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Price escalation and impact to contractors

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This problem has mainly arisen due to lack of clarity and consistency regarding payment of ‘price escalation’ in the tender guidelines and the contract documents. Due to this reason the contractors are deprived of or face difficulties and delays in getting payments for unexpected price increases.

In many tenders the clause pertaining to ‘price escalation’ has been omitted altogether in violation of the national tender guidelines and the contractors who are carrying out the tender work are not able to claim any payment for the unexpected increase in construction materials;· In some of the tenders, there is provision for claims under ‘price escalation’. But the formula used for calculation of price escalation is not on par with the current market prices;· Yet for some tenders, claim of price escalation is possible only for selected building material and contractors are not allowed to claim payments for unusual price increases of the material that are not included in the list as eligible for price escalation claims. Some of the items that are not included in the list are air conditioners, lifts, water pumps, accessories, telecommunication equipment, networking and data communication equipment and CCTV cameras;·In addition, price escalation clauses are altogether omitted for contract work that can be completed within three months.

There have been unusual increases in prices of most of the construction materials in the world market from 2015 onwards. As a result of this and the steep depreciation of the Rupee value against Dollar, the cost of construction has gone up substantially against the cost at the time of awarding the tender. As a general practice, the relevant government institution awards the tender to the lowest responsive bidder. The construction tender process is very competitive and price plays an important role in awarding of the tenders. Due to insufficient construction workload, in order to generate enough cash flow to meet their monthly expenses, the contractors compete fiercely in quoting for the tenders.

Hence, at the time of quoting for the tender the construction companies are required to keep the price low and it is difficult for companies to foresee the future increases in material costs and labour wages, and include that in the tender price. They rely on ‘price escalation’ claims to accommodate the increase in cost. Therefore provision for claims of price variation is a fundamental requirement for a just and equitable contract.Clients’ unwillingness to pay claims for price increases based on the prevailing market prices can irreversibly damage the financial standing of the contractors that undertook the project and at times can even drive the company to liquidation.

Severe challenges

Contractors are facing severe challenges and immense hardship due to reluctance by clients to pay price variances claimed by the contractors based on actual market conditions.

As the companies keep the price low to get a tender, the tender is often awarded at a price below the cost estimate allocated for the tender. Hence the procuring entity is often able to have excess funds from the allocated budget by awarding the tender below the basic cost estimates. This fund can be used to pay for price variations. In addition, as per the tender guidelines, the procuring institutions are required to include a provision to address contingencies and allocate a percentage of the cost for the additional expenses incurred during contingencies.

Clause no. 4.3 of the ‘Government Procurement Guidelines’ under the caption Total Cost Estimate (TCE) states the following: 4.3.1 (a) TCE including all associated costs shall be prepared by the PE. (b) TCE should identify the cost of procurement preparedness activities and post contract awards separately. (c) For post contract award activities the TCE shall include the following contingency provisions:

(i) A maximum of five percent (5%) for procurement preparedness activities;

(ii) A maximum of ten percent (10%) for physical contingencies; and

(iii) A reasonable estimated amount for price contingencies.

As per the rule, the guidelines have to be followed by the government ministries. However, in practice many PEs deviate from this. In some instances they don’t allocate payments for contingencies altogether while at other instances, they don’t use either the correct indices or correct values of the input percentage of the materials while calculating the price variation.

As examples, we have given below two real case studies that illustrate the variances between the price escalation calculated according to the formula and the actual market prices. These projects which were carried out by one of our member companies, gives the interim payments (IPC) made by the client for five months during the course of the project. As illustrated below, the certified amount calculated from the escalation price formula is invariably lesser than the actual market prices at the time of calculating. We have used two different methods to calculate the losses from each project.

Case Study 1:

On an average, the certified prices with reference to this project have been only 69% of the actual prices resulting in the company incurring a loss of over 30%.

Case Study 2: The certified prices with reference to this project have been only 67% (as per the first method) of the actual prices resulting in the company incurring a loss of over 30%

Moreover, in most instances the construction work gets delayed due to reasons that are beyond the control of the contractor. Often the clients don’t allow contractors to claim price escalation when the project delivery period is extended. In addition, when a project is delayed, the cost of construction invariably goes up with time and as a result the asset value of the building will also appreciate with time. For example, if the value of the project at the time of awarding the tender is Rs. 10,000,000 and if the construction work is delayed due to unforeseen reasons and if the cost of construction increases by 20% during this period, the value of the project at the time of completion is likely to be around Rs. 12,000,000. Therefore, the procuring entity will get a new asset worth Rs. 12,000,000 by paying only Rs. 10,000,000. The procuring government institution benefits even if the project gets delayed, at the expense of the contractor who is required to bear the increased cost of construction without any compensation. We are concerned that this might lead to unjust enrichment for the construction client.

The issue with regard to ‘price escalation’ claims has been a longstanding and recurring problem,and construction industry chambers and associations have been consistently highlighting this issue to the Government authorities since 2004. Please find attached copies of the letters sent by us in the past. While we have not been able to reach a permanent solution to this matter, there were instances where Government officers understood the seriousness of the financial crises the contractors were facing and issued circulars to allow contractors to claim price escalation payments in certain circumstances.

For example, in 2006 when National Construction Association of Sri Lanka (NCASL) made representations to the National Procurement Agency (NPA) regarding the severe cash flow problems the contractors were facing due to depreciation of Rupee, the Director of NPA, via the Ministry of Finance & Planning, issued a circular ‘to amend the Public finance circular No. 352(14) to enable contractors to claim reimbursements on price escalations for work executed after Dec. 26th 2004 in the Tsunami affected districts even if such provisions are not included in the contracts’.

Payments for price escalations

There was another instance where a circular was issued to enable contractors to claim payments for price escalations for contract work for less than three months. The contract work of less than three months is generally undertaken by small and micro scale construction companies and this circular was specifically issued to protect the small and micro construction contractors from unfair financial losses.During the period from 1988 to 1990, many cabinet directives were issued to create an enabling environment for contractors. The cabinet paper no. 116 of Dec. 1988 is a good example.

As the above examples demonstrate there is provision to overcome regulatory barriers by issuing legitimate circulars to implement a consistent and fair policy regarding price escalation claims. If further needed, it can even be made into a legally valid document by obtaining cabinet approval. Therefore, the government should consider the enormous financial crisis faced by the construction companies due to price variations and issue a circular to all the Government institutions to include a consistent clause to accommodate price escalation on work contracts as per the market conditions.A sizeable number of contracts that were awarded in 2019 are yet to be completed by contractors due to many reasons such as frequent stoppages of construction work due to COVID lockdowns, payment delays by the clients for the work completed etc.

Labour wages and material costs have increased exponentially during the last three years resulting in the contractor incurring massive losses in executing these contracts. Hence, we propose that a circular be issued to allow the construction companies to claim reimbursements for price variation for all the contracts that were awarded after 2019.

The construction industry has been experiencing severe financial difficulties and hardship during the last six years. Long periods of payment delays for the work completed by them, lack of political stability the country had to undergo during 2015 – 2019, and Easter day bombings and the resultant economic downturn have contributed to the downturn of the construction industry.

Shortage of skilled labour

Furthermore, the outbreak of C-19 pandemic and complete closure of all the construction sites for almost three months during the first wave had created unprecedented economic difficulties for all the industries including the construction industry. Shortage of skilled labour has been a major deterrent to the efficient functioning of the construction industry even before the pandemic. The situation has gotten worse after the onslaught of the pandemic. There is lethargy and hesitancy among the workers who had returned to their villages during the lockdowns, to get back to major cities and towns. This has led to severe shortage of skilled labour in the construction industry.

Most of the construction companies have substantial monthly payment commitments to Banks for the funds they had borrowed from the Banks for leasing of building machinery and materials as well as for their operational expenses. They have been struggling to pay their monthly installments due to prolonged stoppage of work and delays in payment arising from the above reasons. The losses they have to incur due to unfair price escalation clauses adopted in the tenders have further confounded their difficulties. Settling of ODs, guarantees, loans and other facilities owing to the banks by the contractors were either delayed or defaulted.

As per the Annual Report 2019 by Central Bank, “Growth of credit to the Industry sector decelerated to 3.1 per cent, year-on-year, by end 2019….. Within the Industry sector, credit to the Construction subsector, which accounted for around 49 per cent of the total credit flows to the Industry sector, recorded a moderate growth of 5.6 per cent, year-on-year, by end 2019, compared to the growth of 14.1 per cent at end 2018.

Business survey

As per the business surveys conducted by Central Bank of Sri Lanka (CBSL), the long delay in payments for the government related projects which created severe financial constraints for construction firms was highlighted as a barrier for sustaining the growth momentum in the construction industry.(Annual Report 2019, Central Bank of Sri Lanka)”.

As given in the table below, the employment in the construction sector reduced to 693,000 in 2019 from 713,000 in 2018. Construction industry is the fourth largest employer in the private sector after agriculture, manufacturing, retail trade and repairs. Drop in employment in construction sector contribute to the overall unemployment in the country

It’s clear from the Central Bank’s Annual report in 2019 that the construction industry has been experiencing financial difficulties during the last few years. Apart from the prevailing economic conditions, a substantial portion of blame has to be attributed to the occurrence of delayed payments and not allocating payments for the price variations by the Government institutions that awarded the tenders.

The government officers at the procuring entities who deviated from the government procurement guidelines by introducing arbitrary changes and refusing to approve payments for price escalation have contributed substantially to the cash flow crises in the construction industry and thereby to the overall economy, with risk of state officials being liable for acting in infringement of prescribed guidelines.

The negligence on the part of officers from the procuring entities in deviating from the established guidelines severely affects the cash flow of the contracting company which leads the companies to borrow at high interest rates from financial institutions and laying off construction workers employed at their sites. While it is necessary for bureaucrats to be prudent in effecting payments, few officers and consultants deviate from guidelines to deny payments to contractors mistakenly believing that they are protecting the interests of the government by saving money.

However, on the contrary their actionharms the economic development of our country. By their action, they damage business confidence and the entrepreneurial ecosystem of the country. Deviation from the standard rules, regulations and guidelines by not using correct calculations by government officials amounts to violation of the Acts which is an offence. By doing so, they violate the rights of the practitioners in the construction industry and their entitlement for an equitable payment of price escalation as mandated in the Acts.

Fair mechanism for price escalation

Therefore, we propose to the government to issue a circular to include a just and fair mechanism for calculating reimbursements on price escalation.

A special committee needs to be appointed to formulate a mechanism to gather such claims in order to assess the total value of liabilities and find strategies to settle these payments. Furthermore, considering the immense financial difficulties faced by contractors who are yet to complete the projects that were awarded to them after 2018,relevant government institutions should be instructed to allow construction companies to claim payments for price variations for contracts that the contractors entered into after 2018.

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