Price escalation clauses for structural steelwork

Steel – a volatile raw material

Every company that processes steel in larger quantities is at the mercy of steel price developments. This mainly affects the construction industry, but also many industrial companies and their suppliers. A long-term forecast of the steel price is not possible, because steel producers in turn depend on volatile raw materials and do not enter into long delivery commitments. The rising steel prices in the wake of the coronavirus pandemic caused major problems for many steel-processing companies in 2021. Similar price peaks have occurred in the past as well, for example in 2008.

However, companies can protect themselves in various ways against having to bear the risk of rising steel prices – for example, by hedging with price escalation clauses or with suitable financial instruments.

Depending on the industry, there are differences that favour one option or the other.

Price escalation clauses – taking steel price developments into account in the contract

Commentary by Dr. Peter Hammacher, lawyer – mediation – arbitration in Heidelberg

Price escalation clauses are suitable for at least partially offsetting the risks of fluctuating raw material prices on the world market. The contracting parties agree to turn fixed unit or lump-sum prices into flexible prices that depend on the price development of the input materials.

Both sides can have an interest in this: the supplier is relieved of the risk of rising prices and secures its margins. It does not have to include risk surcharges for uncertain material price increases. This in turn lowers the quoted price and benefits the client. If prices rise, however, the client shares in the additional costs. The same applies conversely if prices fall.

Price escalation clauses are not regulated by law, at least in Germany. They must be agreed between the parties. How they are drafted is left to the parties – within the bounds of good faith.

Price escalation clauses are usually expressed as a mathematical formula in which values at the time the contract is initiated (e.g. invitation to tender, submission of a bid) or concluded (e.g. signing of the contract or award) are set in relation to a point in time during contract performance (e.g. order, delivery to site, acceptance).

If an agreed tolerance range is exceeded, the price is adjusted. The closer the measuring points are to the actual events, the more accurately the clause reflects the additional costs caused by the price change. For example, the ratio “calculation of the bid/payment of the material supplier’s invoice” is more realistic than “(possibly delayed) contract award/acceptance of the construction work”.

Whether and to what extent prices have risen is also a matter of perspective, because there is no uniform worldwide standard for measuring price fluctuations. The contracting parties must therefore either make their own arrangement (e.g. the average of three price quotes) or agree on figures determined by third parties (e.g. a commodity exchange, trade associations, statistical offices).

In Germany, public contracts use the formulas of the German federal procurement manual (Vergabehandbuch) (see Hammacher, Rasante Erhöhung der Stahlpreise – Hilfe durch Stoffpreisgleitklausel? Bauwirtschaft -1/2021, p. 8, available free of charge here). According to the German Steel Construction Association (Deutscher Stahlbauverband/bauforum stahl), this also applies to the structural steel industry. The situation is harder to assess for machine and plant engineering. The VDMA e.V. (German Mechanical Engineering Industry Association, editor’s note) no longer gives recommendations or information on this, but advises its members individually.

As always, whether the parties can agree on a fair allocation of risks is a question of how fairly the contracting partners deal with each other, of negotiating skill and/or market power. You should carefully examine the legal situation and the options. Without a contractual provision, the statutory limits apply, in particular § 313 BGB (German Civil Code) “Disturbance of the basis of the transaction”. However, the German legislator, and many courts following it, have set high requirements for this.

About the guest author Dr. Peter Hammacher

Dr. Peter Hammacher is a lawyer with more than 30 years of professional experience, particularly in plant construction and structural steelwork, in consulting, representation, arbitration, mediation and seminars.

His publications include the “Handbuch der Auftragsabwicklung (Amazon affiliate link) ” (Handbook of Order Processing) with template letters, aimed mainly at project managers in steel and plant construction.

Examples and templates for price escalation clauses

Detailed explanations and examples of applying a price escalation clause based on the German federal procurement and contract manual can be found in chapters 2 and 3 of this article by Dr. Hammacher (in German).

Very good templates for wording price escalation clauses, which you can easily use in practice, are also available from the Austrian Economic Chamber (WKO) at this link (pdf).

Suitable indices for price escalation clauses

As Dr. Hammacher’s commentary above explains, when applying price escalation clauses the first thing to clarify is which index they refer to. Here is a selection of steel price indices and commodity exchanges.

Alternative: hedging – protecting against steel price changes with financial instruments

Outside the construction industry, too, raw materials – steel in particular – are regularly purchased and processed. This applies above all to high-volume series production. Here it is not possible to allocate the purchase price exactly to the product sold. Long-term supply contracts also require price stability that cannot be achieved in raw material procurement. You therefore need general protection against rising steel prices.

One means of achieving this is derivative financial instruments. The aim is to protect your own steel requirements against price changes. This is only ever possible for a certain quantity at a certain point in time.

Because steel comes in many different forms, it was discovered relatively late as an underlying for derivatives. Today, contracts for various steel grades such as rebar, wire rod or hot-rolled coil can be concluded on various international exchanges.

How does steel hedging work?

Hedging with a derivative requires that you know your future steel requirements. Only then can you hedge this quantity of steel. Of course, it is also possible to cover only part of your requirements and achieve at least partial cost certainty. Let us look at a small example:

The company Stahlbau GRÜN buys 1,000 tonnes of steel every month and processes it further. It has long-term supply contracts with fixed prices with its customers. The company wants to protect itself against the risk of an unfavourable steel price development over the next 12 months. To do so, it acquires a financial instrument that gives it the right to buy 1,000 tonnes of steel in one year at a price fixed today.

After the 12 months have passed, Stahlbau GRÜN buys 1,000 tonnes of steel at the current market price through its supplier. At the same time, the financial instrument is settled. There are two possibilities:

1. 1. If the current market price is higher than the price fixed in the derivative, Stahlbau GRÜN receives a payment equal to the difference. Although it has paid a higher price for the physical steel, it receives a payment from the derivative as compensation for the costs.
   2. If the steel price on the settlement date is lower than agreed, Stahlbau GRÜN must pay the difference to the issuer of the financial instrument. However, these costs were largely saved when buying the physical steel.

In this way, you can protect yourself against rising costs, and the development of the steel price no longer poses a risk in your costing. However, a fee is payable to the issuer of the financial instrument. The longer the lead time until the settlement date, the higher this fee.

Unfortunately, this form of hedging is only suitable for companies with large steel requirements and the corresponding expertise in trading financial instruments.

Risks of steel hedging

Hedging requires the material in question to be listed on a commodity exchange. As the previous chapter shows, only a few steel grades are traded. This poses a major risk for SMEs, because they process sheets, sections and hollow sections in various material grades that are not listed on the exchange. Although raw material prices correlate, they are only part of the market price. Local shortages, for example due to production bottlenecks or supply problems, are not taken into account. Put simply: if a steel fabricator has to build a structure from seamless tubes and these are currently scarce and therefore expensive, hedging on one of the values mentioned above will not necessarily compensate for the price increase. This type of hedging would therefore be speculative and thus an additional risk. (Cf. Beschaffung Aktuell)

Conclusion: protecting against rising steel prices remains a complex issue

Depending on the industry you work in and your company’s position in relation to your customer, you may be able to pass on price increases to your customers through a price escalation clause.

For many companies, however, this will not be possible, and the use of financial instruments also involves risks. In addition, many applications – especially in machine and plant engineering – lack a suitable reference value, which means that supposed protection against steel price developments quickly turns into speculation.

In such cases, companies have to steer by sight and take care not to enter into commitments that are too long.

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