Price Uncertainty in Fixed-Price Contracts

One of the most significant developments in Australia is how the construction industry is dealing with price uncertainty in fixed-price contracts arising from factors outside of either contracting parties’ control such as the current conflict in the Middle East.

Background

Historically, the fixed-price lump sum pricing model has dominated the Australian construction contract landscape, especially in the private sector. The pandemic presented the first major challenge to this model, resulting in a noticeable rebalancing of risk allocation in favour of contractors in the years that followed. While the “fixed-price” model has remained dominant at least in name, the number and nature of events that qualify for additional time and cost relief for contractors has significantly expanded.

The impact of the pandemic was most felt on-site, in the form of labour and activity restrictions. Similarly restrictive policies from Australia’s major trading partners such as China meant that any shortfall in production was initially softened by the reduction in productivity, though prices began to escalate markedly towards the end of the pandemic and thereafter.

In that period, and the years that followed, the Australian construction contracting market responded by expanding contractor entitlements under bespoke force majeure clauses, and mechanisms allowing for relief for unexpected legislative changes. Overwhelmingly, and perhaps explained by the “lockdowns” from the pandemic, this relief often took the form of time but not cost. That is, the contractor would receive an extension of time (and therefore be excused from liquidated damages for delay) for the relevant event but be required to bear its own costs either in full or to a capped amount; effectively, a risk-sharing regime.

Unlike civil jurisdictions, Australia, as a common law jurisdiction, generally lacks a statutory or judicial standard approach to what constitutes force majeure and how rights and obligations are affected by it. Accordingly, despite some often-recurring commonalities such as war, natural disasters and pandemic-related events, there remains no uniform definition of force majeure or guidance as to what happens when a described event arises. In Australia, the contract between the parties in question would be left to answer this, if the issue were even considered.

The present challenge

And so, Australian construction contracts remain generally ill-equipped (at least in their standard form) to handle the unique set of challenges presented by the recent global instability, centred on the activity in the Middle East from February 2026. Broadly, these challenges include pricing instability driven by:

• actual or anticipated fuel shortages;
• disruption to processing of raw materials such as ethylene dichloride (used in PVC) and copper;
• disruption to shipping routes and freight, heightened by tension in the Strait of Hormuz; and
• high demand caused by these actual or anticipated disruptions.

Principals and their financiers remain reluctant to accept a fixed increase to their contract prices to account for these risks. Firstly, as seen by the ongoing nature of the conflict, the end remains distant. And certainly, the hangover recovery is even more distant. Secondly, many contractors remain unwilling to price this risk in any case.

Accordingly, in the context of Australian construction contracts the relief sought by contractors to mitigate the effects of these challenges is variously referred to as “escalation” or “rise and fall”. Principally, this involves converting a contract sum in its entirety, or a discrete portion of that price referable to an item of the works (such as certain materials), from a “fixed” price to a floating price.

As seen during the pandemic, relief for the contractor for escalation and rise and fall will invariably turn on the terms of the construction contract in question. In the absence of drafting to allow for rise and fall, unanticipated rise or fall does not have the effect of frustrating the terms of a construction contract simply because it becomes commercially unpalatable or even fatal to one party (see British Movietonews Ltd v London and District Cinemas Ltd [1952] AC 166 at 185). Accordingly, there is risk to the contractor party in not addressing the question of escalation in the contract, even if the likelihood is remote. At the same time, any escalation mechanism needs to be adequately drafted to ensure that the clause (and therefore escalation entitlement) is enforceable. In Perera v Bold Properties (Qld) Pty Ltd [2023] QDC 99 [24 - 34] it was held that a clause allowing the contractor to “increase the contract price” to “the builder’s current base price for that house type” was void for uncertainty, finding that there was no “real constraint or reference criteria by which a price increase may be determined”. Although the ongoing conflict in the Middle East means that case law addressing escalation arising from the current situation is unlikely to be published for some time, these principles highlight that the risk needs to be contemplated, and the mechanism addressing this risk needs to be clearly drafted.

Standard-form contracts used on Australian construction projects, such as Australian Standards AS4000, AS4300 and AS4902, do not squarely facilitate escalation in their unamended form.

Parties and their advisers are therefore required to draft mechanisms for addressing these challenges.

• What are the commercially agreed parameters of the relief?
• How will this be verified?
• How does the entitlement translate into payment?
• What is the impact of capped entitlements and commercial viability of the project as a whole?

Commercial considerations

Unless a cost-plus contracting model is used, parties will generally not agree to a complete pass-through of price risk from the contractor to the principal. Often, this is driven by the principal’s project financing structure and terms. In most cases, parties will agree to deal with escalation risk by exception to an otherwise fixed-price contracting model.

In a domestic setting, further limitations on a total pass-through of price escalation may arise due to consumer protection policy and legislation such as the Domestic Building Contracts Act 1995 (Vic) (“DBC Act”), particularly for smaller-value projects such as volume-built homes. The DBC Act also raises further complications for larger contractors constructing residential dwellings, as this legislation may intervene to prevent, or render void, claims for escalation by such contractors notwithstanding the substantial size and value of the development (and associated risk).

Therefore, any recognition of price escalation in construction contracts is typically limited:

• to major projects; and
• by contractually agreed commercial parameters around when a claim can be made.

Fixed contingency

Accepting that a complete pass-through of escalation is unlikely, one approach to managing this risk is for the parties to agree to a fixed amount in the contract sum that is referable to escalation (contingency), allowing the contractor to claim for increased costs (usually, of supply) up to that agreed figure. Some baseline data needs to be included in the contract identifying the original pricing, against which escalation can be measured. From there, the principal will assume the risk of escalation up to the agreed figure. Once exhausted, the contractor assumes the risk of any escalation thereafter.

This approach offers relative certainty, particularly for principals. However, a broad-based application to all elements of a contract sum will mean that there is a higher likelihood that the contingency amount will be used. Further, the currency and accuracy of the baseline allowances in the contract will also be determinative, as there is often a live question on whether the contingency has been utilised for a valid reason and not simply due to the contractor’s own tardiness or miscalculation. Other issues such as when procurement occurs (and, therefore, at what price) are fertile grounds for dispute. Parties may adopt a different view as to whether or not an escalation event for a particular supply could have been mitigated by earlier or later orders, particularly for materials. Lastly, a wholesale pass-through of escalation, albeit capped at a contingency amount, is often not palatable for principal financiers.

For contractors, given the uncertainty surrounding the duration of the Middle East conflict, and its run-off effects, there remains a risk that the contingency included at the outset of the project is inadequate.

Escalation limited by works elements

A more common approach is to limit the escalation events to certain building elements (eg, PVC). In that setting, parties will often incorporate a mechanism permitting escalation to be claimed by a contractor in connection with those building elements only. Again, accurate and clear baseline data is critical to the success of any such clause in a construction contract.

By reducing the number of escalation events, sharper focus can be given to how the particular events are managed. For example, where the escalation events are confined to certain raw or primary materials, tethering the escalation entitlement to a publicly available (and credible) index becomes an option. The pitfalls of indexation are summarised further below. Outside of indexation, parties can otherwise agree to measuring escalation by taking prices from their local market and comparing these against the baseline. In that case, there is always a risk that the local market pricing will deviate from any “true” escalation caused by the conflict, given the more limited sample set.

Additional measures

Regardless of whether any permitted escalation attaches to the contract price as a whole, or specific works elements, parties are generally looking to take additional steps to share the risk associated with escalation.

Where indexation is used, it is common for parties to agree that one party (usually the contractor) will not be entitled to claim for escalation until the total escalation amount exceeds a defined contractually agreed threshold – usually expressed as a percentage. Whether or not this applies to both rise and fall is a matter that the parties will need to consider.

Less commonly, parties will look to identifying what, if any, contingency already exists in the contract price and agree that this contingency is to be used to absorb any escalation before the contractor’s right to make a claim is enlivened. Practical difficulties often arise with respect to drafting and administration of such a mechanism, given that it requires clear isolation of the contractor’s contingency from the outset as a separate item in the contract sum, instead of in-built contingency within each trade package. Furthermore, live questions arise as to the operation of this mechanism where, for example, the contractor’s contingency has been partially or fully eroded, and whether the cause of this, separate to any escalation, is something that the contractor would otherwise be entitled to relief for (for example, a variation).

Consistent with the fixed contingency method above, principals may explore limiting their exposure to escalation claims by capping the contractor’s entitlements under any such regime on an aggregate or per item basis.

Verification

A central issue in the administration of escalation claims under construction contracts is the verification of both the original allowances, as a baseline, and the legitimacy of the actual cost claimed by the contractor.

Without a clearly defined and drafted verification procedure, any escalation mechanism included in a construction contract becomes susceptible to maladministration or, in some cases, even fraud.

Firstly, the contract needs to clearly define what is subject to escalation, inclusive of the allowance for that particular item, covering the unit of measurement, rate, and documentation upon which that allowance is based. Often, that may require contractors to disaggregate works packages more than they may have previously been used to or comfortable with. For example, an escalation regime that allows for rise and fall for PVC would necessitate, as a minimum, isolation of those values for the PVC component of any trade package, such as plumbing. If this is not done, then there will be no clear baseline from which to determine whether or not the item subject to escalation has increased or decreased in price.

Secondly, the contract needs to clearly define how escalation is to be verified. Relying simply on the “actual cost” of the item versus the allowance is unlikely to achieve this and subjects the regime to the risks identified in the opening. Often, reference is made to public indexes such as those published by the Australian Bureau of Statistics. These can be useful but are not always perfect because the publishers of these indexes can change the composition or method of assessment, and the item in question may be “rolled up” into an index covering many different, but similar, kinds of materials. This may produce an indexed figure for escalation that is not aligned with the actual increase or decrease for that particular item, resulting in a windfall gain or loss to a party if there are no other controls in place.

If verification takes place through a “market test” of prices from similar providers of the item in question, then consideration may need to be given to any local economic factors that are skewing the price one way or the other, separate to the issue that the contract is trying to address – namely the price increases driven by the conflict in the Middle East.

Overall, while it is essential to incorporate a verification mechanism into the construction contract, increased complexity heightens the likelihood of administrative errors and miscalculations. Accordingly, to the extent possible, simplicity is to be preferred.

Payment issues

Another key faultline in this issue is incorporating the contractor’s entitlements into the payment regime. Most Australian construction contracts operate on the basis of progress payments. Invariably, payments other than the final payment are on account only, permitting adjustments to be made in subsequent claims. Claims generally arise on a monthly basis. In some jurisdictions, there is a statutory maximum on the due date for payment. For example, recent changes to the Building and Construction Industry (Security of Payment) Act 2002 (Vic) prohibit payment terms in excess of 20 business days from the date of the claim.

Consideration therefore needs to be given to aligning any commercially agreed approach, such as indexation, with the payment terms of the contract taking into account any statutory constraints. To highlight the issue, by way of example, some agreed indexes published by the ABS are on a quarterly basis. This means that contractors may incur escalation costs that would otherwise be claimable for some time before they can be independently verified pursuant to the contractually agreed regime.

The contract therefore needs to consider, up front, the question of whether or not the contractor is expected to carry any cost escalation for the periods in between available indexes or during the verification process. From a principal’s perspective, there would be a natural preference not to make payment until the verification process is performed. However, many contractors are reluctant to carry this risk as it results in potential cash flow issues, which, in some instances, may put the solvency of the contractor at risk.

As the conflict in the Middle East continues longer than initially expected, these risks become more pronounced.

Accordingly, there has been an increase in construction contracts that leverage the payment on account regime to allow the contractor to claim, again on account, escalation based on its actual costs for the qualifying item(s) at first instance. At the prescribed verification or indexation intervals, a reconciliation is then performed, resulting in the principal either making a further “top-up” payment or receiving a credit.

On the basis that the commercial arrangements generally limit or cap the contractor’s entitlements, the risk is higher that the principal will be receiving a credit than making a top-up payment if the contractor is initially paid the face value of its actual costs for the relevant item. This provokes an additional issue, namely for the principal (either directly or through its financier) to be adequately secured for any interim overpayments. Depending on the value and stage of the relevant works, the existing performance security provided by the contractor under the contract may be adequate. However, additional security directly referable to any overpayment or credit may need to be considered.

Effect of capped entitlements and commercial viability

In agreeing to any capped entitlement, parties will need to consider the practical implications if the contractor is compelled to carry the risk of escalation in excess of the capped amount. Here, the cost of insolvency, including appointing a new contractor and the associated price increase and delay, should be taken into account by principals. At the same time, there remains the real prospect that any escalation for which the principal is responsible to pay could have the effect of defeating the feasibility of the project as a whole. Depending on the nature, stage and value of the project, it may be an option to undertake a protracted suspension, or termination for convenience if such rights so exist and the principal has the capacity to pay the contractor its entitlements for these events. However, in most settings, this will be unavailable or unlikely, and highlights that the cost of escalation may in fact be a risk that neither party can afford to bear.

Conclusion

By nature, an escalation regime sitting within an otherwise fixed-price lump sum contract brings additional complexity to an otherwise simpler arrangement. The sudden onset of the economic settings, and speed with which they have had to be addressed in construction contracts means that the approaches to this issue vary substantially from project to project.

With the conflict ongoing at the time of writing, and its effects sure to last beyond its cessation, the need to manage escalation will continue to be a constant consideration for industry participants, rather than what may first have been anticipated as a “one-off”.

In doing so, a balance needs to be struck between introducing a functional mechanism with appropriate protections and ensuring that the escalation entitlement and payments can be administered with limited risk of maladministration. Disputes are best avoided if the mechanism aligns with the parties’ commercial objectives and is understood by the contract administrator. Otherwise, given the nature of such claims, there is substantial risk that errors or disputes can snowball with the passage of time, leading to costly disputes or litigation.