COMPANIES AS DIVERSE as Apple, Boeing, LyondellBasell, and Tesla depend on suppliers for inputs critical to their business (Exhibit 1). Suppliers might possess technological, locational, or infrastructural advantages that make them irreplaceable in the short-term. As such, even temporary disruptions in supply can create severe consequences. For example, bottlenecks in Panasonic’s supply of lithium-ion battery cells recently slowed Tesla’s Model 3 production ramp. Meanwhile, interruptions in power supplied from its electric utility supplier forced LyondellBasell to shutdown its Houston refinery, and deal with the resultant flaring and releases into the surrounding environment.
So how can companies in supplier alliances for critical inputs ensure that supplies are reliable?
This note specifically introduces four types of contractual measures that companies should consider against disruptions in supply, caused by unscheduled and preventable downtime at supplier-managed plants and facilities that are primarily or wholly-dedicated to the customer.
Exhibit 1: Supplier Alliances for Critical Input
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TERMS TO MANAGE PREVENTABLE DOWNTIME
We’ve identified four commonly used categories of deal terms designed to minimize supply disruptions caused by unscheduled and preventable downtime (Exhibit 2). Each is further illustrated below.
Availability guarantees: Under an availability guarantee the supplier commits to a warranted minimum level of asset availability for production over a period, and faces liquidated damages if the warranted level of availability is breached. The commitment implicitly factors in the time required for scheduled maintenance that is informed by the supplier’s maintenance strategy for the asset.
For example, an availability guarantee for a wind farm contracted to provide electricity to a customer, might require the wind turbines to be mechanically available (i.e., ready to produce electricity whenever the wind blows) 96% of the time, on average, in every year for a 10 year term. If the wind farm achieves a lower availability than the average warranted availability in a year, the supplier pays the customer, as penalty, an amount corresponding to the production value of the difference between the warranted availability and the actual measured availability1 . The production value is arrived at using electricity prices in the spot market for the period (on the assumption that the customer will have to purchase replacement power externally to meet the shortfall), and the price of the renewable energy credits the customer is likely to have foregone. The availability guarantee accounts for the time the wind farm will be unavailable due to scheduled maintenance activities. In addition, the supplier could negotiate for the inclusion of exceptional events, the occurrences of which do not count against the actual measured availability (i.e., should these events occur, the wind turbines are deemed available over the period of occurrence). These events could include unavailability due to unscheduled yet critical maintenance, force majeure disruptions, or third-party interference.
While useful in ensuring that the supplier’s assets are mechanically available for production, availability guarantees have their flaws. For one, they are a lagging indicator of non-performance – the customer would already have experienced the consequences of a supply disruption, and only be entitled to liquidated damages, which, however high, might not approximate financial or reputational losses suffered by the customer. Second, an asset’s mechanical availability to produce does not necessarily mean that it will produce and supply output in sufficient quantities. Recognizing this limitation, customers of wind farms, where availability guarantees were traditionally the norm, are moving towards output guarantees based on a negotiated mean level of annual output. Third, an agreement on the guaranteed level of availability (and as a corollary, the permitted level of non-availability) presupposes that the customer has visibility into the supplier’s maintenance procedures and plans – which unless contractually mandated, might not be forthcoming.
Pre-agreed maintenance procedures and plans: These are a set of related measures aimed at providing customers with a deeper visibility into – and some control over – the supplier’s planned maintenance activities for a period. Examples of such measures include the following:
- Annual maintenance allowance: The time explicitly allowed for planned maintenance and repairs (and consequently restriction or complete cessation of production) in any contract year of the term of the agreement. This is typically specified on a preliminary basis for multiple years (say Phase 1 of the contract period), with annual revisions for each contract year subject to a cap (for example, the aggregate allowance in a contract year shall not exceed 20 hours). Unused time in a contract year could be rolled over to the subsequent contract year.
- Maintenance Procedures Manual: A detailed description of the activities the supplier proposes to undertake for preventive maintenance, inspections, calibration, and testing; the instruments, tools, and monitoring equipment to be used; and the number and qualifications of personnel to be employed on maintenance-related activities. This description is developed and attested by the supplier and attached as an Appendix to the alliance agreement.
- Maintenance program: A table describing each maintenance-related activity over the subsequent period, time frame for execution (which days), and available capacity during each hour of scheduled maintenance; and flagging those activities likely to result in severe outages. The format and Y1 program is typically part of the alliance agreement, with subsequent amendments approved by the Steering Committee. The alliance agreement could provide for 2-3 year estimated programs in addition to the Y1 program.
1 There could also be a provision for a bonus payment from the customer as incentive for exceeding warranted availability levels.