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1 February 2018updated 08 Aug 2021 3:27am

The problem with outsourcing is not Carillion but the market itself

The share price of Capita, another outsourcing firm, dropped by 45 per cent on Tuesday morning. 

By Grace Blakeley

In the wake of the collapse of Carillion, Capita’s profit warning has investors spooked. The firm’s share price tumbled 45 per cent on Tuesday morning, while other firms also serving the public sector also took a hit: Serco’s share price was down 4 per cent, Interserve’s 2 per cent, and Kier’s 1 per cent. In the absence of a government bailout for Carillion, and with many commentators predicting the end of outsourcing, this could have been expected. Capita has been awarded ten times as many public sector contracts than Carillion over the last two years.

Some argue this comparison between the two firms is unfair. Unlike Carillion, Capita has responded well to the deterioration of its financial position. After results that were declared “disappointing”, the firm opted to freeze salaries in 2016-17, suspended bonuses, and maintained dividend payouts at 2015-16 levels. The new chief executive identified a number of problems with the firm’s operating model, claiming that the company had become “too complex”, increasingly short-termist, and lacking in “operational discipline”. In response, he has issued this profit warning, suspended the company’s dividends, and attempted to seek out £700m worth of new equity.

Indeed, the contrast with Carillion is fairly stark. As Carillion’s financial situation deteriorated, its debts mounted, and its pension fund deficit skyrocketed, the directors continued paying themselves huge salaries, kept their bonuses, and increased their dividend payouts. The firm’s annual report read like a piece of Orwellian newspeak, saying “[o]ur business continues to benefit from strong positions in our chosen markets, and we believe that the long-term fundamentals for these markets remain sound”. By the time the firm issued its third profit warning, its finance director had fled the scene, its debts far outweighed its assets, and it held just £29m in cash.

Carillion’s strategy for dealing with a recent slowdown in the market for public contracts appears to have been to conceal its cash flow problems by underbidding other firms to win contracts at undeliverable prices. Some analysts believe this race to the bottom on price impacted the profitability of other firms with which it was in competition, sending the market spiralling. The removal of the implicit subsidy enjoyed by these firms when the government refused to bail Carillion out didn’t help matters. Whether or not Capita is able to find investors willing to take up the £700m of new equities it plans to issue could have implications for the whole UK outsourcing market.

The speed with which the Carillion contagion has spread says a great deal about the nature of the outsourcing market in the UK. Carillion was in many ways a unique example of appalling management, but the problem with outsourcing is not a problem with any one particular firm, it is a problem with the market itself. A market which is created by the government.

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Outsourcing was originally introduced as a way to transfer risk from the public to the private sector, ensuring that competition and the profit motive drove down costs, delivering savings for the taxpayer. Unfortunately, and perhaps predictably, it hasn’t worked out this way. Private finance initiative (PFI) contracts – a form of outsourcing in which the private sector raises the capital for a project – have proved particularly expensive. The National Audit Office recently revealed that some PFI contracts are costing the public 40 per cent more than would have been the case had public money been used directly. Over the next several decades, over £200bn of taxpayers’ money will be channelled straight into the pockets of companies like Carillion and Capita.

These high costs are driven by two main factors. Firstly, government borrowing is generally cheaper than private borrowing, because governments are much less likely to default than private companies. Additionally, the loose monetary policy seen since the financial crisis has brought the cost of government borrowing down to historic lows. In this context, the only reason to finance something privately is to pretend that the private finance is kept off the government’s books, making it look like the public sector is less indebted than it actually is.

But there is another, arguably more important reason why PFI has proven so expensive: a lack of competition. The state currently invites companies to bid for contracts and awards them to whichever contractor is able to deliver the project most cheaply. This encourages the emergence of huge conglomerates that gain a cost advantage from operating at such a large scale. Recently, these firms have moved away from privately financed construction projects and have started to deliver frontline public services too. These firms then sub-contract the delivery of these contracts. They make their profits from the difference between the price paid by government and that which they pay to suppliers. As the political economist Colin Crouch has argued, the bidding company becomes a specialist simply in winning public contracts, rather than actually in delivering public services.

Instead of creating competitive markets that compete for public contracts, the government has effectively created outsourcing monopolies whose primary expertise is in extracting value from the public sector. Over the last two years, five companies have won over 80 per cent of all the public sector’s outsourcing contracts, with Capita alone responsible for almost half. This kind of market concentration spells a very unhealthy market. We need a fundamental rethink of public procurement in this country.

The first problem to tackle is that these companies are currently delivering some public services that have no place in the private sector. The idea of private contractors delivering frontline social services on behalf of local government and the NHS rightly makes many people instinctively uncomfortable. The profit motive should not have a place in our healthcare system, in immigration detention centres, or in our community rehabilitation companies. The fact that the private sector often delivers these services at a lower quality and higher cost than the public sector makes the current state of affairs particularly incongruous. The government needs to get a lot more comfortable with the idea of the public sector delivering these things itself.

In the market for those things that can and should be outsourced – large construction projects for example – three changes need to take place. Firstly, rather than granting contracts to a small number of huge multinationals which then commission other, smaller specialist firms to do the work, the government should get rid of the middle man and deal with suppliers directly. This would boost small businesses, and tackle the uncompetitive nature of the current outsourcing market. It would also protect the government from another Carillion crisis.

Secondly, public contracts should not be awarded solely on the basis of “value for money”. Government contracts should be seen as an opportunity to create public value – where value is understood in holistic rather than narrow economistic terms. The government should account for the wider economic and social impact of its suppliers when determining which supplier should be awarded a particular contract. The Labour party’s proposals to account for the quantity and quality of employment created by a supplier, the nature of its corporate governance, its environmental impact and its attitude towards tax suggests how this could be done.

Thirdly, we need to call time on private financing. If the government wants to build a major infrastructure project it should do so through historically cheap public borrowing, on the public balance sheet, justifying the investment based on the economic, social, or environmental impact. Good public investment done well more than pays for itself in the long run. It should also expand its definition of investment to include investment in human as well as physical capital – spending on healthcare and education is just as much of an investment in the long-run economic capacity of this country as investments in roads and bridges.

The crises of Carillion and Capita offer a real opportunity to transform the way in which public procurement is delivered. We should seize it.

Grace Blakeley is a researcher at IPPR thinktank.

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