THE FUTURE OF OUTSOURCED SERVICES IN THE UK DEFENCE SECTOR

Transcription

1 THE FUTURE OF OUTSOURCED SERVICES IN THE UK DEFENCE SECTOR Keith Hartley Emeritus Professor Economics Department University of York York YO10 5DD England 3rd June,

2 CONTENTS EXECUTIVE SUMMARY INTRODUCTION PART A. THE MAIN REPORT I. THE STRATEGIC FUTURE OF THE UK DEFENCE BUDGET II. THE UK EXPERIENCE OF MILITARY OUTSOURCING III. INTERNATIONAL EXPERIENCE IV. FUTURE POSSIBILITIES V. CONCLUSION: Policy Recommendations Summary of Main Findings and Recommendations PART B. THE APPENDIX A.I. The Strategic Future of the UK Defence Budget A.II. The UK Experience of Military Outsourcing: A Brief Historical Overview. A.III. International Experience A.IV. Future Possibilities A.V. Conclusion: Policy Recommendations REFERENCES 2

3 EXECUTIVE SUMMARY i. Military outsourcing involves the transfer to private contractors of activities traditionally undertaken in-house by military personnel and the Armed Forces. ii. UK outsourcing has taken various forms, including contracting-out, contractorisation, privatisation, market testing, PFI/PPPs and PF2. These are described and evaluated. iii. The UK defence budget is facing a major funding problem and a Strategic Defence Review in The defence economics problem identifies the need for difficult choices: something has to go and the key question is what goes? iv. There are various solutions to the defence economics problem such as the UK accepting a reduced world military role and measures to increase efficiency. Military outsourcing represents one source of efficiency savings. It will make a contribution towards improving efficiency in defence spending which will become more important as the UK defence budget faces continuing funding problems. It also provides sponsored reserves, so contributing to meeting the Government s target for reserve forces. v. A central issue for the study is that public sector organisations are public monopolies associated with monopoly prices, inefficiency and a failure to innovate. In-house organisations in the UK Armed Forces are such public monopolies. Outsourcing to private contractors via competition leads to cost savings and innovation. vi. The development of UK policy on defence outsourcing is described from Examples include the RAF strategic air tanker fleet, new buildings, training, strategic sealift, heavy equipment transporters, estates and facilities management and soft services such as catering and cleaning. Some of these are novel and innovatory contracts, such as the air tanker fleet. More such opportunities remain to be explored and introduced and are likely to be beyond conventional procurement policies. vii. Outsourcing is explored and evaluated critically. It embraces the use of competition to select private contractors. The focus is on the problems of specifying requirements, writing, monitoring and enforcing contracts, especially long-term contracts. Budget pressures mean that outsourcing will become more prevalent. 3

4 viii. International experience shows that the UK and USA are at the forefront of military outsourcing. In contrast, Europe s major defence spending nations have only relatively low shares of outsourcing. ix. There remains considerable scope for future expansion of UK military outsourcing. There are proposals for all military support activities to be subject to competitive tendering. Claims that some support activities are core war fighting capabilities need to be subject to critical evaluation. New and innovatory forms of competition and contracting need to be considered with a greater willingness to experiment with competition. x. Examples for future outsourcing include the complete range of services needed to operate military bases, cyber security, the operation of UAVs and the opportunities for some specialist military personnel to be replaced by civilians. Outsourcing is likely to result in cost savings of some 20% (within a range of 5% to 40%). 4

5 INTRODUCTION Terms of Reference: This study was commissioned by the Business Services Association. It required an independent economic study of the history of outsourcing in the UK Defence Sector since the 1980s and the future of UK Defence outsourcing of services. This study focuses on the defence aspects of the 2015 Strategic Defence and Security Review 1. Plan of study 1. The UK Ministry of Defence (MoD) and the Armed Forces have considerable experience of military outsourcing. This involves the transfer to private contractors of activities which traditionally were undertaken inhouse by the Ministry and the Armed Forces. The result is private firms partly replacing public sector organisations, representing a substitution of private organisations for public enterprises and activities but with ownership of assets, policy, strategy and overall management of contracts retained by MoD. 2. The study comprises three major parts, namely: i) An Executive Summary; ii) Part A presents the Main Report and iii) Part B comprises the Appendix. In the Main Report, Section I outlines the defence budget context for military outsourcing. It describes the defence economics problem, the future prospects for the UK defence budget and the inevitable need for difficult choices. Section II presents a brief historical overview of UK experience with military outsourcing. It defines outsourcing, it describes the development of policy and presents an analysis of its economic justification. The recent policy emphasis on the Private Finance Initiative (PFI), Public Private Partnerships (PPPs) and the new development of PF2 are also explained and critically evaluated. Military outsourcing is analysed 1 Acknowledgements. Thanks for help and support with this study to Gemma Norman, Deputy Director of Policy, BSA and to those members who participated in workshops and phone interviews and who commented on drafts of the Report. This is an independent economic study and responsibility for the Report and interpretations remain with the author. 5

6 as a public procurement problem and consideration is given to whether the public sector is inefficient. Examples and case studies of UK experience are outlined. 3. Section III of the Main Report outlines international experience with military outsourcing, presenting comparisons with the USA and other international examples. The comparisons focus on any differences in design and the limits of military outsourcing. Section IV considers future prospects for military outsourcing in the UK and the limits of outsourcing, including the limits of outsourcing for combat forces. Section V concludes with policy recommendations followed by a summary of the main findings and recommendations. 4. The Appendix follows the same format as the Main Report and presents a more detailed treatment of each Section of the Main Report. For example, for section I of the Main Report, the corresponding section in the Appendix is A.I with the same title and similarly for all other Sections in the Appendix. 6

7 A. THE MAIN REPORT I. THE STRATEGIC FUTURE OF THE UK DEFENCE BUDGET Background 5. The UK defence budget has fallen since the end of the Cold War. This has been reflected in smaller defence budgets in real terms and as a share of national output (measured by GDP). The result has been a smaller Army, Navy and Air Force. Nonetheless, the UK retains a world expeditionary role for its Armed Forces. 6. Current UK defence policy, its defence budget and the roles and sizes of the Armed Forces were determined by the 2010 Strategic Defence and Security Review. This Review was the first of regular 5 yearly Defence Reviews with the next Review due in The 2010 Defence Review was part of the general Government policy of reducing the UK s budget deficit. The 2010 Review took place against a background of claims of overstretch and overcommitment of the UK s Armed Forces and of an unaffordable equipment budget (Cmnd 7948, 2010). 7. Concerns have been expressed that the 2015 Defence Review will lead to further reductions in the defence budget, in numbers of military personnel and in the size of forces. Prospects have arisen that the UK defence budget will fall below the NATO 2% of GDP target. But defence cuts are not new: they have been a feature of UK defence policy since the end of World War II. Since 1952, most defence indicators have shown long-run declining trends. The Defence Economics Problem and the 2015 Defence Review 8. The defence economics problem affects all nations. It results from falling or constant national defence budgets in real terms, rising input costs and the Armed Forces increasing demands for more resources (e.g. more and better equipment; larger numbers of military personnel). Limited defence budgets have to fund rising input costs for both equipment and military personnel. Typically, equipment costs have been rising by some 10% per annum in real terms which means smaller numbers of new equipment acquired for the Armed Forces (and correspondingly smaller production orders for the national defence industrial base). Such cost increases mean a doubling in new equipment costs every 7.25 years (Pugh, 1993). Similarly, for nations such as the UK and USA with an all-volunteer 7

8 military force, labour costs have to rise faster than wage increases in the civilian sector: military personnel need to be compensated for the net disadvantages of the military employment contract (e.g. military discipline; working conditions and hours; probability of injury and death). 9. Against these budget and input cost pressures, the Armed Forces will have an ever-increasing demand for new equipment and new force structures, especially where there are new threats (e.g. international terrorism; the Middle East; Russia). New equipment programmes are costly. 10. The defence economics problem means that difficult defence choices cannot be avoided: something has to go and the question is what goes? These choices will be addressed in the 2015 Strategic Defence and Security Review (and later Reviews). There are four broad solutions to this choice problem: i) A radical re-appraisal of the UK s world military role including the US special relationship. In principle, this re-appraisal would evaluate the benefits and costs of the world military role. The costing exercise is relatively easy but estimating the benefits of the world role and the special relationship is much more difficult. Further gradual erosion in the UK s world role is likely, reflected in the withdrawal from some roles and missions. ii) Equal misery or a defence review by stealth. This affects all of the Armed Forces and involves reduced training, fewer attrition buys, some project cancellations, less focus on logistics and support and shifting the new equipment programme to the right (e.g. longer development programmes; delays in delivery; smaller production numbers). Such an option is attractive to politicians who can avoid the need for difficult choices and claim to be maintaining strong UK defences! iii) Increased defence spending. This option shifts the choices elsewhere in the economy. It involves the sacrifice of social welfare spending (e.g. hospitals; schools; elderly care) and is only likely if there is a new and recognisable threat to national security. All the indications from political leaders are that higher defence spending is unlikely to feature in the 2015 Defence Review. iv) Increased efficiency. This involves the search for lower-cost solutions for existing defence outputs as well as a re-appraisal of the 8

9 output levels of some activities. There are a range of policy options including: a) Applying the substitution principle. This recognises that there are alternative methods of achieving defence output, each involving different costs. For example, nuclear forces can replace conventional forces; civilians and reserves can replace regular military personnel; UAVs can replace manned aircraft and ground forces. Some of these substitutions have implications for the traditional monopoly property rights of each of the Armed Forces. For example, air force combat and maritime patrol aircraft replacing Army soldiers and naval frigates. b) A greater use of a competitive procurement policy involving the purchase of cheaper equipment from overseas suppliers (e.g. USA). But such an option is not costless. It would involve the sacrifice of the top tier equipment supply firms in the UK s defence industrial base and the associated benefits of independence, security of supply and wider economic benefits of a strong defence industrial base. c) Military outsourcing offers further opportunities for efficiency savings. Budget cuts and rising costs mean that the efficiency of existing defence spending cannot be ignored. Genuine efficiency savings will reduce the impact of budget cuts on the UK s defence capability. Military outsourcing is one policy option which might make some contribution to genuine efficiency improvements in defence output. II. THE UK EXPERIENCE OF MILITARY OUTSOURCING 9

10 Definitions and concepts 11. Military outsourcing has been subject to various definitions, ranging from market testing to privatisation, contracting-out and contractorisation, Private Finance Initiatives (PFIs), Public Private Partnerships (PPPs) and the current guidance on PF2. These involve the transfer to private firms of activities traditionally undertaken in-house by the Armed Forces. Examples include the Armed Forces managing sites, repairing their equipment, training pilots and drivers and providing accommodation, together with education, transport and catering services. Private contractors undertaking these activities results in the transfer of economic activity from the public to the private sector and the substitution of private firms for inhouse public sector organisations 2. This study focuses on an independent economic evaluation of military outsourcing. In defining outsourcing, a distinction can be made between the equipment supply and equipment support and other support service industries, including estates and facilities management. Clear distinctions are complicated by some equipment suppliers entering the equipment support sector. A further aspect of the wider privatisation debate has to be recognised, namely, the UK s privatisation of its defence industries embracing air, land and sea equipment, together with nuclear and defence R&D activities (e.g. BAE Systems; Rolls-Royce; warship builders, RN Dockyards, QinetiQ and the AWE). 12. Military outsourcing raises two broad questions. First, why do Governments contract-out some activities and undertake others in-house? Second, what are the boundaries (limits) of Government and private sector activities in defence? The answers to these questions involve a choice between private firms and public agencies. The policy problem: An inefficient public sector? 13. In-house public sector activities and organisations can be regarded as public monopolies. Since they are not subject to competition and rivalry, in-house public monopolies will be characterised by monopoly prices, inefficiency and a failure to innovate. 14. There are further reasons why the public sector is likely to be inefficient. In the private sector, efficiency incentives are provided by the 2 Three types of private military firm can be identified. First, military provider firms offering combat services; second, military consultancy firms offering advice and training services; and third, military support firms providing non-lethal services (Fredland, 2004). 10

11 profit motive, by competition and rivalry and by the capital market with its threat of take-over and bankruptcy. These features are absent from the public sector. In defence, there is only one Army, Navy and Air Force each with a monopoly of land, sea and air forces. Military commanders are not entrepreneurs rewarded or penalised through profits and losses; nor can military units be taken-over or suffer bankruptcy (i.e. there are no capital market incentives/penalties). As a result, public sector outsourcing is likely to be inefficient reflected in its type and extent. Yet, defence is a major user of scarce resources so that it is relevant to question the efficiency with which it uses society s scarce resources. Whilst the public sector lacks entrepreneurship and profit incentives, its managers cannot avoid the need to make difficult choices under uncertainty. For defence policy-makers, the uncertainties are great, involving the need to assemble a range of Armed Forces capable of meeting a variety of unknown and unknowable future threats over a long time horizon (e.g. often years or more). 15. Since debates about make or buy (self-perform or outsource) choices depend on efficiency implications, a definition of efficiency is required. Politicians are fond of claiming that their defence policies have achieved efficiencies with little understanding of the concept. Often their efficiencies are achieved by reducing defence output. Efficiency is central to economics and economists define efficiency to embrace two aspects: i) Technical efficiency which focuses on the lowest-cost method of achieving a given output (in terms of quantity and/or quality). ii) Allocative efficiency which involves selecting the best or socially-desirable output. For defence policy, allocative efficiency question requires judgements on the appropriate level of defence spending and its associated output with complications arising since there is no monetary valuation of defence output. 16. Having suggested that the public sector can be inefficient, it cannot be assumed that the private sector is always efficient. Private markets can fail. Market failure can result from imperfections (e.g. monopoly; entry barriers) and externalities, including public goods 3. It also needs to be recognised that the economists perfectly competitive model of efficiency has its limitations. 3 Public goods are a special category of goods which differ from the typical private goods. They are characterised by non-rivalry, non-excludability and free riding with defence as a classic example (Hartley, 2011). 11

12 17. Debates about in-house versus private sector provision also raise issues of methodology and the precise basis for comparisons. Typically, in such debates, private industry takes an ideal model of a perfect private enterprise competitive economy which is then compared with an actual model of an imperfect public sector (or state organisation). Often in such comparisons, the failings of private markets are ignored, namely, monopolies, entry barriers, externalities and corruption. In contrast, public sector supporters adopt an ideal model of a perfect public sector (or state organisation) compared with an imperfect private enterprise system. The supporters of public sector organisations ignore their failures (e.g. some schools and some NHS hospitals). In reality, all modes of organisation are flawed and the relevant comparison is between two imperfect systems and forms of organisation and ownership. The Development of UK Policy: Contracting-out to PFI/PPP and beyond 18. The UK MoD s competitive procurement policy was introduced in 1983 as part of the Conservative Government s defence policy aimed at improving efficiency and achieving value for money. This policy embraced competition for both equipment and support services. Contracting-out support services became part of MoD competition policy where such services could be done more economically in the private sector (offering benefits to taxpayers) without damaging operational capability. As a result, defence support functions were undertaken by the private sector unless it was operationally necessary or more cost-effective to keep the work in-house (Cmnd 675-1, 1989, p35). 19. By 1989, MoD had contracted-out some 120 activities, from bird control and balloon flying to weapon engineering and maintenance, range support and training areas, engineering and supply functions at RAF training bases together with the Royal Navy s use of contractor s aircraft, aircrew and maintenance personnel in target simulation and electronic warfare training. Even where tasks remained in-house, cost savings of between 20% and 30% were reported reflecting the impact of making traditionally monopoly markets more contestable (MoD, 1989, p35). 20. During the early stage of this policy, concern was expressed about the impact of market testing on the Service s operational capability and the contractor s obligations in war and transition to war. Some of these concerns were met by requiring contractors to use sponsored reserves as part of their contractual commitment. Further concerns were expressed about maintaining the quality of service with private contractors; about the 12

13 need for a level playing field allowing in-house units to bid to retain the service; and the need for re-tendering at regular intervals. The estimates of cost savings also need to be critically evaluated. For example, do the savings reflect changes in the quality of service; are such savings achieved when the contract is re-tendered; and whilst savings of 50 million per annum appear substantial, they represented under 1% of the 1989 equipment budget. Indeed, major problems arise in assessing the economic impact of outsourcing when there is limited data on the total value of savings (e.g. a high percentage saving appears impressive but it might only apply to a small total value of spending). 21. In 1992, as part of the Government s new Competing for Quality initiative (CFQ), MoD introduced an expanded programme of market testing. This policy encouraged in-house units to bid against private firms for MoD contracts and it was part of MoD s policy of achieving savings of 20% in support areas. It involved support needs being exposed to private sector involvement and competition (MoD, 1992, p51). MoD and PFI/PPP 22. By 1996, the Private Finance Initiative (PFI) was a recognised part of MoD s drive for increased efficiency and value for money. It involved private finance replacing state finance for capital projects. Instead of purchasing and owning capital assets, MoD agreed that the private sector would finance the creation of the asset with MoD leasing it in return for annual rental payments. Under PFI, private industry commits to financing the often large up-front capital costs of a project and also commits to the provision of services to an agreed standard over many years. Initially, six areas were identified for PFI, namely, training; property and accommodation; information technology; equipment; support services; and utilities (Cmnd 3223, 1996, p 89). Although dedicated war fighting equipment may be beyond the scope of PFI, little else was off-limits including support for front-line units. In 1997 the PFI programme was relaunched under the banner of PPP (and often the terms are used interchangeably). 23. PFI/PPP offer benefits to MoD. These include: i) Achieving better value for money. Also, MoD is allowed to concentrate on its core task of providing operational capability. ii) Innovation and the application of the latest commercial techniques leads to improved quality of services for the MoD. 13

14 iii) Risks are transferred to the private sector through the use of incentive contracts, so reducing risk to MoD. For example, on capital projects, the main achievement of PFI was to transfer the risk of delay and cost overruns to the private sector. iv) Worthwhile projects which could not otherwise be funded by MoD are allowed to proceed, especially where an off-balance sheet accounting solution can be used for project assets. v) MoD staff are exposed to private sector management, commercial and financial skills. Contracts were not signed until they were approved by a bank s technical and legal advisors. This meant a very high level of contract scrutiny. Without such scrutiny, MoD tended to sign sub-optimal contracts containing ambiguous requirements or over-optimistic time-scales. vi) The generation of third party revenues through the sale of irreducible spare capacity or the commercial development of land, building or assets surplus to MoD requirements or the sale of similar services to other foreign armed forces. 24. Industry also benefits from PFI/PPP through the provision of further market opportunities for maintaining the national defence industrial base. There are opportunities to use spare capacity, to share overheads, to transfer knowledge from civilian markets and to undertake long-term investment against the security of income from a long-term contract. Examples of PFI/PPP in UK Defence 25. Many of the MoDs PFI/PPP projects have involved buildings (e.g. accommodation; refurbishment of MoD Main Building) and training services; but there have been some more novel developments including air tankers, strategic sealift, heavy equipment transporters and military satellite communications. One of the largest building projects is the Allenby/Connaught project which is a 35 year commitment at a total life value of 8 billion providing accommodation for Army personnel. 26. Market testing has resulted in some novel and innovatory contracts representing radical changes in MoD procurement policy: 14

15 i) MoD agreed a PFI for its acquisition of a military satellite communication system (Skynet 5) at a cost of 4 billion (October, 2003). ii) An early example of a PFI contract which is close to the frontline involved the Army s heavy equipment transport (HET) service contract with the Fasttrax consortium. iii) The PFI/PPP contract for the RAF s future strategic tanker aircraft (FSTA) involves the MoD paying for the availability and use of air tanker capability and air passenger transport services with a leasing contract for services. This contract replaced the traditional solution whereby the RAF owned, operated and serviced its fleet of tanker aircraft. The partnering element in the contract allows the contractor to hire any spare capacity to third parties (e.g. for commercial air freight operations); but the RAF would always have first call on all the aircraft in an emergency. iv) Long-term support contracts for Royal Navy submarines and warships. These contracts are part of the Terms of Business Agreement (TOBA) which is a long-term partnering agreement with MoD. TOBA provides a stable work programme for warships and submarines, including work at the naval bases in Devonport and Clyde (Babcock, 2014) as well as Portsmouth (BAE Systems). Features of MoD PFI/PPP contracts 27. PFI/PPP were expected to lead to cost savings from competition, innovation and contractual efficiency incentives. The result should be lower construction costs and lower life-cycle costs as risks are transferred to the private sector and contractors are encouraged to be innovative in project design, construction, operation and maintenance. One fallacy must be addressed. Simply transferring resources from the public to the private sector has no effect on efficiency if identical resources are used. A further complication arises since Governments can always borrow more cheaply than the private sector (one to three percentage points in the UK): hence, if PFI/PPP is to result in cost savings, the extra financing costs for the private sector must be offset by savings elsewhere over the life-cycle of the project. 28. The long-term nature of PFI/PPP and other outsourced contracts requires clearly-specified customer requirements with provisions for changes, contract pricing, risk management, performance incentives, procedures for resolving disputes and exit strategies. 15

16 A Critique of UK PFI/PPP Policy in UK Defence 29. The policy is claimed to lead to cost savings, estimated by MoD at some 5% to 40%. However, it is difficult to assess the reliability of such MoD claims: they might involve quality reductions; there is no indication of the cost base to which the savings apply (e.g. 40% saving on 1 million or on 10 billion); and the savings cannot be verified until the contracts have been completed which will be in the long-run. Other studies of the cost savings from competitive tendering in the public sector suggest savings of between 10% and 30% with no adverse effect and sometimes an improvement in service quality. It also appears that competition was more important than the type of ownership (public versus private: Julius, 2008, pii). 30. There are two sources of cost savings from outsourcing. First, the transfer of resources from the public to private sector where increased efficiency reflects profit incentives under private ownership and the pressures and sanctions of the private capital market (the ownership effect). Without such incentives, pressures and sanctions, public agencies will have no incentives to select efficient outsourcing. Second, further cost savings and innovation result from the pressures of competition which forces firms to be efficient (the competition effect). However, there are a number of problems which arise with PFI/PPP and outsourcing policy for defence activities: i) The problems and costs of writing, negotiating and enforcing long duration contracts (25 to 30 years). ii) Firms have incentives to economise or default on those parts of the contract which are difficult and costly to specify and enforce; and this behaviour might have serious implications for military capability. iii) Uncertainty arises over the willingness of private contractors and their staff to serve close to the front-line during conflict. iv) There is the task of formulating contracts which allow competition to achieve both elements of efficiency, namely, technical and allocative efficiency within public interest and legal criteria. 16

17 v) Competition and the loss of capability. To win a bid, a contractor will tender the lowest price which might be too low so failing to provide adequate profits. Such behaviour could be a strategic game where the contractor aims to eliminate the in-house unit and renegotiate the contract as a monopoly and when rival contractors are unable to enter the market quickly to take over the service. vi) Long-term contracts, adaptability of the Armed Forces and renegotiation of contracts. There are concerns that long-term contracts might impair the adaptability of the Armed Forces to respond to new emerging threats and a changing world security position. vii) MoD and Treasury procurement procedures, policies and decision-making processes are too detailed, bureaucratic, complex, lengthy and slow. New guidance: PF2 31. PFI policy has been modified. Before 2008, private finance was relatively cheap and readily available. After 2008, private finance became more expensive. The 2010 Coalition Government had concerns about the PFI model which was regarded as unsatisfactory in the following aspects: i) The PFI procurement process was viewed as slow and expensive. ii) PFI contracts were insufficiently flexible. iii) Concerns that equity investors had made windfall gains. iv) Inappropriate risks were transferred to the private sector. 32. These criticisms led to a modified version known as PF2 whose features are: i) Equity. The Government will consider taking a minority equity stake in future projects. ii) Faster and cheaper delivery. iii) Soft services such as catering, cleaning and security will be removed from all future contracts. 17

18 iv) Greater transparency, including requiring the private sector to provide equity return information for publication. v) Under PF2, there will be greater management of risk by the public sector. vi) The financing of PF2 will be designed to enable access to longterm debt finance and the capital markets. 33. Progress in implementing the PF2 version has been slow with some limited application in the Priority Schools Building Programme and discussions about the application of the model to MoD s future basing strategy and infrastructure investment plans. III. INTERNATIONAL EXPERIENCE 18

19 USA experience 34. US experience with military outsourcing can be divided into pre-and post-iraq. Pre-Iraq, the USA had limited experience with outsourcing. A comparison of US and UK experience of using private contractors and private capital in the provision of defence activities and support services concluded that the UK had been more aggressive than the USA in pursuing such private sector involvement (Rand, 2000, pvii). 35. Pre-Iraq, the US emphasis on outsourcing focused on depot maintenance, base commercial activities, materiel management, finance and accounting, data centres and education and training. By 1996, the US military faced with budget constraints recognised that outsourcing and privatisation offered opportunities for obtaining more efficient and effective support, so releasing funds for equipment modernisation. 36. The Iraq conflict resulted in military outsourcing becoming big business in the USA. Employing large numbers of civilians in theatres of war can be costly but it reduces the need for large numbers of deployed troops, it avoids military casualties, and civilian deaths and injuries are likely to lead to fewer awkward questions from the media. In Iraq, private defence contractors provided base-support functions and security services such as guarding installations, protecting convoys and acting as bodyguards. The use of armed guards for security roles means that civilians are used to provide front-line services traditionally undertaken by the military. Statistics: European and other nations 37. European data show relatively low levels of military outsourcing. Amongst the major EU defence spending nations, the UK had the highest shares of outsourcing in its defence budget with France and Italy amongst the lowest nations. Surprisingly, most of Europe s major defence spending nations have relatively little outsourcing. A European average of some 7% share of the defence budget was considerably lower than the UK average and the share for the USA. 38. The European examples of outsourcing have been fairly standard and typical. France, for example, has considered outsourcing its communications satellites. Germany has restricted outsourcing to nonmilitary services such as apparel, transport, procurement and technical maintenance of heavy equipment, administrative and support services and IT services (Ecorys, 2009). 19

20 39. Elsewhere, Australia and Canada have some experience of outsourcing. Canada has outsourced air traffic control, navaids, logistic services, security, engineering, telecoms and IT. The Australian DoD has outsourced maintenance work on its patrol vessels, weapons systems contracts, simulator-based training and medical and dental logistics services. Conclusion 40. Nations differ in their extent of outsourcing. The UK and USA have major amounts of outsourcing whilst most European nations have only limited roles for outsourcing. These differences might reflect different political philosophies and views about the role and extent of state involvement in the economy. IV. FUTURE POSSIBILITIES 20

21 41. Pressure to reduce defence budgets will require radical policy changes. One policy option is to re-consider the potential for private sector inputs into military operations. The opportunities for savings, especially in equipment support budgets will depend on the behaviour and incentives for budget holders in the individual commands. MoD believes that the commands are in the best position to assess how to use any unallocated funding most effectively. There are seven Top Level Budget Holders which have delegated authority and responsibility for a range of activities that were previously performed centrally including financial planning for the equipment plan and manpower. It is likely that these Budget Holders will have greater incentives to seek lower-cost solutions which should increase the opportunities for more military outsourcing. 42. The Top Level Budgets for each Command provide another indication of the potential size of the UK military market for outsourcing totalling 25.5 billion in However, the reported value of MoD PFI projects are considerably lower suggesting that military outsourcing forms only a small proportion of UK defence spending and that there remains considerable scope for its further extension. A starting point would be for MoD to provide data on the size and extent of the market for outsourced services at both central and local levels. The role of the private sector 43. In the UK, there is considerable experience with the use of private contractors in military support operations. Examples of UK firms involved in military outsourcing include Amey, Aramark, BAE Systems, Babcock International Group, Capita, Carillion, Compass Group, G4S, Interserve, Kier, ISS, OCS, Serco, Sodexo and QinetiQ. But the inevitable question concerns the limits of such private sector inputs into military operations. Is there an essential core of military operations which must always be provided by public sector in-house units? Here, two further policy options can be considered, namely, leasing and private companies undertaking combat missions. The option of private combat missions is meant to be illustrative aimed at identifying the economic limits of outsourcing. 44. Under the leasing option, equipment might be leased from defence firms rather than purchased for ownership by the Armed Forces. Defence firms would enter into long-term contracts offering to provide a guaranteed number of operationally available front-line equipment on a daily basis (e.g. combat aircraft; tanks; warships) with the contractor responsible for maintenance and repair for the duration of the contract and eventual disposal of the equipment. 21

22 45. Another option is private companies providing combat missions. As with the leasing option, a key issue concerns the costs of undertaking transactions. To identify the economic limits of outsourcing, consider some of the issues which are likely to arise if private firms were to be involved in combat roles: i) There are problems of writing and enforcing contracts for unforeseen contingencies and various threats. ii) Asset specificity. Some equipment and training has little value in alternative civilian uses so that firms will be unwilling to invest considerable resources in acquiring such assets. iii) Loyalty, trust and reputation. There is a belief that national (public) military forces are more likely to be loyal and trustworthy than private companies. iv) Contracts and performance indicators for private firms can give unexpected and undesirable results. v) Efficiency versus military effectiveness. Economically efficient solutions might lead to a loss of skills and expertise in the Armed Forces resulting in a loss of military effectiveness. 46. The use of private firms in combat roles is extremely controversial. The benefits and costs of such private roles need to be identified and critically evaluated (including identifying the myths, emotion and special pleading which exist in this area). At the minimum, consideration of private companies providing combat missions will identify the limits of private sector inputs into military operations. It might also identify new opportunities for using private contractors either in the Armed Forces or in support of the Armed Forces. In addition to economic limits, the use of private firms in combat roles is subject to legal limits since their staff could not rely on Crown immunity when undertaking lethal activities. And ultimately, private limited liability companies are not accountable to the wider public but to their private shareholders which makes them further unsuited for combat missions. V. CONCLUSION: POLICY RECOMMENDATIONS 47. Questions arise about the boundaries of Government activities in defence. Why do Governments contract-out some defence activities and 22

23 undertake others in-house? The broad trade-offs can be identified. Private firms offer high-powered efficiency incentives but there are the costs of contracting. In contrast, public agencies offer only low-powered efficiency incentives, but they are good on loyalty and trust, which are attributes provided by nationally-owned military forces. 48. Outsourcing is a transaction cost problem where the limits of military outsourcing arise when transaction costs become too high so that further contracting is not worthwhile. Combat operations are an obvious example where it becomes prohibitively expensive (impossible?) to write and enforce a contract for unforeseeable events. As a result, the economic limits of outsourcing are determined by the costs of writing and enforcing contracts (and by UK and EU legislation on Government contracting). More importantly, there are major legal limitations on the use of private firms in combat roles. 49. Military support operations are the obvious focus for outsourcing, especially where activities are clearly identified and measurable and can be enshrined in an enforceable contract. Not all military support operations will be capable of contracting in the form of a reasonably complete and enforceable contract. Some support activities might be regarded by the military as an essential component of its war fighting capability. Such activities need to be subject to critical scrutiny and opened to competition. 50. Public sector in-house solutions do not solve the problems of public monopoly (i.e. inefficiency; poor quality; lack of innovation). They involve vague and unwritten long-term contracts (in perpetuity) with a public monopoly, soft budget constraints and no re-contracting. Efficient private sector solutions require market competition or contestability, but with long-term contracts, such rivalry is confined to the initial award stage 4. Also, private sector solutions in such forms as PFI/PPPs involve substantial transaction costs. As a result, the alternative forms of public and private sector provision need to be assessed critically and evaluated with evidence on their benefits and costs. 51. Critics of military outsourcing require that the analysis identifies the skills and capabilities which are unique to defence and thereby identifies the boundaries between the private and public sectors for defence activities. This is an area requiring judgement. Economists can contribute to policy on military outsourcing by applying the following guidelines: 4 PFIs for soft services have on-going periodic market testing. 23

24 i) Economists are competent in identifying the costs and benefits of small changes, say, moving towards greater private finance, greater private provision and more outsourcing in defence activities. ii) They also know that competition promotes efficiency and innovation and that the defence sector is characterised by numerous entry barriers. iii) Recognise that military outsourcing involves transaction costs and that all forms of organisation are flawed. A way forward 52. The funding problems facing UK defence policy require drastic and radical solutions. Military outsourcing can contribute: it will help but it is not the sole solution to the UK s defence funding problems. A new policy initiative on military outsourcing is needed embracing the following elements: i) All military support activities need to be subject to competition, allowing private contractors in competitive markets to bid for work traditionally undertaken in-house by the Armed Forces ii) The claims that some support activities are a core element of the Armed Forces war fighting capabilities need to be subject to critical evaluation. The core functions might be defined by whether they are state-inherent tasks involving lethal force only capable of being performed by Government. iii) Government has a comparative advantage in the ability to use its Armed Forces on a variety of tasks without the need for frequent re-contracting. Final decisions about core military functions need to compare economic efficiency criteria with military effectiveness. iv) Future outsourcing will be different. There will be completely new market opportunities for outsourcing, new forms of business organisation and moves to new forms of outsourcing. v) Barriers to new entry need to be addressed. Private firms, especially SMEs, might be prevented from bidding for contracts due to information barriers, access to finance, the requirement that all bidders be members of an established trade association or their small size (including firms gaining entry to established supply chains). Or, 24

25 Government might be opposed ideologically to further privatisation of all public services: in which case, it needs to be aware of the costs of such opposition and its impact on the defence budget. vi) Monopoly problems cannot be ignored. Appeals for more competitive tendering might be ineffective where there are monopolies in a market, including intellectual property rights. vii) There are no direct consumers of defence. Solutions to this problem include greater accountability of groups and individuals through greater budget responsibility of military staffs and civil servants and political accountability of Government ministers. viii) Outsourcing requires that MoD and the Armed Forces acquire appropriate contract expertise capable of bargaining with private contractors, agreeing and managing the contract. 53. Non-core functions can be outsourced with market testing used to identify the boundary between military core and non-core activities. A whole range of military services can be outsourced to private companies via competitive market testing some of which have already been outsourced. New developments in cyber warfare might provide new opportunities for outsourcing with private contractors providing cyber security. Similarly, UAV missions might be outsourced to private contractors. Again, there are legal problems in private contractors operating UAVs in military conflict zones which require military staff to make final decisions about any combat tasks. 54. The future UK Whole Force concept aims to shift from an all-volunteer force to a partnering of regulars, reserves, sponsored reserves and private contractors. Under this concept, contractors through their sponsored reserves offer surge capability to war-fighting. 55. Defence Equipment and Support (DE&S) provides future potential for becoming a Government Owned and Contractor Operated organisation (GOCO). In 2013, it was planned to convert DE&S into a GOCO; but, the plan was abandoned. The proposal for forming DE&S as a GOCO could be revised in the future. The GOCO model might also be suitable for other MoD entities. 56. The general assumption is that private contractors provide services more cheaply than government organisations. A new initiative on military outsourcing offers further opportunities for cost savings with savings of 25

26 10% to 30% although the range might be from 5% to 40%. Here, there is scope for further research by MoD into the magnitude of savings achieved from military outsourcing. Inevitably, there are gains and losses from such a policy but the view of this study is that the potential gains outweigh any losses. A do nothing policy is no solution to the UK s defence funding problems. There is recognition by MoD that the private sector can offer solutions to the UKs defence economics problem. It has been accepted that MoD needs to adopt a bold approach more commonly associated with the best of the private sector to get the most of our valuable assets and that it is often more cost-effective to draw on the private sector to support our core activities (Fallon, 2015). 57. Summary of Main Findings and Recommendations i) Pressures on the UK defence budget provide more opportunities for military outsourcing. Private firms can provide a range of military services often undertaken in-house by military units. These comprise equipment support and other support services, including estates and facilities management services. ii) A new policy initiative on military outsourcing is needed. The initiative needs to comprise private firms and competitive tendering with a greater willingness to experiment with competition. Private firms should be invited to bid for specified and alternative levels of service and be encouraged to submit innovative bids. MoD should consider offering to fund feasibility studies to encourage firms to submit new ideas for outsourcing. iii) There are major barriers to change within the military-industrialpolitical complex which need to be addressed. The innovativeness displayed in the private sector is often absent in the public sector. Myths, emotion and special pleading need to be identified and evaluated critically. iv) The rewards from more military outsourcing are substantial with cost savings of some 20% (within a range of 5% to 40%). 26

27 PART B. THE APPENDIX A.I. THE STRATEGIC FUTURE OF THE UK DEFENCE BUDGET Background 58. The UK defence budget has fallen since the end of the Cold War. This has been reflected in smaller defence budgets in real terms and as a share of national output measured by GDP. The result has been smaller Armed 27

28 Forces leading to a smaller Army, Navy and Air Force. Nonetheless, the UK retains a world expeditionary role for its Armed Forces. 59. Current UK defence policy, its defence budget and the roles and sizes of the Armed Forces were determined by the 2010 Strategic Defence and Security Review. This Review was the first of regular 5 yearly Defence Reviews with the next Review due in The 2010 Defence Review was part of the general Government policy of reducing the UK s budget deficit. The 2010 Review took place against a background of claims of overstretch and overcommitment of the UK s Armed Forces and of an unaffordable equipment budget (Cmnd 7948, 2010). 60. The 2010 Review resulted in an initial planned reduction in the defence budget of some 8% in real terms over a four year period, substantial cuts in numbers of military personnel and in the size of forces. The original plan forecast a reduction of some 17,000 personnel comprising 7,000 Army personnel and some 5,000 personnel for each of the Navy and RAF. By 2012, the Army cuts were revised to lead to a future Army of 82,000 personnel and a Reserve force of 30,000 personnel by Force reductions included the cancellation of the Nimrod maritime patrol aircraft, the withdrawal of the RAF Harrier fleet, reductions in the Tornado force, a smaller number of frigates and the withdrawal of the Invincible class aircraft carriers. Critics claimed that the 2010 Defence Review was budgetdominated and not strategic-focused (Cmnd 7948, 2010). 61. Some key UK defence indicators over the period 1990 to 2014 are shown in Table A1. These are examples of trends in some indicators since the end of the Cold War, including the impacts of the 2010 Defence Review. Defence spending in real terms declined over the years 1990 to 2000 and again between 2010 and 2014 (the 2010 Defence Review period). There have also been substantial reductions in the numbers of warships and fast jet squadrons. Table A1. Key UK Defence Indicators, Indicator Defence spending ( bn, constant prices) D/Y (%)