Dealing with supply cost volatility on major projects: The use of price escalation clauses in construction contracts

After two decades of relative stability of input cost for labour and materials, a perfect storm of events (including COVID-19, global conflict and sanctions, a depleted work force, supply chain issues and rising inflation) has led to cost volatility. As a result of this, we have started to see contractors require the inclusion of price escalation clauses in their construction contracts. This blog post examines how price escalation clauses work and the key issues to consider when drafting such a clause.

What are price escalation clauses?

Price escalation clauses protect against the risk of cost increases by providing a mechanism to adjust the contract price to reflect changes in the costs of materials (e.g. steel, copper or timber), oil or other fuels, power, logistics costs and labour. Depending on the specific drafting, they can also account for a decrease in the contract price where costs fall (referred to as “rise and fall” mechanisms).

Price escalation clauses in standard form contracts

Several standard form contracts include mechanisms for adjusting the contract price to account for fluctuations or escalations in input costs. For example, the:

• FIDIC Red Book 2017 includes an ‘opt-in’ escalation clause, which applies only if schedule(s) of cost indexation are included in the contract. These schedules enable the parties to agree on a method of calculating an adjustment to the construction inputs listed, with any other rise or fall in costs held to be included within the Accepted Contract Amount.
• NEC4 Engineering and Construction Contract provides a Secondary Option X1 that involves setting a base date before tender and calculating adjustments in price by using a Price Adjustment Factor prior to each assessment date, based on changes in the value of agreed indices and weightings set out in the contract.
• JCT Design & Build Contract 2016 provides three options to deal with fluctuation: Option A, which provides only for changes to contribution, levy and tax occurring after the Base Date; Option B, which additionally covers labour and material costs; and Option C, which provides a formula adjustment using the Formula Rules.

How are adjustments made?

The measure of an increase is determined by reference to actual costs or commodity indices. For example:

• A cost-based clause may measure increases by assessing the difference between the actual cost of materials and the contractor’s bid.
• An index-based clause measures increases in materials, labour or other goods against a specific price index.

Indices do not therefore reflect actual cost. In the UK, the most widely-used indices are the Price Adjustment Formulae Indices (PAFI) prepared by the Building Cost Information Service (BCIS) (and used in the JCT Option C, described above). In the US, the Producer Price Index, prepared by the Bureau of Labor Statistics, is widely used and organises prices by final demand/input costs, commodity type and industry. A price escalation clause may be tied to one or a combination of indices. It may also be tied to indices that deal with a specific material, for example steel can be tracked by a specific Eurostat index, or that produced by MEPS International.

Where indices are used, they should be specific to the inputs of production, and parties should consider whether they track costs up to the point of sale, or beyond. If multiple indices are used, the clause should specify the weighting given to each index when calculating a change in cost.

Key issues when drafting a price escalation mechanism

• A contractor and employer should collaboratively consider input costs and which of those inputs is most likely at risk of fluctuations. This requires transparency from the contractor regarding the basis for its price. When drafting a price escalation clause, there should be sufficient clarity relating to the base price:
  • it should be measured by unit or volume cost;
  • the effective date of the base price or base period should be clear; and
  • the source or record on which the base price is estimated should be identified.
• The parties may take a considered approach to selecting and limiting application of a price escalation mechanism to only those inputs which present the most risk – thus, enabling the employer to benefit from paying for less contingency risk in the contract price and the contractor being able to mitigate against the highest likely risk of price increases. In the same vein, a mechanism which provides for the contract price to be adjusted either up or down depending on input prices maintains a balanced risk sharing approach.
• The parties can also agree a mechanism to support or incentivise the contractor to mitigate the risk of cost increases, for example:
  • “threshold escalation”: the clause only applies if the increase exceeds a specified threshold (either a percentage or specific monetary amount); or
  • “delay escalation”: prices are fixed for a period (a set number of days, or for example contemplated completion) and if an excusable delay beyond that is accompanied by increased costs, the price is adjusted accordingly.
• The parties should also consider whether to include:
  • a permitted frequency and maximum limit of adjustments;
  • the method and timeframes for notifying price adjustments; and
  • the level of substantiation required;

as well as considering whether mark-ups for overhead or profit are included.

Conclusion

Escalation clauses are only one means of addressing the risk of cost increases. Others, for example, require proactivity and can include:

• identifying alternative or supplemental suppliers;
• direct purchasing by the owner from the supplier to avoid cost markups;
• pre-purchasing all material at the outset of a project; and
• considering substitutes or alternatives to materials specified in the project design.

Where price is the determinative driver in delivery of a project, parties may also wish to consider providing for suspension or termination of a project in the face of significant cost increases. Ultimately, where parties opt for an escalation clause it must be tailored to the project, the parties, and the prevailing market conditions. Clarity in drafting is also key, given that historically some clauses have proven difficult to operate due to a lack of precision. What is most evident is that during periods of volatility parties should take a holistic approach in identifying options and managing the very real risk of cost escalation.