Cap-and-floor pricing: Overview, definition and example
What is cap-and-floor pricing?
Cap-and-floor pricing is a contract provision that sets both a maximum (cap) and minimum (floor) limit on the price of goods or services. This pricing structure is often used in long-term contracts to protect both parties from extreme price fluctuations. The cap limits how high the price can go, while the floor ensures that the price doesn’t drop below a certain level, providing stability for both sides.
For example, a supplier and a buyer might agree to a contract with cap-and-floor pricing, where the price of a product will not exceed $100 (cap) or drop below $60 (floor) over the next year.
Why is cap-and-floor pricing important?
Cap-and-floor pricing is important because it creates a balanced risk for both parties in a contract. For buyers, it provides protection from price spikes, ensuring they won’t have to pay too much if market conditions change dramatically. For sellers, it guarantees that they won’t be paid too little, even if market prices drop. This pricing structure is especially useful in industries where prices are volatile, such as energy or commodities.
By using cap-and-floor pricing, both parties can plan their budgets and strategies with more certainty, making it a useful tool for long-term contracts.
Understanding cap-and-floor pricing through an example
Imagine a construction company enters into a long-term contract with a material supplier. They agree to a cap-and-floor pricing structure for the cost of cement. The price of cement can fluctuate depending on the market, but the contract specifies that the price cannot exceed $120 per ton (cap) and cannot go below $80 per ton (floor). This gives both parties protection from unpredictable price changes.
In another case, a utility company might use cap-and-floor pricing for the supply of electricity. The company agrees to pay no more than $0.15 per kilowatt-hour (cap) and no less than $0.10 per kilowatt-hour (floor), which helps both the energy supplier and the consumer manage their costs effectively over the contract period.
An example of a cap-and-floor pricing clause
Here’s how a cap-and-floor pricing clause might look in a contract:
"The price of cement supplied under this agreement shall not exceed $100 per ton (cap) and shall not fall below $70 per ton (floor) for the term of the contract."
Conclusion
Cap-and-floor pricing is a valuable tool in contracts to manage pricing uncertainty. It allows both parties to benefit from price stability while protecting against extreme fluctuations. By setting clear boundaries for pricing, this approach helps businesses plan more effectively and reduces the risk of unexpected financial burdens.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.