What Is an Escalator Clause?

An escalator clause, also known as an escalation clause, is a provision allowing for an increase in wages or prices. They are inserted into contracts and are activated under certain conditions, such as when the cost of living or inflation rises.

Key Takeaways

  • Escalator clauses are provisions that allow for an automatic increase in wages or prices under certain conditions.
  • They make it easier for people to enter large or long-term contracts without worrying that future changes in the market could come back to bite them.
  • Escalator clauses can guarantee wage increases are tied to inflation, protect landlords from missing out on higher rents or help property buyers to win auctions.
  • Sometimes escalator clauses include a cap on the allowed increases.

How an Escalator Clause Works

Escalation clauses can take on a variety of forms. Their main purpose is to allow people to enter large or long-term contracts without worrying that future changes in the market could potentially hurt them. In other words, they are utilized to ensure that a contract remains fair and accommodates shifting external circumstances.

Escalation clauses are commonly championed by labor unions, many of which demand that wage increases are tied to the rate of inflation in employment contracts. They are also common in the business contracts of companies that supply goods or services with costs that are prone to wild fluctuations. For example, in the shipping sector charges can swing considerably depending on the volatile price of oil.

Landlords might favor escalation clauses, too. If rents are increasing rapidly, a landlord may be hesitant to sign a long-term rental agreement or lease, since they could lose out on higher rents and property appreciation. By including an escalator clause, whereby rent can increase by a specified amount each period, the landlord can benefit from current market conditions, while the renter can secure a long-term living arrangement.

Sometimes escalator clauses include a cap on the allowed increases. Escalator clauses may also contain de-escalation provisions—an article in a contract that calls for a price decrease if there is a reduction in certain costs.

Criticism of Escalator Clauses

Escalator clauses are not favored by everyone, particularly those that are forced to cover the cost of any increases in wages or prices.

In particular, their use in employment contracts has become controversial. Unions argue that these provisions are necessary to protect workers against a potential loss of purchasing power in times of inflation. On the other hand, economists claim that these clauses destabilize the economy and contribute to escalating the inflation that they are created to relieve.

When wages automatically keep climbing, central banks can struggle to stabilize prices. In this scenario, companies that are unable to pass on higher costs to their customers may no longer be able to afford to pay constantly elevating wages and, consequently, be forced to lay off staff. Such analysis suggests that these provisions are self-defeating.

Several countries in western Europe have prohibited automatic wage adjustments based on concerns that they fuel inflation.

Example of Escalator Clause

In the property market, escalator clauses serve a slightly different purpose. In real estate, an escalator clause may be attached to an offer on a home, indicating that the potential buyer is willing to increase their bid should other higher offers be received.

For instance, if a buyer makes an offer of $400,000, an escalator clause could specify that if a higher offer comes in, the buyer will beat it by $3,000, but only up to $430,000. This would mean that if an offer of $405,000 is tabled, the escalator clause would trigger a new offer of $408,000. On the other hand, if a competing offer comes in at $429,000, the escalator clause would not allow for a new offer adding $3,000 since the clause specifies a cap of $430,000.