Contract Risks in Social Impact Bonds: Research from Pandey et al.

Social Impact Bonds are a relatively new financing mechanism in public policy. They are interesting because they look like an X-prize or a professional athlete’s incentive laden contract, but with social policy targets. A government writes a contract with a private sector entity that specifies a set of goals with rewards earned if targets are met.

Government Executive has published a nice, digestible, overview of what the literature has learned, drawing particularly from “Use of Social Impact Bonds to Address Social Problems: Understanding Contractual Risks and Transaction Costs” by Sheela Pandey (Penn State-Harrisburg), Joseph Cordes (George Washington University), Sanjay Pandey (George Washington University), and William Winfrey (Centers for Medicare and Medicaid Intervention) that appears in a recent issue of Nonprofit Management & Leadership. From the abstract:

 

We conduct an in-depth case study of the Social Innovation Financing Youth Recidivism project (SIF) in Massachusetts. Our case study is comprised of a qualitative analysis of the multi-party contract and multi-year quantitative benefit-cost analysis to understand transaction costs. We draw upon contract theory to develop an analytical framework for the case analysis and highlight the risks and safeguards for the various parties to the contract, and conduct a formal benefit-cost analysis to map out transaction costs. We conclude with a discussion of study implications and future research.

The most obvious advantage of SIBs is the idea that the government only pays for some degree of success, instead of taking on a new costly venture that may or may not work out. However, what much of the article does is attempt to explain these contracts within Contract Theory. Writing a contract is about solving a variety of information problems like adverse selection, moral hazard, and principle-agent problems. What Pandey et al. discuss is that the merits of social impact bonds depend heavily on the types of contracts the public entity can write, either with vendors who would run the program or with their own in-house staff, given their institutional constraints. In principle, this is the same problem underpinning the make-or-buy decision of the for-profit sector, where contracts generate incentives, create information, and provide accountability. A department store like Target and a shopping mall are similar entities that have organized their production with very different contracts. Target executives don’t know exactly the right amount of floor space to devote to women’s shoes in Bloomington or what mix of brands to carry, but they have contracts that attempt to internalize this decision with local management and information systems; the shopping mall attempts to auction off the square footage to the highest bidder, letting the market answer those questions. The former system requires Target executives to have a lot of top level information over how to run a store so they can manage their local managers correctly, while the shopping mall executives forgo those costs entirely but take significant transaction costs by repeatedly accessing the market system to negotiate their floor space. (N.B. “Bosses Don’t Wear Bunny Slippers.”)

What Target and the shopping mall have going is a lot of common interest in making profit, which is observable and the litmus test for participation. In the public space, Pandey et al. make the case that the underlying problems of information, incentives, and transaction costs remain with a political twist. Without a profit motive aligning all the vested stakeholders, many of the information problems are not as easily defined through contracting, and all parties have some incentives for opportunism. The authors provide a framework for thinking through dealing with different types of contractual hazards associated with the stakeholders party to the contracts (p. 513, Table 1):

  1. Standard opportunistic behavior: the private sector agency taking the contract might be a source of risks associated with moral hazard, adverse selection, and other types of incomplete information.
  2. Governmental opportunism: Private sector actors are subjected to risks from governmental agents (which can be much broader than the specific agencies undertaking the contracts). Governments necessarily consist of competing factions of power (e.g., political parties, legislative vs. executive vs. judicial, etc.) that can benefit from contract failure at the expense of their governmental rivals.
  3. Third-party opportunism: A public contract undertakes scrutiny from the public and/or perhaps agencies associated with transparency or contract monitoring. For example, some of these third parties have their own opportunities for profiting from the attention received for being perceived as whistle-blowers.

The case studies provide many examples within this framework, and the paper is very nuanced. The discussion in section 5 is a must read.

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