Select Committee on Defence Minutes of Evidence



SUPPLEMENTARY ANSWERS FROM THE MINISTRY OF DEFENCE FOLLOWING THE ORAL EVIDENCE SESSION ON 3 MAY (19 MAY 2000)

1.   Question: What consideration has the MoD given to alternatives raised in the committee's Defence Research report—namely establishing DERA as a trust or publicly owned corporation, or making much more extensive use of joint ventures—and on what basis did the Department decide not to raise such options in the most recent consultation document [QQ 12-14]?

  2.  As part of the options analysis phase of the study the Department considered all three of these options. The Department's conclusion, supported by specialist financial and legal advice, was that each had significant disadvantages and would be unlikely to meet the PPP objectives. For that reason, they were not put forward in the most recent consultation document. The committee will be aware that a variant of the publicly owned corporation model, which would involve the sale of a minority stake to external investors, is described in the consultation document released on 17 April 2000. This model was developed as an attempt to address some of the weaknesses inherent in a solution based on a plc wholly owned by the MoD. However, as described in the consultation document we concluded that even this revised model would not meet our objectives.

  3.  The major weaknesses of the specific models identified by the committee are summarised below.

    (a)   The Trust Option. Adopting a Trust structure would not expose DERA to the commercial incentives and disciplines necessary to help it meet the changes in the environment within which it operates. This would be particularly the case for a non-profit distributing trust vehicle. From the perspective of DERA's MoD customers, these factors could lead to reduced incentives to deliver enhanced performance and value for money. A trust would have less flexibility in raising future finance as it would not have share capital or be able to issue shares. Funding could only be raised through debt issues. This could constrain DERA's development in the future; it would also potentially reduce the scope to raise proceeds in the PPP transaction itself. In addition, the debt funding required to establish a trust would be likely to require a greater degree of specific security—for example through income guarantees—than other PPP options. This could reduce MoD customer flexibility and leave Government as a guarantor of liabilities incurred by the Trust in a way that would not be necessary if private equity investors are introduced. In a Trust structure, there would also be uncertainty about the status of employees, who would almost certainly not qualify as government employees for the purposes of international collaboration work, thus making it difficult to maintain important collaborative programmes.

    (b)   Publicly Owned Corporation. In general terms, many of the weaknesses with the Trust model were also likely to apply to a publicly owned corporation. Overall it was concluded that this model would provide few additional freedoms over those currently available to DERA as a trading fund and would not therefore help the organisation meet the challenges it will face over the next few years. Although staff would be employees of a publicly owned corporation, they could not legitimately be described as civil servants, and this was a cause of discomfort to our collaborative partners.

    (c)   Making greater use of joint ventures. Recent reinterpretations of HM Treasury rules have given Trading Funds such as DERA the freedom to enter into equity joint venture relationships. DERA has already taken advantage of these new powers to pursue a number of initiatives, in particular in technology spin-out. The recent joint venture with NXT plc for voice recognition technology is an example of an arrangement of this type. It is anticipated that, both pre and post PPP, further joint ventures may be entered into, subject to commercial justification. However, this approach to business development has several limitations as a primary PPP route:

    i.  Any joint venture will tend to be narrowly focused on a particular technology or business case and is unlikely to bring the benefits that MoD is seeking to the wider organisation.

    ii.  A multiple joint venture approach may tend to fragment DERA over time.

    Overall, whilst joint ventures represent a valuable route for exploiting technology within DERA, they do not in themselves meet all the PPP objectives.

4.   Question: The Chairman quoted extracts during the session from Mr Jagger's letter of 23 February 1999 (ref D/DPT/8/1 (50/99)). What are the main points of similarity and difference between the Core Competence model postulated in February 1999 and the version included in the latest consultation document? What changes have been made to address in particular the concerns of the unions, industry and the US authorities [Q34]?

  5.  It is not normal practice to comment on the contents of internal correspondence that has been released without authorisation. However, in order to assist the work of the committee we will respond to the specific question asked.

  6.  An initial PPP options study was carried out between September 1998 and April 1999. A first version of the Core Competence concept was proposed during this study, and was the subject of a degree of evaluation work. This work was completed in March 1999. It was accepted that this specific Core Competence model contained a number of significant weaknesses. However, the conclusions of the analysis were that, with substantial additional work, it would be possible to produce a revised Core Competence model that was capable of meeting the PPP objectives. This did not affect the MoD's overall conclusion that the Reliance model appeared at that time to offer the most promising PPP approach and should form the basis of further consultation. The consultation process subsequently indicated, however, that stakeholders had a number of concerns about the Reliance approach and, as a result, the scope of PPP work was broadened to examine other possible models including Core Competence. Details of the other main alternatives considered have already been provided to the committee.

  7.  The Core Competence model identified as the MoD's preferred PPP option in the consultation document released on 17 April 2000 differs in a number of ways from earlier versions. The main concerns highlighted in relation to the original model arose primarily as a result of assumptions over the nature of the division between Retained DERA and NewDERA. An important capability for Retained DERA would be the ability to pull together the results of programmes carried out by NewDERA and other commercial organisations, academia, or generated from collaborative programmes. There was an initial perception that the posts for such "knowledge integrators" within RDERA would be filled by taking a horizontal slice across DERA at the level of Technical Manager. This would potentially have deprived NewDERA of a key capability to pull together the results of scientific programmes to allow it to continue to provide advice to its main customers and to support the development of new ventures. The original proposal also assumed that MoD would retain the Centre for Defence Analysis (CDA) in its entirety, an approach which, it was argued, would deprive NewDERA of the analytical capability which adds value to its core science and technology work. Taken together, these two factors would have significantly altered the potential business model for NewDERA and impacted on its commercial prospects, potential for offering job security, and its attractiveness to potential investors.

  8.  In addition, it was felt that filling the "knowledge integration" posts through the approach described above would have created an RDERA which had a disproportionate number of senior level staff, a significant percentage of whom would be nearing retirement age. This raised concerns about the sustainability of the organisation and its ability to remain technically current and continue to refresh its skill base.

  9.  The additional work to refine Core Competence has produced a much more flexible approach to filling the "knowledge integration" posts. Under the current proposals, it is envisaged that the task would be carried out within RDERA by small teams that would include staff at a variety of levels of seniority. In addition to their primary task, these teams would also be involved in international collaboration, the conduct of research at the level of defence systems, and would interact closely with the staff retained to work on sensitive programmes. This model produces a much more equitable division of key staff between the two organisations, whilst ensuring that each has the necessary capabilities and expertise to carry out its defined role. The approach would also ensure attractive and varied career opportunities for staff in RDERA and create a sustainable organisational structure. The more flexible approach avoids the risk of dilution within NewDERA of the individuals it regards as key to the development of commercial business. This fact, combined with the proposal that NewDERA could keep a minority of CDA staff would allow it to continue on its existing business model, and consequently enhances its potential in the private sector and its attractiveness to investors.

  10.  It was unclear at the early stages in the development of Core Competence whether it would be practical to achieve a clear separation of DERA into the two distinct organisations without significantly affecting the service delivered to customers. Consequently, the DERA Partnering Team, DERA, and MoD customers have conducted a pilot exercise involving a number of DERA sectors to assess the practical issues that would be associated with making the division proposed in the consultation document. The results provide a high degree of confidence that such a split could be made in a way that will meet the wider PPP objectives whilst continuing to fully meet MoD's requirements.

  11.  In summary, the current Core Competence model has been structured to address a range of issues raised by PPP stakeholders. The separation between Retained DERA and NewDERA meets the most significant concerns raised by industry and our collaborative partners, all of whom wished to be clear about whether staff with whom they had dealings were in the private or public sector. Retained DERA is intended to contain sufficient technical expertise to reassure our allies that they would continue to be able to deal with Government staff who had the specialist knowledge to contribute fully to international programmes. Although consultation is still at an early stage, encouraging responses have already been received and the proposal appears to have been welcomed by industry as a practical and sensible way forward. We hope that the unions will recognise that this approach creates two vibrant and sustainable organisations, both of which are capable of offering exciting and stimulating career opportunities for scientists.

12.   Question: What was the basis for selecting a figure of 35% as the presumed private stake for a "Public Sector Option" [Q48]? What other possible figures were considered, and why were these rejected in favour of the 35% assumption?

  13.  The 35% figure was intended to be illustrative of the type of stake that might be offered in a Minority sale and is not intended to represent a preferred figure. In arriving at the illustrative stake, however, the Department took account of factors that would impose certain constraints on the range of feasible stakes to offer:

    (a)  To preserve the Minority sale concept, less than 50% of the equity can be sold.

    (b)  It was assumed that in addition to any stake sold to outside investors a certain percentage would be made available to employees, in order to provide additional incentives for them within the corporation.

    (c)  The proportion of equity sold would need to be sufficient to give investors a meaningful stake. This was important not only to make the corporation attractive to potential investors, but also to ensure sufficient commercial involvement to introduce private sector disciplines and incentives. In the case of a flotation, there is also a requirement in the UK that at least 25% of the equity should be in public hands.

  14.  If this model had been pursued, the actual size of stake to be offered to wider investors as well as employees would have been determined during implementation in the light of market conditions, investor appetite and the expected value of the business in the PPP.

15.   Question: What is the MoD's (and its advisers') latest view of the potential receipts for the MoD and for the Exchequer overall, from the proposed public-private partnership in DERA [Q86]?

  16.  The potential receipt from any DERA PPP transaction will depend upon a large number of factors. Some of these, such as the state of the markets at the time the PPP is implemented, are not wholly in MoD's control. Others, such as the extent to which a persuasive technology investment case can be constructed for the new DERA, require substantial further work by MoD, DERA and their advisers. Even if there were much greater certainty in these areas, the size of the potential receipt will depend upon yet further factors such as the proportion of the new DERA shares to be sold and the methods of sale.

  17.  MoD's advisers have carried out limited preliminary valuation work using discounted cashflow and multiple-based valuation techniques to inform MoD's assessment of the options for DERA. However, these have focused on identifying very broad ranges of value rather than attempting a single-point assessment of potential receipts, and have not yet taken full account of certain potential sources of value in DERA (such as from technology exploitation where DERA's track record is only beginning to develop).

  18.  Given the current uncertainties in valuation, and the commercial sensitivities of this information, and having sought specialist city advice, the MoD feels that it would be detrimental to the ultimate goal of achieving best value for the taxpayer to speculate at this stage about the size of likely receipt.

19.   Question: The MoD provided some details of DERA's site strategic development plan during its Defence Research inquiry. Can the MoD provide a more up to date summary of the development plan [Q89]?

  20.  An updated version of the Estate Strategic Plan has been produced and is enclosed. The Committee is requested to note the release conditions described in the covering note to this response.

21.   Question: What are the possible options for the future of a Defence Diversification Agency and its relationship with Retained or NewDERA and what is the MoD's current thinking on the likely way ahead [Q109]? What progress has been made in setting up the Defence Diversification Council [Q106]?

  22.  The MoD sees a continuing need for the three main activities currently being performed by the Defence Diversification Agency (DDA), which can be summarised as follows:

    (a)  To encourage the widest possible exploitation in the civil sector of defence technology.

    (b)  To provide information on defence equipment procurements and trends to inform the defence industry's own diversification planning.

    (c)  To facilitate civil sector "spin-in" to defence programmes.

  The DDA was established within DERA last year, with a permanent Director appointed last summer. The Agency is already making a major contribution to defence diversification.

  23.  Options for the future of the DDA include a range of possible organisational solutions, incorporating the DDA and its activities within NewDERA or Retained DERA or possibly elsewhere in the MoD. The Department is considering the implications of the various possible options, in the light of the work done by the DDA to date. Once a firmer view has been reached on an option that can be recommended, the Department will consult more widely and make detailed proposals for the establishment of the Defence Diversification Council, which will have a major role in taking forward defence diversification activity.

24.   Question: The committee would be grateful for any further information it can provide about which sites may be classified as "strategic assets" and on which side of the New/Retained divide they are likely to fall [QQ128, 134]?

  25.  The term strategic assets has generally been used to refer to equipment and facilities, not just sites. DERA has several hundred facilities, virtually all of which provide a capability of importance to one or more MoD customers. There is no central list of such facilities since they are an integral part of DERA's individual business. A list of specific facilities, which currently receive special attention as strategic assets, has been previously provided to the committee.

  26.  There is an existing process for consulting relevant MoD customers when disposal of a facility is under consideration, and it is proposed that the special share would contain provisions requiring NewDERA to follow a similar process when considering closure or disposal of designated strategic assets. During implementation, detailed work would be carried out with DERA and its customers to agree the list of facilities which would be given this status. We also anticipate that, as a responsible supplier, NewDERA would not wish to jeopardise its relationship with its major customer by closing facilities without first discussing the issue with the relevant part of MoD. In addition, contractual safeguards would also protect access to facilities required as part of a specific project.

  27.  It is too early to say which assets will be in RDERA and which in NewDERA and final decisions will be dependent on the feedback from consultation. However, in general terms, where entire business units are retained in RDERA, for example the Chemical and Biological Defence sector or DERA Radiological Protection Services, ownership of the assets will remain with them. Where MoD is retaining individuals from departments that will continue to exist in NewDERA, the general principle is likely to be that NewDERA will retain the assets. It is likely that in certain cases RDERA would establish a contractual agreement with NewDERA for access to facilities that were required for specific tasks. MoD customers are already charged for the use of facilities within the current DERA that are used to support their programmes. Consequently it is not anticipated that there will be any significant changes to facility costs resulting from the proposed new arrangements.

28.   Question: Does the MoD envisage any mechanism under the public-private partnership for ensuring that NewDERA retains particular key staff or teams after it is incorporated/floated?

  29.  Currently the existing DERA organisation has no particular mechanisms for retaining key staff or teams, and indeed DERA faces difficulties in competing with industry for staff with expertise in specific areas of technology. NewDERA, as a private sector company, will enjoy a greater range of options to address this problem. These may include not only pay and other reward flexibilities, but also potentially the opportunity for staff to have an equity share in the success arising from the exploitation of their ideas while at the same time remaining in NewDERA and producing new, innovative ways of meeting defence needs. It will be very much in the interests of NewDERA to ensure that it retains those individuals and teams instrumental in meeting the needs of its principal customers in the MoD. Although RDERA is unlikely to have the same range of pay freedoms, it will continue to offer scientists the opportunity to carry out exciting and stimulating work in a range of professional areas. We are confident that both organisations will be capable of attracting sufficient high-calibre staff to carry out their respective missions.

30.   Question: In deciding whether to grant permission for NewDERA to engage in "defence manufacturing" activities what criteria will the Department apply?

  31.  NewDERA will remain a very significant supplier of science and technology to MoD for the foreseeable future and, as such, will have a powerful business incentive to protect its independence and integrity through internal processes and appropriate values and culture. In order to provide additional assurance, NewDERA will be subject to a compliance framework that will include a prohibition on defence manufacture to be enforced through retention of a special share.

  32.  In relation to defence manufacturing, it is not proposed to prohibit NewDERA from undertaking any activities performed by the current DERA. The prohibition is intended to be consistent with the present restrictions on the development and manufacture of equipments for sale by DERA, which are set out in the Framework Document that governs the activities of the trading fund. It is recognised that for this prohibition to be effective it must be defined in an unambiguous way and, similarly, the processes and procedures used to administer this provision must be clear and not intrusive.

  33.  It is recognised that more detail will be required following consultation to define fully the term "defence manufacture" but it will be based on the following broad principles:

    (a)  NewDERA would not, without the express permission of MoD, be permitted to undertake the manufacture or supply of equipment, products or systems whose principal use is intended to be for a military, defence or security application, other than small numbers of prototypes or demonstrators.

    (b)  Unless there was a clear conflict of interest, NewDERA would be permitted to act as a Systems Integration contractor and to work in partnership with, or as a sub-contractor to industry. This is seen as an important mechanism for ensuring that the results of work within NewDERA can influence the design of new defence systems.

34.   Question: What is the MoD's latest assessment of the number of DERA staff that will not be required, neither by NewDERA nor by Retained DERA? Who will pay for redundancies?

  35.  Staff numbers within DERA have varied in response to customer requirements and changes in the funding available for defence research. Such rebalancing has been ongoing in DERA over the last seven to eight years, with a shift in demand away from traditional technologies and facilities such as wind tunnels and ranges towards "new technology" areas such as biotechnology and communications. DERA's size has remained broadly constant through this rebalancing. This process is independent of PPP and would be expected to continue. The committee will be aware that, as a separate initiative, MoD is introducing greater competition into its research programmes. DERA's success in winning work will potentially have an impact on overall staff numbers, but this will occur regardless of the PPP process. It has never been an objective of the PPP to reduce staff numbers and indeed the opportunities provided by this process to develop new markets for DERA's products should have a positive effect on job prospects. Consequently it is not anticipated that PPP will cause a significant reduction in staff numbers. It is expected, however, that, as at present, the costs of any redundancies would lie where they fall.

36.   Question: How much may it cost to divide staff, facilities, information systems and databases between the NewDERA and Retained DERA organisations? What arrangements are likely to be followed to transfer existing pensions to NewDERA, and what is likely to be the aggregate value of pension commitment transferred by MoD to the new organisation?

  37.  Details of the division have not been finalised and will be dependent on the results of the consultation process. So far only broad estimates of the likely costs of initial separation have been made. However, these estimates are sufficient to give confidence that any costs will be small in relation to the overall size of the project.

  38.  The creation of NewDERA would present staff with the option to transfer accrued PCSPS benefits into the NewDERA pension scheme. This option would be provided under a bulk transfer arrangement on the basis provided for in the recent Cabinet Office statement of practice for staff transfers in the public sector. The aggregate value of pension commitments transferred will depend on the number of staff exercising the option to transfer accrued benefit and this is unlikely to be known until after vesting day of any NewDERA organisation. It should be noted that although the pension transfer represents a cash cost to Government, it is neutral in overall terms as it represents a removal of an element of Government's ongoing pension liability.

39.   Question: The consultation Document speaks of retaining all of the capabilities of the Centre for Defence Analysis, but only the majority of staff. How will that be possible?

  40.  The functions undertaken by the CDA are fundamental to the business of the MoD as a whole, by sustaining impartiality and supporting major expenditure decisions and the coherent development of future defence policy. At the same time, it is recognised that including a number of CDA staff within NewDERA would allow it to continue to operate under its current business model and would add value to the other capabilities offered to customers. Both of these aspects are likely to have a positive effect on NewDERA's ability to win new business and on its attractiveness to potential investors. CDA has capabilities in several technical areas, each of which typically comprises a number of staff and analytical models. Although it is proposed to retain the full range of capabilities in MoD it may not be necessary that the current level of staffing is required to meet only those requirements that must be carried out within Government. Although further work would be required after consultation, there is confidence that in some instances it is possible to create an adequate level of capability within Retained DERA to meet MoD's impartiality requirements in a particular area without keeping 100 per cent of the current staff. This would free up a number of CDA employees who could potentially transfer to NewDERA to provide the company with a core analysis capability. In those areas where it is possible to carry out work in the private sector, NewDERA would remain accessible as a potential supplier to MoD.

41.   Question: Of the DERA departments to be kept in Retained DERA, which ones are intended in particular to provide sufficient assurance to US authorities to protect UK/US collaborative research?

  42.  The creation of a Systems Science Sector within Retained DERA will ensure that MoD retains a systems research capability and a source of impartial advice, manages and participates fully in Government to Government collaborations, and has an overview across the breadth of defence science and technology. It is, therefore, this Sector which will provide the assurance of our continuing support for international research collaborations to our partners, including the US, and help to maintain and develop our collaborative links. During consultation, we will also be discussing with our allies the detail of the processes and principles that would govern the handling of collaborative issues throughout the implementation and transition periods.


 
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