Select Committee on Defence Written Evidence

Second memorandum from the Ministry of Defence

  Following its session on 24 January to take evidence from the Permanent Under Secretary and the Finance Director on the MoD Annual Report and Accounts 2004-05, the Committee asked for a range of additional information. This is set out below.

1.   What are the 25 pinch point trades referred to in paragraph 113 of the Annual Report and Accounts, and how is a pinch point defined and identified (Q5)?

  A manning pinch point is defined as "a trade, or area of expertise, where there is insufficient trained strength (officers or ratings/other ranks) to perform required tasks. This might be as a result of adherence to single-Service harmony guidelines, under manning, and/or levels of commitment that exceed resourced manpower ceiling for the trades or areas of expertise involved." The Manning Pinch Point lists comprise the trades that fall within the Manning Pinch Point definition. These lists are dynamic with trades moving on and off them according to the manning situation. Each Service manages its own Manning Pinch Point list and is responsible for identifying a Pinch Point when the criteria are met. The current Manning Pinch Point lists for all three services are shown below.

  Paragraph 113 of the Annual Report stated that during 2004-05 there were over 25 Pinch Points Trades in the Army. These were broadly the same as the 24 set out below, but at various times during the year also included Royal Army Veterinary Corps Dog Handlers, Vehicle Electricians, Movement Controllers, Royal Signals System Engineering Technicians, Royal Signals Specialist Operators, and Environmental Health Technicians. Military Engineer (Geographic) was not identified as a pinch point trade during 2004-05, but is part of the current list.
Naval Service
Aircrew (Rotary Wing)—Merlin Pilot Vehicle MechanicSquadron Leader Flying Branch
Aircrew (Rotary Wing)—Merlin Observer Recovery MechanicJunior Officer Pilots
Aircrew (Rotary Wing)—Merlin Aircrewman ArmourerJunior Officer Weapon Support Officer
Fast Jet PilotsAmmunition Technician Operations Support Branch (Fighter Control)
Junior Submarine Warfare OfficersChef Operations Support Branch (Regiment)
Junior Hydrographical/Meteorological Officers Petroleum OperatorOperations Support Branch SB (Provost/Security)
Submarine Steward (required for secondary duties) Explosive Ordnance DisposalEngineer
Submarine/Communications Ratings—Petty Officer Clerk of WorksAdministration (Secretarial)
Submarine/Communications Ratings—Leading Hands Military Engineer—FitterAdministration (Catering)
Submarine/Communications Ratings—Able Seaman Military Engineer—C3SAdministration (Physical Education)
Fighter ControllersMilitary Engineer—Geographic Administration (Training)
Surface Ship and Submarine Junior Warfare Ratings Information Systems EngineerMedical
Air Engineering Junior RatingsOperator Military Intelligence Medical Support
Submarine Nuclear Watchkeeper Senior Ratings Operator Military Intelligence (Linguist) Dental
Royal Marines Junior RanksOperator Military Intelligence (HUMINT) Chaplains
Mine Clearance Divers Junior RatingsAnaesthetist Legal
RadiologistWeapons Support Operator (Linguists)
Orthopaedic Surgeon Weapons Support Operator (Air Loadmaster)
General SurgeonGeneral Technician Electronics
General Medical Practitioner Environmental Health Technician
Nurse—General Duties Officer Gunner
Nurse—General Duties Soldier Air Traffic Control/Flight Operations Manager/Flight Operations Assistant
Nurse—Accident & Emergency Aero Systems Manager/Operator
Nurse—Intensive Theatre Unit Air Cartographer
Medical Administrator/Assistant
Psychiatric Health Technician
Staff Nurse
Dental Technician
Dental Hygienist
Laboratory Technician
Operating Theatre Technician
Movements Operator/Controller
Mechanical Transport Technician
Mechanical Transport Driver
Fire Fighter

2.   What impact do these pinch points have on operations and what will be the impact of the deployment to Afghanistan (Q6)?

  We judge that the impact on our planned deployment to Afghanistan and on readiness for future operations is manageable. However, tour Intervals for a number of Pinch Point Trades such as medical, intelligence, helicopter crews, logistic, provost and engineers are likely to breach harmony levels as we increase our scale of effort in Afghanistan. We continue to encourage appropriate contributions from our NATO Allies in Afghanistan in order to take some of the pressure off these Pinch Points.

3.   What computerised management information is available on the situation of individuals in respect of the harmony guidelines (Q8)?

  Individual separated service and breaches of harmony are currently managed under single-Service arrangements using several information systems:

    —  Naval Service separated service relates to those serving on ships with reports being aggregated manually.

    —  Army individual separated service is recorded on a system called UNICOM and aggregate data is compiled manually.

    —  Two systems are used by the RAF—PACMIS (for airmen) and ACMIS (for officers) which record individual separated service and can compile aggregate data.

  The Joint Personnel Administration (JPA) change programme is introducing a harmonised personnel administration system for all military personnel that will make it possible to work out the separated service of every individual in the Armed Services using a single IT system. After JPA roll out (starting with the RAF in the Spring), a Unit Separated Service Report will be available giving a breakdown for each individual covering a rolling period (three years for the RN and Army, and two years for the RAF). Individuals will be able to check their own Separated Service records, and reports will be also available for Formation HQs and MoD use.

4.   What is the impact on civilian manpower of the re-organisation of Land Command and the Adjutant General's Department (Q12)?

  Project Hyperion is taking forward the re-organisation of Land Command and Adjutant General's Department and the establishment of a new collocated Headquarters Land Forces. This is expected to generate savings of about 110 military and 240 civilian posts. A decision on the preferred location of the new headquarters should be taken in the late Spring, following which a comprehensive transition plan will be drawn up. This will cover all personnel-related issues in accordance with established MoD relocation procedures, including full Trade Union consultation. There is a continuing internal communication programme providing face-to-face briefings and regular presentations to staff.

5.   Have the £400 million reported savings in the DLO's operating costs been validated and, if so, what was the outcome of the validation (Q43)?

  The DLO efficiency achievement in 2004-05 is still being assessed in an internal audit to review the evidence supporting judgement of the level of benefits realised in the year. It is likely that this will indicate that some of the operating cost savings included in the total of over £400 million reported in paragraph 209 of the Annual Report and Accounts 2004-05 cannot be validated. Any revision will be reported in the Department's quarterly PSA reports and the Annual Report and Accounts 2005-06.

  Overall the DLO is making good progress towards its demanding target of achieving a 20% reduction in the cost of its output from its creation in 2000 to April 2006. Since 2004, this target has been taken forward under the Defence Logistics Transformation Programme, which stretches across the whole Defence logistic process from industry to the front line. This is a very complex programme embracing several hundred individual projects. The measurement of overall efficiency performance is challenging, but systems for identifying and tracking input benefits are in place and continue to evolve to provide more robust evidence-based demonstration of benefit achievement.

6.   An explanation of the process of target-setting for Agencies, and their apparent variability (Q54). It would be helpful if this could include an explanation of the change in number of targets (Q56)

  The MoD currently has 20 On-Vote Agencies and five Trading Funds. These vary enormously in size and role and cover a wide variety of different types of outputs. Details of individual agency objectives and performance including information relating to key targets can be found in individual agency Corporate Plans and reports and accounts and on the MoD's internet site. A summary is published in Annex E to the Department's Annual Report and Accounts, including a table on key targets achieved that is intended to be reviewed in the context of the supplementary commentary.

The Process of Target Setting

  Defence Agencies' key targets are drawn up as part of the wider business planning process. Targets for Defence Agencies are formally set by Defence Ministers, assisted by senior advisors within the Department responsible for scrutinising individual agency key targets prior to submission to Ministers. These advisors are in turn usually helped by Boards comprising key stakeholders including major customers who can advise on strategic direction, operational demands, possible targets and performance measurement in relation to a particular agency. The specific process used varies from agency to agency but it often makes sense for an individual Agency to put together draft key targets in the first instance. Following discussion and scrutiny between senior departmental officials and individual agency Chief Executives, key targets are then recommended to the relevant Minister for approval. This is normally done on an annual basis. Such recommendations include details of the proposed key targets, past performance, a supporting rationale and information about how targets will be measured. The rationale will normally include relevant contextual information, such as how the proposed key targets relate to the outputs of the agency, the relationship between the key targets and any higher level targets (eg Top Level Budget Holders' Service Delivery Agreements, the Defence Change Programme, and Public Service Agreement targets), and how the chosen targets will drive and facilitate the monitoring of performance improvement. Once the Minister has agreed an Agency's Key Targets these are announced in Parliament and formally incorporated into its Corporate Plan. All those involved in the process of drawing up agency key targets are expected to draw on identified best practice, including the Treasury's November 2003 guidance "Setting Key Targets for Executive Agencies: A Guide" and supplementary internal guidance issued by the Directorate of Business Delivery.

Changes in Targets

  Key targets seek to represent the main business of the organisation concerned. In line with HMT best practice, Defence Agencies typically have between five and 10 key targets. Precise numbers vary depending on the size and complexity of the agency concerned and challenges it faces in a particular year. We recognise that in judging performance it is preferable to have a run of comparable data over a number of years. However, a balance needs to be struck between continuity and the need to improve and amend targets to reflect new or evolving priorities. Any changes to key targets or the way they are measured will be set out for Ministerial consideration. Ministerially endorsed changes to Agency key targets are normally then explained in Agency Corporate Plans and published on Agency web-sites.

  As an example, Ministers agreed to increase the number of key targets relating to Defence Estates from 11 to 15 in 2004-05. This followed a major review in 2004 which assessed the relevance of the existing targets to the Department's and Defence Estate's business and the decision to merge the organisation with the Defence Housing Executive in a single Agency. In light of that Ministers approved the integration into Defence Estate's targets of a number of the Defence Housing Executive's previous key targets, the rolling forward and updating of some key targets from Defence Estate's Corporate Plan 2003, and the introduction of a new customer satisfaction target.

7.   The nature of the Government's Golden Share in Rolls Royce (Q74)

  The Treasury Solicitor, as nominee for the Secretary of State for Trade and Industry, holds the Government's Special Share in Rolls-Royce Group plc, going back to when the Company was privatised in 1987. This is one of a small number of special shares that the Government holds in UK companies.

  The purpose of the Rolls-Royce special share, which has a nominal value of £1, is to protect the UK's national security interests. These include security of supply issues associated with its nuclear business (nuclear propulsion for Royal Navy submarines) and for other defence equipments (mainly aero-engine and ship propulsion). The provisions of the special share are tailored as narrowly as possible and kept under review.

  Key features of the Rolls-Royce special share include:

    —  A 15% limit on the percentage of foreign shares in Rolls-Royce Group plc (the holding company) that can be held by a single foreign shareholder, or foreign shareholders acting in concert. (A foreign shareholder includes an EU national.)

    —  A requirement that the Chief Executive and the majority of directors of Rolls-Royce Group plc (the holding company) are British.

    —  Requirement that disposals of the whole or a material part of the nuclear business, or the Group as a whole, require the consent of the Special Shareholder.

8.   A breakdown of the RAF personnel who exceed the target for detached duty, referred to on page 13, target 4 (Q76)

  The breakdown of RAF personnel who exceeded the guidelines for individual separated service is as follows:

TradeNumber of

Number of
Pilots60Engineer 26
Navigators23Supply 28
Air Electronics Operators1 Administration1
Air Engineers1Admin Secretariat 16
Air Load Masters3Admin Caterers 1
Air Traffic Controllers12 Admin Physical Training1
Fighter Controllers10 Admin Training2
Intelligence Analysts16 Medical21
Regiment35Dental 2
Flight Operations9Legal 2
Provost and Security3 Princess Mary's Royal Air Force Nursing Service 4
Aircraft Engineering Technician10 Aerospace Systems Manager/Operator12
Aircraft Engineering Technician16 Fighter Controllers1
Aircraft Technician (Mechanical)80 Survival Equipment Fitter18
Aircraft Technician (Avionics)70 Painter and Finisher3
Engineering Technician Airframe61 Intelligence Analyst (Imagery)7
Engineering Technician Propulsion32 Photographer3
Engineering Technician Weapon91 Air Cartographer1
Engineer Technical (Avionics)41 Pharmacy Technician1
Engineer Technical Air Electrical31 Operating Theatre Technician1
Engineering Technician Electronics107 Environmental Health Technician1
General Technician Electrical32 Medical Administrator16
General Technician Ground Service Engineers 37Staff Nurse (RGN) 17
General Technician Workshops6 Dental Nurse/Administration4
General Technician (Mechanical)8 Dental Hygienist1
Aerial Erector14Personnel Administrator 35
Mechanical Transport Driver99 Movements Controller/Operator83
Mechanical Transport Technician/Mechanic 21Supplier133
RAF Police68Chef 35
Gunner276Catering Account 1
Fire-fighter25Steward 6
Air Traffic Controller/Flight Operations Assistant (ATC) 7Musician2
Flight Operations Manager/Flight Operations Assistant 29Air Engineers4
RAF Physical Training Instructor11 Languages3
Intelligence Analyst (Voice)25 Air Load Masters21
Intelligence Analyst (Communications)9 Air Electronics Operators7
Telecommunications Controller/Operator 51

  As at 30 December 2005 4.0% of RAF personnel exceeded the guidelines for separated service.

9.   The impact of the c.£5 billion project cost increases reported in MPR 03 (£3.1 billion) and MPR 04 (£1.7 billion), and the project time slippage reported in MPR 03 and MPR 04, on MoD's current and future procurement programme (Q79)

  Cost growth on specific equipment projects inevitably has undesirable consequences for the overall Equipment Programme, because, over time, it reduces the available provision for equipment. This is, however, only one of many variables and does not always create short-term problems. It is impossible to hypothecate the impact of changes in the estimated costs of individual projects to specific changes in the overall programme. As part of the Department's routine planning process we review the underlying plans and assumptions which make up the Equipment Programme. This takes into account changes in the strategic background, fresh operational experience, alterations to project plans, assumptions and threats—which may include both increases and decreases in forecast costs—and pressures elsewhere in the Department, with reference to the outcome of Spending Reviews. All these factors have to be weighed and our plans and assumptions about the Equipment Programme adjusted accordingly to ensure that we are still able to deliver the balanced military equipment capability our forces require within the funds available for Defence. Consequently, whilst it is inevitably the case that if we have to spend more of our resources on one project, less will be available for other purposes, there is not a simple relationship between historic cost-growth on one project and reduced spending elsewhere; the adjustments we make are the result of the interplay of a wide range of issues across the Defence Budget as a whole. What we can say is that the analysis we undertake after the conclusion of the planning cycle demonstrates that we will continue to deliver to our forces the military equipment capability they require.

  We continue to work to reduce cost-growth on equipment projects because widespread and unchallenged cost growth puts pressure on the total capability we can deliver. We are making progress on this. The National Audit Office (NAO) noted in the Major Projects Report 2005 that "There has been further progress on measures to improve performance within the Defence Procurement Agency and elsewhere in the Department. These improvements focus on the following areas: performance of key suppliers; the skills and development of staff; project and risk management; increased use of trade-offs between time, cost and capability of equipment; better joint working of those responsible for acquisition within the Department; and stronger project scrutiny at all levels." The NAO added that "It will take some time before the full impact of these measures will be felt on the large and lengthy projects within the Major Projects Report". Ministers and senior officials will continue to drive forward the necessary changes.

10.   Confirmation that MoD did not buy back any surplus equipment in 2004-05 (Q94)

  We have identified buy backs of the following equipment in 2004-05:

    —  the Sea King Integrated Project Team purchased minor parts costing £500;

    —  the Maritime Logistic Support Integrated Project Team purchased minor spares for workshop based repairs costing £72,836. These replaced items that had previously been sold under a stock rationalisation programme on the basis of low usage but were then subsequently required.

11.   An explanation and annual breakdown of the reported cost savings of £88 million in respect of Tornado, referred to in paragraph 210 (Q98)

  The figure in paragraph 201 comprised:

FY 2003-04FY 2004-05 Total
Reductions in Tornado Propulsion Flight Local Unit Establishment: £4 million£4 million
Reduced engine rejections:
(approx 200 fewer rejections a year @ £250k per rejection)
£21 million (part year)£50 million £71 million
Introduction of pilot contract with Rolls-Royce Defence Aerospace in October 2003: £4 million (part year)£9 million £13 million
TOTAL:£25 million £63 million£88 million

12.   An explanation of the loss of £65 million relating to the impairment of an operational building, referred to on page 194, including an explanation of why MoD incurred the loss if the building could not meet the requirement for which it was designed, and the future plans for the building (Q102)

  The project to which this refers originated in a commitment by the then Secretary of State for Defence in 1978 to replace inadequate waste management facilities and overhaul safety procedures at the Atomic Weapons Establishment (AWE) Aldermaston. As part of this, work to build a substantial facility for treatment of radioactive liquid waste was taken forward during the 1980s. However, despite considerable further modifications during the 1990s it proved impossible successfully to commission the facility and bring it safely and effectively into service. The plant was eventually formally declared unfit for purpose in 2000 and a commercial settlement was reached with the contractor in 2003. No viable alternative use was identified for the plant or the dedicated building containing it, and the facility was formally written off in 2005. Further details are set out below. AWE has continued successfully to meet its safety and environmental obligations by other means despite this facility never entering service.

  There are two separate related entries in the Annual Report and Accounts 2004-05 in respect of this loss:

    —  "A loss of £65,000,000 has been incurred following the impairment of an Operational building. (DPA)" (Page 194). This advance notification refers to building A91 at AWE, which was completed in the late 1980s to house an integrated Radioactive Liquid Effluent Treatment Plant (RALETP).

    —  "A loss of £82,000,000 has been incurred in respect of plant and equipment. (DPA)" (Page 195). This advance notification refers to the RALETP that was designed during the 1980s and integrated into building A91.

  The Radioactive Liquid Effluent Treatment Plant (RALETP) was declared unfit for purpose in 2000 and was the subject of a contractual dispute with the operations and management contractor, Hunting Brae, in which £13 million was recovered. However as most of the problems stemmed from before AWE was contractorised in 1993, and there being no reasonable prospect of rectifying the technical problems within any practicable timescale, we decided in 2002-03 that there was no future for the facility, generating an impairment of £82 million. A91 was built to house RALETP. The building (excluding RALETP) was valued at £65 million in the 1998 opening MoD Balance Sheet. Since 2000, AWE have examined various options for its use. The following considerations were taken into account:

    —  The defective plant was integrated into the fabric of the building. Numerous structural columns exist which would make the design and installation of any significant plant very difficult.

    —  The building is a lot larger than any future facilities would require so that the building would not be economical to run over the longer term.

    —  By the time it could be converted to a new facility, the standards to which it was built would be 20 years out of date.

  Given these considerations, we decided there was no possibility of alternative uses. It was therefore necessary to write off the £65 million value of the building.

  The RALETP and the building (excluding RALETP) are shown separately in the accounts because in 2003-04 the NAO were content that the Note to the Accounts on losses and special payments included the building only. In 2004-05 it decided that the Note should also include the £82 million write off for RALETP itself, and that these should jointly be considered as one loss. The total write-off of £147 million was approved by the Chief of Defence Procurement on 22 November 2005.

  The Department acknowledges that this project was handled badly in a number of significant respects. Lessons have been drawn from the experience, procedures have been changed, and the Department is determined to avoid any recurrence.

13.   An explanation of the loss of £63.8 million on the Landing Ship Dock (Auxiliary) programme, and the latest estimate of the cost of the programme compared to the contract price agreed with the contractor (Q102-Qq 32-41 also refer)

Losses reported in Departmental Resource Accounts 2004-05

  There are two separate losses related to the Landing Ship Dock (Auxiliary) (LSD(A)) programme detailed in the Annual Report and Accounts 2004-05 under Advance Notifications:
Page 194
Advance Notifications
Slippage in the construction programme for two Landing Ship Dock (Auxiliary) caused delay in supplying design information and equipment to a contractor. This resulted in a claim on the MoD relating to the associated delay and dislocation costs. In 2003-04, an amount of £40,000,000 was included in Advance Notification as an estimate of the likely amount of the claim. (DPA) £63.8 million
Page 195
Advance Notifications
HM Treasury has agreed an ex-gratia payment of up to £84,500,000 to Swan Hunter subject to completion of certain contractual conditions relating to the construction of two Landing Ship Dock (Auxiliary) LSD(A). Total paid to date is £38,000,000. (DPA) £38.0 million

  The £63.8 million provision is to meet delay and dislocation claims, against the MoD, from BAE SYSTEMS following the impact of the technical difficulties encountered by Swan Hunter in the relaying of design information and equipment. The MoD has to date paid £37 million against the existing provision. The scope and scale of any additional costs are being negotiated with BAE SYSTEMS.

  The £84.5 million is the cost of the re-negotiated contract amendment with Swan Hunter, agreed in December 2004, for the design and build of the Landing Ship Dock (Auxiliary) vessels, as a result of the technical difficulties encountered by the company.

LSD(A) Project background

  The Landing Ship Dock (Auxiliary) project is for four ships to replace the current Landing Ship Logistics capability provided by RFA of Sir Geraint, Sir Percivale, Sir Galahad and Sir Tristram. The prime contractor and design authority is Swan Hunter (Tyneside), responsible for the build of RFA Largs Bay and RFA Lyme Bay at its Wallsend shipyard. It also provides design information and equipment to BAE SYSTEMS for the build of the two follow-on ships, RFA Mounts Bay and RFA Cardigan Bay at BAE SYSTEMS (Govan and Scotstoun yards). A contract was placed in December 2000 with Swan Hunter and the follow-on contract with BAE SYSTEMS to build an additional two LSD(A)s was agreed in November 2001. Swan Hunter won the original competition with a modification to an off-the-shelf design—the Dutch HNLMS ROTTERDAM and Enforcer Class vessel by Royal Schelde. Subsequent difficulties have shown that the design was not as mature as the company believed at the time.

  Swan Hunter confirmed, in September 2003 it was unable to meet the original programme requirements for the design and build of the two ships. The company accepts that its initial programme was optimistic and underestimated the extent of the development issues inherent in the building of a new ship. The delays caused by the build programme rework, as a result of the modifications of the Royal Schelde design to the MoD specification, led to an underestimation of the price of the overall contract. The slippage to Swan Hunter's programme delayed the delivery of design information to BAE SYSTEMS which impacted upon that company's own build programme. Under the terms of the Swan Hunter contract, this design information is defined as MoD Government Furnished Asset and enables BAE SYSTEMS to claim against MoD for the additional costs incurred as a result of the Swan Hunter delays and subsequent impact upon their build programme.

  The effect of the delays on the programme, together with a range of options for the completion of Largs Bay and Lyme Bay, were re-assessed by the MoD during 2004. The conclusion was that further investment in the LSD(A) contract was the most effective way of protecting the investment to date and in delivering this much needed capability. Therefore the retention of Swan Hunter as the lead yard offered the MoD and taxpayer the best value for money solution for delivering this new capability. Re-approval was sought for the resultant increased costs and revised In-Service Dates. These were approved by the Minister for Defence Procurement and the Chief Secretary to the Treasury and an £84 million contract amendment was agreed on 9 December 2004.

  All four ships have been successfully launched. RFA Mounts Bay, the first of the BAE SYSTEMS vessels, was accepted off contract on 15 December 2005 and is now undergoing her Stage 2 trials (capability) in readiness for meeting her In-Service Date in late 2006.

Current contract values

  Swan Hunter: The original contract value for the build of the two Swan Hunter vessels was £148 million. Following the order for a further two ships from BAE SYSTEMS, an additional £62 million was added into Swan's contract for Lead Yard Services and Equipment, enabling Swan Hunter to pass relevant design information and equipment to BAE SYSTEMS. Following Swan Hunter's confirmation of its underestimation of the engineering requirement MoD increased the original contract by £84.5 million in December 2004. This together with the purchase of spares at £11 million and minor variations to contract, means that the total value of the contract for Swan Hunter is £309 million.

  BAE SYSTEMS: The current contract value for the build of the BAE SYSTEMS vessels is £176 million, which includes £48.5 million for known claims as a result of the impact upon their programme of the Swan Hunter delays and an additional sum for variations to contract and quantity growth. The £63.8 million provision in the accounts includes a further £15.3 million for potential future claims. The original contract value was £122 million.

  Additional cost increases: Swan Hunter confirmed in June 2005 to MoD that it cannot complete its two vessels for the cost agreed in December 2004. BAE SYSTEMS have also notified MoD of likely cost increases, primarily as a result of the delays to their programme caused by the further Swan Hunter delays. MoD is currently in commercial discussions with both companies as a result of these declared cost increases. All options are being assessed and in view of the commercial sensitivities it would be undesirable to give any further details at this point.

14.   An explanation of the basis on which PSA target 1 has been judged to have been met, and why no supporting measures are given in Table 1

  The success of an Operation is judged against the Military Strategic Objectives given to the UK commander by the Chief of Defence Staff. It is formally assessed using military judgement by a group chaired by the Deputy Chief of Defence Staff (Commitments). Every Operation has been judged to have met its Military Strategic Objectives over the period covered by this assessment (April 2003-March 2005). There are no supporting measures in Table 1 to the Annual Report and Accounts 2004-05 because the Technical Note for PSA Target 1 contains no supporting performance indicators.

15.   A note on Private Finance Initiative commitments. Please explain the difference between "on" and "off" Balance Sheet transactions (as referred to on page 177, paragraph 22.1), and why they appear to be accounted for differently. What assessment has MoD made of whether the PFI projects listed on pages 178-179 are delivering the expected levels of service? And to what extent do these substantial long-term financial commitments impact upon MoD's future financial flexibility?

"On" and "Off" Balance Sheet

  PFI transactions are accounted for in accordance with UK Generally Accepted Accounting Practice and Financial Reporting Standard (FRS) 5, Application Note F—Reporting the Substance of Transaction: Private Finance Initiative and Similar Contracts. The purpose of FRS 5 is to identify:

    —  whether the purchaser in a PFI contract has an asset of the property used to provide the contracted services together with the corresponding liability to pay for it or, alternatively, whether it has a contract for services; and

    —  whether the service provider has an asset of the property used to provide the contracted services.

  Under the general principles of the FRS, a party will have an asset of the property where the party has access to the benefits of the property and exposure to the risks inherent in those benefits. The reason that some PFI deals are "on" Balance Sheet while others are "off" is due to the nature and type of risks that each party has retained or transferred in the transaction. The main difference between an "on" and "off" Balance Sheet PFI is that an "on" Balance Sheet PFI scores against Capital Departmental Expenditure Limit (CDEL) on the Control Total Framework and therefore incurs cost of capital charges up front whilst an "off" Balance Sheet PFI does not. The Department only undertakes PFI when it delivers Value for Money and not to secure a particular balance sheet treatment to address affordability concerns. The NAO audit all MoD PFI accounting transactions.

  This is illustrated by way of a couple of examples. A major factor in determining whether a PFI is "on" or "off" our balance sheet is residual value risk. Main Building PFI is "on" our balance sheet because the department has retained the residual value risk for the building. In other words, the department has retained the risk for delivering the required facility. At the end of the PFI contract MoD will own the building. By contrast almost all of our Defence Housing PFI contracts are "off" our balance sheet as the residual value risk has been transferred to the contractor. At the end of the contract the MoD can choose to buy the properties at market value or walk away.

Private Finance Initiative level of service

  In August 2005 the MoD Private Finance Unit initiated a review of operational Private Finance Initiative (PFI) projects to assess how PFI has performed to date, both in construction and in the early years of operation, within the MoD. The structure of the review was developed with the National Audit Office (NAO) and Partnerships UK. The comprehensive review of all PFI projects as defined by HM Treasury with total contract costs in excess of £19 Billion concluded that:

    —  PFI in the MoD substantially delivers projects on time and within budget. All projects were delivered on budget. All except three were delivered within two months of the agreed date;

    —  PFI projects in MoD are performing well and are delivering the services required. All of the project teams surveyed reported that the performance of their PFI project was satisfactory or better. Three quarters of project teams rated the performance of their PFI project as good or very good; and

    —  long term PFI contracts in MoD are flexible enough to accommodate future change and to deliver on a sustained basis. The review identified that 85% of projects reported that their PFI contracts were suitably flexible to accommodate change and had effective change management mechanisms.

  The review was published on 12 December 2005. This is available on, and a copy is attached. It has been received well. The NAO said "We welcome the MoD's review which provides new insights into defence PFI and the conclusions of which chime with many of our own findings across government."

Impact upon MoD's future financial flexibility

  To date, we have signed 54 PFI deals that have brought over £4.3 billion of private sector investment into Defence. A further 12 PFI projects are in procurement, and are expected to inject up to a further £6 billion. We use PFI as a core procurement tool to deliver our investment programme and deliver key services for which we know there is a requirement over the long-term when it is the best way to deliver value for money. Thus our financial flexibility is not constrained by the use of PFI as a procurement tool per se, but by the fact that there is a long term requirement for the service contracted for. It is also commonplace for PFI projects to have a change mechanism set into the contract in order to allow for evolution of the underlying requirement. The review of operational PFI projects referred to above confirmed that long-term PFI contracts in MoD were sufficiently flexible to accommodate future change and to deliver on a sustained basis.

16.   A note on nuclear decommissioning liabilities. Is MoD confident that the current estimate of its nuclear liabilities (page 175) will not increase substantially in the future, or the estimated timescales over which the costs will need to be incurred change significantly? How will MoD fund liabilities of this scale when they arise?

  Almost two thirds of the MoD's nuclear decommissioning liabilities transferred on 1 April 2005 to the Nuclear Decommissioning Authority. These related to facilities used for the production of Special Nuclear Materials by British Nuclear Fuels Ltd and its predecessor the UKAEA. In respect of the liability that remains on our balance sheet, we are confident that the current undiscounted estimates for cost and for timescales will not change significantly. Work is in hand to produce revised estimates for the five-yearly review due in 2007; so far these are in line with previous ones. The change in the Treasury discount rate from 3.5% to 2.2% will however cause an increase of some £0.7 billion in the stated provision in the 2005-06 Departmental Resource Accounts. How such liabilities will be funded will be the subject of negotiation with the Treasury as and when the circumstances arise.

17.   The Committee would also like to be kept informed on the progress of negotiations with the Treasury on the division of the proceeds of the flotation of QinetiQ (Q71)

  We have agreed with the Treasury that we will retain £250 million of the receipts from the QinetiQ IPO for reinvestment in the defence programme. The remainder of the receipt from the IPO will go to the Exchequer.

27 February 2006

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