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John Tizard: Nobel Economics Laureate’s academic work could prevent inappropriate public service outsourcing

Monday October 31st, 2016

The awarding of the 2016 Nobel Prize for Economics to Oliver Hart of Harvard University, Cambridge, MA, USA and Bengt Holmström of Massachusetts Institute of Technology, Cambridge, MA, USA was a recognition of their excellent work over decades on the significance of contracting to economic institutions including companies and the public sector.

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The Royal Swedish Academy of Sciences press release announcing the 2016 prize states:

Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design.

Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions. This year’s laureates have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities.

To privatisation we should add public service outsourcing through which the state contracts with businesses to deliver public services. There have certainly been many contract pitfalls in recent UK public service outsourcing contracts with disastrous consequences for the public, service users, employees and the public finances.

The relationships, behaviours and conditions which Hart and Holmström have studied, analysed and opined on are very relevant when one of the contract parties is a political institution.

The Noble Prize winning economists have demonstrated that traditional orthodox micro-economic theory of the firm has to be challenged. Factors such as company ownership, business structures including capital structures, internal company cash flows/transfers including internal payments between companies/subsidiaries, personal incentives for senior executives and other staff, shareholder expectations and objectives, regulation and much more influence how companies behave.

These influences are very significant and have a major impact on quality of service, consistency of price and sustainability of contracts. For example they will affect the willingness of contractors to be flexible in response to the public sector client’s and user requirements, to be transparent and publicly accountable and how they will strike a balance between service quality and profit.

I have long argued that, when procuring and contracting, a public sector client has to understand much more than bidders’ contract prices. The factors listed in the previous paragraph have to be understood bidder by bidder, and taken into account when awarding and managing contracts.

I would also urge them to always undertake a comprehensive due diligence on bidders and to set contract terms to seek to mitigate risks associated with the business ethos, culture and behaviours of contractors. The public sector should insist on having a right to be consulted and in extremis to have a veto post-contract award over major changes to ownership, business models and practice including executive remuneration and incentives.

If this is not possible and/or if the due diligence identifies risks for the public interest and the sustainability of affordable quality service provision, “no outsourcing” should be the default option. I expect that had such an approach been adopted by the public sector some of the recent failures and pitfalls of public service outsourcing could have been avoided.

Of course, the public sector itself is not immune to its own internal and structural influences, although they sometimes may be different to those in the business sector.

Therefore, a public sector client has to consider and understand how its own culture, behaviours, risk appetite, executive reward (financial and other) and remuneration practices, and political objectives could influence its ability to enter into successful outsourcing contracts.

There will be political objectives and imperatives. This is understandable and right. They should drive the public sector with politicians accountable for intended and unintended outcomes. Such an approach, though, can be incompatible with standard contracting and outsourcing. It is very difficult to address political considerations, which may change frequently and radically in traditional public service outsourcing contracts. Likewise it can be very challenging to contract in a way that addresses the political requirement for managing reputational and political risk. However, contracts should not be allowed to limit or distort political decisions, process and accountability. Unless these can be accommodated prudently into a contract the default option should therefore be not to outsource.

Ultimately the public sector has to strive to achieve the public interest in ways that are sustainable; and the public interest is never well served by inappropriate outsourcing and contracting, especially if a contractor’s behaviours can undermine the public interest. This will have capacity and competency challenges for the public sector but if it is going to continue to outsource it should invest in the relevant skills.

I first encountered the work of Hart when I read his Clarendon Lecture “Firms, Contracts and Financial Structure” (Oxford University Press) and I recommend that those responsible for public procurement policy and practice read this book or similar papers, lectures or articles by the two laureates. I believe that such reading and thinking about contracting through the prism of this academic theory and analysis would improve the quality of public sector contracting and prevent some of the worse public service outsourcing failures, and actually ensure that outsourcing is never the public sector or political default option.

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