of Offshore Installations and Pipelines under the Petroleum Act (the Guidance Notes). The Guidance Notes are designed to help companies through the process of seeking DTI approval for their decommissioning proposals.

Section 29 of the Petroleum Act empowers the Secretary of State to serve a written notice, at any time, on any of a relatively wide range of persons linked to an installation or pipeline, requiring the submission of a costed decommissioning programme for each offshore installation or submarine pipeline. In an offshore installation, the range of persons who may be served with a Section 29 notice will generally include the operator, the licensee, any party to a joint operating agreement, any person who owns an interest in the installation (other than as security for a loan) and any associated company of the above. A company is deemed to be associated with another if one of them controls the other or a third party controls both. The notice must specify the date by which the programme is to be submitted or provide for it to be submitted on or before such date as the Secretary of State may direct.

Once the decommissioning programme has been approved by the Secretary of State, it is the duty of each of the persons who submitted it to secure that it is carried out in accordance with its conditions. In other words, there is a joint and several liability upon each person for the submission and carrying out of the decommissioning programme. The resultant effect of this joint and several liability is that if any licence party is unable to meet its obligations under the decommissioning programme, one or all of the other participants must share the defaulting companys burden.

Reducing Decommissioning Risk

The rationale behind the enforced joint and several liability, and the extension of this liability to associated companies, is to encourage licensees to actively protect against one of them defaulting or going into liquidation. In practice, it is the company with the greatest resources upon which the DTI is most likely to focus when considering the ability of the group to meet its decommissioning liabilities. The members of the licence group will make arrangements between themselves in an attempt to cover themselves as far as commercially possible in respect of contributions to the costs of decommissioning and the consequences of default.

When a company seeks to withdraw from a licence group, the DTI has a discretion to release the departing company from its decommissioning obligations. However, if the DTI considers that the ability of the remaining licensees to meet future obligations would be weakened to an unacceptable extent by the withdrawal of a particular company, the Secretary of State may refuse to exercise that discretion until the remaining parties have established an adequate Financial Security Agreement (FSA). This is likely to be of particular relevance where a major company seeks to transfer its interest to a smaller independent, and the remaining licensee group is constituted solely of smaller independent companies.

If the DTI deems that an FSA is necessary, then the DTI itself will usually be a party to the agreement to ensure that its terms cannot be amended without its approval. A new participant seeking to buy into a licence should therefore be prepared to enter into the FSA along with the existing licensees. Until a satisfactory FSA is put into place, the departing company remains subject to the Section 29 notice and continues to bear liability for decommissioning costs.

An FSA must meet certain minimum requirements to be acceptable to the DTI. These requirements are linked in large part to the level, and acceptability, of the security offered to the DTI by the licensee group.

What constitutes acceptable security to an FSA? In the Guidance Notes, the DTI states that the risk it perceives is that participating companies will have insufficient funds to meet decommissioning costs, or that although such companies may have sufficient funds, those funds may be situated outside UK jurisdiction. Although the serving of a Section 29 notice may give the DTI some leverage over associated companies, it is the security required under a FSA that will usually be its primary focus.

Several Forms of Security

Ordinarily, security provided by the parties under the FSA should equal at least 100 per cent of the expected decommissioning costs of the installations and pipelines covered by the FSA. Security in the form of cash, irrevocable standby letters of credit issued by a prime bank or on-demand performance bonds from a prime bank are all considered acceptable security by the DTI. For these purposes, prime banks are those established in an Organisation for Economic Cooperation and Development country with a UK lending office and that have an AA rating or better (Standard and Poors), an AA2 rating or better (Moodys) or equivalent. The DTI requires that security should cover each companys respective share of the costs of decommissioning the installations and pipelines in the relevant field. The DTI has, though, expressed a willingness to actively consider other proposed forms of security. However, a recent enquiry of the DTI failed to unearth any other form of security that had in practice been approved.

The FSA normally provides for each licensees security to be renewed annually, one month in advance of the relevant security period. In the event of a failure to renew the relevant security for the forthcoming security period, the licence party will usually be treated as being in default, the letter of credit or performance bond will be triggered and the money deposited in a trust fund until called upon to pay for the decommissioning costs.

Other forms of security, such as insurance-based schemes, may in time be deemed to be suitable by the DTI, and a market for such insurance may develop as occurred during the maturing of fields in the Gulf of Mexico. We understand that certain companies have been seeking to develop and promote various insurance-risk finance structures to guarantee the anticipated cost of decommissioning.

Although the DTI deals with matters on a case-by-case basis, it is very unlikely that parent company guarantees would constitute acceptable security, since the credit-worthiness of a licensee group is subject to change in a manner that would not affect other forms of acceptable security. Furthermore, the Secretary of State is likely to want to avoid exposure to the risks involved in attempting to recover decommissioning costs from overseas parent companies.

John LaMaster is the managing partner in Vinson & Elkins' London office. His principal areas of practice in the Business and International Group include international mergers, acquisitions and divestitures, international energy transactions and project development and financing. He has represented clients in the acquisition and divestiture of a variety of companies and assets, oftentimes in the oil and gas, petrochemicals and energy industries. Mr. LaMaster has been involved in a wide variety of oil and gas transactions, from upstream exploration and production transactions to downstream refinery and petrochemicals transactions. He has represented clients in various projects in the UK, most of the countries in western Europe, the Nordic countries, Russia and the former Soviet Union, India and the United States.

Christopher Prior is a partner in Vinson & Elkins' London Business and International Group. He is actively engaged in the firms UK and international corporate mergers and acquisitions and commercial practice, and is also a member of the firms Project Finance and Development, Telecommunications and Biotechnology Practice Groups. His clients include developers of infrastructure projects, major multinational oil and gas companies, engineering firms, manufacturing concerns, lending institutions, private equity houses, telecoms and other high-tech companies. Mr. Prior has significant experience in UK oil and gas transactions and in other European and international mergers and acquisitions (both in share and asset deals) and venture capital transactions. He has recently represented clients throughout the UK and the rest of Europe, the U.S. and the Nordic countries.

This material is not intended to create, and does not create, an attorney-client relationship between you and Vinson & Elkins L.L.P., and you should not act or rely on any of this information. As legal advice must be tailored to the specific circumstances of each case, nothing provided herein should be used as a substitute for advice of competent counsel. These materials do not constitute legal advice, do not necessarily reflect the opinions of Vinson & Elkins L.L.P. or any of its attorneys or clients, and are not guaranteed to be correct, complete, or up-to-date. Vinson & Elkins L.L.P. assumes no liability for the use or interpretation of information contained herein. This publication is provided "AS IS" WITHOUT WARRANTY OF ANY KIND, EITHER EXPRESSED OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, THE IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE, OR NON-INFRINGEMENT. Unless otherwise indicated, V&E attorneys listed are: not Certified by the Texas Board of Legal Specialization. None of the attorneys listed on this website is certified as an "expert" or "specialist" pursuant to any authority governing the practice of law in New York.

Vinson & Elkins is a registered limited liability partnership. Principal office-Houston.


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