Niamh Batterton and Sarah Wilson examine how to deal with inflation within construction contracts.
We have seen inflation have an unprecedented effect on the construction industry over the last 18 months.
External global factors such as Brexit, covid and the Ukrainian war are impacting construction projects by curtailing the supply of goods and materials and increasing costs. In addition, the legislation changing the use of red diesel on projects is making work more costly. As a result the sector is seeing:
- Increased cost of materials and labour, pushing up tender prices;
- Investor uncertainty resulting in tighter financial conditions;
- A shortage of skills at all levels.
All of the above results in uncertainty over completion dates and increased difficulty in estimating future costs. Most contractors already operate on slim margins, therefore increased costs are impacting the bidding process. If contractors do not increase their prices, they will have to absorb the increased cost, resulting in slimmer margins and an increased risk of insolvency.
Contractor insolvency part way through a project will almost inevitably mean the developer/employer pays more than budgeted for the project – even if security is in place. So this is a topic that all parties to the project should take an interest in.
While we cannot control the inflation impact, there are some options which may help mitigate the effects of inflation when drafting construction contracts:
Provisional sums
These can be included in contracts to cover the price increases. Typically, they are included in the contract specification as an estimate of the likely cost of works that either cannot be sufficiently defined at the time of contracting, or works that the employer may choose not to undertake.
They can be drafted very precisely to achieve exactly what the parties require. Consideration should be given to:
- their value when entering the contract;
- any contingency in budgets to allow for increases to provisional sums and any approvals needed from funders;
- the method for instructing or allowing a change to provisional sums;
- their impact on the programme.
Fluctuation provisions
Contracts can include these compensatory clauses to allow the contract price to be adjusted to reflect inflation through the contract period, for example JCT Fluctuations clause and NEC Secondary Option X1.
The benefits of a fluctuation provision is that drafting can be tailored for the circumstances. This does not necessarily mean limitless employer cost exposure or unrestricted contractor recovery.
Cost Plus/Target Cost contracts
Cost Plus is where the contractor is reimbursed for the actual costs incurred for the work done, for example NEC Option E, JCT Prime Cost, FIDIC Short Form. However, the risk of inflation is then wholly with the developer/employer.
Target Cost therefore may be a compromise route – for example, NEC Options C&D, IChemE Burgundy Book. But the decision as to whether to include the inflation provisions will still be a matter to be agreed between the parties.
Bespoke drafting
Tailoring a clause to specifically suit the parties’ requirements. For example, dealing with the price increase in steel as a Relevant Matter (JCT).
Security
Given the increased possibility of contractors going into liquidation, which poses particular risks for employers, consideration should be given to additional security to negate such risks, such as performance bonds, parent company guarantees and vesting certificates.
Other considerations for developers
- Consider sharing the risk of inflation under the contract;
- Ensure there are sufficient insurance levels in place;
- Consider supply chain challenges and more realistic timelines and particularly that a subcontractor insolvency may then push the contractor into insolvency also;
- Reassess material procurement procedures, for example early stockpiling;
- Be willing to negotiate higher fees with contractors if it results in securing performance bonds;
- Perform credit reference checks on all contractors;
- Remember that lowest price does not always equate to best value.
Niamh Batterton (legal director) and Sarah Wilson (partner) work in the construction team at law firm Bevan Brittan LLP
