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Legal Notes: Price escalation clauses protect both contractors and owners

John Bleasby
Legal Notes: Price escalation clauses protect both contractors and owners

Price disruptions resulting from the unpredictable availability of materials and labour have persisted beyond the COVID-19 pandemic, causing serious challenges for project partners.

As Gary Brummer, senior associate at Glaholt LLP , contractors rely on steady, predictable material and labour pricing in their bids. Sudden surges beyond the parties’ control can catch everyone off guard. Unlike COVID-19, not all can be characterized as force majeure.

That’s the purpose of price escalation clauses.

“An escalation clause allows a contractor or supplier to impose price increases for certain labour and material during the term of the contract, thereby shifting the risk of the volatility in material price increases, from contractor to owner,” explains Brummer.

One might think that project owners would not want a clause that places price escalation risks on them, and would prefer a guaranteed price instead.

However, while the advantage of price escalation clauses for contractors might appear obvious, they can be quite useful to owners as well, particularly on long-term or renewable contracted projects. For example, incoming bids need not include contingencies or buffering, allowing more accurate and even lower contract prices.

“Price escalation clauses can be mutually beneficial for both employers and contractors, serving to mitigate the risk of disputes later down the line and in turn preserving amicable commercial relationships between the parties,” Jessica Gates of U.K. law firm Walker Morris LLP.

Furthermore, there are serious risks if contractors are forced to assume price escalations on their own. Contractual arrangements might no longer be financially viable over the course of a project.

“If a contractor is forced to continue to perform the contract at a loss, inevitably this is not going to be in the best interests of an employer either,” Gates writes.

It could cause them to either cut corners elsewhere in order to remain profitable, or even go out of business. Re-bidding and restarting a project with a new contractor can be very costly.

Pricing clauses can work both ways, Brummer explains. Costs might actually decrease, particularly when a contractor has sufficient leverage within a given supply chain.

Including de-escalation provisions can prevent unfair profiteering.

“An open and transparent contractor may be preferred over one that provides no insight on its pricing.”

Selecting the appropriate index or measure to track pricing is important. Articling student Angelina Argento-Scalia and associate Mathieu Santos-Bouffard of Gowling WLG a few suggestions.

They note several agreements use the Statistics Canada Consumer Price Index. However, a general index rather than one that is industry-specific could cause problems, given the industrial sensitivities and volatility not always reflected in general indices.

A specific industrial benchmark such as a Producer Price Index might more accurately reflect the goods and/or services being contracted.

Since each project is somewhat unique, Argento-Scalia and Santos-Bouffard suggest it might at times be more appropriate to use an agreed fixed percentage over the course of the project.

Tamara McNulty, partner at Potomac Law Group, PLLC, and Jef Fagan, National Electrical Contractors Association general counsel, recently construction industry leaders in Washington D.C., that price escalation provisions should be considered during the bidding and negotiating phases.

“Collaborating with the general contractor and the owner to get the related design early, so that at-risk scopes are fully completed and clear can help mitigate the risk.”

Brummer puts forward other risks identification and risk sharing considerations related to material and labour prices that should be part of the process. These include the frequency of any adjustments, their direction up or down, and possible adjustment caps.

What if you’ve entered a contract without any provisions for price escalation? Can they be added later? It doesn’t hurt to ask, says Brummer.

“Many owners would much prefer to keep a dependable contractor on a project, by paying a reasonable price escalation, rather than entering a dispute that could run up legal costs and ruin a relationship or negatively impact the completion of the project.”

John Bleasby is a Coldwater, Ont.-based freelance writer. Send comments and Legal Notes column ideas to editor@dailycommercialnews.com.

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