Taming inflation in contracts

The UK annual rate reached 4.2% in October, and there is a similar situation of inflation hitting levels not seen for a decade in many other countries as well. Some experts have declared this surge of inflation is temporary as a result of such issues as supply chains being interrupted due to the Covid pandemic whereas others are concerned that there will be a more extensive run of price increases. 

Businesses should be thinking about reviewing their existing contracts to check if there are price adjustment clauses and incorporating such provisions into their future contracts, especially when these involve long term contractual obligations. The price adjustment clauses are often in a format where they set procedures for adjusting the price in response to one or more triggering events such as a change in the inflation rate over a specific period of time, fluctuations in exchange rates or commodity prices, or a change in direct input costs.

It is also common for contracts to include provisions which reference the Consumer Price Index (CPI), or some variant of that such as the harmonised index of consumer prices (HICP) – the CPI’s international equivalent. Some contracts use other indices such as the Retail Price Index (RPI) with the main difference between each index being the method of calculation used.

In terms of the specifics of the contractual provisions, one often sees annual increases by reference to the relevant index (such as CPI) and sometimes there is also a fall back mechanism such as a set price percentage – this can be particularly useful if for whatever reason the relevant index figure is not published or available for a particular time period. 

If you are a business in the fortunate position of already having such price mechanism clauses in your contracts then there is a decision to be made on whether to exercise those rights or reach agreement with the other party on an alternative mechanism.

Whether soaring inflation proves to be transient or not, it seems sensible for a business to mitigate its risk  and review what the exposure is under the present contracts.

A year ago independent economists polled by the UK Treasury expected consumer price index inflation to reach only 1.9% by the fourth quarter of this year. On Wednesday, the Office for National Statistics reported CPI had risen 4.2% over the year to October – almost double the Bank of England’s 2% target and the highest in a decade. The squeeze is being felt by businesses across the economy, who are caught between rising costs and potentially putting off customers.

https://www.theguardian.com/business/2021/nov/17/how-rising-costs-are-hitting-uk-businesses-inflation-covid