Cost plus fee contracts in the era of COVID-19

In brief

COVID-19 has changed the certainty of much of the economic spectrum. For construction contracts it has affected its most important variables: cost and time. In this context, cost plus fee contracts can be used as a way to prevent, mitigate and backstop distressed infrastructure projects, since they permit the parties to undertake projects that involve substantial uncertainties¹.

Cost plus fee (or cost reimbursement contracts) are those in which the client pays the contractor all the costs of construction – which include direct and overhead costs – plus a fixed fee. The contractor is assured of earning a fee and enjoying the income attributes of the fee, while the client is more likely to receive the lowest construction cost. In contrast to fixed-price construction contracts, the client avoids payment of the contingency risk premium but assumes the risk of an increase in construction cost².

In the current context of increased uncertainty in construction contracts, the performance of the contractor has been and is variable, which leads to an increase in the real cost of the works in the projects under construction. And in the current circumstances, when entering into new contracts, the real cost of the works cannot be exactly determined either, as it could increase due to new measures or protocols issued by local governments, resulting in greater financial pressure on the contractor in fixed-price contracts. In this scenario, a cost plus fee contract would allow a well-balanced allocation of risk.

COVID-19 has significantly affected the projects under construction with delays and disruptions to their schedules due to issues such as the decrease and loss of labor, equipment and material available to execute the works as planned. It is estimated that construction activity will have decreased by 10-25% in 2020 compared to 2019. This decrease will be generally due to:

• project delays as a result of national lockdowns or construction slowdowns that are generating a 20-60% activity loss;
• productivity losses of approximately 25-40% and cost increases of EUR300-350 per worker and per month from the implementation of new health and safety protocols; and
• supply chain disruptions as a consequence of border shutdowns and SMEs’ weak financial health.

As mentioned above, the main differentiator of the cost plus fee contract pricing method is that the client will bear the risk of an increase in the cost of construction over those anticipated at the time of the conclusion of the contract. To reduce this risk, the contract could establish a guaranteed maximum price that serves as a limit of the risk of increase in construction costs, so if the cost exceeds it, the contractor will absorb these costs, up to the amount of its construction fee. This modified version is known as cost plus fee contract with target price.

To incentivise the contractor to keep costs low in cost plus fee contracts with target price, the parties could agree:

• if the actual costs exceed the target price, that the contractor is only to be paid a percentage of that excess;
• to include a provision that establishes that the savings as compared with the target price will be split between the parties; and
• penalties and/or bonuses for budget or schedule performance.

Should fixed-price contracts be renegotiated to cost plus fee with target price?

This pricing method suits the current circumstances, and could be modified in private contracts with the agreement of the parties. In public construction contracts, however, this will be a longer and more complicated procedure, as a result of local regulations that apply to these types of contract. In those cases where there is no legislative framework for cost plus fee contracts, then modifying the pricing method will not be possible.

Recently, in Peru there have been renegotiations of the payment method of fixed-price private contracts to a cost plus fee model. This inevitably leads to the amendments of different provisions of the contract such as extensions of time, suspension of the works, variations, additional costs and force majeure. Changes were initiated by the contractors, who sought to perform under this cost plus fee with target price to recover the costs incurred of the contract and decrease their financial risks while allowing the client to have a cap for the cost of the works, and also share the benefits for savings related to the maximum price, in addition to the schedule incentive fees for the contractor in case of early completion of the works.

A widely used construction agreement of this kind is the NEC suite of contracts, which is based on a collaborative approach to contracting that has proven to deliver benefits for both parties. The Peruvian government recently announced that Lines 3 and 4 of the Subway of Lima and Callao will be contracted under Government-to-Government procurement, which aims to replicate the successful experience of the works for the Pan-American Games in 2019, where NEC models were used.

In the era of COVID-19, where uncertainty increases with each passing day and where in most if not all contracts there is variable performance by the contractors, the parties need a collaborative and non-adversarial model like cost plus fee with a target price. The open book nature of cost plus fee contracts provide transparency in the contract that will create mutual benefits in the contractual relationship while decreasing construction cost uncertainty and delivering infrastructure on time.

¹ Nash, R. C., Cibinic, J. C., & Cibinic, J. J. (2014). Cost-Reimbursement Contracting. Wolters Kluwer.
² Hoffman, Scott L., The Law and Business of International Project Finance (p. 171). Cambridge University Press. Kindle Edition.