Practical Law

With the recent collapse of the last pillars holding Carillion’s crumbling edifice upright, the usual cries of “how did this happen” have started to echo across the national press.

One suggestion is that Carillion may have been guilty of under-pricing jobs to win work and fill its pipeline. Having had no real dealings with Carillion I would not want to speculate on the cause of its woes. However, deliberate under-pricing does represent something of a systemic issue in the industry, particularly in the public sector and in utilities where procurement regulations apply.

The procurement regulations are designed to ensure that work is placed through an open and competitive market. In an efficient market, economists tell us, the price should be right. If so, how do we end up with a situation where systemic under-pricing is a “thing”?

Filling the pipeline

The story has two sides, but is simple.

A contractor needs a healthy pipeline of contracts to stay afloat, cover its overheads and make a profit. To win work it needs to put in the best tender. Unless it can put forward a demonstrably better technical offering than its competitors, that often boils down to being cheaper and accepting more risk. This puts strong pressure on prices and risk transfer, particularly in lean years where contractors are fighting over scraps.

The employer wants good value. At a basic level this means a low contract price and the allocation of as much risk as possible to the contractor. The tender assessment criteria will therefore usually be structured on a most economically advantageous tender (MEAT) basis. All else being equal, the employer will end up rewarding under-pricing by giving the contract to the most aggressively priced bid. After all, all the contractors bidding have established capability during pre-qualification.

At this point everyone is happy. The contractor’s sales team get their bonuses for hitting their targets and the employer’s procurement team get a pat on the back for bringing in the contract on budget. Roll the clock forward two years and everything still looks hunky dory; we are halfway to the date for completion, the contractor’s programme is showing slippage but still on track for a timely completion and the value of work done is in line with the planned spend curve. True, the variation account is starting to fill with contractor claims which are either rejected or have yet to be properly substantiated, but this is not unusual. Perhaps it is safe to start booking some of the expected profits?

However, roll forward another year and the story changes. The contractor’s optimism about being able to recover from the earlier delays is proving misplaced, defects are starting to emerge and the performance guarantees are looking rather challenging. With a weariness, the contractor sharpens his pencil and starts putting claims together.

Unfortunately the project manager’s job is to assess claims in accordance with the contract. Because the contractor was optimistic about productivity to achieve that low price and accepted more risk than perhaps it wanted to, and then compounded this by under-pricing that risk, some claims may not stand up to proper examination. However the claims must go in, perhaps in part to avoid awkward questions about whether those profits booked last year might need to be written down.

When contracts meet the real world

In theory, an under-priced contract should be a good outcome for the employer – if the contractor is making a loss then the employer must have got a good deal. However for the employer, this is not a zero sum game. Contracting with a loss-making contractor is not fun.

Attention is diverted from delivering the contract. The contractor may deny the existence of defects and refuse to rectify them without a variation. Where compensation events exist, the consequential works will go slowly enough to ensure that the event remains on the critical path. In one case, a contractor threatened to deliberately cause an environmental incident if the employer did not agree to accept a defect.

From the employer’s perspective, there are only three options in this situation:

• Stick to its guns and hope that the contractor will eventually finish the job.
• Terminate the contract.
• Cave in and pay the contractor enough to get it to the end of the job.

The easiest option is usually to just pay up. Whilst it may stick in a lawyer’s craw to pay out against unmeritorious claims, if the additional monies just bring us back to what the contractor should have bid had it priced the job properly, then the employer is not really taking a loss. I have come across at least one example when a post-completion review showed that, even with generous concessions to the contractor, the out-turn price was not far from the median bid price.

This in turn leads to an expectation within contractors that employers will ‘take a reasonable line’ in applying (or rather, not applying) the contract, and shelter contractors from losses. This encourages under-pricing, as bidders have an expectation that the employer will see them right in the end. This ends up being self-perpetuating provided that the employer can find the money. Faced with an austerity-hit public authority employer, this model can rapidly run off the rails.

Whilst admittedly being anecdotal at best, my experience is that under-pricing tends to be endemic in areas, such as the provision of business critical services, where contractor leverage is greatest.

Breaking the cycle?

Getting out of this cycle is surprisingly difficult. Individually contractors can perhaps look to the incentivisation of their sales teams, keep a good link between delivery and pricing teams to keep pricing realistic. On a more strategic level, contractors need to avoid the temptation to chase revenue and accept a smaller, but higher quality pipeline. The problem here is policing this – as I mention earlier, it can be years before under-pricing becomes apparent.

Collectively, there is very little that contractors can do without breaching competition law.

Surprisingly, this is not something that employers can readily fix either. There is scope under the procurement regulations to exclude abnormally low bids, but doing so is inherently risky and could invite claims under the procurement regulations from frustrated bidders (who are usually also the highest scoring bidders). Even if objective rules are applied to exclude outlying bids, this cannot deal with systemic under-bidding.

Employers can modify behaviours by discouraging their procurement teams from talking prices down and instead focus on challenging the sustainability of bids (which may involve talking prices up). Where the employer’s QS has set an appropriate budget, giving an indicative bid price, questions should be asked if a bid comes in at a much lower price.

Scoring criteria can also be weighted less towards price, with more focus on matters like behavioural assessment. However, there is no magic set of assessment criteria that will ensure that the contract goes to the lowest sustainable bidder and employers may find themselves with little choice but to award contracts to bidders that they are convinced have mispriced their bid. In view of what has happened to Carillion and its knock on effects on the industry, employers need to consider whether accepting the lowest bid is ultimately sustainable.