In this article, Senior Quantity Surveyor Ryan Grey considers some practical advice for tackling construction inflation.

Introduction

Domestically, it seems like everyone and everything has been affected by the rising costs of inflation, with rising food and energy costs in particular taking the spotlight.

The same also applies to construction.

As inflation begins to strangle all levels of the UK construction industry, this article explores ways in which we can make it easier to breathe whilst we wait for inflation levels gradually slow down.

Causes of Construction Inflation

In previous articles we have assessed the impact of material and labour shortages, which in short seemed to be caused by Brexit and the spread of the Corona Virus.

Since those articles were published, the invasion of Ukraine has also contributed to price rises, particularly as Europe sources a large percentage of its oil and gas supply from Russia and wheat from Ukraine.

These global events have led to inflation having an unprecedented effect on UK construction over the previous 2 years.

Impact of Construction Inflation

A recent Eurostat report in the Guardian suggests that the cost of labour has increased 30% since the Brexit referendum, double the rise compared to some other EU countries[1].

The same report finds that the price of materials including timber, steel and cement have increased up to 60% between the period 2015 and 2022 as supply diminishes and costs increase.

Additionally, the UK Government announced new legislation concerning the use of red diesel, whereby most users would be forced to switch to the more costly white diesel alternative instead.

Unsurprisingly then, as construction costs increase with inflation, staff wages have not, making it harder for businesses to attract and keep suitable labour.

This will undoubtedly lead to increased construction costs, and therefore reduced profit margins and even potentially programme delays.

The above could also lead to widespread investor uncertainty in the UK Construction market, with many analysts predicting a recession in 2023, with construction output forecast to decrease 4.7% during the year. (Construction Products Association, APA) [2].

The latest Purchasing Managers Index (PMI) found that in a survey of 150 UK based firms, their activity throughout December 2022 and January 2023 would point to a contraction in activity, aligning with the view previously shared by the Construction Products Association [3].

UK construction is clearly slowing and any projects that are progressing will cost more than what was agreed at tender.  So essentially the contractors lucky enough to win work will have to seriously reconsider their margins.

Time to breathe again…

Fortunately, all is not lost and there are several steps you can take throughout the project lifecycle mitigate the risks of inflation.

Tender stage:

Most employers will be aware of inflation so will no doubt be expecting any initial/dated cost estimates to inaccurate.

Although there is usually an urge to price competitively, with soaring inflation, it may be better to make allowances within the tender, through the use of provisional sums if using JCT.

It would be beneficial to understand the mechanisms in place for increasing the provisional sums if required, whilst also stating that if the provisional sum is greater than the actual cost, then the difference is deducted from the contract sum.

If tendering for works through NEC, it is important to note that NEC do not allow for the use of provisional sums as any item of works that cannot be clearly defined should not be included within the contract.

NEC does understand however that some works are unquantifiable at tender stage, so these items should be administered through an agreed Z clause and/or any differences between the actual work and provisional work should be captured within a compensation event.

Upon submitting your tender, it would be wise to review the relevant compensation event and Z clauses relating to provisional works.

Construction Contract:

The form of construction contract the contractor is working under may assist with tackling unexpected costs caused by inflation.

For example, there may be less flexibility in using (unamended) NEC Option A or Option B, as the contractor will be expected to deliver the project based on the agreed contract sum, regardless of the effects inflation has had to the contractor’s actual costs.

NEC Option C and D (unamended) do however offer some protection to the contractor against inflation as they are specifically designed to encourage collaboration and to reward both the employer and contractor on cost savings through a pain/gain mechanism.

If the actual cost is less than the target cost, then the contractor will be entitled to a share of the cost sharing dependent of the level agreed. Conversely, if the actual costs exceed the target cost, then the contractor will be expected to cover a percentage of the additional costs, again dependent on the level agreed.

NEC Target contracts are great in circumstances where the risks are expected to be greater than usual. With Brexit, Covid and the Ukrainian war causing inflation to soar, the risks for any construction project are expected to be high.

As the financial risks are shared between the employer and contractor, it ensures that the contractor is motivated to complete the works as cost efficiently as possible.

NEC Option E or JCT Prime Cost contracts are ‘cost plus’ contracts where the contractor is reimbursed for all the works they have completed plus a contract fee, providing full substantiation is presented.

The employer carries all the inflation risk under these two forms of contract.

Inflation Provisions: NEC

The NEC contract offers provisions to help protect the contractor from inflation in the form of a secondary Option X1 clause which specifically addresses price adjustments for inflation, providing the clause can be agreed between the employer and contractor.

• Option A and B: If X1 is selected, then the price adjustment is added to the fixed cost.
• Option C and D: If X1 is selected, then a slightly different calculation is required as the target cost is the cost that is adjusted.
• Option E: The employer is liable for the defined cost so a secondary X1 clause is not an option.

X1 is important for Compensation Events: Rates are calculated using base date levels at the current date of the assessment. If X1 is not selected, then compensation events are calculated using the rates stipulated in the schedule.

It is important to note however, that the price adjustment factor when applying the X1 clause is frozen at the project completion date. This means the Contractor carries the risk after this date. This is relevant to defects rectification.

For details on the calculation required when applying a secondary X1 clause please do contact ALA for further information.

Inflation Provisions: JCT

It has long been common practice for the employer to remove any inflation clause. However, in the current climate, these clauses are now being given further thought.

JCT has 3 options to address price fluctuations:

• Option A covers Contribution, levy, and tax fluctuations, for example increases to National Insurance contributions or tariff changes as a result of Brexit.
• Option B covers Labour and materials cost fluctuations. It is important to note that delays or shortages in delivery of these items does not serve as a basis for an extension of time.
• Option C covers formula adjustments to the above options.

As with both the NEC and JCT, it is important to note that the presence of inflation related causes does not amount to limitless employer cost exposure, nor unconditional contractor cost recovery.

Other Precontract Recommendations?

If as a subcontractor or employer there are still major doubts over a project’s viability borne out of market volatility, a more expensive solution is a bespoke contract. This can be tailored to protect your requirements, with amendments specific to inflation and risk allocation.

Employers could also consider performance bonds, parent company guarantees and vesting certificates, given the greater unfortunate risk of contractors entering liquidation.

If already engaged in a Contract…

Some contractors may be already engaged on a project with a construction contract that does nothing to mitigate inflation risks.

If so, then there are several steps still available to the contractor to ensure the project can be delivered.

Supply chain support

If a contractor is feeling financial pressure, then subcontractors and the rest of the supply chain are likely feeling them too.

It is always important to maintain clear and concise communication throughout the project, but this is especially true during difficult times.

If the subcontractor cannot keep up with the programme, then the contractor needs to know immediately. Without open lines of communication this is not possible.

Please note, whilst supporting the supply chain is vital, it is also essential to recognise subcontractors / suppliers who will be hindrance to the project. Performing credit checks on prospective new partners is strongly advised.

If a subcontractor enters receivership, this could have a knock-on effect to the contractor from liquidated damages/claims etc.

Framework Agreement

Setting up a framework agreement, may be beneficial as it can ensure cost certainty. This is beneficial for both the contractor and subcontractors.

However, this transfers most of the risk to the supplier and only guarantee success if the supplier continues to trade.

Budget Planning

Market volatility is likely to lead to further inflation. This is likely to lead to price rises in materials, labour etc. This will not only affect costs today, but will also impact final project costs.

It is wise to be pragmatic about the impact of inflation on the project when allowing for additional contingencies or delays and therefore very important to hold regular reviews on all cost items, ensuring the best value is always found through constant, evolving supply chain evaluation.

Order project critical materials now?

One option is to order project critical items now. This is of course a gamble, but it provides the contractor with cost certainty to limit exposure to future cost inflation and to mitigate any delay risks.

Bear in mind that ordering materials early will lead to additional storage and security costs.

Check Insurance Policies

CAR (Construction All Risks) insurance protects employers, contractors and subcontractors for physical damage and specified delays following an insured event.

Insurance premiums are generally determined on project cost or project turnover, whereby a greater project cost will usually result in an increased premium.

Inflation and market volatility could impact the project cost, which therefore could render the actual sum insured insufficient.

Regular reviews of policies can help guard against insurance complacency.

Summary

Hopefully this article has shed some light on strategies to combat the effects of inflation.

For more information on any of the items discussed, please contact one of the team at ALA who would be glad to discuss further.

You can also follow Ryan on LinkedIn.

 

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[1] Brexit: UK construction costs ‘have risen much more steeply than EU’ | Brexit | The Guardian

[2] Construction Industry Forecasts – Autumn 2022 (constructionproducts.org.uk)

[3] 2a6c84ecfb3446b4b6bea281ca9adaa1 (spglobal.com)