With material cost volatility in the current market, the topic of price escalation clauses is more prevalent. Some material costs are up and other costs are now down. Traditional lump sum contract structures do not take into account price escalation or de-escalation; whereas cost plus structures entirely and naturally account for such changes. Owners of construction projects tend to prefer lump sum projects due to certainty in budgeting and other reasons.
A potential mechanism to account for volatility is to include a price escalation clause. This blog post provides the basics of such a clause and asks questions to consider when drafting.
What is a price escalation clause?
- A clause utilized to account for price fluctuation in construction costs for specifically identified materials particularly susceptible to fluctuation (i.e. steel, lumber)
What are the benefits of a price escalation clause for an owner?
- The risk of overpricing materials is reduced
- Such a clause may allow a project to move forward in an uncertain market and may even expand the number of bidders
What are the drawbacks of a price escalation clause for an owner?
- The risk of a price increase is shifted to owner
What are the benefits of a price escalation clause for a contractor?
- The contractor is protected if market conditions worsen
What are the drawbacks of a price escalation clause for a contractor?
- Price escalation clauses may take away upside from the contractor for taking on greater risk
- Additionally, more cost information must be disclosed by the contractor
What are some of the best practices for drafting a price escalation clause?
- Identify the materials to which the clause applies
- Define the baseline cost upon which the contract pricing is based
- Define the price increase/decrease that triggers the clause – material prices must increase/decrease by a certain amount or a percentage over the base amount before the clause is triggered
- Consider whether the clause will be cost-based or index-based
- The clause should include a written notice requirement tied to when the counterparty becomes aware of the material price increase or decrease
If you need help in drafting a price escalation clause, hire an attorney. These clauses are complicated and require both parties to consider multiple legal and commercial terms.
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