The impact of inflation on construction contracts and disputes

I'm an independent consultant and provide project support technical, contractual and commercial.

PHILIPPA PEARCE: Well, thank you for joining us today, Kieran. And I'd love for you to share your thoughts on the impact of inflation on construction contracts and disputes.

KIERAN DINEEN: Right now, UK inflation is about 8% to 10% depending on your method of measurement. Typically, the Retail Price Index (RPI) or Consumer Price Index, (CPI) which define your basket of materials and products and compare what they cost now against what they cost last year.

Construction industry inflation has been quite different and much more volatile. We've seen some really big figure increases, for example ready mixed concrete is nearly 20% and steel prices have been very volatile and the 12 months to February 21 are at about 40% inflation increase. Overall, construction prices are north of 11% for material.

These increases are having a big effect and is harder to account for within the project budgets and prices. I feel we've become used to low inflation to the extent we often don't really consider it. Also, our construction projects, tend to be large value and relatively long duration, so that inflationary impact is eroding profitability right from the very beginning from when the contractor submits their proposal.

Inflation is slowly but insidiously stripping away the profitability. So that's going on for a long, long time. For the client side, the cost of money, the cost of financing projects is impacted, their financing costs are increasing, which leads to a perceived reduction in value for money.

Furthermore, for the contractor, as well as the prices increasing cash flow is impacted. Contracting is often as much about balancing the cash flow through the project, with the cost that you're paying out for labor and plant and materials and construction increasing, and the delay to the payment coming flowing back in through the construction contract, there is a material risk to cash in hand and somehow, we have to fund that gap.

And that cash flow cost is arising because of borrowing money as well. So the inflation metric is having a really significant impact on construction, partly because the values are high and the projects are long, but also because the inflation in construction indices is much more volatile and higher.

PHILIPPA PEARCE: What has the impact of inflation been on pricing?

KIERAN DINEEN: Many of our contracts have mechanisms for dealing with inflation, but sometimes because we've been in this relatively stable low inflation environment, we haven't really paid a lot of attention to them.

Let's just think about how we price our projects. And effectively, three big building blocks. First is fixed price lump sum approach to pricing. This works particularly well where the scope is well known, and we don't expect much change.

The projects are priced on a number of discrete activities. The contractors set a fixed price against each of the activity to deliver the whole project. The contractor gets paid when they complete each of those activities. And as a consequence, because the price is fixed, they tend to carry most of the construction and the price risk.

Secondly, perhaps where the client is fairly confident of what they want, but we do expect change. We might have the contract where it's re-measurable. Here, the contractor would price a unit rate for each activity. For example, to supply and install the foundations, we might say, I will do that for you, Philippa, for £200 (or $200) for every cubic meter of foundation I provide.

And what we will do then is will remeasure how many cubic meters of foundations were required to deliver the foundation to your storage facility. And if the quantity necessarily went up, I would get paid more. And if the quantity necessarily went down, I get paid less.

The foundation is a good example, because the ground conditions are often uncertain. So we're going to provide the necessary foundations, but we'll remeasure the quantity. So as a contractor, I'm still taking on much of the risk in terms of time and labor and materials but not the risk of quantity.

But I am taking the risk of inflation because inflation would affect all the other component parts.

The third big building block for pricing a project, which is particularly popular on large public procurement projects, something we call target cost.

So now, what we're asking our contractors to do is open their books, and we will pay open book actual cost, the actual physical costs you incur in delivering our project. And on top of that, we'll pay a pre-agreed fee, a percentage fee to reimburse you for your overheads and profit along the way.

So in that respect, the contractor wouldn't be taking on the inflationary risk, because if the price is changed, they recover their actual prices. If material costs go up, they recover a higher cost, because it's a real cost. And if the quantities vary, and there's more required, well, they get paid more, because they get paid their actual cost.

So to put a cap on it, we call it a target cost, because prior to starting the work, the contractor and the client negotiate and agree an ambition, target outturn cost for the project. And the contractor goes away and says, if I deliver your project, and I can come in under the target cost, we have a mechanism to share the cost saving.

So if I bring efficiency and innovation and manage to deliver your project quicker and incur less cost and come in under the target, you and I will share the cost savings. So much more profitable for the contractor and encourages them to be efficient and innovative.

However, if I am less efficient and innovative and perhaps logistically, I'm not as well organized, and the costs overrun the target, the client doesn't pay all the cost overrun. that cost overrun is shared with the contractor. So there is some financial pain, and the ambition of target cost is open your books and show me the real costs, share and try and work together and be innovative, and we will share any cost savings.

And if the cost overrun, we'll only part pay the cost overrun. So the contractor will suffer some financial impact. Now, if inflation is affecting the prices of everything, the contractor's costs are rising, but the target doesn't change. So as inflation impacts the project cost, the margin between the contractor's cost and the target is being eroded. So they're moving ever closer to or maybe exceeding the target.

These are the three big building blocks of how we might price things. And then if we look inside them and say, what about inflation inside the contract. Are there mechanisms for dealing with it? Yes, there are, but not in every contract, some say fix your price and that’s it you allow for whatever effect of inflation forecast. And what do we know about forecasting? All we know is we're going to get it wrong.

But some do allow for inflation changes. Our building contracts, for example, JCT building contracts, probably the most widely used construction contract in UK construction. They have three price fluctuation options, A, B, C.

A is commonly used and that allows the prices of any taxes and levies and contributions to be recovered. So if VAT changed, you could recover the extent of VAT or national insurance contributions or taxes on materials or fuel duty.

So where you want to allow for recovery of changes in taxes and legislative contributions only use option A. So we can recover that. And that's typically in most building contracts.

Option B would allow you to recover the effects of price fluctuation on plant labor and materials, which is where the inflation is going to really impact us. But generally, that's been excluded. And generally, we haven't been so troubled, because inflation has been so low. And option C is, again, for price fluctuation but using formulaic indices of price change. The Royal Institution of Chartered Surveyors produce construction cost indexes. Using formulas to calculate the change in price rather than using actual change in price. And generally, B and C have been excluded. And in the negotiation, people haven't been too troubled, because inflation is low.

What we're seeing now is a much stronger conversations around contractors wanting to include that inflationary clause for plant and materials. And obviously, clients being nervous about including it, because they're opening themselves to the impact of inflation, so that's JCT.

NEC contracts, which are probably beginning to dominate in the bigger and certainly publicly procured projects. They have an optional clause for the effects of inflation. And it's a simple framework. So they've written the content of the clause about how inflation review would work.

And it's for the drafter to say, this is the index we're using. And we'll apply it to all of your costs every month. So rather than breaking it down into a fine detail, we can have a single index. Or you can make it complicated and say, we'll have a number of different measurement indexes. And NEC provides the framework of how that would be used.

And what about FIDIC, which is our most widely used international contract? How does that address inflation? FIDIC, has a variety of different approaches, whether you want traditional construction contract, client employer design, a design and build contracts, turnkey projects, engineering and procure and construct and there is an option for price adjustment for the effects of inflation, a schedule of cost indexation. So if it's decided to put this in, we can create a cost index schedule. FIDIC is actually very good as they provide guidance documents with the contracts itself giving examples of a cost indexation formula. So you can have a different inflation index for, say, labor, a different one for equipment, a different one for materials. And we can make it as fine and granular as we would like.

So some of the contracts have inflation accommodating clauses, and I think the discussions are going on around should we include it and how would it work. Contractors want it to be in, and clients are nervous understandably.

PHILIPPA PEARCE: So Kieran, you've mentioned that contracts are a formal way of dealing with inflation issues, but are there other alternatives that are being considered?

KIERAN DINEEN: OK. The contracts have these optional mechanisms for dealing with price fluctuation including inflation.

What are the Alternatives, about how might we manage it. So rather than just being reactive to it, can we be a bit more preventative?

Some discussions around taking the construction part a bit further downstream. So many of our projects are on a design and build basis where the client and their team will develop the scheme and the scope and then let the contract for the contractor to fulfil the design and procure, build and deliver the project. There is some discussion about could we progress the design with the client a bit further downstream more detail and more certainty. What would that do? It would, firstly, perhaps shorten the whole construction program for the contractor, because now, they're focused more on build rather than design and build. Also, in terms of pricing, if we're more certain about the design and what's required, we can be more certain and accurate in the price and the impact.

There's also ongoing discussion across the industry about modern methods of construction. Offsite construction, factory build, modular build, and that's a thread that has been going for a long, long time. It's not without its challenges. Construction projects are quite different to many other elements, and many of the manufacturing industry approaches, whilst good, they need adaptation.

Finally, we might try and discuss and agree how we might deal with the volatility through maybe the allocation of what we would call risk pots.

So what's a risk pot? Agree the risks in the construction project, the main risks and allocate some funds to each, which are only used then if the risk transpires. And you could have a risk pot for inflation. There is some discussion about it.

Accessing the risk pot is the negotiated part. So we might say, here is a risk pot, a pot of money, which we use for the effects of inflation. But it's only accessible if inflation rises above a certain value. The client then sets aside the funds only used if inflation is particularly high and insidious through our projects. And the contractor bears a defined risk and then could access additional funds if the risk exceeds it.

And what we're trying to do in our efforts is reduce the size of the error in our forecasting and try to reach a agreeable way of doing it. So there are some mechanisms outside the formal contract parts. And they are being discussed.

PHILIPPA PEARCE: So can you now give us some updates really, Kieran, on what are you seeing in terms of is there an increase in disputes in the construction industry and the typical cause of those disputes?

KIERAN DINEEN: I suppose you'd be expecting at this stage that, we should be seeing this is feeding through to increases in disputes and higher values and great unhappiness. But we are not measuring this

I'm really happy to report that we're not seeing it feed through into disputes. I guess, my caveat is not yet. Time and cost, two major contributions to project cost . Everything takes longer as well as a reduced pool of skilled labor, so our construction is taking longer. Long lead time on material, supplies, and products, also mean our project is taking longer.

And extending the project delivery time means that the client is seeing a delay in their realization of their project, whether it's for habitation, commercial storage, material supply, whatever it might be. So they are now funding their projects for longer.

And for the contractor, the longer they are on site, the more it's costing them. So they're incurring more cost. a background that as we've talked today is the compound effect of labor, plant, materials, going up in price. The client's finance is increasing costly. The contractor's cash flow coverage is increasing. So higher project costs and lower margins.

So it seems natural fuel to dispute. What are we seeing? I think it's fair to say that UK construction has a fairly well-developed dispute processes in a good way. We all have dispute escalation ladders, and they run through from what could be very simple, negotiation. You and I sitting down and trying to agree, difference of opinion. It could be facilitated.

We've also have alternative dispute resolutions such as mediation, which is an incredibly effective way to resolve disputes, not hugely taken up in the construction industry. Recommended and endorsed by the high courts to say,

And then we have adjudication, which like it or loathe it is actually a primary contributory factor as to why UK construction project disputes are resolved more quickly than most other jurisdictions. If you looked at the time taken to reach resolution the UK, North American and Middle East, the UK lead the way in terms of short durations. Not short but shorter than the others, because we have an adjudication process as part of the law in the UK.

The adjudication society are saying, the number of dispute referrals continues to increase, but it's a gradual upward trend. There's no uptick occurred in the last 12, 24 months. What are the primary causes of disputes? Poor contract administration. So quite simply, the parties involved not following the rules of the contract and what it says.

That's generally leading to the primary issue is extensions of time or valuation of the project. The adjudication process is seeing a linear increase year on year and no significant uptick. So it's working quite well.

The UK dispute resolution time is quite short, and the typical value is not increasing. What we are seeing and one of the global construction reports confirmed is that there is a little hardening of the approach.

At the other end of the spectrum in the high courts, again, they're seeing around about the same number of disputes being referred through the high courts as previously. No significant uptick. In the technology and construction division of the high court, construction is the largest sector by a long margin for high court disputes.

So good news certainly in the short term is that these volatile impacts we're seeing in the industry aren't leading to an increase in disputes just yet. There is a feeling they might, but we haven't realized it. And I think the real answer there is to continue to talk and negotiate and collaborate together.

There are some challenging times that we're facing, and it would be good to continue to face them collaboratively I think, Philippa.

PHILIPPA PEARCE: Fantastic. That's a great message to end on. So Kieran, I want to really thank you for your time contributing to this episode and for sharing your perspective on such an important topic.

KIERAN DINEEN: Thank you.

PHILIPPA PEARCE: Thank you to everybody who listened and thank you for joining the WTW Construction Blueprint podcast. We'll talk to you on the next one.

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