House of Commons - Defence

Select Committee on Defence Ninth Report

NINTH REPORT

The Defence Committee has agreed to the following Report:—

THE FUTURE OF DERA

1. The Committee's Ninth Report of last Session,[8] on defence research, examined the trends in technologies applicable to defence, the challenges these present and the research strategy being developed by the Ministry of Defence (MoD) to deal with those challenges. A significant part of that report dealt with proposals then on the table for a public-private partnership in the Defence Evaluation & Research Agency (DERA), which would have had profound implications for the MoD's research strategy. The MoD had issued a consultation document for a public-private partnership in May 1999, describing what it termed a 'Reliance model'. The key features had been that:

Most of DERA would have passed into an independent private sector company. The MoD would have retained only DERA's Chemical and Biological Defence business and those elements of the Centre for Defence Analysis involved in studies of front-line operations.

The MoD would also have had to establish a body (of between 200 and 300 staff) to manage its research programme and operate formal government-to-government collaborative research agreements.

DERA would have had an ownership and control regime intended to allow the MoD to rely on DERA's independence, impartiality and integrity. This 'compliance regime' would have included: a 'substantial' golden shareholding retained by the MoD; controls over ownership to exclude defence industries, those with conflicts of interest and 'undesirable parties'; an MoD veto over work for third parties; a Compliance Cell within DERA to monitor movements of information and to compartmentalise and protect commercially-sensitive and internationally-sourced information; and an Impartiality Committee of the board of the new company to monitor DERA's proper governance.

Although initially DERA would have continued to be the MoD's main supplier of defence research work, the Department had intended to expose an increasing share of the research programme to competition. But the MoD would have required DERA to integrate the results of its research with knowledge gained from MoD research contracted with other bodies.

The principal factors identified by the MoD which it believed required a change in DERA's structure, were that:

In a world of fast moving technology and declining defence budgets, the MoD considered that it could no longer afford to fund research across the whole range of technologies with defence application, or to rely entirely on its own research to seed UK defence technology.

DERA needed further freedoms to exploit more fully the knowledge it generates for the benefit of the UK economy as a whole. The MoD associated the scope for realising such new business with the 'significantly greater' commercial freedoms that DERA would have 'to access private sector capital and address staff recruitment and retention problems through more flexible reward packages'.[9]

2. Our report examined the possible implications of the then-current proposals in a number of key areas:

Exploiting DERA's capabilities and intellectual property. We noted that DERA's third-party income had been steadily rising (with a 1999-00 target of about £140m); that industry were yet to be reassured about the exploitation of intellectual property rights; and that the then embryonic Defence Diversification Agency's task would not sit comfortably with a commercially minded DERA.[10]

Making DERA a more commercially responsive organisation. We noted that DERA was already performing well, within the commercial philosophy of its Trading Fund status.[11]

Improving DERA's capital stock, including the need to raise funds to finance estate rationalisation and upgrading. We warned that the MoD would need to ensure that there were mechanisms to retain access to strategically important facilities after privatisation.[12]

Improving DERA's human resources. We noted that staff could be properly rewarded and motivated without DERA being privatised.[13]

Implementing 'smart procurement'. We noted the risks of disrupting the partnership between the MoD and industry sought by that initiative.[14]

Retaining the MoD's 'intelligent customer' capability. We were concerned about the potential for a conflict of interest in the advice that the MoD might get from a private-sector DERA, which would not be sufficiently safeguarded by the proposed 'compliance regime' (paragraph 1, third bullet, above). We were also concerned about the difficulty the MoD would have had in keeping current the scientific expertise of its retained research staff.[15]

Protecting international research collaboration, particularly with the USA. We highlighted US concerns about sharing classified material with a private sector DERA, and the difficulty they would have in collaborating with DERA as a foreign firm.[16]

Value for money. We concluded that the main driver for the public-private partnership was the wish to realise the likely significant one-off sale receipt from privatising DERA. We also noted the contradiction in the proposals which meant that while preventing defence firms from owning DERA would have helped retain impartiality, this restriction would have also diminished the likely sale price for DERA.[17]

3. Drawing together these concerns, we concluded that the risks of failure associated with the then current proposals for the future status and ownership of DERA far outweighed the value of capital receipts anticipated, and that the proposals for the future structure of DERA contained in the May 1999 consultation document were fatally flawed and should not proceed.[18]

4. Ours was not the only voice of concern. Our report drew attention to the serious misgivings of industry, DERA staff and the US Department of Defense (DoD), and the current Minister for Defence Procurement has acknowledged that following consultation on the proposals put forward in May last year, "it became apparent that a number of stakeholders had significant concerns, which not only had to be redressed by retaining some activities in the public sector but, of course, by looking at the Reliance model in total."[19] Industry, for example, had had "very trenchant criticisms ... of the Reliance model".[20] The Minister told us—

Consequently, on 17 April 2000, Ministers announced revised plans for the public-private partnership. The further consultation document, issued on that day, proposed what the Department termed a 'Core Competence' model, in place of its previously preferred 'Reliance' approach.

5. In this latest instalment of our tracking of the government's plans for DERA we examine these new proposals, and assess their implications against the main concerns that we highlighted in our defence research report. We examined the challenges of the defence research environment in our report last year, and it has not been our intention here to rehearse again the complex issues involved in the same depth. Instead, our focus has been to highlight where the new proposals put forward by the MoD change the balance of our previous concerns, and to produce a report for the House to coincide with the end of the MoD's consultation period on 9 June 2000. We received written evidence from the Department, the defence industry, the trade unions, professional institutions and others. We also took oral evidence from Baroness Symons of Vernham Dean, the Minister for Defence Procurement; Sir John Chisholm, the chief executive of DERA; and Mr Terence Jagger, the head of the MoD's DERA Partnering Team which had been responsible for developing the public-private partnership proposals.

The options rejected

6. There were three other options for the public-private partnership which had featured in the MoD's recent reassessment of its proposals, but which had been rejected by them and not included in the latest consultation document. These only became apparent in the MoD's responses to our written questions:[22]

A so-called 'Variety Pack' option. This would have broken up the current DERA into a number of individual components, possibly based on the existing DERA sectors, each of which could have been sold separately.[23] The Department considered that those elements to be sold would have been too small to float as independent companies and that most interest would have come from existing defence contractors, creating a significant potential conflict of interest.[24] The MoD told us that this approach would destroy much of the synergy within DERA, reducing the overall level of service to customers, and would not provide the wider benefit to the UK economy specified in the public-private partnership objectives. The MoD were also concerned that the limited numbers of potential buyers for individual pieces of DERA would suppress receipts, and that the costs of restructuring, redundancies and site closures could have been significant.[25]
An option based on the US concept of Federally Funded Research and Development Centres (FFRDCs)—privately operated organisations contracted by a government department to provide a specific long term research or development programme. Such Centres may not seek or compete for work with the private sector. We discovered on our trip to Washington last year that this was one of two models (the other being a 'core competence' approach—see paragraphs 10 and 36) suggested by the US Department of Defense to the MoD during the consultation on the Reliance approach.[26] The MoD has concluded, however, that an FFRDC structure 'would offer significantly fewer freedoms than DERA's current status and would consequently not offer solutions to the problems that the organisation is likely to face over the next few years'.[27]

An 'Employee Public-private partnership'. This would have involved the retention of DERA as a single entity in the public sector, but as a public limited company with a substantial proportion of the shares allocated to staff. The MoD considered that the employee share scheme would have been complex to establish and raise a number of financial, legal and administrative issues.[28] It also seems to believe that it would not have added significantly to the operational, employment practice, pay or funding freedoms that DERA currently enjoys as a Trading Fund.[29] Finally, somewhat surprisingly, given the privatisation of three-quarters of DERA under the new proposals (see below), the MoD were concerned that the Employee Public-private partnership proposal to establish a share scheme might be perceived as signalling a longer-term aim to move to privatisation.[30]

We share the MoD's conclusion that wholesale dismemberment would not be the best way forward for DERA. On the other hand, the Federally Funded Research and Development Centre model has worked well in the US, and if DERA must be privatised this approach does have merit. On the face of it, an Employee-PPP approach could have advantages, but at its core it is little different from a straight-forward privatisation, unless the restrictions on ownership were so narrow as to offer no obvious advantages over the status quo. Otherwise, there would appear to be nothing to prevent its employee owners realising the value of their equity at a later date.

7. We also sought from the MoD its perspectives on why other options raised in our report last year, which would not fall under the banner of 'privatisation', had been rejected. The MoD told us that as a trust DERA would not be exposed to the commercial incentives and disciplines that the MoD believes will be necessary to meet the changing research environment, and that without being able to issue share capital it would have less flexibility in raising finance.[31] The MoD considered that a publicly-owned corporation would provide few additional freedoms over those currently available to DERA as a trading fund.[32] And while joint-ventures set up to exploit specific technological developments were being pursued by DERA, the MoD considered that they were unlikely to bring the benefits the Department sought for the wider DERA organisation, and a multiple joint-venture approach might fragment DERA over time.[33]

8. The latest consultation document described the MoD's now preferred option of the 'Core Competence' model, which we discuss in more detail below, but it also raises the possibility of a less-favoured 'Public Sector Option'. This latter option would involve keeping DERA intact and transforming it into a public limited company, but within the public sector and with only a minority stake sold to external investors.[34] The Minister said of the Public Sector Option that "it was initially a very attractive option ... because ... it had the great merit of keeping DERA together",[35] and the consultation document also sets out its advantages—

9. The Minister told us, however, that although there was a compelling argument for the Public Sector Option,[37] she thought it the much more difficult option in the longer term,[38] and that—

And the consultation document states that 'some stakeholders considered the Public Sector Option to be too similar to the Reliance model'.[40] The company would have obligations to external shareholders, which would not give 'sufficient protection to the MoD in terms of sensitive programmes, collaborating with foreign laboratories, and in those areas requiring the highest levels of impartiality'.[41] When we sought from the Minister her view on how small the minority interest might have to be to avoid insufficient protection for the MoD's interests, she told us that this had not been completely worked through, but that the MoD's modelling had had to have regard to what equity would have to be sold "in order to attract the sort of capital that we are looking for".[42] The MoD's assumption that 35% of its shares would be put on the market, plus 5% for DERA staff themselves,[43] was therefore only an illustrative figure of the proportion of equity needed to be sold to give investors a 'meaningful stake'.[44]

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

9 ibid, para 54 Back

10 ibid, paras 71-72 Back

11 ibid, paras 71-72 Back

12 ibid, paras 74-80 Back

13 ibid, paras 81-86 Back

14 ibid, paras 87-90 Back

15 ibid, paras 91-94 Back

16 ibid, paras 95-102 Back

17 ibid, paras 103-107 Back

18 ibid, para 121 Back

19 Q 1 Back