A Price Escalation Clause Can Protect Contractors From Price Increases

One of the major headlines in the construction industry in 2020 was the dramatic increase in wood prices and the cost of other construction raw materials across the country. Anyone who watches the trends in the construction industry knows that these prices continue to rise with no indication of any decline anytime soon. Earlier this year, Associated Builders and Contractors reported that iron and steel prices rose 15.6 percent from January 2020 to January 2021, and that wood prices rose nearly 73 percent over the same period.

There are several explanations for these price increases, including disruptions in the supply chain and shipping, increased demand for new buildings, and other global economic factors related to the coronavirus pandemic. The reality, however, is that the increase in material costs can cause project budgets to be destroyed and owners and contractors arguing over who should pay the increased costs. As is so often the case, which party bears the costs can be found in the provisions of the building contract itself.

The material costs in the context of a contract can be determined in various ways. For projects built on a cost plus or time and material basis, the contract will likely identify the owner as the partner responsible for the price increases. Due to the open design of these types of contract, builders are usually exposed to uncertainties about fluctuating material costs, while contractors are offered more flexibility and protection.

For projects that are created on a flat-rate or fixed-price basis, the contractor’s price is usually set in the defined scope of services from the outset. With this type of contract, the owner is generally protected from rising material costs and the contractor will likely be the one who has not yet procured the material cost increase for the project.

In addition, owners are generally protected against increases in the price of materials within the framework of “not to exceed” or “guaranteed maximum prices” contracts. With this type of contract, there is an upper limit to the total cost of construction and contractors will often include allowances or contingencies in the pricing structure to protect against things like unexpected material cost escalations.

Since most construction projects can take months or years from start to finish – a period in which material costs can be expected to change – contractors and subcontractors need a mechanism to compensate for increases in costs. With the correct contractual provisions, contractors can attempt to protect themselves against and address price increases between the time of bidding, quotation and contract conclusion and the actual time of purchase of the materials.

Specifically, contractors can protect themselves against price increases by including a price escalation clause. A price increase clause is a provision that can be included in any contract to allow contractors and subcontractors to recover part or all of the cost increases that have occurred in the course of a project under certain circumstances. While the specific language of an escalation clause varies, there are two main types: (1) event or delay escalation clauses; and (2) price increase clauses with percentage change. Contractors who regularly use American Institute of Architects (AIA) owner-contractor agreements should be aware that escalation clauses are not included in these agreements, but can be added through contract negotiations.

In the course of a project lasting several months or even years, the event triggering the price escalation clause can be the exceeding of a certain milestone, a change in the calendar year, a price increase by a supplier, a failure of another party or a change in a specific contractor or supplier. The occurrence of one of these events triggers the price escalation clause and enables the person concerned to be reimbursed for the increased costs. Therefore, if any of these events could have an impact on construction costs, the affected party should consider establishing a provision that shares the risk of the increased costs.

More often, contractors include a price increase clause triggered by certain delays not caused by the party trying to enforce the provision. The delays that trigger the clause include natural disasters, acts or omissions caused by other contractors or the property owner, or, as identified last year, pandemics. Depending on the wording of the clause, the delay could be required for a period of time or the provision could allow a party to reclaim increases, regardless of how long the delay is, as long as the party can demonstrate that the delay caused the increase.

Percentage change price increase clauses allow a party to recover costs once their budgeted costs have increased by a certain percentage. In other words, prices must rise above an agreed threshold (e.g. 5 percent) in order to justify an increase or otherwise trigger such a price escalation clause. Although these types of escalation clauses are rare, they can be very useful when the parties are trying to fairly distribute the risk of cost increases. This type of price escalation clause is particularly favorable for contractors, as it can protect the contractor in the event of significant increases in material costs. In particular, if there is an increase in the cost of materials but the increase is not the result of a delay or does not occur during a delay, the event or delay price increase clause would likely not trigger, but the percentage price increase clause would protect the contractor.

Despite the advantages of an escalation clause, if not carefully worded, it can have unintended consequences. Some, if not most, provisions limit the amount of the increase to the difference between budgeted and actual costs. Such a restriction requires a contractor to be extra careful when estimating construction costs in order to protect themselves from possible losses or financial risks.

At the time of bidding and contract negotiations, contractors should identify materials with price volatility issues, consider the timing of procurement, and incorporate these concerns into their contracts with the owner, subcontractors and suppliers. If possible, all parties should agree on the circumstances under which the right to a price adjustment exists.

It’s no secret that the cost of building materials is constantly changing and prone to instability. Many factors that affect construction costs under a contract, such as the economic impact of a global pandemic, are beyond the control of the contractor. While the contractor may not be able to control the events that take place, the contractor may control the impact of the events or delays on its bottom line. With a carefully crafted escalation clause, a contractor can reduce their financial risk in the event of an unexpected and drastic increase in material costs. Like any contractual provision, escalation clauses can be nuanced and should be implemented with caution. Contractors wishing to include price increase clauses are encouraged to consult an experienced construction attorney to include these in their contracts.

Editor’s note: This article is for informational purposes only and should not be construed as legal advice.

About the author: Keith A. Boyette is an attorney with Anderson Jones, PLLC, a construction law firm based in Raleigh, North Carolina with licensed attorneys in North Carolina, South Carolina, and Georgia. He supports clients throughout the entire process, from pre-filing advice to mediation, settlement negotiations and legal proceedings. For more information or questions about this item, please email Keith at [email protected]

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