Optimal Discounts in Green Public Procurement

By Olga Chiappinelli and Gyula Seres

Public procurement—the purchasing of goods, works, and services by governments and other public authorities—accounts for approximately 15% of gross domestic product (GDP) in OECD-EU countries. Given this large economic impact and being the largest buyers in several markets, public bodies can leverage their purchasing decisions to pursue welfare goals beyond the best value for money.

By using procurement practices that take into account the environmental quality of bids in the award of public contracts, so-called Green Public Procurement (GPP), public bodies can create markets and demand for environmentally friendly products and services, thereby incentivizing suppliers to switch their production to greener options.

Despite its potential as an environmental policy, GPP has thus far been only moderately implemented. A major barrier to larger adoption is the perception that GPP increases the price for the procurer relative to standard procurement. The reasoning underlying this argument is that because producing green products and services is more expensive than producing their conventional equivalents, suppliers would reflect the extra cost of green technology in higher offers when participating in the procurement auction. To the extent that the procurement mechanism rewards environmental quality relative to price, the procurer might therefore face a higher purchasing price.

BCCP Fellows Olga Chiappinelli and Gyula Seres argue that this effect is not clear ex ante. Common knowledge considers the impact of GPP in the auction, while assuming the market structure as fixed. However, by incentivizing investment in green technology, GPP can change the relevant pool of suppliers and thereby affect competition in procurement auctions—and thus purchasing price—in a non-straightforward way. The study aims to provide a theoretical framework to investigate the full price effect of GPP. It does so by considering a dynamic procurement model in which the procurer gives an advantage to green firms in the form of a bid discount.  Before the auction, the firms, which are privately informed of their cost, can invest to switch to green technology—a decision that requires an investment cost and is publicly observable. The study finds that, because investment is costly, only companies that are sufficiently efficient switch their technology. In addition, because investment is observable, it acts as a signaling device: via investment, companies signal their efficiency to their opponents. This signaling mitigates the effect of incomplete information regarding firms’ costs, thereby triggering more competitive bidding among green firms in the auction and putting downward pressure on the purchasing price. This can outweigh the price-increasing effect of giving an advantage to green firms. As a consequence, even a procurer with no or weak preference for green technology can find it optimal to implement GPP to a positive extent.

Their study contributes to the limited economic research on GPP, showing GPP does necessarily imply a trade-off between environmental performance and purchasing price, and suggesting that financial concerns might be less relevant as a barrier than what is commonly believed.

The full article “Optimal Discounts in Green Public Procurement” is published as a DIW Discussion Paper.

This text is jointly published by BCCP News and BSE Insights.