The aftermath of a global pandemic has led to cost uncertainty in the construction industry, exacerbated by ongoing global conflict, surging global energy prices, sanctions, Brexit and a looming recession. In particular, the knock on effects of a downturn in the current economic climate have presented themselves in the form of increased costs of materials due to material shortages and longer lead delivery times, reduced workforces, and supply chain issues. The ban around the use of red diesel in heavy construction plant machinery earlier in the year has also contributed to making projects more costly for contractors to deliver. In this briefing, Walker Morris Construction & Engineering expert Jessica Gates considers price escalation clauses – a contractual mechanism that can be mutually beneficial for both employers and contractors.
Cost uncertainty for contractors
Unless otherwise agreed, the default position for the risk of delay and cost impact as a consequence of material shortages and inflationary price increases is one which is primarily borne by contractors on projects. For example, liquidated damages could be levied against a contractor in the event that materials are delayed. As a result, contractors may find themselves incurring significant losses by being tied into a long term fixed lump sum or remeasurement contractual arrangements which are no longer financially viable over the course of a project.
If a contractor is forced to continue to perform the contract at a loss, inevitably this is not going to be in the best interests of an employer either. Contractor insolvency part way through a project will result in an employer having to pay more than originally budgeted.
There are however contractual mechanisms available to safeguard a contractor’s position. In particular, we are seeing a rising trend of contractors seeking to include price escalation clauses in construction contracts. The purpose of such a provision is to transfer some of the financial risk on a project so that it is absorbed by the employer.
What are price escalation clauses?
A price escalation clause (or ‘cost escalation clause’) is a contractual mechanism that facilitates the contractor passing on increased overheads to the employer. The contractor retains the ability to adjust the contract price in line with the fluctuating costs of raw materials in the market and other elements of the works at the time.
Price escalation clauses can also account for a decrease in the contract price where costs fall. For this reason a fluctuation provision is also known as a “rise and fall” mechanism. In this way, the employer could benefit from potential cost savings too.
Alternatively, where the cost of materials increases or they are unavailable, an adjustment to the contract price could be agreed by way of a variation but this does not automatically guarantee entitlement to additional costs for a contractor.
Price escalation clauses can be mutually beneficial for both employers and contractors, serving to mitigate the risk of disputes later down the line and in turn preserving amicable commercial relationships between the parties. The inclusion of price escalation clauses in contracts may result in lower bids being tendered for works by contractors from the outset. In the absence of a price escalation clause a contractor may inflate the proposed contract sum to compensate for the lack of cost certainty.
Bespoke drafting to maximise cost effective solutions
Careful consideration should be given to the reasonable risk allocation of costs in construction contracts and to parties’ specific requirements on projects. Clear drafting is essential. In particular, thought should be given to the requirements for notification of contract adjustments such as the method, timeframe and level of supporting particulars required.
Some industry standard form contracts incorporate optional or standard cost saving mechanisms as follows:
JCT Design and Build contains a fluctuations provision which allows an adjustment to the contract sum for fluctuations in the market price for labour and material. Option A is the standard position and provides changes to contribution, levy and tax fluctuations occurring after the Base Date. If Option B (labour and materials cost and tax fluctuations) or Option C (formula adjustment) are applicable, the relevant option must be stated within the Contract Particulars.
A contractor’s entitlement to price increases for raw materials could also be dealt with as a Relevant Matter under the contract.
NEC4 Engineering and Construction Contract options A, B, C and D provide a secondary optional provision which caters for the employer agreeing to take on the risk of inflation (Option X1). Option X1 has a wide application but can be restricted to apply to prices of specific raw materials only.
Additionally, clause 16 allows a contractor to suggest an alternative solution i.e. value engineering, which could in turn reduce the cost of the works. The employer determines the amount of value engineering percentage in the tender documents that is used in calculating the reduction in prices.
NEC Option C includes a mechanism in this ‘target cost’ contract where the cost saving or overrun is calculated and split between the parties in accordance with an agreed formula. This is known as the ‘pain/gain share’ mechanism.
In Option E (“Cost Plus”), the default position is that the employer is responsible for the risk of inflation. The contractor is reimbursed for the actual costs it incurs for work carried out plus the allowances for overheads and profit.
In keeping with the collaborative approach of the NEC suite of contracts, a contractor could utilise the early warning process to notify the employer of cost increases, whilst maintaining an amicable commercial relationship. Alternatively, a contractor could claim additional costs by way of a compensation event but there is no automatic entitlement.
Other contractual or commercial options
Other options for employers and contractors to consider include:
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