Rising and falling in 2022 – Contractual responses to cost increases in construction contracts

A lot has happened in 2022 to keep the construction sector on its toes. An ongoing pandemic, floods and sustained wet weather across the Eastern seaboard, supply chain disruption, a change of federal government, war in Ukraine, high profile insolvencies (in particular the residential construction sector), tight labour markets and last, but definitely not least, sustained price rises and other inflationary pressures.

We have focused on the last two items in this article.

There has been no uniformity in how contracting parties in the construction sector have responded to the commercial pressures associated with the rise and fall in the cost of trades and materials. It is very clear that one size does not fit all.

Responses have ranged from a refusal by a principal or head contractor to take any risk in rise and fall, through to contractors and subcontractors proposing contractual positions that are so broad that a lump sum contract effectively becomes a ‘cost plus’ contract.

We have also seen a wide range of more middle ground positions, under which an agreed class of materials or trades are subject to rise and fall.

Our tips for drafting a workable rise and fall mechanism that will not end with one party feeling aggrieved include:

• Objectively considering what risk each project has in relation to rise and fall. If the project is for a short duration and a contractor, supplier or subcontractor has a guaranteed supply of materials that are locally available, then there may be no need to include a rise and fall clause.
• Clearly defining in the contract those trades and materials that will be subject to rise and fall, rather than having a general position for rise and fall for any materials or labour.
• Carefully considering how claims for rise and fall are assessed and what information is provided. Given that a ‘rise and fall’ mechanism is a risk sharing position, it is reasonable for the supporting information to be provided on an ‘open book’ basis.
• Considering whether there will be a range (say +/- 10% of an agreed baseline price) for which a contractor or subcontractor will wear the increased cost (in the case of a cost increase) or have the benefit of a decrease (in the case of a cost decrease). This position should be considered for consumables such as fuel that often vary in price across the course of a project.
• Before agreeing to link an entitlement to rise and fall to a price index, consider whether it is appropriate. Indexes can lag the costs actually incurred on a particular project. It may be easier to administer if there is an agreed baseline rate in the contract, and any entitlement to rise and fall is assessed on the actual rate paid.

We have also seen:

• Clauses that only consider a rise in costs. When drafting the clause, it is reasonable to allow for a fall in costs as well as a rise in costs. This should be considered in particular where a project has a longer duration so that one party does not receive a windfall when the original intent was to assist with managing that party’s risk.
• Clauses that are drafted so that the principal or head contractor still has what is effectively a discretion on whether to agree to pay additional costs, even in circumstances where an increase in cost has been clearly demonstrated. While including this discretion is a benefit to the principal or head contractor, it may be fairer for the contractor or subcontractor to have a clear entitlement to be paid for its additional costs when they have been clearly demonstrated.
• Rise and fall clauses that include a threshold (for example, $50,000), where a party is only entitled to claim additional costs when that threshold is exceeded. The difficulty with including this mechanism is how to administer the process fairly. The reasons for the cost increase may be within the contractor or subcontractor’s control rather than because of ‘true’ rise and fall. For example, if a party has simply made an error in a tender, then this is a different position from where a party has calculated its price based on a rate or a price at a point in time and that rate or price has increased for reasons beyond its control.

Whatever mechanism is agreed during tender negotiations, including a rise and fall mechanism will require additional contract administration. All parties must ensure that their project teams are clear (and aligned) on what the mechanism requires and that the personnel administering the contract follow the agreed contractual process. To do otherwise will increase the possibility of disputes.

In addition to including a specific rise and fall clause, other approaches to managing rise and falls in trades and materials include:

• Using the provisional sum clauses in contracts for trades, goods and materials that would usually have been lump sum prices.
• Paying for goods and materials that would usually be procured on a ‘just in time’ basis as offsite or unfixed goods and materials in order to secure those goods and materials at a fixed price.

Will we be rising and falling into 2023?

When material and labour costs stabilise, we expect that rise and fall clauses will quickly become less popular. There are smoke signals such as falling shipping costs that suggest that pricing will become more predictable in 2023. We also expect that all parties – often driven by project finance – will look to have increased cost certainty as soon as possible. However, exactly when that will happen in the current economic environment is uncertain.

Considering what risk you will take on in relation to fluctuations in costs at the start of a project (and making appropriate cost allowances up front) will benefit all parties to the project.

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Authored by:

Jim Demack, Partner
Paul Calvert, Partner