By Adrian Hart, Director Construction & Infrastructure, Oxford Economics Australia & Thomas Westrup, Senior Economist, Oxford Economics Australia
Latest (March quarter 2024) price data shows that construction cost escalation has slowed (but not reversed) from the unprecedented growth experienced in 2022 and 2023. While this surge in construction costs was primarily driven by pandemic supply-side disruptions and other international factors, we see cost drivers now shifting towards domestic factors. Without substantial improvements in construction industry productivity, this presents risks for a significant reacceleration in construction cost escalation later this decade.
CPI Inflation versus Construction Cost Escalation
It may come a surprise to some outside of the construction industry, but construction cost inflation (typically referred to as cost escalation), has historically outpaced growth in broader household-based inflation measures such as the Consumer Price Index (CPI).
Since the mid-1980s, when the ABS first published its Engineering Construction Survey, growth in the Engineering Construction Implicit Price Deflator (a broad measure of price growth in engineering construction work done) has averaged 3.4% growth per annum against 3.1% per annum average growth in the CPI. Since the 2000s, this difference has only become starker, with the engineering construction IPD growing at an average rate of 3.7% per annum against 2.8% per annum growth in the CPI.
Importantly, this difference is not due to well-known and regularly observed “çost blowouts” on major construction projects (which, by the way, are mainly the result of poor front end project cost estimation and/or the crystallisation of risk which should have been included in contingency). Rather, it is because construction cost indices and the CPI are measuring fundamentally different things. The CPI is focused on a representative basket of goods and services purchased by households, while output-based construction cost indices such as the Road and Bridge Producer Price Index reflect movements in prices for construction inputs, including project owner (client) costs as well as margins of construction contractors.
Movements in prices for raw commodities such as oil, coal, copper and quarry products, upstream manufactured products such as steel, cement and concrete, as well as construction industry wages, tend to have a proportionately greater impact on construction cost escalation than the CPI as they occupy a greater share of the construction industry expenditure than in the representative ‘basket’ of goods and services purchased by households. And prices for these items have generally increased at a faster rate than the CPI given supply/demand imbalances in global and national markets over the past two decades. Furthermore, monetary authorities such as the RBA specifically target CPI to remain within a 2-3% growth band – and are prepared to take corrective action when price growth moves outside the band. There is no specific target set to ”correct” unusually high growth in construction costs.
The recent cost escalation surge
So why did construction prices surge in 2022 and 2023? Essentially, deflationary pressures during the onset of the pandemic in 2020 (including a collapse in oil prices) gave way to a sharp rebound in global economic activity in subsequent years. The strong recovery in demand challenged market capacity, and this was exacerbated by further supply shocks related to sanctions on Russian exports following the invasion of Ukraine in February 2022. These factors culminated in the global energy crisis, wherein natural gas and steaming coal prices reached record highs, including benchmark oil prices returning to 2008 levels. The surge in energy commodities shifted up transport and electricity costs, which was further fuelled by flooding along the east coast of Australia which disrupted coal supply.
Other factors also took their toll: the outbreak of a global shipping crisis compounded disruptions in industrial production, with rising demand for containerised goods and a lack of shipping capacity driving up transportation costs. Import prices were further hoisted by the depreciating Australian dollar, which cycled downwards throughout 2022 and 2023.
Construction price growth now moderating… but not reversing…
In FY24 much of the international price pressures which had driven cost escalation have reversed: nominal benchmark Brent oil prices ($A/barrel) are expected to average a small drop through FY24 compared to the average price in FY23, steaming coal prices should more or less halve and LNG prices should end up around 25-30% lower than the average for FY23. Prices for steel products, such as beams and sections (captured in the ABS Producer Price Index) have already fallen 13% in the year to March 2024. There have been sharper falls for prices of timber products.
Despite this, overall measures of construction cost escalation have merely seen their growth slow rather than reverse outright. Latest readings of the Road and Bridge Index, for instance, show an increase of 1.5% in the March quarter 2024, and an annual increase of 4.2%. If anything, road construction prices showed signs of a reacceleration in the March quarter, whereas previous bouts of strong growth in the RBI were followed by a period of flat growth or even price declines (as in 2016 and 2020).
… while risks are emerging for a reacceleration in construction cost escalation
So why haven’t road construction prices fallen? It’s because price declines for many imported inputs is now being offset by accelerating prices for domestic inputs. In particular, strong demand for construction labour and local construction materials is driving stronger growth in construction wage outcomes and prices for inputs such as quarry materials, cement and concrete. ABS Wage Price Index data shows that wage growth in the construction sector has accelerated from a low of 1.5% in 2020 to 4% currently (and higher again in some states such as Queensland), while prices for quarry products have risen more than 20% over the same period (and well over 30% in some states).
Strong increases in construction activity in most states and territories to meet an array of housing, energy, transport and environmental goals is likely to intensify demand side pressure for local labour and materials later this decade. Meanwhile, a recovering global economy runs the risk of increasing prices for commodities such as oil, bitumen and steel – not to mention shipping costs – unless there is a compensating increase in supply.
At Oxford Economics Australia, we see significant risks of cost escalation for roads and other engineering projects once more surprising on the upside later this decade – even if the RBA is successful at quarantining CPI growth within its 2-3% target band. In particular, we have concerns that escalation will again breach 4% per annum or higher later this decade, potentially adding $200 million in costs on a multi-year $1 billion megaproject. Though improving, supply chains remain relatively ‘thin’ compared to pre-Covid times and this could lead to further sharp spikes in construction costs if global growth were to reaccelerate faster than expected or if further shocks emerged such as geopolitical events (e.g. a ‘Middle East escalation’ scenario), increasing trade protections or even another pandemic. Recent history has shown that global events can have sharp and painful impacts on local cost escalation.
Boosting productivity remains the key
While demand management (i.e. smoothing of the infrastructure pipeline) is an important tool to keep infrastructure costs on a more sustainable footing, this also runs the risk of foregoing some policy objectives or delaying their achievement. As economists, we are used to the problem of trying to satisfy (what may seem like) unlimited wants with limited resources – ultimately there is a cost to the choices we make.
In our view, the best way of avoiding a high-cost infrastructure future in the long run without sacrificing policy objectives is to improve productivity. Industry and governments need, more than ever, to work together now to reduce our pull on resources through doing things smarter, better and generally making less mistakes in planning and delivery. In so doing, the conversation needs to be flipped from ‘how many jobs will this construction project create’ (the usual measure of benefit) to ‘how do we best conserve our stretched skills and resources on this project’ so these resources can deployed to deliver on other projects elsewhere. In turn, a greater focus on productivity makes wage increases sustainable and affordable without driving up infrastructure costs.
Productivity-based solutions are already well known but are often hard to implement in practice as it usually involves significant change. Essentially we need to see more efficient risk identification and allocation, a procurement process focused on rewarding innovation, better front end planning and coordination of the infrastructure pipeline, better project management processes and tools, a heightened focus on education, training and skills retention in the construction industry, better planning for local construction materials and a ‘step change’ in the way technologies are adopted at mass scale in the industry. In many of these areas, incremental or piecemeal improvements are occurring, but with a large upswing in construction activity on the horizon later this decade, the clock is ticking on our window to get it right.