ESCALATION
Unless you have been stuck on a deserted island for the past two years, you will be aware that the pandemic (and latterly the war in Ukraine) is impacting our supply chains, leading to higher and more volatile pricing within the construction sector. Throw in the highest inflation rates in 30 years, border restrictions and surging demand, and there is no wonder that the construction sector is facing the most difficult period it has seen in recent memory. In an effort to provide some clarity on ways to deal with cost escalation and fluctuations, Marcus Hogan, Professional Practice Director, Te Kāhui Whaihanga New Zealand Institute of Architects and Lawrie Saegers, Managing Director, Rawlinsons discusses how the market is changing and responding, the types of fluctuations provisions (evidential and formula), and their associated issues.
WHAT WE ARE SEEING “In the past, contractors were comfortable to offer fixed prices and accept the risk of escalation, but with increases now potentially running into the double digits on some building elements, they can no longer continue to absorb ever-increasing prices”, Marcus says. While for many years, fluctuations in New Zealand and around the world have generally not been paid, in the last two years (and especially the last 12 months) things have changed. Now, most in the industry feel they are in a state of flux with to how to deal with the situation and the issue of payment for cost fluctuations is back on the table.
If those budgets are stretched too much due to increased contingency to deal with fluctuations, then their scope will be cut … “Our integrated ‘just in time’ economy has been disrupted”, Lawrie says. “In the past, in the construction industry, you could go into a store and take what you wanted off the shelf. Now there’s less stock on the shelves, and what is there is significantly more expensive.” This is primarily the result of supply chain and logistic issues coming out of our major traders, the US, Europe and China. It’s combining with labour constraints as well - the labour pool is a lot tighter. When you combine that with increased costs and surging demand, prices inevitably rise. Additionally, costs that were relatively stable and predictable are increasingly volatile. Contractors have less control, leading to uncertainty for them and their clients.
WHAT CAN THE INDUSTRY DO TO EASE THE PAIN? Marcus has considered using fluctuations provisions to deal with the price escalation issue. “The benefit to the contractor of including a suitable fluctuations provision in the contract is that the risk for pricing escalation (that they have no visibility or control over) is removed.”
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The fluctuations provisions contained in New Zealand’s standard form construction contracts (such as NZS 391X suite of contracts and NZIA SCC) have been rarely used since the mid-eighties and are only applicable if they are selected in the specific conditions. “The approach has been to transfer the risk of price escalation onto the contractor, and while this may not yield a particularly competitive price, escalation has been sufficiently stable for contractors to accept the risk without specifically pricing for it”, Marcus says. Following COVID-19, with price escalation having hit record highs, the use of fluctuations provisions is becoming commonplace in new contracts. “While the inclusion of fluctuations provisions in the contract transfers the risk back to the principal, it does mean that contractors are more willing to submit lower prices knowing that if labour or material prices escalate, the contractor will be compensated by an adjustment in the contract price.” Further, the selection of a fluctuations provision does not mean there is unrestricted recovery for the contractor or limitless exposure to escalating costs for the principal, as the provision will usually sit within wider provisions in the special conditions, which will set out the rules around its operation. It is a myth that a fluctuations provision only ever results in an increase to the contract price, as a decrease can also occur.
TWO METHODS FOR CALCULATING FLUCTUATIONS With the provisions not having been widely used, principals and contractors need to
