House of Commons - Trade and Industry

Select Committee on Trade and Industry Written Evidence

APPENDIX 5

Memorandum by the British Amercian Security Information Council (BASIC)

1. SUMMARY

1.1 This submission will address two of the issues that the committee expects to consider, and will have a specific focus on the military aerospace sector:

— the importance of the UK-based aerospace industry to the UK economy; and particularly

— government support for the aerospace industry.

1.2 BASIC gave evidence to the committee in April 2004 on subsidies provided to exporters by ECGD, part of a wider ongoing project to more generally establish the level of subsidies received by companies exporting military equipment. The financial support given to military exports (over 90% of which are now accounted for within the aerospace sector) is significant, and is outlined in a recent September 2004 report published in September by BASIC, Oxford Research Group and Saferworld entitled: Escaping the Subsidy Trap.[3] We summarise these subsidies here, that amount to between £450 milllion and £930 million annually.

1.3 According to SBAC around half of aerospace production is defence-related, so that it is obvious that future defence posture and procurement policies have a significant impact upon the industry. In aerospace at least, government intervention in the civil sector remains highly significant; while the European Airbus project stands out as a successful assault on the dominance of civil aerospace by US companies, the cost of achieving this success needs to be factored in when considering whether this objective was worthwhile. But it is the military sector that is far more subject to government protection, procurement practices that favour domestic producers, and government subsidies to exports.

1.4 Simply put, economists generally agree that government subsidies distort the efficient allocation of resources unless they correct a market failure or are used for specific policy objectives that are independent of industrial policy. Subsidies simply designed to protect particular jobs or economic sectors for their own sake will actually end up costing jobs and harming the economy. If the aerospace industry is indeed as competitive as suggested by those within the industry, it will survive and thrive without government support. There are dynamic issues that affect this conclusion, which are discussed in further detail below.

2. BASIC

2.1 BASIC is an independent research organisation that analyses government policies and promotes public awareness of defence, disarmament, military strategy and nuclear policies in order to foster informed debate. BASIC has offices in London and in Washington and its Council includes former US Ambassadors, academics and politicians. Further information is available on our website, www.basicint.org

Contact details: Paul Ingram, Senior Analyst, BASIC, The Grayston Centre, 28 Charles Square, London N1 6HT; email:pingram@basicint.org tel: 020 7324 4680.

3. THE IMPORTANCE OF MILITARY AEROSPACE TO THE UK ECONOMY

3.1 Much has been made by SBAC and its members about the contribution of the aerospace industry to the UK economy, and in particular its contribution to technology, research and development, and high-skilled employment. There is no doubt you will be receiving submissions reminding you of these arguments.

3.2 Figures supplied by SBAC suggest that the UK aerospace industry is competitive within the global market. It records a long-term average net £2.8 billion balance of trade surplus, and direct employment of some 130,000 people around a third of whom are highly skilled (rising, they claim, to an estimated 275,000 if supply-chain employment is accounted for).[4] UK-based aerospace firms have also managed to break into US production, employing 30,000 people generating an annual turnover of around £4 billion.[5] The military share of aerospace has been growing recently, partly due to the downturn in civil aerospace (caused by a fear of terrorism) and partly to increases in defence spending, particularly in the US and UK, and now account for around half of total production.

3.3 These figures do not in themselves prove the case for aerospace. Crucially they take no account of "crowding out" investment effects, nor the impact upon the civil economy of a skilled workforce lost to the military sector. Nor does it take account of positive and negative externalities. It would take a detailed analysis of alternative investment opportunities and broader costs and benefits to account for the genuine aerospace contribution to the economy. Market investment choices are distorted by government intervention; subsidies attract market investment away from other potentially more efficient uses of the capital and skills and make any genuine comparison of contribution to the wider economy more difficult to measure. The need to undertake an analysis of this kind is all the more vital given the prospects for the future of the military aerospace sector.

3.4 BAE has until now been remarkably successful in staying within sight of the leader pack in global military aerospace, but one has to ask how long this can continue without continuing their trend by leaping with both feet into the North American market and losing its strong connection with Britain. Military aerospace companies in North America enjoy three key advantages:

— Access to a large and protected domestic market, that accounts for over 60% of the global market by value, and a much higher %age of the cutting edge aerospace that requires significant R&D spend;

— Access to leading-edge military technology within the US whose export is tightly restricted, and which is increasingly superior to military technologies in Europe;

— Larger firms, achieve greater economies of scale.

3.5 Will the government continue to see the company as benefiting the UK economy if most of its activities are sited in North America, producing military equipment for the US armed forces? Can the government continue its extentive support for such companies as it becomes increasingly clear that their operations are no-longer focused upon the UK? Just as importantly, will export controls be further compromised and government support increase as it becomes clear that military exports become increasingly crucial to the survival of any UK-based military aerospace?

4. LEVELS OF SUPPORT FOR MILITARY AEROSPACE

4.1 Studies recently into the subsidies received by military exporters do not Noneseparate out the support received by aerospace companies, but as the majority of military exports are aerospace related, and the support offered is received by saeropace exporters, these studies give an indication of the level of subsidy involved. Estimates of the financial cost to the UK taxpayer vary mainly because of different approaches to research and development spending and export credits but they all show that exports benefit from considerable subsidies—between worth at least £228 million and possibly up to up to a possible £990 million a year.[6] Most recently a September 2004 BASIC/Oxford Research Group/Saferworld report, "Escaping the Subsidy Trap", concluded that government subsidies to arms exports are worth at least £453 million and possibly up to £936 million a year.

4.2 The recent export of BAE Hawk trainer jets to India and the related decision by the Defence Secretary, Geoff Hoon, to buy Hawk in the face of reported opposition from his own Permanent Secretary and other government departments, clearly demonstrates the erroneous assumptions driving current policy. Internal government estimates reported in the press indicate that export and employment considerations actually added, rather than saved, £1 billon to the price tag for the advanced trainer jet procurement over the lifetime of the project.

4.3 UK Government support for defence exports is made up of direct subsidies, export credits, distortion of Ministry of Defence (MoD) procurement and a proportion of government spend on development costs. Explicit financial (and political) support of £31 million per year is provided through such organisations as the Defence Export Services Organisation (DESO) within MoD. Export credits are provided as insurance to exporters and purchasers of UK equipment at premium rates well below the market rate, an annual subsidy that amounts to £215 million. The cost of the distortion of MoD procurement to accommodate export promotion is more difficult to estimate, but if the experience of the Hawk deal is in any way indicative, our estimate of £200 million is extremely conservative.

4.4 In addition, there is a subsidy to arms exports that accrues through government contributions to defence R&D. The government spends £1.5 billion on the development aspect of military R&D. Approximately 40% of defence equipment produced in the UK is exported. Yet last year MoD succeeded in clawing back only £12 million of these contributions from the exporting companies. This represents a form of subsidy, though there is major disagreement as to how this should be calculated, as R&D costs may be partially offset by exports and—some commentators argue—this money would be spent regardless of export sales or prospects. If, however, one does assume that 40% of R&D spending relates directly to exports (the same percentage of total UK defence production that is exported), this would give an upper estimate of the R&D subsidy of £483 million.

4.5 We estimate that the subsidies provided to UK companies involved in defence exports are therefore worth at least £447 million and possibly up to £929 million; in other words, between £6,900 and £14,300 for each job supported by exports. At a time when public spending is under pressure the onus is on the Government to withdraw the subsidies and encourage similar withdrawals in other countries.

5. JUSTIFICATIONS FOR SUPPORT

5.1 The government claims that defence exports, in their contribution to covering fixed costs and in the sale of surplus equipment, saves MoD £300 million annually in its procurement budget. This figure has never been justified in public, and has remained at the same level for at least the last 10 years. Any dependency upon such a figure requires justification using recent figures, and needs to address a number of criticisms, namely:

— As the world market in arms is so competitive, exports are frequently sold near the marginal cost of production, with suppliers competing against each other after their fixed costs are covered by protected domestic defence markets.

— Defence exports are highly unpredictable in advance of investment in, and development of, the system, and tend to lengthen the life of production lines rather than the scale (so that some economies are lost).

— Many "fixed costs" are not fixed, and actually vary with the scale of production. This makes sense in managerial terms in that the scale determines the revenue (or expected revenue), which in turn determines the level of investment in so-called fixed costs.

— MoD procurement rules inadvertently allow some level of cross-subsidy for marketing, servicing and risk abroad (in that costs are shared as a proportion of production even when the costs of selling abroad are greater).

5.2 Employment from arms exports as a whole account for around 0.2% of UK employment, under half the level some 10 years ago. Although some localities like Yeovil and Brough may be hit hard by a sudden end to military aerospace exports, unemployment rates in traditional manufacturing areas would only be marginally affected according to a 2002 study by Ian Goudie.[7] This is partly because short-term, targeted government assistance for redundant military workers in such localities can be effective, and partly because of new opportunities created by the divertion of resources towards industries with far greater long-term job-creating prospects. This is why a 2001 study written, in part, by two MoD economists concluded that a halving military exports would result in the loss of 49,000 jobs, and the creation of 67,400 jobs in non-military sectors.[8]

5.3 The justification that has perhaps the strongest efficacy is that any dependency on foreign suppliers may lead eventually to a reliance upon a single monopoly. The obvious scenario is a dependency upon Boeing and Lockheed for our military aerospace requirements. This dependency, if our armed forces are to acquire leading technologies, is inevitable, for the reasons given in paragraphs 3.4 and 3.5, even if BAE remains one of the North American based suppliers. Of course, we may rely upon British-based companies for second-level technologies, but such would not require the level of support received today.

6. CONCLUSION

6.1 It is broadly accepted by economists both in and out of government that subsidy and protectionism leads to inefficiency and waste. Yet aerospace appears to be treated as an exception to the rule, and enjoys levels of significant support from a number of government departments, in a manner that remains uncoordinated and therefore uncontrolled.

6.2 We recommend a review of the support offered to military aerospace with a view at the very least to rationalising it, and eliminating those subsidies that serve no clear policy function independent of industrial considerations.

Paul Ingram

Senior Analyst, BASIC

Emma Mayhew

Project Analyst, BASIC