Gemma Irving, principal associate and Richard Hartigan, partner at Eversheds Sutherland, explain why fluctuation provisions in contracts hold the key to tackling inflation in construction
When acting for an employer, it has become routine to delete fluctuation provisions. Usually, construction projects are priced by the employer setting out their requirements in a tender and accepting an offer from the contractor to carry out the works for an agreed price. The price is only adjusted thereafter in response to specific events and by established variation provisions. This process creates price certainty for the employer and has been very popular. We are experiencing rising inflation in construction, materials and labour shortages, and increased price volatility. Contracting parties may wish for greater flexibility when pricing works to reflect the uncertainties they face in the market.
It may seem counter-intuitive for an employer to accept the risk of inflation in construction and other cost increases when they have enjoyed the benefit of having a fixed price for several years. However, we are currently experiencing a very different market, and it could be that having a fluctuation provision is useful for both the employer and contractor: if there is market volatility, the contractor may “cost dump” this risk into its tender price. This means that the contractor has already inflated its price without grounding this on any real basis.
This could also make it difficult for the employer to compare tenders amongst contractors when trying to establish the best value it is difficult for typical variation mechanisms to accommodate the type of variable and long-term change we are currently seeing in the market if the contractor does not make provision for cost increases during its project, this can erode its profit and make it susceptible to insolvency. Having an insolvent contractor would be a lot more costly in the long term, resulting in disruption to the project. It could also reduce the value of the contractor’s warranties if the works are defective.
It is necessary for the employer to consider the wider picture, including the contractor’s overall financial position when deciding whether or not to accept a fluctuation provision. It could be that the perceived benefits outweigh the potential extra cost associated. A fluctuation provision is a contractual mechanism whereby the cost of a job is calculated as the job progresses, with the final contract sum adjusted accordingly. It allows the parties to price the works to mirror the effects of inflation or deflation in the market over time. This means the tender price could be increased or decreased when finalising the actual contract sum payable.
For certain types of projects, it may not be necessary to complicate matters by having a fluctuation provision. For example, works that have a short duration, are relatively simple and do not rely on specialist plants or materials may be straightforward to cost and may have price consistency.
Some contracts do not need a fluctuation mechanism because the pricing method used already accommodates such changes:
- a “reimbursement contract”, such as that used for Option E in NEC Contracts, means that the contractor is paid its actual incurred costs. This means that if the contractor’s costs change during the progress of the works, this is reflected in the contract sum
- a “term work contract” or “management contract”, such as Option F in NEC contracts, is based on notional quantities and/or a schedule of rates. Still, the individual rates used are adjusted periodically, meaning that the contract sum is regularly recalculated
- a “remeasurement contract”, such as a JCT Standard Building Contract with Approximate Quantities, where the contract sum is based on approximate quantities and a schedule of rates. The actual work is remeasured on completion, but the individual rates and prices are adjusted where appropriate. The contract sum is recalculated using the new rates and final agreed quantities.
There may therefore be an equivalent mechanism set out within the contract, which means that a specific fluctuation mechanism is not required. Parties may be interested in using these forms of contract instead. However, when deciding to use a fluctuation provision, parties may wish to consider what type of fluctuation provision best suits their needs. It should first be considered what the “base date” is. This is the date agreed upon within the contract, from which the adjustments to the contract sum are made. It is usually the date that the tender is returned or the date of the contract. It is an essential provision in any fluctuation mechanism.
Under JCT contracts, there are the following types of fluctuation provisions:
- Option A – this applies automatically unless deleted. This provides for adjustments for changes to the contributions, levies and taxes that the Contractor has to pay in its capacity as an employer. For example, this would capture an increase in National Insurance Contributions or post-Brexit tariff increases.
- Option B – This permits an addition or deduction to the contract sum for any changes to the cost of materials, goods, electricity, fuels or labour. This is in addition to those items already covered by Option A. Option B could be useful if there is price fluidity for key elements of the works, such as steel or oil. However, it should be noted that the fluctuation provisions do not provide the Contractor with an extension of time if there are shortages and delays in delivery. The net amount of any increase or decrease is assessed and included in the valuation of the application made by the Contractor. This can involve a significant amount of administration, but it is possible to limit the application of the fluctuation to only certain items.
- Option C – if the parties wish for the type of adjustments noted in Option B to be carried out more formally, they can elect Option C. This prescribes a formula that can be used for any changes made to the Contract Sum using the Formula Rules. The Formula Rules are a 60-page document which sets out the average measure of fluctuation over an agreed period. Suppose there is more frequent volatility over a shorter period. In that case, this can mean that the formulas are not representative of actual inflation, meaning there can be inaccuracies in the adjustments.
In NEC contracts, a fluctuation mechanism is adopted when Option X1 is selected in the Contract Data. Under this mechanism, the parties can agree on which products will be subject to the adjustment (for example, equipment, plant, fuel etc.). The parties are free to agree on the type of indices they wish to apply. In NEC3, where there was a change in the index, the calculation needed redone according to the new index. This, however, does not apply to NEC4, under which the calculations do not need to be repeated.
Under FIDIC (for example, the Red and Yellow books), there is a clause to deal with adjustments for fluctuations in the cost of labour, goods and other inputs into the works. However, for this clause to apply, the parties must complete the table of adjustment data/schedules of cost indexation in the contract.
As can be seen, there are a variety of approaches to determine how price fluctuations can be dealt with in the contract, so knowledge of the contractual provisions is useful to determine which mechanism is most suitable and how it will impact the project.
Another way in which standard contracts vary is how they deal with fluctuation mechanisms when the works pass the contractual date for completion due to the fault of the contractor (i.e. the contractor is in culpable delay):
- under Options A and B in JCT, no adjustments are permitted;
- under Option C in JCT and NEC Option X1, any price adjustments are made according to the same adjustment factor that was set at the date of the intended completion date;
- and under FIDIC, there is the option for the adjustments to be made either according to the indices/prices applicable 49 days before the date for completion or the current index/price (whichever is most favourable to the Employer).
Parties should consider these variables before entering their contract so there are no hidden surprises later.
In summary, fluctuation provisions can be an effective mechanism to manage pricing risk on a project. The current economic climate has made fluctuations very relevant, and these provisions should be considered at the offset of any contractual negotiation. It is worth considering how the fluctuation provision works according to your contract so that you can be sure it really adds value. Although employers have had the benefit of not using them in the past, consideration should be duly made over them to see if they can add benefit and operate to be favourable to all.