The majority of capital spending by Australian governments and government business enterprises uses traditional procurement, a tender-based procurement method based on a comprehensive input specification and an adversarial contractual framework. Traditional procurement incorporates all or several of the following features:
• A tender evaluation process weighted in favour of lowest procurement cost
• A project specification issued by government agencies and their advisers that provides a definitive requirement of the goods and services to be supplied by the contractor. In the case of buildings, this will generally refer to the design, the method of construction, the finishes and equipment levels.
• The procurement will be required to comply with standard state procurement policies and protocols
• An adversarial contractual framework
• Separation of the design, project management and construction tasks.
In practice, traditional procurement raises several problems, which are more acute with large-scale infrastructure projects.
The first problem concerns the alignment of incentives between state agencies and the contractor with the latter having much to gain from an incomplete specification and variations to the contract or changes to the specification, which may involve additional works. Traditional construction contracts are designed to transfer construction risk to the contractor in an adversarial setting. In the event of variations to the contract, which are not uncommon with large and complex projects, the contractor is incentivised to maximise its margins and expand the scope of the contract. However, the principal's objective is to minimise variations and ensure that the project is delivered on time and within budget. These are competing objectives and incentives, and frequently result in protracted and costly negotiations following completion of the works. The sub-optimal alignment of incentives contributes to sub-optimal procurement outcomes.7
A further factor here is the incomplete nature of long-term construction and management contracts, that is, parties understand that not all of the terms of the contract were agreed at financial close. Incomplete contracts contain mechanisms for dealing with changed circumstances and future events. For example, a long-term road maintenance contract may contain a formula designed to reset financial terms in the event of upgrading of the road or road networks, road closures, increased wear and tear or the construction of new alternative roads. Incomplete contracts, in practice, create information asymmetries that may place greater bargaining advantage with one or other of the parties.8
The second concerns the serviceability of assets. The procurement cost for most fixed assets is a small component of lifecycle operating costs.9 For a standard commercial office building over a 20 year operational life, the ratio of lifecycle to procurement cost (in nominal terms) is in the range 4.5 to 5:1. For complex economic infrastructures such as information and communications technology, dedicated industrial plant and public transport systems, the ratio can be within the range 7:1 and 12:1. For social infrastructure projects such as public hospitals, it may be as high as 32.4:1.10
The third concerns the reduced scope for new technology and, design and construction innovation in an adversarial contract setting. Neither party to the contract is incentivised or rewarded for innovation because the scope of works is narrowly defined within a comprehensive input specification or design and construction is awarded to different contractors. The contractor bids with a one-dimensional view of the construction task and that is to meet the specification at lowest cost. The focus of the contractor's innovation or new technology is to reduce its costs and maximise margins.11
Recent evidence suggests that an output specification (under which the contractor assumes responsibility for design and method of construction), collaborative contractual environments and early consultation with building contractors and facility managers in the design stages of the project, offers greater opportunity to improve innovation and new technology and improve long-term service outcomes. This is particularly important when a contractor assumes lifecycle asset management and costing risk. These approaches, which are building blocks of the PPP procurement model, create an incentive for the contractor to build quality assets designed specifically to deliver services over long service intervals.
Traditional contracts limit the opportunities for private bidders to compete with design and construction innovation or introduce new technologies that may achieve longer and lower-cost service life or improved user and service delivery benefits. The adversarial contractual framework produces a litigious context with disputes over the scope of the contract, rework and variations continuing well past the completion date. This is costly and contributes to low productivity at the industry level. Around 90% of major project procurement in Australia including major plant purchases, construction and civil works is delivered by traditional procurement. Periodic reviews of traditional procurement performance identify systemic problems with post-completion contract disputes, cost and time overruns.12
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7 NAO 2001, 2003a.
8 The theory of incomplete contracts also contemplates other variation mechanisms such as embedded and real options (Rose 1998; De Bettignies and Ross 2009).
9 Lifecycle cost includes real depreciation, capital expenditures for building rehabilitation, repairs and maintenance, and the cost of utilities and services.
10 NAO 2005. The multiple reduces in net present value terms (NAO 2002; OGC 1998).
11 There are numerous compliance audits and performance reviews of state government agencies by their respective audit offices that identify inadequacies: Auditor General of New South Wales 2005; Auditor General of South Australia 2007.
12 NAO 2001, 2003b.