December 9, 2013
Contract uncertainty and price escalation
Procurement Perspectives | Stephen Bauld
I often talk about risk transfer as it relates to the way documents are written. This can greatly affect the end result with respect to the price and overall project.
For example, tenders for supply to be made over a period of years may sometimes provide for the adjustment of price during the course of the contract.
Most major municipalities insist that any price escalation be tied to some objectively determinable standard, such as a defined inflation rate, (e.g., increases in the consumer price index, or the construction price index).
As additional protection, if a price adjustment clause exists, it is also advisable to incorporate a provision permitting the municipality to terminate the contract where prices are in fact increased.
There is often a tendency, when drawing up tender documents, to attempt to shift the risk of adverse price variations to the supplier.
For instance, a contract for shipping or transportation may provide that prices remain fixed for the full term of the contract and that no allowance will be made for any adverse change in the price of fuel.
Such an approach is unwise for two reasons.
First, it is sufficient to discourage many suppliers either not to bid or to qualify any bid that is submitted.
Second, if suppliers can be enticed to bid on the fixed price basis, they will likely have included a substantial hedge in their bid price to reflect a worst case, assumption as to fuel prices.
A far more sensible approach is to include a provision along the following lines, providing for periodic price adjustment in accordance with some objective standard, such as:
“The Region recognizes a pricing adjustment mechanism is necessary for Wet Rates because aviation fuel is a commodity subject to fluctuating prices determined on the global market. Every six months, the Region and the Operator will negotiate in good faith a percentage adjustment to the Wet Rates that reasonably reflects both the percentage change in applicable fuel prices since the previous negotiation and reliable forecasts for the upcoming six (6) month period. Negotiations may consider indices — such as the Platts US Market Scan — New York (Cargo) Price for Diesel Fuel — if readily available as well as the actual fuel costs incurred by the Region for transportation under the Agreement. Negotiations need not focus on the cost at the time of negotiation, but may consider, e.g., weighed average costs over previous periods.
The percentage adjustment will apply only to the portion of the Wet Rates attributable to the cost of fuel (i.e., the difference between the Wet Rates and the Dry Rates).
There will be no charge to the Wet Rates if the parties cannot agree upon an adjustment; failure(s) to agree shall not affect the Region’s option to extend the term of the Agreement.
Negotiated adjustments will be effective once approved by the Region, with the parties aiming to ensure implementation on October 1st and April 1st each year.”
The use of a tender is not necessarily inconsistent with the satisfaction of some future condition following the cost of the tender process.
For instance, a tender might be made “subject to the grant of a licence for the operation of a (specified service) by Transport Canada.”
If such a condition is imposed, the tender documents should explain clearly how it will be determined whether the condition has been satisfied.
Also, it is essential to specify who will be responsible for satisfying the condition, and who will pay any associated cost.
As indicated above, the tender process is most transparent where the contract award decision is tied to single, objective, criteria such as cost.
In some cases, however, such a narrow focus is unrealistic and accordingly each bid must be scored on wider criteria.
Stephen Bauld, Canada's leading expert on government procurement. He can be reached at firstname.lastname@example.org.
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