News / Air and sea shippers weigh pros and cons of index-linked agreements

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Uncertainty on freight rates for the next year is concerning both shippers and carriers as they consider committing to 12-month contracts – both in air and sea. 

One way of reducing risk is through index-linked agreements (ILAs) – but carriers have concerns that rates could fall to unsustainable levels. 

Stanley Smulders, director of marketing & commercial at Ocean Network Express (ONE), told a Xeneta event last month that rates were still volatile. 

“Individual tradelanes will remain volatile, particularly on a short-term basis. The spot market is simple – rates may be high or low and you take it as it comes. But when annual deals come up and you know you’re going to lose money for the next 12 months, that’s an entirely different ball game, and a lot of carriers may not want to do that. 

“This is going to be the real test in the coming months – especially the Asia to Europe trade.” 

To mitigate the vagaries of the spot market, Mr Smulders said: “In principle, we are open to [index-linked contracts] because they save us and the customer a lot of time haggling over freight rates – sometimes weekly. 

“There’s only one ‘but’. Index-linked contracts work as long as the rates go down, as soon as the rates go up, they stop working.” 

Index-linked agreements (ILAs) are becoming more common in air freight. Peyton Burnett, MD of TAC Index, said: “We are doing several ILAs now, on multiple markets for air cargo. 

“One reason why parties use ILAs is that they can neither agree to a fixed term rate and nor do they want to continuously negotiate in a spot market. ILAs provide a middle solution, and also happen to be the most risk-neutral positions.  

“Not only does this save many work hours, when it comes to tender cycles, it also enables the buyer to secure capacity for a period of time. The problem with fixed-rate contracts is that, if over time the spot rate diverges too much, this will increase the likelihood of the contract breaking down – as there will be a winner and a loser to the contract.  

“ILAs follow the market, so greatly reduce the likelihood of the contract being reneged on – both parties are trading at market price. Users can report to their finance department that they are just following the market. It is always a hard ask internally to request more budget to move freight without reference a neutral third-party benchmark.” 

Mr Smulders said an upper and lower limit to an ILA could help. Mr Burnett explained: “For physical contracts, which by their very nature are bilateral agreements, it is up to the counter parties how they draft the ILA clause. At the end of the day, as long as both parties agree terms, that means they are good to go. 

“It is common practice to have ceilings and floors in contract pricing for physical contracts. Floor pricing is more common as the operator needs to cover operating costs.” 

But he said pricing bands were also useful; ie, if the index increases more than 10% for a defined period of time, then the new price takes effect. 

He added: “Another way is to not have the index linking in the main pricing contract clause, but in the break clause. This is actually how the sea container market first started to adopt index linking agreements…through the break clause.”