Understanding Inflation and Escalation Will Make (or Break) Your Career
Current project managers and decision makers have not grown up in an era of rising construction escalation and economic inflation. The last time that happened was in the early 2000s. Most of our current leaders did not have the rough experience of navigating those choppy waters. The fundamentals and good practices are the same but reflection and a crash course in the fundamentals are needed.
Inflations and Escalation Defined
Inflation is an economic term that indicates the increase in the price of goods and services over time. More precisely, inflation can be defined as a persistent rise in the prices associated with a basket of goods and services that is not offset by increased productivity. Inflation causes purchasing power to reduce. The Consumer Price Index (US) is one way to measure inflation.
Escalation refers to a persistent rise in the price of specific commodities, goods, or services due to a combination of inflation, supply/demand, and other effects such as environmental and engineering changes. Factors that affect the escalation include inflation, supply & demand, technological changes, environmental impacts, and political effects.
In summary, inflation refers to the increased price of a basket of goods and services, while escalation refers to an increase in the price of a specified good or service. Inflation is one of the factors that cause escalation.
Current Construction Market
The American Rescue Plan Act, approved in March 2021, sends $350 billion to state, local, and tribal governments. Repairing water and sewer infrastructure was one of the authorized uses of the funds, and states have already allocated at least $10 billion to that purpose. ARPA money is in the process of being released into the market, and the timing of the release will closely coincide in many regional markets.
The Infrastructure Investment and Jobs Act was signed In November 2021. The act provides $50 billion over five years for a range of critical water infrastructure needs: from replacing lead pipes and removing PFAS chemicals to long-needed repairs for water treatment plants and sewers. The recently signed "Inflation Reduction Act" provides hundreds of millions of dollars of additional construction-related investments for green energy.
The influx of federal money into new construction is colliding with a general economy in which prices are rising faster than they have in more than a generation. Even if inflation subsides in the general economy, escalation will continue to increase due to the abovementioned factors (supply & demand, technological changes, environmental impacts, and political effects).
Implications: Alternative Project Delivery
Fitch Ratings recently announced that “high inflation and labor and supply chain challenges are raising project construction costs and will exacerbate challenges for contractors that entered into fixed price construction contracts for public-private partnership (P3) projects in the US and Canada" Fitch further predicts that progressive design-build, where prices are not locked in until certain milestones, will be the preferred delivery method because it shares risks between the different parties.
While this approach is better for contractors than arguing over fixed-value traditional contracts, it does not mean overall costs are going down.
In fact, owners who have been delaying locking into contracts should probably plan to offload a dump truck full of money. The decision to wait in the face of rising and persistent escalation and inflation is an extremely costly one.
Implications: Escalation Reserve Funds
Owners should set up strategies for treating escalation. This need is often overlooked because current leadership was not in senior decision-making roles when the last major rise in construction escalation occurred nearly twenty years ago.
A recent example comes from North Carolina, where state law requires that the Office of State Budget and Management (OSBM) hold funds budgeted for escalation in a reserve fund to be released if needed for inflation or unforeseen events. State agencies estimate the construction costs at the time of budget submission and the mid-point of construction for any new project. The difference becomes the escalation reserve, held by OSBM and released to specific projects if or when they need money to cover escalation.
The NC General Assembly went one step further and is holding some of the surge of federal money to address the growing escalation in the state's construction market. Some external observers falsely refer to this as budget surplus, which underscores the perception issues that any owner will experience in high escalation market conditions when trying to manage risk and uncertainty.
Current project managers and decision makers have not grown up in an era of rising construction escalation and economic inflation. The last time that happened was in the early 2000s. The fundamentals and good practices are the same but reflection and a crash course in good practices are needed.
Your career and your organization depend on you getting up to speed quickly. There will be many extreme losers but only a few winners.
Stermole, F.J., Stermole, J.M. (2014) Economic Evaluation and Investment Decision Methods, 14th edition. Lakewood, Colorado: Investment Evaluations Co.
Circle of Blue – April 7, 2022. https://www.circleofblue.org/2022/world/inflation-weighs-on-u-s-water-utilities/
FITCH WIRE. : https://www.fitchratings.com/research/infrastructure-project-finance/rising-costs-pressure-contractors-in-fixed-price-p3-contracts-11-08-2022
https://www.e-education.psu.edu/eme460/node/546 John A Dutton E-Learning Institute, Penn State e-Learning Cooperative, Penn State University
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