The Innovative Use of Private Finance in Defence Acquisition
Since the 1980s private sector finance has been used increasingly in the UK to provide national defence services through privatization, contracting out and the use of Private Finance Initiatives (PFI) and the wider concept of Public-Private Partnerships (PPP). A dominant factor is the need to use government funds allocated to defence more efficiently and effectively. For the foreseeable future greater efficiencies must be achieved in generating the ultimate outcome of the required military effect in the face of rising unit costs. Within PPP a concept of partnering involving long term relationships between Government and the private sector in more flexible ways than PFI is emerging.
In the view of Government, value for money is the only test by which the judgement to engage private finance in the delivery of defence services and capability should be made. The private sector can bring disciplines to achieve greater efficiency when private interests are engaged partly through innovative design and delivery solutions and partly because there is no cost to Government until a satisfactory project outcome is achieved. Private finance can also be a better way of managing financial risk which correlates more efficiently with the risk of a specific project when private capital markets are engaged. However, affordability in the short term is also clearly an incentive to Government to engage private finance allowing projects involving significant capital expenditure to be taken forward when Government capital resources are limited. A further incentive, not fully acknowledged by the UK Government, is the desire to keep capital expenditure and the attendant capital costs introduced by Resource Accounting and Budgeting off departmental balance sheets.
The principal problem that private sector finance models present relate to ensuring that a supplier can deliver the required quality of service or capability throughout a long term contract when the customer may not be able to identify precise requirements and predict and contract for changes requiring modification over contract duration of 10 to 25 years. Adjustments to requirements will be at cost and can undermine the definitive benefits of clear risk allocation and cost control.
Other challenges are the up front costs of setting up PFIs (making them only suitable for long term larger projects), management of technological risk by the supplier particularly where advanced technology is involved, and peculiarities of the defence environment in which military risk and guarantee of supply may be dominant issues and in which system complexity prevails.
For the purposes of this study, current and planned UK defence projects that are being supported by private finance can be classified as follows:
Operational: military capability and logistic support
- training
- communications and information systems
Non-operational:
- education and training
- communications and information systems
- infrastructure and logistic support
The majority of defence projects lie in the non-operational categories which are not different in kind from projects in the civil sectors. However, all projects of this kind that can benefit from the use of private finance will soon be considered for this treatment. There is a limit, therefore, to growth in these categories. The growth areas for the use of private finance are in the operational categories which already occupy a third of the value of defence PFIs and include many newer costly projects such as the Future Strategic Tanker Aircraft (FSTA). The UK Government has concluded that the classic PFI model is not best suited to information technology projects because the rate of technological change in this sector affects requirements as well as service provision and does not permit rigid long term contracts. However, the MoD envisages one of its most all-embracing information infrastructure projects, the Defence Information Infrastructure, as suitable for a PFI of a kind. Partnering arrangements that are more flexible than the classic PFI will be required. They will need to address the problems of output and project boundary definition and of third party finance. In exploiting the benefits of private finance, innovative ways of achieving efficiency in the use of government finance will be necessary.
Some options are:
- operating leases where lease terms are arranged on assets that could include a range of accompanying services within contracts – so called wet leases
- capability contracts which are an evolution of the wet operating lease in which the customer specifies delivery of a capability rather than an asset
- pooling assets between nations as a further way of spreading the high costs of defence equipment across a number of different customers
Regardless of the way in which private finance develops in the future, its use in the front line is contentious. Where commercial companies are operating in the front line, albeit in a support capacity, commercial and military goals are likely to conflict. Three issues relating to the private sector’s involvement in providing operational capability are responsibility for military risk, guarantee of delivery, and interoperability with other military capability. Military risk can be managed up to a point through government indemnity although definitions of combat and the front line have become blurred by the risk of asymmetric attack. Guarantee of delivery can be managed in the contractual process and by means of Sponsored Reserves. The behavioural aspects of interoperability present a problem that can be best addressed through an incremental approach and exploitation of test cases such as FSTA. If new innovative private finance schemes are to work in the future, the clear understanding of where risks lie is essential. Only then will it be possible to establish necessary, substantial specialist markets with an understanding of the specific risks of the defence sector for debt and equity. All parties in an acquisition that is funded innovatively need to understand the full range of risks and the perspectives of the other stakeholders including the differing perspectives amongst the various customer stakeholders. There is potential in a combined public and private sector approach to profit and risk sharing which could help to develop and protect the secondary markets for defence assets that would be necessary, in many cases, for effective operating leases and capability contracts.
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