A problem for all disputes that may arise as costs escalate on construction projects

What you need to know

• Construction costs are projected to continue rising well into 2023, with a shortage of materials and labour combined with the unprecedented investment in the Australian infrastructure space contributing to price increases at levels never seen before.
• Increasingly, in this climate, contractors are pushing for the risk of cost escalation to be directly addressed in construction contracts, no longer comfortable with common mitigants such as contingencies.
• In the absence of an appropriate cost escalation clause, there is a greater risk of disputes arising as increased costs become practically unmanageable and contractors consider walking away from projects (with or without a legal right to do so). This can have a significant impact on project delivery.

What you need to do

• You should firstly consider whether fixed priced contracts are appropriate for your type of project.
• To minimise the risk of disputes and deliver value for money, you should consider implementing an appropriate cost escalation clause in your contracts, with a particular focus on what costs are escalated, appropriate indices, when the clause is triggered and any relevant restrictions on its operation. 
• Even with a cost escalation clause, parties should still tread carefully – if the clause is not drafted clearly and unequivocally, disputes surrounding the application of the clause inevitably arise.

In our recent Infrastructure Industry Update we discussed how cost escalation has created significant challenges for those procuring infrastructure across the globe.  While there is no "one size fits all" model to address the issue of cost escalation, it is apparent that to mitigate the risk, the approach needs to be tailored towards the specific project. We also discussed the ways in which procuring authorities in some jurisdictions have provided bidders a degree of protection against the current inflationary environment.

In this article, we look further at cost escalation clauses that parties may implement to mitigate these risks and the disputes that may arise in the absence (and sometimes even in the presence) of these clauses.

Why does cost escalation matter?

Construction costs are projected to continue rising well into 2023, as material and labour shortages fail to show any signs of abating.  

Contractors have traditionally borne the risk of fluctuating labour and material costs.  In the absence of appropriate cost escalation clauses, increased costs driven by labour and material shortages which may be largely outside of a contractor's influence could quickly become unmanageable, sometimes leaving the contractor facing a decision about whether to repudiate the contract and walk away.  This can lead to substantial delays to the project and even further costs to the principal, which may or may not ultimately be recovered from the contractor. 

As such, when the risks of cost escalation are not appropriately managed, there can be no winners.  

The key drivers of cost escalation 

As discussed in our recent Infrastructure Industry Update, the effects of Covid 19 continue to plague the industry, causing material shortages and production and shipping delays. Exacerbating this is the unprecedented investment in infrastructure across Australia, resulting in an abundance of major projects being procured simultaneously across the country, leading to significant demand for labour.  Reduced immigration as a result of COVID-19 has only worsened the skills and supply shortage.

While these issues are not new to the construction industry, the perfect storm of labour and material shortages and inflation have catapulted the industry into a period of rising costs never seen before.

How has the construction industry traditionally dealt with cost escalation?

Typically, cost escalation has been dealt with by: 

• the parties reviewing the allowances for construction or labour costs at various stages throughout the project's planning and procurement stages; 
• the parties purchasing materials in advance or "locking in" a fixed price with the relevant suppliers; or
• including a contingency allowance in the project budget, being a sum or percentage that covers any unforeseen events or risks arising out of the project.

Cost escalation clauses

It is becoming increasingly clear that in today's climate, contractors are less and less comfortable with the common mitigants outlined above and they may not deliver value for money to the principal.  Rather, parties are now seeking more certain mechanisms to manage cost escalation – costs escalation clauses. 

Cost escalation clauses can protect a contractor's interests by providing that the price of works is adjusted to account for an increase in material or labour costs.  Compare this to a traditional fixed-price contract, where the contractor is tied to the costs or rates agreed to at the time, regardless of any future fluctuations.  This can be problematic for projects that often take a lengthy period of time to construct and finalise.  A cost escalation clause shifts the risk in the principal's direction, though there are often limitations on the application of the clause.

The most common cost escalation provision is known as a "rise and fall" clause.  Using this mechanism, the parties agree that the contract price will be adjusted to reflect the indexation of specified project costs (but not volume).  This mechanism may apply to the period between tender submission and contract execution or (increasingly) may continue through delivery.

When considering rise and fall provisions, parties must be clear on how they will be applied in practice, specifically, what costs are escalated, what indexes are applied and when they will trigger.  For example, the clause may apply only when a specific threshold is reached (such as when material or equipment cost increases by more than a set percentage).

Other cost escalation mechanisms include cost sharing and benchmarking regimes.  Cost sharing involves the parties agreeing to target costs and each sharing a specified percentage of any cost overrun or underrun.  Benchmarking involves market testing specified costs at agreed points in time and adjusting the contract price based on prevailing market prices.

What disputes can arise in the absence of costs escalation clauses?

If a construction contract is not equipped with clauses that address cost escalation, it may be a breeding ground for disputes. 

Delay claims

Contractors with valid delay claims may be entitled to additional labour, material or equipment costs that arose as a result of the delay.  Where parties have not agreed on how to deal with rising costs, disagreements often arise as to whether the contractor is entitled to compensation for the increased costs. 

Change in law

Contractors may argue that unforeseen costs arising from a "change in law" should be passed on to the principal.  Contracts can include a "change in law" clause which addresses regulatory changes – such clauses may give the contractor rights to an extension of time, suspension, or additional costs in the event of such change.  An example of when a "change in law" clause may be enlivened is the recent COVID-19 measures in China.  These measures have impacted shipping timeframes and material availability, leading to increased costs for contractors.  A contractor may seek to argue that the measures constitute a "change in law" and that they are entitled to the recovery of such increased costs.  Whether or not such an argument has merit will depend on careful consideration of the specific language used in the relevant clause.

Force majeure

In contracts with force majeure clauses, contractors may seek to argue that the rise in costs outside of either party's control (or the factors causing such cost increases, such as COVID-19) constitute a force majeure event under the contract, entitling them to an extension of time or relieving them of their obligations.

Frustration

Contractors may also seek to argue that the contract has been frustrated, where, without the fault of either party, the significant price increase has rendered it impossible for the contractor to perform the contract as contemplated.

Typically, for both force majeure and frustration, the bar is set very high.  Price movements rendering it more difficult to perform the contract may not be sufficient, unless it can be proven that the obligations under the contract have become radically different to that contemplated by the contract and not simply more onerous.

Repudiation

In extreme cases, contractors or subcontractors may no longer be able to economically fulfil the contract if they are forced to bear the burden of the escalated costs.  As such, contractors may threaten to walk away from the project, effectively repudiating the contract.  Principals or owners can then elect to:

• accept the repudiation and terminate the contract; or
• continue with the contract.

In either case, the principal may be entitled to damages.  Such damages are likely to be calculated by reference to: 

• the loss which the principal/owner suffered as a result of the contractor's breach (eg the additional cost of having someone else complete the work); or 
• the profits the principal/owner would have expected had the contract been performed minus the costs they would have incurred to earn that profit.

While the principal may be entitled to damages, there may be substantial time and cost involved in pursuing a claim, as well as the risk that the amount owing cannot ultimately be recovered from the contractor (eg because of insolvency).  In the meantime, the principal may also be left struggling to get their project completed.

Can disputes arise even with the appropriate clauses?

The use of an appropriate cost escalation clause can help to reduce the risk of disputes arising.  However, it is important to recognise that disputes can arise even when parties are armed with the appropriate clauses.

As discussed above, a costs escalation clause will not necessarily cover all increases in material or labour cost and may be restricted in its application.  

Disputes can eventuate where there is a cost increase that the parties failed to contemplate and build into the clause.  Disputes can also arise as to the application of the clause itself, particularly in respect of when and how it applies and whether a price increase has been accurately calculated. For example, where benchmarking is used, parties may be in disagreement as to the applicable market price, affecting their respective calculations.  As such, expert evidence may be necessary to determine the accurate calculation of the cost increase.

Parties should ensure that the clause is drafted as clearly and unequivocally as possible so as to prevent any misunderstanding of its application.  This may include considering:

• specifically setting out the events that trigger the cost escalation mechanism (for example, a certain percentage increase in the cost of a specific material or service, calculated with reference to a certain benchmark or market rate); and
• an overall cap on the amount the contract price can be increased.

Parties should also consider including an appropriate alternative dispute resolution clause which provides an effective, efficient and appropriate forum for the dispute to be addressed.  Further guidance on drafting these clauses can be found in our Quickguide: Dispute Resolution Clauses.

Taking these preventative steps will help safeguard the commercial and financial interests of all parties involved.

Authors: James Clarke, Partner; Jennifer Ingram, Partner; James MacDonald, Senior Associate; Hanna Lee, Lawyer.