Review of Environment, Energy and Economics - Re3 Time Overruns in Public Procurement and Concession Contracts: penalty fee and option value to delay
 

 

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Mar
13
2014
 
Time Overruns in Public Procurement and Concession Contracts: penalty fee and option value to delay
by Chiara D'Alpaos and Sergio Vergalli
Economics - Articles
 

Evidence from ongoing procurement and concession contracts shows that time overruns are widespread. Two key elements, among others, can affect the delays in the execution of the contracts: a) uncertainty over production costs; b) inefficiency in the judicial system. In this article we summarize a couple of works (D'Alpaos et al., 2013 and D'Alpaos and Moretto, 2013), in which the authors theoretically and empirically investigate some causes of time overruns in public procurement and concession contracts and determine the trade-off between the supplier’s option value to delay and the penalty fee to be paid in the event of delay. The main results are tested on Italian public procurement data and show that the supplier's incentive to delay is greater the higher the volatility of production costs and the lower the "efficiency" of the judicial system. 

Keywords: Procurement and Concession Contracts, Option Value to Delay, Strategic time overruns

JEL Classification  D81, H54, H57, L51
 

Suggested citation: D'Alpaos, Chiara and Vergalli, Sergio, Time Overruns in Public Procurement and Concession contracts: penalty fee and option value to delay (March 13, 2014). Review of Environment, Energy and Economics (Re3), http://dx.doi.org/10.7711/feemre3.2014.03.001

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Introduction
Public procurement is worldwide considered as the best tool to achieve value for money. The efficiency increase in public spending involves the search for the best possible procurement outcome  for the least possible investment in terms of time and public money. Its benefits though, can be rapidly erased by the adverse outcomes that usually derive from uncertainty over production costs, information asymmetry (Laffont and Tirole, 1993) and inefficiency in the judicial system. In particular, uncertainty on estimated investment costs generates significant risks and opportunities which may induce suppliers to strategically adopt opportunistic behaviors, such as under-pricing and time overruns (King and Mercer, 1985; Chapman et al. 2000; You and Tam, 2006; Lo, Lin and Yan, 2007).

Construction projects have a long history of cost escalation and delays (Flybjerg, 2000). The difference between early project cost estimates and the final project cost can be significant. Analogous considerations can be made as far as the completion time is concerned: estimated delivery time and actual completion of the works can largely differ. When considering the negative effects arising from delayed duration of projects and investments which, in turn, may generate significant social costs, contract time becomes a key issue in procurement and more specifically in construction works and concession contracts (Hancher and Rowings, 1981; Herbsman et al., 1995; Lewis and Bajari, 2011). Although a variety of contracting methods have been introduced in order to accelerate investments and reduce time overruns, the high number of delays recorded in recent public works construction and concession contracts highlights that good practice is still far from being implemented. To prevent the occurrence of opportunistic behavior and specifically of strategic time overruns, public buyers usually include a penalty clause for delays in public procurement contracts (PPCs, hereafter). Contracting authorities (CAs, hereafter) introduce damage measures that specify in advance the amount of compensation for late completion but whether or not such a penalty has a role in limiting the supplier's opportunistic behavior, typically depends on the committed fee and its enforcement by the court of law to which the parties refer to settle any dispute. Despite contract provisions on delivery time, delays are widespread. There is puzzling evidence in Europe and in North and Latin America that consistent delays are still present regardless of the inclusion of explicit penalty clauses in construction works and concession contracts.

Time overruns in Italian Public Procurement Contracts
Evidence from ongoing PPCs in Italy shows that delays in the completion date are quite common especially for construction works and concession contracts (Guccio et al., 2009; Decarolis and Palumbo, 2011; D’Alpaos et al., 2013). Descriptive statistics performed by D’Alpaos et al. (2013) on the dataset compiled by the Italian Authority (AVCP) responsible for controlling and monitoring public procurement contracts [Note 1] highlight that out of 45,370 fully completed contracts in the period 2000-2006, about 35,312 (corresponding to about 78% of the total) were completed with delays: the average delay was about 157 days and the maximum delay greater than 1500 days. Firstly most of the contracts completed late are of small value (more than 60% of the total PPCs recorded in the dataset fall in the range between Euro 150,000 and Euro 500,000), and secondly PPCs awarded with an open procedure are more than double of those awarded with a negotiated procedure. From a deeper insight in the descriptive statistics it emerges that the majority of the contracts awarded in Italy in the period 2000-2006 involves two works categories: "building constructions" and "roads" amount to 32% and 36% of the total, respectively. By comparing the analysis of these two subgroups with the entire dataset, it can be easily found that the category "roads" presents lower average delays and fewer delayed contracts than the entire set, while the descriptive statistics for "building constructions" are similar to those of the entire set. As far as the CA types are concerned [Note 2],  the analysis shows that Municipalities award the largest number of contracts (52% of the total) showing a higher number of delayed contracts and a higher delay length than the average levels of the dataset. Moreover, considering the number of delayed contracts with respect to the awarding procedure, no very large differences are found: out of the 30,244 contracts awarded with an open procedure, about 80% recorded delays, and analogously out of the 13,189 contracts awarded with negotiated procedures, about 75% recorded delays. The analysis also shows that delays are greater in Southern Italy than in Northern and Central Italy as far as the highest range value contract are concerned. These statistics suggest a correlation between delays and the length of civil trials, since they are more inefficient and longer in the South than in the North and in the Centre of Italy.

Model and results
There are many contributions in the literature on opportunistic behavior in PPCs. Among others, D’Alpaos et al. (2013) and D’Alpaos and Moretto (2013) investigate whether, despite penalty clauses introduced by CAs, time overruns are the result of the supplier’s opportunistic behavior on the optimal investment timing when production costs or future payoffs are uncertain and the judicial system is inefficient. The supplier’s trade-off between the option value to defer and the penalty payment in the event of delays is modeled with respect to public procurement and concession contracts. The two contributions take into account the issue of penalty enforcement, which in turn depends on both the discretion of the court of law in voiding contractual clauses (i.e. the penalties for delays) and the efficiency of the judicial system. In making an irreversible investment, suppliers may find it optimal to delay the completion of the works in the hope of gaining higher payoffs in the future. Perception of future uncertainty can in fact increase the perceived gain earned from deviating from the pre-agreed arrangement. More precisely, though delaying entailed a loss in monetary terms because there are penalties to be paid, the supplier might benefit from waiting to invest and delays finally represent the contracting firm’s optimal investment strategy.

By combining irreversible investments under uncertainty with strategic timing in executing contracts, and based on the value of investment timing flexibility, the two above mentioned contributions complement the existing literature by providing a new investigation on optimal investment timing in procurement and concession contracts. In the first paper, D'Alpaos et al. (2013) investigate in a public procurement setting whether the perceived uncertainty over construction costs generates an incentive for the supplier to adopt an opportunistic behavior in the form of time overruns. They derive the value of a PPC that comprises the option value to wait for ongoing information about construction costs less the value of the penalty expected to be paid in the event of delay. They also address the issue of penalty enforcement by including in their model both the discretion of the court of law in enforcing contractual clauses (i.e. the penalty for delays) and the efficiency of the judicial system (i.e. the length of court trials) [Note 3].  In the same vein, D’Alpaos and Moretto (2013) specifically focus on public works concession contracts and investigate whether investment timing flexibility generates an incentive to defer and determine the supplier’s trade-off between the option value to delay and the penalty to be paid. They firstly consider the investment decision strategy of a concessionaire that, by offering the highest up-front payment to the Government, had been awarded a contract to provide a public utility and gains profits from operating the service. According to contract obligations in the event of time overruns, the provider is liable to pay a penalty for each day of delay. Secondly they investigate the optimal penalty design and determine the penalty fee that induces the concessionaire to comply with the contract rollout obligations on the delivery date (i.e. the penalty fee that annuls the firm’s option value to defer).

D’Alpaos et al. (2013) argue that in a procurement setting, the supplier’s opportunity to defer the execution time becomes analogous to a perpetual Put Option and the value of the contract is the difference between the expected discounted net benefit of investing at a future date at minor costs and the expected value of the penalty to be paid. Vice versa, when considering a concession contract, D’Alpaos and Moretto (2013) argue that the concessionaire’s opportunity to defer is analogous to a perpetual American Call Option. Similarly to the procurement contract case, the concession value is the difference between the expected net benefit from investing at a future date when the investment payoff is greater and the expected value of the penalty to be paid. As far as procurement contracts are concerned, the theoretical model shows, first, that the higher the volatility of production costs, the stronger the incentive to delay; second, that the incentive to delay is magnified whenever the public buyer, i.e. the CA, has little or no chance of seeing the committed penalties enforced because the efficiency of the judicial system is low and/or the court of law has considerable discretion. Analogously, as far as concession contracts are investigated, it is easily shown that whatever the concession’s value (i.e. the expected present value of future profits gained by the provider from operating the utility), the greater the uncertainty over future payoffs the greater the incentive to delay.

In both procurement and concession settings, committed penalties for delay may consequently not represent significant losses to the defaulting party because the enforcement of the penalty results weak, or because the penalty to be paid is small by comparison with the supplier's option value to delay the works.

Finally D’Alpaos et al. (2013) test their theoretical results on the database compiled by the AVCP by implementing regressions to identify the determinants of time overruns. Specifically they verify whether the variance of production costs and the efficiency of the judicial system affect delays. The empirical analysis on Italian PPCs is consistent with the theoretical model's predictions. In all regressions the number of days of delay are positively correlated to the uncertainty over production costs and to the inefficiency of the judicial system. This evidence supports the theoretical predictions that suppliers endogenize their decision about the investment timing of the contract taking advantage of the gains deriving from both the variance of the production costs and the inefficiency of the judicial system in enforcing the penalties.

Conclusions
In this contribution we summarize two papers that investigate whether the uncertainty over investment costs and future payoffs create an incentive to adopt an opportunistic behavior and thus generate strategic time overruns. Whether or not the penalty set by CAs is effective in limiting delays depends on the committed fee level and on its enforcement by the court of law to which the parties refer to settle any dispute. The enforcement of the penalty, in turn, typically depends on both the discretion of law courts in voiding contractual clauses and the efficiency of the judicial system. Numerical simulations show that the option value to delay is very sensitive to the efficiency of the judicial system and the discretion of the court. The greater the uncertainty over construction costs or future payoffs, the more underestimated the penalty fee set in procurement and concession contracts according to the Net Present Value rule. In other words, the greater the uncertainty, the greater the penalty to be set in contracts.

Notes

[Note 1] This database records information on all Italian public works contracts worth between Euro 150,000 and Euro 15,000,000 awarded by municipalities, local/regional public authorities and public firms.

[Note 2] Among the various types of Italian CA, we considered: Public Administrations, Regional Authorities, Territorial Associations in Mountain Regions, Provincial Authorities, Municipalities, the National Health Service, National Railways, National Roadworks Board (Anas), Postal Services, public corporations and other public organizations, concessionaires and administrators of public infrastructures and networks, and the Council Housing Board (IACP).

[Note 3] Specifically referring to the Italian scenario, the enforceability of the penalty is not straightforward. While, on the one hand, Italian legislation establishes that the CA has the right to commit the supplier to pay a penalty in the event of delays, on the other hand, the supplier may oppose payment of the penalty when the amount involved is perceived as "manifestly excessive" (i.e. the penalty fee is not proportional to the "damage" caused by the delay in the delivery of the works) or she claims not to be fully responsible for the delays and thus takes the matter to court.

References

D'Alpaos, C., P. Valbonesi, M. Moretto and S. Vergalli, (2013),"Time Overruns as Opportunistic Behavior in Public Procurement", Journal of Economics, 110, 25-43, doi: 10.1007/s00712-013-0352-6

D'Alpaos C. and M. Moretto (2013), “Option Values and Penalty Fees in Concession Contracts: A Real Option Approach”, Journal of Engineering Technology, doi: 10.5176/2251-3701 2.1.54



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C. D’Alpaos, Department of Civil, Environmental and Architectural Engineering, University of Padua

S. Vergalli, Department of Economics and Management, University of Brescia and Fondazione Eni Enrico Mattei    
   
 
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