July 18, 2022
Inflation around the globe is rising. Inflation in the UK is tipped to be the highest in the G7, not just this year but also in 2023 and 2024. Rising costs of energy, fuel, raw materials and increasing VAT rates in industries such as hospitality, continuing global supply chain shocks and stimulus aftermath from COVID-19 and the ongoing conflict in Ukraine are all contributing to an inflation perfect storm.
High inflation affects businesses across all sectors of the economy. Telecoms providers are particularly feeling the heat as rising inflation is coming at a time of significant investments being made to build new and upgraded network infrastructure and capacity to meet rapid connectivity demand growth, which we explored in our previous article.
The typical knee-jerk reaction within a bi-lateral arrangement is predictable: (1) suppliers will pass on maximum inflation price increases and (2) customers will resist any maximum inflation price increases, in each case to the greatest extent contractually possible. It’s a zero-sum game; the other side gains whatever you give up. Ultimately nobody “wins”, however, if suppliers cease supply because they can’t turn a profit (or even cover their costs) and customers can no longer afford to obtain services at pre-inflationary prices.
This need not be the case. It’s possible for suppliers and customers alike to continue to innovate and remain profitable despite persistently high inflation. Operators accustomed to high inflation environments hold valuable lessons for surviving and even thriving during inflation while building customers and revenue. How these operators navigate inflation challenges is borne out in their commercial contractual arrangements.
Here are some strategies to deploy in your commercial contracting arrangements to share the risks and benefits during challenging inflationary periods:
Swiftly adjust pricing and scope under your contracts
Ensure your supply contracts give you the required flexibility to respond to inflationary pressures and evolving business priorities:
|Party||Inflation cost increases||Service pricing and scope|
|Supplier||Clear rights to pass on any cost increases to customers, including due to inflation.||Clear rights to amend the service scope where needed to account for input cost differences. This could be an opportunity for suppliers to prioritise their more profitable services.
For example, the supplier could narrow the services scope due to input cost increases to focus instead on more profitable services, or to swap out an input more affected by inflation for an equivalent input that is less affected by inflation.
|Customers||No open-ended rights for suppliers to pass on cost increases, including due to inflation. Need pricing certainty from suppliers.||Price increases require the customer’s consent. As part of providing its consent, the mechanism could require the supplier to demonstrate value. This could be an opportunity for customers to tell suppliers which services are a higher priority, and to price them accordingly.
For example, if the supplier wants to increase the price it must also demonstrate how it is providing more for that higher price, or the customer may want the supplier to use different inputs to reflect changes in relative pricing.
Revisit pricing and service models
Particularly when inflation increases rapidly and affects broad swathes of the economy, there’s often a mismatch between the prices and services offered by the supplier and what the customer is willing to pay for them. Your contract could include flexible pricing or service models to ensure that the parties are receiving their expected economic value from the contract, while smoothing out any price shocks over the term of the contract.
Alternative pricing models could include:
- Using consumption or unit pricing rather than lump sum or up-front pricing to better align interests between customers and suppliers, signal what suppliers should prioritise procuring and shape the customer’s control over consumption.
- Identify opportunities for price differentiation between base versus premium products and services, which could also account for inputs that may be affected by different inflationary pressures.
- Modularising and unbundling services to avoid suppliers investing in underutilised assets and customers paying for services they don’t need.
Use your renewal rights
Renewal rights are often overlooked as an inflation cost management mechanism. It may be much more commercially effective to manage inflation-related cost increases and any required re-provisioning of services as part of the contract renewal process. This may draw less commercial ire than a steep inflation price increase being applied part way through the contract. You should ensure your contracts give you maximum flexibility for this process, such as revisiting any renewal restrictions. A zombie renewal restriction limiting any price increases upon any renewal may not make sense in a high inflation scenario and would disincentivise the service provider from offering enhanced services.
Share inflation risk
Too often inflation risks are simply passed on from supplier to customer, leaving the customer to bear the entire inflation risk. Consider whether your contract should include a mechanism for the parties to share inflation risk. This could work by putting banded caps on the amount of inflation passthrough, together with an absolute cap on any inflation charge increase. Particularly for longer term contracts, the parties should periodically review inflation mechanisms to ensure it continues to strike the correct economic risk allocation envisaged at the beginning of the contract.
Use the right inflation index
Commercial contracts typically use the general inflation rate published by the relevant central bank or national statistics authority. This is often due to convenience or the parties being reluctant to identify a more specific measure. However, price increases across different buckets of goods and services vary widely, so it may not always be appropriate for the general inflation index to apply to your contract – why should the increase in prices for fruit and vegetables have any bearing on your network equipment supply contract? You should also ensure that the applicable inflation index is relevant to the goods or services being provided under the contract to mitigate inappropriate inflation risks.
Inflation calculation date and frequency
Your contract should also specify how often inflation indexation occurs. This should align with when the relevant indexation information is officially published, rather than just being the anniversary of your contract.
High inflation environments unfortunately aren’t new. Managing inflation is of course just one of many factors affecting business strategy and will depend on a range of factors such as the relative bargaining power of the parties and their respective positions in the market. A service provider eagerly looking to expand market share may well be more willing to bear inflationary impacts in the short term, while a well-established customer may prioritise smoothing out impacts over a longer period.
We frequently advise clients on strategies for negotiating their commercial supply agreements. Get in touch if you’d like to have a further discussion about your business and we’d be delighted to assist.