At the end of 2011, the federal government’s clean energy future plan was passed into law. The plan, which introduces a carbon pricing mechanism and a number of other clean energy reforms, will have particular implications for the construction industry. Many industry members have been reviewing their financial exposure to the carbon pricing mechanism (Mechanism) since its announcement last year and taking steps to ensure contracts properly deal with the risks identified. Given that the Mechanism kicks into operation on 1 July 2012, it is timely for industry members to again review contracts on foot as well as tenders going forward, to ensure that they have appropriately provided for the impact of the Mechanism.
We have previously summarised what the Mechanism means for the construction industry in our legal update, The carbon pricing mechanism: an industry focus. In this update we highlight contractual regimes for allocating the risk of price variations as a consequence of the Mechanism, with particular attention to what reviews parties should be conducting of contracts for projects already underway and what steps can be taken going forward.
It is obviously essential that parties understand what costs are likely to be passed on to them if they are going to properly minimise their exposure. Although the construction industry will not typically be emitting carbon pollution, and therefore will not be directly liable for reducing emissions or purchasing carbon permits, it will incur increased costs passed down from direct emitters, such as through the purchase of carbon-intensive materials, like steel, cement and aluminium, and increased electricity and fuel costs. The federal government has introduced some schemes to provide assistance to direct emitters, such as the Steel Transformation Plan and Jobs and Competitiveness Program, and consequently some price increases may not be as great as anticipated.
It is also important to understand the mechanism to ensure downstream price increases are accurate. Forecasting indicates that increases in construction and building industry costs due to the Mechanism may be less than 1%, however this is likely to incrementally increases year on year once the government assistance schemes end and the carbon price shifts from fixed to floating.
There are three key ways in which the impact of the clean energy future plan may be managed contractually:
- Pricing structure.
- Change in law or tax clauses.
- Specific Mechanism provisions.
There are a variety of payment structures used in the construction industry, including cost plus, lump sum or schedule of rates (or a combination of them). The payment structure used, and more particularly the means for determining the contract sum, may allow the contractor to pass on price increases resulting from the Mechanism.
For example, under a cost plus contract the contractor is essentially reimbursed for all costs it incurs in performing the work, plus a margin to cover its overheads and profit. Consequently, the contractor is able to pass on any increased costs it incurs as a result of the Mechanism under a cost plus contract. Under this contract structure, it is the principal, and not the contractor, who will be exposed to price increases. Principals who have incorporated a guaranteed maximum price may be able to limit these increases to an extent, in which case the risk of increased prices due to the Mechanism will fall back to the contractor. Where a cost plus contract is subject to a guaranteed maximum price, contractors should ensure that all anticipated price increases are sufficiently provided within the limit of the guaranteed maximum price or that there is an appropriate mechanism by which the guaranteed maximum price can be adjusted for price variations as a result of the Mechanism.
Lump sum and schedule of rates contracts offer less flexibility in price variations than a cost plus structure and generally result in the contractor bearing the risk of managing any price increases. The contract sum under a lump sum or schedule of rates contract will be in effect fixed and will not be increased as a result of the Mechanism, unless specifically provided for in the terms of the contract (see ‘Change in law or tax clauses’ and ‘Specific carbon pricing clauses’ sections below). Similarly, a contractor will bear the risk of price increases resulting from the Mechanism under contracts for domestic building works, as statute significantly restricts the instances where cost escalation is allowed in domestic building contracts.
Change in law or tax clauses
Most contracts contain a regime specifically allowing for price increases where there is a change in law or change in tax. Although the Mechanism is not strictly a ‘tax’, many change in tax clauses are drafted to include government imposts and levies more generally, which would consequently include the Mechanism.
- The introduction of the Mechanism appears on its face to be a change in law, however the drafting of many change in law clauses can severely restrict an entitlement to claim for price variations due to the Mechanism. Close attention needs to be paid to how the change in law clause has been drafted in order to ascertain whether there is an entitlement to claim for price increases resulting from the introduction of the Mechanism. Key obligations to look out for include:
- Notification: in most instances the contractor is required to provide notification to the principal within a certain period. This time bar may run from the actual change in law or an impending change in law – the latter is of significance as the clean energy legislation package was introduced into the House of Representatives in September 2011 and assented to in November 2011.
- Foreseeability: some change in law regimes incorporate a test of whether a reasonable contractor, performing the same type of work as the contractor, would have foreseen the change in law. Even if the notification requirements are from the actual change in law, a contractor may be caught out by this requirement given the announcement of the Mechanism in the middle of last year.
- Extra work: an entitlement to claim increased costs resulting from the change in law may, in some instances, only arise where the contractor has had to perform extra work as a result of the change in law, in this instance the Mechanism. Consequently, where it is simply the cost of materials required for the original work that increases, the contractor may not be entitled to a similar increase in the contract sum, given that no additional work has been required to be performed as a result of the Mechanism.
- Direct costs: a contractor may only have an entitlement to claim the direct costs it incurs as a result of the change in law. As mentioned above, the construction industry will principally contribute to carbon emissions indirectly and therefore is unlikely to have any direct obligations under the Mechanism. An example of a direct cost under the Mechanism is the price paid for a carbon permit. The increased price of cement or aluminium is unlikely to be a direct cost as it is a consequence of the Mechanism.
- One-off cost: a change in law regime typically allows for a one-off payment due to the change in law. The effects of the Mechanism will be ongoing and this will be particularly felt after 2015 when the price for permits is no longer fixed. The contract may not allow for multiple claims. Contractors making a claim under the contract for compensation due to a change in law will need to be careful that such claims are without prejudice to any future claims they may need to make with respect to price increases resulting from the Mechanism.
Specific Mechanism provisions
Some contracts may include provisions specifically dealing with the Mechanism and allocating the risk of any price increases resulting from the Mechanism to the relevant party. Notwithstanding that the Mechanism is not yet operative, parties should already be preparing for the shift from a fixed price for permits to a floating price with a set floor and ceiling. That is, industry members should not only be preparing for the introduction of the Mechanism on 1 July 2012 but also the change from a fixed price per permit to a floating price on 1 July 2015. After 1 July 2015, the price for carbon permits will be determined by the demand for permits under a cap and trade scheme. Although the Government will implement a price floor and ceiling on this floating price, parties will have no real control over the price of permits. Given that after 1 July 2012 entitlements under change in law or tax regimes will be of no relevance, we expect to see a greater use of specific Mechanism provisions in contracts as parties desire greater control over any price increases resulting from the Mechanism.
Industry members need to be prepared for both the introduction of the Mechanism on 1 July 2012 and the shift from a fixed to a floating permit price on 1 July 2015. This will require that parties:
- Understand cost-exposure to the Mechanism and continue to implement measures to mitigate any adverse consequences.
- Review contracts for projects currently on foot with respect to whether there is an entitlement to pass on any price variations due to the Mechanism and if so what conditions precedent need to be satisfied, particularly in regard to notification requirements.
- Check whether tenders in the lead up to the Mechanism and contracts entered into after 1 July 2012 expressly state that there is an entitlement for price increases due to the Mechanism, and if so ensure the contractual regime is appropriate.
- If contracts going forward do not allow for any price increases due to the Mechanism, ensure that any anticipated price increases are appropriately included in the contract sum, being mindful that price increases should not be incurred prior to the Mechanism commences on 1 July 2012.
For contracts involving work being undertaken after 1 July 2015, consider whether an appropriate contractual regime for dealing with increased costs and savings due to the floating price of permits should be included.