Perverse Incentives – Part 2

In the previous article (see Perverse Incentives – Part 1) I discussed why PBC practitioners need to be aware of the potential for perverse incentives in our PBC arrangements.  In this article let’s look at how PBC practitioners, both buyers and sellers, can avoid accidentally including perverse incentive. In a previous article (see Unintended and Perverse Outcomes) I looked at a couple of recent cases that highlighted some possible actions.

From the buyer’s perspective, this requires “testing” of the PBC to see whether the Performance Management Framework (PMF) works as intended based on the three tests described above. You can undertake this testing by:

  • testing the arrangement for all areas of performance, from 100% (or above if incentivised) to 0% performance, observing what conditions result in this, and potential response from the seller;
  • including non-monetary performance measures such as Strategic Performance Measures (SPMs), potentially reflecting enterprise performance and enterprise behaviour  aligning buyer and seller outcomes and behaviours (see When is a KPI not a KPI? for SPM description).
  • monitoring of the performance and behaviours of the seller to watch whether unintended outcomes are occurring, their response as part of  the routine contract management activities.

However, “testing” it isn’t solely the buyer’s responsibility.  I believe sellers have a reciprocal responsibility to make sure, regardless of whether the PMF of the arrangement allows it, to behave fairly.  For example, during both the tendering process and operation of the contract, I believe sellers should have the courage to tell the buyer of any issues they find in the arrangement, especially one that may lead to a perverse incentive.  Equally, buyers should reward constructive feedback from sellers.

For example, in building the first transcontinental railroad in the 1860s, the United States Congress agreed to pay the builders per mile of track laid; a form of ‘time and materials’ basis of payment.  As a result, Thomas C. Durant of Union Pacific Railroad lengthened part of the route forming a bow shape unnecessarily adding miles of track to maximise payment.  In this case, perhaps both buyer and seller needed another performance measure rewarding the most direct route and speed of construction.

While many will argue that this perverse outcome was a result of dishonesty on behalf of the seller, I believe we as PBC practitioners should acknowledge the potential for perverse incentives in our arrangements and take action to remove, minimise or mitigate putting buyers and sellers in this position.

But regardless of the approach, we all need to be aware of perverse incentives to make sure we don’t end up in our very own cobra effect.

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Perverse Incentives – Part 1

“Common sense is not so common.”

Voltaire

In a previous article (see Designing Successful Performance Based Contracts) I highlighted three tests for a highly successful Performance Based Contract (PBC).  These were:

  1. Does the PBC drives the right behaviour in the seller?
  2. Does the PBC provide adequate commercial protections for the buyer?
  3. Does PBC have a usable Commercial Construct?

While you may believe these three tests are basic common sense, unfortunately there are many examples where, despite the best intentions of the drafters, that these arrangements resulted in an unexpected outcome due to perverse incentives.  So what is a perverse incentive?

A perverse incentive is any incentive, both positive or negative, that has an unintended and undesirable result which is contrary to the interests of the buyer.  In the case of PBC, we are specifically looking at whether our contract “drives the right behaviour in the seller”; that is, does the PBC drive the seller to deliver the outcomes desired by the buyer?

There are many examples where this wasn’t the case including my earlier article (see Unintended and Perverse Outcomes).  For example, I recently saw an article which described the commercial arrangements for transporting convicts from England to Australia in the late 18th and 19th centuries.  While this article has been around for over 15 years it is an excellent read on how a simple change in the commercial arrangements can result in extreme, and in this case, dire consequences.  But there are other, less extreme, examples such as:

  • Dinosaur Bones – 19th century palaeontologists travelling to China used to pay locals for each fragment of dinosaur bone that they delivered. However, given locals were paid on the number of bones they delivered, as opposed to the size or completeness of the overall skeleton, the palaeontologists later discovered the locals would break up large bones or complete skeletons into tiny pieces to maximise their payment, but in doing so, greatly reducing their scientific value.
  • Rat Reduction – in Hanoi, Vietnam, under French colonial rule, the colonial administration created a bounty program that paid a reward for each rat killed based on each severed rat tail produced.  However, Colonial officials began noticing rats in Hanoi with no tails.  Instead of killing the rats, the local rat catchers would capture rats, chop off their tails, and then release them back into the sewers so that they could procreate and produce more rats, thereby increasing the rat catchers’ revenue.  On noticing this perverse incentive, the Colonial officials ceased the bounty.

While all of you reading this will agree all these examples are deplorable, and in the case of transporting convicts, that is trading life for money, criminal, PBC practitioners must be aware of the potential for perverse incentives in our arrangements and that we take precautions to make sure that they are not accidentally included. So how do we do this?  In the next article we’ll look at how PBC practitioners, both buyers and sellers, can avoid perverse incentives.

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Happy 2018 Holidays to all the Performance Based Contracting (PBC) Blog Readers

2018 has been a remarkable year for Performance Based Contracting.

During the past 12 months I have seen PBCs becoming more conventional and mainstream with many discussions within our contract and commercial communities.  Everything from the usual Defence and aerospace equipment contracts, but now extending into areas such as health, consulting and ICT as part of “as-a-service” arrangements.  In 2019, I believe PBCs will become even more common as both buyers and sellers try to maximise the value created by their commercial arrangements; hopefully collaboratively in a win-win scenario!

As for me, I am pleased (and more so my family!) to have finally finished my PBC Book (Mastering Performance Based Contracts).  It was a significant effort to put this together over the past 2+ years in what I hope will help both experienced practitioners and those new to the topic.  In 2019, I can again concentrate on providing regular updates to this blog by providing more detailed discussions and case studies. Furthermore, starting in 2019, together with some friends of mine (Jim Bergmann, Dr John Davies, Michael Frith and Greg Laxton), we’ll together be starting a new blog focused on Collaborative Contracting.

Finally, I hope each of you have an opportunity to have a break.  At this joyous time of year, we are grateful for the time we can spend with our own friends and family, and I wish you all abundance, happiness, and peace in a New Year filled with hope. Happy holidays!

Warm Regards

Andrew Jacopino

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Mastering Performance Based Contracts Now Available in Australia!

After checking this morning I am very excited to say that my book, Mastering Performance Based Contracts, is finally available for Australian readers via www.Amazon.com.au.  My apologies for the delay.

For other countries, Mastering Performance Based Contracts is still available now either through the main US portal, www.amazon.com, or local version of Amazon such as www.amazon.co.uk, www.amazon.fr or www.amazon.de.

I hope you enjoy it and welcome any and all feedback.

Kind Regards
Dr Andrew “Jacko” Jacopino

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Performance Based Contracting (PBC) Training

With the release of my book, Mastering Performance Based Contracts, and in conjunction with the International Association of Contract and Commercial Management (IACCM), I am delivering both public and private Performance Based Contracting (PBC) courses.  The 2 courses on offer are:

  1. 3 day PBC practitioner course – designed for people needing know how to put a PBC together including development of the Request for Tender / Proposal (RFT / RFP), tender response, RFT / RFP evaluation, transition and negotiation.  This course includes a copy of the book.
  2. 1 day PBC contract manager course – designed for people with an existing PBC who need to know how to manage it.

The public courses are scheduled as follows:

  • UK Public dates: 28th January 2019 – 1 day PBC contract manager course and 29th – 31st January 2019 – 3 day PBC practitioner course. The location of these courses are in London.
  • US Public dates: 25th February 2019 – 1 day PBC contract manager course and 26th – 28th February 2019 – 3 day PBC practitioner course.  The location of these courses has not been decided.

For private courses, please contact IACCM directly.  You can get more information from the IACCM Website.  I hope to see you there.

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2018 IACCM Americas Conference Presentation – Evolution of Performance Based Contracting

On Tuesday 30th October 2018 I delivered a presentation to the 2018 International Association of Contract and Commercial Management (IACCM) Americas Conference on the Evolution of Performance Based Contracting at St. Petersburg, Florida, USA.  For those who couldn’t attend, please find attached a link to my presentation.  I hope you enjoy it.

IACCM Americas Conference – Evolution of PBC – Dr Andrew Jacopino

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Mastering Performance Based Contracts Update for Australian Readers

After discussions with the folk from Kindle Direct Publishing (KDP) is appears that my book, Mastering Performance Based Contracts, will be available in Australia via http://www.Amazon.com.au from the 15thNovember 2018.  My apologies for the confusion and delay.

For other countries, Mastering Performance Based Contracts is available now either through the main US portal, www.amazon.com, or local version such as www.amazon.co.uk, www.amazon.fr or www.amazon.de.

I hope you enjoy it and welcome any and all feedback.

Kind Regards
Dr Andrew “Jacko” Jacopino

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