Energy and infrastructure project risks around escalation

Alert

19 February 2024

15 min read

In recent years, escalation, and price volatility, has re-emerged in the global economy. The impact on large energy and infrastructure projects will be significant: owners and contractors need to react and adapt.

Introduction – escalation and its impact on large projects

After two decades of low inflation globally, in the past few years, supply chain disruptions and energy shocks caused by COVID-19 and the war in Ukraine have led to huge price spikes and fluctuations in the cost of multiple construction inputs – from material and labour costs, to energy, shipping, and fuel.

This has a profound impact on large projects, where higher budgets and longer durations mean there are more costs to escalate, and longer periods of time in which to do so. It could be ten years between the date that a final investment decision ("FID") is taken on a multibillion-dollar mega energy project, for example, and the date on which it starts operations. If escalation over that period significantly exceeds the parties' initial expectations, then the resulting cost overruns could amount to tens, or hundreds, of millions of dollars.

The impact of price changes in certain inputs can also be particularly significant on sectors where:

there is intense competition for resources. For example, a recent McKinsey & Company analysis found that a high concentration of new LNG projects around the US Gulf Coast – where over 70% of all pre-FID US LNG projects are located – had led to competition over a limited pool of local resources and contractors, and contributed to a 10-20% cost increase for such projects since the pandemic began; or
specific inputs make up a larger proportion of the contract price. For example, in 2021, the International Energy Agency estimated that almost 12% of the cost of an onshore wind project was accounted for by the cost of freight and steel, and the total onshore wind investment cost change between 2019 and 2021 for these two inputs was over 15%. While prices of key inputs have more recently cooled, leading to a resumption in the downward trend of costs for many renewable energy projects, such significant price fluctuations can have a major impact on project budgets.

Parties must consider how escalation is treated under their contracts in order to understand their exposure.

Fixed price, or fixed rate, contracts

Under a traditional lump sum EPC contract, the cost of escalation is borne by the contractor, unless it has a contractual entitlement to be paid for escalation. This will also be the case if the contractor is paid on a remeasurable or time and materials basis with fixed unit rates, where its entitlement to payment varies depending upon the quantity of units installed or expended, rather than on the cost of those units.

In the past, contractors have been able to manage escalation risk by (for example) locking in fixed prices with labour and subcontractors, buying materials early, and including an allowance for escalation in their project contingency. However, given recent price volatility, these measures may no longer be as effective:

Fixed pricing in the supply chain can be harder to achieve and maintain, given subcontractors and suppliers will also want to protect themselves from future cost increases.
While materials can be purchased in advance, the precise requirements for the project will not be clear until the design and procurement is sufficiently progressed, which, on a large project, can take several months, or even years. Bulk buying early may also lead to increased material handling and storage costs, and, when prices are volatile, could simply result in higher prices, just before a fall.
Any greenfield or other union agreement may include cost escalation clauses, providing for labour rates to increase in line with an applicable index. On projects that are delayed or have a long duration, these agreements could expire before the project completes, leading to new, higher, wage settlements mid-project. Strikes and labour disputes are also more likely in an inflationary environment, as workers seek pay increases to maintain their real wages.

Given these difficulties, contractors may be increasingly unwilling, or unable, to accept escalation risk in a traditional lump sum or remeasurable contract, without pricing in a level of contingency that owners cannot accept. In certain circumstances, and particularly in the case of longer-term projects with high capital expenditure, parties may therefore need to consider ways of accounting for escalation in the contract price.

Providing for escalated costs to be payable under the contract

A common way to account for escalation during the works is via an escalation clause, which provides a mechanism for the contract price to increase (and sometimes decrease) in line with prices. These adjustments are usually calculated by reference to applicable indices, though parties might also agree to compare actual prices paid to those anticipated in the contractor's tender.

Escalation clauses are included in some of the most commonly used standard form contracts:

The FIDIC Silver Book 1999 and 2017 editions provide for adjustments to be made to the Contract Price where there are "rises or falls in the cost of labour, Goods and other inputs to the Works", if the parties make provision in the particular conditions for escalation.
In both the NEC3 and NEC4 contracts, the relevant wording is found in option X1 "price adjustment for inflation". If parties select this option, then the contractor's payments are adjusted using a "Price Adjustment Factor", which is calculated using price indices.

The details of the indices and items to which they are linked are left for the parties to agree and include in their contract.

Where an adjustment to the contract price is claimed under an escalation clause, or when negotiating the wording of such a clause, it will be important to consider the following issues:

Precisely what types of cost fall within the ambit of the clause. The costs of labour, materials, and equipment are often treated differently under escalation provisions, but it is not always obvious which precise types of cost fall to be escalated, and disagreements can arise over the meaning of the particular words used. For example, when considering escalation clauses relating to labour costs, courts in England have previously decided that a "wage" did not include holiday pay, while Australian courts have found that an "average weekly wage" could include sick leave. If certain costs are, or are not, intended to be subject to escalation, then that should be made clear when drafting the clause.
When escalation should be assessed and claimed. Parties often agree a certain 'trigger' for an escalation claim, which must occur before a claim can be made. This trigger could be a particular point in time, or the point at which costs fluctuate beyond a specified percentage. If the trigger is based on changes in cost, parties should consider: (a) whether to base this on changes in a particular index, or on actual costs incurred on the project; and (b) whether (and how) the contractor is required to demonstrate that its actual costs have deviated from its original estimate.
How escalation is calculated. Escalation clauses often provide for adjustments to be made in accordance with an algebraic formulae or other methodology, which can be detailed and complex. Errors or inconsistencies in the drafting of these adjustment formulae can render the clause unworkable. While courts and tribunals will generally try to give effect to contractual terms, if they are unable to do so, then, depending on the overall construction of the contract, that may lead to a variety of outcomes, from prices remaining unadjusted, to the contractor being paid a "reasonable price", or the whole contract being found to be void for uncertainty.
Which indices to use. Escalation formulae often use rates taken from price indices as inputs. In order to ensure that any adjustments to the contract price reflect actual changes to the cost of the work, it is important that the parties select indices that are appropriate for their project. For example, a general consumer price index is unlikely to accurately reflect the cost escalation that affects a construction project, and a construction-specific index that applies to an entire country might not be a good gauge for price fluctuations in the particular region where the works take place. Indices tracking the price of particular commodities might also not reflect the price of a specific material under a contract, as the latter would need to account for the cost of manufacturing and transport, and not just the cost of the raw material itself. Indeed, given the impact of recent events on global shipping routes and prices, parties might consider carving out the cost of international logistics from other cost components in their escalation provision.
How to account for escalation costs incurred as a result of contractor default. If the parties intend for the contractor to bear escalation costs attributable to its own default, then this should be expressly stated. In the 2017 FIDIC Silver Book, for example, if the contractor fails to comply with its obligation to complete on time, then adjustments for escalation thereafter are made on the basis of either: (a) the prices that were applicable shortly before the completion date; or (b) the current price index, whichever is more favourable to the owner. If contractor culpability is not addressed in the escalation clause, then disagreements may arise, as owners argue that contractors cannot recover costs incurred through their own default, while contractors claim that, absent an express exclusion, escalation should apply whenever costs are incurred.

Where escalation is not dealt with under the contract

While contracts will often expressly state how escalation costs are dealt with, that will not always be the case, particularly for ongoing projects where contracts were agreed during periods of low, and stable inflation, when escalation was not such a concern.

If the contract does not give the contractor an express right to claim escalation costs, the general position under English law (and related common law systems) is that it has no right to escalation costs. In civil law systems, the position will depend on the provisions of the applicable civil code, but escalation costs can be excluded – or, at least, very difficult to recover - under some systems commonly used on international projects. For example, Article 373(1) of the Swiss Civil Code states that, if payment is "fixed in advance as an exact amount", then the contractor must perform the work for that amount and "may not charge more even if the work entailed more labour or greater expense than predicted". While Article 373(2) provides exceptions to this general rule where there are exceptional and unforeseen circumstances which seriously hinder the contractor's performance, it can be difficult to establish that these exceptions apply in practice.

Contractors may therefore attempt to claim escalation via the contractual variation or claims mechanisms. How these claims are presented typically differs depending on whether the costs relate to base or change scope:

Where the costs relate to change scope, contractors usually aim to have their escalated costs included in the valuation of the change. Contracts sometimes provide for variations or claims to be valued by reference to contractual rates, but allow for a valuation by reference to market rates, or actual cost, where the contractual rates are no longer appropriate or are not specified. A contractor could therefore argue that high escalation means that the original contract rates are no longer appropriate for valuing change.
To claim escalation costs impacting base scope, contractors would likely rely upon the contractual claims mechanism. For example:
- Where a contractor is entitled to an EOT and associated costs, it may argue that escalation costs of completing delayed base scope should be included, as it is now obliged to complete that work later than planned.
- Contractors may argue that escalation caused by trade disruption related to sanctions regimes, or other regulatory changes, is recoverable under change in law provisions.
- Failing all else, contractors could seek relief for force majeure, or argue that the cost of performance has become so onerous that they should be relieved from performance entirely under the common law doctrine of frustration, or similar concepts in civil law jurisdictions. However, the bar for such forms of relief is high: the English courts, for example, have held that a "wholly abnormal rise or fall in prices" was insufficient to frustrate a contract, and that price increases will not generally amount to force majeure.

Options and points to consider

When thinking about how to account for escalation, the key considerations for parties will depend on the status of their projects.

For projects that are still pre-contract, the focus should be on how best to allocate the risk of escalation and strike the right balance between cost exposure and price uncertainty. When evaluating an escalation clause, parties might consider:

Whether the contract price should be subject to adjustment on account of input cost fluctuations in the first place;
If it will be subject to adjustment, whether (and how) those adjustments should account for cost falls, as well as cost increases;
Whether any adjustments should be applied to the entire contract price, or only to specified costs / inputs;
Whether the owner should take on the full risk of escalation, or whether that risk could be shared with the contractor. For example, the cost of escalation could be split between the parties via a 'pain share' mechanism, by setting a cap on the amount of escalation that can be claimed overall, or by setting a threshold which must be met before any escalation costs can be claimed; and
How to ensure that the escalation provisions are consistent with other provisions in the contract, particularly the EOT and claims provisions, and do not allow for the same costs to be claimed via more than one route, or provide relief for events and circumstances which are at the contractor's risk under the contract.

Alternative means of addressing escalation risk should also be considered, such as including provisional sums for escalation in the contract price, or providing for particular aspects of the work to be priced on different bases. As an example, one way to reduce price uncertainty on a long project, where there is a lag between the date the main contract is signed, and the date that key subcontracts or purchase orders are agreed, could be for the parties to agree to a split payment basis, with early works payable on a lump sum or remeasurable basis, while later works are either priced on a reimbursable basis, or left to be agreed subsequently, potentially on an "open-book" basis. That way, contractors do not need large contingencies to guard against future cost increases, and owners have some assurance that they will not overpay relative to the actual market conditions at the relevant time.

However, where elements of the contract price will not be set until part way through a project, as discussed previously, there is a potential for uncertainty and disagreement between the parties:

The cost of later works is impacted by the progress and quality of preceding work, which can lead to disagreements regarding whether particular costs are payable. For example, an owner may object to reimbursing costs, or approving subcontract prices, which are higher in the construction phase of the works due to prior contractor failures in engineering and procurement.
Where different payment bases apply to different elements of the work, this can lead to confrontational dynamics and a lack of alignment between the parties, with owners preferring costs to be treated as incurred in the fixed price works, and contractors preferring to treat them as reimbursable.
Owners may also seek increased visibility or influence over subcontracting processes which relate to reimbursable portions of the work, which contractors may object to.

Where projects are already underway, the priorities of contractors and owners will naturally differ:

Contractors will try to recover escalation costs, whether under an escalation clause, or as part of a claim. A key challenge for contractors in presenting a compelling claim will be finding a way to segregate escalation resulting from compensable events from escalation incurred as a result of the contractor's own performance. This is not always easy, particularly where other delay events, or resequencing, make it difficult to compare the actual resourcing profile of a project with a contractor's original plan.
To understand and respond to these claims, owners should seek evidence of the actual impact of escalation on the contractor's costs. This will entail not only proper substantiation of the actual costs incurred, but a comparison of the actual escalation with the amount of escalation that was already built into the contractor's pricing. That, in turn, will require an examination of the contractor's tender build up and assumptions, and original as-planned schedule and resource distribution.
While owners will focus on defending such claims, they may also need to think practically. If contracts become unprofitable for parties down the chain, that can cause problems, whether in the form of increased claims, reduced performance, or (potentially) threats to walk away from the project. In extreme cases, contractors may be unable to continue with the works, or could become insolvent. In order to successfully complete their project, owners might consider a negotiated settlement, whether that be a temporary or partial restructuring of a contract to a reimbursable payment basis, limited one-off assistance, or some form of incentive scheme.

While these considerations are inherently party- and project-specific, it seems clear that price fluctuations will be a major consideration for all large projects over the next few years, particularly energy and infrastructure projects, where long schedules and supply chains, and high material quantities, increase both the probability, and the severity, of price volatility impacts. Parties will need to consider how this risk has been allocated under their contract, and how that risk allocation is likely to affect party behaviour and claims going forward.

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_{This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.}