CONSTRUCTION CONTRACTS IN INDIA

Generally, in the construction industry, the contractor works in an environment of risk and uncertainty caused by the economic factors such as fluctuations in the costs of materials, labour and equipment. Contractors and suppliers working in today’s volatile materials market find that estimating, bidding and financing the construction projects are challenges. Many face significant losses or erosion of anticipated profits because many of them are locked into fixed price construction contracts where contractors bear the risk of material price and supplier cost increases. Without the price escalation clause that allows for an adjustment to the contract price, if there is an unexpected rise in the market prices of key construction materials, a contractor will have no respite from such increases. It is necessary to have an escalation clause in the contract to guard against a sudden spurt in the cost of materials. To reduce this degree of risk, it is necessary for the contractor to include large contingencies in initial estimates of the contract when he tenders the contract. If the contingencies are overestimated, the probability of the contract being awarded to another contractor is increased. On the other hand, if the contractor does not allow for inflation and interest rate correctly, his initial tender would be too low and he would suffer significant losses (Keller et al., 1982). In high inflationary times, one solution to mitigate the

effect of cost escalation is the use of escalation clauses in the contract (Touran and Lopez 2006). Inflationary trends in economy, boom in construction activity, seasonal affects and cost of borrowing money have increased the inherent risk present in construction projects (William 1994, Keller 1982). This risk could be minimized by inclusion of a escalation clause in the construction contract (Blair 1993, Panchadhari 1992, Kalra 1983). Escalation clauses are used in the contract to avoid cost overrun by the contractor and reduce the contingency amount in the contractor’s bid.

OBJECTIVES

The objectives of the present study are to (i) study the escalation clauses presently used in construction contracts adopted by various Government departments/ agencies in India (ii) the adequacy of compensation paid to the contractor based on currently used escalation clauses in government contracts and (iii) how far cost escalation has impact on the outcome of construction projects.

METHODOLOGY

This investigation was undertaken in two phases. The first phase included a literature review and interviews conducted among experts with more than 25 years of experience in construction projects such as Chief Engineers, Directors (Contracts) and Superintending Engineers. The second phase included a questionnaire survey. Questionnaires were directed towards representatives from Government client organizations and contractors. The questionnaires were distributed to client representatives in the level of Assistant Engineers to Chief Engineers of CPWD, MES and TNPWD and contractor representatives who have executed projects for these organizations.

NEED     FOR     PROPER     ESCALATION      CLAUSES     IN GOVERNMENT CONSTRUCTION CONTRACTS

During the past few years there has been a steep increase in the prices of steel, cement, brick, coarse aggregates, sand and other building materials. The price of cement, steel and brick for the past five years i.e. from 2003 to 2008 is shown in Figures 7.1, 7.2 and 7.3 respectively.

Figure 7.1 Prices of construction materials – Cement

Source: Builders Association of India (Southern Centre)

Figure 7.2 Prices of construction materials – Steel

Source: Builders Association of India (Southern Centre)

Figure 7.3 Prices of construction materials – Brick

Source: Builders Association of India (Southern Centre)

From Figures 7.1, 7.2 and 7.3, it is seen that price of cement has gone up by about 112% ; the price of steel products has gone up by about 267%; and prices of bricks has gone up by about 171%. There have been similar increases in the cost of sand, coarse aggregates and other items used by the construction industry. The rise in wholesale price index for all commodities, cement and steel from1996 to 2007 is as shown in Table 7.1.

Year/Index	1996	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006	2007
All commodities	125.6	131.3	138.9	143.8	152.8	160.7	164.7	173.4	184.9	193.7	203	212.8
Cement	137	129.2	129.3	129.5	129.3	150.5	145.1	146.2	151.1	162.5	190.1	213
Steel	121.9	128.4	132.7	133.9	136.2	136.6	140.8	168.3	222.5	253.5	246.1	269.4

From Table 7.1, it is seen that between 1996 and 2007, the index of cement has gone up by about 56%; the index of steel products has gone up by about 121% and, index of all commodities have gone up by about 70%.

Considering the continuous fluctuation in material prices and wages of labour, there is a need to have proper escalation clauses in construction contract. The basic rationale for a price escalation clause is to compensate the contractor for increase in construction costs which are beyond the control of both parties.

CURRENTLY USED ESCALATION CLAUSES IN GOVERNMENT CONSTRUCTION CONTRACTS

In India, Government departments, organizations, public sector undertakings have adopted different formulae to compensate the contractor on the price variations of materials, labour and Petroleum, Oil and Lubricant (POL). However, some departments continued with fixed rates of contracts without allowing any compensation to contractor. Some typical escalation formulae used in central/ state government construction contracts namely Central Public Works Department, Military Engineer Services, Tamil Nadu Public Works Department are given in Table 7.2. Escalation clauses adopted in Airports Authority of India and Bharat Sanchar Nigam Limited are similar to CPWD escalation clause, hence these formulas adopted by them are not shown in the Table 7.2. An overview of the escalation clauses used in Government contract is shown in Table 7.3, which shows the type of escalation clause, project duration where the escalation clause is applicable in the contract, components involved for the escalation, type of index used for materials and labours in the contract. The details of escalation clauses used in construction contracts in India is presented in Appendix 2.

Escalation formulae used in construction contracts adopted by various government departments/ agencies inIndia

Client organisations have now incorporated escalation clause in the contract conditions. But the question is the efficacy of escalation clause and how well they compensate the contractor The basic formula approach remains the same everywhere with only percentage of profit, material, labour and POL component being the varying part. The study is focusing on base period, index associated with the clause, time period and extension of time and other relevant conditions.

Overview of the escalation clauses presently used in construction contracts adopted by various government departments / agencies in India

From the above, it is clear that in all government construction contracts, the escalation in material prices is measured by using wholesale price index and escalation in labour prices are measured by using the consumer price index.

Escalation Clauses in Central Public Works Department

In India, Central Public Works Department (CPWD) deals with public works of central government works in the country. CPWD is more than 150 years old and contract forms of the CPWD form the basis of many other contract forms followed by other Central and State Government Departments. For the first time in March 1963, a sub-clause 10C was introduced in CPWD contract forms (Gupta, 1992). In the current CPWD Contract agreement, there are three escalation clauses namely Clause 10C, Clause 10CA and Clause 10CC (General conditions of contract for CPWD works (2008)). These are summarized below.

Project completion time 6 months or less

Clause 10C, under this clause increases as a direct result of coming into force of any fresh law, statutory rule or order (but not due to change in sales tax/ VAT) in the prices of any materials and wages of labour beyond 10 percent of the price prevailing at the time of receipt of the tender for the work are reimbursable. Whereas materials issued by the department at a fixed recovery rate are not affected. Base time for purpose of this clause is the date of receipt of tender and the clause is applicable during the stipulated period of contract or duly extended period of work. Any increase/ decrease is not to be considered if the same occurred due to delay on the part of contractor. Engineer-in-charge’s decision in this regard is final and binding. The contractor is required to keep books of records and other documents as are

necessary to show the amount of any increased claim and also required to intimate the department of such increase in a reasonable time.

Project completion time between 0 to 18 months

Clause 10 CA, under this clause contractor is compensated for increases/decreases beyond the price(s) prevailing at the time of the last stipulated date for receipt of tenders (including extensions, if any) for the work, then the amount of the contract shall accordingly be varied and provided further that any such variations shall be effected for stipulated period of contract including justified period extended under the provisions of Clause 5 of the contract without any action under Clause 2. However, for the work done/ during the justified period extended as above, it will be limited to indices prevailing at the time of stipulated date of completion or as prevailing for the period under consideration, whichever is less. The increase/ decrease in prices shall be determined by the All India Wholesale Price Indices for Materials as published by Economic Advisor to Government of India, Ministry of Commerce and Industry and base price for materials as issued under the authority of Director General (Works), CPWD as valid on the last stipulated date of receipt of tender, including extension if any and for the period under consideration. In case, price index of a particular material is not issued by Ministry of Commerce and Industry, then the price index of nearest similar material as indicated in schedule ‘F’ shall be followed

Projects completion time more than 18 months

Clause 10CC, under this clause, the contractor is compensated for increases in the prices of cement, materials, Labour, POL as per formula given in Table 7.2. The method prescribed for working out such increases for the work done during the stipulated period or duly extended period of the

contract. Escalation is payable on 85 percent of the work done as per the bill, running or final after deducting the value of materials supplied at fixed prices by the department and some other items which are payable at the market rate prevailing at the time when the work is executed. The increases for materials and Labours are worked out on the basis of indices issued by Ministry of Commerce and Industry and Ministry of Labour respectively. The month in which the tenders were stipulated to be received is considered as the base month. The escalation is worked out quarterly including the month in which the tender was accepted and thereafter at 3 months interval. The relevant index for any quarter for which escalation is payable is the arithemetic average of the indices relevant to 3 previous calendar months. The value of materials supplied by the department at fixed rates and hire charges of plant and machinery issued by the department are deducted. Full value of material for which secured advance is paid is included in the cost worked out as above and later on adjusted when materials are consumed. The components of cement, steel, materials, labour and P.O.L etc are pre-determined for every work and incorporated in the conditions of contract attached to the tender papers and decision of Engineer-in-charge in working out such percentage shall be binding on the contractor.

Escalation Clauses in Military Engineer Services (MES)

The price variation clause is applicable only for works whose completion period stipulated in the tender is more than six months, irrespective of the cost of the project. Period of working out the variation in escalation payment is three months. Complete set of drawings are issued by the client before the work starts and hence contractor can estimate and plan the project properly. The contractor is not eligible for escalation payment beyond original project duration even if the delay is due to the owner. No adjustment, whatsoever, due to variation in prices of materials and fuel and

rate of wages of labour on account of coming into force of any fresh law or statutory rule or order as provided for in the conditions of contract is made. No adjustment in price system is made for materials brought at site after the due date of completion or after extension of time granted under the contract (whichever is later) for the works done under the contract. For labour component though the escalation is paid on the Minimum Wages still the rise will be payable on the basis of wages increase of unskilled male mazdoor and not of other categories. The clause is highly unjustified. Entire amount is eligible for escalation and profit component is not excluded from the price adjustment clause. The last adjustment for variation in wages of labour is done for period ending on the date of completion or extended’ date of completion. No adjustment is however made for work done after due date of completion or extension of time granted under conditions of contract. The first price adjustment in respect of variation in wages of labour is worked out for the relevant quarter during which the variation takes place

For implementing this provision, the period of reckoning in such quarters is split into two periods i.e. the first period upto which RAR is payable immediately after the date of variation and the second period upto the end of the quarter. Value of L1 at the beginning of the second period is the altered rate of wages. If there are more than one change in wages in a quarter then there will be more than one or two periods of reckoning on similar basis. Amount payable to work done for any quarter is worked out after the minimum wage of unskilled adult male mazdoor as fixed under any law statutory rule or order for the relevant quarter are available. For purpose of calculation of retention money. LD, the recovery of water charges, income tax, the value of contract as revised by the above price is binding Wholesale Price Index applicable for any date shall be the one applicable for the corresponding week ending Saturday. The weekly index numbers of

Wholesale Price Index for all commodities published by the Economic Advisor to the Government of India is generally formed provisional. Final index numbers for the corresponding weeks are published subsequently. It is to be ensured that the variations arc worked out based on the Final index numbers only.

The Comparison study of Escalation Formula with various countries is presented in Table 7.4.

Table 7.4 Comparison of Escalation Formula With Various Countries

Formula	India	Brazil	Malaysia	UK
Selection	Basis CPWD	By Client	General basic	Standard
Adjustment Trigger	Time	Time	Cost % variation	Time
Coefficients	Proportional to contract work set by Engineer.	Fixed	Set by contractor	Set by Engineer
Material Selection	All commodities whole sale index used.	By FGV	By Engineer	By Engineer
Ruling Base Date	Time of Tender	Set by Contractor	30 days before the tender due date.	42 days before the tender due date.
Certificate Index Date	Quarter prior to Certificate	Month of Certificate	Date of proved cost	42 days before certificate.
Fixed Component	15%	none	Variable 30-50% set by Engineer	Variable 10-20% set by Government.
Scope	Labour, Materials, POL	Taxes, Labour, Materials, Fuel and Plant	Labour Materials and Plant	Labour, Material and Plant

Source : Mechanisms for Adjusting Price Variations. Papers on price Variation Clause : NICMAR Publication.

SURVEY RESULTS AND DISCUSSIONS

To study the adequacy and the extent of price escalation compensation to the contractor based on the currently used escalation clause in government contracts and also need to improve the currently used escalation in Government Construction contracts in India a questionnaire survey was undertaken. Out of 215 questionnaires sent/delivered directly to the concerned, 119 responses were received were after personal requests and visits to their respective offices. The response rate of 56 percent is considered to be very good for this kind of a mail survey. During such visits, along with questionnaire responses, discussions/unstructured interviews were also carried out with the above respondents.

Questions regarding how the cost escalation has an impact on the quality of the project produced, project completion time, source of dispute between clients and contractors and need to improve the currently used escalation clauses in government construction contracts were asked from the respondents to indicate their responses based on overall project experience. The summary of responses received from the respondent is presented in Table 7.5.

Table 7.5 Summary  of responses regarding how the cost escalation has impact on the construction projects

From Table 7.5 the survey results show that about 90% of the client representatives are of the opinion that cost escalation affects the quality of the project produced and about 69% of the contractors representatives they disagree that the cost escalation affects the quality of the project produced. About 97% of the clients and 98% of contractors representatives they agree that the cost escalation affects the delay in completion of the projects. About

98% of the contractor’s representatives and 94% of clients representatives are of the opinion that the cost escalation is a source of dispute. All the clients representatives and contractors representatives are of the opinion that there is need to improve the currently used escalation clause in Government construction contracts.

Questions regarding the what extent to which the compensation as per the currently used escalation clause in Government contracts reflect the actual price escalation for the components of cement, steel, materials, labour, petroleum, oil and lubricant were asked from the respondents to indicate their responses based on overall project experience. The summary of responses received from the respondent is presented in Table 7.6.

From Table 7.6, compensation to the contractors based on the currently used escalation clause in government contracts, the survey result shows that about 98% of contractors representatives and 85% of the clients representatives are of the opinion that they are compensated less than 60% of the actual escalation of the cement prices. Similarly, about 95% of the contractor representatives and 88% of the clients representatives are of the opinion that they are compensated less than 60% of the actual escalation of the steel prices. On compensation towards price escalation on materials, 96% of the contractors representatives and 94% of the clients representatives are of the opinion that they are compensated less than 60% of the actual escalation of the material prices.

Table 7.6 Summary of responses in regard to what extent does the compensation as per currently used escalation clause reflect the actual escalation

With regard to compensation towards price escalation on POL, about 90% of client’s representatives and 94% of the contractor’s representatives are of the opinion that they are compensated less than 60% of the actual escalation of POL. Similarly, on compensation towards price escalation on Labour, 90% of the clients and contractor representatives are of the opinion that they are compensated less than 60% of actual escalation of labour wages.

A question as to whether WPI is suitable for calculating compensation for escalation of the construction projects and BCI is appropriate index for calculating escalation payment was asked. The respondent indicated their responses based on overall project experience. The summary of the responses received from the respondent is shown in Table 7.7.

Table 7.7 Summary of responses in regard to whether WPI is suitable for calculating compensation for escalation

From table 7.7, the survey result shows that about 96% of the client’s representatives and 98% of the contractor’s representatives are of the opinion that WPI is not suitable for calculating escalation. Similarly, it is

clear that all contractor and clients representatives are of the opinion specific building cost indices are a more appropriate index for calculating escalation payment for the building construction projects.

Questions regarding satisfaction level of currently used escalation clause in Government contracts was asked. The respondents indicated their responses based on overall project experience. The summary of responses received from the respondents is presented in Table 7.8.

Table 7.8 Summary   of   responses   received from the respondent on satisfaction level of escalation clause in contract

From Table 7.8, the survey result shows that about 89% of contractor’s representatives and 75% of the client’s representatives are of the opinion that their satisfaction level with the currently used escalation clause in government construction contract is low. About 22% of client’s representatives and 12% of the contractor’s representatives are of the opinion that their satisfaction level is average. Only about 5 % of the clients representatives are of the opinion that satisfaction level of currently used escalation clause used in contract is high.

In the questionnaire, questions regarding the appropriate project duration for consideration of escalation clause in the contract based on overall project experience were asked. The summary of the responses received from the respondents are presented in Table 7.9.

Table 7.9 Project duration for which the escalation clause should be included

From Table 7.9, the results show that about 61% of clients representatives and 50% of contractor representatives are of the opinion that if the duration of the project is more than 6 months then, the escalation clause can be considered.

Study of Wholesale Price Index In India: The compensation under escalation clauses of CPWD, MES, TNPWD and all other government contracts in India are based on the variation in wholesale price index. The Office of the Economic Adviser, Department of Industrial Policy and Promotion, Ministry of Commerce and Industry compiles and disseminates weekly Wholesale Price Index (WPI) numbers on an all-India basis. The broad break up of materials covered and weights under WPI index is shown in

Table 7.10.

Table 7.10 Details of weights of various groups in WPI (Base 1993-94)

		No. of items (Base 1993-94)	Weights (Base 1993-94 series)
Group 1	Primary articles	98	22.025
Group 2	Fuel, Power, Light and Lubricant	19	14.22624
Group 3	Manufactured product	318	63.75
	All commodities	435	100.00

From the above, it is seen that around 435 commodities are involved in the groups which includes food items and many materials like fertilizers, tobacco, papers, textile etc which are not actually related to the construction activity. Further going into details on a selective basis, around 12% of listed commodities are likely to affect building industry directly or indirectly and the balance have no impact. From this it is evident that the compensation paid under escalation clause is not reflecting truly because it covers 435 commodities which do not affect building construction industry.

WPI Vs. CPWD Cost Index: The Central Public Works Department (CPWD) has been publishing the building cost indices since 1958. To study the relevance of wholesale price index into building construction industry. The cost indices of WPI and CPWD from 1994 to 2005 were analysed and the same is shown in Figures 7.4 and 7.5.

Figure 7.4 WPI Vs. CPWD Cost index (1994-2007)

Figure 7.5 Steel – WPI vs Actual Market Price Index (1994-2007)

FINDINGS IDENTIFIED AND RECOMMENDATION

The price variation clauses in government construction contracts in India – details of the findings and recommendation are given below:

1. For Material Component: It is found that compensation paid to the contractor based on the present escalation clause in government contracts is not adequate to compensate for escalation in Materials, Labour and POL. This is because the wholesale price index is used in the formula for calculating the payment for escalation. It is recommended that the indices of building cost index should be used for calculating the escalation payment instead of wholesale price index. Price escalation in material components like steel, cement and brick etc. should be reimbursed on actual procurement prices.

• In government construction contract, major material components like steel, cement are supplied by the clients. While, calculating the escalation payment for components of material, labour and POL, the material supplied by the client is deducted from the overall cost of work. In reality when the cost of material supplied by the client is deducted, the cost of handling such material also gets deducted. Whereas in the calculation of escalation the cost of handling materials supplied by the client should be added. In

short the escalation clause should consider the labor and POL cost of handling such material supplied by the client.

• For Labour Component: In government contract, while calculating labour escalation payment, minimum daily wage in rupees for an unskilled adult male mazdoor is used. In reality the construction industry today employs predominantly large skilled labor force. Therefore while considering the escalation for labor component it would be appropriate to consider the average daily wage for both skilled and unskilled adult male mazdoor.

• In government contracts there is no uniformity in terms of time of contract for applying the escalation clause and it varies with the organization. A single uniform standard period is not in vogue. Escalation clause should be uniformly included in every contracts where the project duration is more than six months.

• Escalation during extended period of contract: The clause in most of the government contract states that escalation is not provided for extended period of contract. In Government contract, even if the delay is due to the client, escalation payment is not provided to the contractor. Escalation may be provided to the contractor for

extended period of the contract, if the delay is from the client. If the delay is due to the contractor’s actions, necessary penalty shall be recovered from the contractor. One-sided conditions of contract should be avoided.

• Most of the government contracts have a one sided clause, protecting only the interest of the clients. One-sided clauses in contracts should be avoided. The current government contracts forms have conditions that have not undergone any major change in the last 150 years. These will have undergo major changes to reflect the current day scenario. Government contract forms should be reviewed and modified on the lines of world bank, projects which are quite fair and equitable

CASE     STUDY     OF    SIX    BUILDING               CONSTRUCTION PROJECTS IN INDIA

A brief overview of the building construction projects studied, overall impact of “Escalation of materials, labour and POL components” in each project and comparison of their impact with results of the survey analysis is given in Table 7.12.

Table 7.11    Adequacy of compensation paid to the contractor based on the presently used escalation clause in government contracts in Indian Building Construction Projects

SUMMARY

In India, CPWD is more than 150 years old and contract forms of the CPWD form the basis of many other contract forms followed by other Central and State Government Departments. CPWD has been used as a role model for formulating the contract. Price variation clauses 10C, 10CA and 10CC have many drawbacks/ flaws. Some of the drawbacks in these clauses are: for materials, Wholesale Price Index is not truly representating the actual price rise in construction industry. Lack of Construction Cost Indices forces the client to use Wholesale Price index for escalation payment. The labour is compensated using Consumer Price Index which many times are less compared to Minimum Wages. Escalation is not provided for extended period even if the delay is due to the client. The material component is deducted from all the components viz material, labour and POL which is not fair. Rise in prices of materials like cement, steel, bitumen, explosive etc should be reimbursed on actual basis on the basis of quantities used every month as they form the major part of construction. This is now done in many contracts.

A survey of client and contractor representatives was conducted to study the adequacy of compensation paid to the contractor based on the currently used escalation clause in government contracts and cost escalation impact on the building projects in India. The survey showed that both groups generally agree on the compensation paid to the contractor based on the currently used escalation clause in government contract is not adequate for the components of Materials, Labour and POL. The most important cause for gap between actual escalation occurred and escalation payment made based on currently used escalation clause in government contract is mainly due to applying wholesale price index in the escalation formula for calculating escalation payment. While most client representatives agree that cost

escalation has impact on the quality of the project, the contractor representatives donot agree with this. The survey showed that both client and contractor representatives agree that escalation clause should be included in the contracts where the project duration is more than 6 months. The survey revealed that most client and contractor representatives are not satisfied with the currently used escalation clause in contract and feel the need to improve the currently used escalation clause in government contracts. The respondents opined that cost escalation could impact the project schedule and cause delays in project completion. The dissatisfaction with the escalation provisions could cause dispute between clients and contractors.