The Ratchet Effect in Construction

An Economic Perspective on Construction Procurement 

The incentive problem in short-term contracting is the main issue addressed here. This problem in construction has often been seen from the perspective of the principal-agent problem, where the focus is on motivating the agent and monitoring outcomes. By taking the incentive problem as the focus of the discussion the emphasis shifts away from the relationship between the principal and the agent, which is well understood, to the effort a contractor will make to minimise costs or improve performance. This aspect of principal-agent relations has been a major theme in labour economics, the economics of regulation and elsewhere.

The process of procurement has a number of side effects. While the intention is to purchase, the method determines outcomes. For building and construction projects the method generally used is a form of auction, typically a common-values low bid auction, where bidder costs are the same or similar and the project is awarded to the lowest bidder. This process has all the characteristics of economic models of one period contracts in short-term contracting under information asymmetry. It is also the case that the major public and private sector clients are repeat clients as they regularly bring projects to the market, and this is equivalent to the two periods in models of regulation

Here some of the insights into the behaviour of suppliers or contractors from the economics of regulation is applied to construction contracting. The approach is interesting because it is now generally accepted that procurement can be treated as a subset of regulation, following the model developed by Laffont and Tirole, which treats regulation as a principal-agent problem, with the government as regulator the principal, and the regulated firm (in fact its manager) as the agent. The regulator can observe realized production costs, but not how much effort the firm puts into cost-reduction (a post-contractual hidden effort problem). Importantly, the firm knows more about cost-reducing technology than the regulator (a pre-contractual hidden information problem).

In their model there are two types of firms: low effort firms will not try very hard to reduce their production costs, while high effort firms will be very responsive to cost reduction incentives. Therefore the problem is modeled as one of information asymmetry, with the focus on discovering the manager’s type, whether they are a high-effort Type 1 or a low-effort Type 2.

The first type responds to contractual incentives while the second does not, so the principal can use incentives to induce more information revelation from the agent, i.e. to get the agent to disclose whether they are a Type 1 or Type 2 manager, and the regulator can make transfers to the firm. Such transfers are clearly necessary in the case of procurement, where the principal/client pays the firm/contractor for work performed under a contract to supply goods and/or services.

In this context what is called the commitment problem arises, because the optimum outcome possible in the first period, or round of tenders, cannot be repeated twice. The problem turns on the existence of asymmetric information. In each of the two periods the government/regulator wants to procure a public good, and if they could credibly commit to a long-run (two-period) contract the optimal two period outcome would be the same as the one-period optimum twice. They call this the perfect commitment outcome. The perfect commitment outcome requires credible commitment to a long-run contract.

If the regulator cannot make credible long-run commitments, long-run contracts are ruled out. With the regulator unable to write a long-run contract with the regulated firm, it has instead to govern the relationship by a sequence of short-run (one-period) contracts.

This gives rise to what is known as the ratchet effect, an outcome of the regulated firm’s unwillingness to reveal whether it is a Type 1 or Type 2 firm in the first period, because that would mean the regulator no longer faces asymmetric information, and allow the regulator to take any gains by the firm from, for example, cost reductions that might be the result of the firm’s efforts or use of new technology.

Laffont and Tirole proved that after period 1 the regulator will in general not know the firm’s true type. Intuitively, the ratchet effect implies that information unfolds slowly, as the manager tries to protect his information rents by not revealing his true type. Thus the ratchet effect happens when an agent works hard and shows a good result, but the principal then may demand an even better result in the future. Anticipating this, the rational agent has little incentive to work hard in the first place, and this tendency for performance standards to increase after a period of good performance is called the ratchet effect.

Early formal models of ratchet effects emerged in the 1980s, and ratchet effects were predicted in specific informational and contractual environments where hidden action and hidden information must be present, and the parties must be in a repeated relationship yielding some quasi-rents to both where binding multi-period agreements are not feasible.

How does this apply to building and construction?

Is it likely that construction contractors respond to clients’ requests for bids by attempting to preserve hidden information? Is it possible they will not want to reveal themselves as a Type 1 cost-minimising firm? There seems to be three reasons.

Firstly, it reduces competition to a straightforward shootout on price, but because all tenderers have similar costs this is just a decision on margin, based on current and expected workload. Therefore the competition in any given tender is likely to be driven as much by contractors’ workload considerations as their estimated cost of the project. Even without cartel arrangements this is a form of managed competition, whereby the tenderers will not deviate too far from the client’s expected cost for the project, which will also be similar to industry estimates, thus avoiding revelation of a significant cost advantage on one project that might jeopardise margins on future projects.

Secondly, it allows for gradual improvements in productivity and efficiency, which are neither disruptive nor expensive to contractors, but will deliver a windfall gain to the contractor if a project comes in well under budget or schedule, which may be the result of some innovation by the contractor. This gain will, of course, be hidden from the client and from competitors as much as possible.

This suggests that there might be many cost reducing innovations available to contractors at any time, but the pressure to apply them will be muted by market conditions and a contractor’s appreciation of competitors’ likelihood of using them. Innovation is used here as a broad term that covers any and all product and process developments that can reduce final construction costs. There are costs and risks associated with innovation, so it is in the interests of all bidders to minimise these costs to themselves.

Thirdly, the winning bidder will always have the option of revealing themselves to be a Type 1 firm, if for some reason they want to. There will usually be some innovation available that will reduce project costs, but will be costly (i.e. require upfront investment) to the contractor. Thus the success of many major contractors in winning repeat work through negotiation rather than tendering is explained. By pushing the innovation boundary to reduce costs on the period 1 project the contractor gets the period two project without tendering costs at the new level of the client’s price expectation. (This does not exclude more traditional methods of cost reduction such as cash farming or subcontractor oppression of course).

The general argument made here is that the ratchet effect in the procurement process used in building and construction (typically auctions of single projects) will limit cost reductions from productivity and efficiency gains by contractors and subcontractors. This is an outcome of the unwillingness of bidders to reveal their hidden knowledge to clients, who will then expect future performance at the improved level. This is because clients typically only offer a single project at a time, or sometimes a bundle of projects, instead of sequences of projects. Thus short term contracting under information asymmetry.

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.

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.