Sharing the load: are fixed-price contracts a thing of the past?

With many subcontractors bitterly regretting the fixed-price contracts they signed before inflation spiralled, James Wilmore asks whether fluctuation clauses and advance payments will become the norm

Collaborative risk-sharing will be key to preserving industry resilience and capacity moving forward.” These were the words of the Construction Leadership Council’s (CLC) product availability working group’s co-chairs in November.

But why is risk-sharing so vital? In the CLC’s words, it is due to a “sustained, high level of construction firm insolvencies, particularly among SME builders and specialist contractors”. Among the culprits for these collapses are “economic uncertainty and the difficulty of reconciling fixed-priced contracts with price inflation and reduced cashflow”, the CLC’s statement said.

Since then, further warning signs have emerged. In December, the S&P Global/CIPS UK Construction Purchasing Managers’ Index fell to 48.8. This was the first time business confidence in the sector had contracted since the initial COVID-19 wave. The decrease was attributed to expectations of a recession and poor demand conditions, combined with inflationary pressures. Meanwhile in January, the Construction Products Association (CPA) forecast that construction output will fall by 4.7 per cent in 2023.

“Everyone has an incentive to make sure that the project gets done and no one has an interest in contractors going under”

Noble francis, CPA

Against this backdrop, the idea of risk-sharing may seem… well… at risk. So what kind of risk-sharing is already happening and will this approach hold up?

For context, let’s look at the legal angle first and how things are operating higher up the chain. With inflation still high, albeit showing signs of plateauing, lawyers are noticing an increase in contractors trying to agree “fluctuation clauses” with clients to mitigate the impact of material price increases.

Andrew Parker, a partner at law firm Forsters, says that when main contractors agree these clauses with clients it allows them to take a “pragmatic approach” with their supply chain.

“They realise if they’ve got good subcontractors then it’s in their interest to help them be successful,” says Parker. “They need to look
after the ones that are good and are surviving.”

However, for the clients of contractors, particularly those in the private sector, agreeing to these kinds of provisions is often not an attractive prospect.

Parker says: “The trouble with fluctuation clauses is they do create some cost uncertainty and from [the client’s] perspective that is a risk they are not prepared to bear.”

“On larger schemes, there is a recognition from the contractors and from the developers to get some money into the supply chain early rather than the supply chain taking the risk of funding”

Francis Keenan, FK Group

Nevertheless, others in the legal profession are predicting that these types of clauses could become more common in the industry. “Having now experienced the risk that fixed-price contracts can present in difficult economic conditions, the practical impact of ongoing uncertainty is that 2023 could see a continued rise in the use of fluctuation provisions,” said Amy Pairman, an associate at Brodies, writing for Construction News last month.

For Noble Francis, economics director at the CPA, he can see that fluctuation clauses “make sense”. He says: “Everyone has an incentive to make sure that the project gets done and no one has an interest in contractors going under.”

But he adds: “This does rely on clients being understanding of the issues rather than just going with the cheapest or second-cheapest bid.

“Plus, it also relies on clients not being more hesitant on signing off on new projects due to the uncertainty over spiralling costs.”

The impact of working to fixed-price contracts is tangible. As Francis says, a big problem for specialist subcontractors is the fixed-price contracts they signed up to 12-18 months ago, before the energy, oil and commodity price spikes.

“Their margins just aren’t large enough to absorb the double-digit rates of materials inflation, particularly given strong wage demands in areas where there are shortages of skilled trades,” he says.

He points out that 60 per cent of the 4,039 construction firms in the UK that went bust in the year to October were specialist contractors. Francis puts this largely down to the fact that specialists are often on fixed-price contracts signed more than a year ago. “They’ve also been hit by labour availability issues, IR35, reverse charge VAT and rising personal indemnity insurance costs,” he adds.

“People have started saying to me that they’re not working for certain clients anymore because the risk is not worth the reward”

Rob driscoll, ECA

By contrast, only 6 per cent of the construction firms that have gone out of business were civil engineering firms. Francis says they’ve been less affected as infrastructure activity is “currently buoyant due to major projects and frameworks”.

“In addition, public-sector and regulated-sector clients have tended to be more understanding of issues of cost inflation and less stringent on enforcing fixed-price contracts with smaller specialist contractors,” adds Francis.

Early start

Parker says more could be done at the start of a project. “There could be more collaboration at the very outset,” he says. “There’s still an insistence on getting the best price at the quickest amount of time. But the knock-on effect is the supplier has to agree to that if they want to win the work. This means they have to find ways to get that money back, which means cutting corners. So it could mean they use substandard materials, or they’ll just cut corners in their workmanship.

“You’ve seen things as basic as bolting things on with every other screw, rather than every screw. It seems petty but it saves time and money on a large scale. These kinds of things happen when people get put under pressure.”

Parker also suggests things are still stacked in favour of main contractors. “Tier one contractors are sufficiently resourced and have enough money to stockpile materials,” he says. “I’ve heard of contractors buying scaffolding rather than having to rely on hiring it. It means smaller contractors are finding it difficult to compete because they haven’t got the resources to stockpile in that way.”

Rob Driscoll, director of legal and business at the Electrical Contractors’ Association (ECA), believes risk-sharing has come about through necessity rather than the industry having a sudden epiphany. “It’s not about throwing stones at tier ones in a blame game. Everyone wants fixed risk. I don’t think it’s inevitable that tier ones necessarily survive at the detriment of subcontractors, but increased insolvency risk exists at all levels of the supply chain. People might be risk-sharing more, but maybe not by choice, but because certain trades could not hold their prices because inflation was rampant, just like in the 1970s and 1980s.”

But he adds: “It wasn’t an epiphany, as behind tier ones there are clients and behind clients there are funders and they want capped risk.”

Material differences

So what are the contractors’ experiences of risk-sharing on the ground? Francis Keenan, chief executive of building envelope specialist FK Group, which works for a variety of main contractors, is broadly positive from what his business has seen. He suggests that some of the approaches adopted during the pandemic have remained. “There’s been a lot more granular understanding from main contractors around things like asking, how many labour operatives have you got? What is your capacity? What are
the constraints?”

He points to the New Victoria residential development in Manchester as an example, where FK Group has been working with Vinci and developer Muse. An advanced payment bond was agreed, which saw money released to FK that allowed it to buy materials in advance. FK’s bonds were backed by its bank, HSBC. “We were actually able to start production six months before the panels hit the site,” says Keenan. “On these larger schemes, there is a recognition from the contractors and from the developers to get some money into the supply chain early rather than the supply chain taking the risk of funding.”

Meanwhile, Paul Heather, group managing director at McLaren Construction’s UK business, says the hike in material prices has meant collaboration has been key. He says: “We are thinking, ‘Is there a different material we can use? Is there a different manufacturer we can use? Is there an opportunity to forward-purchase?’”

Heather says that for some of the firm’s fixed-price projects it will forward pay so its supply-chain partner is able to deliver the project at the price it has agreed. “If we just let it flow and inflation takes over then it’s likely to be a loss-making project for them,” he says. “And they don’t want too many of them on their books.”

Looking ahead, Keenan believes these risk-sharing behaviours can become the new normal. “I think they can be maintained and it’s upon all of us to try and work hard to make that the case.”

But Parker still believes that with current market conditions, the power remains with tier ones. “If you’re a big, strong contractor, you’re becoming bigger and stronger in this market,” he says.

Speed of payment – a long-standing source of contention in the industry – is still a big factor too (see Payment 100 feature, p26). “Delayed payments are still a massive issue, it’s still quite hand-to-mouth. Quicker, more regular payments would definitely help and is something that could be achieved without too much hardship,” says Parker.

Driscoll adds that the looming recession is affecting the way that subcontractors choose who they work for. “When you have a downturn, what tends to happen is that intelligent subcontractors start to assess how their clients treat them,” he says. “The subs will migrate away from those who are high insolvency and contractual risk, towards those who are more strategic and fairer.

“People have started saying to me that they’re not working for certain clients anymore because the risk is not worth the reward.”

Where are material prices heading?

Key to understanding where the issue of risk-sharing might head and what sectors it will affect is the direction of travel of material prices and supply issues. According to the CPA’s Noble Francis, the majority of supply issues have dissipated, but issues around microchips and semi-conductors remain. “This is a global medium-term issue and not only affects construction but also electronics, IT, automotives and engineering,” he says.

In construction, the problem affects smart meters, electrics, heat pumps, EV chargers and boilers. But Francis adds: “As it is has been an issue for over 18 months, most major housebuilders and contractors have factored these extended lead times into their business models.”

According to the CLC, price inflation has also stabilised. Timber prices have continued to fall but are expected to increase in Q2 as European mills reduce production over winter. The price of some energy-intensive products, such as bricks, cement and PIR insulation, increased by around 10 per cent in January due to energy and distribution costs, it has noted.

However, with continuing economic uncertainty, some suppliers have deferred price increases. Nevertheless, as the CLC highlights, with general inflation still above 10 per cent, the hikes are likely to be implemented by Q2.

While some of this sounds positive, the CPA’s Francis has spotted a worrying sign. Despite construction output being 4.1 per cent higher in October 2022 than pre-pandemic, materials prices and insolvencies continued to rise. With demand now predicted to fall in key sectors such as housebuilding, there is concern this could mean a further increase in insolvencies.

He suggests the biggest issues are likely to be for smaller, specialist subcontractors working on residential new-build and improvements. He adds: “There are areas that were previously buoyant but where new work is falling away and so they are likely to suffer from falls in demand as well as the price rises in December and January. This points towards specialist subcontractor insolvencies rising further in the coming months.”

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