THE RISING THREAT OF INFLATION
Some 12 months ago, I wrote that the extraordinary stimulus measures to assist the global economy in recovering from the pandemic were fuelling price rises in many economies.
Inflation refers to a rise in the average level of prices sustained over time, which also corresponds to a fall in the internal (domestic) purchasing power of money. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.
It has been well documented that inflation has hit its highest level in decades. Initially inflation was driven by the pandemic-related fiscal and monetary stimulus, which led to a much faster economic recovery than was thought possible at the end of 2020, and then enhanced by Russia’s invasion of Ukraine, which escalated energy prices etc.
Rates of inflation are increasing rapidly in many economies across the globe. The parties involved in construction projects are not only noticing that essential materials and skilled labour are significantly more expensive, but with the supply chain under pressure, shortages are making it harder to secure needed construction materials.
In many construction projects in this region, due to the lump sum nature of the contract price, the risk of any increase in the price of materials or labour is generally born by the contractor. Given the current situation, the parties in construction contracts should revisit the management of the risk concerning inflation and price escalation and consider which party is best placed to manage these risks.
One solution could be a fluctuation provision. Such clauses in construction contracts allow the contract sum to be adjusted to take account of changes to the price of labour, materials, and other costs on the construction project.
Calculating the increased cost may be achieved using an index-based formula or a published list of market prices for various items. There are fluctuation provisions in standard forms of contract such as the JCT, NEC, and FIDIC suite of contracts. When drafting a fluctuations clause, it is vital to consider whether and how the fluctuations provisions shall apply if there is a delay in completing the works.
Using the FIDIC suite of contracts as an example, the Red, Yellow and Pink Books allow the cost under the contract to be adjusted for any rise or fall in the cost of labour, goods and other inputs into the works. However, for this clause to apply, the parties must complete the table of adjustment data/schedules of cost indexation in the contract. If this is not completed, then fluctuations are deemed not to apply.
The FIDIC suite of contracts deals with the matter of fluctuations when the contractor is in delay by providing that any adjustments to prices after the date for completion are made using either: the indices or prices applicable 49 days before the date for completion; or the current index or price.
In the FIDIC suite of contracts, where currencies need to be converted from a foreign currency to the local currency relevant to the contract, the parties need to bear in mind that there will be some element of price risk. The parties can state the exchange rate in the appendix to tender/contract data, and then that rate is applied to the costs under the contract. If in practice, the exchange rate then moves up or down, one party will gain, and the other will lose out depending on which way it moves.
If the parties do not include the exchange rates at the outset, then the rate current at the base date determined by the central bank of the relevant country is deemed to apply to the contract. The parties could adjust the standard terms to apportion or allocate this fluctuation risk if required.
Overall, inflation is here to stay, and parties need to adopt a pro-active approach to manage the associated risks.