I recently bought a new home. One thing I noticed during my house search: new homes are in low supply, and those coming on the market are often subject to contract provisions containing escalation clauses addressing construction material prices. At each development, I heard the same story; developers are unable to assign a price to identified home plans because they are unable to lock in a price with their material suppliers. The developer wanted me to bear the financial risk of increases in material prices. Due to the volatile pricing of building materials, such escalation clauses are not unique to residential construction and are becoming more commonplace in construction contracts across the country.
What Are Escalation Clauses?
Escalation clauses shift the risk of volatile material prices from the supplier to upstream party with whom the supplier contracts. Typically, the owner of the project will ultimately bear the price escalation risk. The transparent shifting of this risk sets expectations from the onset, creates clarity and minimizes costly legal disputes. These escalation provisions can take many different forms. While some contracts reflect any/all increases in material pricing, others adjust material prices when they exceed an identified percentage of existing material price indexes, such as the Producer Price Index “PPI” produced by the Bureau of Labor Statistics.
The Suppliers’ Perspective on Escalation Clauses:
Escalation clauses exist because suppliers shift the increasing cost of materials to contractors who further shift the impacts to project owners. Suppliers must balance their desire to shift financial risks with maintaining a strong reputation for value in the construction community. For this reason, it is important that suppliers set contractor expectations by identifying the materials subject to a price escalation clause, the price of the identified materials, and the duration of time for which the identified price is valid.
The Contractor’s Perspective on Escalation Clauses:
A contractor is always responsible for monitoring its total costs as compared to bids, thus highlighting the importance of keeping up with market trends and working knowledge of historical escalation rates. Contractors can mitigate the risk of material prices by buying all anticipated materials for a project in bulk at one price or by including an escalation clause in its contracts, shifting the risk of increased material prices. When drafting these escalation clauses, the contractor needs to ensure that the escalation clause clearly establishes a deadline for the material prices and discourages owners from relying upon material escalation as a means to terminate an otherwise enforceable contract. The escalation clause shall further require the owner to provide written notice of any contract termination and compensate the contractor for all costs owed to date and a prorated percentage of the contractor’s anticipated profit.
The Owner’s Perspective on Escalation Clauses:
The owner’s goal is to clearly understand its financial liability and limit the extent of the risks shifted from the supplier and the general contractor. As a result, owners need to make sure that any escalation clause identifies the pricing methodology and contains a cap on total liability. All escalation clauses should obligate the contractors to use their best efforts to obtain lowest possible prices from reputable and/or agreed-upon suppliers and require production of written notice identifying the impacted materials, the increased cost, the source of the supply, and the accompanying invoices or bills of sale. Owners also need to ensure that the escalation clause contains a method for them to terminate the contract if their financial liability exceeds their identified financial threshold (an escalation clause is not akin to a blank check).
Escalation Clauses Permitted on Federal Projects:
Federal Acquisition Regulation FAR § 16.203- Fixed-Price Contracts With Economic Price Adjustment, permits escalation clauses in those instances where “there is serious doubt concerning the stability of market or labor conditions that will exist during an extended period of contract performance” and “contingencies that would otherwise be included in the contract price can be identified and covered separately in the contract.” FAR §16.203-2. The FAR recognizes three types of escalation clauses: i) adjustment clauses tied to established prices; ii) adjustment clauses tied to actual costs versus bid prices; and iii) adjustment clauses tied to indexes of labor or material. Ultimately, the Federal Government aims to lower costs by limiting the large contingencies placed into contractor bids.
Carefully crafted escalation clauses can benefit all parties by shifting financial risks while limiting built-in contingency pricing. If done properly, escalation clauses clearly identify the potential risks for the supplier, contractor, and owner and bring predictability into an otherwise unpredictable market. These provisions can also help avoid disputes. Some important factors to consider when drafting an escalation clause include:
- Precise identification of materials subject to price escalation;
- Precise methods for calculating the increased costs;
- The time duration for the identified material price;
- The source of the impacted materials;
- Requirement mandating that the contractor substantiate the increased costs;
- Requirement that the contractor use its best efforts to obtain lowest possible prices from reputable and/or agreed-upon suppliers;
- Provisions that discourage owners from terminating an otherwise enforceable contract; and
- If termination is unavoidable, mechanisms for notice of owner termination and compensation to the contractor for its costs and a prorated percentage of profit.