Since our last article, speculation has continued on whether we are heading for a "hard" or a "soft" Brexit. The answer is not yet clear but it would be prudent to prepare for something that is at the harder end of the scale. A hard Brexit would likely result in restrictions on the free movement of people from the EU and limited access to (or exit from) the EU internal market. For the construction industry this is likely to increase costs:
- Construction employs many workers from the EU. If that supply is stopped (or new visa requirements make it more difficult) then the smaller labour pool may result in wage inflation.
- Goods and services coming from the EU could incur import tariffs. Tariffs on goods and services from outside the EU may also increase as trade with those countries may no longer be governed by EU trade deals.
In addition, the devaluation of the pound will make imports more expensive and wages paid in sterling less attractive.
All of this unpredictability makes the accurate estimation of construction costs on projects with a significant construction period more difficult. The picture will be no clearer until the UK leaves the EU (around March 2019 on the Government's current timetable). In a market dominated by fixed price contracts contractors face some challenges. Under existing contracts there is unlikely to be much scope to claim extra monies if costs increase. Economic hardship is rarely enough to trigger contractor relief even if the works have become less profitable (or even loss making).
While this could be seen as a contractor problem, employers should be wary because insistence on fixed price contracts for new projects may lead to:
- fewer bidders (and therefore less competition)
- significant premiums to cover the risk of price increases.
So how can parties deal with the risk more efficiently? One option is to include price fluctuation provisions in otherwise fixed price contracts.
Price fluctuation clauses
A number of industry contract forms already contain price fluctuation clauses either as standard (e.g. FIDIC Yellow Book cl. 13.8) or as options (e.g. JCT D&B 2011 cl.4.19 and Schedule 7). (It is notable that JCT has chosen to delete a number of the price fluctuation options in the new D&B 2016. We suspect this decision was made before the Brexit vote). For a number of years it has been market practice to delete these clauses because low inflation has meant costs have remained either stable or subject to relatively predictable increases. However, the unpredictability of Brexit may see them re-emerge.
Fluctuation clauses can be as simple or sophisticated as required. There is wide scope to make them project specific. Most feature some kind of pre-agreed formula to be applied to price components as costs increase (or decrease). These can include:
- specifying which published indices will be used to make the necessary adjustments – this can be as simple as pegging prices to inflation or as complex as specifying indices for individual materials and trades
- allowing relief if the "market rate" for materials or labour increases.
There is significant scope for compromise. For example, the parties may agree to share the risk by allowing relief for price fluctuations on only those materials (or trades) which are most critical to delivery of the works e.g. steel.
Words of warning
Price fluctuation clauses are not an easy fix. As they have been out of fashion for a while, parties will need to ensure they’re clear on how they work. Their flexibility means time (and specialist advice where appropriate) is needed to draft and agree a solution which works for the specific requirements of the project. Issues to think about include:
- which cost components will be covered?
- which indices will be used?
- which formula will be used? (e.g. will the price components for the works be weighted?)
- how will the details be recorded? This is often in a separate schedule prepared by the QS cost consultant.
If this is all too difficult the parties may prefer to use:
- a target cost or cost-plus type contract (a topic for a future article)
- an alternative remedy for the contractor such as a more generous change of law provision (see previous article).