Paying the price: high inflation and short supply
There is always tension between an employer’s need for costs certainty and a contractor’s need for flexibility, but current circumstances twist the knife. In the first of two companion articles in the 2022/23 Annual Review, Lucinda Robinson looks at what parties should currently be considering when negotiating their contracts.
2022’s construction headlines have repeatedly featured material and labour shortages, and soaring materials, labour and energy costs. According to Building, between June 2021 and June 2022, fabricated steel rose 46.3 %, builder’s woodwork by 19%, and plastics for doors and windows by 24.3%, whilst labour costs increased by 4.5%. On 1 July 2022, Construction Enquirer reported that manufacturers of energy intensive materials like cement would only accelerate as energy prices escalate. Improvement looks unlikely in the short term, as Brexit and Covid-19 implications continue to unravel, the war in Ukraine proceeds, and inflation hits a 40-year high (as reported by the Financial Times on 6 September 2022). The harsh reality is that construction projects are costing more and more, and delay is more likely. But who pays the price?
That question can be answered in advance and the risk allocation recorded in the contract. Set out below is a suggested agenda for such an upfront discussion, followed by a look at the price fluctuation and extension of time provisions that come into focus when these anticipated risks arise.
Issues to discuss at the outset
Parties’ negotiating contracts now should recognise reality and factor in the risk of increased costs and delay. Several ways to do this can be considered.
Design: Specifying materials that are quicker, easier, and cheaper to source.
Suppliers: Identifying multiple suppliers to avoid dependence on just one and checking their financial position to ensure they are likely to continue in business.
Materials: Ordering materials in advance and using bonds to secure any advance payments needed to facilitate this. Storing them securely and, if off site, clearly allocating them as property of the employer and providing vesting certificates.
Substitutions: Agreeing that alternative materials can be used if those specified cannot be procured or become difficult or more expensive to procure.
Prices: Including a fluctuations clause covering key materials (if not all) labour and energy.
Programmes: Including float in the programme to allow for delays caused by labour shortages or supply issues.
Delays: Allocating responsibility for delay fairly, in terms of time and costs.
A fair allocation of risk is critical. Whilst an employer may be tempted to pass all risk of increased costs and delays to the contractor (especially in a design and build contract), this may not be wise. Where contractors are willing to take on D&B projects, tender prices are increasing and negotiations over the terms and conditions are intensifying. The spectre of insolvency looms large with over 3,400 construction businesses closing between April 2021 and April 2022 (according to the Financial Times on 26 June 2022). Contractors and subcontractors are acutely aware of how quickly their profit margins will disappear if costs multiply and they have not obtained the protections they need in the terms, programme, or price.
What contractual clauses might help
Key clauses that parties might need to turn to as prices and resources decrease, include price fluctuation clauses and extension of time provisions. These are worth focusing on when new contracts are negotiated and, on existing contracts, becoming familiar with.
Fluctuation clauses
Fluctuation clauses, allowing contractors to charge more if prices increased, were largely overlooked during years of stable pricing. When picking their battles, contractors opted to take the risk of (unlikely) price increases and negotiate on other issues instead. Now, price increases are one of the most significant risks on any project, fluctuations clauses should be a top priority. Contractors will want the benefit of such a clause and should also ensure the contract includes a “base date” from which the increase is calculated (e.g., date of tender or contract).
NEC4 deals with price variabilities in two ways. Primary Option clauses tackle pricing head on, with the contractor taking the risk of fixed costs under Options A and B, some form of risk sharing applying under Options C and D, and (the contractor’s utopia) costs reimbursable Option E enabling the contractor to recover the actual cost of its works. Secondary Option clause X1 provides a specific fluctuations clause and, if selected, the Contract Data needs to include the details needed to make it work.
JCT 2016 includes fluctuation terms which can be incorporated by selection in the Contract Particulars. Parties can select Option A covering contributions, levy, and tax fluctuations; B covering fluctuations in labour and material costs as well as tax; or C which is a price adjustment formula using indices from RICS. The wider the better, from a contractor’s perspective.
If there is no fluctuations clause, the contractor’s only routes to more money will be through variations or loss and expense claims. In either case, the contractor will have to meet the criteria for such claims to succeed, which may be a challenge. Including a contingency for price increases in the contract price might help to mitigate this, but quantifying the contingency is not easy when prices are so volatile, and the resulting bid may not be attractive.
Time
Material or labour shortages can cause significant delay but will rarely justify an extension of time on their own under standard form contracts. It is the reason for the shortage which will dictate whether the contractor qualifies for relief from liquidated damages. Brexit, Covid-19, and the war in Ukraine are commonly referred to as the reasons for material shortages, but it can be hard to disentangle these reasons and trace a particular supply issue back to one of those events precisely. For example, delayed manufacture and supply of one component may result from a shortage of labour because the workforce has returned to home countries following Brexit or Covid-19, as well as the absence of a specific material originating from Ukraine.
Once a reason has been identified, it must then be linked to a relief event in the contract.
Under NEC4, the Contractor will obtain an extension of time if it can prove a compensation event has occurred. Potentially relevant compensation events may be:
- Option X2 – Changes in law occurring after the Contract Date.
- 60.1(1) – If performance becomes impossible, as opposed to more difficult or more expensive.
- 60.1(19) – An event delays practical completion which neither party could prevent, and an experienced contractor would have judged so unlikely to occur that it would have been unreasonable to plan for. This is NEC4’s version of force majeure. In 2022, Covid-19 and the war in Ukraine are foreseeable, so would not fall into this category now.
Under JCT 2016, the Contractor can claim a Relevant Event in similar circumstances.
- 2.26.1 – If variations are instructed to overcome supply issues. If, for example, a product is substituted, then time may be recoverable (as well as loss and expense because there is a Relevant Matter).
- 2.26.12 – A change in law. This can entitle a contractor to time (but not money), provided there really is a change in the law and not just the exercise of statutory powers.
- 2.26.14 – Force majeure. JCT 2016 does not define force majeure, so its interpretation is informed by common law. Even if war or pandemic are covered, the challenge is that they are probably an indirect, rather than direct, cause of delay to a project. Loss and expense is not recoverable for force majeure under JCT 2016.
Unfortunately for contractors, none of the provisions in either contract is a neat fit. Under existing contracts, the contractor will need to work hard to demonstrate that its circumstances do meet the necessary criteria to afford relief. When negotiating new contracts, the contractor could try to widen the number, or scope, of relief events. For example, by including war, pandemic and material or labour shortages as relief events, or inserting a definition of force majeure that includes them.
So, who pays?
Ultimately, the parties must decide between them who pays if prices escalate, or delays occur because labour and materials are scarce. It is easy for employers to say this is the contractor’s problem and push the risk downstream, but it is everyone’s problem if the contractor, or another key supplier, folds and cannot complete. Collaboration will be the key from the beginning to end. Ideally, risk should be understood and carved up pragmatically at the outset, so the project is more likely to withstand these external pressures.
If claims arise, then it is hoped that the parties will adopt a collaborative approach to resolving them. Either way, the contractor can be expected to use any contractual hooks and commercial pressure it can. The usual considerations will, of course, apply. Is the drafting of the relevant provisions clear and not beset by ambiguities or conflicting provisions across the contract documents? Do the parties have the requisite records to prove their points? Have all notice requirements and conditions precedent been fulfilled? Where every penny counts, getting these basics right is more important than ever.