Until recently, construction material and labour prices have been generally stable – so fluctuation clauses, have commonly been unused. But now things have changed, and those prices are no longer so predictable.
So, is it time to take another look at fluctuation clauses?
What are fluctuation clauses?
The term “fluctuation provisions”, or “fluctuation clauses”, refers to compensatory clauses in construction contracts that allow the contract price to be adjusted to reflect changes in the cost of materials or labour during the contract period. You may also see them described elsewhere as “variation of price”, “variation in cost”, “rise and fall” and “cost-adjustment”.
In most construction contracts where fluctuation provisions have not been used, the risk of price rises are borne primarily by the Contractor. At the time of tender, the Employer and the Contractor agree a contract for a certain price, and the Contractor is the one who suffers if the materials or labour required go up in price.
With fluctuation provisions, the aim is to transfer some or all of the effect of price changes (more commonly, of course, in an upward direction by reason of inflation) in the cost of labour or materials during the contract from Contractor to Employer by adjustment of the final contract price.
However, if the price of materials inflate to a high level, the Employer risks spending increasing, and perhaps unforeseen, amounts.
Different contracts tend to deal with fluctuation provisions in different ways. For example, JCT includes this in the Contract Particulars, whereas NEC has a Secondary Option X1 that would need to be selected when the contract documents are assembled.
In recent years, these fluctuation provisions have commonly been deleted (or options ignored, as the case may be) without much consideration – prices were historically stable enough that Contractors were comfortable to value projects and take the low risk of price changes, and Employers were able to enjoy competitive tenders and certainty of the price of projects.
Volatility in the industry
However, in 2021, the construction market experienced its most difficult conditions since the 2007-2009 global crisis. The cost of materials were seen to rise across the board, well above forecasted figures. Steel prices rose 77.4% in 2021 and timber prices rose 80% in the first half of that year. The cost of labour also went up, with advertised salaries of construction workers rising 6.7% over the first half of 2021. In addition to the hikes in prices, delays in deliveries occurred due to the impacts of Brexit and COVID.
The upward trend in prices is expected to continue into 2022, with the Construction Leadership Council's Construction Product Availability Statement (January 2022) saying "rising energy costs and price inflation continue to cause concern, with the latest forecasts anticipating 2022 price inflation from 7-10+%, with multiple increases expected for some products".
Also noteworthy is a recent blog by the JCT, in which attention is drawn not only to general inflation, specifically stating that:
"even in a low inflationary climate there can be significant volatility in the cost of materials. Construction material’s inflation frequently diverges from the general inflation level which is around 2%. For example, the World Construction Industry Steel Purchasing Price Indices show a 40% increase between April 2020 and February 2021, or the oil price that has risen by close to 400% since April 2020. Consequently, where there is a high content of certain items in a building project, profit margins can be quickly eroded, unless there is protection under the contract".
Crucially, construction inflation is a different beast to general inflation.
As such, parties should ask themselves whether it is appropriate to consider the incorporation of fluctuation provisions following their risk assessments.
Considering fluctuation clauses
Whether or not it is appropriate to include fluctuation provisions, and the form of those provisions, will depend on a number of issues - including the type of project, the form of contract used, the risk to the project, key materials used which are particularly at risk of price increases, the Employer's budget including lenders' viewpoints, the stability of the Contractor's supply chains and more.
There are more factors therefore at play than simply including fluctuation clauses wholesale in JCT, NEC or other contracts – and the specific wording of the clauses should be looked at in light of these. It may be that the parties could agree to incorporate fluctuation provisions in principle, and then agree alternative wording to the standard clauses in their JCT or NEC contract if these aren't appropriate for their circumstances. For example, Option X1 of the NEC has a wide application, but parties could state that it will only apply to the prices of timber or steel.
One other key point to check is whether the Contractor will be entitled to benefit from fluctuation provisions in the event that it is in delay in completing the works. The Contractor should not ordinarily be entitled to benefit from its breach and be paid more as a result of any fluctuations where it is in delay.
Understanding the impact of the fluctuation clauses you are using and the options available is also important. In the JCT's Standard Building Contract and Design & Build Contract 2016, fluctuations are dealt with under three Options: A, B and C. If the parties intend to incorporate one of these Options, they must include additional details in the Contract Particulars. Each Option covers different types or approaches to fluctuations, with Option A covering contribution and levy and tax fluctuations, Option B covering labour and materials cost and tax fluctuations, and Option C covering formula adjustments.
There are different nuances to each of the Options too, which is again why the parties should properly understand what they are agreeing to. For example, how fluctuations are addressed after the Completion Date are not the same, with Option C taking a different approach to Options A and B.
So what does this all mean in practice?
Looking ahead, Employers are likely to see increasing amounts of negotiation around the inclusion of fluctuation provisions, particularly in larger, long term projects, and will need to budget accordingly. Contractors will want to mitigate the risks of price increases and may have to walk away from tenders if they are unable to take the financial risk where an Employer refuses the inclusion of any fluctuation provisions.
As fluctuation clauses are not simple, have significant consequences for the Employer and Contractor, and have not been used by the industry for many years, if a fluctuation clause is to be used it is also vital that the Contract Administrator understands what the contract says about fluctuations and how to apply these provisions.
With the predicted shortages in materials, price inflation expected to carry on throughout 2022, inflationary growth anticipated to increase to 5% by 2025, and with rising energy costs highlighted by the CLC, it is clear that the common practices of the past are on the verge of changing.