MILITARY OUTSOURCING: UK EXPERIENCE. Professor Keith Hartley Director Centre for Defence Economics University of York

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1 MILITARY OUTSOURCING: UK EXPERIENCE Professor Keith Hartley Director Centre for Defence Economics University of York Introduction The UK Ministry of Defence (MoD) and the Armed Forces have considerable experience of outsourcing. This is involves the transfer of activities which were traditionally undertaken in-house by the Ministry and the Armed Forces to private firms. Outsourcing is part of the UKs general policy towards privatisation. This Report reviews UK experience with military outsourcing. It describes the development of policy, including examples, together with an analysis of its economic justification. The current policy emphasis on the Private Finance Initiative (PFI) and Public Private Partnerships (PPP) is also considered and critically evaluated. Here, consideration is given to the arrangements for competition, contracting, management and the monitoring of contracts. The Development of UK Policy on Military Outsourcing In 1983, as part of its aims of improving efficiency and achieving value for money, MoD introduced a new competitive procurement policy, embracing competition for equipment and for support services. It became part of MoD competition policy to contract-out support services where this could be done more economically in the private sector and without damaging operational capability. Thus, policy aimed to ensure that 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). By 1991, MoD was reporting the use of contractors and market testing in areas such as catering, cleaning, laundry, security guarding and maintenance, together with engineering and supply, range operation and support, training/instruction, bird control, academic and support functions at Military Colleges and target simulation and electronic warfare training. Some concerns were registered about the implications of contractorisation during war and the transition to war and the impact of the policy on Service morale. Overall, market testing, even where the task remained in-house, was estimated to have resulted in cost savings of some 20% to 30% (Cmnd 675-1, 1989). In 1992, MoD introduced an expanded programme of market testing as part of the Government s Competing for Quality initiative. Under this policy, in-house units were actively encouraged to bid against private firms for MoD contracts. MoDs Competing for Quality programme required its support needs to be exposed to private sector involvement and competition through privatisation, strategic contracting-out or by market testing which allowed outside bidders to compete with

2 MoD s internal suppliers ((Cmnd 2800, 1995). In fact, by 1995, MoD stressed that its...evolving Competing for Quality programme will foster and strengthen a valuable partnership of ideas and experience between the Department and the private sector, which will in turn assist in improving the efficiency and quality of support to the front line (Cmnd 2800, 1995, p100). Note the reference in this statement to a partnership between MoD and the private sector. This statement coincided with the Ministry s commitment to a new policy initiative, namely, the Private Finance Initiative (PFI), which aimed at the greater use of private sector finance and management expertise in the public sector for the advantages of both (Cmnd 2800, 1995, p100). MoDs New policy Initiative on Outsourcing: PFI and PPP INSERT A (pp 19-22) INSERT B (pp24-26) The Economics of Outsourcing MoD and the Armed Forces have to decide on whether to undertake activities in-house or to buy goods and services from the market (ie. the make or buy decision). In-house units in the Armed Forces can be viewed as public monopolies protected from competition (eg. where each of the Services have responsibility for repairing and maintaining their equipment). In the absence of competition, there are no alternative sources of information and no alternative cost yardsticks to enable MoD to assess the efficiency of these in-house units. Competitive tendering or market testing provides a solution to the problem of assessing the efficiency of in-house public monopolies. To its supporters, competitive tendering (or the threat of rivalry) means improved efficiency and cost savings. Competition promotes innovation, the application of new management techniques, the introduction of new equipment and new methods of working and allows MoD to recontract with different suppliers and for different levels of service (eg. manning levels can be reassessed and part-time workers can replace full-time staff). Successful firms in a competition are also subject to the disciplines of the capital market and the incentives and penalties of a fixed price contract (ie. there is a hard budget constraint compared with the soft budget constraint typical of inhouse units). Critics of competitive tendering and contracting-out claim that it leads to poor quality and unreliable services and that private contractors are less reliable than in-house units. For example, it is suggested that private contractors are liable to default and bankruptcy and are less able to respond to emergencies. Critics also claim that any cost savings are short-lived: low bids can be used to buy into an attractive new contract and eliminate the in-house capability, so that the MoD loses its bargaining power. As a result, MoD becomes dependent on a private monopoly which, in the long run, means higher prices, a lack of dynamism and a poor quality service. Competitive tendering also involves transaction costs which are often ignored by the supporters of contracting-out (eg. costs of organising a competition, negotiating, policing and monitoring the contract). The arguments for and against competitive tendering provide opportunities for independent economic analysis, critical evaluation and empirical testing. Some of the arguments obviously represent special pleading by those interest groups most likely to gain or lose from the policy. For

3 example, if MoD requires improved efficiency, contracting-out is not sufficient: competition is also required (hence, competitive tendering). There are also some distinctive features of military outsourcing which can be grouped around its implications for operational capability. The use of civilians to replace military personnel might have adverse impacts on the morale and fighting spirit of the Armed Forces (eg. a change in organisational culture). Also, there are unresolved issues about the use of civilian contractors in support of deployed operations in overseas theatres (CONDO: contractors on deployed operations). The UK has approached this issue by creating a new class of reservist, a Sponsored Reserve. But the prospects of using contractors in conflict situations requires flexible contracts different from contracting for support operations during peacetime. Many of the issues surrounding contractors in conflict situations (CONDO) are issues of trust, confidence, mutual understanding and partnership: such features are difficult to include in a standard contract (RUSI, 2000). A central feature of outsourcing and the economics of contracting is the notion of transaction costs. These are the costs of running the economic system and include the costs of negotiating, monitoring and enforcing contracts (Williamson, 1975). It is difficult to write fully-specified contracts which meet all unknown and unknowable future events, especially where contracts cover long periods of time, where technologies, costs and the strategic environment are highly uncertain and where the contractor has to commit to funding costly and highly specific investments. Imperfect information enables parties to a contract to behave opportunistically exploiting information asymmetries (eg. about the true costs or quality of supply). There is also the winner s curse where the contractor bids a low price to win the contract, but finds that the resulting revenues are inadequate to fund the service and earn a normal profit (eg. the BAE Systems competitive bid for Nimrod MRA4). This might be a strategic policy in which the winning contractor bids low with the aim of renegotiating later when the MoDs capability is disbanded and other contractors cannot enter quickly and take-over the service. Overall, the transaction costs analysis shows that the costs of managing contracts, including arranging bids, monitoring outcomes and taking legal action for contract failures, may offset any efficiency savings (Kavanagh and Parker, 1999). Writing complete contracts is problematic and costly. However, transaction costs can be reduced where contracting reflects reputation (based on past behaviour) and trust (based on expectations of future behaviour) leading to long-term partnerships between the buyer and contractor. Some of these features of transaction costs, the economics of contracting, reputation, trust and partnership are relevant to analysing MoDs experience with its new PFI and PPP policies. An Overview of the UKs Private Finance Initiative This section describes the UKs general policy on PFI, including its economic justification and some of the features of this new procurement policy which provides the background for MoD policy in the field. The UK Government launched the Private Finance Initiative (PFI) in 1992 and the Labour Government of 1997 re-launched the PFI programme under the banner of Public Private Partnerships (PPP). Under PFI/PPP, private capital and private sector companies finance and operate infrastructure that previously was publicly funded and managed. The economic arguments

4 PFI/PPP are expected to lead to cost savings through specifying clear and enforceable contracts, transparency in the bidding process and proper cost efficiency incentives. Typically, the private sector becomes responsible for the initial design, construction, operation and maintenance of the project, so providing incentives for low-cost construction and minimum life-cycle costs. As a result, project risks are transferred to the private sector (eg. reducing cost over-runs and delays during construction) and private firms are encouraged to be innovative in project design, construction, operation and maintenance. One feature of PFI/PPP appears attractive, but needs addressing, namely, the desire by governments to transfer expenditures from the public budget to the private sector so as to avoid exceeding government financing limits (eg. to meet Maastricht criteria). Simply transferring resources from the public to the private sector has no effect on resource allocation if identical resources are used. Moreover, governments can always borrow more cheaply than the private sector. If PFI/PPP contracts are to lead to genuine cost savings, the extra financing costs for the private sector must be offset by savings elsewhere on the project (eg. management and running costs over the life of the project). Procurement features of PFI/PPPs PFI forms one amongst a number of alternative procurement mechanisms. The alternatives include: i) Privatisation; ii) Contracting-out; iii) PFI; iv) Joint ventures; v) Partnering and framework agreements; vi) Separate contracts for construction/development and operation; vii) Traditional procurement. A National Audit Office (NAO) Report defined PFI as governments negotiating projects founded on the principle of using private sector expertise, including finance raising, to provide services which traditionally would have been provided by the public sector (HCP 739, 1999). PFI projects involve private sector financing the construction of a major physical asset, operating it and recovering the cost over time through charges for services paid by a government department. To government departments, PFI projects mean that the department does not have to find all the money for the capital asset up-front during its construction (see economic arguments above). In formulating PFI contracts, the NAO recommends that government departments follow a number of principles, including the following:

5 i) A clear specification of the departments requirements, focusing on outputs rather than inputs. ii) Limit the range of options before seeking competitive bids (to simplify bid preparation by contractors and to ensure fair comparisons of different bids). At the same time, the department should avoid imposing unnecessary constraints on how the private sector can undertake the project. iii) Identify the scope for innovation and risk transfer. iv) Aim to maximise competitive tension throughout, so that tenderers will always feel under pressure to submit their best possible bids. This means that departments should not ask an excessive number of firms to submit bids and incur the costs of bidding when they believe that their chances of winning the competition are low. But successful competitions require a good tender list of firms invited to bid. Where appropriate, departments need to conform to EU procurement directives, including the requirement to issue notices in the Official Journal of the European Communities. v) Establish a public sector comparator against which the bids will be judged. (including forecasts about the volume of services required and assumptions about discount rates). vi) Selection of the winning bid will be multi-dimensional embracing such criteria as the degree of risk-taking by the contractors, innovation and price-quality trade-offs (ie. the most economically advantageous bid). Design is the area with the greatest scope for innovation and bidders need to be given freedom to suggest different designs. Innovation is also possible in the operation and delivery of the required service, including the possibility of bidders suggesting alternative deliverables. vii) Value for money on PFI contracts requires appropriate risk allocation between the public and private sectors. Without risk transfer, the private sector receives the benefit of a secure income stream (cf. a gilt-edged security), but may set charges which result in a return which is far higher than can be earned on such securities. Where different degrees of risktaking are available, departments should ask bidders to submit tenders showing the effect on price of alternative risk allocations. Departments should then convert bidders proposed annual contract payments into a single net present value figure (using the Treasury discount rate of 6% in real terms). viii) The optimum length of contract. Typically, the contract needs to be short enough to give the department flexibility if its needs change but long enough to encourage serious commitment from the contractor. ix) Contract changes. Change is inevitable; but it is not possible to anticipate all changes, especially in the long-term: hence, the contract needs proper procedures for handling change and for resolving disputes. x) Departments should minimise the risk of price changes or any other major changes in the

6 period after the preferred bidder is selected and the contract is awarded. This can be achieved by informing the preferred bidder that the contract will be finalised in a short specified period of time. Also, one of the unsuccessful bidders might be asked to remain involved until the contract has been awarded. xi) Windfall gains. Departments need to consider whether they need to include mechanisms for clawing back windfall profits earned by the contractor so that there is at least some sharing of such profits. Alternatively, departments might ask bidders to submit prices with and without any clawback arrangements. xii) The use of external advisers (eg. financial, property and technical consultants; lawyers). Typically, external advisers should be appointed after competition with the choice based on price and the quality of advice.