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Thursday, September 22, 2022

Preparing for financially self-reliant and accountable regulators

by Rishika Rangarajan.

Introduction

Indian regulators are tasked with important functions in key sectors such as standard setting, supervising, and monitoring entities, enforcing standards, etc. Crucially, some regulators, namely the Real Estate Regulatory Authority, need to work towards developing and promoting their respective sectors. Achieving these goals involves employing technical and scientific capacity, engaging with relevant stakeholders, collating, and analysing sectoral data, etc. A regulator's ability to conduct these activities, independently and efficiently, requires adequate financial resources and flexibility.

In June 2022, the Insolvency and Bankruptcy Board of India (IBBI) published a Discussion Paper proposing a methodology for the regulator to become financially self-reliant. Currently, IBBI largely meets its budgetary requirements from government grants, with only 20% of its financial resources coming from regulatory fees. The paper observed that IBBI’s mandate being a resource-intensive one, requires “financial independence which allows the Board to have the required flexibility and human resources”. In the past, regulators such as the Securities and Exchange Board of India (SEBI) and the Competition Commission of India (CCI) have also asserted their financial independence, claiming that fees are a means to achieve self-reliance. While it may seem intuitive to allow regulators to charge fees to secure independence, there may be important consequences of such a fee-based model on the accountability of regulators as well (Rangarajan, 2021).

In this article, I discuss the implications of a fee-based model and the potential concerns that may arise lacking such a framework - for example, an unchecked ability to raise fees by regulators may allow the misuse of funds. This article: first, discusses the key sources of funding and the importance of financial capacity; second, provides a summary of the incomes of SEBI, Pension Fund Regulatory and Development Authority (PFRDA) and Food Safety and Standards Authority of India (FSSAI) between 2015 and 2020; third, discusses important case laws on fee-based models; and finally, concludes the need for a formal and codified process for raising fees by Indian regulators, in line with accepted international practices.

Designing financially self-reliant, independent, and efficient regulators requires careful deliberation, which has not yet been done. It is critical that a fee-based model be designed to factor in principles of independence, accountability, and transparency.

Key Sources of Funding

Each parent Act creates separate accounts for regulators which will hold the grants of the government, fees and subscription charges and any other income such as interest, penalties, or disgorged amounts. Currently, the key sources of income for regulators are (i) grants-in-aid, (ii) fees and charges, and (iii) other funds. The process of raising money for each source is briefly summarised below:

  1. Grants-in-Aid: To receive funds from the Appropriate government, parent statutes of regulators require regulators to prepare a budget with estimated receipts and expenditures each Financial Year. This budget is forwarded to the respective central ministry each Financial Year which will grant money from their annual budget, after due appropriation. This money is then taken from the CFI and is approved during the annual Union Budget presentation.

    For example, each Financial Year, IBBI submits their estimated revenue, capital and expenditure to the Ministry of Corporate Affairs. The Ministry, after considering the Actual Revenue and Expenditure for the previous year, determines the budget for grants-in-aid during the annual Union Budget discussions. The funds, after approval, are credited to the IBBI Fund established under Section 222 of the IBBI Act 2016. All regulators follow a similar procedure to receive grants from the Appropriate government.

  2. Fees and charges: Regulators raise money through fees from regulated entities to conduct services such as registration, licensing, granting approvals, and other such activities. Commonly, regulators impose three types of fees: flat fees, fees based on the value of the transaction, and fees based on the nature of the transaction.

    The Act does not prescribe any process to calculate the quantum of fees and regulators have the flexibility to determine the required fees. Regulators issue regulations that prescribe the quantum procedure for collecting fees from regulated entities. These are laid before the Parliament. Currently, there is also no requirement for regulators to publicly disclose the rationale for imposing prescribed fees on regulated entities.

  3. Other funds: Regulators can also invest their funds and receive interest on such investments. Other sources of money include penalties, donations, income from publications, interest from deposits, income from the sale/disposal of assets, etc. In addition, some regulators have a separate fund that holds other incomes.

    PFRDA can establish a separate Subscriber Education and Protection Fund which holds grants and donations received, interest on investments made and penalties imposed by the authority. Similarly, SEBI credits all amounts disgorged to an Investor Protection and Education Fund. Regulators can also own capital assets and hold separate capital/corpus funds and earmarked/ endowment funds which are reflected in their Balance Sheet.

The importance of financial capacity

The mandate of regulators is resource intensive. Some of the key expenses regulators incur include: (i) establishment expenses for salaries, wages, allowances, and other such expenses for employees; (ii) administrative expenses consisting of expenses on rent, electricity and water, vehicles, stationary, etc; (iii) grants and subsidies given to institutions or individuals (for ex., FSSAI offers grants to strengthen Food Testing Labs in states); and (iv) expenses for developmental activities including monitoring and supervising their sector

OECD’s Best Practice Principles for Regulatory Policy highlights that funding is one of the important pillars of regulatory authorities. Financial capacity is not only linked to efficiency, but also independence. It ensures that regulators have sufficient funds to conduct their activities and remain independent from any external factors, including the government or private sector.

Despite the early optimism around regulators, they often face similar capacity issues as the State. In 2018, the FSSAI cited that financial constraints have led to failure in upgrading their food safety mechanism. FSSAI sought a ‘quantum jump in budgetary allocation’ pointing out that counterpart organisations in other countries have a much higher proportionate budget.

On the other hand, SEBI is an entirely self-reliant regulator raising over Rs 800 crores through investments and fees in the Financial Year 2021 with a surplus of close to Rs 200 crores. Although there have been calls for transferring SEBI’s surplus funds to the CFI, there is nothing in the mechanism preventing regulators from raising fees that go above their budgetary requirements. This goes against notions of accountability and transparency - principles that form the bedrock of any public institution. Although a fee-based model allows regulators greater flexibility by avoiding delays and complications arising from the CFI disbursement process, it lacks processes that ensure accountability that come with a grant or tax-based regime.

Comparing incomes of regulatory authorities

To understand the role of fees and grants in the financial capacity of regulators, I have considered the income sources of three regulatory authorities SEBI, PFRDA and FSSAI, between 2015 and 2020. Income accounts of regulatory authorities provide us with a summary of the two key sources of funds: grants and fees/charges.

Evidently, the three regulators largely rely on either of the two sources (i.e., grants and fees) while the proportion differs for each regulator. For example, while SEBI does not rely on any grants from the central government, PFRDA and FSSAI, through the five-year period, largely rely on grants. Both FSSAI and PFRDA’s reliance on fees and subscriptions fluctuates through the period.

SEBI was also able to raise a sizable amount of money through income and interest earned which includes deposits in banks and other institutions; interest through loans provided to employees and interest from brokers.

SEBI makes available their board meeting minutes on their website, which includes the meetings where they decide the quantum of fees. These meetings reveal some of the contexts for why and how SEBI charges fees and the methodology they follow to decide the quantum. For example, in 2017, SEBI reduced the fees payable by brokers by 25% taking into account the projected income and expenditure for the subsequent three financial years and reducing the overall cost of transactions in the market. Similarly, in April 2020 they reduced the broker turnover fees and filing fees on offer documents to counter the challenges faced due to COVID-19.

PFRDA also makes available some of their board meetings - but, of the available minutes, none of them discussed any determination of fee matters. FSSAI does not make any board meetings publicly available and therefore there is no information on their fee determination.

Moving towards fee-based models

Fees have emerged as an important source of income for regulatory authorities, being seen as their way to function independently of the government.

The Report on Financial Sector Legislative Reforms Committee (FSLRC Report) submitted to the Ministry of Finance in 2013 reviewed the legal and institutional framework of the Indian financial sector. While discussing recommendations to reform the regulatory ecosystem, the report raised the importance of maintaining regulators’ independence. Amongst the reasons put forth, the FSLRC Report stated that regulators funding itself through fees would create “operational efficiencies” and ensures that the stakeholders who are the beneficiaries of the relevant market will bear the cost of regulation rather than the public as a whole. Regulators can also achieve freedom from the government on pay, potentially facilitating the hiring of experts. Fees can empower regulators to maintain independence from regulators and enable them to take timely decisions.

Fees are also easier to raise as compared to taxes, the latter being an important source of revenue for the central and state governments. The process of raising taxes is codified in the Constitution of India under Article 265 - “No tax shall be levied or collected except by authority of law”.

The process to raise taxes follows a multi-step process which begins almost six months prior to the date of presentation. Each ministry is required to submit estimated receipts and expenditures to the Government of India for their financial year which is examined by the Ministry of Finance in consultation with the Union Cabinet or the Prime Minister. After a series of consultations and discussions, the budget is presented in the Lok Sabha, usually on February 1st every year (commonly known as the Union Budget most recently presented by the Finance Minister, Nirmala Sitharaman).

Fees, on the other hand, are used by government departments, local authorities, and regulators to raise money to cover the costs of any services rendered. Over the years, courts have differentiated fees from taxes, empowering regulators to use fees to fund their activities and services. Courts have recognised fees as a legal means to fund regulators' activities but highlighted the need for a fair correlation between the fee charged and the cost of services rendered.

Differing standards of fees

In 2001, the Supreme Court of India considered the petition filed by stockbrokers challenging SEBI’s high registration fee charges. SEBI required stockbrokers to pay an annual registration fee based on their annual turnover over a period of five years. This is one of the earliest cases that dealt with regulators’ right to impose fees on regulated entities to fund their activities. The petitioners argued that the high fees were “excessive”, “unreasonable and arbitrary”. Second, they claimed that the fee is without the authority of law and is a tax guised as a regulatory charge. Finally, the levy has no nexus to the purpose for which the fee is collected and the demand for collection based on annual turnover extended over five years is arbitrary.

The Court rejected their arguments and found that SEBI does have the right to impose fees under the parent statute and therefore is authorised by law. The court did not consider the arguments on the quantum of the fees but held that regulators are not required to show a co-relatable quid pro quo. The court, however, refers to the Justice Mody Committee report which recommended preferable methods to calculate reasonable fees with SEBI in principle agreeing to implement them.

More recently, in 2020, insolvency professionals filed a writ petition, seeking the striking down of IBBI’s regulation charging ad valorem professional fees on them. They contended that there was excessive delegation, and the Act does not empower them to charge fees based on annual turnover or remuneration. They also raised that IBBI has not provided a quid pro quo to justify the charges. The Madras High Court ruled that regulators do not have to present a direct correlation between the fee earned and service rendered. In recent years, other regulators including PFRDA, CCI and PNGRB have also started to charge fees on an ad valorem basis.

As evidenced by the instances above, fees are specifically differentiated from taxes. Currently, taxes are the largest source of revenue for central and state governments with the process to determine and raise taxes set forth in the Constitution. Fees are becoming similarly significant to regulators. However, the same institutional safeguards are not put in place for regulators.

Designing financially self-reliant regulators

To raise taxes, governments must go through a rigorous and intricate process which accounts for principles of independence, transparency, and accountability. This has been coded into the Constitution of India. A similar framework is lacking for regulators funded through fees and charges, raising some concerns. While flexibility is necessary for regulators, equally, checks and balances need to be formalised to prevent misuse of their powers.

An unfettered right to raise fees can have far-reaching consequences on the relevant sector. High fees can impact the market since they are often translated into costs to the public directly or indirectly. To avoid this, it is important to ensure that there is a reasonable nexus between the cost of the services rendered and the fees charged. The FSLRC report highlighted that regulators should “clearly explain the fees it is charging and demonstrate that the fee is not disproportionate to the cost for the regulator”. The OECD report on The Governance of Regulators stated that the funding processes of regulators should be transparent and efficient while protecting their independence and objectivity.

An international example of good practice in raising fees is the Financial Conduct Authority (FCA) in the United Kingdom which is funded entirely by the fees and levies from the firms they regulate. On their website, they explain how they calculate their annual fees and in addition publish an annual consultation paper which sets out its proposal on fees for the upcoming year and the model for calculating the various levies. The paper is open to comments from all FCA fee payers and businesses considering applying for FCA authorisation or registration. Similarly, the parliament of New Zealand also published a document on guiding principles for the levy of fees and charges.

Similar processes are lacking in the Indian context. Currently, regulators are not required to conduct consultations to determine fees nor required to disclose their justification of the fees to the public or the regulated entities. This makes it challenging for the government, regulated entities and the public at large, who indirectly bear the indirect burden of high regulatory fees to question and examine regulatory budgets.

Conclusion: formalising transparency and accountability

It is argued that budgetary independence is related to the larger autonomy of regulators - regulators can determine their staffing, they can incur sudden or additional expenditures without immediate justification to the State, and it may also improve the quality of their operations by allowing investment in new technologies or requirements to upgrade internal processes.

Regulators that raise money need to be accountable to regulated entities and the public. When governments raise taxes, they must comply with certain constitutional and legal principles before deciding on the quantum. Principles that are enshrined in the Constitution. The same processes are not sufficiently imposed on regulators - their parent Acts do not provide any limitation to their right to raise funds through levies nor does it prescribe any requirements for transparency.

With an increasing number of regulators and increasing responsibilities imposed on them, their role in Indian governance is critical. In this context, the need for financial capacity cannot be denied but does the current process to raise funds by regulators ensure the necessary accountability? We need to consider creating a codified framework that sets out the above principles for self-reliant regulators.

References

Rangarajan, R. (2021) Financial Autonomy of Independent Regulatory Authorities: Analysis of Legal Framework.

Kapur, D and Khosla, M (eds.). (2019). Regulation in India: Design, Capacity, Performance.

Burman, A., & Krishnan, K. (2019).Statutory regulatory authorities: Evolution and impact.

Burman, A., & Zaveri, B. (2018). Regulatory responsiveness in India: A normative and empirical framework for assessment. William & Mary Policy Review, 9 (2).

Sundaresan, S. (2018). Capacity building is imperative. Column titled Without Contempt in the editions of Business Standard dated August 2, 2018.

Report of the Comptroller and Auditor General of India. Union Government Accounts of the Union Government, No 44 of 2017.

Ministry of Finance, Department of Expenditure. General Financial Rules 2017.


Rishika Rangarajan is a Researcher at the National Law School of India University, Bengaluru

How are securities laws enforced in India: some facts from a new data-set of SEBI orders

by Devendra Damle and Bhargavi Zaveri Shah.

Introduction

The Securities and Exchange of Board of India (SEBI) is one of the most powerful regulators in India. As the regulator of one of the world's largest stock markets by market capitalization, SEBI has a variety of enforcement tools at its disposal. These include the imposition of monetary penalties, license cancellation and pursuing criminal proceedings against violators. The law empowers SEBI to issue directions to intermediaries, and more broadly, to persons associated with the securities market. Such directions may be of a prohibitory nature, such as restricting companies from raising capital in the public markets, disqualifying persons from acting on the board of publicly traded issuers and restricting access to the capital market altogether. They may also be of a remedial nature such as disgorging illegal gains made by violators or directing restitution to wronged investors. The grounds for issuing such directions are wide.

How has SEBI used these enforcement powers over time? Has it prioritized enforcement against some kinds of misconduct over others? If yes, have the priorities stayed static or changed over time? Do certain types of violations consistently entail certain types of sanctions? How efficient are the enforcement proceedings in terms of the time taken, and what is the success rate for enforcing such sanctions? Unlike some Indian financial sector regulators, SEBI follows a due process before issuing such orders, involving the issuance of a show cause notice and a hearing and publishes each enforcement order passed by its officials systematically on its website. This transparency in enforcement allows us to establish some basic facts on securities laws enforcement in India over a long observation period. In a new paper, we analyse over 8,000 enforcement orders passed by SEBI over a span of ten years to answer some of the questions we mentioned above. In this article, we summarize the key findings of our work.

Data description

In our study period beginning 1st January, 2011 and ending on 31st December, 2020, SEBI passed 9048 enforcement orders, of which we were able to sucessfully download and parse 8032 orders. We then analysed these orders, using text-mining software we designed ourselves, to arrive at some summary statistics on the frequency and type of enforcement undertaken by SEBI during the study period. To answer more detailed questions on the nature of enforcement, we manually analysed a stratified random sample of about 10% of these orders. The sample was drawn from the set of orders involving four regulations, which are most frequently enforced by SEBI (as per our data), namely, orders pertaining to fraudulent and unfair trade practices in the Indian securities market (FUTP), violations of the Insider Trading regulations, the Takeover Code and Broker regulations.

As mentioned above, the SEBI Act empowers SEBI to pass two types of orders, namely, orders imposing monetary penalties and orders issuing directions. Such orders can be issued against intermediaries, market participants, issuers of capital or persons generally associated with the securities market. Until 2019, monetary penalty orders could be passed only by adjudication officers and directions would be issued by whole time members of the SEBI board. With effect from 2019, the members of the SEBI board have also been empowered to pass orders imposing monetary penalties. In addition to these, the law also empowers SEBI to settle violations upon the payment of a settlement fee, without passing a guilty verdict against the violator. Basis this scheme of the SEBI Act, we categorize the enforcement orders in our data set into three categories shown in the Table. On an average, SEBI issues 250 enforcement orders with directions and double the number of orders imposing monetary penalties each year. The SEBI Act also empowers SEBI to initiate criminal prosecution against persons accused of having violated the SEBI Act or the regulations made by it, but we do not take account of this typology of enforcement proceedings in our study.

Table: Enforcement orders (2011-20)
Type of order Type of sanction Total^
Orders by Adjudicating officers Monetary penalties 4911 (61)
Orders by Chairperson/member Non-monetary sanctions 2484 (31)*
Settlement orders Settlement fee 637 (8)
Total 8032 (100)
^Numbers in brackets are a percentage of the total. *We estimate that not more than 30 orders may involve a monetary penalty.

As is evident from the Table, securities law enforcement is largely undertaken in India through monetary penalties, but the proportion of enforcement undertaken through non-monetary sanctions is not trivial. Settlements account for less than 10% of the total enforcement orders in our data. The annual distribution of these types of orders is shown in the Figure. The Figure shows that from 2018 onwards, there has been a sharp increase in the intensity of enforcement, with the number of monetary penalty orders nearly doubling from the previous years. The proportion of settlements has also increased over time, particularly after 2016. While the growth in the size of the market, an increase in the intensity of regulation and enforcement capacity are intuitive explanations for this jump, more precise, causal explanations require further research.

Figure: Year-wise types of enforcement orders (2011-2020)

Findings

SEBI draws its substantive powers from a set of three laws, over and above the SEBI Act, namely, the Companies Act, 2013 (and its preceding legislation), the Securities Contracts (Regulation) Act,1956 (SCRA) and the Depositories Act, 1996. While the Companies Act largely deals with the incorporation of Indian companies and the governance of their affairs, it also governs primary issuances, the requirements to be met by public offer documents and some aspects of the governance of listed companies. These matters under the Companies Act are administered by SEBI. The SCRA governs the conceptual definition of securities and securities contracts, regulates some types of securities contracts and governs the licensing and affairs of stock exchanges. The Depositories Act, 1996 deals with the regulation of depositories and depository participants. Under each of these laws, and in particular under the SEBI Act, SEBI has issued regulations defining the registration and reporting requirements for intermediaries, the kinds of misconduct that will elicit penalties, and so on.

We find that orders against fraudulent and unfair trade practices (FUTP) are the single largest group (15%), followed by orders dealing with violations of the provisions of the Companies Act (11%), insider trading regulations (10%) and the takeover code (9%). The enforcement actions (i.e. the number of orders) under the remaining regulations are few, with some of them having witnessed enforcement not more than once during the study period. Some of these seemingly rarely-enforced regulations, such as the regulations governing alternative investment advisors, are relatively new, which may explain why they do not appear more often in our data. However, others, such as the regulations governing venture capital funds, stock exchanges and clearing corporations, are older, but we see fewer orders issued under these regulations as compared to other regulations. Whether this is because the regulations themselves are not violated as frequently by market participants, or because SEBI chooses not to enforce them, requires further study.

To answer more specific questions of these enforcement orders, we manually analysed a random sample of 818 orders (approximately 10% of the total sample) from amongst the orders against the following types of violations: (1) FUTP, (2) insider trading, (3) violations of the takeover code and (4) violations of brokers' regulations. Some findings from this micro-study are summarised below:

  1. Duration of the enforcement proceedings: The formal enforcement process at SEBI begins with the appointment of an investigating authority who investigates the facts and reports her findings to the SEBI board. If the findings are adverse, a show cause notice is issued to the accused by the adjudication officer (where the proposed sanction is a monetary penalty) or a whole time member of the SEBI board (where the proposed intervention is a direction). We find that the median time for the issuance of a show cause notice is a little more than three years from the date on which the violation was committed. Further, the median time from the date of issuance of a show cause notice to the date of an order imposing monetary penalties is a year and a half. It is a little more than two years for orders issuing directions. A regulation-wise analysis of the duration suggests no relationship between the complexity of the violation involved and the duration of the enforcement proceeding.
  2. Subject and outcome of enforcement: A bulk of the enforcement actions are in respect of unregulated entities, that is, entities that are not SEBI-licensed intermediaries. This phenomenon could be attributed to the type of violations that are most often enforced against, namely FUTP and insider trading. Both these practices would likely involve traders and market participants that are not SEBI-licensed intermediaries. Further, in nearly 80% of the cases, SEBI found the person(s) guilty of all the violations that they were charged with, with a marginally higher conviction rate for unregulated entities compared to regulated entities. The conviction rate for violations of the Takeover Code is also marginally higher, compared to violations under the three sets of regulations. It is hard to comment on the optimality of this high conviction rate as these enforcement proceedings are undertaken and decided by SEBI officers themselves. All orders of SEBI, except those rejecting an application for settlement, are appealable to the Securities Appellate Tribunal (SAT). The rate of appeals and the outcome of appeals before the SAT could be a rough proxy to evaluate the optimality of this conviction rate and would be a good direction for further research.
  3. Proportionality of sanction: We find a lot of variation in the amount of penalty levied across cases. While the median (i.e. typical) size of the penalty is in the range of Rs 5,00,000, the average is in the range of Rs. 57,00,000. This difference indicates that while there are few cases where large penalties are issued, the size of these penalties is very large compared to the typically-imposed penalties. One explanation that could account for this variation is the amount involved in the violation. The SEBI Act requires an Adjudicating Officer to take into account, among other factors, the amount of disproportionate gain or unfair advantage made as a result of the default or the amount of loss caused to investors as a result of such default. However, we find that in a vast majority of the cases in our sample (90%), the size of the violation was not calculated.

    We similarly find a lot of variation in the orders that impose sanctions other than monetary penalties. Out of 118 such orders, 82 orders restricted the market access of the accused. The duration of such restrictions varied from 15 days to 4 years, and we could not discern any relationship between the duration of the restriction on the one hand and the violation or the purpose of the restriction on the other. Further, courts have repeatedly held that SEBI's direction making powers are remedial and preventive in nature, and not punitive. However, it is unclear at what point an order that operates to restrict market access starts to become punitive in nature, since none of the orders in our data clearly draw the line between remedial and punitive measures.

Conclusion

In India, the field of securities laws is often studied from the perspective of a specific case, individual legislative amendments or specific judgements of courts. While such analysis is useful, a slightly different, more quantitative approach is necessary to gain a systematic understanding of the manner in which the regulator uses the wide variety of enforcement tools available to it, the manner in which it seeks to enforce against different kinds of misconduct and the efficiency of its enforcement functions. The consistent publication of easily accessible enforcement orders by SEBI on its website makes it possible to undertake such systematic research on securities laws enforcement in India. This paper is one such effort to begin developing more systematic knowledge on enforcement of private law in India.

The data used for this analysis can be found here. The data-set can be cited as Zaveri Shah, Bhargavi; Damle, Devendra (2022), "Securities law enforcement in India", Mendeley Data, V1, doi: 10.17632/ppdk9pzfdp.1.


Devendra Damle is an independent researcher. Bhargavi Zaveri Shah is a doctoral candidate at the National University of Singapore.

Sunday, September 18, 2022

The make vs. buy decision of the union government

by Aneesha Chitgupi and Susan Thomas.

Introduction

Like every organisation, the government faces the question of make vs. buy in carrying out its functions. Should it recruit people, and take on management responsibilities of directly making goods/services? Should it enter into contracts with private persons who already specialise in this production? Each choice has a different cost when using public funds. Managers in government face a Markup in State Production, which is the inefficiency of the state in direct production, and the state has to deal with a Markup in State Contracting, which is its inefficiency when contracting for procurement (Kelkar and Shah, 2022).

This question needs to be set in some basic facts. How large are the magnitudes of make vs. buy in the Indian state? Over the years, is there a bias towards producing goods/services in-house? Is there a process of growing maturation where the buy ratio is going up, or have the spate of difficulties in government contracting of the recent decade led to a certain retreat from buy in favour of make? In this article, we collect evidence for the union government, to offer some answers to these questions.

Methodology and data constraints

We use the methodology in Sharma and Thomas (2021) to estimate what the Union Government spends on procurement in a year. This uses the annual statement of accounts (Accounts at a glance) published by Controller General of Accounts (CGA). The books of accounts of government follows cash based system, recording only cash transactions (as opposed to accrual based system where transactions are recorded upon becoming payable).

The calculation of what was spent on procurement uses the expenditure under various ``object heads''. This is only feasible from 2015-16 onwards, when the CGA started disclosing expenditure under object heads in their annual reports. In the work presented here, we undertake this measurement from 2015-16 upto 2019-20. We ensure comparability by converting nominal values to real using the CPI.

Our calculations differ from the methodology employed by Sharma and Thomas (2021) on three counts:

  1. We only report the procurement expenditure of the Union Government, which includes only the expenditure under its ministries. We do not include expenditure in Central Public Sector Enterprises (CPSEs), which accounted for 3.5x the procurement of the entire Union Government.
  2. We calculate procurement expenditure for the Railways Ministry using a combination of its annual reports and the capital expenditure reported in the CGA annual reports for the Ministry.
  3. We include only those items that can be unambiguously classified as procurement for the Union Government.

Results

Figure 1 shows the real actual spending of the Union Government for 2015-16 to 2019-20. The fraction of procurement spending has been quite stable at around 17-18 percent of the total expenditure. The remaining 82-83 percent of budget each year is spent on salaries and pensions and payments in the form of Grants-in-Aid, which are about 20-25 percent of the budget each year.

 

Figure 1: Union Government spending, with fraction of total procurement, inflation adjusted, 2015-2019


Figure 2: Union Government procurement expenditure, with fractions of capital and revenue, inflation adjusted, 2015-2019   

Source for both figures: Annual statement of accounts by CGA, Annual report of the Indian Railways, and authors' calculation.

While the share of procurement within total expenditure has been stable, there is a small shift in the composition of Union Government procurement. In Figure 2, we see that share of capital in total procurement increased from 53.7 percent to 57.5 percent between 2015-16 to 2019-20.

Table 1: Changes in share of total and procurement expenditure of Union Government as GDP (in %), 2015-2019


Total expenditure Procurement expenditure Capital procurement

/ GDP / GDP / GDP
2015-16 14.36 2.42 1.30
2016-17 14.37 2.50 1.38
2017-18 13.92 2.37 1.31
2018-19 13.55 2.40 1.39
2019-20 14.23 2.39 1.37

Source: Annual statement of accounts by CGA, annual reports of Indian Railways and authors' calculation.

How have these changed as a share of overall GDP? Table 1 shows that these fractions tend to be stable, whether it is the total spending by govt, or the spending on procurement or on capital procurement spending. There are some changes during 2017-18. This is likely a result of lack of maneuverability to reduce revenue expenditure, and an emphasis on items such as subsidies (RBI, 2020).

Discussion

Government contracting is a critical part of state capacity that influences how the government chooses between make or buy in providing public goods. Given the more intractable problems faced by the Indian state in its attempts at recruiting people and producing internally, the possibility of contracting out to private firms is appealing. In the best examples, capabilities in public procurement have fostered innovation. But, this requires state capacity in government contracting. The evidence in India points to weak capacity in government contracting. Whether it is high levels of public litigation at courts (Mehta and Thomas, 2022; Damle et al, 2021), increasing levels of delayed payments at PSEs to vendors (Manivannan and Zaveri-Shah, 2019) and delays in project completion (Burman and Manivannan, 2022). Private parties are increasingly withdrawing from contracting with state (Mehta and Uday, 2021). This hampers purchase by the state as there is an inferior landscape of potential sellers.

A strategy of procurement reform could potentially put the Indian state on a path to higher capacity. The foundations of the field, of procurement reforms, lies in establishing basic facts:

  1. How large are the magnitudes of make vs. buy in the Indian state? About 17% of the expenses of the union government work through buy, the remainder work through make.

  2. Is the buy ratio something that is stable or does it fluctuate from year to year? The buy ratio is remarkably stable; it changes very little from year to year.

  3. Is there a process of growing maturation where the buy ratio is going up? Or alternatively, have the spate of difficulties in government contracting of the recent decade led to a certain retreat from buy in favour of make? The buy ratio is highly stable; it shows no time trend. What has changed is a small shift towards a increasing spending for capital procurement.

This shows that, in real terms, the allocation between the make vs. buy choice of the union government has remained the same. But there has been a rise in the share of capital procurement spending. This tends to involve spending in projects with longer maturity, with greater risks to the project during the contract implementation and management phase being the underlying driver for procurement failure. Bottlenecks to resolving problems in this stage of procurement will become an important area to focus on as the government reforms public procurement rules and processes.

References

Vijay Kelkar and Ajay Shah. In service of the republic: The art and science of public policy. Second edition, 2022, forthcoming.

Pavithra Manivannan and Bhargavi Zaveri. How large is the payment delays problem in Indian public procurement?. The Leap Blog. 22 March 2021.

Charmi Mehta and Susan Thomas. Identifying roadblocks in highway contracting: lessons from NHAI litigation. The Leap Blog. 13 July 2022.

Devendra Damle, Karan Gulati, Anjali Sharma and Bhargavi Zaveri. Litigation in public contract: some estimates from court data. The Leap Blog. 26 May 2021.

Pavithra Manivannan and Bhargavi Zaveri. How large is the payment delays problem in Indian public procurement?. The Leap Blog. 29 March 2022.

Perun. Defence economics, and the U.S. production advantage, YouTube, 31 July 2022.

Charmi Mehta and Diya Uday. How competitive is bidding in infrastructure public procurement? A study of road and water projects in five Indian states. The Leap Blog. 22 March 2021.

Anirudh Burman and Pavithra Manivannan. Timeliness in government contracting: Evidence from the country's largest metro-rail network. The Leap Blog. 12 August 2022.

Anjali Sharma and Susan Thomas. The footprint of union government procurement in India. XKDR Working Paper 10, November 2021.



Aneesha Chitgupi is a Research Fellow at XKDR Forum, and Susan Thomas is a Researcher at XKDR Forum. We thank Abhishek Gorsi for excellent research assistance, Josh Felman, Sudha Krishnan, Anjali Sharma and Ajay Shah for their inputs and comments.

Thursday, September 08, 2022

Announcements

Position for researcher in the field of The Land Market

XKDR Forum is looking for a researcher to work on a project, on the land rights and land ownership by women. The project involves studying women's land rights, holding patterns and control over land resources through field and desk research.

XKDR Forum is a Mumbai-based inter-disciplinary group of researchers working in the fields of land, household and firm finance, financial markets, public finance management and public procurement. In these fields, the group engage in academic and policy oriented research, and advocacy. The new recruits will come into an active research program in the field. Our published work in the field of land include the following:

XKDR Forum is looking for one researcher with the profile described below.

Research Associate

As a research associate, you will work on project deliverables under the supervision of the Research Lead. The requirements for the role of research associate are: a background in law/economics and public policy, quantitative skills are desirable, two years of work experience. You must be comfortable in working in an inter disciplinary research environment with people from varying backgrounds such as economics, law, public policy and data science. You must be curious and passionate about research and must be willing to work on independent outputs as well as in teams.

The remuneration offered will be commensurate with your skill and experience and will be comparable with what is found in other research institutions.

Interested candidates must email their resume with the subject line: Application for "Research Associate" at XKDR Forum, to Ms. Jyoti Manke at careers@xkdr.org by 15th September, 2022.

Friday, August 12, 2022

Timeliness in government contracting: Evidence from the country's largest metro-rail network

by Anirudh Burman and Pavithra Manivannan.

Introduction

Infrastructure projects in India are plagued by delays (MOSPI, 2022). Proposed explanations include failures of government contracting for public procurement (Singh, 2010, Sinha and Vatsa, 2021, etc.). In this article, we measure delays in the procurement process of the largest metro-rail network in the country -- the Delhi Metro Rail Corporation (DMRC) -- which is considered a successful project. It fares well on global ranks on some parameters such as network length and ridership. The early phases of this metro rail project have been lauded for timeliness in execution and contract payments (Expenditure Management Commission, 2016).

We look at two distinct datasets to obtain a birds eye view and a procurement-oriented view of the delays in DMRC. We find that DMRC is prompt in stages of the contracting processes for which we are able to find evidence, but that the overall project implementation suffers from time overruns. We put this knowledge together to obtain insights into government contracting.

Our approach

As with contracts drawn between any two counterparties, government contracting is a pipeline that runs through four phases (Mehta and Thomas, 2022): (I) Contract specification and design, (II) Contract tendering and award, (III) Contract management and (IV) Contract closure. Flaws in government contracting shows up as inefficiencies in public procurement such as delays in infrastructure projects, which in turn, results in cost overruns, loss in revenues, vendor dissatisfaction and lack of competition when government wants to procure, and ultimately, deprives the public of the intended benefits.

We use three data-sets to understand the timeliness of government contracting in DMRC projects.

  1. A data-set of the time taken by the various DMRC projects, sourced from the CapEx database published by the Centre for Monitoring Indian Economy (CMIE).
  2. A data-set of tenders awarded by DMRC, hand-constructed from the 'Contracts Awarded' section of the DMRC website;
  3. A data-set of payments made by DMRC, hand-constructed from the 'Vendor Payment Details' section of the DMRC website and from an RTI application.

The first data is sourced from the CMIE CapEx database. The CapEx database records the date of significant events for each project. We collect data for the three operational metro networks constructed by DMRC, that is, Phase 1, 2 and 3. This data-set consists of project level information such as, the date of announcement of the project, initial completion date, actual completion date and time overruns.

The second dataset is a hand-constructed data-set consists of tender level information for awarded contracts of DMRC, such as the department calling for tenders, nature of work, date of publication of Notice Inviting Tender (NIT), date of issue of letter of acceptance and value of the contract. This data-set covers this information for 892 tenders for a period of 5 years (2016-2020). DMRC categorises these tenders into 7 heads: Civil and Architecture Works, Electrical Works, Operations and Maintenance, Rolling Stock, Track Works, Signalling and Telecom and Property Development.

In addition, we categorise the contracts for IT services and housekeeping works as 'Miscellaneous' and the procurement done by DMRC for other metros in the country as 'For Other Metros'. The highest number of contracts were awarded for Operation and Maintenance works (623) and the least for Rolling Stock (2). Table 1 shows the typology of procurement undertaken by DMRC during our study period.

Table 1: Typology of DMRC Procurement
Category 2016 2017 2018 2019 2020 Total
Civil and Architecture Works 17 28 9 15 9 78
Electrical Works 5 1 3 5 13 27
Operations and Maintenance 0 65 167 200 191 623
Rolling Stock 0 0 0 2 0 2
Track Works 12 2 0 1 3 18
Signalling and Telecom 8 1 0 0 3 12
Property Development 0 5 3 10 5 23
Miscellaneous 4 14 23 8 13 62
For other metros 5 7 17 8 10 47

Our second hand-constructed data-set consists of monthly bill payment status of DMRC. Pursuant to government communication (vide D.O.18(18)/IFD/2019 dated 05.11.2019), DMRC uploads its monthly vendor payment details on its website since December 2019. This data gives us periodic information about the bill submission date and the bill payment date of DMRC vendors. Since the website does not archive its data we obtained our data partly from the DMRC website and partly vide an RTI application made for this purpose. Our data-set consists of 20,654 bills for the period between November 2019 to August 2021. The payment period is unknown for about 1,550 bills in our data-set, which we discard in our analysis.

We restrict our study to benchmark DMRC's performance against the timelines prescribed by its internal guidelines (DMRC Procurement Manual, 2016 and General Conditions of Contract, 2019) and the Central Government procurement guidelines (General Financial Rules, 2017 and the Manual for Procurement of Works, 2019). We do not employ a comparative analysis with other procuring entities for two reasons: One, availability of data in government portals such as the CPPP (Central Public Procurement Portal) and websites of the procuring entities are often sparse and sporadic. Second, a deeper understanding of the fundamental functioning, internal rules, processes and organisational structure of each entity is required for a meaningful comparison and it warrants a separate study.

Findings: Time overrun in DMRC project implementation

In the CapEx data, we are able to see that, between 1995 to 2021, there were three projects announced, implemented and completed by DMRC. These are the Phase 1, Phase 2, and Phase 3 lines. These have been operational from 2006, 2011 and 2021 respectively. From this data, we are able to locate various timelines for all three phases, including the date on which the Phase was announced, to the date on which they were completed and commissioned for public use for fully operational metro lines. We calculate the time overruns as the difference between the date projected initially as the completion date for a Phase and the date on which it was actually completed and operationalised. These are presented as project delays in Table 2.

Table 2: Project delays (in months)
Phase 1 15
Phase 2 32
Phase 3 102
Source: CMIE Capex Database

Findings: Timeliness in contract award by DMRC

High-income countries, countries with greater political accountability, and countries with greater economic freedom process public works procurement in a more timely manner (Djankov and Bosio, 2020). Each of these countries does infrastructure procurement following its own regulations to award contracts. In India, works procurement is guided by the Manual for Procurement of Works, 2019. According to Clause 5.6 in this manual, the time taken by Ministries and Departments from the date of opening the tender to the date of awarding of contract is 90 days.

We estimate the actual time taken by DMRC to award tenders (Table 3). This is calculated as the time taken from the date of opening of the tender to the date of issuing of the acceptance letter. We find that, on an average, DMRC takes 91-92 days to complete the tendering process.

Table 3: Time taken to award tenders (in days)
Year No. of tenders Average time taken
2016 51 101
2017 123 98
2018 222 103
2019 249 81
2020 247 89
Average 178 92

Findings: Timeliness in making vendor payments by DMRC

Payment delays are endemic in public contracts in India. DMRC has sought to avoid payment delays by including provisions for both interim and final payments within its Procurement Manual and General Conditions of Contract, 2019 (GCC). Depending on the type of contract, payments may be made at different stages of the procurement cycle. At Clause 11, the GCC provides for set timelines for the scrutiny of invoices and payments to be made by the procuring entity:

  • Interim payments: A contracting firm may apply to the respective project engineer of DMRC requesting for an 'interim payment certificate'. This certificate will be issued based on achieved milestones or prescribed payment schedule in the contract, if any.
    1. Within 21 days of the request, the project engineer must issue the interim payment certificate specifying the amount due to the contractor.
    2. DMRC is mandated to make 80% of the certified payment amount within 7 days of issue of the certificate.
    3. The balance 20% is to be made within 28 days of issue of the certificate.
  • Final payments: Once the project engineer certifies that the contractor has completed all his obligations related to a particular work, the contractor is entitled to apply for a 'final payment certificate' with the required supporting documents.
    1. Within 28 days of receiving this request, the project engineer must issue the final payment certificate stating the final amount due.
    2. DMRC is mandated to pay the amount certified in the final payment certificate within 56 days of issue of this certificate.

We look at the vendor payments data-set of DMRC to analyse the adherence to these timelines. We find that, on an average, DMRC takes about 4 days to clear its dues from the date of submission of the bill by the vendors (Table 4). For the data-set in our study, the maximum days taken by DMRC to make its payment is about a year.

Table 4: Time period for clearance of dues (in days)
Year No. of bills Average time Median time Minimum time
2019 1326 5 2 0
2020 9887 4 3 0
2021 7891 4 4 0
Total 19104 4 3 0

Payment delays by public sector enterprises in India to their vendors far exceeds their procurement values (Manivannan and Zaveri, 2021). We find that DMRC is an outlier in terms of maintaining payment discipline to its vendors, and in adhering to the timelines provided in its GCC.

Discussion

The public discourse on government infrastructure procurement focuses on delays and time overruns being an indicator of poor government contracting. In this article, we have analysed the capability of a procurement-intensive public sector enterprise to keep up with its timelines in two stages, that is, in contract award and payments. We find that DMRC takes about 3 months to award a contract, and about 4 days to clear its payment dues to vendors. Regardless of this exemplary performance on awarding contracts and paying vendor dues, we also find that the overall project implementation by DMRC failed to meet scheduled timelines to complete. All three phases took a longer time than originally expected. In fact, we observe that the overall project time delays increased from the Phase 1 project to the Phase 3 project.

Executing infrastructure projects on time has been a continuous concern and challenge in India. Our analysis about DMRC timeliness in awarding contracts and in making payments provides evidence against the popular perception that public projects are delayed due to delays in decision-making by the public authorities and their inability to make timely payments. Instead, we speculate that these are because of other factors for overall project delays, some of which could be misaligned allocation of scope and risk in procurement contracts and poor contract management. A deeper analysis into each project, procurement practises, financial and institutional structure of DMRC may help in understanding the reasons for its timely performance in certain procurement processes and the potential causes of time overruns. These learnings can then be adopted by other procuring entities to achieve better procurement and project outcomes.

References

Ministry of Statistics and Programme Implementation Infrastructure and Project Monitoring Division, 434th Flash Report on Central Sector Projects, January 2022.

Ram Singh, Delays and Cost Overruns in Infrastructure Projects: Extent, Causes and Remedies, Economic and Political Weekly, Vol 45, No. 21, May 2010.

PC Sinha and Ananys Vatsa, Delays in Project Completion in India, Indian Journal of Projects, Infrastructure and Energy Law, January 2021.

Erica Bosio and Simeon Djankov, Timely procurement of public works, World Bank Blogs, February 2020.

Department of Expenditure, Ministry of Finance, General Instructions on Procurement and Project Management, October 2021.

Expenditure Management Commission, Recommendations of the Expenditure Management Commission, December 2015.

Department of Expenditure, Ministry of Finance, Manual for Procurement of Works, 2019.

Delhi Metro Rail Corporation Ltd., General Conditions of Contract, November 2019.

Pavithra Manivannan and Bhargavi Zaveri, How large is the payment delays problem in Indian public procurement?, The Leap Blog, March 2021.

Charmi Mehta and Susan Thomas, Identifying roadblocks in highway contracting: lessons from NHAI litigation , The Leap Blog, July 2022.

Charmi Mehta and Diya Uday, How competitive is bidding in infrastructure public procurement? A study of road and water projects in five Indian states , The Leap Blog, March 2022.


Anirudh Burman is an Associate Research Director and Fellow at Carnegie India. Pavithra Manivannan is a Senior Research Associate at XKDR Forum and Chennai Mathematical Institute. We thank Susan Thomas for valuable comments and discussions.

Wednesday, July 13, 2022

More ammo: Improving resilience against extreme surges in demand

by Ajay Shah.

The Javelin anti-tank guided missile is important for the defence of Ukraine. Under normal times, the production capacity seems to be about 3600 a year. The Ukrainians seem to be using 500 per day, or roughly one missile per kilometre of battlefront per day. The peak load is about 50 times bigger than normal times.

Vershinin, 2022 estimates the Russian army is using 7,176 artillery rounds a day, and argues that these numbers are challenging for the modern Western military manufacturing capacity. He estimates that present US annual artillery production would last for about two weeks of combat in Ukraine. In more recent times there are estimates about Russian use of as much as 60,000 rounds/day.

It may appear that with precision guided weapons, a smaller number of weapons will be required to get the job done. However, precise information about targets is lacking, and the military is reduced to shooting at numerous low probability targets. There are more pathways to target acquisition owing to drones, low earth satellites, night vision, etc., and therefore there are more opportunities to use ammo per unit time. The Ukrainian Armed Forces (UAF) innovated with their new `GIS Art for Artillery' system, where rumoured gains on the delays in the kill loop run from 20 minutes to 30 seconds. As a consequence, modern wars are facing production constraints. As an example, in the small air war in Libya in 2011, the UK and France quickly ran out of precision guided munitions (PGMs).

Such problems with the peak-to-base ratio are not unique to ammo. Consider medical oxygen. The peak load in the delta wave was much bigger than normal times. Alongside this, the bulk of the oxygen production is in the economically advanced peninsula, the biggest demand was in the Hindi heartland, and transporting oxygen is difficult as the refrigerated trucks cannot go at over 25 kph.

Or consider surgical masks and personal protective equipment (PPE). The peak demand during the pandemic perhaps went up by 50 to 100 times when compared with normal times.

Or consider medical education. With students returning from Ukraine, there was a small surge in demand for medical education in India. In a healthy economy, there should be a supply response. In a well functioning society, the resource allocation is not fixed.

Or consider electricity. Electricity demand peaks in the evening, windmills are unreliable, the sun shines in the day and can be obscured by clouds. There is substantial intra-day variation of demand (that is quite predictable), but supply is unpredictable and has a different natural intra-day variation. The puzzle of the energy system lies in dealing with the peak-to-trough ratio.

How should we think about such problems? How does the price system respond to these challenges? Is there market failure? What, if anything, is the role for the state in improving things?

Surge capacity as an option

The right but not the obligation to buy is an option. When the buyer has the right, but not the obligation, to buy 2$\times$ more or 20$\times$ more from the seller, at a preset price, this is an option.

As we know from the field of options, options are always valuable (i.e. they come with a non-zero cost). Being there with excess capacity is not free, for the seller. And, the value of the option goes up when there is more volatility. While financial options loom large in the imagination, the world is full of real options.

Surge capacity in the price system

Prices move, from moment to moment, till supply equals demand. When faced with a shortage, prices go up so as to ration out many prospective buyers. And, equally, those high prices tickle firms into producing more. Vast amounts of patience and intelligence are put in, by buyers and sellers, in order to reduce demand (e.g. by finding substitutes) and increase supply (e.g. by producing in innovative ways). Every surge in prices contains the seeds of its own demise, as buyers establish alternatives, and through the supply surge that follows. Covid vaccines were always going to be a short hot market, and production is now being shut down.

When demand surges or supply drops, the price system sends out signals for firms to produce more through high prices. This tends to be accompanied by a lot of hand-wringing about shortages and high prices. If you think "something should be done", to increase output, you should be happy at what is unleashed by the price system, as there is no force more powerful than high prices, in encouraging buyers to buy less and sellers to produce more.

The market economy is not a bureaucracy; it thinks in all sorts of creative ways. If the price of oxygen is high enough, steel factories will stop making steel and sell oxygen into the public market. If prices go sufficiently high, oxygen cylinders from the Indian peninsula, and from abroad, would be airlifted into the Hindi heartland. The sources of increased supply will always surprise us.

But with the best of effort, mobilising enhanced output is hard and takes time. There is a cost to reallocating the resources of the economy, in order to shift from making widget $x$ to widget $y$. The price system finds this reallocation at the lowest cost to society, at the lowest disruption to society, without harming the incentives for sound behaviour and long-term growth.

Many times, a disruption on the output side is also a disruption of the inputs of the firm. When vast increases in output are required, the inputs (whether physical raw materials or the precise human capital) also become costlier. Both supply and demand curves change in many a surge. Such a combination of factors exacerbates the price rise.

Resilience

The price system will sort things out, in the sense of finding the price at which demand equals supply. It is interesting to go one step further and ask: How big was the supply response, of masks produced per day at its peak divided by masks produced per day before the pandemic? A more resilient economy is one where the price system induces a bigger output surge in a shorter time while requiring a smaller rise in the price.

Alternatively, we can focus on quantities and wonder, under what conditions can very large surges be achieved? We can identify a few sources of resilience.

Complexity in the production process

In a country where many things are produced, and in a country with deep pools of skilled people, there will be more headroom for adaptation. If there is a civilian aircraft industry, it can more easily retool to make military craft. If the world's biggest vaccine manufacturer is in our backyard, it can license a good vaccine from abroad and mass produce it. Tractor factories can become tank factories. For a contrast, a country like Saudi Arabia or Russia has simple structures of production, and the price system has inferior raw material to work with.

A successful software tool
is one that was used to do something
undreamed of by its author.

-- S. C. Johnson

The most important ingredient is the human capital: the managers, the chemists who know multiple routes to get to a given molecule, the creative people who can hack a machine or a software system to do things that were `undreamed of by its author'. Resilience comes from deep pools of these individuals, who are sparked into self-interested action by the price system. It is equally about the raw STEM knowledge, and about the creative thinking of the business folk who see profit opportunities, who imagine new kinds of deals, who innovate. These pools of capacity lie in the private sector. Even when a government-controlled system has the creative people, it does not have the incentives for them to think, take risks, innovate, and solve problems.

Of particular importance are adjacent products and dual-use technologies. A factory that makes vaccines can be the right starting point to rapidly get a factory to make Covid vaccines. Cylindrical engineering products made using special alloys, for civilian applications, can be rapidly retooled to make ammo. The lowest costs for augmenting supply come from the presence of these neighbours to the desired product.

In normal times, the optimal structure of production tends to become monolithic. The market tends to collapse into a small set of firms and techniques of production. Monolithic methods of production are inherently risky. When crises come along, we see the value of more diversified and more eclectic methods of production. Price surges, in a crisis, create profit opportunities for obscure strategies for production, and obscure producers. These occasional bouts of profiteering serve to keep these obscure firms, these option sellers, alive.

Private sector confidence

The private sector will stand ready with option-like capabilities, it will be alert, it will move mountains to produce when there is a price surge, all in search of one outcome: high profit rates in those brief extreme moments. A society that views supernormal profits as unjust, and tries to expropriate these private firms, is a society where private firms will layer risk premia on top of their ordinary market-based responses. In other words, we would require an even bigger price surge to elicit the supply side response when the probability of expropriation of the firms goes up.

Globalisation

High domestic prices incite imports; the productive capacity of the whole world is brought to bear upon the shortage within one country. Covid vaccine manufacturing in India was about an Indian facility that licensed a British vaccine design, and used numerous imported materials. A deep engagement with globalisation also increases resilience by fostering higher human capital of the elite. An inward oriented economy, with barriers to cross-border activities in the laws and in the minds, is likely to be less resilient.

Storage

If more ammo, oxygen or PPE are held in storage, this creates greater resilience. There is no free lunch; this storage has costs in terms of the opportunity cost of capital, the cost of storage and depreciation. Someone has to pay for this.

Production capacity that has an upside

Consider a factory that makes ammo. If the private person has a contract where there are the assembly lines and staff running at 1 shift, but are ready to jump up to 3 shifts, then there is headroom for a 3$\times$ increase in output. Sometimes assembly lines can be designed in a way where additional workers can be added and the line then runs faster. This can potentially create space for another 2$\times$ increase in output.

In the case of oxygen, firms in the field of industrial gases can have additional equipment on standby, through which medical oxygen output can go up on demand.

As with storage, there is no free lunch. The private firm would have to have contracts with skilled workers in order to be able to surge the production on demand, and design a production system with this kind of headroom. As with the `disaster recovery systems' in the world of software, the principal should randomly trigger these provisions every once in a while, and verify that each agent is indeed able to surge output as promised under contract.

Capabilities in government contracting

When there was a sudden requirement to fly students from Warsaw to India, the best pathway lies in the government rapidly running an auction, where global airlines compete to deliver the lowest price. Surge capacity for the state lies in the combination of (a) A capable and innovative private sector and (b) A state that is able to enter into contracts with private persons.

Is there a role for public policy here?

Fighting wars is a service that is produced by the government. The strategic planners in the field come up with a requirements document such as `We need to be able to sustain a war for 3 months where we are using 100 tubes a day'. Establishing this level of surge capacity is required as part of production of the public good of defence.

In the case of health, what is required is a careful counting of deaths owing to Covid-19, and assessing the number of deaths which are attributable to the shortage of medical oxygen. A careful analysis is then required, where the statistical value of a life is compared against the costs to society of higher surge capacity for oxygen. If a certain enhanced surge capacity for oxygen is able to save lives, while spending less than the statistical value of a life, there is market failure, and then there is a case for public policy to think about state action.

The fact that there is a surge in oxygen demand does not necessarily imply that there is market failure. We can envision private hospitals propositioning health insurance companies and to individuals, saying that they have established the following kinds of surge capacity for oxygen. This is not unlike the work that private hospitals do, in order to assure themselves of electricity in the event of a disaster. We should skeptically evaluate whether we want a government to do something.

Consider the field of masks and other personal protective equipment (PPE) at the early stages of the pandemic. When demand went up by 50 to 100 times, prices skyrocketed. Some policy makers were red in the face and barged into the economy, with export bans, with efforts to supplant the managers of private firms and organise production. But the right response was to do precisely nothing. High prices created near-magical responses by the private sector; there was a surge of import and production, and competition drove down prices.

State intervention that harms surge capacity

When the price system gets going, solving the mismatch between supply and demand through high prices, we often get many calls for state intervention into the working of the economy with tools like price limits and ordering private firms to operate in certain ways. It is ironic that the very feature that incites more production and reduces the demand -- high prices -- is what irritates some people.

Firms will earn supernormal profits in a surge. These supernormal profits are the fair return for (a) The hard work to modify production capacity in a short time; (b) The alertness and risk taking when faced with an incipient surge; and (c) The long years of holding option-like capabilities which are not earning high returns in normal times. When a society begrudges these supernormal profits, and uses state power to expropriate firms, the response of firms is to be less alert, take less risk, do less hard work in modifying production capacity and hold less real options, all of which worsens the problem faced by society in responding to the surge.

To commandeer resources, to order private firms, without proper compensation, is expropriation. During the second wave, many private firms were forced to stop their production in order to transfer oxygen to medical applications. If they were not compensated for their lost production, this constitutes expropriation.

Price controls hamper the very process of healing. High prices kick off the modification of the resource allocation in order to produce more and consume less. When policy makers use state coercion to force transactions to take place at artificially low prices, this reduces both responses. The one thing worse than a price that moves rapidly by a lot is one that does not.

There are always eclectic and opportunistic firms that jump into the fray and reap huge profits when a certain situation presents itself. These firms might even earn nothing at normal times, and just provide options to society. When the state interferes with the 'profiteering', their viability is adversely impacted.

State intervention that gets surge capacity at an excessive cost

One path to having the requisite amount of peak ammunition is to build a large number of public sector factories, which are idle in normal times, where the full cost of a factory is paid and the workers do nothing. While this does get the job done, it is an inefficient path; it does not harness the cleverness of private firms to get the same surge capacity at a lower price.

When there is a shortage in the country, it is tempting to ban exports. This appears to augment supply in the country, and bring down prices, in the short term. But it harms the trust of all firms to produce in India and thus harms India's long-term growth.

The Indian state attacked firms who were importing oxygen concentrators at the time of their peak demand [example]. This amplified the required rate of return for doing this important work.

The most damaging state interventions are those that directly control the resource allocation (e.g. forcing factories to close down so as to grab their oxygen), and in violating the rule of law with outright threats to coerce private persons. When the state becomes such a bull in the china shop, it tends to disrupt the complexity and sophistication of the resource allocation of the market economy. This encourages private people to produce less in India.

The discussion here, of unwise state intervention, is related to the problem of supply chain resilience when faced with Chinese exports of APIs to the Indian drugs industry. There also, it is possible to do clumsy things. Bambawale et. al. 2021 show how to do this better, how to go with the grain of the price system.

Going with the grain of the price system for surge capacity in ammunition

In the field of defence, strategic thinking should ideally generate a requirements document such as `We need to be able to sustain a war for 3 months where we are using 100 tubes a day'. Alongside this, there may be a peacetime requirement of 5 tubes a day, i.e. a peak-to-base ratio of $20\times$. This problem would get handed off to defence economics.

The best way for defence economics to solve this problem is to undertake the following kind of contract:

  1. To ask for multiple private vendors who add up to a peak capacity of 100 tubes/day while actually running every day in peacetime at one-twentieth this rate;
  2. The private firms would find the cost-minimising paths for obtaining this flexibility in production, and they would do this better than a PSU or a government department;
  3. Each private firm would be subjected to random fire drills, where they are asked to suddenly up their production by $20\times$ for a period of $n$ days with $n < 90$.

In this procedure, we have fixed the surge capacity and are procuring on the price. Alternatively, the procurement can fix the price of the tube, and ask for bids which promise the highest surge capacity.

Through this, the energy and intelligence of the private sector would be brought to bear on the problem of obtaining surge capacity for the public goods of defence. It is better to have multiple private vendors, rather than one, so as to avoid single points of failure/attack, and to set off the spiral of quality where private firms compete with each other to deliver bigger surge capacity at a lower price.

This requires complexity in government contracting. Government contracting is a critical homeostatic capability that is required by all states, which works poorly in India. This is an important field for research.

Once contracts are in place, state actors must work within the rule of law: they must not not coerce private persons to behave in ways which were not contracted. Once the Indian state has behaved correctly for a few generations, the private sector will become more comfortable, and will require reduced safety factors in their pricing.



I thank Akshay Jaitly, Amrita Agarwal and Pranay Kotasthane for useful conversations.

Identifying roadblocks in highway contracting: lessons from NHAI litigation

by Charmi Mehta and Susan Thomas.

Introduction

Government contracting is an important foundational process which shapes state capacity. Under Indian conditions, there is limited state capacity in government contracting, which leads to a significant rate of contracting failure. One manifestation of contracting failure is litigation. Defects in the contracting process are often associated with litigation. In addition, litigation leads to delays in project completion, and the prospect of litigation deters some private firms from working with government thus hampering competitiveness in government contracting (Mehta and Uday, 2022). The study of litigation is, therefore, a pathway to creating knowledge in the field of government contracting. An example this was Damle et al, 2021.

In the `contract life cycle approach', government contracting is a pipeline that runs through four phases: I - Contract design, II - Contract award, III - Contract management and IV - Contract closure. We must measure the incidence of defects across the four phases, so as to prioritise resourcing, in the field of policy research, and in the activity of government contracting.

In this article, we construct a novel data-set about contract related litigation at the National Highways Authority of India (NHAI), which is the single agency that does the largest number of government contracts. Using this data-set, we measure the share of each of the phases of the procurement life-cycle in litigation. In our knowledge, this constitutes the first empirical evidence about the role of the phases of the government contracting life cycle in inducing litigation.

Methodology

We hand-construct a data-set which draws upon information from three sources.

Delhi High Court case orders
NHAI contracts and concession agreements give the Delhi High Court exclusive jurisdiction over its contractual disputes from anywhere in India. We find 1165 cases in 2007-2020 that emanate from NHAI contracts. For each case, we observe the date of initiation and disposal, and the names of parties involved.
Extracting facts from court documents
We read 635 out of the 1165 (65 percent) court documents. Using these, we extracted the cause of dispute whenever it was available. These were found to be one of the following: Interim relief, Appointment of arbitrator, Challenging arbitration award, Seeking extension of time, Seeking award enforcement, Restraining NHAI, Reimbursement of costs/Compensation, Challenging claims demanded.
The NHAI Draft Red Herring Prospectus (DRHP)
While filing for the NHAI Infrastructure Investment Trust listing with SEBI, MoRTH was mandated to disclose all large-value disputes involving the NHAI (that are in arbitration), along with a list of all outstanding claims. This had 40 disputes listed, with information about the dates of initiation, cause of disputes, the model of contracting used for the project under dispute, and the names of parties involved. As a self-disclosed data source, this served as a tool to validate observations from the Delhi High Court case orders data.

We find that NHAI accounts for almost 40% of the cases that the Union Government is party to (1165 out of the Union Government's 2912). We also find that cases involving the NHAI have grown at a rate of 17.15% on average during this period. NHAI is the petitioner for about 45% of the cases, while the corresponding figure for other government agencies is about 30%.

NHAI is such a large scale litigant, that reducing the litigation intensity at NHAI would make a different to the working of the judiciary. This work is thus relevant not just for the field of government contracting, but also for the field of the judiciary.

We develop a two-step process for classifying NHAI contract related litigation orders into the four phases of the government contracting life cycle. In the first step, we categorise cases based on causes of dispute as follows:

  1. Related to arbitration proceedings: One set of cases pertain to petitions that (1) seek interim relief from the court under Section 9 of the Arbitration and Conciliation Act 1996, (2) seek the court's intervention in selection of the arbitrator (on account of delays or disagreement in appointment), and (3) appeal awards announced by the arbitral tribunal, which accounted for a significant fraction of the arbitration related matters.
  2. Payments related: This could be about payments, revision of payment terms, price estimation due to changes in scope/ additional components midway into the construction phase or changes in law or policy leading to adverse conditions of work for the private party. Changes in terms of the contract result in parties disagreeing over revised cost estimates or the method of calculating these revisions. In several cases, the delays were related to reimbursements to the private party on account of delays in land acquisition, or operationalising toll plazas. In some cases, the private firm sought restraining orders from the court against the NHAI invoking bank guarantees when there was a delay in the firm achieving financial closure.
  3. Related to wrongful termination/debarment of contractors: Concession agreements embed the terms of contract termination. Prior to the 2020 amendment in the model concession agreement (which allowed a mutual exit clause), the contract perceived termination as default by either side, with the opposite party having a right to compensation and damages. In the process, NHAI often debarred/black-listed contractors from bidding for tenders, a decision that contractors appeal in court.
  4. Reason unclear: For 253 cases, we were unable to classify the cause of dispute since the order was unclear for interpretation. This may reflect blemishes in the Delhi High Court website. We are conservative and classify a case under `Reason unclear' when we are not confident about placing it into the other three categories.

We go on to classify cases into the four phases of the life-cycle of a contract. This mapping is sensitive to the domain; our classification processes are specific to government contracting in highways and infrastructure.

In all the cases that we studied, there was none in the first phase (the "Contract design" phase).

Litigation associated with defects in the pre-award phase involves disputes on the tendering/awarding processes. For example, this includes disputes regarding unfairly awarded tenders, wrongly classifying bids as non-responsive and irregular financial bid-opening processes, all of which are placed within the pre-award phase.

Reading the orders shows that arbitration-related and payments-related causes of disputes take place once the contract has been awarded. This is also true for some of the cases that are classified as wrongful debarment/termination which arises because of the non-performance of contractual obligations. Since these disputes arise after the contract is awarded, we classify these cases in the post-award phase. Some of the orders contain details about the type of contract between the parties. For example, SPVs are often formed for the construction of a highway, and are named '... Tollway Pvt. Ltd.' which indicates a legal entity that was formed for the purposes of executing a contract or an award. This can be identified from the names of the parties, even if the specific causes of dispute might be unclear in some cases. We use this information in classifying cases under the post-award category.

Traditionally, cases pertaining to payment delays are categorised within the post-completion phase. But in the case of NHAI contracts, payment schedules vary across the commonly used models of Hybrid Annuity (HAM), BOT-Annuity models and EPC. Payments are made to the concessionaire either at the start of construction, or at regular frequencies such as semi-annually, with payments usually linked to the achievement of project milestones. We place such cases in the post-award phase rather than in the post-completion phase. Similarly, case orders that seek to resolve arbitration-proceedings related disputes are also categorised as post-award since these disputes arise from a contractual relationship between two parties to approach alternate dispute resolution mechanisms, which can only exist in the event of a contract being awarded.

Findings

Table 1: Number of cases by drivers of litigation

Cause of dispute NHAI as petitioner Firm as petitioner Total
Arbitration proceedings related 123 137 260
Payments related 15 75 90
Wrongful termination/ debarment 1 31 32
Total 139 243 382

In Table 1, we summarise the number of cases falling under Categories 1-3 listed above. We further break up the cases under each category as the number of cases where NHAI was the petitioner and where the private firm was the petitioner. A large volume of cases are a) arbitration-proceedings related, and 2) payments-related (delayed payments). We see that arbitration related matters are nearly 70 percent of the sample of case orders. In this category, both the NHAI and the firm are almost equally likely to petition an arbitration matter. In the other two categories, NHAI is more likely to be litigated against.

The analysis based on case classification into phases of the contract life-cycle is presented in Table 2. This shows the number of disputes which we classify as falling within the pre-award, post-award, and post-completion phase. In this table, we present both the actual number of cases identified in a given phase, as well as the share of the cases as a fraction of the total.

Table 2: Share of disputes by the phase of the contract life-cycle

Phase of the contract life-cycle Share (% of Total) Number of cases
Pre-award 1.75 11
Post-award 66.14 420
Post-completion 0.15 1
Unclear/No data recorded 31.95 203
Total 100.00 635

Table 2 shows that over 65% of the cases are concentrated in the post-award or the contract management phase.

Discussion

In this article, we have analysed one important government contracting organisation, and attributed its litigation into the four phases of the contract life cycle. The results diverge from the commonly held view that the problems in public procurement arise because of problems with Phase 2 or L1 tendering. This analysis suggests that the hot spot in litigation is Phase 3 or the Contract management phase. This suggests that policy researchers and policy practitioners should allocate greater resources on strengthening this phase.

Another finding is that there is a large volume of arbitration-proceedings related disputes, which indicates the limitations of alternate dispute resolution (ADR) mechanisms. Strengthening ADR mechanisms in India would result in less litigation.

Recent reforms of the government contracting process have initiated movement on this front. The General Instructions on Procurement and Project Management (2021) built provisions to address concerns around arbitration and dispute resolution. It acknowledges that the majority of the cases appealed by government agencies end up being awarded in favour of the opposite party. In this context, the General Instructions emphasize the need for the government to actively take steps to minimise litigation. Further, it inserts Rule 227A in the General Financial Rules (GFRs) 2017 for Arbitration Awards, which mandates that the concerned ministry pay 75% of the amount of the arbitral award against the bank guarantee, even if it contests the award in a court of law. This is a step in the right direction as it takes away the incentive for either party to benefit from prolonging a dispute or appealing to a higher authority to delay payment of claims awarded by the arbitral tribunal.

References:

Damle D., Gulati K., Sharma A., and Zaveri-Shah, B. Litigation in public contracts: some estimates from court data., The LEAP Blog, May 2021.

Mehta C., and Uday D., How competitive is bidding in infrastructure public procurement? A study of road and water projects in five Indian states, The LEAP Blog, March 2022.

Charmi Mehta is a researcher at XKDR-Chennai Mathematical Institute and Susan Thomas is professor at the Jindal School of Business and a researcher at XKDR Forum. The authors thank Shailesh Pathak and Bhargavi Zaveri-Shah for their inputs in shaping the study, and Yajat Bansal and Diya Mal for their research assistance in this study.