Inflation Adjustment: Managing Commercial Risk in Construction Contracts
The construction sector has battled with a harsh inflationary reality throughout 2022.
September’s Output Price indices (OPIs) show 12-month inflation at 11.8% for new construction work and 6.8% for repair and maintenance activities. New infrastructure works have suffered the highest rate of inflation, with prices increasing by 18.1% during a 12-month period since September 2021 [1]. Employers, and contractors alike, are faced with competing demand and shortages of both labour and materials.
Figure 1: ONS: Output Price Output Indices (OPIs), Sept 2021 – Sept 2022
Inflation Adjustment in Construction Contracts
Indexation is a widely used contracting tool, which enables a contractor’s prices to be adjusted for inflation.
Typically, inflation adjustment clauses allow prices to be automatically updated based on a specific index at a defined frequency – this could be monthly, quarterly, or annually. Most construction contracts follow a single index method whereby adjustments are made to all of the contractor’s prices, rather than having different indices for each Bill of Quantities (BoQ) item. For example, in the JCT contract suite, Option C allows for adjustments to be made to the Contract Sum using defined Formula Rules.
Today’s inflationary pressures highlight the importance of including effective indexation clauses in construction contracts.
Objectives and Benefits
Indexation provisions gained popularity in the early 1970s during a sustained period of high inflation. Consumer Price Index (CPI) calculations identify a 12-month inflationary figure of 24.5% in August 1975, and strong inflationary pressures were experienced into the early 1980s [2]. Indexation clauses have since been used across many industries, particularly the construction sector.
Figure 2: ONS: Consumer price inflation, historical estimates and recent trends, UK: 1950 to 2022
Indexation provisions can enable employers and contractors to attain increased value from contracts and improve the longevity of partnerships – particularly during periods of volatile prices.
This is achieved by shifting inflation-based commercial risk onto the employer and away from the contractor. Where contractors are required to fix their prices for a long period of time, a large commercial risk premium will be included in their tender proposals – this will be based on ‘worst case’ inflation estimations. Indexation clauses can reduce the contractor’s risk by providing an assured method of adjusting revenue relative to inflation.
Indexation clauses support more competitive tender proposals and help the contractor to make sustainable levels of profit, which reduces the risk of insolvency.
Types of Inflation Adjustment Indices
RICS identifies four different types of indices that can be used to adjust prices for inflation in the construction sector [3].
Published resource cost and output price datasets are the most commonly used indices in construction contracts. Tender price indices (TPIs) are used less frequently in indexation clauses, as contractors’ tender prices may already include a level of inflation-based risk, making these indices more speculative. As output price indices tend to lag behind other types of indicators, contractors will typically prefer a resource cost index, which represent recent changes to actual costs.
Choosing the Right Index and Methodology
Selecting an appropriate index and methodology is crucial to ensure that indexation clauses can effectively manage inflation-based commercial risk.
Identifying the right index
General inflation indices are not considered to be appropriate for construction contracts. Indices such as RPI and CPI are based on individual spending and are not necessarily representative of sector-specific price fluctuations. Similarly, general construction indexes such as COPI lack the level of discipline-based data present in resource cost indices [4]. For example, PAFI is broken down across several labour, plant and materials indices which can be weighted by the employer to align the indexation provisions with the specific scope of work.
More nuanced indices are preferred over general indicators, as discipline-based indices can be selected depending on the contractor’s actual cost drivers. For example, PAFI enables employers and contractors to establish bespoke weightings for key labour, plant and material costs based on the scope of works. Discipline-based indices reduce the likelihood of inflicting additional risk on contractors, which often occurs when general indices such as RPI or COPI are used [5].
Applying the right methodology
Employers should clearly define their methodology and measurement rules when drafting inflation adjustment clauses. This will include the following key details:
Many construction employers do not follow the above guidance, exposing their supply chains to inflationary risk. Contractors continue to include a large risk premium in tender proposals. Those who do not are likely to request in-life price amendments to safeguard profits and solvency.
Contact us to find out how Deecon’s subject matter experts can support your organisation in drafting effective contracts which help to mitigate commercial risk.
Words By Robbie Smiles
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