The construction industry has had to mitigate the effects of Brexit and COVID-19 and is now beset with additional inflationary pressures in the wake of the war in Ukraine. This article is the first in a series on how the industry may manage projects in this environment.
Unfortunately, inflation is unlikely to be brought under control in the short term and will be with the industry for some time to come. This means that businesses across the supply chain need to find ways to manage the risks of cost escalation over the life of a project that are fair and proportionate to all parties. This may lead to a re-allocation of risk in existing and future contracts.
What is a fluctuations clause?
A fluctuations clause is a contractual term allowing the price of a construction contract to be adjusted to reflect changes in the law, the cost of materials and/or the cost of labour during the contract period.
Fluctuations clauses in standard form contracts were usually deleted when prices for construction projects were stable, because contractors were prepared to accept the risk of any increase in the cost of materials, plant and labour. However, recent events have caused price volatility not seen since the 1970s, particularly of key construction inputs such as energy, steel and timber, as well as wage inflation. Fluctuation clauses increase the Contract Sum in accordance with objectively measured price rises.
There are a range of fluctuations clauses in standard form contracts and which ones are adopted needs to be considered carefully in relation to the overall project and duration. For example, certain fluctuation provisions may be more appropriate for projects of a longer duration or for particular materials that are subject to high price volatility.
Regardless of the provisions of the contract, if cost inflation is seriously impacting the project or one or more of the parties, then all parties should work together to find a way to manage it.
Where can I find fluctuation clauses in standard contracts?
In JCT 2016 contracts, there are three fluctuations options to choose from to cover different types of price increases:
- Option A covers contributions, levy and tax fluctuations (essentially statutory changes)
- Option B covers labour and materials cost and tax fluctuations
- Option C is a formula, which adjusts prices, using cost indices produced by the RICS.
Fluctuations clauses can be incorporated by reference in the Contract Particulars. The Contract Conditions also include the operative clauses in the payment provisions of each contract which are essentially additions to the interim payments. The current default provision is Option A but .parties should consider whether for example Option C, which is broader in scope may be more suitable. The JCT Minor Works and Intermediate Building Contract forms only contain the Option A provisions and do not refer to the other JCT Options, but these other options can still be incorporated by clear reference. The logic for this is that these contracts are designed for simpler projects with shorter work programmes. The Contract Particulars also enable users to specify their own fluctuations provisions. Options B and C are available on the JCT website.
In NEC4 contracts, there are three groups of options in relation to price inflation:
- Under Options A and B, there is a lump sum for the works and the supplying party carries the cost risk, including inflation, save for Compensation Events that can allow for more time or money, or risks allocated under the terms of the contract.
- Under Options C and D, the parties agree a target price for the works and respective shares of savings (where the works come in under budget) or overrun (where the price is exceeded) – otherwise known as pain/gain sharing. The proportions are agreed within the contract and do not have to be a 50/50 split.
- Under Options E (cost reimbursable contract) and F (management contract), the parties agree levels of overheads and profits and the client pays the agreed overheads and profits, plus the actual cost of the works, so in effect, the client carries the risk on costs, including inflation. However, under Option F, risk allocation can be varied using the options chosen in the specific sub-contract.
Fluctuations are dealt with in Secondary Option X1. Where this is used, the details needed for calculating the adjustment need to be set out in the Contract/Subcontract Data.
If negotiating a contract how can inflation be addressed?
The starting point is whether the proposed terms and conditions allow for any price increases and if not, the parties should consider how it can be best addressed in relation to all the circumstances of the project.
If the works are being procured by way of a standard form contract and it is agreed that the contract’s fluctuation provisions apply, then this must be made clear by making an entry in the Contract Particulars/Contract Data and in any schedule of amendments to the contract that the fluctuation clauses are being used.
Attention must also be paid to the date inserted into the contract for the “Base Date” from which any fluctuation provisions will apply:
- In JCT contracts, the Contract Sum is deemed to have been calculated at the agreed Base Date. The Base Date is usually stated to be the date of the tender or priced offer, which means that the risk of inflation between the tender and contact execution lies with the supplying party. However, if the date of execution of the contract or commencement of the works is used as the Base Date, then the risk of inflation over this period rests with the employer.
- In NEC contracts, if Option X1 is utilised, the parties also need to specify the base date from which the inflationary indices will apply.
If the proposed contract is entirely bespoke, consider whether there are any existing clauses allowing for payment adjustments or variations due to price inflation and make sure they work for all parties.
If not using standard contract fluctuation provisions, consider seeking to agree to link price increases to other published building and construction price indices best suited to the project, such as those compiled by the Department for Business, Energy and Industrial Strategy (BEIS) and the Building Cost Information Service (BCIS). Whatever index is used, check that is adequately and regularly updated as needed.
It is not recommended to use general indices such as the Retail Price Index (RPI) or Consumer Price Index (CPI), as inflation on certain construction supplies, such as steel and timber, may continue to run considerably ahead of general inflation. Parties should seek to use those indices that best reflect the nature of the relevant works.
If there is no scope for price increases in the contract, consider carefully at the time of tender what contingency should be taken into account to cover any such increases.
Produced on behalf of and in conjunction with Build UK.