Monday, 21 March 2016

Cities and Built Environment Policies

Why measuring the built environment sector is important

One of the Turnbull Government’s points of difference with its predecessors is the focus on cities and the built environment. When announcing his first ministry Malcolm Turnbull said: “Liveable, vibrant cities are absolutely critical to our prosperity. Historically the Federal Government has had a limited engagement with cities and yet that is where most Australians live, it is where the bulk of our economic growth can be found.” He then identified productive cities, housing affordability and transport diversity and integration as issues.

Cities are at the heart of the emerging digital economy and society, and these days there are a range of different’ big picture’ ideas about what cities can or should be: creative cities, functional cities, nodal cities, compact cities and so on. In Australia the emphasis has come to be on planning and productivity, although this consensus is a fairly recent event, and has yet to extend much past the major public and corporate stakeholders involved.

Cities as economic and social phenomena are also enormously varied and complex. Significantly, there is also an industry, or collection of industries, that creates and maintains cities. The building and construction industry, at around 7 percent of gross domestic product, is the core, but the role of the construction industry linking suppliers of materials, machinery, products, finance, professional and technical services is also important.

These two views have been called broad and narrow, with the narrow industry defined as on-site activities of contractors and subcontractors and the broad industry as the supply chain of materials, products and assemblies, and services. The term that arguably best encompasses the extraordinarily large number and range of participants in the creation and maintenance of the built environment, from suppliers to end users, is the built environment sector.

Based on the studies that have quantified the relationship between the narrow and broad definitions of construction it is reasonable to conclude the wider industry is around twice the size of the narrow industry. The 2003 UK report by David Pearce on The Social and Economic Value of Construction found contractors accounted for around half the total of employment, the number of firms, their turnover and value added, in the five industry groups included in the broad definition. An Australian study in 1999, Mapping the Building and Construction Product System in Australia by the Australian Expert Group on Industry Studies, found the narrow industry is 51 percent of income and 48 percent of employment in the broad industry.

The way to turn this rough estimate into a more credible measure would be through the preparation of what is known as a satellite account, which reclassifies expenditures usually presented in different industry groupings into a single sector. These are used to provide more detail on sectors that are not adequately represented in the national accounts. A previous post discussed these.

At this time the most widely found satellite account is for tourism (nine countries, all irregular, often jointly funded by industry and users), but they have been produced or proposed for a range of other industries such as health, the environment, R&D, information technology, infrastructure, non-profit institutions, human capital and households. Built environment sector is also the obvious choice of a name for a set of satellite accounts.

The reason understanding the extent and of the role of the built environment sector is important is that, despite repeated policy efforts by governments across a wide range of issues, the built environment is often seen as under-performing, based on measures such as housing affordability, traffic congestion and flows, amenity and access to services, energy efficiency and carbon abatement, water capture and so on.

An important part of the explanation for the difficulty in getting significant outcomes through policy interventions is the under-appreciated complexity of the built environment sector, partly due to the fact we don’t adequately measure its role and extent. Getting a better definition and integrated data would allow better monitoring of the effectiveness of future cities and infrastructure policy initiatives.

It is unlikely any single policy would address the complexity of the built environment sector, and why and how the many overlapping layers of users, clients, regulators, creators, providers, maintainers and managers makes effective policy implementation very difficult. In particular, the multiple layers of approval processes and the lack of inspection and enforcement of standards are critical issues that the Commonwealth Government typically affects indirectly. Across Australia there is great diversity in state legislation, and regulation of building and construction is typically distributed across several departments within states.

Clearly, the sector is over-regulated, and therefore it is not surprising it is under-performing. Much of the regulation is inefficient or ineffective, sometimes due to regulatory capture, but really it’s a case of policy accretion over time. The real problem is that much of the regulatory framework is aging badly, some parts are now decades old, and is poorly adapted to the rapid pace of development in construction technologies and products.

The Government also has the Productivity Commission report on Infrastructure to consider. Many of the recommendations in that report are serious and, in some cases, significant reforms to the selection, financing, tendering and contracting of major building and construction projects. Their application extends past engineering infrastructure to the rest of the built environment sector. The recommendations provide an outline of what an industry policy backed by Commonwealth funding for new cities and built environment projects could look like. There are many possibilities. Tax exempt infrastructure bonds targeted at self-funded retirees issued by a statutory authority that decides on the projects might be politically attractive.

Malcolm Turnbull’s agenda for cities set three main policy goals: integrated planning, infrastructure funding and ‘greening’ cities. In the past a set of policies like these would be seen as affecting a diverse number of industries, or industry sectors. Bringing these industries together as the built environment sector, and measuring that sector’s development and performance, could make an important contribution to policy initiatives in related areas such as energy, transport and so on.

With the election campaign now launched there is a general expectation that cities and built environment policy proposals will emphasise planning and productivity issues. There is an opportunity  here to integrate those proposals with the emerging narrative from the Government of lifting Australia’s rate of productivity growth, levels of research and innovation, and facilitating the transition from our recent but now past resources economy to a modern, post-industrial information and services economy.

Wednesday, 16 March 2016

Australian Construction Industry Inquiries

Three Royal Commissions in 25 Years

Following reports from the ABC and Fairfax media groups in 2012-13 on corrupt and illegal activity in several Australian trade unions, in particular the Construction Forestry Mining and Energy Union (CFMEU), the Health Services Union (HSU) and the Australian Workers Union (AWU), a Royal Commission was appointed in 2014 to inquire into trade union finances and activities. While the terms of reference covered a range of issues around union corruption, the CFMEU was the catalyst and provided justification for the inquiry. Over half the Commission’s hearings were on the CFMEU, the behaviour and associates of certain union officials, and payments or other deals made with employers in NSW, Victoria and Western Australia.

The Royal Commission into Trade Union Governance and Corruption was headed by a former High Court Justice, Dyson Heydon, and found evidence of blackmail, theft, intimidation and death threats, use of motorcycle gangs and other criminal groups as hired muscle, interference in union elections and illegal agreements with employers. The Final Report highlighted poor union record keeping, false invoicing and destruction of documents, union ‘rubber stamp’ committees which failed to enforce rules, payment of large sums by employers to unions for dubious ‘training’ schemes and ‘services’, and influence peddling in the Labor Party through inflation of union membership figures. The sums of money involved were also significant, with many officials benefiting from their positions through fraud or theft from the union (HSU in particular), or in the CFMEU through arrangements with employers for work on properties owned by officials.

Based on that evidence around 50 people, unions and companies were referred to various authorities for possible prosecution, including police and public prosecutors, the Australian Securities and Investments Commission (ASIC) and the Fair Work Commission. Some of the large private companies caught up in the inquiry were Thiess, John Holland, ACI, Downer EDI, Cbus, Winslow Constructors and Mirvac. Companies were found to have made payments to unions to get onto tender lists

The Final Report, released in December 2015, had 79 recommendations, over half concerned with the regulation of unions (24) and union officials (14). The first recommendation was “Commonwealth and State governments give consideration to adopting a national approach to the registration, deregistration and regulation of employee and employer organisations, with a single regulator overseeing all such organisations throughout Australia.” This Registered Organisations Commission would have investigative powers similar to ASIC, and focus on financial compliance with new rules on management and disclosure. Other recommendations were for significant changes to industrial relations laws, to restrict union privileges, and Federal competition laws on price-fixing and bid rigging.

Although the Royal Commission reported “widespread and deep-seated misconduct” across a number of unions throughout Australia, Commissioner Heydon said the Royal Commission had uncovered only “a small tip of an enormous iceberg”. There was also a confidential sixth volume because “a large volume of evidence cannot be publicly released due to serious threats made to certain witnesses and their families” and “reveals grave threats to the power and authority of the Australian state.”

Heydon’s most important recommendation was for the reestablishment of the Australian Building and Construction Commission (ABCC) as an independent industry regulator “For the purpose of seeking to combat the culture of disregard for the law within the Construction, Forestry, Mining and Energy Union”. Originally set up after the 2003 Cole Commission recommended widespread changes to the industry’s industrial relations laws, legislation establishing the ABCC as a statutory authority to monitor workplace relations was passed by the Howard Government in 2005. The ABCC was deeply opposed by the unions and in July 2012 was replaced by the Gillard government by the Fair Work Building and Construction Inspectorate, a body with much reduced scope and powers.

Before the Heydon Royal Commission there were two previous Royal Commissions into the building and construction industry, both headed by judges. Roger Gyles headed the Royal Commission into Productivity in the Building Industry in NSW (1991-1992) and Terence Cole the Royal Commission into the Building and Construction Industry for the Commonwealth Government (2001-03). At this time it is worth revisiting the findings and outcomes of those inquiries.

Both concluded the fundamental problem was a lack of respect for the rule of law, a phrase found repeatedly throughout both final reports, and this was a problem on both the employer and union sides. Cole said Culturally, first, there needs to be recognition by all participants that the rule of law applies within the industry” and Gyles suggested those who break the law should be punished.

Gyles also said “Observance of the law and law enforcement in general play very little part in the industry. The law of the jungle prevails. The culture is pragmatic and unprincipled. The ethos is to catch and to kill your own … Once it becomes acceptable to break, bend, evade or ignore the law and ethical responsibilities, there is no shortage of ways and means to do so.”

Gyles found illegal activities “…range from physical violence and a threat of physical violence at one end to petty pilfering of building materials at the other. In between there is a great variety of illegal activities, essentially economic in nature or effect, from collusive arrangements involving giant corporations and industry associations to labour-only sub contractors paying small amounts of graft to project managers. Those involved range from managing directors of large corporations to labourers on site. No sector of the industry has been immune.”

Nevertheless, Commissioner Gyles concluded that industrial relations was overwhelmingly the most important issue and the union’s conduct and philosophy the fundamental cause of the industry's problems. He recommended the government deregister the BWIU (now the CFMEU) in both the State and Federal jurisdictions, and his Commission’s Building Industry Task Force pursue cases and recommend changes to the law. Gyles made 63 recommendations to the NSW Government, of which all but two were adopted.

Following Gyles came the NSW Code of Practice for the Construction Industry (1996), then the Commonwealth, State and Territory governments through the Australian Procurement and Construction Council (APCC) introduced a National Code of Practice for the Construction Industry (1997). Many codes and guidelines have been issued and revised at both levels of government over the last decade. Victoria, NSW and Queensland all have similar Codes of Conduct and Guidelines, and all three States have used, or made attempts to use, their role as major clients to enforce compliance with legal obligations. Policy interest in this area escalated significantly after 2003 when the Cole Royal Commission reported.

Ten years after Gyles the same problems were still prevalent. In his final report Commissioner Cole envisaged an industry where … disputes are resolved in accordance with legislated or agreed dispute resolution mechanisms rather than by the application of industrial and commercial pressure. The rule of the law must replace industrial might.”

Cole found a disregard for enterprise bargaining, unlawful strikes and use of inappropriate payments. As a result 31 individuals were referred for possible prosecution, 392 instances of unlawful conduct were found (including 30 by employers), and 25 different types of unlawful conduct and 90 types of inappropriate conduct identified.

His view was “These findings demonstrate an industry which departs from the standards of commercial and industrial conduct exhibited in the rest of the Australian economy. They mark the industry as singular. They indicate an urgent need for structural and cultural reform. At the heart of the findings is lawlessness. It is exhibited in many ways.”

The final report had 212 recommendations, the great majority about changes to federal workplace relations legislation governing the building and construction industry and proposed an Australian Building and Construction Commission (ABCC) to monitor illegal behaviour by unions. While the ABCC clearly had a restraining influence on the industry in general and the CFMEU in particular it obviously did not fundamentally alter “standards of commercial and industrial conduct”.

It is worth asking if the recommendations of the Gyles and Cole Commissions, the other State efforts and the APCC codes, had all been implemented and followed through, would a third Royal Commission have been necessary? However, that would have been an expensive exercise, due to the cost of closely monitoring projects and adding resources for enforcement of existing laws to the relevant agencies. Also, The Heydon Royal Commission had a much wider remit than the building and construction industry, finding "It is clear that in many parts of the world constituted by Australian trade union officials, there is room for louts, thugs, bullies, thieves, perjurers, those who threaten violence, errant fiduciaries and organisers of boycotts."

While the recommendations from Gyles and Cole did become legislation, and Heydon’s may yet, perhaps the real underlying issue that should be addressed is why the building and construction industry operates the way it does. None of these Royal Commissions produced a vision of a different industry, apart from a law abiding one, and made no recommendations on the direction that strategic development of the industry might take.

Commissioner Gyles acknowledged the complexity of the industry: “the issues thrown up … have been manifold. Some have been controversial ... some are complex or technical ... In relation to some issues, I have fairly well developed and precise views as to what ought to happen. In relation to other issues, I … leave them to the government or interested parties to follow through, or make suggestions as to procedure by which they ought to be resolved.”

The three Commissioners agreed the problem is a culture of lawlessness, and the three inquiries found widespread illegal behaviour by both union officials and contractor managers. Their recommendations, in various ways, focused on increased regulation and enforcement through legislative action. In this they had “well developed and precise views”. However, while necessary, increased regulation does not address the issue of why the building and construction industry has such a culture. What are the causal factors at work in creating this culture? How might they be affected by industry practices and institutions in areas like recruitment and training, tendering and procurement, wage setting and tripartite agreements between unions, employers and government?

Construction has a reputation for corruption and collusion, and is ranked by Transparency International as the world’s most corrupt industry, mainly due to issues in developing countries. But this is also a problem across countries in the OECD, not just for Australia, because many countries have found entrenched anti-competitive practices and criminal involvement in the industry. For example, the recent Charbonneau Commission in Canada into awarding of public contracts in Montreal concluded corruption and collusion are "far more widespread than originally believed" and organised crime had “infiltrated” the industry.

Industry policy and industrial strategies are very much out of fashion in Australia and elsewhere these days. In their absence we get quasi-judicial agencies and an emphasis on law enforcement and industrial relations. It is unlikely these agencies will ever get the resources needed to cover an industry as large and diverse as building and construction, thus it is unlikely that the issues of criminality and illegal behaviour can be solved by increased regulation alone.

Monday, 7 March 2016

Construction Industry Collusion

Christian Brockmann’s Big Idea 

The issue of market power in the construction industry is not one that gets a lot of discussion, despite the associated issues of competitive behaviour and appropriate regulation. A distinctive contribution is Christian Brockmann’s ideas on collusion and corruption, where three related arguments were made. First he put forward an analysis of bidding for projects as an auction that typically results in a price below marginal cost for the winning contractor. Second, he then argues the logical response of contractors as bidders to this outcome is collusion, which is illegal. Third, he identifies the auction and bidding process as an abuse of market power by clients that should be regulated. It’s worth reviewing Brockmann’s arguments and their validity, as he provides a somewhat different perspective on the issue of construction industry collusion.

In a market with a single buyer, as with a building or construction client, it is possible to gain market power through bargaining with potential suppliers. Bargaining power is found in bilateral negotiations over terms and conditions of supply between trading partners. In a bargaining framework buyer power is the ability to extract concessions or a surplus from a supplier, typically through individually negotiated discounts. Buyer power in this case is the bargaining strength a buyer has with respect to suppliers with whom it trades, where bargaining strength depends on the ability to credibly threaten to impose an opportunity cost if it is not granted a concession. The most important issue is therefore the relative bargaining power on the buyer and seller sides of the negotiation.

Competitive tendering, in Brockmann’s view, is the exercise of such bargaining power by clients. By using an auction to select the winning bidder based on lowest price (known as a first price sealed bid auction), projects are won by bidders who are willing to sacrifice margins or have underestimated costs (the ‘winner’s curse’). In this case the ‘individually negotiated discount’ would be the difference between a contractor’s marginal cost and the market price for the project.

In a first-price procurement auction, the low bidder is awarded the contract. In a common-values auction, the cost of performing the contract is common to all bidders but is uncertain, bids are based on estimates, and this sort of auction can result in the winner’s curse. Therefore bidding estimated cost, on average, results in a loss because the lowest of several independent estimates of the true cost, on average, is less than the true value, and rational bidders avoid the winner’s curse by bidding above their cost estimates.

The problem with first-price sealed bid auctions is that increasing the bid too little results in lost revenue to the contractor while too much loses the competition. Also, the larger the number of bidders the less likely a bid at equilibrium price will win. Brockmann argues that these sealed-bid auctions have four characteristics, and in the estimating and bidding process all these effects will overlap and aggregate:
  1. Are biased with regard to estimating errors, driving the low-bid award price below equilibrium price;
  2. Are biased with regard to information, driving the low-bid award price below equilibrium price; this is especially true in a two-phase award process, when the auction is followed by price negotiations;
  3. Are biased with regard to uncertainty, resulting in over-optimistic assumptions and driving the award price below equilibrium price;
  4. As institutions are biased with regard to technology, driving the award price below equilibrium price.

In the diagram above P* is the equilibrium (market) price and Pa is the auction price. The outcome of the auction is a price below the equilibrium price, and this augments the clients’ surplus (C) by the same amount that it reduces the contractors’ surplus. In addition there is a decrease in both surpluses (A+B), a deadweight loss, which measures the reduction of social welfare. The reason the winning bid is below marginal cost is because tenderers cannot estimate their costs accurately, due to non-systematic errors across the work breakdown structure used to get estimates. If estimating errors are normally distributed the lowest bid will be below the mean price (in auction theory this is known as the ‘winner’s curse’, where the winning bid makes a loss), which can be taken as the market price. The curve on the right hand side of the graph is the distribution of costs of the tenderers, the mean price is P*.

Brockmann concludes clients have buyer power, and the industry’s response to their use of that power is to collude in a variety of ways. Although a list is not proof, widespread evidence of collusion in the building and construction industry would suggest, in many circumstances, this can be the case. For example:

  • The Japanese dango system of market sharing on public works;
  • The Dutch industry cartel (650 companies fined €239 by NMa in 2003);
  • The lift and elevator cartel (EU Competition Commission €992 fine in 2007);
  • Montreal’s ‘Fabulous 14’ control almost 80% of public work;
  • The Scandinavian ‘Big 3’ do around 70% of all building and construction;
  • 112 UK companies were caught in a price-fixing case in 2009;
  • The steel, cement and concrete industries are repeat offenders for anti-competitive practices in many countries;
  • Australian ACCC cases include fire installation, unsuccessful tender fees and housing contractors, and a 2015 Royal Commission uncovered illegal payments between contractors, unions and crime figures, as did the Charbonneau Commission in Montreal.
There are many other examples. Brockmann says For contractors collusion “is a business decision and the players are business unit managers” and “Individuals have only the chance to walk away from the game as this will continue to be played by others”. In his view collusion is more of a structural problem than an ethical dilemma, with large groups of contractors involved individual decisions have no effect on the behaviour of the group.

Brockmann also, uniquely as far as I know, argues for regulation of buyer power. How this might be achieved is left as an open question that he does not discuss, beyond noting the industry’s frequent encounters with competition regulators around the world. However, he does discuss the difficulty in getting people to behave ethically under these conditions of procurement through auctions and settlement through claims and variations. While collusive behaviour by contractors is illegal, he strongly believes many clients can and do behave unethically when negotiating with contractors:

Why is it ethically acceptable that buyers have such market power? Why is it acceptable they can use ‘shrewd’ negotiating tactics? Collusion is both an ethical and structural problem. It will persist as long as the institutions of procurement are not changed, giving both sides equal power and reinstituting perfect competition on the project market through regulation of the buyer’s behaviour.

This is a challenging argument that raises the role of clients in shaping the behaviour of the industry. It is also a key factor in the important issue of improving procurement processes. Nevertheless, despite the theoretical neatness of the argument on auctions and estimating errors, there are more than a few points that are controversial. Among these are:

  1. If competitive tendering produces undesirable outcomes, a proposition many would disagree with, should the bid closest to the mean be selected, or the second lowest bid as in a Vickrey auction? Or another alternative?
  2. How can perfect competition be found in the market for major projects when there are a limited number of credible bidders? Oligopolies are notoriously conducive to collusion.
  3. There is also the problem of information asymmetry. A well-informed client with a reasonably accurate estimate might well have an advantage over potential suppliers, but for the great majority of projects the clients are infrequent and inexperienced and could be disadvantaged.
 The problems of poorly informed clients and profitless contracting have a long history, in the 1830s London builders refused to tender for many projects under the building agreement in use at the time. Even earlier, Marshall Vauban, a military engineer and builder of fortifications for the French monarchy, insisted suppliers should be selected on quality not just on price. In a letter from 1685 to his Minister he complained about buyer behaviour and delays due to budget cuts, and argued:

Breaking of contracts, failures to honour verbal agreements and new adjudications, only serve to attract those firms which do not know which way to turn, rogues and ignoramuses, and to make those with the knowledge and capability of directing firms, beat hasty retreats.

I would add that they delay and inflate considerably the cost of these works, which are the worst since these cuts and the cheapness sought are imaginary. For the contractor is ruined … He does not pay the merchants who supply the materials, pays badly his employees, cheats on those he can, has only the worst, and since he is cheaper than the others, uses the poorest materials, quibbles about everything and is always crying for mercy …

… go back to plain dealing; pay the price for the works and do not deny an honest salary to a constructor who fulfills his duties; that will always be the best deal you can find.

While this was, and is, good advice, clients and their advisers are deeply committed to tendering and awarding the contract to the lowest bid, despite the fact that it is unlikely a competitive tender will result in a fair price. The purpose of a tender is price discovery, particularly for non-standard goods, and the industry is adept at bidding low to win work then making a project profitable.

On the other hand, the widespread evidence of collusive tendering and anti-competitive practices undermines the rationale for such reliance on competitive tendering. When you get situations like Japan and Holland, where industry associations have facilitated market sharing agreements across the country, it’s pretty clear the traditional system of tendering and contracting is deeply troubled.

Brockmann, C. 2011. Collusion and Corruption in the Construction Sector, in Gerard de Valence (ed.), Modern Construction Economics: Theory and Application, Oxford: Spon. Quote on page 59.

Letter from Vauban cited by Callender, G. 2003. A Short History of Procurement, in P. Nagel (ed.), Supply Chain Management: A Procurement Perspective, Melbourne: Hargreen Publishing, 2-9.