What can be done to overcome the challenges of rising labour costs and inflation in construction?
With UK inflation having risen above 9 per cent, it would be short-sighted not to predict that this is likely to cause significant issues for construction projects that are currently live and planned over the next few years.
Most obviously, the price increases in fuel, energy, and raw materials will have a knock-on effect on tender prices and contractor’s costs over a project’s lifespan.
There is no unanimous consensus among economists on what is causing the high levels of inflation, but many theories attribute it to product shortages caused by global supply chains – largely the aftermath of the Covid-19 pandemic and the war in Ukraine. The latter has led to an increase in prices of oil-based products such as asphalt and diesel.
Within the construction industry the impact has been felt severely as supply chain issues, increased demand after the Covid-19 “reopening”, shipping and other production issues have led to predictions that inflation in the construction industry is likely to reach 10 per cent this year.
The Financial Times has also reported that there has been a huge increase in UK property companies filing for insolvency in the back end of 2021, with companies who took loans to fund speculative development projects prior to the pandemic said to be particularly at risk.
The government moratorium on winding up petitions during Covid ended in 2021 and funders and lenders are no longer hamstrung by that restriction. If a developer goes into insolvency, there are then likely to be financial implications for their wider supply chains.
How will this impact the industry?
The obvious answer is that rising costs could prevent projects being funded and given the green light in the first place. It is also quite possible that well-funded or cash-rich employers may decide to commence projects as soon as they can to try and tie down their costs, rather than waiting for prices to continue to rise.
More and more contractors will currently be trying to balance the twin desires of trying to secure pipelines of future work and getting work through the door, along with the desire not to be caught in long term fixed-price contracts which are likely to cause them significant losses if the current costs in the market continue to increase. Contractors would be wise to look to try and negotiate the inflation, fluctuation and fixed costs elements of their contracts immediately.
With suppliers and subcontractors reportedly holding their price for 24 hours, any contractor signing up to a fixed price contract without also securing their supply chain on back-to-back terms could be creating significant future cashflow and profit problems.
We are already seeing significant amendments to the standard form JCT (Joint Contracts Tribunal) and NEC (New Engineering Contract) contracts, which traditionally have envisaged little scope for the contractor to claim for increased costs due to market changes. Common changes include amending the extension of time and loss and expense provisions to include relief for contractors.
Other options include using bespoke mechanisms to allow for a change in the price for certain elements or materials in the works, although most employers will seek to limit these to specific and key-risk items of works.
So is it likely that more contractor-friendly forms of contracting – for example “cost plus” and “cost reimbursable” – are going to become more popular in the UK?
We are not seeing this currently and employers are unlikely to agree to take on most or all of the risks of inflation and price increases on projects. More likely is that current forms of contract, such as the JCT Design and Build, will be amended to include mechanisms whereby the parties can negotiate price increases in certain situations. This is not dissimilar to the Brexit and Covid clauses which many parties included, which tried to apportion the risk of those issues impacting the timing and price of delivering projects.
An alternative form of procurement which might become more common in the current market is “target cost contracts” which will include a “pain/gain” mechanism, where the parties agree to share the pain of cost overruns, and the gain of efficiencies or savings – thereby aligning their commercial interests more closely.
The NEC Suite of Contracts has secondary option X1 on price adjustment for inflation. This is an option on all NEC4 contracts and can relatively easily be included. This is normally linked to a “base date” – typically around the tender submission date – and then there is a price adjustment factor based on changing values of a prices index or indices which are set out in the contract.
Employers should be careful when choosing the appropriate price index as they can be general (ie UK consumer prices index/ retail index) but those won’t be construction specific. It would be more appropriate for employers to try and use indices for the specific labour, materials, fuel and equipment used on the project itself – which would provide a better model of inflation.
What about contracts which are already formed and live?
We are seeing more parties attempt to renegotiate the terms agreed and enter into deeds of variation reflecting revised prices and terms. Employers are being placed in the invidious position where their supply chain is telling them they simply cannot provide the works for the pre-agreed fixed price. The employer is then faced with a commercial decision as to whether to renegotiate the contract or else risk contractor insolvency and having to re-tender the works in the 2022 market.
Most employers when faced with that decision will prefer to work with their current supply chain, as it is quite unlikely that they are going to be able to find a cheaper alternative contractor. Re-tendering is also likely to lead to severe delays.
As ever, early engagement and negotiation between the parties on projects will be essential to successfully navigate this difficult situation. Any contractor would be well advised not to unilaterally cease works or demand price increases where they are not contractually entitled to do so, as this is likely to result in a repudiatory breach of contract and/or economic duress on the part of the contractor.
It would also be naïve to think that the current labour disputes and industrial action won’t potentially spill over into impacting the construction industry. Unite the Union recently submitted a demand for a 10 per cent pay rise to the Construction Industry Joint Council.
As the cost of living increases, many unions representing workers in the construction industry are likely to consider industrial action if industry bodies do not agree to their demands for inflation-linked wage increases. The industry bodies will be seeking to try and find a balance between the longer-term health of the industry with supply chain and labour demands.
Most forms of contracts allow contractors an entitlement to an extension of time for industrial action and strikes, provided that the strike doesn’t only impact the contractor or specific site. Therefore larger scale industrial action across the industry as a whole is quite likely to provide contractors with entitlement to extensions of time, but not additional loss and expense or costs.
Rising levels of inflation will continue to cause significant issues and risks for everyone working in the construction industry. Employers, contractors and the wider supply chain are likely to going to have difficult conversations and difficult decisions to make. They will need to work together in good faith where possible to try and limit the negative impact on the projects in which they are involved.