With inflation at its highest for many years, many businesses are looking again at price indexation clauses. This briefing explores when they can be useful, which index to use, and whether the best known index - RPI - has a future. It's the second in our series of briefings on pricing and payment issues in commercial contracts.
Linking prices to inflation: a short guide to indexation clauses
Overview
What is an indexation clause and why use one?
Indexation clauses typically allow prices to vary in line with inflation. This gives the supplier a measure of protection against cost increases, whilst preventing it from raising prices entirely at its own discretion (as may be the case where the supplier has a unilateral right to review prices, as discussed in the first briefing in this series). As such, indexation clauses can be a useful compromise between the supplier's desire to have maximum freedom to vary prices and the customer's desire to impose constraints on any increases.
By tying increases to an index which fluctuates in response to changing economic conditions, indexation also avoids the parties having to "predict the future" by electing to have prices increase by a set percentage over time, which can produce unfortunate results - see the case of Arnold v Britton, discussed below. That said, one downside of using an index is the inevitable uncertainty over how much prices will change and the possibility of spikes in inflation, as has occurred recently. However, this can be mitigated by applying a cap (setting a maximum ceiling for price increases) and/or a collar (setting a minimum floor).
The dangers of using a fixed percentage each year
Arnold v Britton (2015) concerned a 99 year holiday chalet lease entered into in 1974. The service charge was originally set at £90 but the lease provided for it to increase by 10% every year on a compound basis. By the end of the lease, the compounding provisions would have resulted in a service charge of over £1,000,000. The tenants argued that this was an absurd outcome which could not have been the intention of the parties. However, the Supreme Court ruled that there was nothing inherently offensive to commercial common sense in the drafting; inflation had been very high at the time the lease was entered into (16%, rising to 24% in 1975) and the parties had simply assumed (wrongly) that it would continue at a double digit level. Had indexation been used, the increases would have fluctuated in accordance with actual inflation, which had been below 5% for much of the previous 30 years.
Relative simplicity
Indexation clauses also represent a relatively straightforward way of resolving issues over price, compared with at least some of the alternatives.
For example, parties sometimes opt for a process where they must agree what the revised prices should be, failing which the matter will be referred to an expert for determination (a similar model is often used for rent review in commercial leases, where a lease will contain a set of assumptions and disregards to assist the parties' surveyors to negotiate an open market rent, with the matter being referred to an expert or arbitrator if the parties cannot agree).
However, all of this takes time and sometimes results in somewhat fraught negotiations, which may have a negative impact on the parties' broader relationship. An indexation clause, by contrast, will normally be based on a formula allowing prices to be determined fairly swiftly, with little scope for debate.
Later in this series we will also be discussing benchmarking and open book pricing, which have some similarities with indexation, but both approaches typically involve greater complexity.
Having said all that, it is essential to set out a clear methodology for calculation of price increases by reference to your chosen index - and as discussed in this video briefing, it can often by helpful to include a worked example.
Which index should you use?
The indexation mechanisms we most frequently see in commercial contracts are outlined below. All of them seek to track a basket of goods and services purchased by UK households; they are therefore general measures of inflation which reflect primarily how it feeds through to final consumers, rather than businesses.
- The Retail Prices Index (RPI): this is perhaps the most well-known index, although its long term future is unclear and the National Statistician has described it as "a very poor measure of general inflation," for a number of reasons, including treatment of housing costs and problems with the formula and weightings used. However, the index is likely to continue to be available until at least 2030 and there is nothing to stop parties still using it in contracts if they wish.
- The Consumer Prices Index (CPI): this is regarded as a better measure of inflation than RPI because it is seen as having more representative coverage, both in terms of goods and services tracked and population base. In particular, it excludes housing costs, since the housing market can sometimes have a distorting effect.
- The Consumer Prices Index with Housing (CPIH): this index is largely the same as CPI but with owner occupiers' housing (OOH) costs included.
How do these indices compare?
Historically, RPI has tended to be higher than either CPI or CPIH. The difference between CPI and CPIH has been less marked and it has not been the case that CPIH is always higher than CPI (or vice versa). It follows that there may be rather less to choose between CPI and CPIH – and as noted above, they are generally regarded as more accurate measures of general inflation than RPI.
As regards the future of RPI, current proposals suggest that it may be retained (owing to its use in certain financial instruments), but could be reformed so that in the longer term, it will end up being closer to CPIH than it is at present. However, a final decision has not been taken and RPI is likely to remain available until at least 2030. The uncertainty over the future of RPI highlights the importance of ensuring that any price indexation clause includes a mechanism for replacing the relevant index if it is discontinued or otherwise unavailable.
More specialised indices
In some cases, other, more specific indices may provide a better measure of how suppliers' costs are changing. For example:
- the Average Weekly Earnings Index (AWE) is an indicator of short-term earnings growth, providing monthly estimates of the level of average weekly earnings per employee. It may be more appropriate for contracts where the supplier's main costs arise from the labour element.
- BEAMA, a trade association representing suppliers of energy infrastructure technologies and systems, produces a series of indices tracking the cost of labour and materials in the electronic and mechanical engineering industries. These indices may be more appropriate for projects in those sectors.
The advantage of using these more specialised indices is that inflation in the wider economy, as represented by measures such as CPI, CPIH or RPI, may not always reflect the additional costs being experienced by the supplier. For example, if earnings are rising strongly due to labour shortages, this is likely to be reflected more quickly and accurately in the AWE index; it may take longer to filter through to more general measures of inflation. Conversely, if general inflation is being driven primarily by rising energy prices, the AWE index could be expected to rise at a slower rate than other, broader measures (for example, the latest annual figure for pay growth based on the AWE index was 6%, as against almost 9% for CPIH).
Blending indices
It is also possible to "blend" indices – for example, your clause could provide that price increases will be set by reference to the average of more than one index. We sometimes see this in cross-border contracts where the parties may wish to make use of two indices – one in the customer's jurisdiction and one in the supplier's jurisdiction. However, this adds complexity to the clause, which may not always be desirable.
Cumulative effect
Note that many price indexation mechanisms seek to capture the cumulative rise in the relevant measure of inflation over the period between the last price review exercise and the new one; this will often produce a higher percentage increase than a clause which works simply by taking a "snapshot" of inflation at the time of price review and then applying that percentage to generate a revised price (although that may not be the case where there has been a significant spike in inflation which happens to coincide with the "snapshot" used for the price review - hence the recent concern about the impact of such clauses in B2C telecoms contracts, discussed below).
Price indexation clauses in consumer contracts
Whilst this briefing is concerned with B2B agreements, price indexation is sometimes also used in B2C contracts, where the need to comply with consumer protection law adds a further layer of complexity. As we discussed in this briefing, concerns were raised last year by regulators over whether businesses are doing enough to explain mid-contract price changes when customers sign up to new deals, particularly in the telecoms sector – where many firms look to increase prices by reference to the rate of inflation plus an uplift of e.g. 3.9% Indeed, telecoms regulator Ofcom has recently announced an investigation into use of inflation-linked pricing by phone and broadband providers.
More information on pricing and payment issues
Pricing and Payment Series
This is the second in a series of briefings about pricing and payment issues in commercial contracts. The first briefing was entitled: "Price review clauses: when can suppliers force through an increase?". You can sign up to be notified of more content here.
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