A Price Escalation Clause Can Protect Contractors From Price Increases

One of the major headlines in the construction industry during 2020 was the dramatic increase of lumber prices and costs of other raw construction materials across the country. Anyone monitoring construction industry trends knows that those prices continue to increase with no indication of decreasing anytime soon. Earlier this year, Associated Builders and Contractors reported that iron and steel prices were up 15.6 percent from January 2020 to January 2021, and that lumber prices had increased by nearly 73 percent in that same timeframe.

There are several explanations for these price increases, including supply chain and shipping disruptions, increased demand for new home construction, and other global economic factors related to the coronavirus pandemic. Nevertheless, the reality is that the increase in costs of materials can lead to project budgets being shattered, and owners and contractors disputing which party is responsible for absorbing the increased costs. As is often the case, the answer as to which party will bear the expense is usually found in the provisions of the construction contract itself.

The cost of materials under a contract can be determined in many ways. For projects constructed on a cost-plus or time and material basis, the contract will likely identify the owner as the party responsible for price increases. Due to the open-ended structure of these types of contracts, owners typically face uncertainty with regard to fluctuating material costs while contractors are given more flexibility and protection.

For projects constructed on a lump sum or fixed-price basis, a contractor’s price is generally locked in at the outset under the defined scope of work. Under these types of contracts, the owner is generally protected from the rising costs of materials and the contractor will likely be the one to bear the increase in costs of materials not yet purchased for the project.

Owners are also generally protected from material price increases under “not to exceed” or “guaranteed maximum price” contracts. Under these types of contracts, there is a cap on total construction costs and contractors will oftentimes include allowances or contingencies in the pricing structures to protect against things such as unexpected material cost escalations.

Since most construction projects can take months or years to complete from start to finish — a period during which changes in materials costs are expected — contractors and subcontractors need a mechanism to provide for compensation related to cost increases. With the right contract provisions, contractors can seek to protect against and address price increases between the time of bidding, proposing, and contracting, and the actual time of purchasing the materials.

Specifically, contractors can protect themselves against price increases with the inclusion of a price escalation clause. A price escalation clause is a provision that can be inserted into any contract to provide a way for contractors and subcontractors to recover some or all of the cost increases that occur over the course of a project under certain, specific circumstances. While the specific language of a price escalation clause varies, there are two main types: (1) event or delay price escalation clauses; and (2) percent-change price escalation clauses. Contractors who regularly use Owner/Contractor agreements from the American Institute of Architects (AIA) should be aware that price escalation clauses are not contained in those agreements, but could be added through contract negotiations.

Over the course of a project covering several months or even years, the event triggering the price escalation clause could be the passage of a particular milestone, a change of the calendar year, a supplier issuing a price increase, a default by another party, or a change of a specific contractor or supplier. The occurrence of any of these events triggers the price escalation clause and allows the affected party to seek reimbursement for the increased costs. As such, where any of these events could impact the cost of construction, the affected party should consider the addition of a provision that shares the risk of the increased cost.

More frequently, contractors will include a price escalation clause that is triggered by certain delays that are not caused by the party attempting to enforce the provision. The delays triggering the clause include natural disasters, acts or omissions caused by other contractors or the property owner, or, as realized over the past year, pandemics. Depending on the way the clause is written, the delay could be required to last for a certain period of time or the provision could permit a party to recover for increases no matter how long the delay lasts so long as the party can prove that the delay caused the increase.

Percent-change price escalation clauses allow a party to recover costs once their budgeted costs have increased by a certain percentage. In other words, the prices must increase beyond an agreed-upon threshold (e.g., 5 percent) to justify any increase or otherwise trigger this type of price escalation clause. While these types of price-escalation clauses are rare, they can be very useful where the parties are attempting to equitably distribute the risk of cost increases. This type of price escalation clause is particularly favorable to contractors, as it can help protect the contractor in the event of a substantial increase in the cost of materials. Specifically, if a spike in the cost of materials occurs, but the spike is not the result of a delay or does not occur during a delay, the event or delay price escalation clause likely would not be triggered, but the percent-change price escalation clause would provide the contractor with protection.

Despite the benefits of a price escalation clause, if not carefully drafted, they could carry unintended consequences. Some, if not most, provisions limit the amount of the increase to the difference between the budgeted cost and the actual cost. Such a limitation requires a contractor to be particularly diligent in their estimation of construction costs to protect against possible losses or financial exposure.

At the time of proposal and contract negotiations, contractors should identify materials with price volatility concerns, consider the timing of procurement, and account for those concerns in their contracts with the owner, subcontractors, and suppliers. Where possible, all parties should agree upon the circumstances in which the right to a price adjustment will exist.

It is no secret that the costs of construction materials are ever-changing and prone to instability. Many factors which impact the cost of construction under a contract, such as the economic impact of a global pandemic, are out of the contractor’s control. While the contractor may not be able to control the events that take place, the contractor can control the impact the events or delay may cause to its bottom line. With a carefully drafted price escalation clause, a contractor can reduce its financial exposure in the event of an unexpected and drastic increase in the cost of materials. Like any contract provision, price escalation clauses can be nuanced and should be implemented with caution. Contractors seeking to include price escalation clauses are encouraged to consult with an experienced construction attorney for drafting and negotiating them into their contracts.

Author’s note: This article is intended only for informational purposes and should not be construed as legal advice.

About the author: Keith A. Boyette is an attorney with Anderson Jones, PLLC, a construction law firm located in Raleigh, North Carolina, with attorneys licensed in North Carolina, South Carolina, and Georgia. He assists clients throughout the litigation process, from pre-filing advice to mediation, settlement negotiations and trial. For more information or questions about this article, please email Keith at [email protected]