Managing the risk of currency fluctuations in the international and domestic construction sector
This article first appeared in the April 2019 issue of Construction Law www.constructionlaw.uk.com and is reproduced with permission.
The completion of construction and engineering projects involve a number of uncertainties. One reason for this is that the work can take many years to complete. It is not always possible at the outset to predict how the specific environment – political, economic, regulatory and legal – in which the project is being delivered might change during this period. It can, however, be foreseen that there might be change and this creates risks to the parties.
Currency fluctuation is one such a risk that can have a dramatic impact on the viability of a project if not managed carefully.
Since the UK voted to leave the EU in 2016 Sterling has weakened and further currency fluctuations are likely if a disorderly Brexit occurs on 29 March 2019. Planning for risks of this type and ensuring appropriately drafted risk clauses are included in construction contracts is essential.
Currency fluctuation and construction and engineering projects
The effect of currency fluctuations are felt on construction projects in two principal ways: directly on the price payable for the works and indirectly in contractors' input costs.
In international construction contracts, it is not uncommon for the works to be valued in one currency and paid, at least in part, in another. Similarly, the currencies of these payments sometimes do not match the currencies of the contractors' input costs. Whenever any currency conversion is involved, these payments are vulnerable to changes in currency exchange rates and can create risk for a contractor.
For domestically funded UK projects, currency fluctuations can have a more indirect effect on the cost of a project. Contractors' input costs are made up of a number of items including those of material, equipment, labour, sub-contractors, insurances and bonds. The market price of these can increase during the course of a project due to inflation. Where the supply chain is dependent on the international market for resources, inflation of the market price is partly driven by changes to currency exchange rates.
Given the scale of many construction and engineering projects, the sums and the risks involved can be extremely significant.
Who bears the risk of currency fluctuation?
A central purpose of construction contracts is to allocate the risks between parties for events that occur after the contract has been signed. Currency fluctuations fall within these risks. The contracts seek to foresee the potential changes in circumstance and implement regimes that will govern the consequences if they arise.
The starting point is that the contractor will be entitled to payment for the works in the currency named in the contract. If a contractor agrees to complete the works for a price in one currency that is also payable in that currency, it is typical for the contractor to bear the risk of any fluctuations to currency exchange rates which may affect the contractor's costs. However, beyond this, it becomes less straightforward and dependent on the terms of the specific contract, including whether the currency of valuation is the same as the currency of payment, whether any exchange rate is fixed and whether there is any mechanism for the adjustment in prices. Ultimately, this is a commercial matter for negotiation and agreement between the parties.
JCT Fluctuation Options B and C allow for the contract price to be adjusted to reflect increases in the cost of labour and materials. NEC Option Clause X.1 allows for a price adjustment to reflect inflation but does not deal with currency fluctuations expressly. The 1st editions of the FIDIC Red and Yellow Books 1999 (Sub-Clauses 13.8 and 14.15) fix a currency exchange rate at the outset. The contractor then takes the risk of the increase in costs for items such as labour, equipment and materials for the first 12-18 months of the project and thereafter is entitled to an adjustment to the contract price in the event of fluctuations in the price of these items.
These clauses give the contractor entitlement to an adjustment of the contract price based on changes in cost. These clauses can also provide a degree of protection to contractors where a currency exchange rate is fixed, so long as the clauses are drafted and operated properly.
To determine the relevant adjustment to the contract price, it is usual for formulae to be included in the contract that are used to calculate the appropriate adjustment based on cost indices or reference prices. These cost indices or reference prices include, for example, dedicated construction cost indices, Harmonised Indices of Consumer Prices (HICP), Retail Prices Index (RPI) or an alternative measure of inflation recorded by an appropriate statistical institute.
Managing the risk of currency fluctuation
Risk management involves identifying the risks, quantifying them, mitigating them so far as is possible, appropriately allocating them to the various parties to the contract and then managing the consequences in the event that they occur. Of course, employers and contractors are powerless to control the currency exchange rates. However, they can take certain measures to manage and mitigate the risk.
When considering the allocation of risk of currency fluctuation in the contract, the most important time – and when there is the greatest possibility to make meaningful changes – is during tender negotiations. If the contract is to contain provisions to deal with the risk of currency fluctuation, the specific details of these provisions, such as payments in different currencies and price fluctuation formula, must reflect both the agreed risk allocation and the reality as to where the costs are likely to be incurred, with appropriate cost indices or reference prices chosen. Other mitigation measures, particularly on large projects to be implemented over several years, might include taking steps to insure against currency fluctuations, such as through hedging products.
Fluctuations in currency exchange rates – driven by external political and economic factors – has the potential to undermine the financial viability of a construction project. This risk will only increase in light of the current procurement trend towards larger, single-package contracts.
The UK construction industry relies heavily on imported goods and services with around 60% of building materials used on UK construction projects being imported from the EU. In an industry which traditionally operates on very tight margins, fluctuations in the strength of the pound following Brexit - as well as the potential for additional EU tariffs and UK taxes - could have a very significant impact on project affordability.
The risk of currency fluctuation faced by a contractor is amplified if the project (a) is long term i.e. more than 12 months; (b) is based in a country or to be paid in a currency that presents a high risk of fluctuations in currency exchange rates (which arguably currently includes the UK in the current political climate); (c) uses materials and/or labour and/or equipment obtained from a different country and/or is being paid for in a different currency; and (d) utilises third party financing and is to be repaid in a different currency to the Contract Price.
If any, or a combination of the above factors exist, it is important to ensure that the risk of currency fluctuations is properly and clearly addressed in the contract, for example, through a price fluctuations clause or bespoke currency fluctuation clauses.
For more information please contact the author of this article:
Senior Associate, London
T +44 (0)20 7264 8336