7 avril 2020 | Local, Aérospatial, Naval, Terrestre, C4ISR, Sécurité

ON TRACK - Defence Procurement Offsetting: Best Practices & Challenges in Canada & around the world

ON TRACK is the official journal of the CDA Institute. Through its pages, the CDA Institute promotes informed public debate on security and defence issues and the vital role played by the Canadian Armed forces in society. ON TRACK facilitates this educational mandate by featuring a range of articles that explore security, defence, and strategic issues that may have an impact on the Canadian strategic interests and on the safety of its citizens. The views expressed in ON TRACK are those of the authors and do not necessarily represent those of the CDA Institute.

VOLUME 25

INTRODUCTION: DEFENCE PROCUREMENT OFFSETS AS IMPLEMENTED IN CANADA, AND A EUROPEAN ANGLE

Author: Charles Davies

Context

“The power of any government depends ultimately upon its finances.”

Winston Churchill

Most Canadians will understand, at least at a conceptual level, that the nation's ability to afford the defence, security and other capabilities it needs depends upon not only political will but also the strength of its economy. Most would also acknowledge that, as a trading nation, Canada needs to make some level of ongoing contribution to the maintenance of adequate continental security and global stability in order to minimize constraints on the free flow of commerce.

Less widely acknowledged are the more practical implications this. To consider only one example, within our continental economic and security partnership with the US our American neighbour will quite legitimately do what it must to defend itself and its maritime, air and space approaches, which by and large are also Canada's maritime, air and space approaches. Any serious erosion of Canada's relative contributions to continental security will force our US partners to fill the gaps, which they will certainly do, and each time this happens it will inevitably erode our sovereignty. Consequently, it may be that the most serious long-term threat to Canada's national security and sovereignty is the fact that our economic performance consistently lags that of the US. In 1980 Canada's GDP per capita was roughly 90% of that of the US, but today it is only about 75%, and this gap continues to slowly widen.

Or, perhaps this is not the threat it appears to be. We don't really know. The true dynamics of this economy – security relationship are neither well defined nor well understood in the Canadian context because it has not been the subject of serious sustained study. This makes it difficult to have any kind of serious factual debate on the subject. We need to invest in the development of a good body of academic research in this area and to this end the CDA Institute is encouraging academics, graduate students, and others with backgrounds in various disciplines to consider studying the many diverse aspects defining the scope, scale, and complexity of the relationship between Canada's economy and its defence and security. As part of this effort, the Institute partners with organizers of the annual Defence and Security Economics Workshop hosted by the Norman Patterson School of International Affairs at Carleton University in Ottawa to sponsor panels on related subjects.

Role of the Defence Industry Sector in Canada's Economy

One area where there has been some ongoing research, as well as a certain degree of policy focus by successive governments, is Canada's defence industrial sector. This body of work by no means covers the full scope of the economy – security relationship, but it offers a good start point for tackling the question.

Defence and security systems typically integrate multiple complex technologies and the companies employ disproportionate numbers of scientists, engineers, technologists and technicians compared to many other sectors. In other words, they offer exactly the kinds of jobs and opportunities for Intellectual Property development and exploitation that the Finance Minister's Advisory Council has identified as being key to Canada's economic future.

The question remains, however, whether Canada's defence industrial sector, as it exists today, is as effective as it can be or needs to be – either as an important foundational element of the country's defence and security capabilities or as an engine of growth in the wider economy. In order to answer this question, much more research is needed to:

Develop a clearer and more comprehensive understanding of the “as-is” condition of the defence and security industrial sector in Canada, including supporting and enabling government policies, programs, and plans. There is also a need to identify and explore issues that should influence and shape the future evolution of Canada's defence and security industries, both in terms of meeting the country's strategic defence and security needs and enhancing the sector's contribution to the wider economy.

The articles in this edition of On Track by Ugurhan Berkok, J. Craig Stone, and Renaud Bellais, with a heavy focus on offset policies and their implications, aim to dissect and provide solutions for the issues central to Canada's defence industrial sector.

DEFENCE INDUSTRIAL POLICY, PROCUREMENT AND OFFSET MULTIPLIERS

Author Ugurhan Berkok

INTRODUCTION

Mandatory offsets in defence procurement are policy instruments used by forty or so countries to leverage their procurement contracts to develop domestic industries either for operational and strategic reasons or for economic development objectives otherwise-called infant-industries.[i] These policies amount to import substitution by using quotas imposed on the prime contractor that, effectively, a large percentage φ of the value of the procurement contract be invested in the purchasing country. “The amounts invested to meet obligations are therefore very different from the overall value generated by offset projects. When a company wins a government procurement contract which is subject to offset obligations, it becomes what is known as an obligor and signs both the main contract for the product being sold with the contracting entity and a second offset contract, which creates local value, with the government of the contracting entity. The obligor then has to produce the obligation percentage through projects which create value added in the buying country.”[ii] This infant-industry policy[iii] gives rise to imaginative procurement agency regulatory instruments, such as offset credits, and prime contractor strategies especially in developed market economies where the opportunity cost of the policy could be high as those defence industries seeking and enjoying protection do not necessarily exhibit potential comparative advantage. While it is true that such costs can always be outweighed if the value to strategic and operational needs happen to be high, sound benefit-cost studies will establish the net value of those projects. Since benefit-cost studies are either inexistent or ignored, resources transferred from efficient sectors, with their high opportunity costs, are rarely incorporated into offsets implementation decisions. Operational security needs may necessitate offset arrangements, arguments for using offsets for economic and other strategic objectives[iv] abound, especially from the perspective of local industries advocating for both arguments.

OFF-THE-SHELF VERSUS UNDER-OFFSETS ACQUISITIONS

The direct offsets[i] process works as follows. First, under an off-the-shelf acquisition policy[ii] as a benchmark, a portion D0 of the value of the contract C0 would normally have been generated through production in the domestic economy.[iii] As the prime contractor is typically a consortium including domestic partners, these latter would originate from internationally competitive sectors and the inputs they produce will cost no more than international competitors' prices. The remaining portion of the contract, i.e. M0 = C0 – D0, would be the cost of components manufactured abroad and, of course, the cost of the final assembly.

Second, under an offsets policy, a portion of the remaining value M0 consists of parts that would not have taken place domestically under standard business decisions but the prime may now find it profitable to expand the domestic production of components by an amount D to avoid offset obligations applicable to remaining imports M at an offsets rate of φ, which stands at 100% in Canada. The cost of the acquisition under an offsets policy becomes

C = D0 + D + M(1 + φ) > D0 + D + M > D0 + M0 = C0.

We note that the second inequality would correspond to a mandated import-substitution policy where a portion D of M0 is required to be produced domestically but resulting imports are not subject to mandated domestic investment or new business activity generated at the rate φ. We also note that the higher cost is due, first, to a higher production cost of components whose production is repatriated and, second, to the prime's remaining offset obligation. This third portion, i.e. M(1 + φ), triggers misallocation of resources or an increase in the procurement cost by a fraction of the offset percentage imposed because the prime will build into its bid not only the expected cost increases deriving from inefficiently produced direct inputs D but also the offset-obligation costs.[iv] This latter is due to the mandated new business activity generation which may not be profitable and hence a potential cost item folded into the overall bid.

An illustration of the breakdown {D0, D, M(1 + φ)} is provided in relation to Canada's involvement with 42 aerospace companies holding contracts in the Joint Strike Fighter project. Since these contracts have been won in competition with global supply chains[1], they are at the frontiers of aerospace technology as well as competitive globally. If Canada were to purchase F-35s, the components manufactured in Canada would correspond to D0. Moreover, if Lockheed-Martin concedes to government pressure to switch the manufacturing of further components to Canada, their cost will correspond to D and this cost will be higher than if those components are imported because they would have been manufactured by more efficient suppliers already contracted by Lockheed-Martin. As such, those components are not exportable and Canada would have to pay the cost difference. And, finally, should Lockheed-Martin concede to offsets, it would generate business activity in Canada equivalent to some fraction of , depending on the relevant offset multipliers: The higher the offset multipliers the less costly for Lockheed-Martin to satisfy the required business activity constraint . It must, however, be noted that higher multipliers may induce inefficient investments because multipliers lower the opportunity cost of investing in targeted areas regardless of whether expected returns justify such investments.

OFFSETS AND DOMESTIC INDUSTRIAL ABSORPTION CAPACITY

The local industrial expansion and the offset-obligation investments depend on the domestic industry's absorption capacity[i] as well as the offset-multipliers on offer, the former lowering expansion cost to the economy and hence the procurement cost, and the latter lowering the offset-investment cost to the prime. As multipliers channeling offset investments towards low-absorption sectors generate costly expansions, it is advisable that rigorous benefit-cost analyses be conducted prior to policy implementations.

Absorption capacity can be explained using the traditional economic development concepts of backward (upstream) and forward (downstream) linkages supplemented by a more efficiency-related and recent concept of clusters. The concept of linkage relates to the successive stages in the production of any good. If we considered an aerospace example, the manufacturing of landing gear would need a metallurgical backward linkage and an aircraft factory as a forward linkage in an economic region. The whole process may be integrated under a single roof but, if they are separate, then market coordination intervenes to connect them.[1] The existence of a whole chain of linkages would facilitate a foreign prime contractor's expansion of local production to satisfy the offset requirements whereas a mere existence of metallurgical works would provide for a weaker environment for the expansion.

The former case would then exhibit a higher industrial absorption capacity. This, then, brings us to industrial clusters. If, there exist several metallurgical works in proximity, keen competition for the prime's subcontracts can not only lower costs but also ensure quality and timeliness, and facilitate innovations through various channels. This horizontal cluster may provide the innovation (or IP generation) platform through which firms learn by doing, by commercializing products, by having to compete, by interacting due to proximity, and by imitating. Whereas horizontal clusters over a given product may change by firms leaving the industry and new firms entering, vertical clusters refer to the evolving industrial organization of the stages of production or the changing boundaries of firms in the cluster.

In the current context, the prime's direct-offset-obligation investments are facilitated by the existence of vertical clusters or, more specifically, backward linkages as the forward linkage would correspond to the equipment being procured. If such an environment exists, the absorption capacity tends to be high and the resulting industrial expansion envisaged is less costly as clustered firms gain in productivity through “sharing tailored facilities, infrastructure, and suppliers; matching workers productively through deep labor markets; and learning through dense, knowledge-rich environments that facilitate knowledge exchange and innovation between interdependent firms.”[i]

The process of generating innovation and knowledge involves the following: scientific, technological, and organizational training and substantial learning efforts based on individual experience in production process (learning by doing), commercialization and use (learning by using), in the incessant search for new technical solutions in research and development units or in less formal situations (learning by searching); interaction with external sources, such as suppliers of raw materials, components and equipment, customers, users, consultants, partners, universities, research institutes, government laboratories and agencies (learning by interacting); specific interactions for outsourcing inputs, components or products (learning by subcontracting); or even competitor imitation processes (learning by imitation).

The same cost criteria would apply to indirect offsets as well. Since absorption capacities vary across sectors, the total cost of domestic acquisition will be an increasing function of the mandated offset ratio. In other words, sectors with les absorptive capacity are less efficient and hence costlier. This line of argument explains the increasing marginal cost of offsets.

OFFSET MULTIPLIERS

Offset multipliers provide a conditional discount to the prime for its offsets obligation, the condition being that the prime generates economic activity in sectors targeted under the defence industrial policy.[1] As such offset multipliers relax the constraint to the prime by industrial sector as a dollar of investment into a targeted sector saves more than a dollar to the prime in terms of offset obligations and may lower the cost of offsets to the purchaser because, effectively, multipliers shrink the costly intensive margin. However, this latter effect critically depends on the choice of multipliers: If the sector benefiting from a high multiplier exhibits low absorption then the prime's investment will increase the purchaser's costs while high multipliers reduce the prime's investment cost. A high multiplier is a hidden subsidy to the target sector by inserting a wedge between the buyer's and seller's costs and reduces the effective offset ratio to the sector.

Policy-makers use multipliers to induce the prime contractor to direct its offset-obligation investment in high-multiplier sectors. Intuitively, the use of a high multiplier relaxes the mandatory offset constraint. However, such investments depend on the absorption capacity of the domestic industry targeted. If this capacity is low, import substitution becomes expensive and the prime may rather choose to invest elsewhere. About 20 countries[i], including Canada, India, South Africa and Turkey[ii] use offset multipliers in order to channel such industrial development towards their priority sectors. These countries use differing ranges of offset credit multipliers depending on their strategic priorities.

Offset multipliers are powerful policy instruments provided the prime contractor perceives them to be credible or non-negotiable, i.e. immune to lobbying efforts. Also, from the perspective of the acquisitioning government there are policy recommendations. First and foremost, a uniform offset requirement may not be the best option if absorption capacity is rather low in relevant sectors. Thus a benefit-cost estimate may have to be in order. For example, might bargaining for a price discount on the base platform and then using these proceeds to purchase new technology on the open market be preferable to the offset?[iii] Alternatively, perhaps government could provide direct subsidies to a targeted industry and foster growth more effectively in the domestic economy compared to the offset. Second, when an offset is selected as an attachment to the transaction, the government should construct a well-defined contract specifying (a) a list of products and/or firms in the domestic economy that the seller can partner with to fulfill the offset obligation; (b) a schedule for fulfillment of various stages of the offset obligation; and (c) a penalty clause for non-compliance. Canadian offset policy implementation appears weak in terms of offset arrears and dismal in the evaluation of success beyond the contractual period. Third, the offsets policy raises questions about massive amounts of public funds. First, by raising the cost of acquisition over and above the off-the-shelf prices, the policy generates expenditures. Second, since primes have a time window through which they have to generate the economic activity promised in the contracts, it is as if they carry debts owed to the government. Such debts carry opportunity costs for the government that are not obvious to the taxpayer. Offset audits can generate the transparency that would empower “public-at-large decide whether the losses or profits are worth the original objective.”[iv]

The interaction between offset multipliers and targeted industries' absorption capacities yields the cost of the offsets policy. Ironically, the use of offset multipliers may reduce the offset obligation cost to the prime but significantly increase the cost of expansion in targeted industries with low absorption capacities. As any prime will build the extra cost into its bid price, the use of multipliers may increase procurement costs beyond a simple offsets policy without multipliers. Since particular industries may be targeted for strategic rather than economic reasons under offsets policies, strategic and economic objectives conflict if targeted industries exhibit low absorption capacity. This leaves policy-makers in a bind because strategic objectives can be highly costly to achieve as a result. This inevitable tradeoff may be considered the tradeoff of the past if policy-makers trust strategic partners in an alliance in which case high offset multipliers need not be used for low-absorption domestic industries.[v] The existence of such trust, not only relaxes the “buy domestic” constraint in certain longer term acquisition needs, but may also guide policy regarding overall offsets themselves by necessitating “a serious effort to develop criteria to distinguish between beneficial offsets and detrimental offsets.”[vi] Moreover, stated alternatively: “Since institutions and economic infrastructures differ across countries, governments considering offsets for international procurement need to be cognizant of the efficiency tradeoffs between markets, offsets, and other policies. A prescriptive model is developed that explains these tradeoffs under various economic settings. Mandatory procurement policies that require offsets for all government procurement above a particular threshold are found to be detrimental to the country's welfare.”[vii]

OFFSET CREDITS AND MULTIPLIERS: POLICY LESSONS

A careful analysis of offset policies suggests prudence in structuring and implementation. First, the cost of offsets policy increases if absorption capacity and offset multipliers diverge in opposite directions because a high multiplier incentivizes investment whereas the sector has low absorption capacity and the further sectoral production will come at higher costs. Perhaps a more judicious policy would incentivize building the required clusters or backward linkages at a lower cost to precede the development of the sector. Second, offset policies are exposed to risk as sectors incentivized may never develop to become part of global supply chains beyond the offset contract period. This risk exists even if initial absorption capacity may be high. After all, a high absorption capacity may just signal a high likelihood that such sectors will succeed in becoming part of global supply chains as in the case of Canadian companies that won contracts in the Joint Strike Fighter project. Perhaps, in such cases, subsidies may be directed towards export support rather than using multipliers. Third, offset policies expose both purchasing and selling countries to corruption, an area left unexplored in this short article.

Also left unexplored are recent efficiency-improving policy developments such as offset credit banking where the prime can transfer credits intertemporally or exchange them with other prime contractors in offset credit markets. Moreover, primes can speculate in these markets, especially if they have multiple procurement contracts with corresponding offset agreements with the buyer.

OFFSETTING RIGHT: WHAT CAN BE THE RIGHT BALANCE BETWEEN EXPECTATIONS AND COMPANIES' COMMITMENT?

Author Renaud Bellais

INTRODUCTION

Arms-importing countries expect to get the highest return possible from their defence procurement. It is therefore not surprising that the most ambitious of countries have set up an offset policy that looks at industrial and technological benefits domestically. Stakes are important, not only because of the size of military procurement (absorbing billions of dollars each year in Canada alone) but also because offset policies can result in several local jobs, the creation of hi-tech activities domestically and, eventually, the development of new exporting companies thanks to transferred technology and knowhow. This is the reason why offset “obligations” can become a lever for nurturing the domestic economy of the importing country–if managed in a comprehensive approach.

However, some offset expectations are far from being fulfilled, either through local jobs and domestic turnover, or with the creation of sustainable technological and industrial assets. Is it then possible to reconcile short-run expectations and long-run ambitions?

This paper analyses offset requirements from a European perspective, through the lens of major arms-producing countries and their companies committed to international contracts. How to work together with arms-importing countries to make offsets right? What are the valuable experiments to help design the most effective defence industrial policy linked to offsets?

OFFSETS AS A CHALLENGE FOR A MEDIUM-SIZE COUNTRY

For medium-size arms-exporting countries like France, the United Kingdom, Germany or Italy, there is no choice but to accept offset requirements from importing countries in order to be able to export. Indeed, domestic orders are not sufficient to guarantee a sustainable domestic defence technological and industrial base (DTIB). Exports constitute a means to lengthen production series and then help preserve the competences of the domestic DTIB. This is necessary not only to reduce unit prices but also to avoid gaps in production schedules that could occur if production would rely only on domestic orders. Such gaps are likely to result in the loss of competencies and knowhow that would damage the sustainability of the DTIB.

Therefore, most European companies have been very committed to accept offset requirements with the support of their home country. Winning export orders is a sine qua non condition to maintain a vivid DTIB when domestic orders are not sufficient.

We should keep in mind that this trend is also perceptible inside Europe, as arms production is concentrated in few countries. Many European countries just have a limited DTIB. Nevertheless, these countries expect that arms imports will go along with some industrial workload as well as production and technological transfers for the domestic industry. This is the reason why European major companies have developed an expertise to satisfy the requirements of importing countries inside as well as outside the European Union.

However, offset obligations somehow contradict the reasons why European companies and countries export: the sustainability of the domestic DTIB in order to preserve some level of strategic autonomy. Indeed, transferring production and technology to third countries and companies is likely to reduce the benefits for sustaining the DTIB of the exporting country. A share of the workload must be withdrawn from the exporter's DTIB. Eventually, technology transfers can create possible competitors, which would not only substitute for its own companies at domestic level but also compete with them on international markets (either for end-products or for components and subsystems).

This is the reason why exporting companies have to find the right balance between fulfilling the offset requirements of potential customers and preserving domestic activities in their home country, notably in order to nurture the appropriate level of innovation.

DO NOT CONFUSE MEANS AND OBJECTIVES

Offsets can have economic and social grounds (which represent the motive for offset policies historically), but they also represent a legitimate means to achieve sovereignty. Even though not all countries expect to set up a comprehensive DTIB, many of them want to master some critical competences necessary to prevent exporting countries from imposing restrictions in the use of acquired capabilities or in maintaining and retrofitting them throughout their lifecycle.

In the short run, offset obligations can have social and economic benefits for the importing country. Since the 1950s, non-producing countries have set up offset requirements in order to counterbalance the financial and economic impacts of importing defence capabilities. Therefore, exporting companies are compelled to buy local content, to create local industrial jobs, requiring high skills and remaining sheltered from offshoring, and to transfer technologies. Working for defence needs also favours the development of advanced competencies, which go beyond the sole DTIB and constitute a driver for research and innovation, pulling upwards the competitiveness of the domestic economy. In some arms-producing countries, defence procurement can even represent a substitute for innovation and industrial policy.

Nevertheless, quite often, these social and economic dimensions go along with political goals. In fact, a domestic DTIB constitutes the technological and industrial way to enforce a country's sovereignty. Even if jobs or domestic activities are looked for, the emergence of a relevant DTIB appears as the main objective of several arms-importing countries as stated in recent years from India to Canada, from Poland to United Arab Emirates. Therefore, how can offsets achieve this objective?

We could wonder whether sometimes means and objectives are not confused. We could consider that offset policies achieve their political aim if and only if they contribute to set up a sustainable and competitive domestic DTIB able to fulfill the needs of national armed forces (or, at least, a sustainable domestic technological and industrial base contributing to this objective). However, it seems that, sometimes, short-run political targets overwhelm long-run strategic objectives. Indeed, many decision-makers prefer aligning the timescale of offsets with their own political horizon. However, quick wins are unlikely to deliver sustainable outcomes.

Indeed, offset policies help create jobs and spur production domestically but long-run assessment (1) underlines that offset policies do not help create large or sustainable activities inside the importing country. Quite often, these activities are limited to the side production of a given import contract. There is no guarantee of any follow-on or side projects. Moreover, local companies do not access the most advanced technology and knowhow that would allow them going beyond transferred or subcontracted production or services. Technology transfers are now usually included, but they remain limited and rarely favour a sustainable domestic industry able to develop innovative and competitive domestic projects.

Many companies resulting from offset obligations are likely to eventually stagnate or decline, being limited to a role of supporting in-service fleets. It is quite unlikely that these companies can take part of international defence value chains. This is the reason why many offset-related local activities are likely to become “white elephants” rather than the spearhead of the domestic industry and innovation (especially when the domestic economy is not able to absorb transferred technology and knowhow).

Even when offset requirements delivers some results, they are far below what we can expect from free investment and localisation decisions from companies (which would lead to the concentration of arms production in very few countries due to several barriers to entry from required investment to scale and scope economies). As The Economist underlined: “Imagine that Apple could sell iPhones in Brazil only if it ploughed 20% of its projected revenues there into local technology firms. That may sound absurd, but this is what happens when governments buy arms from foreign contractors.” (2) Offsets appear as a second-rank solution since public regulation significantly modifies the choices of economic agents. Such misallocation of resources is the reason why the World Trade Organisation (WTO) banned offsets, which are still allowed in the realm of defence because military goods is excluded from the perimeter of the WTO.

Thus, it is not surprising that many countries (like Poland with F-16s or South Korea with helicopters and, more recently, F-35s) appear disappointed by the stalemates of offset policies or the underperformances of their outcomes. These latter can favour a domestic production but with a limited growth potential beyond a given programme or with reduced perspectives of diversification in the long run. In addition, offset-related activities can have a limited integration into the domestic industry or innovation system.

Additionally, even when offsets policies aim at strengthening the domestic DTIB, a comprehensive strategy is required to nurture a local industry in the long run and to favour its insertion into international value chains for defence capabilities.

Offsets must be considered as a divergence from an industrial rationale, as they create duplications internationally and disturb ex ante value chains, but the objective of reinforcing national sovereignty can legitimise their existence. As defence procurement is by essence a sovereign decision (as stated in the Marrakech Agreement that founded the WTO), it is then relevant to define the best ways to guarantee that offset policies achieve these objectives.

OFFSETTING RIGHT: THE PARTNERSHIP APPROACH

Most offset policies define how to implement requirements, but they can be less clear on the reasons why requirements would truly benefit the local economy and, more particularly, the domestic DTIB as a lever to support armed forces. However, the development of a DTIB supposes a long-run approach. Pointillism is not an option, since an ever-changing policy can only deliver poor results – except if one country just wants to get jobs and compensate imports.

If the ambition consists in affirming the national sovereignty, then the spirit of offset policies should evolve towards a partnership strategy. It seems quite impossible to build up an effective DTIB from scratch only by requiring exporting companies and countries to transfer a complete industry off the shelf. For instance, both India and Saudi Arabia tried for decades to nurture a domestic DTIB with limited success. This it the reason why India promoted its “Make in India” objective under Prime Minister Modi while opening defence industry to private and foreign investors. Similarly, Saudi Arabia changed its approach by creating SAMI (Saudi Arabian Military Industries), a state-owned company leveraging on compulsory partnerships with foreign companies, as a sine qua non condition to access defence markets locally, to ramp up its own capacities. Developing an effective DTIB takes time and it is far from being a quiet and easy way. This is the reason why, beyond offsetting arms imports, international procurement constitutes an opportunity to develop a long-run partnership with the exporting companies. This requires an ability to fix long-run targets and to avoid overestimating the benefits linked to import contracts while remaining ambitious.

Very few countries have succeeded in implementing effectively such strategy. Nevertheless, the trajectory of South Korea and Turkey proves that this is possible as we demonstrated in a previous research (3). Since the turn of the century, both countries were able to turn import contracts into transformative forces that have been nurturing a stronger and stronger domestic DTIB. For instance, both South Korea and Turkey now expect to produce a domestic fighter aircraft with sufficient local content by the middle of the 2020s. How did these countries manage such a transformation? These results are quite impressive since these countries were not able to extract more value from offsets than other countries over several decades. What has changed was the adoption of a comprehensive approach of offset policy, which favours the selection of suppliers accepting to commit to a true partnership with domestic companies that helps nurture their own DTIB.

The field of helicopters can illustrate such strategy. South Korean KHP and Turkish T-129 Atak programmes served as a major lever for preparing a more indigenous programme for the next generation of platforms. Offset requirements were built up in order to maximise local content, but incrementally, and transform domestic companies into partners of international suppliers in a long-run perspective. In each case, the selected supplier was a European company (Eurocopter in South Korea and AgustaWestland in Turkey), since they were the only ones willing (and able) to develop a true partnership with the local DTIB. Their American counterparts rejected such extensive requests.

What does precisely such partnership spirit mean? South Korea and Turkey chose to limit the short-run economic and social benefits from offsets in return for benefitting from a support that exporting companies provided to local companies in order to master technology and knowhow necessary to increase their autonomy. From suppliers these local companies became partners of exporting companies for a co-development of parts of the capabilities.

Through this approach, domestic DTIBs did not become autonomous rapidly, as expected in previous approaches, but they were able to increase their scope and competencies incrementally in order to master parts of defence capabilities. This step-by-step approach is only possible because of this co-development process that truly facilitates the absorption of foreign technology and knowhow. In such approach, ambitions are more limited in the short run but more realistic in terms of domestic capacities and their betterment. Nevertheless the progressive improvement of the domestic DTIB can secure a bigger role for the local companies in the long run and eventually give them the opportunity to become partners in international value chains (like what happened, for instance, for Chinese companies in civilian aeronautics).

South Korea and Turkey accepted to reduce short-run benefits from offsets but bet on the potential development of a sustainable domestic DTIB. Their success story proves that offset policies can become a win-win approach when interests of all stakeholders are aligned. However, is it possible to systematize this approach?

These examples proves that a comprehensive approach of offsets can deliver long-run benefits without sacrificing local social and economic impacts. However, this is achievable if and only if the offset policy relies on a long-run strategy that nurtures the rise of a domestic DTIB able to take part of international defence value chains.

DEFENCE PROCUREMENT OFFSETS AND THEIR ECONOMIC VALUE IN CANADA

By J. Craig Stone

INTRODUCTION

Most economist have a negative view on the issue of offsets and there is a significant amount of literature that questions the long-term value of offsets. Kogila Balakrishnan made the point that “both theoretical and empirical discussions, mainly in the form of case studies, by the majority of the economists conclude that offsets overall has had very little positive impact on economic development.” Critics of offsets often refer to them as a “free lunch” and ultimately someone has to pay for the benefits. This is in contrast to Ron Matthews' work on offsets that notes offsets are enjoying “compound annual growth of 3.5 percent, with obligations expected to increase by 36 percent between 2012 and 2021 to reach a cumulative total of more than $425 billion.”This does not mean economic benefits are directly related to offset growth but rather to note that the literature covers a wide spectrum of issues and readers must be clear about what they are reading and what the reading is intended to argue.

Offsets are mandatory requirements in most countries and governments continue to view offsets as beneficial for economic development, technology transfer and industrial benefits. The World Trade Organization rules do not allow trade offsets with defence/national security being the only notable exception The national security exception clause is what allows nations to make defence procurement purchases with some sort of offset expectation and/or to favour their own national defence industries. More specific to the Canadian case, the North American Free Trade Agreement (NAFTA )(soon to be USMCA) has a similar clause but government's in Canada have historically chosen competition rather than exercising the national security exemption. The reasons behind this are two-fold. First there is a belief that competition leads to a better price and second, the interprovincial trade agreement between the federal and provincial governments makes it politically more difficult to exercise the national security exemption. This has changed more recently under the current government.

A related but somewhat separate issue is that the European Commission gave direction in 2009 that limits offsets in defence procurement and argued that offsets were “a distortion of European trade” and that banning them would lead to a European defence industrial base that would be cost effective and more competitive. The direction is actually intended to limit the defence procurement to only those occasions where nations in the EU can justify the requirement for national security exemption. Nevertheless, nations are still engaging in defence offsets despite the directive. Mathews and Ansari note that member states are reluctant to lose the perceived economic benefits that offsets provide and consequently offsets will become less transparent and “Subterfuge offset will likely evolve, packaged under different forms, such as joint ventures, partnerships and interconnected but undisclosed investments.”

It is important to note that there is a significant amount of literature on offsets using a variety of approaches to study the issues. Unfortunately, the empirical evidence to support the argument that offsets are good or that offsets are bad is contradictory. Part of the reason for this is that offsets are often conducted in a veil of secrecy and confidentiality in order to protect national security and commercial intelligence information. What then is the appeal for offsets when most evidence appears to suggest they are not beneficial and how does Canada approach the issue?

The intention with this article is to look narrowly at Canada's approach to offsets in defence procurement. Canada's approach to offsets has evolved over time and its latest 2018 Industrial and Technological Benefits Policy falls into the category of mandatory offsets with a focus on Direct offsets vice Indirect Offsets. Although offsets are not just a defence issue and can apply to other types of public procurement activity, this article will focus on defence issues as the most significant aspect of offsets in the Canadian context. In order to frame the discussion on Canada's approach it will be useful to first provide some context and definitions about offsets.

Offsets in General

There is no simple way to define offsets. It can be as generalized as the OECD definition of “an offset is any pledge or commitment made by a seller to the purchaser in order to win the business” and as detailed and specific as the Bureau of Industry and Security of the US Department of Commerce with specific definitions for an offset agreement, an offset transaction and offsets in general. It is also important to note that the literature on offsets can be complicated by its entanglement with what can be perceived as more controversial arms trade issues. The General Dynamics Land Systems sale of light armoured vehicles to Saudi Arabia is a recent example of such a controversy. Various terms like commercial and industrial countertrade, bilateral government trade, economic cooperation agreements, coproduction, license production, Subcontractor production, to name just a few, can all figure prominently in offset deals.

The US government considers offsets “to be “economically inefficient and trade distorting” and prohibits any agency of the U.S. Government from encouraging, entering directly into, or committing U.S firms to any offset arrangement in connection with the sale of defense articles or services to foreign governments.” Despite this prohibition, the Bureau of Industry and Security (BIS) notes that “U.S. defense contractors have informed U.S. Government agencies, including BIS, that offsets are usually necessary in order to make defense sales – sales which can help support the U.S. industrial base.” The BIS'annual report to Congress in April of 2019 indicated that in 2017 “21 U.S. firms reported concluding 543 offset transactions with 29 countries to fulfill offset agreements.”

Most nations have a mechanism in place to capture offset obligations and ensure companies are fulfilling their obligations. Nevertheless, the awarding of large defence contracts is a political issue and there will always be individuals and companies critical of the government decision. Reasons behind decision are not always made public because of issues of intellectual property and corporate secrecy. This perceived lack of transparency adds additional ‘evidence' to those critical of both arms sales and government decisions and that offsets distort prices, promote inefficiencies and encourage corruption. The Counter argument to the transparency issue is that offsets “are regarded by the defence industry as commercial arrangements and therefore subject to legitimate business confidentiality, allegations of offsets being insufficiently transparent are therefore misplaced.” Despite the criticism, most government continue to demand offsets when purchasing defence equipment and defence companies expect that to continue. With no expectation that this will change, the requirement is to have a policy that is both effective at providing economic benefit to the nation while not adding significantly to the cost of the acquisition.

Canada's Industrial and Technological Benefits Policy

Canada has utilized offsets for defence procurement since the mid 1970s's and its policy has evolved since that time. Unlike many nations, Canada has a unique relationship with its neighbour to the south and any discussion on the evolution of Canada's approach to offsets needs to acknowledge the history of this relationship, the establishment of the Defence Production Sharing Arrangement (DPSA) and the Defence Development Sharing Agreement (DDSA), and how that has influenced the evolution and development of Canada's defence industrial base. The establishment of these agreements recognized that Canada was not large enough to sustain and support a full scale integrated defence industrial base. Today Canada's defence industrial base generally provides specialization in sub-systems and components as tier two and three suppliers to larger original equipment manufacturers (OEMs). There are exceptions to this such as General Dynamic Land Systems and the production of Light Armoured Vehicles and the building of ships by Irving and Seaspan.

Canada's offset policy has evolved from its initial stages in the 1970s where the obligations were focused on companies conducting economic activity in Canada with a regional benefits focus to the policy structure today that is much more focussed and structured on areas desired by the government.The most recent 2014 offset policy updated the Industrial and Regional Benefits Policy to an Industrial and Technological Benefits Policy with a value proposition. Significantly the inclusion of industrial benefits has shifted from a pass/fail requirement in the bid assessment to a scored and weighted assessment along with technical merit and cost.

In terms of the economic benefit and the arguments about the efficiency and effectiveness of offsets, the new policy is now connected to Canada's key industrial capabilities and could force industry to think more strategically about how they develop their offset packages as part of a procurement bid The government notes that “The introduction of KICs represents a strategic approach to leveraging economic outcomes” and that “with the introduction of KICs, industry will have greater predictability on where to focus investments in preparation for upcoming procurements” The government makes the argument in its ITB policy that the policy will leverage the significant investments in defence to support

  • the long-term sustainability and growth of Canada's defence industry
  • the growth of bidders' Canadian operations as well as their suppliers in Canada, including SMBs in all regions of the country;
  • enhancement of innovation through research and development (R&D) in Canada;
  • increase the export potential of Canadian-based firms; and
  • promotes skills development and training to advance employment opportunities for Canadians.

In its 2019 annual report on the ITB policy, the government notes that the IRB and ITB policies have generated close to $47B in economic obligations since 1986. The breakdown of this $47B is $36.1B is completed work, $7.1B is in progress and $3.7B remains as future work. The challenge is that this is based on what industry has told the government and not necessarily based on a critical evaluation by a third party on the real value that is being contributed to the Canadian economy.

Table 1 summarizes the annual economic impact discussed in the ITB annual report. The report also identifies the regional distribution of benefits as well as benefits for SMEs, research and development activities and export opportunities for Canadian industry

Table 1: Annual Economic Impact Issues

Direct Indirect Induced Total
GDP Economic Impact $2.3B $1.3B $1.1B $4.7
Jobs Economic Impact 21,620 12,847 11,212 45,679

Source: ITB Policy 2019 Annual Report,4.

Importantly, the reader should also be aware that both the Canadian Defence and Securities Industries Association and the Aerospace Industries Association also provide reports from ISED and Statistics Canada surveys on the economic impact of their respective industries and the values for both are significantly higher based on the success of Canadian industries to export to other markets Data like that contained in both of the reports is the type of data utilized to support the benefits of governments imposing offsets obligations on defence contractors. The difficulty is that governments do not provide an assessment of the offset premium or how much more expensive equipment is because of the offset obligation. As discussed at the beginning of this article, the literature argues for both perspectives in terms of the economic benefit or not from offsets. However, the literature is also clear that firms price-in the cost of diverting production to countries. In discussing Australia's explicit policy of “no cost premium” expectation” Brauer and Dunne note “But this is illusionary. The administrative cost of off sets alone is believed to cost arms sellers anywhere from 7 to 10 percent of contract value (Markusen, p. 71), and this cost must be recovered in some form. In practice, many countries recognize and pay for the additional cost.”

Looking ahead, industry expects national practices requiring offsets for defence purchases will continue. That means the dichotomy of standard economic theory arguing that “offsets are economically inefficient and welfare-diminishing reflecting trade diversion rather than trade creation will continue to struggle with the reality of “compound annual growth of 3.5 percent, with global obligations expected to increase by 36 percent between 2012 and 2021 to reach a cumulative total on more than $425 billion What is required in the Canadian context is for ISED to continue down the path it has started to better measure ITB contributions. Both ISED and the defence industry need to be more transparent with Canadians on what the cost of providing ITBs is for a procurement and what economic benefits are being achieved by those ITBs.

https://cdainstitute.ca/on-track-25-28-feb/

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