Select Committee on Defence Minutes of Evidence

Examination of Witnesses (Questions 20-39)

5 MAY 2004


  Q20 Mike Gapes: Does anybody else want to say anything?

  Mr Frost: The view I have is perhaps a little more cynical in that I feel that playing cricket when everyone else has great big baseball bats is perhaps a British way of doing things but is not terribly effective. They will do what they want to do and we just need to recognise where we are. I think that is perhaps the first thing and that is being pragmatic about all this. The other point I would like to make is that, if big investments are being made in those countries' industries, they are hard-headed people and they will get their money back and the way they get their money back usually is in the cost of support. All I would ask is that perhaps, in these procurement decisions, the UK should look very carefully at what the life cycle cost in reality is going to be, not least through access to rights over technology that will now allow MoD to actually maintain and support that equipment in years to come. So, it is not a question of handouts, it is a question of what we are actually buying, a very clear-headed question about the support costs and life cycle costs of such equipment. I do not think any government is subsidising an industry to no purpose. It is subsidising an industry because it thinks it is economically beneficial to its own country.

  Q21 Mr Roy: First of all, I was very interested in your comments about lack of investment in shipyards especially in Clydeside. Years ago, I only wish that managers with powers such as yourself would have listened to trade unionists when we were making those very same arguments. However, I am still caught between what you were telling us and what you were saying and what was said in the Daily Telegraph when one of your spokesman was talking. In that quote, it was said that there had been expressed an interest in looking at any approaches and that offers to increase shareholder value. That is slightly different from shipbuilding in the future and the shareholder value.

  Sir Richard Evans: I think the shareholder value issue is inherently related to the well being of the business itself. It is not simply a matter of selling the silver in order to pass it across to the shareholders. The shareholders have an interest and a stake in this sort of business, all the employees have a stake in the business and the managers have a stake in the business but, at the end of the day, we have to do what is the right thing to develop the business and, as I say, the fact of the matter is that here in the UK and across Europe there is too much capacity in this business at the present time. I think that a lot of the investment we are putting into the naval shipbuilding business today is not simply directed at improving the facilities and the fabric of the buildings etc that people work in, it is actually building up and reconstituting the intellectual capacity that was closed down when the Naval Architects Office was closed and therefore redeveloping a design capability not just for the ships but the integration of the systems that actually go into those ships and it is very interesting today that, if you go up to Barrow and look at the engineering block there, there are significant numbers of people who are moving from the south of England and are actually transferring those skills up into Barrow. The same sort of thing is going on in the yards in Glasgow as well. To do that, we have to fundamentally have a capacity that is matched to the market. If somebody can do that better than we can do it today, it is in everybody's interests that we should listen to what—

  Q22 Mr Roy: I am just talking about a difference in emphasis. I thought you were giving an approach where you were actually putting public interest a wee bit more focused as opposed to shareholders' value and I think it would be wrong, if anyone is watching this, to say that Sir Richard is really putting a great emphasis on the need for public interest when, a couple of days ago, your company was saying that it was really all about shareholder value and it would be wrong for anybody to take that message away from what you said earlier on.

  Sir Richard Evans: If you think there is a wide difference or disparity in those views, then, I am sorry. I genuinely do believe that it is very easy to absolutely crystallise one particular piece of interest as being in the interest of the shareholders, one in terms of employees etc. At the end of the day, what we want to do is to see this business being hugely successful. If somebody can make a better job of that for the reasons that I have described, it will be completely wrong for us to prevent it happening. Conversely, if we are able to do that in partnership and with our partners here in the UK, that will be absolutely fine as well.

  Q23 Mr Roy: If I can just take that one area, for example, where I suppose the public interest and shareholder value that you hold so dearly would certainly join up in relation to value for money. Both you and your Chief Executive over the last couple of months have questioned the MoD's definition of value for money. How would your company like to see value for money defined?

  Sir Richard Evans: I think in the context of a specific definition we would like there to be a much wider definition of value for money than is the very narrow definition that the Procurement Agency actually takes. I very much hope that as defence industrial policy gets better and better people will begin to think differently and people will begin to take a different view of it. I would just like to give you one example where I think this is highlighted. It is an actual example, and I go back again to the Hawk decision. The recommendation from the Procurement Executive to ministers was to acquire the Aermacchi plane. We had various doubts and reservations about the way the analysis had been carried out, particularly the cost of ownership, but nevertheless we were not party to it, this was a competition position between two separate entities. The UK Government in the early 1970s awarded to the predecessor company, now part of BAE Systems, Hawker Siddeley, again as a result of competition, the design and development of an advanced jet trainer for the Royal Air Force. At the time the value of the contract was about £350 million and in today's money that is about the equivalent of a billion. The contract was implemented. Subsequent to that, and as a result of that, the UK has sold 800 Hawk aircraft around the world generating sales value today to the equivalent money of about £15 billion. In our view, supported by the professionals in the sales organisation, in the MoD, there is a view that there is a continuing market for the Hawk, albeit with further development that you would expect to take place over a period of time, that would result potentially in a further market of about 400 to 500 aircraft. In the decision taking or the recommendation that was made to the ministers, there was absolutely no account taken of that additional value to the UK. You might argue why should the MoD take it into account? Are they paid to take that into account or not? I think that is one of the wider value issues that should be taken into account. I can tell you that since that decision was taken, the Indian Government have placed an order for 66 Hawks which, had that decision gone against us, would not have been placed. The Indian requirement will almost certainly exceed 200 aircraft. There is a huge replacement programme for earlier Hawk aircraft that have already been delivered. I can genuinely see us actually being able to sell a further 400 to 500 aircraft. On the basis of an investment made 20-odd years ago, £350 million, to throw that away and actually give another five billions' worth of business to the Italians or somebody else, and at the same time shut a factory and make a lot of people unemployed, whatever the bloody rules of economics are, that is certainly not economics as I understand it. Somehow in the process of evaluation that was the recommendation that was made. How on earth it could have been made, I cannot believe. Ultimately it required the Secretary of State for Defence to issue a ministerial directive to overturn it. This is the lunatics having taken over the asylum.

  Chairman: You have made your point. Frank, carry on.

  Q24 Mr Roy: You spoke at great length and, I have to say, a lot of it was going over my head there. Can we focus in a wee bit more. The question was how do you define value for money in such a way that the Government does not?

  Sir Richard Evans: I thought I had given a reasonable example. Had the recommendation been adopted by ministers that was made by the procurement organisation, I think that we, the UK, would have lost business to the tune of about 500 more aircraft in the export market. That has a value to the UK. It is a huge amount of money that goes to the Exchequer. Nowhere in the recommendation is that brought into account. My point is that when you look at these sorts of recommendations there is a much wider issue and this should not be looked at absolutely narrowly, and even looking at it in a narrow sense we think it was an injustice anyway.

  Q25 Mr Roy: How has the Government responded to you?

  Sir Richard Evans: The Government responded by issuing a ministerial directive forcing the Ministry of Defence civil servants to change the recommendation to sign up for the Hawk—it has not been signed up at the moment but it has been announced—and the result of that is patently clear for all to see, that already we now have an additional 66 aircraft in the order book that we would not have had otherwise.

  Chairman: We have got another 15 questions to ask still, but I take your point.

  Q26 Mr Jones: You say obviously the MoD is the main customer and you made reference to exports in terms of their importance. The defence industry is obviously very important to many of our constituents in terms of jobs and in terms of UK plc. What damage has been done to that, not just to your company but to the industry in general, by the allegations this week in The Guardian newspaper? Is it important that when we are winning contracts abroad, we are not just seen to be winning because we have the best product but we do it in an ethical way? Clearly there are issues which affect your particular company but obviously it paints a broad brush picture across the defence industry in general. What can you do to actually put forward the best face of UK plc defence when you have got allegations that clearly are being made and are being used by those people who are against the UK defence industry?[1]

  Sir Richard Evans: These allegations stem from one source, which is The Guardian newspaper. This is a campaign that has been running for a long period of time. In the context of the recent allegations, which incidentally I would remind everybody are always published either at the time of our Annual General Meeting or the time of our results in order to inflict the maximum amount of damage on us, there is actually nothing new in them. When we completed the Marconi transaction we gave absolutely definitive and binding commitments to the Government of the United States in the context of adopting completely the US Foreign Corrupt Practices Act. That was implemented and we actually had a team of lawyers from the US responsible for giving advice in the context of the way in which American companies have implemented this process and it was taken on board with all the safeguards, including hotlines, whistleblowing, etcetera. Subsequent to that, of course, the OECD recommendations were implemented and here in the UK they were put into legislation through the Anti-Terrorism Bill, became law in Parliament and those constraints go much, much further than the US Foreign Corrupt Practices Act. I am satisfied, insofar as I reasonably can be, that all of the appropriate safeguards exist in our organisation, but I have to say that when these allegations are made they are obviously damaging. Nobody thus far has produced evidence to us, despite the fact that we have made a number of invitations to people to do so, other than that which was ultimately submitted to the SFO. Obviously if there is new evidence available and it is brought forward then clearly it would have to be investigated. Certainly in the context of the practices that we and all other companies work to, because all of us have to operate within the framework of the law, we have a duty to our shareholders to ensure that we are completely compliant with the law, not just here in the UK but wherever we are operating.

  Q27 Mr Hancock: Are you saying that article was not true?

  Sir Richard Evans: I am saying that the allegations contained in this article are of wrongdoing, and I think you have got to be quite careful about how you define wrongdoing in these contexts, certainly the allegations and assertions of the laws being broken, etcetera, are allegations that I at this time, and regularly, completely refute. Until there is some evidence that we have broken the law that I do not have at the moment, obviously I have to continue to refute it.

  Q28 Mike Gapes: You may not have broken the law in the context of the UK but nevertheless you might have made payments to members of the Saudi royal family which would be regarded as unethical or immoral. If we have changed our practices as a result of recent US legislation or anti-terrorism legislation that is all to the good, but clearly there are issues that date back a number of years. As far as I have seen, the allegations are something that goes over several years and talks about events three, four, five years ago, at least. Would you agree with me that in the past there has been lax practice and that things have been done that would not be tolerated today?

  Sir Richard Evans: I think that business practices have been changing over a period of time. I can certainly assure you that we, and I believe most companies, are not in the business of making payments to members of any government. I would just like to reiterate that not only are we bound here by the laws in the UK but we are bound by the laws wherever we operate. This is not a question of people passing, as you suggest, large sums of money to employees of governments, it is just not the way that business is done. There is a huge amount of speculation that goes on on this subject and it makes good copy possibly but it is pretty far from the mark.

  Mike Gapes: We will await the outcome of the investigation, I think.

  Q29 Mr Cran: Can I move us on to the question of risk sharing. The danger of this whole issue was recognised in the original document of 2002, Defence Industrial Policy, which must be bedtime reading for the lot of you. It says: "If this risk becomes unmanageable, it could have serious implications for the companies involved and the equipment programme as a whole". That is fairly clear. I think the Committee was interested, and I certainly was, when your Chief Executive was put in front of the Committee of Public Accounts on 23 February this year, and he said this: "Industry took far too much risk in the past and we, BAE Systems, are not doing it in the future." I mean no impropriety about that whatsoever. "There is a far more attractive market in the United States if the MoD terms of trade do not change." That is a powerful statement. You must certainly agree with it, Sir Richard, but does everybody else agree with that?

  Mr Howe: Risk was one of the points I alluded to earlier, I think it is one of the defects of the present system that not enough is invested in exploring and limiting risks at the beginning of major projects and decisions are taken to embark on major projects without sufficient investment on that front. I would agree with you on that front. I have to say primarily I think the solution is in the hands of the customer to make sure that he does not take these very large decisions to proceed with major projects until sufficient preliminary work has been done because obviously, as you implied, risk cannot simply be passed on to industry. If a project does not work or is not delivered then the customer suffers at the end of the day. It is a joint problem.

  Q30 Mr Cran: I take it that there are no dissenting voices to that?

  Sir Richard Evans: No.

  Mr Prest: No.

  Q31 Mr Cran: Where is the balance? Clearly you have been making representations to the Government, I would be very surprised if you had not, particularly on the 2003 completion of the review of this particular document. The question is (a) whether you have made representations and (b) what has been the Government's reaction to that, or the MoD's or whoever?

  Sir Richard Evans: I think also at the PAC meeting to which you referred, both the Chief of Defence Procurement and the Permanent Secretary made exactly the same point that we have been making, and that is that we have to find a way of getting a much better balance on the whole issue of risk. Reference was made to the National Audit Office report on major projects where, from memory, I think the figure reported in the context of pre-main gate expenditure was 4.4 per cent against a recommendation contained in the smart procurement arrangements of 15 per cent. That gives you a measure of the gap. Both sides have learned an awful lot out of this. There is a sort of dichotomy in this in that to get to what is called main gate and, therefore, to get approval, you have to have a price for the programme and you have got to have specific delivery dates identified with that price. The fact of the matter is I think we are all agreed that through circumstances we have been forced to go to main gate far too early, ie before we have expended 15 per cent of whatever it is to de-risk the programme. I have to say that it is a consistent criticism, it is in the existing NAO report but it has been in many earlier NAO reports, that the original price and dates for delivery that are quoted to get through main gate virtually all change, without exception, over the life of the programmes. As I say, the Chief of Defence Procurement was saying exactly the same as we are because this is an issue of mutuality. It is just as important to them that they understand what it is they are paying for and when they are going to get it as it is for us to understand that we can actually design and build and deliver it. This is not an issue where we are on opposite sides of the fence. There is a lot of work going on at the moment to get a much better understanding of how we achieve these objectives.

  Q32 Mr Cran: This is a rather important issue for you certainly, for all of you. Could give the Committee a sense of when you think that you are going to get a resolution of this? A lot of work is being done, you say.

  Sir Richard Evans: I do not think that there is a big bang solution to this, that we are going to wake up one morning and say that suddenly we have got a complete answer to this. In part, at any rate, the answer to this depends upon the specific programmes. There are things that are happening that you can look at today that will give you, and should give you, encouragement on this. The carrier programme is a really good example where the original intention was to go through main gate in something like March time and that was largely because the existing pre-contract funding effectively ran out at the end of the financial year. We and Thales, who are in the partnership in the context of being required to bid who had bid and created the partnership in the context of continuing with this programme, were advising the MoD that there had been insufficient de-risking. From memory, at that time I think the amount of expenditure in what we call the de-risking phase was about two per cent compared with the 15 per cent, not even where the NAO average of 4.4 per cent was, not anywhere near it. The result of that is that the programme has not been presented for main gate approval. Additional funding has been found to keep pre-main gate funding running forward and that will enable a lot more work to be done. Both of us are very clear that we do not want to go to main gate until both of us are confident on what it is we are pricing and offering on delivery and for the supplier and for the buyer to have a reasonable degree of confidence that that is what he is going to get.

  Mr Howe: I have nothing to add to that at all. Good progress has been made by the team in continuing with the design, so I would not like you to think that the work has been going badly. The work that is going on at the moment to complete the design and to assess the risk associated with that is essential before the Ministry takes that big decision.

  Q33 Mr Cran: In asking my next question I do not want to imply that you are not going to succeed in the dialogue that you are having with the Government over this issue and that you are not going to reach a rapprochement. Your Chief Executive did actually say: "There is a far more attractive market in the United States if the MoD terms of trade do not change". What is it about the US market that makes it so attractive, apart from, I guess, the money, the technology and all the rest of it? Is that transplantable into the United Kingdom?

  Sir Richard Evans: Certainly it is transplantable. It is interesting that pretty much the same contracting processes were operating in the United States something of the order of 12/14 years ago as are operating here today with regard to programme launch, lack of investment and de-risking etcetera that virtually brought the entire US defence industry close to bankruptcy. It caused a complete reassessment of the whole of the contracting processes and procedures to be introduced and those procedures that are operating today in the US are very much in line with the recommendations that we would make today, and have made today, to the MoD. They are largely about breaking these programmes down into bite-sized opportunities, not having to definitively say on day one "this is what it is going to cost and this is when it is going to be delivered", desirable though that would be to do if we could do it, ensuring that sufficient de-risking has been undertaken before we get to the point where we are definitively pricing and at the same time recognising that if you do not start with a delivery date and do not start off with a price, there have got to be some review points in those programmes where both sides can step back from it. For instance, if we see the risks, and even on the US basis after the programme had been launched there are review points, and if the risks are working out not to be in line with the initial assessments that were made then the buyer has the opportunity to say "We either want to stop the programme and review the programme or there are certain circumstances in which we can abandon the programme because there is no point travelling in hope here if the costs are going to continue to escalate because we cannot get the risk under control". Secondly, against that, there is obviously a very different corresponding position and view of profit. The actual profit allowances in the United States are vastly different from the profit allowances here in the UK. In competitively contracted business—I stand to be corrected on this—I think the current profit rates in the US are running at about 12 per cent on sales. Indeed, the Pentagon themselves recently have been seeking to increase the rates of profit in order to improve the financial health of the contractors in order to be able to get more investment from the contractors back into the R&T budget. Corresponding numbers here in similar circumstances under the current arrangements are probably more like five per cent. There are two issues, one is a much more sensible view towards the management of risk, the assessment of risk and breaking programmes down into manageable pieces without at the front end committing ourselves for the next 25 years and at the same time looking at how you get the risk-reward ratios into the right balance in the context of what the contractors can actually earn. Under those circumstances, the Pentagon, ie the procurement agency of the United States, has every right to come and expect the companies to be investing into R&T to support defence programmes.

  Q34 Mr Cran: To state the obvious, I guess you have been making exactly the same points to the Government and I guess the Government are considering it.

  Sir Richard Evans: Absolutely. I do genuinely believe, notwithstanding where the NAO have been coming from, that the procurement people in the MoD are looking at some of these arguments, there is certainly the issue of risk assessment and the agreement now is that there is going to be much more money spent on that risk assessment phase than has historically been the case. That is desirable and that is certainly going to happen at the US end. As always, the problem with the MoD people is simply budgetary constraint. The process of government accounting has always been a bit of a mystery to those outside it but it seems to me at the moment that the great problem the MoD has is that its actual liabilities in terms of current programmes, notwithstanding what it may have to do tomorrow, in respect of the programmes that it is currently committed to, exceed what we would describe as the asset base, which in their case is the budget. In the external world, the next stop is to go and talk to the administrators. There is a certain amount of sympathy we all have for the MoD and to do these things differently does in the short term sometimes require additional investment but in the long term, over the life of these programmes, will without a doubt pay back very handsomely.

  Q35 Mr Cran: My last question is simply this: just so that we know how far you are prepared to go to back your views, and all of you hold them very strongly on this particular subject, have any of you actually withdrawn from a contract, assuming the terms of the contract allowed it, where it became apparent to any or all of you that the risk that you were being asked to take was too great, or becoming too great?

  Sir Richard Evans: I can give you one recent experience where we were in the consortia we were operating with for the tanker programme and we simply walked away because the amount of risk that we were being asked to take could not be justified and there was a potential issue in terms of whether the consortia bidding for that, which we were in, ultimately could afford to expose sufficient of its balance sheet to the potential liabilities. There are other examples as well.

  Q36 Mr Cran: Any others, so we may know if this is common practice?

  Mr Frost: Yes, but on a much smaller scale where on one or two UK programmes the volumes were so small and as an equipment supplier the numbers of aircraft were so small that it simply would not justify the amount of investment we would have had to put into both the proposal costs, which were significant, and of course the unfunded elements, such as development. I would like to add a comment. It seems obvious to me, just looking at it from that level and from a distance, as to why any risk equation in selling defence equipment to the US would look totally different. It is simply a matter of scale and volume. If my company is going to sell one thousand ship sets of something, we are much more likely to increase the ante in the risk we take on the non-recurring development end compared with a programme, perhaps, where the UK is buying 50. It is simple economics.

  Q37 Mr Hancock: What about when you are buying two, like two carriers? Are you close to the breaking point on the risk assessment you have made on the cost of the carriers and your ability to carry that risk?

  Sir Richard Evans: As yet, there simply has not been sufficient work done to get us to the point where anybody, and by that I mean anybody on the industrial side or anybody on the procurement side, could realistically today make a full assessment of risk. If it were the case that you could make that assessment of risk then this programme would have gone through main gate and, as I have said previously, it has not done. I suspect there is probably realistically at least another year's worth of work to be done before we begin to see whether the scale of risks here can be managed and how they can be managed.

  Q38 Mr Hancock: This really relates to working in alliances, does it not, and whether or not it can materialise as a financial gain for the company as well as offering the defence industry stability. Why do you think there is so much speculation about BAE Systems remaining the prime contractor for the carriers?

  Sir Richard Evans: First of all, I should say that the original decision that was announced was that there would be an alliance and the alliance was between BAE Systems and Thales. That was announced after the result of the bids was made public. We and Thales then basically brought our teams together under an alliance and have been working under that alliance very satisfactorily ever since. I think our concerns now are that what is actually developing is some sort of procurement committee and this programme, which is certainly the biggest single military programme that would have been launched in recent years, is in some way going to be managed by a committee. The committee will be chaired by a procurement officer from the Ministry of Defence who will have a balancing vote on the committee. We are somewhat concerned when it comes to the issue of who is responsible for what risk whether a committee can adequately deal with the management of a programme of this scale. We have no problem at all if that is what the customer wants to do because, let me be clear, it is the customer's prerogative to decide how he wishes to have his programmes managed. If we were not to be within that committee grouping in the ideas that are just being bounced around at the moment then quite clearly we would want to become a subcontractor to the management team and make our shipyards available and all of our engineering skills available in order to make the programme a success, not to be sitting as part of a committee at the top that may generate risks that ultimately would become uncontrollable. Absolutely we recognise if that is what the customer wants to do then he is entitled to do it.

  Q39 Mr Hancock: Providing he pays.

  Sir Richard Evans: Well, at the end of the day, providing this committee can manage the programme within the budgets which have been agreed when it does go through main gate, we know that everybody will be deliriously happy and rightly so as well because it is a hell of a challenge, but if that were not to be the case, if people start sort of shuffling the deckchairs around looking to see who is actually responsible for whatever the failings are, it is a bit like good old-fashioned consortia where everybody has got a bit of it, but no one individual is actually responsible. However, under the current proposals or as they were proposed, there is no doubt about it that Thales and we together, shoulder to shoulder, are absolutely locked in in this right at the front end of it.

  Chairman: Thank you. We will come on a little later to this.

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