Cost Increases Up the Ante for the Construction Industry – Is a Price Escalation Clause Your Best Bet?

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Charter schools have experienced some of the highest enrollment growth due to pandemic-related factors influencing how we rethink education. As a result, there continues to be significant increase in the renovation and construction of charter school facilities around the country. Efficient contracting practices are essential for budget-conscious charter schools seeking to complete construction of educational facilities and instructional spaces in a cost-effective and timely manner. As discussed in this article, contractors are increasingly seeking to negotiate price escalation clauses with owners as more and more construction projects are affected by supply-chain disruptions and rising material costs. Strategically negotiating such a clause could lead to more reliable and market pricing since contractors will not need to inflate their bids to cover the potential for substantial post bid increases in the cost of certain materials.

High Stakes and Even Higher Prices

The COVID-19 pandemic and the war in Ukraine have raised the stakes for participants in the construction industry, triggering a surge in the cost of materials due to market volatility and global supply-chain disruptions. In late 2021, the Associated General Contractors of America reported that inflationary construction costs continued to outpace contractor bid prices by more than ten percent based on producer price indices. Even though soaring material costs are affecting both contractors and owners alike, contractors are shouldering more of the financial risk from these post-pandemic price increases. For contractors bound by construction contracts with a fixed sum or guaranteed maximum price, this price volatility erodes a contractor’s profit margin on a project, which – depending on the size of the project and the work involved – may lead to more devastating financial consequences for a construction firm.

To ensure the viability of a construction project so that performance of the work remains feasible and profitable in today’s market, owners and contractors must be prepared to mitigate the threat of cost overruns and delivery delays from supply shortages. While it may not necessarily be an ace up your sleeve, one way to strategically manage and allocate this financial risk may be through the use of a material price escalation clause.

Striking A Deal

A price escalation clause provides for adjustment of the contract price based on an objective metric or price index that the parties agree upon ahead of time. For instance, one objective metric might be the difference between the price of a material quoted at bid time and the price of that material when delivered. If the price change between the two dates exceeds an agreed-upon percentage threshold, then the contract price is adjusted accordingly. Escalation clauses serve to distribute the risk of steep price increases more equitably between owners and contractors, so that both parties are adequately protected and able to move forward with a project.

Many owners recognize the impact of the pandemic on the construction industry, which means they understand the need for a price escalation clause and may be willing to work with a contractor to accommodate these price increases. Still, most owners desire certainty and will be unwilling to consider a price escalation clause without clear safeguards to protect them from exorbitant price increases. Others may expect the contractor and its subcontractors to be vigilant in staying ahead of the market and take all necessary steps to control costs from the outset of a project. And, on large or complex projects with hundreds of trades, owners and construction managers will be reluctant to negotiate separate price escalation clauses with each trade.

Despite the obvious benefits to negotiating a price escalation clause, such a clause can have unintended consequences if not carefully drafted. For instance, the inclusion of certain materials in an escalation clause may risk the implied exclusion of others if a dispute later arises and the construction contract is subject to interpretation by a judge or arbitrator.

Furthermore, when drafting such a clause, it is important to choose a reliable price index and/or objective metric that specifically targets the pricing issues involved on the project at hand. A price escalation clause may also be accompanied by a de-escalation clause, which provides owners the opportunity to share in cost-savings on a project if the price of materials happens to decrease beyond a certain threshold.

When drafting a price escalation clause, a number of considerations should be made:

  • Identify which specific materials are at risk of marked volatility;
  • Establish an objective measure of change, e.g., published price index, bid price vs. purchase price, or percentage threshold of cost increase;
  • Agree on a threshold, above which or below which the material price will be adjusted;
  • Agree on a percentage “cap,” above which or below which the price will not be adjusted;
  • Identify which suppliers (if any) will provide fixed pricing for a fixed period of time;
  • Opt for early procurement and storage of materials, where possible, to keep costs down; and
  • Specify a method of notice to the owner and an obligation to provide supporting documentation or data evidencing the price increase.

All Bets Are Off

Drafting a strong and appropriate escalation clause will require consultation with an experienced construction lawyer. Such clauses should be negotiated upfront when drafting the contract for a new project, or otherwise negotiated as part of an amendment to an existing construction contract if both parties agree, as a means of risk management. Doing so is a “best practice” given the present reality of today’s construction industry for owners and contractors alike.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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