Managing the risk of hyper-inflation in domestic and international construction projects
Whilst raw material prices have reduced in the last 6 months from unprecedented levels, with the ongoing Ukraine war and unstable relationship between major global powers, raw material price fluctuations and general market volatility is unlikely to stabilise anytime soon.
Given this economic climate it is essential for both domestic and international contractors to negotiate contractual provisions that protect them against rising material costs which can otherwise impact the financial viability of any project. Crucially, if a contractor fails to make adequate provision for relief from material price fluctuations in the contract, they are unlikely to have any sound legal argument (especially contracts governed by the laws of England and Wales) to re-negotiate the contract price should the delivery cost increase significantly.
Managing Material Price fluctuations
There are a range of contractual models for delivering construction and engineering projects, however, by far the most popular is the lump sum fixed priced contract which places all construction risk on the contractor to deliver the project on time and for the price agreed. Under the lump sum contract model the contractor usually takes the risk of the materials needed to perform the works increasing in price, and the cost of labour increasing and/or labour shortages occurring that can affect the viability of a project. Similarly, the contractor will generally take the risks of the site, including political and industrial risks albeit perhaps with some carve outs.
Whilst there are other, more contractor-friendly models of contracting available, such as cost plus, target cost and pain/gain share mechanisms which allow both contractor and employer to share unexpected increases in material costs, or the benefit of any material cost decreases, these contracting models are rarely used. The reason? There is little incentive for employers to use alternative models of contracting when contractors remain largely willing to deliver projects on a fixed lump sum basis.
Given the economic climate and volatility of raw material prices, it is far less viable for contractors to agree to deliver projects, that might take years to complete, on a fixed lump sum cost basis without ensuring key protections are incorporated into the contracts. In particular, contractors can and should protect against material price escalations by negotiating price escalation relief provisions. From experience, employers are likely to be most receptive to this idea by focusing on the benefits to them of having such clauses and which, in truth, are many. For example, if the contractor is forced to take the sole risk of material costs increasing, the employer runs the risk of the project becoming financially unviable for the contractor to deliver either at all, on time and/or using materials and manufacturing processes that will achieve the best results for the project. If any of these scenarios eventuated themselves, the likely success of the project will be seriously compromised, including in particular, the cost of delivery.
As well as bringing benefits to the employer and project delivery generally, price escalation clauses can be specifically tailored to the specific risks of the project. It is also important that the clause is drafted in a way that the parties are clear as to exactly what constitutes a material price rise that might entitled the contractor to additional payment.
Principally, the employer needs to be aware that increases under a price escalation clause will only occur if / when material prices actually rise i.e. the contractor is not seeking a route via the backdoor to raise prices. Whether or not a material cost has actually increased should be by reference to credible independent data from recognised indices. It might, for example, be appropriate to use a formula that utilises a reasonable basket of material price indices. This will help prevent disputes and the need for experts if disputes do arise.
The clauses can be tailored to the needs and risk profile of the parties. There will be many questions to consider, for example:
- Would a 1% increase above the material base price stated in the contract justify a contractor request for an equivalent payment rise from the employer, or should an increase of, say, 5% or 10% be necessary before any such entitlement arises?
- Should the employer become liable for the entire increase in the material cost over and above the agreed percentage, or should the increase be split 50/50 between employer and contractor? Should a 50/50 split only occur if the rise is above a certain percentage?
- Should there be a cap on the employer's potential liability if material prices rise beyond all expectations, or should the percentage contribution between the parties increase or decrease above a certain percentage price increase?
- If material prices decrease from the base sum stipulated in the contract, should the contractor share that gain with the employer?
As well as agreeing the material price increases (and perhaps decreases) required for the price escalation clause to kick in, the parties might also want to impose additional conditions and safeguards before any entitlement arises. For example, a need to formally notify cost increases within a particular time frame and with the provision of specific information or evidence to justify the increase sought.
These are all important practical considerations that can be negotiated so that the contractor walks away without shouldering the entire risk of material prices increasing, and the employer satisfactorily limits the extent of their exposure to market volatility, whilst gaining potential project benefits by reducing the risks mentioned above.
Given the ongoing Ukraine war and the potential for more Covid style shutdowns in the future, material prices are likely to continue to increase and remain volatile thereby placing more financial pressure on contractors and suppliers delivering projects. It is therefore essential for contractors to ensure their contracts contain provisions which take some of this risk away and shares it with the employer. As outlined above, this can be to the mutual benefit of the parties and for the success of the project overall.