A town government and a private fuel-oil company have a standing contract that they have renewed for several years in a row. The contract is again up for renewal, and the town manager is under pressure from his constituents to reduce the city’s heating costs and avoid tax increases.
The city’s fuel-oil consumption has remained relatively stable during the past five years, yet costs have shot up almost 60%. As a longtime client, the town feels it should get some protection from the sudden price jumps.
The town manager hits on the idea of asking the company to provide a guaranteed annual price-increase cap of 10% in exchange for agreed-upon delivery dates and amounts for the life of the contract.
With a price cap in place, the town would not have to increase its fuel-oil budget by more than a certain amount each year. Although the town might have to pay a slightly higher per-gallon cost over the life of the contract in exchange for the consumption guarantee, this could be a reasonable tradeoff. The fuel-oil company has never agreed to a price cap for a municipal customer, but it ultimately agrees to the manager’s requests for fear of losing the city’s business and facing negative publicity.
The price cap proposed by the town manager is a type of contingent agreement, in which a range of “If this happens, then we do this or that” promises are added to a negotiated contract to reduce risk in the face of real-life uncertainty about the future. Whenever negotiation strikes a deal, both sides must make forecasts and assumptions. Will current conditions remain the same or change after the agreement is signed?
Will the other side hold up its end of the bargain? By including contingent incentives or penalties in a contract, you can protect yourself from the risk that your negotiating partner will renege on a commitment as well as improve the prospects of compliance. Contingent agreements can add new complexities to negotiations; but, with a little preparation, the benefits will far outweigh the costs.
Adapted from “Don’t Like Surprises? Hedge Your Bets with Contingent Agreements,” by Lawrence Susskind, Professor, Massachusetts Institute of Technology.
Originally published October 2009.