House of Commons - Defence

Select Committee on Defence Ninth Report

The 'compliance framework'

46. To help protect the various interests of the MoD, industry and the UK's collaborative partners from the potential disadvantages of a commercially-minded New-DERA, the Core Competence model envisages a 'compliance environment' to circumscribe New-DERA's operations and ownership. In the earlier Reliance proposals for the public-private partnership, the MoD had envisaged a complex 'compliance regime' (paragraph 1) mainly designed to protect the MoD from the potential risks of dealing with a largely private-sector DERA. Under the 'compliance framework' of the new Core Competence plan, the controls are less onerous[139] than the regime previously envisaged because areas where impartiality was particularly important are now to be retained within the MoD. The latest consultation document sees the need for such controls to underpin the MoD's confidence in the independence, integrity, values and culture of the private-sector New-DERA, controls which the firm too would want to see preserved in order to retain MoD work.[140] The main features of the new 'compliance controls'[141] are:

Retention of a special share— This is a type of the so-called 'golden share' which would allow shareholding restrictions to be placed on New-DERA through its Articles of Association, possibly including a restriction on foreign ownership, and a maximum limit on individual shareholdings. The Minister told us that the special share would be kept as long as the MoD deemed it necessary.[142]
Approval of Directors--The MoD would, through its special share, retain the right to approve directors on security grounds.
Strategic assets—Through the special share, the MoD would have the right to return certain, named strategic assets to public ownership, under 'exceptional circumstances' such as New-DERA's insolvency.
Contractual conditions —A contractual framework between the MoD and New-DERA would include confidentiality clauses, adherence to the Official Secrets Act and other security provisions, and processes for organisational, physical and information separation and compartmentalisation. It will also include conditions governing the use of third party intellectual property (paragraph 20).
Defence manufacturing—To preserve its impartiality and independence, New-DERA would not be permitted to engage in 'defence manufacturing'. Subcontract manufacturing work for defence manufacturers would be subject to prior MoD approval (paragraph 22).
A Compliance Committee—The company would put in place a compliance committee to maintain the company's standard of performance in respect of the compliance framework. A non-executive director, reporting directly to the chairman will oversee the committee's activities.

47. Many aspects of the compliance framework are clearly going to be important for international collaborators, including the US who have expressed a reluctance to deal with a private sector foreign research institution on the favourable terms previously given to DERA. Industry too have a particular interest in the operation of the compliance framework in ensuring New-DERA's good conduct, particularly for example the difficult-to-enforce contractual conditions designed to protect their intellectual property shared with DERA, and the imprecise bar on New-DERA undertaking 'defence manufacturing' (paragraph 22). The initial close proximity of New- and Retained-DERA on individual sites, while it persists, might also be a concern to industry and the MoD's international partners. DERA's Chief Executive told us that the Department of Defense and other collaborative partners were well used to establishing effective arrangements for defining sets of staff with whom information could be shared.[143] DERA's stakeholders will nevertheless want to be assured that such impregnable Chinese walls are erected between the public and private elements of the organisations, to help ensure fair competition for industry and security guarantees to satisfy foreign defence departments.[144]

48. Significant aspects of the compliance framework have yet to be clarified to meet stakeholders' outstanding uncertainties and anxieties, including the protection of strategic assets (the MoD provided us with a list of those assets currently given special attention as 'strategic assets',[145] but final decisions have yet to be made about which facilities would be protected under the terms of the compliance controls[146]); and definitions of 'manufacturing'; and New-DERA's ownership, where we were not reassured that the MoD had not yet decided what restrictions 'possibly' might be included in the compliance controls over foreign ownership or individual share-ownership.[147]

49. Underpinning the compliance framework would be a Compliance Committee,[148] designed to ensure New-DERA's adherence to the compliance framework. Mr Jagger told us that this would be a committee of New-DERA and would be analogous to a company's audit committee. Its details had not been worked out, but Mr Jagger told us that he would envisage the Committee having a duty to make regular reports, perhaps within the company's annual report.[149] We would welcome a requirement for transparency in the application of the proposed compliance regime for New-DERA, which the MoD should build into the Articles of the new company. But the compliance committee, as proposed, will in no way be analogous to the external regulators seen in other privatised sectors, and it will have no sanctions. If it proceeds with its public-private partnership proposals, the MoD is likely to need other means to assure itself about New-DERA's compliance with its operating constraints, as will industry and the MoD's overseas research partners. If those groups have doubts about the rigour and integrity of the proposed compliance regime in practice, New-DERA will not be trusted and the putative benefits arising from its freedom to operate in the commercial marketplace, such as they might be, will be lost. By the same token, if the compliance regime is too onerous, the benefits will again be diluted or lost. This is another example of where it seems to us the risks of getting the new regime wrong almost certainly outweigh the supposed benefits to be gained from the change of ownership structure.

Value for money and the flotation of New-DERA

50. The case for a public-private partnership for DERA is closely linked to the level of the MoD's overall budget. There will be costs of separating DERA's staff, facilities, information systems and databases[150] between the two organisations being formed. The consultation document states that work to define precisely the separation between them will not be completed until 'the autumn'.[151] The MoD has produced broad estimates of the costs of separation, which though 'small in relation to the overall size of the project', it was not prepared to divulge to us.[152] The major impact, however, will be the potential one-off receipt when New-DERA is floated on the Stock Exchange.

51. The original public-private partnership proposals appeared in the Strategic Defence Review and formed part of the government's wider Comprehensive Spending Review in 1998. The MoD's budget for 2001-02, set in those Reviews, presupposes that a £250 million slice of the sale proceeds of the DERA public-private partnership will be available for the MoD that year. The rest would go to the Treasury. In this inquiry, as in the last, the MoD has been reluctant, not unreasonably, to share with us their expectations of the total sale receipts from the public-private partnership proposals, citing the project's remaining uncertainties and the risk of talking-down the sale price for New-DERA's flotation.[153] As a rough guide, they pointed out that the public-private partnership envisages three-quarters of DERA being subsumed within New-DERA, and that the value of three-quarters of DERA's balance sheet assets is currently about £450 million.[154]

52. Rather than asset values, of course, the real value of New-DERA depends more on potential investors' views, when they come to be asked to subscribe for its shares, of the value of future income that the business will generate. This will hinge in turn on a range of factors—the likely long term trends in the volume of MoD research work; the speed with which the MoD might put out to competition its research work currently allocated to DERA, and New-DERA's ability to win that work; the opportunities investors might see for generating more third-party income at margins exceeding the additional cost of the capital raised to fund that additional work; and perhaps even the amount of work the US and other countries might offer in future. Although the compliance controls (paragraph 46) put on the new organisation by the MoD are less onerous than under the Reliance model, they must surely act to lessen the new company's value at flotation and also limit its subsequent flexibility for generating revenue. Mr Jagger told us, however, that he did not believe that these controls would materially affect its value—"there is an enormous amount of value still in DERA".[155]

53. Another factor which could influence the value of New-DERA may be the extent to which investors consider that Retained-DERA may in the future seek to extend its remit into the domain of the new company. The risk is real because the boundary between undertaking primary research (New-DERA's main role) and pulling together the strands of knowledge from such research (Retained-DERA's role) is ill-defined and permeable. On one side, New-DERA might seek to replicate and market some of the higher-value technology integration capabilities of Retained-DERA, while on the other Retained-DERA might seek to extend its activities into primary research to support its knowledge integration work. Such breaches of the watershed separating the two streams of activity might be more frequent and acute if MoD Integrated Project Teams are able to deal with both the public and private parts of the DERA organisation.[156] DERA's current chief executive told us that "there is actually something rather virtuous about duplication in science—having different researchers in broadly the same field operating, publishing their results, spinning ideas off each other."[157] Duplication of knowledge and expertise between New-DERA and Retained-DERA may be desirable in an ideal world, but it comes at a cost which the MoD will ultimately have to pay. Several of those submitting evidence to us pointed out the irony of the effective reversal of the policy of recent years which had sought to make research more efficient by rationalising the disparate research bodies in order to form the Defence Research Agency, and then DERA itself [158]. The IPMS believe it possible that the Defence Procurement Agency and even some commands might seek to re-grow a capability for research and, in particular, equipment evaluation.[159]

54. Under the Core Competence approach the MoD would, rightly, seek to position within Retained-DERA the systems assessment and knowledge integration tasks that better allow it to maintain the MoD's intelligent customer capability. These tasks tend to be the areas where expert judgement comes into play, and they add significant value to the raw scientific research upon which it is based. Systems integration work is likely to be the area with the highest added-value, and without it New-DERA may be regarded by potential investors as a less attractive organisation with lower potential. This is another example of the dilemma—whether to beef up Retained-DERA to meet stakeholders' concerns, or to beef up New-DERA to boost its value—which can never be resolved satisfactorily, and exemplifies clearly the risk of proceeding with this public-private partnership.

55. But New-DERA's flotation price is likely to be of only marginal significance for the MoD. With its budget already having been based on the assumption of the appropriation of £250 million from the flotation, and nothing more, the longer term value of the DERA deal for the MoD depends on the extent to which New-DERA's prices for its research outputs will fall, including the extent to which any efficiency improvements it achieves are shared with the MoD. Indeed, unless New-DERA can make additional efficiency improvements and generate third-party income to more than offset the new company's higher cost of servicing its capital, and can be forced to pass on the benefits to the MoD through competition, the MoD's funds spent with the firm will buy less research. If such benefits do not materialise, dealing with a private-sector DERA may put additional pressure on the MoD to raise its research budgets just to stand still.

56. The assumption of falling costs arising from the disciplines of private enterprise and competition are therefore the only really substantial rationale for DERA's restructuring, and it is an assumption yet to be tested. Furthermore, such benefits will have to cover the substantial part of the flotation proceeds going to the Treasury if the sale is not to be an effective cut in the MoD's budget. This is because New-DERA will have to charge the MoD more for its research in order to cover the cost of the capital raised for New-DERA's acquisition. It could be argued that that in itself might not financially disadvantage the MoD if it were to receive the full sale proceeds, which could then be used to offset the higher research costs. The Treasury's take represents a cut from that otherwise neutral position.

57. Under the MoD's current proposals, New-DERA would be incorporated as a public limited company and floated on the Stock Market 'as soon as its potential is judged to be suitably developed, which could be during 2001, subject to value for money considerations and provided it has achieved appropriate performance targets.'[160] As an interim measure, the MoD intends to use 'strategic financial investors' to take up New-DERA shares following its incorporation,[161] as part of the flotation process.[162] The MoD is likely to retain initially a 'significant' financial stake in New-DERA, although retention of such a stake is not seen by the Department as a long term position (its 'special' shareholding, which need only be at a nominal level, would be kept for longer).[163]

58. The MoD aims to float New-DERA sufficient time after its incorporation to allow potential buyers to gain more confidence in the new company's value, and thereby bolster its flotation receipts for the Treasury (the MoD's share of the take being a fixed £250 million). This whole arrangement seems to us to set up an entirely unhealthy set of conflicts between the Exchequer and the MoD. The Minister told us that there had been "different strands of advice" over the relative merits of flotation and a private sale,[164] but that—

165

59. Yet the timescale of the Comprehensive Spending Review for generating the receipts required by the Treasury presents a challenge for the Department, as the Minister was ready to acknowledge.[166] The flotation timetable, she told us, was not however set in concrete.[167] It will depend on the MoD advisers' views at the time about when New-DERA has established a sufficient track-record.[168] With the Treasury set to gain most from the timing of DERA's flotation, we can also expect that the Treasury's priorities will be influential on the timing of the sale.

Conclusions

60. In retaining a greater part of DERA within the MoD, including additional sensitive areas such as the Radiological Protection Board, the new proposals for the DERA's future ownership and structure are generally an improvement over the MoD's earlier plans which we dismissed as ill-conceived and unworkable. Compared to the earlier Reliance model, the MoD will have a stronger capability as an 'intelligent customer' of New-DERA's work — with impartial advice supplied by Retained-DERA, where before it would have had none. It is also evident that to some extent the concerns of the UK defence industry[169] and the US Department of Defense have been addressed by the MoD's new proposals. The Core Competence approach nevertheless raises new concerns about the interface now necessary between the two new organisations that would be formed from DERA, which will themselves need to be resolved if we and other stakeholders are to be reassured that the interests of the taxpayers, the MoD, our international defence partners and the UK defence industry will be protected. In our earlier inquiry we concluded that the public-private partnership then proposed for DERA was fatally flawed and should not proceed. Retaining more of DERA within the Department may smooth over some of those flaws, but the potential benefits of a partial privatisation remain to be convincingly demonstrated by the MoD. In our judgement the current risks of proceeding with the public-private partnership—even in its new and improved format—continue to outweigh the still hypothetical benefits. The MoD needs to do more to persuade their Treasury colleagues that the likely receipts from DERA's flotation will be only a negligible fraction of the MoD's equipment procurement budget over the lifecycle of major programmes, and that such a receipt does not compare well against the risks inherent in the public-private partnership for the UK's continued ability to acquire militarily effective equipment for our armed forces.

61. If, despite the dangers of proceeding with the public-private partnership, the MoD do decide to push on with the privatisation of three-quarters of DERA, we have concluded that the size and capability of Retained-DERA must be further strengthened to meet the proper concerns, which we share, of DERA's key stakeholders. We recognise that this may weaken the prospects for the successful and higher-value flotation sought by the Treasury. So be it. If the MoD genuinely seeks a partnership it must be prepared to bolster the capabilities it retains, to more than offset the consequences of the privatisation of New-DERA. The balance struck between these two new organisations will tell us ultimately whether the current initiative is a public-private partnership, or simply a privatisation misleadingly labelled.

62. In the meantime, damage has been done to the Department's relations with industry, DERA's personnel and the US Department of Defense. The DoD, in particular, appears to be some way from finishing its assessment of the implications of the latest proposals, and already it appears that the flow of collaborative research work may have been impeded because of US misgivings about the status of its chief collaborative partner. We expect the MoD to reveal to the maximum extent possible the inputs into its latest consultation process on the future of DERA, especially those from the USA.

63. Closer to home, while the MoD has acknowledged that 'DERA is critically dependent on the skills, innovation and expertise of its staff, and the success of both New-DERA and Retained-DERA will depend heavily on generating commitment to the venture at all levels,'[170] the way that the MoD has handled its public-private partnership initiative suggests that the Department have forgotten this. By the time the division and partial privatisation of DERA are effected—if the plans proceed—the MoD must not be surprised if critical relationships of trust have not been irreparably damaged.

64. Our purpose in undertaking this brief inquiry was to add our comment to the latest consultation exercise. The latest consultation document, however, like its predecessor, gives insufficient details of the MoD's intentions, and our oral and written evidence from the Department indicates that there are still many issues and details to be resolved — how competition for the MoD's research will be managed equitably for all concerned, for example; how Retained-DERA's scientific foundation will be maintained in the long term; how the interface between New- and Retained-DERA will be managed; how genuinely open collaboration with US laboratories will be maintained; how particular parts of DERA (such as Boscombe Down) will be organised within a private sector environment; and how some of the features of the compliance framework will operate, such as controls over the ownership of New-DERA and 'strategic assets.' In the absence of more definitive plans from the MoD at this stage, this report can only serve as an interim response to the consultation exercise. Although the Minister told us that primary legislation would not be needed to proceed with the public-private partnership[171] (though there may be a need for secondary legislation in order to revoke or vary the scope of the Order which established DERA as a trading fund), we will return to this matter. If and when any prospective legislation is presented we will certainly examine it critically. More immediately, we will take evidence to test the credibility of the MoD's final blueprint of any public-private partnership from Ministers and the new chief executives of any successor organisations to DERA. There is too much staked on the future success of DERA in sustaining capabilities critical to our defence for us to accept without further examination proposals that currently rely far too much on a wing and a prayer.

139 Ev p 25, para 5 Back

140 MoD Consultation Document, op cit, para 22 Back

141 MoD Consultation Document, op cit, para 23 Back

142 Q 97 Back

143 QQ 50-52 Back

144 See eg Ev p 37, para 2.2; Ev p 45, para 2.4; Ev p 34, para 5 Back

145 Ev p 27, para 20 Back

146 Ev p 31, para 26 Back

147 Ev p 27, para 17 Back

148 MoD Consultation Document, op cit, para 23 Back

149 QQ 137-140 Back

150 See eg Ev p 38, para 2.10 Back