Inflation is an economic concept that refers to an increase in the price of goods and services in an economy. It typically is expressed as a percentage rate over a period of time. The rate of inflation varies depending on the state of the global economy and the macroeconomics of individual countries.

Simply put, as inflation increases the average price of goods and services rises, which in turn decreases purchasing power. The reverse is also true, as inflation decreases, spending power increases.  Increases in inflation can have a significant impact on the cost outcome of construction projects due to the global nature of the industries' supply chain.

This article is written by Maximilian Benz a quantum expert based in Singapore who has considerable experience in handling matters involving inflation. The article shall discuss inflation risks and the mitigation considerations.

Inflation Risk

There are several inflationary risks that developers/owners and contractors should take into consideration when procuring and tendering for projects. This article covers some of the key risks and discusses the measures that can be taken to manage these risks.

Cost Escalation

Cost escalation is commonly understood in the industry to mean an increase in the prices and affects materials, labour, and equipment. These are the essential ingredients for all construction projects and require careful consideration through all stages of a project to keep the project on budget. Potential ways to mitigate the impact of cost escalations are to enter long-term purchase agreements or lock vendors into framework agreements. However, this places pressure on the supply chain which could result in other detrimental consequences such as liquidation and bankruptcy. It is suggested that when developing the project budget, it is better to allow for a reasonable cost escalation contingency in line with market conditions which can be accessed if cost escalation becomes a driving factor to the successful delivery of the project. 

Contractual Disputes

A common issue that arises as a result of inflation is disputes this is especially apparent where contract forms to not allow for inflation and its impact on costs. One common one observed in the region is the increase in the cost of raw materials such as sand. If the contract in such instances does not permit the increase required to allow the project to proceed in a financially sound manner, then steps may need to be taken to re-negotiate contractual terms or to inject additional finances to cover these increases.

Delays

Inflator issues may lead to delays on a project. This is because suppliers and vendors may not be able to offer the same product they had at the beginning of a project at the same price. This can lead to the need to re-negotiate with suppliers and vendors and / or source alternative options which in turn can delay the project programme.

Financing

Inflation can affect the financing of construction projects. Lenders may become more cautious due to the uncertainty surrounding project costs and returns. Borrowing costs might increase, and financing terms may be less favourable, potentially putting pressure on project budgets.

Inflation can lead to demand-supply imbalances in the construction industry. Suppliers might struggle to provide the necessary materials and equipment, resulting in delays and higher costs. Skilled labour shortages could also occur if wage expectations don't align with inflation increases.

If inflation leads to excessive increases in the amount a developer or owner was considering for a project, this can raise questions around the feasibility of a project. This is because the project may become unprofitable or require additional financing which, as discussed above, may be difficult to source. From experience during recent times a number of developers have “shelved” projects this also has a tertiary implications for those working on said projects.

Similar to feasibility if a project is ongoing and there is a significant impact on the value of it due to inflation then the final product may not be something that was originally envisioned. If inflation continues post completion, the value of the project's outputs additionally may not align with the original envisioned financial forecasts. This may affect returns on investment.

In light of the above highlighted risks and from experience there are a number of steps that may be taken to mitigate the risks of inflation, these include:

Contracts that allow for adjustments for inflation can lead to a reduction in a contractor’s risk in pricing for labour, plant, machinery and materials. One notable example is the use of Contract Price Adjustments (“CPA”) in FIDIC contracts. This uses specific cost indices to adjust on a monthly basis the interim payments E.g. for steel, sand, labour etc. This however does present a risk in itself to the employer as they would need to financially allow for these adjustments ensuring adequate contingency is present.

All too often the cost schedule is used as a fixed document and drawn down as the project progresses. Adjusting this approach by having periodic cost reviews can mitigate the impact of inflation. This, from experience, can be a monthly review of large value items and how they are tracking with market data i.e. the cost of concrete, steel, cladding etc. This reduces potential surprises should items be needed in future and no consideration, or a lack thereof, has been made of them.

Hedging is the financial concept of locking in future prices to ensure price certainty. This however presents its own issues such as with the oil crash in the 2000’s when the oil price dramatically decreased and those hedging were forced, due to the contracts they entered, to purchase oil at a higher price that they had contracted to in the prior years. This led to the downfall of a number of businesses.

Accounting for potential inflation risks in a contract and its impact on the programme can be managed by ensuring contingencies by way of float are introduced into the programme from the onset. Economies are cyclical so reviewing this data in line with a projects programme may be an option in this regard.

Risk management strategies such as developing a risk register linked to items that present a potential exposure to higher inflation or other external factors i.e. the impact of war on the supply chain have a great benefit in managing projects. These however have to be regularly managed and checked to ensure parties involved are informed of potential risks as a project progresses.

Building contingency into a contract price by understanding the risks associated with specific items can reduce the impacts. From experience I have seen this drawn against risk registers allowing sums against high-risk items that may be drawn on should the risk materialise.

One mitigation method seen in recent times is the introduction of bespoke tools to address the considerable increases in inflation. A specific example would be the use of templates with cost indices introduced into them, these tracking monthly progress payments, taking the cost indices and applying them to specific areas of work to ensure an accurate calculation of inflation i.e. cost indices in relation to the inflation of concrete steel etc. This in turn produces a separate payment application that accounts solely for the impact of inflation on the project.

In summary, inflation can significantly impact construction projects by increasing costs, introducing uncertainty, causing delays, and affecting overall project viability. Careful planning, contract adjustments, and risk management are essential to navigate these challenges successfully, the earlier consideration is made the more likely it is to be mitigated.