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Super-Inflation and the Construction and Energy Sector in the UK

By Vijay Bange and Tanya Chadha
December 2021
Construction Law

Super-Inflation and the Construction and Energy Sector in the UK

By Vijay Bange and Tanya Chadha
December 2021
Construction Law

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Don’t panic Mr Mainwaring!” was the phrase coined by the fictional character Lance Corporal Jones in the famous BBC comedy Dad’s Army. Douglas Adams emblazoned the Hitchhiker’s Guide to the Galaxy with a similarly reassuring “Don’t Panic”. More recently the message from the UK government has been don’t panic, in response to the petrol crisis at the fuel pumps caused by a shortage of lorry drivers (with the army on standby). But should we be panicking?

The shortage of drivers has led to exponential increases in gas prices to industry, and had knock on effects on steel production (including on prices and temporary plant closures). The shortage of drivers and the ensuing consequences for all industry sectors is of course not limited to the UK. There continue to be instances in the US of ships laden with containers anchored off shore waiting in queues to offload goods and materials, or being diverted to other ports, because the goods could not be collected by lorry drivers.

The Covid pandemic has challenged all economies, and that possibly may have masked the Brexit-related issues which are now surfacing in relation to: (1) lorry driver shortages; (2) labour shortages (skilled and otherwise); and (3) the availability of materials in various sectors of the economy.

Whatever the causes, the UK construction sector has suffered supply issues and massive cost hikes on certain basic construction materials (including wood and cement) driven by nonavailability or long lead-in times. This has led to price ‘super inflation’ in the industry.

This whole series of events may have the result of putting projects on hold, creating an oddity where whilst there is demand in the real estate/residential sector the build costs are prohibitive or economically no longer viable. The commercial landscape when original bargains were entered into may have dramatically changed as a result of one or a combination of the events described above. Potentially there may well be instances where the price changes mean that the contract is now totally different from that originally agreed, in which case some of the doctrines discussed below may warrant consideration.

Contractors will need to consider how the risk of these current events are allocated. Are contractors stuck in crippling contracts (where they make little to no profit, or worse lose money) or are there provisions of which they can avail themselves to avoid that scenario? Equally, the employer may need to consider whether they should explore ways of getting out of a problematic agreement.

As to who bears the risk for the increased costs, the answer will lie in the contract. Even if, on the face of the contract, there is a “fixed price”, fluctuation provisions may still apply to adjust the contract price in certain situations. It is also worth bearing mind that because of the unusual and perhaps unpredictable circumstances, the parties may ( for commercial reasons) mutually agree to resolve the position and amicably adjust the new risk/cost between them. In a stable market, amendments to price fluctuation clauses may not be top of the parties’ agendas so what do the standard forms say?

JCT

The JCT Design & Build 2016 edition (JCT) includes three variations of a fluctuations provision; options A, B and C. The Contract Particulars also allow the parties to decide that no fluctuation provision, or a bespoke provision, applies. If there is no express agreement on fluctuations, option A applies by default.

Options A, B and C are detailed, lengthy and should be read with care. All three options treat labour, materials and sub-contracting costs separately:

  • Under option A, the contractor can (in principle) recover price increases for labour caused by a change in contribution, levies, tax and increases to materials caused by a change in duties or tax. Appropriate adjustments will be made to the contract sum. The contractor cannot claim for additional profit but the parties may agree an additional percentage to be added to fluctuation payments.
  • Option B adopts the same approach as option A but allows the contractor to also claim the cost of labour increases pursuant to the rules or decisions of a wage-fixing body together with a change in market prices for materials, goods, electricity and fuel.
  • Under option C, fluctuations will be calculated in accordance with the JCT’s Formula Rules.

NEC

The NEC4 Engineering and Construction Contract (NEC) contains an optional ‘Price adjustment for inflation’ clause as option X1. Clause X1 allows a contractor to claim a price adjustment for a change in an index. Option X1 is not applicable to main options E and F.

Given that option X1 requires the parties to expressly ‘opt-in’, one may assume that a failure to incorporate X1 automatically results in the contractor bearing the risk of inflation. Whilst that may be the case under main options A or B (both fixed price options), main options C – F deal with inflation through the pricing structures. Options C and D (both target cost options) don’t expressly deal with inflation but any increase/decrease in costs will be taken into account when determining the total amount due to the contractor. The target cost won’t increase as a result of inflation. However, the Defined Cost will increase and the risk of that increased cost is dealt with under the pain / gain share mechanism. Under main options C and D, the parties may therefore end up sharing the risk.

Options E and F (cost reimbursable) allow the contractor to recover increased costs of inflation. The most likely exception is found in the second bullet point of ‘Disallowed Cost’ which includes cost that should not have been paid to a subcontractor. If a contractor therefore pays a subcontractor increased prices as a result of inflation, and the subcontract did not allow the subcontractor to recover those additional sums, then they may be Disallowed Cost and irrecoverable.

Inflation is not in itself a Compensation Event under NEC. However, when a contractor claims a Compensation Event for another reason (for example a change to the Works Information), then the contractor may be able to claim the increased costs arising on the additional works as a result of inflation under that Compensation Event.

More controversially, if all else fails, a contractor may be able to claim that one or more of the underlying events that has led to super-inflation could be a compensation event pursuant to clause 60.1(19), where the contractor can show that that event (i) has prevented the contractor completing the works either by planned Completion or at all; (ii) could not have been prevented by either party (which is likely in the case of supply and labour shortages); and (iii) had such a small chance of occurring that it would have been unreasonable for the contractor to allow for it. This last point will depend on what was known, and what could reasonably have been anticipated, when the contract was entered into.

FIDIC

The FIDIC Conditions of Contract for Plant & Design Build 2017 edition (FIDIC) includes clause 13.7 that deals with “Adjustments for Changes in Cost”. This clause will only apply if schedules of cost indexation are expressly included in the Contract by the parties, so it effectively operates as an ‘opt-in’ clause. Where clause 13.7 does apply, amounts payable to the contractor are adjusted for both rises and falls in the cost of labour, goods and ‘other inputs to the Works’ in accordance with the agreed schedule of cost indexation.

Generally

It is worth bearing in mind that whilst the above analysis considers inflation only, the contractual fluctuation provisions apply equally to deflation and in such scenarios, contractors may find themselves allowing sums back to employers.

However, these provisions alone may not assist with all of the potential challenges raised above. Whilst it goes without saying that all projects will be fact specific, other issues that may potentially warrant further consideration are as follows:

  • There is usually little point forcing a contractor to perform works that are unprofitable or worst still causing a massive loss. Project insolvencies will introduce a whole plethora of other problems for the parties and the project.
  • Parties can be collaborative and via renegotiation seek a recalibration of risks to create a fair platform, and ultimately the successful delivery of a project without claims for additional time or money, and from the employer’s perspective LADs. The parties are stuck with the bargain they have entered into absent a consensual variation of the terms originally agreed.
  • Parties should review their respective contracts (as agreed) to see if they assist on clarifying risk allocation. The above analysis of the standard forms will invariably not reflect the position of the parties as they may have been amended.
  • Do parties need to consider the termination provisions as a way out for one of both? This will require legal advice given the serious consequences of a wrongful termination (which may include damages and/or claims for specific performance, amongst other things).
  • Do these events arguable give rise to a force majeure event, either individually or collectively as a cumulative effect. This requires careful analysis and will depend on the contractual clauses which relate to the scope of a force majeure event ( for example, issues relating to the Covid-19 pandemic or Brexit may already be excluded).
  • Do the circumstances render the contract impossible to perform? Consider whether impossibility gives rise to potential frustration arguments.
  • Is the contract now so different to the original bargain that the doctrine of frustration of contracts applies? If so, this may discharge the obligations on both parties (but is unlikely to provide a route to allow the contract to continue with adjusted terms). However, this will be fact specific (noting that there has been uncertainty about whether the doctrine applies to construction contracts). It is also worth bearing in mind that the extent to which prepayments on account, or work which leaves one party with a valuable benefit (made before the frustrating event), would be recoverable also requires consideration.

Conclusion

The present scenario of events has created challenges. As we come accept to some degree controlling and living with the Covid threat, attention is turning to other challenges caused by a multitude of events, which are focusing attention on long term strategy with the green agenda in mind. Do we revert back to more reliance on delivery of goods from roads to freight trains? The petrol crises have led to businesses and consumers looking at electric vehicles, to creating more sustainable green economies (such as sourcing materials more locally). The gas price hikes for industry, absent government intervention, will focus attention on alternative energies for industry.

Whatever the route through, careful consideration must be made on a case by case basis of the routes available and strategic solutions.