BUILDING COST ESCALATION

IN ABU DHABI and OTHER EMIRATES

UAE
45634
October
TABLE OF CONTENTS

Abstract

Introduction

1.0 Cost Escalation

Construction Congestion

Schedule

Labour and Market Cost Increases

Risk Perception

2.0 Principle Causes of Construction Cost Escalation

2.1 Construction Congestion

2.2 Schedule

2.3 Labour and Material Costs

2.4 Risks

3.0 Contractual Considerations

4.0 Minimizing Impact of Cost Escalation

4.1 Familiarization of Market Condition

4.2 Managing Cost Escalation

4.3 Sharing Risks

Conclusion
Abstract

This paper examines the causes and implication to the contractual parties of
excessive cost escalation on construction projects. The paper particularly
focuses upon the Gulf region and in particular the United Arab Emirates
where rapid cost escalation has been a common feature of most projects in
the past few years. The implication of different types of Contract to each party
is also investigated and means by which the contractual risks may be
reasonably shared are discussed. Finally the paper will examine measures by
which the risks associated with rapid cost escalation may be mitigated during
the feasibility planning and execution stages of construction projects.

The main sources of information for the paper comprise articles from local
publication from Arabian Business.com and in particular, articles published by
International Cost Consultant E.C. Harris who have published significant data
relating to cost escalation in a range of articles. This paper will provide the
reader with an understanding of the potential causes and effects of rapid cost
escalation and provide some guidance as to how associated risks may be
addressed.
Introduction

During the past five years the author of this paper has been engaged as a
Quantity Surveyor on various infrastructure and large building projects within
Abu Dhabi in the United Arab Emirates. Over this period the UAE has
embalked upon an unprecented phase of development, which has occurred
concurrently with rapid development of emerging markets within Gulf and Asia.
The result has been rapid escalation of construction costs, delays and
unavailability of materials plant and labour and ultimately dispute between
Contractual parties as to who should bear the resulting direct and indirect
costs. What has been evident to the author has been the lack of planning
during the feasibility planning, development and pricing of construction
projects for potentially excessive cost escalation despite its common
occurrence over an extended period. The implication of the inaction to
address the risk of escalation has been the bankrupting of many local
Contractors without the capacity to manage excessive associated losses and
the delay to completion of many projects.

The objective of this paper is to identify to the reader the major causes of cost
escalation and to provide guidance as to how they may reasonably and fairly
address the associated risks in planning when entering into a large contract
where significant cost escalation could occur.

Following an explanation of the causes of cost escalation the paper will

examine its implication to the Contractual parties within differing forms of
Contract and how the risks may be reasonably mitigated or shared.

1. Cost Escalation in the UAE - Recent Trends

Construction output remains buoyant in the UAE with continued growth in

orders across Dubai, Abu Dhabi and the other Emirates. New construction
work load continues to drive prices and it is anticipated that tender prices will
continue to outstrip retail price inflation in late 2008 and 2009 albeit at a lesser
extent than experienced during the post-credit crunch period of 2006 to mid
2008 which is the main focus of this paper.

During 2007 the UAE experienced inflation of more than 9% according to

International Cost Consultant EC Harris. Construction costs rose by more
than twice the rate of inflation at an estimated rate of 20% with steel prices
rising by 46%, structural steel by 38% and cement by 30% [1].

The first quarter of 2008 saw a continued trend with construction costs
increasing by a further 5-7%. With the total volume of projects estimated to be
in excess of US $ 1 trillion in the Gulf region, such price increases have an
enormous impact towards Developers and Contractors involved in their
execution [1].
The principle causes of excessive construction cost increases can broadly be
categorized as follows:

 Construction Congestion
 Schedule
 Labour and Material Cost Increases
 Risks Perception Introduction
Construction Cost Index –UAE
(Base January 2006 =100)
Abstracted from Article entitled Construction Cost Bulletin by EC HARRIS
Each of these factors is examined in Section 2.0 of this paper.

2.0 Principle Causes of Construction Cost Escalation

2.1 Construction Congestion

The most significant factor affecting construction cost escalation has been
market congestion. Construction activity has been very strong in all market
sectors for several years in the Gulf region with the current annual growth rate
in construction activity being around 8% per annum [2]. This is resulting in a
very high demand for construction services. Coupled with this very high
demand has been a severe shortage of resources and labour due to the high
domestic demand in countries within Asia and particularly the subcontinent
from where cheaply imported labour and materials have traditionally been
available to the UAE and have in the past help to suppress significant cost
increases.

2.2 Schedule

Many of the projects undertaken during the past five years within the UAE fall
within the category of mega-projects with contract periods extending over
periods of several years. With the projects also being often complex, multi-
faceted and subject to significant variation to accommodate changing
requirements of the owners delays are inevitable. Delays in a project increase
the costs in two ways.

In the first instance, the delay increases the impact of escalation.

The second impact is the pressure on the project team to accelerate the
project, which can involve pre-bidding portions of the work deferred approvals,
or simply accelerating/crashing the schedule. All of these can have a marked
effect on the construction cost. For a AED 1 billion project a 1 month delay
could result in additional construction costs of AED 10-20 million, which must
be borne by one or both of the Contractual Parties.

2.3 Labour and Material Cost

The 20% increase in construction costs recorded in 2007 has been largely
driven by increases in material prices in excess of 30% and labour costs
which have been increased more than 10% [2]. High demand equating to high
commodity prices and an extremely competitive market for both material and
labour have been the main contributory factors behind material and labour
cost increases. With material prices representing 40-50% of a typical
construction project and labour up to 25% the impact of associated price
increases has been crippling to many Contractors.
In addition to increased commodity prices the cost of materials has been
impacted by exceptionally high energy prices that have significantly increased
both production and transportation costs. Price increases of many key
construction materials are set to moderate with 2008 due to reduced
commodity and energy prices. Significant increases in labour costs are
however set to continue due to the following factors:

a) Continued shortage in supply of skilled labour

b) Shortage of accommodation and high rents

c) Shortage of available area for labour camps and increasing rental rates.
Land for labour camps has until recently been made available to
Contractors free of charge or at nominal rates. Provision of labour
camps are more recently provided on a commercial basis with recent
increases in the cost of labour camps per person estimated to be
increasing by $55 (AED 200) a month [2].

d) Changes to visa regulations and increased associated costs

e) The possible implementation of a minimum wage in the near future.

2.4 Risk

Each of the factors identified above has an impact on constructions costs.

However when combined, they add to the perception of risk, which is a major
factor in cost escalation for large Civil Engineering and Building Projects due
tot the following:

a) Large Civil Engineering and Building Projects are normally long in

duration and can be complex.

b) Recent rapid changes in the cost of labour, plant and material have
severely impacted contractors on long term fixed price contracts and as
a result contractors are unwilling to commit to future long term
contracts without significant risks premiums built into their bids.

c) Possible schedule impacts due to shortages in labour and materials.

With the volatility in labour and material prices in recent years and likely
continued shortage of resources within the foreseeable future, these factors
increase the perceived risk of the project to the contractor and as a result
contractors and sub- contractors are more likely to increase their bids to take
into account of future market volatility. Combined with the shortage of skilled
contractors and reduced requirement to bid very competitively to win contracts,
these risk factors contribute to a high degree of caution and bid premiums
being included in contractors bids, particularly on fixed price, traditional
contracts.
3.0 Contractual Considerations

Until recently, traditional fixed price contracts based upon the FIDIC, or FIDIC
based forms of contracts have been prevalent in the United Arab Emirates. In
the authors experience forms of contracts used within the UAE have
traditionally been developed to favor the Employer, particularly with respect to
price escalation. Relevant clauses within FIDIC and similar forms of contract
that facilitate reimbursement to the contractor for price escalation have been
consistently written out of contracts. During the period of 2003 to 2005 a large
number of contractors engaged in infrastructure projects under the terms of
such fixed price contracts suffered severe looses as a result of excessive
price escalation from which many failed to recover. In addition to financial
losses to the individual contractors, projects were inevitably delayed as
contractors struggled to finance day to day costs and procurement leading to
further losses associated with penalties due to late completion.

Losses associated with fixed price contracts are not however one sided. In the
event of contractors’ inability to complete a project due to bankruptcy,
Employers are faced with the costs of re-tendering or awarding the works to a
new contractor at higher rates due to escalation, in addition to the significant
additional costs associated with removing and replacing a contractor. Clauses
in most contracts that facilitate reimbursement to the employer in the event of
the contractor’s bankruptcy, rarely cover the employer’s associated costs.

Similarly, Employers have been faced with additional financing of projects due
to their delayed completion not envisaged in their budgeting/forecasting that
has greatly detracted from their cost benefit. There has accordingly been a
realization from both contractual parties that the risk associated with fixed
price contracts in a market where high cost escalation is prevalent is too high
and there has been a tendency to adopt clauses within contracts that facilitate
reimbursement to contractors for cost escalation based upon market indices
and to a greater extent the adoption of cost plus contracts where the
contractor is fully reimbursed for his costs plus a percentage fee which can be
fixed or performance related .The advantage of these forms of contract are
that the contractors are fully compensated for price escalation and can avoid
financial looses and limitations that may prohibit or delay completion of project.
The disadvantage is that the financial risk associated with excessive price
escalation are entirely bourne by the Employer and risk his ability to finance a
project to its completion.

4.0 Minimizing Impact of Cost Escalation.

4.1 Familiarization of Market Conditions

The most important action that each contractual party can take to minimize
the impact of cost escalation is to fully familiarize themselves with existing and
potential market conditions during the planning and tendering the project. The
employer must ensure that feasibility studies and cost benefit analysis include
an analysis of the risks and opportunities associated with cost escalation. In
addition to impacting, the financial feasibility of a project, consideration of
potential price escalation may impact the selection of the type of contract to
be used, the manner in which the work packages are tendered and the
assessment criteria for selection of a contractor.

For contractors tendering for a project, potential cost escalation is a similarly

critical consideration. Understanding the potential problems of a congested
market where materials, labour and plant required for execution is not readily
available is of prime importance due to its impact towards direct procurement
costs and indirect costs associated with delays and the associated
requirement to expedite or accelerate critical elements of the works.

Fully appreciating the cost of importing, recruiting and housing the labour with
ever changing legislation that generally results in cost increases is of further
critical importance. In the authors experience, a number of foreign contractors
that have recently entered the UAE Construction market have failed to pre-
assess the risks of establishing themselves within a congested market and
have suffered heavy losses, particularly during execution of initial contracts
undertaken without the knowledge of local conditions.

4.2 Managing Cost Escalation

Measures that an Employer could take to minimize the impact of Cost

Escalation include:

a) Dividing the works into smaller work packages with shorter duration
within fixed prices that would minimize their risk and the impact of
excessive escalation towards Contractors.

b) Confirming that selection criteria for Contractors ensures that means to

address price escalation is considered in their bid.

c) Ensuring that the selected type of Contract is compatible with the

potential risks associated with cost escalation allowed for within their
budget for the project.

In a conjested market the Contractor frequently has the upper hand in

negotiations relating to the means by which aspect such as cost escalation
will be addressed in the Contract terms. With many the larger projects being
negotiated the Contractor can ensure that a Cost Plus or alternative type of
Contract that compensates him for price escalation is adopted.

Within a fixed price Contract the Contractor has the ability to minimize the
impact of escalation by fixing prices with the supplier or bulk ordering during
the early stages of the Contract Period. Negotiations with subcontractors
would also play an important role in sharing potential escalation risks.
4.3 Sharing Risks

Most importantly a project has the best chance of success in terms of both
time and cost if the the risks of cost escalation are reasonably shared by the
Contractual parties either during the tendering process or through
compensating clauses written into the Contract. Prior to entering into the
Contract there should be clear consensus regarding the responsibility of each
party in relation to cost escalation in order for the respective risks to be fully
evaluated.

The grounds for potential (Clause 12) or extra-contractual claims (under the
Civil Code) should be clarified/eliminated during tender negotiation to avoid
unforeseeable losses and potentially costly litigation.
Conclusion

Cost Escalation has been extremely high in the United Arab Emirates
construction market during the past few years resulting in severe financial
losses to some Developers and Contractors. Escalation has been mainly
related to the high volume of work (congestion), high price of materials and
labour due to local and international demand associated delays to completion
and increased tendering costs due to perceived risks.

Recent changes in the generally used Form of Contracts from fixed price to
cost plus or other forms of Contract that compensate the Contractor for
increased construction costs have resulted in a more reasonable distribution
associated risks between the Contractual parties but have placed significantly
more risks on the Employer and potential feasibility of projects. Both
Contractual parties can minimize their risks through detailed risks assessment
based upon a detailed understanding of market conditions. Adopting the
correct form of contract and a joint understanding of each party’s
responsibility for cost escalation under the Contract is also essential in
avoiding unforeseen costs and potentially costly litigation. Early action in
procuring and subcontracting works during the initial stages of Contract can
ultimately minimize the risks of excessive cost escalation during the Contract
Period.

References

1. www.echarris.com/research Construction Cost Bulletin UAE (Dubai, Abu

Dhabi)

2. www.arabianbusiness.com Middle East Business, Financial & Industry