Tender price inflation forecast

The UK construction sector continues to navigate a complex environment

The S&P Global UK Construction PMI continues to show sector activity improving. The PMI fell to 53.6 in August, up from 55.3 in July although companies reported a sustained rebound in total business activity in August. A reading above 50 suggests expansion, with a reading below 50 marking contraction.

Source: S&P Global, Office for National Statistics

The increase is underpinned by a sustained rise in new orders, although workforce numbers reportedly fell the near-term outlook remains optimistic. Restored client confidence has evidently unlocked a pipeline of previously deferred projects.

Commercial activity was the best-performing sector, civil engineering saw moderate improvement while housing grew at its fastest rate since September 2022 with mortgage rates falling.

The Department of Business and Trades (DBT) Material Price Index recorded an annual 0.9 percent fall in June 2024, following a 2.0 percent fall in May. While the annual inflation rate has fallen for 13 successive months, greater construction activity could lead to renewed material price pressures.

At the same time, wage growth is volatile. The Office for National Statistics reported that average weekly earnings in construction eased to 2.3 percent in July on the three-months-on-three-months measure, down from 2.6 percent in June. On this measure, wage inflation was below 1 percent between August 2023 and May 2024. The annual rate fell from 4.6 percent in June to 3.8 percent in July.

Continued skilled labour shortages are driving wage inflation and hindering project delivery. Our survey of contractors highlighted this as the most pressing challenge to deliver on projects, surpassing concerns over rising construction costs. Lack of skilled workers is also undermining project efficiency, leading to delays, reduced productivity and operational bottlenecks.

Sector capacity is further constrained by the large number of insolvencies due to high interest rates, cost pressures, labour shortages and a challenging economic climate. The total number of insolvencies in the year to May 2024 reached 4,287, representing a 1.9 percent increase compared to the same period in 2023.

However, adjusting the number of insolvencies to the number of firms reveals a less alarming picture. Construction ranks third in terms of insolvency rate at 1.3 percent, only marginally higher than the 1.0 percent pre-pandemic level of 2019. While the overall number of insolvencies is concerning, the industry’s relative performance is not as worrying as might be initially perceived. However, it is essential to consider the cyclical nature of the construction sector and the potential for further insolvencies as economic conditions evolve.

Source: Insolvency Service and Office for National Statistics

Financial constraints also remain a risk factor for the sector. The RICS Construction Monitor report highlights financial constraints as the primary factor limiting activity, with 61.0 percent of respondents citing this issue. Tight credit conditions have exacerbated this challenge, impacting the industry's capacity to undertake new projects. Fortunately, the prospect of further interest rate cuts in 2024 and 2025 may offer some relief.

What does this mean for our forecast?

The UK construction industry is experiencing a cautiously optimistic outlook. While material prices are still high, despite recent dips and labour shortages remain a challenge, there is a positive shift in sentiment.

The proposed reforms to the National Planning Policy Framework (NPPF) may potentially boost sector activity, even if delivering 1.5 million new homes over the next five years remains a major challenge given the industry’s capacity constraints and the other challenges highlighted above.

While confidence continues to improve, the key indicators that drive TPI forecasts have not changed materially since the last review. As a result, we have chosen to keep our forecast unchanged from the 2024 Q2 UK market intelligence report.

Our real estate TPI remains at 3.0 percent for 2024 and 2025, followed by increases over the forecast horizon as lower interest rates boost growth in both the economy and construction demand.

Figure 7:

Tender price inflation: annual percentage changes

Source: Turner & Townsend survey

Our forecasts are representative for the UK as a whole and inflation may vary by project size, value, procurement route and region. Projects need to be assessed on an individual basis and may not always align to our central scenarios. For further assistance on cost assurance and inflation analysis in your area, please contact Turner & Townsend.

Source: Turner & Townsend survey

Infrastructure is less impacted by cyclical factors and more reliant on public sector initiatives. As we have discussed previously, infrastructure projects will be driven by the capital investment proposals set out by regulators in the water, rail and energy sectors.

Therefore, we maintain our previous infrastructure TPI forecast. We expect inflation rates to remain at 4.5 percent for 2024, increasing to 5.0 percent over the forecast horizon to 2028.

Source: Turner & Townsend survey

Balancing inflation and insolvency risk

While material cost volatility and overall tender price inflation have moderated, both labour cost pressures and the risk of contractor insolvency remain elevated.

However, programme teams should be wary of asking suppliers to take on significant project risk through the use of fixed price contracts.

The bids received for fixed price contracts, which contractors may regard as unfavourable, will be risk-adjusted, i.e. more expensive, and are more likely to come from firms in greater need of securing turnover than those received for contracts offering a more pragmatic apportioning of risk.

Managing risk equitably

Rising new orders and the relative choosiness of many tier one contractors mean this is far from a buyer’s market. In this context, tenders which seek to place excessive risk on contractors may be met by a lack of bids, poor quality or low value bids - and create a strained working relationship with the supply chain. Procurement teams should therefore:

1.

Aim for an equitable transfer of risk by following the guidance in the Private Sector Construction Playbook to share risk ‘fairly and equitably’ between client and supply chain.

2.

Not expect suppliers to underwrite a risk they cannot price. A compromise might be for contractors, who are more closely connected to logistics chains, to take on the delay risk, with the client factoring material cost contingency into its cost planning.

3.

Procure partners as much as suppliers to ensure the relationship starts, and stays, collaborative. Productivity will quickly erode if one party feels the contract is unfair to them. Defined goals need to be agreed and embedded in a project charter, which sets out clearly the shared objectives, values and measures of success to avoid tension and mistrust.

Incentivise and reward outperformance

The most sophisticated commercial models often balance risk and reward for both the client and its suppliers, enabling all parties to benefit from better performance and programme outcomes. This balance can be achieved through:

1.

Blending risk, incentive and value, for example by combining a guaranteed maximum price contract with a target cost agreement to give the client the reassurance of a cost cap while also incentivising the lead contractor to accept greater risk in return for the chance to benefit from any savings they make during delivery.

2.

Multi-layer incentivisation which provides contract-level incentives to individual contractors who hit agreed targets, as well as programme-level incentives which reward all suppliers when clearly defined collective targets are met.

3.

Making integration integral between the different contractors delivering different packages of work. Contracts should spell out where the responsibility for integration lies, and the commercial model should support integration between contractors while ensuring the client is set up to actively manage interface risk.

Exert influence, ensure visibility and control costs across the supply chain

Organisations which are willing to contract directly with second tier suppliers can control costs and prevent defects better, but successfully managing deeper into the supply chain requires strategic, rather than tactical, procurement. Decision-makers who take this approach will need to build additional capability and capacity to manage work allocations, contracting and the interface between subcontractors. They should therefore:

1.

Consider pre-tendering critical packages such as groundworks or enabling works as well as facades, electrical and mechanical elements, but prevent silos by ensuring there is absolute clarity on roles and responsibilities. While the lead contractor may have overall responsibility for performance outcomes, all suppliers must share a sense of purpose and be aware of how their own targets are critical to programme success.

2.

Remember that certainty and stability run both ways. Procurement teams who tender smaller, well-defined packages of work with robust assurance mechanisms can make themselves more attractive to the market – and thus improve both the quality of the bids they receive and the final project outcome.