Price fluctuation clauses are becoming an increasingly crucial subject in construction contract negotiations and disputes. The construction industry faces significant cost pressures arising from current global events: material and labour costs are rising as the economic fall-out from the pandemic restrictions bites, with the trend set to continue as governments struggle to shield individuals and businesses from rising energy prices.
In the past, parties might have been able to rely on ‘force majeure’ type clauses to provide contractual relief against such unprecedented circumstances. The FIDIC suite, for instance, allows the Contractor to claim ‘Cost’ incurred as a result of war or hostilities, provided that the event in question is not something that the Contractor could have reasonably provided against before entering into the contract. This may have assisted Contractors in respect of FIDIC contracts entered into before the start of the Ukraine conflict. Now that the conflict is known about, however, it is highly questionable whether the ‘foreseeability threshold’ will be met. The mere fact that contract performance has become more onerous or expensive will not be sufficient on its own.
With ‘force majeure’ provisions offering increasingly limited assistance in relation to cost recovery, parties are instead turning to price adjustment mechanisms. In this article, we explore the approach taken on price fluctuations in the JCT and NEC forms of construction contract, together with some of the problems that can arise when parties fail to expressly tackle cost risk allocation in negotiating their contract terms.
The JCT 2016 suite includes three ‘Fluctuations Options’: A, B and C. All three options are included for:
In contrast, only Option A is available for other contracts in the suite, such as the Intermediate Building Contracts and the Minor Works Contracts. The JCT adopts this approach to reflect that these contracts are typically used for shorter-lived engagements where the more comprehensive Options B and C should not be needed.
Option A is narrow in its operation, dealing only with post- Base Date changes in taxation of labour and imported goods, materials, electricity, fuels and waste. In the current global climate, this Option is likely to be considered too ‘light touch’ by many Contractors. Whilst potentially useful in the context of Brexit and changing import tariffs and customs duties resulting from that, Option A does not provide any cost relief for increases in the price of labour and materials themselves.
Option B goes a step further and accounts for changes in the actual cost of labour and materials, as well as the taxation provisions contained in Option A. It is worth noting that the fluctuations mechanism permits both increases and decreases to the Contract Sum, so if market rates drop then the Employer will benefit from a price reduction. Notwithstanding this, many Employers will proceed with caution in considering a proposal from a Contractor for Option B to apply entirely unamended. The standard wording transfers significant risk to the Employer, covering the cost of all labour, materials and goods, as well as electricity, fuel and the tax payable on the disposal of waste from the site. A more balanced approach might be to amend the standard form, such that it only applies in respect of a pre-agreed list of materials and goods that are considered particularly at risk of unsustainable price increases, or requiring the Contractor to assume the risk of price increases below an agreed percentage threshold.
Option C permits adjustments to the Contract Sum in accordance with the ‘JCT Formula Rules’. These are extensive and complex formulae which calculate the rate of permitted price fluctuations depending on a multitude of factors, including categories of work. Although this Option allows significant flexibility as to the fluctuations offered, the formulaic approach is extremely technical and detailed, so it should only be used where the Employer has engaged an appropriately experienced cost consultant to (i) advise on the likely implications for the project budget; and (ii) manage the administration of the price adjustment mechanism in practice.
The main forms of NEC contract include two fluctuation mechanics, with the applicability of each being dependent on which pricing option is selected.
Where Main Option A, B, C or D is chosen, then Secondary Option X1 is available, allowing the Prices to be adjusted in accordance with selected indices. Option X1 applies to the entire ‘Price for Work Done to Date’, effectively passing all of the inflationary risk occurring after the selected ‘base date’ to the Client. As with JCT Fluctuations Option B, Clients may well wish to press for amendments to the standard form drafting, to narrow the Contractor’s entitlement and ensure that more of the risk is shared.
It is also important to consider whether amendments are required to other parts of the NEC standard form, to offset the wide-ranging cost risk that is passed to the Client as a result of Option X1. For example, all of the NEC ‘compensation events’ afford the Contractor a right to both an extension of time and additional payment. From the Client’s perspective, it is worth analysing whether this default position should be amended such that certain compensation events attract time entitlement only (to reflect that the Contractor is already significantly safeguarded on cost risk by virtue of Option X1).
Where Main Option E is chosen, the Contractor is shielded from inflationary impacts by the pricing mechanism itself (and therefore Secondary Option X1 cannot be selected). Option E is a cost reimbursable contract, whereby the Contractor is paid the actual costs it incurs in carrying out the works, plus an additional fee (representing OH&P). This approach therefore transfers even greater financial risk to the Client, as (unlike in an Option X1 scenario) there is not even a tendered benchmark price to which inflationary adjustments are then applied. For this reason, even with global markets as unpredictable as they currently are, Option E still tends to be reserved for niche circumstances such as urgent repair work following a fire, where the scope cannot be properly defined at the outset.
For the foreseeable future, it seems fair to say that the Employer luxury of a fully fixed price construction contract will be largely reserved for low-risk projects of short duration. The days of a standard form contract’s fluctuations pages being left unthumbed and gathering dust are most certainly behind us. It is therefore more important than ever that parties understand the fluctuations options available to them, so that they are well versed for managing contract negotiations and (once the contract is signed) smoothly administering the final price adjustment mechanism.
Where parties have not adequately engaged with the issue of cost risk allocation in negotiating their contract terms, significant project disruption can occur, as without a fluctuations provision there can be very limited circumstances in which a Contractor can seek additional payment to obtain some reprieve from the pressure of market prices. Often, a Contractor can be limited to tying costs to variations which may only cover limited items. In these circumstances, if the parties do not reach a negotiated increase to the contract sum by way of a deed of variation, there is a very tangible risk that a Contractor will seek to find a way to exit the project rather than continuing with an unprofitable job (perhaps even electing to take its chances with an unlawful termination claim from the Employer, rather than completing the project at a loss). In other cases, a Contractor may enter a formal insolvency if they are not able to continue a project and pay any debts falling due. Such outcomes ultimately lead to difficulties for all involved. The Employer will be faced with appointing a new Contractor (who is likely to price at the high material prices the original Contractor was facing), but with the original Contractor holding limited assets against which the Employer can claim those additional costs by way of damages.
Allocating increasingly burdensome cost risks in today’s unpredictable climate is undoubtedly a complex and sensitive task. Nevertheless, parties who enter into contracts for high value, complex and/or lengthy projects, without express and considered drafting to address this issue head-on, do so at their peril. Directly engaging with the matter pre-contract signature may well result in some testing negotiations, but it could also avoid a far more difficult discussion later if the final contract is silent, unclear or weighted heavily in one party’s favour.
If you require advice on any of the issues raised in this article, please contact our Construction & Infrastructure team.
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