By: Tyler S. Lemen
Since March of last year, construction input prices are up 12.4%. Certain materials, like softwood lumber, iron, and steel, are up 83.4% and 37.5 %, respectively, since this time last year. COVID-19 undoubtedly played a role in year-over-year price growth but prices continue to increase month to month. It is unclear when or if prices will plateau and whether prices will drop in the future as production and transportation capacities normalize. The primary means of managing post-contract price escalation risk is through the use of a material price escalation clause.
Generally, a material price escalation clause will entitle a contractor to a change order where the price of certain types of materials increases either between the time of bid submission or the time the contract is effective and when the contractor orders the material. The amount of additional compensation the contractor can seek may be based on either the actual price of the material versus the amount included in the bid or by using a commodity index to calculate the increased amount. While sometimes overlooked in the past, escalation clauses are now being prioritized in contracts.
There are also certain situations where an owner may request a price escalation clause (which effectively acts as a de-escalation clause) anticipating a price reduction. For example, such a clause makes sense when the price of a certain material shot up quickly prior to bid and is expected to go back down by the time the material is ordered. Owners may choose to negotiate a modification to the material price escalation clause whereby the contractor takes the risk on the first, say, 5% or 10% of the material price increase so that the owner and contractor are sharing the risk. Sometimes the owner will request a cap on their risk, however, as long as the owner has a termination for convenience clause in the contract they are protected against a price increase that is so great that the project does not make business sense anymore. Contractors should carefully consider the risks involved before agreeing to a cap on the owner’s risk.
When evaluating whether an escalation clause makes sense in your contract, consider the practical effects of the clause.
1) Does the clause allow adjustments for price increases and decreases, creating parity in price volatility, or are adjustments limited to increasing or decreasing prices?
2) Are all materials included within the clause? Certain materials may be excluded if not expected to increase. Such exclusions limit the scope of the clause and the corresponding risk. Alternatively, only certain items may be included within the clause if particular prices are increasing, or a particular increase in a certain input (lumber or steel) would change the economic considerations for the project.
3) What is the method by which escalating prices will be measured? A common escalation measure is an index that measures changes in the prices of input materials. For instance, the Bureau of Labor and Statistics publishes a Producer Price Index that tracks increase in prices up to the point of sale. In other words, such an index fails to consider freight, storage, or installation costs. Another common escalation method relies on the Engineering News-Record (“ENR”) indexes which publishes information based on prices reported in designated U.S. cities. These can include a labor component.
4) What is the method of notifying the other party of a basis for price adjustment? Is there a certain time by which this notification must be made from the date the basis for a price adjustment arises?
5) Are mark-ups for overhead or profit contemplated within the clause?
6) Is there a maximum limit to how much the price can be adjusted?
7) Will the contractor be granted an extension of time to provide materials due to delivery delays, or material unavailability?
8) What supporting documentation must be provided to justify the price adjustment?
Owners and contractors should also consider the effect of the escalation clause once triggered. For instance, the clause may be an “any-increase” clause, a “threshold” clause, or a “delay escalation” clause. For an “any-increase” clause, a contractor or supplier may be entitled to reimbursement or a change order for any price increases occurring between biding or signing of the contract and construction. Whereas a “threshold” clause only entitles the contractor or supplier to additional compensation for price escalations exceeding a certain percentage or dollar amount. Finally, a “delay escalation” clause freezes a fixed price for a limited period of time and allows the downstream contractor additional compensation if the project is delayed beyond a given number of days or a specified date. Depending on the project and its participants, each of these clauses may be preferable.
It is important that both owners and contractors consider the risks involved in changing material prices between the time of the bid and ordering of the materials, and establish each party’s expectations through specific contract terms prior to contract execution.
For those contractors or subcontractors dealing with significant price increases in the absence of a contractual right to price adjustments, there are few potential options for relief. A contract’s force majeure clause may permit a price adjustment depending upon the terms. Alternatively, some courts have found that unforeseen input cost increases can be significant enough to merit an adjustment or contract reformation. Such adjustment could be sought as an equitable adjustment to the contract. These options are less certain than a dedicated price escalation clause and should not be relied upon as a primary means of shifting the risks associated with market volatility.
For questions about material price escalation clauses, contact Tyler Lemen at firstname.lastname@example.org or your DSV construction attorney.