Sir Ian Wood, in his recent report on the UK’s upstream offshore oil and gas industry and its regulation, recommends the creation of a new regulator empowered with the ability to issue informal and formal warnings to, and impose sanctions on, licensees when they are not acting in accordance with the strategy for ‘Maximising Economic Recovery from the UK Continental Shelf’. The Department for Energy and Climate Change has historically been reluctant to use the powers presently available to it to ensure compliance with licence terms. At what is a crucial moment in the evolution of the UK’s petroleum regulatory regime, this article examines these powers and reflects on their limitations.

The background

The Petroleum Act 1998 prescribes the regulatory regime applicable to oil and gas exploration and production both onshore and offshore in the entirety of the United Kingdom (except onshore Northern Ireland). Under the Act (and the previous legislation that it replaced), all rights to "search for, bore for and get" petroleum are vested in the Crown. Oil and gas companies therefore undertake onshore and offshore exploration and production activities under the terms of exploration and production licences granted by the Secretary of State for Energy and Climate Change.¹

The licence takes the form of a deed, under which the licensee is bound to observe the terms and conditions of the licence as set out in secondary legislation known as the “Model Clauses”. The Model Clauses applicable to a particular licence are those which are in force at the time the licence is granted.

There are three main types of licence: (i) Seaward Production Licences (SPL) for the exploration and development of offshore fields; (ii) Petroleum Exploration and Development Licences (PEDL) for the exploration and development of onshore fields; and (iii) Seaward Exploration Licences (SEL), which are awarded in relation to certain offshore exploration activities.

The Model Clauses contain a range of provisions which prescribe the licensee’s obligations in relation to exploration and development of the licensed area, and also require the provision of certain information by the licensee to the Secretary of State. These obligations are drafted on the basis that the licence has been granted to a single licensee, and a shortcoming of the Model Clauses in this respect is that they fail to reflect the reality that most licences are held by more than one licensee. Although the licence may be granted to one or more licensees, legally the licence is held by the licensees collectively as a single entity, and they are jointly and severally liable in respect of obligations arising under, and operations conducted pursuant to, the licence.

Where there are multiple entities which together constitute the licensee, the entities enter into a joint operating agreement (JOA) under which they apportion the joint and several liability assumed under the licence between themselves. They also appoint an operator to conduct the joint operations on their behalf. The Secretary of State does not interfere in this arrangement, notwithstanding that since 1975 all joint operating agreements must be approved by the Secretary of State.

In principle, this regime works well for most of the obligations set out in the licence. A key obligation is that the licensee is obliged to carry out the work programme (which is agreed between the parties at the time of applying for the licence) during the initial term. The licensee is also required to obtain consent before drilling a well, and is not entitled to carry out any appraisal or development work in the licence area before obtaining prior approval from the Secretary of State for its work programme. Once a work programme has been approved by the Secretary of State, the licensee is obliged to perform its work in accordance with such work programme. The licensee must conduct the operations in accordance with the methods customarily used in good oilfield practice and take “all steps practicable” – a wide concept – to prevent the waste or escape of petroleum into waters in or near the licensed area. The licensee is also required to keep “full and correct” accounts, retain sundry records and samples, and furnish quarterly and annual returns detailing all geological work done and results obtained.

In addition to obligations relating to the conduct of operations in the licence area, the licence also imposes restrictions on the licensee. Licences cannot be sold, transferred, assigned or otherwise dealt in without the consent of the Secretary of State. The creation of a charge on a licence also requires the consent of the Secretary of State. Where a change of control of a licensee or entities which together constitute the licensee has occurred, the Secretary of State is entitled to require a further change of control in the relevant entity. The licensee (or entities which together constitute the licensee) is also obliged to keep confidential all information relating to the licence and the operations thereof, and to avoid making public announcements suggesting or implying that the Crown or any government department has formed or expressed any view in relation to the prospectivity of the license area.

Consequences of noncompliance

The remedies available under the Model Clauses for the failure by the licensee to perform its obligations or comply with the restrictions imposed by the licence are limited to either the expiry of the licence or the revocation of the licence by the Secretary of State.²

With regards to the licensee’s operational obligations under a licence, the licence will naturally expire if certain crucial obligations are not met. The SPLs and the PEDLs are granted for a series of terms to conduct exploration, appraisal and production activities. The licence will expire at the end of: (i) the initial term (exploration), unless the licensee has completed its work programme; or (ii) the second term (appraisal), unless the Secretary of State has approved a development plan.

The Model Clauses for the SPLs and the PEDLs also allow the Secretary of State to revoke the licence on the occurrence of certain ‘trigger’ events. These include: the insolvency of the licensee; assignment of the licence without the prior consent of the Secretary of State; change of control of a licensee with the licensee failing to take steps to address the Secretary of State’s objections to that change in control; rental being outstanding for two months after it is due; breach of any condition subject to which an approval was provided; and any other breach or non-observance of the licence terms.

Both of the above-mentioned remedies will result in the licence being completely withdrawn from all of the entities which together constitute the licensee, irrespective of whether the breach was committed by a particular entity which was part of the licensee entity. However, the restrictions listed above in relation to assignment, confidentiality, change of control, etc., are wholly within the control of each of the entities which constitute the licensee. It is not unusual for companies active in the UK Continental Shelf to make an announcement in the press or to include information in their marketing resources about the status of their operations. Licensees generally take great care to ensure that they comply with the confidentiality obligations under the JOA, but scant regard is paid to similar obligations under the licence to the Secretary of State.

In relation to operational matters, the available remedies are defensible where joint operations are conducted by the operator on behalf of all the entities which together constitute the licensee. However, where the operations are conducted on a sole risk basis (as permitted under the joint operations), a breach by the sole risk licensee of, for example, an obligation to provide certain information to the Secretary of State (relatively minor), or of an obligation to obtain consent for the field development plan (a major breach), could also result in a complete revocation of the licence. The JOA does not offer the non-defaulting entities adequate protection from such an eventuality. The sole risk participant typically undertakes to fully indemnify the non-participants in respect of any liabilities which those non-participants may incur in consequence of conduct of the sole risk operations. However, the (typical) exclusion of consequential losses liability would mean that the innocent non-participants are exposed to the loss of the licence caused through no fault or participation on their part.

A partial solution

A number of unsatisfactory situations have arisen as a result of the widely acknowledged injustice of this remedy. For example, licensees were permitted to make out-of-round applications for a production licence for an area in respect of which a previous production licence had been revoked, to enable the revoked licence (in this case, for the insolvency or default of one member of a licence consortium) to be re-granted to the non-defaulting members. This practice was prohibited in 1995 because it was inconsistent with the competitive allocation requirements of the Hydrocarbons Licensing Directive.

In 2008, a solution of sorts was introduced in the Petroleum Licensing (Production) (Seaward Areas) Regulations 2008 through the right of partial revocation made available to the Secretary of State. The Secretary of State now has the power to revoke the interests of one or more, rather than all, of the entities which together constitute the licensee where:

1. the entity concerned becomes bankrupt or insolvent;

2. there is a change of control of the entity concerned and the entity failed to take steps to address the Secretary of State's objections to that change in control; or

3. the entity concerned ceases to have a fixed place of business in the UK from which operations under the licence are carried out.

Where a licence interest is revoked in relation to one entity under the licence, the entity whose interest has been revoked remains jointly and severally liable for any obligations arising before the partial revocation takes place. After partial revocation, the rights, obligations and liabilities associated with the licence continue to have effect in respect of all the remaining persons under the licence.

A crucial gap in the new partial revocation powers is that it still cannot be employed by the Secretary of State where there has been a breach of the operational obligations under the licence by a sole risk licensee, nor where there has been a breach of the assignment, confidentiality and other similar restrictions in the licence.

The ability to revoke the licence in respect of some and not all of the entities which together constitute the licensee is absent from the Petroleum Licensing (Exploration and Production) (Seaward and Landward Areas) Regulations 2004. It cannot therefore be employed in relation to a breach of obligations under an onshore PEDL or SEL. In the context of a shale gas project, it could be argued that a partial revocation would be inappropriate since the remaining parties to the licence may not have the technical and financial capabilities to deal with the variable economic and productive profile of such project.

Increasing the set of regulatory tools

The remedies available to the Secretary of State where there is a breach of licence obligations by a licensee or a particular entity which was part of the licensee entity are remarkably limited and arguably draconian. Unsurprisingly, the Secretary of State has never completely or partially revoked a licence, which may perversely encourage licensees to consider a breach of their obligations. In this context, Sir Ian Wood’s proposals to expand the set of remedies available to the new regulator and, in particular, to create remedies proportional to the severity of the agreement breaches, can only be welcomed.

_{1. The latest Model Clause provisions for SPLs are contained in the Petroleum Licensing (Production) (Seaward Areas) Regulations 2008, while the latest Model Clauses for PEDLs and SELs are contained in the Petroleum Licensing (Exploration and Production) (Seaward and Landward Areas) Regulations 2004.}

_{2. The Secretary of State has, on the occurrence of certain breaches by the licensee, the right to revoke the licence in relation to some but not all of the licence area. However, in contrast to the statutory remedy of partial revocation, the revocation in respect of part of a licence area will apply to all of the entities constituting the licensee, rather than only in respect of the entity in breach. Obligations under the licence}