Law

Navigating and applying price escalation clauses

As material prices continue to rise, it may be beneficial to find ways to share risk with clients.

Following a trend that began in 2020 with the onset of the coronavirus pandemic, and continued due to, among other reasons, the persistence of supply chain and labour shortage issues, construction costs continue to rise. With the uncertainty of these costs, suppliers, subcontractors, contractors or owners entering into a new contract involving the procurement of material should consider how best to manage the risk associated with material price increases. This risk may best be managed by using a material price escalation clause. These clauses are designed to protect a contractor from increasing job costs by potentially passing the risk of price increases – or the benefit of price decreases – along to the client or owner. However, they have an added benefit of creating some certainty as to who accepts the risk of a price increase by protecting all parties from unnecessary defaults that might shut a project down. With cost uncertainty and hesitation from contractors to enter into agreements without some reservation of risk, parties appear to be increasingly prepared to cooperate. None of the project participants benefit if the project is shut down, or if a contractor abandons the project, or if there are significant delays in the delivery of materials that delay the overall project. More and more, parties are being forced to work together to achieve a mutually advantageous result.

DRAFTING A CLAUSE

If using a typical Canadian Construction Documents Committee (CCDC) or Canadian Construction Association (CCA) standard-form fixed-price contract with supplementary conditions, the safest approach is to build in a material price escalation clause to mitigate against rising material costs.

Contracting parties can consider proposing the inclusion of a mutual or bilateral clause where each party stands to accept some of the risk and some of the reward. In that approach, price increase risk shifts to the owner, but a corresponding benefit will also be provided to the owner if material prices drop.

Before a material price escalation clause is chosen for a contract, the contracting parties should have in mind the two preliminary considerations.

First is whether all materials are to be included within the clause. By limiting the clause to a specific product, it increases risk, but may serve as an incentive to a client or owner who would not entertain entering into a broader price escalation clause.

The second is whether the clause should include an adjustment for price decreases as well. If a party is entering into a project that could last three to five years, costs could fluctuate in both directions. A carrot for the owner or client could involve granting a price de-escalation clause.

Two of the more common triggers used in material escalation clauses are event-based clauses and threshold-based clauses.

In a delay- or event-based clause, the contractor agrees to stand by its material prices for a certain period of time. Sometimes this is as short as the day the contract is signed.

For this type of clause, the parties should consider how the price increase will be verified. If there is no index for the material, what is the material price measured against? Options include the insertion of a formula into the supplementary conditions of the contract. In those circumstances, is a neutral third party assigned to the task of assessing the price, or is the onus on the contractor to provide reasonable proof?

With a threshold- or percentage-based clause, once material prices on the open market increase by a certain pre-agreed percentage beyond the estimated amount, the owner and contractor will agree to adjust the contract to account for the excess in the form of either full or partial additional compensation.

STORAGE AND OTHER CONSIDERATIONS

When drafting supplementary conditions involving material price escalation clauses, parties should also consider whether storage costs may be incurred, and whether the parties are prepared to share costs that allow materials to be purchased at quoted prices at an earlier stage.

The method and timing of notice under the contract should also be well defined, along with an agreed-upon method to illustrate there has been a price escalation – or price decrease – and possibly how to arbitrate such a claim.

Additional considerations include how material cost mitigation may impact a party’s entitlement to obtaining overhead and profit, whether limits should be placed on price escalation clauses, how often cost increases can be sought, and whether there’s a maximum increase that could trigger an entitlement to terminate the contract.

Ultimately, parties will need to be creative when entering contracts aimed at minimizing risks associated with the continued rise in material prices.

Erin Cutts, partner, and David Major, senior associate, are construction lawyers at Borden Ladner Gervais LLP. This article provides an overview and is not intended to be exhaustive of the subject matter contained therein. Although care has been taken to ensure accuracy, this article should not be relied upon as legal advice.

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