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Defence sector change: collateral damage?

As the UK continues to adjust its strategic posture, the MoD should not lose sight of its defence-industrial partners.

The global strategic context has changed greatly since the 2010 Strategic Defence and Security Review (SDSR)

The Parliamentary Accounts Committee recently noted that the world is more dangerous and unstable than it has been since the end of the Cold War and that the United Kingdom’s prior assumptions that the military would focus on ‘fragile states’ and lightly armed insurgents through enduring stabilisation operations are no longer true. Instead, there is a growing recognition of the requirement to support stability in a dozen different theatres simultaneously and to engage with both unconventional and conventional threats.

The United Kingdom cannot ignore these challenges and neither can its defence-industrial sector, which will be increasingly expected to support the agile development of defence capabilities in response to rapidly changing operational requirements.

The defence budget is not protected and the equipment and support budgets are likely to come under increasing pressure

Unlike the health and education budgets, defence is not protected. However, Defence Secretary Michael Fallon has committed to “increasing the defence equipment budget by at least 1% more than inflation throughout the parliament”. This is not as good news as it seems with current negative inflation. According to Professor Malcolm Chalmers, director of research and UK defence policy at the Royal United Services Institute (RUSI), “even in the optimistic scenario defence’s share of GDP will have fallen by a third: from 2.6% of GDP in 2010 to around 1.75% by 2019” and, assuming that savings are required, “air, maritime, and land systems could all be vulnerable”. In addition, as defence inflation continues to run ahead of other measures of inflation by three or more percentage points, this suggests a real-term erosion of defence capability, valued at 15%-20% of the equipment programme’s budget over the next decade.

The UK defence industry provides substantial benefits to the United Kingdom

The UK defence industrial base employs more than 100,000 people, has an annual turnover of more than £22 billion ($34.7 billion), and delivered export sales of £8 billion in 2014. It not only makes a substantial contribution to the defence and security of the United Kingdom, but also contributes to the economy, provides employment in high-value-added jobs, supports manufacturing and technology, and, through exports, provides support to foreign policy as well as relationships with coalition partners, in particular those with the US.

Shrinkage of the defence budget is not necessarily accompanied by a reduction in capability need or ambition

The front-line commands now own the equipment and support budgets and are likely to protect new equipment programmes through improvement initiatives across their portfolios. For example, the Joint Force and Land commands are working to develop open standards-based architectures that could enable:

  1. The disaggregation of information and communications-based services into lots so they can be procured individually or in competition, rather than from a single prime contractor
  2. The MoD to ‘in-source’ the integration activity and risk premium of its major projects (albeit with some support from commercial ‘customer-side’ partners) potentially removing the traditional industry role of prime contractor
  3. Increased competition for standardised products off catalogue.

These initiatives could potentially save up to 10% of the equipment and support programmes (around £10 billion to £15 billion), probably starting in the land and communications and information system (CIS) sectors before moving to intelligence, surveillance, targeting, and reconnaissance (ISTAR) and other areas.

These actions may have some unintended consequences for the UK defence industry

The MoD’s improvement initiatives could result in some unintended effects on the UK defence-industrial base. For example:

  1. The acquisition of disaggregated services as lots, via shorter duration contracts, would encourage competition from new commercial market entrants who are able to leverage agile, short development cycle business models, but for whom defence may not be their primary, or even long term, focus
  2. A reduction in the prime contractor role could reduce revenue and margins for companies that focus on this area, particularly in the CIS and land sectors
  3. Increased competition in the product market could lead to reduced revenues and margins.

It is important that the MOD works with the UK defence industry to secure the greatest long term benefits from the UK defence industrial base

While the effects described may reap short-term economic benefits, longer term they may constitute a ‘perfect storm’ for some members of the supply base when taken together with budgetary pressures and defence inflation, potentially reshaping segments of the industrial base; reducing its capacity to maintain current levels of contribution to national security, GDP, employment, export earnings and international relations; and affecting the commitment of boards and shareholders to invest further in security and defence.

As a result there are calls for the government to consider how it can work with the industry to sustain and expand the sector’s already considerable contributions to national security and economic resilience

It is imperative that both the MoD and the defence-industrial sector work together over the coming months to shape a common strategy that will provide the greatest short- and long-term benefits, as well as ensuring that future decisions are evidence based and that the data required is available and made visible.

To prepare for such a dialogue, the boards of UK defence companies may wish to examine: what potential impact these changes might have on both their UK and export businesses and portfolios. They should consider whether further investments in, for example: new and more agile business models, standards compliant architectures and products, and also enhanced capabilities to bid against increasingly short cycle requirement, would be justifiable.

David Pile is a defence expert at PA Consulting Group

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