Very high levels of inflation caused by COVID-19 and the war in Ukraine have led to construction price increases across the world. Pressures on the manufacturing sector are expected to increase as price volatility in the energy market is exacerbated during the winter months with industries which require high levels of energy in their manufacturing processes, such as glass, scale back their production as energy costs increase. As a result, it is expected that inflation will persist for the rest of the year and into 2023.
This grim outlook has highlighted the challenge of quantifying and managing increases in the cost of materials and labour in the construction industry. Parties to construction contracts are beginning to look for alternatives to the fixed price lump sum contracts which have been prevalent in the industry.
The FIDIC Red and Yellow Books (second edition, 2017) both include provisions for adjustments to be made to the contract price to reflect changes in costs of labour, goods and other inputs required for the works. These provisions are optional and have traditionally been used in long-term complex construction projects where contractors cannot take the risk for price escalation over the contract term. This optional nature has been enhanced by the removal by FIDIC, in the re-print of the Second Edition issued in November 2022, of the formula from the General Conditions into the Special Conditions at the back of the Contract.
The FIDIC guidance on these clauses states that they may be required where it would be unreasonable for a contractor to bear the risk of escalating costs due to inflation. This opens up the possibility of the provisions being used for shorter term projects which would ordinarily be fixed price.
For these provisions to apply, the parties are required to prepare a schedule of cost indexation which is then included within the contract. Failure to include a schedule of cost indexation in the contract, even if the parties intended for there to be indexation provisions, means that cost fluctuations are deemed not to apply to the contract. Where the provisions apply, amounts payable to the contractor are adjusted for rises or falls in the cost of labour, goods and other inputs as calculated by reference to the schedule of cost indexation.
It is essential that both parties take professional advice in relation to the preparation of these schedules of cost indexation. This is particularly important as it is required that the schedules include formulae for the calculation of how the contract price is to be adjusted. A failure to prepare the formulae correctly could result in them being or becoming invalid or could result in the formulae generating the wrong outputs when used. The FIDIC guidance gives the following example formula:
Breaking this formula down, Pn is the final output of the equation and the adjustment multiplier to be applied to the contract value carried out in the relevant period (n). The relevant period is to be agreed between the parties but this could be annual or monthly.
The symbols a, b, c and d are coefficients for certain elements of costs. In this example, a represents a fixed element of the contractual payments. The other coefficients represent the weighting of other cost elements such as labour, goods and materials which are intended to be subject to adjustment, as stated in the accompanying table.
Ln, En and Mn are the current cost indices or reference prices as stated in the schedule of cost indexation for the period agreed between the parties. Lo, Eo and Mo are the base cost indices or reference prices as at the relevant base date.
The accompanying table sets out the coefficients and the scope of the index (e.g. b = 0.2 for Labour). Where payments are being made in different currencies, then each index should be linked to a particular currency. The index should also be properly sourced with the value stated on a particular date which can assist the parties clarifying the source of the index if required.
Where the contractor is in delay and fails to complete the works within the Time for Completion, the adjustment provisions would still apply but any adjustments after the Time for Completion are made by using whichever is more favourable to the employer: the index applicable 49 days before the expiry of the Time for Completion or the current index.
As the above demonstrates, the formulae required for the correct implementation of these adjustment clauses are complicated and contain a number of potential pitfalls for the unwary, especially in the choice of indexation used. Particular care should also be given where a contract utilises different currencies for different elements of work.
International Quarterly is produced quartely by Fenwick Elliott LLP, the leading specialist construction law firm in the UK, working with clients in the building, engineering and energy sectors throughout the world.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
