Not long ago, our news feeds were dominated with worrying headlines …. “Global supply chain crises”, “inflation”, “labour shortages”, to name a few. These factors prompted a volatile economy and set in motion a series of events that led to record price escalation in the construction industry. Projects ground to halt, parties up and down the construction pyramid went out of business, and those that survived the unprecedented volatility have prioritized the inclusion of price escalation provisions in their contracts.
What is a price escalation clause?
Material prices tend to rise steadily in a mostly predictable manner, which allows contractors, subcontractors, and suppliers to account for this in their bids. But what happens when these surges in material and labour prices become unpredictable? That's what a price escalation clause is for.
An escalation clause allows a contractor or supplier to impose price increases for certain labour and material during the term of the contract, thereby shifting the risk of the volatility in material price increases, from contractor to owner. Escalation clauses generally only apply to specified labour or material that can be tied to an objective price index, such as commodity prices or published union rates and will typically permit the contractor to recover all or a portion of a price increase above a certain negotiated threshold (i.e., 10% relative to the index).
These clauses are generally used in lump sum or fixed fee contracts, particularly when the duration of a project is long and potential fluctuation of material prices could be significant. In a time and materials contract, escalation is generally not a concern for a contractor, because the owner already takes on the risk of having to pay higher prices due to fluctuations in the market.
Why use an escalation clause?
The primary benefit for contractors that have an escalation clause in their contract is that they are shielded from volatile material prices and potential price surges. The construction industry, at least in Ontario, can be extremely competitive, forcing contractors to cut into their profit margins to get work.
What is the benefit for an owner? It seems that owners would be disincentivized to agree to an escalation clause. While not overly apparent, COVID-19 has shown us that well-drafted prices escalation clause can provide several benefits for an owner. One such benefit is that when price escalation clauses are used, bidders don't need to include contingencies for the risk of surges in material prices, which allows them to bid on the project more accurately, which can lower the initial contract price. As the owner bears the risk, it is less likely that a situation will occur where a contractor is in a position that surges in material prices will cut into all their profit, which is probably the last thing that an owner wants. A desperate contractor can cut corners to stay alive, walk off the project, or declare bankruptcy. All these situations could be avoided with a reasonable price escalation provision. The last thing an owner wants is to replace a contractor midway through a project, at a significant premium.
A further benefit for an owner is that escalation clauses can work both ways, creating the possibility where an owner can seek a decrease in the contract price, if material prices decrease below a certain threshold. Those situations create a win-win and a fair allocation of risk – the contractor doesn’t carry the risk of price surges but cannot profiteer from price decreases.
How does a contractor negotiate the inclusion of a price escalation clause?
The starting position for most owners is that they would want to resist the inclusion of an escalation clause that pushes the risk of the price increase completely on them. An owner may want a contractor to provide a guaranteed price.
There are strategies that a contractor can use to negotiate a fair price escalation clause.
- Certain contractors have the necessary bargaining power if they are leaders in their field or provide a specialized service that only a handful of contractors can provide. Leveraging this bargaining power can make it easier to convince the owner.
- Many owners acknowledge the impact the past few years have had on the construction industry and have learnt from costly lessons. A contractor who can educate and inform an owner, in a quantifiable and transparent manner, as to the fluctuations in material supply and prices will have a better chance to make provision for such increases in their contract. An open and transparent contractor may be preferred over one that provides no insight on its pricing.
- An owner may be more willing to accept a price escalation provision if there is a reasonable allocation of risk, for example, if their liability is limited only to excessive price increases. One way to implement this is to have the contractor absorb the price increase up to a certain percentage, as it normally would in a more stable economy, and then have the owner pay for any increases above that percentage, or that the parties share the risk, by splitting the difference in the price increase.
- A contractor can offset the risk, by passing on any saving to the owner by including a de-escalation clause so that the owner can benefit from any price decreases, or to have a maximum percentage increase that the owner will pay so that the owner knows there is a limit to the price increase.
What makes a good escalation clause?
While it is possible to have a “standard” price escalation clause, this is one of those instances where it really benefits the parties to formulate a project specific provision. There are primarily three things to consider when crafting an escalation provision, namely:
- Specifying the labour and material that will be subject to escalation, as well as the base quantity and value that will be subject to adjustment.
- Identifying the price index that will be used for quantifying the escalation, and specifying the base value from which any escalation will be measured.
- The method of price adjustment should be specified, including how the change in the price index will be used to escalate the base price, including any thresholds and which parties will bear the risk of any increase or decrease.
What if you already have a contract and no provisions has been made for price escalation?
While the general rule is that if the parties have not made provision for material price escalation in their contract, a contractor would not be entitled to claim an increase in the contract price from the owner, there are still mechanisms that a contractor could use.
- Nothing hurts to ask – we have seen it firsthand, that many owners would much prefer to keep a dependable contractor on a project, by paying a reasonable price escalation, rather than entering a dispute that could run up legal costs and ruin a relationship or negatively impact the completion of the project.
- Force majeure clauses, depending on the wording, can allow the parties to change certain contractual obligations if an event beyond the parties’ control occurs, such as a worldwide pandemic. Generally, most off the shelf construction contracts do not allow for price escalation in the event of a force majeure, but if care has been taken in the drafting, then there are instances where increases in material and labour will permit such a claim.
- Where a project is delayed, and the contract does not contain a price escalation clause, contractors might instead be able to recover material and labour costs for price escalations that occur because of owner-caused delays or suspensions.
Conclusion
Anticipating an issue before it arrives can be critical towards avoiding claims and conflicts. A well thought out price escalation clause can assist the parties to ride the storm when things become unpredictable, by identifying and sharing the risks of increases in material and labour prices.