The negative effect of price variation clauses | IAPM

When implementing a project, it is common for contracts to be signed at least between two business partners, a client and a contractor. Due to the market fluctuations and the associated economic risks for both parties, contracts often include so-called price variation clauses. However, if these contracts are not meticulously designed, managed, and monitored, there can be instances of abuse involving these price variation clauses. This article illustrates how donor-funded projects by international government organizations in Asia and the Middle East are particularly vulnerable to such abuse due to local cultural conditions.

Price Variation Clauses in Fixed-Price Contracts with Economic Price Adjustment

When a contract is established between two or more parties for the execution of work, the supply of goods, consulting, or technical services, a so-called fixed-price contract is the simplest contract form. Here, the costs for work and goods are determined in advance, eliminating the possibility of later adjustments to the demands.

However, in medium- and long-term projects, agreements may be sensible for both contracting parties to protect themselves against certain market risks (known risks) and force majeure (unknown risks). In such cases, a fixed price economic price adjustment (FPEPA) contract should be chosen. While the price in this contract form is also fixed in advance, it can be adjusted using a price variation clause, depending on inflation, changes in material costs, or fuel prices. However, the extent as well as the conditions under which these price variation clauses take effect must be specified in detail.

For example, FPEPA contracts can be tied to the inflation rates of the regions where the contract is to be implemented. When properly specified, the contract amount automatically adjusts up or down according to the price variation clause when the inflation rate in the implementation area — be it the country, sub-region, or region — changes.

Are Price Variation Clauses Also Beneficial for the Client?

There is often a misconception that when price variation clauses are triggered, they always lead to an increase in the contract amount. In reality, the agreed price can also decrease if the external environmental factors, which both parties accepted as the basis for adjusting the contract amount, improve. Whether such an improvement has occurred is reviewed at the so-called payment milestones: at pre-agreed dates set by the contracting parties, the value of the contract is reassessed based on current market conditions — and adjusted accordingly.

How Can Price Variation Clauses Be Abused?

It is easier to understand the potential for abuse of price variation clauses by familiarizing oneself with the actual practice of contractual design and management. Based on my more than ten years of experience, I can narrow down the practical handling of contracts to four resulting procedures:

1. Using the RIGHT contractual procedure to resolve an APPROVED need or motive.
2. Using the RIGHT contractual procedure to resolve an UNAPPROVED need or motive.
3. Using the WRONG contractual procedure to resolve an APPROVED need or motive.
4. Using the WRONG contractual procedure in attempt to resolve an UNAPPROVED need or motive.

The following discussion will not address points 3 and 4, as these procedures are primarily used by contract specialists to set up processes from which they can benefit. Here, issues such as “conflict of interest, contractual fraud, greed and zero integrity” play a crucial role. The focus, therefore, is on the first two points. In these contexts, there has been a significant increase in the abuse of price variation clauses through contract design, implementation, and management in donation-funded projects.

Funding of International Government Organizations

Most International Government Organizations (IGOs) based in America and Western Europe are largely funded through their tax systems. In contrast, IGOs in Asia and the Middle East — particularly those whose state organization is based on the Islamic faith — are mainly funded by individuals who are often motivated by their faith to donate generously. The Quran, in its second chapter, urges believers to “give to the poor in secret” to be freed from their earthly sins. Additionally, it is common in Islamic belief not to accept interest on borrowed money to avoid the charge of usury and exploitation. Together, this results in a significant amount of money available for the realization of various kinds of projects. The difference in the foundations of funding for international government organizations creates a distinctly different framework for contractual agreements and responsibilities. While the former primarily must account for the use of funds during a state or government audit, the latter are mainly motivated by the need to comply with their faith. Accountability is not required before an earthly authority. However, this has consequences concerning price variation clauses: without government pressure, it is much less likely that IGOs will challenge price adjustments in contract costs.

Case Study

A contractor independently performs necessary work that has not been approved. Such activities usually come with additional costs that can exceed the set project budget. This scenario raises the following questions:

• Should IGOs even retroactively accept the additional work performed, even though it was not approved (e.g. unapproved) in advance?
• The IGO accepts the work performed without approval for a project that does not have a budget surplus. What contractual steps should now be taken to cover the additional costs?
• Should the contractor be sanctioned for carrying out the unapproved work?
• Can the IGO, from a legal perspective, insist that the additional costs for the unapproved work be fully borne by the contractor?

In practice, many IGOs are willing to deliberately disregard rules, guidelines, and procedures to pay for unapproved work. But how should increasing demands actually be handled? And how should a contract be designed to prevent arbitrary cost increases?

• There should be zero responsibility for an IGO to pay for unapproved work.
• Price adjustments following the execution of unapproved work should not be encouraged.
• In fixed-price contracts, an order is awarded based on a specific performance description and scope. Price adjustments after the award should not be accepted under any circumstances if the performance and scope remain unchanged. Why?If a subsequent price adjustment were allowed, bidders could gain an illegitimate advantage during the bidding process by deliberately underestimating the costs for the requested services. They underbid competitors significantly and secure the contract. This often involves a plan to significantly increase the original contract volume through subsequent price adjustments. Bidders who submit realistic offers based on the current market situation during the bidding process are thus disadvantaged.
• Any clause that states the costs can be increased or decreased by X% of the original contract amount, without explicitly specifying the conditions under which this clause comes into effect, should be avoided; for this represents the greatest potential for abuse of price variation clauses.Savvy contractors often exploit scope creep or gold plating to ensure they claim the maximum amount still covered by the contract (X+X%). While scope creep refers to the incremental expansion of the project’s basic scope, gold plating describes a qualitative enhancement of individual project elements without expanding the project scope quantitatively — in a figurative sense, the project is “gilded”. In any case, the contractor can be sure that if there is no precise specification regarding the activation of the price variation clause, the deliberately accepted increase in overall costs will be borne by the client.

Summary

In principle, and under the right conditions the use of price variation clauses within a fixed-price contract with economic price adjustment can be recommended. However, to prevent abuse by savvy contractors, all conditions that could trigger the clause and possibly lead to increased project costs must be clearly defined and contractually fixed. The same applies to fixed-price contracts: if an adjustment of the contract costs becomes necessary due to additional work that is no longer covered by the fixed-price contract (e.g. lump sum contract), this should only be done based on a process that is recorded and regulated in the contract.

From my perspective, the only way to avoid unjustified price adjustments by contractors is as follows: IGOs must stop disregarding their own rules, guidelines, and procedures. Contractors must never be paid for unapproved work — even if this work improves the quality of the implemented project by gold plating. Especially in donation-funded projects, where there is no pressure to justify expenses to a state or government, a change in thinking is needed. A “new reality” can only emerge if contract specialists are given the necessary authority to design, implement, and enforce contracts. The overarching principle must always be: no payment for unapproved work under any circumstances.

Originally published at https://www.iapm.net.