Understanding How to Write an Escalation Contract Tied to the Consumer Price Index
Most contracts are filled with defined elements such as mutual consent, adequate consideration, and capacity.
Contract law deals with agreements that create mutual obligations that are legally enforceable between two or more parties. Most contracts are filled with defined elements such as mutual consent, adequate consideration, and capacity.
Many contracts also contain escalation clauses that guarantee a change in the agreement if a particular factor outside the control of either party affects a pre-determined value. In these types of contracts, the consumer price index or CPI is frequently used to measure an escalation clause. It’s a useful way for both parties to agree on incremental changes in negotiating prices for long-term contracts.
Unfortunately, many escalation contracts tied to the CPI are vague. More carefully worded contracts can minimize ambiguity and prevent future disputes.
Understanding Escalation Contracts
Sometimes referred to as cost-of-living adjustments or annual escalators, escalator clauses automatically adjust upwards any defined compensatory rates by an agreed-upon percentage or amount on an agreed-upon date. These types of provisions are often contained in agreements with what’s known as evergreen annual renewal provisions once the initial defined term is reached. A primary benefit of escalation clauses is they help protect against diminishing purchasing power related to inflation.
The CPI measures monthly the average change in the prices consumers pay for certain goods and services such as oil and gas, healthcare, food, and housing. It reports rising prices (inflation) and falling prices (deflation), both of which can harm a healthy economy. The Federal Reserve monitors prices changes to ensure economic growth remains stable. For instance, during the pandemic-driven shutdown, the CPI declined anywhere from 0.2% to 0.7%, the largest drop since 2008.
Because thousands of CPIs are published each month, it’s essential to draft escalation contracts that specify critical parameters, such as:
- Whether the CPI-U or CPI-W is to be used.
- Which of the hundreds of CPI item categories should be used in the contract.
- The reference base to be used.
- Whether a specific geographic area will be used.
- Whether to use an index that is seasonally adjusted.
Other considerations include specifying the timing and frequency of the escalation, specifying the base dollar amount, and including floor and ceiling amounts.
Escalation Clause Types
Contract escalation clauses make it easier for people to enter into long-term or high-value contracts without worrying how future market changes could come back to harm them. For instance, they’re used to guarantee wage increases are tied to inflation, help real estate buyers win during a seller’s market, and shield landlords from missing out on higher rents.
Typical escalation clauses include:
- Fixed percentage. Due to their predictable costs, guaranteed increases, and streamlined implementation, fixed percentage escalation clauses are often used in evergreen contract renewal scenarios. The parties typically agree to a percentage amount that will apply to the prior year’s compensation rate. Weaknesses to this type of escalation clause occur during times of instability when the predictable cost increases they call for might not reflect economic reality.
- Index-based. This escalator clause sets forth an agreed-upon cost index that will be applied to prior rates of compensation. There are unexpected times when a payment reduction could occur, but a structure tied to an index tends to offer deflationary protection and reduces the risk of payment outside of fair market value (FMV). To ensure an index-based escalator clause works as intended, the parties should thoughtfully choose and properly identify in the contract the appropriate index.
- Hybrid. As the term suggests, a hybrid escalation clause blends elements of the fixed and indexed approaches. It typically relies on the higher of a fixed percentage or a specific CPI index as the escalator amount. For industries vulnerable to inflation and spending, such as healthcare, hybrid escalation clauses are often seen as attractive alternatives to fixed and variable structures.
Considerations When Implementing An Escalation Clause
When drafting an escalation contract tied to the CPI, the contract must define precisely how periodic adjustments will be made and the figure the adjustment is applied to. For instance, in a rental agreement, the adjustment might be made solely to the base rent amount, or it could be applied to a higher figure that includes secondary items such as maintenance services or utilities.
The parties must also specify the particular variation of the CPI to be employed in the escalation clause and decide how often adjustments are to be made or considered. Though an annual basis is the most common, the parties are free to apply them more or less frequently.
Finally, the specific formula for adjustment should be stated in the contract. While most price adjustments use a percentage equal to the CPI’s percent change, others might stipulate using a multiplier that results in a greater or lesser adjustment. Some contracts also stipulate a maximum total price increase or guarantee a periodic minimum increase.
Reliable Contract Law Guidance
Munizzi Law Firm can advise you on a variety of contracts that contain escalator provisions and help provide you with the most desirable outcomes. Contact us today to learn more.