An Approach to the Recovery of Escalation Costs
INTRODUCTION
Escalation costs refer to additional costs incurred due to material and labour cost increases while undertaking a project. Since the onset of Covid-19 and other global events, Australia has seen unprecedented increases in material costs, placing many contractors into financial distress or even insolvency.
A contractor’s ability to successfully negotiate a claim for escalation costs does not negate the obligation of the contractor to properly plan and expedite the works, or forecast increased costs. It should be acknowledged that arguing escalation claims in the absence of express contractual entitlement is no small feat and requires a considered approach; or otherwise should be avoided.
Where you don’t have any express entitlement to claim escalation costs under a contract, it is prudent to submit a claim to your client if:
- downstream contracting parties have incurred increased costs due to materials escalation costs beyond what was reasonably anticipated at tender (that is – pre-award); and/or
- you have incurred losses during the letting process (due to for escalation and future price risk).
It is also important to advise the upstream contracting party of escalation costs if the extent of cost is significant enough to adversely impact your own performance or the performance of a downstream contracting party. Downstream contracting parties that cannot sustain the losses incurred by way of escalation of costs may seek to recover their costs in various ways or may simply cut their losses and abandon the project. This behaviour is likely to lead to dispute between parties and will have an adverse impact on the delivery of the project as a whole.
NATIONWIDE MATERIAL COST INCREASE
In 2022, the Master Builders Association of New South Wales (MBA NSW) reported[1] that building material costs have increased across Australia at their fastest rate since 1980. The MBA NSW also confirmed that the rate of increase was similar across all six capital cities. Over the financial year up to March 2022, the sharpest price increases related to the following building materials as detailed in Table 1.
Table 1: Yearly Price Increase to March 2022
| Trade | Increase (%) |
|---|---|
| Reinforcing steel | 43.50 |
| Steel beams and sections | 41.50 |
| Structural timbers | 39.20 |
| Plywood and boards | 29.80 |
| Electrical cables and conduits | 27.10 |
| Plastic pipes and fittings | 26.50 |
| Copper pipes and fittings | 25.70 |
| Terracotta tiles | 21.50 |
| Metal roofing and guttering | 19.90 |
| Insulations | 14.00 |
This unprecedented material cost increase has put building practitioners at increased risk of financial distress as a result of having faced losses on many of their projects.
Further to its analysis of the increase in cost of building materials, the MBA NSW stated that:
‘it is [in] no one’s interests for their builder to go to the wall over a fixed price contract that could not have foreseen these increases. Clients with builders that go under will be left to navigate complex insurance claims and may in the end be both out of pocket and unable to secure a builder to finalise construction. It is a far more sensible approach to re-negotiate the current contract considering the unforeseen changes in material costs and timeframes.’
The MBA NSW has strongly encouraged all parties who have signed contracts to be flexible and realistic and seek to renegotiate the building material cost element of fixed-price contracts.
The Australian Constructors Association[2] recently reported that:
‘hyper-escalation of construction costs for contractors locked into fixed price contracts is emerging as one of the biggest challenges for the construction industry. If not addressed, it could significantly impact on the ongoing sustainability of the industry and in the process harm Australia’s economy.’
Additionally, the Australian Constructors Association commented that:
‘the industry is seeing examples of price rises over a 12-month period of up to 70 per cent and yet clients continue to expect fixed prices. The industry cannot continue to bear the cost of these steep price increases—some costs will need to be passed on to halt the growing trend of insolvencies.’
THE REALITY OF EXCESSIVE PRICE INCREASES
Payment of reasonable escalation costs is necessary, in order to avoid:
- contractors stopping work and leaving projects in an attempt to cut their losses;
- project delays caused by re‑tendering of works, particularly critical works;
- project delays caused by disruption of the works as a result of replacing contractors; and
- contractors seeking recovery by:
- increasing the number of contractual claims made under the contract; and
- increasing the amounts claimed in each claim,
which is likely to have the effect of increasing the risk of commercial dispute which often has an effect on the performance of the contractor, not to mention the extra resources required to assess and negotiate these claims.
Contractor performance issues will adversely affect the delivery of the project. Where the performance issues are related to a subcontractor or multiple subcontractors, this can have serious repercussions for a head contractor and open it to claims made by the project principal.
In the event that a commercial dispute arises, it is possible that this dispute could be resolved by way of commercial negotiation, however any resolution reached is likely to involve compromise with respect to costs and therefore before the dispute arises and significant resources are expended on negotiation, compromise on the issue of escalation should be duly considered.
In the event that the dispute is not resolved by way of negotiation and legal proceedings are commenced, the costs associated with carrying on such proceedings may far outweigh the escalated costs being claimed by a contractor.
Accordingly, if the upstream contracting party adopts a strict view on entitlement under the contract and rejects the submission for escalation of costs by the downstream contracting party, it is likely that this will be to the detriment of the project and all parties involved.
Upstream contracting parties that are cognisant of the practical risks associated with failing to duly consider a downstream contracting party’s claim for escalation costs will reap the benefits of paying reasonable escalation costs. Due consideration of escalation costs will remove the potential for project disruption, delay and adverse behaviours that can affect working relationships and avoid a distressed project situation.
ENTITLEMENT UNDER THE CONTRACT
Under certain contracts, construction lawyers may argue that substantial price escalation made it impossible or commercially impractical to perform the contract work (which may be the case for specific trades).
In the current environment, it may be possible to negotiate specific contractual provisions regarding escalation, and even though this assigns a certain level of risk to the upstream contracting party which may have not been typically assigned to it, any upstream contracting party that wishes to deliver a successful project and protect its commercial relationship with a good contractor should be willing to consider such provisions.
Claims for escalation costs are strengthened in cases where significant delays have been caused by the upstream contracting party. Where this is the case, the upstream contracting party is likely to be open to paying the portion of the total escalation cost that relates to the delay it has caused, notwithstanding the provisions of the contract might limit the extent of delay costs that are claimable.
CONSIDERATIONS FOR CONTRACTORS
Some upstream contracting parties develop corporate social responsibility (CSR) to preserve an image of good corporate citizenship. CSR relevant to the construction industry includes the following activities:
- the moral obligation to be a good citizen;
- sustainability;
- reputation;
- relationships with employees and unions;
- relationships with suppliers and community representatives; and
- a commitment to reporting on CSR.
A government client or large private organisation that upholds the values of a responsible corporate citizen is unlikely to ignore the reality of escalation on their projects. Good corporate citizens would typically seek to be fair and equitable under the circumstances and are likely to agree to the inclusion of contractual provisions regarding escalation if not already present in their standard form contracts.
APPROACH TO CLAIMING
Skilful and timely communication with your client is essential, along with ascertaining their initial thoughts and approach to paying an agreed proportion of the costs.
Early advice to your client concerning the extent of costs being incurred is important, which can be followed up later with a formal submission after discussions are initially held.
Consider your client’s position and the extent of costs that might be palatable for the project type and size. This may necessitate claiming the downstream contracting party’s direct costs only and not pursuing your own letting losses (as an example).
- Calculate a reasonable allowance for escalation included in the tender price/contract sum over the original contract duration.
- Calculate the actual cost of escalation across all trades (actual costs incurred per trade), initially by reference to industry escalation data – as a guide.
Actual costs (as opposed to industry data) would be a combination of both
a) claims made by subcontractors and suppliers; and
b) letting losses incurred (calculated by comparing actual let values to the ‘target trade budget’, that is – after deductions are made for ‘buying’ to achieve the business plan margin).
After the initial submission is made using industry data, the client’s commitment should be sought to apply a reasonable methodology for the final valuation and payment.
Clients are likely to opt to firm up a lump sum settlement amount to close out risk of future costs / claims and, as such, they may prefer to settle on industry data as the basis for the calculation., This enables the client to review the actual costs across a number of selected trades (only) – to validate the industry data.
This can lead to a joint assessment of actual costs incurred on a sample of trades only and, ultimately, a lump sum settlement that both parties can live with.
INDEPENDENT REPORT
In most circumstances, it is prudent to engage an independent consultant and/or quantity surveyor to substantiate the quantum of escalation costs being claimed.
CONCLUSION
Price escalation is a reality, and responsible upstream contracting parties should be open to paying reasonable costs to ensure the successful completion of their projects. Failure to do so is likely to lead to the creation of a distressed project situation which has consequences for all parties involved.
Where the upstream contracting party is attempting to demonstrate compliance with the CSR principles, the failure to duly consider cost escalation issues may have serious repercussions for their standing as responsible corporate entities.
Proper planning and forecast of costs, considered contract negotiation, skilful, detailed and timely communication of all claims, combined with a properly considered claim strategy, will put you in a good position to recover some, if not all, of your escalation costs.
To learn more about how Calibrate can assist you with recovery of your escalation costs, please contact the author, Darren Gordon, or the Calibrate Consulting office at info@calibrateconsulting.com.au or +61 9188 7444.
