Select Committee on Defence Second Report


THE DEFENCE BUDGET

The SDR Settlement

141. The Strategic Defence Review represented the MoD's contribution to the new administration's Comprehensive Spending Review. The CSR established a division between Annually Managed Expenditure (AME)—generally demand-led expenditure subject to cyclical fluctuation and annual budget review—and Departmental Expenditure Limits (DELs) which set cash budgets for each department for the three years 1999-2000 to 2001-02. In the MoD's case, its £1.2 billion AME largely represented its then Vote 4 Service pensions expenditure. The remainder, its DEL, was some £68 billion for the three years of the CSR.

142. When we examined the financial implications of the SDR in 1998, we noted that the budget for 2001-02—the third year of the CSR settlement—was 4% less in real terms[345] than 1998-99. The MoD would be able to retain £250 million of any sale receipts from the proposed public-private partnership for the Defence Evaluation and Research Agency (DERA), and this would bring funds available to the Department in 2001-02 up to £23,222 million in real terms (2.8% less than the 1998-99 budget).

143. We noted in our SDR report that "defence spending has now reached an historically low level ... Any proposals for further cuts in real terms below the third year baseline will almost certainly cause the entire strategy to unravel".[346] (Figures 12 and 14 reproduced from our SDR report show the decline in defence spending over the last decade and more.) At the same time we were somewhat sceptical that, in living within that budget, the MoD would be able to afford the capabilities and tasks required of it. When the Secretary of State gave evidence to us during our SDR inquiry, he told us that "the key to affordability rests first on [estate] asset sales of over £700 million by 2001-02 and an additional £250 million in that final year. The second key is an achievement of three per cent improvement in efficiency."[347]


Source: DASA

Figure 13: MoD Departmental Expenditure Limits
   
1999-00
2000-01
2001-02
DEL (cash)
£22,280m1
£22,815m1
£22,972m1
Equivalent in 2001-02 prices2:
£23,410m
£23,390m
£22,972m
Possible additional expenditure supported by PPP of DERA (para 154)
   
   
+ £250m3

£23,222m
Real-terms percentage change since 1998-99 budget (£22,240m, or £23,890m in 2001-02 prices)
- 2.0%
- 2.1%
- 3.8%4

[or -2.8% including use of DERA disposal income.]


1  These DEL figures are in each year £15m less than those set out in the SDR because of minor technical adjustments, mostly reflecting the transfer of some of the Royal Travel budget from the MoD to the DETR (Cm 4201, page 22).

2  Using Treasury GDP deflators (updated December 1999).

3  Table 2 of the MoD Expenditure Plans 1999/00-2001/02, Cm 4208, notes that the £250m from this 'one-off asset sale' (that the MoD may retain and spend) is at 2001/02 prices.

4  The Committee's SDR Report (HC 138-I) noted the reduction as 4%. The lower 3.8% figure reflects more recent GDP deflator data which now assume 2.25% GDP growth in 1999-00 rather than 2.5% as previously assumed.


Source: 'Financial and Economic Data Relating to NATO Defence', NATO, December 1997

144. Before the publication of the Spring Supplementary Estimates for 1999-2000, it is not possible to establish unambiguously how well the Department is faring within the financial settlement of the SDR. There are signs however that suggest that pressures on the budget may be already emerging in this first year of the MoD's CSR settlement. The 1999-2000 Winter Supplementary Estimates[348] noted that the MoD's DEL expenditure after the first six months of the year was running 4.3% ahead of forecast.[349] This suggests that if this were to continue for the whole financial year unchecked, the MoD could overspend by some £950 million.[350] We were told that additional costs of Kosovo operations falling on this year's budget were likely to be nearly £400 million,[351] but if this were met from the Reserve it would still leave a significant further margin to be clawed back by the Department in order to avoid breaching its cash limit.

145. The Department told us that—

    ... we have found, in the early part of this year, that we were spending money at a higher rate than anticipated, and so we had to look hard at the areas where this was occurring. It was occurring in one or two of our Top Level Budget areas but, also, on the expenditure on the new equipment programme. It is not clear whether that was being caused by Smart Procurement having beneficial effects earlier than we expected, in the sense that things were being delivered which we thought might not have been delivered.[352]

    ... we did a full survey, as usual, with our budget holders ... to ensure that they could so organise their affairs that they would not overspend their allocations ... That analysis caused us to move some provision from the logistics area, where the rate of expenditure was rather slower, and some out of the procurement area, because that rate was going too fast. Some of those bills will now, effectively, be slipped into next year—maybe a couple of hundred million pounds' worth—and other budget holders have had to tighten their belts in one or two areas. There have been one or two examples of exercises being cancelled or curtailed ... The tempo of activity, particularly with all the operational activity that is going on, has been high. That has allowed people to rein back in other areas of their budget on which, in a more stable period, they might have been spending. The position remains tight, but the measures that have been taken, primarily on the procurement budget, to move money on bills into the early part of next year, we are confident should enable us to stay within our overall cash limit.[353]

146. We examined further these pressure points—the exercise programme, higher procurement expenditure and the financial implications of operations—as well as the affordability challenges set out by the Secretary of State during the SDR (paragraph 143 above).

Cancelled Exercises

147. Two UK and eight NATO or UN exercises (in which the UK would have had a role) have been cancelled because of the operational commitment of forces to the Kosovo campaign[354] (paragraph 71). Two other major UK exercises, however, were cancelled because of financial constraints—

  • The annual Royal Marines arctic warfare exercise in Norway was cancelled by the Commander-in-Chief Fleet, saving £3 million.[355] The MoD suggested that the fact that the Royal Marines were due to be deployed to Kosovo mitigated the disadvantages of the cancelled exercises.[356] It is for the Commander-in-Chief Fleet to assess how best to make good the reduced capability, and we were told that his organisation would next year be looking hard at measures necessary to do that.[357] This exercise must be reinstated next year.

  • HMS Westminster's participation on the Flotex exercise was cancelled, again as an 'in-year budget management measure',[358] and the ship was instead a feature of the New Millennium celebrations on the Thames.[359]

Given that so many exercises had to be cancelled because of over commitment it is deeply worrying that there was insufficient money to pay for some of even the residual exercises planned. Without regular exercises for high intensity conflict, standards in our Armed Forces will plummet, whatever the quality of the people and equipment.

Pressure on Procurement Expenditure

148. The proposed reallocation of budgets to bolster the funds available this year for equipment procurement[360] is significant, not least because it follows two years of significant underspending in this area—some £500m in total. In 1997-98, the former Vote 3 procurement allocation was underspent by £204 million.[361] When that procurement underspend was carried over into 1998-99, it was diverted to other Votes. Instead the procurement budget was reduced by £220 million, but it was still underspent (by £111 million).

149. When we questioned why the cash limit for procurement was reduced in 1998-99, instead of being raised as a result of carrying-over the previous year's underspend, the MoD told us that 'there is no simple correlation between [1997-98] Vote 3 and the [1998-99] Procurement Executive[362] equipment programme. The relationship is masked by transfers of responsibility between the PE and the [logistics commands], and the consequent transfer of funds from Vote 3 to Vote 2.'[363] More significantly, though, there is an in-built bias towards adjusting procurement programmes to ensure an underspend on the cash limit. The MoD told us last April that 'natural slippages in the programme [in 1998-99] have enabled the Department to protect its overall cash limit, through backfill. This was also the case in 1997-98'.[364] Similarly, last month they stated that the MoD

    ... has a long tradition of recognising that even when all of the individual projects have been properly screened and scrutinised, in agregate we never spend that total amount of money—something, somewhere goes wrong unexpectedly. CDPs ... have a long history of block adjusting the total of the Vote so that it more accurately reflects what they think they will in aggregate spend'.[365]

The Cost of 'Unprogrammed Operations'

150. The MoD's budget is set each year without regard to the additional costs that may arise from operations—in recent years mainly in the Gulf and the Balkans.[366] Rather, the MoD collects the additional costs involved as they arise, which may then support a transfer into its budget from the Reserve. Such adjustments are usually formalised late in the financial year in the Spring Supplementary Estimates, when a clearer picture is possible of the likely extra costs. In seven of the last ten years, additional funds have been added to the MoD budget in respect of such 'unprogrammed operations', with the MoD's annual budget enhanced by between £178 million and £497 million in those years.[367] The MoD currently estimates that the additional costs of the Kosovo operation falling within the 1999-2000 financial year to be almost £400 million,[368] although this excludes the cost of replenishing munitions and other items consumed that will fall in later periods.[369]

151. When last April we took evidence from the MoD on the previous Performance Report they told us that the additional costs of operations in 1998-99 were assessed by the MoD at £200 million. Because the finalisation of the SDR reduced the budget required that year, however, the MoD found that it could absorb £115 million of these costs, leaving only £85 million of such costs to be met from the Reserve [370] (although with other aspects of the claim on the Reserve that year, including carry-over of previous underspending, the total settlement was £310 million—see Figure 15).[371] In our hearings last month we further questioned the basis on which claims on the Reserve for unprogrammed operations would be made. We were told that the Treasury expect the MoD to try to absorb unprogrammed costs if this is possible within an otherwise underspent budget.[372] The extra costs of 'smaller' operations costing perhaps £20 million or £40 million,[373] such as patrolling the Iraq no-fly zones and East Timor, would also ordinarily be met from within the MoD budget.[374] We noted for such operations, including those in the Gulf, that no separate financial constraints operated on the consumption of munitions, although we were told that in deciding on the use of weapons "cost will be a factor".[375] The Committee will be visiting UK forces in the Gulf next month, and we intend to establish how financial constraints might be operating locally, on an operation where the extra costs are not being underwritten by the Reserve.

Figure 15: 'Unprogrammed Costs' and agreed total Claims on the Reserve
    
1994-95
1995-96
1996-97
1997-98
1998-99
Unprogrammed costs[376]
£58m
£109m
£231m
£196m
£199m
Total transfer from the Reserve agreed between MoD and Treasury, subsuming budget carry-over as well as unprogrammed costs.[377]
£0m
£379m
£381m
£178m
£310m


152. We recognise that the costs of unprogrammed operations can vary significantly from year to year, making it difficult to budget for these costs at the outset. When we raised the notion with the Department of making some financial provision at the start of the year, they were sceptical about any possible advantages. The Treasury agreed early on that it would meet the extra costs of Kosovo operations[378] and as a result cutbacks had not been necessary because of the costs of that operation.[379] Retrospective adjustments to the budget may work satisfactorily when the Treasury have agreed at the outset that the additional costs will be met, as we were told was the case for Kosovo,[380] but when there is uncertainty about such settlements the current system can put pressure on budget holders to contain costs more than they need to. In April 1999, for example, we were told that the very late stage at which the MoD's claim on the Reserve was approved (for funding relief for overseas operations and for procurement expenditure carry-over) left the MoD with little opportunity to reverse its deliberate constraint on its procurement expenditure, imposed because of the risk that the additional funding sought would not be granted in full.[381] If the extra costs of operations are to remain 'unprogrammed', the MoD and the Treasury must agree firm ground-rules (in place of the current ad hoc horse-trading) that guarantee that genuinely additional operational costs will be met in full, and only then should offsets be made to accommodate any budget-wide underspending.

Estate Disposal Receipts

153. The former Secretary of State had singled out in the SDR the financial importance of estate disposals, the public-private partnership in the Defence Evaluation and Research Agency (DERA) and efficiency savings. As regards estate disposals, the SDR presumed receipts of £700 million in the four years to 2001-02. This is a challenging requirement given that in the previous four years disposals totaled £473 million.[382] Although another two years have to run, the MoD does appear to be making good progress, with over half the target secured at the half way stage.[383] This year's target of £251 million hinges above all on the disposal of the Duke of York's Headquarters in Chelsea.[384]

Figure 16: Estate Disposal Receipts
    
1998-99
1999-00
2000-01
2001-02
Total
Target[385]
-
£251m
£178m
£108m
£705m
Achievement
£168m[386]
£261m[387]
   
   
£429m

DERA Public-Private Partnership

154. The SDR confirmed the MoD's intention to proceed with a public-private partnership for the Defence Evaluation and Research Agency (DERA). Of any receipts generated by the sale or flotation of a privatised DERA—probably in the third year of the Comprehensive Spending Review—the SDR envisaged that the MoD would be permitted to retain £250 million. Although this receipt would supplement the MoD's departmental expenditure limit, it would be naive to consider this money as a windfall for the MoD for use on desirable but not necessarily essential programmes. An alternative, and more realistic, view would be to assume that the money needed to meet essential activities depends on the injection of these sale funds, and that without them the MoD will be in further financial difficulties.

155. In our recent report on defence research[388] we warned the MoD, in the strongest of terms, that—

    The risks of failure associated with the current proposals for the future status and ownership of DERA far outweigh the value of capital receipts anticipated. We conclude that the proposals for the future structure of DERA contained in the consultation document are fatally flawed and should not proceed.[389]

156. We have not been alone in expressing strong reservations, and the current Secretary of State has extended the consultation exercise. Last month he told us that—

    I read the Committee's report very carefully, together with a number of other responses that were received. In the light of those responses I judged that I was not, at that stage, ready to make a decision on the options that were then before me. The Committee will be aware that, in the meantime, I asked that further consideration should be given to developing further options. That process is under way. I cannot tell the Committee today what the conclusions will be because we are still examining carefully the alternatives but there will be a public-private partnership. It will not necessarily be in the precise form that was alluded to in our earlier submission but I cannot go any further, at this stage, to say what the precise outcome will be.[390]

157. If the MoD decides ultimately to proceed with the public-private partnership we will be examining the revised proposals closely. We take this opportunity, however, to repeat our call for the Department to abandon its plans and for the proposed £250 million funding to be added to the baseline in the Spending Review now getting underway.

The Efficiency Programme

158. The SDR settlement was based, it seems, on the achievement of 3% a year cumulative efficiency improvements over the four years to 2001-02. In our SDR inquiry we heard that this amounted to about £500 million worth of new efficiency measures to be found in each of those years.[391] More specifically, the target for 1998-99 was £505 million, and against that target the MoD have now told us that they achieved £594 million—a 3.9% efficiency gain.[392] The target for the current year is £525 million.[393]

159. There is, it seems to us, a fundamental implausibility in the total efficiency claimed by the MoD over the years. In our SDR inquiry, we heard how all the measures introduced since 1988 suggested a department operating nearly £5 billion more efficiently than it was ten years before, and at the end of the CSR period this would be well in excess of £6 billion per annum. Taken at face value, we are being asked to accept that without these efficiency improvements the MoD would need a budget about 30% higher than it is today in order to deliver the same level of output. It seems to us that a major weakness in the current system is that as costs are cut in response to budget reductions, the Department do not have sufficient information to be able to demonstrate conclusively that defence outputs have not also diminished—in other words that the MoD is simply doing less with less money. The introduction of RAB will we hope bring improvements in this area, with cost data linked to activities and then to outputs, but this still remains some way off (paragraph 34).

160. In the meantime, we intend to explore further the validity of the MoD's claims of improved efficiency. When we examined the Department on its 1997-98 Performance Report in April 1999, we obtained from them a list of a few of the measures which would support their overall efficiency claims.[394] The MoD told us that it does not collect detailed information centrally on all efficiency measures (between 1200 and 1300 last year),[395] but for our more recent review of the 1998-99 Performance Report we have been able to extract some additional details, including the savings each Command contributes to the total.[396] We have not had an opportunity to delve any further, but we have signalled our intention[397] that we will want to collect information on all of the higher value efficiency measures claimed, and then to examine more closely a selection of case studies. We cannot be expected to believe the MoD's assurances that these measures are genuine efficiency savings, and not cuts, until it produces this evidence. A year-on-year programme of efficiency savings can have a debilitating effect at all levels of command, and can be destructive to the quality of life that will sustain retention in the Armed Forces.

161. Overall, we conclude that the condition of the defence budget is sufficiently poor to give rise to serious concern. The cumulative evidence of cancelled exercises, delayed equipment programmes and of resources apparently insufficient to reverse the problems of overstretch and undermanning suggest that if the wheels have not yet come off the SDR, they are certainly beginning to wobble alarmingly. The Department's finances should be rebalanced in the current Spending Review. Commitments and resources have to be brought back into line, or we risk finding ourselves stumbling from one crisis to the next.


345   More up to date GDP deflator data now suggests a figure of 3.8% Back

346   Eighth Report, Session 1997-98, op cit, para 435 Back

347   ibid, para 389 Back

348   HC (1999-2000) 4, 18 November 1999 Back

349   HC (1999-2000) 4, p 11 Back

350   4.3% of £22,288 million Back

351   Q 313 Back

352   Q 272 Back

353   Q 276 Back

354   ibid Back

355   QQ 278, 300 Back

356   Q 281 Back

357   ibid Back

358   HC Deb. 16.12.99, c256w Back

359   Q 288 Back

360   QQ 272, 276 Back

361   The Vote 3 cash limit in 1997-98 was 'fined' by £63m because of overspending the previous year, and then raised by £241m in response to the additional costs of operations in Bosnia. Back

362   Now the Defence Procurement Agency Back

363   Ev p 183 Back

364   ibid Back

365   Q 264 Back

366   Ev pp 44, 183, 162 (para 30.1) Back

367   Letter from Minister for the Armed Forces to Mr Mike Hancock MP, 6 November 1999, placed in the House of Commons Library (HC Deb 26 July 1999, c54w refers). Back

368   Q 313 Back

369   QQ 326-329 Back

370   Ev p 26 (Q 142) Back

371   Letter 6 November 1999, op cit Back

372   Q 269 Back

373   QQ 320, 336 Back

374   QQ 269, 320, 332 Back

375   Q 334 Back

376   Ev p 44 Back

377   Letter 6 November 1999, op cit Back

378   Q 315 Back

379   Q 317 Back

380   QQ 315-317 Back

381   Ev p 183 Back

382   Ev p 48 Back

383   Q 376 Back

384   Q 373 Back

385   Ev p 162, para 29.1 Back

386   ibid Back

387   Q 373 Back

388   Ninth Report, Session 1998-99, Defence Research HC 616 Back

389   ibid, para 121 Back

390   Q 742 Back

391   Eighth Report, Session 1997-98, op cit, para 395 Back

392   Ev p 163, para 31.1 Back

393   ibid Back

394   Ev pp 44-46 Back

395   QQ 394, 420 Back

396   Ev p 163, para 31 Back

397   Q 413 Back


 
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