Managing inflationary risk in construction

Managing inflationary risk in construction with PAFI and Forecasts of PAFI

Managing inflationary risk on contracts is one of the biggest priorities for our clients, not least over the last three years where soaring costs are making more parties consider inflation clauses. Here are some of our most frequently asked questions on the topic.

What are the typical costs for contracts that implement Price Adjustment Formulae Indices (PAFI)?

A recent survey of BCIS clients revealed that the cost of contracts on which the indices are used can vary dramatically – everything from £100,000 to £billions. However, the length of a contract is equally, if not more, important, as the longer the contract, the more difficult it is to predict the impact of inflation.  

In the highly inflationary period of the 1970s, when PAFI were introduced, inflation adjustment clauses were included in most contracts. In more stable times they tended only to be used on contracts over two years. However, the current high level of inflation has made the task of estimating future costs even harder, especially on materials prices, labour costs and plant rates and it’s become more common to see them included on shorter contracts. The use of index linked inflation adjustment clauses, such as PAFI, provides a simple and transparent method of calculating and reimbursing fluctuations in the underlying costs of a project. They allow contractors to price and manage a contract knowing that they don’t need to price in the risk of inflation.

How do you choose the right index and series?

PAFI indices track inflation from more than 200 construction resources and work categories, which are tailored to our industry. This allows the resources to be modelled to a specific project design that will cover the actual inputs to a project. The monthly PAFI index also allows adjustments to be applied in the month that the change in cost occurred, which provides results that most closely match costs as they happen.  

We would always recommend you use the latest series. If you are preparing a contract for the first time then we’d recommend you specify the latest series available, appropriate to the works. Link it back to rules 1 and 2 of our 6 golden rules of ‘be clear about what you’re trying to measure and how you’re trying to apply it.’ Then think about the index or group of indices that most closely match to that work. For example, on a refurbishment contract, you can include indices for the finishes, fittings and services included in the design.

Is it possible to use the same index for subcontractors that’s implemented in the main contract? 

The contractor will often apply the same inflation adjustment to their subcontracts, they should make sure that they use the indices that are relevant to the subcontract, rather than the mix of indices being applied to the main contract. 

Can general inflation indices be used in construction cost indices for inflation adjustment clauses? 

Any index can be used but it makes sense to use one that reflects the work in the contract. General inflation indices (retail prices (RPI) or consumer prices (CPI)) are the most widely available indices. However, construction projects will not inflate at the same level as the domestic consumables measured in the RPI or CPI – such as food, clothes or electronic items. While these measure general inflation, PAFI measures changes to specific construction resources or work categories.  

The differences between them can be quite dramatic, particularly with some of the more volatile materials – for example, steel, which increased 80% more than the CPI over a two-year period (from Feb 21-23). The use of general indices means that contractors are likely to inflate their rates to cover the risk, due to insufficient provision for inflation, which means that tendered rates could be higher.  

How has PAFI been implemented on construction projects?

Perhaps one of the most well-known projects where BCIS PAFI has been implemented is Crossrail.  

As part of the contract negotiation process, the project was broken down into different work categories, and all data and calculations were agreed between the parties and defined in the contract data. Each contract had a different mix and weightings of the indices modelled to the works that were to be delivered.  

The secondary X1 clauses in the New Engineering Contract (NEC) were applied to a number of stations, systems and civil engineering contracts.  The mix of work and contract duration of each were considered to represent the best opportunities for Crossrail Ltd to take on the cost risk associated with inflation.  

Your data suggests that labour is currently the biggest cost driver. What are your labour indices based on?

The labour indices for individual trades are based on:  

• Nationally agreed wage awards
• Overtime, based on an assumption on working hours derived from the ONS Annual Survey of Hours and Earnings (ASHE), which are reviewed annually
• Allowances for travelling, tools, etc. covered by the appropriate working rule agreement (the employment terms agreed between the unions and employers)
• Holiday pay covered by the working rule agreement (may also be influenced by statute)
• Pension contribution covered by the working rule agreement (may also be influenced by statute)
• Sick pay covered by the working rule agreement or statute
• National insurance
• The indices are applicable to the UK and relate to calendar months. The monthly indices are compiled so that changes will be included in the index for the month in which they occur, by weighting them according to the number of days to which the changes apply

Does BCIS have engineering indices?

BCIS has a whole section of specialist engineering indices related specifically to civil engineering contracts. This covers structural steelwork, electrical engineering (including cables), mechanical engineering, sprinklers and lifts and escalator.

Where can I find all the background information I need on an index?

Go to the index section of BCIS Online and select the index you’re interested in. Then go to either the results page or view page. To the right of the index title there’s a ‘?’ icon. Hover over that to find one or more links to the pages that contain all the details and definitions for the index. Or go to the top right-hand corner of the home page of the service where you’ll find a ‘?’ icon. Click on this to select documentation. Within that section you’ll find the different pages that contain definitions for all the indices.  

What were the reasons for developing your new product Forecasts of PAFI?

The past few years have been an exceptionally volatile period for the industry, with project managers less able to plan and budget with confidence, due to greater uncertainty in construction costs.  

Understandably, our clients (construction clients, contractors, consultants, funders, etc) are seeking tools that will help them budget and plan more effectively for the future, provide stability in turbulent times and increase their protection against insolvencies.  Forecasts of PAFI has been designed in response to this. The new product presents five-year forecasts of inflation for construction labour, materials and plant at a granular level, for over 150 of the indices.  Our forecast indices include individual work categories and materials, so that clients and contractors can select the most appropriate indices for their projects – for example, concrete piling or different kinds of cladding materials. Similar to PAFI, it is updated monthly.

What are the key differences between PAFI and our new product Forecasts of PAFI?

While PAFI doesn’t produce any forecasts, Forecasts of PAFI makes it possible for both the client and contractor to do cash flow projections that are adjusted in line with a forecast of inflation. Clients can assess the risk of inflation on a new project, selecting from indices that are more closely aligned with the project​, while contractors can assess the risk in their tenders. Forecasts are available for the full suite of current PAFI indices (please note – it does not cover the superseded series, although forecasts can be derived for these).

Can you use Forecasts of PAFI in a contract to price in the risk of inflation?

PAFI can be used with the standard inflation adjustment clauses in contracts. These provide a retrospective adjustment for inflation.  This can be significant on large projects lasting several years. These clauses can allow for changes in taxation, changes in escalation costs and increases in head office or admin costs. Forecasts of PAFI is not relevant to these clauses. 

There have been examples of bespoke clauses allowing for reimbursement where the actual price increase differs significantly from the forecast at date of tender. 

How are the new forecasts calculated?

The BCIS Forecasts of Price Adjustment Formulae Indices are calculated from the same approach as the PAFI indices themselves. Each work category is built up from a weighted combination of resource indices which might be Producer Price Indices (PPI) from ONS, special resource indices compiled by BCIS and special labour indices.  

For example, the labour indices are generally forecast by reviewing already promulgated wage awards and national insurance changes. Further awards are estimated by the BCIS forecasting group who will consider official and industry forecasts of the CPI and other key economic indicators and Average Weekly Earnings projections. Some labour resources are forecast from AWE where appropriate. 

In order to forecast the PAFI series, BCIS forecasts all of the individual resources that go into PAFI.

How reliable are the individual resource forecasts?

While the forecasts were first produced and published at the end of 2023, BCIS is committed to a continuous monitoring of their performance to test their reliability.

Apart from managing inflationary risk, what are the other main benefits of the new product?

While a bespoke forecasting model could take days per month to maintain, the forecasting product will significantly reduce this time. They’re designed to help everybody in construction better plan and control cash flow, no matter where they are in the supply chain, including design teams who can consider future costs in their design and specification choices. They can also help users monitor fixed price contracts in their portfolio to reduce the risk of financial surprises.