Having spent the last eight years in the Middle East, I have recently returned back to my roots in beloved Newcastle. Whilst I left the UK with no children, I have somehow managed to return home with my better half and two kids (a three-year-old and a five-year-old!). Making sure the family home is fit for purpose has been a high priority, resulting in frequent visits to the local builders’ merchant and Greggs for a quick pasty lunch. These experiences tell me something has significantly changed, especially when it comes to paying for goods and services.
The construction industry has often been faced with unique challenges, but price escalation has become a particular concern due to recent global factors.
Author: Robbie Beattie, Associate Director, Teesside, UK
Formulae based approaches can offer a relatively straight-forward way to calculate price escalation, but only if a mechanism is included in the contract agreement.
The reality is that most construction contracts do not include an agreed formulae to deal with price escalation. Accordingly, my article explores the use of formulae when a contracting party is looking for potential solutions to significant price escalation challenges the industry has faced in recent years. I have decided not to discuss the thorny issue of force majeure and will stick to my role of being a QS.
Background to global factors
The COVID-19 pandemic led to sharp price increases due to changes in supply and demand from services to goods [1]. This significantly impacted the construction and engineering industries on a global scale. This was compounded by unplanned maintenance works and shutdowns at global energy producing plants [2]. Further, increased demand and unfavourable weather conditions led to a decrease in energy production and volatile increases in energy prices [3]. Most recently, the Russia- Ukraine War has resulted in unprecedented increases in materials and energy prices as sanctions have been imposed [4].
Abnormal price escalation
Published statistical data shows that recent sharp price increases do not reflect typical price increases that were experienced in prior years. For example, the Construction Producer Price Index (CPPI) and Construction Cost Indicator (CCI) published by Eurostat [5] show that abnormal price escalation related to construction activities has been observed during the last three years as follows [6]:
Figure 1 – Eurostat Construction Producer Price Index
Statistical data collated by Eurostat also reveals that purchasing prices for typical commodities used in construction abnormally increased by between 23% and 60% from September 2020 to September 2023, compared to the previous three years [7].
This is set out as follows:
Table 1 - Price Escalation for Sampled Commodities
Accordingly, the quantification of price escalation, whether for cost and value monitoring or for the purpose of seeking relief under a contract or governing law, has become increasingly important for contracting parties in recent years.
Contractual risk of price escalation
The default position for many construction contracts is that the risk of price escalation is borne by the contractor, rather than the employer. Construction contracts often state that adjustments for changes in cost do not apply or more simply, that the contract price is fixed for the duration of the works. Unfortunately, contractors are sometimes burdened with heavy losses as a result of incurring more cost than originally budgeted for.
In the absence of explicit contractual clauses that permit adjustments in cost, then contractors may only be able to construct a case whereby the reason that the contractor has suffered losses is the result of an employer risk event under the contract that entitles the contractor to recover its losses.
For example, where the contractor has suffered delay as a result of an employer risk event, and that risk event entitles the contractor to recover cost, then the contractor may be entitled to recover the associated damage or the additional cost incurred for the specific employer risk event. In such cases, the recovery of damages or additional cost incurred is unlikely to be demonstrated through the use of formulae.
Price escalation formulae
Some construction contracts do include clauses whereby the quantification of price escalation using formulae is accepted. For example, Sub-Clause 13.8
[Adjustments for Changes in Cost] of the FIDIC Red Book 1999 and secondary option X1 for the NEC4 contracts (Options A, B, C and D) offer formulae to calculate price escalation. These formulae often contain two main variables that require careful consideration by contracting parties before agreeing on formulae in construction contracts.
(1) Proportions of the Contract Price Subject to Price Escalation
Price adjustment formulae often set out the proportions of the Contract Price that can be adjusted and the proportions that cannot be adjusted due to price escalation. This information is normally included on a percentage basis in a table of data in the appendix to the contract. For example, a table of data may show that the adjustable proportions of the contract price are labour, materials and equipment on a 20%, 50% and 15% basis respectively, and the non-adjustable proportions that are not subject to price escalation are 15%. Some of these proportions may be broken down further, such as steel for reinforcement and concrete for foundations.
The proportions described in the table of data should therefore reasonably reflect the proportions included in the contractor’s priced estimate of the works. For example, if the contractor’s estimate of the works for a mechanical and electrical project included 20% for steel pipes and 30% for cables and wires that are subject to adjustments, then this data should be accurately reflected in the table of data for the agreed formulae.
(2) Reference Price Indices
Consideration should also be given to the reference price indices used in the quantification of price escalation. These indices should be applicable in terms of relevance, reliability and geography i.e., the locations where the goods were purchased from. For example, for a construction project located in Europe, it may be advisable to adopt indices that collate specific data in European countries, such as Eurostat, rather than from the Federal Reserve Economic Data which may contain data more relevant to the United States of America.
Further, if an aggregated price index is used, then the data collected by the statistical body should be relevant to the works being undertaken by the contractor [8].
For example, an aggregated index for residential house building in the UK, may not be appropriate for a structural steel frame project or a roads and infrastructure project located in Norway.
Summary
Recent global events have put a spotlight on the impact that price escalation can have on construction projects. Price adjustment formulae offer a pragmatic way to calculate rises and falls in prices without the burden of establishing actual losses incurred, but only if an agreed mechanism is included in the agreement.
Careful consideration must be given before contracting parties enter into a construction contract so that an appropriate formula is included.
When contracting parties have not included a price escalation mechanism in their contract, then it will be necessary to substantiate the actual damage or additional cost incurred as a result of an employer risk event. This would normally require extra effort than simply relying on an unagreed formula, as an accurate quantification of actual losses incurred will be needed. The general rule that the asserting party must prove an actual loss has been incurred as a consequence of a breach of contract will apply.
In the absence of a contractually agreed formula, a third-party dispute resolver will apply the conventional approach of understanding the duties of each party under the contract, decide whether a given party has committed a breach of contract, and then ascertain the damages flowing from the breach. Unagreed formulae and indices may assist with settlement negotiations, but they will not be sufficient in front of a third-party tribunal.
Practitioners should therefore obtain expert advice on the suitability of a formulaic approach for the quantification of price escalation when agreeing construction contracts. Likewise, if you are experiencing a significantly delayed project caused by another party to the contract, but do not have the benefit of an escalation provision, there may be other avenues to explore that could mitigate the effect of price escalation. Ultimately, success always depends on what your contract says and the specific facts of your project.
This article was written for issue 27 of the Diales Digest. To view the publication, please visit: www.diales.com/diales-digest-issue-27
1. https://www.ship-technology.com/features/global- shipping-container-shortage-the-story-so-far
2. https://www.iea.org/commentaries/what-is-behind- soaring-energy-prices-and-what-happens-next
3. https://www.iss.europa.eu/content/europes-energy- crisis-conundrum
4. https://www.europarl.europa.eu/RegData/etudes/ BRIE/2023/739366/EPRS_BRI(2023)739366_EN.pdf
5. https://ec.europa.eu/eurostat/statistics-explained/ SEPDF/cache/51867.pdf
6. The CPPI is a European Union (EU) business cycle indicator that measures the prices of construction activities (new residential buildings). The CCI shows the trend in materials, labour, equipment and energy costs of new residential buildings in the EU.
7. https://ec.europa.eu/eurostat/databrowser/view/sts_inppd_m$defaultview/default/table?lang=en
8. Aggregation means the process of combining or adding different sets of statistical data to obtain a higher level of statistical data.