key takeaways
This article explores the recent escalation and volatility in construction pricing, why traditional approaches to managing risks are failing, and where the market is going.
1. Limitations in traditional contract models
In order to explore where the market is going, it is helpful to understand why contract models are the way they are and why these models are failing in current market conditions.
The pre-pandemic market was characterised by a problematic contractual balance of time, cost and quality requirements under largely fixed-price contract models. Client and financier requirements for certainty drove these models and include regimes for managing changes to time, cost and quality underpinned by assumptions that do not generally fluctuate outside a set of relatively stable market conditions. The market's relative stability at this time allowed project participants to estimate prices for material and labour, anticipate lead times, and program works with relative confidence. The margin for error was often managed through diligence and contingencies in pricing and programs, often using limited provisional sums where necessary.
Since the pandemic began, the construction industry has experienced unprecedented volatility primarily driven by economic instability, rising inflation, labour and supply chain issues. This volatility has impacted the assumptions that underpin many contract models, with the effect that diligence and traditional contingencies in pricing and programs have been wholly insufficient to manage the time, cost and quality impacts that have arisen. This change of assumptions underpinning contractual models has required the market to re-assess how projects are procured and to consider solutions to ensure the viability of projects and the financing and delivery of assets.
2. The state of construction and infrastructure pricing
Government and private sector participants in Australia face challenges in managing and delivering both ongoing and new projects. The cost of labour and materials is high, and supply chain delays hard to predict, making it challenging to estimate impacts on projects in ways that are acceptable to principals, financiers and contractors in the market.
Construction pricing is subject to a range of factors, some of which are outside industry control. Factors such as supply and demand, labour costs, and raw material costs have been upheaval in recent years, resulting in a perfect storm of instability and escalating prices that are difficult to forecast. While many factors are at play, we highlight two of particular relevance to many contract negotiations.
- 1Since the unfolding of the Covid-19 pandemic, the Australian construction industry has experienced a significant constraint on the growth of its workforce arising from border closures. Nowhere is this more apparent than in the national unemployment rate, sitting at 3.5% in June. The shortage of available and readily skilled workers has placed a severe burden on resourcing for projects. This has contributed to increased labour costs and made it difficult for contractors to resource projects at reasonable rates, putting projects under stress.
- 2Simultaneously, material costs have soared due to global supply chain disruptions and limitations, including international conflict issues. It is more difficult, costly, and takes longer to procure material. This is increasing project costs and delaying project timelines. The inflationary pressures we have witnessed are not insignificant, particularly in respect of key construction materials.
The market has responded. We have witnessed the introduction of a myriad of contractual responses to help manage pricing risk and COVID-19 market volatility. In construction and infrastructure contracts, these responses have included the re-introduction of cost escalation clauses, the expanded use of provisional sums, specific relief events for COVID-19 impacts and wider force majeure provisions being introduced. The responses have provided mechanisms to help provide greater flexibility to respond to a disrupted and volatile market. However, flexibility comes at the price of historical certainty, requiring financiers to consider their exposure to project risks carefully.
3. Heightened insolvency risks are driving changes in the market
As we move through this year, the list of contractor failures has dramatically increased. This trend is supported by recent ASIC data and illustrated below, which shows external administrations rising over 72% from June 30 2022 to June 30 2023. [1]
The list of high-profile failures impacts the market, and the importance of rigorous due diligence by financiers on contractors and borrowers cannot be understated. In some market sectors, a critical risk is whether a viable contractor will commit to a project to make it bankable. This ensures that if the financier needs to step in, it will have an experienced contractor in place to complete the project.
We have observed two additional shifts in the Queensland market as insolvency risks have increased.
- 1Heightened attention from the regulator on building licenses that are required to carry out building work in Queensland. This is particularly relevant in light of increasing insolvency risks. Contractors risk having their building licenses suspended or revoked if they don’t act quickly to handle their license requirements. The impact is significant, as a suspension or loss of licence prevents contractors from generating revenue. The importance of acting early cannot be overstated.
- 2We have also witnessed changes further down the contracting chain. Subcontractors, alert to the risk of contractor insolvency, are increasingly turning to subcontractors' charges in Queensland to hedge against insolvency risk instead of pressing disputes to adjudication.
3. Heightened Insolvency Risks Are Driving Changes In The Market
We have observed an increased expectation on contractors to plan for market volatility, price increases and supply chain issues. We anticipate that subject to political or legislative intervention or a wave of large contractor insolvencies that further constrains the market, that this expectation will continue. We anticipate the market to develop in three ways.
No. | Where the market is going: key insights |
|---|---|
1 | Principals and financiers will resist further shifts towards cost-plus pricing solutions in larger projects despite a push from contractors. The exceptions to this will likely be projects with limited contractor availability, arrangements with caps, and hybrid cost models that provide sufficient certainty for financiers. |
2 | Contractors will find it increasingly challenging to obtain COVID-19-specific relief for time and cost in their contracts. The market will continue to shift towards an expectation that COVID-19 impacts can be anticipated and managed. We think this is likely to mean that contractors may need to consider alternate approaches to managing these risks, such as including provision in contracts to source and use alternate materials where necessary. |
3 | Risk allocation in traditional forms of contract will continue to shift in a more balanced way towards contractors in the short to medium term, particularly in 'at risk' sectors and areas of the market. We anticipate that this will be driven by a need for principals to secure experienced and well-resourced contractors to obtain finance for projects. |
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The Construction Team at McInnes Wilson Lawyers can help our clients to help proactively anticipate the market and to draft, negotiate, and deliver contractual solutions to create win-win outcomes for clients and projects.
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