The construction sector is in for a rollercoaster ride, but organisations can take measures to mitigate inflation-related risks, write Adam Symonds and Steve Dobson.
Has inflation peaked or will it continue to rise? Are we heading towards recession?
Economic forecasting has rarely been more difficult than now. International political tensions are interacting with COVID-19’s ongoing global impacts on production and supply chain efficiency, soaring energy and fuel prices, worker shortages, rising social discontentment, and a worldwide spike in large-scale climate-related emergencies.
While news media are preoccupied by consumer price inflation – the cost of living crisis – prices are rising even faster in construction, bringing a cost of building crisis. The divergence started before 2020 but is accelerating.
Annual producer price inflation hit 24% in June 2022, with the price of metals, minerals and diesel fuel rising fastest of all. Russia’s invasion of Ukraine has cut supply of iron and steel from both countries. Russian and Belarussian timber exports are under sanctions. The energy price shock affects production of everything. And in April the UK construction sector and its value chain was banned from using tax-exempt red diesel, with the aim of discouraging vehicle use and thereby curbing carbon emissions.
Office for National Statistics data for Q1 2022 show earnings in construction growing at 5.7% compared to 4.2% for the economy as a whole. Workers are in short supply. There are twice as many unfilled job vacancies as the long-term average.
Starting to hurt
Input cost inflation is being reflected in tender price inflation, currently forecast at between 8% and 10% for 2022 – highest for civil engineering and in London/the south east.
Tender price inflation may be tempered by the rising cost of borrowing, which is already causing clients in both the public and private sectors to shelve or cancel projects. The Construction Products Association warns of weakening construction output: it has revised its growth forecast down from 4.3% to 2.8%.
In the optioneering phase, clients and their advisors may be able to find ways to build less and still meet their desired outcomes by changing the way they use existing assets, or by employing nature-based solutions instead of or alongside hard-engineered ones. Where projects are progressing, clients, contractors and suppliers alike should be asking:
- Has allowance for inflation been built into the price?
- Is there an adequate escalation clause in the contract?
- Are there sector-specific inflation risks?
- Has inflation been forecast accurately for future work?
- Can rising input costs be offset by making delivery more efficient, using digital solutions?
If these questions have not been addressed there will undoubtedly be suppliers who cannot afford to continue working at current rates. As they falter or fail, or while prices are renegotiated, delivery programmes will suffer.
Getting sector specific
Inflation varies across the construction sector. Bespoke indices are important for helping clients and their value chains in rail, water, electricity transmission or commercial buildings, for example, to assess their exposure to price-related risks.
Bespoke indices are built by analysing procurement data to produce an organisation or sector-specific ‘basket of goods’ bought. Every item in the basket is indexed to past and forecast cost data, enabling an inflation profile to be built. Alongside published indices, items in the basket can be priced using an organisation’s own cost data. This can help by shining a light on potential cost escalation risks, and enabling past procurement and cost management activities to be compared and benchmarked.
What's ahead for rail?
Mott MacDonald’s rail index provides a sector-specific snapshot of the industry’s price inflation challenges. Two years ago, at the end of 2020, rail industry costs were rising at 1%. Now the rail index is running at 11%. Inflation is forecast to fall to around 5% by late 2023 and fluctuate between 4% and 5% for the following three years – although inflation could be higher if the energy crunch continues far into 2023.
The compound effect is that a project priced at £100M in 2020 will cost nearly £140M by the end of 2025.
Office for Rail & Road data for January to March 2022 shows passenger numbers and revenues are 60% below pre-COVID levels. UK rail fares rose by 3.7% in March, just behind the retail price index (RPI). For the last three years the RPI has been higher than the rail index, which has in turn been higher than the consumer price index (CPI).
But our current rail index forecast suggests that rail industry inflation will be higher than both the RPI and CPI from now until at least 2026. This will compound the imbalance between revenue and the cost of construction.
Bespoke indices have an important role to play in keeping procurement competitive, when linked to contracts such as the NEC.
NEC contracts enable clients to choose option X1, ‘price adjustment for inflation’. X1 sets a ‘base date’, normally a couple of weeks before the tender submission date. It calculates a price adjustment factor based on the changing values of an index or a series of indices.
Clients can choose which index to link to – from the retail and consumer price indexes to the general civil engineering cost index or a bespoke index. An enlightened client might ask bidders to comment on the appropriateness of the proposed indices.
Transparent mechanisms for price adjustment allow inflation risk to be allocated and shared fairly between clients, contractors and suppliers. It helps help keep bidders engaged and enables them to price more keenly, without making large provisions to protect themselves from materials and labour cost spikes.
More for your money
Efficiencies realised using digital solutions should be viewed as part of the fightback against cost inflation. For example, our Moata digital platform supports solutions that enable substantial cost and time savings, and performance improvements, in planning, design, construction and operation.
Applications include design optimisation – determining whether needs can be met by adapting existing assets and so avoiding the need for new construction, configuring projects to simplify and minimise the extent of construction, and generatively producing the best solution within defined parameters. Carbon and cost are closely allied; reducing capital and operational carbon emissions using Moata Carbon Portal can deliver substantial cost savings.
Automation, employing artificial intelligence, is enabling the time taken to perform tasks to be reduced from weeks to hours, freeing skilled professionals to focus on other, higher value, activities. Sequencing, scheduling, training, rehearsal and visualisation solutions, plus design for manufacture and assembly, are accelerating construction, improving safety and quality, and reducing the risk of clashes, mistakes and rework.
And smart infrastructure – applying sensors, data collection and analysis, decision support and control systems to operational assets – is making it possible to fine tune their performance and extend their lifespan, improving whole life value for money.
In some situations, smart infrastructure solutions can reveal ways of achieving objectives with existing assets, by adjusting the way they are operated or by modifying or augmenting them.
Prepare for the worst
Forecasting is never certain. Efforts to control inflation may be effective and recession is not inevitable. But the wise will prepare for the worst and employ the solutions available to keep current projects going, and start new ones, to meet their current and future needs. Finding ways to combat inflation will pay, even if the worst doesn’t happen: costs controlled will convert to savings in the bank.
Adam Symonds is cost intelligence consultant, Mott MacDonald
Steve Dobson is cost intelligence lead, Mott MacDonald