Incentives and risk-sharing in public procurement of innovations. Towards contracting strategy framework

Publication Date03 Jun 2019
AuthorNiko Suhonen,Timo Tammi,Jani Saastamoinen,Jarkko Pesu,Matti Turtiainen,Lasse Okkonen
SubjectPublic policy & environmental management,Politics,Public adminstration & management,Government,Economics,Public finance/economics,Taxation/public revenue
Incentives and risk-sharing in
public procurement of innovations
Towards contracting strategy framework
Niko Suhonen,Timo Tammi,Jani Saastamoinen,Jarkko Pesu and
Matti Turtiainen
University of Eastern Finland, Joensuu, Finland, and
Lasse Okkonen
Karelia University of Applied Sciences, Joensuu, Finland
Purpose Public procurement of innovations (PPIs) addresses a specied need of the public-sector
customer or aims at fostering private rmsinnovativeness. In an operational sense, issues of information
asymmetry and risk sharingbetween the public agency and the supplier are of paramountimportance. The
purpose of thispaper is to focus on the contract design issues of PPI.
Design/methodology/approach Explicit and implicit contracting methods are reviewed, and a
conceptual framework is proposed in which procurement characteristics are analyzed, focusing on the
dimensionsof the suppliers sensitivityto the procurement riskand the power of implicit contractingmethods.
Findings Because of its complexnature, applying cost-plus contracts instead of more commonxed-price
contractsis advisable in PPI.
Originality/value Possiblereasons for the more prominent role of contract designin the USA as opposed
to the European Unionprocurement are discussed.
Keywords Public procurement, Risk-sharing, Innovation, Incentives, Contracts
Paper type Research paper
Policy-makers, public sector authorities and designers of public procurement have shown
considerable interest and optimism towards the public sectors ability to foster rms
innovativeness by using the mechanism of public procurement of innovations (PPIs). As
many scholars argue, the insufciency of other innovation policy instruments, such as
regulation, research and development(R&D) subsidies and investments in the production of
scientic and technological knowledge and dissemination, has driven a shift towards using
demand-driven innovation policy tools in the context of public procurement (Edler and
Georghiou, 2007;Aschoff and Sofka, 2009). In recent years, there has been a great political
interest in implementing the idea of PPI in practice (Edquist and Zabala-Iturriagagoitia,
2012;Lember et al., 2015). Despite this, the uptake of PPI has been slow which has been
attributed to public procurersriskaversion, short-term orientation and inexible legislation
(Lember et al., 2015).
The rationale for PPI is multifaceted. On the face of it, the public sector may purchase
innovative goods or services for the sake of higher quality and/or lower costs of producing
This study was nanced by the Finnish Funding Agency for Innovation and Technology research
grant number 40055/14.
procurement of
Journalof Public Procurement
Vol.19 No. 2, 2019
pp. 129-145
© Emerald Publishing Limited
DOI 10.1108/JOPP-06-2019-029
The current issue and full text archive of this journal is available on Emerald Insight at:
and delivering them for its own purposes (Cave and Frinking, 2003). In a more functional
sense, it can be used to satisfy human needs and/orto solve societal problems (Edquist and
Zabala-Iturriagagoitia, 2012). On the other hand, however, the idea of using public
procurement as a means to stimulate private sector innovation raises several additional
issues such as accelerating R&D, encouraging the dissemination of the results of R&D,
reducing costs and barriers to innovation and increasing the level of R&D in the economy
(Cave and Frinking, 2003). These policy objectives considerably change the nature of public
procurement as an arena of interactionbetween the public sector and relevant private sector
rms and the actual winner of the innovation game (or its pre-game). As argued by
Rolfstam et al. (2005), the nature of interaction changes from a game between more
knowledgeable suppliers and the designer of auction rules and rather standardized
contractual stipulations into a more complex interaction, information sharing and
co-operation between the userand suppliers. In addition, from a theoretical perspective,the
traditional market-failure argumentloses its relevance in justifying innovation policies and
is accompanied by a system failure argument (Georghiou etal.,2014), which highlights the
importance of contracting strategies in dealing with information asymmetries,risk-sharing
and incentivizing issues. Finally, Uyarra et al. (2014) suggests that risk aversion and poor
risk management practices are perceived as qualities of public buyers (Edler et al., 2015a;
Edler et al., 2015b). Hence, some objectives of PPI are at stake because of a gap betweenthe
complexity of interaction between buyers and suppliers of innovations and the current
contracting strategies applied by contracting authorities. More precisely, what seems to be
lacking is knowledge of the role incentives and risk-sharing play in motivating rms and
formulating contracts in PPI. In particular, this can be seen in the Europeancontext where
the use of incentives and contract design does not have a long tradition compared to the
defense procurementcarried out by the US federal government (Bower and Dertouzos,1994).
As a result, a combination of conceptualtools from economics and law are needed to analyze
this problem, especially in the contextof the European Union (EU) legislation and traditions
concerning publicprocurement.
This paper lls this gap between the stylizedobjectives of public innovation
procurement policy on theone hand and contracting practices of sharing risk and designing
incentives in PPI on the other hand. On thebasis of a selective literature review, this article
develops a contracting strategy framework by setting a broader scene for contracting
strategies and by analyzing the incentive contract according to the suppliers risk
sensitivity, the contract type and the complexity of the procurement characteristics. The
paper concludes with a short discussion on the relevance of the proposed framework for
procurement practices, possible reasons for the low appliance of incentive mechanisms in
the EU as opposed to US procurement and furtheracademic research.
Policy context: ideas and renements denitions
What is an innovation? Although often interchangeable in everyday speech, a distinction
can be made between invention and innovation; as Abernathy and Clark (1985) suggest,
what may be a startling breakthrough to the engineer,may be completely unremarkable as
far as the user of the product is concerned.Fagerberg (2005)distinguishes between the two
by their practical value: Invention is the rst occurrence of an idea or a new product or
process, while innovationis the rst attempt to carry out into practice. A similar sentiment
is shared by Edquist (1997) for whom innovations are new creations of economic
signicance, eitherentirely new products or reorganizations ofexisting elements.
According to Kline and Rosenberg(1986) and based on Schumpeter (1934), an innovation
is hard to measure, as it may contain several dimensions. More specically, they dene

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