The Building Cost Information Service reported that construction material price inflation peaked at 26% in June 2022. Political instability, extreme weather and recessionary pressures saw the construction industry in the UK continue to grapple with the challenge of inflation, which has significantly impacted project costs, programmes and overall project viability. Official data from the Insolvency Service showed that 4,165 construction firms became insolvent in the twelve months ending on 31 March 2023 so it is clear that the construction industry is suffering, not least where main contractors and sub-contractors are employed on a lump sum basis with fluctuations provisions not included.
For main contractors and sub-contractors seeking to protect themselves from the ravages of construction material price inflation, the obvious solutions are the fluctuations provisions that accompany many of the industry standard form contracts. During the recent period of unusually high inflation we have been asked to advise upon such provisions and how they may, or indeed may not, protect project participants.
We explore below how price fluctuations can be dealt with in two of the most widely used industry standard forms: the JCT Design and Build Contract 2016 and NEC4 Engineering and Construction Contract.
JCT Design and Build Contract 2016
This widely used design and build contract contains standard mechanisms which can facilitate the adjustment of the contract sum in response to the rise and fall of market forces and input costs beyond the control of the parties. There are three standard form "Fluctuations Provisions" that can be selected in the contract particulars or the parties could agree to incorporate a bespoke approach.
Option A (Contribution, levy and tax fluctuations)
Under Option A (the simplest and most easily navigated of the three JCT options), the contract sum is expressly deemed to have been calculated using:
- types and rates of contribution, levy and tax payable by the Contractor in its capacity as an 'employer'; and
- types and rates of any applicable duty and tax (other than VAT) payable in relation to any import, purchase, sale, processing, use and disposal of materials, goods, electricity and fuels necessary for the execution of the works,
each calculated as at the base date which the parties agree and insert into the contract particulars.
Under this Option, the contract sum will fluctuate if:
- there is an increase or decrease in the rates mentioned above;
- if any of the types of contribution, duty, levy or tax mentioned above are no longer payable; or
- if a new type of contribution, duty, levy or tax becomes payable.
In order to properly ascertain the existence and extent of any fluctuation, the onus is on the Contractor to notify the Employer and provide evidence and computations, however it is worth noting that any price fluctuation does not alter the Contractor's profit margin and the contract sum does not fluctuate when the Contractor is in culpable delay.
If the primary concern of project participants is construction material price inflation then this Option is not going to be helpful. Although it is simple and relatively easy to operate, Option A does not respond to the increase or decrease in the prices of materials and would not provide comfort to a contractor concerned with the impact of inflation.
Option B (Labour and material cost and tax fluctuations)
As with Option A, the contract sum under Option B responds to increases or decreases in the levies and taxes applicable to the Contractor's role as an 'employer', and to duties and taxes applicable to any import, purchase, sale, processing, use and disposal of materials, goods, electricity and fuels necessary for the execution of the works. Option B goes further, however, and provides for adjustments to the contract sum in relation to fluctuations in:
- labour rates and expenses as a result of decisions, rulings, or incentive schemes of wage fixing bodies like the Construction Industry Joint Council;
- workpeople's transport charges specified in the Contractor's Proposals as a result of decisions, rulings, or incentive schemes of wage fixing bodies like the Construction Industry Joint Council; and
- fluctuations in market prices for materials, goods, electricity, fuels or any other solid, liquid or gas necessary for the execution of the works (and related duties and tax payable thereon).
Just like Option A, the contract sum under Option B is adjusted upwards or downwards to reflect fluctuations of the relevant rates and prices occurring after the base date. The Contractor is also subject to the same requirements as under Option A in respect of the notification and provision of evidence as to the amount payable; is not be entitled to any uplift in its profit; and is not entitled to any adjustment of the contract sum for periods during which it is in culpable delay.
Option B goes further than just addressing levies and tax fluctuations dealt with in Option A by specifically addressing labour costs and material costs. Option B is likely to be more helpful in the current climate of high construction material price inflation but one would question whether there is a compelling need for levies and taxes to also fluctuate.
Option C (Formula adjustment)
Option C is the most complex and comprehensive of the JCT Fluctuations Options, incorporating the 64-page JCT Formula Rules to calculate the amount by which the contract sum should be adjusted. The Formula Rules themselves refer to 'monthly bulletins', namely the BCIS Price Adjustment Formulae Indices Online, which inform how inflation has affected various items and values of work during the relevant period, to be used in calculating each interim payment.
The Formula Rules are set out over three sub-parts each containing separate formulae to be applied. The applicable part of the Formula Rules is to be nominated in the Employer's Requirements or Contractor's Proposals.
- Part I: Work Category Method – Appendices A-1 and B-1 to the Formula Rules contains a list of "work categories" consisting of detailed separate activities for categories of work such as piling; concrete; cladding; waterproofing; windows and doors; and finishes. The Work Category Method uses a formula to determine the adjustment of each interim valuation based on the separate indexation of these individual "work categories".
- Part II: Weighted Work Group Indices Method – The Weighted Work Group Indices Method combines the "work categories" from Part I into "work groups" and then applies weighted indexation formulae to adjust the value of these combined "work groups". The Contract Sum Analysis should contain a schedule setting out which "work categories" are in which "work groups".
- Part III: Specialist Engineering Installations Method –This Part relates to specific specialist engineering work carried out by the Contractor such as electrical installation; HVAC and sprinkler installations; lift installations; structural steelwork; and catering equipment installations. Here much more complicated price adjustment formulae are used incorporating separate weightings for things like materials, labour and on- or off-site installations.
Fluctuations Option C provides robust and comprehensive methods of determining and valuing the impact of price fluctuations on the Contract Sum, not lease those associated with material price inflation. If any of the methods provided are not entirely suitable for a particular circumstance, there is an express provision setting out how the parties may themselves agree any alteration to the methods and procedures to more appropriately calculate the required adjustments. However, the complexity and high administrative overhead associated with Fluctuations Option C would make the application of this option challenging on all but the largest of projects.
NEC4 Engineering and Construction Contract
The NEC4 Engineering and Construction Contract is intended to be a much more collaborative contract than the more conventional JCT approach and is purportedly drafted in more of a 'plain English' style. Consequently, the NEC4 ECC price adjustment options are more simply worded and employ succinct drafting to transfer inflation risk onto the employer.
Of the 22 secondary 'X options' that can be selected in the NEC4 ECC, Option X1 – Price adjustment for inflation, is particularly relevant to managing price fluctuations.
Option X1: Price adjustment for inflation
Option X1 uses a "Price Adjustment Factor" (PAF) to change the "Price for Work Done to Date" since the last assessment under the contract. The PAF is calculated using a relatively simple formula based on changes in value between the products listed in:
- an index or indices (as specified in the Contract Data) as at the base date; and
- the latest version of the same index/indices as at the date of assessment of the amount due.
In the case of priced contracts using an activity schedule (Main Options A and B) the Lump Sum payable is increased or decreased by the amount calculated for inflation. In the case of target contracts (Main Options C and D) the Target Price is increased or decreased by the amount calculated for inflation. Option X1 cannot be used for cost reimbursable or management contracts (Main Options E and F).
Option X1 also deals with the Defined Cost associated with compensation events. The PAF will be used to assess the relevant cost of compensation events to ensure any effects of inflation are taken into consideration. Compensation costs in respect of people and equipment are, however, still assessed as at the base date and so the effects of inflation are not factored into those costs.
One can select either a single index or multiple indices when using Option X1 which allows the parties to use it in as targeted a manner as they would like. Applied to the current inflationary climate, Option X1 is beneficial in that one can tailor the Contract Data to reflect the most appropriate index or indices for the project.
The drafting in Option X1 also ensures that after the Completion Date the PAF will not be changed, meaning that if the Contractor is in culpable delay it will carry the risk of increased prices due to any further effects of inflation after the date the PAF is frozen.
Further Information
If you have any questions or concerns about the topics raised in this blog, please contact Peter Metcalfe or any member of the Real Estate & Construction team.
About the Author
Peter Metcalfe is a partner in the Real Estate & Construction team with extensive experience on all aspects of construction and engineering projects, from procurement and the drafting and negotiation of contracts, to contract administration and the avoidance and resolution of disputes.
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