Material Price Increases in the Global Construction Industry
Inflation and increasing costs may present the biggest challenge for the construction industry in the year ahead. Already, in the United Kingdom, major infrastructure projects are experiencing headwinds: the Department for Business, Energy and Industrial Strategy reported in September 2022 that construction materials across the UK bore inflation of 18% between August 2021 and August 2022. This has led to suggestions that a number of infrastructure projects there could be revised or abandoned.
The global picture is variable, but only in degree, not in kind. Overall inflation in the Eurozone and United States was 9.2% and 6.5% respectively in calendar 2022. Such pressures will continue to place strain on global construction projects as the impact of Russia’s war in Ukraine and post-Covid-19 pandemic supply chain issues continue.
In this context, parties will almost certainly seek to minimise the extent to which they will be required to incur additional costs in order to finalise construction projects. This issue is complicated by the fact that many parties will have entered into contracts a number of years ago, with prices agreed on the basis of comparatively stable inflation. This update therefore looks at common construction contract positions and the ways both owners and contractors may seek to mitigate these risks.
The terms of the parties’ contract
Unsurprisingly, contractual terms will be key in determining the extent to which either an owner or a contractor can minimise exposure to additional expenses that may arise on a construction project. Subject to any legal restrictions that may exist in the relevant jurisdiction, parties are often free to negotiate and enter into contracts on their desired terms.
Parties to large scale construction projects have traditionally entered into Engineering, Procurement and Construction (“EPC”) contracts, under which the contractor typically is paid a lump sum price to complete all aspects of the works required to hand-over the project to the owner, including subcontractor costs. Under an EPC contract, the contractor typically assumes all or most of the risks for completing the project to specification and on time, and, in doing so, warrants that it has taken into account all matters and risks when calculating its price for completion. Perhaps unsurprisingly, this contract model is under pressure in today’s environment of rising prices, however many such contracts remain in place.
The 2017 International Federation of Consulting Engineers (“FIDIC”) Silver Book is a common example of an EPC contract, where the Contract Price and the Time for Completion will be pre-agreed. Where delays are claimed to have arisen or costs are said to have increased, the owner (“employer” or its representative) under the default FIDIC Silver Book terms, determines claims for additional time or costs submitted by the contractor. The contractor will, however, often have provided an express warranty that it has taken into account all risks when entering into the contract, thereby limiting the scope for claims considerably.
A claim is also barred under the FDIC Silver Book unless the contractor serves notice of the event within 14 days of the date it became aware or should have become aware of the event it considers is the cause of the delay and/or additional costs. Finally, if the contractor disagrees with the employer’s decision, there is only limited recourse to challenge the employer’s decision, thereby leading to engagement of the dispute resolution provisions of the contract.
The position is similar under American Institute of Architects (“AIA”) form contracts, which are often used for complex and/or large scale construction projects in the U.S. Under AIA 133-2009 – where the basis of payment is the cost of work plus a fee with a Guaranteed Maximum Price – the contractor has limited ability to dispute the owner’s decision regarding any variation. Furthermore, in contrast to FIDIC, the contractor is not entitled to any extension of time for delay of the Project that is caused, whether in whole or in part, by the contractor, or a party to whom they have subcontracted. This provision applies irrespective of whether the act or omission causing or contributing to such delay is foreseeable or unforeseeable.
Notwithstanding the above, there are some limited protections that may be available to a contractor where delays or additional costs are caused by exceptional events. For example, under clause 18 of the FIDIC Silver Book, the contractor is entitled to claim costs for an ‘exceptional event’ or otherwise terminate the contract if that event is prolonged. Such events may also be referred to as force majeure.
The definition of an exceptional event is nonetheless stringent and may be expressly limited to certain events under the contract, meaning reliance on this provision will be limited in practice. Under the 2017 Silver Book, an Exceptional Event is construed as one that:
- is not substantially attributable to a party to the contract;
- is beyond a party’s control;
- could not reasonably have been provided against before entering into the contract; and
- could not reasonably have been avoided or overcome.
How this clause is interpreted will depend on the final wording of the contract and the governing law. Under English law, recent caselaw suggests the event will need to be the sole cause of the failure to perform the contractual obligation (see, for example, Seadrill Ghana Operations Ltd v Tullow Ghana Ltd  EWHC 1640). The clause in the contract must also be capable of encompassing the specific circumstances that give rise to the claim, meaning the burden to establish an event is high.
Further English appellate authority has emphasised, in Mur Shipping BV v. RTI Ltd , 2022 `(EWCA Civ, 1406), that the courts construe each clause on its own terms, “albeit that we do so against the background of the general law […] we are not concerned with reasonable endeavours clauses in general, or even with force majeure clauses in general.” The general law is therefore kept in the background where the issues are addressed in the parties’ agreement.
In the U.S., most AIA contracts will not include an exceptional event clause but may provide protections for the contractor in enumerated circumstances, such as where there is a change in work ordered by the owner, an adverse weather event or an act of neglect by the owner or their architect, or a similar event beyond the contractor’s control. In such circumstances, the contractor is entitled to a reasonable equitable adjustment of the contract price and/or extension of time. Nonetheless, the standard list of events entitling the contractor to claim for adjustment is typically smaller than those provided in standard FIDIC form contracts.
Alternatively, contractors may be able to rely on change in law provisions. Under the FIDIC Silver Book, this provision enables the contractor to claim additional costs where these have been caused by a change in law in the country where the project is being carried out. This can be difficult in practice. Firstly, there must indeed be a change in law, which must be proven to have directly increased costs. Secondly, in an international project, the contractor is just as likely to be affected by laws in another country as in the country where the project is taking place; materials and labour may be procured offshore, yet changes in laws in foreign jurisdictions may not be caught by a change of law provision in an EPC contract. Most AIA contracts do not contain express change in law provisions.
Although EPC contracts are common, they are not the only form of contract that parties may use to deliver construction projects. For example, in some industries, Engineer, Procure, Construct and Manage (“EPCM”) contracts are becoming more common. Under EPCM contracts, contractors do not typically assume the same level of risks as they would in an EPC contract; contractors more commonly adopt the role of a project manager responsible for managing various subsidiary contractors. Other different and hybrid contracts are increasingly being adopted, as discussed at the conclusion of this note.
Can certain domestic legal principles offer relief?
Economic hardship, and other circumstances caused by significant unforeseen changes in market conditions, can sometimes provide grounds for adjustments to the contract terms, where those circumstances were unforeseen and beyond the control of both parties. While this may offer relief to contractors in civil law systems, contracts providing for English law – as well as the law of many common law systems – are unlikely to attract such relief.
A contractor experiencing economic hardship may otherwise consider asserting that their contract has been frustrated within the context of the legal doctrine of ‘frustration’. Claims based on the doctrine of ‘frustration’ will normally require the occurrence of an unforeseen event that makes the contract impossible to perform, not merely uneconomic.
Ordinarily, an increase in the commercial difficulty of the contract will not constitute frustration. Frustration also cannot be invoked where the contract already includes provisions for a problematic event. Hence, it is unlikely to be applicable to contracts containing exceptional event clauses or provisions similar to those discussed above, particularly, at least in England, in light of the referenced decision in Mur Shipping BV v. RTI Ltd.
Risks of repudiating a contract
Contractors facing serious labour, supply, and inflationary pressures may look to find grounds for termination, rather than continue to fund a project at a loss. However, where the risk of cost increases has been assumed by the contractor under the terms of its contract, this approach presents numerous risks.
Many EPC contracts, for example, contain provisions that allow the owner to retain an alternative contractor to complete the works at the expense of the original contractor, should the owner lawfully terminate the contract (or should the contractor unlawfully terminate the contract). Additional costs under such replacement contracts will almost certainly exceed the cost the contractor was grappling with, as the replacement contractor will take time to assume its role and complete the works without many of the advantages of the original contractor.
Furthermore, owners would likely be able to call on security bonds and parent guarantees in such circumstances. Often such security will represent a significant portion of the price of the works and the calling of security can affect the contractor (and its parent) under the terms of other contracts or lending arrangements, as well as its reputation in the relevant market.
Negotiating construction contracts in the current climate
Given recent developments, owners should anticipate an increase in demand from contractors for contracts containing more owner side risks. Such hybrid contracts that deviate from EPC and EPCM models are increasingly being adopted, whether insisted upon by powerful contractors or the result of owners meeting the market in an environment of rising prices.
This can be advantageous where owners, keen to pursue a project of economic value or ensure timely completion, are able to exert greater industry pressure on subcontractors and suppliers than their contractors. Parties may also wish to consider a joint approach to subcontracting; it could also be advantageous to both the owner and contractor in this environment to obtain more money up front from subcontractors. Either the owner or contractor may also wish to offer incentives to subcontractors to ensure they deliver on time or seek price commitment letters from key subcontractors.
Overall, however, owners should be wary of accepting responsibility for procurement and subcontracting in cases where they have limited connection to either the industry, construction method or location of the project. Such agreements may also make it more difficult to raise project finance, due to higher owner side risks. Owners should also consider the adequacy of security and insurance arrangements in those contractual scenarios where they are taking on more risk than was otherwise the case in more stable price environments.