Construction & delivery risk - BESS projects - Liquidated damages and penalties
This article has been co-authored by Suriya Edwards from Freeths, UK and Volker Herrmann from orka, Germany. We advise on energy projects where delivery risk is material - particularly where projects are complex or under pressure.
Our view: “If your liquidated damages are wrong, you’ve either priced failure too cheaply, not sync-ed it to reality and route to market contracts —or made the clause unenforceable. This is a concept that defines the unusual i.e., pricing for failure in advance.”
Liquidated damages (LDs) are the mechanism by which parties agree, up front, what certain failures are worth. A commercial figure is pre-agreed and inserted in contracts.
The laws of England and Wales have tended towards a more generous computation of such pre-agreed risk allocation. The test follows Cavendish v Makdessi, where the question asked is whether a clause is penal, where the test is whether the clause imposes a detriment on the contract-breaker that is out of all proportion to the innocent party’s legitimate interest in enforcing the primary obligation. The court asks (i) what legitimate interest is being protected, and (ii) whether the stipulated sum is proportionate to that interest. In a nutshell a legitimate interest such as delay, financing, revenue loss etc. is taken into account; and under English law it needs to be commercially defensible.
In the absence of LDs a party would otherwise be required to prove actual loss which can be costly, time-consuming and uncertain at a time when cash is needed to mitigate risk. The LDs concept replaces such uncertainty with a pre-agreed commercial number or formula that is capable of arriving at the payment that one party is required to pay the other. Delay LDs here (that respond to delivery delays or failure to complete by the agreed date) can be expressed as a daily rate or a percentage of the contract price per day. Performance liquidated damages (attached to failure to meet technical guarantees) can operate as a buy-down mechanism which reduces the price if output or capacity for example falls short.
Delay LDs are often subject to sub-caps, typically 10-15% of the contract price. Performance liquidated damages are separately capped; both in turn subject to an aggregate cap in respect of liquidated damages. Typically, a contractor will want all liquidated damages payments to fall within that global limitation of liability, meaning if LDs are claimed it consumes the contract cap.
Liquidated damages are also identified as the sole and exclusive contractual remedy for the relevant failure. This means if liquidated damages apply, a party under the laws of England and Wales will be prevented from claiming anything more even if the actual loss suffered is significantly higher.
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So, what must you watch out for?
Underestimation of risk: LDs set too low leave the employer under-compensated
Penalty risk: LDs set too high risk being struck down but of course where there are two parties negotiating such contracts with equal bargaining power the risk of this tends to be low. Suggest maintaining clear records of decisions reached on this subject
Cap exhaustion: Once the liquidated damages cap is reached, the remedy shifts and often to termination. A structured exit once LDs are reached is necessary within contracts
Invalidation: it is useful to anticipate what happens if LDs are invalided. Often in English law contracts, express provisions allow for general damages to apply but subject to similar caps
A note on German law:
German law draws a fundamental distinction between contractual penalties (Vertragsstrafe) and liquidated damages (pauschalierter Schadensersatz), i.e. a genuine pre-estimate of loss. A penalty serves a dual purpose: it compensates the innocent party and acts as a deterrent against breach. Further, pursuant to default rules of the German Civil Code, general damages for the same breach may be claimed but penalties paid will be deducted. In addition, the agreed penalty must be paid in case of breach regardless of whether any actual damages were incurred. Penalties contained in standard business terms are however (again) subject to statutory content control and corresponding clauses may inter alia be struck down if the agreed amount is unreasonably high or the clause stipulates that the penalty will become due regardless of fault of the debtor for the breach in question.
Liquidated damages, by contrast, are a genuine pre-agreed estimate of the likely loss. Contrary to a liquidated damages clause governed by English law, German case law has not yet finally determined whether an LD clause excludes claims for further general damages respectively gives the debtor a “no injury defence”. However, liquidated damages clauses contained in standard business terms may be challenged if the agreed amount exceeds the damage typically expected at the time of contract conclusion for the breach in question or if such clauses do not permit the debtor to prove that the actual loss was significantly lower (“no injury defence”). In individually negotiated BESS contracts, these restrictions are less acute, but the characterisation of a clause as either penalty or liquidated damages remains a critical drafting question with significant practical consequences.
In German construction contracts practice, contractual penalties for delay are common and typically capped at 5% of the relevant contract price – a threshold established by case law of the Federal Court of Justice as the upper limit of what is generally considered reasonable in case penalty clauses are used in standard business terms. This is notably lower than the 10–15% sub-caps commonly seen in English law EPC contracts. Performance-related penalties in BESS contracts, for example, for failure to meet guaranteed capacity or efficiency levels – are less standardised under German law and require careful calibration to withstand scrutiny.
From a German law perspective, what must you watch out for?
Characterisation matters: Whether a clause is classified as a penalty or liquidated damages is relevant because the applicable legal framework for both instruments is not the same. Drafting should make the intended characterisation clear. If a liquidated damages clause instead of a penalty clause is being used, the clause should clarify whether general damages are available on top of the LDs or not
The 5% threshold: Delay penalties exceeding 5% of the contract price contained in standard business terms not individually negotiated between the parties risk being held unreasonable. In BESS projects with high contract values, this cap may leave the employer significantly under-compensated relative to actual delay costs (though the latter may still be recoverable as general damages)
Right to prove lower damage in the event of liquidated damages contained in standard business terms: Under German law, the debtor must be permitted to demonstrate that the actual loss was lower than the pre-agreed amount. Clauses that exclude this right are vulnerable to challenge
Cumulation of penalties: Where both delay and performance penalties apply, care must be taken to ensure that their aggregate does not produce a disproportionate result. German courts assess proportionality on a cumulative basis
We like this clause. It allows parties to consider risks in advance and set a price for it. It is a provision that avoids disputes and when it is well-thought through and discussed, is a clause that takes a market hedge on a risk with buy-in from both parties entering a contract.
The content of this page is a summary of the law in force at the date of publication and is not exhaustive, nor does it contain definitive advice. Specialist legal advice should be sought in relation to any queries that may arise.
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