UK: Product As Service Agreements: A Stepping Stone To A Circular Economy

Last Updated: 1 August 2019
Article by Alec Van Vaerenbergh and Félix Leyman

Introduction

The transition towards a circular economy contributes to a sustainable and low-carbon economy, as is well-known by now. In addition, the transition towards a circular economy creates financial opportunities. Businesses are increasingly aware of this economic potential and are increasingly willing to respond to the transition. However, this requires appropriate business models and therefore an appropriate contractual framework that takes into account the characteristics of a circular economy.

An emerging class of agreements: Product as service agreements

The question arises as to why the transition to a circular economy requires a contractual framework that differs from the usual contractual framework. In order to answer that, it is important to understand the principles of a circular economy. The circular model aims at a long-term preservation of the value of a good, thereby extending its life cycle. The recycling of raw materials is not a priority. After all, it is possible to obtain the optimal yield of raw materials at various other levels.

The transition towards a circular economy is also marked by a shift in production and consumption patterns. When it comes to consumption, for example, the traditional focus on ownership shifts to sharing products and purchasing services instead of products. Instead of purchasing a certain product, parties may (merely) predetermine a certain result, after which the supplier is free to choose the means to achieve this result.

A prime example of this is Philips, a lamp manufacturer that has been offering lighting as a service for a number of years now. Instead of selling light fittings and lamps, users pay for the purchase of a certain amount of light over a certain period of time. This approach creates an incentive for manufacturers to ensure that their products are as sustainable as possible. After all, sustainable products mean that fewer repairs will be required, which in turn increases the producer's profits.

Just as Philips offers lighting as a service, other products may also be offered as a service. Where consumers used to buy a washing machine and a coffee machine, for example, consumers can now choose to only pay for the use of a washing machine/coffee machine instead of paying for the ownership of a washing machine/ coffee machine. If so, the consumer will be provided with a washing machine/coffee machine of which the ownership remains with the producer or supplier. Subsequently, the consumer periodically pays an amount for the use (or, in other words, availability) of the machine, or the consumer may pay for the number of coffees made/washes done.

It is expected that both businesses and consumers will increasingly opt for a product as service agreement in the future, rather than the traditional agreements whereby the user acquires ownership of the product. The rest of this article provides an overview of the essential characteristics of such a product as service agreement.

Essential provisions in a product as service agreement

Core obligation: Ensuring the service and keeping the product available

The service provider is first and foremost under the obligation to take the necessary steps to provide the stipulated service. The provision of the product as service also means that the product (either certain specific goods or more general, intangible concepts such as light, furnishing, sanitation, washing facilities, etc.) must be made available to the user.

As the user is merely interested in obtaining a certain result or service, the service provider will also be responsible for the maintenance of the products in accordance with a maintenance plan. Through this maintenance, the service provider must ensure that the user can enjoy the service for the entire duration of the contract. In addition, the service provider is also responsible for remedying malfunctions and repairing and replacing defective or worn parts.

Thus, the service provider will have to guarantee a high degree of product continuity (availability) as a result-based obligation. This can be a permanent continuity or availability at any time (24/7, 365 days a year), but usually it is a high degree of continuity where the user will tolerate certain moments of planned or unplanned unavailability.

Periodic availability fees and potential availability discounts

The user pays the service provider a periodic availability fee for the services provided. This availability fee will obviously have to allow the service provider to recover their purchase and investment in the goods provided by the service provider within the duration of the contract, but neither the periodic fee nor the duration of the contract will usually be directly linked to this. Indeed, the service component is just as essential and it is precisely the intention of such a circular agreement that the duration does not depend on the economic lifetime of the goods made available.

The user, for their part, will desire certainty about the availability of the services. This should also be addressed in the product as service agreement. For example, parties may include a clause granting the user a certain discount in the event that the service provided does not correspond to the agreed level of service (in particular if the service provider does not achieve the performance indicators (or KPIs) set out in the agreement). This system of flat-rate availability discounts is a well-known concept in DBFM agreements (design, build, finance, maintain agreements), which are regularly concluded with public-private partnerships for major infrastructure works. Likewise, parties can also agree that the service provider will receive a bonus if the service provider provides the services entirely correctly.

The user's duty of care

Subsequently, the parties to the contract will stipulate that the user must maintain the goods in their possession with due care. This obligation is of great importance in this service contract. After all, the user is not the owner of the goods, which creates a risk of reduced care on the part of the user.

Obligation of the service provider to innovate and keep the product up to date

In view of the transition to a circular, and therefore more sustainable economy, parties to the service contract may determine whether and how the service provider has an obligation to innovate. The user naturally wants to benefit from innovative developments on the market. By analogy with the ESCO agreement, the parties can link the innovation obligation to a bonus-malus system that may or may not reward the service provider when the service provider achieves a contractually determined energy saving. In this way, the service provider has an extra incentive to make the products more energy efficient.

Take-back obligation and safeguarding the circular character

The service provider commits themself to take back the goods made available or to have them taken back by a third party with whom the service provider has a contractual relationship. The goods made available are taken back at the end of the lifespan of the products, at the end of the service agreement or in case of innovation of the products made available.

However, such an obligation to take back the product in no way guarantees that the service provider will repurpose the product in a sustainable manner. It is therefore recommended that the parties include a clause in the service agreement in which the service provider guarantees that they, or a third party, will reuse the product (or components thereof) in a high-quality manner (in order to guarantee its circular nature).

In the absence of clear rules on what constitutes circular usage (and in many cases a lack of technical and commercial clarity on re-use), it is often necessary for the contracting parties to be creative in this respect.

Conclusion

Due to the growing interest in a circular economy, it can be expected that the product as service contract form will continue to grow and will be acknowledged as a distinct type of agreement. As explained above, this will often involve the use of more innovative contractual mechanisms (mainly in terms of determining the remuneration), as we also know from ESCO or DBFM agreements. Although this type of agreement is becoming more and more commonplace, at present the notion of a product as service agreement remains a tailor-made option which must take into account the service offered, the party who will acquire the service and the context in which the service is provided.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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