Price flexibility in construction contracts: the importance of drafting in price adjustment clauses

Inflation in the construction industry since mid-2021 has led to industry participants seeking greater price flexibility.

This article discusses some commonly used techniques to achieve pricing flexibility and a price escalation clause that recently led the District Court of Queensland to hold that the clause was void.

Uncertain and "unfair" price escalation clause found void

In the case of Perera v Bold Properties (Qld) Pty Ltd [2023] QDC 99, the applicants (Owners) entered into a contract with Bold Properties (Builder) for the construction of a house. The contract was for a "fixed price" of $645,370. However, Special Condition 7 said the price may be varied by the Builder:

"In the event that commencement has not taken place by the anticipated start date… the builder reserves the right, at the builder's sole discretion, to increase the contract price to the current base price of the house type, which is the subject of this contract and identified in the Contract Tender, to the builder’s current base price for that house type."

Two months before the anticipated start date, the Builder informed the Owners that the price would increase by $51,342 (approximately 8%). The reasons included:

"… significant cost increases over the last 12-18 months as a result of inflationary industry demand, Insurance Repair Work, shortages in various key building trades, the recent wet weather and disruptions to the industries supply chain as an unfortunate consequence of the COVID 19 pandemic."

The Owners argued that Special Condition 7 was void for uncertainty and an unfair contract term under the Australian Consumer Law (ACL). Judge Barlow held that there was "no real constraint or reference criteria" by which the price change would be determined. Special Condition 7 was therefore held to be void for uncertainty and unenforceable, because there can be "no concluded bargain if a vital matter has been left to the determination of one of the parties".

Judge Barlow also held that Special Condition 7 was an unfair contract term under Part 2-3 of the ACL (and therefore also void for this reason). His Honour's reasons were that the term was in a consumer contract that was a standard form contract and the term:

• would cause a significant imbalance in the parties' rights and obligations arising under the contract;
• was not reasonably necessary to protect the legitimate rights and interests of the Builder;
• would cause detriment to the Owners if applied; and
• was not transparent.

The imbalance in the parties' rights was exacerbated in this case because the Owners did not have a right to terminate the contract if the Builder sought to vary the price.

The case is to be distinguished from the Western Australia context where the Home Building Contracts Act 1991 (WA) permits price escalation in certain circumstances but requires that the owner have a right to terminate in some cases (Chellem v Kulowall Construction Pty Ltd [2022] WASAT 95; Vadakkumkaraputhaveedu v Kulowall Construction Pty Ltd [2023] WASAT 29).

Industry responses to rapid price escalation

The case is a reminder of the challenges facing the construction industry in recent years. Abnormal inflationary impacts on construction materials have created unsustainable differences between agreed fixed contract prices and actual delivery costs. This has contributed to an increase in insolvencies which, according to the ASIC Insolvency Statistics current at 4 July 2023, are up approximately 73% in the sector in the financial year to 18 June 2023 compared with the previous financial year.

Current levels of high inflation have been attributed to various causes, including supply chain disruptions caused by COVID, "excess" fiscal and monetary stimulus, the war in Ukraine and the 2022 floods in Eastern Australia. Price inflation has been even more extreme in the construction industry than in the general economy, with ABS data indicating certain home construction inputs are on average 50% more expensive than before the COVID pandemic.

Many commonly used standard form contracts in Australia provide for a fixed price and do not allow contractors to be compensated for general price escalation in the market. As shown in the Perera case, parties wishing to transfer the risk of price escalation from contractors to principals by adopting price variation provisions should ensure the mechanisms are clear and objective, and rely on accessible data sources.

Some ways in which enforceable pricing flexibility can be achieved include:

• advanced rise-and-fall clauses which provide for price adjustment to respond to changes in the market, applicable once a materiality trigger is reached to ensure the parties share the risk of cost increases, with a painshare/gainshare or KPI regime to mitigate the lack of cost control;
• cost plus or provisional sum mechanisms which provide for the contract price to be based on actual costs plus an agreed margin, supported by an open book approach and robust audit and verification rights; and
• complex indexation clauses which apply an adjustment:
  • based on annual changes in a materials index published by the Australian Bureau of Statistics;
  • more frequently to reduce the impact of any time lag of the standard indexation mechanism; and
  • for specific types of materials where the change in the index for a material type materially exceeds the change in the standard indexation.