The prevailing approach to construction contracting used to be relatively straightforward: developers wanted price certainty, and contractors provided it by agreeing to deliver for a fixed price.
A decade ago, most construction contracts we prepared were fixed-price. These required contractors to accept the majority of construction risk with limited contractual relief in the event things went wrong.
Increasingly, construction contracts now incorporate cost-plus, escalation or target-cost mechanisms, whether limited to specific commodities or addressing broader risks such as unknown site conditions that cannot reasonably be quantified at tender.
This shift reflects a recognition that some risks are inherently difficult, or impossible, to price accurately when a contract is entered into, not simply a response to rising costs.
This is part of our construction series Breaking Ground.
Historical context
The traditional fixed-price model offers obvious attractions for developers: by providing budget certainty, it simplifies financing, feasibility assessments and investment decisions. However, price certainty does not eliminate the underlying project risks, it merely shifts them into the contingency cost priced into the tender by the contractor, who must allow for events that may occur but for which no additional payment is available.
However, contingency pricing is inherently imprecise. Where the risk is well understood, a contractor may be able to make a reasonably informed allowance. But where the risk is genuinely uncertain, such as the future price of a commodity, the extent of latent ground conditions, or the timing of a third-party approval, the contractor is pricing something it cannot reliably quantify. If the contractor prices conservatively, the developer may pay a significant premium for an event that never occurs. If the contractor prices aggressively, or makes inadequate allowance, the contract may be entered into at a price that proves unsustainable, with consequences extending well beyond the contractor’s contingency.
Drivers for change
A number of events over the past several years have exposed the limitations of traditional fixed-price contracting.
The COVID-19 pandemic was a significant catalyst, disrupting global supply chains, constraining manufacturing capacity and causing unprecedented price and availability fluctuations for materials that had historically been relatively predictable.
These pressures have persisted beyond the pandemic. Construction projects remain exposed to commodities and manufactured products (steel, concrete inputs, fuel, timber, electrical equipment and mechanical plant), any of which may be subject to substantial price movements between tender and procurement. Geopolitical events compound these challenges: the conflict in the Middle East has affected shipping routes, freight costs, fuel prices and the availability of particular materials. More broadly, construction projects are increasingly connected to global supply chains, meaning events occurring thousands of kilometres away can materially affect the cost and timing of a local project. For many contractors, the issue is not simply that costs have increased, but that the historical assumptions underpinning the tender price are no longer reliable.
Construction projects are also becoming more complex, often involving multiple interfaces, sophisticated technology, constrained sites, multiple interconnected and complex approvals and significant third-party dependencies. The greater the number of unknowns at the time of tender, the harder it becomes to accurately price a fixed lump sum, particularly where construction commences before sufficient information is available to properly understand the project.
Implications of inaccurate pricing
There is nothing inherently wrong with allocating risk to a contractor. The problem arises where a contractor is allocated a risk that it cannot realistically assess, control or mitigate. Attempting to transfer every conceivable risk to the contractor does not necessarily protect the developer, it may simply result in that risk being priced into the contract, inadequately priced, or becoming the subject of a dispute.
Contractor insolvency
Where a contractor has materially underpriced a project, its ability to absorb cost overruns may be limited. A contractor operating on a relatively modest margin may not be able to withstand significant unforeseen costs, which in extreme cases can contribute to insolvency. That creates a much larger problem for the developer, as the cost and delay associated with replacing the contractor, completing incomplete works and dealing with subcontractors and suppliers almost invariably substantially exceed the value of the original pricing risk. Whilst it is possible to build a number of insolvency protections into contractual frameworks, many of the challenges associated with resetting and restructuring a project in this scenario cannot be avoided.
Projects being halted or delayed
Even short of insolvency, where the parties cannot agree on how unforeseen costs should be dealt with, projects can become commercially unviable. A contractor may have little incentive to continue performing work on which it is losing substantial amounts of money, while a developer may be unwilling or unable to fund costs it considers to be the contractor’s responsibility. The result can be claims, disputes, suspension of works and significant delay.
Government projects and public scrutiny
These issues can be particularly sensitive where the developer is a government entity, which is subject to audit and other disclosure requirements, in addition to the requirement to competitively tender all projects. A project that experiences significant cost overruns, delays or contractor insolvency can attract substantial public scrutiny. A contracting strategy designed to maximise apparent price certainty at the outset can ultimately result in greater cost and uncertainty for the public.
Solutions
Better project planning
There is no single contractual solution to construction pricing risk. The better approach is to identify risks early, understand which can be priced, and allocate each to the party best placed to manage it. The more information provided to contractors at tender, the greater the prospect of obtaining meaningful and competitive pricing.
Where site conditions are relevant to construction costs, appropriate investigations (geotechnical, contamination, services) should be undertaken before the contract is awarded. More broadly, developers should ensure all relevant project information is made available to tenderers, including existing reports, surveys, designs, approvals and information concerning third-party interests. A contractor cannot accurately price risks it has not been given the information to assess, and transparency reduces the prospect of pricing adjustments after contract award.
Third-party dependencies (access rights, easements, landowner consents, utility interfaces) are another common source of unexpected cost and delay. If left until after contract signing, the contractor may have priced on the assumption that consents will be obtained promptly, while the third party may subsequently seek compensation or impose conditions affecting the project. Where possible, these arrangements should be investigated and negotiated before the construction contract is entered into.
Escalation mechanisms
An escalation mechanism allows the contract price to be adjusted during the project to reflect actual changes in the cost of specified inputs, rather than requiring the contractor to price that risk into an upfront contingency. A well-designed mechanism can be tailored to specific materials or commodities, with agreed baseline prices or indices, measurement periods, adjustment thresholds, caps or collars, and evidentiary requirements. This provides considerably more transparency than an undisclosed contingency embedded in a lump sum, while giving both parties a defined process for managing price volatility.
Early Contractor Involvement (ECI)
We are increasingly seeing pre-construction phases built into almost every project, during which the parties work together to develop scope and further investigate project risks. This stage will involve collaboration, investigation, progression of pre-approval activities, value management and development of design culminating in an offer to deliver the work. The contractor may be paid for this phase, in other models the contractor is only paid if its offer is rejected.
PPPs are increasingly being delivered using a strategic or development partner-type phase during which design and approvals are progressed, and in some instances, financing and construction contractors are procured, culminating in the submission of an offer to deliver the work. We are also seeing this model used on large electricity infrastructure projects.
This structure solves the challenges identified above, namely compelling a contractor to price the delivery of work when it is at a knowledge disadvantage.
Incentivised Target Cost
Another approach is an incentivised target cost (ITC) model under which the parties establish a target cost rather than an absolute fixed price. The contractor is incentivised to deliver below the target, with savings shared according to an agreed formula. Equally, where costs exceed the target, the contractor may bear an agreed proportion of the overrun. The advantage is that the model acknowledges the parties may not be able to predict every project cost at the outset while still giving the contractor a financial incentive to control expenditure.
The principal trade-off is that an ITC does not provide the same level of absolute cost certainty as a fixed-price lump sum (the final cost may be higher or lower than the target). However, where absolute price certainty is required, an ITC mechanism can sit within a guaranteed maximum price structure, under which the developer’s exposure is capped while the incentive and cost-sharing arrangements continue to operate below the ceiling.
To work effectively, an ITC model requires robust contractual controls. The developer should have sufficient visibility of project expenditure, including regular cost reports, forecasts to complete, variance reporting and early warning mechanisms. An open-book approach should clearly establish what constitutes a reimbursable cost and provide access to underlying records and procurement documentation. Where the contractor has discretion to self-perform cost-plus work, controls are important, and the parties may agree requirements around competitive tendering, benchmarking or developer approval above specified thresholds. Finally, the developer should consider what rights it needs to direct procurement strategy, construction methodology or sequencing, with the contract clearly addressing how those directions operate and how their cost consequences are treated.
Conclusion
Fixed-price contracting is not going away, but it is no longer the only answer. The market is increasingly recognising that a more nuanced approach to risk allocation, one that matches the pricing mechanism to the nature of the risk, can produce better outcomes for all parties. Developers who engage early, share information openly and design fit-for-purpose contractual frameworks will be better placed to deliver projects on time and within realistic cost expectations.
