Costs and Benefits of the Price Adjustment Clause in FIDIC MDB

Prianka N. Seneviratne
Asian Development Bank
6 ADB Avenue
Mandaluyong City
Metro Manila
Philippines

Tel: +63 2 632-4444

Fax: +63 2 636 2428
Email: pseneviratne@adb.org

(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.
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.
Seneviratne 3

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. In theory, if a contractor knows at the bidding stage that payments for his
work will be periodically indexed, he will have less of a need to add a premium to the bid price
for possible cost increases during construction. This reduces his risk of losing the contract by
adding the premium. Adjustment provision in a contract also lowers the risk of contractors
underestimating cost increases, and later experiencing financial difficulties and defaulting on
their obligations. A project owner, on the other hand, ideally can benefit from lower bid-prices,
less likelihood of contractors going into bankruptcy mid stream of a project, and lower final
Contract Price, especially when costs are declining. These rationales, which were postulated
more than 30 years ago, have led to the price adjustment clause becoming a standard feature in
most construction contracts worldwide. It is also a standard clause (Clause 13.8—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). The
standard bidding documents of eight donors are based on this contract form since 2005, when
its first version was released.

A typical adjustment clause specifies the method, the terms, and the conditions of adjustment.
These include the timing (start date, end date, and frequency), trigger values (i.e., range of price
change, over which a contractor can claim adjustments), definitions of the value of works that
will be adjusted, and the computation method. This means that the clause designers must
determine the terms and conditions that best suit the project in hand. They also have to choose
from three common computation methods: invoices, formulae, and a hybrid of the first two
methods (2). A good overview of the history of price adjustment is provided in Ndihokubwayo
and Haupt (3).

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) + ......

Where:
Pn = adjustment multiplier to be applied to the estimated contract value in the relevant
currency of the work carried out in period ―n‖, this period being a month unless otherwise
stated in the Contract Data;
a = fixed coefficient, stated in the relevant table of adjustment data, representing the
non-adjustable portion in contractual payments;
b, c, d, etc. = coefficients representing the estimated proportion of each cost element
related to the execution of the Works, as stated in the relevant table of adjustment data;
such tabulated cost elements may be indicative of resources such as labor, equipment
and materials;
Ln, En, Mn, etc. = current cost indices or reference prices for period ―n‖, expressed in the
relevant currency of payment, 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); and
Lo, Eo, Mo, etc. = base cost indices or reference prices, expressed in the relevant
currency of payment, each of which is applicable to the relevant tabulated cost element
on the Base Date.
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. For each formula, a and all
the cost elements-- L, M, E, etc--must also specified. The default Base Date for Lo, Eo, Mo, etc,
is defined in FIDIC MDB as the date 28 days before the final bid closing date. Each bidder must
propose the values of b, c, d, and unless the Owner has specified, the source(s) of the indices
or reference prices for L, M, E, etc. The default adjustment frequency is once a month, but may
be altered by the Owner. These data are provided in the ―table of adjustment data‖ and the
particular conditions of contract in the bid document.

This paper has two objectives. One is to analyze the sources and rationales behind the common
answers to questions about price adjustment in FIDIC MDB. These are questions frequently
asked by agencies implementing Asian Development Bank (ADB) financed road projects in
Central Asia and the Caucuses. The other is to propose an analytical tool that can help the
agencies test and use these answers, and make the price adjustment process systematic. The
paper is based on data from ADB-financed road works contracts, a review of literature on global
experiences on price adjustment, and interviews with 10 staff from road agencies and ADB.
Using Monte Carlo simulation, the present author presents that, intuitively, the price adjustment
procedure in FIDIC MDB is beneficial to both the Owner and the Contractor. However, an owner
can only gain small financial rewards by changing the default parameters such as Base Date,
start date, and by increasing the non-adjustable portion.

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, and 85% of these states provide adjustments for fuel
and 79% for both fuel and liquid asphalt (4). Adjustment provisions are included in about 75%
of all contracts let by these states each year. The adjustment parameters are based mostly on
the United States Department of Transportation’s Technical Advisory 158 (5).

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
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). The indices are taken
from the Road and Bridge Construction Index published by the Australian Bureau of Statistics
(7). The bitumen adjustment provision is applied separately to contractor-supplied bitumen at
the rate of change in Class 170 bitumen price. Class 170 is used as the reference because it is
assumed to represent all classes of bitumen. In the United Kingdom, the Building Cost
Information Service (BCIS) publishes formulae and indices, and provides guidance on their use
(8).

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). Previously it was applicable to only to contracts of 18 months or more. 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. This change was brought in after a survey
found that 61% of the bidders were small contractors, who are more likely to experience
cashflow problems in inflationary times.

The Philippines has a comprehensive guide on design and use of price adjustments in works
contracts. The Government Procurement Reform Act of the Philippines (10) provide for
adjustment in ―extraordinary circumstances‖, which include fortuitous events, and extraordinary
inflation and deflation. It provides formulae for 52 different work items. In Pakistan, guidelines
Seneviratne 5

issued by the Engineering Council, which is the statutory body entrusted to regulate the
engineering profession, must be followed for formulating and implementing price adjustment in
all public works contracts (11). However, the cost elements and the other coefficients are still
left to be determined by the project owner and the bidders.

Several other developing countries also have legislation on terms and conditions of adjustment
to be followed, even when FIDIC MDB is used. However, the country guidelines are in the form
of rules that make price adjustment mandatory--no instructions on how to determine the
parameters. For example, 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- of the circular), but it does not specify thresholds or parameters
(12). In Sri Lanka, formulae (same as FIDIC MDB) are specified by the Institute for Construction
Training and Development for different work items (13), but the corresponding guidelines too
are not helpful to a project owner or a bidder. The National Highway Authority of India permits
formula based adjustments subject to certain conditions, but also does not prescribe parameters
(14). This formula is similar to that specified by BCIS in the UK.

The effect of the adjustment provision in a contract is not widely reported. The most extensive of
the few published findings is a survey of the state DOTs by Skolnick (4). That has not shown
discernible difference in the overall bid prices, market stability (number of contractors entering
and leaving the market), defaulting contractors, and the number of bids per contract as a result
of adjustment provisions. However, the survey data differences in some items such as steel.
Additionally, it showed that the Engineers spend 86 hours a month per contract on average
administering the adjustment provision. On the other hand, 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. They have found that
post-2006 bid prices were on average 12.7% lower for items eligible for adjustment compared to
ineligible items.

ADJUSTMENT PARAMETERS
According to ADB’s procurement guidelines, the price adjustment provision must be included in
contracts longer than 18 months (15). Failure of a bidder to accept the price adjustment
provision is a basis for rejecting his bid (16). If provided and accepted, the project owner and the
bidders must determine the following parameters, terms, and conditions of adjustment:

(i) Base date and Start Date1

(ii) Triggers and caps
(iii) The non-adjustable portion (a);
(iv) Cost elements (L, M, N, etc)
(v) Weightings of the cost elements (b, c, d, …)
(vi) The source of the indices or reference prices for L, M, N, …

For project owners in developing countries who do not have tested and legally enacted price
adjustment procedures, the decisions on these parameters can be challenging. Information in
the donor’s guides is scant. They can indeed turn to textbooks (e.g., 17 and 18), periodic FIDIC
seminars, and discussion groups on the internet. However, they generally lack experience and

1
Default start date is based on the start date of the program, which the Contractor must submit within 28 days of the
Commencement Date, and the default Base Date is the date 28 days prior to the latest date for submission of the
tender. Commencement Date is the date of the Engineer’s notice to the contractor that the conditions set out in
Sub clause 8.1 in FIDIC MDB have been fulfilled.
Seneviratne 6

historical data needed to analyze each parameter in detail, and hence continually grapple with
myriad questions. Among them, the following are some frequently asked questions:

(i) What are the optimum start and base dates?

(ii) Can upper and lower bounds be set to trigger the adjustments (i.e., adjustments are
allowed only if a price or an index change stays with 3 and 10%)?
(iii) What are the appropriate cost elements and weightings?
(iv) What is the optimum non-adjustable portion (adjustment formula constant)?
(v) What are the reliable and appropriate price or index sources?
(vi) When and how can a family of formulae (separate formula for separate for work
items) be used?
(vii) Should bidders be allowed to propose the weightings?
(viii) 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, which is ―the date 28 days prior to the latest
date for submission and completion of the tender‖ (1), has been retained in most ADB contracts.
A 48-month contract let in Afghanistan in 2011 is an exception. In that, 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). The date 28 days before the start of the 18th
month was used in a contract in Armenia.

Start Date: This date, which is the first date of the first adjustment period, is important, because
a default date is not specified in FIDIC MDB, most global guidelines and ADB (1, 16, and 19).
The Philippines is the exception--the date six months after the date of signing the contract is
defined as the default start date (10). With few exceptions, the Commencement Date (as
defined in FIDIC MDB) is the start date in most ADB –financed contracts examined for this
paper. In the Afghanistan contract mentioned above, the first adjustment period starts on the
date 24 months after the Commencement Date. The reference date for the first set of current
indices is the date 722 days after the Commencement Date (i.e., Commencement Date + 720
days + 30 days – 28 days). The underlying rationale for the late start—to discourage
unrealistically low bids from firms expecting to delay the works and benefit from rising prices.

In a 2011 contract let in Tajikistan, the adjustments for asphalt works2 was set to start on the
date 12 months after the Commencement Date, with the first set of current indices based on the
date 311 days after the Commencement Date (i.e., Commencement Date + 360 days – 49
days). The remaining work items are adjusted starting on the Commencement Date. 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. Hence, adjustments for cost changes in the first
12 months should not apply to asphalt works. The formulae used here are similar to those of
Queensland Department of Main Roads (7).

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. This uncertainty can cause a bidder to add a risk premium to
the tender price, and undermine the advantages of the adjustment provision.

2
The value of all work less the value of asphalt work is adjusted in each period starting on the Commencement Date.
Seneviratne 7

Triggers: The Philippines has set legal and technical thresholds for adjustment, starting 6-
month after the effective date of the contract (10). 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). 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. 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). 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 donors’ guidelines make no
reference to this option although it can be easily provided under FIDIC MDB. It can avoid the
need for defining start dates and corresponding base dates, and indirectly show the level of risk
that the owner is willing to take.

Cost Elements: FIDIC MDB cites labor, materials, and equipment as possible elements. Labor,
bitumen, cement, steel, and equipment are the common elements in contracts examined for this
paper as shown in Table 1. Ideally, the elements should be those making up the total cost of a
particular work item, component, or all works. Pakistan has prescribed several steps for a user
to follow in determining the elements (11), and the Philippines prescribes the elements for each
of the 52 work items (10).

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. 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). In India, project owners tend to set some and leave the other
weightings to be proposed by the bidder (14). 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. The Indian approach lowers this risk while also
providing the bidders the opportunity to define their cost composition. The ranges of weightings
assigned to common cost elements found in this study are shown in Table 1.

Table 1. Adjustment Formula Parameters from the Sample of Contracts

Cost Georgia Kazakhstan Afghanistan Tajikistan Azerbaijan Kyrgyz India
Element
Fixed 20-55% 10% 40-50% 25-30% 10-15% 25% 15%
Local Labor 9.5-
7-20% 25% 5-10% 10-25% 5-15% 20%
21%
Foreign
- - - 45% - - -
Labor
Fuel 6.1- 20-
5-25% 14% 11-15% 5-17.5% -
(Diesel) 21% 40%
Petroleum,
Oil and - - 20% - - 5%
Lubricants
Bitumen 11% and 30- Project
0-4.5% - 16-20% 2.5-25%
Note (a) 40% Specific
Cement 11% and Project
11-13% 25-50% 5% 15% 10%
Note (a) Specific
Steel 4.6- 2-6% 5% 12% and 15-30% 10% Project
Seneviratne 8

20% Note (a) Specific

Aggregates 2.6-
13-27% - - - -
19%
Plant and 20-
- 5% - 5-11% 4-10% 5%
Equipment 30%
General
- - - 15%
Materials
Foreign Project
- -
Inputs3 Specific
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. It can also be viewed as the share of overheads and profits, deemed to be unaffected by
inflation. There are different views on the appropriate value of ―a” depending on whether it is
considered the contractor’s risk or his profit (22). In the UK, BCIS Highways Term Maintenance
Price Adjustment Formula for highway maintenance works has it fixed at 10% (8). South Africa,
the Philippines, and India (2, 10, and 14) have set it at 15%, but Pakistan (11) has set upper
and lower-bounds of 35% and 65% respectively. The values used in Central Asian and the
Caucuses countries in ADB financed projects ranged from 10-55% as shown in Table 1.

Index and Price Sources: Under FIDIC MDB, a project owner can require bidders to use
national sources or ask them to propose sources. In the latter case, if the element is an
imported good, bidders can propose either an official source-country index, a global index, or a
national index, if available. Because this index will be used to price the bid and future
adjustments, it should be representative, easily accessible, and regularly published. A concern
that contracting parties may have about each other’s proposed sources, which can later lead to
disagreement, is their reliability, continuity, and timeliness. Countries such as New Zealand and
the UK provide for using alternative national sources in case one source is discontinued (20 and
8). Timeliness is particularly important to keep the Engineer’s workload to a minimum. If late,
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. At the
state DOTs, engineers spend 85 hours a month on administration (4). This cost will increase
with the frequency of adjustments.

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. However, parameter selection at
road agencies in Central Asia is still an ad hoc process, driven partially by donors. There is a
large spread in the adjustment parameter values (see Table 1) even in the same country in the
same time period. For instance, in Georgia, 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. This is partly attributable to the lack of information and guidance. There is a dearth of
examinations like those by Skolnik (4), Kosmopoulouy and Zhou (6), and Weidman (23) that
highlight lessons learned from design and application of adjustment provisions in aid-financed
contracts.

In Tajikistan, in 2011, equal weightings were assigned to all cost elements and 45% to foreign
labor. However, bitumen was the most volatile cost element in the 2008-2009 period and the

3
Includes inputs such as technical personnel, construction plant, etc.
Seneviratne 9

other cost elements either remained unchanged or declined as shown in Figure 1. In Kyrgyz, the
most volatile element between 2007 and 2010 was local labor (See Figure 2). However,
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, and current and past economic conditions.
Whether this is because the project owners lacked experience and the donors’ guidance came
from different sources is not apparent from the preliminary data. But the adjustment provisions
in the sample of contracts analyzed here have few commonalities despite the similarities of the
project scopes.

Figure 1. Tajikistan Indices

Seneviratne 10

Figure 2. Kyrgyz Indices

RISK-BASED PARAMETER EVALUATION

An adjustment provision based on wrong assumptions can be worthless to both the owner and
the contractor. Therefore, project owners must use their knowledge as well as analytical tools to
formalize and improve the adjustment provisions. One such tool is Monte Carlo simulation,
which is used by leading global companies to forecast returns and manage risk (24). 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.
Its sensitivity to different level of uncertainty about future market conditions, especially when
historical data are unavailable or unreliable, can also be tested. Simulation allows prices and
indices to be represented, and the final Contract Prices to be computed as probability
distributions. Indeed, it does not produce the ultimate or final result, but simulation allows more
systematic assessments compared to the traditional binary sensitivity analyses, and can provide
all parties a higher level of comfort about how adjustment provisions will address their
respective inflation risk. Touran and Lopez (25) have previously shown the usefulness of Monte
Carlo simulation compared to other methods for representing the uncertainty of price volatility.

Simulation Example
Monte Carlo simulation is a useful method of testing the sensitivity of the contract price to
adjustment parameters. To demonstrate this, an Excel-based software program (26) was used
with the set of input parameters given in Table 2. 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, without deductions for advance repayment recovery, day
works, etc., or additions for change orders;
Seneviratne 11

(ii) value was assumed to be comprised of three cost elements, and the coefficients a, b, c,
and d in the adjustment formula were assumed to be given;
(iii) monthly relative index for each cost element (Ii/Io ) was assumed to have a triangular
distribution. Touran and Lopez (25) have used a normal distribution. The triangular
distribution is useful for subjectively describing a population with only limited sample
data. 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, most likely, and highest values—were assumed to be
given;
(v) base index of each cost element was assumed to be equal to 1; 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, and the distribution of the total adjusted price (the final Contract Price).

Table 2. Basic Inputs to Simulation Model (Scenario 1)

Input Value
Accepted Contract Amount $100,000,000
Time for completion 36 months
Frequency of adjustment Monthly
Base Date As per FIDIC MDB, 2010
Base Index of All Cost Elements 1.0
Non-adjustable portion 30%
Cost Element 1 Weighting and Reference Index 40%; Triangular; (0.98,1.0,1.05)
Probability Distribution Parameters
Cost Element 2 Weighting and Reference Index 20%; Triangular; (0.98,1.0,1.06)
Probability Distribution Type Parameters
Cost Element 2 Weighting and Reference Index 10%; Triangular (0.97,1.0,1.08)
Probability Distribution Type Parameters
Number of Simulations Per Test 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, a bidder can use
simulation to determine what premium, if any, to include in the bid price to cover inflation
until adjustments start under FIDIC MDB Sub clause 13.84. Likewise, the owner can
estimate the final Contract Price under different start dates and the level of confidence,
and decide whether or not to postpone, and determine the contingency to include in the
budget.

The simulated values shown in Table 3 suggest that when the start date is the default
date (Commencement Date), the mean final Contract Price is $100.8 million. If
adjustments start 24 months after the Commencement Date, it will be $100.4 million or
about 0.4% lower than the default case. In other words, the owner will save $400,000 by
starting adjustments later. However, 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.
Therefore, there seems little value in delaying the start date.

4
If this Sub-Clause applies, the amounts payable to the Contractor shall be adjusted for rises or falls in the cost of
labor, Goods and other inputs to the Works, by the addition or deduction of the amounts determined by the
formulae prescribed in this Sub-Clause. To the extent that full compensation for any rise or fall in Costs is not
covered by the provisions of this or other Clauses, the Accepted Contract Amount shall be deemed to have
included amounts to cover the contingency of other rises and falls in costs.
Seneviratne 12

Table 3. Sensitivity of Final Contract Price (in $ million) to Start Date Under Scenario 1
Start Date After
Statistic Default Date
12 Months 18 Months 24 Months
Minimum 100,437,700 100,272,900 100,152,000 100,076,800
Maximum 101,147,900 101,045,900 100,950,400 100,768,400
Mean 100,800,000 100,640,000 100,520,000 100,400,000
Std Deviation 130,122 122,184 119,243 100,944
% Change Mean -0.2% -0.3% -0.4%

What if the volatility is much higher (Scenario 2)? To test this, the maximum value of the
relative index probability distribution of each cost element was increased to 1.1. This
means a possible maximum rise in any adjustment period (month) is 10%. The average
savings accruing to the owner by delaying the adjustment start date by 24 months in this
case were about $900,000 as seen from Table 4. It can also be seen that the savings
from the 24-month start date is $500,000 higher under Scenario 2 (Table 4) than
Scenario 1 (Table 3). However, given the higher volatility and uncertainty over the 24
months are likely to cause bidders to add a higher premium to the tender prices.

Table 4. 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 101,177,600 100,776,700 100,490,500 100,270,100
Maximum 102,482,300 102,040,700 101,818,200 101,477,600
Mean 101,800,000 101,440,000 101,170,000 100,900,000
Std Deviation 217,871 202,065 193,260 176,457
% Change Mean -0.4% -0.6% -0.9%

What if the prices are constantly increasing with minor monthly rises and falls (Scenario
3)? To test this, all distribution parameters were assumed to increase by 5% of the
previous month’s rate in the 12th, 18th, and 24th month and remain at the elevated rate in
between. The figures in Table 5 show that the average saving to the owner from starting
adjustment in the 25th month is about $1.5 million. Once again, a bidder may seek to
recover the loss due to price rises in the first 24 months through a higher bid price.

(ii) Non-Adjustable Portion: Some road agencies and ADB staff advocate higher non-
adjustable portions. To test the impact of this, the value of a in the adjustment formula
was increased while proportionately reducing the weighting for Cost Element 1, which
was assigned the highest weighting in Scenario 1. The weightings of the others were
held constant. It can be seen from Table 6 that the final contract price is not very
sensitive to the non-adjustable portion. Increasing it from 10% to 50% under the high
volatility scenario (Scenario 2) reduces the mean final Contract Price by less than 1%.
The difference is about 3% even if volatility is set higher (i.e., the upper bounds of the
three indices are set at 1.3, 1.25 and 1.2). These numbers also suggest that the owner’s
Seneviratne 13

savings in the very high volatility case may be offset by the bidder’s risk premium, and
that there will be no substantial gain from increasing the non-adjustable portion. This is
particularly true if the increase is from 10% to 30%.

Table 5. Sensitivity of Final Contract Price (in $ million) to Start Date Under Scenario 3
Start Date After
Statistic Default Date
12Months 18 Months 24 Months
Minimum 105,922,133 104,841,448 104,170,140 103,595,347
Maximum 105,893,183 105,699,965 105,011,823 104,267,752
Mean 105,383,330 105,223,348 104,578,334 103,933,323
Std Deviation 134,914 125,678 120,038 106,725
% Change Mean -0.2% -0.8% -1.7%

Table 6. Sensitivity of Final Contract Price (in $ million) to Non Adjustable Portion Under
Scenario 2
Non-Adjustable Portion
Statistic
10% 20% 30% 50%

Minimum 101,413,400 101,284,200 101,002,400 100,741,100

Maximum 103,419,700 102,838,900 102,457,000 101,724,100
Mean 102,300,000 102,033,300 101,766,700 101,233,300
Std Deviation 275,462 237,022 209,625 160,250
% Change in
Mean 0.0% -0.3% -0.8%

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 1.0, 1.03, and 1.10). The other parameters were assumed to
remain unchanged. The resultant adjustment factor does not change much. It is
normally distributed with a mean of 1.02 with a very small standard deviation, and there
is less than 15% chance of the mean final Contract Price exceeding $103 million.
Seneviratne 14

Figure 3. Distribution of Adjustment Factors

Figure 4. Distribution of Mean Final Contract Price

(iii) Expected Bid Price: If one assumes that a=0 and the Engineer’s estimate is $100
million, and the total value of works is adjusted each month as per one composite index
with triangular distribution (0.98, 1.0, 1.3), the final Contract Price mean will be about
$108 million. There is about 5% probability that it will be more than $110 million or less
than $ 106 million as shown in Figure 5 below. From this, it is reasonable to deduce that,
in the absence of an adjustment provision, 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. On the other hand, if the adjustment provision is retained with the
default values and project information is equally accessible to all bidders, bid prices are
unlikely to deviate much from the Engineer’s estimate. Rational bidders are unlikely to
Seneviratne 15

quote unrealistically low prices and expect to recover the losses from adjustments under
Sub clause 13.8 in FIDIC MDB by delaying work, even in a highly volatile environment.

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. Also,
only the volatility of Cost Element 1 was considered by setting b=1 with default start and
base dates. Regardless, bid price estimation is a separate topic and has been reported
elsewhere (28, 29, 30), but the impact of an adjustment provision on bid prices is not
considered there.

Figure 5. Distribution of Final Contract Price After Adjustments

SUMMARY AND CONCLUSIONS

The empirical data, interviews with ADB and road agency staff, the literature review, and
simulation results, although limited, revealed the following:
(i) there are no published empirical and theoretical studies of the adjustment provision in
FIDIC MDB. However, there are many internet sites (e.g., 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;
(iii) some interviewees supported establishing specific national practices, like what the
Philippines has done, to reduce uncertainty:
(iv) some supported changing parameters such as the start date and the non-adjustable
portion, and using a family of formulae;
(v) the reasons for changing default adjustment parameters ranged from discouraging low
bidders and slow work (i.e., prevent bidders benefitting from price rises) to limiting
eligible work items and material (e.g., only asphalt paving and not all works);
(vi) interviewees had either not considered or were unaware of adjustment triggers and
limits, and no related provisions were found in the sample of contracts studied for this
paper;
Seneviratne 16

(vii) Monte Carlo simulation can be used to estimates the final Contract Price, provided that
all other conditions such as designs, scope, etc., remain unchanged;
(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, and save on
the adjustment provision administration cost; and
(ix) simulation can help test the adequacy of a projects’ budget under different inflation
scenarios.

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) this pattern is likely to cause bidders to add premiums in the absence of an adjustment
provision. It is likely that the premium will be higher than the simulated mean of the
adjustments, especially if price and index data are unavailable and unreliable;
(iii) final Contract Price is not very sensitive to the adjustment start date, and hence the
likelihood of the default start date encouraging low bids (because the contractors expect
to make money later) is small;
(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;
(v) final contract price is also not very sensitive to the adjustment formula constant and
weightings;
(vi) when future conditions are uncertain, pushing back the start date can be expected to
create a perception of risk in the minds of bidders, particularly of international bidders,
resulting in higher bid prices;
(vii) bidders’ perceptions and behavior are likely to be the same as above when the non-
adjustable portion is increased although its financial implications are minimal in a high
value contract.
(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, decide against bidding, or underbid and run into financial difficulty
cannot be determined through simulation. However, in an actual tender, 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.

Based on the foregoing, it can be concluded that:

(i) in the absence of sufficient empirical evidence, project owners will continue to grapple
with questions regarding the adjustment provision in FIDIC MDB. 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;
(ii) simulation provides an additional perspective on the impact of various underlying
assumptions, but it is not panacea. It can help answer some, but questions like
adjustment provision’s impact on the number of bidders per tender and market stability
require well-designed and controlled surveys;
(iii) simulation results will improve and may be different when more data, particularly on cost
element distributions, are available. 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; and
Seneviratne 17

(iv) regardless of these limitations, simulation results are sufficient to intuitively suggest that
a contract with an adjustment provision with default parameters is more likely to attract
lower bids and result in lower final contract prices than one without a provision and one
with a provision but adjusted parameters.
Seneviratne 18

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