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After a sustained period of global economic stability, a number of market factors today are combining to create economic volatility. While the impact of COVID-19 is diminishing, other factors such as the war in Ukraine are driving up inflation generally, and particularly the cost of fuel and construction materials.
Finance & Tax
In the pre-construction phase, this makes it difficult for developers to plan their construction or refurbishment projects, and difficult for contractors to price them. For many years, the trend has been toward fixed pricing, with contractors (and subcontractors and suppliers down the supply chain) taking the risk of fluctuations in labor and materials costs.
Every risk allocation, however, carries a cost, and the risk premium of covering new inflationary factors in these uncertain times may be prohibitive for contractors, particularly in hotel projects, which often have long construction periods. Increasingly, developers are considering introducing price fluctuation mechanisms that allow contractors to adjust their prices, with reference to impartial indices (whether the official inflation index of the relevant country or an index that tracks changes in prices of steel or other materials or of local labor). These provide certainty to contractors, but not to developers.
So, how can a developer assess the profitability or even viability of a construction project when the capital expenditure cost is uncertain not only during the planning and design stage, but also during construction? And in an environment where projects are increasingly difficult to finance, will financiers be willing to provide development finance on a project that has limited price certainty?
A hybrid system, either with a sharing of cost overruns or a guaranteed maximum price ceiling, may provide a compromise solution.
For contracted projects, this volatility is also causing significant complications. Most construction contracts will not allow for price adjustment, meaning the contractor needs to absorb any cost increases. Even if the contract does allow for price adjustments, commitments that contractors, subcontractors and suppliers are giving on their other fixed-price projects are leading to supply chain insolvencies, which can be highly problematic to a construction project, since they inevitably cause delays and duplication of expenditure, as well as continuity and quality concerns. During the last decade, a degree of complacency has developed over financial due diligence toward counterparties, over bonding for advance payments and insolvency, and over the passing of title (and vesting certificates establishing title before payment). Unsurprisingly, all of these factors are quickly becoming important.
Inevitably, such uncertainties lead to claims. The construction contract may provide an entitlement to additional time and/or additional cost, depending upon the cause of the external factor. Most construction contracts, for example, would consider both COVID and the war in Ukraine as forces majeures, giving an entitlement at least to extensions of time. Any claim to give effect to this entitlement needs to be carefully managed, however, and many construction contracts contain pitfalls for both parties if claims procedures in the contracts are not followed. Similarly, claims received need careful handling, to avoid any acceptance of liability for excessive or invalid claims.
Particular care is required when a contract allows no entitlement for the event that is causing delay and cost. In these circumstances, rather than simply absorbing this delay and cost, many contractors or subcontractors will seek to mitigate their losses by attributing their delay and cost exposure to other events that do legitimately give rise to an express entitlement.
During periods of extreme volatility, formal disputes may become inevitable. For this purpose, detailed record-keeping is key, as it may be the only way to establish or disprove an alleged entitlement.
As we move away from COVID, with many regions keen to revitalize their tourist industries and generate revenue back into their economies, construction deals will continue to be made. The market volatilities that we are seeing will make those deals more complex. And contract terms that might have been considered acceptable even 12 months ago may now carry a dangerous level of risk. Developers, contractors and funders alike need to be wary.