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Reputation and corruption in public procurement Interview with Francesco Decarolis, Associate Professor at Einaudi Institute for Economics and Finance in Italy. Francesco is currently a Research Fellow of the National Bureau of Economic Research. He was recently awarded ERC Starting Grant to investigate reputation and corruption in public procurement. iTunesTranscriptHello, Francesco, welcome to the podcast.Hello, thank you for this invitation.Francesco, I usually like to start the interviews by getting the guests to speak a little bit about their background. Could you tell us a little bit more about yourself?Yes. So I have been working in the last 12 years in the USA, so as you were saying, I completed my PhD in Economics at the University of Chicago, where I focused on the analysis of auction and procurement markets, which is a rapidly growing and very successful area of economics, with a broad range of applications, from auctions and procurement systems that government use to various private sector applications.. Examples include spectrum, allocation for telephone operators, the allocation of oil and gas exploration permits, and really almost every other area you can think of. My origin is Italian, and while studying in the US, and learning about this new area of economics, I realised that there was a big discrepancy between many of the economic models and the practice. The actual way in which certain procurement, important procurement markets, were arranged, and that it was particularly interesting to try to bridge what was in our economic textbooks with what was happening in the practice, because these textbooks were missing some key features of the real-world environment. But also these real-world environments, and the rules under which they developed, were sort of addressing in an imperfect way, in a potentially problematic way, some of the real problems that they were facing. And so this is how I began to build a career as a researcher in the area of auctions and procurement. My studies are based mainly on the empirical analysis of auction and procurement data, but also with some focus on the underlying theory.What brought you back to Italy, then?So, in essence, the ERC grant. I worked in several universities in the US. Most recently, I was at Boston University, in the Department of Economics, and while I was there, more precisely I was on sabbatical at Stanford University during the Fall 2015, I learned that I was the recipient of one of the ERC StartingGrants for economics. This grant is an absolutely fabulous opportunity to allow me to conduct research on areas of public procurement that I did not have the time or the resources to explore before, but that I always found very interesting and fascinating. Especially the use of past reputation in public procurement and the role of corruption in procurement. And the reason why I mentioned that I didn’t have the resources is also that for doing some of these studies, especially the one that I’ll be glad to tell you about in a few minutes, I collaborate closely with contracting authorities that implemented these rules, and working with the contracting authorities to try out different procurement formats, evaluating from an ex-ante perspective how to design the new auction formats, then doing the work of collecting the data, analysing, possibly having multiple meetings, both with the contracting authorities and with the suppliers, are very time consuming activities. And so thanks to the ERC grant, I have now all the financial means to perform these activities. Hence, I was very happy to relocate back to Italy. Right now, I am in the Einaudi Institute for Economics and Finance, which is an institute created by the Italian Central Bank to be an excellence in the study of Economics, and here in this institute, several important researchers for the area of public procurement have affiliations, as well. Giancarlo Spagnolo and Elisabetta Iossa for instance.Very well. So, if you could drill a little bit into the details of the grant, and the research, what are you actually going to be looking at, more specifically?The premise is that when we think about contract procurement, two features are absolutely crucial. The first is that it is unavoidable that there is some cost uncertainty at the time of bidding. So regardless of whether the procurement is a very complex contract, for instance, for the construction of new military equipment, or whether it is a contract for something easier like repaving a road, there is intrinsic uncertainty. Even in repaving a road, typically the bidding takes place several months before contract execution, and what the weather condition, what the cost condition will be at the time of the execution of the contract, cannot be known for certainty by the firms at the time of bidding. Second, coupled with this intrinsic uncertainty with contract procurement, there is typically a difficulty to verify ex-post performance and to eventually enforce penalty in all those cases where things have not followed the original contract specification. This is a feature that makes contract procurement very different from the type of auction markets that the economics literature has extensively analysed, and for which a lot of important results have been established. For instance, if the auction entails a transaction that will clear right after the auction, think about the auction for a painting, in which individuals or firms bid, but then the transaction clears immediately, then the kind of problems and the kind of solution are extremely different, relative to those of contract procurement, and in particular, in contract procurement, this issue of the ex-post life of the contracts becomes crucial, and makes competition - which is the typical tool that we see as being so important and so effective in auction - a double-edged sword. Things can go pretty bad if competition is pushed and exacerbated in an environment with cost uncertainty and difficulty to verify performance, ex-post, because firms that are unreliable are willing to offer a low price at the time of the auction, might not perform as they should afterwards.So what does the private sector do in the face of this? Well, a series of things. It can require financial guarantees, like bonding, letters of credit, and it can embed the decision maker to use some form of discretion in selecting bidders. So discretion in the form of contract, or awarding method, negotiations vs auction, or also - and this is typically the case - discretion in the use of past performance. Just think of a very simple example: when you’re renovating your apartment, the past performance of the firm that work with will certainly play a key role in your choice, and this is widespread in the private sector. Now, what is remarkable about public procurement, and especially European public procurement, is that the use of past performance is strictly limited. To be more precise, until very recently, until the latest round of European directives, the use of past performance was strictly forbidden in Europe. And this is peculiar, not just because it makes the public sector so different, relative to the private sector, and potentially it limits a great tool to prevent the problems that I was mentioning at the beginning, of poor performance, but also because it puts the European system at odds with the US public procurement system. In the US, in a nutshell, since 1994, there was a major reform of the Federal Acquisition Regulation, that put past performance of contractor at the heart of the system for selecting suppliers in federal procurement, and the main idea was exactly that of mimicking the good practices of private sector. Now, Europe is gradually moving towards something similar, but very, very slowly, and we are still far away. So what I want to study with this piece of research that I am now conducting is to what extent this reform tried by the US, and other possible reforms, based on the role of past performance in public procurement, can be an effective way to combine improvements in performance together with, still, the objective of limiting prices. And in particular, what I wanted to understand, and study with this research, is how to combine the use of past performance within system of awardings based still on auctions, on transparent auctions, and in particular, how to change from price only auctions, or scoring rule auctions, that do not include reputation, to price plus reputation auctions. So scoring rule auctions that included reputation. So how to measure reputation and how to include reputation into the scoring rule, and then quantify how this matter, how this approach could impact both the performance delivered and the cost of this potential improved performance. So this was the key idea of this piece of research, and the implementation of it is something that is still ongoing, but I have some preliminary results that, if you are interested, that I am happy to discuss.And we will do that in a minute. Before we get to that, I would like to go back to something that you said about taking into account past performance being strictly limited. Yes, and no. It’s true that you cannot, in EU procurement, use past performance to assess the quality of a tender. You can use it, however, to assess the quality of a tenderer in a previous moment to the actual bidding. So, for example, if you have a restricted procedure, if you use a restricted procedure, you can use, and you can allocate significant points, number of points, to the performance of the economic operators coming to the auction, or coming to the procedure. With the open procedure, it’s a little bit more complex, especially now with the changes that have been introduced, but it can also be done in a certain way. So, from my perspective, and obviously I’m coming from a legal background, so from my perspective, what you’re suggesting could fit within the current rules, and the current rules exist for a very good reason, or a very reasonable reason, at least, which is to ensure equal access to the markets, not only to companies with a huge trading history, but also to companies that do not have a lot of trading history with the public sector. So that’s why you have this clear separation, and this clear rule based on the principle of equality, to make sure that companies or that tenders, at the tender stage, are analysed on as much of an equal ground as possible.I have two answers. One is about what the current rules say, but the second is even more important, because you have mentioned what I think is really the greatest departure in the view between economists and legal scholars. So let’s jump absolutely into this, and great that you asked. Why you said, essentially, that the rule to limit the use of past performance is there for a good reason? Because you want to keep an open market. Now, this is absolutely, absolutely at odds with how economists see the problem. Why? Don’t we care about open market and new firms and preferential treatment? Of course we do, but the issue is that you are sort of tying the hands of these public administration in a way that is not realistic. In a sense, whenever you are specifying how past performance shall be used in a contract, you must also specify how firms with little or no reputation must be treated. Now, the fact that you are using a system that is based on reputation does not necessarily mean that you are going to say, “We are going to use past performance for those who have, and for those that they don’t have it, they cannot enter the auction.” You can say something completely different. You can say, “We are going to use past performance for the firms that have a past performance, and for those that don’t have it, we are going to give the maximum points, or the minimum points, or the average points, or points estimated in a certain way.” This is what we call a design issue. It’s completely in the hands of the designer., You can think of the designer as whoever writes the law, the rules of the game. So, what happens to firms with no reputation, to new entrants, to firms that also have, maybe, little reputation, is the result of a designer’s choice. And so it’s something that can be optimised and tailored to the market. The most important thing, the only message that I want to communicate is that you don’t have to see that there is a necessary block created for new firms from the use of past reputation, because it’s fully a designer choice, what happens to new firms. So tell me if this sounds convincing to you or not, because this is really something which seems to be misunderstood in many discussions about past performance, like those on the potential implementation of a reputation system in the European Directives, and I’ve seen this in the debate around Article 57.Yes. In which the European Directives 24 2014 has introduced some use of past performance, along the lines you were mentioning at the beginning of your remark, and I see that the point that you mentioned, the criticism that you mentioned, was really prominent there. And tell me if I manage to be clear or not, because this is a key point. It’s really a designer’s issue. So things should be decoupled. We should first decide if we want to use past performance, because, if we think it’s important. Then we can argue, “What’s the best way to treat new firms?”I gave you the opinion, the general opinion from legal scholars, and why the rules are why they are. In my opinion, as time goes on, I think that you are on the right track in the sense that there is a lack of reputation being actually taken into account in a good way. That doesn’t mean that it’s quite easy to do within the logic of the system, which is to ensure that both new entrants, and older entrants, are not discriminated against, because even with the design, and yes, it’s a design issue, even with the design, it may be very difficult, in practice, to actually making sure that the compensation given to the new firms actually does not create arbitrage, because if it makes life a lot easier for new entrants, then what’s going to happen is that the existing companies, or existing economic operators, will create shell companies to actually be as fresh entrants into the market.Absolutely.There’s a risk then if you think about how the system works in general, and I’ve mentioned this in previous podcasts, the public procurement rules in Europe exist not to enable great procurement. They exist to avoid really, really bad procurement. So avoiding corruption, avoiding making stupid mistakes, those are two of the key objectives of procurement, not to be economically efficient, because if you’re designing a system to be economically efficient in terms of public procurement, we might end up with something very different from what we have now. So my perspective, and my personal view, is that yes, we should be moving towards a system where reputation is taken into account. So, about a year, or two years ago, I remember writing a blog post suggesting that perhaps we needed something like the eBay ratings system, or Uber, where both parties of a transaction, at the end of a transaction, are compelled to provide feedback on the counterparty, on some sort of exchange that is public, and that anyone can consult, and you end up with a registry of reputation for both the contracting authority and the supplier. So we actually address the reputation issue from both ends. I haven’t written anything more specific about it, but that was something that I was thinking about, because even for a supplier, it’s important to know how reliable the contracting authority is, because…Let me tell you a story, if you want, exactly on this. So in Italy, following this directive, and the implementation of Article 57, in the Italian Public Procurement Code, there has been a lot of debate, and essentially the authority in charge of super…
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