Managing cost volatility in construction contracts: rise and fall clauses

In recent years, the COVID‑19 pandemic and the Russia‑Ukraine war have highlighted the vulnerability of contractors in the construction industry in Australia, particularly in respect of fixed price construction contracts. Now, with the conflict in the Middle East, contractors will again be exposed to escalating delivery costs, mainly for materials and labour, which are often not recoverable from the principal.

To offset this risk, a contractor may seek to include a contractual mechanism, commonly known as a rise and fall clause, whereby the contract price is adjusted to reflect changes in the contractor's underlying costs during the lifecycle of a project.

When should a contractor include a rise and fall clause?

A rise and fall clause is particularly important for a contractor in circumstances where there is:

1. a disruption to the supply chain (such as an overseas conflict) which causes an increase in the cost of key building materials;

2. a large portion of the contract price relates to material costs, increasing the contractor's exposure to events that affect the supply;

3. limited or no alternative suppliers, restricting the contractor's ability to mitigate cost increases;

4. a prolonged period between the date the contractor becomes bound by its price (for example, on contract execution) and the commencement of works. This includes where the principal must satisfy conditions precedent, such as obtaining funding, before the contract comes into effect; and

5. a multi-year project, which increases exposure to inflationary pressures and rising interest rates.

The current conflict, particularly the disruption to shipping in the Strait of Hormuz, the narrow but critical waterway linking the Persian Gulf to the Gulf of Oman, has had a direct impact on Australia’s construction industry. As a key global shipping route through which around 20 per cent of the world’s seaborne oil passes, any blockade or interference immediately constrains supply and drives up oil and gas prices.

These increases affect a contractor's bottom line because, beyond direct fuel and shipping costs (and the delays associated with shipping), many essential building products are derived from oil, gas and petroleum. These include asphalt and bitumen for roads and roofing, PVC pipes, insulation foams, paints, coatings, epoxies, adhesives, and components used in renewable energy such as solar panels and wind turbines.  

Such immediate and unexpected increases in costs can quickly erode a contractor’s margin or result in losses. Escalating costs are frequently cited as a contributing factor in contractor insolvencies.

Examples of rise and fall clauses

A badly drafted rise and fall clause may be found to be void for uncertainty. In Perera v Bold Properties (Qld) Pty Ltd [2023] QDC 99, Mr and Mrs Perera (Owners) entered into a fixed price contract with Bold Properties (QLD) Pty Ltd (Builder), for the construction of a house. The contract contained the following special conditions:

In the event that commencement has not taken place by the anticipated start date… the builder reserves the right, at the builders [sic] 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.

The Builder informed the Owners that due to delays with materials as well as increased costs of materials connected to the COVID-19 pandemic, that the contract price was to increase.

The key issue before the Court was whether the clause was void for uncertainty. The Court held that it was, finding that there was no "real constraint or reference criteria by which a price increase may be determined". In other words, the clause failed to set out objective criteria for determining price increases.

Therefore, a simple rise and fall clause may seek to adjust the contract price by the difference between the tendered amount and the amount actually paid by the contractor for certain materials. However, a principal may resist this, as it has chosen a fixed price contract rather than a reimbursable contract for a reason.  

A nuanced approach, likely to be more palatable to a principal, often contains a formula which is used to adjust the contract price. While the exact drafting varies between contracts, most formulae draw on the following common principles:

1. Affected items – the agreed components of the contract price which may be adjusted, whether specific trades or materials or otherwise;

2. Base and adjustment dates – the date on which costs are measured from, such as the "date of tender" or the "date of contract" and the date(s) when the adjustments are made such as when the materials are purchased; and

3. Index – price indices track how the value of specific materials or labour inputs changes over time, and rise and fall clauses use those movements, measured by agreed indices such as CPI, to adjust the contract price between two dates.

However, in return, a principal is likely to require cost transparency with detailed evidence of the contractor's costs on an open book basis. The principal may also require the contractor to bear the risk of fluctuations below an agreed threshold, so that the contractor may only claim an adjustment once prices change by more than a specified amount (for example, 5 per cent).

Additional cost volatility provisions

In the current climate, a contractor tendering for new work should consider including a rise and fall clause to mitigate cost escalation risk. However, this should only form part of a broader risk management approach in fixed price contracts alongside provisions addressing provisional sums, changes in law, force majeure events, extensions of time and delay costs. A more fundamental alternative may be to move away from a fixed price contract altogether and request that the principal considers a reimbursable pricing model.

If you have any questions or would like to know more, please contact our Construction and Infrastructure team.

‍