Inflation indexation is a typical provision to adjust tariffs and unitary payments in a continuous basis. Since price and cost indexes used are publicly available, this provision economizes on transaction costs. To adjust service charges by indexation, a choice should be made concerning the price or cost index to apply, the proportion of tariff subject to adjustment, and whether the indexation rule itself will be revised periodically. Regarding the price or cost index to be applied, there is an important trade off to consider. If the index used is not specific to the sector, e.g. the retail price index (RPI), it is likely that its variations do not mimic the changes in the private partner's non-controlled costs. This may lead to price adjustments failing to track the relevant cost changes, thus distorting incentives. On the other hand, if the index is too industry-specific, it is likely that its variations could be influenced by the tariff level of the regulated service, and so manipulated by the private-sector party itself (Armstrong et al., 1994). The proportion of tariff subject to indexation also matters: to provide a proper hedge against observable, non-controlled cost overruns without distorting incentives, the proportion of tariff subject to indexation should match the proportion of variable costs in total costs (HM Treasury, 2007). Since fixed costs are known in advance, involving no risk, the proportion of the tariff that covers them should not be indexed.
The payment mechanism should include arrangements for changing the price of service to prevent the service charge from becoming insufficient to meet the project's operation costs and financial obligations for reasons beyond the private-sector party's control. Inflation indexation is typically a low-cost device to implement price variations.
In using inflation indexation, two important issues should be taken into account. First, the contract should specify the price index to be applied. In choosing between a general price index or an industry-specific price index, the public-sector party should consider a trade off. On the one hand, a general index like the retail price index is available at low cost, but it leads to price adjustments that fail to track the relevant cost changes to the extent the general price variations do not mimic the changes in the private-sector party's non-controlled costs.
On the other hand, an industry-specific price index may properly reflect the relevant cost changes, but it is costly to elaborate and its variations could be heavily influenced by the private partner's own price when the market structure is concentrated.
Second, the contract should determine the proportion of the tariff or unitary payment to be indexed. In this regard, it is a good practice to apply indexation only to the proportion of the service charge that matches the proportion of variable costs in total costs. This provides the private sector with a proper hedge against non-controlled costs without distorting incentives. Accordingly, it is not advisable to over-index service charges, i.e. to index the whole price of service aiming at reducing the initial bid price of the private partner.