Carillion, Capita and the costly contradictions of outsourcing public services

Is it time to stop outsourcing? Joe Giddens/PA Wire/PA Images

When major construction company Carillion collapsed, much of the attention was focused on issues specific to its business model and corporate governance, or on the UK’s PFI model of funding large infrastructure projects. Yet such explanations miss the broader lessons of this tragedy. With other outsourcing firms such as Capita now facing similar woes, it is becoming clear that there is a deeper and more fundamental problem with modern public sector outsourcing.

The key here lies in the qualifier “modern”. Delivery of public services by private providers is nothing new. In the 17th and 18th centuries, “privateers” conducted naval operations on behalf of the British state. In the early 1800s, Jeremy Bentham argued that what he called “patriotic auction” – granting official positions to the person willing to undertake the role for the least salary – would provide the best result for the least cost.

But the logic of modern outsourcing is fundamentally different. Bentham thought patriotic auction would produce better public services because it would select people driven by a liking for the work, rather than a desire for money. The idea of companies making a profit through exercising powers on behalf of the Crown was deeply controversial in his day.

Jeremy Bentham. Henry William Pickersgill via Wikimedia Commons

Modern public sector economics, however, places its faith in the very thing Bentham rejected: the desire for money. It subscribes to auction theory, which suggests that providers, driven by the profit motive, will compete fiercely for contracts, driving up quality and driving down costs. The same thinking has been reflected in official UK policy since the Deregulation and Contracting Out Act of 1994.

Reality bites

In reality, the power of the market has always been limited, as Carillion’s collapse and Capita’s difficulties go to show. Some services were outsourced to great effect: a 2013 National Audit Office report cites examples such as appointment booking call centres. But as the scale and complexity of outsourced services increased so did the complexity of the tendering process.

Firms which proved adept at coping with this complexity invested further in acquiring expertise and in consolidating with other firms. This was exacerbated by government policies seeking to boost the participation of smaller companies in outsourcing. The intention behind these policies was to open up outsourcing to small business. But their main effect was to further stratify the market into two tiers of firms.

The first was the firms operating at the coal face of public services – serving school meals, cleaning hospital wards, maintaining computers, laying railway track, and so on. The second was specialist outsourcing firms operating as a second bureaucracy: preparing bids, managing contracts, and coordinating the actual delivery of public services by smaller, private providers. Meanwhile, they provided very few services in-house.

The result was a relationship of mutual dependence between the government and specialist outsourcing firms. The government became reliant on a small number of firms for a growing number of tasks, as its own capacity to perform them atrophied. But, equally, specialist outsourcing firms became dependent on the government. Their business could only be sustained through a pipeline of large projects, which only the government regularly provides.

Both sides thus became vulnerable to the predation of the other. Contractors might be tempted to inflate their prices – the example of one hospital PFI contract that resulted in light-bulbs costing £333 to change springs to mind. Government, meanwhile, might be tempted to use its buyer power to force down prices, or to mandate higher service standards.

Struggling to do more with less

Under normal circumstances, each of these tendencies checks the other. But this delicate balance was upset by the austerity policies of the 2010s. Revenues to spend on public services were depleted as money was diverted towards servicing the debts of failed financial institutions. Government bodies were pressured to do more with less, and negative press coverage of fat margins meant that this was also transferred to contractors.

A reduction in the costs of privately provided public services can only be achieved through aggressive negotiation practices, making the conclusion of a contract conditional on accepting a lower price. This was precisely the strategy pursued by the government in recent years.

Less money, less capacity. shutterstock.com

Normally, a firm would walk away if a customer was not prepared to offer sufficiently profitable terms. Yet several outsourcing companies took on loss-making contracts. This is the inevitable consequence of the relationship of mutual dependence that modern outsourcing creates. Without a steady stream of government business, specialist outsourcing companies could not maintain their scale. And if they could not maintain their scale, they would be less able to compete in future.

One response is to downsize, as companies like Serco did. Likewise, Atos terminated its contract providing disability benefit assessments for the Department of Work and Pensions.

Reducing the level of service is also an attractive option, especially for firms providing services far from the public eye. Immigration and asylum offers a rich seam of examples for this – from replacing advisors with self-service kiosks to unsanitary housing conditions. But entities which cannot downsize or pare back quality will inevitably be forced down the path of ever-thinner margins.

This seems to be what happened to Carillion, whose thin capitalisation and lack of assets forced it into a vicious cycle of chasing further contracts at ever slimmer margins to pay its suppliers. The same problems lie at the heart of Capita’s dividend suspension.

Capita seems to be forced down a similar path, allowing itself to become, in the words of its Chief Executive Jonathan Lewis, “too widely spread across multiple markets and services” while at the same time it “underinvested in infrastructure”. This was seemingly logical for a firm whose core strength is competing in complex tendering processes. Like Carillion, it ended up seeking new business to compensate for losses.

All this is far removed from what the proponents of outsourcing envisaged, but it should have been entirely predictable. The relentless expansion of outsourcing to ever more complex domains was premised on a level of competition which is impossible to achieve, and it ignored the phenomenon of mutual dependence which is impossible to avoid.

That most economists ignore this problem suggests that the economic study of the state has become, as John Rapley has provocatively argued in Twilight of the Money Gods, more concerned with vindicating its belief in its official doctrines, than with generating new knowledge about economic institutions. Yet the view that competition among public service providers will necessarily lead to improved services at lower costs is no longer tenable.