How is Inflation Impacting Existing Construction Contracts?

Have you reviewed your construction contracts following the rise of inflation? In this article, Construction Law Partner, Phil Caton, shares practical tips on what firms and sub-contractors should be looking for in existing contracts amid inflation.

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Through my role, I’m currently working with lots of companies acting as sub-contractors on major UK construction projects and one of the biggest challenges they’re faced with right now is contract fulfilment.

Sub-contractors who entered fixed-price lump sum contracts more than six months ago are finding that many of these existing construction contracts are no longer economically viable, and the ramifications are huge.

A lot of the issues being experienced can be linked back to Brexit, inflation, rising shipping costs, the increase in the cost of raw materials and labour shortages. The combination of all of these is causing something of a perfect storm in the UK’s construction market.

Some of those I speak with are seeing raw materials go up by as much as 50% and these costs only look set to increase as the cost of energy increases due to the ongoing war in Ukraine, creating lots of issues up and down the supply chain.

One of the key points I make to clients is that the courts won’t rescue you from a bad deal and therefore, risk management is vital. The situation right now means it is possible that we could see more cases in court, but not if the issue is purely an economic one, so construction companies must tread carefully as we navigate the tricky waters ahead.

Issues around fulfilling existing construction contracts

Whilst there are many ways in which construction works might be procured, the most common form of a construction contract is a lump sum contract. Under a lump sum contract, a single price for all works is agreed upon before the works begin.

There are generally only limited circumstances in which the contract sum can change and therefore if the cost of procuring materials or labour increases during the term of the contract, the sub-contractor bears the risk of such increases.

When you consider that most construction projects run over several months or years, it means longer contracts and therefore more inflation risk to be mindful of. Prices can be calculated to a certain point in time and this is called the “base date”. The price is fixed by reference to the base date which is usually the date that the sub-contractor returns his tender, effectively providing his quote for the works, and given the current market volatility, it is good practice to push for this to be built into any contracts as close to the start date for the works as possible that construction companies are considering bidding for.

Although there are some other forms of contracts that can and do offer more flexibility if set up correctly with the right expertise and support, I’m finding that many companies are now committed to projects with quotes or costs that are, to put it simply, financially unviable.

Managing market fluctuations

Many in the construction industry are now dictating fixed sums – this is usually directed from the top down. It starts with the funder such as a bank which requires a fixed price so that they have assurances that the project will be completed within the loan facility they provide. This approach is then passed down the supply chain from bank to employer, employer to contractor and then contractor to sub-contractor.

Given these negotiations, the sub-contractor usually has little bargaining power to object to a fixed price lump sum if that is what has been agreed in the existing construction contracts further up the supply chain.

One of the most popular suites of construction contracts used in the UK is the Joint Contract Tribunal (JCT) suite, which dates back to 1931. 

Historically, it has contained the traditional full fluctuations provisions for labour and materials (called Option B) which means that if the cost of materials or labour increases, the sub-contractor is entitled to an adjustment to the contract sum to allow for this.

In the latest edition of the JCT suite (the 2016 edition), Option B is not included in the JCT contract document, but it continues to be available on the JCT website.

As JCT pointed out in their October 2021 blog, inflation since 1992 had only exceeded 5% on one occasion, so it is not surprising that Option B had fallen in popularity with the perceived risk of inflation being so low. But inflation is now more than 9% (as of May 2022) and is expected to reach 11% later this year with predictions of a recession, highlighting how serious the situation is right now.

What we’re seeing, as a result, is a shift in the market towards full fluctuation provisions. While full fluctuation provisions for labour and materials have fallen in popularity in recent years given that inflation has been relatively stable, soaring costs over the last 12 months are making more parties consider inflation clauses.

Key considerations for sub-contractors in construction

When it comes to managing some of the macro issues that are impacting the UK’s construction sector right now, I believe early communication is key. Not only is this often a condition precedent to a sub-contractor’s claim, but it ensures that the matter can be considered at an early stage and possible mitigation strategies considered.

Sub-contractors should be looking to work with partners who understand global market impacts. I am seeing that certain funders and employers would prefer to increase the loan facility or allow increases to contract sums to accommodate increased costs within the supply chain, rather than applying a more rigid and contractual approach to costs in order to get a project over the line.

Similarly, we are also seeing an increase in the number of sub-contractors who are not prepared to tender on a lump sum basis and therefore it will be increasingly important that those operators further up the supply chain are prepared to adopt a more flexible approach to pricing. This will ensure that there is adequate interest from the supply chain in taking on their project.

Another important aspect is having partners on board who pay their sub-contractors on time, as this also helps the sub-contractor to lock in better prices and improves the probability of a successful project.

What happens if issues regarding existing construction contracts cannot be resolved?

If matters cannot be resolved amicably in the event of a disagreement, sub-contractors should consider seeking early legal advice.

However, there are measures that sub-contractors should consider in the current climate to mitigate the risks of inflation.

These include:

• Use of cost fluctuation provisions such as JCT Option B or NEC Option X1
• Work specifications could be drafted to give Sub-contractors greater flexibility when procuring materials, this can be useful, particularly when materials are on long lead times, imported from outside the UK or are in limited supply.
• Provisional sums could be allowed to give greater price flexibility
• Advance payments could be negotiated to secure the early procurement of materials, particularly those at risk of extreme price volatility
• Tender prices could be subject to continuous monitoring to the point of entering contracts, to ensure that those older tenders are still appropriate
• Sub-contractors could consider moving away from lump sum fixed contracts where negotiations will allow it and pricing the contract on a “target cost” or “cost reimbursable” basis.
• Where this is not possible and lump sum tendering is the only option, sub-contractors should consider entering the contract close to the time that materials will need to be purchased so that the procurement risk for materials is low. Sub-contractors should also try and negotiate for “listed items” so that they can be paid for materials or goods prior to their delivery to the site.
• Consider the duration of the contract. Shorter contracts will have less risk with regards to inflation risk and the cost of labour/ materials will be more foreseeable.
• Consider contract value. Contracts representing a higher percentage of the subcontractor’s overall turnover will carry more risk if costs increase. Working across smaller schemes may help mitigate inflation risk than working on fewer large schemes.

It is important that sub-contractors consider these issues and deal with them prior to submitting their tender so that the risks can be factored into the overall sub-contract price. Often, such issues are not considered until after tenders are submitted and the draft sub-contract has been received for review, at which point, the sub-contractor has lost some bargaining power.

Sub-contractors may take comfort from the fact that they are not alone in dealing with this issue and the Construction Leadership Council has set out plans to mitigate the impacts of steep inflation. The organisation has developed a five-point plan to ease the impact of construction inflation.

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If you require advice or support relating to any of the construction law matters raised in this article, please don't hesitate to contact Phil Caton, by completing the enquiry form below.