Inflation in Spain stands at 9.8% in March 2022, with core inflation (i.e. excluding unprocessed food and energy prices from the inflation calculation) at 3.4%. In this scenario in which the prices of goods and services have skyrocketed (aluminium has increased its price in one year by 62.5%) and, in view of the risk of supply shortages, many doubts have arisen as regards how to deal with this reality in works agreements in order to avoid disputes between the parties.

In this newsletter we propose different contractual alternatives to deal with the effects of the increase in the price of materials in works agreements:

1. Fixed-price works agreements

A first alternative would be to agree a fixed price for the works to be carried out by the contractor. In this case, the contractor will not be able to request a price increase if the cost of materials increases, except if the owner/developer approves a modification of the project that involves an increase in the works, as provided for in Article 1,593 of the Spanish Civil Code. It is for this reason that the exceptional revision of the prices due to the variation in the cost of the materials under this contractual modality has no place and it will be the contractor who will assume the risk of an increase of the prices.

The following aspects should be considered when choosing this approach:

(a) The fixed price agreed for the works will generally be higher than in those contracts signed a few months ago, since it will reflect (i) the price increase that the raw materials have undergone up to the relevant date and (ii), to a certain extent, the risk of future price increases.

(b) It is important to include a clear wording in the agreement's recitals reflecting the current situation of inflation and price increases in order to prevent that the contractor may allege the application of the rebus sic stantibus principle and, consequently, request an increase in the works agreement price due to an extraordinary and unforeseeable alteration of the circumstances under which the works agreement was signed.

(c) In these cases, it will be equally important to verify if the contractor, in an attempt to win the contract, has prepared a proposal that is too low or reckless and that, as a result of the increase in the cost of materials or other setbacks, it will not be able to comply with the mandate and the execution of the works will be probably suspended.

2. Escalation clauses

In the current context of inflation and strong increase in the cost of some raw materials, the parties could reach an agreement to include the so-called “escalation clauses”, which allow a revision of the price of the works agreement if an excessive increase in the price of one or more of the materials has an impact on the economic balance of the parties under the works agreement.

Thus, in the event of such an increase in the price of a given material, the contractor would be entitled to increase the contract price in the amount resulting from (i) applying a coefficient resulting from a polynomial formula that the parties may include in the works agreement or (ii) in accordance with the variation of a certain index selected by the parties.

It is advisable for this type of clause to agree on a minimum variation in the price of the specific material or materials (e.g. 5-6%) in order to be considered, for the purposes of the contract, as a "significant increase" in the price of the relevant material, which may entitle the contractor to request an increase in the contract price.

On the other hand, it is also advisable to establish a maximum percentage variation of the contract price under this system (e.g. 20%), which would be the maximum price to be paid by the owner/developer regardless of whether the cost of the relevant material/s has increased at a greater percentage.

The introduction of such clauses in works agreements will make it easier for contractors to offer a lower starting price compared to an agreement in which a fixed price has been agreed upon, as the contractor will not have to cover the risk of material price increases upfront.

Other aspects to be considered when drafting this price variation mechanism are the following:

(a) The clause could also be configured to include a reduction in the prices of the relevant materials. In this regard, the owner/developer would benefit from a hypothetical reduction in the cost of the materials, being entitled to request a downward price adjustment.

(b) It is advisable to limit the possible adjustment of the contract price to the increase in the cost of one or more specific materials, such as aluminium or steel.

(c) It would be advisable to attach as an annex to the works agreement a breakdown of the different materials to be used in the works, with an indication of their price at that time. Subsequently, the contractor should provide the owner/developer with an updated list of the materials´ prices on the date on which they were acquired, so that the positive or negative variation in the price of each material can be calculated.

(d) It is important to stipulate in the works agreement that the contractor shall not be entitled to request a price adjustment if it has not taken reasonable measures to avoid suffering this adverse effect from the increase in materials costs (for example, if the increase in the price of the relevant material occurs after the contractor should reasonably have purchased the materials). The contractor will also not be able to request any compensation for the materials that it had in stock and that it had acquired prior to the execution of the works agreement at a lower price than the price of the materials subject to the price adjustment at the time of the execution of the works agreement.

(e) The incorporation of other requirements for the application of the price adjustment could be considered, such as (i) that a minimum period of time has elapsed since the signing of the works agreement and/or (ii) that a minimum percentage of the project has been executed.

The aforementioned price escalation clauses are a solution very similar to the price adjustment system provided for in the public works agreements regulations recently amended by Royal Decree-Law 3/2022, of 1 March, which incorporates exceptional measures regarding price adjustments in public works agreements.

3. Open book contracts

Open book agreements are a type of works agreement in which the owner/developer and the contractor collaborate for the execution of the works. In these contracts, the contractor is responsible for the management of the entire project and agrees to share with the owner/developer its accounts and the costs to be incurred. The price of the works is calculated based on the real costs of the project, plus a margin or fixed fee for the contractor, which usually consists of a percentage of the final cost or a fixed amount.

Open book contracts often include mechanisms to incentivize the contractor to work efficiently, so that, for example, the contractor may receive a bonus or a penalty if the final cost of the project exceeds or falls below the estimated or target project cost set at the start of the works agreement.

See below the advantages of this type of works agreement:

(a) Possibility for the owner/developer to monitor the entire process and to be informed of the costs of the different items. Consequently, the owner/developer will assume the increase in the cost of the materials but will be able to control the relevant expenses.

(b) The owner/developer ensures that the price of the works is competitive and linked to the actual cost of the works. With respect to a fixed price works agreement, the developer/owner avoids having to pay additional amounts to the contractor to cover possible contingencies (which in some cases can be up to 10% of the construction budget) or having to pay a fixed price that is higher than the effective cost of the works.

(c) Reduction of the contractor's financial risk, as the works agreement guarantees the recovery of expenses attributable to the works and the obtaining of a reasonable profit.

In any case, the choice of one or another of the aforementioned systems or the inclusion of other similar mechanisms to face the exceptional situation that we are experiencing, will depend on multiple factors such as the following:

(i) The time period agreed for the execution of the works.

In a project with a short execution period (for example, a maximum of 12 months), it seems more difficult to expect significant variations in the price of materials. This circumstance will be more favorable in those contracts that will last longer. However, even in these cases, it could also be understood that occasional increases in the prices of some materials could be also offset at a later stage by a decrease in the price of the relevant materials without the need to apply any contractual correction.

(ii) Contractor's diligence, type of work and materials’ stock.

(iii) Contractor's margin for the execution of the contracted works. In the event that the contractor has enough margin for the execution of the works, it could be worth waiting until a possible decrease of the price of some of the materials to be used. However, this possibility should always be considered based on the works suspension clauses that are usually included in these agreements and that can entitle the owner/developer to request the termination of these contracts.

Finally, as an alternative solution to those mentioned in this newsletter, it is quite common to see how many developers are agreeing with their respective contractors to temporarily suspend the execution of their respective works agreements already in force for a few weeks with the expectation that there will be a readjustment of the prices of certain materials and that the situation of shortage of some of them will be solved.

For more information please contact our Real Estate Department: 

Miguel Ferre. Partner Real Estate

Jaime Gutiérrez. Associate Real Estate

Marta Santos. Senior Lawyer Real Estate