By Brian C. Padove of Watt, Tieder, Hoffar, & Fitzgerald LLP
What happens when construction material prices abruptly rise by 15%, 35%, 50% or more within a year? Moreover, what happens to a construction project when such volatility occurs? While there is no definite answer, more likely than not, the construction project will be impacted by delays in procuring such materials and cost overruns. The question then becomes what steps can parties take to mitigate the impact of material price fluctuations?
This question has become frequent the last 15 months as owners, contractors, and suppliers work through extraordinary construction material price increases. Notably, from April 2020 to April 2021, the U.S. Bureau of Labor Statistics’ producer price index (an index measuring average price changes over time) reveals a substantial increase to a number of different construction materials. For example, from April 2020 to April 2021, there have been increases to the producer price index for lumber (by 90%), iron and steel (by 58%), and plastic construction products by (14%). See BUREAU OF LABOR STATISTICS, U.S. DEP’T OF LABOR, PPI Detailed Report (Apr. 2021). Undoubtedly, the unprecedented COVID-19 pandemic in conjunction with extraordinary supply chain disruptions caused, at least in part, these price increases. That said, while there is no statistic quantifying the impact such increases have had on the construction industry, the increases surely have had an influence, whether it has been through lost profits, delays, or damage to contractors’ otherwise strong reputation for timely performance.
With that in mind, this article will provide practical guidance for parties to consider in mitigating the impact of price escalation prior to and after executing their contract and will conclude with a list of best practices for all parties to consider.
Considerations Prior To Contract Execution
The first way to mitigate price escalation is identifying materials most susceptible to price volatility during the bidding process. Namely, once the parties identify these materials, they can have an open discussion with the upstream parties regarding potential price volatility that may occur. The bid may also include either (1) an allowance for the materials providing additional funds, if necessary, should the material price increase, or (2) a shortened timeframe in which the bid is open, which would, on account of the reduced time, mitigate the likelihood of price shifts.
Once the bidding is completed, another mitigation strategy is to utilize material price escalation provisions within the contract itself. These provisions are common throughout the industry, frequently incorporated in contracts on both private and public projects. For example, Federal Acquisition Regulation (“FAR”) §16.203-3 permits price escalation provisions in certain agreements when the government’s Contracting Officer determines that the use of an escalation clause is necessary. Similarly, ConsensusDocs includes a price escalation provision amendment designed to establish “baseline prices” for materials identified by the parties as potentially “time and price-impacted” and provide a method for adjusting the contract price due to the fluctuation in those baseline prices. See ConsensusDocs 200.1, Amendment No. 1, “Potentially Time and Price-Impacted Materials.” In relevant part, the ConsensusDocs provision calls for price increases or decreases to specified materials, a “baseline price” for each material designation, and notice requirements for subsequent contract adjustments. The provision also allows for the possibility of a time extension if there is delayed delivery due to material unavailability outside the contractor’s control. These price escalation provisions are just a few of the many examples of specific contract clauses parties can utilize to mitigate the impact of price escalation on future projects.
Overall, price escalation provisions have similar characteristics to consider and recognize. First, the provisions generally require specific identification of the materials to which the clause will apply, or in other words, the parties must identify the materials which are anticipated to have price fluctuations during the course of construction. After identification, parties will agree to the “baseline price” for the materials, which will generally be premised on anticipated or current market conditions and are oftentimes linked to published material cost indexes such as the previously cited U.S. Bureau of Labor Statistics’ monthly publication providing national price information on all sorts of products, including construction materials (e.g., lumber). Tying the baseline price to a published cost index will provide the parties with an objectively verifiable method of determining the extent of any material price fluctuation. From there, the provisions can sometimes include a minimum fluctuation triggering threshold which will allow for an adjustment only if there is a change over a minimum amount (e.g., there must be an increase over 3% of the market price for there to be a contract adjustment). There also may be limits as to the maximum adjustment amount, such as in FAR § 52.216-2, which sets a standard 10% increase limit. Finally, price escalation provisions will generally require adherence to specified notice procedures in order to qualify for an adjustment.
While a price escalation clause may initially seem entirely in favor of contractors, the truth of the matter is that there are benefits to all parties. For contractors or suppliers, the benefits are rather obvious – there is “protection” when facing market conditions similar to those parties are dealing with today (where the costs of certain materials has rapidly increased 50% or more over a year). On the other hand, including a price escalation clause can also benefit owners and other upstream parties as its inclusion may result in limiting delayed performance claims related to material price escalation, avoiding potential costly defaults and terminations, and ensuring that parties are paying relatively close to market prices for the materials used on the project. Accordingly, utilizing price escalation clauses can prove to be the key factor in mitigating the impacts of future material price volatility.
After Executing The Contract – Can I Still Mitigate Price Volatility?
Unfortunately, sometimes it is impossible to foresee which materials will be impacted by unanticipated events and the extent to which a price may fluctuate before completing a project. Thus, what happens when an extraordinary price escalation occurs that the parties did not account for when contracting?
The first step is to go to the contract to determine whether a price escalation clause is included or if there are any other provisions that may assist in determining responsibility for unanticipated changes and the steps parties must follow to address such changes. As referenced above, the majority of price escalation provisions include steps that parties must follow to adjust a contract when fluctuation occurs (e.g., notice requirements). Other contract provisions should also be reviewed for guidance and potential alternative relief. For instance, impacted parties should check whether the contract includes a force majeure provision addressing delays caused by events outside the contractor’s control. While these provisions will typically allow for additional time to perform the contract work if certain criteria are met, they often will not allow additional compensation. Both the AIA A201-2017 General Conditions and ConsensusDocs 200 Series establish procedures for obtaining changes based on impacts to work that are outside of the contractor’s control. See AIA 201-2017 General Conditions §8.3.1; ConsensusDocs 200 §6.3. Similarly, change order provisions should be carefully reviewed to determine the extent the contract price may be adjusted on account of either a change in the scope of work or price relating to material price fluctuation. The change order provisions will likely specify the necessary documentation needed to obtain a price adjustment as well as the requirements contractors must follow prior to making such a request. Finally, it is also prudent for parties to be aware of any contract acceleration clauses. By way of example, where price escalation coincides with a delay in the delivery of materials to the project, the owner may have a right to require acceleration and the contractor may have additional rights and remedies when such acceleration is required.
Best Practices
While the above considerations may assist parties when faced with an unforeseen material price escalation, one thing is certain: open communication is key to mitigating the impact of price escalation. If the owner does not have knowledge of the contractor’s difficulties in obtaining materials at contract cost, for instance, early opportunities to negotiate a resolution to overcome such challenges and efficiently progress the project may be lost. If the contractor promptly advises the owner of a substantial and unexpected price increase, however, the owner and contractor may be able to come up with alternative materials or revised plans for the project. Not only does this reduce the likelihood of potential delay claims and default, but it also allows the parties to work together towards their common goal – timely project completion. With that in mind, below is a list of best practices parties can utilize in order to de-escalate the impact of price escalation:
- Review and Research - Before negotiating your contract, do your research on the price volatility of materials required for the project by using experienced contractors or suppliers and examining U.S. Dept. of Labor national price index statistics.
- Price Escalation Clauses - Negotiate a price escalation clause that works for you. There is no uniform clause that fits every contract but consider using a clause allowing for a triggering price that can adjust both upward and downward.
- Document - Make sure to continue your review of material prices throughout the course of the project and keep detailed documentation of price changes along with potential supply chain disruptions that may impact work on the project.
- Early Purchasing - If possible, allow parties to pre-purchase, and be paid for, materials which can be ordered early and which may be particularly susceptible to volatility.
- Communicate - Be sure there is open communication between the parties. Open and comprehensive communication can lead to mitigation efforts by all parties which, taken as a whole, may result in a minimized impact on the project.
Brian Padove is an associate attorney in the Chicago office of Watt, Tieder, Hoffar, & Fitzgerald LLP licensed in Illinois, Indiana, and Wisconsin. Padove focuses his practice primarily in the areas of construction, surety bond, and commercial litigation. He can be reached at bpadove@watttieder.com or 312.219.6900.