Top 5 tips for cost escalation clauses in construction contracts

Cost escalation clauses, interchangeably referred to as rise and fall clauses, have been a major topic of conversation in the construction space and appear to be a crucial answer to the uncertainty facing builders when it comes time to try to price jobs. It became increasingly common for projects that were initially profitable to eventually become unprofitable, primarily due to significant increases in variable costs like materials and labour from the time of pricing to project completion. Cost escalations clauses appear to be the solution to this problem as they allow you to claim for these increased costs. Over a series of articles, we have explained:

• what to do if a builder attempts to increase the price of a build contract (https://rcrlaw.com.au/builder-increases-prices-under-contract/);
• what a cost escalation clause is and the need for builders to have one in their contracts (https://rcrlaw.com.au/cost-escalation-clause-guide/); and
• the findings of the current leading judgement regarding cost escalation clauses in QLD (https://rcrlaw.com.au/builders-beware-major-changes-for-construction-contracts/).

Making sure that these clauses are drafted and implemented correctly and lawfully are the key in ensuring that your clause will be valid and that it protects your interests. Below we outline our top 5 tips to make sure that your clause is compliant and will have effect in your contracts. These tips are a combination of our experience regarding this area and the key conclusions reached in the judgement of Perera v Bold Properties (QLD) Pty Ltd [2023] QDC 99 (Perera).

TIP 1: MAKE SURE YOU UNDERSTAND WHAT A COST ESCALATION CLAUSE IS

Before you attempt to insert a cost escalation clause into your contract, it is important that you understand:

• what they are;
• how they differ from variations; and
• how they work.

Cost escalation clauses are a contractual mechanism that essentially allow a builder to pass on increased costs that they may have incurred onto the party that they were doing the construction work for. These clauses are not implied and must be expressly written into a contract. In the case of Industry Standard Contracts such as the QBCC Industry Standard Contracts, cost escalation clauses are usually included by inserting special conditions into the contract.

There is a notable difference between a cost escalation clause and a variation. Variations are for claiming an increase or deduction or in the contract price as a result of increases or decreases in a project's scope of work. In contrast, cost escalation clauses are for the claiming of increased costs even though the project's scope of work has not increased.

The specific way that your cost escalation clause would function and the manner in which any increased costs could be claimed would need to be done in accordance with the clause as it is drafted. Generally thought this would likely be done by the builder providing a cost escalation notice to the owner which would have the result of increasing the contract price sum. Any disputes regarding this process would generally follow the dispute resolution process as provided by the contract.

TIP 2: MAKE SURE YOUR COST ESCALATION CLAUSE IS NOT "UNCERTAIN"

A cost escalation clause will be void and unenforceable if it is "uncertain". In determining whether a contract or term of a contract is void for uncertainty, the three relevant principles are:

1. if the parties to a contract do not agree on a fundamental term there will be no contract at all;
2. there is no contract if its effect is that one party is left to choose whether or not it will perform it; and
3. there can be no concluded bargain if a vital matter has been left to the determination of one of the parties.

In Perera, the third principle was relevant in determining if the clause was uncertain, ultimately finding that the clause was uncertain as:

• the clause did not provide what any increase might be;
• the clause did not provide how the price increase would be calculated and;
• any price increase was solely within the builder's power and discretion.

TIP 3: MAKE SURE YOUR COST ESCALATION CLAUSE IS NOT "UNFAIR"

A contractual clause must not be "unfair". The clause being unfair refers to s23(1) of the Australian Consumer Law (ACL) that a term of a consumer contract or small business contract is void if (a) the term is unfair; and (b) the contract is a standard form contract. Per s24(1) of the ACL, a term is unfair if:

• it would cause a significant imbalance in the parties' rights and obligations; and
• it is not reasonably necessary in order to protect the legitimate interests of the party who would be advantaged by the term; and
• it would cause detriment to a party if it were to be applied or relied on.

In Perera, it was found that the cost escalation clause was unfair as:

• the clause was not transparent (primarily because the clause was not readily available as it was not placed on the first page of the contract schedule and it failed to identify how price increases were to be calculated);
• the clause resulted in a significant imbalance of power between the parties (primarily because the builder could arbitrarily adjust the contract by an arbitrary amount regardless of whose fault it is for the increased costs);
• there would be detriment to the home owner as a result of the builder relying upon the clause (primarily because the home owner would have to either repudiate the contract and face contractual damages as a result, or pay the higher price); and
• the clause was not shown as necessary to protect the builder's interest (primarily because the clause allowed the builder to rely on a delay (including their own) to claim increased costs).

TIP 4: MAKE SURE YOUR CONTRACT HAS A SUFFICIENT "WARNING"

Schedule 1B, section 14(6)(a) of the Queensland Building and Construction Commission Act 1991 (QLD) (QBCC Act), provides that if the contract price may be changed under a provision of the contract, the contract must contain a warning to that effect. This warning must be in a prominent position on the first page of the contract schedule. An attempt to use a special condition to amend the warning, to the effect that the warning paragraph should be amended to include the Special Conditions and Tender Conditions, is ineffective. The "warning" that is required is that the contract price may change. An example of a sufficient warning was provided in Perera:

"The contract price is subject to change, either increasing or decreasing."

TIP 5: MAKE SURE YOUR CONTRACT HAS A SUFFICIENT "EXPLANATION"

The "brief explanation of the effect of the provision" is a separate and additional requirement to that warning."

Schedule 1B, section 14(6)(a) QBCC Act provides that if the contract price may be changed under a provision of the contract, the contract must contain a brief explanation of the effect of the provision allowing change to the contract price. This explanation must be in a prominent position on the first page of the contract schedule.

The originally worded warning and explanation contained in Perera is included below:

"WARNING

The contract price is subject to change. The clauses that allow for changes to the contract price are clauses 9, 10, 11, 13, 15, 16, 19, 20, 21 and 23."

An explanation along the lines that the relevant clauses allow for "changes to the contract price" fails to describe properly the effect of those clauses, it does not warn a consumer that the price may be increased, nor does it explain how each clause may lead to a change in the contract price.

An example of a sufficient warning and explanation was provided in Perera:

The contract price is subject to change, either increasing or decreasing. The clauses that allow for changes and their effect are the following:

Clause 20: where a written variation is made to the works or to the manner of carrying out the works (see definition of "variation" in clause 38.1) the contract price may increase or decrease.

Special condition 7: if commencement begins after the anticipated start date, the builder may increase the base price component of the contract price to the builder's then current base price for the same house type and increase the contract price by the same amount.

TAKEAWAY

Navigating the complexities of cost escalation clauses in construction contracts requires careful attention to detail and a comprehensive understanding of legal requirements. As highlighted throughout our series of articles, these clauses serve as crucial mechanisms for addressing the inherent uncertainty surrounding project pricing, particularly in the face of fluctuating material and labour costs. Our top 5 tips, informed by both our experience and the insights gleaned from the Perera judgment, offer actionable guidance for builders to ensure the effectiveness and compliance of their cost escalation clauses.

Through engaging Rostron Carlyle Rojas Lawyer's service to meticulously draft and implement these provisions, you can mitigate financial risks and protect your interests. We can help you master the nuances of cost escalation clauses, empowering you to navigate market volatility with confidence, preserving profitability and enhancing the overall success of your construction projects.