European defense industrial policy and the United Kingdom’s defense industrial base

T he United Kingdom’s defense industrial base (UKDIB for short) cannot be viewed in isolation; it needs to be seen in the context of the European Union and its relationships with the United States. Both the EU and the U.S. protect their defense industries using Article 296 of the EU treaty and the Buy America Act (together with other protectionist policies). Compared with the United States, the European Union lacks a single European defense equipment market. In 2004, about 1


The defense industrial base in the European Union and in the United Kingdom
In 2003, employment in the world's arms industries was almost 7.5 million with the EU accounting for almost 10 percent of the total (see Table 1). Employment declined substantially following the end of the Cold War when the world's arms industries employed over 16 million people in 1990. Between 1990 and 2003, major employment reductions took place in Hungary, the Ukraine, Russia, and Germany. In contrast, employment reduction in the United States was relatively small, which might reflect its world power status, the influence of its military-industrial-political complex, and the defense sector's recovery due to the Afghanistan and Iraq conflicts. Defense 3 industry employment is also concentrated in a few nations with the United States accounting for 36 percent of the 2003 world total compared with 19 percent of the total in 1990. Within the EU, the top three nations of France, the U.K., and Germany accounted for 72 percent of total EU defense industry employment in 2003 (and an 80 percent share in 1990 but based on a smaller EU). Table 1 also shows the major size differences between the United States' defense industrial base (USDIB) and each of the top three EU nations; and the large number of European nations with relatively small defense industries. Such size differences between Europe and the United States and within the EU confirm the costs of national protection in Europe and the potential efficiency gains from a single EU Market for defense equipment. 4 Since the end of the Cold War, a major re-structuring involving mergers and acquisitions in both the EU and the United States has led to larger defense firms and increased market concentration. European examples include BAE Systems (UK), EADS (Netherlands), Finmeccanica (Italy), Safran (including Snecma: France), and Thales (France). There has also been the emergence of military service companies reflecting military outsourcing, especially in the United Kingdom and the United States (some U.S. service companies have obtained contracts as a result of the Iraq war, e.g., KBR/Halliburton). 5 Data on size, value added, and profitability of the top EU and U.K. defense firms is shown in Table 2. Problems arise because the data reflect both military and civil sales and are confined to the aerospace and defense group. Nonetheless, significant differences in the size of firms measured by sales, value added, and employment may be seen. By sales, EADS, BAE, and Thales are the largest European firms. There are also performance differences, reflected in value added and profitability. Within Table  2, Vosper Thorneycroft -a warship builder -has the lowest value added productivity and Dassault Aviation has the highest. Profitability varies from losses by Finmeccanica and BAE Systems to substantial profitability by Dassault, Cobham, and Megitt. Comparisons with the all-U.K. and all-European company averages show that aerospace and defense have higher value added productivity than the industry averages that represent the alternative use value of resources. However, for some companies these performance indicators are likely to reflect the economies of scale and learning from large-scale civil sales (e.g., EADS/Airbus; Rolls-Royce). Moreover, European and U.K. aerospace and defense are relatively less profitable than the industry averages raising questions about their continued presence in what appears to be a relatively less profitable industry.

EU defense industrial policy
Defense industrial policy involves procurement choices between the extremes of supporting a national defense industrial base or importing foreign arms (with or without offsets) or the intermediate solutions of international collaboration and licensed or co-production. Each option involves varying degrees of work-sharing and technology for the buying nation with corresponding alternative prices. 6 Economic theory offers two key policy guidelines for EU defense industrial policy, namely, gains from trade and gains from scale and learning economies. Most EU defense markets are protected with preferential purchasing and support for national champions (e.g., Article 296 of the EU Treaty). Free trade among member states would lead to gains from specialization with trade based on comparative advantage. This requires abolition of tariff barriers, subsidies, and preferential purchasing by member states, thus allowing free entry and competition for national defense contracts. Firms from member states would be allowed to bid for defense contracts in each nation-state. In late 2005, EU member states agreed a voluntary Code of Conduct for defense procurement to encourage competition in the EU defense equipment market where traditionally arms contracts were exempt from the normal EU internal market rules. 7 Additional cost savings are available where arms industries are decreasing cost industries (e.g., aerospace). Greater output reduces unit R&D costs and leads to economies of scale, learning, and scope: such economies are not achieved in small- scale EU national defense markets but are available in a single arms market embracing all member states of a military alliance. Estimates suggest that competition effects might lead to unit-cost savings of 10 percent to 25 percent with scale and learning economies probably contributing a 15 percent to 25 percent reduction in unit costs. 8 Policies to introduce an efficient defense industrial policy will, like all policies, involve gainers and losers. Potential gainers include those industries and firms which are privately owned and have already been exposed to competition and competitively-determined fixed price contracts. Possible losers will be state-owned firms which operated in protected markets receiving subsidies and cost-plus contracts. Changes to establish a more efficient industrial policy will involve adjustment costs and will take time. There will be some unemployment and underemployment of resources, reflected in job losses, plant closures, exits from the industry, and local unemployment. Potential losers will oppose change and will lobby for "fair and managed" competition with work allocated on a juste retour basis and protection for EU defense industries (e.g., Fortress Europe). With such pressures from producer groups, the ideal of an efficient defense industrial policy might soon be transformed into cartels, collusive tendering, a lack of rivalry, and inefficient EU defense industries.
Within Europe, collaboration has been the most distinctive of its defense industrial policies, especially in aerospace systems (e.g., 3-nation Tornado; 4-nation Eurofighter Typhoon). In theory, ideal or perfect international collaboration leads to savings in 9 development and unit production costs. Actual collaboration involves departures from the ideal case with work-sharing based on political, equity, and bargaining criteria (juste retour) rather than efficiency criteria, resulting in inefficiencies in both development and production and longer development times. Collaboration fails to exploit gains from trade; but it does achieve economies of scale and learning although these are not fully realized due to each nation's desire for a final assembly line.
A U.K. study provided evidence on the inefficiencies of collaboration. It estimated that total development costs on collaborative projects were some 140 percent to almost 200 percent higher than comparable national programs, depending on the number of partner nations; but the U.K.'s cost share on collaborative programs was about one-third of total development costs. On production, it was found that collaboration achieved scale and learning economies in the region of half of those on national projects with collaboration causing an average of 11 months delay. Cost 10 overruns and delays on collaborative programs reflect the transaction costs of international contracting, including the management of collaborative programs, the cooperative industrial arrangements, and changed order quantities as well as budget constraints and delayed approvals by national partners. Current European defense 11 industrial policy is focused on creating a single market for defense equipment and a European defense industrial base based on initiatives pursued by both the European Commission and the European Defense Agency (EDA).

A European defense market: market openness and offsets
The European Defense Agency has introduced initiatives to create a single European market for defense equipment. These include an inter-governmental agreement for a voluntary Code of Conduct aimed at opening defense markets of member states and promoting competition, including transparency and accountability procedures. With this new system, EDA will publish procurement opportunities and contract details through an electronic bulletin board. Under the Code of Conduct, member states are committed to purchasing defense equipment from each other on the basis of best value, instead of automatically contracting with a national supplier. The Code covers defense equipment purchases that governments choose to exempt from EU public procurement rules under Article 296 and that do not usually involve any cross-border competition. Member states requiring an exemption from the Code of Conduct must provide an explanation to the agency. However, the Code of Conduct is not legally binding so is unlikely to achieve much impact. There are also concerns that efforts to create a common European defense equipment market will be affected by state support, subsidies, state ownership, security of supply, intra-community trade, export policies, and different military requirements. Furthermore, EDA is assessing the impact of offsets on competition and defense industry restructuring. There is a concern that offsets distort competition, promote inefficiency in defense procurement, affect transparency in procurement, and might impair efforts to establish a European Defense Technology and Industrial Base. Questions arise as to what is known, what is not known, and what it is necessary to know to formulate a sensible policy on offsets in the European defense equipment market. 12 Estimating offsets Import data in Table 3 can be used to provide an upper bound estimate of the annual value of offsets for participating member states of the European Defense Agency in 2005. This upper bound estimate of i4.2 billion is based on the limiting assumption that all imports are associated with an offset -an unrealistic assumption but one which provides a starting point for estimating the value of offsets for EDA member states. On the basis of the import data, we expect the annual value of offsets for all members to be less than i4.24 billion in 2005. These data refer to annual values only: typically, offset data are shown for the total value of the offset, which usually involves transactions over a number of years (e.g., see data in the annual SIPRI yearbooks).
The upper bound estimate can be modified further by considering some countries' offsets as a share of total defense equipment foreign trade (exports or imports). For example, for U.S. defense equipment exports to the U.K. over the period 1993-2005, offsets accounted for 84 percent of the total value of such exports. Similarly, for U.S. defense exports to the top-9 EDA member states over this same period, offsets accounted for some 79 percent of the total value of such U.S. exports. On this basis, © www.epsjournal.org.uk -Vol. 3 The European defense equipment market: market openness Table 3 also provides estimates of import penetration of defense equipment markets, data which are useful in assessing the openness of participating EDA member states' defense markets and the contribution toward the development of a European defense equipment market. There are substantial variations in market openness ranging from almost 100 percent for Greece to under 1 percent for France. The average market openness is 16 percent. (An alternative estimate is 10 percent for military markets compared with 25 percent for civilian orders. ) Typically, the nations with a 14 relatively large defense industrial base (employment of 20,000 or more) were the ones with relatively low degrees of import penetration, suggesting substantial market protection. France, Germany, Italy, Sweden, and the U.K. each had import penetration rates below the EDA member states' average (Poland was above and Spain was at the average). A rank correlation based on the top-7 defense industries found a significant and positive correlation between defense industry employment and the degree of protection (measured by import shares; r = 0.75, significant at the 5 percent level), but when the sample was extended to include other nations, the rank correlation was not significant (r = 0.0061). 15

United States data on European and United Kingdom offsets
The United States Congress publishes regular reports on offsets in defense trade. These reports provide data on offset percentages and country policies for EU nations based on U.S. defense exports. Table 4 shows the average percentage offsets for the < For EDA nations, offsets achieved varied substantially from 28 percent for Portugal to 174 percent for Austria. Often, the achieved offset was substantially below the country target percentage. Even nations with a large defense industrial base did not achieve their 100 percent target (i.e., France, U.K.) while countries with a relatively small defense industry often achieved a relatively high percentage offset (i.e., Austria, Greece, the Netherlands). < Indirect offsets accounted for some 60 percent of all offsets. Typically, 16 purchases, usually aerospace-related, accounted for over 60 percent of the value of indirect offsets. However, the data on indirect offsets are dubious. They are defined as defense goods and services unrelated to the defense export, suggesting that they are indirect defense offsets. However, the text in the U.S. Congressional reports implies that they include indirect civil sales.

Offsets and the European defense equipment market
Critics regard offsets as a source of inefficiency in defense procurement and a barrier to the creation of a European defense equipment market through their introduction of non-price factors into procurement choices and value for money criteria. Further, they claim that offsets, if badly targeted, can conflict with the aims of creating a European defense Offset percentages: -Europe regional total: 99 (EDA median: 99) -North and South America regional total: 97 -Middle East and Africa regional total: 43 - industrial base and that all offsets are difficult to administer and to deliver in practice. Such claims need to be evaluated.
Offsets might lead to the discovery of lower-cost suppliers and allow entry into highly-protected defense markets. Also, the criteria for the most economically advantageous offer in any procurement competition allows consideration of non-price factors. The point about badly targeted offsets and the European defense industrial base suggests that there are correctly targeted offsets that might contribute to creating such a defense industrial base. Finally, claims about administration and delivery of offsets are empirical issues requiring supporting data on transaction costs.
There are various options for an EU policy on offsets. First, there could be a ban on all offsets for defense trade between member states involving EU firms. Such a ban would be strongly opposed by various member states who support offsets and would place EU firms at a competitive disadvantage with U.S. defense firms in European markets. Second, there could be harmonization of offset policies where the harmonization might involve minimum thresholds or a maximum offset percentage (e.g., a cap of 100 percent) or the specification of the weight to be placed on offsets in procurement choices and the introduction of a common external offsets policy (similar to the common external tariff). Third, efforts might be made to identify "desirable" and "undesirable" offsets in relation to their impact on the European defense industrial base. The European Defense Agency could also act to break the offsets trap where nations are competing to maximize offsets (cf., subsidy trap). Or, policy might focus initially on transparency requiring that member states specify their offset requirements in all invitations to tender with a possible further requirement that offsets be non-discriminatory between national and other firms. In fact, current EDA policy on offsets aims "to create the market conditions and the European DTIB structure, in which the practice may no longer be needed -and meanwhile to consider how adverse impact on competition and the DTIB might be mitigated." However, 22 there are more serious issues concerning the creation of a European defense equipment market. Typically, member states rely on the national security exception in Article 296 to make most of their defense purchases on a national basis. Efforts 23 to open up national defense markets of member states continue to offer the greatest opportunities for substantial efficiency improvements. There are also wider issues about the European defense industrial base.

The European technological and defense industrial base
The European Defense Agency has announced a policy on the future European Defense Technological and Industrial Base (EDTIB). This is needed to supply equipment to the EU's armed forces, including world-leading technology equipment and to allow independent operations. A EDTIB is also seen as a valuable economic asset as a major source of jobs, exports, and technological advance. However, the agency recognizes the need for fundamental change in policy toward a EDTIB. A truly European defense technological and industrial base is no longer economically sustainable on a national basis with separate national research and development and procurement programs. For example, Europe has four main battle tank programs compared with one in the United States; twenty-three national programs for armored fighting vehicles; and eleven frigate programs compared with one in the United States. 24 The EDA view of the EDTIB is one which is "... more integrated, less duplicative and more interdependent -increased specialisation at all levels of the supply chain, must take over from all (or at least too many) trying to do everything. Centres of excellence should emerge from a market-driven process, moderated by policy considerations including the requirement to achieve an appropriate regional distribution." Policy also refers to identifying, preserving, and developing "key" 25 European technologies and industrial capacities as well as ensuring security of supply for all member states in a "truly European DTIB." 26 Attractive though a European DTIB policy appears, there is a need for much more clarification. Concepts such as "key" technologies and industrial capabilities are vague: what are these capabilities, why are they key, and are they to be retained regardless of costs? Potential conflicts are likely between the aims of an EDEM and an EDTIB: a genuinely competitive and open defense market is unlikely to support an "appropriate regional distribution" of the "key" technologies and industrial capabilities. Nor are there any indications of the optimum size of EDTIB and of its constituent firms. For example, which nations have a comparative advantage in which areas of air, land, and sea systems as well as in R&D, production, and subcontracting? Will the EU market only support one monopoly supplier for some types of defense equipment (e.g., aircraft carriers; nuclear-powered submarines; space systems)? Further potential problems arise between the desire for a EDTIB and national preferences for retaining key defense industrial capabilities (e.g., as in the U.K.'s Defense Industrial Strategy).
The U.S. defense industry which supplies a large single American market might provide a model for an EDTIB. The U.S. Department of Defense submits an Annual Industrial Capabilities Report to Congress.
This outlines ideal industry 27 characteristics such as a reliable and cost-effective defense industrial base, including an "adequate" number of competitive suppliers in key and emerging technology areas and opportunities for new entry by innovative suppliers. The reports contain a detailed analysis and assessment of industrial and technological capabilities embracing primes, subcontractors, and critical sole-source suppliers (e.g., missile solid rocket motors). For example, in the aircraft industrial sector, the report questions Boeing's future in the combat and transport aircraft sectors and raises doubts about the future availability of titanium for the aerospace industrial base. It also suggests that suppliers not associated with the F-35 program are at risk. Increased industrial concentration is highlighted. In ground vehicles, it notes that during the 1990s, the number of prime contractors reduced from eleven to two © www.epsjournal.org.uk -Vol. 3, No. 1 (2008) (General Dynamics Land Systems and BAE Ground Systems Division). Similarly, in missiles, the number of primes fell from over twelve to six (dominated by Raytheon and Lockheed Martin) and bottlenecks in the supplier base remain. In shipbuilding, there are six major U.S. shipyards shared equally between Northrop Grumman and General Dynamics. Significant excess capacity exists, leading to higher overhead costs. Concern was also expressed that the United States' unique submarine design industrial base could downsize significantly, as happened in the U.K. where the eventual result was large cost overruns and schedule delays.
A similar annual report on European defense industrial capabilities would provide EDA and policymakers with the necessary information for making informed choices on the EDTIB. Significantly, the U.K. recently published a similar comprehensive review of its defense industrial base in the form of the Defense Industrial Strategy which has implications for the development of European defense industrial policy.

The United Kingdom's defense industrial base and its defense industrial strategy
The U.K. Ministry of Defense (MoD) is a major buyer of defense equipment and services, spending some £16 billion on R&D, equipment, and support in 2005.This buying power forms a major component of the demand side of the U.K. defense equipment market and can be used to determine the size, structure, behavior, performance, and ownership of the UKDIB. Exports are a further component of market demand, valued at some £7.1 billion in 2005. U.K. defense industrial policy is based on the 2005 Defense Industrial Strategy (DIS), and the associated Defense 28 Technology Strategy (DTS). The DIS is the most comprehensive statement of U.K. 29 defense industrial policy ever published by a U.K. government. It provides data on the UKDIB; it provides guiding principles for the Strategy; it outlines the problems facing the defense industries; and it identifies the key industrial capabilities which will be retained in the United Kingdom.
The DIS contains data on the UKDIB, and some of the main features are shown in Table 5. The Table shows annual MoD spending and its allocation between R&D, equipment, and support services. Support services accounted for over 50 percent of MoD spending and the DIS forecasts a significant growth of this business. The DIS also confirms the relative openness of the U.K. defense market, where over 30 percent of MoD industrial spending was with foreign-owned companies, collaborative programs, and imports (with imports accounting for about 14 percent of equipment spending in 2005). Labor productivity in the UKDIB is higher than the average for U.K. industry suggesting that the defense industries are more productive than the average alternative use of resources (i.e., the UKDIB makes a net contribution to national output). However, employment in the UKDIB has declined substantially from 740,000 employees in 1980/81 to 550,000 at the end of the Cold War and the 310,000 personnel in 2005. The DIS forecasts further employment reductions and substantial excess capacity in U.K. production facilities. Indeed, the DIS reflects the need for the UKDIB to adjust to a future of major gaps in development and production work, raising questions as to which defense industrial capabilities the United Kingdom wishes to retain, how such capabilities will be retained, and at what cost.
The DIS specifies that the sectors to be retained in the U.K. include submarines, core workload warship building, small arms ammunition, and cryptography together with support capabilities for manned fixed wing aircraft, helicopters, and armored fighting vehicles. Elsewhere, the United Kingdom retains the right to buy from overseas for large aircraft, trainer aircraft, helicopters, missiles, torpedoes, and some warships. Future business in the defense industry is expected to be dominated by support and upgrading of platforms. It is also recognized that as industrial rationalization continues, sustaining competition for domestic requirements will be increasingly difficult. Once the current generation of major projects enters service, there is forecast to be substantial excess capacity. For example, the projected end of any new design manned fast jet aircraft threatens the U.K.'s existing design, development, and manufacturing capabilities (e.g., BAE plants at Brough, Woodford, Warton, and Samlesbury).
The DIS plans to retain key parts of the UKDIB by offering protected and guaranteed markets to preferred suppliers through long-term partnering agreements. These agreements will be with domestic monopolies and will replace competition as a means of delivering best long-term value for money (e.g., where competition is not possible or inappropriate). Inevitably, concerns arise about the economic impact of the shift from competition to monopoly and partnering. Standard economic theory predicts that partnering will lead to monopoly behavior reflected in higher prices, inefficiency, monopoly profits, and a poor performance on innovation. There are also potential conflicts between the DIS partnering model based on protected and guaranteed U.K. defense markets and the EU's efforts to create a European defense equipment market based on open and competitive markets. Interestingly, before the DIS, U.K. procurement policy was based on open and competitive markets.
The DIS raises further issues of concern. There will be more emphasis on non-competitive contracts with all their problems (e.g., estimating and agreeing costs, profits, and prices). The role of wider factors in procurement choices represents a further unknown in the DIS (e.g., what are these wider factors; are they based on market failures; do they allow Ministers opportunities for distorting procurement choices?). Also, supporting key U.K. defense industries involves a willingness to pay for such capabilities, but various parts of the DIS refer to the need to avoid paying a U.K. premium. Finally, the dominant position of BAE Systems with its domestic monopolies in air, land, and sea systems needs to addressed. There are concerns about a cosy relationship between the contractor and MoD which might be controlled by treating BAE as a regulated firm or subjecting it to periodic efficiency audits by the U.K. Competition Commission. 30

Conclusion
European, U.K., and U.S. defense firms are faced with change. Defense firms have a long history of change and uncertainty. New technology has resulted in revolutions in arms and armed forces. Examples include the emergence in the twentieth century of manned aircraft, missiles, and nuclear weapons. Continued technical change and the emergence of new threats (e.g., international terrorism) means that the future defense firm will be different from today's defense firm. Not all existing arms firms will survive and adjust to new technologies. Future aerospace firms will shift from manned combat aircraft to unmanned combat air vehicles, missiles and space systems, and the electronics industry is likely to become more important providing the next generation of new entrants, systems integrators, and prime contractors. New forms of industrial organization will also emerge characterized by buying rather than making, using international supply chains in a global economy leading to more international arms firms. 31 Costly, defense specific equipment will create further challenges for European and U.K. governments and the defense industrial base. Examples include aircraft carriers, main battle tanks, manned strategic bomber aircraft, and nuclear-powered submarines. Increasingly, these are purchased in small numbers with long gaps in development between new generations of equipment. Where such systems require highly specific human and physical capital (e.g., nuclear-powered submarines), there will be 32 problems and costs in maintaining such assets during gaps in development. The absence of competition for these weapons means that their prime contractors will have to be treated as regulated firms requiring procurement agencies to review their regulatory policies for non-competitive contracts (cf., regulation of natural monopolies). Continued industry re-structuring among both prime contractors and suppliers means that national markets will be dominated by larger firms and domestic monopolies. Competition remains an efficient policing mechanism, but it will require a government's willingness to open up its national defense market to allow foreign firms to bid for arms contracts with possible adverse impacts on the EDTIB and domestic defense industries.
For the EU, there are likely to be conflicts between its efforts to open up national defense markets and the desire to create and maintain an EDTIB and for nations to retain a domestic defense industry (e.g., the U.K.'s DIS). The notion of an EDTIB remains vague (e.g., compare the U.S. model). Even if the defense industrial base can be defined, choices will be needed about its geographical distribution (e.g., the desire for fair shares), the likely monopoly of some costly and highly specialized industrial capabilities (e.g., aircraft carriers; missiles; space systems; nuclear-powered submarines), and the possibility of duopoly-oligopoly in other sectors of the EDTIB (e.g., helicopters; manned combat aircraft; transport aircraft; main battle tanks).
The United Kingdom is already making such choices through its Defense Industrial Strategy, which has identified key capabilities that the U.K. plans to retain through guaranteed markets and partnering agreements with preferred suppliers. The development of an EDTIB might require the U.K. to make further difficult choices through being more selective about which defense industrial capabilities are to be retained in the U.K. For example, can the U.K. (and France) afford to retain a costly submarine industrial base supplying one product to one customer in small numbers? It might be more cost-effective to focus on the U.K. aerospace industry as a successful defense industrial sector. Nor can the U.K.-U.S. relationship be ignored in formulating a European defense industrial policy. The U.K's major defense firms have substantial business investments in the U.S. defense industry (e.g., BAE, Roll-Royce) while American and European defense firms own substantial parts of the UKDIB (e.g., Smiths Aerospace owned by GE; AgustaWestland owned by Finmeccanica). For U.K. firms, the U.S. defense market is a large and relatively profitable market. The creation