Newsletter construction and property law

1. Provisional sums

Most contracts in the UK construction industry at present are “lump sum” or “fixed price”, which contain mechanisms for changing the contract price, but not usually for price inflation. Essentially, the contractor provides a price for the works to the employer or client, and the contractor bears the risks of changes in expenditure. Examples of such contracts include the JCT Standard Building Contract, the JCT Design and Build Contract, the NEC Engineering Construction Contract Option A and common wording used in the FIDIC Yellow and Silver books.

Some parties to construction contracts are now using “provisional sums” to tackle the increases in prices.

These sums are included in contract specifications and are an estimate of the likely cost of works that either cannot be sufficiently defined at the time of contracting, or works that the employer or client may choose not to undertake.

When providing the works, the contractor typically has a right to amend the provisional sum and the employer or client has the option to either instruct an increase in the contract sum in line with the increase to the provisional sum, or alternatively employ a different contractor to carry out the specific works which were linked to the provisional sum.

Provisional sums should be drafted very precisely to achieve exactly what the parties require – for example, employers and contractors should carefully consider:

• the value of provisional sums when they are entered into specifications for the works, as they could substantially increase the price of the project
• any contingency in budgets to allow for substantive increases to provisional sums and any approvals needed from funders
• the method for instructing or allowing a change to provisional sums, as this varies between the standard form contracts
• the impact of provisional sum discussions on the programme for a project.

2. Fluctuation provisions

Broadly, a “fluctuation provision” is a compensatory clause in a construction contract that allows the contract price to be adjusted to reflect changes in the cost of materials or labour during the contract period. Until recently, these provisions were commonly deleted, however, there are increasing demands from contractors for them to be included.

Employers and contractors need to be aware though that different standard form contracts deal with fluctuation provisions in different ways. And there are more factors at play than simply including fluctuation clauses wholesale in standard forms of contract, including the specific risks involved for each project and party.

As such, parties could agree to incorporate fluctuation provisions in principle, but agree alternative or amended wording to the clauses in their standard forms of contract if these aren't appropriate for their circumstances.

Drafting can be tailored for circumstances, such as: only allowing fluctuations for specifically identified materials which are at higher risk of price changes, like steel; providing that where the fluctuations are allowed on certain materials, the contractor goes “open book” on these items; and tying price increases to national indices like RPI, BCIS etc (although careful thought must be given to which index to use).

For more on fluctuation provisions, see fresh look at fluctuation clauses in construction contracts.

3. “Cost plus” and “target cost” contracts

Another potential way to address significant changes in materials prices is to consider a cost reimbursable contract, also known as a “cost plus” contract.

Here, the contractor is reimbursed for the actual costs incurred for plant, materials and labour on a project, plus an additional fee to account for the contractor's overhead and profit. The contractor could therefore pass on all price increases to the employer or client. Examples of standard form cost plus contracts are the NEC Engineering Construction Contract Option E, the JCT Prime Cost Building Contract and the FIDIC Short Form Contract.

Although cost plus contracts are seen in use in the United States, their use in the UK has been limited, as the primary risk is the uncertainty of the final cost of the work and concerns around a lack of incentive for the contractor to limit its costs.

An alternative to cost plus contracts is a “target cost” contract with a “pain/​gain” sharing mechanism, whereby the contractor is rewarded with increased profits for providing the works more cheaply than the targeted cost, but is financially worse off if it overspends. Examples of target cost contracts are the NEC Engineering Construction Contract Options C and D, and the IChemE Burgundy Book.

4. Practical steps

There are also practical implications of the increases in the cost of materials.

One particular area for concern is the potential insolvency of subcontractors and suppliers. As reported by Construction News, industry experts are projecting an increase in administrations, and fear that the current willingness among some employers, clients and main contractors to put more money into projects rather than let firms go under may soon change. Additionally, there are further strains on subcontractors and suppliers, with high energy prices, and with increased costs of testing materials once the UK Conformity Assessment (UKCA) certification applies from 1 January 2023.

Parties therefore need to consider obtaining appropriate security where possible, such as parent company guarantees, performance bonds, and vesting certificates from at risk subcontractors and suppliers, and to also ensure that adequate credit checks are carried out before contracting. Where practical, it may be prudent for materials to be stored on site, and for warehousing to be set aside to store goods provided by suppliers with at risk suppliers.

There is no perfect “solution” to deal with construction price rises, but, as ever, realistic conversations and negotiations between the parties as to how to tackle the impact of such price increases is vital to prevent cost overruns, delays and disputes during the works.