10 December 2018

Interserve is the latest Government contractor to run into trouble. The Government must fix the way it manages the outsourcing market, says Tom Sasse.

Interserve – one of government’s largest contractors, which works in prisons, schools and hospitals – is in talks with lenders in efforts to avoid collapse. It is unclear if it will survive. This comes on the heels of Carillion’s collapse earlier this year. 

The Cabinet Office must deal with the crisis immediately before it gets worse

Labour has called for Interserve to be temporarily banned from bidding for any more contracts. Given Interserve’s balance sheet, and the fact that it relies on government for 70% of its revenue, that might spell the end for the company.

If Interserve does collapse, how will government mitigate the impact on people’s jobs and disruption to vital services, while protecting taxpayers? Interserve is the largest provider of probation and offender rehabilitation services in England and Wales, with a contract to supervise 40,000 offenders for the Ministry of Justice.

After Carillion, companies including Interserve have been piloting ‘living wills’ – lining up other suppliers to take on contracts like these in the event of collapse. But it is unclear if Interserve will have had enough time to complete its plans.

These problems show why it is urgent that all of government’s major suppliers have living wills. In Carillion’s case the Government stepped in and almost all the company’s services continued without interruption, but at a cost of £148 million to the taxpayer.

The Government must do more than simply manage the crisis

The Cabinet Office’s response to Carillion has focussed on how to manage the immediate fallout when contractors collapse.

But Carillion and Interserve are not simply one-off problems with individual companies. They are indicative of fundamental issues with government’s stewardship of the outsourcing market. Government is failing to create a healthy, competitive market for the services it contracts.

In recent years, the profit private providers are making on contracts have fallen significantly, while the risks for companies when contracts fail remain high. Interserve’s profits on running probation and cleaning services fell from 3.1% in 2013 to minus 0.4% last month. Other companies have spoken publicly about being tied into long-term contracts that are heavily loss-making, such as Serco’s contract for looking after asylum seekers.

As profits decline, companies are forced to chase more work. An investigation by the FT last week found that some of the Government’s largest outsourcers – including Interserve, Serco, Capita and Mitie – have “bankrupt” business models and “worryingly weak balance sheets”, which rely heavily on the promise of winning future contracts. As with Carillion before its collapse, this leaves little to fall back on should the flow of cash dry up.

The Government is not only left with a volatile sector that is vulnerable to suppliers collapsing, it is also failing to ensure competition – the rationale for outsourcing work in the first place.

Major companies are not bidding for contracts because they look too risky

In May, the Scottish Government awarded an eight-year contract for escorting prisoners in Scotland worth £238 million to the only bidder after G4S and Serco, which both have experience running similar contracts, pulled out.

The Government urgently needs to conduct a review of the state of its procurement markets. As a forthcoming Institute for Government report finds, the Government’s largest suppliers are winning more and more business.

Last year, roughly a fifth of all central government procurement spending was spent with ‘strategic suppliers’ – up from around an eighth in 2013. But several – including Interserve – have been hit with financial difficulties and the outsourcing market continues to show signs of serious distress.

If government doesn’t fix the problems that are causing companies to run into trouble in the first place, it will only be faced with further crises as more contractors hit the rocks. 

Further information

On 13 December we will launch our new report Government procurement: the scale and nature of contracting in the UK.

Comments

Outsourcing of public services is not the only aspect of public procurement where the government has failed to create a healthy, competitive market. The same is also true for the market in defence equipment. In fact, it is the ill-considered policies of previous governments, including that of Tony Blair, that exacerbated the problem of concentration in the UK economy.

The dominance of just a handful of manufacturers, the Select Few, has been a distinctive feature of the defence equipment market for as long as anyone can remember.

Unlike the market in consumer goods and services, there is only one customer for defence equipment – the government. Consequently, the purchasing decisions taken by the government has a significant bearing upon the composition and diversity of players in the defence equipment market. And because taxpayers money is used by the government to procure military equipment for the Armed Forces, the condition of the defence equipment market should be of concern to anyone who has an interest in the proper functioning of open and free markets, and in securing best value for money, as it relates to the expenditure of public funds.

Nowhere is the market in defence goods more concentrated than in the naval shipbuilding sector, as exemplified by the number of bidders who entered the competition to build the Type 31e general purpose frigates for the Royal Navy. It is the first time that a contract for combat ships has been competed openly on a global basis, to identify the bidder that will construct the five Type 31e frigates. Hitherto, the contractor to receive such a single-source design and build contract has always been selected on a preferential basis (from the Select Few) – by successive generations of people in the pay of the State who have a poor understanding of how free markets work, not least, because they have not spent a single day of their lives in the private sector.

The consequence of this misguided attempt at shaping the shipbuilding industry has been an unmitigated disaster. Only three industry teams have responded to the (second) announcement to submit an expression of interest for consideration by the procuring authority, the Ministry of Defence – this, after the government went out of its way to relax the demanding technical specification requirements incorporating stringent naval standards, specifically to attract commercial shipyards. A minimum of seven bidders are required to run the winner-takes-all competition efficiently. See this illustration pic.twitter.com/RUToAZ6thx.

It may be that foreign companies do not believe the government’s word when it says that it will run a genuinely fair competition open to all-comers, including offshore yards – only to then surreptitiously favour domestic contractors, as has happened so often in the past.

For an island nation with a long tradition in naval shipbuilding going back centuries, such an outcome is a huge disappointment and it leads one to conclude that there is a serious lack of competitiveness in the naval shipbuilding sector. It is the number of bidders entering a competition that determines how competitive a product market is – the higher the count, the healthier and more vibrant the market, and the keener the desire on the part of contestants to win the contract.

This dire situation has come about because successive governments, going back decades, have sought to protect domestic equipment manufacturers from being exposed to the full rigours of the free market, that is to say, shield them from ‘feeling the heat’ of competitive market forces – which has, in itself, led to this market concentration.

The creation of the monolithic entity called BAE Systems which dominates the defence equipment market today – from the acquisition of various business units of Marconi Electronic Systems in 1999 with the tacit acquiescence of the Blair government, without referring the merger to the then Competition Commission – further reduced the number of independent participants in the market.

BAE Systems then went on to use this dominant market position to stifle competition and coerce the Brown government into signing a 15-year Terms of Business Agreement in secret which, in effect, hands out a series of cost-plus, naval shipbuilding contracts worth £3,450 million up to 2024. In so doing, future governments have been denied freedom of manoeuvre in the management of public finances.

What’s more, in common with concentration elsewhere in the UK economy, the defence equipment market monopolised by the usual suspects is plagued by excessive mark-ups, insignificant investment in innovation, R&D and product development and persistently low wages for the vast majority of its workers.
@JagPatel3

Thanks Jag - interesting to make comparison with defence procurement, especially when procurement process and aim to get competition hits up against other objectives (domestic defence policy etc.). I think will provide useful lessons as govt increasingly finds itself with shrinking number of suitable bidders in services / other sectors. Would be interested in hearing more about procurement process itself in Defence sector too. Will DM you.

Cheers

Tom