Innovation and IT Procurement in UK Defense: Challenges and Solutions

1. EC 307: Economic Policy in the UK Week 15: Innovation, IT procurement Defence procurement Multi-unit procurement

2. Whole-life costs EUK Lecture 5

3. More Meat • Criteria must be: • Mentioned in contract documents and weighted for relative importance • Relevant to the subject of the contract (i.e. directly incurred) - should relate to intrinsic qualities of the bid, not secondary or external costs or benefits • Beneficial to contracting authority - benefit includes quality aspects, in line with value for money policy • Consistent with basic treaty principles of non-discrimination, equal treatment and transparency • Allowable costs may be indirect to the product/service, which directly benefit the contracting authority e.g. installation of less energy efficient IT equipment generates more heat, stresses the air conditioning system and therefore increases energy costs. This can be included as an indirect whole-life cost, because it is directly incurred through the purchase of the product. • Not allowed: • Any criteria introduced for the first time at the end of the procurement process • Specified geographical origin or location (discriminatory) • Air miles in delivery (no direct benefit to purchasing authority) • Pollution by-products (not directly related to the subject matter of the contract) • Social policies of the supplier e.g. race, equality, gender balance, basic skills (related to the characteristics of the organisation as a whole) • Good-practice application of MEAT: • Differentiate financial and non-financial criteria for consideration in separate strands • Mix and weighting of criteria should be clearly tied to the business requirement; • Unless one bid dominates (both best quality and lowest price), the contracting authority must come to a judgement balancing out the business risks. EUK Lecture 5

4. The Supply side • “Defence Industrial Base” – in 2000/1: • 310,000 employed (70,000 dependent on exports), down from 740,000 a decade earlier • Almost all privately-owned (the R&D sector used to be dominated by DERA, but this was partially privatised, with the bulk of activity now in private hands (Qinetiq) and a small public activity (DSTL) • The sector is concentrating rapidly through merger (BA + GEC + Marconi -> BAE systems; Rolls-Royce/Vickers; Alvis/GKN) • These big players (BAE systems, Rolls-Royce, AgustaWestland (why Heseltine left government), QinetiQ) dominate the sector. EUK Lecture 5

5. Current problems, 1 • Continuing cost, time, quality failures (see NAO Major Equipment Reports on www.nao.org.uk) • “…in [2004], costs on the MOD’s 20 biggest equipment projects have increased by £1.7 billion and (…) these projects have been delayed by three months each on average. The … principles of Smart Acquisition have not been consistently applied and the NAO expects .. more problems … in future. • …less than the £3.1 billion … reported last year. The total cost of these projects is now expected to be £50 billion, which is 14 per cent higher than originally planned. • There is little evidence that acquisition has been improving. Many problems can be traced to the fact that the MOD has not spent enough time and resources in the assessment phase. Projects less than halfway through their procurement are already expected to be delivered later or to cost more than approved. The 15 most recent projects are moving rapidly towards their ‘not to be exceeded’ approvals and six have already breached them. • Some changes in cost, schedule, spec may be desirable. • Problems in applying private sector management model to MOD environment (no analogues for governance roles of profit motive, competition, capital markets) • Smart procurement benefits are pretty modest: 2% of equipment budget EUK Lecture 5

6. A particular problem: IT procurements • Always go wrong, despite dominance by large firms: • EDS • RAF (Pay2000) – “reconstruction” of contract • NHS computerisation • Inland Revenue and DWP – glitches and delays – loss of £350M contract • Child Support Agency - £450M contract cost parents up to £750M • US Navy contract (£3.6B contract) – profits warning, 75% market value loss • Others • Fujitsu/ICL: (Post office counters) Pathways, scrapped after £700M spent • Lockheed/Martin: new ATC project (£350M) 5 years late, £120M over budget • Accenture: Nat. Ins. Payments £90M over budget • Capita: Individual learning accounts Budget £43M, cost £93M, scrapped after hacking • Siemens: Asylum-seekers system (£80M) on budget, but scrapped after discovery of basic flaws EUK Lecture 5

7. Dominance by the few (top IT projects, 1999*) EUK Lecture 5

8. Other problems • Human capital on the supply side (who understands these things, conflict between techies and bean-counters, incentives to learn and share) • Risk and uncertainty aversion • Unintended consequences of competition • Maintaining the pressure during the contract • “If you don’t fail sometimes, you’re not taking enough risk” • Well thought-out risk-taking • Separating state from effort • The value of a failed attempt • Avoiding mere novelty • Exploiting ex post and informal innovation EUK Lecture 5

9. What to do? • Intelligent customer role • Incremental acquisition/staged procurement • Separation of RTD, supply contracts • Procurement teams • Firewalls around prime contractor • Changes to IPR arrangements • Broadening the supply base • … EUK Lecture 5

10. Defence procurement in the UK • A monopolist facing a ‘thin’ and dependent supply sector • Heavy emphasis on technological progress • Changes in supply side ownership (privatisation) and structure (mergers, entry, exit) directly controlled by policy • Declining amounts over the past 2 decades: set to increase again • 1985/6: £32.7 Billion – 20% cost-plus • 1990/1: £29.7 Billion – 1% cost-plus • 2000/1: £23.5 Billion –41.4% capital and 37.2% labour • Defence equipment is very costly (e.g. £90+ Million for a single Eurofighter) and inflating rapidly • Policy relies heavily on competition to produce VFM (since 1983) • Firm and fixed-price contracts and incentive contracts • Risk transfer – use of single ‘prime contractor’ • After mid-90’s narrow VFM broadened to include capability maintenance • Special arrangements for ‘non-competitive’ contracts; profit formulae and pricing at the beginning (NAPNOC) • Smart Procurement (since 1998): incremental acquisition, integrated project teams, partnering, inflation control • Use of PPP and PFI for outsourcing of military functions (e.g. housing, training, logistics) EUK Lecture 5

11. The Supply side • “Defence Industrial Base” – in 2000/1: • 310,000 employed (70,000 dependent on exports), down from 740,000 a decade earlier • Almost all privately-owned (the R&D sector used to be dominated by DERA, but this was partially privatised, with the bulk of activity now in private hands (Qinetiq) and a small public activity (DSTL) • The sector is concentrating rapidly through merger (BA + GEC + Marconi -> BAE systems; Rolls-Royce/Vickers; Alvis/GKN) • These big players (BAE systems, Rolls-Royce, AgustaWestland (why Heseltine left government), QinetiQ) dominate the sector. EUK Lecture 5

12. Current problems, 1 • Continuing cost, time, quality failures (see NAO Major Equipment Reports on www.nao.org.uk) • “…in [2004], costs on the MOD’s 20 biggest equipment projects have increased by £1.7 billion and (…) these projects have been delayed by three months each on average. The … principles of Smart Acquisition have not been consistently applied and the NAO expects .. more problems … in future. • …less than the £3.1 billion … reported last year. The total cost of these projects is now expected to be £50 billion, which is 14 per cent higher than originally planned. • There is little evidence that acquisition has been improving. Many problems can be traced to the fact that the MOD has not spent enough time and resources in the assessment phase. Projects less than halfway through their procurement are already expected to be delivered later or to cost more than approved. The 15 most recent projects are moving rapidly towards their ‘not to be exceeded’ approvals and six have already breached them. • Some changes in cost, schedule, spec may be desirable. • Problems in applying private sector management model to MOD environment (no analogues for governance roles of profit motive, competition, capital markets) • Smart procurement benefits are pretty modest: 2% of equipment budget EUK Lecture 5

13. Current problems, 2 - Inflation • Defence-specific costs inflate faster than GDP, but Variation of Price (VOP) contracts use GDP deflator (uncovered portion due to fixed-price contracts and deflator gap about 30% of defence contract cost increases) • But much of this is endogenous to the firm or MOD contracts! • SP “solution”: • Firm price up to 5 years • Output price indices instead of input price indices for VOP • Larger non-variable elements in contract price (up to 70% in 20-year PFI) EUK Lecture 5

14. Current problems, 3 – PFI/PPP • Private Finance Initiative and Public-Private Partnerships are very popular: • Claimed to reduce construction and life-cycle costs • Risk transfer to private sector • Transfer of assets ‘off the government’s books’ • Encourages greater flexibility to innovate in all phases of project life-cycle • Reality is different • Transfer of resources does not reduce cost – indeed, private cost of capital typically higher • Defence as a public good – is it really, if privately provided and privately paid for? (IFF, air-to-air refuelling) • Writing and enforcement of ling contracts is tricky • Incentive to economise on uncontracted aspects EUK Lecture 5

15. Reviews of procurement policy • The Bates Review • PFI and other PPPs offer potentially huge benefits to Government by bringing the skills of the private sector to the provision of public services. As well as improving value for money, PFI/PPPs can help ensure a higher sustainable level of investment in public services. • Private sector invests 17-20% of total public sector investment under PFI. • Trying new types of relationship under wider PPP programme. Joint ventures to exploit untapped commercial potential or spare capacity in public assets under HMT's Wider Markets guidance. • Abolition of universal testing and streamlined and simplified process has increased PFI. • But serious weaknesses remain, for example, in public sector skills in contract negotiation and project management. • The Gershon Review • whole process of acquisition from third parties by Government, including goods, services and large capital projects • Weaknesses in organisation, process, people and skills, measurement and contribution of "centre" Government • Recommended formation of OGC to determine, disseminate good practice, institute Gateway reviews, build ‘intelligent customer role’ aggregate demand, etc. EUK Lecture 5

16. Public Procurement and Innovation • Context: • Large scale of procurement expenditures • EC target in Lisbon Agenda: increase R&D to 3% of European GDP and increase private R&D investment from 55% to 67% of total by 2010 • Other endorsements – Kok report on Lisbon Strategy (2004), UK Innovation Report (2003), Irish S&T Agency (2003), Spanish COTEC foundation (2003), Nl. De. • Rationale • Greater propensity for R&D expenditure to produce real outputs • Does not pay for R&D directly (demand-pull on private R&D) • Launching customer role to lower risk • Inclusion of testing technological requirements, value engineering clauses can stimulate innovation races EUK Lecture 5

17. Competition and innovation • Cost savings, efficiency gains from Single market, liberalising contracts • Need to respect Treaty Principles (equal treatment, non-discrimination, transparency) • Innovation challenges these directly: • Dominance of big firms in doing R&D, owning IP • “Apples and Oranges” nature of technologically diverse bids • Uncertainty connected with “promises to innovate” • Need to select based on criteria “directly related to the subject matter” seems to rule out broader benefits • Maintenance of the Supplier Base – keeping enough firms active to provide competition without weakening ‘evolutionary’ incentives and/or scale economies • Where firms are similar and compete head-to-head, increased (price-based) competition provides incentives for leaders to escape from the pack and followers to catch up via innovation • Where a (few) firm(s) dominate, more competition reduces innovation by reducing the probability and payoff to catching up. The leader can afford to innovate, but at the more leisurely pace needed to maintain his position. EUK Lecture 5

18. Pro-innovation possibilities • Foresight, market analysis and ‘technical dialogue’ • Technical specifications – to communicate needs to bidders and to facilitate bid evaluation • Should be as ‘functional’ as possible, but linking the function to the proposed technology may be hard • Should invite high-quality and diverse offers, but what combination? (variant solutions must have a reasonable a priori chance of success to encourage R&D investment) • Can let bidders point out additional benefits • Selection criteria: what is the ‘capacity to innovate? Is it measured by past performance? Does inclusion of track record discriminate in favour of incumbents and/or against start-ups? • Award criteria (“utility function” to rank bids): can include “innovativeness” directly or indirectly via “expected value for money” • Confidentiality: keeping technical or trade secrets during the bidding stage. There may be a case for disclosure afterwards in cases of multiple supply or at the end of the contract – but this may be harder when the contractor invested in the original R&D • Performance clauses: IPR, gain sharing, value engineering EUK Lecture 5

19. The general innovative procurement environment • Intelligent customer (managing both risk and uncertainty – professionalism and skills) • ID needs and opportunities (know thyself) • Specify functional cost, quality requirements (network) • Design suitable mechanism (auction forms, etc.) • Assess tenders (specific knowledge – especially on whole-life costs, competition effects) • Contract management and design (make lawyers, engineers and users talk) • Acceptance, verification (testing) • Intelligent supplier • Foresight and technology strategies • Demand aggregation: • total demand increases leverage and ‘pull’ • Interoperability and critical mass • accumulation of monopsony power • barriers to SME entry • exit of ‘losers’ increases risk, reduces variety • Co-sourcing, variable supply chains, subcontracting • Combinatorial (package) auctions • Affordable design competitions EUK Lecture 5

20. Innovation and the tendering process • Where to exercise flexibility (tender requirements, qualification/selection criteria, award criteria, ex post negotiation) • Management of risk (including signalling/incentive issues relating to e.g. “too good to be true” offers • Choosing an appropriate mechanism • Menu auctions • Combinatoric auctions (including multiple ‘winners’) • Power bids and share bidding • Unbundling R&D, main supply, re-tender, etc. • Choosing a good contract • Duration: longer contracts mean sharper bidding and greater innovation incentives, but also more lock-in costs and competitive distortion. PFI deals are often 20 years or so, service contracting-out is f-4 years (+ 2 year renewal) • Specified performance, liquidated damages: include performance underwriting • Liability: some standard-form contracts still impose unlimited liability – but it is uninsurable, its value is not comparable across bidders (depending on size, financial posture, etc.) and it may conflict with incorporation rules – thus reducing competition. EUK Lecture 5