If the service charge is set for the project term, the private party typically seeks to protect itself against the effects of inflation through appropriate adjustments to the service charge. To achieve this, the service charge agreed to by government is usually indexed, either fully or partially, over the project term. If indexation is not incorporated into the pricing mechanism, the private party tends to build contingencies into its initial bid to cover inflation risk. Owing to uncertainties in forecasting future inflation rates, this approach does not generally yield a value for money outcome for government. For this reason, an indexation mechanism is preferred.
The indices to be applied should be clearly agreed and specified in the project documents and be capable of objective observation. Allowing competing bidders to propose alternate indices generates difficulties in comparing competing bids. Choosing an index that is not independently published, has a narrow focus or a short lifespan, may produce complications.
The indices may be nationally-based, based on a specific region or an appropriate industry sector (for example, a construction index). Government should consider which is the most appropriate index to apply and the proportion of the service charge that is to be subject to indexation. In practice, different cost components of the service charge may be subject to different indices - for example, average weekly earnings for a wages component and a chemicals index for chemical inputs.
The extent of the service charge to be subject to indexation should reflect the underlying cost exposure of the private party, but may be structured to promote real costs savings that can be shared with government.