Chapter 7. Corruption risks in revenue spending and social investment projects

Corruption in public procurement and investment

Corruption in public procurement and investment can take the form of tender rigging, budget capture, embezzlement, extortion, bribery and kickback from suppliers or customers in exchange for securing contracts and deals, patronage, cronyism and clientelism (e.g. officials granting projects to members of their inner circle), abuse of office, diversion of public funds allocated to social projects to benefit private interests, misuse of public assets and violation of regulations (e.g. ordering goods and services not authorised in the budget, investing public funds in other projects than those initially foreseen in budgets or development plans,1 theft of government supplies, etc.).

Tender rigging includes practices such as collusive pricing, lowballing (i.e. underpricing of bids using change orders to raise costs), contract steering and favouritism in contract awards as detailed in previous chapters. These corrupt practices tend to particularly affect the procurement of large, capital-intensive and complex public works projects such as infrastructure building (World Bank, 2007). However, even smaller projects involving the provision or financing of power generators to communities may be tainted by conflicts of interest.2

Corruption and misuse of public funds in connection with public spending and investment in local communities development

In producing countries, national legislation may require local governments to spend a share of revenues from resource extraction on social services such as health, education and capacity development for local communities living in the vicinity of the production area. Earmarked resources may however be diverted or misused and spent for other purposes.3

In some countries, a share of the resource revenues may be directly transferred to traditional authorities who are responsible for funding local community development projects. In this case, the allocation and spending process may be undermined by risks of elite capture, cronyism and clientelism, and appropriation of resource revenues by traditional authorities and leaders for personal enrichment.

Bribery and misuse of public assets

Fossil fuel subsidies4 commonly funded out of resource revenues can represent a driver of corruption in the refining and marketing segment of the oil value chain. The most common associated corruption schemes include the misuse of public assets and bribery (World Bank, 2007). Fossil fuel subsidies in the form of the imposition of price controls for fossil fuels often results in product shortages creating opportunities for lucrative corrupt activities and smuggling practices. For instance, the literature reports the case of subsidies for petroleum products used to fuel corruption and illicit activities. Refined products purchased on international markets were sold domestically at a control price of less than a quarter of the import price. Yet, a very high percentage of this cheap gasoline went right back out of the country through smuggling and illicit trade (World Bank, 2007). This type of scheme may involve the payment of bribes and kickbacks to public officials in the negotiation phase of product import contracts and may also be part of more complex schemes involving crude-for-refined-products swap contracts described in the previous chapters.

Fraudulent overbilling and cost overruns

Fraudulent overbilling and project cost inflation may be used to conceal corrupt conduct in public spending and investment. Illegal payments or misappropriated funds may be recorded as payments for goods and services not received or for unearned salaries following for example a failure to ensure the timely deletion of names of former staff from the payroll (World Bank, 2007).

Moreover, corrupt agents may encourage the use of substandard materials or practices in construction projects in order to divert part of the funds dedicated to the project.

Use of offshore bank accounts and shell companies

Corrupt agents may resort to offshore bank accounts or shell companies to conceal the proceeds of corruption or diverted funds.

Fossil fuel price controls and subsidies

Price control policies and subsidies may serve as a vehicle for corrupt conduct and smuggling practices.

Insufficient capacity for budget planning and execution

Corruption in public spending may be attributable to poor budget planning and execution capacity, at the local level in particular. Local authorities may be faced with the challenge of estimating budgetary inflows and outflows. The lack of access to comprehensive and transparent budgetary information and revenue estimation and collection may result in poor cash planning and predictability of funds and systemic overestimation of revenues (World Bank, 2007). On the expenditure side, budget formulation may be undermined by the misalignment of spending choices with development objectives (e.g. education, health care, drinking water, infrastructure, etc.) (UNDP, 2015); the lack of consultation with beneficiaries, and the ineffective design of development projects (e.g. specifications, scope of work, deliverables, project completion milestones and assumptions about project risks) (UNDP, 2015). Moreover, the lack of absorptive capacity of the local administration and the local economy (e.g. local domestic supply of qualified labour, training capacity, ease of access to inputs, ease of access to credit for businesses, and presence of management systems and institutions) challenges the ability of local governments to transform financial resources into concrete infrastructure and social services (Acosta, 2015).

Budget planning and execution may suffer from additional weaknesses including the lack of clear definition and segregation of roles and responsibilities among officers in charge of budget formulation and execution resulting in excessive power discretion and the lack of regular independent audits of public expenditures to ensure timely project completion, quality deliverables and value-for-money (UNDP, 2015). Weak local government capacity tends to de facto legitimise traditional authorities’ power, increasing risks of political discretion and corruption (e.g. trading in influence, collusion, nepotism) (Standing and Hilson, 2013).

Lack of transparency in public procurement processes

With regard more specifically to public procurement processes, corruption may arise from the lack of open, publicly advertised and competitive bidding for the selection of contractors and subcontractors. When public procurement is made through bidding, corruption risks may be attributable to vague and unclear pre-qualification and evaluation criteria or excessive discretion of evaluators in bid evaluation systems. Moreover, possible collusion between traditional leaders and extractive companies or between traditional leaders and members of local or central governments may result in inefficient allocation of resources including duplication of funds for identical projects;6 the awarding of “exclusive contracts”; or unpredictable renegotiation of awarded contracts.

Inadequate control and monitoring by central authorities

Ineffective and insufficient state control and monitoring over local governments’ revenue administration may contribute to increasing corruption risks in public spending. More specifically, vulnerabilities may result from non-adapted state certification systems, weak accounting practices and reconciliation procedures, irregular, inaccurate or incomplete fiscal reporting or the lack of penalties for deviations from planned revenue and expenditure targets.

Overly rigid allocation rules may provide little leeway for local authorities to respond to unexpected or urgent needs and incentivise them to commit irregularities (e.g. making informal agreements with contractors to obtain extra goods or services without including them in the receipts).

Finally, in some countries, central authorities may face difficulty in ensuring resource revenue traceability and control due to the lack of transparency and accountability over funds directly transferred and allocated to traditional authorities (Standing and Hilson, 2013); or the lack of clear and explicit legislation regarding the role and responsibilities of traditional authorities in local political processes (Standing and Hilson, 2013).

Mismanagement of extra-budgetary allocations

Another risk factor for corruption in public spending consists of mismanagement practices in extra-budgetary allocations such as those made to resource-related funds, special investment vehicles (e.g. regional development or targeted funds) or state-owned extractive companies. The lack of transparency and accountability over the use of these extra-budgetary allocations combined with the lack of commercial viability of domestic investments made through these special investment vehicles contribute to increasing exposure to corruption risks.

In the case of state-owned enterprises, risk factors include: the lack of clear definition of their ownership structures and fiscal role, the lack of separation between their commercial and non-commercial activities such as policy, regulatory and social obligations (NEITI, 2011), the lack of compliance with international accounting standards and inclusion of their financial information in the national budget (NEITI, 2011), the lack of regular and independent audits, and the lack of public disclosure of financial audits and information on their activities, in particular on quasi-fiscal activities (World Bank, 2007).

Inadequate energy subsidy system

Risk factors contributing to corruption related to energy subsidies include inadequate levels of price controls and subsidies, the lack of transparent competitive tendering for import contracts and insufficient metering capacities to detect fraud in oil volume reporting or theft.

Corruption in connection with mandatory local development funds or programmes

It is quite common for extractive companies to be required to grant additional funds above licence fees to the central or local government with the understanding that those funds should be spent to finance local development projects such as the building of irrigation infrastructure, schools and hospitals for the benefit of the communities directly affected by those extractive activities. These funds are usually administered through local development funds which may be state-managed, firm-managed or state-established and community-managed. Hybrid governance structures involving all three types of stakeholders may also occur (Dupuy, forthcoming 2016).

In this case, corruption schemes in connection with the creation and management of local development funds may include elite capture, embezzlement, misappropriation and misuse of funds for purposes other than those governing the fund.

During the approval process for the allocation of funds, decisions, including those over the choice of contractors, may be tainted with risks of conflicts of interest, elite capture, political interference, favouritism, and clientelism. The construction phase itself may suffer from unjustified over-expenditures suggesting diversion or misuse of the funds.7 Local infrastructure construction projects carried out as part of resettlement projects may also be exposed to such corruption risks. For example, a member of the Working Group on Corruption Risks reported the case of the misappropriation of funds as part of a resettlement project financed by a large multinational company. The owner of the subcontracting company in charge of building the housing and other community infrastructure for the resettled communities allegedly benefitted from good political connections for the award of the contract and was suspected of embezzlement resulting in poor infrastructure delivery to resettled communities.8

Corruption related to contractual and non-contractual contributions in the form of charitable donations or sponsorship

Extractive companies may also make contributions as part of or outside contractual arrangements to support local community development taking the form of charitable donations or sponsorship.

In both cases, most commonly found corruption schemes include bribery as well as diversion and misuse of public assets. The OECD Watch online database reports a case of alleged diversion and misuse of public assets in connection with charitable donations whereby an agreement between the government and a foreign company provided for the donation of trucks to the government purportedly intended to support agricultural activities in rural areas. The company indicated that there was an understanding with the government that the relevant ministry would ensure the proper distribution, use and monitoring of the vehicles. However, it is alleged that the vehicles ended up mostly in the hands of the members of parliament and decision makers that had a say on issues regarding the company’s future investments in the country.

Voluntary contributions may also serve to influence the licensing decision process and be used as a bargaining chip in exchange for undue advantages (e.g. awarding of the licence, exemption of certain obligations, etc.).

Fraudulent overbilling and cost overruns

Fraudulent overbilling and cost overruns may be used to conceal corrupt conduct in the social expenditures by private companies.

Fraud and distortions in accounting and reporting

Social expenditures by private companies channelled through the government or directly transferred to local communities may not be appropriately reported and accounted for in the government’s books and records. Voluntary contributions may be particularly vulnerable to this type of fraud as they do not always appear in contractual provisions.

Lack of transparency and asymmetry of information about social expenditures made by companies

On the government’s side, opacity, vagueness and inconsistency may characterise the rules and procedures governing social expenditures by companies. The confusion may come from: the lack of distinction between social expenditures mandated by law and voluntary commitments by companies; the inadequate level of transparency and selective information disclosure on contractual provisions between the companies and public authorities regarding social expenditure; and the time lag existing between a licensing decision or contract negotiation process and the actual disbursement of social expenditure.

The information asymmetry regarding social expenditures does not exclusively occur when funds are centrally managed and exclusively entrusted to central authorities. Such funds may also be conferred by extractive companies to traditional leaders or local governments, without central government’s proper oversight and monitoring (PH-EITI, 2015b).

These factors, combined with the lack of transparent and proper recording in public accounting of the private companies’ contributions to community development projects (in particular with regard to non-contractual contributions),9 make tracking and monitoring difficult (NRGI and RELUFA, 2014). On the company’s side, the lack of harmonised practices in reporting on social expenditures may further challenge the government’s ability to track and reconcile payments (PH-EITI, 2015b).

Mismanagement and misallocation of social expenditures

Corruption may thrive as a result of mismanagement and misallocation of social expenditures by government authorities. Diverse factors may account for corrupt practices starting with the inconsistent allocation of social expenditures with local development plans and actual needs (NRGI and RELUFA, 2014; PH-EITI, 2015b). Moreover, the decision-making process over social expenditure management and allocation may be inappropriate – either too centralised, excluding local communities and authorities, or alternatively, delegated to influential local elites and unaccountable local institutions. When funds are centrally managed, the lack of collaboration and consultation with local community leaders and members may result in ill-designed solutions for the selection, design and implementation of projects (NRGI and RELUFA, 2014; Transparency International, 2012). When funds are directly transferred by the extractive company to traditional leaders, the legislation may not offer a proper framework for the negotiation between the company and traditional leaders and the use of funds by traditional leaders (Standing and Hilson, 2013). Finally, mismanagement practices may perpetuate owing to the lack of proper assessment and monitoring by public independent control bodies of how funds provided by private companies are managed and spent (NRGI and RELUFA, 2014; PH-EITI, 2015a) or to inadequate delays in publication of audit and assessment reports on implementation.

In some cases, the company is directly involved in spending choices and project implementation which however, does not prevent the process from being marred with corruption. Factors on the company’s side which increase corruption risks include:

• Lack of, or inadequate internal rules and corresponding contractual clauses in the agreement with the public authority regarding planning, project financing, implementation and supervision, including verifying the economic viability of the infrastructure plan, defining compliance requirements for contractors’ selection; agreeing on instalment payments on the basis of measurable work in progress;10

• Failure to define clear and transparent criteria for the selection of projects, selection of the contractors that will perform the activities foreseen for local development projects financed by private companies through grant/sponsorship/donation, identification of the beneficiaries of the activities in the agreement with the government.11

• Insufficient collaboration and consultation with local community leaders and members for the selection, design and implementation of projects (NRGI and RELUFA, 2014);

• Lack of adequate due diligence carried out on the beneficiaries (including local communities’ leaders) (NRGI and RELUFA, 2014).

Weak governance of social development funds

When social expenditures are administered through social development funds, corruption may arise from the lack of a transparent, independent, inclusive and accountable governance structure and of professionalisation in the management of the social development funds. Indeed, this may leave room for high discretionary power of the private executives or public officials managing local development funds and social expenditures;12 or, when the fund is administered by local communities, political interference and discretion of influential local elite. In one of the cases reported in the OECD Watch online database, the social development fund was to be administered by a hybrid committee formed by the foreign company and the government which could be complemented by local management committees in the recipient regions. Yet, the company seemed to have little control over the way the money was spent. It is reported that the majority of those involved with the management of the fund were presidential appointees and that local community members were largely marginalised and excluded from the process.