Managing UK inflation risks
Laura Thornton, Associate Director, Sarah McCool, Associate Director, and Daniel Cashmore, Partner, Osborne Clarke
ALTHOUGH inflation has eased, it remains at a 40-year high and the construction industry continues to face serious knock-on effects from the increasing cost of debt, delayed supply chains, energy prices and labour shortages. It is clear that increasing prices for essential building materials are having a real and significant impact on the construction sector. According to the UK’s latest Government Building Materials and Component Index, material prices increased 24.1% in the past year.
Some materials have been particularly affected – using structural steel as an example, prices have increased to around £800 per tonne and more in recent months, an increase of around 40% since May 2020. To add to those woes, there have also been warnings that labour inflation could become a bigger problem than material price inflation in 2023.
For an industry that operates on small margins this could tip many constructors and their supply chains into the red which is not good for an industry that is so important to the UK economy. It could also cause disruption, delay and additional costs to be incurred on projects.
In this article we explore how parties may seek to manage these current inflation risks in their current contracts and their new contracts. We also consider the impact of varying existing tendered contracts under the UK’s procurement regime and the potential for increased flexibility brought about by anticipated changes to the law in that area.
Existing contracts and the current procurement regime
Given the fact that the UK has enjoyed low levels of inflation for decades, it is perhaps not surprising that, until recently, in most one-off construction contracts the overall contract price or individual rates and prices have been fixed for the duration of the contract. Despite the fact that many of the standard forms provide for price fluctuation provisions as optional clauses (e.g. NEC4 ECC option X1, JCT fluctuation options and FIDIC Red Book escalation clause), these are rarely used, and contractors have typically borne the risk of any increases in the cost of materials and labour after entry into the contract.
Contractual entitlements
The current market conditions are prompting contractors to review their contracts to ascertain whether there is any way to transfer or share the price inflation risk with the employer.
a) Price fluctuation provisions
- Price fluctuation provisions provide a mechanism for the adjustment of the contract price(s) to reflect changes in material and labour costs. If a contract contains price fluctuation provisions, these will be the first port of call for adjusting the price.
- Even if a contract does include a price fluctuation mechanism, this may still not provide adequate relief to the contractor. For example:
- If the mechanism only provides for an annual adjustment, the contractor will bear the risk of any price increases until the next annual adjustment. Given the sharp increases in prices the industry has seen, this may mean incurring significant shortfalls in the short term.
- The methodology for calculating the adjustment may result in a shortfall. For example, a contract may provide for rates or prices to be increased in line with the then-current Retail Price Index (RPI) rate. So, if the annual adjustment took place in say February 2022 that would have meant an increase of 6.8% on rates, which falls short of the actual increases in the costs of many construction materials.
b) Other contractual entitlements
- A contractor may need consider whether other relief is available under their contracts. Common avenues being explored by contractors are force majeure and change of law provisions. This is potentially a separate topic in its own right and the answer to whether a contractor can seek relief under these provisions will depend on the precise drafting of those provisions and the factual matrix involved. The potential difficulty in the current circumstances is that there are many factors contributing to the current price increases and the contractor will need to demonstrate that the factor relied on (e.g. war and hostilities, changes in law following Brexit, etc.) has caused the increase claimed, rather than other issues which would not entitle it to relief under the contract.
Commercial discussions
The current market conditions are prompting contractors to review their contracts to ascertain whether there is any way to transfer or share the price inflation risk with the employer.Where there is not an adequate contractual route to address the current price increases, a contractor may need to approach their employer to discuss whether there is scope to ‘do a commercial deal’ and agree an extra-contractual uplift to the price [and/or other measures to minimise the impact (e.g. utilising alternative suppliers)].
Employers may be reluctant to agree an extra-contractual uplift for a variety of commercial reasons including the fact that that risk is ordinarily borne contractually by the contractor and the impact that such an uplift will have on their own CapEx budgets or financing arrangements.
Where extra-contractual uplifts are under consideration, questions also arise in relation to compliance with the public procurement regime where the employer is a contracting authority within the public contract regulations (PCR) 2015. The scope for contract variation in circumstances where the intention is necessarily to alter the economic balance between the parties is quite limited, as it must fall within one of the so called ‘safe harbours’ in regulation 72.
The safe harbours cover several possible scenarios:
- Modifications which are provided for in the contract in clear, precise and unequivocal review clauses.
- Extension of the contract to cover additional works, supplies or services where a change of contractor is either not possible for interchangeability or interoperability reasons or where a change would cause significant inconvenience or substantial duplication of costs for the contracting authority. Such extensions may not increase the contract price by more than 50%.
- Replacement of the contractor either under a review clause or following a corporate restructure or insolvency event.
- Where the need for the variation is brought about by circumstances which a diligent contracting authority could not have foreseen, with the proviso that the modification does not alter the overall nature of the contract nor lead to an increase of more than 50% in the value of the contract.
Employers will be aware that requiring contractors to bear the full risk of price increases in the current market may impact on the delivery of their projects.Where the need for a variation to uplift the contract price has arisen as a result of market forces which could not have been foreseen at the time of contract award, it may be possible to rely on this safe harbour to enable the variation to proceed.
Application of the safe harbour will require a case by case analysis, which should include the employer’s knowledge at the time of entry into the contract and any steps taken to actively consider the potential impact of known risks at that time.
Consideration of whether any of the safe harbours is available is a complex assessment and we recommend taking legal advice on the particular circumstances of the contract.
Employers will be aware that requiring contractors to bear the full risk of price increases in the current market may impact on the delivery of their projects, for example:
- Failures to pass on and compete with increasing labour rates as workers look to mitigate against the cost of living crisis could lead to labour shortages causing delays to certain trades.
- An inability to increase unprofitable rates down the line may well lead to cash flow or solvency issues within the project’s supply chain. In the event of insolvencies this could result in major delay or disruption to the project.
- There is a potential for a reduction in quality as contractors seek to minimise their exposure by ‘cutting corners’ or using cheaper materials.
- There is a potential for an increase in claims for additional costs and variations as contractors seek to try and recover overspend on projects.
- Liquidated damages may not be an adequate remedy for any delay (e.g. in many power generation projects they are not, or they cap out quite quickly, leaving little incentive after that to complete quickly).
- There may be increased legal and management costs incurred in dealing with the issues and claims referred to above.
Given the fact that the UK has enjoyed low levels of inflation for decades, it is perhaps not surprising that, until recently, in most one-off construction contracts the overall contract price or individual rates and prices have been fixed for the duration of the contract.There is therefore an incentive for employers to consider whether some sort of extra-contractual uplift to the contract price in order to share the burden of price increases is appropriate and/or workable in their particular circumstances. If an uplift is not appropriate, there may be other practical measures which could mitigate the impact on the contractors.
If an extra-contractual uplift or other measure is agreed upon, the parties should be careful to ensure that any such change is properly documented and provides sufficient detail and clarity as to how it will operate.
In order to ensure the change is binding and enforceable the parties should also consider the variation provisions in the contract such as whether it needs to be in writing and signed by the parties.
It is recommended that parties seek professional legal advice where changes are agreed upon with a significant commercial impact to ensure they reflect the bargain struck, that any unforeseen consequences are dealt with and that it is legally binding on the parties.
Future contracts
Where contracts have not yet been signed, the parties have an opportunity to ensure that the terms of the proposed contract fully reflect their commercial intentions for the management of price volatility risk.
Price fluctuation provisions
As set out above, price fluctuation provisions provide a mechanism for adjusting the contract price to account for changes in the ‘input’ prices (e.g. materials and labour).
Some of the key issues to consider in developing a price fluctuation provision for a contract include:
- Which prices the fluctuation provision will apply to – the parties will need to identify which elements of the prices (i.e. packages or even specific elements of specific packages) are at most risk of fluctuations.
- Basis for price adjustment – will the price adjustment be calculated by reference to actual costs, or specific price indices? If the latter, which index or combination of indices should apply? While index based adjustment may be easier to manage from an administrative perspective, indices do not reflect actual cost, and can take time to ‘catch up’ with market conditions. If based on cost, then the parties will want to consider the level of detail required to substantiate such costs.
- Whether the price can be decreased as well as increased – sharing both the ‘pain’ and the ‘gain’ may make the provisions more likely to be perceived as a balanced approach to risk sharing, and therefore more palatable to employers.
- Whether there are any other parameters on the operation of the provisions e.g. value thresholds to trigger entitlement to price adjustment, restriction of the time period in which the provisions apply, caps on the value of price adjustments etc.
There is ample scope for a price fluctuation provision to be tailored to meet any contract-specific requirements, however given the potential complexity of these provisions, it is recommended that parties seek professional legal advice when drafting them.
Advance orders/Payment for off-site materials
As set out above, price fluctuation provisions provide a mechanism for adjusting the contract price to account for changes in the ‘input’ prices (e.g. materials and labour).
Procurement of certain materials at the outset of a contract may also help to increase cost certainty and mitigate delays during the contract.
When considering this as an option, employers will need to weigh up the benefit of increased cost certainty against the risk of placing the order when the prices are at or nearing a peak.
Some of the other key issues for the parties to consider include:
- Which key material prices merit being ‘locked in’ at the outset of the contract.
- Proposed payment arrangements for those materials – if there will be advance payments by the employer, or payment for off-site materials, then the employer is likely to require security for those payments.
- How the usual off-site materials risks will be allocated and managed (e.g. ownership of the materials, vesting and storage arrangements, insurance, responsibility for damage), particularly dealing with the potential for insolvency of the contractor or supplier.
Other options
Other options for addressing the risk of price increases might include:
- Elements of direct procurement by the employer e.g. specific materials or discrete packages.
- Permitting greater flexibility in the supply chain e.g. identifying alternative suppliers/subcontractors within the contract.
- Increased use of provisional sums.
- The risks and benefits of these approaches would need to be balanced by the parties on a contract-specific basis
Future changes to the law on variation of public contracts
The Procurement Bill, which is currently before parliament, is set to affect a number of changes to the procurement regime and among them is the introduction of a new safe harbour for variations which are needed in response to materialisation of a known risk.
At the time of writing, the current draft of the bill allows a contract to be modified where:
- A known risk has materialised other than as a result of any act or omission of the contracting authority or contractor and as a result of that fact, the contract cannot be performed to the satisfaction of the contracting authority.
- The modification in these circumstances may go ‘no further than is necessary to remedy that fact’ and may not increase the contract value by more than 50%.
- A known risk is defined as a risk that the contracting authority considered could jeopardise satisfactory performance of the contract but because of its nature, could not be provided for in the contract as awarded. Known risks must be identified in the transparency notice for award of the contract and therefore published at the outset of the contract.
The introduction of this new safe harbour will increase flexibility for projects where risks were identified at an early stage and provides an inverse to the existing safe harbour (which is proposed to continue) allowing for modifications which could not have been foreseen. Where the current market anticipates inflationary pressures continuing and even increasing, once these provisions are in force (likely late 2023) employers may wish to consider inclusion of inflation as a known risk at the point of contract award.
Conclusions
For existing contracts, contractors will no doubt be looking for ways to transfer or share in the pain of current price inflation impact with employers.
For existing contracts, contractors will no doubt be looking for ways to transfer or share in the pain of current price inflation impact with employers. Given fluctuations provisions have not been commonly used in recent times, contractors may be considering other ways of mitigating these risks, whether in a contractual or practical sense.
Communication between the parties will also be key as these are likely to be issues that are not easy to resolve and may require honest discussion and disclosure from both sides in order to find a route through to ensure the successful delivery of a project in the current circumstances.
If the parties do agree a commercial solution, then they should take legal advice on properly documenting that and, in the case of public contracts, avoid falling foul of the PCRs.
For future contracts, there are plenty of contractual and practical options that parties can adopt to seek to manage the risk of price volatility and, unsurprisingly, there has been a sharp uptake in including these in recent times. Again, the key here will be honest and frank dialogue between the parties as to how best deal with the current price volatility risk and finding a model that fairly and clearly balances those risks between the parties.
Laura Thornton, Associate Director, Sarah McCool, Associate Director, and Daniel Cashmore, Partner, Osborne Clarke
laura.thornton@osborneclarke.com
Sarah.mccool@osborneclarke.com
daniel.cashmore@osborneclarke.com