ESCALATOR CLAUSES



Purchase contracts, transportation contracts, commercial leases, and collective bargaining agreements are among the different types of contracts that may contain escalator clauses. When included in such contracts, escalator clauses indicate that both parties have agreed that the base prices, wages, or rents in the original contract may increase over time under certain conditions. Typically, escalator clauses provide for increases based on similar increases in an agreed-upon index or other indicator. For example, a collective bargaining agreement may contain an escalator clause that provides for an increase in wages when the consumer price index rises by a certain amount. Such wage increases are called cost-of-living adjustments.

Escalator clauses tend to be used more frequently when inflation rates or expectations are high. Their use in industrial purchasing declined through the 1980s and 1990s as inflation remained under control. Industrial purchasers use escalator clauses to protect themselves from sharp price increases. From the suppliers' point of view, escalator clauses allow them to pass on those cost increases that were caused by inflation. For commercial property owners, escalator clauses can keep their rental income from being eroded by higher prices.

According to a 1993 survey by Purchasing magazine, contracts using escalator clauses accounted for an average of 13 percent of all goods purchased in 1993. That compared with 16 percent in 1989 and 24 percent in 1981. The relatively lower percentage for 1993 was explained as a combination of lower inflation expectations and fewer purchasers relying on escalator clauses as a tool to control sharp price increases. Approximately four of every ten surveyed purchasing professionals believed they were effective.

When escalator clauses are included in a contractual agreement, both parties must agree on which index or indicator is to be used. The most commonly used indicators are one or more of the indexes calculated by the U.S. Bureau of Labor Statistics (BLS), such as the consumer price index (CPI). It is critical, however, that the selected index bear some relation to or accurately reflect the prices in the contract. Since the CPI is unrelated to industrial prices, industrial purchasing contracts may rely on various producer price indexes or industry data as the relevant indicator for their escalator clauses. In some cases it may not be possible to find an appropriate index.

Other problems associated with indexing prices include the fact that data may be outdated by the time it is published or otherwise becomes available. Many industrial purchasers feel that escalator clauses send the wrong message to suppliers and that they may not watch their costs as closely as they should. As an alternative to escalator clauses, industrial purchasers may favor developing long-term, partnering relationships with suppliers to control price increases.

Another problem associated with escalator clauses is that the agreed upon indexed prices may in fact rise above market prices. For example, oil price increases tend to drive the BLS industrial commodities index higher. When oil prices decline, however, the index does not go down at the same rate. As a result, contract prices may increase substantially above market prices, if they contain escalator clauses.

Recent developments in industrial purchasing contracts have allowed purchasers to shift the risk of price increases to the supplier's ability to cut costs and improve quality. Long-term contracts may contain a market price limiter, which lets the buyer retain the option of paying either the market price or the indexed price according to the terms of the escalator clause. In other cases, floors and ceilings are written into escalator clauses to place a cap on price increases.

Different indexes may favor one or the other of the contracting parties. In the transportation industry, for example, the railroad cost recovery (RCR) Index is the one most commonly used by railroads in negotiating escalator clauses with shippers. While the RCR measures certain railway industry expenses, it does not measure productivity improvements realized by railroads. That is, the index reflects the cost of resources, but not how much transportation is provided by each unit of resource. As a result, shippers do not share in the benefits from a railroad's productivity increases when escalator clauses are based on such an index.

The Interstate Commerce Commission (ICC) developed a railroad cost adjustment factor (RCAF) that can be used as an index in escalator clauses. In addition, the ICC developed a productivity adjustment factor to be used in conjunction with the RCAF. While the RCAF indexes the cost of inputs, the productivity adjustment factor indexes the cost of output. Thus, any productivity improvements would be reflected in the productivity adjustment factor. If the productivity adjustment factor were used in an escalator clause, it would have the effect of allowing shippers to share in the productivity gains realized by railroads and other carriers.

Escalator clauses must be carefully negotiated if they are to fairly protect the contracting parties from inflation and unexpected price increases. In addition to the basic escalator clause, contracts may contain a variety of other escalator mechanisms and provisions to add further protection. A key factor in successfully negotiating escalator clauses is finding an appropriate index that accurately reflects the costs involved and that is fair to both parties in the contract.

[ David P. Bianco ]

FURTHER READING:

"Buyers See as Many 'Downs' as 'Ups' with Escalator Clauses." Purchasing, 20 July 1989, 28.

"Partners Sign Long Deals, Avoid Escalator Clauses." Purchasing, II November 1993, 18.

"Think Twice before Locking Contracts with Escalators." Purchasing, 25 October 1990, 20.



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