Market volatility - renegotiating lump sums in construction contracts

Lump sum contracting, particularly on multi-year, complex projects, is inherently risky for contractors. The potential for profitability can diminish rapidly if projects are delayed, or underlying costs escalate, which is common during periods of market volatility. The recent scarcity and increased price of energy, materials and labour, coupled with currency fluctuations and national responses seeking to stabilise local economies present significant market challenges.

Contractors and employers alike are revisiting their lump sum contracts to understand what, if any, scope exists for price adjustments; all too often such options are limited, particularly where contracts were agreed in more stable times.

In this blog we consider the common mechanisms for price and risk adjustment which should be considered when structuring, or executing, any major project in the current turbulent market.   

What contractual mechanisms could result in a pricing adjustment? 

Various contractual mechanisms may exist for pricing adjustment depending upon the particular circumstances of the project:

• Price escalation - Changes to market prices affecting project execution

Price escalation impacts all parties involved in project development. For employers it can impact on project assumptions and viability. For contractors, it can become an existential issue if they are over-exposed to price fluctuations across their project portfolio. Increasingly, employers are recognising the risk to project execution and completion posed by sharp fluctuations in the price of certain costs and commodities (for instance energy, labour or materials) and the need for proportionate risk allocation to protect their interests and ensure on-time completion. Price escalation clauses are therefore gaining increased focus and scrutiny in negotiations (a discussion of price escalation clauses can be found here). Such provisions clarify which contracting party bears the risks of increased or decreased prices for specified resources where market pricing exceeds contractually agreed parameters and can provide an avenue for a contractor working on a lump sum basis to claim additional funds if the relevant contractual conditions are met.

Similarly, where a contract provides for payment in one currency but the supply of key project elements is to be paid in another currency, the parties may have negotiated a clause to address ownership of the risk of volatile currency fluctuations. Such clauses typically would not result in a price adjustment per se, but rather either a stipulated conversion rate or rate calculation which may insulate the contractor from currency risk.  

• Changes to the nature, quantity, or quality of the contracted works 

An employer may also seek to mitigate the effects of market volatility by varying contractual terms – for instance, through lowering quality requirements or changing specifications to try to manage increases in the cost of plant or materials, particularly where it bears the risk or where project completion is at risk if it fails to take action to offset unforeseen cost increases. Typically, a variation clause will provide for additional payment where certain changes to the originally contracted works are made. It is not unusual for contracting parties to disagree on the types of changes captured by such clauses, or for requirements that a formal process of notification and determination be followed before any conclusion on additional payment is reached.

The mechanism for adjustment of the contract price contained in a variation clause will be relevant where an employer seeks to descope aspects of the works and reduce project cost. In such situations, contractors should consider whether, in addition to a reduction in project cost, there is additional cost that will be incurred to affect the descope (for instance, through re-design or reinstatement works).

For employers, assessment of variations / change requests may require careful assessment of contractual entitlement weighed against the risks to project completion.

• Delays to timing of project delivery  

In the current global market, it is not only price escalation impacting projects; supply chains are under unprecedented strain, with lead times for key materials and equipment vulnerable to significant delay. Whereas once contractors may have been content to shoulder the risk of delays from key suppliers, current volatility means they are increasingly less able to do so.

Where works have been delayed through events which are beyond its responsibility, a contractor may be entitled to an extension of time and, if permissible under the contract and governing law of the contract, costs associated with prolonged presence on site. If an employer is responsible for delays that push the contractor into an inflated costs environment, those costs may also be claimable as part of a prolongation costs assessment.

Interim extension of time and prolongation cost claims can be an avenue for lump sum contractors to recover, or at least mitigate, cost overruns during project execution. However, often the parameters of recoverable costs are not articulated in construction contracts and local law advice will be required, which may be subject to differences in interpretation between contracting parties.

• Compliance with changing national legislation   

Certain jurisdictions may swiftly adopt changes to national legislation to mitigate the impacts of market volatility on the local economy. Contractual provisions concerning changes to local legislation may provide a contractor with recourse to negotiate for additional funds, time or employer support where compliance becomes more onerous.

Where changes in legislation impacts foreign investors and provides an avenue for the expropriation of profits, recourse to compensation may be available through claims brought under international investment treaties. The impacts of legislative change can also extend beyond pricing, to affect the possibility of performance more broadly. This can be compounded by geo-political events, such as the imposition of sanctions, trade restrictions or tariffs.

Adjusting contractual risk allocations beyond pricing?

Market volatility could be so extreme as to require a general reallocation of contractual risk – for instance, where performance has been rendered either partially or wholly impossible.

Broadly, a contractor should consider whether there are hardship or force majeure provisions in the contract or under the governing law of the contract that permits relief through the termination or redress of obligations to perform or suspension of certain performance (and, potentially, a longer timeframe for ultimate project completion) as a result of an unforeseeable event beyond the parties’ control. The interpretation of such clauses and their consequences will depend upon the circumstances faced, and the position under the governing law of the contract.

Generally, the doctrine of frustration operates in common law jurisdictions to excuse strict performance where an unforeseen event renders that performance impossible. This legal mechanism is also generally reflected in many civil codes, where an obligation is automatically terminated upon determination that it has been rendered impossible due to an unforeseen event beyond the parties’ control. This is, however, an extreme result for both parties who ultimately want to be able to deliver the project.

Additionally, many civil law jurisdictions empower local judges to adjust contractual obligations where strict performance is determined to be unduly onerous on one party (see Article 249 of the UAE Civil Code).

Pragmatic approaches to lump sum risk allocation 

While there is a greater focus on risk allocation in contracts which are currently under negotiation, for those agreed during a period of relative stability the contractual tools to rebalance risk may be limited. Employers may be facing stark decisions and the need to weigh enforcement of contractual rights against the need to achieve project completion. Engagement with broader project stakeholders can prove key to promoting a pragmatic resolution aligned with all parties’ interests in the project; for instance, through jointly agreed (and potentially financed) recourse against project insurers. 

Ultimately, working together with a contractual counterparty will be key as any negotiated outcome is far preferable to the inherent uncertainty of formal dispute proceedings or, in extreme cases, insolvency.