The Risk of Volatile Prices on a Building Project

Blog author: Peter Hibberd

In September 2021, the Bank of England stated that inflation may reach 4% by the end of that year. The talk, by some, that this was alarmist and that we should not overreact to rising prices is now seen to be way off beam. General inflation has increased significantly since then and in September 2022 it had risen to circa 10% according to ONS. How wrong can one be! The construction materials indices are even more variable and reflect price increases in specific materials affected by supply problems. Overreacting now to inflation and volatile prices is one thing but making sensible provision is another.

Fluctuations in labour and material prices in relation to construction projects can, and do, quickly erode a contractor’s margin. Conversely, overproviding for them in a tender means the employer pays more than necessary. Over recent years, prior to the start of 2021, price inflation had been benign. That situation led to those entering building contracts giving little consideration to its impact and for the need to incorporate fluctuations provisions in their contracts. Consequently, much knowledge of fluctuations, together with the expertise to advise and calculate them, has been diminished.

Prior to 2021, yearly inflation had, since 1992, only exceeded 5% on one occasion, so perhaps that is not surprising. However, during the previous twenty years (1971-1991) it was seldom below 5% and reached a peak of over 24%. That is history, and many people never contemplated that history would repeat itself.  Well, it seldom does exactly, but sufficiently enough to put one on notice. History, and indeed economics, will also tell us that a significant upward movement of prices, such as we have been experiencing recently, can also quickly turn downwards, particularly so for certain goods. The question then becomes, are we going to react to inflation just as the curve turns downwards. Maybe, maybe not. The problem is we do not know, we can only make an informed assessment. What we do know is that over the past year or so there has been increasing concern about inflation because of monetary and fiscal policy, both here and abroad. Furthermore, inflation is being exacerbated because of shortages, both of materials and labour, and additionally could also lead to project delay, which could further affect the prices paid for construction inputs. Also, there is a greater risk because of an increase in geopolitical tensions.

Predicting inflation rates in such circumstances is fraught with difficulty and it is now clear that inflation is a bigger problem than many have previously encountered. Although it may be near, or over its peak, it will remain a significant issue for some time. Therefore, it is prudent to make provision for dealing with price volatility in a building contract. That is generally true, regardless as to whether inflation is benign or otherwise because volatility in levies and prices can emerge without much warning. Provision for inflation in a building contract should not be by just simply increasing the tender price by an arbitrary figure, or indeed pricing the risk in a sophisticated way. It may prove more than adequate, and the building employer may well pay more than they might otherwise. Conversely, it may be inadequate, and the contractor suffers loss that in some instances could be terminal. Some see the main advantage of fluctuations is that the employer only pays the actual cost incurred rather than the contractor’s estimate of increased costs, however, others understandably have a different view.

The increased possibility of changes to the types and rates of contractor’s contributions, levies, and taxes payable as an employer, was evident with the recent introduction of the national insurance surcharge, albeit quickly reversed. It is a sign of the times and of how quickly things can change. There is a need to keep an eye on government finances following the cost of support provided during the coronavirus pandemic and any consequent decisions to redress the situation. Such events could readily trigger other changes in contributions, levies and taxes and there is an increased chance that such changes will arise. Although VAT is outside the remit of the fluctuations provisions, and not adjusted under them, it is still another factor that may have an impact.

The other issue that urges consideration of the incorporation of fluctuations provisions is that there can be significant volatility in the cost of materials regardless of general inflation. Construction material’s inflation frequently diverges from general inflation. Two years ago, when general inflation was around 2%, we could see, for example, the World Construction Industry Steel Purchasing Price Indices showing a 40% increase between April 2020 and February 2021, and that the oil price had risen by close to 400%. Consequently, where there is a high content of certain items in a building project, contractor’s profit margins can be put at risk, unless there is protection under the contract. Or, depending on the timing of events, employers would pay more than they need. During 2022 these figures have changed significantly. General inflation is now around 10%, whereas the price of steel and diesel has fallen back. Shortages in supply exacerbate price increases and it is not difficult to identify commentators predicting that certain materials will be likely in short supply during 2023. The point here is that we are seeing wide variation in input prices and the ability to second guess what they will be at the point of purchase during a building project is extremely limited.  Therefore, as a matter of risk management, one must consider the effect of inflation upon the building contract at the time of entering the contract. A point that is made in the Construction Playbook version 1.1 September 2022 under the section on risk allocation, but curiously, not made in the earlier version of December 2020. A sign of changed times.

In determining the approach to fluctuations, the usual principles of risk management should be followed. That is assessing what chance the risk will arise, who is best able to assess that risk and who is best placed to mitigate and/or incur the consequences of that risk should it arise. When carrying out this process in relation to fluctuations we should keep reminding ourselves that although prices generally trend higher, they can go down as well as up and often do following steep rises. Fluctuations provisions in a building contract are for the benefit of both parties, but they are seldom viewed that way.

The RICS published a guidance note entitled ‘Fluctuations’ in 2016 and which sets out what it considers best practice. In that guidance it makes the point that QSs need to be familiar with the respective contract methodologies, and the associated means of assessment. Fluctuations are also referred to at 2.6.1 in the RICS New Rules of Measurement 2nd edition UK October 2021 (NRM2). RICS members are on notice and must act with care. A failure to do so puts them at risk of professional negligence.

JCT has always recognised the risk of inflation and makes provision for it in its fluctuations clauses. JCT provides for three approaches to fluctuations, namely Option A (which deals only with contribution, levy, and tax payable as an employer), Option B (which additionally covers labour and materials costs) and Option C (formula adjustment using the Formula Rules).

The principal 2016 editions of JCT contracts that refer to all three Options are: Design & Build Contract (including its sub-contracts), Standard Building Contract (including its sub-contracts), Intermediate Named Sub-Contract, Construction Management Trade Contract, and the Management Works Contract.

The Minor Works, and the Intermediate Building Contract, only contain what is Option A, with no reference to the Options B or C. The logic is that those forms of contract are for small scale, short duration work and, consequently, the risk is deemed to be small, perhaps to be accurate one should say smaller. Smaller contractors and clients can be impacted disproportionately because of their inability to withstand relatively small changes. Consequently, in certain circumstances, such as those which currently prevail, it is appropriate to consider whether Option A alone is sufficient, and indeed, the Contract Particulars of those contracts allow for the incorporation of Options B or C by clear reference, or the insertion of the parties’ own fluctuations provisions.

In September 2020, I advised that ‘in such circumstances those entering contracts for projects of more than a few months should consider the desirability of using a suitable fluctuations provision.’ That advice remains because everyone must now be aware of the problem with rising prices and increasing volatility.

By contrast to other JCT principal contracts for large scale works, neither the Major Project Construction Contract nor the JCT – Constructing Excellence Contract expressly contain fluctuation provisions. However, that does not mean they cannot provide for them. That can be done through the Pricing Document under the Major Project Construction Contract, and by identifying fluctuations as a risk under the JCT – Constructing Excellence Contract when the contract sum option is used. In either case, one must include or specifically identify details of how fluctuations will be determined. Such requirements may be modelled on one of the JCT Options. At present, fluctuations are a significant risk, and the allocation of that risk needs particular consideration.

To reiterate, it is essential prior to entering a contract to carry out a risk assessment, which must include fluctuations, and the availability of materials and labour. Such an assessment will guide the user to the most appropriate means of dealing with the identified risks. Current circumstances suggest that wide cover is secured in respect of fluctuations unless one is entering into cost plus type arrangements. That means the use of either Option B (Labour and materials cost and tax fluctuations) or Option C (Formula adjustment).

The time involved in preparing calculations, especially for materials, under Option B, has put off some practitioners from using it, but it should not because all approaches to calculating fluctuations involve time and effort with the exception of a broad-brush approach. The latter approach of a single index, or similar, may work but its accuracy for any given project is questionable. Whatever route one chooses it is essential that there is the experience in the team to ensure that fluctuations assessments can be properly carried out. If not, it could lead to claims, and with a myriad of associated problems.

Where Formula adjustment is adopted, it is prudent to consider the Work Category method in preference to the Work Group method because of hugely variable price changes related to some materials and trades. In such circumstances it should more accurately reflect the differences that arise. The BCIS currently publishes Price Adjustment Formula Indices (PAFI) for various sectors but those for building and specialist engineering are the most relevant for JCT contracts. The BCIS indices are a subscription service, which may lead some to make an alternative, and possibly inappropriate decision as to the fluctuations provisions to be used.

Never overlook the impact of volatility of wages and materials and changes to levies etc. To do so will often end in pain for one or other party. Be sure to incorporate the relevant fluctuations provisions following a risk assessment. General inflation is one thing, construction specific inflation is another. Where they simultaneously arise it spells an even bigger danger to the parties to the contract.