March 20, 2023
The costs to deliver an Australia project have soared due to extraordinary price escalation of materials, increased labour costs, rising interests rates, inflationary pressures, and continued supply chain disruptions. These pressures have pushed a number of industry participants to breaking point. Recent collapses of the industry’s bigger participants, such as Probuild and Condev, have reignited discussion surrounding the efficacy of the ‘traditional’ fixed price commercial model.
Fixed Price Dilemmas
Generally, the expectations under a fixed price contract are simple. The Principal pays a Contractor to perform a defined scope of works of which the Contractor must complete within a fixed time and at a fixed price. This may be a suitable model to adopt in more stable market conditions where project costs are capable of being forecast with a relatively high degree of accuracy. However, infrastructure and other large projects will span a number of years and it can be difficult to predict market conditions down the line. In periods of sustained market volatility, such as the present, a fixed price contract can be rigid and unforgiving, particularly for a Contractor who is unable to absorb a disproportionate amount of financial risk within a razor-thin margin. As we have seen, where market conditions take a turn for the worse, and persist for some time, the likelihood of business failures increase.
Significant and prolonged price escalation can mean disaster for even the most conscientious of Contractors. Increased business failures put further pressure on those projects left behind, in terms of both time and cost, and leave fewer construction firms in the market to deliver the national pipeline of work. Of the firms that are left and who have the expertise to deliver large scale projects, many are currently operating at, or above, 90% capacity (Source: Infrastructure Australia). Something has got to give.
With reduced Contractor capacity and a diminished Contractor pool, we may expect to see a number of changes in construction procurement norms and the types of project delivery models adopted for future projects. In practice, this might look like:
- a shift in bargaining power from Principals to Contractors;
- a decrease in Contractor appetite for one-sided risk allocation;
- an increase in Contractor selectivity of the types of projects and contractual models pursued;
- a decrease in procurement trends whereby Principals select bids at the lowest price possible, under an arguably mistaken perception of value for money; and
- an increase in Contractor preference for:
- more collaborative contracting options such as cost-plus or alliance contracts, rather than fixed price contracts;
- the inclusion within fixed price contracts of rise and fall mechanisms; or
- the provision within project bids of greater contingencies for unknown price risks.
An Equitable Future?
The traditional fixed price approach to allocation and management of price risks is due for a change. We are already beginning to see some changes through the adoption of cost-plus arrangements on a number of large long-term projects which pass on price risks directly to the Principal, while ensuring the Contractor retains its margin. Further, for projects already underway, we have seen an increasing number of fixed price contracts converted to cost-plus models, or varied to include price adjustment mechanisms.
As the number of players in the market continues to reduce, we expect to see an increase in Contractors driving the push for alternative contracting options which adequately allocate and manage unknown risks. We expect to see a greater surge in cost reimbursable contracting regimes in circumstances where Contractors command greater bargaining power and enjoy more flexibility in selecting the projects they wish to pursue. At the very least, we expect to see fixed price contracts with significant cost reimbursable elements which wholly, or partially, protect Contractors from unknown price risks. This could come sooner, rather than later, if we do not see a meaningful shift in approaches to procurement, largely supported by Principals.
Parties can navigate through the current challenges by coming to a clear understanding on:
- scope of works;
- price escalation; and
- allocation of risks.
Further, parties should administer their contractual arrangements as written. If price certainty is a requirement, parties may address this through the importation of a target cost mechanism into a contract which incorporates pain and gain share provisions.
With this in mind, project participants should consider the adoption of contractual models which equitably share the risks between participants, particularly those risks that are unknown. The health of the Australian construction industry may very well depend on it.
Lamont Project & Construction Lawyers
We have the industry knowledge and experience to assist both Principals and Contractors in all major construction projects. If you would like to discuss any of the matters raised in the above article or the forthcoming series as it relates to your specific circumstances, please contact Lamont Project & Construction Lawyers.
The content of this article is for information purposes only; it 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.
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