March 18, 2024
2023 was a volatile year for the Australian construction industry and current forecasts point to an equally unpredictable 2024. The construction industry continues to feel the effects of, among other things, wet weather delays, supply chain issues, labour shortages, and general escalation in material costs. Consequently, budget blowouts are expected to persist, along with the late delivery of projects across the country.
Particularly given the current construction climate, problems faced on site often lead to one party suffering significant loses. This pushes parties towards long and costly litigation to determine who contractually bears the loss. To mitigate this risk, Principals and Contractors alike must ensure likely risks are clearly addressed within contractual drafting to assist with prompt resolution if they arise. This is facilitated through clear and considered contractual drafting, in which parties’ liabilities are understood and accurately defined.
This three-part series will explore key contractual mechanisms to mitigate the above risks, namely:
- cost escalation clauses;
- time bars; and
- indemnity clauses.
COST ESCALATION CLAUSES
While the application of a lump sum contract provides cost certainty for Principals, Contractors bear the risk of fluctuating labour and material costs. This allocation of risk is not conducive to:
- Contractors who are unable (or reluctant) to confidently assess the risk of price changes for the life of the project; or
- Principals who will likely be required to pay an inflated price for the transfer of escalation risk.
As such, parties ought to seek to include mechanisms in their contract to manage uncertain market conditions, which may be facilitated through the utilisation of cost escalation clauses.
What are Cost Escalation Clauses
Cost escalation (or ‘rise and fall’) clauses are contractual provisions which allow the price of a lump sum contract to be varied in line with changes in market rates. Practically, it mitigates against the Contractor’s risk that prices increase beyond that allowed for when the contract was first priced.
While these provisions may act as a solution in ensuring that Contractors do not lose profits or potentially make a loss, they do reduce the principal’s certainty around the total cost of the project. It is ultimately more common for prices to rise than fall, which tends to favour the Contractor in terms of risk allocation. Consequently, including this provision may require negotiation between the parties during tender and careful drafting to ensure that the commercial interests of both parties are considered.
Considerations When Drafting
To avoid costly dispute resolution after-the-fact or the clause being rendered void, clear and precise drafting is required to moderate any ambiguity. In Perera v Bold Properties Pty Ltd[1], the cost escalation clause was ultimately considered void because it did not specify any criteria for how an increase should be calculated, which resulted in a significant imbalance in the parties’ rights. This has been echoed by the recent changes in the Unfair Contract Terms (UCT) regime which we will consider next week.
As such, cost escalation clauses should be carefully drafted to explain which costs can be covered, the method for calculating claimable costs, and the process for claiming price variations. Practically speaking, four critical elements need to be considered and included in any drafting, being:
- affected material and price;
- applicable price index;
- risk buffer; and
- reference and adjustment dates.
Affected Material and Price
Rise and fall clauses typically do not apply to the entirety of the contract price and therefore, the specific material or commodity which is subject to escalation needs to be clearly defined.
Applicable Price Index
Price indexes record the market price of a certain material or commodity that is to be used as a comparative figure to derive the claimable cost. The Australian Bureau of Statistics publishes a range of indexes, the most commonly used is the Producer Price Index which is the predominant price index tracking cost fluctuations of building materials. Alternatively, for residential projects, the ‘Input to the House construction industry’ can be used which includes the overall trends in prices for building materials across each capital city. While there is no index specific for commercial construction, for infrastructure projects the ‘Output of the Construction industries’ can be used where Contractor’s subcontract all works to independent subcontractors.
Risk Buffer
A risk buffer functions to apportion the risk of increasing material prices between the Principal and the Contractor. For example, the clause may stipulate that the Contractor bear the first 5% of the increase in material cost and then any above percentage is subject to the rise and fall clause. This reduces the Principal’s liability for cost increases and ensures more fastidious administration, such that both the Contractor and Principal don’t waste their time on trivial claims.
Reference and Adjustment Dates
The reference date concerns the date from which the rise and fall of the price of a commodity is to be calculated. This may be:
- the date of tender;
- the contract date; or
- a specific date following the Contractor’s access to site.
This is an important consideration as different permutations can have varying commercial consequences depending on market conditions.
Separately, adjustment dates concern when and how often prices are to be adjusted under the contract. This may be monthly, quarterly, or yearly depending on the scope of the project (or may even allow the ability to claim as increased material costs are incurred).
Plainly establishing and adhering to these dates is critical in claiming a variation. Most contracts will contain time bar provisions to prevent Contractors from claiming additional costs outside of the agreed times or if a party does not adhere to the agreed upon process. Stay tuned for part two of this series, where time bar provisions are explored in greater detail.
Lamont Project & Construction Lawyers
The Lamont Project & Construction Lawyers team has extensive knowledge regarding various contract mechanisms to mitigate current industry risks for both Principals and Contractors. With this knowledge and expertise, Lamont Project & Construction Lawyers can provide the required support and advise on major projects with respect to design risks across the life cycle of a project.
If you would like to discuss any matters raised in this article as it relates to your specific circumstances, please contact Lamont Project & Construction Lawyers.
The content of this article is for information purposes only and does not discuss every important topic or matter of law, and it is not to be relied upon as legal advice. Specialist advice should be sought regarding your specific circumstances.
Contact: Peter Lamont or Kathryn Easton
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