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As costs rise, is your project agreement in for a surprise?

It’s hard to ignore the current cost of living crisis impacting the UK. Inflation is now at a record high of 9.1% and average gas and electricity prices rose by 53.5% and 95.5% respectively in April this year [1].

Rising costs are likely to be a key issue for long term contracts, including PPP and PFI contracts, where prices and the ability to increase them may have been fixed at the outset. The current economic climate will also mean increased scrutiny on costs. Our specialists Lynsey Oakdene, Kathryn Vickers and Rebecca Riding examine some of the key contractual issues relevant for both public sector bodies and private contractors.

Light bulb on an electricity bill

Who bears the risk of price increases?

Who bears the contractual risk will depend on what you have agreed in your project agreement.

While project agreements often follow a similar structure and contain broadly comparable provisions, each will need to be assessed on an individual basis. Understanding the contractual position allows you to consider your options against the background of rising costs. Project agreements, along with any applicable contract changes and/or variations, may need to be located first so that a thorough review can take place.

Cost and price review mechanisms

The starting position for most long term contracts is likely to be that the price payable for the service is fixed, or at least that parts of it are. The risk of increases in the cost of providing the service therefore often sits primarily with the contractor. However, this is likely to be subject to some caveats:

  • Price Indexing

Prices are often increased to reflect increases in the Retail Prices Index (RPI) but (i) this may not completely cover overall cost increases where some of the costs of the service (such as electricity and fuel) have increased by more than RPI and (ii) it only happens once a year and is effectively a year behind so won’t fully relieve the burden on a contractor’s cash flow.

  • Market testing and benchmarking

Where costs are not fixed at the contractor’s sole risk and are wholly or partially at the public body’s risk, market testing and benchmarking of prices may be provided for. These processes are often seen as a way of ensuring the public body pays a market rate, but they are in fact important for both parties as they can allow a contractor to recoup increased costs. Following the process in a timely way is essential to ensure that (i) the increased price is paid as early as possible to ease a contractor’s cashflow and (ii) the market prices are as up to date as possible to ‘future proof’ the price as far as possible.

Where the market is a particularly difficult or narrow one it can be challenging for contractors to comply with the agreement’s requirements. In our experience, the contractor and the public body can be proactive in these circumstances but will need to be mindful of the need to be open and transparent and make sure that the review exercise is robust and achieves best value.

  • Gainshare/painshare mechanisms

These risk sharing mechanisms allow the parties to share in the pain or gain of any change in the cost of providing the service from the base level assumed at the outset of the project. They may not necessarily be labelled as a gainshare or painshare so the parties should check for any risk sharing mechanisms, whether the relevant cost properly sits within one of them and what the correct base level should be.

Other risks arising from increased costs

Even where a cost sits with the other contracting party, it’s worthwhile considering the bigger picture and whether rising costs pose any other risks for the contracting parties.

  • Performance

If a contractor is not able to recover its costs through the agreed price, it may impact on performance e.g. through the use of cheaper and lower quality materials or through a lower standard of performance. The parties should consider whether this is permitted under the project agreement. If so then the public body may want to consider whether it’s willing to accept this lower standard of performance or whether it wants to change the agreement to require the original standard [2]. If it’s not allowed, then the parties should consider what the financial consequences are e.g. performance deductions.

  • Insolvency

Inevitably, the lack of an adequate price review mechanism which properly reflects rising costs will have a financial impact on a contractor. The impact will be compounded if a contractor has many similar contracts which it is significantly out of pocket on. This could lead to solvency issues for a contractor and potentially a need for the funder or authority to exercise step-in or termination rights.

  • Strike Action

Many employees and workers in the public services sector (and indeed other sectors such as transport, manufacturing and food production) have taken part in industrial action in recent months. Further strikes around the UK are unfortunately inevitable.

Depending on the scale of the action, a strike may impact the contractor’s ability to perform the contract. This might mean that payment is not due in respect of any services not provided, e.g. where charges are calculated on the basis of the volume of services actually provided. Alternatively, it may entitle the public body to make performance deductions. The project agreement should be checked carefully for this, including any notice requirements which must be strictly complied with.

Force majeure, excusing cause and/or relief event provisions could also apply. Strike action is commonly included in at least one of these clauses but the extent of any relief and the procedural requirements will vary.

Public bodies and contractors should also think about how the services could be continued during the period of the strike and whether there are any mitigating actions which could be taken by either party and/or lawfully insisted upon by the authority. Our previous briefings on force majeure and industrial action may be of interest.

How we can help

Our specialists can help you better understand your contractual position and what rights you might have to avoid or reduce the impact of rising costs on your project. Advice at an early stage can help to make sure that any such rights are exercised properly and promptly and are not lost.

Even where the position on a particular cost is unclear in your project agreement or does not appear to be in your favour, we can often help with a broader review of the position. We can advise on how best to approach the topic of exceptional costs rises with your contracting partner. Once informed on the position under the project agreement, it may well be better to work out solutions to these issues and head off any disputes.

Please contact Lynsey, Kathryn or Rebecca if you have any queries or need advice or assistance.

 

[1] What is the UK inflation rate and why is the cost of living rising? – BBC News

[2] Watch out for details of our webinar on varying contracts in the public sector coming up in October 2022

Lynsey
Oakdene

Director

Dispute Resolution

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Kathryn
Vickers

Senior Associate

Dispute Resolution

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+44 (0)113 283 4093

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Rebecca
Riding

Associate

Dispute Resolution

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0113 283 2659

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