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Price escalation: Impact on contractors and economic development

a year ago

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PART I  Construction contractors face immense financial difficulties due to problems encountered by them in claiming payments for “price escalations”. This problem has mainly arisen due to lack of clarity and consistency regarding payments for “price escalations” in the tender guidelines and contract documents. Due to this, contractors are deprived of or face difficulties and delays in getting payments for unexpected price increases.
  • In many tenders, the clause pertaining to “price escalation” had been omitted altogether in violation of the national tender guidelines and the contractors who are carrying out the tender work are not able to claim any payment for the unexpected increase in construction materials
  • In some of the tenders, there is provision for claims under “price escalation”, but the formula used for calculation of price escalation is not on par with the current market prices
  • Yet, for some tenders, price escalation claims were possible only for selected building material and contractors were not allowed to claim payments for unusual price increases of materials that were not included in the list as eligible for price escalation claims. Some of the items that were not included in the list are air conditioners, lifts, water pumps, accessories, telecommunication equipment, networking and data communication equipment, and CCTV cameras
  • In addition, price escalation clauses were altogether omitted for contract work that can be completed within three months
There were unusual increases in prices of most of the construction materials in the world market from 2015 onwards. As a result of this and the steep depreciation of the rupee against the US dollar, the cost of construction rose substantially against the cost at the time of awarding the tender. Lacking workload and fierce competition As a general practice, the relevant government institution awards the tender to the lowest responsive bidder. The construction tender process is very competitive and price plays an important role in the awarding of the tenders. Due to insufficient construction workload, in order to generate enough cash flow to meet their monthly expenses, the contractors compete fiercely in quoting for the tenders. Hence, at the time of quoting for the tender, the construction companies are required to keep the price low, and it is difficult for companies to foresee the future increases in material costs and labour and include that in the tender price. They rely on “price escalation” claims to accommodate the increase in cost. Therefore, provision for claims of price variation is a fundamental requirement for a just and equitable contract. Clients’ unwillingness to pay claims for price increases based on the prevailing market prices can irreversibly damage the financial standing of the contractors that undertook the project and at times can even drive the company to liquidation. Contractors were facing severe challenges and immense hardship due to reluctance by clients to pay price variances claimed by the contractors based on actual market conditions. As the companies keep the price low to get a tender, the tender is often awarded at a price below the cost estimate allocated for the tender. Hence, the procuring entity is often able to have excess funds from the allocated budget by awarding the tender below the basic cost estimates. This fund can be used to pay for price variations. In addition, as per the tender guidelines, the procuring institutions are required to include a provision to address contingencies and allocate a percentage of the cost for the additional expenses incurred during contingencies. Clause 4.3 of the “Government Procurement Guidelines”, under the caption “Total Cost Estimate (TCE)”, states the following: 4.3.1 (a) TCE including all associated costs shall be prepared by the PE (b) TCE should identify cost of procurement preparedness activities and post contract awards separately (c)  For post-contract award activities, the TCE shall include the following contingency provisions:
  1. A maximum of 5% for procurement preparedness activities
  2. A maximum of 10% for physical contingencies
  3. A reasonable estimated amount for price contingencies
As per the rule, the guidelines have to be followed by the government ministries. However, in practice, many PEs deviate from this. In some instances, they don’t allocate payments for contingencies altogether while at other instances, they don’t use either the correct indices or correct values of the input percentage of the materials while calculating the price variation. As examples, we have given below two real case studies that illustrate the variances between the price escalation calculated according to the formula and the actual market prices. These projects which were carried out by one of our member companies, gives the interim payments (IPC) made by the client for five months during the course of the project. As illustrated below, the certified amounts calculated from the escalation price formula is invariably less than the actual market prices at the time of calculating. We have used two different methods to calculate the losses from each project. Case study 1 On average, the certified prices with reference to this project have been only 69% of the actual prices resulting in the company incurring a loss of over 30%. Case study 2 The certified prices with reference to this project have been only 67% (as per the first method) of the actual prices, resulting in the company incurring a loss of over 30%. Moreover, in most instances, the construction work gets delayed due to reasons that are beyond the control of the contractor. Often, the clients don’t allow contractors to claim price escalation when the project delivery period is extended. In addition, when a project is delayed, the cost of construction invariably goes up with time and as a result, the asset value of the building will also appreciate with time. For example, if the value of the project at the time of awarding the tender is Rs. 10,000,000 and if the construction work is delayed due to unforeseen reasons, and if the cost of construction increases by 20% during this period, the value of the project at the time of completion is likely to be around Rs. 12,000,000. Therefore, the procuring entity will get a new asset worth Rs. 12,000,000 by paying only Rs. 10,000,000. The procuring government institution benefits even if the project gets delayed, at the expense of the contractor who is required to bear the increased cost of construction without any compensation. We are concerned that this might lead to unjust enrichment for the construction client. Part II of this report will be published next week.  (This report was compiled by the Ceylon Institute of Builders)

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