A year of hyperinflation — Lessons from inside construction
Unprecedented global supply chain issues and hyperinflation of building materials were undeniably the most significant challenge faced by the construction industry in 2022.
While those pressures are predicted to ease in 2023, the ripple effects will continue to impact existing projects for some time to come. As we begin the new year, a number of valuable lessons from the construction industry will assist councils in better preparing for future project procurement.
The effect of cost pressures is most commonly manifested in requests for additional payments by contractors who, in turn, needed to pay their subcontractors and suppliers.
Under most lump sum fixed price contracts, contractors assume the risk of rise and fall in construction costs. This has left councils in a difficult position when it comes to dealing with claims by contractors - by having to either take a hard contractual line, forcing contractors to absorb increased costs or by ‘sharing the pain’ with councils having to make additional payments to the contractor.
The first of these options carries with it the significant risk the contractor will be financially unable financially to continue with the project. In that case, a council would ultimately be left in a position where it is forced to re-tender the project at significant additional cost, also resulting in the project being ‘moth-balled’ until such time as another contractor could be appointed to pick up where the original builder left off.
Even if the original contractor is able to continue with the project, there is increased pressure and risk of cutting corners in order to offset increased costs, impacting the quality of the build.
While the second option has a greater likelihood of the project continuing, it has its own challenges. In most instances, councils have very little visibility over project costs. Where a council is prepared to make a financial contribution, the challenge is in determining the extent to which the contractor’s financial difficulty has arisen from unprecedented market conditions as distinct from other factors within the contractor’s control, such as having tendered low in the first instance in a bid to secure the project or due to a lack of understanding about its scope. In our experience, the truth usually lies somewhere in between.
Faced with these alternatives, it is unsurprising that, in most instances, there is a general preference by councils towards making ex gratia payments in recognition of the increased cost pressures faced by contractors. In doing so, councils should consider the following:
- Due diligence: determination of a figure which appropriately shares the risk of cost escalation between the parties requires a degree of transparency by the contractor. As a condition to entertaining a claim for an ex gratia payment, the contractor should be required to ‘open its books’ by providing evidence of how its original tender price was calculated, along with copies of updated quotations from subcontractors/suppliers;
- Payment structure: even if a figure can be agreed upon, there remains a risk the contractor will not have the financial means to complete the project. Council should consider linking any ex gratia payments to the completion of milestones to incentivise timely progress and completion;
- Security: consider requesting additional security to cover the additional value of the project and agreeing for the security to be cashed in the event of insolvency;and
- Procurement policies: any consideration of ex gratia payments (or other mechanisms for the resolution of contractor claims) must be considered within the framework of the relevant organisational procurement policies.
The challenges presented by 2022’s market conditions are unfortunately not over yet. But they have provided some valuable lessons on how better to protect councils for future procurements, including by:
- Timely procurement: projects should ideally be put out for tender once they are both market and ‘shovel ready’. Proceeding to market with an incomplete design or with elements remaining ‘to be confirmed’ gives rise to uncertainty in scope and pricing, opening up avenues for contractors to seek additional payment.
- Consideration of rise and fall: more contractors are seeking to negotiate ‘rise and fall’ provisions. If such a provision is to be considered, can its effect be quarantined by, for example, limiting it to certain trades?
- Advance payments: requests by contractors for advance payments for materials are becoming far more common. Such requests should only be considered on the basis the contractor is to provide separate security for the advanced payment, which is only to be released upon delivery of the materials to the site and transfer of title. If the contractor cannot provide security, is the council able to pre-purchase and store the materials?
- Consider alternative procurement models: while the lump sum fixed price model theoretically provides greater cost certainty, other models which are better suited to recognise the impact of unprecedented market conditions include managing contractor arrangements, gross maximum price and ‘early contractor involvement’ processes.
A change in approach?
The catastrophic impact of post-COVID market conditions on the industry has challenged traditional modes of procurement. A more collaborative approach which recognises the range of stakeholder interests in ensuring the successful completion of construction and infrastructure projects is now required.
While the repercussions will be felt for some time yet, councils can and should implement learnings from these experiences to improve their procurement process and tighten contract administration. This is not just for their own protection but for the planning and preparedness of local projects for their communities.
If you have further questions about cost escalations or other construction-related queries, please contact our Partners, Anna Scannell, Paul Woods or Simone Holding from our Construction & Projects team.
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