Three options for managing inflation risk using JCT construction contracts

We look at three options available under the JCT suite of standard form contracts that contractors and clients alike should consider at a project’s outset.

Current practices

Deleting the fluctuation provisions in standard form contracts had been an accepted practice for many years. The current shortage of materials and high inflation in the construction market – amid the war in Ukraine – has necessitated a rethink.

We are seeing more negotiations around fluctuation risks where some contractors add a high premium against inflation risk. Others are ready to walk away from projects where the fluctuation responsibility is entirely placed upon them.

There is a general reluctance for contractors to commit to fixed price contracts, which clients have been able to expect in the low inflation environment which has prevailed since the early 1990s.

In the absence of fluctuation clauses, the risk of inflation is borne by the contractor and any variation of costs due to inflation is unlikely to affect the contract sum. Whether it is appropriate to include fluctuation clauses is a matter for the parties to assess in the context of each project and based on several factors such as the type of activities, materials to be used, supply chain stability and geographical location.

The JCT standard form of contract provides three options for dealing with price adjustments that contemplate not only an increase, but also a decrease in the cost in situations where the contract base date is at the peak of the underlying cost.

Option A – Contribution, levy and tax fluctuations

This is a set of clauses that provides for adjustments to the contract sum for alteration in contributions, levies or taxes payable by the contractor in its capacity as employer, or alteration in statutory refunds receivable by the contractor in its capacity as employer. It also allows for adjustments to the contract sum for changes to taxes or statutory duties affecting goods, materials, fuel or electricity.

Use of this provision will not assist in relation to material cost increases. However, they provided a useful mechanism for managing risks of tariff increases as the UK left the European Union and may need to be at the forefront of thinking if the Northern Ireland Protocol is suspended and leads to a trade war and additional tariffs.

Option B – Labour and materials cost and tax fluctuations

When incorporated, this option allows the contract sum to be adjusted for fluctuations to the cost of labour, materials, goods, fuel and electricity – including changes to taxes and statutory duties affecting these.

Option B operates so that if the market prices for materials, goods, electricity, fuels or other solid liquid or gas necessary for the execution of the works increases or decreases from the market price of the materials at the contract’s base date, the net amount of the increase or decrease can be assessed and included in the valuation of the applications made by the contractor. This is also the case if the duty payable for disposal of waste from the site increases or decreases.

The parties are able to agree the amounts payable. There is no alteration to the contractor’s profit as a result of the additions.

Contractors cannot benefit from their own delays by use of the fluctuation provisions as the contractor is not entitled to an adjustment for periods beyond the completion date where it is responsible for the delay.

Option C – Formula adjustment

This option can be used when the parties agree to use the ‘formula rules’ published by JCT to calculate the adjustments to the contract sum.

The formula rules are complex, running to more than 60 pages.

On each application for payment, the contractor includes a statement of the allocation of the value and the amount of the adjustment in accordance with the JCT Fluctuations Option C.

Again, there is the ability to agree amounts rather than relying on indexation, which can be an imperfect method of calculation as it is seldom up to date.

Under Option C, the fluctuation adjustment formulae is based on indices that measure the average fluctuation over a defined period. There is an inherent risk of difference between the inflation measure by the index and the actual inflation cost that the contractor has to account for. 

Selecting the right option

With contractors understandably reluctant to commit to fixed prices, understanding and selecting the appropriate fluctuation provisions will be an increasingly important exercise for clients and their cost consultants in negotiations with contractors. Understanding the financial pressures caused by the current political and economic conditions and providing for them will become an important contractual consideration in the coming months.

Co-written by Hamza Sekkar of Pinsent Masons.