Cost escalation in infrastructure projects

Introduction

The aftermath of Covid 19, the Russian invasion of Ukraine and factors such as the post Brexit fallout and unprecedented weather events in Australia have all contributed to the almost unprecedented levels of cost escalation being experienced globally. 

This undoubtedly presents a significant challenge for those procuring infrastructure projects. Around the world, procuring authorities are grappling with how best to deal with escalating prices and situations in which bidders may be refusing to adhere to the kind of fixed price bids so often favoured by authorities looking to secure a price within their budgetary constraints. Bidders themselves are grappling with how to deal with these challenges. The infrastructure procurement market remains 'hot' in many parts of the world, offering numerous opportunities for bidders but the inflationary pressures and the constant state of flux in supply chain costs are posing challenges for bidding strategies. Bidders want to remain competitive while at the same time protecting themselves and their supply chains in an inflationary market in which many suppliers are struggling to hold prices for any significant period of time.

To give some examples of the scale of the challenge:

• UK: the Construction Material Price Indices for "All Work" saw a 27.2% increase in the 12 months to May 2022, with the greatest price rises being experienced in concrete reinforcing bars (64.9%), fabricated structural steel (52.7%) and particle boards (30.2%). Construction materials saw no price decreases during this time¹;
• Australia: the first three months of 2022 saw a 2.9% increase in building construction prices and overall there has been a 10.1% increase in the past 12 months. The Australian Bureau of Statistics has identified contributing factors to the increase as including the continued investment in infrastructure projects, supply constraints, higher freight costs, skills shortages and strong activity in the residential sector²; and
• Middle East: the construction industry has shown no signs of slowing down and demand for construction materials remains high. In 2021 alone, in some parts of Saudi Arabia it is estimated that the price of aluminium, copper and iron ore increased by between 45% and 51% and the price of steel reinforcing bars rose by as much as 46%³.

This article draws on our recent experience in the infrastructure market globally and looks at what solutions are emerging to deal with these issues. It follows on from our report "Resilient Infrastructure – Rising to the challenge of a more sustainable future" where one of the questions we asked was how issues such as climate change, sustainability, technology and Covid 19 would affect the pricing of infrastructure going forward.

As many of the projects we have considered in producing this article are currently in procurement, individual projects have not been named.

1. A global issue

Just like the Covid 19 pandemic, this is a global issue which has no respect for international boundaries. The same kinds of issues are arising in infrastructure procurement around the world, whether it be Australia, the UK, Europe, the Middle East or the US. As a result, as solutions emerge, they are likely to be of general application and we may see common approaches emerging across jurisdictions.

An exacerbating factor is the time frames for delivery that large scale infrastructure projects face. This raises the possibility of cost escalation over what could be a significant period of time, coupled with a desire from procuring authorities to make sure that any protection given should be flexible enough to deal with changing circumstances if inflationary pressures ease and some level of 'normality' returns, whatever that may be.

Over the past few years in a number of jurisdictions, we have seen debate regarding the most appropriate forms of contract for infrastructure procurement as some authorities seek to move away from more 'hard nosed' D&C contracting to more collaborative forms. These range from more flexible forms of D&C contracts with a greater proportion of shared risks to target cost approaches and alliances. While the form of contract can, in part, mitigate the degree of cost exposure from a bidder perspective (and reduce the level of risk contingency bid back to authorities) there is still a need for a degree of price certainty at the outset. This is because there needs to be a baseline against which methodologies, such as pain and gain share, can be measured. Bidders will be reluctant to increase the risk of 'pain' by exposing themselves to unprotected cost escalation. For procuring authorities trying to budget for their infrastructure spend, a move towards a more collaborative style of contacting can make budgeting more difficult (and the contingency provision greater) when compared to a more 'fixed price' approach and is particularly challenging if a project is within a regulatory environment where the key determinant is price. However, this has to be measured against a desire to reduce risk pricing for contingent risks that may never materialise along with general value for money considerations. 

2. The current position

Based on our recent experience globally, from both closed deals and on going procurements, there is no consistent pattern as to how the issue of cost escalation is being dealt with. While the issue is constantly raised by bidders, in the majority of cases a solution (if any) will be project specific and driven by a number of factors, such as the nature of the project, which materials will make up the bulk of the construction costs, supply constraints for those materials, the projected construction timeline and the degree of competitive tension.

It is also the case that rhetoric at the bid stage may not always translate into a final bid position as bidders take a view on the competitiveness of their bids and try to achieve the 'sweet spot' between the bid back of contractual terms (where permitted) and overall price. In some cases, bidders have not pursued cost escalation protection and presumably have added an element of contingency to their bid in order to mitigate against the risk (whether this is enough to offer 'real' protection, time will tell). In other cases, bidders have sought widespread protection. Rhetoric at the market sounding stage also needs to be treated with some caution as potential bidders may be more bullish on taking 'fixed price' risk at this early stage (and to help a project come to market) but will be more circumspect later on in the procurement. 

From the point of view of a procuring authority, they are understandably reluctant to give protection as a matter of course and therefore set a precedent for future projects. In some jurisdictions there may also be balance sheet considerations for an authority if they take on aspects of this risk. Therefore, if protection is offered, this is generally on a project specific basis where there is a particular justification or exposure. 

3. Intervention and voluntary schemes

In some jurisdictions, procuring authorities are taking a front foot approach and are offering bidders a degree of protection against the current inflationary environment. 

In Ireland an Inflation Co operation Framework has been developed for those parties engaged under a public works contract⁴. This was introduced in May 2022 with the aim of safeguarding public projects already under construction and to mitigate the significant losses being sustained by contractors. It recognised the effect the exceptional inflation in construction materials and energy is having on public work contracts and also the potential impact this could have on the willingness of contractors to participate in public works contracts that form part of Irelands National Development Plan. The Framework is voluntary, though parties are being strongly encouraged to participate.

Key features include:

• the back payment of a proportion of inflation related costs (on materials and energy) to 1 January 2022 on those contracts in progress since the beginning of 2022 (50% up front and the remainder apportioned over future payments);
• going forward, recovery for energy/fuel price inflation in addition to some protection for materials (inflation analysis will use the relevant indices published by the Central Statistics Office in Ireland);
• the State bearing 70% of the additional costs arising due to inflation with the remaining 30% being borne by the contractor. This is on the basis that contractors should bear some degree of additional costs in recognition of the original terms on which they tendered, but the majority of the costs should be borne by the State. This recognises the limited capacity of contactors to bear these costs, uncertainty as to the duration of the inflationary environment and the fact that the State, as ultimate owner of the asset, is keen to ensure that quality materials are used; and 
• contractors not being held liable to pay liquidated damages where it can be shown that supply chain disruption has led to a delay in completing the project.

The latter point is particularly noteworthy as it affords liquidated damages relief to contractors as opposed to being an extension of time entitlement. As the following section demonstrates, while an approach to cost escalation is slowly emerging, the focus has primarily been on cost rather than delay. It will be interesting to see whether this is aimed primarily at smaller contractors on smaller projects who may have less ability to absorb the cost of delay, in particular where this is exacerbated by liquidated damages. 

In the UK the Construction Leadership Council (CLC), an industry/government council jointly chaired by the Minister for Business and Industry and an industry appointee set out plans in May 2022 to mitigate the impacts of inflation hitting companies across the sector⁵. The CLC is seeking to co ordinate industry efforts to minimise risk and reduce the impact of inflation where it can. Its plan includes developing market intelligence about risk hotspots, publishing guidance on price inflation indexation and commercial issues, preparing case studies on good practice in response to current inflation and running industry briefings on conflict avoidance. It is also researching long term capacity loss from Ukraine, Russia and Belarus and the impacts on the sector.

As an aside, for a summary of how the three common standard form contracts used for construction and infrastructure projects in the UK – JCT, NEC (commonly used by the UK Government) and FIDIC - address the risks associated with cost escalation arising from unforeseen events, see our article here. This article also considers potential recourse in terms of suspension and termination rights, and some of the ways in which these contracts can be drafted for future projects to address the issue of cost escalation. 

The US Department of Defence issued Guidance on Inflation and Economic Price Adjustments in May 2022 in recognition of the major inflation challenge faced by government contractors⁶. The Guidance focuses on both existing and new contracts and recognises that where economic price adjustment (EPA) clauses are contained in contracts then these will apply according to their terms to offer protection, but where, for example, a fixed price contract does not provide the contractor with the benefit of an EPA clause, the risk should remain with the contractor. For new contracts it recommends that where an EPA clause is considered it should focus on the key areas of price escalation, rather than being of general application.

4. Is a pattern emerging?

Globally, procuring authorities are understandably reluctant to expose themselves to general cost inflation risk and so there appears to be strong resistance to any kind of blanket protection. Procuring authorities are however conscious of the increasing pressure on global supply chains and recognise the need to consider alternative approaches in light of this.  Where we are seeing protection offered, this is usually on a bespoke basis tailored to the particular nature of the project. Themes that are emerging include:

• Identification of specific commodities/materials: the need for agreement on which commodities/materials are subject to the greatest level of volatility and which of these are significant in the context of the particular project. Examples include bitumen/asphalt, cement, steel, timber and containers. We are seeing less of a focus on costs such as labour;
• Indices: links to specific indices which best track the relevant costs and the application of these indices to adjust particular elements of the contract price only;
• Caps and collars: should any pricing protection afforded by a procuring authority only apply once a particular level of escalation been reached (and likewise any share in the upside of price reductions only apply once a certain level of reduction has occurred)?;
• Level of protection: should the level of cost protection provided to a contractor for a particular commodity be less than 100% in order to incentivise the contractor to control costs?;
• Profit element: addressing the profit element on any adjusted element. Logic suggests that where the contractor is obtaining the benefit of cost protection any adjustment should be limited to the cost element only (without any additional margin for the contractor on the adjusted element); 
• Volume risk: in relation to a particular commodity procuring authorities are not generally willing to accept volume risk as it is seen as a risk best controlled by the contractor;
• Duration of protection: where some pricing protection is provided then ideally authorities will want to limit this to the period between bid submission and contract close (or financial close, if relevant, given the link to debt sizing and the robustness of the financing package). We have, however, seen projects where protection has been provided until the end of the construction phase (and this is where a lot of the bidders focus remains). In this case it will be particularly important that the authority can benefit from any cost reductions if inflationary pressures subside. The challenge with restricting cost escalation to a period that ends at contract close is that in many cases this may not reflect the bidders subcontracting strategy. Obtaining insights into bidders subcontracting strategy will be important to allow authorities to better consider the period during which adjustments can be made; and 
• Evaluation: consideration of how best to ensure that any pricing mechanisms that are bid back are properly evaluated in order to ensure a level playing field is maintained.

While protection is generally being considered at a project specific level, many governments are exploring options for positions that could be adopted as a general rule across sectors. We are yet to see a whole of government position taken in the context of the current pricing constraints, but many governments are considering whether price escalation issues should be treated as a whole of government issue with a view to maximising consistency across procuring authorities and mitigating risks of project specific outcomes setting precedent positions. In some markets, such as the Middle East, the issue of protection is taking slightly longer to come to the fore but given the number of procurements in the region this may only be a matter of time. 

5. Other forms of mitigation

If a procuring authority is not willing to offer any cost protection to bidders then bidders will have to decide whether they wish to pursue the bid and, if so, whether other forms of mitigation are available. One option for bidders is hedging. For example, in a project with a high bitumen content can the bidder protect itself by hedging against the oil price and does it then need to factor in the price of the hedge into its bid? Even if the bidder is able to hedge the risk, the period of time suppliers are able to 'hold' their pricing means that bidders still need to move much quicker than before to 'firm up' pricing. Another consideration is whether the bidder can spread the relevant cost risk over a number of its projects.

If the authority is willing to offer protection to bidders in respect of a particular commodity then it will need to consider whether to put in place mitigation measures itself. Where an authority takes the risk of foreign exchange movement between bid submission and contract close, we have seen foreign exchange hedges taken out in order to mitigate against this exposure. The same could be considered for a particular commodity. 

Finally, we are seeing anecdotal evidence that authorities are looking more closely at the impact that government policies around purchasing requirements may have on prices and access to supply chains, for example, requirements for local content or use of local suppliers and whether departures from these policies may allow for some decrease in prices (at least temporarily). For regions more heavily dependent on the import of construction materials but who are actively working to mandate an increase in local content requirements (with a relatively limited supplier pool), this is potentially going to increase pricing further due to lack of competition - ultimately it will be a policy decision between development of local skills against cost.

6. Conclusion

The current inflationary and supply chain cost pressure is affecting infrastructure projects globally and we are seeing similar issues across projects in Australia, the UK, Europe, the Middle East or the US.

In terms of approach, to the extent there is appetite at the procuring authority level to provide protection the trend is towards limited protection in respect of an identified set of commodities with volume risk remaining with the contractor. This kind of protection is primarily manifesting itself in those projects currently in procurement with relatively little appetite to re open executed contracts. There are exceptions to this, however, the Inflation Co operation Framework in Ireland being an example.

Over the coming months we expect to see this issue develop further as more projects close that will have had to agree a position on cost escalation. This will help identify if a consistent 'market' approach is developing and if certain indices come to the fore, either in a particular jurisdiction or globally. 

Authors: Harvey Weaver, Partner; Mark Disney, Partner; Yvonne Cross, Partner; Sadia McEvoy, Counsel; Matthew Taylor, Senior Associate and Lillian Yeung, Senior Associate.

<sub>1. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1087494/22-cs7_-_Construction_Building_Materials_-_Commentary_June_2022.pdf
2. https://www.abs.gov.au/statistics/economy/price-indexes-and-inflation/producer-price-indexes-australia/latest-release#construction
3. https://www.jll-mena.com/en/views/impact-of-price-inflation-on-middle-easts-construction-sector
4. https://www.gov.ie/en/press-release/a346d-minister-mcgrath-introduces-measures-to-address-the-impact-of-construction-material-price-inflation-on-public-works-projects/
5. https://www.constructionleadershipcouncil.co.uk/wp-content/uploads/2022/05/CLC-Press-Release-25-May-CLC-acts-to-ease-impact-of-construction-inflation.pdf
6. https://www.acq.osd.mil/dpap/policy/policyvault/USA000999-22-DPC.pdf</sub>