Price adjustment clause: What is it?
After parties enter into a contract, changes to general economic, financial and commercial conditions can leave the parties dissatisfied with the agreed upon price. Each year, the inflation rate and the corresponding price of many commodities fluctuate. In the context of the COVID-19 pandemic, the steep rebound, unexpected by some, led to a surge in inflation in the price of many goods and services that has not been seen in many years. In anticipation of such volatility, parties to long-term commercial contracts may increasingly be inclined to protect their interests with a price adjustment clause.
A price adjustment clause can be used to ensure that the price of goods and services supplied under the contract change to reflect market conditions. Not only does such a clause provide flexibility to account for changing circumstances, but it also establishes set procedures for adjusting the contract price in response to one or more triggering events. Triggering events refer to factors that are outside of the parties' control, such as a change in the inflation rate over a specified period, a fluctuation in exchange rates or commodity prices, or a change in direct input costs.
Why is it important?
Businesses have many incentives to include some form of price adjustment mechanism in their contracts to help safeguard against the possibility of a party halting performance due to unfavourable market conditions. For sellers of goods and services, an inability to adjust the contract price in response to rising input costs, for example, might expose them to increased business risk and decreasing profitability over time. In such a situation, price adjustment clauses work to the sellers' advantage by providing certain assurances on profit margins under their existing contracts. Sellers also have an incentive to add a price adjustment clause in contracts with their clients if their suppliers have, themselves, used such clauses in their supply contracts. On the other hand, a price adjustment clause triggered due to rising input costs could negatively affect the profitability of the activities of goods and services purchasers, as they may be unable to pass cost increases on to their ultimate customers. Given that most commercial parties occupy the role of both buyers and sellers, price adjustment clauses are important to ensure cooperation and manage overall business risk. In addition when possible, such clauses must be negotiated to reflect a fair understanding of how prices will evolve. It is important to note that contracts with consumers that include a price adjustment clause are normally subject to a specific set of rules protecting consumers, such as the Consumer Protection Act in Québec; therefore, such contracts must be drafted cautiously.
Price adjustment clauses in Canadian Commercial Contracts
One of the most important considerations for negotiating a price adjustment clause is to base the adjustment on a reliable and well-established price index. While indexing can take multiple forms, commercial agreements most commonly reference either a general benchmark, an industrial benchmark, or a fixed percentage or price increase.
1. General benchmark
In Canada, several agreements use the Statistics Canada Consumer Price Index (CPI), which is published on a monthly basis, as a baseline for calculating price increases over the term of a contract. This is likely due to the CPI's ease of application and comprehension, reliability and relative lack of volatility when calculating price movement.
Despite its seminal status as a price indicator, the CPI has its downfalls. For one, the CPI is subject to a departure from real inflation, as the basket weight of each commodity might not represent the price volatility experienced in a certain industry. Some US parties might ask for an American related index (such as the U.S. Core Consumer Price Index or the Consumer Price Index, as provided by the U.S. Bureau of Labor Statistics) to be used. Canadian parties should be weary of using other countries' indices if there are no cross-border exchanges of value in the agreement. The CPI is also not specific to any one industry. In other words, it measures price movement in a wide range of consumer goods and services, most of which are probably not applicable to the types of goods and services being purchased in a commercial contract.
2. Industrial benchmark
Some parties choose to use an alternative index to the CPI for greater accuracy in measuring cost changes, such as an industrial benchmark. The Producer Price Index (PPI) refers to a family of indices specific to certain industries (such as selected manufacturing, construction, mining and service industries), which more accurately reflect the goods and/or services being contracted. The PPI is used in instances where the seller does not have control over the wholesale price of the desired product. For example, a long-term contract for roadwork may be adjusted for changes in asphalt prices by applying the percent change in the PPI for asphalt to the contracted price for roadwork.
When utilizing a PPI-based price adjustment clause, it is important for parties to clearly identify which index will be used and cite an appropriate source for the index selected. While the primary official source of PPI data is provided by Statistics Canada, some parties may decide to reference country- or province-specific indices (such as the American Bureau of Labor Statistics PPI) of price fluctuations for certain commodities, set by independent organizations. Other parties may use internationally recognized public market futures prices as their reference for indexation, such as the Chicago Commodity Exchange or the London Commodity Exchange.
Some parties may agree to use a benchmark that is based on data published by an independent organization or a trade group. It is important, when doing so, to ensure that data used by the organization is reliable and that professionals oversee the calculation.
3. Fixed percentage or price increase
Rather than referring to an established benchmark, such as the CPI or PPI, parties may base the potential price adjustments on a percentage price increase clause that is fixed over the term of the contract (such as a two percent fixed-price increase per year). Percentage price increase clauses can pose problems in longer-term contracts when the percentage price increases deviate from a general benchmark or an industrial benchmark. Parties are more likely to use an indexation method in industries that are less subject to price volatility.
Other elements to consider when reviewing price adjustment clauses
Beyond identifying the proper indexation method, parties to an agreement containing a price adjustment clause must also consider:
- The frequency of the adjustment. Price adjustments are normally made on an annual basis and often coincide with the contract renewal. The practice of clearly establishing the frequency of adjustments allows for greater transparency among the contracting parties. It also enhances predictability because the increase is only effective at a set date and not when a certain index threshold is reached. For example, if the buyer knows that the contract price will increase by a predetermined amount upon renewal, they can factor this expense into their budget for the upcoming year.
- The direction of the adjustment. In addition to identifying how often the contract price will be adjusted, parties must understand the nature of the adjustment – that is, whether the clause provides for both increases and decreases in the contract price, or if they are unidirectional. Take the following clause, extracted from a service contract, as an example:
"The hourly wage agreed by the parties when the Contract is awarded is fixed for the first year of the Contract on the date agreed to by the parties and is subject to increase or decrease every subsequent year on the Contract anniversary date in accordance with the following formula […]."
Since this clause does not limit the adjustment only to increases, the party paying the adjusted amount would get the benefit of a lower price in years where the change, as determined by the formula incorporating the reference index, is negative.
- Caps and timing on the adjustment. Some price adjustment clauses may explicitly limit the amount of the adjustment and the period to which the adjustment will be applied. For example, some clauses may state that the price review is "prospective", meaning that the adjustment is solely forward-looking. In other words, if the hourly rate specified in a service contract happens to decrease from one year to the next, the reduced rate will only be applied to the services to be rendered going forward.
- Formulas. Depending on the nature of the agreement, formulas may be used to calculate the price adjustment. It is recommended that parties use a sample calculation to better understand exactly how both positive and negative price adjustments would work.
Price adjustment clauses have their benefits; they provide for increased cooperation between contracting parties and allow for greater economic stability and predictability. During the term of an agreement, however, various reasons may lead one of the parties to ascertain that the price adjustment clause no longer makes economic sense. In anticipation of such a situation, parties should consider including a clause (with a reasonable notice period) that allows them to revisit and revise the price adjustment clause in an addendum to the agreement.