Addressing Rising Costs In Construction & Infrastructure Projects

Recent global conflicts, ongoing workforce shortages, procurement and supply chain difficulties, rising inflation and unprecedented investment in construction and infrastructure continue to exacerbate cost escalation across Australia. Increasingly, contractors are requesting that the risk of cost escalation be addressed explicitly in construction and infrastructure contracts.

This update focuses on how project parties can take proactive measures to allocate and manage responsibility for such risks.

What is a rise (cost escalation) and fall regime?

A ‘rise and fall’ or ‘cost escalation’ regime allocates risk between the parties by providing a mechanism to adjust an otherwise agreed contract sum, in order to reflect changes in the cost of goods and materials; plant, equipment and fuel; labour and logistics; taxes, import/export duties and other levies; as well as variations in rates of wages and award conditions.

Cost escalation clauses in standard form contracts

In their unamended form, the commonly used Australian Standards that provide for a fixed contract sum (subject to the usual adjustments such as approved variations) do not include a ‘rise and fall’ regime. They require careful, project-specific negotiation and drafting to address cost escalation risks.

The following considerations are relevant when there is a request for a cost escalation entitlement:

• The most common cost escalation provisions operate within a ‘rise and fall’ regime – that is, the contract price is adjusted to reflect indexation of specified project costs, but not volume. This can apply from tender submission to contract execution or, now more commonly, continue throughout project delivery
• Should schedules of cost indexation be included in the contract? These schedules help facilitate agreement on how to calculate adjustments to the construction inputs listed
• Should the parties set a pre-tender base date and calculate adjustments using a price adjustment factor before each assessment date, based on changes in agreed indices and weightings?
• As a precondition to entitlement, is there to be a minimum percentage or monetary threshold increase in cost, with open-book substantiation required?
• Limiting cost escalation parameters by category – for example, providing only for changes to taxes, import/export duties and other levies after the base date; alternatively, include labour and material costs, with formula adjustment according to drafted rules
• If the executed contract does not commence full operation until certain conditions precedent are met (such as financial close, granting of permits, relocation of services, demolition works), what is the validity period of the contract sum? Is there a contract sum review regime or even a ‘get-out’ regime based on the expiry of the conditions precedent satisfaction sunset date?
• Parties may consider cost sharing arrangements, agreeing on target costs with each party sharing a specified percentage of any overrun or underrun
• Benchmarking can be used, involving market testing specified costs at agreed times and adjusting the price based on current market prices
• It is important to address the interface of finance facility agreements, tripartite deeds and other security documents.

Making adjustments

The specified causes must be beyond the control of the contractor and of a nature such that an experienced, prudent and diligent contractor could not have avoided, remedied or mitigated them at any time post-tender.

The adjustments are measured typically by reference to actual costs or commodity indices. For example:

• A cost-based clause may measure increases by assessing the difference between the actual cost and the tendered cost
• An index-based clause may measure increases against a specific price index.

A cost escalation regime can be linked to one or a combination of indices covering specific materials, plant and labour. Where multiple indices are used, the drafting should clearly reflect the weighting given to each index when calculating cost changes.

There should also be clarity on whether the entitlement includes margin, attendance, on-site and off-site overheads and preliminaries.

Key negotiation and drafting considerations

Parties should consider whether to impose limits on the frequency of adjustments, set a maximum cap on adjustments, define the method and timeframes for notifying price adjustments, and specify the level of substantiation required across the contractual chain. Additionally, they should address:

• Specifying which parts of the scope (including early works, separable portions and staging plans) may be subject to cost escalation entitlement
• Whether, if the principal or superintendent considers any cost escalation claim to exceed market price, either may direct the contractor to seek additional quotes from the market
• The roles and associated costs of consultants involved in assessing claims, including quantity surveyors and key consultants.

Beware of the risk of unintended cost escalation entitlements when negotiating and drafting:

• Delay or extension of time provisions – contractors with valid extension of time claims may be entitled to additional labour, material or equipment costs, as well as on-site and off-site overheads. Careful consideration should be given to how these provisions ‘cover the field’ for such claims
• Statutory requirements – while the contract allocates responsibility for the time and cost impacts of changes in statutory requirements, particular attention is needed regarding taxes, duties and levies.

Provisions allowing suspension or termination for ‘force majeure’ events and termination ‘for frustration’ (that is, ‘impossibility of contractual performance’) should be drafted carefully, in order to avoid unintended consequences arising from cost escalation, particularly where they establish final payment mechanisms.

Concluding remarks

If parties are unable to agree on a ‘belts and braces’ cost escalation regime, other options include negotiating:

• Hybrid entitlements to extensions of time, for example qualifying causes of delay for procurement and variations for additional cost, subject to specific mitigation measures to be proven and by reference to an agreed schedule of materials, labour and other items
• A regime for alternative or additional suppliers and principal-supplied materials
• Alternatives to materials specified in the project design, whether through value management and innovation drafting or otherwise.

Depending on the principal’s risk appetite, parties may consider cost-plus contracting models, which require carefully balanced drafting.

In the absence of prior contractual agreement on cost escalation management, there is a real risk of otherwise avoidable disputes arising, which can have a significant impact on project delivery.

Please contact a member of our Construction and Infrastructure team if you would like to discuss cost escalation risk management for your project.

This publication is for information only and is not legal advice. You should obtain advice that is specific to your circumstances and not rely on this publication as legal advice. If there are any issues you would like us to advise you on arising from this publication, please let us know.

© Cooper Grace Ward Lawyers

Cooper Grace Ward is a leading Australian law firm based in Brisbane.

This publication is for information only and is not legal advice. You should obtain advice that is specific to your circumstances and not rely on this publication as legal advice. If there are any issues you would like us to advise you on arising from this publication, please contact Cooper Grace Ward Lawyers.