Cautiously Pessimistic: A Brief Guide to Fluctuation Clauses

Introduction

It is usual for clients to insist on a fixed price contract, whereby the contractor takes the risk of all changes in the cost of the works due to statutory revisions and market price fluctuations. However, after decades of price stability and the ability of contractors to price inflationary risks into fixed price contracts, we are now seeing the return of fluctuation provisions in construction contracts.

In recent years the construction industry has been increasing volatile and unpredictable. The industry has seen how covid-19 and the consequences of Brexit have depleted resources, increased prices and delayed the delivery of materials. As the government lifted its Covid restrictions and there was a surge in the number of new projects, the situation worsened. More recently, there has been a huge hike in energy prices and Russia’s invasion of Ukraine. The resulting turmoil has caused a shortage of both materials and skilled labour, causing prices to soar.

Construction inflation has proved to be quite different to general inflation. The problems have been especially acute in respect of imported products and materials, due to factors such as escalating freight costs, shortages of haulier workforce and the creation of new cross-border systems.

The impact is being felt for every trade, and at every stage of a construction project. With seemingly no prospect of these issues abating any time soon, contractors are becoming more reluctant to agree fixed price contracts.

Standard forms of contract contain optional fluctuation clauses which provide mechanisms for dealing with the effects of inflation. If these clauses are utilised, the contractor can be reimbursed for price increases over the duration of the project.

Below we provide an overview on the position for JCT and NEC contracts.

What are fluctuation clauses?

Fluctuation clauses are clauses in contracts that allow the contract sum to be adjusted to reflect changes in the cost of labour or materials etc during the contract period.

As the term ‘fluctuations’ indicates, these are clauses that deal with both the rise and fall of prices. Consequently, the adjustments can result in either an addition or a reduction to the contract sum. A common misconception is that fluctuation clauses only apply increases to the Contractor, which is not the case.

In most main contracts the risk of cost increases is carried by the Contractor, so fluctuation clauses are not used. The parties agree a contract for a lump sum price, and the Contractor takes on all the risk of any cost increases. Similarly, in most sub-contracts the risk of cost increases is carried by the Sub-Contractor.

The aim of fluctuation provisions is to transfer some / all of the effect of increased cost during the contract period:

  • from Sub-Contractor to Contractor (under sub-contracts); and
  • from Contractor to Employer (under main contracts).

Standard forms of contract deal with fluctuation provisions in different ways. For example, JCT contracts include various different options, which must be selected within the Contract Particulars, whereas the NEC contract has a Secondary Option X1, which would have to be included in the contract documents.

JCT Contracts

The JCT’s family of contracts include the following, all of which contain fluctuation provisions:

Standard Building Contract

  • Standard Building Contract With Quantities (SBC/Q)
  • Standard Building Contract Without Quantities (SBC/XQ)
  • Standard Building Contract With Approximate Quantities (SBC/AQ)
  • Standard Building Sub-Contract (SBCSub)
  • Standard Building Sub-Contract with subcontractor’s design (SBCSub/D)

Design and Build Contract

  • Design and Build Contract (DB)
  • Design and Build Sub-Contract (DBSub)

Intermediate Building Contract

  • Intermediate Building Contract (IC)
  • Intermediate Building Contract with contractor’s design (IC)
  • Intermediate Sub-Contract (ICSub)
  • Intermediate Sub-Contract with sub-contractor’s design (ICSub/D)
  • Intermediate Named Sub-Contract (ICSub/NAM)

Management Building Contract

  • Management Works Contract (MCWC)

Construction Management Contract

  • Construction Management Trade Contract (CM/TC)

Minor Works

  • Minor Works Building Contract (MW)
  • Minor Works Building Contract with contractor’s design (MW/D)
  • Minor Works Building Sub-Contract with sub-contractor’s design (MWSub/D)

Whilst all the above contracts include optional fluctuation provisions, the provisions in the Intermediate and Minor Works forms are somewhat more limited to that found in the other forms.

JCT Fluctuation Clauses

The JCT contracts used for larger and more complex projects, such as the Standard Building Contracts and the Design & Build contracts, contain three fluctuation options for calculating any price adjustments that may be required:

  • Option A (contribution, levy and tax fluctuations);
  • Option B (full fluctuations in labour and materials costs); and
  • Option C (a formula adjustment using the JCT Formula Rules).

These optional clauses can provide substantial protection for the Contractor from increased costs, but they do not apply to all types of project costs. For example, they do not apply to head office costs. However, to compensate for this contractors can include for an adjustment to their rates to allow for non-recoverable cost increases. (Refer to paragraph A.12 of Option A and paragraph B.13 of Option B).

Application of the fluctuation provisions relies on the Base Date (or ‘Sub-Contract Base Date’ in the subcontract forms), from which any fluctuations may be calculated. Hence, the Base Date should be agreed between the parties to the contract and entered into the Contract Particulars.

As one might expect, Option A is included within the printed JCT text. However, since 2016 Options B and C are no longer detailed within JCT contract documents (even though parties can still choose for them to apply). Instead, the parties are referred to the JCT website for details of Options B and C. This policy is expected to change, as contractors will be keen to push for these fluctuations to be included in any future contracts they sign.

The JCT also contemplates the possibility of the parties using an alternative fluctuation or cost adjustment formula, in which case the relevant document(s) should be identified in the Contract Particulars.

Details of JCT Fluctuation Options A, B and C are provided below.

JCT Fluctuation Option A

JCT fluctuation Option A allows the Contract Sum to be adjusted to take account of changes in taxes, levies, duties etc that are levied by the government in respect of labour and materials.

Option A is the default provision and will apply unless it is deleted in the Contract Particulars. It consists of 12 paragraphs (A.1 – A.12), covering nearly 4 pages, and is included as one of the Schedule’s toward the back of the contract. For example:

  • In the JCT DB 2016 and JCT SBC 2016, Option A is found at Schedule 7
  • In the JCT DBSub 2016 and JCT SBCSub 2016, Option A is found at Schedule 4

Option A provides for recovery of all increases in the rates of contributions, levies and taxes on the employment of all work people on and off site after the Base Date. Option A also allows the contractor to be reimbursed for all increases in duty or tax “on the import, purchase, sale, appropriation, processing, use or disposal of the materials, goods, electricity, fuels, materials taken from the site as waste or any other solid, liquid or gas necessary for the execution of the Works”. (Option A, paragraph A.2.1 refers).

Paragraph A.4.2 is a condition precedent that deals with notification from the Contractor. If notice is not given “within a reasonable time after the occurrence of the event to which it relates” the Contractor is not entitled to payment. What would be considered a ‘reasonable time’ is not entirely clear, although one important consideration is whether the Employer has an opportunity to check the facts.

Paragraphs A.1.2 – A.1.4 relate to statutory contributions, levies and taxes payable by a person/company in its capacity as Employer. Paragraphs A.1.5 – A.1.7 relate to statutory refunds or premiums which are made under or by virtue of an Act of Parliament to a person/company in its capacity as Employer.

Paragraph A.2 deals with alterations in statutory duties or taxes affecting materials or goods.

Paragraph A.3 requires the Contractor to incorporate fluctuation clauses in Sub-Contracts, “to the like effect as the provisions of JCT Fluctuations Option A … including the percentage stated in the Contract Particulars pursuant to paragraph A.12”.

Paragraphs A.4 – A.11 deal with the procedure for dealing with fluctuations.

Given the increased risk of changes in the government’s tax policies, which has arisen because of the need to redress government finances following the cost of support provided during the Covid-19 pandemic, contractors might be keen to utilise Option A.

JCT Fluctuation Option B

JCT Fluctuation Option B appeared in the JCT form up to and including the 2011 edition. However, since the 2016 edition, Option B is no longer included in the contract, but is available from the JCT website, and may be incorporated into the contract via the Contract Particulars.

Option B consists of 13 paragraphs (B.1 – B.13), covering approximately 5 pages.

With JCT fluctuation Option B, the client takes on more risk than with Option A, as it will be responsible for paying all increases that occur:

  • in Option A circumstances (i.e., contribution, levy and tax), plus:
  • from changes caused by market forces, such as inflation, and supply and demand.

Option B includes in respect of:

  • Increases in rates of wages for work people on and off site as well as site staff in accordance with appropriate wage fixing bodies, such as the Construction Industry Joint Council (refer to paragraphs B.1 and B.2).
  • transport charges (refer to paragraph B.1.5 and B.1.6).
  • materials, electricity and fuels (refer to paragraph B.3).

Paragraph B.5.2 is similar to paragraph A.4.2 in Option A. It is a condition precedent that deals with notification from the Contractor. If notice is not given “within a reasonable time after the occurrence of the event to which it relates” the Contractor is not entitled to payment. What would be considered a ‘reasonable time’ is not entirely clear, although one important consideration is whether the Employer has an opportunity to check the facts.

Paragraphs B.1 and B.2 deal with alterations in wages “and the other emoluments and expenses (including holiday credits) which will be payable by the Contractor”.

Paragraph B.3 provides for alterations in market prices in “materials, goods, electricity, fuels or any other solid, liquid or gas necessary for the execution of the Works”. Such alterations are to include alteration of any “duty or tax (other than any VAT which is treated, or is capable of being treated, as input tax by the Contractor)”.

Paragraphs B.4 – B.12, which are substantially the same as paragraphs A.4 – A.11 of Option A, deal with the procedure for dealing with fluctuations.

The Contractor is not entitled to an increase in respect of a wage award that becomes effective during the course of carrying out the Works, but which had been announced by the Base Date (Refer to paragraph B.1.1.3).

JCT Fluctuation Option C

Similar to Option B, Option C appeared in the JCT form up to and including the 2011 edition. However, since the 2016 edition, Options B and C are no longer included in the contract, but are available from the JCT website, and may be incorporated into the contract via the Contract Particulars.

Option C provides for adjustment of the Contract Sum in accordance with the Formula Rules published by the JCT. Whilst Option C consists of 6 paragraphs (C.1 – C.6), covering 1½ pages, the JCT Formula Rules that it refers to is considerably longer, amounting to 45 pages, plus a further 15 pages of Appendices.

Option C is reasonably easy to operate and, whilst not necessarily taking account of actual costs, is generally considered to be a fair adjustment.

Option C (at paragraph C.1.1.1) explains that the Contract Sum is adjusted in accordance with JCT Formula Rules current at the Base Date. The Formula Rules relies on a series of indices that were originally published by the National Economic Development Office (NEDO). The indices are now known as the Price Adjustment Formula Indices (PAFI), which are maintained by BCIS.

The JCT Formula Rules refers to a ‘Base Month’, which is a calendar month that should be recorded in the Contract Particulars. The Base Month will normally be the calendar month prior to that in which the tender is due to be returned.

The type of formula varies depending on the type of work being carried out. There are 60 different categories of work noted in the JCT’s Formula Rules (listed at Appendix A-1). At the end of each period, the value of each work category is adjusted using the most relevant index. Hence, each interim valuation is adjusted by the increase, or decrease, in a standard mix of indices. With Option C, there is an inherent risk of the difference between the inflation measure by the index and the actual inflation cost incurred by the contractor.

The Formula Rules include a provision for a ‘non-adjustable element’. This is intended to deal with those parts of the contract sum that are to remain fixed regardless of adjustment elsewhere. The non-adjustable element might include things like overhead costs and the cost of things supplied directly by the contractor.

Contractor Culpable Delays

It should be noted that any fluctuations provisions included within the contract are frozen from the point completion should have been achieved and the contractor is in culpable delay (Refer to paragraph A.9 of Option A, paragraph B.10 of Option B, and paragraph C.6 of Option C).

NEC Contracts 

The NEC contracts takes a different approach to JCT contracts. In the NEC Engineering and Construction Contract (“ECC”), the approach also differs depending upon which of the six main options the contract is based on:

  • Option A – Priced contract with activity schedule
  • Option B – Priced contract with bill of quantities
  • Option C – Target contract with activity schedule
  • Option D – Target contract with bill of quantities
  • Option E – Costs reimbursable contract
  • Option F – Management contract

Main options A and B (the lump sum options) place the risk on the Contractor, with options C and D (the target cost contracts) splitting the risk between the Parties in accordance with the pain / gain mechanism. Under these four main options it is also possible to include Secondary Option X1, which would allow the Contractor to be reimbursed for price increases that occur after the Completion Date. Options E and F place the risk of price increases on the Employer.

NEC Option A 

Option A is a lump sum contract based on an activity schedule, to be provided by the Contractor. Each activity is priced, with interim payments being made upon the completion of each activity. The Contractor carries the risk for all quantities and rates. If the risk of price increases is to be passed to the Client, Secondary Option X1 must be used.

NEC Option B 

Option B is also a lump sum contract, but it is based on a Bill of Quantities, which is to be provided by the Client, and priced by the Contractor. The Client carries the risk in respect of the quantities. The Contractor carries the risk for rates. Unless Secondary Option X1 is included, the Contractor takes on the risk of the rising price of labour and materials.

NEC Options C and D 

The NEC target contract options are found at main options C and D.

A target cost contract is a reimbursable contract where the contractor is paid the ‘actual cost’ it incurs in carrying out the works. To incentivise the contractor to avoid unnecessary expenditure, the parties agree that the works will be subject to an overall target cost.

Options C (Target contract with Activity Schedule) and D (Target contract with Bill of Quantities) provide a more favourable position for contractors, although this is reliant on the parameters of the pain/gain mechanism.

With these main options, any target cost is agreed, but a mechanism is incorporated whereby if the actual cost of the project exceeds the target cost, the amount paid to the contractor beyond that point is reduced by a pre-agreed share. Likewise, if the actual cost incurred is less than the target cost, the parties share that saving in accordance with pre-agreed proportions.

Although contractors would prefer to avoid all cost increases, Options C and D are preferable to Options A or B where nothing can be recovered from the client. Clients might be reluctant to accept this position, although it is possible for them to negotiate low percentages.

NEC Option E 

This is a cost reimbursable contract, and hence the most favourable for contractors, especially in the current market conditions. With this main option, the contractor is reimbursed the actual costs it incurs in carrying out the works, plus an additional fee (albeit also less ‘Disallowed Cost’). Consequently, the financial risk in this contract is largely the Client’s.

NEC Option F 

Option F is described as a management contract. It is similar to a cost-reimbursable contract. The works are constructed by a number of different works contractors, who enter into contracts with the management contractor. The management contractor is paid a fee to manage the works.

Secondary Option X1

The fluctuation provisions of the NEC ECC are not as detailed as those contained within JCT contracts. Instead of using the term ‘fluctuations’, Secondary Option X1 refers to “price adjustment for inflation”. Option X1 is for use with main options A, B, C and D. Main options E and F already contain payment mechanisms that facilitate the contractor to be paid the costs of inflation. Unless Option X1 is included, the contractor takes all the risk of inflation under main options A and B, but shares the risk under the Target Costs Main Option C and D.

Under Option X1, the contractor bases all its prices on estimates of cost current at a ‘Base Date’, which is recorded in the Contract Data – Part One. The Base Date should be a date close to the starting date. The contractor’s price is varied by a ‘Price Adjustment Factor’. The Price Adjustment Factor refers to:

  • the ‘Base Date Index (B)’, which is the “latest available index before the base date”; and
  • the ‘Latest Index (L)’, which is the “latest available index before the date of assessment of amount due”.

The source of the published priced indices to be used is to be identified in Contract Data – Part One. So too are the proportions of the total value of the works to be linked to the index for each category. Similar to JCT contracts, the NEC mechanism allows for a non-adjustable proportion, which is to be identified in the Contract Data. Option X1 can have a wide application, but parties could state that it will only apply to the prices of (say) structural steel or timber.

Clause X1.1 of NEC4 explains that the Price Adjustment Factor at each assessment date is the “total of the products of each of the proportions stated in the Contract Data multiplied by (L-B)/B for the index linked to it”.

Clause X1.3 deals with price adjustment for main options A and B, whilst clause X1.4 deals with price adjustment for the target cost main options, C and D.

Conclusions

It has been several decades since the construction industry has seen prices so volatile. With this expected to continue throughout 2022 and possibly beyond, parties will need to rely on their contracts to protect their position so far as they can.

Most clients do not accept fluctuation clauses in construction contracts because it produces uncertainty as to price. In fact, the use of fluctuation clauses was so unusual that when the JCT published its 2016 edition, it removed two of the three fluctuation options from its printed form. Fluctuation Option A remains in the printed document, but the details of fluctuation Options B and C are now only available online.

With NEC ECC contracts, Secondary Option X1 should be used if the contractor wishes to minimise risk of price rises.

Contractors will wish to mitigate the risks of price increases. Consequently, clients can expect more and more contractors to ask for the inclusion of fluctuation clauses. There is likely to be increasing amounts of negotiation on this issue, especially in respect of larger, long-term projects.

Incorporating fluctuation provisions into the contract could provide a benefit to the Employer, in that contractors might well be prepared to bid much lower, knowing that they will be reimbursed for rises in prices.

When clients attempt to transfer the risk of fluctuations in costs onto the contractor, it does not mean there is no cost for the client. Either a mechanism is included in the contract to deal with the risk of fluctuations in price, or the contractor will price the risk and include it in its tender.

Contractors might wish to submit two bids for each project. One tender being on the basis of a contract containing fluctuation provisions, and the other tender significantly higher, with the contractor taking on the risk of price increases. If contractors do not get the contract provisions they seek, they might be willing to walk away from tenders.

Hopefully the industry will take a realistic, conciliatory approach.

If you have any questions on what rights you have in your contract to increase prices, please get in touch.

 

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