Using Escalation Clauses to Address Rising Construction Costs

Rising construction costs are a frequent topic of discussion within the industry. Construction projects continue to be affected by increasing costs for essential materials. A number of factors contributed to rising material prices, including supply chain disruptions due to the COVID-19 pandemic; geopolitical actions such as the Russia-Ukraine conflict; and price and wage increases caused by inflation.

The consequences of these factor are very real. The Producer Price Index shows the costs of all construction materials rose approximately 46% between March 2020 and March 2022. CBRE’s Construction Cost Index forecasts a 14% year-over-year increase in construction costs through 2022. Unsurprisingly, these rising costs created heartburn for many within the industry. The U.S. Chamber of Commercial Construction Index reported that 97% of contractors indicated that construction price fluctuations had a moderate to high impact on their businesses.

Significant increases in material costs were not as common prior to the COVID-19 pandemic, so construction contracts often did not address the risk of increased construction costs. In the absence of any contract language, the risk of rising material prices normally rests with the contractor, particularly if the contract is priced as a stipulated sum (lump sum) or guaranteed maximum price (GMP). However, the current landscape of price volatility has construction parties discussing ways in which the risk of material price increases can be shared between the owner and contractor.

Not Recommended: Claim Force Majeure

One way in which contractors seek relief for price escalation is through a force majeure provision. Force majeure provisions generally excuse a contractor’s performance if its work is impacted by an unforeseeable event outside of its reasonable control. Force majeure provisions are narrowly construed, so material price increases must be specifically listed in the force majeure provision to constitute a force majeure event.

Force majeure provisions are common in construction contracts, but several issues exist when claiming force majeure for price increases. First, a force majeure event must be unforeseeable. The level of disruption to supply chains due to the COVID-19 pandemic was certainly unexpected at first, but price increases are arguably now something contractors can anticipate. Second, force majeure provisions usually provide contractors with an extension of time as its sole basis of recovery and no additional compensation. As such, force majeure provisions may be a good way to address long lead times in materials but not rising material costs.

Close but Not Quite: Seek Damages for Delay

Contractors may be more successful obtaining monetary relief if a price increase in construction materials is due to a delay caused by the owner. For example, an owner’s late release of the plans and specifications could cause a contractor to order materials at a time when the supplier’s quoted price has already expired, thereby increasing material costs to the project. To claim relief under this method, it is very important for contractors (a) to follow the notice provisions under the contract and (b) ensure a contractor did not waive its right to compensation for owner-caused delays through the inclusion of a no-damage-for-delay provision in the contract. ?However, not all material price increases are caused by delays due to the owner, so reliance on such a provision to address market volatility is not recommended.

Recommended: Negotiate an Escalation Clause

The best way to address price volatility is through the use of price escalation clauses in construction contracts.?Price escalation clauses allow for an adjustment in the contract price for fluctuations in the cost of certain construction materials. These clauses help contractors shift some or all of the risk of increased construction prices upstream to the owner and, if made mutual, allow an owner to avoid overpaying for materials should market pricing decline. Escalation clauses are generally found in stipulated sum or GMP projects where the duration of the project is long. Such clauses are typically not necessary if a contract is priced on a time and materials basis because the owner is already taking on the risk of paying increased material prices during construction. For T&M contracts with long durations, however, the parties may see benefit to using an escalation provision to adjust hourly rates to account for fluctuating labor and equipment costs.

Owners generally do not want to take on the risk of increased prices on fixed-price projects. The alternative, however, is that contractors and downstream parties will generally submit higher-than-normal bids in an effort to protect themselves from rising costs. The use of an escalation clause can allow owners to receive more competitive bids in exchange for sharing in the risk of increasing material prices.

Price escalation clauses can be difficult to negotiate. Here are some things to consider:

a.???Identify the Materials Subject to Escalation

Rather than allow for adjustments to the contract price for all materials, it is instead recommended to specifically identify the material(s) that will be subject to price escalation under the contract. Contractors are encouraged to include those materials that are most likely to encounter price increases on the project. Examples of materials commonly subject to price escalation include steel, lumber, concrete, and fuel.

b.???Determine How Price Escalation is Determined

The most common price escalation clauses allow for an adjustment to the contract price when material prices increase by a certain percentage over the estimated cost of the materials when the construction contract was signed. These escalation clauses typically come in two varieties: (1) clauses that compare actual versus estimated material costs and (2) clauses that peg material costs to an index.

Clauses based on actual costs compare the difference between the actual cost of materials to the estimated cost of materials. An example of a clause is one in which the contractor receives a price adjustment if the price of lumber increases by 5% over and above the estimated cost in the bid. These types of clauses typically require contractors to provide proof of its bid prices and actual costs – even of lump sum jobs – to substantiate its basis for a cost adjustment.

Index escalation clauses tie certain material costs to an index so that the material price changes as the index for the material changes. The family of indexes published as the Producer Price Index by the Bureau of Labor Statistics are commonly used because using such indexes allow the parties to select an index specific to an industry and/or commodity. When negotiating index escalation clauses, it is not uncommon for owners to request a de-escalation clause that will provide for contract price decreases if the cost of materials decreases as indicated by the index.

c.????Notice for Escalation Claims

A price escalation clause should describe when and how the contractor provides the owner with notice of escalation. The contractor should provide the owner with notice of price escalation within a reasonable amount of time backed up with prices from the contractor’s original quote and the current price. It is also recommended that contractors prepare a change order request for the increased price and get the owner’s approval before ordering materials. Effective notice ensures (a) the owner has an opportunity to determine whether to procure the materials or consider a substitute and (b) the contractor can order materials without a later argument that the owner did not agree to pay increased material prices.

d.???Limits on Escalation

Because owners desire price certainty, some owners may seek to include a maximum cap on the amount of price escalation it will assume under the construction contract. Owners may also seek to include language to allow the owner to procure the materials itself.

e.???Other Considerations

Other factors to consider when preparing escalation clauses include:

·????????The time period during which a contractor may seek adjustment for escalation, e.g., should the right to price escalation remain open for only a limited period of time;

·????????The standard that applies to a contractor’s efforts to procure materials and negotiate pricing prior to requesting escalation, e.g., should the contractor be required to use its “best efforts” to obtain the lowest possible price; and

·????????The owner’s right to terminate the contract for convenience because of price escalation.

?Recap

Price escalation clauses can be a powerful tool in addressing rising material costs on projects. These clauses can be very complex and highly nuanced. For this reason, it is recommended that construction professionals seek the advice of experienced construction counsel to help them draft and negotiate escalation clauses.