Construction and infrastructure professionals have a mixed outlook on the current energy crisis, according to a poll at our annual Ankura Great Debate event. Some see renewed opportunity as wholesale energy prices have fallen to levels prior to the Ukraine invasion; others view last year's record price spikes as a taste of things to come in a world grappling with energy security amongst other challenges. Here, we capture the key themes and points discussed by our panel on the impact of limited energy supply and rising energy costs on infrastructure and broader construction projects, and how the sector can mitigate.
What caused the energy crisis?
In February 2022, Russia invaded Ukraine, causing turmoil in international energy markets through sanctions, supply restrictions, and even alleged sabotage. While there were other factors, including post-pandemic demand, harsh winters, and inadequate storage, the conflict in Ukraine has resulted in a perfect storm. Between March and August 2022, gas prices peaked at ten times the typical price.[i]
Some argue that Western governments could have anticipated the conflict and pre-emptively diversified energy supplies away from Russia. In the UK, some feel that there has been a lack of commitment to decarbonization and whether a path to net zero will require a "detour" via further investment and longer-term use of hydrocarbons than previously anticipated.
How has the energy crisis impacted infrastructure and other construction projects?
Soaring energy prices impacted society at all levels, from government policy to households choosing to "heat or eat." Meanwhile, it has affected the infrastructure sector at a political, financial, operational, and legal level.
Policy – more uncertainty as energy security usurps climate security
The energy crisis has forced some governments to prioritize energy security over climate security in the short term. This has brought more renewable projects to the table. However, it has also caused governments worldwide to rapidly change policies, sometimes contradicting former sustainability claims.
The uncertainty caused by sudden policy change impacts infrastructure at the highest level of planning and investment. Why should investors risk backing clean energy if a government has just committed to supporting oil and gas exploration?
When energy security creates policy change
- In March 2022, The EU signed an agreement to import more gas from Norway to the EU in response to Russia reducing flows from its Nord 1 pipeline. The statement said Norway will remain a "large supplier" to Europe beyond 2030 and expressed support for increasing its oil and gas exploration.[v]
- In April 2022, the UK Government published its Energy Security Strategy, which doubled the UK's hydrogen and carbon capture targets. Meanwhile, its March 2023 Powering up Britain plan paved the way for eight carbon capture and 20 hydrogen projects.[vi]
- In April 2023, Chile, the world's second-largest lithium producer, announced it would nationalize production of the essential metal for electric vehicle batteries. The move shocked the industry giants, which will have to transfer control of the reserve to a state-owned company.[vii]
Finance – inflation is making investors and insurers nervous
Record energy prices combined with broader inflationary pressures such as food inflation for example have forced the Bank of England to steadily raise the base rate since December 2021. The resulting increased cost of borrowing means securing funding for infrastructure projects is harder. Increased risk at project level (see below) has also made it much more expensive to insure and refinance projects.
Operations – projects are battling delays and spiraling costs
The most visible impact of the energy crisis on infrastructure and other construction projects can be seen at ground level in project delays and, in extreme cases, terminations.
Material costs have increased substantially, particularly those, such as steel and concrete, that are energy-intensive to produce. The price index for the broad range of construction materials increased by 10.6% in February 2023 compared to February 2022 (when the invasion began). [viii] In addition, rising fuel prices have increased the cost of logistics.
The related scarcity of materials has led to costly delays and resequencing of construction activities.
Legal – disputes are rising (but lawsuits are not)
Inflation is causing more challenges throughout the supply chain. For example, contractors are questioning who accepts the risk of increased cost up and down the contractual chain and to what extent, resulting in tensions and unforeseen exposure for client employers, and in difficulties down the supply chain including insolvencies of smaller businesses.
Suppliers on fixed-price contracts have struggled to meet their obligations due to inflation. In many cases, parties are seeking to recover losses through negotiation as they, and their clients, do not have the appetite, time, or funds for long-running disputes.
How can we mitigate future crises?
The energy crisis has shown a need for a more open conversation about sharing risk by all parties involved in infrastructure construction projects.
Policy - agility without uncertainty
The UK government reacted to the recent energy crisis by re-awakening mothballed assets, such as coal fire power stations and LNG gas terminals. It also announced plans to reincarnate old projects by retrofitting them to handle ammonia and hydrogen[ix].
However, many major construction projects are at the ambition stage, meaning that suppliers and contractors cannot commit to them using normal established risk-sharing approaches. Stability is premium, as always in construction.
Financial and Legal – a call for Pragmatism
Contract renegotiation is typically considered something to be avoided, but it can be a pragmatic last resort for projects impacted by the rising costs and delays caused by the energy market and other geopolitical and socio-economic situations. UK public procurement rules mean renegotiation is not an option. However, elsewhere in the world, it is acceptable when prices change dramatically. Should the UK follow other countries in relaxing the rules?
Operational – clients need to widen their pool of suppliers
Infrastructure construction project clients and contractors should create a broad pool of suppliers to enable them to be more resilient should one fail due to macro-reasons, such as a pandemic or geopolitical uncertainty, and not be able to fulfill contractual commitments.
Project-level mitigation could also include new and alternative contracting structures that allow for risk sharing, such as alliance or relationship contracting. We are seeing more contracts involving cost plus, target cost, and provisional sums versus lump sums, as well as more indexation to account for price fluctuation. We last saw the typical use of such mechanisms in UK construction in the 1970s. They work on a granular level, down to which party will accept which element of risk for a particular material or other resources.
A crisis for the construction and project world to solve
Wholesale energy prices may be falling, but geopolitics and socio-economics are here to stay. It seems unlikely this will be our last crisis in costs resulting from uncertainty in energy markets, and geopolitical and socio-economic events.
Infrastructure is in a unique position: it is both impacted by the problem of energy security and instrumental in solving it. This will take collaboration at all levels and a fresh approach to risk.
[i] https://eciu.net/analysis/reports/2023/the-cost-of-gas-since-the-russian-invasion-of-ukraine
[iii] https://www.ons.gov.uk/economy/inflationandpriceindices/articles/costoflivinginsights/energy
[iv] https://eciu.net/analysis/reports/2023/the-cost-of-gas-since-the-russian-invasion-of-ukraine
[vi] https://www.gov.uk/government/publications/powering-up-britain
© Copyright 2023. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.
