To Fix or Fluctuate
Over the last 25 years, UK Plc has had a relatively stable growing economy. Consequently, fluctuation clauses, intended to deal with variations in costs such as labour, transport and materials, are now often omitted from contracts. In fact it is quite likely that most construction professionals practising today have never worked on a project with fluctuating clauses. But, in the current economic climate where we are experiencing significant volatility in material prices, should we be reinstating these clauses to protect our clients? Or are there other measures we can take to manage this risk?
In August 2016, the RICS updated their guidance note RICS professional standards and guidance, UK Fluctuations 1st Edition. It states:
"It is not difficult to imagine the sorts of problems that could be encountered in assessing the price risk to the contractor of entering into a ‘fixed price’ contract in times of financial volatility’ and ‘therefore in estimating their costs and preparing their tenders, contractors will be tempted to err on the side of caution".
Are we in a time of financial volatility or should we continue to buy out the cost risk with our contractors and their supply chain, passing the problem down the line?
The construction industry has seen materials price increases spike across a whole range of areas, giving the highest increase for 15 years. Is this the volatility the RICS was envisaging?
Since our last TPI was published, there have been a number of significant issues arising:
- A shortage of gas, which commentators are predicting will affect us domestically in our energy bills and in food supply and prices. It is not a huge leap to suggest that we will start to see the effect of this in construction costs through increased cost of manufacturing products such as bricks, steel and the like.
- Shortage of fuel at the pumps and food in supermarkets due to shortage of HGV drivers.
- Unusual weather patterns causing the UK Plc to fall back on more traditional electricity production rather than the environmentally friendly wind farms.
- China play an important role in determining global commodity prices and their lower domestic demand could impact prices, particularly steel. The collapse of Evergrande (or a legitimate fear of it collapsing) would subdue the Chinese construction market and dent demand.
- But with China’s recent sell off in metals, which pre-dates Evergrande, costs are being impacted by:
- Policymakers in China looking to cap steel output this year at 2020 levels in order to reduce emissions which
- caused a drop in steel output in July and August, reducing supply and a rise in prices globally
The resulting effect of this is that iron ore prices have dropped 54% since May (to end of Sep 2021), so the trend of falling prices clearly goes back earlier than Evergrande.
Against this backdrop, our current belief is that the market should begin to soften in early to mid-2022 due to a natural rebalancing of supply and demand.
According to data from the London Metals Exchange (LME) and Trading Economics, in the year to 27th September 2021:
- Copper prices rose by c. 42%
- Iron ore prices, after climbing strongly for nine months, fell rapidly from mid-July and are now 6% lower on an annual basis
- Hot rolled coil steel prices rose by c. 86%
In a paper published by Oxford Economics in August 2021, the global economic forecaster analysed commodity prices from 3Q 2020 and provided forecasts through to 3Q 2022. It predicts that a year from now (3Q 2022) prices will have fallen as dramatically as they rose. It forecasts that:
- Copper prices will ease, settling at around 20% higher than 3Q 2020 levels
- Iron ore prices will be c. 5% lower than 3Q 2020
- Hot rolled coil steel will continue on the general downward trajectory it started in May 2021 with prices forecast to be around 45% higher than in 3Q20
In tendering projects without fluctuation clauses, are we asking contractors and their sub-contractors to price these global factors?
How is this reflected in the current tender returns?
Cost consultants are usually instructed to obtain cost certainty in procurement for their clients, which is obtained through requiring a fixed price from the contractor market. Therefore, in tendering construction projects now, tender prices are being returned that reflect the current spikes in material and labour costs. This is then overlaid with the fixed-price risk element for future cost movements to give a lump sum price.
We are finding that in a number of instances the contractor is not willing to provide a fixed price until the contract is executed, pushing back the timescale of cost certainty.
From recent tender returns, it is evident that contractors are “erring on the side of caution” and assume prices will continue to rise at the current or similar rate of increase, in order to protect their business from rising costs with no recovery. We are finding this is particularly the case when employing two stage or negotiated contracts in which this surge pricing is occurring.
The result of all of this is having a significant impact on the viability of schemes.
Due to the significant volatility of input prices, all construction professionals tendering schemes at the moment are experiencing surge pricing. We must now analyse the risks and carry out a detailed cost benefit analysis on a project by project basis to help our clients make informed decisions.
Referring back to the RICS guidance notes on fluctuating clauses, it states:
- Fluctuation clauses provide a mechanism whereby the actual cost, or a near approximation to it, can be calculated as the project progresses
- Fluctuation clauses are seen as a fairer way than placing all responsibility with the contractor and is probably more in keeping with the ethos of collaboration and pain/gain sharing
- They benefit the client, who does not pay for the predicted fluctuations (risk) but the actual cost based on the agreed mechanism ie if there is no rise there is no cost
- Finally, it is not an upward only mechanism. In other words, if the costs reduce as is predicted (see above) this would also be reflected in the emerging final accounts
We must not forget the ability to include provisional sums for work – where the work is defined but not bought or the price fixed at the time of the lump sum tender. The contractor allows for the work in his programme together with all preliminaries and on costs, leaving the procurement until later in the programme where the prevailing market price will be secured.
Similarly, at a more granular level, there are prime cost allowances for specific work items, where the variable material cost is identified as a prime cost and adjusted at actual price. The work item should include fixed costs for all other elements of labour, plant and overheads leaving the material supply as prime fluctuating on actual cost.
Depending on the scale of the project it may be appropriate for clients to early order bulk materials in advance on contractor procurement. We would typically see this in steel for fabrication and curtain walling aluminium components. The risk is carried by the client with the price fixed at the time of buying but is also controlled by the client.
We are facing a time of volatility, whether it be with materials, labour, transport, fuels or power. As cost consultants, we would always recommend to our clients that a fixed price offer is obtained. However, for major projects with a long duration, is now the time to get an alternative offer – one that is subject to fluctuations or risk share through provisional or prime cost allocation?
The pricing risks of projects in the current economic environment and the options set out above need to be clearly and carefully discussed with our clients so that the risks are understood and correctly accounted for within any business plan. At G&T we believe that the identification of risk, understanding the cost of that risk and then allocating it to the most appropriate party to carry are the goals of successful procurement.