After around 30 years of relative stability, inflation has made a resounding comeback, playing havoc with economies around the world. The COVID-19 pandemic, supply-chain disruptions, and the Russia-Ukraine War have all contributed. Even though the current inflation outlook seems to have eased and a degree of stability has returned, recent events have shown inflationary pressures can change rapidly and dramatically: The next inflationary crisis could be just around the corner.   

In this white paper, Senior Managing Director Daniel Hanson, Consultants Kajal Kumar and Khalil Sabourian, and Economic Analysts Daisy Chu and Margot Cintract explore the implications of this changing inflationary environment on commercial infrastructure contracts.

Specifically, the authors explore:

• How inflation measures (such as the Consumer Price Index (CPI)) and commodity-specific indices respond differently to economic shocks. See illustration, which shows how the % year-on-year inflation in aggregates and concrete were different to the CPI;  

• How indexation can be used to limit inflation exposure;
• The importance of accurately forecasting project-specific inflation by using econometrics; and
• How to assess compensation for inflation-related costs in force majeure disputes.

To illustrate their points, the authors use a stylised example based on previous work on these issues and actual expenditure profiles from major real-world infrastructure projects. They demonstrate how relying on economy-wide indices, such as the CPI, instead of creating a precise index tailored to a specific project, can result in substantial underestimation of inflation costs. In 2022, this underestimation could amount to as much as 11% of nominal spending the project for that year (worth £268 million in the context of the stylised example).

Measuring, forecasting, and indexing inflation is challenging but needs to be done properly, as the stakes are so high.