Dealing with the impacts of global supply chain disruptions in construction contracts
In the wake of the global COVID-19 response, the construction sector is facing an unprecedented level of pressure in supply and demand for building materials both domestically and internationally, resulting in a sharp surge in costs and delays and disruption in construction and infrastructure projects.
In a matter of months, we have seen supply chain-related risks evolve from a minor peripheral issue (often capable of resolution through a simple cost-fluctuation clause) to a key risk consideration for parties entering into a construction contract. In this article, we provide an overview of some of the different ways that we are seeing principals and contractors address supply chain risks in their construction contracts.
Although supply chain risk is nothing new to the construction industry, the impacts of COVID-19, as well as the surge in demand for materials in the United States, China, and the European Union as their construction industries head back towards full capacity have exacerbated some of the key factors that have led to the current supply constraints. These constraints include shortages in raw materials and competition in manufacturing slots, low shipping container availability, congestion in ports and delayed port clearance and a restriction in the ability to move materials through domestic travel routes. This is with the backdrop of a continued surge in residential and non-residential construction (such as new builds for distribution and warehousing facilities) domestically and internationally, and rising geopolitical tensions affecting global trade. These factors have significantly impacted the ability of parties to source building materials, lock in prices for those materials, and import them for construction, all of which contributes to significant cost increases and delays.
Up until recent times, the starting point under construction contracts in New Zealand is that, under fixed price contracting models, contractors would generally bear the risk of any increase in the price of materials and labour during the term of the contract. Further, contractors would only be entitled to an extension of time for procurement delays if they arose from circumstances ‘not reasonably foreseeable by an experienced contractor at the time of tendering and not due to the fault of the contractor’. However, this position is now becoming increasingly challenging in the current global market context. We are seeing a shift in the market with contractors actively pushing back on the risk of supply chain-related costs and delays falling solely on them, and principals taking pragmatic steps to work with contractors to achieve ‘best-for-project’ outcomes to address supply chain related issues. Examples of steps that we are seeing parties take to achieve such ‘best-for-project’ outcomes are as follows.
Principals are identifying supply chain disruption as a key project risk and are taking active steps to address supply chain-related risks at the earliest opportunity. At the tendering stage, we are seeing principals include requirements in their tender documents for tenderers to identify any at-risk trades and outline cost mitigation strategies in their tender proposals. This allows parties to identify and find solutions for particular pinch-points that they are aware of, to put in place risk mitigation strategies in the event of supply chain-related cost increases or delays, and to discuss and expressly agree the contractual risk allocation arising from such events before entering into any contractual obligations.
We are seeing parties enter into early procurement agreements whereby contractors agree to undertake certain early procurement activities, such as sourcing and ordering materials, in advance of entering into a contract. Booking manufacturing slots for the supply of steel in advance of an award of a construction contract, for example, appears to now be the norm rather than an exception. In a market where price increases and material shortages are key risks, this has the double benefit of allowing the contractor to lock in the current pricing and gives both parties comfort that the required materials will be available for the project when required. Where applicable, such early procurement arrangements may be consolidated with arrangements for early works, such that the contractor also performs certain preparatory works on the site (such as demolition, foundations and piling) and plans their resources, ahead of the parties agreeing upon the final terms of the contract for the main works.
Advance payments for materials not yet on site
Previously an exception to the rule, we are seeing principals becoming more receptive to requests from contractors to make advance payments for materials which have not yet arrived on site. In fact, principals are front-footing this and are asking their contractors to identify, in their tenders, the level of advances they require.
Such advances are typically conditional. They are made subject to sufficient security being put in place, such as through advanced payment bonds; securities being registered over the materials in favour of the principal; and/or off-site materials agreement (such as in the form attached to Schedule 14 of NZS 3910:2013).
In the wake of rising prices for materials, contractors are generally unable (or unwilling) to risk price cost increases into fixed price contracts. Further, parties are finding that the standard cost fluctuation adjustment provisions in the NZS suite of construction contracts, which entitles contractors to an adjustment of the contract price in accordance with a prescribed formula (based on labour cost and producer price indices published by Statistics New Zealand), do not properly reflect the exponential price increases currently being seen in respect of building materials.
In response to this, we are seeing a trend in parties agreeing to bespoke arrangements for addressing cost increases under their construction contracts, that are more tailored to the specific risks for their project. For example, some principals are granting an adjustment to the contract price only to the extent that the contractor can demonstrate the actual cost increase on an open-book basis or limiting the cost adjustment to a certain time period or to the cost of materials only. This is often a more palatable position for principals as it gives them the certainty of paying the actual, demonstrable increase in the cost as opposed to relying on general, industry-wide indices to determine the amount of the increase.
Extension of time
As mentioned above, the extent of a contractor’s relief for supply chain-related delays in New Zealand construction contracts has traditionally been limited to an extension of time for ‘any circumstances not reasonably foreseeable by an experienced contractor at the time of tendering and not due to the fault of the contractor’. Many contractors successfully relied on this provision for an extension of time in the immediate aftermath of the first COVID-19 alert level restrictions. However, reliance on this clause is becoming increasingly difficult as the impacts of COVID-19 and supply chain disruptions are now widely known issues in the construction sector and it is becoming harder for contractors to argue that such impacts are ‘unforeseeable’.
In response to this, we are seeing some parties agree to new entitling events that specifically cover procurement-related delays which could not have been avoided or overcome by the contractor through reasonable planning and which are not specific to the contractor or its subcontractors (such as where it is an industry-wide delay). This provides the contractor with an express entitlement to an extension of time to complete the works where there are procurement-related delays.
Construction Sector Accord recommendations
The Construction Sector Accord recently published a guidance paper setting out their recommended approaches to COVID-19 construction risk management for public sector agencies. The paper recommends that parties develop ‘risk management plans’ that directly address how they will manage COVID-19 related issues on an ongoing basis, allocating each COVID-19 related risk to the party that is best equipped to control and manage such risk. The paper also sets out a number of suggested amendments to NZS 3910:2013 to more adequately provide for the active management of COVID-19 related risks (such as including COVID-19 related risks as grounds for a variation and an extension of time).
The Accord’s recommendations place an overarching emphasis on developing a ‘culture of good risk management’ where the parties give due consideration to the macro-environmental factors affecting the sector (such as industry-wide supply chain disruptions) when allocating COVID-19 related risks in construction contracts. These recommendations were issued with a focus on public sector agencies and, given the current procurement environment, it will be interesting to see the extent to which the underlying principles of the Accord’s recommendations are adopted by the private sector.
Among the numerous challenges that COVID-19 has posed to the construction sector, the disruptions it has caused to the domestic and global supply chain for building materials seems to be the most tangible and long-lasting. Unlike the narrow impacts of the immediate COVID-19 response that we saw last year, it is likely that the impacts of these supply chain disruptions are wider-ranging and will continue well into the foreseeable future. It is therefore critical for principals and contractors to actively turn their minds to how these risks can be managed and mitigated to achieve the best outcomes for their projects. We highlight a number of key points for parties to consider:
- Principals should think about strategies that they can implement in the early stages of the contracting relationship to address these supply chain-related risks – a lift and shift approach on this risk is unlikely to be accepted by the contractor market. This may include requesting tenderers to identify those specific trades that they consider are high-risk and include cost mitigation strategies in their tender proposals, or entering into early procurement arrangements with contractors to begin sourcing materials as soon as possible.
- Parties should think about ways that they can work together to mitigate the impact of any potential cost increases or delays to the project (to the extent possible). This may include principals providing advances for materials not yet on site (even if it means that it will be exposed to paying for materials earlier than intended), providing mechanisms for cost adjustments in prescribed circumstances, and/or providing extension of time for genuine procurement-related delays.
- Contractors should also consider their supply chain risk. Contractors will be asked, in their tendering activities or negotiations, how they intend to deal with this risk – a carefully considered strategy will place the contractor in good light with its principal.
 NZS 3910:2013 Conditions of contract for building and civil engineer construction, clause 10.3.1(f).
 Clause 12.8 and Appendix A.
 Clause 10.3.1(f).
This article was co-authored by Sean Kim, a solicitor in our Construction team.