Tackling cost escalation in International Construction & Engineering projects
Parties involved in international construction and engineering projects are dealing with highly volatile market conditions resulting from the pandemic and its knock-on effects. The situation in Ukraine has further exacerbated pressures on the prices of materials, labour, commodities, shipping, fuel and energy, leading to inflation. Contractors experiencing cost escalation need to check their contracts but may be best served by finding collaborative solutions.
Is there a right to claim cost escalation?
EPC contracts for long-term projects signed before the pandemic in calmer (or certainly less volatile) economic conditions were typically tendered on lump sum fixed prices with no entitlement for the contractor to claim cost escalation. Fluctuation clauses, which entitle contractors to be paid adjusted sums to account for rises and falls in market prices, were commonly either not included in contracts or were deleted where standard forms were used. In such cases, pure inflationary cost escalation is the contractor’s risk.
Where there is a fluctuations clause in the contract, the amounts payable to the contractor may be adjusted to account for increases (and sometimes decreases) in market prices for certain heads of cost incurred by the contractor. Sub-Clause 13.7 in the FIDIC Silver Book 2017 edition contains a straightforward fluctuations mechanism, for example. This clause provides that, “[t]he amounts payable to the Contractor shall be adjusted for rises or falls in the costs of labour, Goods and other inputs to the Works, by the addition or deduction of the amounts calculated in accordance with the schedule(s) of cost indexation in the Particular Conditions”. So long as the parties include the relevant cost indexation schedule in the Particular Conditions, the sub-clause applies and the amounts payable to the contractor will be adjusted.
It is more likely the case that the contract does not include a fluctuations clause, however. In these circumstances the contractor needs to assess whether costs escalation may be claimed as an entitlement to additional payment arising due to an event that has occurred. Such events are generally restricted, but include actions of the employer that prevent, hinder or impede the contractor from carrying out the works. The employer delaying site access for several weeks would be an example, as would failing to provide free issue materials on time.
In those circumstances, if the contractor can show that the cost escalation would not have been experienced but for the Employer’s breach of contract, then in principle the Contractor can claim the escalation (subject always to the particular terms of the contract). If the employer was obliged to give access to the site on 1 January, for example, but in fact prevented access until 1 May, in which time costs escalated, the contractor could claim the escalation resulting from the employer’s prevention. The circumstances in which this may apply are fact-specific though and as such may in practical terms be limited.
What other options does the contractor have?
Contractors are not banks, and generally cannot afford to finance projects for others. While there are measures contractors can take to avoid or minimize increased costs, there will be a limit to the cost escalation that contractors can bear. Unfortunately, market conditions are difficult and 2022 has already seen several insolvencies.
Under English law, contractors do not generally have the right to terminate contracts for convenience nor in the event the project is costing too much (although in civil jurisdictions there may be hardship claims available). For a contractor to exercise contractual termination rights it will need to have grounds for termination—usually these are confined to non-payment or the employer becoming insolvent. Exercising termination rights is high risk and must be carefully handled.
Increasing cost escalation risks putting contractors in an invidious position—continuing with the project risks insolvency and termination whereas not continuing the contract risks breaching the contract and entitling the employer to terminate and claim compensation.
The lack of good options means it is best to avoid taking precipitous action such as attempting to terminate the contract—at least without taking appropriate advice.
We suggest the parties take a step back and a deep breath. Even in the most fractious contractual relationships interests remain aligned at least in principle—ultimately both parties want the project completed: employers to have the completed asset start generating revenue and contractors to move on to other projects. Keeping the focus on how best to achieve project completion is important from both the employer and contractor points of view.
Employers cannot be spectators in this—I consider it is better to describe employers as “owners” because they ultimately own the project. They have the largest stake in its outcome and are part of its delivery. It is likely to be cheaper and less disruptive over the long term for the Employer to support a contractor facing excessive cost escalation than taking the serious step of terminating the contract (and inviting the associated risks) and employing a new contractor even if there is performance security to help smooth out the financial turbulence. Assuming the termination and replacement runs smoothly (which is quite an assumption) the new contractor will certainly command higher prices anyway and may not take any risk for the partially completed work done by its predecessor.
For contractors facing cost escalation issues that risk causing distress to projects, we would urge employers and contractors to meet and discuss whether there are means by which the cost escalation pressure can be relieved. The onset of the pandemic showed that parties can be collaborative and pragmatic in times of crisis and we would encourage parties to embrace a similar mindset so that projects can be seen through to completion without risks to businesses.
It is possible to make changes to the project to bring about completion in a way that will work for both parties, for example by re-baselining the schedule and/or agreeing contract amendments that involve more of a risk share approach to cost escalation—whether generally or in relation to specific types of cost.
Where there is no fluctuations clause, we urge parties to explore all such options before resorting to contracts that were created for yesterday’s world.
The content of this page is a summary of the law in force at the date of publication and is not exhaustive, nor does it contain definitive advice. Specialist legal advice should be sought in relation to any queries that may arise.
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