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Legal Notes: Price escalations give birth to new contractual models

John Bleasby
Legal Notes: Price escalations give birth to new contractual models

Volatile material pricing and supply chain disruptions have added new risks to all sectors of Canadian construction.

First was COVID-19 and the associated closures and health mandates. Since then numerous factors, like the Russian invasion of Ukraine, have disrupted supply chains, increased material pricing volatility and caused fuel prices to skyrocket.

The numbers tell the story. According to Statistics Canada, residential construction costs across a consensus of 11 Canadian metropolitan areas increased 36 per cent from Q1 of 2020 to Q1 of 2022. Although not as severe, non-residential construction costs over the same period increased 15 per cent. And that’s if builders could get hold of what they needed when they needed it.

The Canadian arm of international underwriter Victor Insurance spells out the problem very clearly in a recent Risk Management Advisory.

“Materials often represent half or more of the cost of a fixed-price contract,” Victor says. “Unanticipated increases could easily wipe out the construction team’s profit and create severe financial hardship for contractors and subcontractors unless they can pass on the added costs.”

Combined with labour availability issues that can also disrupt scheduling, the future of fixed price contracts is in doubt.

“Bidders commit early in a competitive procurement before they know about third-party and site conditions or before a design is at the advanced stage,” Sahil Shoor, partner at Gowling WLG told the Daily Commercial News. “This has resulted in contractors either losing money or backing out of the market.”

Various forms of price escalation clauses in contracts can spread the risk between designers, owners and contractors.

Although many private sector project owners may not like anything that sounds like “cost-plus” or “price fluctuation clause,” making some accommodation to today’s realities may be necessary if there is to be a competitive bidding process at all.

Some have suggested breaking the project pricing issues down into elements rather than tackling the entire project as whole. That may allow certain materials to be purchased sooner and stockpiled to protect pricing. Even designers can play a role by being flexible in their material choices or the building processes required.

“It’s very painful to hear about projects coming in over budget and late,” Richard Wong, partner at Osler, Hoskin and Harcourt LLP, explained in a recent webinar. “Many times, that can very well be attributed to exuberance on the part of owners and their consultants. We have to be sober about setting expectations. That is even more of a duty when planning a project.”

One solution can be the inclusion of price escalation provisions.

Wong explained these are not new. A variety of established indices can be used to provide proof to owners in the case of a price change submission and thus reduce the use of excessive contingencies. The challenge with any index, however, is that data collection takes time. The resultant lag time may not take the latest changes into account.

The misalignment of interests when excessive risks are shifted to contractors through various fixed price strategies has resulted in new collaborative procurement models gaining traction on large-scale infrastructure projects in Canada, says Shoor.

One such model Shoor identifies is the alliance model.

As described by KPMG, “Alliance contracts bring innovation and collaboration between the contract parties to the forefront during the procurement process where target outturn cost and performance targets are set for the joint (integrated) owner-contractor project team. In an alliance, risk sharing amongst project delivery team members is achieved via a risk-reward framework (frequently referred to as ‘pain/gain’ mechanism) included in the alliance agreement that applies to all alliance participant organizations.”

The other is the progressive design model.

“With progressive design-build a fixed amount for subcontract work is not determined until the builder has gone out to tender and the owner has had the opportunity to review the quotes with full transparency,” write Wong and his fellow partner at Osler, Joel Heard. “This model thus provides the owner with greater cost certainty and predictability.”

John Bleasby is a Coldwater, Ont.-based freelance writer. Send comments and Legal Notes column ideas to editor@dailycommercialnews.com

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