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Smoothing the Procurement Process Premium

Towards Better Contracting

Authors: Tadelis, Steven

Date: Third Quarter 2017

Tags: PPP, public-private partnership, procurement, contracting, award mechanisms

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A public-private partnership between the state-owned Saudi Railways Organization and a consortium of 12 Spanish companies illustrates the challenges that commonly plague large, complex infrastructure projects. The consortium came together to build a high-speed rail link between Medina and Mecca. From a business perspective, the project represented a prestigious, lucrative opportunity to showcase a feat of engineering on an international stage. But problems quickly surfaced after the contract was won in October 2011. None of the partners wanted to take responsibility for something that hadn't been budgeted for, like the issue of how to keep sand off the tracks, for which the consortium demanded an additional $1.4 billion to resolve. The Saudi government balked at this request, which in turn led to protracted negotiations, pushing out the completion date to more than a year behind schedule.

How could a project of this scale be launched with a contract that did not recognize potential problems arising from sand in Saudi Arabia, and allowing for some response to unforeseen problems?

Unfortunately, this is not an isolated example. Many public-private partnerships experience cost overruns and project delays, largely owing to the difficulty of drawing up contract terms that account for changing circumstances as the project unfolds. The stakes are high for the parties involved, as disputes can leave governments and suppliers mired in years of costly arbitration and endless delays.

In my research on public- and private-sector engagements in the procurement of goods and services, I have found that each party operates under different types of constraints. In this article, I will explain the rationale behind these differences, drawn from work I have published on contracts and award mechanisms of public procurement processes, which are distinct from those of the private sector. By understanding some of the tools available, both public- and private-sector actors may be able to gain flexibility and efficiency, while at the same time avoiding some of the headaches associated with these special arrangements.

Adapting to Circumstances
The first tension arises from the different ways that the public and private sectors approach contracting. Up until the turn of the 21st century, economists generally treated procurement of goods or services as a "mechanism design" problem with a very clear agency problem: the buyer and supplier both know exactly what needs to be done, but the supplier has private information about production costs that the buyer does not have. The buyer must, therefore, design a mechanism -- i.e., a contract -- to infer the supplier's costs, such as offering the supplier several potential projects to choose from, each with an associated price. The supplier then selects the one that will be produced, thus revealing its costs.

In practice, however, there is more to it than a supplier revealing its costs, all of which are easier said than done:

First, the buyer has to decide what exactly needs to be procured and how to precisely convey these needs to potential suppliers.

Second, a contract must lay out the supplier's obligations, well-defined outcomes and methods of compensation.

Third, an award mechanism must be adopted that allows the buyer to select the most suitable supplier.

Finally, as adaptations are needed throughout the production process, both parties must find ways to implement both necessary and desirable changes in a cost-effective way.

Then, there are procedural issues. Fixed-price contracts and competitive bidding have become standard features of public procurement for two main reasons: they promote competition, resulting in fair and efficient market price discovery; and they are highly transparent, making it easier to prevent corruption in the public sector. These features, as well as arguments for equal opportunity, provide justification for the use of public tender auctions.

But to best manage contractual flexibility and minimize the disruptive impact of unforeseen modifications associated with large, complex projects prone to the sort of setbacks described earlier, other arrangements may be preferable -- namely, cost-plus contracts that are negotiated with one potential supplier.

A cost-plus contract is an agreement by a buyer to reimburse a supplier for expenses stated in a contract plus a dollar amount of profit, often stated as a percentage of the contract's full price. To protect against cost overruns, many contracts specify that the reimbursement cannot exceed a specific dollar amount. This may incentivize contractors with proven track records to deliver the desired results, on time and at a reasonably competitive price.

Consider data describing private-sector, non-residential building construction projects in northern California from 1995 to 2000: 44 percent were procured using negotiations, many of which were cost-plus contracts. Such arrangements are also common in high-tech procurement contracts and in software.

Yet, with the exception of some defense contracts, they are seldom used in the public sector, in the United States at least. Despite their commendable traits of promoting transparency and competition, blind adherence to fixed-price contracts awarded through sealed-bid auctions as standard operating procedure may be counterproductive.

Another issue is that the entire process is predicated on the belief that the suppliers know so much more than the buyers at the outset. In actual fact, it is the uncertainty both parties share about design changes after the contract is signed and production begins that is the real source of the problem. And the more complex the project, the more likely it is that design failures, unanticipated conditions or regulatory changes will crop up.

As such, focusing on mechanisms that are aimed to lower costs at the outset is misguided, when the real costs result from the wasteful renegotiation that accompanies subsequent adaptation. The strong incentives to reduce costs under fixed-price contracts may lead parties to dissipate surpluses that later might turn out to be extremely valuable when adaptations need to be renegotiated.

Especially when there is lock-in of the current supplier, these inefficiencies will be exacerbated as both parties haggle over prices, using the inevitable need for adaptation to their advantage. In short, regulations meant to constrain public procurement agencies in order to promote transparency, efficiency and fairness can cause the whole endeavor to suffer, actually inflating costs and sacrificing efficiency.

Given all these tendencies, projects need to be better delineated. Simple projects, where what needs to be produced is easy to design and unforeseen problems are very unlikely, should continue to be procured with fixed-price contracts and awarded through competitive bidding, accompanied by high levels of design completeness. Complex projects, on the other hand, which are hard to design and are prone to big, costly, unforeseeable setbacks, would be better procured with cost-plus contracts and awarded through negotiations with a qualified, reputable supplier, accompanied by low levels of design completeness.

In either case, further steps will need to be taken to reduce the risk of corruption: more on this subject later.

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