Risk allocation and pricing approaches: the government guidance, explained

The key facts

• The note builds on chapter 8 of the Sourcing Playbook and gives detailed guidance on risk allocation when devising a commercial strategy.
• It applies to all central government departments, their executive agencies and non departmental public bodies, referred to as in-scope organisations, and other contracting authorities may adopt it at their discretion.
• It is expected to apply to new procurements above the relevant threshold set out in the Procurement Act 2023, on a comply or explain basis.
• The objective of risk allocation is not to transfer as much risk as possible to suppliers, but to place each risk with the party best able to manage it.
• Reputational risk cannot be transferred: government is still held to account publicly for services that fail.
• Suppliers should not be asked to take unlimited liabilities, apart from an agreed list including tax and national insurance, supplier employee claims, certain third party intellectual property claims, TUPE transfer liabilities and ICO fines.
• The three inflation management mechanisms are escalation factors, indexation, and cost plus payment mechanisms and their variants.
• Price indices must come from an official government source, in the UK the Office for National Statistics, and only published index data may be used, not forecasts.
• Section 12(4) of the Procurement Act 2023 requires authorities to have regard to barriers facing SMEs, which in practice means not transferring excessive liability and cash flow risk.

What this guidance is and who it applies to

The guidance is a Cabinet Office note on risk allocation and pricing approaches. It builds on chapter 8 of the Sourcing Playbook and sets out, in more detail than the Playbook itself, how contracting authorities should think about risk when they design a commercial strategy for a contract or an outsourcing initiative. It is aimed squarely at practitioners: the people identifying risks, drafting payment mechanisms and settling contractual terms.

It applies to all central government departments, their executive agencies and non departmental public bodies, which the note calls in-scope organisations. Other contracting authorities may choose to adopt it. It is expected to apply to new procurements with an expected contract value above the relevant threshold set out in the Procurement Act 2023, and in-scope organisations are told to judge whether the recommended approach suits their particular procurement and to take a comply or explain approach where it does not.

The reason for the note is blunt. Inappropriate or disproportionate risk allocation is recognised widely by government, suppliers and independent bodies such as the National Audit Office as one of the key reasons why government contracts underperform or fail. Feedback and enquiries go to the Cabinet Office markets, sourcing and suppliers mailbox.

The principles: allocate risk to the party best placed to manage it

Risk allocation is a core commercial principle. Each party seeks to minimise risk and maximise reward, which creates an inherent tension, and government manages that tension by negotiating provisions that place each risk with the party best placed to manage it. The guidance is explicit that the objective is not maximum transfer to the supplier. Effectiveness and value for money will only be achieved where allocation is equitable.

Where a supplier ends up managing an inappropriate balance of risk, the note predicts three outcomes: poor value for money because a high risk premium is loaded into the price, underperformance as supplier focus shifts to cost cutting, and an onerous contract that could ultimately collapse. Where a supplier publicly designates a contract as onerous, that should prompt root cause analysis and a conversation about options. The Model Services Contract includes provisions on publicly declared onerous contracts in its Financial Reports and Audit Rights Schedule.

The party in the greatest position of control over a risk has the best opportunity to reduce the chance of it materialising and to deal with the consequences if it does. Capability to manage a risk efficiently may come from a greater ability to assess it, an ability to negotiate with or pass the risk to third parties at a reasonable price, a higher capacity to reduce the probability of occurrence, or a higher capacity to mitigate and repair damage. Where transferring a risk will cost more in risk premium than the expected loss of retaining it, the authority should consider retaining it.

Two further points cut across everything. Reputational risk cannot be transferred: the public holds government responsible for public facing services regardless of the contractual position. And a lack of early market engagement has been a key feature of poor government contracts, because an authority that does not understand what it is buying cannot allocate risk sensibly. Section 12(4) of the Procurement Act 2023 requires authorities to have regard to barriers facing SMEs, which in practice means not transferring excessive liability and cash flow risk.

Where risk allocation sits in the commercial lifecycle

The guidance sets out a structured, seven stage view of risk across the commercial lifecycle: risk identification, risk analysis, risk evaluation, risk treatment, risk allocation, risk monitoring and risk reporting. Identification produces a holistic view of risks, usually organised by taxonomy, and continues throughout the lifecycle. Analysis considers likelihood and level through a risk register built on common criteria. Evaluation compares the analysis against the authority's appetite to decide what further action is needed.

Treatment decides whether to avoid, accept, reduce or transfer each risk. Allocation defines which party assumes each risk and to what extent, supported by a risk allocation matrix or risk transfer matrix. Monitoring tracks whether and how the risk profile is changing and how well each party is managing. Reporting gives stakeholders the information they need to judge whether decisions sit within risk appetite. The approach is aligned with HM Treasury's Orange Book.

Timing matters. An initial risk identification and assessment should be done before the procurement starts, as part of the outline business case or the delivery model assessment, and should inform the commercial strategy. Risks should then be reviewed periodically as the process evolves. The note warns against treating risk as a one off exercise, and tells authorities to impact assess and take legal advice on any in-life change to risk allocation. A risk allocation matrix is prescribed by the Green Book as a key component of the commercial case, and can be shared with bidders during market engagement to seek their input.

Pricing structures, payment mechanisms and inflation

The payment mechanism is the main tool for allocating delivery risk and incentivising performance, and it goes hand in hand with risk allocation. The aim is to reflect the optimum balance between risk and return, generally by linking payment to service outputs and supplier performance. The first question is whether pricing applies to inputs, outputs or outcomes. Supplier risk rises as you move from inputs to outcomes, because payment becomes more contingent on results. Market intelligence should shape the choice, taking account of policy novelty, the number and size of market participants, market capacity, delivery flexibility, cash flow implications for SMEs and voluntary, community and social enterprises, and the point at which results become measurable.

Input based mechanisms pay allowable costs and suit cases where the authority wants tight control, but they leave the authority holding most of the risk, should not carry risk premiums, and reduce the incentive to innovate. Caps on input prices can reduce exposure but must be set at levels that let the supplier recover unavoidable cost increases. Output and outcome based mechanisms give suppliers room to innovate but should be expected to carry higher margins. Critically, an authority using an output based model should not also specify inputs: overly prescriptive specifications lead to poor performance and hold suppliers accountable for results outside their control. Hybrid mechanisms can share risk where that reduces it for both parties.

Incentives can be built in through additional payments, for example an enhanced unit price above a target volume, and disincentives through service credits. Service credits and liquidated damages should be proportionate, capped at the contract profit level, free of ratchet mechanisms, and checked against the primary payment mechanism so suppliers are not penalised twice. Key performance indicators should be easily measurable and objective, with suppliers held accountable only for results they can influence.

On inflation, the three mechanisms are escalation factors, indexation, and cost plus and its variants. Escalation factors uplift a base price by a set factor agreed at the outset and transfer all inflation risk to the supplier, so they are only reasonable where prices are stable or predictable and only in the short term. Indexation links prices to a chosen index and allocates inflation risk to the authority, and is advisable where there is considerable inflation uncertainty. Cost plus passes input costs through, so no further mechanism is needed, but it removes the incentive to match industry productivity gains and is not recommended if inflation is the sole consideration.

Applying indexation properly

The guidance sets firm rules for indexation. Indices must come from an official government source, in the UK the Office for National Statistics, so that they are independently compiled to international best practice, and only published index data may be used so payments reflect actual values rather than forecasts. A Should Cost Model helps identify the cost drivers and where indexation is needed, and different indices can be applied to different cost lines.

Output price indices are more suitable for most government contracts, with input indices reserved for highly exceptional circumstances. Output indices include production and delivery costs, an element of productivity gains and profit, which incentivises the supplier to keep pace with industry productivity, whereas input indices reflect only input costs and do not incentivise efficiency. The note warns that uplifting labour costs above the industry average risks spiralling labour inflation and wage price spirals.

The mechanics are specified. The base period is an average of the twelve months or four quarters before the contract date, and the uplift period an average of the twelve months or four quarters before the uplift date, using only index values falling entirely within the period. Costs incurred before the first uplift period must be priced by a method not subject to indexation. No inflation risk premium is needed because the indices track market prices. Caps and collars distort indexation and may push suppliers to price in a premium anyway. If an index pauses publication, use the original index where at least six months of values exist, otherwise move to the closest replacement advised by the statistical authority. If an index ceases, the parties must negotiate a replacement. If it is rebased, use the rebased series or calculate a link factor. Open Book Contract Management can complement all of this.

How eSourcing Data helps

The guidance asks for something that is easy to state and hard to sustain: a live, evidenced record of how risk was identified, allocated and priced, reviewed periodically rather than fixed at the outset. eSourcing Data gives commercial teams a single place to hold that record. Risk registers, risk allocation matrices, market engagement notes and the rationale behind a chosen pricing approach can sit alongside the procurement they belong to, so the evidence for a comply or explain decision is where an auditor or a business case reviewer would look for it.

Because the platform runs the procurement itself, the link between risk and pricing is not lost in translation. Market engagement can be run and logged before the process starts, so the input the guidance asks authorities to seek from bidders on the risk allocation matrix is captured rather than remembered. Tender documents, worked examples of the payment mechanism and clarification exchanges are versioned and timestamped, which directly supports the note's point that bidders who do not understand the payment mechanism will price it badly. Evaluation records show how performance criteria were applied and by whom.

After award, the same record supports contract management. Key performance indicators, service credit positions, indexation base dates and uplift calculations, and changes to risk allocation over the life of the contract all need to be traceable, and reporting across a portfolio helps spot where a particular pricing approach is producing risk premiums or performance problems. eSourcing Data does not replace legal advice on liability, indemnity or insurance, and it does not build your Should Cost Model. What it does is make sure the decisions you take on risk are recorded, defensible and available to the people who inherit the contract.

What to do about it

1. 1Run an initial risk identification and assessment before the procurement starts, as part of the outline business case or delivery model assessment, and use it to shape the commercial strategy.
2. 2Build a risk allocation matrix, share it with the market during engagement, and use it to drive the commercial model and pricing approach rather than treating it as a business case annex.
3. 3Test whether each risk you plan to transfer is genuinely within the supplier's control, and retain risks where the likely risk premium exceeds the expected cost of holding them.
4. 4Decide deliberately whether pricing applies to inputs, outputs or outcomes, and if you choose an output or outcome model, stop specifying how the supplier should deliver.
5. 5Scenario test the payment mechanism internally and with the market at multiple activity and performance levels, and involve the contract management team before you settle it.
6. 6Choose an inflation management mechanism to match the pricing approach, use published ONS output indices where indexation applies, and avoid caps and collars that push suppliers to price in a premium.
7. 7Check liability, insurance and service credit provisions against the standard positions in the Model Services Contract, keep deductions capped at contract profit, and avoid ratchets.
8. 8Review risk periodically through the contract term and impact assess any in-life change to risk allocation with legal advice before agreeing it.