Price adjustment clauses: legal and commercial implications for construction contracts

Construction projects around the world continue to experience extreme levels of cost escalation due to a combination of factors such as the conflict in Ukraine, supply chain constraints affecting manufacture and transportation, pervasive labour shortages and unprecedented weather events. These factors have been further compounded by rising levels of construction activity as well as more localised issues such as managing the post-Brexit environment and rising energy costs (in the case of the UK).

Whilst some standard form construction contracts – such as the JCT, FIDIC and NEC4 forms – include fluctuation mechanisms, parties to negotiated construction contracts have until recently tended to opt out of incorporating these provisions. This is particularly true of contracts entered into prior to the Covid-19 pandemic and the conflict in Ukraine under which inflationary risk has tended to sit with the contractor.

More recently, contracting parties have been increasingly required to consider flexibility in pricing and not just for longer term projects where inflation risk could otherwise attract a significant cost premium. For projects with a shorter duration, price adjustment clauses are generally less common, with parties continuing to rely on contingencies and conventional risk allocation. However, there are exceptions where costs are considered to be particularly sensitive to inflationary pressures.

In this blog post, we explore recent trends in price adjustment clauses and the legal and commercial implications of incorporating such clauses into construction contracts.

Recent trends

At the time of writing, it remains the case on longer term projects that contracting parties will look for price adjustment to be directly addressed in contracts, rather than relying on built-in contingencies that could otherwise be too risky or too expensive as well as more conventional provisions such as force majeure and change in law clauses.

On projects with shorter durations, price adjustment clauses continue to be less common in general. Although, this depends on matters such as the prevailing market conditions, supplier locations, and/or the nature of the project. Whilst many employers are reluctant to move away from fixed pricing on a wholesale basis, there are instances where price adjustment mechanisms have been negotiated in relation to specific costs for which particular sensitivities in pricing are known at the time of contracting.

One example of this is the cost of international logistics which, over the past few years, has been difficult to fix price due to prevailing supervening matters such as the Covid-19 pandemic, volatility in fuel prices and the need to adapt transportation routes following the outbreak of the conflict in Ukraine.

One way in which parties have dealt with this uncertainty is to treat such costs separately from fixed price components of the contract and to pay for them at cost.  Another way is to include provisional sums at the outset which are converted to fixed prices when the supply or subcontract packages are bought. Employers in these circumstances tend to insist on corresponding cost mitigation measures, such as rules around open book tendering at supply chain level and/or possibly an option for the employer to omit and procure items itself.

Common features of price adjustment clauses

Price adjustment clauses tend to be a feature of more sophisticated construction contracts and will usually provide a limited scope of relief rather than blanket protections. Whilst price adjustment clauses will typically consist of highly bespoke drafting, they might include some of the following features:

• Relief being limited to specific costs that are particularly exposed to higher levels of volatility, for example raw materials such as timber and steel, as opposed to labour. However, this also depends on local market conditions, so in some jurisdictions, labour in addition to certain raw materials might also be brought within the scope of the clause.
• Costs being tied to specific material price indices and the price adjustment mechanism triggered only where costs increase above a certain threshold. Indexation can, however, be a thorny issue and it is not unknown for an employer to be 'burnt' where there are extreme peaks and troughs in the relevant indices. This risk is particularly acute where the price adjustment mechanism is linked to the value of an index at a particular point in time, rather than an average of that index over a longer period. The choice of indices to be applied can also become contentious.
• Capping the level of cost protection at a certain amount and/or limiting the duration of any cost protection.
• Parties to share the 'pain' of any cost increase so that the employer and the contractor are both incentivised to manage cost escalation (although inevitably this will attract some inclusion for risk in contract prices). Similarly, incorporating a mechanism for the parties to share the benefit of any cost reductions in the future.

Commercial considerations

The main commercial challenge for contracting parties when negotiating a price adjustment or similar clause, relative to a fixed price, is trying to strike a fair balance between mitigating the risk of extreme cost exposure (impacting the contractor) and achieving some level of price certainty (for the employer). It goes without saying that the more the parties move towards a price adjustment model, the less cost certainty there will be at the outset. Employers will also be conscious of the risk of setting a precedent for future dealings with contractors.

Another important question for all parties involved is whether prolonged negotiations over a complex price adjustment mechanism is in the best interests of the project. Depending on the circumstances, it may be more commercially prudent to treat certain items as provisional sums and to agree on more conventional cost mitigation measures.

At the time of writing, price escalation on its own does not appear to be driving parties' decisions on the overall procurement method. However, given the increasing focus on achieving 'value for money', more collaborative pricing mechanisms, or potentially more collaborative forms of contracting, may need to be considered going forward even after market conditions have stabilised. This includes by parties who are perhaps more familiar with lump sum, fixed price structures (subject, of course, to any budget or project finance requirements).

Implications for claims and disputes

As with any contractual provisions, a poorly drafted price adjustment clause can give rise to claims and disputes, as can the way in which rights under such clause are exercised.

In addition to the need for accurate drafting of the clause itself, a price adjustment clause needs to be considered in the wider context of the relevant contract. It will therefore be important to review a price adjustment clause against other provisions that similarly provide relief to the contractor in unforeseeable or exceptional circumstances. In this regard, particular care needs to be taken to ensure that clauses, such as change in law or force majeure that may be more broadly drafted, do not undermine the effect of a narrowly drafted price adjustment clause by providing a 'back door' to claiming additional time and/or money.

Further, even where permitted by the contract, contractors need to make sure that their price adjustment claims are properly submitted in accordance with the contract and substantiated with supporting documents (e.g. original quotes provided at the time of tender along with proof of prices actually paid). Conversely, the employer should also interrogate price adjustment claims just as it would any other claim, including by exercising any contractual audit rights and confirming that notices have been given in accordance with the contract.

Concluding thoughts

There is no 'one size fits all' approach to price adjustment clauses or other contractual mitigation measures, which will primarily be driven by project-specific considerations. However, whether it is through the adoption of an express price adjustment clause or otherwise, it will be in all parties' interests to find a sensible way of managing extreme cost escalation in order to avoid a scenario in which the contractor has no choice but to submit more or inflated claims or needs to walk away from the project altogether.

For further information, please contact Tim Healey, James Doe, Noe Minamikata or your usual Herbert Smith Freehills contact.