With United States inflation running at a 40-year high, energy contractors are increasingly concerned about its impact. The below table illustrates the extent to which various measures of construction costs are steepening:
GAILLE PLLC represents both owners and contractors with respect to the negotiation, drafting, and administration of more than a billion dollars of energy construction agreements annually—and price inflation/escalation terms have increasingly taken center stage. This issue of the Gaille Energy Blog discusses five tools that can be used to manage inflation risk in construction and services agreements.
- Cost-Reimbursable Commercial Structures. Cost-reimbursable contracts are one of the easiest ways to mitigate the contractor’s risk of cost uncertainty. In particular, we are seeing more “Actual Cost + Fixed Fee” structures for energy construction. In this structure, the contractor is reimbursed all of its direct costs and is paid a fixed dollar fee for profit and overhead. The fixed dollar fee retains a “soft” incentive for the contractor to control costs because the contractor’s compensation for profit and overhead remains the same—whatever it happens to spend on the work. On the other hand, the below figure illustrates how commercial structures that allocate the risk of cost uncertainty to the contractor (e.g., lump sum) are better suited for environments of decreasing cost uncertainty.
- Contingency Caps. When contractors are asked to bid on lump sum or unit price agreements in the midst of price uncertainty, the result is usually excessive contingency. The practical result can be that the owner is left paying for a “worst case” forecast of inflation—whether or not that worst case actually materializes. One way to address this is for the parties to agree on a lump sum that reflects current pricing and an estimate of future pricing, but provides for a contingency bucket of a fixed dollar amount that can be called upon by the contractor if pricing for a line item increases due to circumstances beyond the contractor’s control. Once the cap of the contingency has been reached, though, the contractor is not entitled to seek any further compensation.
- Allowance Items. Under an allowance item approach, certain portions of the work (with less cost uncertainty) can be paid on a lump sum or unit price basis while other portions of the work (with greater cost uncertainty) can be reimbursed on an actual cost basis. For example, materials and fuel might be carved out of the lump sum and reimbursed, thereby mitigating the need for contingency.
- True-Up for Material, Fuel, Labor, and Equipment Costs. Under a true-up approach, the parties must agree on a detailed basis of estimate and build-up of costs for the lump sum, which fixes quantities of materials, fuel, labor, and equipment—but allows the rates for the same to be variable inputs. Thus, whether or not the contractor completes the work more or less efficiently than anticipated is irrelevant to the true-up model. All that matters are the rates. When the project has been completed, the parties ascertain what the actual rates were for materials, fuel, labor, and equipment. The model is updated to reflect the actual rates, and its output is a “trued-up” lump sum. For example, if the forecasted rates equated to a lump sum of $20 million, and the actual rates experienced by the contractor equated to a lump sum of $23 million, then the contractor would receive a true-up payment of $3 million.
- Indexing. One of the problems with indexing costs is that indexes may or may not accurately reflect the costs of a particular construction project, in a particular location, at a particular time. For example, in 2021, prices for diesel fuel increased by 80%, for lumber by 41%, and for fabricated steel by 25.1%— but flat glass prices increased by 5% and concrete prices increased by 3.8%. Indexing works best when it is being applied to profit and overhead costs. For example, we are seeing actual cost with fixed fee agreements that are coupled with a monthly CPI adjustment to the unpaid portion of the fixed fee. This substantially protects the contractor’s profit and overhead from being eroded by inflation.
Owners and contractors must collaboratively address the new reality of inflation—one way or another.
About the Gaille Energy Blog. The Gaille Energy Blog discusses issues in the field of energy law, with periodic posts at www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School and the author of seven articles in the Energy Law Journal.
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