What Is Take or Pay?
Take or pay is a provision, written into a contract, whereby one party has the obligation of either taking delivery of goods or paying a specified amount. Take or pay provisions benefit both the buyer and the seller by sharing risk, and can benefit society by facilitating trade and reducing transactions costs.
- Take or pay is a type of provision in a purchase contract that guarantees the seller a minimum portion of the agreed on payment if the buyer does not follow through with actually buying the full agreed amount of goods.
- Take or pay provisions can commonly be found in the energy sector, where overhead costs are high.
- Take of pay provisions benefit buyers, sellers, and the economy as a whole by sharing the risk of overhead investment and facilitating commerce that might otherwise not occur.
Understanding Take or Pay
Take or pay provisions are generally included between companies with their suppliers, which require that the purchasing firm take a stipulated supply of goods from the supplier by a certain date, at the risk of paying a fine to the supplier if they don't. This sort of agreement benefits the supplier by reducing the risk of losing money on any capital spent to produce whichever product they are trying to sell. It benefits the buyer by allowing them to ask for a lower negotiated price since they are taking on some of the supplier’s risk. It can be an overall net gain to the economy because, by better sharing of the risk between buyers and suppliers, it facilitates transactions that might otherwise not occur, along with their accompanying gains from trade.
Take or pay provisions are very common in the energy sector, because of the substantial overhead costs for suppliers to provide energy units like natural gas or crude oil and the volatility of energy commodities prices. The overhead costs of providing crude oil as compared to a haircut, for example, are very high. Take or pay contracts provide energy suppliers an incentive to invest capital up front because they have a measure of assurance that they'll be able to sell their products. In the absence of take or pay provisions, suppliers bear all the risk that the buyer’s ongoing need for the energy might dry up or that a price swing might induce the buyer to break the contract. Suppliers could also be subject to a hold-up by the buyers if they have made overhead investments that will lose value if the buyer does not buy the output as agreed, without the minimum guaranteed revenue of a take or buy agreement. Hold-ups are a type of transaction cost, identified by economist Oliver Williamson, that occurs with these kind of relationship-specific assets.
For example, Firm A can contract to purchase 200 million cubic feet of natural gas from the supplier, Firm B, over 10 years at an agreed rate of 20 million per year. Firm A may find, however, that in a given year they will only need 18 million. If they do not purchase the planned 20 million, they will be subjected to a fee, which is agreed to in the original contract. Typically these fees are smaller than the purchase price; having forgone 2 million cubic feet in purchased natural gas, Firm A may be subject to a fee of 50% of the contract price of 2 million cubic feet.
Alternatively, is world gas prices fall during the course of the contract, Firm A might want to decline to take delivery of the gas and instead purchase gas from another supplier, Firm C, at the new, lower price and instead pay the agreed penalty to Firm B. It is in Firm A’s interest to do this if the total cost of the gas from Firm C plus the penalty is less than the originally negotiate price to take Firm B’s gas.
In this situation, both parties benefit from the take or pay provision. Firm A gets only the amount of gas they need from Firm C, at a lower total cost than they would have paid; Firm B receives the penalty price from from Firm A, rather than gaining nothing if Firm A were to simply switch suppliers in the absence of the take or pay provision.