journal of public procurement

JOURNAL OF PUBLIC

PROCUREMENT A scholarly journal sponsored by The National Institute of Governmental Purchasing, Inc., and Florida Atlantic University Public Procurement Research Center

VOLUME 15 NUMBER 4 WINTER 2015

JOURNAL OF PUBLIC PROCUREMENT Mission. The Journal of Public Procurement (JoPP) seeks to further the understanding of public procurement by exploring theories and practices of public procurement keyed to: - Functional areas, including but not limited to procurement policy, procurement strategic planning and scheduling, contract formation, contract administration, evaluation, and procurement methods and techniques; - Substantive areas such as government procurement laws and regulations, procurement economics and politics, and procurement ethics; and - Topical issues such as e-Procurement, procurement transparency, and green procurement. JoPP covers not only procurement at the federal, state and local government levels in the United States and Canada, but also government procurement in developed and developing nations. It will include research studies, narrative essays, exemplar cases--both good and bad–from past experiences, commentaries, book reviews, and occasionally, reprints of informative published government reports. Background. Under the sponsorship of the National Institute of Governmental Purchasing, Inc. (NIGP), the U.S. General Services Administration, and Florida Atlantic University/Public Procurement Research Center, JoPP provides researchbased, in-depth analysis of government procurement by some of the world's leading educators, executives, and practitioners. Audience. JoPP serves procurement officials in all areas of the public sector, vendors and contractors who provide goods and services to public entities, researchers, the general public, and particularly NIGP members and libraries. Subscription Information. Journal of Public Procurement is currently published three times per year. The subscription rate for Volume 15 (2015) is as follows: Individual and Government Rate $400.00 (+ $20.00, foreign postage) Institutional Rate $500.00 (+ $20.00, foreign postage) All orders must be prepaid by checks. Please mail payment with your order to: PrAcademics Press, 4315 Tranquility Dr., Highland Beach, FL 33487; or pay electronically by visiting www.pracademics.com. Manuscript Preparation and Submission. See end of issue. Copyright © 2015 by PrAcademics Press. All rights reserved. Neither this work nor any part may be reproduced or transmitted in any form or by any means, electronic or mechanical, microfilming and recording, or by any information storage and retrieval systems without the permission in writing from the publisher. Contributions to this journal are published free of charge.

Printed in the U.S.A. CODEN: JoPP 15(4), 405-536 (2015) ISSN 1535-0118 (print) ISSN 2150-6930 (online)

JOURNAL OF PUBLIC PROCUREMENT Editor-in-Chief: Khi V. Thai, Florida Atlantic University Practitioners’ Corner Editor: Darin Mathews, Metro Regional Government, Oregon Book Review Editor: Wendell C. Lawther, University of Central Florida Copy Editors: Paula Altizer and Vivian Mydlarz, PrAcademics Press Artistic Designer: Loy Nguy, PrAcademics Press EDITORIAL BOARD GIAN LUIGI ALBANO, Consip, Italy ALESSANDRO ANCARANI, University of Catania, Italy J. A. (HANNIE) BADENHORST-WEISS, University of South Africa JAMES D. BARTHA, National Contracting Organization, US Army Corps of

Engineers BENON BASHEKA, Uganda Technology and Management University JENNIFER BRANCHE, United Nations GUY CALLENDER, Curtin University of Technology Business School, Australia PAUL DAVIS, Dublin City University, Ireland RICHARD DOYLE, Queensland University of Technology MICHAEL ESSIG, Bundeswehr University Munich, Germany CAO FUGUO, Central University of Finance and Economics, China STEPHEN B. GORDON, Old Dominion University, USA BARBARA R. JOHNSON, Columbus Regional Airport Authority, USA DAVID JONES, University of Brunei, Brunei DAE IN KIM, Ewha Women University, South Korea I-MING LIAO, National University of Kaohsiung, Taiwan ODYSSEUS MANOLIADIS, Democritus University of Thrace, Greece LAWRENCE L. MARTIN, University of Central Florida CLIFF MCCUE, Florida Atlantic University, USA TERESA MEDINA-ARNÁIZ, University of Burgos, Spain JOSEPH NTAYI, Makerere University, Uganda SANDER ONDERSTAL, University of Amsterdam, The Netherlands GUSTAVO PIGA, University of Rome “Tor Vergata,” Italy JACK PITZER, Florida Atlantic University, USA ERIC PRIER, Florida Atlantic University, USA RENE RENDON, Naval Postgraduate School JEANNETTE RENNIE, The World Bank JOSEPH J. SCHIELE, Oakland University, USA KEITH SNIDER, Naval Postgraduate School, USA TUNDE TATRAI, Corvinus University of Budapest SATORU TANAKA, Kobe City University of Foreign Studies, Japan FRED THOMPSON, Williamette University, USA JUNSOK YANG, Catholic University of Korea, South Korea

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INVITATION TO AUTHORS Journal of Public Procurement (JoPP) encourages practitioners and scholars to submit manuscripts dealing with the practice and study of public procurement at all levels of government in every country. Manuscript Submissions and Suggestions. JoPP invites readers to submit comments, communications and suggestions for the reprinting of informative government reports to the editor (Khi V. Thai at [email protected]). For further information, please visit www.pracademics.com. Please see “Information for Contributors” at the end of this issue for manuscript style and submissions.

JOURNAL OF PUBLIC PROCUREMENT Number 4, Winter 2015 Public Infrastructure Procurement: A Review of Adversarial and Non-Adversarial Contracting Methods ............................................ 405 M. Regan, P. E.D. Love and J. Smith The Enlightenment Underpinnings of the Public Procurement Profession.......................................................................................... 439 W. E. Klay Public Procurement Reforms in Greece: The Impact of Improved Transparency on Government Expenditures ................. 458 I. Giotopoulos, G. Pavlou, S. Danchev, and A. Tsakanikas Characteristics of Private Markets and Accessibility of Small and Medium Enterprises To Public Procurement Markets: Pharmaceuticals In Egypt ............................................................... L. Abdellatif and M. Zaky

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The Role of Accountability In Federal Acquisition: A Search for Context ........................................................................................ 514 D. Fox and J. C. Morris

PrAcademics Press Contributions to this journal are published free of charge

JOURNAL OF PUBLIC PROCUREMENT, VOLUME 15, ISSUE 4, 405-438

WINTER 2015

PUBLIC INFRASTRUCTURE PROCUREMENT: A REVIEW OF ADVERSARIAL AND NON-ADVERSARIAL CONTRACTING METHODS Michael Regan, Peter E.D. Love and Jim Smith* ABSTRACT. Adversarial contracting methods are used for most public infrastructure procurement and timely delivery on budget remains a problem. In the past 20 years, OECD countries have adopted a number of alternative procurement methods that are based on collaborative principles including public private partnerships, long-term outsourcing arrangements and relationship/alliance contracts. We review the theoretical principles that operate for both adversarial and collaborative contracting methods. We identify the characteristics of non-adversarial contracting methods such as the output specification, qualitative selection criteria, the alignment of incentives, discrete allocation of residual control rights, life cycle costing, and risk-weighted value for money measurement that are delivering better procurement outcomes for government. INTRODUCTION

Most public infrastructure is provided by traditional procurement methods generally based on quantitative selection techniques and adversarial contracting principles. Evidence suggests that this method of contracting is inefficient, and is often delivered late and over-budget (Flyvbjerg, Skamris, & Buhl, 2004; Raisbeck, Duffield, & Xu, 2010; Love, Lopez, Edwards, & Goh, 2012). Furthermore, the adversarial nature of ------------------------* Michael Regan, Ph.D., is Professor of Infrastructure, School of Sustainable Development and Architecture, Bond University, Australia. His research interests are in infrastructure and Public Private Partnerships. Peter E. D. Love, Ph.D., is Professor, School of Built Environment, Curtin University, Australia. His research interests are in Construction rework, error mitigation and procurement. Jim Smith, PhD., is Professor of Urban Development, School of Sustainable Development and Architecture, Bond University, Australia. His research interests are in construction economics and strategic client briefing.

Copyright © 2015 by PrAcademics Press

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the contracts means that disputes over variations, changes to specification, poor documentation and rework or renegotiation may lead to lengthy and costly ex-post negotiations or civil action (Love, Cheung, Irani, & Davis, 2011a). To address the limitations of traditional procurement methods, alternative procurement methods (APM) were introduced at the behest of public sector clients adopting a less adversarial contracting approach in which ownership (of decisionmaking) and responsibility and risk for design and operation of the service-producing asset passed to the contractor with the state (ownerclient) adopting a more passive regulatory role (Kumaraswamy, Love, Dulaimi, & Rahman, 2004). A further reason for the use of APM was the growing complexity of infrastructure services, the pursuit of innovative design and construction outcomes and growing recognition of the importance of risk and life cycle costing to long-term investment. However, non-adversarial contracting may not be appropriate for all forms of infrastructure procurement. They may require longer lead times and increase forecast or predicted construction costs. Thus, it is more beneficial to use APM when projects are long-term and complex, when risks are high and service outcomes can benefit from private sector entrepreneurship, innovation and new technology. In recent years, non-adversarial procurement has been specifically employed to improve capital-intensive social infrastructure services in corrective services, public administration, health and education. The importance of this development is the shift in emphasis from state ownership of infrastructure assets to that of a buyer of infrastructure services. These contracts are non-adversarial to the extent that the relationship between the contractor and the state is one of long-term relationship management. Evidence suggests that APM is achieving better time and cost performance than adversarial methods and through greater efficiency, is contributing to improved service delivery and lower life cycle costs (Raisbeck, Duffield, & Xu, 2009; Love, Davis, & Chevis, 2011b). Against this contextual backdrop, adversarial and non-adversarial contracting methods used to procure public infrastructure are reviewed with emphasis being placed on identifying the change drivers that are producing improved infrastructure service outcomes for governments. Adversarial contracts are examined, specifically with ownership in the form of residual control rights, the form of

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contract, contractor selection, the form of specification, risk, governing policy framework, contractual relationship, and mechanisms for managing change. Next, collaborative contracting is analysed, using the alliance contract model and the public private partnership (PPP). Comparative performance of these procurement methods is also presented. ADVERSARIAL CONTRACTS

Traditional contracting is the procurement of public works by governments (as principal) to private contractors who are selected by auction or pre-qualification and negotiation. Traditional procurement of goods and services has a long history as the favoured method for the delivery of public infrastructure. Public procurement by auction was evident in Mesopotamian city states as long ago as 2,600BC, classical Greece and the Roman Empire (Cameron & Neal, 2003; Bernstein, 2008). The ancient Sumerian city-states around 2,400BC possessed civil codes that provided for the regulation of public and private contracts, recognised a party’s right to pursue self-interest in a contract and imposed penalties on parties who failed to deliver what they had promised. Traditional contracting and legal institutions that dealt with contractual disputes were also evident in early Roman private law and later European states in the western tradition. The term traditional contract is generally applied to contracts for government procurement of goods and services generally offered by auction with a detailed input specification and lowest price bidder selection criteria. In fact, the term traditional is something of a misnomer, suggesting something of enduring cultural value or significance. Traditional contracting certainly has history on its side, but its uses and abuses over time suggest little of either value or significance. Traditional contracts are adversarial which is determined by the form of contract, allocation of risk, mechanisms for dealing with disputes, the alignment of incentives and responsibility for decision-making. The arrangement for payment of the contractor is also important as it is this mechanism that determines which of the parties carries time and cost risk. When carrying out work in a fixed price contract, much of the contractor’s work is unobservable or either too difficult or costly for the principal to monitor. In an adversarial contract, the incentives that

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drive the parties over the term of the contract are mismatched or non-aligned and contractual disputes after the fact are common, absorbing significant management time, and are costly to resolve (Love et al., 2011a). The principal’s expectation is to receive the specified goods or services in accordance with the contract documents and delivered on time and within budget. In a competitive bid market, the contractor will bid to win the contract and if successful, the manager’s focus will be on ameliorating margins by taking advantage of an incomplete specification, poor documentation, change in scope of works, ambiguity in the contract, and disputes. Resolution of disputes does occur during the life of the contract although many claims may be unresolved long after the works have been completed. Elements of the Adversarial Contract Traditional procurement is the default procurement option of government and its typical structure has the Principal (owner or client) contracting with the Main Contractor, who takes responsibility for, employs and manages sub-contractors to carry out the actual work under the contract. It is a method suited to short term complete contracts for the acquisition of plant and equipment, materials, civil works and construction in which the assets may be fully specified. Traditional contracts may use standard form documentation on projects that can be put to market quickly and incur low transaction costs compared with other methods of procurement. Contractor bidding costs for traditional contracts are, on average, around 30% to 60% less than bids of similar size for public private partnerships and build own transfer transactions (Infrastructure Association of Queensland, 2010). This form of contracting has a number of distinguishing characteristics, which are now analysed and discussed. Ownership In a traditional and complete contracts, ownership in the form of residual control rights or the decision-making prerogative is exercised by the principal (Estache, Iimi, & Ruzzier, 2009). Control in project procurement is important as it creates the incentive framework that applies to stakeholders and influences the conduct of both the principal and the contractor over the life of the contract (Forborn and Pejovich, 2001). Under a complete contract, the principal is also


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responsible for project risks not specifically allocated to the builder. This is a potential problem if the principal is responsible for posthandover service delivery and life cycle-operating costs such as energy, maintenance and repairs. Moreover, poor build quality may affect service delivery costs or, in the case of health, education and corrective services, adversely influence their reliability and quality (Besley & Ghatak, 2003). Most adversarial contracts of short duration vest ownership and decision-making with the principal. The benefits of this include faster decision-making and lower transaction costs. The disadvantages to the principal include limited risk transfer and less opportunity for design and construction innovation. An adversarial contract is vulnerable to disputes and disagreements over changes to the specification (quality), the scope of the project and information asymmetry that is a consequence on non-aligned incentives between the parties. The Form of Contract Traditional contracts generally take the form of short-term complete contracts, which attempt to take into account all variables which are, or may become relevant, over the term of the contract (Selanie, 2005). Short-term construction contracts are generally written as complete contracts with provisions that deal with disputes between the parties, change management and externalities that include risk and decision-making in conditions of uncertainty. Default mechanisms including mediation and arbitration provisions to deal with externalities including force majeure events which may frustrate the contract or result in legal action. These events effectively terminate the contractual relationship and may result in judicial proceedings which are a costly and unpredictable solution for both sides. In the common law system, in an adversarial or fault context, a court may resolve contractual disputes with several remedies including orders for specific performance, termination and/or damages. Contractual relations rarely continue beyond judicial determination of commercial disputes and the appellate process. Traditional incomplete contracts extending over long service intervals raise different issues. These contracts cannot address all of the future contingencies that will arise over terms of 20 years or more and it may well prove costly to try to do so (Hart, 2008). Incomplete

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contracts address this by providing mechanisms for managing change, resolving disputes (alternative dispute resolution) and dealing with renegotiation (embedded and real options). Incomplete contracts discourage separation of ownership and management which is important from a contractor’s perspective if the contract transfers lifecycle cost risk or imposes strict standards on occupational and operating service delivery. They also provide the contractor strong bargaining power towards completion which can lead to opportunistic behaviours. Nevertheless, the decision to be made by the principal is the trade-off between the disadvantages of less control and the advantage of lower transaction costs by not having to run periodic bids for contracts of shorter duration. Contractor Selection Infrastructure contracts are commonly let by competitive auction in the form of an open tender or tender by invitation. Depth in infrastructure bid markets is influenced by the frequency of transactions (the project pipeline) and few contractors will retain the specialist skills needed to bid on complex projects if transaction flow is irregular, or the likelihood of success in large bid fields is small. Similarly, if bidding costs are high, contractors will only bid when the chances of success are reasonable. Controlling bidder depth and bid costs for infrastructure projects is a difficult task for government and schemes to reimburse bid costs, limit bid fields or adding a prequalification process may increase hold-up risk, prove costly and may only be of limited value. In the case of projects requiring specialised technology or know-how, the procurement authority may select a preferred contractor from a pre-qualification process and enter into a period of exclusive negotiation for the contract. Contracts let by exclusive negotiation have a greater risk of renegotiation largely as a result of their adversarial nature and limited competitive tension in both the preliminary and handover stages of the project (Rothkopf & Harstad, 1994; Tadelis & Bajari, 2006) A further characteristic of traditional contracts is the use of lowest price criteria for selection of the contractor. Critics of the lowest costbased approach argue that the winner of a competitive auction is likely to incur optimism bias in pricing of the work (the winner’s curse). Transactional evidence suggests that contractor selection should include a significant level of qualitative criteria which may include the


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contractor’s experience and capabilities, its track record with successful projects, and the value of risks transferred between the parties and wider benefits that the contractor brings to the project including new technology and innovative work practices (Partnerships Victoria, 2001). An important interplay exists between the mechanism that awards the contract and the incentive structure that constrains the ex post behaviour of the contractor (Bajari & Lewis 2011). Form of Specification Adversarial procurement is generally based on an input specification (prescriptive contract documentation) issued by the principal and its advisers that provides a definitive requirement for the work to be performed, the materials to be used and the form (but not the method) of construction. This approach assumes that the principal and its advisers have the best design, construction and service delivery solutions. This is particularly the case with public spending on corrective services, health and education where recent evidence suggests that non-traditional approaches to building design and innovation can deliver improved and innovative services including lower recidivism rates, higher educational standards and improved staff productivity (National Audit Office, 2005). The alternative is the output specification which was introduced with the early build own operate (BOT) procurement methods in the 1990s. The output specification defines the principal’s service requirements but leaves the ‘how to’ question to the contractor. The output specification effectively allocates design, construction and life cycle cost risk to the contractor or bidding consortium. The contractor exercises control of the project and has a strong incentive to deliver quality assets that minimise life cycle costs. The contractor also has an incentive to employ new technology and innovative design and construction practices if their effect is to lower construction costs, improve productivity and ensure sustainable service delivery. Risk Control over project decision-making carries with it the burden of initial, and operational project risks not specifically assigned to the contractor, such as penalties for late delivery, cost overruns and postconstruction warranties. The principal meets the cost of the project, all variations and carries life cycle cost risk. The allocation of risk between principal and contractor may be reconfigured by the form of contract

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and state or organisational procurement policies. Gross maximum or fixed price contracts may allocate specific time and cost risk to the contractor and reconfigure the contract’s incentive framework. For example, under a fixed price contract, the contractor is, in effect, incentivised to raise the cost of variations and ‘cut corners’ to find cost savings. These contracts are also prone to renegotiation and dispute. If the contractor has no role in future asset management or service delivery, build quality and low life cycle costs are traded for an expedient construction outcome. Conversely, in a cost plus or managing contractor arrangement under which the contractor is paid an agreed margin, most construction risk resides with the principal and the contractor is incentivised to extend the contract for as long as possible with the maximum resources. Remuneration provisions in the contract will also affect incentive frameworks. For example, in a cost plus or managing contractor arrangement, an incentive payment mechanism structured as a share of cost savings may also drive specific behaviours and limit the likelihood that the contractor will let contract run over budget. However, it should be recognised that the two major risks in infrastructure projects are the construction and life cycle cost stages which, for service intervals of twenty or more years for conventional buildings, may be a multiple of the original construction cost (National Audit Office, 2002). Governing Policy Framework The procurement of public goods is governed by state procurement policies which may require the unbundling of projects into staged work parcels for construction, design, consulting, project management, and facility management. The services may be provided by different organisations, some may be public and others private. Recent studies suggest that bundling of the design and construction tasks or early contractor engagement in the design phase of a project may improve communications, improve delivery cost and time, and stimulate both innovation and adoption of new technologies (Hart, 2003; National Audit Office, 2005a). Policies may also limit the scope for reconfiguring tender, bid selection and form of contract parameters designed to improve alignment of incentives, reduce the adversarial nature of traditional contracts and encourage the contractor’s contribution to improved innovation and lower life cycle costs.


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Contractual Relationships Adversarial relationships place the principal and contractor in competition for the capital available to the project with the likelihood of greater interparty friction. The principal endeavours to deliver the project at, or better than, the budget, and the contractor is working to benefit from changes in project scope or specification, the manner of work and disputes over rework, faulty materials and workmanship, and ambiguity or uncertainty in the interpretation of the contract. The relationship between the principal and contractor is also governed by the form of contract. A fixed price contract passes time and cost risk to the contractor, whereas a managing contractor or cost-plus arrangement ensures the principal retains all project risk. The form of contract also determines the formula for the calculation of the contractor’s margin (flat fee or incentive-based) and the form of specification (an input specification limits contractor liability to matters specified in the contract whilst an output specification passes design, construction and possibly operational risk to the contractor). When a contractor claims greater cost recovery for variations or specification changes than the principal is willing to pay, costly disputes follow together with risk of cost overrun, late delivery and extended post-contractual negotiations to resolve matters in dispute, or judicial proceedings, both of which increase transaction costs. Essentially, the parties to the contract are caught in a conflict between self-interest and their obligations under the contract. The adversarial relationship is not confined to the principal and contractor and where the agency unbundles these services into separate contracts, friction may also apply to the relationships between the contractor and sub-contractors, the designer and consultant. When a contractor has bid competitively to secure the contract, the incentive exists to auction or ‘shop’ the sub-contract components to the lowest bidder. This friction limits opportunities for collaboration and innovation, and can increase transaction costs and disputes. Incentive Framework What incentives operate with adversarial construction contracts? Traditional contracts are used to transfer the major proportion of time and construction cost risk to the contractor. The agency’s objective is to ensure delivery to specification, to minimise variations and to

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ensure that the project is delivered on time and within budget (Songer & Molenaar, 1997). Under a fixed price contract with time constraints, the contractor will endeavour to meet its obligations under the contract, contest liquidated damages for late delivery, manage and, where possible under contractual obligations, minimise costs. In construction contracts, there is also a risk that contractors will bid strategically and competitively to win the contract and then when work commences ‘cut corners’ or exploit variations to the specification or scope of works to reduce costs and improve the margin during the term of the contract (Hart, Shleifer, & Vishny, 1997). These practices include poor build quality and building sustainability, non-durable fixtures and finishes, and low-efficiency plant and equipment. The risk is greater with complete and fixed price contracts than for incomplete or cost plus margin contracts (Estache, Iimi, & Ruzzier, 2009). Change Management Complete contracts provide little flexibility for dealing with change and externalities outside the conventional alternative dispute resolution and judicial solutions. Disputes in traditional procurement may be resolved by alternative dispute resolution (ADR) procedures, although full recourse to legal sanction is always an option. Settlement of a dispute in a court of law may carry the risk of outcomes beyond contemplation of the parties, including contract termination. Legal action is also adversarial and likely to lead to a breakdown in the relationship of the parties to the contract which may take many years to resolve and is costly. Competing objectives give rise to disputes over costs that are resolved by negotiation and arbitration following completion of the works. Nevertheless, unless otherwise agreed between the parties, recourse to judicial proceedings to resolve intractable disputes remains an option. In incomplete construction contracts, a significant part of the contractor’s performance may not be observable to the principal or it may be non-contractible. This may arise because the performance cannot be verified, or it is a consequence of decisionmaking by the contractor. Monitoring may be too costly, or uncertainties exist in the scope of works and the specification in relation to the quality or quantity of labour and/or materials used. Unobservable work may take several forms, but is generally


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concerned with the quality of materials and standards of workmanship. In an adversarial contract, unless strong incentives induce the contractor to contribute additional investment in time, resources and/or money to improve construction performance and quality, the contractor will under-invest in non-observable works especially when cost saving from ‘cutting corners’ improves overall return. Information is not readily available for actual costs incurred by contractors and principals although estimates are provided by Allen Consulting Group (2005) and Thompson (1998). Data published by UK building firm Laing O’Rourke in 2009, suggests the average sum in dispute on completion of short-term construction contracts is 9.5% of aggregate contract value. The time taken to resolve contractual disputes is an average of 7.2 months (Laing O’Rourke Ltd Annual Report, 2010). In adversarial contracts, the sub-optimal alignment of incentives contributes to sub-optimal procurement outcomes as traditional contracts are generally limited to production of the asset rather than its whole service life. NON-ADVERSARIAL CONTRACTS

In the early 1990s in the wake of a world recession, many countries sought to improve microeconomic performance, reduce public deficits and unemployment, and renew aging infrastructure. These reforms led to wider use of outsourcing of government services, the privatisation of many state business enterprises, and the introduction of new privately-financed procurement methods. In fiscally constrained times, the appeal of private capital was also very attractive. The role of government also began to change from the ownership and production of public services to the purchase of services from private producers. In the years that followed, a number of new methods were adopted that took a very different approach to the relationship between the state as principal and contractor as agent. The more common non-adversarial contracts currently in use include build operate transfer (BOT) arrangements and public private partnerships (PPPs) and outsourcing arrangements including concessions and franchises. This group of procurement methods are based on a very different set of principles to traditional adversarial procurement and commonly feature the following characteristics: - long-term incomplete contracts;

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- bundled services; - an output specification; - a non-adversarial contract structure that encourages long term relationship management to resolve disputes, renegotiate elements of the contract affected by change, and to maintain services; - significant risk transfer from principal to the contractor; - a contractor selection process that places equal or greater reliance on qualitative factors than it on quantitative or price criteria; and - greater alignment of incentives to encourage innovation and efficiency. Non-adversarial contracting for delivery of state infrastructure services is not new. There is evidence that concessions were widely used in Ancient Greece in the 3rd Century BC for quarrying, maritime transport and mining, the outsourcing of colonial administration in the Aegean and Asia Minor, and private control of the grain import trade. The Seleucid monarchs of Persia favoured private provision of roads and postal services and the Romans entered into franchises for the construction of bridges, punts, roads, the delivery of water in towns and cities, and the collection of taxes (Easton, 1970; Lall, 1998). The opportunity existed then, as it does now, for private investment and management to deliver infrastructure services to, and on behalf of, the state when the state’s capacity to do so is constrained, or its ability to deliver services efficiently and at optimal cost is impaired. Public failure is a characteristic of state institutions and describes state interventions whose cost exceeds the benefits in welfare terms, and activities that could be produced with greater efficiency and at lower cost by private agents (Andrews, Boyne, & Enticott, 2006). Public failure is, or should be, factored into the economics of public procurement as a risk premium (National Audit Office, 2000). The two most common alternative procurement methods used to deliver infrastructure are alliance contracts and BOT concession (including public private partnerships).


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Alliance (Relationship) Contracts An alliance, a form of relationship contracting, is used for shortterm or multi-stage construction and civil works projects. Relationship contracting is based on a collaborative approach to the preparation of the project scope and specification, sub-contractor selection, cost estimation, project management and governance. Alliance contracts can be used to deliver complex and multi-stage projects in which the works specification is incomplete at the time of commissioning the contract. The Form of Contract The contract is negotiated between the consultant and the principal together with a target cost estimate (TCE). The contract is designed to create a collaborative contractual framework in which the contractor and its subcontractors and consultants work cooperatively with the principal to deliver the project to specification, on time and within the TCE. The characteristics of an alliance contract may include (Love et al., 2011): - joint residual control and collaboration on sub-contractor selection; - sharing of information, innovation and technology; - an ‘open book’ project governance and accounting framework; - a joint approach to project costing (target cost estimate) and negotiation of the contractor’s margin; - aligned incentives driving the conduct of the parties; - joint selection of the project managers, sub-contractors, consultants and advisers; - risk of cost overrun borne by both parties and the contractor stands to lose all or part of its margin and corporate overhead; - cost savings and early completion gains shared between the principal, the contractor and sub-contractors; and - disputes resolved by ADR methods with limited judicial proceedings.

recourse to

Alliance contracts may be implemented quickly, reducing transaction costs by eliminating tender and bid evaluation stages. For

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complex projects, project design may proceed concurrently with early costing work with the contractor engaged in all aspects of design and preparation of the specification. This provides opportunity for shared innovation, new technology and wider consultation on matters affecting life cycle costs and service quality (Walker & Rowlinson, 2008). However, the aggressive element of price competition between bidders is reduced when compared with traditional procurement. Contractor Selection Contractors are generally pre-selected against qualifying criteria which includes the readiness, experience and track record of the contractor’s management team. Additionally, contractor selection also includes the contractor’s record of innovation and collaboration and a willingness to work toward joint objectives with an appropriate culture fit with the client. Contractors submit to an audit review process in order to pre-qualify for a panel from which the agency may invite a contractor to submit an expression of interest for a project. The calculation of total project cost, completion time and the contractor’s margin are achieved by negotiation without competitive tension. Alliance contracting is a significant move away from traditional adversarial contracting with a focus on transparency, good governance, shared decision-making and aligned incentives (Miller et al., 2009). Form of Specification Alliance contracts may be used with complete and incomplete specified projects and are employed widely with projects in which the design and specification is incomplete at the commencement of works. Alliance contracts are also suitable for complex and multi-stage projects delivering civil works, infrastructure (interstate highways, railways), public buildings (Blyth Community College, Northumberland, UK), integrated transport terminals (Heathrow Terminal 5, London), schools (Kingsmead School, Hoylake, UK), defence (Logistics Organisation Offices, Andover, UK), port reclamation (Port of Brisbane) and water treatment (Thames Water, UK) (National Audit Office, 2005b).


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Ownership The alliance model is managed by a project control group generally with equal representation from the principal and contractor. The project control group creates the governance and reporting framework, recruits the project manager and monitors performance. Residual control rights are exercised collaboratively in the best interests of the project. The ownership and decision-making for the project is performed by the project control group. Alliance contracts in Australia are delivered under a national alliance contracting policy and guidance framework (Infrastructure Australia, 2011). Risk As a general rule, the TCE and delivery schedule are two of the primary measures of procurement performance. Risk and reward in the form of early completion or cost savings are shared, and penalties for time and cost overruns are carried jointly by the principal and contractor. However, in many contracts, the contractor’s financial loss may be limited to project profit and corporate overheads. Few alliance contracts are similar and the agreement for risk sharing will be negotiated between the parties. The cost savings and bonus payments for early completion and improved performance are also shared between the principal, the contractor and the sub-contractors. In most alliance contracts, sub-contractors are paid directly through the project control group and the contractor is paid the cost of construction work and site overheads (Petrie, 2007). Contractual Relationship The relationship between principal and contractor is nonadversarial; incentives are aligned in a common purpose and information is shared, minimising the asymmetries that add to transaction costs with adversarial traditional contracts. Alliance contracts are generally designed to simplify monitoring and dispute resolution procedures and, as is the case with other alternative procurement methods, enforcement may employ responsive regulatory principles (Walker & Rowlinson, 2008). This applies a graduated penalty framework for minor breaches of the contract such as direct negotiation and minor financial penalties (or a redeemable points system) which escalates to higher penalties, warning notices and possibly contract suspension for repeated and more serious breaches

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(Ayers and Braithwaite, 1992). The attraction of responsive regulation is the focus on relationship management and avoidance of contract failure. Alliance contracts are designed to minimise renegotiation and time lost with disputes over changes to specification or scope of works. The transactional experience suggests that it is these characteristics that are reducing transaction cost and improving value for money outcomes. Ex Post Service Delivery Alliance contracts are typically employed for construction work and may be used with long-term contracts when articulated over several stages. Alliance contracts do not generally extend to post-handover service delivery. Where a project requires the contractor to provide post-construction asset management services, a separate management service agreement is entered into (NSW Government, 2008). Incentive Framework The incentive framework is significantly different between traditional and alliance contracts with the distinction grounded in the ordering of the incentives. In an adversarial contract, self-interest is in tension with the parties’ obligations under the contract. Parties will appropriate benefits from an information advantage and there are no mechanisms for sharing the benefits of innovation and new technology (Walker & Rowlinson, 2008; Miller et al., 2009). In collaborative contracting, the risk and reward sharing formula encourages full disclosure, innovation and a joint approach to resolving problems at the least cost. In semi-collaborative contracts such as public private partnerships, the emphasis is on handover and life cycle service delivery rather than on pre- and post-contract construction asset delivery. The principal is not a buyer of the asset, but is a buyer of the service that it produces. As the state agency is only paying for services delivered to the specification, the sole focus of the contractor is to produce the service to specification (NSW Government, 2009). The contractor may improve the marginal return on investment with better productivity or by investing more in the production process. There is no financial benefit to the contractor in cutting costs while constructing the asset, if the result is an increase in life cycle costs or reduction in service quality.


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PPP CONTRACTS

Public private partnerships (PPPs) were a development of the BOT procurement method widely used as a vehicle for project finance in the resources industry in the 1980s. PPPs were adopted in the Australia and UK in 2001 and in other jurisdictions shortly thereafter. In Australia, PPPs were formed by state governments, administered by Treasury agencies and supported by a dedicated PPP unit and a comprehensive policy framework. PPPs were first used in Victoria in 2001, although earlier BOT transactions were undertaken in Sydney (Harbour Tunnel project) and Melbourne (Citylink toll roads). A uniform national PPP policy was adopted in 2009 and currently, PPPs are used in around 130 countries and are a preferred strategy of the multilateral development agencies to fast track infrastructure in developing nations (World Bank, 2012). In Australia, only projects complying with PPP policy are described as PPPs, although in other jurisdictions, most private investments in infrastructure are described this way (Infrastructure Australia, 2008; KPMG, 2010). PPPs can be distinguished from other infrastructure procurement methods by the following characteristics (Infrastructure Partnerships Australia, 2010; Regan et al., 2011): - are implemented within a comprehensive policy framework, which operates independently of state procurement policy. PPPs are negotiated for terms of up to 40 years; - are evaluated by the agency and modelled on a risk-weighted and life cycle cost basis against a traditional procurement benchmark (the public sector comparator); - contractors are selected either by competitive tender or by prequalification and negotiation. The bids are contested by sole contractors or consortia for larger projects which may include a sponsor, construction contractor, asset and/or facility manager, and possibly sub-contractors and consultants; - the cost of the asset and service provision is met by the consortium and its lenders. The successful bidder derives income from a unitary or availability charge to the agency or accepts market (patronage) risk; - the agency only pays for the services it receives and payment is abated and/or penalties applied when the contractor fails to meet

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service delivery or quality standards or other key performance indicators; - PPP contracts are long-term and incomplete. This requires contractual provisions to resolve disputes and deal with change without recourse to legal action; - The contractor is selected on the basis of the best value for money proposition making use of qualitative (contractor track record and experience, innovation, technology, service outcomes) and quantitative criteria; - ex post service delivery is based on a relationship management approach with a focus on responsive regulation and a nonadversarial management framework; and - investment economics favour high debt: equity ratios which contribute to greater transaction costs than traditional procurement methods. These costs concern bid and establishment expenses, long lead times to prepare bid documentation, a lengthy bid process, and the conduct of postselection negotiations with the principal. The Form of Contract The PPP transaction embodies a bundle of contracts that pass effective control of the asset and service delivery to the consortium over the term of the arrangement. Service performance is monitored by a state agency under a comprehensive contract management framework. The contract is essentially incomplete and while regulated internally, it contains mechanisms to deal with changeover service intervals as long as 40 years. The agency pays for service delivery and abates payment when the services do not meet the output specification. The state only pays for the services that it receives at the required standard. The consortium has acquired a franchise to deliver services over the life of the contract that is largely protected from market competition (Partnerships Victoria, 2001, Partnerships Victoria, 2012). The opportunity exists for the contractor to improve productivity and profitability over the term of the contract and take advantage of increases in contract value to revalue and refinance assets and raise the marginal return on investment. The PPP contract is not fully collaborative, but it achieves a level of transactional transparency and cooperation not found in traditional procurement methods.


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Contractor Selection A contractor or consortium is selected from a competitive bidding process which may take the form of an expression of interest prequalification followed by a request for tender by invitation. The selection process attempts to maintain competitive tension between several pre-qualified consortia while minimising bid costs which can be very high with this method of procurement (Yescombe, 2007). Form of Specification PPPs are bid as an output rather than a detailed input specification although, for complex projects, the output specification may be accompanied by detailed operational standards and requirements. The consortium meets the cost of service delivery and is responsible for the design, construction, commissioning and operation of the assets and the services that it delivers. The consortium carries life cycle cost risk and has an interest in ensuring good build quality (Partnerships Victoria, 2001). Ownership The PPP transfers decision-making to the consortium, subject only to the agency sign-off on key matters such as final design and service commissioning. The role of the agency is to monitor construction and manage the relationship with the consortium during construction and following commissioning, during the service delivery term. The contractor has the incentive to improve productivity and efficiency and invest further if the pricing mechanism includes bonus payments for service performance exceeding requirements (Regan et al., 2011). The pricing may be based on a points system with breaches of contract and non-conforming services attracting point deductions and consistently high service quality rewarded with additional points. In a monthly or quarterly period, aggregate points exceeding the performance benchmark attract bonus payments and scores below the benchmark result in abatements or penalties. Points systems such as those used in United Kingdom hospital PPP projects are redeemable either within the review period or for reconciliation with later periods (National Audit Office, 2005c).

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Risk The consortium carries the full risk of service delivery and in some transport projects it may also carry market risk. In the latter transactions, market risk may be mitigated by ‘take or pay’ provisions in the contract, and other forms of agency guarantee, that ensure minimum revenue levels sufficient to support consortium debt servicing (Partnerships Victoria, 2001). The principal only pays for the services delivered and therefore carries no operational risk. However, the principal carries residual political risk in the sense that if the consortium fails for any reason, the agency must work with the project financiers to identify a buyer of the contract and/or resume the asset with compensation. In Australia, 12% of projects have failed in the sense that the consortium cannot meet its debt servicing requirements (Regan, 2008a, 2009). The state also carries the electoral risk that the electorate will hold government responsible for poor service quality or service delivery failure (Infrastructure Australia, 2010). There has not been any service delivery failure of PPPs in Australia, although projects have been delivered late (i.e. Ararat Prison Contract II and Southern Cross Station, both in Victoria, Australia). Governing Policy Framework PPPS are delivered under the national policy framework with some variations adopted by the states and territories for local conditions. PPPs are not subject to general state procurement policy, although they are subject to the governance and performance monitoring processes in the states and territories. PPPs are not generally available to local government without the consent of local government ministers at state and territory level (Infrastructure Australia, 2008). Contractual Relationship The PPP is an incomplete and non-adversarial contract that operates to minimise the risk of interparty friction. Additionally, decision-making resides with the party most concerned about life cycle operation, service quality and the marginal return on investment. The role of the financier and the consortium is particularly important in a PPP because it provides a limited indemnity to the state against project failure: as a limited recourse loan, the financier may appoint


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an administrator to the development vehicle in the event of consortium default. The state requires continued service delivery and the financier’s requirement is to maintain cash flow and debt servicing. In the event of default under either the PPP or the loan agreements, the financier may subrogate an administrator to manage the PPP contract with a view to finding a new buyer of the contract. A change in control of the ownership of a PPP contractor or consortium requires agency approval (Yescombe, 2007; Infrastructure Australia, 2008; Regan, 2008b). The financier also applies capital market discipline to the consortium by enforcing contractor compliance with the terms of the contract such as service delivery standards and debt servicing covenants in the loan agreement. In the event of default under either the PPP or the loan agreements, the financier may subrogate an administrator to manage the PPP contract with a view to finding a new buyer of the contract. A change in control of the ownership of a PPP contractor or consortium requires agency approval (Regan, 2009). Ex Post Service Delivery As a long-term incomplete contract, PPPs include the ex post service delivery stage of service provision. This creates an important connection between building quality, life cycle cost risk and the quality of service provision. If the contractor is responsible for life cycle costs over the term of the contract, it is in the interests of the contractor to ensure that assets are constructed with a view to durability, low maintenance and minimal energy consumption. Unlike an adversarial contract, ex post performance under the contract is conducted under responsive regulatory principles within a relationship management framework designed for early resolution of service delivery and compliance issues at the project level (Bajari & Tadelis, 2001; Bajari & Lewis, 2011). Incentive Framework A PPP aligns the incentives that drive behaviours for the three principal parties to the contract, the financier, the consortium and the state agency as buyer of the service (Love et al., 2011). Each has an interest in sustained high-performance service delivery, the avoidance of protracted and costly disputes, and the resolution of change management issues. The tensions that may exist at the

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project level over compliance matters suggest that PPPs may not be a fully collaborative contract, in the same way an alliance contract. Nevertheless, the alignment of risk, incentive and objectives within the PPP arrangement suggest a cooperative approach that is a significant departure from conventional adversarial contracting (Miller et al., 2009). COMPARATIVE PROCUREMENT PERFORMANCE

Reports by the UK National Audit Office in 2001 and 2003 identified late delivery and over-budget performance in around 70% of public projects (National Audit Office, 2001, 2003). Moreover in 2007, a study of traditional contracts and PPPs in Australia found that traditional adversarial contracts for major projects were systematically delivered late and over-budget compared with PPPs (Allen Consulting and University of Melbourne, 2007). Land transport projects, in particular, attracted a high level of optimism bias reflected in overestimation of revenues and underestimation of delays, coordination problems, and costs (Standard and Poor’s, 2004; McDonald, 2002). The Standard and Poor’s 2004 study examined patronage (forecasting) error for over 87 international road projects and identified an average 20% to 30% per cent overestimation. The study also compares evidence for toll and non-tolled roads and builds on the evidence of two earlier firm studies (Standard and Poor’s, 2002, Bain, 2003). The problems are significantly greater for non-standard buildings and civil engineering works, and equipment procurement (Mott McDonald, 2002). There has been a subtle shift away from the use of traditional contracting in an attempt to ensure that infrastructure projects meet pre-defined service deliverables. The National Audit Office in Britain conducted a review of complex projects delivered with traditional and alliance contracting across a number of applications including primary, secondary and tertiary education, airports, property, medical services, water and public buildings. Contracts designed on collaborative contracting principles delivered better quantitative and qualitative preconstruction and construction and handover service outcomes than adversarial contracting benchmarks (National Audit Office; 2005a, 2005b). Despite the shift to collaborative contracting, infrastructure projects are still not being delivered on time and to budget. In the UK, for example, the Construction Industry Key Performance Indicators


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revealed that 55% of current projects are delivered late, and 37% are not delivered to the intended budget (Construction Excellence, 2011). Similarly, in Australia, Blake Dawson (2011) found that less than 48% of infrastructure projects surveyed were delivered on time, on budget and to the required quality. A fundamental shift in the public sector’s ethos to contracting is required in order to address this unending pervasive problem. Procurement theory views project procurement in all its forms through the lens of the principal-agent relationship (Estache et al., 2009). A difficulty with the principal-agent model is asymmetry of information and unobserved conduct. When the principal selects a contractor in an auction (tender) using criteria weighted in favour of quantitative values such as price, the principal encounters adverse selection problems because it cannot easily measure or verify the contractor’s efficiency, embedded technology, willingness to innovate, commitment or propensity for litigation. A principal is also unlikely to know if the contractor will cut corners to improve margins and whether or not the contractor has made errors in constructing its bid. This matters if the principal is carrying life cycle cost risk or if there is a risk of impaired service outcomes. In agency, these problems are usually resolved with incentives designed to improve build quality and a trade-off between a lower procurement cost and increased life cycle costs over the longer term (Laffont & Martimort, 2002). In state procurement contracts, an additional problem can be the limited discretion agencies have to reconfigure selection criteria within rigid policy criteria. Collaborative contracting is difficult to view through the principalagent model. In PPPs, the principal is a buyer of services under a long-term supply agreement. The contractor is the producer of services with possession of the assets, decision-making authority and responsibility for lifecycle costs. Because the contractor can improve its investment return from innovation and efficiency in both the construction and management of the asset, it can appropriate the surplus (the marginal return on investment). The principal has no capital at stake, it is buying and only paying for services that meet specification and its objective is to ensure that the service meets requirements. The value for money test is an ex ante determination made in a competitive bid context and the relationship between the parties is simply an arm’s length supply contract between a vendor

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and buyer of a service (Department of Infrastructure and Planning, Queensland, 2008; Infrastructure Australia, 2010; Regan et al., 2011). Procurement theory suggests that complex procurement contracts deliver better performance when the contractual framework incorporates non-adversarial principles (Bajari & Tadelis, 2001). That is, the relationship of the parties to the contract benefit from cooperation (Bajari & Tadelis, 2001). In this sense, cooperation is the sharing of information, the alignment of objectives and incentives, the encouragement of innovation and productivity by aligning decisionmaking and responsibility for project outcomes, and the adoption of a responsive and relationship management approach to ex post contract administration. This approach is supported by empirical evidence where the performance advantage of PPPs and alliances is well documented. (National Audit Office, 2005a, 2005b; Regan et al., 2011). Complete contracts for short-term construction and civil works can benefit from incentive-based contracts that place the principal and the contractor on a less adversarial footing. Delivery performance may be improved with the integration of the design and construction tasks, early contractor involvement, wider use of output objectives in the project specification to encourage contractor innovation, and specific incentives relating to build quality with a view to reduced lifecycle costing. Where possible, life cycle contracts can lead to significant time and cost savings with complete contracts. However, it does require the redesign of state procurement policy to permit more flexible bidder evaluation criteria. TECHNOLOGY ENABLED COLLABORATIVE CONTRACTING

A leitmotiv that contributes to the failure to deliver infrastructure projects predictability is ‘poor quality information’ (Love et al., 1999; Andi & Minato, 2003; Love et al., 2006; Crotty, 2012). According to Barrett and Barrett (2004) “projects that run over time and budget are often underpinned by faulty documentation that looks professional, but in fact does not properly describe the built solution”. Under a traditional contract, complete design documentation is generally not fully available when a project goes to tender (in theory, it should), which explains why few projects are actually completed within the tendered price. This is also the case for non-traditional approaches as design activities are undertaken in a concurrent


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manner and preliminary information is released earlier to proceeding tasks (Evbuomwan & Anumba, 1996). This approach is typically adopted to reduce design time and errors as well provide feedback to solve problems that may have manifested earlier in the design process (Arundachawat et al., 2009). Using preliminary information when design tasks are overlapped often leads to information changes, which arise due to evolutions in design. The early release of information may cause unnecessary rework due to redundant data, and an increase the time and effort to prepare for the release of information as checks and quality assurance processes need to be implemented (Eastman, 1980; Love et al., 2012). Information is pivotal to reducing the construction costs as well the whole-life cycle costs of a facility. For this reason, the ability to access in-built information within equipment, systems, and spaces a Building Information Modelling (BIM) approach informs design decisions as the project progresses. The Government Construction Client Group (2011) in the UK states “clients should expect all consultants to be familiar with BIM and to be actively developing ways in which processes can be made more cost effective and value adding”. It has been estimated that BIM can provide (Centre for Integrated Facility Engineering, 2007): - 7% reduction in schedule; - 10% saving in contract value through clash detection; - 40% elimination of unbudgeted change; and - 80% reduction in the time taken to generate a cost estimate with cost estimation accuracy within 3%. Clients, particularly those who will operate and maintain an asset will benefit most from implementing BIM. Essentially, BIM is a process and technological innovation that enables project team collaboration and integration to occur and provides a platform for sharing information. BIM requires a collaborative contracting approach known as Integrated Project Delivery (IPD) to be used to realise its full potential. IPD is defined as “an approach that integrates people, systems, business structures and practices into a process that collaboratively harnesses the talents and insights of all participants to optimize projects results, increase value to the owner, reduce waste, and maximize efficiency through all phase of design, fabrication, construction” (AIA California Council, 2008). The use of

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IPD is somewhat akin to the concept of alliances with emphasis being placed upon (Eastman, Teicholz, Sacks, & Liston, 2008; Sacks, Koskela et al., 2010; Love et al., 2012) the following: - a multi-party contract; - early involvement of key participants; - collaborative decision-making; - sharing of risks and rewards; - liability waivers among key participants; and - jointly developed project goals. All of the above characteristics must be incorporated into a project for IPD to be realized in its ‘purist’ form. Projects using IPD in Australia do not employ all of these characteristics; instead they use some elements to increase the likelihood project success (Allen Consulting, 2010). While the use of IPD provides the ideal platform to use BIM, it is not a necessity. However, IPD without BIM is better than BIM without IPD. BIM enables designers to view an asset and its contents from all angles, which can reveal potential problems during the formative stages of the design process. Sections, elevations and 3D views can be created instantly, reducing the need for check plots. Changes to any one of these elements affect all of the others, including materials, costs and construction schedules. With BIM, detailed information about each building component is contained within its modelled element. Primarily, BIM improves coordination among project team members by making design changes, and all their consequences evident and available to all users of a parametric model. The synchronized and collaborative nature of BIM allows for earlier clash detection between the numerous members of the design team. Earlier clash detection therefore shortens the time required for building design and reduces costs associated with rectifying clashes that were undetected during design reviews. In Australian construction projects, for example, it has been estimated that 60% to 90% of all change orders are a result of poor design documentation– a failing that BIM enabled technology can readily address, particularly during the design phase of a project.


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CONCLUSION

Traditional and adversarial methods of contracting have been reviewed to provide decision makers with an understanding of reasons and basis for continuing with the tried and tested approaches. The advantages and disadvantages of the traditional approach have been discussed and their use is based in the sharing of risk between principal and contractor. The often ignored advantage of the traditional approach is the fact that it preserves government probity through competition and having the minimum barriers to entry to new participants. Pre-qualification can dilute these characteristics, but applied fairly and sensitively can reduce risk of non-performance for the principal. A major disadvantage identified in this approach is the culture of adversarial relations between the parties and this engenders division rather than cooperation between the parties. Non-adversarial approaches re-balance risks towards the contractor and the party that can best manage them. Bearing risk does not come without cost and the parties, especially the contractor, must price this additional burden in their tender. The expansion of public tenders to go beyond the delivery of the infrastructure for the principal and include service delivery for a designated period (up to 40 years), has increased the risk profile of the successful bidder. However, the performance and deliverables often measured by the project parameters of time, cost, quality and scope have improved under collaborative contracting. However, they are not infallible and poor decisions often captured in optimism bias can result in failure and termination of the service contract and selling off the infrastructure asset. These have occurred on some projects around the World and whilst these failures are regrettable, in most cases the public purse does not suffer. In fact, the public sector may gain an infrastructure asset at a cost less than the replacement cost to be retained or auctioned to a second provider. The use of BIM and IPD for infrastructure delivery in Australia has been limited to date. However, there are positive predictions as to the influence BIM will have on reducing documentation errors on projects. Poor documentation is a chronic malaise within the construction industry. Yet, accurate contract documents (specification, drawings, schedules and bills of quantities) are an essential pre-requisite to all procurement approaches, whether produced by the principal’s agents

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(design team) or the contractor. Error-free documents would not only improve contractual relations between the parties (less conflict), but would also improve time, cost and quality parameters. A corollary of good documentation is a reduction in disputes and greater potential for project delivery success. REFERENCES

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Songer, A. D., & Molenaar, K. P. (1997). “Project Characteristics for Successful Public-Sector Design-Build.” Journal of Construction Engineering and Management, 123 (1): 34-40. Standard and Poor’s (2002, September). Traffic Risk in Start-Up Toll Facilities (Infrastructure Finance). London, UK: Author. Standard and Poor’s (2004). Traffic Forecasting Risk: Study Update 2004 (Infrastructure Finance). London, UK: Author. Thompson, R. M. (1998). Efforts to Manage Disputes in the Construction Industry: A Comparison of the New Engineering Contract and the Dispute Review Board. Blackburg, VA: Faculty of Civil Engineering, Virginia Polytechnic Institute and State University. Tadelis, S., & Bajari, P. (2006). “Incentives and Award Procedures: Competitive Tendering vs. Negotiations in Procurement.” In G. Piga, N. Dimitri, & G. Spagnolo (Eds.), Handbook of Procurement (pp. 121-139). London, UK: Cambridge University Press. The Economist Intelligence Unit (2009) Partnerships for Progress? Evaluating the Environment for Public-Private Partnerships in Latin America and the Caribbean, Findings and Methodology. UK: London, UK: Author. Walker, D. H. T., & Rowlinson, S. (2008). “Innovation Management in Project Alliances.” In D. H. T. Walker & S. Rowlinson (Eds.), Procurement Systems: A Cross-Industry Perspective (pp. 400422). Oxford, UK: Taylor and Francis. World Bank (2012) PPP in Infrastructure Resource Center for Contracts, Laws and Regulation. [Online]. Available at http://ppp.worldbank.org/public-private-partnership/legislationregulation/laws/procurement. (Accessed August 3, 2012). Yescombe, E. R. (2007). Public-Private Partnerships: Principles of Policy and Finance. Oxford, UK: Butterworth-Heinemann.


WINTER 2015

THE ENLIGHTENMENT UNDERPINNINGS OF THE PUBLIC PROCUREMENT PROFESSION William Earle Klay* ABSTRACT. Enlightenment philosophers profoundly influenced the emergence of democracy. Enlightenment ideas underlie much of the theory and practice of public procurement today. Economic theory, dating from the writings of Adam Smith and his mentor Frances Hutcheson, assumes that suppliers will act in their own self interest. Knowing this, public buyers seek to fashion incentives to align the private interests of suppliers with public needs. But Hutcheson and others argued that civic duty and benevolence should guide public servants in seeking value for their fellow citizens. That argument is the basis of our codes of ethics. The clams of public procurement to being a profession will be greatly bolstered when it is recognized that our knowledge base is rooted in the same Enlightenment thinking that undergirds other professions and academic disciplines. INTRODUCTION

The practice of public procurement can be traced back to ancient times, but efforts to professionalize it are relatively recent. Obstacles do exist. Procurement is conducted within organizations, not by independent practitioners as is common in law, medicine and auditing. Leaders of public organizations, persons who formerly looked upon “buying” as a clerical activity, now need to be convinced that public procurement is worthy of being considered a profession. Perhaps the greatest obstacle to gaining recognition for procurement as a profession is that it has not firmly rooted itself in academic disciplines. When it can be demonstrated that a field’s ---------------------------* William Earle Klay, Ph.D., is Professor and Director of the Askew School of Public Administration and Policy at the Florida State University. A former practitioner in federal and state governments, he teaches courses on public procurement, on public policy and financial management, and on the history of public administration.


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body of knowledge is rooted in academic disciplines, its claims of being a profession become more credible (Savage, 1994). The following pages describe how some of the fundamental concepts of modern public procurement are derived from ideas that were framed in the “Enlightenment,” also known as the “Age of Reason.” Researchers who seek to build a theoretical foundation for public procurement research tend to emphasize such concepts as competitive bidding, principals and agents, transaction costs, and contracting (Flynn & Davis, 2014). Each of these concepts was explored by the Enlightenment thinkers who established the foundations of modern academic disciplines, ranging from the natural sciences to sociology and economics. When professionals in public procurement better understand the Enlightenment roots of their field, their efforts to advance its professionalization are likely to be enhanced. REQUISITES FOR A SUCCESSFUL PROFESSION: KNOWLEDGE AND TRUST

There is a general consensus as to the characteristics of mature professions (Larson, 1978). Professions are occupations that have gained deference and prestige. Professionals organize themselves in formal networks to advance the quality of practice and to defend against erosion of hard earned recognition. Membership in professions requires that aspirants obtain and demonstrate competencies in a definable knowledge base. Training in the knowledge of the field is institutionalized and leads to formal licensing or other certification of competence. Standards of practice are delineated and codes of ethics guide the practice of a profession. Mature professions have considerable autonomy. They have relatively free rein to practice their occupation according to professional standards and personal judgment. Finally, mature professions investigate and discipline their own members. Professional work is inherently knowledge based. In the most mature professions, notably law and medicine, knowledge was once attained largely through practice. Young persons aspiring to become attorneys read law and clerked for practicing lawyers. Aspiring pharmacists and medical students observed and emulated practitioners until they were deemed capable to practice on their own. Young architects and engineers did likewise. But eventually every mature profession moved toward university-based training. Training in

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universities has long been a means of establishing claims for recognition and exclusive authority to practice a body of knowledge. It also provides marketability advantages for practitioners (Savage, 1994). Public procurement is an immature profession, one that is in an early aspiring stage. Examinations for certification are becoming increasingly prevalent, but the knowledge base that exists comes overwhelmingly from practice. There is nothing wrong with emphasizing practice-derived knowledge; it is an essential form of knowledge. One of the weaknesses of practiced-based knowledge, though, is that practitioners who convey the knowledge of a field may have little understanding of the historical origins of their practices. Ignorance about the historical origins of a field can contribute to a lack of awareness of the richness of its underlying theoretical framework. Knowing the history of the ideas underlying a field of practice can help to clarify its ethical framework, the normative standards that guide practice. In order to be successfully recognized as professionals, members of an occupational group have to present themselves to society as being both highly knowledgeable and as being worthy of trust (Macdonald, 1989.) If practitioners lack an understanding of the historical origins of their normative standards, it is possible that those standards might be less well observed. Fortunately, the intellectual roots of public procurement are deep. Modern norms of practice can be traced to the ideas of some of the most influential framers of theories of democratic governance. The relevance of their ideas is especially evident in the context of aspirations for professional autonomy. As in other professions, practitioners of public procurement seek professional autonomy. When society, through laws and social custom, extends deference to professionals, the result should be enhancements in the quality of practice. But, if the desire to serve others is weak, professional autonomy might only stroke egos and advance the economic self interests of practitioners with no corresponding enhancements in service to the public. One of the justifications for seeking greater professional autonomy for public procurement professionals is to enable them to better resist efforts by political officials when they want to steer purchases toward favored constituents. Procurement professionals

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are thereby seeking to become more effective participants in systems of checks and balances. Enlightenment writers such as John Locke (1632 – 1704) and Francis Hutcheson (1694 – 1746) were among the earliest proponents of such systems. The steering of purchases toward favored constituents has become unacceptable in the contemporary ethics frameworks of democracies. Doing so violates the belief that all citizens inherently deserve equal treatment under the law. This tenet of democracy was advanced by many Enlightenment writers such as Locke, Hutcheson and Jean-Jacques Rousseau (1712–1778). Other concepts that are now being advanced in the context of professionalizing public procurement are also rooted in the Enlightenment. THE ENLIGHTENMENT

In 1784, the eminent philosopher Immanuel Kant (1724–1804) wrote a brief essay titled “What is Enlightenment?” He concluded that enlightenment occurs in a person’s life when they become capable of critical thinking, of reasoning for one’s self without the need to rely upon the authority of others. Enlightenment writers argued that knowledge was best developed from empirical evidence accompanied by sound critical thinking about the implications of that evidence. What has been called the Age of Enlightenment occurred primarily in the 16th and 17th centuries in several European countries. It emerged from the flourishing of arts and science in the Renaissance and from the questioning of authority that occurred in the Protestant Reformation. The ideas promoted by Enlightenment thinkers became driving forces in the English Revolution (1688), the American Revolution (1775–1783), and the French Revolution (1789–1799). Living in the midst of political turmoil in England, John Locke applied critical thinking to explore the claims of monarchs that they were divinely chosen to rule. He refuted those claims and reasoned, instead, that each person has an equal right to have a say in choosing how they are to be governed. Locke concluded that a rule of law was needed to restrict the arbitrary authority of monarchs who might otherwise choose to restrict liberties and seize property. Locke and those who followed him created the philosophical foundations of democratic government. In procurement today, it is generally accepted that all qualified vendors should have an equal opportunity


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to respond to a solicitation. This normative assertion, that all should be treated equally under the law, is derived directly from Enlightenment thinking Ideas related to contracts were central in the thinking of Enlightenment philosophers. Frances Hutcheson who was considered the father of the Scottish Enlightenment extended the ideas of Locke. Hutcheson (1753, p. 272) wrote, “It must therefore remain that some deed or contract of a people must be the sole natural origin of all just power.” The end of that power, argued Hutcheson, was to serve “a society of free men united under one government for their common interest” (p. 270). By logical extension, each law that empowers procurement officials to engage in their profession is a contract with the people to serve them well. Seen from an Enlightenment perspective, procurement officials are citizens who, upon accepting public employment, enter into contracts to serve their fellow citizens equitably. Hutcheson discussed contracts extensively, especially the conditions that create valid contracts. He explored such concepts as risk management and surety bonds and he proposed the use of arbitration to resolve conflicts. Hutcheson also pioneered in the development of basic concepts of economics such as value, prices, and utility. When procurement officials seek to use reason and empirical evidence to define “value” as being something more than simply lowest price, they are following in the footsteps of Enlightenment predecessors. Adam Smith, Hutcheson’s most famous student, extended his mentor’s inquiries to become the acknowledged founder of the field of economics. Much of the knowledge base of public procurement is derived from economics (Flynn & Davis, 2014). When procurement officials seek to understand the market dynamics of a particular industry, they are engaged in economic inquiry. When they apply costbenefit calculations to perform a make versus buy analysis, they are applying early economic concepts. Unfortunately, the writers of the Enlightenment generally failed to address the specific situations of practitioners who would later seek to apply their ideas to actual situations. Even though some Enlightenment philosophers, especially those in Scotland, sought to make philosophy applicable to practical situations, they were not administrators.

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Enlightenment writers were political theorists. They elaborated ideas that justified establishing a government in the form of a representative democracy, and they suggested ways to avert the abuse of power by dividing it, but they were not administrative theorists. They left it to others to figure out how to apply their concepts to the actual administering of a government. APPLYING THE ENLIGHTENMENT TO PUBLIC ADMINISTRATION

In 1789, a newly elected first American President faced a predicament. Less than two years earlier, George Washington had presided over the Constitutional Convention that had produced a constitution for the new nation. The delegates to the convention extensively deliberated the ideas of Enlightenment thinkers on ways to structure a legislature and, to a lesser extent, a judiciary. But their deliberations on how to structure an executive were startlingly sparse. This can be partly attributed to their trust in Washington who had earlier put down potential military uprisings and who had surrendered his authority as commanding general to the Continental Congress. Had they not trusted the man, they might well have created a plural executive rather than a single president. Washington’s dilemma reflected a gap in the thinking of Enlightenment authors. Men like Locke and Hutcheson wrote at length about the structuring of legislatures and of judiciaries, but they gave little explicit attention to how to organize the executive functions of a democratic government. The deliberations in America’s Constitutional Convention mirrored the concerns of the Enlightenment writers who inspired them. Convention delegates debated the structure and functions of the new Congress at great length, and they spent a fair amount of attention on the judiciary, but they gave Washington essentially a blank slate. In their deliberations, they had rejected a monarchy and a plural executive, and they gave the president certain powers, but they gave no guidance as to how the new executive branch should be structured, how it should administer finances, the criteria for selecting subordinate employees, or the criteria for making purchases of goods and services. All of these were left to Washington to devise. Washington was well aware of the fates of the Athenian democracy and the Roman Republic, as well as that of the parliament’s dictatorial takeover of government in England by


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Cromwell and his associates in the mid-17th century. He sought to avoid past errors and to fashion administrative practices that would enhance legitimacy – the lasting acceptance and support of the people for a representative form of government. Washington used Enlightenment concepts to construct a coherent theoretical framework to guide the “public administration” (his term) of the new government. The theoretical framework fashioned by Washington has been recently described by Cook and Klay (2015). The thousands of letters written by Washington, most now available online, reveal that he was a very clear thinker. His thinking was clearly in line with Enlightenment thought – he believed in the power of reason, he regularly questioned underlying assumptions such as the claims of divine rights by kings, he promoted science and education grounded in critical reasoning, and he even came to believe in the underlying equality of humans in a “state of nature.” Unlike Jefferson, Washington came to think that slaves were shaped by their circumstances not an inherent inferiority (Weincek, 2003). Washington deeply believed in the Enlightenment concept that all citizens, especially officials, should be subject to the rule of law. But that alone was not sufficient. In a letter to a friend, the English historian and activist Katherine Macaulay Graham, Washington wrote, “I always believed that an unequivocally free and equal Representation of the People in the Legislature, together with an efficient and responsible Executive, were the great Pillars on which the preservation of American Freedom must depend.” Washington, a “man of the Enlightenment” as some historians have called him, sought to frame the administration of a representative government in ways that would secure the continuing support of the people whom it served. To earn this legitimacy, he reasoned, officials must strive to conform to the rule of law and, in particular, demonstrate stewardship by being both efficient and responsible in their actions. A representative government, he believed, would not survive if citizens thought that officials placed themselves above the rule of law or behaved in ways that seemed self-serving and wasteful. Contemporary thought in public procurement closely parallels that of Washington. This is seen best in codes of ethics. They typically reaffirm the rule of law and they emphasize officials’ stewardship obligations to treat fellow citizens equitably, to seek value for them,

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and to avoid self-serving conflicts of interest. Each of these core values of public procurement is rooted deeply in the Enlightenment. When procurement officials adhere closely to these ethical norms, they behave in ways that are likely to enhance the legitimacy of democratic governments. CONTRACTS AND THE RULE OF LAW

Contracting is a vital process in assuring the rule of law. Hutcheson (1753, p. 168), for example, wrote that, “Contracts are of absolute necessity in life, and so is the maintaining of faith in them.” The most fundamental contract is that which forms a government. This “covenant or contract,” said Hutcheson, was an agreement that bound government officials to “a faithful administration of their trust” (p. 273). As experienced procurement officials know, successful contracting requires that there be penalties for breaking a contract. Hutcheson advised that officials who misuse power “deserve the highest punishments” (p. 313). To maintain faith in the trustworthiness of their members, mature professions insist on the right to remove misbehaving members from practice. In public procurement, serious breaches of ethics can sully both the profession and the legitimacy of governments. The necessity of strong sanctions for misbehaving procurement officials is deeply rooted in Enlightenment reasoning and is justified by that reasoning. Contracts depend on liberty. To work well they need to be freely entered by both parties. Hutcheson emphasized that placing undue coercion on a party could invalidate a contract. He hastened to add that contracts entered into by a party who does so under legal pressure from a “just magistrate” are presumably in the public interest and therefore valid (p. 178). He also stressed that all elements of contracts must themselves be lawful. Liberty, however, needs to be accompanied by personal responsibility. Failure by a party to understand well the implications of a contract does not relieve that party from being bound by it. Due diligence, “the duty of a discreet cautious man” (p. 182) is to be expected. Accordingly, the performance of due diligence is an appropriate expectation in the behavior of anyone who seeks to be recognized as a professional in public procurement. An important part of doing due diligence is the vetting of the backgrounds and past performances of bidders. The importance of


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this has always existed but it is becoming increasingly important in the procurement of advanced technology. When a government buys computing and communications technology, especially software, it enters into a long term relationship with the providers. Closely scrutinizing the qualifications and past performance of providers, especially their ability to resolve problems, is a key in successful contracting for information technology (Bowden & Klay, 1996). Nearly three centuries ago, Hutcheson noted the importance of vetting in contracting. He cautioned that where risk might be associated with contractors’ failure to perform, it is appropriate to require surety insurance “as a wise arbiter judges sufficient” (p. 177). The fundamental equality of each citizen is a basic tenet of the rule of law. Enlightenment writers understood well that some persons might gain great wealth and influence and that some will seek to use that influence to sway public decisions. George Washington believed that government should stimulate commerce and economic development through policies that promoted education, scientific research, transportation infrastructure, and a sound banking system. But he also cautioned that governments needed to adopt regulations to avoid the undue influence of those with “wealth and power.” In a letter to Thomas Jefferson, Washington (1784) echoed the thoughts of Hutcheson when he wrote, “From trade our citizens will not be restrained, and therefore it behooves us to place it in the most convenient channels, under proper regulation, freed as much as possible, from those vices which luxury, the consequence of wealth and power, naturally introduce (italics Washington’s).” In the context of public procurement, regulations that protect against undue political influence from campaign contributors and other persons of wealth are actions taken to assure equitable applications of the rule of law. MERIT, EQUITABLE TREATMENT, AND LEGITIMACY

One of the surest ways for a government to lose popular support is for it to become perceived as unfair. Legitimacy is related to norms regarding how citizens should be treated and how the revenues of a government should be spent. Perceptions of legitimacy are related to the likely success of major procurement projects (Russell & Meehan, 2014). Washington was deeply concerned that spending practices might be perceived as unfair. He saw that the new American nation

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might split apart. States in New England were inclined at several points in the early history of the nation to go their separate way. He feared that settlers west of the eastern mountains might establish a separate nation. He especially worried that the southern states might split the nation apart as they later did in 1860. He promoted several strategies to counter these centripetal tendencies. For example, he promoted the establishment of a national university in which talented students from all parts of the nation would study together and form lasting ties of friendship and shared national identity. Washington believed that procurement policy could help prevent the new nation from splitting apart. This is best seen in the manner in which he guided the procurement of ships for a new navy (Crawford & Hughes, n.d.). The American navy was to be miniscule, only a half dozen ships, compared to the hundreds of Great Britain and other European powers. It was decided that the American ships should be of superior quality to ships of equivalent size in other navies to give them a likelihood of success in single encounters. Costs had to be contained to satisfy a Congress that was very quick to suspect executive officials of financial mismanagement and corruption. To constrain costs and ensure high quality, Washington was advised to contract to build the ships in a single shipyard. He rejected that advice. Washington decided instead to award the contracts to builders in multiple ports in the north, mid-Atlantic, and southern states. He did so because he believed that the public would perceive the procurement to be fairer if the work was distributed equitably across several states. He realized the costs were likely to be higher, but he believed that public support of the new government was more important. In short, he applied a concept of value in which the enhancement of legitimacy was a primary consideration. To assure high quality, Washington’s administration chose ship designers and builders of proven ability in each location. The men who were to become the commanders of the ships were assigned to supervise the contractors in the design and construction of the ships. In short, the future ship captains acted as both project managers and on-site representatives of the government. To constrain costs, the tradesmen who did the actual building were hired as government employees rather than as employees of the contractor. The quality of the ships that were built was high. Two of those ships remain afloat in


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the 21st century – The “Constitution” in Boston and the “Constellation” in Baltimore. Both prevailed in battle in single encounters as they had been designed to do. In public procurement, the concept of “merit” applies both to the selection of vendors and to the hiring and promoting of procurement officials. Favoritism in the selection of vendors threatens public perceptions of the fairness of their government and, hence, of its legitimacy. It is equally important that procurement officials be hired and promoted on merit, not political connections. Political hires bring obligations to act on criteria other than merit. Hutcheson wrote of the importance of promoting only persons of proven integrity. From an early age, Washington applied merit criteria in selecting and promoting subordinates. When he left his command of the Virginia militia at the close of the Seven Years War (called the French and Indian War by Americans), Washington’s subordinate officers wrote to thank him for his adherence to merit criteria in dealing with them (Zagarri, 1991, p. 66). The later successful procurement of the American navy’s first ships is also largely attributable to the application of merit criteria in selecting the procurement supervisors, the ship captains who served as project managers, and in selecting the contracted ship designers. From the perspectives of Enlightenment thinkers, it is incumbent upon public officials to treat fellow citizens equitably. Each person is entitled to equal treatment under the rule of law. Assurance of equitable treatment is enhanced when concepts of merit are applied in selecting among vendors and in selecting persons to become procurement officials. Contemporary norms in public procurement that emphasize the importance of merit -- treating all potential vendors equitably, selecting among them based on merit criteria, and using merit criteria in selecting procurement officials -- are manifestations of Enlightenment thinking. When procurement officials emphasize merit criteria, their actions advance the legitimacy of a government. Washington sought to be geographically representative in spending and hiring to counter the localism that threatened to split apart the nation to which he was devoted. In many parts of the world today, the challenge is to apply the concept of equal rights under the law to all citizens regardless of their ethnicity, religious beliefs, or similar characteristics. The concept that all persons possess equal

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rights under the law is fundamental to Enlightenment thinking. It is affirmed in the first sentence of the Universal Declaration of Human rights which refers to the “equal and inalienable rights of all members of the human family.” The belief that governments should enhance equality of opportunity is derived directly from this concept. Advancing equality of opportunity under the law – through spending and personnel practices -- is a moral obligation and a principal challenge of public procurement today. PUBLIC SERVICE MOTIVATION – BENEVOLENCE AND STEWARDSHIP

Enlightenment writers paid great attention to exploring “human nature.” Philosophers such as Hutcheson, David Hume and especially Adam Smith concluded that self interest is a motive that explains much of human behavior. The concept of self interest is central to public procurement. Procurement law and practices are built on the assumption that vendors will act in their own self interest. It is up to procurement officials to try to get vendors to behave in the public interest. But if humans are motivated only by self interest, what might motivate procurement officials themselves to act in the public interest rather than solely in their own self interest? Laws and procurement regulations, as well as codes of conduct, typically address this dilemma from a “negative ethics” perspective. This perspective can be best summed up as being the perspective of “Thou shalt not.” Procurement officials are told that they must not create conflict of interest situations in which their self interest (and that of others close to them) conflicts with the performance of their public tasks. Though perhaps tempted to do otherwise, procurement officials are told to “accept nothing” of value from prospective vendors. In contrast to a negative ethics perspective, a positive ethics perspective emphasizes the things that motivate a person to strive hard to serve others well. Frances Hutcheson assumed that self interest is a major motivator. His pupil Adam Smith used that assumption to form the primary motivational assumption of the field of economics – the assertion that people can be predicted to act in their economic self interest. But Hutcheson went further. His own observations and reasoning led him to conclude that there were limits to economic self interest. He reasoned that people need a higher sense of purpose in their lives than can be fulfilled solely by material


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wealth. A minister as well as a philosopher, Hutcheson reasoned that the human capacity and inclination for benevolence was a proof of the existence of a benevolent creator. It is through acts of benevolence, Hutcheson reasoned, that people come to experience their higher purpose in life. He further reasoned that acts of benevolence toward future generations are of exceptional merit. The concept of public service is rooted in this line of reasoning – that we humans achieve greater sense of purpose in our lives when we perform acts of benevolence, of service, toward others. The idea of public service motivation is central to both theory and research in public administration. Public service is a form of benevolence. In selecting subordinate officials, Washington sought evidence that they were motivated to serve the public, not merely themselves. In framing our codes of ethics, and in selecting and leading our subordinates, public procurement officials need to look beyond a negative ethics perspective. The quality of public procurement seems likely to be greater when we embrace and practice the higher aspects of our public service traditions. EDUCATING PUBLIC PROCUREMENT PROFESSIONALS: ABILITY AND INCLINATION

In 1749, Benjamin Franklin wrote an essay on education. In it, Franklin wrote that “true Merit” consists of “an Inclination join'd with an Ability to serve Mankind, one's Country, Friends and Family” (Franklin, 1749). The notion that it is necessary to educate young people to become inclined to serve others -- along with an ability to do so -- is deeply grounded in Enlightenment thought. It is a perspective that serves to guide the educating of persons for careers in public service. It is not enough to only develop abilities, to learn the techniques of a profession. Professional education for public service also needs to inculcate an inclination to serve others. George Turnbull (1698–1748), a Scottish professor and clergyman, extensively described how Enlightenment perspectives could be used to enhance the education of young people. He emphasized that children should be encouraged to learn to reason for themselves. Like other Enlightenment writers, Turnbull emphasized the importance of learning logic in order to question underlying assumptions and to reflect on empirical evidence and one’s own

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experiences. Contemporary efforts to promote critical reasoning in education are derived directly from Enlightenment thought. Turnbull, Franklin, and others believed that teaching young people history, particularly the fates of past governments, would help them to reason for themselves that democratic forms of governance are worthy of support. Similarly, the study of philosophy would help young people to reason for themselves that there are higher purposes in life than mere accumulation of material wealth. The need to be educated in other topics, ranging from mathematics to physical education, was also emphasized. The study of procurement history is needed to enhance both the inclination and abilities of public procurement professionals. Ours is a practiced profession. Learning how past master practitioners have created procurement innovations to meet pressing challenges is likely to enhance future practitioners’ abilities to fashion innovative solutions. The mastery of such skills will facilitate the recognition of procurement as an executive function that can contribute to the fashioning of organizational strategy. Learning how past master practitioners have adhered to the ideals of public service, while facing pressures to do otherwise, might motivate future procurement professionals to do the same. George Washington (1796) spoke of the need to prepare youth “in the science of government.” For Washington, this meant education along the lines that Turnbull had promoted. He specifically emphasized the importance of applying reason and empirical evidence in doing sound policy analysis. In a letter to Alexander Hamilton, Washington described the kind of policy advice he sought, “My desire is to learn from dispassionate men, who have knowledge of the subject, and abilities to judge of it, the genuine opinion they entertain of each article of the instrument; and the result of it in the aggregate” (italics Washington’s, 1796). If public procurement is to be perceived by top officials as a mature profession, its practitioners must show that they can contribute to the framing of strategy by doing sound policy analysis. Conducting solid “make versus buy” analyses is especially important. Such analyses require a full investigation of costs and benefits and the relative utility of alternative options. These are basic economic concepts that were first developed by Enlightenment writers such as Frances Hutcheson and Adam Smith. In his final annual address to


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Congress (1796), Washington offered advice on “make versus buy” decisions. He preferred that the government purchase, rather than make, those things that private manufacturers are capable of manufacturing. But Washington’s experience with the poor performance of private contractors in the war for independence led him to prefer direct government manufacturing of defense goods. ALIGNING INCENTIVES

David Hume (1711–1776), a Scottish academic who ranks among the greats of philosophy, described the difficulties of aligning self interest with public interest. Political writers have established it as a maxim that, in contriving any system of government, and fixing the several checks and controls of the constitution, every man ought to be supposed a knave, and to have no other end, in all his actions, than private interest. By this interest we must govern him, and, by means of it, make him, notwithstanding his insatiable avarice and ambition, co-operate to public good. (1748/1777, p. 42). The essential challenge and perennial responsibility of public procurement professionals is to create arrangements in which sellers with self interests are induced to “cooperate to public good.” In the above quote, Hume provided one of the earliest descriptions of what contemporary scholars call the principal-agent problem. Also called agency theory, principal-agent theory provides a theoretical framework for creating contractual arrangements as well as studying the participants in those arrangements (Van Slyke, 2006). The theory assumes that agents, those who contract to undertake work, know best what they are capable of doing. In their own self-interest, they might surreptitiously take advantage of their situation and do less than they are capable of doing. The shortchanging of a principal is called “moral hazard.” Enlightenment thinkers understood the principal-agent dilemma. Some eighteenth century practitioners, influenced by the Enlightenment, understood that their essential challenge was to align self interest with public needs. In the USA, the new nation’s Superintendant of Finance Robert Morris tried to establish a contracting system during the Revolutionary War to accomplish this

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alignment. “Morris sought to harness economic self-interest to the public good” (Card, 1984, p. 214). Adam Smith (1776), in creating the foundation for modern economics, explored extensively the implications of the pursuit of self interest. To induce better performance, Smith recommended the use of what we now call performance contracting. But Smith did not think things through in this matter. Smith (1776) recommended that professors be paid solely on the basis of the number of students they could attract. Doing that might encourage good teaching but it could also cause professors to neglect other things, such as research and technology transfer, that are now known to be essential in knowledge based economies. Performance contracting only works when incentives are carefully aligned to encourage all important aspects of contractor performance. Consequently, public procurement professionals need to study performance measurement carefully. CONCLUSION – STEWARDSHIP ORIENTED PROFESSIONALISM

Washington deeply believed that the long term survival of democratic governments depends on the qualities and actions of the public employees who implement policy and who actually provide services to citizens (Cook & Klay, 2015). Public procurement officials are agents of the public. According to Washington’s logic, where procurement officials are seen as agents who strive to serve the public well, democratic governments are likely to be better supported and longer lived. On the other hand, if the public perceives procurement officials as being essentially self-serving, democracies might be weakened and the efforts of those officials to become accepted as professionals are likely to be rejected. Principal-agent theory assumes that people will always be primarily self serving in their motivations. In many ways, procurement officials must act upon the assumption that self interest is what is likely to primarily motivate potential vendors. But, if procurement officials want to enhance the legitimacy of their governments and if procurement officials want to become recognized as professionals, then they need to become stewards, not merely agents. Stewardship theory is based on the belief that some persons will act primarily in the interest of a greater community to which they belong (Davis, Donaldson, & Schoorman, 1997).


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True professionalism is based on stewardship. The Hippocratic Oath is an affirmation of the obligation of physicians to be stewards. Frances Hutcheson’s 18th century advice fits well the needs of the public procurement profession in the 21st century. He advised that it must be assumed that self interest is a powerful motivator in contractual relationships. But he also reasoned that there is a higher form of self interest that leads persons to perform acts of benevolence for others. Each public procurement official is presented with the opportunity to be a steward who acts on behalf of the well being of fellow citizens. If George Washington was right, each time a public procurement official in a democracy acts like a steward, the long-term prospects for that government might be enhanced, if only by a smidgen. REFERENCES

Bowden, M., & Klay, W. E. (1996). "Contracting for 21st Century Infrastructure." Public Budgeting, Accounting, and Financial Management, 8(3): 384-405. Card, E. W. (1984). To Starve the Army at Pleasure: Continental Army Administration and American Political Culture 1775-1781. Chapel Hill, NC: University of North Carolina Press. Cook, S. A., & Klay, W. E. (2015). “George Washington’s Precedents: The Institutional Legacy of the American Republic’s Founding Public Administrator.” Administration & Society, 47(1): 75-95. Crawford, M. J., & Hughes, C. F. (no date). “The Reestablishment of the Navy, 1787-1801: Historical Overview and Select Bibliography.” Naval Historical Bibliographies, No. 4. [Online] available at www.history.navy.mil/biblio/biblio4/biblio4a.htm. [Retrieved December 29, 2012]. Davis, J. H., Donaldson, L., & Schoorman, F. D. (1997). “Toward a Stewardship Theory of Management.” Academy of Management Review, 22(1): 20–47. Davis, J. H., Donaldson, L., & Schoorman, F. D. (1997) “Davis, Schoorman, and Donaldson Reply: The Distinctiveness of Agency Theory and Stewardship Theory.” Academy of Management Review, 22(3): 611–613.

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Flynn, A., & Davis, P. (2014). “Theory in Public Procurement Research.” Journal of Public Procurement, 14(2): 139-180. Franklin, B. (1749). Proposals Relating to the Education of Youth in Pensilvania. Philadelphia, PA: University of Pennsylvania Archives. [Online]. Available at www.archives.upenn.edu/primdocs/1749 proposals.html. [Retrieved March 30, 2015]. Hume, D. (1777/originally 1748). Essays Moral, Political, Literary. (Edited and with a Foreword, Notes, and Glossary by E. F. Miller, with an appendix of variant readings from the 1889 edition by T.H. Green and T.H. Grose, revised ed.). Indianapolis, MD: Liberty Fund (1987). Essay VI. [Online]. Available at http://oll.libertyfund. org/title/704/137488. [Retrieved February 2, 2014]. Hutcheson, F. (1753). A Short Introduction to Moral Philosophy (in Three Books); Containing the Elements of Ethics and the Law of Nature. (2nd ed). Glasgow, UK: Robert and Andrew Foulis. [Online]. Available at Brigham Young University Library. https://archive.org /details/shortintroductio00hutc. [Retrieved March 30, 2015]. Kant, I. (1784). “What is Enlightenment?” [Online]. Available at www.columbia.edu/acis/ets/CCREAD/etscc/kant.html. [Retrieved February 6, 2014]. Larson, M. S. (1978). The Rise of Professionalism: A Sociological Analysis. Berkeley, CA: University of California Press. Macdonald, K. (1989). “Building Respectability.” Sociology, 23(1): 55–80. Russell, C., & Meehan, J. (2014). “Exploring Legitimacy in Major Public Procurement Projects.” Journal of Public Procurement, 14(4): 495-537. Savage, D. A. (1994). “The Professions in Theory and History: The Case of Pharmacy.” Business and Economic History, 23(2): 129160. Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. [Online]. Available at www.gutenberg.org/ebooks/ 3300. [Retrieved March 30, 2015]. Van Slyke, D. (2006). “Agents or Stewards: Using Theory to Understand the Government-Nonprofit Social Service Contracting


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Relationship.” Journal of Public Administration Research and Theory, 17(2): 157–187. Washington letter to Katherine Macaulay Graham, New York, January 9, 1790. Library of Congress. George Washington Papers at the Library of Congress 1741-1799. [Online] All Washington documents cited are available at http://memory.loc.gov/ ammem/gwhtml/gwhome.html [Retrieved March 30, 2015]. Washington letter to Thomas Jefferson, Mt. Vernon, March 29, 1784. Library of Congress. Washington letter to Alexander Hamilton, Philadelphia, July 3, 1795. Library of Congress. Washington’s Eighth Annual Address to Congress, December 7, 1796. Library of Congress. Wiencek, H. (2003). An Imperfect God: George Washington, His Slaves, and the Creation of America. NY: Farrar, Straus, and Giroux. Zagarri, R. (Ed.) (1991). David Humphrey’s ‘Life of General Washington’ with George Washington’s Remarks. Athens, GA: University of Georgia Press.


WINTER 2015

PUBLIC PROCUREMENT REFORMS IN GREECE: THE IMPACT OF IMPROVED TRANSPARENCY ON GOVERNMENT EXPENDITURES Ioannis Giotopoulos, Grigoris Pavlou, Svetoslav Danchev, and Aggelos Tsakanikas* ABSTRACT. During the recent economic crisis, public procurement reforms have received a great attention as a key mechanism that enables significant cost savings and improves transparency in the public sector, particularly in countries which are under a process of extensive fiscal consolidation like Greece. This paper examines the effects of improved transparency on public procurement cost in the light of the ongoing structural reforms taking place in Greece. The basic finding indicates that ensuring transparent practices in public procurement processes reduces government expenditures by about 1.8 - 3.4 percentage points. A dataset on 2309 public supply contracts for goods was used, supplementing the pooled OLS estimates with quantile regressions.

--------------------------------* Ioannis Giotopoulos, Ph.D., is an Assistant Professor, Department of Economics, University of Peloponnese. His research interests include firm and industry dynamics, economics of strategy and technology, entrepreneurship and innovation. Grigoris Pavlou, M.Phil., is a Researcher, IOBE Foundation for Economic and Industrial Research. His research interests are focused on macroeconomic growth, industrial and public policy, technological change and human capital. Svetoslav Danchev, Ph.D., is the Head of the Microeconomic Analysis and Policy Unit of IOBE Foundation for Economic and Industrial Research. His research interests include applied economics, energy economics and history of economic thought. Aggelos Tsakanikas is an Assistant Professor in the field of economic evaluation of technological systems, at the Laboratory of Industrial and Energy Economics, National Technical University of Athens. His main research interests are in the area of technology strategy of the firm, business strategy, economics of innovation, entrepreneurship and relevant public policies.


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INTRODUCTION

In recent years, it has been widely recognized by many policy makers, academics and practitioners that strengthening the public procurement systems is a key strategic tool in enhancing efficiency in public organizations. Public procurement is the procedure by which public organizations and authorities (including different levels of government i.e. central government and local authorities) purchase goods and services from the private sector using public funds (Thai, 2001). The overall process of procurement includes several tasks from the identification of needs, selection of sources, preparation and award of contracts, and all the stages up to the end of a contract’s execution. The public procurement process allocates a major part of public expenditure, varying from road construction, street lighting, military meals and clothing, to public education and health care equipment. Public procurement entails considerable government expenditures in the European Union (EU), accounting for almost 16%-20% of EU GDP annually (European Commission, 2012). During the recent economic crisis public procurement has received a great attention as a key mechanism that enables significant cost savings, particularly in countries where a fiscal adjustment program is under implementation. Given budgetary constraints in the public sector, policy makers in such countries face a great challenge, namely the implementation of structural reforms, to improve efficiency and transparency in the public procurement system. CONCEPTUAL FRAMEWORK

The structural reforms in public procurement may have significant economic and social effects. Τhe significance of transparency in public procurement practices has been highlighted in the literature (e.g. Thai, 2001; Schapper et al., 2006; Ohashi, 2009; United Nations, 2011). Transparency principally refers to publishing information and conducting procurement processes with clear and fair rules. Evennet and Hoekman (2005) argue that the impact of improved transparency in the procurement procedure is twofold. On the demand side, improved transparency diverts government expenditure away from goods that could foster corruption. On the supply side, it increases the number of firms involved in the bidding process. Ohashi (2009) claims that “the effect of improved

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transparency on supply is to force the ring to lower its price”. This statement is supported by empirical evidence from Japan suggesting that improved transparency reduces public procurement cost by up to 8%. Overall, such reforms are expected to increase competition among firms, reduce prices and guarantee better quality of public services. In that context, countries that are under a process of extensive fiscal consolidation like Greece, are currently struggling to implement public sector reforms, in order to achieve cost savings, and improve business efficiency and transparency. The establishment of the Single Public Procurement Authority (SPPA) in Greece is a fundamental reform introduced in September 2011 within the context of the adjustment program currently underway. The principal goal of SPPA is to ensure transparency in public procurement processes, contributing to cost efficiency in the public sector. Its responsibilities include the conduction of spot checks to monitor if the procurement procedures follow fair and clear rules, the consideration of objections throughout the relevant procedures, and the interruption of any ongoing tendering procedures that entail law violations. Thus, the SPPA is expected to be a watchdog of transparency and a supportive mechanism for the efficiency of the public procurement system in Greece, without however serving as a centralized public procurement agency. The specifics of the SPPA procedures are provided in the Appendix section in more detail. During the same period the wide use of a Transparency Portal, the so-called “Diavgeia”, also helped towards this direction, since its main objective has been to ensure transparency of government actions. In particular, all government institutions are obliged to upload their acts and decisions on this portal. Each document is digitally signed and assigned a unique internet uploading number certifying that the governmental decision has been uploaded at the “Transparency Portal”. Thus, the obligation of governmental bodies to publish online their decisions facilitates the identification of corruption, the rule of law and the adherence to good administration practices. Notably, since other relevant reforms, i.e. wide use of eprocurement;1 centralization of processes; and simplification of the legislative framework, have not yet been implemented (European Commission, 2013), the only observable economic impact that can


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be evaluated at the present concerns the SPPA reform and the wide use of the Transparency Portal. This paper explores the effect of improved transparency on public procurement costs in Greece due to the introduction of the “SPPA” along with the wide use of the Transparency Portal in the same period. Moreover, this study examines the potential effects of competition and openness in procurement processes, while it also attempts to control for economic cycles and for the quantity and the quality of products. When public organizations adopt the general procurement principles of competition and openness and these principles are combined with operational efficiency and eprocurement, the result is a greater value for money. Improving public procurement procedure is expected to increase competition among firms, reduce prices and guarantee better quality of services for citizens.2 Those extra issues and their importance are discussed in more detail in the next section. To explore these linkages, the paper utilizes a dataset on 2309 public supply contracts for goods, supplementing the pooled OLS estimates with quantile regressions. The findings have considerable policy implications for countries that need to reduce government spending and undertake structural reforms in their public sector, especially in times of crises. METHODOLOGY AND DATA

For the needs of this work we collected monthly bidding data on 2309 public supply contracts for goods derived from the General Secretariat for Commerce of the Ministry of Development in Greece over a span of 12 years (2002-2013). Our dataset includes a variety of purchased goods, ranging from military food, military and police clothes and uniforms to health equipment, office equipment, furniture and military and police means of transportation. The study period has been divided into 2 sub-periods, before and after the establishment of SPPA and the wide use of Transparency Portal, by using a time dummy which takes the value of 1 for the period after September 2011, and the value of 0 for the period before September 2011. To estimate the impact of transparency on average cost of public procurement we use the following model:

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where the dependent variable, “ ” stands for the unit price (winning bid) of bidder i , in supply contract, i.e. project j , at time t . Unit prices were converted into real values using a monthly CPI deflator provided by the Hellenic Statistical Authority (EL.STAT.) and scaled by natural logarithm. “ ” denotes the time dummy as explained above. “Comp” corresponds to the number of bidders in project j at time t. This variable measures the intensity of competition in procurement processes, expressed in natural logarithms. Thus, a further potential effect of public procurement reforms, undertaken in this empirical work, stems from the increase of the intensity of competition. By transforming the acquisition process from a bilateral negotiation to an auction the likelihood to achieve cost savings for the public sector increases. The main channel by which a competitive procurement procedure leads to cost savings is demonstrated extensively within the context of auction theory (Krishna, 2009). The lack of simple and clear competition rules in public procurement procedures is a factor that yields significant uncertainty about the fair conditions of a public tendering process. This uncertainty along with the contracting authorities’ flexibility, mainly in the stages of awarding and contracting, discourages the participation of potential candidates in the tendering processes. The variable “Quant” controls for the quantity of the goods purchased per project j. In that way, it is possible to capture the potential impact of centralization3 in public procurement processes which leads to the exploitation of scale economies and increased bargaining power of the contracting authority (Albano and Sparro, 2010). In addition, the centralization of public procurement procedures allows scale economies to arise when procurement contracts are to a great extent homogeneous and standardized. Moreover, one of the basic advantages of a centralized procurement system is that it removes the diffusion of accountability for procurement decisions by transferring this to the agency that holds the funds. It also helps capacity to be developed in the user agencies, where there is a greater need (Hunja, 2001). In general, a centralized


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procurement process ensures standardization and accountability of government contracts. Due to the variety of goods supplied and in order to take into account of difference in the measurement units, we expressed this variable as a ratio by dividing each observation (i.e. the quantity for the particular tender) to the specific sum of quantities of the same type of goods. “Loc” is a binary variable controlling for the location of bidders, taking the value of 1 for winning bidders located in the two largest metropolitan areas of Greece (that is Greater Athens and Thessaloniki), and 0 for bidders located in the rest of Greece. “ Inter” is a further location variable capturing the international base of bidders, taking the value of 1 for bidders located abroad, and 0 for bidders located in Greece. One limitation of this study is that it cannot capture in a direct way the quality of goods purchased due to unavailability of relevant information in the dataset used. However, the involvement of regional location and international base of bidders in our model may provide an indirect signal for the quality ladder of the bidders. The greater the international participation in a public procurement tender, the higher the expected project quality. Regarding the urbanization aspect, we expect that bidders located in large urban centers have a greater probability to provide products with a higher quality, due to the exploitation of network externalities (Krugman, 1998), the so-called agglomeration economies. These increased returns are related to the greater concentration of high-skilled employees and the higher specification of equipment and other resources that characterize metropolitan areas. “Open” is a binary variable capturing the openness of awarding procedure, taking the value of 1 when the procurement process is open, and 0 when it is negotiated or restricted. “Restr” is also a binary variable, taking the value of 1 when the procurement process is restricted, and 0 when it is negotiated or open. Also, openness concerns the possibility and feasibility of individual stakeholders --e.g. businesses-- to participate in the public procurement procedure --e.g. to submit the bid-- (OECD, 2013). An open public procurement procedure could lead to an efficiency enhancement effect in submitted tenders (Carayannis & Popescu, 2005). To ensure that the goal to achieve cost savings does not cause a sharp drop in quality,

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one way may be to allow openness in public procurement processes and get feedback from participants. The “GDP” variable, that is the monthly real Gross Domestic Product of Greece expressed in natural logarithms, is included in our model to control for macroeconomic factors that vary over time. The constant term aij captures the unobserved project-specific effects, while uij,t is the error term. Finally, parameters  denote the slope coefficients. Note that the coefficient is of primary interest in our study, since it captures the effect of improved transparency on public procurement costs per project. Table 1 and Table 2 below describe some basic summary statistics for quantitative and qualitative variables undertaken in our examined model. TABLE 1

Descriptive Statistics for Quantitative Variables Variable Unit Price (ln) Competition (ln) Quantity (%) GDP (ln)

Mean 5.38 1.15 0.15 4.60

Standard Deviation 4.39 0.66 0.25 0.11

TABLE 2

Descriptive Statistics for Qualitative (Binary) Variables Variables Location International Base Openness Restricted

Frequency (%) Value of 0 Value of 1 24.73% 75.27% 98.77% 1.23% 44.38% 55.62% 55.88% 44.12%

Figure 1 shows the distribution of the projects’ unit prices using a kernel smoothing density.4 This figure illustrates that the dependent variable of our model does not follow the lognormal distribution. Based on the results of skewness/kyrtosis tests, the hypothesis that


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the residuals follow normal distribution was also rejected. Therefore, we additionally ran quantile regressions introduced by Koenker and Bassett (1978), commonly applied in order to deal with skewed distributions in linear regression models (Buchinsky, 1998; Dimelis and Louri, 2002). Hence, the use of a quantile approach may significantly contribute to the robustness of our estimates. A further powerful characteristic of this method is that it can be used to estimate the slope effects (e.g. the improved transparency effect on unit prices of projects in our case) at various percentage points (quantiles). Hence, this technique enables the exploration of potential differences in the transparency effects among supply contracts with low, medium and high unit costs. As a result, the analysis undoubtedly benefits greatly from quantile regressions since in that way it can consider the heterogeneity of goods purchased (i.e. hospital equipment is more expensive than military meals and FIGURE 1

Unit Price Distribution of Public Procurement Projects

.1 .08 .06

Density

.04 .02

0 -10

0

10

20

Unit Price (ln)

Notes: kernel = epanechnikov; bandwidth = 2.5; solid line: kernel density; dashed line: normal density.

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clothing). In other words, quantile regressions for several percentage points of the entire distribution, that is the low cost procurement projects (i.e. estimates in the 10% and 25% percentiles), the medium cost projects (i.e. for the median, 50%) and the high cost projects (i.e. estimates in the upper percentiles of 75% and 90%), allow to overcome the limitation of different products in our dataset. RESULTS

The results of the empirical analysis are presented in Table 3. The second column reports the estimates for our basic equation using a pooled OLS regression (model 1). The third column presents the OLS estimates including also dummies to control for the different type of contracting authority (model 2). Respectively, the last two columns show the results when we control for the quantity of the goods purchased, with and without dummies for contracting authorities. The pooled OLS estimates reveal that improved transparency due to the establishment of the SPPA in Greece reduces significantly the public procurement unit costs, with the coefficient ranging from -1.80 percentage points to -3.37 percentage points.5 We also find that competition in the bidding processes affects negatively the unit price of projects. This means that the higher the intensity of competition in public procurement processes the lower the unit cost of the projects. Quantity seems to have a significant and negative impact on the unit price of goods purchased, implying thus that some economies of scale are exploited mainly due to the centralization of public procurement processes (applied up to now mainly in the health sector). Moreover, the results suggest that location affects positively the unit price of projects. In other words, the winners of bids located in the large urban centers appear to offer higher average prices compared to those located in the rest of Greece. This finding may be explained on the grounds that firms operating in the metropolitan areas of Greece supply products of higher quality and hence can secure higher unit prices. Also, we found a strong and positive effect of openness on the dependent variable, implying unexpectedly that higher average prices are observed mainly in open tenders. However, by controlling the type of contracting authorities6 in models 2 and 4, this effect becomes insignificant.


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TABLE 2

Unit Cost of Public Procurement Projects in Greece (2002-2013): Pooled OLS Regressions Variables Transparency Competition Quantity Location International Base Openness Restricted GDP Constant term R2 Adjusted R2

Model 1 -3.36*** (0.53) -0.97*** (0.11)

Model 2 -2.53*** (0.51) -0.87*** (0.11)

-

-

0.93*** (0.18) 2.97*** (0.71) 4.17** (1.75) -0.37 (1.75) -0.44 (0.63) 5.75* (3.37) 0.38 0.37

0.74*** (0.17) 3.09*** (0.68) 2.53 (1.61) -0.99 (1.67) -0.37 (0.60) 9.21*** (3.59) 0.44 0.44

Model 3 -2.53*** (0.58) -1.13*** (0.14) -1.83*** (0.36) 1.16*** (0.22) 3.86*** (1.35) 3.14* (1.76) -1.32 (1.76) 1.61* (0.84) -2.68 (4.30) 0.37 0.36

Model 4 -1.80*** (0.56) -1.03*** (0.13) -1.37*** (0.35) 0.96*** (0.21) 3.64*** (1.29) 1.95 (1.69) -1.46 (1.69) 1.56* (0.81) 0.83 (4.64) 0.44 0.43

Notes: Standard errors are reported in parentheses. *The null hypothesis that each coefficient is equal to zero is rejected at the 10% level of significance. **The null hypothesis that each coefficient is equal to zero is rejected at the 5% level of significance. ***The null hypothesis that each coefficient is equal to zero is rejected at the 1% level of significance. Models 3 and 4 include dummies for the type of contracting authorities.

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Table 4 presents the results derived from quantile regressions for several percentage points of the entire distribution. Afterwards, Τable 5 provides also quantile estimates controlling for the quantity of the goods purchased. TABLE 3

Unit Cost of Public Procurement Projects in Greece (2002-2013): Quantile Regressions Variables

10% quantile -0.83 Transparency (1.19) -0.12 Competition (0.13) 0.18 Location (0.16) 1.41 International Base (0.88) -2.66** Openness (1.34) -3.48** Restricted (1.37) -0.72 GDP (0.88) 15.52*** Constant term (4.26) 2 Pseudo R 0.08

25% quantile -2.59*** (0.67) -0.51*** (0.11) 0.59*** (0.16) 1.59 (1.89) -0.26 (0.67) -2.87*** (0.76) 0.17 (0.62) 9.09*** (3.12) 0.15

50% quantile -3.50*** (0.97) -0.77*** (0.09) 0.64*** (0.14) 4.17*** (1.29) 3.23*** (0.89) -1.36 (0.91) -0.06 (0.42) 7.35*** (2.28) 0.35

75% quantile -2.48*** (0.59) -0.68*** (0.11) 0.66*** (0.15) 3.29*** (0.45) 6.46*** (0.61) 0.82 (0.54) -0.14 (0.38) 4.67** (1.95) 0.41

90% quantile -1.99** (0.95) -0.87*** (0.16) 0.83*** (0.33) 2.76*** (0.49) 8.09*** (0.50) 2.95*** (0.47) -1.58* (0.90) 9.90** (4.29) 0.31

Notes: Standard errors are reported in parentheses. *The null hypothesis that each coefficient is equal to zero is rejected at the 10% level of significance. **The null hypothesis that each coefficient is equal to zero is rejected at the 5% level of significance. ***The null hypothesis that each coefficient is equal to zero is rejected at the 1% level of significance. Dummies for the type of contracting authorities are included.


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The quantile regressions broadly confirm the robustness of the above findings, providing further insight into the impact of the public procurement reform. In particular, the estimates suggest that improved transparency in procurement exercises a negative and significant effect on the unit price of procurement projects in the 25%, 50%, 75% and 90% percentiles respectively, ranging from -2 p.p. to -3.5 p.p. On the other hand, for the lower unit price projects (i.e. the 10% percentile), the reduction in public expenditure is found to be insignificant. Competition appears to have a significant and negative impact in most percentiles. Finally, in Table 5 controlling for the quantity of the goods purchased we found significant effects (above 2 percentage points) of improved transparency on government expenditures in all quantiles. TABLE 5

Unit Cost of Public Procurement Projects in Greece (2002-2013): Quantile Regressions with Control for Quantity of Goods Purchased Variables Transparency Competition Quantity Location International Base Openness Restricted GDP

10% quantile -2.34* (1.37) -0.10 (0.14) -2.29*** (0.80) 0.38*** (0.13) 3.60 (3.39) -1.05 (0.91) -1.52* (0.83) 0.50 (1.04)

25% quantile -2.06* (1.23) -0.66** (0.28) -2.19** (0.94) 1.04*** (0.22) 1.71 (4.10) 0.68 (0.79) -2.39*** (0.68) 0.92 (1.24)

50% quantile -2.98* (1.57) -0.95*** (0.14) -2.00*** (0.45) 1.15*** (0.19) 4.48 (2.98) 4.96*** (0.61) -1.22** (0.54) 0.95 (1.01)

75% quantile -2.58*** (0.55) -0.93*** (0.11) -0.83** (0.42) 0.80*** (0.15) 2.89*** (1.11) 6.70*** (0.39) -0.02 (0.44) 1.19** (0.54)

90% quantile -2.21*** (0.86) -1.18*** (0.173) -0.01 (0.45) 1.30*** (0.37) 2.93*** (0.70) 6.87*** (0.70) 0.98* (0.54) 0.84 (0.83)

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TABLE 5 (Continued)

Variables Constant term Pseudo R2

10% quantile -0.41 (4.92) 0.02

25% quantile -0.37 (5.68) 0.09

50% quantile 0.01 (4.71) 0.31

75% quantile -1.12 (2.67) 0.41

90% quantile 0.95 (3.93) 0.32

Notes: Standard errors are reported in parentheses. *The null hypothesis that each coefficient is equal to zero is rejected at the 10% level of significance. **The null hypothesis that each coefficient is equal to zero is rejected at the 5% level of significance. ***The null hypothesis that each coefficient is equal to zero is rejected at the 1% level of significance. Dummies for the type of contracting authorities are included.

CONCLUSIONS

This paper examines the effect of a major public procurement reform on costs using data for 2309 public supply contracts for goods in Greece over the 2002-2013 period. Our results clearly indicate a significant impact of establishing transparent practices in public procurement procedures. In particular, our estimates show that improved transparency reduces the public procurement cost by about 1.8% - 3.4%. These results indicate that the public procurement reforms are indeed effective and important for Greece since they contribute significantly to cost savings. ACKNOWLEDGEMENTS

We would like to thank Georges Siotis and Niall Bohan from European Commission, DG ECFIN economists, Spyros Panagopoulos from SPPA, and Alexandra Kontolaimou from NTUA and three anonymous referees for their useful comments and constructive suggestions. The views expressed in this paper are those of the authors and do not necessarily reflect the views of the Foundation for Economic and Industrial Research (IOBE).


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NOTES

1. The adoption of ICT solutions in public procurement (“eprocurement”) is usually justified on account of speeding up processes and enlarging the set of potential participants. Thus, the adoption of electronic solutions to award public contracts, such as e-auctions, may further increase cost savings (Carayannis & Popescu, 2005; Moon, 2005; Vaidya et al., 2006). 2. Public procurement is also a potential key driver for demanddriven innovation (Edler & Georghiou, 2007), and a stimulus for job generation, since public sector constitutes a huge buyer for the products and services of private businesses, and hence it plays a crucial role on the way in which businesses evolve in a national innovation and production system. 3. Significant results have been already observed in terms of cost savings derived from the centralization of health procurement system in Greece (see Kastanioti et al., 2013). However, more effort is required for the implementation of the reform related to the centralization of the public procurement procedures of the other contracting authorities on the basis of the relevant commitment of Greek Government under the 2nd adjustment program. 4. The density presented in Figure 1 is estimated using the bandwidth of 2.5. The bandwidth parameter (i.e. the width of the neighborhood at each point) determines the degree of smoothing in the density under estimation (Silverman, 1986). Estimation with different bandwidths does not yield qualitatively different results. 5. To ensure that this impact comes from the SPPA reform and from the crisis impact, we estimated several regressions for different time points after the beginning of crisis in Greece (e.g. 2008, 2009, 2010) without finding significant effects. Also, we have controlled for the economic recession by including in the equation monthly GDP of Greece. 6. More particularly, controlling was done through 8 dummy variables (n-1 dummies) since contracting authorities were classified in 9 general groups, that is health units, ministries of economic affairs and development and supervised public bodies, ministry of agriculture and supervised public bodies and

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organizations, military forces, ministry of transport and supervised public bodies, ministry of public works and supervised public bodies, regional administrative units, security forces. REFERENCES

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APPENDIX

The specifics of the SPPA procedures are the following: - The SPPA supervises and coordinates the public procurement actions of the central government agencies and participates in collective government institutions as the authority responsible for issues related to public procurement. - The SPPA promotes the national strategy in the field of public procurement and ensures compliance with the rules and principles of EU and national public procurement legislation. - The SPPA provides opinions on the legality of any provisions of draft laws or regulatory acts related to public contracts and participates in the relevant legislative committees. The competent authorities are obliged to take into account the opinion of the SPPA. - The SPPA publishes and uploads in its website regulations for particular technical issues regarding public procurement, mainly concerning the interpretation of the relevant national and EU legislation, taking into account the national and EU legislative frameworks. It also provides guidelines to relevant public bodies and contracting authorities and recommends to the Ministries the issuance of relevant decisions and acts. - The SPPA publishes tendering standards and procurement plans after consultation where appropriate with relevant public bodies. It also creates rules for the standardization of technical specifications in cooperation with the competent bodies and monitors their harmonization with the general principles of the national and EU regulatory framework. - The SPPA monitors and evaluates the efficiency and effectiveness of the actions of public bodies in the field of public procurement, including Ministries, administrative bodies with monitoring and supervising duties, and contracting authorities, within the framework of the national and EU legislative and regulatory framework for public procurement. - The SPPA performs random checks, taking the initiative to seek information and data on ongoing tendering, awarding and


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contracting procedures from the involved public and private bodies. - The SPPA supervises and evaluates monitoring administrative bodies in the field of public procurement with respect to the exercise of their duties in accordance with applicable national and European legislative and regulatory framework and guidelines of the Authority. - The SPPA provides comments on public procurement issues, and especially for the interpretation of the public procurement law, either in writing or orally on its own initiative or at the request of the courts. - The SPPA keeps National Data Base on Public Procurement. - The SPPA has a consulting role to contracting authorities, on its own initiative or at the request of the latter, especially in the litigation stage or during the examination of preliminary rulings, concerning the lawful award and execution of public procurement contracts. - The SPPA participates in the relevant European institutions, as the main national authority, in the exchange of views, information and data on the national strategy, the legal framework and the procedures of tendering, awarding and execution of public contracts. It also represents the country in international organizations and meetings in the field of public procurement. - The SPPA prepares and submits its annual activity report to the President of the Greek Parliament, in the first quarter of each calendar year.


WINTER 2015

CHARACTERISTICS OF PRIVATE MARKETS AND ACCESSIBILITY OF SMALL AND MEDIUM ENTERPRISES TO PUBLIC PROCUREMENT MARKETS: PHARMACEUTICALS IN EGYPT Lobna Abdellatif and Mohamed Zaky* ABSTRACT. The current paper explores the effect of private market characteristics on the access of small and medium enterprises (SMEs) to public markets in some sectors. Using survey data of small and medium enterprises in the pharmaceutical sector in Egypt, we confirmed this effect. We found that regulations of drugs pricing and registration in the private market constrained the capacity of those firms to compete in the public markets. However, some other factors play it the other way. The policy implications of these findings indicate that governments need to account for private markets characteristics when designing support packages for smaller enterprises in public procurement markets.

INTRODUCTION Public procurement constitutes an important portion of gross domestic product (GDP) in developing countries. It accounts for up to 25–30% of GDP (United Nations Conference on Trade and Development (UNCTAD), 2012). Governments have the opportunity to support small and medium enterprises (SMEs) directly through their purchasing policies. However, public procurement markets (PPMs) are referred to as a conspicuous example of corruption and lack of transparency. Many country studies and surveys have highlighted the negative impact of these symptoms on SME engagement in PPMs (e.g. Decker, Schiefer, & Bulander, 2006; Mutula & Brakel, 2006). ----------------------------* Lobna Abdellatif, Ph.D., is Professor, Department of Economics, Faculty of Economics and Political Science, Cairo University. Her research interest is in fiscal governance. Mohamed Zaky, Ph.D., is a Lecturer, Department of Economics, Faculty of Economics and Political Science, Cairo University. His research interest is political economy of fiscal policy.


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However, the potential transferred impact of characteristics of private markets to PPMs has not been looked at in the literature as a factor that may reshape, for the better or the worse, the presence of SMEs in PPMs. The current paper aims to explore this issue with application to the pharmaceutical sector taking Egypt as an exploratory case study. The health sector, including pharmaceuticals, is prone more than others to challenges in procurement. Health systems operations and value chains are highly complex. In addition, public procurement in the health sector ranks very high in terms of weak transparency (Transparency International, 2006). In fact, the World Health Organization (WHO) estimated that almost 25% of spending on public procurement in the health sector worldwide is lost due to corruption (WHO, 2007). Issues of transparency and corruption in Egypt are common, as in other developing countries. According to the European Bank for Reconstruction and Development’s (EBRD, 2013) assessment of the legal framework and practice of PPMs in Egypt, the country has problems related to transparency and integrity. This paper is structured into five sections. Following the introduction, the second section provides the literature review and conceptual framework. The third section describes the pharmaceutical sector and public procurement in Egypt. Our empirical work is in the fourth section. The last section concludes with policy implications. THE RESEARCH FRAMEWORK

Research on SMEs and PPMs could be categorized into two lines; the first assumes the relation between public procurement and SMEs to be an inter-actor relationship within the public market and the second sees the relationship as an association between actors in two markets. By relationships we refer to the governing rules, regulations and disciplines that control how public agents acquire and exercise authority related to public procurement. Poor governance means vague rules and regulation, which could be accompanied by loose disciplines in exercising authorities (World Bank, 2013, p. 70). This would manifest itself in lack of transparency and corrupt practices and would reflect negatively on fairness of competition.

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Most of the existing research lies in the first line. It deals with PPMs as an interface1 between government actors (organizations, employees, agents, etc.) and SMEs. Studies in this segment highlight the impact of weak, vague and complicated regulations and procedures and the resulting weak governance of PPMs (Eadie, Perera, Heaney, & Carlisle, 2007; Holmes et al., 2009; Vincze et al., 2010; Uasail, 2010; Kaspar & Puddephatt, 2012; Glover, 2008; Rogers, Denton, Biddiscombe, & Kennedy, 2006). These factors create corruption and anti-competitive attitudes which militate against SMEs accessibility to PPMs (Office of Fair Trading, 2004; Fresh Minds Research, 2008; Republic of Uganda, 2010). Accessibility is measured by the number of winning public tenders. Under the first line of research, we also find many surveys and country studies assessing the challenges faced by SMEs in PPMs. Problematic features were found to be common in many developing countries. Nepotism, bribes, and cronyism are manifestations of corrupt behavior. Moreover, information asymmetry, common embezzlement of public expenditures and collusion create the possibility of corrupt preferential treatment for some companies in some transition countries (Ateljevic & Budak, 2010; Engelbrekt, 2011). Additionally, the legal framework, being weak, may result in corruption as shown by Jones (2009) who studied Cambodia, Indonesia, the Philippines, Thailand, and Vietnam. Along this line, we sort the research on tools and mechanisms that firms use to affect the governance structure of the PPMs2. The legal structure in many countries allows for subcontracting and collaboration in bids. While networking can result in better SMEs accessibility to PPMs, it could also work against them. Collusion among large firms constitutes a challenge for SMEs in PPMs competitions. Also firms can try to influence the rules of the market such as laws, regulations, and perceptions, leading to state capture (Hellman, Jones, & Kufmann, 2000). Nevertheless, state capture most likely works against SMEs as it could result in more stringent pre-qualifications and complicated tender procedure. Studies falling under the second line of research are very few; yet we can differentiate between types. The first linked the performance of firms in their private markets to that in PPMs. Estache & Iimi (2011) and Withey (2011) directed attention to the impact of performance in private markets on SMEs accessibility to PPMs.


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Factors that impact firms in private markets may affect their attitude towards PPMs. Being occupied in private markets would limit SME engagement in PPMs. Additionally, success records in private markets give support to SMEs and encourage them to expand to PPMs. In this context, success in private markets is seen as essential for SMEs to get an opportunity in PPMs. This process of self-selection and preparation may end up with low participation. The other type, which lies under this line, combines studies that highlight the interaction among sectoral market structures and governance factors, PPMs and SMEs. The health sector, specifically pharmaceuticals, is a major focus of such studies. In 2010, the World Bank (2010) surveyed manufacturers and suppliers of health sector goods with the aim of improving procurement and highlighted the impediments for SME accessibility. Medicine Transparency Alliance (2014) provided many case studies in this area as well3. The World Health Organization (WHO, 2009 & 2010; Kohler & Baghdadi-Sabeti, 2011) provided an analytical framework to measure transparency in the pharmaceutical sector. The framework incorporates eight functions, namely: registration including pricing, licensing of medicine establishments, inspection of drugs manufacturing, promotion, clinical trials, drugs selection, PPMs, and distribution. Findings for the developing countries surveyed recorded a high level of weak governance on average (Kohler & Baghdadi-Sabeti, 2011). Critical vulnerability to corruption and weak transparency were found in the functions of inspection on drug establishment, drug promotion4 and selection. Comparisons of findings among surveyed countries revealed common weaknesses in the formation and procedural work of committees for drug selection and registration. However, case studies which used the WHO framework went into assessment of each element separately in isolation of others. The interaction of aspects of PPMs with any other areas or functions, were not looked at. Hence, the potential combined impact was not recognized or assessed before. Our argument goes as follows. There is a carry-over effect from private market characteristics, including structures and regulations, to the public market. While governments set sectoral regulatory policies to impact the private market, their influence may trespass to the public market. Additionally many internal structure created by the private market to facilitate doing business will extend itself to PPMs.

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Moreover, as previous studies showed, performance in private markets stretches itself to shape firm attitudes in PPMs. The current paper considers those elements altogether in one framework and questions their possible interaction with factors of transparency and corruption in PPMs. Then it explores its impact on SMEs performance in PPMs. Figure 1 summarizes the main idea and displays how it works in pharmaceutical sector. Success factors in private markets are based on the competitive position of the firm, which is based on its production and pricing policies. Both are affected by government sectoral factors such as regulations of registering new products and pricing. In developing and least developed countries, government policies are seen as highly impactful on the performance of firms (Roberts & Riech, 2011, p.1). The firm’s competition strategy depends on the nature of its products (drugs); i.e. originators (brands) or generics (Danzon, Mulcahy, & Towse, 2011). SMEs are likely to be players in the generic segment of the market. It means that their FIGURE 1

The Research Framework SMEs accessibility to PPMs Governance factors in PPMs

Private Market structure & regulations

Corruption Product plan

Product mix

Pricing plan

Number of products

Government regulations

Price taker

Price maker

Transparency


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competitive strategy depends on relatively lower prices and networking with service providers through incentives to create a semi niche market for their generic products. Weak governance in implementing regulations because of lack of transparency or corruption, would affect the production and pricing of products. In turn, this impacts the performance of firms in private markets. Danzon, Mulcahy, and Towse (2011) calculated that generics are generally priced less than their originators by almost 47%. Therefore, market shares in private markets are important to support the firm financially so it is able to offer discounts that reach 28% in PPMs (Danzon, Mulcahy, & Towse, 2011). Additionally, Private market agents’ structure has an impact on the capacity of SMEs to connect to the value chain. Persuasion, advertisement and other tools for information dissemination play a vital role in gaining market share in private markets (Hurwitz & Caves, 1988). Their influence is expected to spillover to PPMs in developing countries where physicians of public sector are involved in both private markets and PPMs. While they have private clinics, they also work in public hospitals. On the other side, we expect that any point of strength in private markets structure would stretch its positive impact to PPMs in a way that would level up the playing field for SMEs. In Figure 1 we depict factors in both private markets and PPMs. We will consider these factors, as well as their interaction, in our empirical analysis in order to assess our proposition. While the figure shows a one way relation from private markets to PPMs, previous literature assured the importance of the other way relation from PPMs to private markets. For instance, the success in PPMs supports SMEs to grow in private markets (World Bank, 2010; Kohler & Baghdadi-Sabeti, 2011). Also all of the above factors, whether negative or positive, could be linked to fairness of competition in both markets. However, a full-fledged analysis of this type is beyond the scope of this paper. PPMs AND PHARMACEUTICALS IN EGYPT

This section provides an orientation to our case study. It provides a comparative understanding of the pharmaceutical private and public markets in Egypt through a comparison between factors of transparency and corruption in private markets and PPMs of

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pharmaceuticals with other developing countries. In addition it sheds light on channels of weak governance of transparency and corruption. Egypt’s Pharmaceutical Private Market The Egyptian pharmaceutical private market comprises two types of companies; suppliers and distributors. In 2012, there were 530 drug suppliers through direct manufacturing or importing5. The concentration ratio of production among the biggest ten suppliers is almost 50%. However, the concentration level is relatively low as the Herfindahl-Hirschman Index (HHI) in 2011 was just 390.04%, 6 indicating an important role of SMEs in the sector. The second type of companies in the pharmaceutical market, distributers, are only 10 companies that have widespread distribution channels and warehouses all over the country. Recently, they have started to provide other services in public procurement market of pharmaceuticals, such as disseminating data on previous public tenders. Moreover, they play the role of facilitators between SMEs and the public tenderers where SMEs subscribe through them to public tenders. The support provided includes not just the provision of logistical services, but also financial (collateral letter) and technical support. The private pharmaceutical market turnover (retail and wholesale market of pharmacies and private hospitals) stood at USD 4.1 billion (Business Monitor International (BMI) 2012). This is equal to 1.9% of GDP and 30.6% of health expenditure (BMI, 2011b) in the country. The Chamber of Pharmaceuticals7 in Egypt estimated sales revenues through public procurement to be up to one third of the revenues in the retail market in 2011, but no published data is actually available on pharmaceutical PPMs in Egypt8. Egypt’s pharmaceutical sales are divided into three main drug categories: patented and multinational company drugs (originators), generic, and over the counter. The overall sales mix in 2010 was as follows: 57% patented drugs, 27% generic drugs and 17% over the counter drugs. This sales mix changed in 2007 with the percentage of generic drugs increasing at the expense of patented and multinational company drugs. This trend is expected to continue in the long term (BMI, 2011b).


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Governance in the pharmaceutical sector shares elements of the transparency problem framework highlighted by the WHO (2009). The World Medicines Situation study of 2011 (Kohler & Baghdadi-Sabeti, 2011, p. 6) applied WHO unified framework of analysis for transparency and corruption in applying government regulations. The study found that 18 out of the 25 developing countries surveyed suffered from transparency problems in the selection of registration committees and their operating policies and procedures, in addition to the presence of conflicts of interest. Abd Elsalam (2011) used the same WHO methodology to assess governance of the sector in Egypt. Figure 2 compares her results with those of Kohler & Baghdadi- Sabeti (2011). It is clear from this data that Egypt has an issue with transparency and there is a moderate issue of vulnerability to corruption9. Egypt’s score is almost in the average range of results obtained previously for other developing countries. Table 1 displays the detailed results of Abd Elsalam (2011). It is clear that, in the area of governance of registration, Egypt’s highest vulnerability is related to forming committees and setting work procedures; otherwise it has a moderate status. Drug pricing in Egypt is administrated by Ministry of Health and Population (MoHP) through registration committees. Figure 3 depicts the process of registration and pricing. The registration process starts with clustering drugs according to some equivalent criteria. .In particular, drugs can be clustered “according to: chemical (identical products with same active principle); pharmacological (chemically different but pharmacologically related drugs); or, therapeutic equivalence (all drugs used to treat a particular condition)” (Galizzi, Ghislandi & Miraldo, 2011). Then follows the pricing process where a reference price for each cluster is defined. The general rule is that the price of the originator is the average of its price in a selected set of comparably socioeconomic countries. Generic prices are reduced by 60% of the reference prices of the originator product for the first subscriber - and then reduced by 10% for each successive subscriber. Prices, however, can be negotiated based on the country of origin of imported materials and the range of innovation introduced to

FIGURE 2

Source: For Egypt: Abd Elsalam (2011, p. 54). For other countries: Kohler & Baghdadi-Sabeti (2011, p. 15).

Transparency Status and Vulnerability to Corruption

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TABLE 1

Scores for Each Registration Indicator No. Indicator Score 1. Is there an up-to-date list of all registered 0.57 pharmaceutical products available in the country? 2. If such a list exists, does it provide a minimum level of 0.48 information? 3. Are there written procedures for applicants on how to 0.74 submit an application for registration of medicinal products? 4. Are there written procedures for assessors on how to 0.38 assess applications submitted for registration of medicinal products? 5. Is there a standard application form publicly available 0.76 for submission of applications for registration of medicinal products? 6. Are there written guidelines setting limits on how and 0.69 where medicines registration officers meet with applicants? 7. Is there a functioning formal committee responsible 0.93 for assessing applications for registration of pharmaceutical products? 8. Are there clear written criteria for selecting the 0.08 members of the committee? 9. Is there a written document that describes the 0.25 composition and terms of reference of the committee? 10. Are there written guidelines on conflict of interest 0.09 (COI) with regard to registration activities? 12. Are there clear and comprehensive guidelines for the 0.15 committee's decision-making process? 13. Is there a formal appeals system for applicants who 0.93 have their medicine applications rejected? Total 0.504 Final score 5.05 Source: Abd Elsalam, 2011, p. 36, Table 3.

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FIGURE 3

Registration Process in Egypt

Source: Based on Abd Elsalam (2011, p. 52). Geneirics.10 This pricing policy, considered predatory, has been strongly critiqued. Among the reasons of this criticism is that the deviation from free competition has led to distortions and unfair competition. In addition, MoHP restricts competition in the market by limiting the number of generics (chemical or pharmacological) allowed to be registered in each drug cluster Egypt, to ten products. This policy named the “Box” was created under the justification of saving companies from fierce competition and nudging them to direct their resources to other boxes that still contain less than ten generics. Like elsewhere, doubts on the effectiveness of generics may be used against SMEs. Not all companies can afford good dissemination of information about their drugs; therefore developing relations with physicians as service providers is critical. Yet, it could open a door for corruption as physicians working in the public sector are allowed to run private clinics as well. The WHO acknowledged that the function of medicines promotion suffered from a recognizable degree of weak


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governance in most developing countries. Out of 21 surveyed countries, 20 countries recorded moderate to extensive vulnerability in this area (Kohler & Baghdadi-Sabeti, 2011, p. 6, Table 1.1). Last but not the least, the process of registration in practice is lengthier and extended much more than the periods officially set. Public Procurement Market for Pharmaceuticals Law no. 89 for 1998 for public tenders and auctions, named Public Procurement Law, controls participant interactions and the practice of authority related to PPMs. In Egypt, two public authorities oversee and audit PPMs. The first is the Public Authority for Governmental Services (PAGS), which has a mandate to oversee procedures relevant to law implementation; it makes sure that the bidding process in terms of actions, timing, and actors’ interactions are in accordance to law. One of those actions is information dissemination about bids including all the required details as required by the law. Recently, PAGS was assigned the task of directly keeping SMEs- who are all entitled to register for this service- informed of new public bid openings. . The second authority that oversees PPMs, the Central Audit Authority (CAA), does post-auditing of all public bids to assure compliance with law. The EBRD (2013) conducted a comparative assessment of PPMs in Egypt, Jordan, Tunisia, and Morocco in addition to the Organization for Economic Co-operation and Development (OECD) countries. Table 2 summarizes results of that assessment. Generally Egypt’s record regarding the status of the regulatory and effectiveness gaps of integrity, as an anti-corruption status, and transparency, was found moderate. Specifically to SMEs, common features of moderate corruption, non-existent accountability measures, difficulties in tracing contract opportunities, and the impact of favoring large bidders, are pinpointed and highlighted as impediments to the accessibility to public tenders (Kaspar & Puddephatt, 2012). Ahram Center for Political and Strategic Studies (ACPSS) and Center for International Private Enterprise (CIPE) (2009) indicated that misperceptions and inconsistency in the performance of government offices add to obstacles facing SMEs engaged with government agencies. It was proposed by them to simplify and review regulatory frameworks and procedures in order to overcome the

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TABLE 2

Egypt’s Rank in Integrity and Transparency Integrity Very high compliance High compliance

Medium compliance

Low compliance Very low compliance

Transparency Albania, Georgia, Latvia, Turkey, Mongolia, Hungary Estonia, Slovak Republic, Hungary Turkey, Montenegro, Albania, Kazakhstan, Russia, Croatia, Kazakhstan, Georgia, Bulgaria, Latvia Slovenia, Lithuania FYR Macedonia, Bosnia Montenegro, Croatia, Serbia, and Herzegovina, Serbia, Armenia, Kyrgyz Republic, Azerbaijan, Tajikistan, Armenia, Kyrgyz Belarus, Moldova, Lithuania, Republic, Mongolia, Slovak republic, Poland, Tajikistan, Belarus, Egypt, Morocco, Jordon, Russia, Ukraine, Tunisia Bulgaria, Romania, Poland, Egypt, Tunisia Slovenia, Romania, Estonia, Bosnia and Herzegovina, FYR Moldova, Jordan Macedonia Turkmenistan, Ukraine, Uzbekistan, Azerbaijan, Uzbekistan, Turkmenistan Morocco

Source: authors based on (EBRD, 2013) for Egypt, Morocco, Jordan & Tunisia & (EBRD, 2010) for other countries. problems created by the gap between the regulatory framework and implementation. Kaspar and Puddephatt (2012) also pointed out that in the area of public procurement there exists a divergence between the SMEs law no. 141 for 2004 (Small and Medium-Sized Enterprises Development Law in Egypt) and its implementation. The Ministry of Foreign Trade (2002) indicated that the extra costs and burdens of dealing with SMEs may lead to a preference for larger firms. These costs may come in the form of reviewing and assessing small bids as opposed to large ones; social costs incurred when sacrificing


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economic efficiency; and the drawbacks of violating the terms of international trade agreements when including non-tariff barriers as a form of protectionism. This may be seen as an inconsistency with the law on SMEs as the law states that SMEs must supply 10 percent of the value of all government procurement. While the law is attempting to encourage the access of SMEs to PPMs, it is not functioning in practice. In reality, neither of the authorities (PAGS and CAA) track information on the degree of SME access to PPMs or related to the profiles of bidders. However, this is not odd when compared with other countries. At least 63% of OECD countries do not track this issue (OECD, 2013, p.18). Moreover, none of the by-laws on public procurement or SMEs in Egypt delineate procedures, such as lots division, or rules guiding or compelling actions for public actors to facilitate the accessibility of SMEs to PPMs. Nevertheless, it is worth mentioning that two thirds of the OECD countries do not have such regulations (OECD, 2013, p.13). Additionally 32% of those OECD countries that have such a regulation do not make it mandatory (OECD, 2013, p.18). Table 3 highlights some of the negative implications of public procurement law (and its executive regulation) for SMEs. Other requirements of the law are also difficult for SMEs. For example, the law indicates that, the public agency has the right to amend the contract, either increasing or decreasing the requested quantities with the same prices and specifications11. We reviewed supplied quantities for two tenders that took place in August 2007. We found procurement under those tenders was in progress until August 2012. Increase in quantities supplied was at least one and half times the tender quantity and not limited to 25% as per the Law12. Governmental agencies also have the right to renew contracts without changing the prices and specifications until the completion of new tender. Government also has the right to oblige companies to continue supplying items if those are not included in subsequent tenders. It is worth noting that most of these tenders don’t specify the exact increase or decrease that could imposed on bidders in amended contracts. This increases bidding risk as increases or decreases in quantities can affect supplier costs. This burden is particularly heavy on SMEs.

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TABLE 3

Analytical Overview of Public Procurement Law from the Perspective of SMEs Theme

Content

Methods of  Identify the public prodifferent methods curement of public tendering.  Identify the cases for applying short list and restricted tendering.  Highlight the maximum value for applying local short list tendering approach.

Preparing

Stages Regulations and Rules Articles No. (1), (3), and (4).

Articles No. (2)

Macro-rules Emphasize the of public necessity of tendering enforcing transparency, and openness and providing equal opportunities in public tenders and auctions.

Challenges The articles are broad and loose and may lead to unfair competition against SMEs. For example article no.(3) deals with the case of short list tendering without providing the proper definitions and conditions, in a clear manner. The article or the regulations also do not provide the full meaning of the financial and technical conditions which the contractor and supplier should meet. This leads to over qualification that SMEs cannot deal with. The article is broad. In addition, it doesn’t propose any follow-up and assessment of implementation. Also in practice drug tenders usually have an article stating that the public authority is not obligated to disclose the reasons for refusing bidders.


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TABLE 3 (Continued)

Preparing

Stages Regulations and Rules Articles No. (7), and (8).

Article No.(14)

Awarding

Articles No.(16), (19), (38), and Article No(134)of executive regulations

Article No. (37)

Theme

Content

Delega-  Identify the tion and threshold of direct discrecontracts for tion minsters.  Delegate the Prime Minister in absolute necessity the authority for direct contracting. Emphasizes the responsibility of all administrative units to keep a record including a database of all contractors and suppliers. PrefeGive govern-mental rential units which are treatsubject to public ments procurement law no.89 for 1998 the discretion to contract with each other through direct agreement, and delegate each other in holding contracts of specific task Tender Disallow the disaggre combining of tenders gation disaggregation in order to circumvent the rules, conditions, and procedures of the law

Challenges The articles are very loose. They don’t identify the full meaning of “absolute necessity” it provides a great deal of authority to tenderers without any restrictions. Regulations do not elaborate on them. The article, or any other regulations, doesn’t identify any follow-up and assess-ment mechanisms. Records available are very difficult to be retrieved. While article no. (2) of the law emphasizes the equal opportunities position, granting this preferential treatment for the public units might open the door for unfair competition between private sector, especially for the smaller companies, and public sector companies. This article has prevented any tender disaggregation. Administrative units usually resort to aggregated bid to avoid any contradiction with the law. Actually these practices hinder SMEs competitiveness in public tenders.

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TABLE 3 (Continued)

Procuring

Stages Regulations and Rules Article No. (23), and Article No. (94) of executive regulation

Theme

Content

Challenges

Penaltie s of procurin g delay.

Give governmental units the authority to approve the extension of deadlines for the supply of awarded items. Give them the authority to set a penalty of 1% of the value of delayed items for each week of delay or part of week, to a maximum 3%

It led government units to continue requesting supply and don’t close the tender, especially in cases of goods such as drugs that are always requested, giving the cost of doing an new tender. Also there are no written regulations for the procurement schedule.

To conclude, Egypt’s pharmaceuticals private market and pharmaceutical PPMs have issues with transparency and corruption However, Egypt does not represent a unique case. Compared with other developing countries, Egypt is almost in a middle scale of transparency and corruption indicators of pharmaceutical PPMs and pharmaceutical private market. Negative implications of qualification criteria, time and schedule of procurement, weak transparency of registration committees, drug promotion, and ambiguity in legal provisions are some of symptoms of weak governance in pharmaceutical private market and pharmaceutical PPMs in Egypt as well as in many other developing countries. EMPIRICAL WORK

This section empirically handles our proposition of the transferred influence of pharmaceutical private market to pharmaceutical PPMs. The paper explores and tests this proposition through using a micro set of data collected from interviewing a stratified sample of companies both large and SMEs working in the pharmaceutical sector in Egypt.13 We conducted the interviews using one questionnaire to ensure consistency in data. In addition we did five structured interviews with five distribution companies to explore their


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role in pharmaceutical PPMs. Information on sampling, stratification and reclassification can be found in Appendix A. We utilized the framework of analysis in Figure 1 to build the questionnaire used in the interviews. The questionnaire was divided into six sections, starting with company information which focused mainly on labor and production facilities (8 questions). The next two sections comprised questions related to companies’ perception of governance in the sector including MoHP policies on drugs registration, pricing regulations and the Box policy, as well as information on number of licensed and produced drugs (15 questions). The fourth section gathers information about company interest in applying to pharmaceutical PPMs and their view of the challenges facing them related to size, collusion, favoritism and others (58 questions). The fifth section profiles the role played by distribution companies in SMEs’ accessibility to pharmaceutical PPMs (17 questions). Finally, section six seeks SMEs’ recommendations for better accessibility (15 questions). The produced set of data is used to perform two tasks; firstly to explore our proposition, then secondly to empirically test its validity. Exploring the Proposition Profile of companies Our survey results reveal that large companies are in a better situation regarding production capacities. All surveyed large companies have at least one factory. This percentage goes down to just 42.5% for SMEs. None of the large companies has a utilization rate for its production facilities less than 80%, whilst, 57.5% of SMEs have utilization rate less than 50%. On the other side, competition in the market is high. Most of products are substitutes and price differences are relatively small. Just 20% of drugs produced by SMEs have five or less substitutes. While prices are fixed by MoHP in the retail (consumer) market, they trend downwards in the wholesale market, where all firms have to offer discounts for pharmacies. 64% of surveyed SMEs regarded lower prices as the strategy to compete in the wholesale market. Additionally, all firms compete in the same local markets and import their inputs from almost the same international markets.

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Status in pharmaceutical PPMs Results show that all firms, including SMEs, were found to be interested in pharmaceutical PPMs. They seek pharmaceutical PPMs opportunities and subscribe to tenders; however, the larger companies are more likely to be awarded the tenders (Table 4). TABLE 4

Firms’ Attitudes towards Pharmaceutical PPMs Size Total SMEs Large % firms that seek information on public bids 78.8 100 81.1 % firms that subscribe to public bids 76.3 100 78.9 Indicators based on survey questions

% firms that have a winning history % awarded bids to total subscriptions

73.8 57.3

100 82.5

76.7 60.8

Transparency Despite all the facts about weak transparency in the public market, the survey indicates that transparency is high in pharmaceutical PPMs. Table 5 shows the perception of interviewees to aspects related to flow of information on previous tenders. This is highly important in shaping not only the decision to apply, but it also leads to better preparation of offers and quotations. The questionnaire included question on availability of information on quantities and prices of previous bids in addition to a question on transparency related to making public the reasons for denial of awards. The importance of that variable is that it adds to the learning curve of SMEs. Information on previous tenders (awarded companies, price and quantities), it was found, is not officially published; distribution companies, however, collect this information and make it available to their customers. More than 60% of surveyed SMEs seek information from distribution companies. Other sources of information are private companies specialized in following up public tender news. Also networks of company representatives are important channel. The latter constitutes the most important source of information for large companies. Also this source allows for diffusion of information on tenders before they are advertised


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officially, which gives advantages to large companies as it gives more time to prepare for the tender. As results of Table 5 show, large companies are better informed compared to SMEs. However, the transparency level for the overall market is relatively high. Contrary to the above, transparency of information on opportunities to register new products and the methodology of pricing new drugs was found to be low. While companies can collect information from the market on products already on sale, information on products in the queue is not available. Moreover, companies are never fully informed about the pricing methodology and no definite or clear answer is available. Also Table 5 provides more evidence on the unfavorable status of SMEs regarding lack of transparency on pricing and registration. Their perception to the vagueness in the market is higher than the large companies. Interesting to mention than while 41% of SMEs rejects the “Box” policy as being against fair competition, 70% of large firms supports this policy. TABLE 5

Transparency of Pharmaceutical PPMs and Pharmaceutical Private Market Regulations Indicators based on survey questions

Company Size SMEs Large Total

Transparency of pharmaceutical PPMs % information on awarded company in 90.16 100 91.55 previous tenders are available to companies % information on procured quantities in 80.33 100 83.1 previous tenders are available to companies % information on awarded price in previous 85.25 100 87.32 tenders are available to companies % of companies which were given the 70.49 100 74.65 reasons for losing the tender Channels of information on opportunities in pharmaceutical PPMs % of companies that gather information from 81.0 60.0 78.1 Distribution Companies % of companies that gather information from 30.2 20.0 28.8 the website for government procurement

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TABLE 5 (Continued)

Indicators based on survey questions % of companies that gather information from their representatives network % of companies that gather information from newspapers tenders agents % of companies that gather information from companies specialized in following tenders Transparency of pharmaceutical sector Registration (% of companies) % of companies that consider the number of drugs in a box as available information Pricing methodology (% of firms) Based on the opinion of the Committee Based on the cost of the raw material Based on the country of origin of raw material Based on rank in the box Relative to prices of substitutes in the local market

Company Size SMEs Large Total 11.1

30.0

13.7

9.5

10.0

9.6

7.9

10.0

8.2

23.1

50.0

25.0

72.5 45.0

40.0 90.0

68.8 47.9

21.2

40.0

23.3

13.7

0

12.2

4.5.0

10.0

5.5

Corruption Regarding corruption, questions involved the three aspects of corruption as highlighted by Jones (2009) and quoted in Kaspar & Puddephatt (2012): bribery, cronyism/favoritism, and collusion. Results highlighted practices that lead to manipulation of tender technical conditions in favor of specific companies. Personal relations outside the public tender market seem to be important. Collusion in terms of phony bidding and bid rigging also appears. As survey results indicate (Table 6), large companies are more likely to rely on collusion and market segmentation, while SMEs prefer the manipulation of tender technical conditions, which partially involves bribery and favoritism.


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TABLE 6

Features of Corruption in Pharmaceutical PPMs (In %) Indicators based on survey questions SMEs Large Total Bids are often awarded to specific companies 26.2 20.0 25.4 Companies collude to award the bid to one of 8.2 20.0 9.9 them Companies collude to divide the bids among 21.3 40.0 23.9 themselves Physicians’ experience in their private clinics could impact awarding in pharmaceutical 41.0 70.0 45.1 PPMs Bid technical qualifications favor some 100.0 100.0 100.0 companies in particular pharmaceutical PPMs favor large companies 87.5 50.0 80.0 Rivals spread rumors on effectiveness of drugs 37.7 40.0 38.0 to impact awarding in pharmaceutical PPMs Rumors actually affect awards 43.5 75.0 48.1 Prevalence of pre -qualification conditions 44.6 60.0 47.0 impact awarding in pharmaceutical PPMs Success Factors The age of the company and number of products have a major impact on company capacity to apply to pharmaceutical PPMs. The same applies for number of products. While the median of products of SMEs is 20 products, none of the large companies has less than 70 products. Therefore, MoHP’s policy towards pricing and registration is expected to have an impact on accessibility of firms to pharmaceutical PPMs. Better registration and pricing polices support companies to apply for pharmaceutical PPMs. Companies perceive drugs requested in pharmaceutical PPMs as a signal of which additional drugs they might register. Also better policies14 are considered of high importance for accessibility to pharmaceutical PPMs (Table 7).

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TABLE 7

SMEs

Large

Number of responses % of responses

Number of responses % of responses

Factors Qualifying to Apply to Pharmaceutical PPMs (Based on Survey Questions)

Primary factors qualifying companies accessing pharmaceutical PPMs (N = 67) Years of experience 32 65.0 2 50.0 Number of drugs 29 59.0 2 50.0 Turnover value 6 12.0 1 25.0 Factors seen as important to encourage companies to apply for pharmaceutical PPMs (N = 138) Drugs required in bids are indicative of 46 73.0 10 100.0 drugs for which successful registration efforts might be made Better registration policy 47 58.8 8 80.0 Better pricing policy 45 56.3 7 70.0

Testing the Proposition To test our propositions and assess the most significant governance grabbed from pharmaceutical PPMs and pharmaceutical private market affecting SMEs performance in pharmaceutical PPMs, we conduct a multiple regression model. The dependent variable is the percentage of awarded tenders over the last five years as a proxy for the accessibility of the public tender market to SMEs. The explanatory variables are two composite indices for transparency and corruption of pharmaceutical PPMs. Composite indices have the ability to summarize complex or multi-dimensional issues in a simple manner. To capture specific effects of weak governance of policy regulations in pharmaceutical private market the model was fed by additional specific variables. They are two indicators on Box policy: the status of specific Box which the firm is interested to register in and the general perception of Box policy as a tool to restrict


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competition. The other two indicators on the transparency of the regulations based on assessment of companies for transparency of pricing and registration policies. The two pharmaceutical PPMs composite indices of transparency and corruption were constructed based on data collected from our survey15. Table 8 shows the variables used in each composite index. In addition, the table shows the difference between SMEs and large firms in their perception of transparency and corruption issues as composite phenomena. For details on the composite indices, the model tests and Hickman selection test see Appendix A. TABLE 8

Construction of Composite Indices

Corruption index

Transparency index

DimenIndicators based on survey questions sion

Company Size

Small Large Total Information on awarded companies in previous tenders Information on awarded quantities in previous tenders 81.557 100 84.15 Information on awarded prices in previous tenders Reasons provided for not awarding the tender Bids are often awarded to specific companies Collusion among companies to award the bid to one of them Collusion among companies to divide the bids among themselves Influence of personal experience of public agents (physicians) regarding drugs on 24.59 35.00 25.78 awarding the tender The technical conditions favor specific companies Impact of rumors on the effectiveness of a drug on the awarding of the tender Impact of conditions of previous qualifying experience in the bids

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Stepwise regression analysis is then used to assess the magnitude and direction of each independent variable on the dependent variable (% awarded bids). The stepwise multiple regression model was run using SPSS Package with all 6 predictors and produced a model in which R² = .935, F= 241.126, p < .001. The results (Table 9) indicate a statistically significant relationship between the two independent variables of transparency of pharmaceutical PPMs and registration policy, with the percentage of awarded bids as the dependent variable. The result indicates that 87.1 percent of the variance in the total bids awarded has been significantly explained by those two transparency factors. It is interesting to note that both transparency factors are part of the pharmaceutical private market characteristics. Transparency of pharmaceutical PPMs, as shown by its composite index in Table 8, is a function of the positive work done by the distribution companies in providing information to all firms. Additionally the model confirms that any improvement in the transparency of the registration policy would improve the accessibility to pharmaceutical PPMs. Factors related to corruption were found to be insignificant. Factors related to the box policy in general or the specific status of any box was also found to be insignificant. Finally, transparency of pricing policy was found to be insignificant which is explained by the fact that the pricing policy imposed by MoHP on companies does not apply on pharmaceutical PPMs where each company forms its own bidding strategy. TABLE 9

Regression Results Model Transparency variable of pharmaceutical private market Transparency index of pharmaceutical PPMs

Unstandardized Standardized Coefficients Coefficients Std. B Beta Error

t

Sig.

0.195

0.041

0.520 4.738 0.000

0.325

0.082

0.435 3.963 0.000


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While model results apply to the whole market, implications for SMEs could be deduced given the difference of transparency levels as shown in earlier responses based on survey results. The level of pharmaceutical PPMs transparency was found to be higher for large firms than for SMEs and perceived transparency in pharmaceutical private market regarding the regulatory policy is also higher for large firms than SMEs. That is to say while transparency is important in the awarding of public tenders, given the context in the sector, model results show a lower probability for SMEs to be awarded the tender due to the higher level of transparency that larger firms enjoy. CONCLUSION

The current paper aims to broaden the context of analysis of factors that hinder SME accessibility to public procurement markets. The conventional vision focuses on the transparency and corruption challenges in those markets. Our work directs policy attention to additional dimensions of reform. This alerts to the possible failure of reform packages that limit their actions purely to public tender problems. We argue that factors impacting the success of SMEs in the private market carry over their impact into the public tender market. We collected micro data for SMEs in the pharmaceutical sector in Egypt to explore our proposition. Egypt could be seen as an example of a developing country suffering from the challenges of a moderate level of transparency and corruption in public procurement markets and in regulations controlling the private market, in a way comparable to other developing countries. Our findings showed that some of the features of the private market present solutions for some of the defects of the governance of public tenders. However, other features complicate the problem. Nevertheless, our analysis provides evidence that governance problems of private market outspread their sectoral domain and inhibit SMEs’ accessibility to public markets in a way that supersedes the common known problems of public tender markets. However, our results should be interpreted in their context, as highlighting a new dimension of analysis that would invite more research.

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ACKNOWLEDGEMENT

This work benefited from a financial grant (RIAD”#2012-033) from the Economic Research Forum. The authors would like to acknowledge the research assistance provided by Gehan Aman and Marian Adel. Comments by Sahar Tohamy, Ola Emara, and anonymous referees of JOPP are acknowledged. Authors are indebted to ZAD Farma Industiral, Dalta Bio Pharma Company and Ibn Sina Distributing Company for sharing wealth of knowledge and data of the sector. NOTES

1. PPMs is not the only interface between government actors and firms. Utilities, taxes, and judicial system are others. 2. Governance comprises also accountability and fair competition. 3

Data of the Medicine transparency Alliance could also be retrieved from www.who.int/medicines/areas/coordination/meta/en.

4. Along the current paper, we use the words “drugs” and “medicine” for the same meaning. 5. As of data of the sector for the year 2012 produced by www.IMShealth.com. 6. Herfindahl-Hirschman Index (HHI): uses the market shares of all the firms in the industry, and these shares are squared in the calculations to place more weight on the larger firms. 0