Global Fraud Alert: PPP Model Boosts Fight Against Corruption

fraudBy Henry Teitelbaum
Editor, P3

A priority issue for governments around the world as they contemplate large scale infrastructure programs should be the ruinous cost of corruption. For one thing, it exists nearly  nearly everywhere, even in countries regarded as well-governed. And its effect  on development can be as catastrophic as it is insidious.

While there is no substitute for vigilance, the transparent processes and incentives that go into Public-Private Partnerships can do much to prevent corruption from disrupting large-scale public development programs. When executed with clear policy objectives and consistent political support backed by a robust legal framework, PPP can also go a long way towards rooting out the fraud that is too often accepted as the cost of doing business.

PPPs, unlike traditional Design and Build projects, require private sector companies and their financial backers to bid not only for the right to deliver a public asset, but to provide up front funding as part of a long-term design, build, operate and maintenance agreement. They have a record of not only providing better value-for-money over the life of a public asset, but better resistance to corrupt influences. They accomplish both of these goals by locking in private sector partners to a system of performance measurements that come with mandatory financial penalties for failing to meet them.

Nicholas Jennett, head of the European Public-Private Partnership Expertise Centre (EPEC) at the EIB, says PPPs are a vast improvement over standard procurement models because “they tie down contractually what is happening,” and uphold the principle of “competition at every level.” This principle is put in place through the course of project tendering, when financing is arranged, and throughout the delivery, operational and maintenance phases. On top of this, says Mr. Jennett, “scrutiny is brought by third party funders” so that performance is monitored by parties who are incentivized to deliver the best results.  It is on this basis that the EIB and EBRD are providing a majority of their financial support to pan-European development projects, including the Trans-European Transport Network (TEN-T) program for multi-modal freight and passenger transportation.

The superior level of third party scrutiny that PPP, or as it’s known in the UK, PFI (Private Finance Initiative) encourages was recently evidenced in the UK Ministry of Defence’s decision early this year to abandon the £6 billion SAR-H rescue helicopter PFI project. The decision followed revelations regarding improper access to confidential information by one member company in a bidding consortium, that helped the consortium, Soteria, to win preferred bidder status for the project’s delivery.  What is interesting is not that the irregularities were found out, but rather that the consortium itself brought the information to the attention of the MoD. What’s even more interesting is that even before the MoD had decided what to do in response, the consortium’s banker, RBS, pulled its funding rather than continue associating itself with a tainted project.

PPPs in North America are known as P3s, while in the UK and other countries they are either PFIs (Private Finance Initiatives) or just PPPs. The model in its various forms in the developed world has a generally good record of delivering value for money, but is becoming especially popular in emerging countries. This is because many of these countries lack either the public infrastructure – whether it’s highways, bridges, schools or hospitals – or the means to pay for one. Civil servants in many of these countries, moreover, often lack the skills needed to manage large scale projects, and are handicapped by entrenched practices that discourage a fair competitive environment.

Richard Clegg, partner at Wolf Theiss, a leading law firm in Central, Eastern and Southeastern Europe, says problems with standard procurement practices in these countries begin with the fact that public money is tapped upfront. “This leaves decision making in the hands of officials who are likely to be either directly influenced by price without consideration for quality, or when long-standing business relationships built on one form or another of corrupt influences causes decisions to be made in favor of particular contractors.”

There’s also a large gray area of decision-making where local tenders for projects, particularly in developing countries, can be made to look artificially attractive on cost, Mr. Clegg says. This is because vertically integrated local companies can offer cost advantages by sourcing raw materials internally or through their own long-standing relationships, based on kickbacks to local materials producers.

At least as troubling is how corruption prevents the private sector from playing its crucial role in development. It discourages honestly run businesses from competing for public projects because it undermines faith in the tendering process.

“Corruption stops development because it turns away the long-term investment that is most desperately needed in developing countries” says Mr. Clegg.

In last year’s annual Global Fraud Survey, commissioned by Kroll and carried out by the Economist Intelligence Unit, 48% of respondents indicated that fraud deterred them from engaging in business in at least one foreign country. Of those that have entered new markets, 21% believed that their exposure to fraud has increased because of the move.

Corrupt practices are by no means limited to developing countries.  In the euro zone, development in both large and small economies, typified by Italy and Greece respectively, suffers due to long-standing and deeply entrenched corrupt practices. A recent study found, for example, that in Italy, where contracting decisions follow long-standing closed procedures that overwhelmingly favor local players, highways cost on average seven times as much per kilometer as in Portugal, where PPP is the norm.

The added costs, it is worth noting, can be measured in lower productivity and higher government deficits. Italy, which in 2010 had a debt to GDP ratio of 118 per cent, was exceeded  in Europe only by Greece, with a ratio of 144 per cent.

The US is also far from immune from corruption. The Global Fraud Survey showed that a troubling 7% of respondents indicated that fraud had deterred them from operating in North America.

Of particular concern is that criminals are attracted to precisely the kinds of large scale public works programs that are now being undertaken in the US.  During the 1930s, corruption thrived during the implementation of President Franklin D. Roosevelt’s Public Works Administration and other programs, with spending and hiring decisions becoming hostage to political patronage while newly empowered labor unions brought large scale abuse, much of it against union members themselves. Many historians now point to corruption as a key factor in the failure of the Roosevelt administration’s main economic policy initiative before the war.

Some have argued that the administration of President Barack Obama may be making the same mistakes with the $787 billion American Recovery and Reinvestment Act of 2009 that was enacted a month after taking office. There are certainly similarities between the two programs, at least in that neither has been able to generate much in the way of private sector job growth and both have been susceptible to fraud. One senior fraud investigator put the level of fraud risk to the current stimulus package at 10% of its value.

What’s more, Mr. Obama is not done with investing in infrastructure: a key initiative for his administration over the next year involves the creation of an Infrastructure Bank with $50 billion of federal funding to help catalyze long-term private infrastructure investment, with much of it funded through P3 initiatives.

The use of PPP as a procurement model is already well established in Europe. Interest in its use in the developing countries of central and eastern Europe has even become a priority for western-supported financial institutions due to deeply established cultures of corruption in many of these countries. The current focus is on scaling up their use in programs aimed at closing the infrastructure deficit that exists between the EU members and candidate countries, primarily through the European Investment Bank and the EBRD.

Blake Coppotelli, a senior managing director for Kroll’s Business Intelligence and Investigations division, says the PPP model holds good potential for fighting corrupt influences in the US as well, but warned there’s “no fail safe mechanism.”  Mr. Coppotelli, who was previously chief of the Labor Racketeering Unit and New York State Construction Industry Strike Force in the Manhattan District Attorney’s office, says the increased transparency and level playing fields that are built into the competitive tendering of a P3 project are helpful measures. But he warns that there’s no substitute for close oversight.

“The P3 format is a step in the right direction,” Mr. Coppotelli says, “but it’s only as good as the integrity of the players.”

He has good reason for skepticism. The value for money proposition in Japan’s PFI program over the past decade was diminished by a tangled bureaucracy, a slow and expensive tendering process, poorly understood goals and a near-absence of cheap long-term private sector funding. In the UK, where the PFI model was first developed during the early 1990s, similar problems have sometimes negatively impacted outcomes.

But in Japan, the cumulative effect of these influences was to discourage competition and leave projects in the hands of a few well-heeled domestic infrastructure delivery companies. Even worse was that projects fell victim to the country’s deeply rooted culture of corruption, where party politics mingles with business interests and organized crime.

Gary Sturgess, executive director of the Serco Institute, said one key lesson from Japan’s experience is that public sector contracting requires “norms and rules that result in more transparency” and encourage healthy competition.

That corruption can impact major policy initiatives in Japan, which ranks among the world’s most transparent and accountable nations, underscores how pervasive the problem remains in developed countries. The Economist Intelligence Unit recently reported that 84% of construction companies in the developed world were hit by fraud, with 18% of this related to corruption and bribery. Mr. Coppotelli says that even though publicly funded projects have better protections against fraud than commercial projects, they remain “unbelievably susceptible.”

And the stakes are growing. In its 2007 report, “Infrastructure to 2030”, the Organisation for Economic Cooperation and Development estimated that the amount of investment that will be needed by 2030 just in roads, rail telecommunications, electricity and water infrastructure will reach $71 trillion. That figure, which doesn’t even take into account social infrastructure such as schools and hospitals, airports or seaports, represents about 3.5% of global GDP over the same time period. With so many new public infrastructure projects entering the procurement pipeline around the world, it’s no surprise that more and more public sector authorities are looking to scale up their use of fraud-resistant procurement models such as PPP.

Some countries, most notably Canada, have adopted the best of the UK PFI model and made it far more efficient and thus better able to resist corruption while delivering greater value for money. The UK’s own experience, while often portrayed as a mixed one at home, has produced a great deal of valuable data, skills and knowledge that are now being made available to other countries through organizations such as the CityUK.

Mr. Jennett says much has been learned from early experiences with PPP and PFI about the building blocks to making programs more effective. For example, he says PPP works best when it has broad popular support. “Consistent political support for PPP is important,” he says, “so it’s important to come to the market with programs rather than individual projects.”

Moreover, says Mr. Jennett, building support for the PPP model across party lines requires the successful implementation of programs over the course of several terms of government. “Consensus can only emerge over the question of value for money, so the more we can focus on circumstances where value for money can be demonstrated, the more political consensus will follow.”

This feature has also been published in Infrastructure Journal