Contracting for an Uncertain Future: A checklist for contracting in a high-risk inflationary market
The global construction and engineering industries are grappling with inflationary pressure, continued impacts from COVID-19 plus material and labour price increases. Whilst limited attempts at indexation/price review may be found in some contracts, we see a vast majority of projects where the contract machinery and governing law offer little relief against these seismic shocks. The geopolitical situation in Ukraine, the energy crisis in Europe, economic slowdown in China, and a potential global recession have all had far reaching consequences for parties whether considering new projects or already in the execution phase.
These pressures have been a catalyst for an already-growing reluctance by Contractors to enter into EPC fixed priced contracts, joining an increasing number of project Owners becoming dissatisfied with the same model not delivering the certainty it supposedly offers. The EPC fixed price contract is the required form of procurement model for most project financiers and it is here to stay for the foreseeable future. That said, much of the industry is interested in exploring areas in which the model could be adjusted to take into account new market conditions. In light of these new market conditions we set out below a checklist of key issues parties may wish to consider when entering into construction contracts in these turbulent times.
- Long lead item procurement and advance payments. While long lead procurement is a longstanding feature of EPC contracting, current conditions may add a further advantage for those seeking to expand the list of items that are procured, or at least ordered, early. Procuring long lead items at the earliest possible opportunity may reduce the risk of future delays if supply chain issues arise and may also minimize potential for late stage price fluctuations. The parties may want to negotiate advance payments (secured by advance payment bonds) for the purchase of long lead items under the construction contract in order to manage Contractor’s cash flow and enable early orders to be made.
- Back-up suppliers. Given the current global supply chain challenges facing the industry, prudent parties will be considering at the tender stage contingency arrangements in the form of potential alternate suppliers for key pieces of required kit and materials. If there is a significant risk with any key suppliers, parties may need to consider favourable termination rights with that supplier (including rights to terminate for negative financial status events) and robust post termination obligations to provide required information to any new supplier (such as fabrication ‘shop’ drawings or design information).
- Financial due diligence and audit rights. Inflationary pressure has put significant financial strain across the supply chain. Increased insolvency risk means financial due diligence has become even more important. Parties should consider conducting credit checks on all parties in the project chain. Upstream parties may also wish to take full advantage of their audit rights to request documents and records from counterparties in order to identify any potential issues such counterparties may be experiencing as early as possible and evaluate switching in back-up suppliers in the event that a particular supplier suffers a negative financial status that could impact its performance for the project.
- COVID-19 is now a known risk. As such, it is prudent for parties to discuss COVID-19 impacts and consequences and expressly agree risk allocation in the contract. Parties may not be able to rely on their previous experiences of COVID-19 claims when entering into new contracts e.g. if there have been no post contract changes to law or COVID-19 related measures introduced, parties may not be able to rely on the generic claim provisions of a “Change in Law”, Force Majeure or Authority Caused Delays.
- Using the market to hedge risk. Owners and Contractors will already be familiar with currency hedging; given the recent increase in key commodity prices, parties may also consider using the market to hedge their risk for the price of key materials. For example if a Contractor knew that it required a certain amount of steel for the project which was currently being sold at $X/tonne, the Contractor could take a “Long” position on steel i.e. the Contractor is betting the price of steel increases. If the price of steel increases the Contractor would make a profit from its trade, which potentially offsets having to purchase the steel at a higher price. If the price of steel decreases, the Contractor would make a loss on its trade, however would be able to purchase the steel at a cheaper price.
Given the current market conditions parties may wish to make more significant changes to the EPC model to create a hybrid model of contract. This may be suitable where a project does not require a fixed price from the outset and the Owner is willing to accept some specified pricing fluctuation in the interests of attracting a broader base of bidders and a reduction of the Contractor’s price risk contingency. In such a scenario the parties may consider any one or more of the following mechanisms for inclusion in such a ‘hybrid’ model:
- Material Price adjustment provisions. If parties cannot agree on the risk allocation of a specific material price, it is possible to prepare a material price adjustment clause. These clauses allow parties to set a predetermined mechanism by which the contract price can be adjusted to reflect any changes in the price of certain specified materials. The clause can be drafted to provide for both a decrease and increase in the contract sum providing a mutual benefit to the parties. The key matter in making this a potentially workable mechanism is the ability to determine and agree upon the baseline index or other metric against which the contract pricing for the relevant material will move.
- ‘Wedding cake’ risk sharing for price increase. The parties may seek to allocate ‘layers’ of risk between themselves as a way to spread the risk. For example, the Contractor may agree to bear the risk of any material price increases of specified material or equipment up to a set amount; after which the risk of any such price increases shall be borne by the Owner (further ‘layers’ of risk allocation being possible beyond that).
- Labour rate review provisions. Similar to material price adjustment provisions, parties may consider including a mechanism for a review of labour rates (or at least certain categories of labour). Such provisions will normally use a method of indexing labour rates. As per material price adjustments, the key to making this a potentially workable mechanism is the ability to determine and agree upon the baseline index or other metric against which the labour rate will move.
- Provisional sum items. Provisional Sum items are not uncommon in EPC Contracts, however they will generally only be used on a limited basis for works of a minor value to maintain relative price certainty. The inclusion of more provisional sum items in the contract can be drafted in both parties’ interests; if the actual price of such part of the works is less than the provisional sum, the Owner stands to benefit, and if the price is greater, the Contractor will be covered by a corresponding adjustment to the contract price.
- Owner supplied materials. If the parties find that Contractors are unable or unwilling to take on certain items due to price volatility or supply chain issues, parties may wish to consider carving certain items out of the contract scope to be supplied by the Owner.
What are you experiencing? Would you consider adopting a hybrid model? We’d like to hear the industry’s views. Please email: firstname.lastname@example.org
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.