Due to the ongoing Coronavirus pandemic, there have been noticeable supply chain disruptions and shortages in materials affecting the construction industry, resulting in both prolonged delays and increased costs for many projects. It is imperative for all parties involved in a construction project to identify these issues early on and strive to mitigate the associated risks.
The current environment
A perfect storm of factors such as lockdowns, workplace restrictions, border closures and natural disasters has caused significant interruptions in the production and manufacturing of building materials, and both domestic and international supply chains. Add to this the uncertainty caused by the Chinese government’s dual control system of total energy consumption and energy intensity policy which may restrict the operating hours of Chinese factories.
The supply-side issues have been exacerbated by the simultaneous increase in demand for materials, largely due to injections of stimulus by governments around the world to keep their economies afloat during the pandemic.
It is in the interests of both principals and contractors to ensure that the risk of supply chain delays and materials shortages are appropriately managed. For principals, the main risks are delays to completion and the solvency of the contractors. For contractors, the main risks are exposure to increased construction costs and liability for liquidated damages for delayed completion.
Fortunately, there are a number of ways that parties can seek to manage the risks of supply chain delays and materials shortages through contractual mechanisms. These include:
Ordering supplies early
Where particular building materials may be more susceptible to being affected by supply chain delays or shortages leading to price increases, it may be worthwhile for the principal to make early payment to the contractor for the relevant materials so that they can be ordered in advance. Of course, the principal should require the contractor to provide it with security (eg a bank guarantee) for an amount equal to the early payment.
Participants in the construction industry will generally be familiar with such an arrangement for long-lead items. Where such an arrangement is extended beyond traditional long-lead items, this may assist in ensuring that materials are received within the required time and will also provide price certainty. The simultaneous provision of the bank guarantee to the principal will serve as protection for the principal should the contractor become insolvent prior to the materials being incorporated into the relevant works.
Considering substitute materials
Prior to entering into a construction contract, if parties identify that certain materials selected may be difficult to obtain or subject to price fluctuations, it may be beneficial to thoroughly consider if those materials could be substituted. If there are suitable options that are subject to less supply chain risk and price risk, parties could substitute materials or make provision for several alternatives to be used depending on future market conditions.
Requiring the contractor to demonstrate its contingency plans
During the pandemic, it has become a common requirement for contractors to prepare a COVID management plan which sets out how the contractor will manage the impact of COVID on its operations.
A robust COVID management plan will require the contractor to set out its contingency plans where supply chain delays result in critical materials becoming unavailable.
Including supply chain provisions in the contract
Supply chain risk has traditionally been allocated to the contractor to manage. In some circumstances, these uncertain times may mean that this risk is more appropriately shared between the parties – this may be in the form of extension of time right for the contractor (without cost). Where such an extension of time right is being contemplated, the principal will want to ensure there are strict parameters in place so that the right is not open-ended and only applies where the supply chain delay is affecting all contractors working on similar projects. Further restrictions on the extension of time right could be to limit its application to certain materials and to certain locations.
Rise and fall for specified materials
While it will usually be the principal’s (and their financier’s) strong preference to have a fixed-price contract, where there is uncertainty as to the cost of building materials, contractors are likely to build in a buffer to protect themselves against future price rises. In the current environment, there may be some benefit for the principal in allowing specific materials to be subject to some degree of rise and fall (by way of, say, a ‘cap and collar’) so that the principal avoids paying too much of a premium for its fixed-price contract.
The unexpected delays and price increases associated with supply chain issues and materials shortages are some of the most common risks currently facing the construction industry. These consequences could make or break a project. It is therefore essential that parties proceed with caution, consider the risks that may arise and clearly allocate those risks before committing to a project.