Labour and materials prices on the rise: Understanding escalation risk in construction contracts
Price escalation for labour and materials is hitting Australian construction projects hard. Global supply chain disruption, fuel shortages, inflationary pressures and geopolitical instability continue to squeeze project pricing and delivery. This article explores how existing contracts likely deal with inflationary pressures and what options are available to best manage the risk.
Part 1: Impact on existing contracts
Fixed price contracts:
Most major construction contracts entered into prior to the Iran conflict are fixed price. They typically provide that the lump sum price includes all amounts necessary to complete the works and are not subject to rise and fall adjustments, including for labour and materials cost escalation. That means the contractor, not the principal, carries the risk of cost escalation.
Force majeure
Many people (contractors especially) are reviewing force majeure clauses in their contracts (to the extent they are included at all) in light of the impacts on performance as a result of the Iran conflict. In Australia, force majeure has no common law definition; it depends entirely on the contract. Even where triggered, force majeure clauses will typically entitle a contractor to relief through a right to suspend work or claim an extension of time only, not additional costs. For a broader discussion of how force majeure provisions operate in periods of geopolitical and economic disruption, and the associated insolvency and director risk considerations, see our earlier article here.
Delay costs: a narrow path
Contractors may try to link rising costs to delay events. However, standard building contracts usually confine compensable causes to principal caused delays and variations. Price escalation caused by supply chain disruption, labour shortages or market volatility is typically not recoverable as delay costs.
Provisional sums: tightly controlled
Provisional sums allow contractors to recover actual costs for specified works or items when instructed to proceed. Where the actual costs are higher than the original estimated amount, the contractor is entitled to recover its actual costs. However, provisional sum clauses do not operate as a general escalation adjustment and do not re-open pricing of the broader works.
Change in Legislative Requirements
This standard ‘change in legislative requirements’ clause in building contracts became a focal point during the COVID pandemic when contractors sought to claim escalation costs through the change in law provisions. The difficulties with this type of claim is first identifying the change in law (during COVID-19, laws were passed restricting trade and labour – there is no change of law resulting from the Iran conflict) and secondly, linking the additional costs as being caused by the change in law (providing evidence of causation is difficult).
Frustration: an uphill battle
In extreme scenarios, a contractor may argue that the contract is frustrated. Australian courts have consistently treated price escalation, supply cost increases and market volatility as foreseeable commercial risks. A contract will not be treated as frustrated simply because performance has become more difficult or expensive, however severe the price rises.
Part 2: Solutions to deal with price rises in new contracts
There are a number of solutions available to manage rising construction costs, which include the following:
| Solution | Description |
|---|---|
| Cost escalation clause | Where pricing has been obtained prior to the Iran conflict but a contract has not yet been signed, a cost escalation clause may allow for the pass-through of additional direct costs incurred by the contractor which are attributable to the Iran conflict. Such clauses should clearly define the scope of the affected materials, the applicable base rates for each items, extent of risk sharing (e.g. shared costs and/or maximum cap), as well as the process, timing and evidence required for a claim for a contract sum adjustment. A cost escalation clause may provide a mechanism for increased costs to be passed through to the principal, or shared between the parties. However, it is unlikely to be straight-forward to administer given that the cost of goods and materials rarely includes a component that is expressly linked to a specific oil or fuel price. There is a risk that general cost increases of goods and materials may lead to cost escalation claims, whether or not they are caused by the Iran conflict. |
| Alternative procurement model / open books | Adopting an open-book or cost-reimbursable procurement model (especially for select trades and contract packages) allows the principal to gain transparency over actual material costs, thereby reducing the risk of inflated tender prices arising from fuel-driven price volatility. This approach shifts the pricing risk away from the contractor and enables both parties to make informed decisions on expenditure in real time. However, these procurement models shift most cost risk onto the principal and typically do not provide the level of cost certainty required by principals and financiers for major projects. |
| Provisional sum allowance | Including provisional sum allowances for fuel-sensitive materials or works provides contractual flexibility to accommodate price uncertainty at the time of tender. This mechanism, commonly used in Australian Standard contracts, defers final pricing to the point of procurement and allows adjustment based on actual costs incurred. However, provisional sums are typically limited to specific items which remain subject to instruction by the principal. As such, they may not be well suited to address the broad impacts of cost escalation arising from the Iran conflict. Again, widespread use of provisional sums also undermines the cost certainty provided by fixed price construction contracts and may not be acceptable to principals and financiers. |
| Substitution of materials | Permitting the substitution of specified materials with suitable, cost-effective alternatives can mitigate exposure to price spikes affecting particular supply chains. Any substitution regime should be clearly defined in the contract, including approval processes and compliance with the relevant Australian Standards and Building Code requirements. |
| Resequencing and bringing forward orders | Strategically resequencing works or adjusting the dates for procurement of fuel-sensitive materials may allow parties to better manage market volatility by managing when pricing of individual subcontracts is locked in. This approach requires careful coordination with the construction programme and should be supported by contractual provisions addressing variations to sequencing and early procurement funding. Given the high levels of uncertainty regarding the Iran conflict and the restoration of global oil supplies, there is also no guarantee that early or late procurement of materials will result in cost savings. |
| Ex gratia – both sides compromise | Where contracts have already been executed and contractual mechanisms are insufficient or absent, parties may potentially agree on an ‘ex gratia’ or voluntary basis to share the burden of unforeseen price increases, preserving the commercial relationship and avoiding potential subcontractor insolvency and costly dispute resolution. Any such arrangement should be documented by way of a formal deed of variation or side agreement to ensure enforceability and to clearly record the basis upon which concessions are made. |
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Authored by:
Adrian Clifford, Partner
Daniel Middleton, Partner
Matthew Taylor, Partner
Emily Loader, Special Counsel
Get in touch
- Adrian Clifford
- Partner, Melbourne
- +61 3 9612 8427
- adrian.clifford@gadens.com
- Daniel Middleton
- Partner, Melbourne
- +61 3 9252 2520
- daniel.middleton@gadens.com
- Matthew Taylor
- Partner, Sydney
- +61 2 9163 3007
- matthew.taylor@gadens.com
