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High rises and higher rises: Tackling inflation in construction contracts

28 November 2022

As inflation in the UK hits a 40-year high of 11.1 per cent this month, we explore the mechanisms for dealing with inflation under construction contracts. 

The high rise in the UK's inflation is a particular issue for the construction industry which, already dealing with the after effects of COVID and supply chain disruption, has seen product and material price increases in excess of 24 per cent. We explore how contractors and developers alike can protect themselves from price increases in a volatile market.

Type of Contract

For the past few years the preferred forms of construction contracts have 'locked in' the price at the start of a project.  This is achieved through the use of lump-sum contracts or fixing contract rates for certain materials in measurement contracts.  In these types of contract, the contractor takes the risk of price increases.  However, where there are significant price fluctuations this can put stress on cash flow, and threaten the supply chain. 

Target cost contracts, which operate on a pain/gain mechanism where the actual cost is assessed at the end of the project, may become more widely used (e.g. NEC Main Options C and D). Similarly, cost reimbursable contracts (e.g. NEC Main Options E and F, JCT Prime Cost, FIDIC Green Book and IChemE Green Book) allow the contractor to be paid for the actual costs incurred plus an amount of overheads and profit. It is essential that the contractor keeps accurate records of all amounts spent when using these form of contracts. In addition, the contract must appropriately incentivise the contractor to complete on time so that the Employer is not exposed to inflationary pressures as the programme extends.

Fluctuation provisions in Building Contracts

Fluctuations clauses allow the contractor to claim increased materials costs or increased labour costs- throughout the duration of the build. In recent years, fluctuation clauses have commonly been deleted from building contracts and so the onus has been on the contractor to price the contracts appropriately to factor in fluctuations in the price of materials or labour. If the prices go up the contractor bears the risk, whereas if prices go down the contractor may benefit from the reduction. 

The JCT, NEC and FIDIC forms of contract all contain optional fluctuations mechanisms which the parties can agree to adopt: 

  • The JCT Standard Building Contract and Design and Build include three options to deal with fluctuations. Option A deals with levy and tax changes and increased costs of materials. Option B deals with labour and materials cost and tax fluctuations. In particular, Option B also entitles the contractor to be reimbursed for changes to the market price of energy and fuels. Option C adjusts the contract sum in accordance with the JCT Formula Rules at the base date. Options A and B can also be flowed down into sub-contracts. 
  • The NEC3/NEC4 Engineering and Construction Contract (using main options A-D) include a secondary option X1 clause which flips the risk of inflation onto the Employer/Client. Main options E and F already put the risk of inflation onto the Employer through the pain/gain mechanism. Option X1 can be drafted in more detail than the JCT by setting out the items subject to inflation along with referencing the relevant inflation index.
  • FIDIC Red, Yellow and Pink books all cater for fluctuations including dealing with payment in multiple currencies and fluctuations in exchange rates. 

In times of high inflation and increased interest rates, it is likely that more contractors will request the inclusion of fluctuation provisions to shield them from spiralling construction costs. However, in an uncertain market the inclusion of such provisions may bring some comfort to an Employer that the Contractor is tendering on the best price and not over inflating the contract sum to cater for such uncertainty. The other benefit to both parties is it avoids the risk of supply chain collapse due to insolvency.

There are several factors which need to be considered when including fluctuations provisions:

  • The price index on which inflation is calculated: a lot of indices are consumer or retail focused and may not reflect the situation in the construction industry. 
  • Whether the rate of liquidated damages for delay will rise in line with inflation. If the Employer accepts the risk of incorporating fluctuations wording it may elect to pass on some risk to the contractor in the rate of liquidated damages and so keep the contractor incentivised to complete the works on time.
  • Rise in construction costs coupled with delays to materials: should the contractor benefit from fluctuations if it is also in delay? Clauses should be carefully drafted so that contractors do not inadvertently benefit from their own culpable delays. Where the price increase and delay is due to material shortages the Employer may take a view on whether the costs can be shared. Option X1.2 of the NEC automatically puts the risk of fluctuations on the Contractor where it is in delay. 

Provisional Sums

Provisional sums are included where an item of work cannot be adequately priced at the time the contract is entered into, either where the design is not sufficiently developed or the contractor cannot price the work so a 'best guess' is included. In theory, provisional sums may be useful to delay the pricing of a particular material or item of work until after the contract is signed, however, caution should be exercised to ensure that the mechanism for dealing with provisional sums is adequately contractualised. 

Managing Inflationary Risk

Practically, there are various steps which parties to a construction contract can take to minimise the effect of inflation, including:

  • Approve design packages and order materials as early as possible to lock in the best price and minimise delays. 
  • Consider the benefit of off-site storage – particularly where there are long lead times for materials, keeping in mind the requirement for advance payment bonds and vesting certificates where the Employer is paying for materials up-front. 
  • Consider modern methods of construction, where appropriate, such as off-site fabrication and alternative materials. 
  • Work with trusted design teams and investigation teams to cost the whole of the works as accurately as possible at the outset to reduce unexpected risks. 
  • Communicate and work collaboratively to identify risks as early as possible and mitigate delay. Delays on site increase the impact of inflation and enforcing liquidated damages may not be in the best interests of the parties if it triggers insolvency. 

Conclusion

If you would like to discuss managing inflation in construction contacts, please contact Natalie Tunstall-Jackman or your usual DWF contact.

Further Reading