Construction contracts: mitigating the challenges presented by economic instability

A falling pound, inflation at its highest rate since the 1980s and price volatility not seen since the 1970s mean that the already struggling construction sector has entered a challenging period. Whilst the pound has largely recovered from the record low of USD 1.03, economic forecasters continue to predict parity with the US dollar by Q4 and inflation remaining high in the medium term. This means that the sector must take proactive, collaborative steps to mitigate the pressures it finds itself under.

Challenges facing the construction industry

The challenges the sector is facing are wide-ranging. These challenges include:

• increases in the price of materials (particularly energy, steel and timber), labour and imports, resulting in supply chain pressures and shortages of materials and labour;
• increases in the cost of fuel, resulting in the increased cost of operating fuel dependent plant and transporting materials and labour to site;
• greater difficulty in obtaining funding for projects, particularly in relation to projects which are high in value, complex or which have a long build time; and,
• coverage issues, particularly in securing coverage given a perceived increased risk profile as a result of price inflation and in relation to builders’ risk and construction all risk policies where coverage is linked to the estimated contract price and contractors find themselves underinsured as a result of price inflation.

Taken together, these challenges result in delays to completion, reduced profit margins and a greater risk of insolvency.

What steps can parties take to mitigate the challenges?

The challenges faced impact on current and future projects. In both circumstances, the parties should be looking to manage the risks of price inflation over the lifetime of the project in a manner that is fair and proportionate to all parties involved.

In respect of current projects, it is important to carry out a comprehensive risk analysis of the life of the project. This risk profile will aid in identifying the particular challenges the parties face and will assist the parties in setting a collaborative path. The next step is to consider the terms of the relevant contracts. If the contract contains fluctuation provisions, the parties should ensure that these provisions are operated properly and fully. If the contract does not contain fluctuation provisions and price inflation is having a detrimental effect on the project, the parties should manage the challenges proactively and collaboratively. These steps will include mitigating price increases and supply problems and considering whether it is prudent to reach a deal to re-allocate the risk of price inflation in whole or in part to a party better placed to absorb the additional or increased cost.

In respect of future projects, there are several steps which will hold parties in good stead:

• carrying out an early and comprehensive risk assessment;
• carrying out early and comprehensive financial planning, including funding and insurance;
• planning for early and comprehensive set-up of the project, paying particular attention to the forms of contract, the design and coordination of the project and the methods of construction;
• planning for the early sourcing of materials and payment thereof; and,
• thorough consideration of the allocation of risk of price fluctuations.

The allocation of risk of price fluctuations can be achieved by several methods and it is imperative to select the method most appropriate for the particular project and the particular challenges that project is likely to face. The most transparent method to address price fluctuations is to have clear, express provisions in the contract. Standard form contracts, such as JCT 2016 and NEC4, include a range of fluctuation provisions which can be selected or amended as appropriate. If the parties are utilising a bespoke contract, then thought will need to be given either to adopting clauses from a standard form or linking price increases to specialist building and construction price indices. The price indices most commonly used are those provided by the Building Cost Information Service (BCIS) and the Department for Business, Energy and Industrial Strategy (BEIS). As with standard form contracts, it is necessary to select the most appropriate index for the particular project and the particular challenges faced. Parties should not rely on non-construction specific indices such as the Retail Price Index or the Consumer Prices Index. If there is no scope for including fluctuation provisions in the contract, the parties will need to agree a contingency to allow for price inflation.

Whilst the challenges facing the already struggling sector are significant and widely felt, any party to a construction project would be wise to take proactive steps to mitigate the challenges faced by focusing on prudent risk and financial management of both current and future projects.

If you have any questions on mitigating risk and financial issues in construction projects, please contact Louise Elmes.