Like many other sectors, the construction industry’s growth resurgence is being increasingly impacted by volatile and unpredictable supply chains for materials and labour. Clients and contractors are seeking both to protect their position and, increasingly, agree to share the risk that current market conditions pose, by implementing fluctuations provisions. Used incorrectly, such clauses may have unintended consequences and this article explores some of the issues they present and potential solutions or compromises that our clients may want to consider.
A primary concern for clients at the outset of a project is cost certainty and why a ‘fixed price’ contract, such as the JCT D&B contract, is frequently selected (and why many bespoke development agreements follow its treatment and control of contractor expenditure). A fixed price contract specifies a contract sum that accounts for the amount the contractor has deemed will cover the labour and materials necessary to complete the works (and the contractor’s margin) and gives limited grounds for costs to be claimed above this agreed amount.
As a result, any subsequent increase or decrease in the costs of materials or labour are a risk (or benefit) to the contractor and the tendered (and agreed) contract sum remains fixed so the contractor takes on both potential risk and opportunity of any change in the market.
On this basis fluctuation mechanisms (such as the JCT D&B Option B (Labour and materials cost and tax fluctuations) are often removed or disapplied from building contracts. This means that any changes in costs of materials or labour have no contractual effect on the contract sum that the employer is required pay. Save for an employer variation or impediment or other limited and specific neutral grounds, the contractor will be expected to take the risk of any increased importation or material costs on the basis that, when the contract is entered into, such risk was accounted for in the agreed contract sum.
The impact of Brexit and Covid-19 has prompted the Construction Leadership Council to acknowledge a “volatility” such that “the availability and pricing of labour and materials is likely to be something we must live with for a while to come and could have a significant impact on the timeframes and delivery costs of many projects”. The cumulative effect of increased freight costs, availability of raw materials, capacity of transportation, introduction of new safety accreditation together with new cross-border import/export systems and EU immigration rules has created an unprecedented challenge for contractors operating under inflexible fixed price contracts which do not provide any contractual right of price reassessment for such conditions. Only this month, several brickmaking companies have given notice to contractors already on their order books to expect price rises of up to 11% on new orders or pre orders for the first quarter of 2022. The Construction Leadership Council has in response urged both employers and contractors to consider and adopt contractual measures to minimise damage to all levels of the industry.
Our employer clients are increasingly seeking contractual solutions that enable them to deliver a manageable and cost-effective project in this current climate. While the introduction of any fluctuation mechanism will lead to a degree of cost uncertainty, a refusal to coalesce on some risk share could lead to contractors demanding an upfront price increase on the fixed contract sum that reflects the additional risk they are taking on in order to protect their margin. At the same time, it is neither desirable nor practical for an employer to open up, what should be, a fixed price contract to something akin to an open book cost reimbursement contract, given the additional management and monitoring controls that would be required to certify the legitimacy and quantum of any price increases a contractor seeks to claim that may, in the contractor’s view anyway, constitute a perceived legitimate change to the pre agreed contract sum.
The Construction Leadership Council urges cooperation and sharing of risk, suggesting that contractors and clients need to “find ways to work together so that this growth opportunity is maximised, and a sustainable industry supply chain is maintained”.
How can this be achieved in a way that balances cost efficacy, risk apportionment and effective project management?
While it is understandable that contractors do not want to over-expose themselves to turbulent conditions which they cannot easily predict (let alone control), neither do employers want to disincentivise a contractor to carry out the works in a cost efficient manner (or even provide opportunity for contractors to exploit fluctuations mechanisms in a way that maximises their own margin) and end up paying a contract sum that exceeds their budget or funding allowance. Furthermore, in terms of delivery, employers may also want to consider the implications of holding a contractor to a price that is no longer profitable or viable and could result in poor work quality and/or risk contractor insolvency if conditions reduce or negate any margin on a large project that a contractor may be reliant on.
We advise that employers and contractors collaborate at the contract formation stage to address the risks posed by the turbulent market conditions described above as far as possible, and may wish to consider the following:
- identifying those products, materials or other labour (if any) which are at the greatest risk of turbulent price or timing fluctuations;
- placing orders for key or high risk items at an earlier stage in order to secure supplies;
- arranging for such materials to be delivered to site (or an alternative location) and stored before they are needed (and the feasibility and cost consequences of doing so), with appropriate precautions such as requiring vesting certificates for such materials. While such provisions are frequently used for specialist materials, there may be an increasing trend to apply these to wider elements of the works that would not previously merit such treatment;
- making advance payments for the supply of materials, whilst requiring appropriate security e.g. an advance payment bond or similar, for specific orders;
- Providing for price adjustments for particular items and/or works, using any of the following mechanisms:
- fixing the contract sum for a defined period, after which outstanding works (or particular categories of such works) become subject to adjustment in accordance with an appropriate index, with the full uplift to be borne by the employer or shared by the parties in pre-determined proportions; and/or
- providing for some material or other specified costs to be payable on cost-reimbursement basis, with or without a maximum price.
The pervading uncertainty in the industry’s supply chains over the last few years has compelled contractors to prioritise protecting their margins. In the absence of clear mechanisms and processes to deal with this uncertainty, project delays and disputes will inevitably arise. Employers will be best protected if they adopt robust commercial and contractual processes that are properly managed and tailored to the particular risks that may exist or arise on each project.