The aftermath of the 2020 bushfires and the COVID-19 pandemic – how to deal with the rising cost of building materials and labour shortages in your construction contracts

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By Scott Laycock, Partner, Saarah Khalessi, Associate and Brittany Flower, Lawyer

Summary

Construction projects in Australia rely heavily on the importation of building materials such as steel and timber. Consequently, the effects of the COVID-19 pandemic and the bushfires in early 2020 have created a significant backlog in the production and supply of building materials in Australia.

Whilst Australia does produce its own timber and steel, the bushfires have destroyed a large supply of local products such that the normalised production of timber in Australia has not been able to fully recover. Coupled with the COVID-19 pandemic and its associated effects, being labour shortages, lockdowns, logistical difficulties and isolation requirements – the price of materials and labour is increasing at a rapid rate. This is ultimately increasing the cost of construction projects and there is an inherent conflict as to which party to a construction contract should bear this fluctuation risk during the life of a project.

The increase in the cost of construction materials, difficulties with obtaining materials and the impact of COVID-19 has made it difficult for materials to be received at all or in a timely manner. This has in turn made it difficult to manage the sourcing of materials to ensure that construction projects can be completed on time and within budget.

This article discusses the key things for parties to consider when entering into construction contracts, in order to determine which party should bear the relevant time and cost risk and how to either apportion or ameliorate that risk.

Cost risk

The most common form of contract has historically been a construction contract with a lump sum price. This form of contract requires a builder to be responsible for completing projects to ensure that the lump sum price is not exceeded (except for increases permitted under the contract such as variations or provisional sums).

Under a lump sum contract, there is ordinarily a provision that obligates the builder to accept the ‘rise and fall risk’. This means that the builder accepts the risk of any rise and fall in cost, wages, materials, exchange rates or other economic conditions including taxes. The builder therefore generally absorbs any rise or fall in cost in these items and the contract price cannot be upwardly adjusted to take into account any increases. This form of contract is more favourable to developers because of the predictability and cost certainty.  It also has less risk from a finance perspective as the builder absorbs price fluctuations and the developer is not required to increase its funding for the project on account of these issues.

Due to the uncertainty and upward trend in the current cost of materials, it is becoming increasingly difficult for builders to be able to submit a lump sum price for certain projects. It is therefore becoming more common in this current climate for builders to propose that the parties enter into a contract with a cost-plus pricing mechanism. This form of contract entitles the builder to be reimbursed for the actual cost of performing the work, the actual cost of materials and any payments to subcontractors plus its margin for profit and attendance. This form of contract is obviously more favourable to builders given the current climate and the developer is left with less cost certainty. It is essential in such contracts, from a developer’s perspective, that there are appropriate competitive tendering and open book provisions incorporated into the contract.

A middle ground position that can be adopted by the parties is to introduce a ‘hybrid’ lump sum and cost-plus contract. This will allow the parties to enter into a contract with lump sum and cost-plus mechanisms. The lump sum components would be things that the builder can price for with certainty (i.e. preliminaries, design and off-site overheads) and the cost-plus components would include things like materials and labour.

Another alternative available to parties is to incorporate provisional sum items which provide an estimate of the cost of a particular item of work for which the builder cannot reasonably provide a lump sum amount when the contract is entered into. A provisional sum will only become payable under a construction contract if it is directed by the Principal’s Representative or Superintendent to be carried out or supplied. There are also some clauses that prevent a provisional sum from being payable if the provisional sum amount exceeds 110% of the amount that is stated in the contract. This provides a further layer of protection to developers to prevent any substantial increase in the cost of provisional sum items specified in the contract without approval. Other approaches may be to have cost escalation provisions providing for a risk sharing approach.

Time risk

In addition to the cost risk, a key consideration for parties to a construction contract is which party will bear the time risk as a result of labour and material shortages and COVID-19 delays. The construction industry has experienced significant absentees from work due to isolation requirements. It is therefore common for contracts to now include COVID-19 delays as a qualifying cause of delay. Similarly, it is also increasingly common for builders to request that delays as a result of material shortages associated with COVID-19 be included as qualifying cause. Qualifying causes of delay entitle builders to claim an extension of time (but not delay costs) as a result of any delay and subsequently liquidated damages relief.

Depending on the way the contract is drafted, a builder should still be required to show that any delay affects the critical path of WUC. In assessing the entitlement, there would normally also be an obligation for the builder to have mitigated the effect of any delay and to have not caused or contributed to the delay.

There can be no doubt that the effects of the bushfires and the COVID-19 pandemic have significantly undermined the ability for construction projects to commence and complete on time and within budget. These potential impacts are ultimately items which need to be discussed and agreed by parties before entering into a construction contract. It is a risk sharing issue that should be sensibly negotiated and allocated between the parties prior to contract execution.

For further information, please do not hesitate to contact us.

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