Price increases in construction materials are a factor in rising inflation, yet inflation is evidence of past escalation. For projects already on the go, those involved will be left to bear cost increases in the manner allocated by the construction contract.
For future construction projects, the inflation figures confirm that escalation is a real risk. However estimators, both principal and contractor side, will likely be more interested in the anticipated further change in prices. This article considers that risk at a macro and micro level and the existing tools available to avoid or manage the risk.
How can principals manage the risk of escalation?
For principals, speed to market is key. Time is a key cost driver. Delays in the planning, design and procurement phases crystallise escalation risk.
The delays inherent in the planning system are largely out of principals’ hands. Streamlining and reducing the overall duration of the planning process would offer significant benefits for projects. Delivering those efficiencies is one of the goals of the current reform process of the resource management system currently underway, although it is difficult to gauge at this stage how effective the reforms will be.
Options to generate time efficiencies and trade-offs
Principals should consider other available means to generate time efficiencies when scoping the project and developing a management plan. Options to consider include:
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Consultants – Consider the capacity, as well as the capability, of designers to undertake the works. Then, when in contract, what incentives and disincentives are there to ensure that the consultant delivers design documents to the required level of development and co-ordination on time?
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Contract terms – In an escalating environment, pricing at the head contract and subtrade level can only be held for so long. Orders need to be placed and that will only be done once there's a commitment. Significant amendments to standard forms can delay signing the contract. Intelligent contracting considers whether a change is required, the time and cost impact of the change, and whether that change meets market. Amendments to the standard form are often required but principals should consider what is important to them and the project specific issues, and try and limit the special conditions to those matters.
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Packaging work – Packaging early works enables a quicker start on site while the procurement of the main contractor is underway. The selected main contractor can then hit the ground running. In a vertical build, separating the groundworks and foundation from the structure creates a perceived risk by splitting responsibility, but that risk can be managed. Principals will need to consider the perceived risk in more detail and weigh up the risk in splitting responsibility against the risk of cost escalation.
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Procurement – The traditional design, bid and build approach is tried and true but results in sequential stages, with limited overlap between those stages. Similarly, a lump sum is preferred by principals as it gives the greatest degree of cost certainty and is easiest to manage. However, in this environment, the traditional approach delays procurement and a lump sum may include a risk premium that is not worth the risk transfer, or will simply not be possible given contractors' risk appetite and ability to forecast. Alternative procurement approaches could be considered such as early contractor involvement or procuring based on immature design.
A key trade-off in going to market early is the ability of the market to accurately price. Immature design results in risk being priced in. To avoid the principal paying this premium, cost plus regimes tend to be used. Cost controls can be implemented by ensuring cover pricing is obtained. Incentives and risk sharing regimes could also be considered to ensure the contractor is incentivised to manage the risk and deliver within budget. Contractors should be wary of cost regimes that seek to disrupt or control their supply chain.
Where greater cost certainty is sought, principals will need to get into the detail and understand which packages could be subject to a fixed price or fixed rates and which packages contain too much risk for contractors to fix a price and focus on these packages. For instance, which packages are material? And, is there an alternative to cost plus, eg increases linked to an agreed index? The degree of cost certainty needed will be informed by the key project players and their requirements, in particular financiers and the typical requirement for a fixed price.
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Long lead items – Similar to packaging work, principals should be able to identify long lead items that can be procured ahead of main contractor procurement. Typically, the purpose of the principal procuring materials is to maintain the overall project duration. In an escalating environment, there is also a benefit in that the order is placed earlier, which avoids escalation. The NZS suite of contracts doesn’t neatly deal with the risk in free supply items and a special condition would be required.
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Advanced payments for off-site materials – The same principle that applies to long lead items applies here. Typically, contractors will order later rather than sooner to avoid a negative cashflow position, but ordering early avoids escalation. If the principal has appropriate protections in place, paying earlier than usual can mitigate the risk of cost escalation.
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Storage – Are there any logistics issues, eg a constrained site, that prevents the early ordering of materials and storage? Principals should consider the practical, as well as the commercial opportunities, to unlock the benefit of ordering early. Insurance sub-limits would also need to be considered.
Longer term considerations for principals
In the longer term, efficiencies in design and construction can reduce the overall project duration and time-related costs.
Repetition and process improvement create efficiencies but construction in New Zealand is largely bespoke. As a principal, there are a few questions to ask yourself:
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Are we able to standardise design?
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If we have an attractive programme of work, how is our contracting and procurement structure incentivising our contractors to invest in people and resources?
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What relationships should I invest in to mitigate the time and cost risks otherwise inherent in the supply chain and how?
Considerations for contractors
For contractors, helping to ensure that the project gets off the ground can create longer term problems. Ensure that any alternative materials or systems you may offer is made subject to the same allocation of design responsibility as is contemplated by the construction contract, or consciously take the design risk and consider how that is managed and limited.
Please get in touch with one of our experts below if you would like to discuss how this update may relate to you and your organisation.
This article is intended only to provide a summary of the subject covered. It does not purport to be comprehensive or to provide legal advice. No person should act in reliance on any statement contained in this publication without first obtaining specific professional advice. If you require any advice or further information on the subject matter of this newsletter, please contact the partner/solicitor in the firm who normally advises you, or alternatively contact one of the partners listed below.