By Stuart Robertson, partner, and Victoria Bortsova, solicitor, in Dentons Kensington Swan’s Major Projects and Construction team.
Over the past few years, New Zealand (like many other countries) has experienced an increase in the cost of materials and labour exacerbated by Covid-19 related disruptions to the supply chain. This cost volatility and uncertainty means that contractors are bearing more risk and there is a growing degree of uncertainty in tenders and construction contracts currently on foot.
This can be ameliorated by utilising Provisional Sums or a Cost-Plus form of contract. But these may not be attractive to principals. It is therefore timely to examine the cost fluctuation provision under NZS3910:2013 (NZS3910), New Zealand’s most used standard form construction contract.
The benefit of a cost fluctuation provision is that it aims to fairly transfer some of the effect of price changes in the cost of labour and materials during the contract period from the contractor to the principal.
Overview of cost fluctuation provision
The cost fluctuation provision is found in clause 12.8 and Appendix A of NZS3910. It allows the contract price to be adjusted to reflect changes in the cost of materials and labour during the contract period. However, it is an opt-in mechanism which means that the parties must clearly specify in Schedule 1 (Specific Conditions) whether or not they wish to allow for cost fluctuation adjustments.
If cost fluctuations are agreed to, the contractor can adjust the contract price using the Labour Cost Index and Producer Price Index as a way to measure an increase in price (these indices are found online).
The parties should consider whether the Appendix A default position is appropriate. The default position allows for a weighting of 40 percent labour price increase and 60 percent materials price increase. Once this rate is calculated, it is then multiplied by the certified value of the works in the relevant quarter.
Although NZS3910 provides for cost fluctuations, in practice, cost fluctuation provisions are not often used in horizontal construction projects. This means that the risk of price escalations sits with the contractor (especially where the works take substantially longer to complete due to non-culpable delays such as those caused by Covid-19 and border closures).
As a result, the contractors are the ones who suffer if the materials or labour required for a project go up in price.
Incorporating a cost fluctuation clause
Whether or not it is appropriate to include a cost fluctuation provision will depend on a number of issues. These include the type and nature of the project, the form of contract used, whether the key materials are prone to particular risk of price increases, as well as the stability of the contractor’s supply chain.
In light of the growing rate of inflation (which is expected to carry on throughout 2022), contractors will be keen to mitigate the risks of price increases and may turn down opportunities to tender where the principal refuses to include a cost fluctuation clause.
In considering how to best negotiate a cost fluctuation provision, contractors need to be aware of the potential issues with the current formula under NZS3910.
One notable flaw is that the formula (incorrectly) assumes that the 40-60 percent recoverability split (labour/materials) will be appropriate for every type of project. The contractor should carefully consider whether this weighting is appropriate in the circumstances.
The contractor should also bear in mind that the default formula is based largely on industry wide indices and not the actual costs that the contractor is likely to encounter.
Also, given that the formula requires calculations to be done on a quarterly basis, this may not be appropriate in light of the current pace of price increases in the industry (as well as in the future).
There are a number of alternatives to the standard cost fluctuation provision that should be considered. This includes using a modified cost fluctuation clause that gives more allowance/weighting to the cost of materials (for example, an 80 percent recoverability percentage).
Another alternative is incorporating a bespoke material price increase clause which takes into account the specific materials used on a project and the likely increase in price of these materials. These are likely to be more appropriate than a standard cost fluctuation clause as they are project-specific and also mean that the contractor is able to better transfer some of the risk of price increase of materials.
What does this mean in practice?
Looking ahead, contractors are advised not to enter lump sum contracts unless it contains the standard or a bespoke cost fluctuation provision.
Additionally, while a cost fluctuation clause may still be adopted, it may be more appropriate for contractors to negotiate a cost reimbursement contract (if this is appropriate for the given project and the type of materials used), or to identify certain materials or subtrades as a Provisional Sum. Provisional sums may be more appropriate as they better allocate price risk.
Under NZS3910 clause 12.9, a provisional sum is an allowance included for an item of work that has an estimated price when the contract is executed. The contractor is paid for the work valued as if it were a variation, or the net purchase price of the materials plus a reasonable allowance for profit and expenses.
This means that the provisional sum is substituted with the actual cost; resulting in the principal bearing any price increases.