The impact of rising energy prices on the infrastructure sector

Out-Law Analysis | 20 Oct 2021 | 4:01 pm | 5 min. read

In summer 2021 it became apparent that due to the combination of disrupted imports due to the Covid-19 pandemic and Brexit, and increased activity as major global markets emerge from lockdown, there were shortages in construction products and raw materials including timber, steel, pitched roofing, plastics and cement.

Now a massive hike in energy prices in recent months, from China and India to Europe and the UK, has led to a double whammy of reductions in the production of major building materials such as steel, aluminium and cement and an increase in the cost of such materials available to contractors.

The surging prices result from a combination of the global economy’s recovery from the pandemic, a shortage of supplies and increasing efforts to reduce the use of fossil fuels.

Early indications suggest that this is likely to last for several months at least and will lead to the next phase of cost inflation in the construction sector. The problem in the UK could be exacerbated by fuel, labour and HGV driver shortages.

Next phase of cost inflation in construction

Higher energy prices for gas and coal will impact contractors delivering on fixed price contracts. On 1 October 2021, British Steel announced a £30 per tonne price hike, saying it could no longer absorb rising energy costs alone.

Steel is one of several energy-intensive industries which could suffer if energy prices remain high, along with others such as glass and cement production.

In early October 2021, head of strategic research and insight for consulting firm Arcadis, Simon Rawlinson, told an industry magazine the British Steel price hike was a sign of the “next phase” of the cost inflation crisis. He said it could lead to further inflation in the cost of domestically manufactured products such as bricks and blocks that have an energy-intensive production process.

Shortages of materials and staff are already being experienced, and the combination of lack of raw materials and price increases may lead to delayed decisions on contract awards.

Impact on long term contracts

Those working in the construction and infrastructure sectors should take action now to mitigate the potential impact of the energy price crisis on contracts. If contracts contain express clauses dealing with fluctuations and indexation clauses, they should be examined to determine if they cover situations associated with the current market price increases.

In many contracts these have been deleted. If these mechanisms exist in an agreement, it is important to ensure they are being properly administered.

Contractors should also consider existing or anticipated delays to projects, and work out who bears the risk. There must be a causal link between any time or costs claimed and the event relied on as the basis of the entitlement. Parties are generally required to mitigate any costs claimed as far as possible.

It is unlikely parties will be able to rely on force majeure clauses, as it is arguable that price rises are foreseeable – even though the percentage increase for some materials is significant.

Contractors believing they do have a valid claim for time or money will have to give notice of the claim and demonstrate actual delay or loss and expense.

On a more practical and commercial level it is vital to communicate early. Nobody in the supply chain benefits if a contractor or subcontractor goes bust as a result of no longer being able to manage costs on their contracts.

Employers and other stakeholders may wish to revisit the UK government guidance on responsible contractual behaviour in the performance of contracts impacted by the Covid-19 emergency (3 page / 111KB PDF) in light of the current issues being faced.

If employers take a hard stance and push down all risk relating to these energy, labour and material price increases to the supply chain, it could lead to parties terminating contracts because it could, unfortunately, be economically more advantageous to terminate than continuing with a loss making project. Therefore if all parties in the supply chain can have an early and honest conversation this could help to avoid such situations arising in the months to come.

Impact on contracts being tendered

There are several questions to be considered when it comes to projects currently being tendered:

  • does the contract include indexation and if so, what indices are being used? Is there an annual adjustment for payments, or are periods shorter?
  • does the tender process allow for indexation to be introduced or proposed mechanics to be changed to take account of specific items, or sudden price changes?
  • is there provision for supervening events such as market disruption in addition or as an alternative to price indexation?
  • is there opportunity to include provisional sums to take account of aspects of the work that will be hardest hit by fluctuations?
  • are main contract provisions consistent with supply chain arrangements?

There is good news for the UK infrastructure sector as the UK government has set out plans for a pipeline of projects worth over £650 billion in the next decade – although one effect of new opportunities coming to the market may be to exacerbate current constraints and create pricing headaches for procurers and tenderers, alike.

The National Infrastructure and Construction Pipeline includes £31bn worth of planned procurement of social and economic infrastructure to take place by the end of the 2021/22 financial year, and the government expects to procure around £200bn worth of work up to 2024/25, according to the pipeline.

The target to achieve net zero carbon emissions by 2050 also offers opportunities to contractors. When picking up new UK contracts, it will be important to negotiate clauses dealing with risks associated with delays, increased costs and future supply chain risk.

In this regard, procurers and tenderers should remember the (positive) direction of travel being set out in the government’s Construction Playbook.

It is in the industry’s best interest to negotiate viable contracts and avoid further impact of major insolvencies, such as the 2018 collapse of Carillion, which have a significant effect on the sector.

Parties should consider advance payment provisions, as the early placement of orders could lead to less delay. Fluctuation provisions could also be applied to specific materials.

Impact on decarbonisation plans

Decarbonisation and net zero are at the top of the current agenda as climate negotiators and governments prepare to gather in Glasgow for the 26th UN Climate Change Conference (COP26).

Fossil fuel supply has been falling for years due to lower investment in extraction. Part of this is down to efforts to reduce carbon emissions. However, if prices increase, investors and operators could have a change of heart about new oil; investor interest in oil and gas is already rising.

In order to ease the energy crisis, Russia and Qatar need to increase the supply of oil and gas, and China needs to secure its coal supply. This could be negative from a climate change perspective, suggesting a potential relaxation of emissions standards.

There could well be a push-back against green objectives and a stall in the transition to green energy, which relies on natural gas.

A focus on net-zero construction could avert future energy crises as well as provide alignment with government projects. Construction and infrastructure companies aligned with these goals may well find themselves best-placed to win future tenders, despite the energy price crisis.