by the CI Editorial Committee
Anyone monitoring construction industry trends knows that the prices of raw construction materials, particularly steel and lumber, have increased rapidly since early 2020. Associated Builders and Contractors reports that iron and steel prices were up 15.6% from January of 2020 to January of 2021, and that softwood lumber prices increased by as much as 73% during the same period. Although the market for materials has recently demonstrated some movement back toward pre-pandemic prices, in general, prices remain substantially higher for most items than they were in 2019, and many expect this to remain the case for the foreseeable future.
The reasons for these price increases vary, ranging from supply chain and shipping disruptions to the increased demand for new home construction, many of which arise from changes introduced to the global economy by the COVID-19 pandemic. In addition, the market for construction components is facing shortages of available material in a number of areas, many of which are critical for retail and hospitality construction projects.
Short supplies and increased material prices mean one thing for owners and contractors: higher construction costs. Explanations for these cost increases provide little comfort to builders and owners faced with busted budgets and difficult conversations, sometimes resulting in litigation, about which party is responsible for absorbing the increased costs when projects are already underway. As is often the case, the answer likely lies in the particular provisions of the contract for construction.
Cost-plus or “time and materials” contracts are likely to identify the responsible party as the owner. The relatively open-ended pricing structures in these contracts provide the least price certainty to owners, and most flexibility to contractors, in dealing with fluctuations to the costs of materials.
On the other end of the spectrum are lump sum, or fixed price contracts. Under these pricing structures, a contractor’s pricing is generally locked in at the outset for a defined scope of work, and owners are unlikely to voluntarily provide any cost relief when material price escalations cause budgets to be exceeded for categories of materials that have not yet been purchased.
A third type of contract, priced on a not to exceed, or guaranteed maximum price basis lies somewhere in the middle. In such contracts, owners are generally better protected from material price increases due to the cap on total construction costs, and constructors often build allowances or contingencies into their pricing structures to protect against, among other things, unexpected material cost escalations. Contractual mechanisms like shared savings clauses can incentivize contractors to be smart with owners’ funds even where material prices are skyrocketing, in the hope that intelligent procurement strategies will both save the owner money and improve the contractor’s bottom line.
One important variable factor is whether a given contract specifically addresses the risk of material price escalations with what is commonly referred to as an “escalation clause.” Rarely seen in cost-plus contracts, these clauses are gaining popularity with contractors as a method of hedging against, or merely more equitably sharing, the risk of material price escalations in light of the reality that material prices seem to increase year over year, and precipitously so in some years, as the industry has recently experienced. These clauses most typically address one of two scenarios.
In the first form, often referred to as a “delay” or “event” escalation clause, when a delay of a certain duration or other specific event takes place, the contractor can seek additional compensation for increased material costs. In essence, a contractor is agreeing to stand by its material prices for a fixed period of time (sometimes as short as the day the contract is signed) and, after that time, will look to the owner to share in or fully absorb any material price increases.
The second form of escalation clause is the “percentage-based” or “threshold” escalation clause. These clauses provide that, once material prices on the open market have increased by a certain percentage above the contractor’s estimate at the time the contract was signed, the owner and contractor will adjust the contract sum to account for the excess, either in the form of full or partial additional compensation to the contractor for the cost increases.
The selection of an appropriate project delivery method and negotiation on whether to include a material price escalation clause are just two of the ways that owners and contractors are addressing the challenges of finding certainty in a rapidly changing market. Whether material price escalation clauses become the norm in response to current market conditions remains to be seen and, for now at least, they are one more variable to bear in mind before signing on the dotted line.
