Government and Industry: Problematic Partnering

By Professor David Kirkpatrick, Professor of Defence Analysis,
15 Nov 2004

The relationship between Her Majesty’s Government (HMG) and the British defence industry has been particularly stormy in recent years. Robust speeches by politicians, procurement officials and captains of industry have revealed serious tensions and disagreements which in former times might have been resolved behind closed doors. Many of these disagreements arise from the particularly challenging environment within which defence equipment acquisition is accomplished, and from the convergent and divergent interests of government and industry within that environment. Furthermore the Chief of Defence Procurement has recently stated that the current MoD policy of ‘partnering’ with industry on equipment projects (announced in 1998 as one of the Smart Acquisition Initiatives) has not yet been effectively implemented (though this overall judgment probably conceals considerable variation between projects). This disappointing news, and the fractious public statements from both government and industry representatives, have stimulated a growing debate about the UK government’s industrial policy. To provide a background for that debate, this paper discusses the particular features of the environment surrounding the acquisition process, and some of the recent developments which have made that process even more difficult. It then reviews the development of the relationship between the UK government and the British defence industry, and considers how that relationship may evolve in the future.

The environment of defence equipment acquisition

Warfare has always been extremely competitive, with uniquely-severe penalties for the defeated military personnel and for their defeated nation. In the conventional wars which scarred the 20^th century (and which may recur when the world is no longer dominated by a single superpower), it was vital for a nation’s armed forces to be at least as well equipped as those of its potential enemies. It is now equally important to have a marginal advantage in asymmetrical warfare against fanatical terrorists or organised criminals, though in this type of warfare the quality of surveillance, communication and information management systems are at least as important as firepower and other traditional measures of military capability. Nations therefore strive to equip their armed forces with the most advanced and effective equipment which they can afford.

In recent decades the technological arms race, driven by military rivalry and by globalised industrial competition, has dramatically increased the sophistication (and the unit cost) of many types of modern defence equipment. Accordingly these types require a protracted and expensive process of design, development, test and evaluation before they enter service. Because the up-front cost of this process is spread across a relatively-short production run ( combat aircraft and armoured fighting vehicles are produced in hundreds whereas consumer goods are manufactured in millions) most defence projects exhibit economies of scale. Governments therefore prefer to procure such projects as infrequently as possible, by choosing multi-role rather than single-role designs and by keeping equipment in service for as long as its effectiveness can be sustained by occasional upgrades. The resulting scale and rarity of new defence equipment projects gives then great military, industrial and financial significance, and they consequently attract the attention (and interference) of many interested groups of stakeholders.

The level of demand for defence equipment is occasionally interrupted, in the prelude to a UK military operation, by a flock of Urgent Operational Requirements (UOR) issued by MoD. These UOR are principally intended to implement vital modifications to major equipment and to supplement inadequate stocks of munitions and other equipment particularly relevant to the intended operation (e.g. desert boots for Iraq 2003). UOR are often more expensive than regular procurement and occasionally arrive late, but the alternative of maintaining forces at 100% readiness for each of several credible scenarios would require significantly higher defence budgets in peacetime.

The MoD’s requirement for a new equipment project is generally demanding and complex. It is demanding because the equipment must use untried technology to attain unprecedented performance, in order to outclass the threat. It is complex because the new equipment must operate satisfactorily in the very different environments of peace and war (and in several alternative scenarios) and it must interface effectively with other reconnaissance, command and combat units in its battle-space. Such sophisticated projects with complex requirements must be governed by comprehensive contracts incorporating rigorous test and evaluation procedures.

The MoD’s requirement for a new project arises from intelligence assessments of emergent threats, from comparisons of alternative classes of equipment which could remedy a shortfall in UK military capability, and from developments in the relevant technologies – all driven by evolving government security policy and constrained by funding limits. Most of these processes and influences are obscured from defence contractors, which have to await clarification of MoD requirements before submitting proposals to satisfy them. Commercial companies, on the other hand, can use surveys to identify trends in their mass market and invest in new products which anticipate these trends, but in the defence market the scale and risk of such an investment would be prohibitive.

Economies of scale in the development and production of defence equipment have yielded a concentration of industrial capacity within a few large prime contractors, and the high cost of major weapon systems limits the number of governments rich enough to afford them. In addition the extensive technical knowledge and skill required to produce sophisticated weapon systems provides a barrier to entry to the defence market. Accordingly this market is ‘imperfect’ having few buyers and few sellers. Furthermore each government imposes strict regulation on its own national defence industry – restricting foreign shareholding, restricting recruitment to exclude spies and saboteurs, stipulating the physical and electronic security of contractors’ sites, and controlling exports. The defence market is thus very different from the free markets presented in elementary textbooks on economics, and cannot be managed by simplistic prescriptions.

Thus the environment of defence equipment acquisition is characterised by

Big, infrequent, advanced (and hence risky) projects
Protracted and expensive project development
Many interested groups of stakeholders
Occasional bursts of demand for Urgent Operational Requirements
Complex Service requirements
A very imperfect market

It should be noted that many of the characteristic features of the defence market are becoming more extreme (e.g. network-centric warfare demands more complex interfaces, and the number of suppliers continues to fall) and hence more different from the commercial market. It should also be noted that many prime contractors have become trans-national companies, that their supply chains have become globalised, and that many contractors (e.g. in micro-electronics) are much less dependent on government orders than formerly, and are thus less susceptible to government influence.

The evolving government/industry relationship in the UK

A few centuries ago the government’s demand for defence equipment was supplied largely from its own Royal Dockyards, Ordnance Factories and Powder Mills, which were expected to hold stocks of combat equipment and to have sufficient production facilities and raw material to surge production in a crisis. These public-sector organisations were founded because their products were not available from the commercial market, and because direct government control facilitated quality assurance and standardisation (e.g. of calibres) which yielded operational benefits. Later the industrial revolution and the development of mass markets enhanced the capability of private-sector companies, and in both World Wars the UK government was able to exploit their capabilities to meet the unprecedented demand for quantity production of defence equipment.

More recently, successive UK governments have become convinced that the provision of defence equipment by public sector organisations does not yield good value for money. It was argued that such organisations, shielded from market forces, were intrinsically reluctant to adopt new concepts and technologies in equipment design, and were equally reluctant to institute more-efficient production methods and procedures. Accordingly responsibility for equipment production, support, design & development and research (apart from some particularly sensitive areas) has been progressively transferred to the private sector.

This transfer encountered a few problems. The dual requirements of assured support of defence equipment in high-intensity war (even in a dangerous and unpopular war) and of economical support in peace have yielded an ongoing three-way tug of war for repair, maintenance and logistic support work between Service branches, government agencies manned by civilians and commercial contractors. The transfer of design and development work proceeded more smoothly in areas (like aero-engines) where the military and commercial designs used similar technologies, but it proved more difficult in areas where the technologies were defence-specific and contractors had to accumulate the appropriate expertise. It was also discovered that, while it was relatively straightforward to place a production contract for a defined design, it was more difficult to transmit a clear understanding of priorities and constraints from Service requirement staff via a procurement branch to an industrial contractor, and to formulate contracts governing design and development to meet a complex statement of operational requirements..

Even after the responsibility for design and production of defence equipment had largely been transferred to industry, the UK government remained closely involved. The MoD funded defence-related research and technology demonstrators, and gave its contractors access to the results. It placed cost-plus contracts, which shielded its contractors from the financial consequences of unexpected technical or other difficulties. It monitored the workload on the defence industrial base and arranged the timing and allocation of contracts (where practicable) to minimise costly restructuring. In the decades following World War II, the UK defence industry was regarded as a key national resource and MoD had a specific remit to promote its growth and prosperity.

This ‘cosy’ situation was transformed by the reforms introduced by Mr. Peter (later Lord) Levene who was appointed Chief of Defence Procurement in 1985. Levene policies for defence procurement included open competition for defence contracts, fixed-price contracts, and a ‘taut’ (i.e. adversarial) relationship between MoD and its contractors. This policy severely restricted interaction between MoD staff and the contractor after contract award, based on the assumptions that the contractor possessed all the understanding and competences to deliver what the Service customer wanted and that he would exploit any MoD interference to excuse any subsequent performance shortfall or delays in the project and/or any increase in its price. This distant relationship inhibited the pull-through of government research to industrial application, and it downgraded the perceived importance of technical expertise in MoD procurement personnel (culminating in the Defence Procurement Agency’s current belief that it needs no Chartered Engineers).

The policy of open competition for most contracts was initially welcomed by UK industry as invigorating, enhancing its competitiveness in export markets, but soon afterwards industry began to complain that competitions were slow and expensive, and eroded the capability of the UK’s defence industrial base. Open competition also encouraged contractors to bid optimistically-low prices, believing that their first priority was to win the contract and that there would be later opportunities to re-negotiate the price, after the government’s prestige and part of the funding had been irretrievably committed. By the 1990s the resulting spate of cost overruns had become intolerably embarrassing, and the incoming Labour government demanded further reforms.

The Smart Acquisition Initiatives published in 1998 included plans for less-adversarial ‘partnering’ arrangements between MoD and its contractors. This new policy recognised that, when MoD and a prime contractor were committed together for decades on a project whose success was important to both parties, their relationship should not be governed by the rules of the bazaar. The proposed partnering arrangement involved mutual trust, unrestricted exchange of relevant information, cooperation on risk management and gain-sharing contracts; in addition contractors would be full members of the MoD’s Integrated Project Team managing a defence project.

Unfortunately, government and industry had very different expectations about partnering. Industry hoped for a long-term partnership extending right through a project from concept to disposal, and extending to include related and successor projects in MoD’s programme for equipment acquisition. But MoD wished to retain competition as the key element of its acquisition strategy, and hence preferred temporary partnering on a contract-by-contract basis, without long-term commitment. In any partnering arrangement the line managers from government and industry may be prepared to share all their information, but they may be unaware of all the relevant political or corporate machinations of their respective bosses. The Service customers want equipment superior to that of their enemies, but industry would prefer a design successful in the world market. The government may have moral or diplomatic reasons to prohibit exports to some foreign governments, whereas industry has a strong incentive to sell its products as widely as possible. It follows that any partnering arrangement between government and industry will sometimes be strained by their divergent interests, and by their respective responsibilities to the electorate and to the shareholders.

Which way forward?

It is possible that with greater effort and goodwill partnering arrangements can become more successful, as government and industry become accustomed to the concept and shed their traditional prejudices and antipathies. Updated guidance on ‘Smarter Partnering’ was formulated by a MoD/Industry working group in 2002. But partnering is little more than a compromise between the project management styles before and after the Levene reforms. MoD still needs an overall strategy to manage its acquisition programme, and simultaneously to preserve the essential elements of the UK defence industrial base.

If the MoD chose to procure its equipment by competition in the international market, it would be able to procure each project at the lowest cost. However it would have to accept off-the-shelf equipment which might not be an ideal solution to its requirements, and it would incur the risk that procurement or support might be interrupted if a foreign contractor had other priorities or if its government disagreed with some UK policy. The risk would be less serious if the product was generic, and if there were many alternative suppliers in the world market. For specialised equipment MoD might mitigate the risk by making a lifetime buy of spares and by creating UK-based facilities for maintenance and repair; this would significantly inflate the procurement cost.

The risk of interruption of supply might in principle be reduced by restricting equipment competitions to UK-based contractors (broadly defined as those making a substantial value-added contribution to the UK economy). In practice however the UK government has long accepted (notably since its procurement of Polaris ICBM in 1962) that it would be unacceptably extravagant to seek self-sufficiency in defence equipment. Accordingly much of the current MoD procurement programme relies on foreign contractors, as suppliers of off-the-shelf systems or as participants in collaborative projects or as suppliers of specialised components. To reinforce this policy of interdependence, the UK has negotiated treaties (the Framework Agreement with European allies, and the bilateral Declaration of Principles with the USA) which provide mutual assurance that inter-alliance trade in defence equipment will continue unhindered.

Some of the UK’s allies have procurement policies which explicitly favour their own national industries. The UK defence industry is naturally concerned that it has to compete at a disadvantage relative to its international rivals, and that its capacity will be progressively eroded whenever foreign contractors win competitions to supply UK forces. In response to these concerns, MoD has undertaken to assess the impact of each major procurement decision on the UK’s industrial base, and in some cases this may increase the chance that a UK-based contractor will be selected.

Whenever MoD decides to procure defence equipment from a private-sector contractor (based in the UK or overseas), it recognises that the contractor has its own priorities and imperatives. MoD can try to influence its behaviour, but cannot guarantee that the influence will be sufficient to produce the intended result. Any UK contractor specialising in one type of defence equipment now faces long gaps between orders from MoD. These gaps can only partially be filled by export orders and by upgrade work on in-service equipment. In this situation shareholders may be unwilling to tolerate many years of under-utilised capacity and low profit margins (particularly since the company cannot be sure of winning any forthcoming MoD competition). They might choose to withdraw from the defence sector, unless they could persuade the government to bear the costs of the job losses and restructuring arising from a gap in orders.

In the (very few) special cases where MoD considers it vitally necessary to maintain a particular industrial capability, it might form a long-term strategic partnership with a chosen commercial contractor based on an extended programme for delivery of the contractor’s products. A guaranteed market would in principle enable the contractor to optimise his workforce and facilities and thereby provide better value for money to MoD. But that arrangement might in practice revisit some of the notorious problems in the history of British nationalised industries. The chosen contractor would be at least partially shielded from market forces, and its relationship with government would have to rely on shared ideals and interests.

In some areas where the private sector proves unwilling or unable to provide the goods and services which MoD requires, HMG may have no alternative to the creation of a public facility, similar to the Defence Microelectronics Activity (DMEA) in Sacramento which the US government has established to provide US forces with electronic components and subsystems which are no longer available from the private sector. In other, particularly-sensitive areas, even if the private sector were willing to supply the relevant goods and services, HMG regards them as so vital that they must remain under its own direct control (e.g. cryptography).

Conclusion

There are many varieties of defence goods and services purchased in many different markets, so it is likely that MoD will continue to be supplied by

Open competition, taking account of security of supply and of UK industry
Long-term strategic partnerships
Public sector agencies under government ownership and control

The volume of procurement from these different sources will vary with the convergence and divergence of the defence and commercial technologies and markets. The crucial issue remains whether HMG can formulate coherent research, acquisition and industrial policies, and whether it can evolve these policies to maintain their effectiveness in a fast-changing world. The technology-driven Revolution in Military Affairs, the burgeoning of asymmetrical terrorism, and the progressive globalisation of the market for defence goods and services all demand new policies for the 21^st century.

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