Costs and Benefits of Price Adjustment Clause in FIDIC.pdf

Costs and Benefits of the Price Adjustment Clause in FIDIC MDBPrianka N. Seneviratne Asian Development Bank 6 ADB Avenue Mandaluyong City Metro Manila Philippines Tel: +63 2 632-4444 Fax: +63 2 636 2428 Email: [email protected] (Abstract = 260) (Main Text with References, Figures and Tables = 6670 Words) Disclaimer: The views expressed in this paper are entirely of the authors’ and do not reflect that of the Asian Development Bank. The authors accept the responsibility for any errors, omissions, and accuracy of the information presented. TRB 2013 Annual Meeting Paper revised from original submittal. Seneviratne 2 ABSTRACT Project owners, bidders, and construction supervision engineers continue to grapple with questions on the price adjustment clause in the Conditions of Contract developed by the International Federation of Consulting Engineers for Multilateral Development Banks. The first question faced by a project owner is whether the adjustment provision should be retained, and if not, why? If retained, the questions that ensue have to be dealt with by both the project owner and the bidders. These are about the adjustment terms and conditions—start date, base date, thresholds, and the adjustment formula parameters such as cost elements, indices, and weightings. Although answers to these questions are available from different sources and been legislated in some countries, clear, empirical evidence of the benefits of providing for adjustment—increased competition, lower bid prices, market stability, and less risk of contractors defaulting—is lacking. Also, the effect of changing default adjustment parameters is largely unknown. This paper first examines literature and experts’ views on the above questions in relation to Asian Development Bank financed road construction contracts in Central Asia and the Caucuses. Then, Monte Carlo simulation is used to evaluate alternative answers to the questions. Simulation results show that project owners and bidders can both benefit from the adjustment provision. Bidders can increase their competitiveness by not adding an inflation risk premium while the owner can expect more realistic bid prices and benefit from price drops during construction unlike in fixed price contracts. However, neither party will gain from changing the default parameters, which increases uncertainty and cause bidders to add risk premiums. TRB 2013 Annual Meeting Paper revised from original submittal. = current cost indices or reference prices for period ―n‖. En. Where: Pn = adjustment multiplier to be applied to the estimated contract value in the relevant currency of the work carried out in period ―n‖. if a contractor knows at the bidding stage that payments for his work will be periodically indexed. These rationales. ideally can benefit from lower bid-prices. d. Eo. on the other hand. The standard bidding documents of eight donors are based on this contract form since 2005. = base cost indices or reference prices. and the conditions of adjustment. Ln. The formula in FIDIC Conditions of Contract for Multilateral Development Banks (FIDIC MDB) is of the form: Pn = a + b(Ln/ Lo) + c(En/Eo) + d(Mn/Mo) + . A good overview of the history of price adjustment is provided in Ndihokubwayo and Haupt (3). which were postulated more than 30 years ago. trigger values (i. end date. representing the non-adjustable portion in contractual payments.. c.. expressed in the relevant currency of payment.e. when its first version was released. Mo. the terms. etc. over which a contractor can claim adjustments). have led to the price adjustment clause becoming a standard feature in most construction contracts worldwide.. b. each of which is applicable to the relevant tabulated cost element on the Base Date.8—Adjustments for Changes in Cost) in the General Conditions of Contract prepared by the International Federation of Consulting Engineers (FIDIC) for Multilateral Development Banks (1). expressed in the relevant currency of payment. Mn. and the computation method. It is also a standard clause (Clause 13. a = fixed coefficient. definitions of the value of works that will be adjusted. These include the timing (start date. In theory. etc. and later experiencing financial difficulties and defaulting on their obligations. and lower final Contract Price.. etc.3 Seneviratne INTRODUCTION Price adjustment clauses in construction contracts are intended to reduce the financial risk to project owners and contractors if the input costs rise or fall sharply during construction when the contract period is long. formulae. and frequency). this period being a month unless otherwise stated in the Contract Data. each of which is applicable to the relevant tabulated cost element on the date 49 days prior to the last day of the period (to which the particular Payment Certificate relates). TRB 2013 Annual Meeting Paper revised from original submittal. Adjustment provision in a contract also lowers the risk of contractors underestimating cost increases. = coefficients representing the estimated proportion of each cost element related to the execution of the Works.. and a hybrid of the first two methods (2). such tabulated cost elements may be indicative of resources such as labor. and Lo. he will have less of a need to add a premium to the bid price for possible cost increases during construction. especially when costs are declining. This reduces his risk of losing the contract by adding the premium.. less likelihood of contractors going into bankruptcy mid stream of a project. A project owner. stated in the relevant table of adjustment data. A typical adjustment clause specifies the method. range of price change. as stated in the relevant table of adjustment data. They also have to choose from three common computation methods: invoices. . This means that the clause designers must determine the terms and conditions that best suit the project in hand. equipment and materials. guidelines TRB 2013 Annual Meeting Paper revised from original submittal. but may be altered by the Owner. . and make the price adjustment process systematic. The adjustment parameters are based mostly on the United States Department of Transportation’s Technical Advisory 158 (5). E. Adjustment provisions are included in about 75% of all contracts let by these states each year. the Building Cost Information Service (BCIS) publishes formulae and indices. Mo. c. M. The default Base Date for Lo.L. These are questions frequently asked by agencies implementing Asian Development Bank (ADB) financed road projects in Central Asia and the Caucuses. the present author presents that. However. In Pakistan. the price adjustment procedure in FIDIC MDB is beneficial to both the Owner and the Contractor. Queensland Department of Main Roads in Australia and government legislation provide for formula-based adjustment (rise and fall provisions) in contracts of 365 days or more. The Government Procurement Reform Act of the Philippines (10) provide for adjustment in ―extraordinary circumstances‖. who are more likely to experience cashflow problems in inflationary times. The bitumen adjustment provision is applied separately to contractor-supplied bitumen at the rate of change in Class 170 bitumen price. Previously it was applicable to only to contracts of 18 months or more. and provides guidance on their use (8). etc. These data are provided in the ―table of adjustment data‖ and the particular conditions of contract in the bid document. and extraordinary inflation and deflation. This paper has two objectives. and unless the Owner has specified. It provides formulae for 52 different work items. The Philippines has a comprehensive guide on design and use of price adjustments in works contracts. a and all the cost elements-. intuitively. The other is to propose an analytical tool that can help the agencies test and use these answers. M. The default adjustment frequency is once a month. Using Monte Carlo simulation. the source(s) of the indices or reference prices for L. GLOBAL PRACTICES AND VIEWS ON PRICE ADJUSTMENT Price adjustment provision is standard in works contracts of 47 state Departments of Transportation (DOT) in the United States. a review of literature on global experiences on price adjustment. The government Hong Kong has a policy since 2008 that provides for contract value adjustment for labor and materials cost changes in all government capital works contracts of any duration (9). an owner can only gain small financial rewards by changing the default parameters such as Base Date. The indices are taken from the Road and Bridge Construction Index published by the Australian Bureau of Statistics (7). The monthly indices for labor and materials costs published by the Census and Statistics Department of Hong Kong are used with a formula similar to the BCIS formula. Each bidder must propose the values of b. and interviews with 10 staff from road agencies and ADB. In the United Kingdom. and by increasing the non-adjustable portion. and 85% of these states provide adjustments for fuel and 79% for both fuel and liquid asphalt (4). One is to analyze the sources and rationales behind the common answers to questions about price adjustment in FIDIC MDB. etc--must also specified.Seneviratne 4 The project owner must specify either one formula for adjusting the total value of all the works completed in a period or different formulae for different work items. etc. which include fortuitous events. Class 170 is used as the reference because it is assumed to represent all classes of bitumen. The formula is applied to 85% of the value of a work item or material (minus the value of bitumen and the value of work completed after the Date for Practical Completion). For each formula. d. This change was brought in after a survey found that 61% of the bidders were small contractors. The paper is based on data from ADB-financed road works contracts. start date. E. is defined in FIDIC MDB as the date 28 days before the final bid closing date. Eo. M. Information in the donor’s guides is scant. The most extensive of the few published findings is a survey of the state DOTs by Skolnick (4). ADJUSTMENT PARAMETERS According to ADB’s procurement guidelines. and discussion groups on the internet.7% lower for items eligible for adjustment compared to ineligible items. They can indeed turn to textbooks (e. This formula is similar to that specified by BCIS in the UK. M. 17 and 18). periodic FIDIC seminars.5 Seneviratne issued by the Engineering Council. the country guidelines are in the form of rules that make price adjustment mandatory--no instructions on how to determine the parameters. which is the statutory body entrusted to regulate the engineering profession. . Cost elements (L. N. the price adjustment provision must be included in contracts longer than 18 months (15). However. the decisions on these parameters can be challenging.of the circular). etc) Weightings of the cost elements (b. However. Failure of a bidder to accept the price adjustment provision is a basis for rejecting his bid (16). but it does not specify thresholds or parameters (12). Commencement Date is the date of the Engineer’s notice to the contractor that the conditions set out in Sub clause 8. defaulting contractors. market stability (number of contractors entering and leaving the market). terms. must be followed for formulating and implementing price adjustment in all public works contracts (11). but also does not prescribe parameters (14). the comparison of Kosmopoulouy and Zhou (6) of bid prices for Oklahoma State DOT contracts before and after the state allowed adjustment to asphalt binder items in 2006 has revealed a difference. it showed that the Engineers spend 86 hours a month per contract on average administering the adjustment provision. For example. c. the Ministry of Construction in Vietnam issued a circular in July 2010 specifying the FIDIC MDB formula (in Article 7--Method of adjusting contract prices for adjustable unit-price contracts. and the default Base Date is the date 28 days prior to the latest date for submission of the tender. and the number of bids per contract as a result of adjustment provisions. If provided and accepted. d. However.g. …) The source of the indices or reference prices for L. which the Contractor must submit within 28 days of the Commencement Date. In Sri Lanka. Additionally.. TRB 2013 Annual Meeting Paper revised from original submittal. That has not shown discernible difference in the overall bid prices. … For project owners in developing countries who do not have tested and legally enacted price adjustment procedures. even when FIDIC MDB is used. Several other developing countries also have legislation on terms and conditions of adjustment to be followed. formulae (same as FIDIC MDB) are specified by the Institute for Construction Training and Development for different work items (13). they generally lack experience and 1 Default start date is based on the start date of the program. They have found that post-2006 bid prices were on average 12. On the other hand. but the corresponding guidelines too are not helpful to a project owner or a bidder. the cost elements and the other coefficients are still left to be determined by the project owner and the bidders. the survey data differences in some items such as steel. However. the project owner and the bidders must determine the following parameters.1 in FIDIC MDB have been fulfilled. The effect of the adjustment provision in a contract is not widely reported. The National Highway Authority of India permits formula based adjustments subject to certain conditions. and conditions of adjustment: (i) (ii) (iii) (iv) (v) (vi) Base date and Start Date1 Triggers and caps The non-adjustable portion (a). N. adjustments for cost changes in the first 12 months should not apply to asphalt works. Start Date: This date. In that. the following are some frequently asked questions: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) What are the optimum start and base dates? Can upper and lower bounds be set to trigger the adjustments (i. and 19). The date 28 days before the start of the 18th month was used in a contract in Armenia.e. the Commencement Date (as defined in FIDIC MDB) is the start date in most ADB –financed contracts examined for this paper. and hence continually grapple with myriad questions. The underlying rationale for the late start—to discourage unrealistically low bids from firms expecting to delay the works and benefit from rising prices.6 Seneviratne historical data needed to analyze each parameter in detail. . the adjustments for asphalt works2 was set to start on the date 12 months after the Commencement Date. the 28 days is counted from the first day of the 25th month or 692 days after the Commencement Date (that is Commencement Date + 720 days – 28 days). most global guidelines and ADB (1. the first adjustment period starts on the date 24 months after the Commencement Date. with the first set of current indices based on the date 311 days after the Commencement Date (i. With few exceptions. which is ―the date 28 days prior to the latest date for submission and completion of the tender‖ (1).. The remaining work items are adjusted starting on the Commencement Date. Linking the base date to either commencement date or start date instead of tender submission date is risky for a contractor because they are dependent on the preceding approval stages and conditions that must be fulfilled. The rationale for this two-stage approach for the 13th-month start date is that asphalt works are programmed to commence in the 13th month.. The formulae used here are similar to those of Queensland Department of Main Roads (7).. In the Afghanistan contract mentioned above. adjustments are allowed only if a price or an index change stays with 3 and 10%)? What are the appropriate cost elements and weightings? What is the optimum non-adjustable portion (adjustment formula constant)? What are the reliable and appropriate price or index sources? When and how can a family of formulae (separate formula for separate for work items) be used? Should bidders be allowed to propose the weightings? Is 6 to 12% of the Contract Amount specified by ADB (19) an adequate contingency for price adjustments to be provided in the project budget? Base Date: The default Base Date in FIDIC MDB. Among them. 2 The value of all work less the value of asphalt work is adjusted in each period starting on the Commencement Date. because a default date is not specified in FIDIC MDB.e. The Philippines is the exception--the date six months after the date of signing the contract is defined as the default start date (10). Hence. This uncertainty can cause a bidder to add a risk premium to the tender price. TRB 2013 Annual Meeting Paper revised from original submittal. Commencement Date + 360 days – 49 days). Commencement Date + 720 days + 30 days – 28 days). A 48-month contract let in Afghanistan in 2011 is an exception. In a 2011 contract let in Tajikistan. 16.e. has been retained in most ADB contracts. is important. and undermine the advantages of the adjustment provision. The reference date for the first set of current indices is the date 722 days after the Commencement Date (i. which is the first date of the first adjustment period. 1205-25% 14% 11-15% 5-17. steel.7 Seneviratne Triggers: The Philippines has set legal and technical thresholds for adjustment.62-6% 5% 12% and 15-30% 10% TRB 2013 Annual Meeting India 15% 20% 5% Project Specific Project Specific Project Paper revised from original submittal. . the elements should be those making up the total cost of a particular work item. It can avoid the need for defining start dates and corresponding base dates. project owners tend to set some and leave the other weightings to be proposed by the bidder (14). Ideally. The ranges of weightings assigned to common cost elements found in this study are shown in Table 1. and equipment as possible elements. The Philippines has preset the weightings for each element in the 52 formulae (10) and New Zealand’s Transport Agency for five types of road works (20). Oil and 20% Lubricants Bitumen 11% and 300-4. component. It also suggests providing a contract cancellation clause if escalation exceeds 125% or 200%. Oklahoma DOT has opted to allow adjustments if the price increases by more than 3% in any period (6). Threshold-based adjustments are not common in aid-financed contracts. The technical thresholds are either two standard deviations from the 30-month mean of the applicable price index or greater than 10% increase in the index (if historical data are not available). In India. cement.5-25% Note (a) 40% Cement 11% and 11-13% 25-50% 5% 15% 10% Note (a) Steel 4. materials. The donors’ guidelines make no reference to this option although it can be easily provided under FIDIC MDB. The disadvantage of this is that it allows higher weighting to be assigned to the most volatile element and zero to the least volatile element without reference to the cost composition. Pakistan has prescribed several steps for a user to follow in determining the elements (11). Adjustment Formula Parameters from the Sample of Contracts Cost Georgia Kazakhstan Afghanistan Tajikistan Azerbaijan Kyrgyz Element Fixed 20-55% 10% 40-50% 25-30% 10-15% 25% Local Labor 9. Cost Elements: FIDIC MDB cites labor. Weightings The project owner can include the weightings in the table of adjustment data in the tender document or require the bidders to propose them.57-20% 25% 5-10% 10-25% 5-15% 21% Foreign 45% Labor Fuel 6. Upward and downward adjustments are permitted at a rate of the adjustment percentage plus or minus 5% for each period corresponding to the approved schedule and critical path. and equipment are the common elements in contracts examined for this paper as shown in Table 1. Labor. bitumen.5% (Diesel) 21% 40% Petroleum. Table 1. and the Philippines prescribes the elements for each of the 52 work items (10).5% 16-20% 2. and indirectly show the level of risk that the owner is willing to take. United States Department of Transportation suggests between 25% and 100% as the range for the ceiling (upper bound) for change in the index in which adjustments will be provided (5). or all works. The Indian approach lowers this risk while also providing the bidders the opportunity to define their cost composition. starting 6month after the effective date of the contract (10). easily accessible. However. Countries such as New Zealand and the UK provide for using alternative national sources in case one source is discontinued (20 and 8). but Pakistan (11) has set upper and lower-bounds of 35% and 65% respectively. which can later lead to disagreement. Index and Price Sources: Under FIDIC MDB. in Georgia. parameter selection at road agencies in Central Asia is still an ad hoc process. if available. continuity. There is a large spread in the adjustment parameter values (see Table 1) even in the same country in the same time period. adjustments have to be done twice--once with interim data and subsequently when the final data are available—at an added cost to the owner and payment delay to the contractor. a project owner can require bidders to use national sources or ask them to propose sources. . In Tajikistan. There are different views on the appropriate value of ―a” depending on whether it is considered the contractor’s risk or his profit (22). and timeliness. and regularly published. However. In the UK. a global index. 10. At the state DOTs. etc. TRB 2013 Annual Meeting Paper revised from original submittal. and 14) have set it at 15%. equal weightings were assigned to all cost elements and 45% to foreign labor. or a national index. bidders can propose either an official source-country index. in 2011. It can also be viewed as the share of overheads and profits. Because this index will be used to price the bid and future adjustments. it should be representative. Timeliness is particularly important to keep the Engineer’s workload to a minimum. This is partly attributable to the lack of information and guidance. If late. This cost will increase with the frequency of adjustments. construction plant. and India (2. is their reliability. if the element is an imported good. Kosmopoulouy and Zhou (6). engineers spend 85 hours a month on administration (4). A concern that contracting parties may have about each other’s proposed sources. For instance. ADJUSTMENT PARAMETER SELECTION The various guidelines and advisory notes cited in this paper indicate that the parameters must fit the cost structure of the works and the economic conditions.8 Seneviratne Aggregates Plant and Equipment General Materials Foreign Inputs3 20% 2. deemed to be unaffected by inflation. the fixed portion range is from 20 to 55% in five relatively similar contracts financed by two different donors between May 2009 and December 2011. and Weidman (23) that highlight lessons learned from design and application of adjustment provisions in aid-financed contracts. The values used in Central Asian and the Caucuses countries in ADB financed projects ranged from 10-55% as shown in Table 1. BCIS Highways Term Maintenance Price Adjustment Formula for highway maintenance works has it fixed at 10% (8).619% Note (a) Specific 13-27% - - 5% - - - - 15% - - Project Specific 5-11% - - - 4-10% 2030% 5% Note (a): Apply only to 2011 contracts Non-Adjustable Portion (adjustment formula constant): This is defined by the UK Institution of Civil Engineers (21) as the portion of the inflation risk the owner wants the contractor to share. South Africa. driven partially by donors. bitumen was the most volatile cost element in the 2008-2009 period and the 3 Includes inputs such as technical personnel. the Philippines. In the latter case. There is a dearth of examinations like those by Skolnik (4). the most volatile element between 2007 and 2010 was local labor (See Figure 2). But the adjustment provisions in the sample of contracts analyzed here have few commonalities despite the similarities of the project scopes. Whether this is because the project owners lacked experience and the donors’ guidance came from different sources is not apparent from the preliminary data. weightings between 30 and 40% were assigned to bitumen and between 20 and 30% to equipment. These inconsistencies suggest that both project owners and bidders have not given sufficient consideration to the cost composition. However. Tajikistan Indices TRB 2013 Annual Meeting Paper revised from original submittal. and current and past economic conditions. In Kyrgyz. Figure 1.Seneviratne 9 other cost elements either remained unchanged or declined as shown in Figure 1. . Its sensitivity to different level of uncertainty about future market conditions.. Indeed. To demonstrate this. project owners must use their knowledge as well as analytical tools to formalize and improve the adjustment provisions. Kyrgyz Indices RISK-BASED PARAMETER EVALUATION An adjustment provision based on wrong assumptions can be worthless to both the owner and the contractor. Therefore. One such tool is Monte Carlo simulation. A road agency can use it to test the sensitivity of the final Contract Price to different economic scenarios with and without adjustments and the sensitivity to different adjustment parameters. and the final Contract Prices to be computed as probability distributions. especially when historical data are unavailable or unreliable. but simulation allows more systematic assessments compared to the traditional binary sensitivity analyses. an Excel-based software program (26) was used with the set of input parameters given in Table 2. . etc. and can provide all parties a higher level of comfort about how adjustment provisions will address their respective inflation risk.Seneviratne 10 Figure 2. day works. The simulation model for the base case (Scenario 1) was formulated as follows: (i) monthly value of works eligible for adjustment was estimated by multiplying the Accepted Contract Amount by the contractor’s monthly cashflow forecasts (percentage) in a typical 36-month contract. it does not produce the ultimate or final result. TRB 2013 Annual Meeting Paper revised from original submittal. without deductions for advance repayment recovery. which is used by leading global companies to forecast returns and manage risk (24). can also be tested. Simulation Example Monte Carlo simulation is a useful method of testing the sensitivity of the contract price to adjustment parameters. Touran and Lopez (25) have previously shown the usefulness of Monte Carlo simulation compared to other methods for representing the uncertainty of price volatility. or additions for change orders. Simulation allows prices and indices to be represented. However.4 million or about 0. (0.1. the owner can estimate the final Contract Price under different start dates and the level of confidence. to include in the bid price to cover inflation until adjustments start under FIDIC MDB Sub clause 13. 2010 1. c. and (vi) simulated adjustment factor for each month was multiplied by the value of work determined in step (i) above to arrive at a distribution of adjusted value of works for each month. (iii) monthly relative index for each cost element (Ii/Io ) was assumed to have a triangular distribution.11 Seneviratne (ii) value was assumed to be comprised of three cost elements. Triangular.4% lower than the default case.97. TRB 2013 Annual Meeting Paper revised from original submittal.06) 10%. there seems little value in delaying the start date.1.0. the Accepted Contract Amount shall be deemed to have included amounts to cover the contingency of other rises and falls in costs. Therefore. Triangular.0.000. Triangular (0. b. most likely. To the extent that full compensation for any rise or fall in Costs is not covered by the provisions of this or other Clauses.98. If adjustments start 24 months after the Commencement Date. and decide whether or not to postpone.05) 20%. . Basic Inputs to Simulation Model (Scenario 1) Input Accepted Contract Amount Time for completion Frequency of adjustment Base Date Base Index of All Cost Elements Non-adjustable portion Cost Element 1 Weighting and Reference Index Probability Distribution Parameters Cost Element 2 Weighting and Reference Index Probability Distribution Type Parameters Cost Element 2 Weighting and Reference Index Probability Distribution Type Parameters Number of Simulations Per Test Value $100. if any.98.0 30% 40%. there is a possibility that even risk-averse bidders will include a premium in their bids for the expected loss in the first 24 months. it will be $100. Goods and other inputs to the Works. The triangular distribution is useful for subjectively describing a population with only limited sample data. (0. Touran and Lopez (25) have used a normal distribution. by the addition or deduction of the amounts determined by the formulae prescribed in this Sub-Clause. the mean final Contract Price is $100. 4 If this Sub-Clause applies. and d in the adjustment formula were assumed to be given. Likewise.0. and highest values—were assumed to be given. the amounts payable to the Contractor shall be adjusted for rises or falls in the cost of labor. Table 2.8 million.1. In other words. and determine the contingency to include in the budget. a bidder can use simulation to determine what premium.000 by starting adjustments later.08) 1000 The simulated results of the different scenarios tested in this example are summarized below: (i) Start Date: If start date is different from the Commencement Date. and the distribution of the total adjusted price (the final Contract Price). One only requires some knowledge of the minimum and maximum and an inspired guess as to what the modal value might be (27). (iv) distribution parameters--lowest.1. The simulated values shown in Table 3 suggest that when the start date is the default date (Commencement Date). and the coefficients a. (v) base index of each cost element was assumed to be equal to 1.84.000 36 months Monthly As per FIDIC MDB.1.1. the owner will save $400. It can also be seen that the savings from the 24-month start date is $500.147. a bidder may seek to recover the loss due to price rises in the first 24 months through a higher bid price.400 100. . all distribution parameters were assumed to increase by 5% of the previous month’s rate in the 12th. This means a possible maximum rise in any adjustment period (month) is 10%. the value of a in the adjustment formula was increased while proportionately reducing the weighting for Cost Element 1.776.000 higher under Scenario 2 (Table 4) than Scenario 1 (Table 3).4% -0.e. Table 4. the upper bounds of the three indices are set at 1.12 Seneviratne Table 3.065 193.200 101. To test the impact of this.045.270.477.700 101.3% -0.640.818.000 101.500 100.000 101.440.700 101.400.122 Start Date After 12 Months 18 Months 24 Months 100. 18th.6% -0.. The weightings of the others were held constant.900 100.170. Sensitivity of Final Contract Price (in $ million) to Start Date Under Scenario 2 Start Date After Statistic Default Date 12 Months 18 Months 24 Months Minimum 101. Increasing it from 10% to 50% under the high volatility scenario (Scenario 2) reduces the mean final Contract Price by less than 1%.272.152.100 Maximum 102.000 122.3. Once again.260 176.300 102.5 million.768.000 100.25 and 1.400 100. The average savings accruing to the owner by delaying the adjustment start date by 24 months in this case were about $900.184 119. The difference is about 3% even if volatility is set higher (i.800.1.437. Sensitivity of Final Contract Price (in $ million) to Start Date Under Scenario 1 Statistic Minimum Maximum Mean Std Deviation % Change Mean Default Date 100.900. given the higher volatility and uncertainty over the 24 months are likely to cause bidders to add a higher premium to the tender prices.000 Std Deviation 217. the maximum value of the relative index probability distribution of each cost element was increased to 1.482. However.800.600 100.490.900 100.871 202.177. These numbers also suggest that the owner’s TRB 2013 Annual Meeting Paper revised from original submittal. which was assigned the highest weighting in Scenario 1. It can be seen from Table 6 that the final contract price is not very sensitive to the non-adjustable portion.520.000 100.2).000 100. The figures in Table 5 show that the average saving to the owner from starting adjustment in the 25th month is about $1.040.600 Mean 101.900 100.000 100.700 100.944 -0. 1.000 130.4% What if the volatility is much higher (Scenario 2)? To test this. and 24th month and remain at the elevated rate in between.9% What if the prices are constantly increasing with minor monthly rises and falls (Scenario 3)? To test this.243 100.800 101.457 % Change Mean -0.950.2% -0. (ii) Non-Adjustable Portion: Some road agencies and ADB staff advocate higher nonadjustable portions.076.000 as seen from Table 4. 700 102.170. Sensitivity of Final Contract Price (in $ million) to Start Date Under Scenario 3 Statistic Default Date Minimum Maximum Mean Std Deviation % Change Mean 105.300 160. TRB 2013 Annual Meeting Paper revised from original submittal.741.8% -1.7% Table 6.348 125.2% 18 Months 24 Months 104.0.700 209.0% 30% 50% 101.595.13 Seneviratne savings in the very high volatility case may be offset by the bidder’s risk premium.8% Figures 3 and 4 below show the distributions of the adjustment factor and the adjusted final Contract Price when the volatility is high (the distribution parameters of all three cost elements are set at 1.100 101.900 102. This is particularly true if the increase is from 10% to 30%.200 103.000 101.462 237.323 120.419.100 101.725 -0.02 with a very small standard deviation.838. . Table 5. and there is less than 15% chance of the mean final Contract Price exceeding $103 million.400 101.284.330 134.334 103.10).033.448 105.914 Start Date After 12Months 104.03.133 105.300 275.823 104.183 105. The resultant adjustment factor does not change much. and 1.002.413. The other parameters were assumed to remain unchanged. and that there will be no substantial gain from increasing the non-adjustable portion.140 103.766.578.011.300.841.625 100.267.400 102.922.223.752 104.383.233.038 106.000 102.347 105.678 -0.457.933.724.022 0.893.3% -0. 1.250 -0. Sensitivity of Final Contract Price (in $ million) to Non Adjustable Portion Under Scenario 2 Non-Adjustable Portion Statistic 10% Minimum Maximum Mean Std Deviation % Change in Mean 20% 101. It is normally distributed with a mean of 1.699.965 105. Distribution of Mean Final Contract Price (iii) Expected Bid Price: If one assumes that a=0 and the Engineer’s estimate is $100 million. 1. bid prices are unlikely to deviate much from the Engineer’s estimate.98. a rational bidder will quote at least $8 million more than the Engineer’s estimate to be 50% certain of not losing money and competitiveness. the final Contract Price mean will be about $108 million. Distribution of Adjustment Factors Figure 4. From this. . and the total value of works is adjusted each month as per one composite index with triangular distribution (0. 1. it is reasonable to deduce that. if the adjustment provision is retained with the default values and project information is equally accessible to all bidders. Rational bidders are unlikely to TRB 2013 Annual Meeting Paper revised from original submittal. On the other hand.0.3). There is about 5% probability that it will be more than $110 million or less than $ 106 million as shown in Figure 5 below. in the absence of an adjustment provision.Seneviratne 14 Figure 3. interviews with ADB and road agency staff. and using a family of formulae. the literature review. Distribution of Final Contract Price After Adjustments SUMMARY AND CONCLUSIONS The empirical data. TRB 2013 Annual Meeting Paper revised from original submittal.g. although limited. revealed the following: (i) there are no published empirical and theoretical studies of the adjustment provision in FIDIC MDB. .15 Seneviratne quote unrealistically low prices and expect to recover the losses from adjustments under Sub clause 13. even in a highly volatile environment. to reduce uncertainty: (iv) some supported changing parameters such as the start date and the non-adjustable portion. prevent bidders benefitting from price rises) to limiting eligible work items and material (e. there are many internet sites (e. Figure 5. and simulation results. only the volatility of Cost Element 1 was considered by setting b=1 with default start and base dates. However. but the impact of an adjustment provision on bid prices is not considered there.. 30). reference 31) that post opinions on myriad topics. (ii) only about half the interviewees cited inflation risk sharing and increasing competition as rationales behind providing for price adjustment while the other half considered it a donor requirement. bid price estimation is a separate topic and has been reported elsewhere (28. (v) the reasons for changing default adjustment parameters ranged from discouraging low bidders and slow work (i. Regardless. and no related provisions were found in the sample of contracts studied for this paper. 29. (vi) interviewees had either not considered or were unaware of adjustment triggers and limits. only asphalt paving and not all works)..8 in FIDIC MDB by delaying work. The bid price discussion above is based on the assumption that the Engineer’s estimate is robust and a bidder will not be able to leverage much lower prices for the inputs. (iii) some interviewees supported establishing specific national practices.. like what the Philippines has done. Also.g.e. (viii) whether a later start date and a large non-adjustable portion (high value of the coefficient a) will make some bidders add high premiums and make themselves uncompetitive. but questions like adjustment provision’s impact on the number of bidders per tender and market stability require well-designed and controlled surveys. it can be concluded that: (i) in the absence of sufficient empirical evidence. The following is a summary of the impact of adjustment provisions under different scenarios: (i) net adjustment to the Accepted Contract Amount (negotiated price) will be always positive if the index probability distributions are positively skewed like in Tajikistan and Kyrgyz. for which the monthly data from 2008 to 2010 were tested in the present example. (ii) simulation provides an additional perspective on the impact of various underlying assumptions. project owners will continue to grapple with questions regarding the adjustment provision in FIDIC MDB. (iv) savings to an owner from delaying the adjustment start date will be reduced by the increased administration cost of implementing a complicated adjustment provision as in the case in Tajikistan referred to earlier. (ii) this pattern is likely to cause bidders to add premiums in the absence of an adjustment provision. However. and (ix) simulation can help test the adequacy of a projects’ budget under different inflation scenarios. It will require a harmonized effort similar to that for producing FIDIC MDB to collate data and conduct the tests required to answer these questions with certainty. Based on the foregoing. scope. decide against bidding. remain unchanged. but it is not panacea. or underbid and run into financial difficulty cannot be determined through simulation.. in an actual tender. and hence the likelihood of the default start date encouraging low bids (because the contractors expect to make money later) is small. especially if price and index data are unavailable and unreliable. (vi) when future conditions are uncertain. etc. (viii) simulation results can help decide whether to retain the adjustment provision in a contract or opt for a fixed price contract with no adjustments for inflation. (vii) bidders’ perceptions and behavior are likely to be the same as above when the nonadjustable portion is increased although its financial implications are minimal in a high value contract. This study has not tested the relative effects of different types of price or index distributions and the numerous combinations thereof to make definitive conclusions. provided that all other conditions such as designs. .Seneviratne 16 (vii) Monte Carlo simulation can be used to estimates the final Contract Price. simulation can be used to compare the bid prices with simulated final contract prices to determine whether it is unrealistically low and the contractor can absorb the risk. and TRB 2013 Annual Meeting Paper revised from original submittal. and save on the adjustment provision administration cost. It is likely that the premium will be higher than the simulated mean of the adjustments. (iii) final Contract Price is not very sensitive to the adjustment start date. particularly of international bidders. It can help answer some. particularly on cost element distributions. resulting in higher bid prices. 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