Construction Cost Inflation on Verge of Reacceleration Upward, Warns Oxford Economics Australia
Construction cost Inflation may accelerate to over four per cent per annum after FY2028, potentially adding $200m on top of a $1bn project
Current period of slowing cost growth follows “unprecedented” spike in 2022 and 2023
Drivers of cost growth have shifted from international (supply chain disruptions, commodity volatility) to domestic (productivity, building boom, sustainability push) factors
Sydney, Australia, 2024 – Construction cost escalation has slowed from the unprecedented inflationary spike experienced by the sector in FY2022 and FY2023, according to leading independent analyst and industry forecaster, Oxford Economics Australia.
However, the company – which is releasing findings from its Construction Costs and Inflation Research Briefing today – warns that inflationary pressures remain, with construction cost growth expected to reaccelerate later this decade adding potentially hundreds of millions of dollars to the cost of infrastructure projects.
“The recent surge in construction costs was primarily driven by supply-side factors; commodity market volatility and the energy cost crisis has shifted up manufacturing and transport costs, compounded by supply-chain disruptions from the lingering impacts of the pandemic,” said Thomas Westrup, study co-author and senior economist for Oxford Economics Australia. “However, cost growth now is increasingly being driven by domestic factors. Without substantial improvements in construction industry productivity, this presents risks for a significant reacceleration in construction cost escalation later this decade.”
The difference between CPI Inflation versus Construction Cost Escalation
According to the study, construction cost inflation (typically referred to as cost escalation and captured by measures such as the ABS Engineering Construction Implicit Price Deflator or IPD), has historically outpaced growth in broader household-based inflation measures such as the Consumer Price Index (CPI).
Fig 1. Engineering Construction IPD and Headline CPI, 2008-2028
Since the mid-1980s, when the ABS first published its Engineering Construction Survey, growth in the Engineering Construction IPD (a broad measure of price growth in engineering construction work done) has averaged 3.4 per cent growth per annum against 3.1 per cent 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 cent per annum against 2.8 per cent per annum growth in the CPI.
“This difference is not due to well-known and regularly observed ‘cost 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,” said Adrian Hart, study co-author and Oxford Economics Australia's Director of Construction and Infrastructure. “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 engineering construction IPD reflect movements in prices for construction itself, including not just bespoke construction inputs but also project owner (client/government) costs as well as margins of construction contractors.”
According to the Oxford Economics Australia study, 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, 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 per cent growth band – and are prepared to take corrective action when price growth moves outside this band,” said Hart. “There is no specific target set to ‘correct’ unusually high growth in construction costs.”
The Cause of the Recent Construction Cost Escalation Surge
The recent surge in economy-wide inflationary pressures has highlighted the increased exposure of construction cost escalation to domestic and international market factors, with a range of relevant price indices indicating growth in construction costs exceeding general inflation as measured by the CPI.
Construction cost escalation, as captured by the engineering construction IPD, grew at record rates over financial year 2022 (5.7 per cent) and 2023 (8.2 per cent) – again exceeding growth in the CPI – underpinned by the combination of various severe shocks to demand and supply in domestic and overseas economies.
According to the study, deflationary pressures during the onset of the pandemic in 2020 (including an initial collapse in oil prices) gave way to a sharp rebound in global economic activity in subsequent years– supported by fiscal stimulus (partly targeted towards public infrastructure investment) and the loosening of movement restrictions. The strong recovery in demand challenged market capacity, and this was exacerbated by 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,” said Hart. “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…
As shown in Figure 1, FY2023 represented the peak in construction cost escalation growth (with the quarterly peak in growth being the December 2022 quarter of that year). Since then, there have been significant price falls in key energy and metal commodities which are inputs to the construction industry.
With much of the data for FY2024 already in, Oxford Economics Australia expects nominal benchmark Brent oil prices ($A/barrel) to average a small drop through FY2024 compared to the average price in FY2023, a halving in average steaming coal prices, and an average price reduction of 25-30 per cent for LNG prices. Prices for steel products, such as beams and sections (captured in the ABS Producer Price Index) have already fallen 13 per cent in the year to March 2024.
However, while there has been a significant fall in some key construction input prices, overall measures of construction cost escalation have merely seen their growth slow rather than reverse outright – as characterised by sectoral engineering construction implicit price deflators sourced from the ABS in Figure 2 below.
"Worse, the latest ABS engineering construction price data (March quarter 2024) released alongside last week's National Accounts suggests annual construction cost escalation may be 'bottoming out' at a rate above two per cent and is now starting to reaccelerate," said Hart.
Fig 2. Annual Growth in Sectoral Engineering Construction IPDs
Domestic Pressures Offsetting Potential Declines… and Could Lead to Reacceleration
So why haven't construction prices fallen?
“Essentially, price declines for some key construction inputs is being offset by accelerating prices for other inputs,” said Hart. “Instead of international factors driving escalation, domestic price pressures are now driving escalation based on sustained high demands from construction activity.”
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 per cent in 2020 to four per cent currently (and higher again in some states such as Queensland), while prices for quarry products have risen more than20 per cent over the same period.
“At Oxford Economics Australia, we see significant risks of cost escalation once more surprising on the upside in coming years – even if the RBA is successful at quarantining CPI growth within its 2-3 per cent target band,” said Hart. “From as early as FY2026 we are forecasting another 'decoupling' of construction cost escalation and the CPI.”
The company forecasts cost escalation reaccelerating towards four per cent per annum by FY2028 and pushing even higher towards the turn of the decade.
"Escalation of this magnitude could easily add $200 million in costs on a multi-year $1 billion megaproject,” said Hart. “And cost growth will likely be even higher in states such as Queensland and Western Australia where growth in construction activity and demand will be strongest.”
Oxford Economics Australia believes the key drivers of cost reacceleration include:
Firstly, the full impact of the latest inflationary episode on construction industry wages which is yet to play out. More Enterprise Bargaining Agreements (EBAs) are to be restruck over the coming 12-18 months which will aim to claw back sharp falls in real wages during 2022 and 2023. This will incrementally 'lock in' relatively higher wage growth outcomes for several years.
Secondly, strong targets for building new housing, energy, water, transport, health and education assets – alongside new investments across Defence, the resources sector and even the Brisbane Olympics – are anticipated to drive a substantial upswing in construction activity later this decade (as discussed in Oxford Economics Australia's March 2024 blog post) and this will likely increase demand-side price pressure on local construction wages and materials.
Thirdly, laudable moves to reduce carbon emissions in the construction sector as part of broader movements towards net zero may involve, in the short term at least, a trade off with costs as newer, more sustainable 'low-carbon' products and processes (e.g. materials recycling) are adopted.
Finally, while significantly improved over the past year, global supply chains are likely to remain relatively 'thin' compared to pre-Covid times and prone to further disruptions/cost pressures from rising demand (as the global economy reaccelerates later this decade) or if future shocks emerge 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,” said Hart.
Boosting productivity remains the key
“Our outlook assumes some success in reversing the construction industry's poor productivity performance – and a callout to the Australian Constructors Association: the cost of poor productivity now well exceeds $56 billion per annum based on the latest data,” said Hart. “Improving industry productivity is critical not just to minimising escalation risks, but in actually delivering on the many infrastructure and housing promises targeted by the governments across Australia given limited market capacity.”
Essentially, the company says the best way of avoiding a high-cost future without sacrificing policy objectives is to reduce the sector’s pull on resources through doing things smarter, better and generally making less mistakes in planning and delivery that requires rework.
“For government and industry this requires more efficient risk allocation and procurement, better front end planning and coordination of the infrastructure pipeline, a heightened focus on education, training and skills retention in the construction industry and a 'step change' in the way government and industry implement known technologies (e.g. what's referred to in the industry as Modern Methods of Construction such as modularisation and prefabrication) to boost productivity,” said Hart.
About Oxford Economics Australia
Oxford Economics Australia, formally known as BIS Oxford Economics, is Australia's leading provider of industry research, analysis and forecasting services.
Following the acquisition of BIS Shrapnel in 2017, Oxford Economics Australia now has unparalleled capabilities in helping clients to understand issues across over 100 sectors at the granular local area through to the global economy. This analysis is underpinned through robust economic models that are fed by reliable and most importantly detailed market data, analysis of developments, and thoroughly researched forecasts.