Tariffs, Taxes and Trade Wars: Using Material Price Escalation Clauses to Mitigate Risk in an Uncertain Political ClimateAugust 1, 2018
Current economic conditions and recent changes to trade policy governing the importation of goods crucial to construction activities –such as aluminum, steel and fuel – will likely have a significant impact on the cost of these and other goods in the coming years. In a standard lump-sum contract, typically the contractor bears the risk of these fluctuating material costs. As a result, contractors must be prepared to mitigate the risk of material price escalation in order to preserve the feasibility and profitability of their projects. As discussed in this article, contractors have a series of risk mitigation strategies available to them at different stages of the project: at the time of bid; during procurement; during contract negotiation, and even after execution of the contract. The most effective risk mitigation strategy, however, is the inclusion of a thoughtfully drafted materials escalation clause in the contract itself.
What is Material Price Escalation?
The term “material price escalation”- sometimes referred to as “volatility” or “inflation”- refers to changes in the cost or price of specific goods or materials in a specified economy over a period of time. While gradual growth in material prices are not uncommon, material price escalation is particularly problematic for contractors where material prices unexpectedly explode – such as when new regulations, taxes or tariffs come into effect – causing the price of materials to increase more than would be otherwise anticipated.
In early March 2018, the Trump Administration announced intended tariffs of 25% on imported steel and 10% on imported aluminum. This had an immediate effect on the price of steel, causing it to rise, even though the tariffs in question had not yet gone into effect. Such an unanticipated and sudden increase in prices could have devastating results for contractors who failed to allow for a cost increase in their bids or contracts.
How Can Contractors Mitigate the Risk of Material Price Escalation?
Contractors can employ different strategies to mitigate the risk of increased material prices at different points in the contracting process.
First, at the time of bid, the contractor should consult a cost index such as the Building Cost Index (BCI) or Turner Cost Index (TCI) in order to estimate what the likely increase in material costs should be. Then, the contractor should ensure that the bid contains a generous contingency that accounts for potential cost escalation. This approach must be carefully implemented, as a bid with an overly generous contingency may become uncompetitive in certain markets. Bid formulation is also a good time for the contractor to lock in material prices with suppliers, effectively shifting the risk of material price changes downstream.
The contractor can also minimize the risk of material price changes during the procurement process by purchasing materials with the most volatile prices as early as possible. However, if a contractor is employing this strategy it must also consider the impact of any potential design changes and must account for possible increased storage and handling costs. This approach requires a complete or reliable design early in the project and works best when the owner, designer and specialty contractors are on board and working cooperatively. This is particularly useful when using a highly collaborative project delivery method such as integrated project delivery or a design assist process. Contractors can also build in additional security through careful negotiation of supplier agreements. By limiting suppliers’ rights for material price increases to only those rights the contractor has upstream, the risk of material price increases is limited. Contractors can also employ fixed limits on their suppliers’ ability to raise prices, thus capping the risk associated with these materials.
Finally, a contractor’s best opportunity to limit the risk associated with material price escalation is to negotiate an escalation clause at the time of contracting. In a typical lump-sum contract the contractor bears the risk of any financial impact arising from fluctuations in material prices, potentially putting contingency, overhead and profit at risk. By negotiating an escalation clause up front, contractors can limit or shift this burden, thus protecting their financial bottom line.
Types of Material Escalation Clauses
There are three types of material escalation clauses most commonly used in general contracts: “Day One”, “Threshold”, and “Delay”.
A “Day One” escalation clause requires the upstream party to pay for any increases in material costs once the contract is executed. The contract must define exactly what materials are subject to the clause and must include baseline prices for those materials. A typical “Day One” clause reads: The prices of materials contained in this contract are those in effect as of (date); Contractor shall be reimbursed for all increases in the cost of material as of the date of purchase plus overhead and profit.
A “Threshold” escalation clause shares the risk by requiring the upstream party to pay for material price increases above a defined threshold. The contractor is reimbursed only for significant price increases which occur between the bid (or contract date) and the date of installation or purchase or materials. This type of clause shifts the risk of significant price increases to the upstream party, but vests the contractor with the risk of price increases up to the threshold level, effectively capping the contractor’s potential exposure.
For example: In the event the price of certain materials (e.g. structural steel), increases by more than 10% between the date of this Contract and the date of installation (or purchase by the Contractor), the Contract Sum shall be equitably adjusted by the amount which exceeds a 10% price increase over the material’s Baseline Price. The Contractor’s equitable adjustment shall be made by Change Order in accordance with the procedures set forth in the Contract Documents.
A “Delay” escalation clause holds a fixed price for a limited period of time, but allows the contractor to receive an equitable adjustment if the project is delayed or, more commonly, if it is not feasible to purchase all materials for the project at the start of construction. For example: This Contract contemplates that the Contractor will complete its Work by (date). In the event the Work is not completed by that date, through no fault of the Contractor, the Contractor shall be reimbursed for all increases in the costs of the following materials: (e.g. steel, asphalt) plus overhead and profit. When utilizing a “Delay” escalation clause, it may be helpful to use specific milestones as deadlines.
Mutual or Bilateral Escalation Clauses Can Convince Reluctant Owners
While contractors may recognize the importance of including a material price escalation clause in the contract, it can sometimes be difficult to convince an owner to share in the risk and include such clauses. In these instances, contractors should consider proposing the inclusion of a mutual or bilateral clause where each party stands to accept some of the risk and some of the reward.
These clauses shift the risk of price increases to the owner, but also provide a corresponding benefit if material prices drop. Such a clause should usually take the form of a “Threshold” escalation clause to avoid unnecessary forfeiture of the contractor’s margins. Given the likelihood that prices will increase in light of the tariff uncertainty, such a clause operates to provide protection to contractors with minimal sacrifice. For example: In the event the price of certain materials (e.g. structural steel), increases by more than 10% between the date of this Contract and the date of installation (or purchase by the Contractor), the Contract Sum shall be equitably adjusted by the amount which exceeds a 10% price increase over the material’s Baseline Price. The Contractor’s equitable adjustment shall be made by Change Order in accordance with the procedures of the Contract Documents. In the event the price of certain materials (e.g. structural steel), decreases by more than 10% between the date of this Contract and the date of purchase by the Contractor, the Contract Sum shall be equitably adjusted by Change Order in accordance with the procedures of the Contract Documents to provide a credit to Owner for the decreased price.
What Relief Is Available in Existing Contracts?
While the best course of action is to ensure each contract contains an appropriate material price escalation clause, contractors may be able to find relief from unanticipated changes to the price of materials in existing contract clauses or through application of equitable principles. Contractors should carefully examine the Change in Law provisions and Force Majeure provisions to see if the imposition of new taxes or tariffs allows the contract price to be adjusted. For example, Consensus Docs section 3.21.2 allows for an equitable adjustment for additional costs or time resulting from any change in law, including increased taxes, enacted after the date of the agreement.
If the existing contract provisions do not provide relief, the contractor may also be able to argue the equitable theories of mutual mistake or commercial impracticability. These arguments, however, are difficult to make and should not be considered the primary avenue for obtaining relief.
Contractors should be aware of the potential negative impacts resulting from uncertain trade relations and an unsettled political climate. The best way to mitigate this risk is to proactively manage the bidding and procurement processes and to ensure incorporation of an appropriate materials escalation clause wherever possible.
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