The construction sector has been one of the industries hardest hit in the last few years.
The downtime and supply constraints associated with the pandemic, followed by similar disruptions brought about by the war in Ukraine, with material price increases that have been building up for years, crowned by rampant inflation have all had a disastrous effect on the sector.
Unsurprisingly, the sector is now facing a number of challenges such as declining profitability and shrinking margins.
Investments planned not so long ago may now be below the break-even point, with the completion of many ongoing projects being called into question. Contractors are therefore starting to seek ways to mitigate the overwhelming risks. One such method is for investors to assume some of the risk in terms of increased project costs, for example by applying contract indexation.
The consideration of whether to use contract indexation and how to do it was one of the hottest topics subject to public debate in 2022, and one which will certainly continue in 2023.
What exactly is indexation?
In simple terms, indexation is a modification of the agreed remuneration to make it as realistic as possible. The purpose of indexation is to bring the current value of the contractual remuneration closer to the level which the parties originally assumed when deciding to cooperate, if this value has changed over time.[1]
In practice, this usually means that the investor agrees to pay a surcharge on the originally agreed remuneration, so that the current contract value reflects the amount agreed with the contractor (months or even years) earlier.
As such, the contractor will not have to pay extra out of its own pocket, i.e. it will not suffer a loss on the purchase of materials, or will retain at least a minimum margin to protect itself from bankruptcy, etc. In return, the investor enables the project to be completed on the originally planned date.
Project completion – why is indexation needed?
Naturally, at this point, the question arises as to what will the investor actually get out of this? To answer briefly: first and foremost, a finished project.
Many people overlook this aspect, pointing out that since the parties to a construction contract agreed on a flat-rate remuneration, they should expect that, no matter what, the budget of the project should remain unchanged and the contractor should have taken into account all potential financial risks in any offer it makes.
However, as the market reality shows, this is not always possible.
A contract’s flat-rate remuneration is beneficial for the investor as long as unforeseen cost increases beyond the agreed budget do not start to overwhelm the contractor. If the additional costs go significantly beyond such flat-rate remuneration, the contractor’s losses may not be restricted to solely its potential profit, but its entire financial health may be disrupted.
In carrying out their projects, investors must bear in mind that the overriding aim of the investment process is to complete the project and to generate future income from an operating facility (especially in the case of industrial facilities). In this context, timely project completion is crucial to its successful implementation. Investors are therefore wise to take an individual approach to the indexation of concluded contracts based on the business objectives of the ongoing investment process.
Methods of contract indexation
When it comes to contract indexation, several methods can be distinguished:
- Indexation clause in the contract. If certain circumstances occur (price increase or decrease, inflation rate change, etc.), the remuneration indicated in the contract is automatically modified or can be modified at the request of one party.
- Annex to the contract. The parties may also agree on concluding an annex to the contract to modify the agreed remuneration.
- “Extraordinary change in circumstances” clause or demand for an increase in the flat-rate remuneration. As a last resort, especially in the absence of a consensus, the parties may apply statutory mechanisms allowing the court to change the remuneration amount in the contract, e.g. by virtue of an “extraordinary change in circumstances” clause (Article 3571 of the Civil Code[2]) or by requesting an increase in the flat-rate remuneration (Article 632(2) of the Civil Code).
The choice of the optimum method depends primarily on the specific factual situation and the possibility of reaching an agreement between the parties.
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[1] In the context of an insurance contract, cf. Supreme Court Judgment of 5.01.2011, III CSK 125/10.
[2] Civil Code Act of 23 April 1964 (uniform text: Journal of Laws 2022, item 1360, as amended).
