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Our Executive Director Nigel Ball will be returning to his regular blog to pick up some of the upcoming themes of our annual Social Outcomes Conference (you can submit a proposal for a session here). This month, he kicks off with a reflection on how the public sector view risks when working with outside suppliers.  

Around five years ago, I was in the thick of finalising arrangements for West London Zone’s social impact bond. Delivery was due to start but crucial contract details still had to be worked out, and our commissioner’s in-house lawyer was serving out her last week in the job. It was now or never. My team and I eagerly showed up, lawyers in tow, at a recently spruced-up council headquarters in West London, but there were no meeting rooms free. Our sizeable group had to squash ourselves knee-to-knee into a tiny ‘booth’ next to the coffee station. A high-walled magenta sofa was an unexpectedly intimate setting in which to thrash out the final details of a million pound-plus contract. 

Anyone who has negotiated a big contract knows that there is often an increasingly high-stakes flurry of negotiation immediately prior to signing. But then the document, so painstakingly raked over (more than 100 pages of it, in our case), gets chucked in the bottom drawer. Hopefully it is not looked at again, because if it is, something has probably gone wrong. 

Pre-empting risk 

This points to one of the fundamental functions of a contract, to manage the allocation of risk between the parties. The basic assumption is that not everything that might affect the relationship in the future can be predicted, so you need to try and agree who absorbs the costs – or reaps the benefits – of those uncertainties. You can do this upfront and try to create the perfect ‘complete’ contract, but the more you time you spend discussing it, the more it will cost to get the deal done. 

The work of three Nobel prize-winners – a Briton named Ronald and two Americans named Oliver – has been particularly influential in exploring these problems. Briton Ronald Coase won in 1991 for introducing the idea that these ‘transaction costs’ should be factored into the decision to buy something (rather than make it yourself). Oliver Williamson won in 2009 for showing that covering every possible eventuality in a contract would take too long and be too expensive, but whatever you left out could give the other party the chance to get one up on you. Oliver Hart, awarded most recently, in 2016, explored an antidote to this dilemma: you can emphasise the building of trust between the parties, and include in the contract an explicit expectation that you will need to re-negotiate things as you go along. 

Contracts under COVID-19

COVID-19 vaccine procurement provides a topical example of these ideas in practice. It has been reported that the European Commission (EC) wanted vaccine suppliers to remain liable for any defects in the vaccine. That sensibly allocates the risk of poor quality production to the party that can best control it: the manufacturer. But suppliers were developing vaccines at pace in emergency conditions. Negotiating this sort of risk transfer is bound to slow things down. Britain and America proceeded without it, suggesting it may have contributed to the supply delays that are partly to blame for the slower roll-out of vaccines in Europe – which in turn might mean longer lockdowns there than elsewhere. In the words of journalist Stanely Pignal, the EC ‘saved itself hypothetical millions at the cost of actual billions’.  

Impact bonds (increasingly known as 'social outcomes contracts’) provide further case studies of these ideas because they bring the risk discussion front and centre, by introducing a third party – a social investor – who is there to underwrite the risks. There is no single approach to how this is done. Some projects agree at the start on a strict methodology to determine what success looks like, and hold to it, come what may. That hasn’t always created a ‘win-win’: investors in the first US project famously lost their shirt, and changes to national policy beyond either party’s control hit investors hard in an early UK SIB. In other cases, project stakeholders have gone back to the negotiating table if things change along the way, realising that inflexibility will help neither of them achieve their goals. In my own case, it wasn’t long before I was back in the council offices – but this time I got my own chair.