Updated: Jul 7, 2025
When explicit indexations create risk
Passing the Buck
We all know the story: first, supply chain disruptions in the wake of Covid, then the Ukraine invasion and its consequences on commodities, have caused global inflation to soar. Significant losses were recorded by suppliers who had pre-fixed their prices (for example, offshore wind turbine manufacturers [1]).
In reaction, suppliers now increasingly include indexation clauses in their contracts: the final price changes based on a commodity price index.
These clauses explicitly transfer the risk from the supplier to the buyer (from the manufacturer to the wind farm operator in our example).
The buyer now exposed to commodity prices volatility must, in turn, find solutions to mitigate the risk induced by these indexations. The most natural way for protecting his profitability - at least partially - may be to adjust his own selling prices accordingly:
- Implicitly if the company has enough pricing power [2] or
- Explicitly if these very prices are also indexed: see for example the case of some solar projects in France where the electricity price is adjusted according to the so-called K coefficient [3] – which has a steel, copper and aluminium component.
But in many cases, the market or the price fixation mechanism does not allow for a perfect adjustment of the selling prices and it is interesting to explore risk mitigation via hedging transactions.
Spot the Difference
Hedging instruments enable companies to tackle the problem of indexation at its roots. To achieve this though, you will need to take some precautions.
Indeed, commodity derivative instruments are only tradable on specific indices. For the hedge to be most efficient, the indexation clause in the supplier contract must refer to the very same index.
Unfortunately, it is not so easy to navigate the jungle of commodity indices and to know which ones can be hedged in practice.
To identify a commodity price index precisely, you need to check at least:
1. The publishing entity:
We have seen some clauses referring to the Iron Ore 65% CFR China index published by Platts, while derivatives mainly have as a reference the index with the same name but published by Metal Bulletin instead.
2. The quality/grade of the commodity:
Platts publishes Iron Ore CFR China indices with 62% iron content and this is hedgeable with derivatives instruments but it also publishes prices for 58% grade and this one has no associated tradable instruments.
3. Its delivery location and method:
For example, Platts publishes Gasoil 0.1% indices with delivery FOB Barges Rotterdam or CIF Cargoes NW Europe (typically delivered between Hamburg and northern Spain) and both indices are tradable.
We encounter similar issues with retail inflation: we have seen indexation clauses referring to the Harmonized Index of Consumer Prices in the European Union, as published by Eurostat, but derivatives are most liquid on the Eurozone index excluding tobacco products.
As much as possible, indexation clauses should refer to hedgeable indices. This at least makes hedging a real possibility: the company can work on sizing the commodity exposure and approach counterparties to gauge their appetite for hedging transactions. Whether this risk is ultimately covered or not becomes the company’s choice. Regardless of any hedging considerations, these indices are also generally very liquid and therefore mirror more objective market prices.
Conversely, if the company wants to hedge but tradable derivatives are based on a proxy index that is not the one referenced in the contract, then trading such derivatives will create a basis risk: the commodity risk is mitigated only if both indices move in the same way. If they don’t, a net loss (or profit) will materialize depending on the difference in movements between these 2 indices.
The Price is Right
Quantifying this basis risk will allow the company to decide if it is bearable, or not. And if not, it will be necessary to open negotiations with:
- Either the supplier on the possibility to modify the reference of the contractual indexation
- Or the potential hedging counterparties to check whether they would accept to warehouse the risk and trade a derivative referencing the “non tradable” index.
In any case, the supplier or the hedging counterparty will likely adjust their pricing for this basis risk.
While negotiating the indexation clauses (or hedging on an illiquid index), the company will thus need to make its own assessment of the economic impact of different indices:
What is the fair price to replace the Iron Ore CFR China 58% by the 62% index?
If there are no market prices, the basis risk will need to be analysed on the given time horizon. For example: over the next three years (the duration of the contract indexation), how much on average can the Iron Ore CFR China 58% index deviate from the 62% index? What are the typical deviations from this average?
A proper quantification of the basis risk will also allow:
- if negotiations to align the indices fail, to anticipate the contingency amounts to be provisioned for the basis risk, and their potential cost.
- to compare the offers provided by several suppliers if they refer to different indices or if some are based on fixed prices.
ESTER is there to help you manage the commodity risk embedded in these tricky indexation clauses:
in-depth analysis of your contract to determine the most prominent exposures
derivatives market expertise to identify unhedgeable indices and potential replacements or proxies
precise quantification of the basis risks to make informed decisions
