Disincentivising overbidding for toll road concessions

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DISINCENTIVISING OVERBIDDING FOR TOLL ROAD CONCESSIONS In the context of cost-side bias, Flyvbjerg and COWI (2004) recommended that the UK DfT use optimism uplifts based on empirical evidence from reference classes in the tendering process. For road projects, a reference class of 172 road projects was applied (of which 128 were in Britain). The size of the uplift was determined with reference to these comparator projects and as a decreasing function of the willingness of the DfT to accept risk. Typically, the DfT looks to ensure that the risk of cost overrun is less than 20%. For the construction of roads, this results in an uplift on forecast costs of 32%. The potential for reference class forecasting has been reflected in HM Treasury’s Green Book since 2003: There is a demonstrated, systematic, tendency for project appraisers to be overly optimistic. To redress this tendency appraisers should make explicit, empirically based adjustments to the estimates of a project’s costs, benefits, and duration...it is recommended that these adjustments be based on data from past projects or similar projects elsewhere. 71 Optimism bias uplifts have since been used in numerous transport infrastructure projects in the UK, including the Crossrail project in London and the Edinburgh Trams Line 2 proposal (where an uplift of £145m was given to the forecast). 72 The reference class forecasting model has also been endorsed by the American Planning Association (APA): APA encourages planners to use reference class forecasting in addition to traditional methods as a way to improve accuracy. The reference class forecasting method is beneficial for non-routine projects such as stadiums, museums, exhibit centers, and other local one-off projects. Planners should never rely solely on civil engineering technology as a way to generate project forecasts. 73 The benefits of reference class forecasting are likely to be greater in situations where bias is a result of optimism rather than strategic behaviour. Moreover, the Edinburgh trams example highlights that, even after adjustments are applied, forecasts can still vary widely from outturn costs or patronage. 74 In the case of the toll roads sector, which is still in the early stages of its life cycle, there may be difficulties in determining a suitable reference class for comparison. Menu-based appraisal This section briefly introduces the notion of appraising bids on the basis of a ‘menu’ of options. The idea behind menu-based appraisal, explained in more detail in a case study in section 4, is to elicit truthful revelation of costs by presenting bidders with a choice of options. The motivation for this approach can be considered by exploring the notion of an incentive, and of ‘incentive compatibility’. One of the problems with the current procurement process in the toll roads sector is that bid appraisal effectively comes down to who offers the highest upfront premium. As such, truthful revelation of patronage estimates is not incentive-compatible—that is, bidding consortia have incentives to provide high estimates rather than accurate ones. Box 2.4 Identifying and defining an incentive In everyday language, an incentive is a factor that encourages and motivates someone to follow a particular course of action; any decision that individuals (or companies) make consists of weighing different options and picking the one that yields the highest benefit. The decision process of firms therefore involves comparing the benefits associated with different actions (at the same time, any project is compared with the firm’s outside option; namely, not to take any new action). This concept is captured by the incentive-compatibility constraint, which means that actions will not be undertaken where they do not result in net benefits to the party undertaking the action. 71 HM Treasury (2003), ‘Supplementary Green Book Guidance – Optimism Bias’. 72 See, for example, Ove Arup & Partners Scotland (2004), ‘Scottish parliament, Edinburgh tram line 2 review of business case’; Flyvbjerg, B (2006), ‘From Nobel Prize to Project Management: Getting Risks Right’, Project Management Journal, 37:3, 5–15. 73 American Planning Association (2005), ‘APA article calls on planners to help end inaccuracies in public project revenue forecasting’, cited in Flyvbjerg (2008), op. cit. 74 The project has been subject to significant time and cost overruns after a contractual dispute between Transport Initiatives Edinburgh and the Bilfinger Berger Siemens consortium that was tasked with delivering the project. See, for example, Audit Scotland (2011), ‘Edinburgh trams – interim report’, prepared for the Auditor General for Scotland and the Accounts Commission, February 2nd. 26
2 │ LITERATURE REVIEW In this instance the incentive-compatibility problem stems from there being an ex ante information asymmetry between the public sector (procurer) and the bidding consortia, since the latter are likely to have a better understanding of how accurate their demand forecast is and what outturn volumes will actually be. Similar considerations play out in the field of regulation, where companies, which have a better understanding of their costs than the regulator does, may have an incentive ‘to game’ the regulatory body by submitting business plans that overstate the amount of capital expenditure (CAPEX) they expect to incur over the period for which prices are set. However, Laffont and Tirole (1993) showed that, if the choice of regulatory contracts is welldesigned, the use of a ‘menu’ of options, from which the company is allowed to choose its preferred option, should automatically lead the company to reveal its scope for cost reductions. 75 This acts as a truth-revelation mechanism, since, provided that the menu is well-designed, the company will choose the option that is in its best interest. An example of how such a mechanism has been applied in utilities regulation in the UK is given in section 4.3. 2.3.5 Post-contract award Unless companies feel that their bids represent an actual commitment to deliver the stated outcomes once the contract has been awarded, they may have an incentive to push up their bids, on the basis that they can later be revised down. Ensuring that the government has a credible commitment not to renegotiate could thus provide another way of reducing the incentives to overbid in some jurisdictions; although, as noted previously, this is not likely to be applicable in Australia, where the state governments have already established a track record of not renegotiating contracts. 2.3.6 Discussion The literature has identified a number of potential mechanisms for overcoming or reducing the problem of overbidding. These potential solutions apply to distinct stages of the concessions process, but it is important that consideration is also given to incentive compatibility across the procurement process as a whole. Some of the potential solutions highlighted in this section are strongly founded on theoretical rather than practical applications. Best-practice principles, which build on insight from international precedent and interviews, are presented in section 5 of this report. 2.4 Summary The review of the literature has highlighted several potential explanations for overbidding in the tendering process for concessions. These include: •• strategic behaviour by agents in both the public and private sector; •• a misalignment of incentives within bidding consortia; •• the criteria for bid appraisal; •• a natural, systemic tendency to make forecasts that are optimistically biased; •• a belief that the terms of the contract are subject to renegotiation; •• a winner’s curse arising from the auction of concessions with a common value; and •• technical error, which causes overbidding in the short term but should correct itself as the industry evolves. These are summarised, alongside potential solutions, in Table 2.3. Ultimately, the evidence would seem to suggest that the overbidding is not the result of simple error. 76 Flyvbjerg et al. (2002, 2005) prefer an explanation based on the strategic behaviour of bidders, who make deceptive bids for reasons other than (short-term) financial gain. 77 It has been argued in this section that bidding should not be seen as intentionally deceptive, and instead represents profit maximising behaviour as determined by the incentives inherent to each of the stages of the procurement process. 75 Laffont, J.J. and Tirole, J. (1993), A Theory of Incentives in Procurement and Regulation, Cambridge, MA: MIT Press 76 Since Flyvbjerg et al. (2002) and Bain (2009) find that the mean of the distribution of errors in their sample of transportation projects is significantly different from zero. See Flyvbjerg et al. (2002), op. cit.; Bain (2009), op. cit. 77 Flyvbjerg et al. (2002), op. cit.; Flyvbjerg et al (2005), op. cit. 27
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