Corruption Information

Cost of corruption

As explained in What is corruption, GIACC uses the term "corruption" in the wider sense to include bribery, extortion, fraud, deception, collusion, cartels, abuse of power, embezzlement, trading in influence and money laundering.   Consequently, the discussion in this section applies to all such criminal activity.

There are many types of corruption cost in the infrastructure sector. Many of these costs will be difficult to identify or quantify. They include the following (where caused or contributed to by a corrupt act):

  • Inflation of project financing costs due to:

    • Inflated interest rates
    • Inflated fees or commissions
    • Bribes paid to secure the provision of financing
  • Inflation of project price due to:

    • Anticipated corrupt non-payment by the project owner
    • Inclusion of cost of bribes paid on contract award
    • Inclusion of cost of bribes paid during contract execution (to obtain certificates, payment, approvals)
    • Inclusion of cost of facilitation payments (to obtain government permits)
    • Fraudulent claims
  • Sub-quality final product due to:

    • Competent, non-corrupt contractors withdrawing from a corrupt market
    • Under-supply of materials and equipment
    • Supply of defective materials and equipment
    • Supply of defective works
    • Approval of defective materials and works
  • Inflation of the operating tariff due to:

    • Fraud by the operator in initial agreement of contract terms
    • Agreement of corrupt terms between the operator and government official
    • Inclusion of cost of bribes paid on contract award and/or during contract execution
  • Theft of the product due to:

    • Inadequate monitoring
    • Corruption of inspectors
    • Overcharging of consumers
  • Losses suffered by non-corrupt companies due to:

    • Loss of contract award because of refusing to bribe
    • Loss of contract payment or other contract entitlement due to refusal to bribe
    • Loss of business due to withdrawal from corrupt markets
    • Legal fees in challenging corrupt project decisions
  • Social and economic damage due to:

    • Depletion of public funds due to white elephant, overpriced or defective projects
    • Lack of adequate infrastructure
    • Death and personal injury where safety measures are circumvented, or contract quality is compromised
    • Circumvention of environmental safeguards
    • Economic and reputational damage to the construction and engineering industry
    • Economic and reputational damage to the country resulting in reduced investment.

Calculating the cost of corruption in infrastructure

It is impossible to give any accurate figures of the cost of corruption in the infrastructure sector on a national or international scale. Corruption is concealed. Most corruption is never discovered. Even if it is rumoured to exist, it is often not investigated. Relatively few prosecutions are brought, and even if they are, proof is difficult. Finally, even where corruption is discovered and successfully prosecuted, the full extent of the losses due to corruption may be difficult to establish.

Estimating the cost of corruption in infrastructure

In view of the difficulty in calculating the actual loss to corruption, attempts have been made to estimate this loss. A common form of estimate uses the average percentage of project value that is assumed to be required to be paid as a bribe in a particular country in order to win a main contract. For example, it could be said that in Country X, bribes are normally in the region of 5% of the main contract price for public sector projects. This estimate is then used to provide an estimated global figure of the loss to corruption by taking a similar percentage of total infrastructure expenditure worldwide.

However, even as an estimate, this is not necessarily representative of the full cost of corruption on a particular project. It may be only a small part of the equation. In particular, it takes no account of the bribes that may have been factored into contract prices further down the contractual chain in order to win sub-contracts and supply contracts. The cost of these bribes is normally included in the contract prices all the way up the contractual chain. As a result, a bribe of 5% paid to win a main contract will be calculated on a build up of sub-contract prices which in themselves may already include bribes. The overall loss to bribery on award of all the project contracts could therefore be far higher than the 5% paid at main contract level. This can be demonstrated in the following example where the ostensible bribe on the main contract was only 5%. However, the overall loss to the public purse due to bribery was $16 million, this being 16% of what the main contract price should have been.

Contractual chain Contract price with bribe (i.e. other sub-contract price + own price + bribe) ($) Contract price without bribe ($)
     
Sub-sub-sub-sub-contractor
0m + 20m + 5% bribe = 21m		 20m
Sub-sub-sub-contractor 21m + 20m + 5% bribe = 43.05m 40m
Sub-sub-contractor 43.05 + 20m + 5% bribe = 66.2m 60m
Sub-contractor 66.2m + 20m + 5% bribe = 90.5m 80m
Main contractor 90.5 + 20m + 5% bribe = 116m 100m

 

The above example assumes that each sub-contractor is obliged to pay a bribe of 5%, and has included the cost of the bribe in its own contract price. This then means that the project owner/taxpayer (in the event of public sector projects) or the project owner (in the case of private sector projects) eventually bears all those bribery costs. However, to the extent that this does not happen, then the relevant contractor or sub-contractor will itself suffer the cost of the bribe.

The above method of estimate also does not cater for other types of corruption that may take place during the project. The "Effect of Corruption on Project Costs" (below) provides an example of how different types of corruption throughout the cycle of an infrastructure project result in a very large cumulative increase in project cost.

Example: The 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 a infrastructure project.

Scenario: 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:

    • 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.

The relevance of the cost of corruption

Measuring the cost of corruption is often considered to be a necessary part of determining how to combat corruption. The view is that a suitably significant cost must be shown in order to justify the cost of implementing anti-corruption measures and in order to indicate where the focus of anti-corruption measures should be. However, as shown above, it is not possible accurately to estimate the cost of corruption, nor is it possible to identify where the greatest corruption may take place in a project. Attempts to do so may result in a distorted picture of the degree of corruption in any particular project phase with a consequent mistaken focus of anti-corruption measures.

The decision to combat corruption should be made on the following assumptions:

  • No individual or organisation is immune to corruption;
  • Corruption can occur in developing or developed countries;
  • The incidence of corruption is a function of the degree of anti-corruption measures in place;
  • The fewer anti-corruption measures in place, the greater the risk of corruption;
  • In any infrastructure project:

    • there is a significant likelihood of corruption;
    • corruption can occur in any phase;
    • the higher the value of the project, the higher the likely loss to corruption.

Appropriate preventive measures should be implemented on the basis of the above assumptions and not on the basis of any (most likely inaccurate) estimate of the costs of corruption in any particular country, sector, type of project or project phase.

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Other resources

Several organisations provide guidance and information on the above issues. These organisations are listed below in alphabetical order.   If the following details are inaccurate or incomplete, or if you are willing for your organisation to be listed below, please send details to GIACC.   Only services and tools which are available free of charge will be listed.

 

The Chartered Institute of Building

 

Transparency International

 

U4 Anti-Corruption Resource Centre

 

World Bank

 

Page updated on 1st May 2008

© 2008 GIACC

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