Understanding Escalation Clauses in the Construction Industry (Should I include a Rise and Fall Clause in my Construction Contract in 2024?)

Escalation Clauses are once again (slowly) becoming a part of the Australian construction industry. This type of contractual protection is increasingly important as the Industry continues to face volatile markets, limited resources, increases in the cost of materials, and inflation.

Escalation clauses, also called Rise and Fall Clauses, are intended to safeguard against unexpected price fluctuations and inflation after a Construction Contract is signed. If used properly, they’re meant to keep Contractors from losing money as market conditions change during the term of the Project.

Escalation Clauses / Rise and Fall Clauses. Image of a city skyline with the word "price" superimposed. Blaze Business & Legal Logo.

Unfortunately, most of the Construction Contracts currently on foot in the Industry are fixed price contracts, without Escalation Clauses. This has caused many Contractors to struggle financially, and the regular insolvencies we are seeing across Australia show the challenges that fixed price contracts bring in the current market.

Key Takeaways

  • Escalation clauses are intended to act as safeguards in Construction Contracts against unexpected price fluctuations and inflation.
  • These clauses allow for adjustments to the Contract Sum by accounting for market variations in the cost of materials and other items (depending on the drafting of the clause).
  • They operate both when costs rise and when costs fall (hence the name, “Rise and Fall Clauses”).
  • It is more usual for prices to rise, however, which tends to favour the Contractor over the Principal in terms of risk allocation where an Escalation Clause is included in the Contract.
  • Escalation Clauses are intended to protect both parties from financial loss or gain, but may not work that way in practice.
  • If an Escalation Clause is included in a Contract, Principals need to make allowance in their Project budget (and internal approvals process) for price fluctuations, as the Contract Sum is not truly fixed with an Escalation Clause.
  • Unfortunately, most of the Construction Contracts in the Industry (excluding the larger Projects where Rise and Fall Clauses are more common) do not currently contain Escalation Clauses.
  • With the challenges in the Construction Industry of Australia at the moment, it’s time for Principals and Contractors to agree to include Escalation Clauses in their Construction Clauses as a matter of course.

Key Recommendation

Contractors and Subcontractors in the Construction Industry should try to negotiate to include an Escalation Clause in your new contracts. These clauses can help you recover the increased costs of materials (and potentially other items) over the term of the Contract.

Do you have a current Construction Contract where you’re struggling? I’d suggest that you ask the Principal to vary the Contract and insert an Escalation Clause. And don’t forget that you need to first adjust your prices to current industry standard prices as part of the variation process - Rise and Fall Clauses work off the Contract Sum benchmark, and if you haven’t had any increase in the Contract Sum for many years, that benchmark will be skewed (and an increase will still not get you where you need to be)!

In my view…

Given the large number of insolvencies in the Construction Industry within Australia over the last couple of years, and given the significant changes within the Industry as a result of COVID-19, material and labour shortages, and inflation, in my view it is appropriate for Rise and Fall Clauses to once again be included in most Construction Contracts as standard.

While Principals may prefer the certainty of a fixed price contract, I think the Industry as a whole needs to come together and deal with the challenges facing it, including the unforeseen struggles that Contractors are facing financially where they are locked into fixed price contracts entered into a couple of years ago.

Having said this, I think we can find a compromise between the interests of the Principal and the Contractor - for many of my clients, I recommend a fixed price contract with a Rise and Fall Clause to cover material cost changes and other narrowly-defined circumstances.

Understanding Escalation Clauses in the Australian Construction Industry

Escalation clauses, also known as Rise and Fall Clauses, are slowly making a comeback in the Australian construction industry. These contractual provisions are designed to protect against unexpected increases in construction costs and currency exchange rate fluctuations. Their primary aim is to distribute risks affecting project costs between parties, making them increasingly important in an industry facing volatile markets, limited resources, and inflation.

Definition and Purpose of Escalation Clauses

Escalation clauses can range from simple to complex, depending on the defined price adjustment mechanisms. These mechanisms take into account factors such as cost index, labour cost, material prices, and other variables that could contribute to increased expenses during the lifespan of a construction contract. Therefore, an escalation clause includes formulas for adjusting payment disbursements when a predetermined event occurs.

These clauses play a significant role in mitigating cost overruns under fixed-price contracts. They have gained popularity among contracting individuals in Australia as they provide certainty regarding cost exposures throughout the construction lifecycle.

Types of Escalation Clauses

Different forms of escalation provisions exist in the Australian construction sector. An escalation clause is a contractual arrangement that accounts for fluctuations in raw material prices, labour costs, and other expenses. Companies use several variations of escalation clauses to allocate risks between buyers and suppliers or contractors.

Different forms of escalation clauses will suit different projects based on their scope, duration, budget, and materials required. For instance, a flexible pricing index is suitable for a long-term project where the construction would extend beyond a year as it helps mitigate the risk of sharp fluctuations in input costs.

Advantages and Disadvantages of Including Escalation Clauses in Contracts

The inclusion of escalation clauses in contracts has its advantages and disadvantages.

Advantages include protection against inflation, certainty of pricing, and protection from unanticipated costs. 

Disadvantages include increased complexity, potential for misunderstandings, and limited control over prices. When deciding on the use of these clauses, it is important to consider certain factors like project complexity and length.

Historical Context

In Australia's construction industry, escalation clauses were widely used in the 1970s as a safeguard against inflation when constructing large buildings. Today, they remain popular but are often only included as a secondary option.

In the early 2000s, it was very common to include Escalation Clauses in Construction Contracts. But a few years later, they started to become used less frequently within Australia. And 10 years after that, they were rarely seen outside of the large infrastructure projects and PPPs.

The wheel turns, however, and we’re headed back to Escalation Clauses becoming more common.

And with the current economic climate and challenges in the construction industry, it's time for principals and contractors to agree to include escalation clauses in their construction contracts as a matter of course.

Implementing Escalation Clauses in Construction Contracts

Implementing escalation clauses in construction contracts allows for adjustments in contract prices depending on fluctuations in raw material costs, labour rates, and other market forces. These clauses act as a safety net for both contractors and clients, ensuring that any unforeseen circumstances outside their control do not impact the project's profitability or completion deadlines.

Incorporating Escalation Clauses Requires Advanced Planning of Contingencies

All possible cost factors should be identified beforehand to prevent disputes during the project. Other critical considerations while implementing escalation clauses include examining the type of contract involved, timelines, payment structure, or project complexity.

Best Practices and Industry Standards

Escalation clauses are becoming increasingly popular in contracts as protection against inflation. However, there are several industry standards that must be followed to ensure their effectiveness. One such standard is to make the clause specific and clear; ambiguous language can lead to disputes between parties. Including a cap on the increase amount and a timeframe for exercising the escalation clause is also critical.

Conclusion

Understanding how escalation clauses work and how they can be implemented effectively is essential for players in the construction industry. Construction companies can leverage these provisions to optimise their operations while safeguarding themselves from external factors beyond their control.

Frequently Asked Questions

  1. What is an escalation clause in a contract and how does it affect the Australian construction industry? An escalation clause in a contract allows for adjustments to be made to the agreed upon price based on changes to the cost of labour, materials, or other factors. This can have a significant impact on the construction industry as it allows for flexibility in pricing and can help protect contractors and subcontractors against unexpected cost increases.
  2. Are escalation clauses common in construction contracts in Australia? Escalation clauses are increasingly becoming a part of the Australian construction industry. They are intended to act as safeguards against unexpected price fluctuations and inflation, allowing for adjustments to the contract sum by accounting for market variations in the cost of materials and other items.
  3. Who benefits from an escalation clause in a construction contract? Both the contractor and the client can benefit from an escalation clause in a construction contract. It provides protection against unexpected increases in costs and can help ensure that the project stays on budget. However, it's more usual for prices to rise, which tends to favour the contractor over the principal in terms of risk allocation where an escalation clause is included in the contract.
  4. What are the potential drawbacks of an escalation clause in a construction contract? One potential drawback of an escalation clause is that it can make it difficult to accurately budget and plan for a project. It can also lead to disputes between parties if there are significant cost increases that are not accounted for in the contract. Furthermore, if an escalation clause is included in a contract, principals need to make allowance in their project budget for price fluctuations, as the contract sum is not truly fixed with an escalation clause.
  5. How are escalation clauses typically calculated in construction contracts? Escalation clauses are typically calculated based on a number of factors, including changes in the cost of labour, materials, transportation, and market conditions. The specific formula used may vary depending on the contract and the needs of the parties involved.
  6. Can escalation clauses be negotiated? Escalation clauses can be negotiated between the parties involved in a construction contract. It's important to carefully consider the terms of the clause and ensure that they are fair and reasonable for all parties involved. Contractors and subcontractors in the construction industry should try to negotiate to include an escalation clause in new contracts. These clauses can help recover the increased costs of materials (and potentially other items) over the term of the contract.

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About the Author

Rachelle Hare

Rachelle Hare

Rachelle Hare is a highly experienced Construction Lawyer and Contract Lawyer, with over 23 years of experience in Tier 1 and Tier 2 Construction Firms, Top Tier Private Practice and Government.

With 23+ years of experience as a Senior Lawyer, Strategic Contracting Adviser and Management Consultant in Construction Law, Contracts, Major Projects, Commercial Advisory, Compliance, Procurement, Contract Management and Risk Management, Rachelle has the rare skills to offer you seamless business advice and legal advice to help support your organisation.


As well as a Lawyer and Business Adviser, Rachelle has also acted as a Strategic Procurement Adviser, Compliance Manager, Strategic Risk Adviser and Commercial Manager.

Rachelle owns
Blaze Business & Legal, a combined Commercial Law Firm and Business Advisory Firm located in Brisbane, Queensland, Australia. Blaze Business & Legal assists a broad range of clients in the Construction Industry and related industries, and advises owners, contractors, subcontractors, NFPs and other organisations on a broad range of Construction Law, Commercial Law, Business Advisory and Management Consulting issues in Brisbane, Queensland and around Australia.

Rachelle also owns Blaze Professional Learning, where she offers practical contracting skills, hands-on experience in drafting and working with contracts, and industry insights to help Professionals upskill and advance their careers with real-world skills.

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