Inflation in infrastructure projects: a risk we need to address

It’s not often an economics story makes the headlines but as we start 2022, inflation is a lead news item. The understandable focus has been on how inflation affects people in their daily life, but there are also stories on how inflation is impacting companies and supply chains. My interest is in understanding inflation risk in infrastructure projects and how this risk is allocated between key stakeholders. My recently published a paper on Inflation shopping: how transport infrastructure project cost evaluation is affected by choice of inflation index addresses this, which I hope is of interest to others in the project profession. I wish I could say I had the foresight to predict this back in early 2020 when I started looking into the effect of inflation on infrastructures projects, but the truth is, it’s complete coincidence.  

I started to look into inflation risk in infrastructure projects having read the January 2020 National Audit Office (NAO) report High Speed Two A progress update where the NAO voiced their concern about the management of risk taken by HS2 Ltd. They advised that looking ahead HS2 Ltd will need to manage risks that could cause costs to increase further. There are many views on the nature and cause of risk in major projects, but one that received almost no attention is inflation risk. To put this in context, the budget for HS2 started to take shape in 2013 and has been updated periodically since, where the business case estimates the scheme’s cost through to commencing passenger services in 2033-36 on Phase 1 and perhaps 2036-40 on Phase 2. An error in how inflation is included in these costs by one per cent will compound over 20 years to result in a 22 per cent error in the budget, which would equate to £20bn or so of unallocated risk. It may be nerdy backwater, but if no one is paying attention to inflation as a source of risk then we can be pretty sure it won’t be diagnosed, assessed and mitigated.  

When I delved into inflation in infrastructure inputs, e.g. professional services, wages, materials, etc, what I found is they typically run at a different rate to standard measures of inflation that track inflation in the economy overall such as CPI and GDP. Even amongst construction sector inflation indices, there’s a choice to be made between those produced by The Royal institution of Chartered Surveyors and those produced by the Office for National Statistics. I refer to this choice as ‘inflation shopping’. In the paper mentioned before, I use publicly available data from Crossrail to help quantify the implication this choice of inflation index has on determining the cost of a project, including establishing whether it is close to exceeding its agreed budget or not.  

What I hadn’t fully appreciated at the start of this research is there is more than one ‘inflation shopping’ choice to be made on an infrastructure project. It turned out there are at least three choices to be made and these choices determine which party holds the inflation risk. A savvy project consortium, aware of this issue, will use these decisions to allocate as well as manage the risk while those that are oblivious to inflation risk, or the choices, will no doubt find themselves looking surprised and confused at some stage down the line. The main ‘inflation shopping’ decisions are:  

1. How will the project’s agreed funding change over time in line to accommodate inflation?  

1. How will the project’s agreed budget change over time in line to accommodate inflation?  

1. How will the project’s suppliers agreed contracts change over time to accommodate inflation in their inputs and costs?  

To illustrate the options I’ve created a diagram below*. Let’s take the example of a public sector infrastructure project where the principal parties are central government who agree its funding, a public sector management team that acts as the client and private sector suppliers who undertake a substantial amount of the works. The basis for price changes is the agreed way that prices change over time to reflect changes in input costs, i.e. inflation. Options A to E show different combinations of ‘inflation shopping’ choices and the implications these have for where inflation risk is allocated.  

	Basis for price changes
	A	B	C	D	E
Financial case: project funding, e.g. Taxpayer via finance ministry	GDP (actual)	GDP (actual)	GDP (actual)	GDP (actual)	GDP (actual)
Economic case: project budget, owned by management team	Firm budget, no changes	Fixed budget plus 2% (GDP deflator) increase	Fixed budget plus 2% (GDP deflator) increase	Fixed budget plus sector specific index increase	Variable budget based on time and materials
Commercial case: Agreed contract pricing with suppliers	Firm price contract, no changes	Fixed price plus 2% (GDP deflator) increase	Fixed budget plus sector specific index increase	Fixed budget plus sector specific index increase	Variable pricing based on time and materials
Allocation of inflation risk	Suppliers hold all inflation risk	Suppliers hold inflation risk above 2% on inputs	Management team holds inflation risk on inputs above 2%	Funder holds most inflation risk.	Funder holds all inflation risk.

Options for inflation shopping to allocate inflation risk between principal parties 

Option A does not transfer price changes that occur in project inputs during the project’s delivery. This means the suppliers hold all the inflation risk. As the funder’s income is likely to vary with GDP, which typically rises, the effect is that suppliers subsidise the project’s cost, although it is likely that suppliers will have costed the inflation risk and priced accordingly at the outset, adding an allowance for contingency.  

Option B links the project budget to an approximation for GDP, the two per cent GDP deflator, with a ‘back to back’ agreement to increase supplier pricing by two per cent per annum. This means suppliers hold inflation risk on price changes above two per cent on their inputs. The funder bears inflation risk where actual GDP differs from two per cent.   

Option C links the project budget to an approximation for GDP, the two per cent GDP deflator, and supplier pricing changes in line with an approximation for changes in their input costs, the Infrastructure Index. Here suppliers hold no inflation risk, unless their inputs differ significantly from those tracked by the Infrastructure Index. Price changes pass to the management team, who hold the inflation risk on price changes to inputs above two per cent. Like option B, the funder has to bear inflation risk where actual GDP differs from two per cent.   

Options D and E are variations on a ‘back to back’ arrangement where changes in suppliers’ input prices are transferred via the management team to the funder, who holds all/the vast majority of the inflation risk.  

I’d encourage people in the project profession to use this approach to examine their own projects and identify how price changes over time are accommodated. This should help identify which parties hold inflation risk, and may be useful to spur a conversation on the implications for the project’s resilience as well as prompt remedial action now and on future projects. 

*Source: Chapman, P. (2021), How Transport Infrastructure Cost Evaluation Is Affected by choice of inflation index, Engineering Project Organization Journal, Vol 10, Issue 2