While the world should be starting to feel more optimistic about the prospect of a post-Covid economy, there are still market forces which are causing inflationary price increases impacting domestic and international construction projects.
Labour shortages, high demand for raw materials, energy prices and the geopolitical situation in Ukraine and the consequent impact on oil and gas supplies are all serious causes for concern. The statement on product availability from the Construction Leadership Council (21 April 2022) noted that increased energy and raw materials costs currently remain key factors driving rising prices for construction in the UK. Demand for materials from certain sectors such as logistics and re-purposing office space also remains high.
What steps can parties take to mitigate these risks?
Existing contracts
For existing contracts, contract provisions may contain force majeure clauses which entitle extensions of time or additional reliefs in certain, limited circumstances. The conflict in Ukraine could conceivably amount to force majeure under JCT contracts but whether that would in fact entitle contractors to contractual relief needs to be considered on a case-by-case basis depending on contractual terms and the particular circumstances. For example, the position where a specific product or materials can be manufactured only from one plant is different to the position where products or materials can be sourced from alternative supplies or from existing stock. Establishing the effective cause of delay is not straightforward especially if materials shortages were an issue prior to the conflict; and taking into account obligations for contractors to mitigate delays.
Whether additional reliefs are available would depend on the contract provisions, but force majeure does not entitle additional cost to the contractor under the JCT contracts, unless otherwise agreed. Other provisions would need to be considered to determine if any entitlement to additional relief for price changes was available, but in the absence of price escalation clauses entitling additional costs, increased costs in materials or inflationary pressures because of high energy prices is likely to be a contractor risk.
Procurement Options
Contracting using a single lump sum agreed before the works commence has been a popular procurement route for employers in recent years, for example using the JCT Design and Build Contract. Such contracts achieve a degree of price certainty since contractors bid a fixed price against a clear risk allocation and scope of works, although contract adjustments can be made in various circumstances such as variations, the occurrence of relevant events or where provisional sums or fluctuations clauses are included.
The current market conditions mean that for many commercial schemes we are seeing a move towards two-stage tendering. In this case, contractors are appointed to provide certain services under a pre-construction services agreement enabling the contractor to work up prices in its sub-contractor packages before the building contract is fully priced. The employer can then decide whether to proceed with the works for the second stage. Locking in prices for sub-contractors and the supply chains can reduce pricing risk for contractors and firm up delivery schedules for materials. Employers will still need to be careful around issues such as contractor contingencies in prices for the second stage, or potential charges should the works not in fact proceed to the second stage.
Provisional sums
Another option is for parties to make use of provisional sums to mitigate the impact of inflation on specific materials. Provisional sums are generally considered to be estimates of the likely cost involved in the work to be done and are used where uncertainty around the scope of elements of the works makes contractor commitment to a fixed price difficult. In the words of Lord Justice May in Midland Expressway v Carillion Construction, 2006, "… A provisional sum is usually included as a round figure guess. It is included mathematically in the original contract price but the parties do not expect that round figure to be paid without adjustment. The contract usually provides expressly how it is to be dealt with. A common clause in substance provides for the provisional sum to be omitted and an appropriate valuation of the work actually carried out to be substituted for it. …. "
The use of provisional sums creates cost uncertainty for employers especially if the provisional sum relates to a large element of the works to be done as the price risk for provisional sums is an employer risk. The RICS New Measurement Rules used by the JCT forms of contact enable provisional sums to be categorised as defined or undefined. Where the provisional sum is undefined, employers will take the risk of the final cost of the work done including programming impacts as assessed under the contract. This contrasts with the position for defined provisional sums where employers take the risk of the price adjustment but not the risk of programming and pricing of preliminaries since the contractor is deemed to have allowed for these elements. From a risk perspective defined provisional sums are therefore a more attractive option to employers since the cost uncertainty is limited to the actual cost of the work done.
Fluctuation provisions
The use of fluctuation provisions which allow the contract sum to be adjusted to take into account inflationary pressures is also an option. Whether such provisions are appropriate to include will vary from project to project and depend on issues such as the location of the works, the nature of the materials to be used and the contractor's ability to manage its supply chain. Using the JCT provisions as an example, there are three options, Option A, B or C and each take a different approach to fluctuations. Option A covers contribution, levy and tax deductions, Option B covers labour and materials cost with Option C dealing with formula adjustments. Option A is the default option, though is frequently deleted from contracts, and there needs to be a selection in the Contract Particulars for either Option B or C to operate. Care needs to be taken before using such provisions in their entirety to ensure that parties understand how these provisions operate. Depending on the circumstances, it may be preferable to deal with price risks to particular materials only rather than adopting one of the standard Fluctuation options.
Letters of Intent
Uncertainties in the market have led to an increased use in letters of intent to mitigate inflationary pressures. Letters of intent can enable a quick start on site and early ordering of materials to head off future cost increases.
The use of letters of intent should always be done on the understanding that such letters are rarely binding on either party in respect of the eventual agreed terms of the building contract. Letters of intent work on the basis that the contractor carries out specific activities for an agreed price up to a maximum amount. The letter may provide for significant advance payments to the contractor for off-site materials, so specific protections would be required for employers to ensure that they have access to materials ordered in this way if for any reason the building contract was not subsequently entered into. Depending on circumstances, provisions may also need to be included to deal with issues such as cancellation charges in the event that the project does not proceed, or is terminated, on the basis that the contractor's supply chain may have imposed greater upfront costs on the contractor.
Employers should also bear in mind the downsides to enabling a contractor to get started on a project without a full contract. Having a letter of intent can significantly reduce any negotiating power that the employer may have. There is also the risk of the project proceeding without a full contract ever being agreed, as we reported on here.
Concluding Remarks
In reality, in a market-driven by global events, increased costs and inflationary pressure look to be here to stay at least in the short term. The industry has shown throughout the last two years that it is adaptable and can respond to challenges. Good relationships between employers and contractors in understanding pricing risk will be key to enable parties to work through these challenging market conditions.
