Examples of the cost of corruption on infrastructure projects

Example 2:  Example of the cumulative effect of corruption on project costs

Corruption can occur all the way down the contractual chain.  A major infrastructure project may have thousands of contractual links, between the main contractor, sub-contractors, sub-sub-contractors and suppliers.  

At the top of the chain, the main contractor may pay US$30 million as a bribe to the government representative in return for the award of a major infrastructure project.  

At the bottom of the chain, a sub-sub-contractor or supplier may make a payment of US$500 to the procurement manager of a company in exchange for a minor sub-contract or supply contract.  

Fraud (such as false or inflated claims) can also have an enormous impact on the overall contract price.  It can occur at every contractual link.  

The cost of the bribes and false claims will often form part of the final contract price, and have a cumulative effect.  A bribe or false claim at the bottom end of the chain may be passed all the way up the chain, with an overhead cost added at every level, magnifying the cost of the initial bribe or fraudulent act.  

While the costs and effects would vary tremendously from project to project, the following hypothetical scenario illustrates the cumulative effect of bribery and fraud on an infrastructure project.

Assumed facts

Assume that a power station would cost $100 million if properly engineered, if awarded after a genuine arms-length open-market tender, and if managed in an environment free from bribery and fraud.  The following example analyses what could happen to the $100 million price if the environment was not free from bribery and fraud.  The calculations and methodology are deliberately simplistic.

• A utility in a developing country requires a power station, and calls for international tenders to build the power station.
• The power station which should cost $100 million is over-designed and over-specified by 20% so as to maximise the opportunities for bribery amongst the government ministers and utility staff. Additional cost: $20 million.  Power station cost now $120 million.
• The contract calls for a 10% retention.  The contractor assumes that it will never be paid the retention, as it is aware that the utility will probably create false claims against the contractor to set off against the retention.  The contractor therefore adds the value of the retention into the contract price twice. Additional cost: $12 million.  Power station cost now $132 million.
• A bribe of 10% of the contract price is required.  The contractor includes the cost of the bribe in the contract price.  Additional cost: $13.2 million.  Power station cost now $145.2 million.
• The power station cost is to be covered by an export credit guarantee in the form of a buyer credit.  15% of the project cost will be paid by the utility in cash direct to the contractor.  85% of the project cost ($123.4 million) will be financed by a loan from an international bank secured by the export credit.  The utility is based in a high risk country for which the export credit agency charges a premium of 8%.  The premium on the uninflated cost of $100 million is already included as part of the $100 million cost.  The additional unnecessary cost of the power station is $45.2 million.  The additional premium on this amount is $3.6 million (8% x $45.2 million).  Power station cost now $148.8 million.
• The infrastructure period is 3 years.  The loan on 85% of the project cost charges interest at 6% per annum over 15 years.  Interest during the 3 year construction period is to be capitalised.  The utility would in any event be paying interest during construction on the uninflated cost of $100 million.  The additional unnecessary capitalised interest during construction is $8.8 million (8% x $48.8 million x 3 years).  Power station cost now $157.6 million.
• The project is completed late, and there are some defects and performance deficiencies in the power station.  The contractor and the utility blame each other.  The contractor makes claims against the utility for variations and loss and expense.  The utility has no intention of paying the contractor’s claims.  It also wishes to keep the retention of 10%. It therefore counterclaims against the contractor for liquidated damages, defective work and performance deficiencies.  The counterclaim of the utility is equivalent to 10% of the contract price plus the value of the contractor’s claims.  The contractor increases its claim to a figure which matches the utility’s claim.  The claims and counterclaims therefore effectively neutralise each other.  A large proportion of both the contractor’s claims and the utility’s counterclaims are false or exaggerated.  After each incurring legal and expert fees of $0.4 million, the contractor and the utility settle on a walk away basis.  The contractor is compelled to absorb costs which it should have been able to recover from the utility had the utility not falsified counterclaims.  Power station cost to the utility now $158 million.
• The capital cost of the power station is therefore, at the date of completion of the project, $58 million higher than it should have been.  The cost will further increase during the lifetime of the 15 year loan, as interest of 6% per annum will be paid by the utility on the additional unnecessary cost of $58 million.  This results in the utility paying additional unnecessary finance charges of $3.5 million per annum.
• As a result, the utility has a capital overspend of $58 million which needs to be repaid, and an additional annual finance charge of $3.5 million.
• The consumers who use the electricity produced by the power station would not be able to afford the electricity if the true cost of producing the electricity were taken into account.  The utility therefore charges a subsidised amount for the power, and its income as a result is too low for the utility to be able to repay the capital and pay the interest on the loan for the power station.  The utility defaults on the loan.
• The power station breaks down. Because of the default on the loan, the utility is unable to borrow further sums to purchase spare parts.  The contractor is aware of the utility’s financial difficulties, and therefore refuses to supply spare parts and to repair the power station unless it is paid in advance in cash.  The utility cannot do so.  The power station is not repaired.  The consumers receive insufficient electricity.
• The bank is paid its annual interest under the export credit guarantee.
• Eventually, part of the outstanding capital and interest in relation to the loan for the power station is written off as a result of an international debt relief package.  The bank is re-paid its capital under the export credit guarantee.

Result of above assumed facts 

In consequence of the assumed facts above:

• The consumers in the developing country do not receive a continuous supply of electricity due to the late completion, breakdown and non-repair of the power station.  This damages industry in the developing country.
• Aid to the developing country is cut back due to the loan default and rumoured corruption in relation to the project.
• The $58 million overspend means that this sum is not available for use on other projects.
• Part of the ultimate cost of the bribe and project overspend is paid by taxpayers in the developing country, who cannot afford such a burden.  The balance is paid by taxpayers in the developed country owing to the debt write-off.
• No further orders for major capital projects are placed by the developing country due to lack of aid.  The consumers in the developing country lose the opportunity to improve their lives.  Contractors in the developed world lose potential business.
• In the short term, the contractor and the bank gain, as the contractor is paid the contract price, and the bank is paid the capital and interest on the loan.  However, in the long-term, they lose potential business in the country due to lack of further development.
• The contractor and its relevant employees face the long-term risk that the bribe will be discovered, and that they will be prosecuted for bribery.  The bank and export credit agency and their employees face the risk of being prosecuted for aiding and abetting if they knew of the circumstances of the bribe, or were wilfully blind.
• Ultimately, only the recipients of the bribe gain.  They may move country to avoid prosecution.  The bribe money is normally retained in offshore bank accounts for the use of the recipients of the bribe and their families.