Fluctuation provisions – JCT
In our previous blog, A State of Flux, we covered the volatile state of the materials and labour markets, and the difficulties experienced by both developers and contractors in fixing a contract price. In this blog, Construction Associate Moe Yassin of the Group’s specialist corporate and commercial practice, Beyond Corporate, looks at fluctuation provisions in JCT contracts and the benefits to both employers and contractors.
The elephant in the room
Let’s demystify fixed-sum contracts in construction first. Most employers have two primary goals: one, fixing its financial commitment and two, obtaining a competitively priced contract value. The “lump-sum” contract model has been the established way to strike a good balance between both objectives. Consequently, most developers and lenders will not accept fluctuation provisions in building contracts for one main reason; it creates uncertainty as to price in a situation where there is a finite amount of funding available. In fact, use of the JCT fluctuation options was so uncommon due to long periods of low inflation that when releasing the 2016 edition, the JCT decided to remove two of the three options from the standard form (B and C – which are now only available online) leaving option A only.
Transferring the risk of fluctuations
However, transferring the risk of fluctuations in costs onto the contractor does not particularly yield a competitive cost for the employer. Risk is still risk, and either a mechanism is included in the contract to deal with that risk (which provides some comfort to the contractor), or the contractor will simply price that risk and include it in its lump sum tender. In both cases, that risk has still been valued, and it is still being paid for.
Therefore, what a lump sum contract actually represents is the maximum commitment of cost which an employer is willing to bear, in exchange for not having to be concerned about fluctuations in the contract price. That certainly achieves the employer’s first goal, but not the second.
The potential benefit to the employer, if it were to consider using a fluctuation provision, is that contractors may well be prepared to bid much lower in the knowledge that they will be compensated if prices rise. There is no reason to front load the risk in the lump sum tender in this case.
So what are fluctuation provisions?
These are optional contractual provisions designed to deal with the effects of inflation and changes in costs, the operative word being optional. Those familiar with NEC contracts can draw similarities with the secondary options, that is, they do not apply unless you expressly state that they apply in the contract particulars.
If a change occurs which is captured by a fluctuation provision, an adjustment to the contract sum is made. The adjustment, unless the contract is expressly amended to say otherwise, can result in either an addition or a reduction to the contract sum. A common misunderstanding is that a fluctuation provision will only apply to the betterment of one party – which is not the case.
What are the options?
There are three fluctuation options in the JCT:
Option A – allows for adjustments to the contract sum in respect of changes to tax, levies and contributions which the contractor is required to pay. That would cover a change in tax payable on imported goods for example.
Option B – allows for adjustments to the contract sum in respect of changes to the price of labour and material cost. It covers adjustments to the market prices of materials, goods, fuel, gas (and more) which were current at the Base Date.
Option C – is a formula led adjustment to the contract sum. In this instance, the JCT Formula Rules issued by the Joint Contracts Tribunal will apply depending on the type of work being carried out (and there are a vast range of formulas).
You mentioned Base Date?
Base Date is a term often overlooked in JCT contracts. It is the starting point for dealing with a range of issues which may arise during construction developments, for example, the effect of new legalisation coming into force or changes to powers of local authorities or a statutory body. In the case of fluctuation provisions, it is the nucleus for determining any adjustment to the contract sum
Take, for example, a situation in which Fluctuation Option B applies. Contractors will be asked to bid on the basis of prices for materials and labour which are current at the time of tendering. In most cases, the date the tender is returned is the Base Date. If the market cost of timber changes, it is compared against the cost of timber which was current at the Base Date. If the price of timber has decreased, then it is costing the contractor less money to build the development than he estimated it would have cost at the Base Date. The contract sum is accordingly adjusted to reflect a reduction in cost by reference to state of the market at the Base Date.
As an employer, I want to limit my cost exposure
Most fluctuation provisions are calculated by reference to published price indices, such as the government inflation index, Consumer Prices Index (CPI) or other industry published reports. The parties can choose how prescriptive, simple or complex the provision should be:
- It could be as simple as allowing price increases in line with CPI.
- It could be as discrete as applying only to changes in price for one specific material. For example, if the main concern is the price of steel, the fluctuation provision could be drafted so it applies only to steel, and only by reference to a pre-agreed steel index.
- Conversely, it can be broad in the sense of what the provision captures, but very specialised in how the cost is assessed by using a specific index for each type of material or item.
- When dealing with short term and generally low value works, it can be as unsophisticated as merely agreeing a discretionary award based on increases in the market rate for labour or materials.
The key message is that adopting a fluctuation provision does not mean limitless cost exposure for the employer, or unrestricted recovery for the contractor. The benefit to the employer is that he may not be adopting much more risk than he would have already taken under a lump-sum contract but attracting more economically priced tenders than he otherwise would have been able to obtain. The benefit to the contractor is that he is no longer required to price for a risk which, if the length of the project was over several years, he may not have been able to adequately foresee. Diligent drafting is key, but a balance can be achieved for both parties.
In the next of this blog series, we look at fluctuation provisions in engineering contracts including MF1, NEC and FIDIC. If you would like to discuss any of the issues raised in this blog, please get in touch. Our expert lawyers are here to help you.