Imagine two contractors, both managing the construction of new office buildings along Omaha’s Dodge Street. A sudden global event causes material prices to skyrocket. Contractor A, without a price escalation clause in their contract, must absorb these unexpected costs, risking financial strain or even losses. In contrast, Contractor B included a price escalation clause, which shifts the burden of increased costs to the project owner. As a result, Contractor B is protected from unpredictable market changes, while Contractor A faces potential financial difficulties.
This scenario underscores the importance of accounting for market fluctuations in construction contracts. In today’s interconnected world, local events can rapidly escalate into global crises, impacting prices across the board. Price escalation clauses help contractors manage these risks by allowing for adjustments in costs due to unforeseen circumstances. Similarly, project owners benefit by clearly defining which costs they might need to cover, ensuring transparency and fostering positive relationships with contractors.
This article will explore what price escalation clauses are, why they are vital for both contractors and owners, and how they can be effectively used to safeguard financial interests in construction projects.
What are price escalation clauses?
A price escalation clause is a contractual provision that enables a contractor to account for potential changes in the market price of the materials and labor necessary to complete a project. Price escalation clauses are typically tied to a material price index (such as the consumer price index), allowing a contractor to recover all or part of a price increase above an agreed upon threshold. Standard form contracts from the American Institute of Architects (i.e. AIA) that are commonly used in the construction industry do not include price escalation clauses, and thus such clauses often must be negotiated into the contract.
There are a few things that contractors and owners should consider when inserting a price escalation clause. First, what events do the parties want to protect against? Some examples of events that may warrant coverage by the price escalation clause include: natural disasters, material tariffs, price surges, scarcity issues, and legislative changes. Second, what items and materials do the parties want the escalation clause to apply to? When deciding what the clause should cover, parties should think about the materials they anticipate needing large quantities of and what materials are most likely to be subject to major price fluctuations. While it is possible to insert a blanket escalation provision stating that the prices of materials are subject to change, it is worth considering drafting a more specific clause that can provide some sense of predictability for the contract and project owner, as well as help reduce frustration with shifting contract prices.
Why are price escalation clauses important?
Construction projects often span months or even years, during which time economic conditions can change significantly. One of the most critical aspects affecting project costs is the price of raw materials, which can experience sudden price hikes due to situations such as natural disasters, changing political situations, and global supply chain disruptions. For example, due to supply chain disruptions associated with the COVID pandemic, the costs of steel nearly doubled from August 2020 to August 2021—marking the largest relative spike in metal prices since the United States government started tracking metal prices in 1920. By including a price escalation clause, a contractor can preemptively protect themselves against situations like this, thereby avoiding potentially diminished profits or significant financial losses.
Price escalation clauses also provide advantages for project owners. For example, including a detailed price escalation clause increases project owner’s confidence by setting expectations related to price increases at the outset and making clear both what the owner may be on the hook for and what the owner will not be obligated to cover. This makes it easier for a owner to predict how a rise in prices will impact their pocketbook and can help contractors maintain positive customer relationships by ensuring that customers feel a sense of transparency about necessary adjustments to contract prices. Price escalation clauses can also benefit owners by enabling contractors to provide a more accurate bid at the outset. Removing the need for a contractor to bake a risk-buffer into the contract to protect themselves in the event of a change in cost of materials allows contractors to provide more accurate bids at the start of a new project.
In sum, price escalation clauses are an extremely useful tool for those in the construction industry. Not only can escalation clauses protect general contractor’s bottom lines, but they can also protect relationships between contractors and owners by providing predictability and transparency about changing contract prices. Accordingly, the prudent contractor and prudent project owner should consider having a price escalation clause inserted into contracts that have a total value that could materially impact the viability of their company. If you have questions about price escalation clauses and how to have one inserted into your contract, please do not hesitate to contact one of the members of Koley Jessen’s Construction Industry Practice Area.
