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 kick in 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 take on a variety of forms. In the main, their purpose is to allow people to enter large or long-term contracts without worrying that future changes in the market could come back to bite 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 fairly widespread in the business contracts of companies that supply goods or services whose costs are prone to fluctuate wildly—an example being the shipping sector, where 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 he or she 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 foot the bill for any increase in wages or prices that they impose.

Their use in employment contracts, in particular, has come under fire. Unions argue that these provisions are necessary to protect workers against a potential loss of purchasing power in times of inflation. Economists, meanwhile, claim that these clauses destabilize the economy, serving to escalate the inflation they were created to relieve.

When wages automatically keep climbing, central banks struggle to stabilize prices and cool the economy. Against such a backdrop, companies, particularly those unable to pass on higher costs to customers, might 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

Escalator clauses serve a slightly different purpose in the property market. In real estate, an escalator clause may be attached to an offer on a home, indicating that the potential buyer is willing to increase his or her 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. That means 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 the 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.