Invest in inflation. It’s the only thing going up!
Inflation is a profoundly destabilising force – Ronald Reagan memorably described it as being "as violent as a mugger, as frightening as an armed robber and as deadly as a hitman." What steps can we take to deal with the impact of current inflationary pressures in construction contracts? How can we ensure commercial clarity for all parties in a time of financial instability?
This article will look at some of the steps that can be taken to deal with inflation in lump sum contracts, i.e. contracts in which the parties agree that specific work will be carried out for a specific price within a specific amount of time.
A contract where the contractor is not going to be paid the proper cost of doing the works is a high risk exercise and likely to lead to claims, increased costs, delays and potential insolvencies.
The myth of the fixed price contract
True fixed price contracts are as rare as hens' teeth. All construction contracts will contain provisions which will allow the cost of the works to increase or decrease in specified circumstances: it is just a question of using the appropriate mechanism. Dealing with inflation is conceptually little different from dealing with any other event which may lead to an increase or decrease in costs.
Standard contract fluctuation provisions
The classic way of dealing with inflation in contracts is to include fluctuation provisions, sometimes also referred to as rise and fall, cost adjustment or variation in price clauses.
These provisions have not been in regular use for many years. It may be time to see what they have to say.
Fluctuation provisions typically fall into three categories:
- Clauses which cover actual changes in contributions, levies and taxes.
- Clauses which cover actual changes in costs of labour and materials.
- Clauses which calculate increases or decreases in costs by applying an agreed formula to specified items of cost.
Industry standard form contracts usually adopt one or a combination of these approaches, for example, the JCT has three fluctuation options, A, B and C, each of which caters for different categories of cost and each of which works in a different way.
In very brief summary:
- Option A provides for increases or decreases in statutory contributions, levies, or taxes on labour and materials that may occur after the Base Date (being a fixed date chosen by the parties: usually the date of tender returns) and during the contract period, and is found at Schedule 7 of the standard form. Option A automatically applies unless it is struck out, which it invariably is.
- Option B provides for increases or decreases in labour and materials costs, as well as tax fluctuations, and is found in a separate document.
- Option C offers two different formulae and indices to be used to calculate the increases or decreases in labour and materials costs. It is the shortest of the three options and is again found in a separate document. It requires detailed bills of quantities.
The NEC Engineering and Construction Contract has a fluctuations provision at secondary Option X1, price adjustment for inflation. This is for use only with Options A, B, C and D. Under this option, the contractor bases its prices on estimates of cost current at a base date, and this is then varied by a defined price adjustment factor.
The FIDIC and the ICC fluctuations clauses use the formula method, the ACA has options for all three.
There are other steps that parties can take to mitigate the impact of inflation which do not go as far as fluctuations provisions.
Purchasing materials in advance. Consider in this case:
- Using an advance payment bond.
- Requiring vesting certificates to deal with the ownership of the materials.
- Practical implications that might arise, such as where the materials are going to be stored pending their use in the project.
Using provisional sums for specific materials may be a tidy solution if specific materials are likely to cause problems. This is a solution best used sparingly.
Alternative procurement routes?
Consider moving away from the lump sum contract model and using a different procurement route which offers more price flexibility.
Construction inflation is currently running at a much higher rate than inflation in the economy generally. The unfortunate combination of events which is causing it - the war in Ukraine, covid, increasing energy costs, and Brexit - is not going to go away any time soon.
Failing to factor inflation into contract drafting is not going to be a sensible option for much longer. Take the time now to understand the options and consider which are best suited to your project.