In the continued aftermath of the COVID-19 pandemic and ever-growing economic uncertainty, the construction industry is experiencing a worldwide increase in the price of materials, transportation and labour. Data from the National Housing Finance and Investment Corporation has analysed the impact on the construction industry and recorded, between 2020 to 2022, material costs having the fastest growth since 1970[1]. Additionally, the same analysis has shown labour costs are increasing[2]. Overall national construction costs for materials have increased from 2021 to 2022 by 10%[3]. Although COVID had the most significant effect, statistics reveal that Australian construction costs have increased by more than 25% over the past five years, showing that COVID merely exacerbated an existing trend[4].

This article discusses the use of the price escalation clause, often referred to in Australia as a ‘rise and fall’ clause, as a risk management method. A ‘rise and fall’ clause attempts to reflect economic changes that occur during construction, to provide flexibility in cost management. It can be used with a fixed-priced or lump-sum construction contract, to reflect increases (and potentially decreases) based on cost fluctuations due to circumstances outside the contractor’s control.

With the expected continued effect on the construction industry from cost increases, this article explores the ‘rise and fall’ clause, in the Australian context, and potential considerations in the drafting process.

Legislation

There is no restriction to including a ‘rise and fall’ clause in any state in Australia concerning industrial, commercial, or infrastructure-related construction contracts. However, there are prohibitions against including a ‘rise and fall’ clause in Western Australia and Victoria when building domestic use infrastructure. Still, if the final construction value of a domestic use structure is over $200,000 and $500,000 in Western Australia and Victoria, respectively, then there is no prohibition for the inclusion of the clause. There are further particularities regarding domestic constructions in these states but these are outside the scope of this article.

Government Contracts

A commonly used contract for Government funded projects is the General Conditions of Contract (GC21). The cost escalation provisions in the GC21 are found in the standard schedule 7 ‘Costs Adjustment Formula’. The schedule explains how the standard clause operates and how to redraft the clause to tailor it to the needs of the project, if desired.

The GC21 formula is accompanied by guidance on its application, including on what action to take if any relevant index is discontinued.

The ‘General’ clause 1.1 provides:

“The Contract Price will remain fixed for a period of two years from the Date of the Contract, after which the amounts payable for the balance of the contract price, for payment claims and the Final Payment Claim, will be subject to adjustment as specified below. The Rates and Lump Sum Prices for any additional work added to the contract will also be adjusted as specified below. No further cost adjustment will apply to the accepted rated and lump sum prices.”[5]

Although somewhat restrictive in preventing cost adjustments in the first two years, the clause is well-drafted and the formula provided is relatively easy to use, making it an effective framework.

Australian Standard

Prepared by Standards Australia, an independent not-for-profit organisation recognised by the Australian Government, the AS Series of contracts are mainly used for commercial projects but can be used for larger residential projects.

Some of the contracts in the AS Series do not include a ‘rise and fall’ clause, but for the AS Series contracts that do include a ‘rise and fall’ clause, the drafting is clear and effective. As drafted in AS 2124-1992 and AS4300-1995, relating to Daywork in the project:

“Amounts payable for Daywork shall not be subject to adjustment for rise and fall in costs notwithstanding that the contract may provide for adjustment for rise and fall in costs.”[6]

As drafted, in the two standard contracts, no adjustment is to be made unless the parties themselves include a ‘rise and fall’ clause. The AS2124 and AS4300 are older standard-form contracts; both were drafted when the inclusion of a ‘rise and fall’ clause was commonplace and include a clause that allows parties to annex the ‘rise and fall’ clause at the end of the contract. However, the newer AS4000-1997 and AS4902-2000 standard form contracts do not include a ‘rise and fall’ clause.

Management of Cost Escalation

The simplest way to manage cost escalation is through a ‘rise and fall’ clause if it is not already included as part of a standard form. Negotiations, which help scrutinise the clause in the contract, allow both parties to come to a mutual agreement regarding the drafting of the clause. Ideally, negotiating the clause will enable both parties to tailor it to suit their needs or, if the standard contract didn’t include the clause, to include a draft that was mutually agreed upon between parties.

Potential considerations that need to be taken into account when agreeing on a rise and fall clause include:

1. Base date

2. Triggers for applying the clause

3. Any caps on price increases

4. Non-adjustable portion

5. Applicable cost elements

6. Relevant reference indices

7. Calculation formulation for cost escalation

8. Currency variables

9. Provision for de-escalation

The key variables need to be considered carefully to avoid putting the contractor in a disadvantageous position when dealing with the employer as issues arise. The key variables, noted above, will directly impact the effectiveness of the clause. Thus, if the clause is considered carefully and drafted properly, the clause will enable the commercial success of the Contractor. For example, the contractor and employer can define the clause to trigger only when a certain material cost increases above a certain level. A cap could also be in place to prevent any cost from going above a certain degree of increase. This creates a window of a defined margin, mutually agreed upon between parties, which contributes to both parties risk management, and supports a successful commercial relationship and contract.

However, if the clause is ambiguous, the Courts, while reluctant to strike out an entire contract due to the failure of one clause, will do what they can to interpret the clause to ensure functionality and operate sensibly “within the reasonable confines of its language.” [7] However, it is possible that this could create unintended or unfavourable outcomes as was explored in the case in Lewis Construction (Engineering) Pty Ltd v Southern Electric Authority of Queensland, in which the index reference date was ambiguously drafted.[8]

An alternative method is the use of Alliance-type contracts, under which the employer and contractor(s) work together to collaboratively determine the best project solution and deliver the project effectively. Alliance-type contracts are a relationship-based procurement method, selecting alliance participants based on a soft dollar evaluation rather than a traditional tender price evaluation. An important element of Alliancing is the team culture that focuses on an open book and no-blame relationship.

Benefits

The inclusion of the ‘rise and fall’ clause may appear to be on the side of the contractor, but there are also benefits for the employer. Not including the clause could lead to contractors seeking the recovery of costs one way or another, for example, under headings such as a change of law, force majeure or variations. Whether or not these claims may have merit, the commencement of disputes can result in significant costs for both parties, and a deteriorating commercial relationship.

Specifically to the employer's benefit, a ‘rise and fall’ clause allows contractors to bid more accurately and competitively, resulting in lower bid prices for the employer. Additionally, the inclusion of a ‘fall’ provision also reduces the employer’s exposure if deflationary trends prevail during the project.

Finally, perhaps the greatest mitigation of risk that including a ‘rise and fall’ clause can have, in terms of overall impact, is that it prevents the project being endangered by a contractor defaulting due to severe and sudden escalations in cost.

There are benefits all around from the inclusion of a ‘rise and fall’ clause, and although it may seem like a risk for the employer to accept the clause, the continued uncertainty of the economy and the rise of material and labour costs could cause existential risks to ongoing and future projects. The certainty provided to all parties by a ‘rise and fall’ clause should be considered holistically in this context.

References

[1]How is supply and demand affecting building material costs? | The Property Tribune
[2]Ibid
[3]Backlogs for tradies mount as construction costs soar 10% | Savings.com.au
[4]No reprieve for home builders as construction costs continue rising | CoreLogic Australia
[5]General Conditions of Contract Edition 2, Schedule 7 Costs Adjustment Formula, New South Wales Government (February 2021)[6]Australian Standard 2124-1992, clause 41
[7]Hely v Sterling [1982] VR 246
[8]Lewis Construction (Engineering) Pty Ltd v Southern Electric Authority of Queensland (1976) 50 ALJR 769