Tuesday, 22 September 2009

What's wrong with cover pricing?

The OFT has just fined a bunch of building companies £129 million for "cover pricing", which is described as "the practice of submitting an artificially high bid for a contract which you do not intend to win".

But, I thought, companies do that all the time. If a client comes to me with a project that I don't want to do for £20k, I may well be willing to do it for £50k. So I put in £50k, fully expecting not to win, but if I do, then great.

Hearing the vague explanation on the BBC this morning, I figured there must be something more to it. This article from Contract Journal explains it better.

The issue is not actually the high prices as such. It's the fact that there's collusion between suppliers, ensuring there is no real competition for the tender. As CJ says:
What is cover pricing?
Cover pricing is when a contractor bids for a job with no intention of winning the tender.

For example, Company A has been invited to tender by a client, but for various reasons, it has no interest in winning this particular job. However, Company A wants to stay in favour with this client, and stay on its tender list.

So, Company A contacts Company B, which is also bidding for the job, and asks for a 'cover price'. Company B supplies Company A with a price roughly 5%-10% higher than its own bid. Company A supplies this price to the client as its own, safe in the knowledge it will not win. Company B is happy with the arrangement as it has not given away knowledge of its actual bid.

Why is cover pricing illegal?
The process of putting in an artificially high bid is not a breach of competition law - however, the brief conversation between two bidders which confirms it is sufficiently high not to win is an infringement.
So - collusion is anticompetitive and illegal - no quibbles on that.

But this still allows for some uncomfortable scenarios. What if Multicorp contacts Joe's Builders as a potential subcontractor on the job? Multicorp may genuinely wish to put the whole job out to Joe, and add a 5-10% margin for profit. It may not be aware that Joe is also bidding directly. Joe happily tells Multicorp his (objectively determined) price for the job, Multicorp adds a margin and bids, and Joe also bids to the end client at the same price he quoted Multicorp.

Now most tenders do contain a clause forbidding companies from both bidding directly and also being a subcontractor to another bidder, which is presumably designed to stop this happening. But it does rely on Joe and Multicorp being willing to share information on who the client is. In a more commoditised, less transparent market, Multicorp might well ask Joe for a quote without giving full details of the project or the client. In this case, the bidders might inadvertently be colluding - with exactly the same effect on competition and on the price paid by the client - but be completely unaware of it.

I believe that client procurement procedures are partly to blame for this practice. This doesn't excuse collusion, but the customer is partly in control of this situation.

A friend points out that one reason for clients to request a tender is because they don't know an accurate market price for the job. In this case, they are relying on suppliers giving an honest answer as part of their price discovery process.

While I can see the logic of this argument, it seems to show a naive faith in market liquidity. There are any number of reasons apart from collusion why this process might fail to produce a representative or indeed low price. Bidding costs, lack of understanding of the project, fluctuations in resource availability affecting the supply curve, uncertain risk (and the market for lemons), the incentive to underprice the core project and overcharge for variations - there are many reasons why competitive tenders may not work.

And why should clients expect suppliers to provide them with free market intelligence? Unfortunately many clients will use a new supplier as a stalking horse - to get leverage in a negotiation with an existing supplier, having no intention of switching. Suppliers know this, and are wary of spending a lot of time on a bid which they have little chance of winning. Therefore, a bidder is likely to include a high contingency element unless they have confidence that there is a reasonable chance of winning.

At the heart of this problem seems to be the dysfunctional practice of requiring suppliers to bid for every contract in order to stay on the list for the next opportunity. Surely if a supplier is not interested in a project they should be able to opt out without penalty?

And on the other side, surely suppliers who don't want a contract should just increase the price until they do want it. Never mind talking to your competitors - just give whatever figure will make it profitable and attractive for you. If that happens to be the lowest bid, then lucky you - you have won a project you didn't expect, at a price you're happy with.

If, on the other hand, you are sharing information with competitors because you don't trust your own ability to set the correct price - that is, if you're worried about winner's curse - then perhaps you shouldn't be in the industry in the first place.

Again, the illusion of efficient markets and rationality misleads market participants into suboptimal behaviour. To operate effectively, both clients and suppliers need to take into account the cost of acquiring information and the uncertain nature of the service to be delivered.

1 comment:

Anonymous said...

Well said,

Rather than throwing around accusations of price fixing, I think a little more attention paid to the quality of specification writing and procurement documentation would realise greater savings for the tax payer.

I've worked as a contractor to public services for fourteen years and I am frequently appauled at the rubbish that gets turned out by the public sector as so called tender documentation.

Most specifications are so ambiguous I would be amazed if the procurement department responsible could make any serious comparison between bids received, regardless of any slightly inflated 'cover bidding'taking place.

Collusion is one thing but by submitting the occassional 'unlikely' tender, all the contractor guys are doing is trying to keep a healthy sales pipeline open in the eyes of their investors. Its also bad form to drop out of a tender process at a late stage, even if you have more attractive business on the table or have been put off by dubious tender documentation.

The public sector should stop issuing fines and throwing dirt around about contractors and get its own house in order.

Anon