Key issues for clients and contractors 10 min read
Against the backdrop of the war in Ukraine, ongoing supply chain challenges associated with COVID-19 and a red-hot infrastructure market, 2022 was the year that Australian contractors firmly rejected the traditional approach to input cost risk allocation.
For a generation, major infrastructure projects in Australia have not typically contained 'rise and fall' mechanisms. Contractors have borne the risk that their price will make sufficient allowance for escalation of input costs (eg materials and labour) during delivery of the project. However, this traditional approach is changing.
This insight, co-written with Jonathan Harrison of Connell Griffin, discusses the issues that are likely to be relevant to both clients and contractors in reaching a mutually acceptable risk allocation regarding input costs, and addresses three main areas:
- the changing position regarding input cost risk;
- key issues to consider in developing a rise and fall mechanism; and
- an example rise and fall mechanism.
The changing position regarding input cost risk
In the two decades between 2000 and 2020, prices for materials and labour were relatively predictable.1
As a result of this relative price stability and a desire for cost certainty on the part of clients and their financiers, there was a developing expectation that contractors take (and price) the full risk of changes to input costs.2 This approach was generally accepted by the contractor market and is consistent with the view that contractors (who control purchasing decisions) are better placed than clients to manage the risk of price escalations. As a result, rise and fall clauses became less prevalent in major project construction contracts.3
Recent disruptions to domestic and international markets, variously associated with COVID-19, the war in Ukraine and increased activity in the infrastructure sector, have resulted in significant fluctuation in the prices of power, fuel, bitumen, steel, copper and sea freight. These challenges have broadly coincided with a movement by clients (particularly public clients procuring major infrastructure) towards contract models that share risks and promote collaborative behaviours – this movement is evident across sectors, delivery models and state borders.
The result is a market where the traditional risk allocation regarding input costs is not acceptable to:
- contractors, who are reluctant (and often unable) to assess the risk of price changes in a robust or reliable way in the context of current price volatility; or
- clients, who will likely be required to pay an unacceptable price for the transfer of escalation risk to contractors.
While it will be difficult for some clients to take unlimited risk of price fluctuations, especially in relation to projects that are financed on the basis of lump sum contracts or fixed ‘rental’ returns, there are opportunities to craft bespoke rise and fall mechanisms that reduce contractor risk in a manner that can be accommodated by clients and their financiers, especially if lump sum prices are reduced by significant amounts to reflect the sharing of escalation risk.
Key issues to consider in developing a rise and fall mechanism
Clients have traditionally taken the view that contractors are better placed to assess and manage risks associated with price fluctuations. This is largely true, save for circumstances in which a client is supplying inputs. There are various recent examples in Australia of clients supplying proprietary equipment and various commodity items including fuel, aggregates, ballast, rails and sleepers.
By way of contrast, a contractor typically has control over purchasing decisions and, subject to contractual constraints associated with local industry participation, can generate and take advantage of competitive tension among suppliers to optimise price. If a contractor is also responsible for design, there may be opportunities for a contractor to ‘design out’ or minimise components that are at risk of material price increases. On longer-term projects, contractors can transfer risk to third parties, eg by effecting financial hedges or entering into forward contracts for a variety of inputs, including ‘green’ credits. Many multinational contractors achieve significant savings by establishing international purchasing hubs in low-taxation locations, exploiting purchasing power by pooling demand across multiple projects to secure volume discounts and investing in offshore manufacturing to take advantage of lower production costs.
However, in an environment characterised by rapid and pronounced price fluctuations, the contractor market will seek to share the risk of price increases.
Our recent experience suggests that the following matters should be discussed when negotiating a risk-sharing mechanism:
Unless the procurement model involves an alliance or early involvement process, contractors may be reluctant to provide a client with a full breakdown of its tender price. It will be much easier for parties to negotiate a rise and fall mechanism if the contractor provides the client with information as to how it has calculated its base allowance for inputs proposed to be subject to the rise and fall mechanism, and the way it has priced the risk of cost fluctuations. With this information to hand, a client will be able to readily compare potential reductions to the tender price against potential exposure under a rise and fall mechanism. Transparency is the basis for the parties being able to explore value for the client and risk mitigation for the contractor.
Clients may be reluctant to agree that the entire construction sum be subject to rise and fall, especially in circumstances in which the risk of price increases differs between inputs. Accordingly, a better approach may be for parties to identify the high cost / high volume inputs that are most at risk of price fluctuations and investigate opportunities for sharing of price risks associated with a limited number of inputs. For example, the parties may agree that there is no need to accommodate changes to the price of copper in relation to a civil project that involves minimal mechanical and electrical work, despite there being a high risk that the price of copper may fluctuate dramatically within the contract term. By contrast, fluctuations in the price of bitumen are highly relevant to civil projects that involve road surfacing works.
Contractors have a range of options to manage the risk of price fluctuation and it is reasonable for clients to expect that contractors will remain incentivized to adopt best-practice procurement processes. This expectation is often reflected in a rise and fall mechanism by incorporating a ‘collar’ or ‘trigger point’ (which can be expressed as a percentage, volume or whole dollar value), below which the contractor takes risk of price increases and above which the client is on risk (or risk is shared). The rise and fall mechanism therefore addresses material, rather than 'business as usual', fluctuations.
It is reasonable for a client to expect that, in return for it taking risk on material price increases, it should benefit from material price decreases. Under a reciprocal mechanism, the client may agree to take the benefit of price falls with a ‘mirror image’ collar or trigger point. For example, a client may agree to compensate a contractor for price increases exceeding 20% of an agreed baseline, whereas the contractor will be exposed to a price reduction only if the price falls more than 20% below the baseline.
Contractual payment schedules and constraints are usually designed to ensure that a contractor remains cashflow positive throughout the course of a project. If there is a risk that a contractor’s cashflow positivity may be impacted by input price fluctuations, it may be sensible for the parties to undertake a price review on a monthly or quarterly basis. However, if cashflow positivity is unlikely to be a significant issue, parties may prefer to simplify administration by undertaking price reviews on an annual basis. As a general observation, if there is a reasonable prospect that prices may decline as well as increase during the course of a project, it may be sensible for parties to agree that prices will be reviewed at the completion of the project, or timed to coincide with the contractor’s purchase of selected inputs.
Parties will have most confidence in the integrity of a rise and fall mechanism if price changes are calculated by reference to an objective measure, such as an index or exchange-traded commodity. If this is not possible, for example if the selected input is not a commodity product, a client will normally require visibility of (and possibly audit rights in relation to) the contractor’s procurement process and documentation.
An effective rise and fall mechanism should ensure that it does not have the unintended consequence of transferring other risks from the contractor to the client. The parties should consider, for example, whether the client should bear escalation risk to the extent that the contractor has deviated from its procurement plan, is running late (ie, materials are procured after the relevant date for completion), or ultimately procures a greater volume of the relevant input than was allowed for in its tender price.
Example rise and fall mechanism
We anticipate that the features of any rise and fall mechanism will require detailed and nuanced discussions between clients and contractors. We suggest that the following mechanism may be a useful place to start these negotiations, noting that this mechanism will in large part address the issues identified above regardless of whether prices rise, fluctuate or fall over the course of a project.
A Periodic Assessment (Commodity) will be calculated on each Assessment Date in accordance with the following formula:
Periodic Assessment (Commodity) = (Indexed Price – Benchmark Price) x Commodity Amount (Periodic)
where:
- Assessment Date means the last day of the Quarter immediately following the contract date, and the last day of each quarter thereafter until the date for completion
- Benchmark Index means the value of [agreed commodity index] as at the contract date
- Benchmark Price (Commodity) means [agreed commodity price as at the contract date, per unit weight or volume)
- Commodity Amount (Periodic) means the amount of the commodity purchased by the contractor solely for the purposes of the works within the Period
- Current Index means the value of [agreed commodity index] as at the Assessment Date
- Indexed Price (Commodity) means the Benchmark Price (Commodity) x [Current Index / Benchmark Index]
- Period means the period between each Assessment Date and the immediately preceding Assessment Date or the contract date, as relevant
Within one month of the date of completion, the contractor must submit to the principal a Final Assessment (Commodity), being the sum of all Periodic Assessments (Commodity).
If the parties decide that neither party will have an entitlement to relief unless the total costs of the commodity rise above or fall below an agreed threshold (for example, 20%), the following clause may facilitate the intended reconciliation:
If the Final Assessment (Commodity) is equal or greater than 120% of the Contract Allowance (Commodity), the principal must pay the contractor an amount equal to:
Final Assessment (Commodity) – (Contract Allowance (Commodity) x 1.2)
If the Final Assessment (Commodity) is equal or less than 80% of the Contract Allowance (Commodity), the contractor must pay the principal an amount equal to:
Final Assessment (Commodity) – (Contract Allowance (Commodity) x 0.8)
where:
- Contract Allowance (Commodity) means an amount equal to the Commodity Amount (Final) multiplied by the Benchmark Price (Commodity)
- Commodity Amount (Final) means the sum of the Commodity Amounts (Periodic)
If a client is seeking to ensure that its contractor consumes the commodity as efficiently as possible, the parties can agree that the Commodity Amount (Final) will not exceed an agreed amount, and that Periodic Assessments (Commodity) will not occur once the sum of all Commodity Amounts (Periodic) reach the agreed amount.
Conclusion
With the benefit of perspective, it appears the popularity of contractual rise and fall mechanisms is cyclical. In the current cycle, participants in the market will for some time be required to grapple with the impact of input cost volatility to reach a position on rise and fall that is acceptable to both clients and contractors.
Footnotes
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For example, since 1992 the annual change in the price of concrete has exceeded 5% on only four occasions. Steel has perhaps been the notable exception, with prices fluctuating more than 20% on four occasions within the same period.
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This position has not always been the case in Australia, and is different from some international jurisdictions. In Australia, rise and fall provisions have been prevalent during periods of economic and political uncertainly – for example, during the Great Depression of the 1930s and again during the recession of the late 1980s (and the associated rapid depreciation of the Australian dollar). Internationally, rise and fall is commonplace in some international jurisdictions, either in widely-used standard form contracts or as a matter of law (eg, in certain civil law European jurisdictions through 'material adverse change' relief, or in South Korea where state counter-parties are empowered to adjust contract prices due to price fluctuation).
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There are exceptions to this rule. Many older forms of contract, some of which remain in use today, contain rise and fall mechanisms, which applied variously to the entire construction sum (eg, the GC21 form used by the former NSW Roads and Maritime Services) or major inputs such as bitumen (eg, the standard form amendments to AS-2124 used by the ACT Government Major Projects packages).
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Written in collaboration with:
Jonathon Harrison
Director, Connell Griffin
Jonathan has over the past 25 years worked on many of the most significant infrastructure projects in Australia, New Zealand and Asia, specialising in the negotiation of commercial arrangements for rail, road and energy projects.