Credit: Grispb/Adobe Stock

Scott Stiegler
Partner, Vinson & Elkins, London
sstiegler@velaw.com

Yasmin Bailey
Senior associate, Vinson & Elkins, London
ybailey@velaw.com

In recent years, a series of significant events have impacted the availability of materials and labour globally. This has had a direct effect not just on planning projects but also on the delivery of domestic and international construction projects alike. Inter-related with this is the pressure from inflation at rates the world has not experienced for decades. Inflation in the United Kingdom exceeded ten per cent in July 2022, the highest it has been in 40 years. In developing regions, the situation is sometimes far worse.

Profit margins have, of course, always been tightly controlled on construction projects, so even slight pricing fluctuations can have a significant impact. This is not only true for live projects, but also for those in their early feasibility stages.

Prior to the pandemic and Brexit, the price of materials and labour in the UK had been relatively stable, and at least predictable. As a result, fixed-price lump sum contracts were a viable option as they were founded on the premise of an existing stable supply chain, meaning that the risk of rising prices was predictable and relatively low. Until recently, this was also true of many international construction contracts: it would not be unusual for a form of price adjustment mechanism to be adopted to cater for specific situations relevant to the project or jurisdiction in question but the review period that traditionally was measured in years is now too long to wait.

The industry as a whole has entered new territory where many aspects of the pre-existing paradigm are no longer appropriate. This article looks at how parties to construction contracts can approach the rising risk of inflationary pressure on existing and future contracting structures in the current climate.

Existing contracts and the fixed price lump sum model

The lump sum contracting model is well known and understood and is regularly employed. Lump sum fixed-price contracts will usually include mechanisms that cater for adjustments to the contract price only for specific and defined events. However, the starting point is that the contractor generally bears the risk of price escalation on the contract price itself. This model is obviously appealing to employers, but often brings with it a heightened risk of disputes arising over those events providing time and cost relief. In the current uncertain and unpredictable climate, this type of arrangement may no longer be a viable starting point.

The impact of inflation in a traditional lump sum contract is often unaddressed. In the absence of specific price fluctuation or escalation mechanisms, increased costs in materials, labour and other inflationary pressures that impact the contract price are a risk borne by the contractor. In a common law context, it might be that the only options are for the parties to either renegotiate the terms of their contract or to carve out some of the scope and address that by using a different contractual arrangement (eg, on a cost-plus basis as further discussed below). This means compromise from the employer. Of course, if the parties were to find themselves in dispute, a damages claim may include damages for inflation-related costs resulting from, for example, delay, although this will depend on the circumstances and the relevant contractual provisions – often such losses are excluded by consequential loss provisions. In an international context, avenues for contractors may exist under principles of civil law for equitable rebalancing, such as where contracts are in jurisdictions that cater for such options.

When it comes to addressing pricing escalation for change events, while there are limited examples in standard form contracts, one example is the NEC3 Engineering and Construction Contract (the ‘NEC3 contract’) Option A (priced contract with activity schedule). The NEC3 contract provides for a fixed-priced contract with an activity schedule, meaning the contractor generally takes the risk of any change to expenditure, including those that may arise from changes in the price of labour, plant and materials as a result of inflation.

However, a mechanism may permit the contractor to account for subsequent price escalation for compensation events. Clause 60 of the NEC3 contract prescribes the available compensation events. Under the NEC3 contract, the contractor is to provide a quote for the relevant compensation event to the employer, which is essentially a proposal from the contractor to change the contract price or to extend the time as a result of the compensation event.¹ Ordinarily, assessment of a compensation event will be based on the quotation, except in circumstances where the contractor fails to follow the contractual mechanisms.

Clause 63 of the NEC3 contract sets out the manner in which such compensation events are to be assessed. In particular, clause 63.1 provides that changes to the prices (defined as the lump sum price for each of the activities on the activity schedule) are to be assessed as the effect of the compensation event upon:

1. The actual defined cost of the work already done. The ‘defined cost’ is defined as the cost of the components in the Shorter Schedule of Cost Components whether work is subcontracted or not excluding the cost of preparing quotations for compensation events.

2. The forecast defined cost of the work not yet done.

3. The resulting fee. The fee is defined as the sum of the amounts calculated by applying the subcontracted fee percentage to the defined cost of subcontracted work and the direct fee percentage to the defined cost of other work.

While under NEC3 Option A, it is the contractor that bears the risk for increases in expenditure (including inflation-related increases), when assessing compensation events, the contractor is entitled to make an allowance for matters that have a significant chance of occurring and that are at the contractor’s risk under the contract. This is expressly provided for in clause 63.6 of the NEC3 contract, which provides that ‘Assessment of the effect of a compensation event includes risk allowances for cost and time for matters which have a significant chance of occurring and are at the Contractor’s risk under this contract.’ This could include inflation and is recognised in the NEC’s guidance notes.

The High Court of Justice in Northern Ireland considered whether the assessment of the effect of a compensation event is to be calculated by reference to the forecast or the actual cost incurred (in circumstances where the assessment is being made after the impacts of a compensation event are known) in the case of Northern Ireland Housing Executive v Healthy Buildings (Ireland) Limited² specifically by reference to the assessment process under the NEC3 contract. The Court considered two specific questions:

1. Should the assessment of the effect of the compensation event be calculated by reference to the change in forecasted charges under the contract or the actual cost incurred?

2. Were actual costs relevant to the assessment process for compensation events?

The Court held that an actual cost approach was to be preferred with regard to both questions. This was, of course, in the context of the facts at hand, where the compensation event was being assessed after the event.

Quoting from Keating on NEC, the judgment highlighted that there are:

‘indications of a broader approach within the wording of the contract. First, Clause 63 requires the effect of compensation events to be assessed. Every clause uses the words “assessment”, “assess”, “assessing” or “assessed”. Assessment suggests an idea of appraisal or judgment’.³

The Judge decided that when assessing the compensation event, the actual costs were most relevant, stating: ‘Why should I shut my eyes and grope in the dark when the material is available to show what work they actually did and how much it cost them?’⁴

The Court also held that:

‘to give an efficacious and business-like interpretation to the contract a quotation which arises in those circumstances, rather than as a genuine forecast, ought to be informed by the best information available as to the actual cost and time incurred’.

This situation may be different if the compensation event is being assessed contemporaneously, and whereby an assessment needs to be made of the forecast defined cost. The subsequent assessment is often the subject of much debate, and the selection of applicable indices for the assessment of inflation is a forum usually for expert submissions.

Similarly, in a common law context, it has been held that damages based on the cost of repair should be assessed as of the date the repairs ought reasonably to be carried out, rather than at the date of the breach. This prospective approach can of course be significant in times of rising inflation.⁵

Outside of the NEC3, mechanisms for inflationary adjustment are also contemplated in certain JCT contracts. However, international forms are usually less developed in addressing this aspect of risk allocation.

Parties to existing contacts may wish to consider the terms of their contracts in detail in order to determine whether the provisions, even in a lump sum fixed-price contract, may provide the opportunity to seek relief for inflationary-related cost increases.

Negotiation of construction contracts in the current climate

Contractors and employers negotiating construction contracts in the current climate have a number of possible approaches available to them which will assist in managing the risks of price increases and inflationary pressures.

Sticking to the lump sum model will likely not appeal to all contractors. This option may result in tenderers submitting cost proposals that cater for pricing uncertainty through increased prices or may even result in fewer bids being received. The consequence for the employer is that it is faced with less choice, higher costs, and likely a more proactive approach from contractors to claims management aimed at ensuring that any additional costs are subject to recovery steps.

To temper this, employers may wish to consider including specific price escalation provisions in their contracts. Escalation clauses may work in a number of different ways.
These could be structured, for example, to trigger at a certain level for the contract price as a whole, or be aimed specifically at compensation events like the approach taken in the NEC3 contract (Option A) discussed above. It will be important to prescribe carefully how such clauses operate, including what formula or indices are to be used. For example, a ‘base date’ from which the price escalation clause is to apply will usually need to be specified in the contract. Drafting of these clauses could also be tailored for specific circumstances, for example, only allowing fluctuations for specific materials. Whether an escalation clause is appropriate will depend on the project at hand, for example, long-term contracts in particular are likely to benefit from such clauses. Other factors that may be relevant are the location of the project and the materials being used.

There are alternative contracting models that address the consequences of inflation. Parties may choose to enter into a cost reimbursable contract, also known as a ‘cost plus’ contract, where the contractor is reimbursed for the actual costs incurred in carrying out the works, plus an additional fee (usually to account for the contractor’s indirect costs such as overheads, as well as profit). This places the risk of price fluctuation with the employer and is a model obviously favoured by contractors. This model generally requires a significant amount of cost management to ensure that the costs claimed by the contractor are properly due. For the employer, it would be prudent to include measures that control the incurring of costs by the contractor. At the very least, obligations ought to be placed on the contractor to ensure costs are reasonably and necessarily incurred, and that appropriate audit provisions are adopted to ensure costs can be scrutinised and verified. Further, the contract ought carefully to define the allowable costs reimbursable to the contractor, exclusions from the reimbursable costs and how the resulting fee is calculated. A benefit of the reimbursable contract is that it represents a simple contracting model which eliminates the need for complicated rules relating to price adjustment and the payment of claims and pricing risk is largely eliminated for the contractor. Instead of a ‘stick’, an employer may want to offer a ‘carrot’ through the payment of a bonus where reimbursable costs are, for example, kept below a pre-agreed target cost. However, while prudent, incentivisation of the contractor through such risk/reward sharing mechanisms can quickly become complicated, particularly when pricing risk is comingled with risk allocation provisions on quality of performance and time.

An alternative approach may be to break the contract price into several portions, with some elements being fixed and other elements being either ‘cost plus’ or even nominated as a provisional sum.

A provisional sum is usually included in the contract as a specific sum or a definable amount, but generally the original contract sum is adjusted according to whether the actual expenditure ordered is greater or less than the provisional sum accounted for in the contract. The price risk for provisional sums is therefore an employer risk under this arrangement, which creates some cost uncertainty for employers, especially if the provisional sum relates to a large element of the works to be done. Parties choosing to contract on the basis of provisional sums will also need to ensure that this is done in a clear and certain manner. There have been some cases in the English courts holding parties to estimates as a fixed price quotation rather than an indication of expected costs. These cases highlight the fact that the specific circumstances and terms of the contract will always be relevant.⁶

Conclusion

The current climate indicates that construction contracts not yet entered into or currently under negotiation will likely need to consider moving away from a fixed price lump sum model, shifting what has traditionally been a contractor risk into perhaps a shared risk. As illustrated above, there are a number of options parties may choose from to manage price risk in the current volatile market conditions. Whichever method parties choose to address in the current climate, it is likely that some sort of risk-sharing to deal with inflationary pressures and price increases may be the most beneficial for all parties. Good relations between contractors and employers will be essential in navigating these challenging market conditions. Where complicated mechanisms are being incorporated into construction contracts, it is imperative that clear drafting is used to ensure that they operate in the intended manner.

Notes

1 Clause 62 of the NEC3 contract.

2 [2017] NIQB 43.

3 See para 47 of the judgment and 7-109 of David Thomas, Keating on NEC (Sweet & Maxwell 2022).

4 See para 54.

5 See Dodd Properties (Kent) Ltd v Canterbury CC [1980] 1 All ER 928.

6 See, eg, The Sky’s the Limit Transformations v Mirza [2022] EWHC 29 (TCC).