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The defence industrial base: European rationalisation and transatlantic cooperation

A Note by the Director (Ditchley 2000/08)
 
(in association with BAE SYSTEMS)
 
22-24 September 2000
Over the weekend of 22-24 September we took a critical look at the defence industries on either side of the Atlantic, their recent moves towards rationalisation and prospects for increased transatlantic cooperation.  We began by reminding ourselves of the unique characteristics of the Defence industry.  The market was constrained by considerations of national security, by the fact that Governments were overwhelmingly the biggest commissioners and consumers of defence equipment and that the expenditure of public money inevitably brought with it public, sometimes very public, scrutiny.
We also reminded ourselves of a range of factors which were currently influencing the way in which defence industries in Europe and North America were operating.  The biggest single factor was a change in the strategic balance flowing from the events of 1989.  This had led to very large reductions in defence budgets (70% in the case of the USA).  Other factors had been Governments’ recommendations in favour of consolidation (the “last supper” in the USA and the Franco/British/German tripartite letter in the case of Europe) which had prompted the emergence of three major American defence corperations and two or possibly three major groups in Europe.  These groups were now operating in a radically different market place.  The new industrial giants were the telecommunications, media and technology businesses.  The whole US defence and space sector was now worth just 14% of Microsoft’s market capitalisation.  Defence industries were competing for the same highly skilled staff as these “new economy” companies but, with low or falling share prices, had difficulty in retaining and incentivising their workers through stock options.  At the political level, defence related issues, with rare exceptions like National Missile Defence, had a much reduced political resonance and, in the scale of national interests, a lower priority than hitherto.
Against this changed, and changing background we looked at developments in America and Europe and tried to identify some future trends.  We started with a much used cliché – fortress  America, or fortress Europe, depending on your point of view.  Both the Americans and Europeans present disclaimed any intention of building a fortress.  But as the discussion developed it became clear that past case history and present misunderstandings still influenced attitudes on both sides.  Recent European decisions to purchase the Meteor missile and A-400M transport aircraft had led some Americans to detect a buy-European policy while the US Congress, technology transfer regulations, and a comparison of how many contracts the Americans had won in Europe compared with the (smaller) list of contracts won by European firms in the US, were all aired as indications of US discrimination.  The general conclusion was, however, that we should all try to look forward rather than back to see if mutually agreeable transatlantic solutions could not be found.  The market was too small, and the risks too high, for regional autarky to be a sensible goal.
We looked in some detail at developments in the USA.  We noted that it had, by several orders of magnitude, a bigger defence market than Europe.  Any firm aspiring to a leading position in the defence field had to win contracts in the USA.  In reviewing the results of the consolidation process, the comment was made that while there had been a large number of mergers and acquisitions there remained scope for genuine rationalisation. There was still overcapacity in a number of sectors.  The Europeans present drew attention to the fact that, unlike European Governments, the US Administration had helped with the costs of rationalisation.  We examined the role of Congress as an apparent obstacle to non-US companies winning contracts in the USA had heard that there was a bias among both the US military and in Congress against joint ventures with foreign firms on grounds of delay, cost and reliability.   But, it was asserted, the widespread belief that Congress systematically used the technology transfer regulations to obstruct foreign companies entering the US market was exaggerated.  The Washington bureaucracy in the defence field was a maze in which even Americans could lose their way and experience delays and frustration.  And the Administration, in the form of the State Department, was just as likely as Congress to cause complications.  Foreign companies which set up production facilities within the USA, as BAE SYSTEMS and Rolls Royce had done, experienced many fewer problems.
Commenting on developments in Europe, a view was expressed that although some had hoped for more rapid progress following the tripartite letter in 1998, we had now reached a position not dissimilar to that in the USA.  Two large groups, BAE SYSTEMS and EADS, had emerged – joined recently by Thomson/Racal.  We had little doubt that one of the prime motives for this had been the consolidation in the USA.   Apart from the fact that, unlike America, the EU comprised a collection of sovereign governments, the other main differences were more widespread state ownership in Europe and the greater concentration of defence production (85%) in four countries. The balance of importance between competition and employment was also different  in Europe to the USA.  A thriving European defence industry helped to maintain public support for defence policy.  For Europeans, it mattered “where the wages were paid” even if it was less important now who paid them.  It was also important that the intellectual property rights were retained in the country of origin, and not necessarily subjected to the US laws controlling technology transfer.  Interestingly, one or two European participants commented that possible restrictions on the future transfer of technology was a factor to be weighed when considering whether to set up production in the USA.  We speculated about the effects of transnational companies and the ability of companies like EADS or Thomson/Racal to claim a variety of different nationalities.  “Companies need many fatherlands” and “Global reach, local touch” were among the expressions used.
There was some discussion of the institutional architecture in Europe.  An agency for Joint Armament Cooperation had been set up.  Its members were the major European arms producers and in the medium term it might exercise significant influence on European Defence purchases.  We considered possible supra-national bodies capable of ensuring a level playing field for European defence industries.  The EC Commission was mentioned.  It was recognised that this went to the heart of the exception given in Article 269 of the Rome Treaty which had so far excluded the Commission from defence matters.  But, we asked ourselves, in a world where dual-use technology was becoming more widespread could this distinction be maintained?  Some indeed argued that the record of the competition directorate of the Commission in other fields would justify its introduction into the field of the defence industries.  Others cautioned that there was little expertise in the Commission in this area and, importantly, if the Commission were to become involved, tacitly or otherwise, the European Parliament (and the European Court) would also demand an overview with wide potential effects on the substance and speed of policy making.  In addition, progress was needed on common rules of procurement, reciprocity and European company law.
Other factors influencing developments in Europe were also identified.  We thought the EU commitment at Helsinki in December 1999 to a Headline Goal of forces and capabilities to fulfil the Petersberg peace keeping tasks would drive EU member states to look for greater efficiencies, increased capabilities and better value for money.  At the very least it would ensure that European Heads of State and Government took a closer interest than hitherto in defence production and procurement.  Both cooperation and competition between European and US companies was thought to be desirable.  But US differentiation between its European partners in NATO over technology transfer was seen by many as divisive.  To which the US response was that change would only come a step at a time.  We should seek to build on the changes the US Administration had announced.  The present level of cooperation between the UK and the USA was based on trust and confidence and was a product of many years of close cooperation which had included its share of sharp differences of opinion.  It was not ruled out however, that further moves by the US Administration to encourage cooperation between European players and the US could be in the pipeline.
An important distinction was drawn by some participants between prime and second tier suppliers.  While there might be reservations, particularly in the USA, over awarding lead status to non-American firms, at the level below prime contractors, European firms were already supplying the US market with large quantities of high-tech defence equipment.  Some thought that this might, at least in the short term, prove to be the most fruitful field for transatlantic cooperation.
Discussion also focussed on a number of general issues.  Competition was generally thought to be essential in controlling cost and as a spur to innovation.  But uncontrolled competition could give rise to difficulties.  On both sides of the Atlantic the question of what to do about the “losers” in bidding for major contracts was becoming an increasing problem.  Given the long life time of major defence platforms, losing a contract was tantamount to an exit from that segment of the market with consequent problems for future competition.  Suggested solutions included European firms providing competition in the US market and vice versa, European/US transatlantic partnerships or mergers which would spread the risk, and, finally open architecture groups which could bid for large contracts without going as far as mergers.  A voice of experience commented that large programmes required the resources and expertise of large prime contractors to see them through.  To which was added the caution that security of supply was a major consideration for Governments in placing large contracts.
The importance of interoperability between systems made in the USA and Europe was stressed.  The practitioners claimed that this problem had been exaggerated.  In the past, ways of enabling different systems to work together had been found.  But others thought that in the new world of C4 communications this might be a greater problem.  It was suggested that common funded NATO programmes might help to push forward transatlantic cooperation.  The need to make use of civilian technology rather than paying for exclusively military designs was seen as growing trend.  But if defence firms wanted  access to the results of civil R & D in high-tech areas, coupled with the reduced costs that came from continuous production, they would have to design flexibility into their military systems to take account of the long equipment cycles in the military field compared with the much shorter cycles of civilian production.
Looking at the possibilities of further mergers or take-overs across the Atlantic, we found ourselves divided between those who thought that recent activity had created groups which needed time to reorganise and drive efficiency through their present operations and those who thought the logic of the market would continue to demand further mergers and consolidation in the relatively short term.  We were reminded, however, of the overriding need to create value as a result of any M & A activity.  Without that, the markets would take a negative view with consequences for the share-price and thus on employee options and the ability to raise capital.  The question of the future direction of defence industrial effort was also linked to the threats we expected to face in the next decade or so.  Unsurprisingly given the well-known difficulty of forecasting future crises, our views ranged from the possibility of cyber-terrorists disrupting our information systems to the more recognisable conventional threats we had experienced in recent years in a variety of theatres.
Overall, at the end of the conference there was a feeling that, although the industry was passing through a period of unprecedented change, we should resist any tendency to try for exclusively national solutions to the problems which faced us on both sides of the Atlantic.  Increasing transatlantic defence industrial cooperation seemed a real possibility, with Governments, including the US Administration, taking initiatives to facilitate this.  This mood was reflected in a widely supported proposal that US/UK industry should create a transatlantic industrial forum to debate these issues and invite governments to attend.  Balancing cooperation and competition would remain a key challenge, as would adapting to the “new economy” and potential new threats.
I would like to express my thanks to BAE SYSTEMS for their help and support for this conference.
This report reflects the Director’s personal impressions of the conference.  No participant is in any way committed to its content or expression.
 
 
PARTICIPANTS
Chairman  :  The Rt Hon Sir Malcolm Rifkind KCMG QC
Member of Parliament (Conservative), Edinburgh, Pentlands (1974-97); Secretary of State for Defence (1992-95) and for Foreign and Commonwealth Affairs (1995-97).
 
CANADA
Dr Alistair D Edgar 

Associate Professor, Department of Political Science Wilfrid Laurier University, Waterloo, Ontario. 
Mr Robert Leboeuf
Executive Vice-President, SNC-Lavalin.
FRANCE
M Marwan Lahoud

Senior Vice-President, Mergers and Acquisitions, European Aeronautic Defense and Space Company (EADS).
Professor Guillaume Parmentier
Founder and Head, French Centre on the United States, IFRI.
M Guillaume Schlumberger
Deputy Director, Strategic Affairs, Ministry of Defence.
GERMANY
Dr Thomas Enders

Executive Vice President,  Defence and Civil Systems Division, European Aeronautic Defence and Space Company (EADS) and member, Executive Committee.
Herr Klaus von Sperber
Director, Organisation for Joint Armament Co-operation, Bonn.
Professor Michael Stürmer
Chief Correspondent, Die Welt.
ITALY
Mr Alberto de Benedictis

Senior Vice President, Finmeccanica SpA.
NATO
Mr Robert Bell

Assistant Secretary-General for Defence Support, International Staff, NATO HQ.
UNITED KINGDOM
Mr Hans J Ashbourne 
Adviser and lecturer on Anglo-German defence issues. 
Mr Norman V Barber 
Lately Chairman, Aerospace Group, Smiths Industries plc.
Mr Colin Budd CMG
Director for EU and Economic Affairs and Deputy Under Secretary, Foreign and Commonwealth Office.
Rear Admiral Richard Cobbold CB
Director, Royal United Services Institute for Defence Studies, London.
Mr Charles Coltman
Director - Corporate Development, Rolls-Royce.
Major General Christopher Elliott CB MBE
Director General, Development and Doctrine, Ministry of Defence.
Mr David Hart
Consultant to BAE SYSTEMS and The Boeing Company.
Professor Keith Hayward
Head of Research, Society of British Aerospace Companies Ltd (SBAC).
Dr Brian J Hilton
Senior Lecturer, Royal Military College of Science, Shrivenham.
Mr John Howe CB OBE
Director of Defence Strategy, Thomson Racal Defence Ltd. 
Mr Tom McKane
Deputy Head, Defence and Overseas Secretariat, Cabinet Office.
Mr Ron Nailer OBE
Managing Director, Aviation Support and Electronics Distribution, Dowty Group.
Mr Geoffrey Norris
Prime Minister's Policy Unit.
Mr Michael Pakenham CMG
Foreign and Commonwealth Office;  lately Deputy Secretary (Overseas & Defence) and Chairman, Joint Intelligence Committee, Cabinet Office.
Sir Robert Walmsley KCB
Chief of Defence Procurement and Chief Executive, Ministry of Defence.
Mr Peter Watkins
Team Leader/Smart Acquisition, Ministry of Defence.
Mr John Weston
Chief Executive, BAE SYSTEMS.
UNITED KINGDOM/UNITED STATES OF AMERICA
Mr Ian R Stopps

Chief Executive, Lockheed Martin UK Limited.
UNITED STATES OF AMERICA
Mr Jeffrey P Bialos

Deputy Under Secretary of Defense for Industrial Affairs, Ministry of Defense.
Mr Steven L Krause
General Manager, International Business Development, Military Aircraft and Missile Systems Group, The Boeing Company.
The Honorable David R Oliver Jr
Principal Deputy Under Secretary of Defense for Acquisition, Technology and Logistics, Ministry of Defense.
Mr Mark Ronald
Chief Executive Officer and President, BAE SYSTEMS North America Inc.