Contract killer

The provision of public goods and large projects by or with substantial input from the private sector is often controversial. This has been particularly true with regard to provision of water services in developing countries.

Fredrik Segerfeld of the Cato Institute rehearses the familiar arguments of those who advocate greater private sector involvement in his 25 August FT piece The private sector can get water flowing to the poor.

As activists and others will be quick to point out, there is no shortage of examples where private contracts for water services provision have gone seriously wrong in practice. The reasons can be many and complex. I want to raise one relatively non-political point in what can be an over-politicised argument. That is, that at least one of the fundamental issues here is the design of contracts and incentive schemes (whether the contractor be public or private).

An interesting newish take on this was reported in The Economist (Blue Skies Thinking, 18 August) with regard to Terminal Five at Heathrow.

Of course if you think more air travel is a bad thing Terminal Five is not a public good. But please set aside what is being built for one moment and consider the how:

"[BAA] studied many badly-run projects from the past, which led it to the conclusion that the traditional idea that risk could be passed on to suppliers by means of complicated contracts was a fiction. 'If a supplier does a bad job, I might get a few million off him in compensation,' says [Tony Douglas, the man in charge]. 'That's great, but it doesn't get my airport built.' And, he says, traditional contracts tend to lead to a misallocation of resources: 'if you're a supplier, your best brains go into your legal department, so that when things go wrong you can write creative excuses. '

The Terminal 5 contract tries to align the interests of BAA and its suppliers so that risks can be managed properly. Risk payments, which are normally part of a supplier's quote, are instead put in a central pot. If a job is done on time, the firms get a cut. If there are problems, they are solved with money from the reserve. That also ensures that suppliers work together to sort out any snags, since problems caused by one firm cut the size of the bonus pot for the rest. Contractors share their books with BAA, which reduces the scope for waste (and creative accounting). The incentives seem to be working: BAA says that 80-85% of the jobs on site get finished on time, compared with around 60% for the rest of the building industry"