Have you considered an Escalation Clause to cope with Rising Costs?

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Smith Gambrell RussellEarlier this year, the soaring cost of lumber and other construction materials made headlines throughout mainstream media as contractors and owners grappled with the consequences of market volatility. While the construction industry has seen a significant decrease in the cost of lumber in recent months, the August 2021 Producer Price Index published by the Bureau of Labor Statistics reported that the cost of materials and components for construction has increased 19% over the past 12 months. ¹In light of this market volatility, it is unsurprising that third-quarter data from the U.S. Chamber of Commerce Commercial Construction Index indicates that 98% of contractors reported that price fluctuations have a moderate-to-high impact on their business.²

Because of this price volatility, many projects are being impacted by cost overruns. As a result, many contractors are more frequently having difficult conversations with owners regarding who bears the risk of increases in material prices. As is often the case, the answer to this question will depend upon the terms of the contract.

If the contract contains an escalation clause, then the risk of the increased cost of materials likely sits with the owner or is shared between the owner and contractor. As discussed in more detail below, an escalation clause is a contractual provision that allows for an adjustment to the contract price to account for certain fluctuations in the cost of materials. To determine who bears responsibility for certain material prices, the parties simply need to apply the conditions of the escalation clause to the material price increase at issue.

Prior to the COVID-19 pandemic’s disruption of the global supply chain, significant unexpected material price increases were relatively infrequent. As a result, construction contracts often did not directly address such risks. Unless directly addressed through an escalation clause, the risk of an increase of material prices most often sits with the contractor, especially if the contract has a fixed-price or a guaranteed maximum price.

A contract’s silence regarding which party bears the risk of price escalation does not automatically foreclose a contractor from seeking relief from unanticipated increases in material prices. The viability of a contractor’s claim for a price adjustment will largely depend upon the language of the contract, the cause of the price increase, and the attitude of the owner. Often there are few potential options for relief if the contract does not directly address price escalation. However, Contractors may look to the contract’s force majeure or owner-caused delay provisions to seek relief from increases in the cost of materials.

Force majeure provisions vary across construction contracts, but they are generally based upon the concept that a contractor’s ability to perform its obligations was impacted by causes beyond the contractor’s reasonable control. Unless specifically enumerated in the force majeure clause, price increases alone typically do not constitute a force majeure event absent extenuating, unforeseeable circumstances. The early impacts of the COVID-19 pandemic fit within the framework of certain force majeure provisions, which were utilized as a legal basis for pushing material cost increases upstream to owners. More often than not, however, a force majeure provision will stipulate that an extension of time is a contractor’s sole remedy for a force majeure event. In other words, the contractor will receive extra time to perform but will not receive additional money.

Contractors do tend to have better success obtaining cost relief if the increased cost of the contractor’s performance is the result of an owner-caused delay. For example, if a contractor can demonstrate that a delayed release of plans pushed the contractor’s purchase of materials beyond the price validity period quoted by a supplier, then the contractor will likely be entitled to an adjustment of the contract price. This is one of many reasons why contractors should be wary of “no damages for delay” clauses, especially during times of market volatility.

The options described above are less certain than an express escalation provision. As such, they should not be relied upon as a primary means of mitigating the risks associated with market volatility. Contractors who wish to manage the risk of price inflation should specifically note the risk of price escalations during the bidding process and should include price escalation clauses in construction contracts going forward.

Price escalation provisions are not one size fits all, and they must be carefully drafted so that the escalation clause encompasses most of the contractor’s price risk. To determine the best fit for their businesses, contractors should consider 1) the type of escalation clause, 2) the method of price adjustment, and 3) the materials subject to escalation.

Escalation provisions can take many different forms, but the two most common are delay escalation and threshold escalation. A threshold escalation clause is one that provides for an adjustment to the contract price when material prices on the open market have increased by a certain percentage beyond the cost estimated at the time the contract was signed. A delay escalation clause fixes pricing for a limited period of time and allows for additional compensation if prices increase because the project is delayed beyond the specified period of time, which is usually given in number of days or by a specified date.

Once the type of escalation clause is selected, the method by which escalated prices will be measured must be defined. Price escalation clauses may be cost-based or index-based. If cost-based, the amount of additional compensation the contractor can seek is based upon the difference between the actual price of the material versus the amount included in the bid. If a cost-based escalation clause is used, then contractors should take care to confirm the completeness and accuracy of its bid. The use of cost-base escalation provisions is also typically accompanied by significant requirements for substantiation that may require a contractor to open up its books in a manner not typically agreed to.

If an index-based clause is used, material costs are tied to an index for the applicable commodity. This allows the contract price to fluctuate in line with changes to the price index for that commodity. Two common indexes are the Producer Price Index published by the Bureau of Labor and Statistics and the Construction Cost Index published by Engineering News Record. Owners who agree to index-based escalation clauses often request that the provision allows for downward adjustments of the contract price in the event of significant decreases to the cost of materials.

Finally, the materials subject to escalation must also be determined. Very rarely are all construction materials subject to price escalation. Instead, a contractor typically identifies essential materials or labor categories that are expected to experience economic fluctuation during construction. When proposing or drafting an escalation provision, contractors should carefully identify those materials and components of construction with the greatest likelihood of cost increases.

Ultimately, the price escalation provision included in the construction contract will be the product of negotiation between the parties. Most owners desire price certainty and will likely push back against the inclusion of a price escalation provision, so it is important to propose escalation clauses in a manner that does not overreach. After all, open dialogue regarding how to fairly and equitably manage economic uncertainty is in the best interest of both parties. Most owners will understand that, if a contractor is protected from significant losses by the inclusion of an escalation provision, then pricing will not be significantly inflated to hedge against the risk of future increases. Further, fair allocation of risk at the outset of a project will allow the parties to avoid disruptions during construction.

Like most contractual language, price escalation provisions can be nuanced, subject to various state and federal laws, and should be implemented with caution. Contractors seeking to include price escalation clauses are encouraged to consult with an experienced construction attorney.

¹ United States Bureau of Labor Statistics, PPI Report Data for August 2021 (Vol. 25, No. 8).

² United States Chamber of Commerce, Commercial Construction Index Report for Q3 2021 (September 2021).

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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