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52
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52 (147) 2022

Real estate and construction

Looking for new balance – impact of rising construction costs on construction contract negotiations

By Piotr Staniszewski, partner, Real Estate Poland, Dentons
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For the past 12 months, the Polish construction market witnessed significant increases in the cost of building materials and labour. The present situation is comparable only to 2010-2012, when projects connected with the Euro 2012 football championship and large-scale infrastructure projects cumulated, creating a pricing bubble. This increase came unexpectedly and is a result of overlap of multiple internal and external factors.

Costs increase, among others, due to rise in inflation, which is the highest in 20 years. The inflation rate, in turn, was caused by supply chain disruptions during the pandemic and unprecedented flow of funds resulting from government measures aimed at supporting and re-animating their economies. Another element contributing to construction cost increase are rising labour costs, resulting from labour shortages, aggravated by the closing of borders which interrupted the flow of migrant workers. And costs connected with climate change (including energy prices) also have an increasing impact on construction works costs. In January 2022 an 28% year-on-year increase in construction materials costs (compared to prices in January 2021) was reported.

Increasing costs of construction work gradually put pressure on re-shaping risk allocation under construction contracts. The Polish legal system does not include a statutory standard of construction-works contract, in any manner similar for instance to the German VOB. Instead, practically all contracts are subject to (sometimes quite extensive and time-consuming) negotiations between the investor and the contractor.

Until recently, the most wide-spread contract model was a fixed-price contract. The fixed-price contract provided for relative safety for the investor and the bank financing the investor with respect to project costs, which were in principle not subject to change or adjustment during the time for completion, save for variations. With the pricing remaining largely constant, it did not matter when exactly the works and materials will be contracted, so the designing and contracting process could run in parallel, during the time for completion of the works. To save time, the contractors were frequently entrusted with preparing the execution design. This was also justified by their better knowledge of the construction-materials market, available subcontractors and long-term relationships with subcontractors, which also stabilised the prices offered.

These circumstances changed. Now, with a 4% increase of prices between December 2021 and January 2022 reported, it becomes more and more important to contract the works and materials as soon as possible to avoid the pricing risk. Therefore, currently, securing pricing of materials and subcontractors requires very quick decisions from the contractors and, in turn, the investors. Frequently there is not enough time to take all necessary decisions during the pre-contract execution phase. This may be caused for instance by lack of complete and comprehensive execution designs and specifications, defining precisely what materials will be necessary to complete the works. Entrusting the contractor with execution design does not mitigate the pricing risk, as the execution design needs to be prepared and agreed with the investor before the works begin and the materials are contracted – and this takes precious time.

Therefore, if the parties to the construction contract are not in a position to take all decisions necessary to contract the works and order the materials before the contact execution, important arguments arise to alter the fixed-price model into one of more flexible alternatives.   

Two frequently contemplated alternatives to fixed price model are: GMP (guaranteed maximum price) and open-book contracts. Both options in principle involve the investor and the contractor jointly in the subcontractor selection process. This selection process should ensure transparency and grant the investor an opportunity to select the best available (not necessarily the cheapest) offer. Both options, however, also imply, that the investor needs to be much more involved in the contracting process and can no longer simply rely on a fixed price agreed with the contractor in advance.

In the GMP model, the contractor offers to uphold a maximum price for the full scope of construction works and materials. However, particular scopes, defined in the GMP contract, are contracted separately in a competitive process and the contractor’s margin is added on top of the selected subcontractor offer. Ultimately, the final price for the works will be built up from the particular scopes contracted independently and should not exceed the agreed maximum price.

The open book contract operates a similar model as the GMP but does not include the ‘maximum price’ element.

Changes in the contracting model may have impact on financing of the investments. So far, the financing banks limited the risks connected with development loans by expecting construction contracts to be executed in the fixed-price model. If this model will turn out to be exceedingly difficult to achieve on the market, loan contracts may need to be adjusted. The banks could expect a lower loan-to-cost ratio to be observed, forcing the investor to fund more equity into the project. Additionally, cost-overrun guarantees from the investor may be expected, in addition to contingency amounts typically allocated in project budgets.

Even though provisions on construction contracts in the Polish Civil Code are very limited in scope, there is one statutory instrument which may be re-animated in the changing market circumstances. This is the payment guarantee, which if requested by the contractor needs to be delivered by the investor in form of a bank or insurance guarantee or surety within the designated deadline, not shorter than 45 days from delivery of the contractor’s request. If the investor fails to submit such guarantee, the contractor may terminate the contract and claim compensation from the investor, including the expected contractor’s profit. This instrument was not very widespread so far, but then, the costs of contract execution were more foreseeable. The investors should take this into account and be ready to respond to such requests, as this provision cannot be contractually excluded from application.

It will be very interesting to observe, whether the current construction price increase will lead to permanent change in the contracts, leading to evolution of pricing model from fixed price into more open and flexible remuneration schemes. The fixed-price scheme was a result of deep and long lasting mistrust between the investors and the contractors, but once both parties have a chance to test other solutions, and as a result are better equipped to deal with flexible models, maybe this re-balancing will become a more permanent (even if ultimately limited) feature of the market in Poland?  In the meantime, the market will require more involvement of cost consultants and contracting specialists to achieve as predictable outcome of the construction costs, as reasonably possible in constantly changing circumstances.

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