Key inflationary and deflationary pressures
Based on our observations of the market, survey feedback and our extensive discussions with the supply chain, we have established that a number of inflationary and deflationary pressures are likely to impact tender pricing. While many of the pressures from our previous TPI report continue to impact tender pricing, a few new ones have become more prominent in recent months. However, the inflationary pressures continue to outweigh deflationary pressures.
Material prices rose throughout much of 2021 but tapered off slightly from August as some of the supply chain issues began to ease as production caught up with strong demand. Despite the general easing of material price inflation between August and October 2021 and indications from December’s construction PMI survey that availability of materials is improving, some pressures remain. Higher fuel and energy costs have pushed up the prices for some raw materials. Materials requiring energy intensive manufacturing processes such as steel and cement are the most exposed to energy cost rises. Higher energy prices are also flowing through to plant and transportation costs, pushing up overall construction costs.
The latest Construction Product Availability Statement from the Construction Leadership Council (CLC) affirms the recent purchasing managers sentiments. The CLC indicates that the seasonal decline in activity has largely been responsible for taking some of the pressure of price rises but that challenges still remain in relation to UK production capacity, logistics and shipping. With construction activity expected to remain strong this year, supply chain pressures are likely to be with us for much of 2022, bringing with them further price rises and longer lead times.
The CLC has flagged up various issues with the following construction materials and products:
- Bricks and blocks: long-term supply issues ongoing and imported products are being relied on to meet shortfalls in UK capacity until new lines come on stream in 2023/24. With strong demand lead times will be an issue in 2022 and builders will need to work closely with manufacturers to ensure availability and to mitigate delays in delivery
- Cement: few issues with stocks currently but merchants are being advised not to deplete stocks in preparation of annual winter maintenance shutdowns. Manufacturers have raised concerns of rising energy costs leading to cement price inflation but have committed to produce as much supply as they physically can
- Roof tiles: demand remains high and average lead times are 24 weeks. However, timber battens have overtaken concrete roof tiles as the most difficult to obtain
- Timber: supply on many products (eg structural timber) has returned to normal levels and prices have come down from their recent highs but some products (eg tongue & groove) remain in short supply
- MEP products: certain electro-technical products (ie those with electronic components and those made from steel) such as cable trays and twin and earth cable remain in short supply. Product pricing has become a particular challenge for small-medium contractors working on tight, fixed price contracts
While supply pressures will continue to act on material prices for the short-term and push up average cost burdens, December’s PMI survey showed the overall rate of inflation eased for a fourth month running. In fact, according to IHS Markit’s ‘Input Prices Index’ the rate of input cost inflation was the lowest since March 2021. Furthermore, availability and delivery times for essential products and materials also improved.
Despite the softening rate of material price inflation, there’s no getting away from the fact that many key construction materials have increased significantly in price over the course of 2021. Steel and timber, which have risen by around 70% in the year to October 2021, were key drivers of material price inflation but recent higher energy prices will affect a broader range of construction materials. We’ve seen cement (which requires a high energy intensity of 150-175 kWh/tonne to produce) begin to increase in price since September, prompting producers to announce £15/ tonne (or 16%) price hikes which came into force at the end of 2021. The industry-wide hike means cement will break through £100/ tonne, hitting major projects and Government projects particularly hard.
In November, construction material price growth was flat for the first time since September 2020. The BEIS ‘All Work’ material price index showed no month-on-month rise in prices. Prices for several key materials levelled off or even fell in November compared to the previous month, with imported timber seeing the largest monthly decline (-7.6%). However, this levelling off may be short-lived with rising energy costs likely to produce a second (albeit less pronounced) wave of material price inflation in early 2022.
Steel, which fell marginally in price in November according to BEIS data, is being affected by soaring wholesale energy prices. Unable to absorb these, British Steel recently announced a second energy-related price increase of £30/tonne – a temporary surcharge of which £25/tonne is down to energy inflation and £5/tonne to HGV salary inflation and haulier prices. Acting against the impact of rising energy prices on steel production, prices for the steelmaking ingredient iron ore fell by more than 50% between July and mid-November, helping to keep steel prices relatively stable in the Autumn period. However, offsetting these lower iron ore prices has been high coking coal costs, which have now risen to an all-time high. With iron ore prices ticking up once again and sustained high energy prices, we’re likely to steel prices drift even higher.
Material price inflation is unlikely to subside significantly as new pressures come to the fore. Although widely welcome, the worldwide shift to low-carbon energy production will take many years. In this transitionary period, many countries will make efforts to restrict the amount of pollutive materials they produce. For example, China has now begun to curb energy-intensive steel production as part of its overarching goal to cut carbon emissions as a country. Consequently, China's crude steel production fell sharply in November 2021 and was down 22% (to 69.3 million tonnes) compared to the same month one year earlier. This follows a 15% decrease in its steel output in 2020 compared to what was produced in 2019. Such measures will likely result in shortfalls in global supply at a time when demand for raw materials is sky high.
The worst of the supply chain issues may have peaked but high material prices and shortages will still put pressure on costs in 2022.
Labour pressures continue to mount as skills shortages and a high number of construction vacancies push wages higher. On a seasonally adjusted basis, average weekly earnings in construction rose by 4.6% in the three-months to November 2021 compared to the same period one year earlier. With the low base effect (ie the artificially low earnings data during peak furlough in 2020) now dropping out of the data, a clearer picture of real earnings growth in the sector is emerging.
Over the past year, construction wage inflation has exceeded the broader rate of wage inflation across the ‘whole economy’, which was 4.2%. At 4.6%, the annual (three-month average) construction wage growth in the year to November 2021 was also significantly higher than the sector’s long-term annual wage growth rate of 2.9%. Given the current dynamics in the UK construction labour market, we expect that wages will continue to outpace the long-term average rate of annual earnings growth in 2022 and beyond.
While rising construction labour costs have not been the key inflationary factor across the whole industry, rates in certain trades such as brick and blockwork increased massively in 2021. With Brexit having stemmed the flow of migrant labour supply, the current skills shortage will only intensify in the coming years, resulting in above-trend levels of labour cost inflation. However, labour shortages are not just being driven by a shortage of EU labour in the wake of Brexit. In fact, a recent study by the Construction Industry Training Board (CITB) using ONS 2020 labour force survey data found that British nationals are leaving the industry at just the same rate as foreign-born workers. The number of non-UK born workers in the UK construction industry fell from 305,000 in 2019 to 280,000 in 2020, broadly in line with employment trends throughout the industry over the same period.
Amid widespread reports of recruitment difficulties, the CITB noted construction employers are not training enough homegrown talent, nor are they coping with the new points-based immigration system. This is putting pressure on wages and is likely to lead to wage inflation spiralling even further. Recent commitments in the Autumn Budget to improve skills and recruit talent will all take time to come to fruition, but the demand to build is high now. The current market dynamic could result in increased competition between regions for labour, with London and the South East (which generally offer higher salaries) potentially pulling resource away from the rest of the country at a time when the Government has pledged to address regional inequality and level up the country.
Construction staffing numbers continue to rise according to the UK construction PMI Employment Index, but the rate of job creation is easing and in December the rate was the least marked for nine months. This is also reflected in the ONS data which shows that the total number of people in construction employment has increased for each successive three-month period since September 2020. However, we’ve seen the first significant dip in UK construction vacancies since they started to recover in Spring 2020. In the September-November period in 2021, the number of construction vacancies fell by 5% (to 43,000). While too early to tell if construction vacancies have peaked, improving client demand and positive new order growth (as outlined in December’s PMI survey report) suggests that labour resource requirements will remain strong.
With a limited pool of skilled labour to draw from, the stage is set for a new labour-driven price cycle. There are concerns that the squeeze on labour will increase rates and dampen appetite for new investment or that workload will shrink to fit the reduced labour market. Neither outcomes are ideal. So far, the Government has resisted the pressure to provide more short-term visas to Europeans to ease the labour shortage, but there are doubts that such workers could even be enticed back even if such visas were available. While emergency visas may be a useful ‘shot-in-the-arm’, the longer-term solution will have to focus on investment in the UK domestic workforce, with the aim of drawing more young people into the industry and improving existing training and education.
A growing concern that was flagged in G&T’s last Main Contractor Survey is high staff mobility, with workers moving around looking for the best pay packages. This has caused significant disruption to projects in recent months with some smaller contractors having to turn down projects because of the current lack of available workers. Larger firms have been able to navigate the disruption caused by shortages (due to their scale and greater bargaining power), but smaller specialist sub-contractors are evidently struggling. An average of 266 construction business per month collapsed in the three months to October 2021 according to the latest Insolvency Service data – the largest number since before the pandemic.
With the anticipated steadying of material price inflation as certain inflationary drivers fall away, labour is set to take over and put significant upward pressure on input cost inflation.
PROFITABILITY AND PROCUREMENT
OH&P and Preliminaries
Although showing an upward trend over the past year, there have been no significant swings in on-costs over the last three months. Most of our TPI survey respondents reported that both main contractor overheads and profit (OH&P) and preliminaries costs were unchanged from the previous quarter. However, slightly higher proportions of respondents thought that both OH&P and preliminaries had increased in Q4 (18% and 32% respectively compared to 14% and 27% in the previous quarter).
Rising labour rates and fuel prices, along with reduced availability of plant, are set to keep upward pressure on preliminaries costs in 2022. Rising costs for skilled management will also factor in as firms vie to retain good staff. Materials and labour shortages could constrain construction activity and productivity on site. If programmes become extended as a result, this will translate into higher preliminaries costs. Equally, any return of pandemic-related restrictions could potentially impact on project delivery and site productivity, weighing in preliminaries costs.
In terms of OH&P, with improving market conditions and demand for work getting stronger in many sectors, contractors will be looking to bolster their margins after a turbulent couple of years. On the whole, contractor pipelines are fairly secure for 2022 and into 2023 which will help push up OH&P levels as contractors pick and choose the projects they wish to bid for. This will not be a broad-brush trend though. Certain sectors are suffering from reduced or lagging demand and will push some contractors to absorb rising input costs through lower margins. Fewer tendering opportunities will invariably lead to further pressure to win work by reducing margins.
Although we continue to see all forms of procurement, two-stage tendering remains the preferred route according to nearly 50% of our survey respondents.
With so much volatility in the supply chain, it is understandable why many contractors are reluctant to tender on a single stage basis, but choice of procurement is driven by a variety of factors including sector, project size, length of programme and design liability. Having said this, survey respondents have generally experienced good levels of contractor engagement on major projects in two-stage tendering opportunities, given the level of prevailing inflationary pressures and ongoing concerns over price fixity. A handful of respondents even noted that changing the original procurement route to two-stage achieved better engagement levels from the market.
In sectors where workloads are lower and activity is subdued, total risk transfer via single-stage tendering appears to be more prevalent and acceptable to contractors. Similarly, lower value projects are more likely to be procured on a single stage basis. Regardless of the procurement route chosen, it was emphasised that early engagement with the supply chain was proving to be hugely beneficial in helping to mitigate risks and in 2022 we expect this to be more vital than ever.