PRIVATIZATION IN NACC COUNTRIES Defence Industry Experiences and Policies and Related Experiences in Other Fields COLLOQUIUM 1994 ********* COLLOQUE 1994 PRIVATISATION DANS LES PAYS DU CCNA Experiences et politiques des industries de defense et experiences comparables dans d'autres secteurs Colloquium 29-30 June, 1 July 1994 Brussels ---------------------------------------------------- DEFENCE INDUSTRY PRIVATIZATION: THE BRITISH CASE Michael Bell Defence companies in the UK were treated differently from other nationalised industries in the UK's privatization programme. They were sold or floated on the stock market, some as a whole, and some broken up. The government retains a "Golden Share" in three key companies to protect the national interest but the bottom line is that the market rules, and this has been reinforced by the Ministry of Defence's adoption of procurement policies based on competition. This process has not been painless in an era of falling defence budgets; jobs have gone and sites have closed. But the companies have become leaner and more customer-focused. Export orders were a record last year - at no cost to the taxpayer. Michael Bell is Britain's Deputy Under-Secretary of State for Defence Procurement, Ministry of Defence The present privatisation initiatives are commonly regarded as being the result of policies introduced by the Conservative Party which came to power in 1979. Their intentions for privatisation went much wider than defence, though naturally this presentation deals only with defence. If we look at their manifesto we see that it "strongly opposes" the Labour Party's nationalisation plans and that it will "offer to sell back into private ownership the recently nationalised aerospace and shipbuilding concerns, giving their employees the opportunity to purchase shares". It said that in order to become more prosperous, Britain must become more productive and the British people must be given more incentive. State spending was to be reduced and instead of relying on state intervention, industries were to become more responsive to market forces. The three key factors in the strategy, which was designed to revolutionise UK industry, were relaxation of state controls and increased privatisation and competition. However, there was no distinct policy for privatisation with clear set objectives. At that time, privatisation perhaps more accurately described an approach to industrial policy rather than a policy in its own right. The implications of this approach meant that British industry faced a period of tremendous cultural change. It had to change a lot of things at the same time, and quickly, in order to become more competitive and survive. Today's management gurus describe this as "discontinuous change". Defence equipment producers and suppliers were to be treated in the same way as those in other industrial sectors - they were not singled out as a special case. In the eyes of the government, there was no overpowering reason why defence equipment and services had to be provided by nationalised organisations. However, the story goes back even further than that. In 1968, the Mallabar Committee was asked to investigate efficiency in government industrial establishments, with a view to determining whether the existing organisation and systems of control and accountability presented impediments to achieving full efficiency and how these impediments should be removed. In its report in 1971, the committee recommended that the Royal Ordnance Factories and The Royal Dockyards should be given a financial structure more like that of a commercial undertaking and should be placed on a Trading Fund basis of accounting. Consequently, the ROF's were placed on a Trading Fund basis on 1 July 1974, but a decision on the future of the Dockyards was delayed. Fifteen years on, it is possible to say that the major objectives of privatisation have evolved as: - Reducing government involvement in the decision-making of industry. - Permitting industry to raise funds from the capital market on commercial terms and without government guarantee. - Raising revenue and reducing the public sector borrowing requirement (the PSBR). - Promoting wide share ownership. - Creating an "enterprise culture". - Encouraging workers' share ownership in their companies. - Increasing competition and efficiency. - Replacing ownership and financial controls with a more effective system of economic regulation designed to ensure that benefits of greater efficiency are passed on to consumers. So how was this privatisation achieved? The main ways are by being sold to the highest bidder, floated on the stock market or by being split up into smaller units which are then floated or sold off. Other avenues which have been used include management buy-outs and employment of management contractors. These methods, used in defence privatisation, have also been applied to the privatisation of UK national utilities. In each case advice was sought from financial experts on the best method to use. In 1981, British Aerospace (BAe) became incorporated as a public limited company and at that time half of the shares were sold to the general public. In 1985 the Government sold its remaining ordinary shares in BAe. We have a similar story for Rolls Royce, which became a public limited company in '85, and was floated on the stock market in May 1987. The favoured route to privatising Royal Ordnance was initially that it also should be floated on the Stock Market. However, this was impractical within the timescale involved and instead it was decided that it should be sold as a package by way of private sale to the highest bidder. ROF Leeds, which made tanks, was sold separately to Vickers in July 1986, so that the business could be reshaped to meet future requirements. A number of companies submitted bids for the rest of the company. The number of bids was reduced in stages and eventually the company was sold to British Aerospace in July 1986. In October 1989, Shorts of Belfast was sold to the highest bidder, Bombardier of Canada. Prior to privatisation, in a memorandum to the House of Commons Trade and Industry Committee, Shorts stated that "the company is in favour of privatisation because it believes that decisions on investment, and on re-equipment and future development of the business, are best taken in a business environment, based on sound commercial reasoning and without constant involvement of Government/political considerations." In the shipbuilding world, the yards which made up British Shipbuilders were sold off separately by various means, including management buy-outs, during the mid-1980s. As mentioned previously, the Mallabar Committee had recommended that the Royal Dockyards of Rosyth and Devonport, should operate on a Trading Fund basis. The option which was chosen in this case was to appoint a company or companies, to be responsible for the commercial management of the yards. Following open competition, seven-year contracts were awarded in April 1987 to Devonport Management Ltd for the management of Devonport Dockyard, and to Babcock Thorn Ltd for the management of Rosyth. These contracts are almost completed and in May this year we advertised the dockyards for sale. In the interim, the seven-year management contracts have been extended for up to a year. Although the Government has relinquished control of the privatised defence companies, in a few cases special arrangements have been put in place to protect essential national interests. This has been done through the mechanism of a "special share" which the Government continues to hold in some of the privatised defence companies, BAe, Rolls Royce and VSEL. These special shares give the Government the power to veto certain changes to the fundamental rules of each company which are contained in their Articles of Association. The special shares thus ensure some measure of control against the company coming under foreign control, by allowing the Government to restrict the proportion of shares owned by non-UK interests, and to stipulate that the companies' boards have a majority of UK directors. So now we have a situation whereby almost all of our defence industry is in the private sector and although the British Government does hold a "special share" in Rolls Royce, British Aerospace and VSEL, these give no say in the management, development and profitability of the business, which are entirely for the Board and the ordinary shareholders. These companies have had to undertake a very thorough self-examination to make sure that they are in the right market, producing the right goods and that their shareholders, many of whom we must remember are employees, receive the best possible return for their investment. This is counterbalanced with the aims of the Ministry of Defence in buying equipment, which is to achieve best value for money for the taxpayer. At the same time as industry was adjusting to the changes brought about by privatisation, the Department began to increase its use of competitive tendering for contracts. This does not mean that the intention was always to select the cheapest option. When we reach the stage of assessing competitive tenders, we take a whole range of factors, one of which is price, into consideration. We have to determine the best option from those put forward and to assess the risks involved. We need to decide whether we can rely on the tenderer to deliver and whether they have the technical and managerial capability to do a good job to the required standards. When we do look at price we do so within the context of these other factors. The Department's move to competitive, usually fixed price, contracts means that companies have to assess very carefully the costs they are likely to incur. They should be able to make a reasonable profit, but if all other factors are equal, then obviously the company which can do the job the most economically stands a better chance of being awarded the contract. In order to become more competitive as a result of increased exposure to market forces, defence enterprises have had to restructure. Some have had to change direction, many now have radically different cultures and it is significant that they have reorganised their businesses to become more customer-oriented. From the Government's perspective, privatisation has enabled us to pursue our policy of opening up defence procurement as fully as possible to competitive pressures, by removing the inevitable distortion of competition which arises when the Government is both the customer and one of the potential suppliers. The much greater use of competition in defence procurement has produced substantial economies to the defence budget in recent years. It has also ensured that the process of adjustment within the defence industry as a result of the changed international situation is being shaped by commercial and industrial logic to a much greater extent than it would have been had large sections of the UK defence industry remained in public ownership. Divesting ourselves of ownership of suppliers in this way has meant that we have been able to draw a clear line between ourselves as customers and the defence industry as suppliers, and to leave industry free to take the decisions which are properly theirs to make about their future direction and strategy. The culture change which has occurred in the privatised defence industries was well summed up recently by the Chairman of British Aerospace, when he said that the company had changed from a "cost-plus" business to a "cost-conscious" one. This brings us to another benefit which has arisen from privatisation: increased accountability, which applies both to employees and to products. Workers are being given the responsibility to ensure that their own work is of the required standard and are being encouraged to put forward new ideas and to feel that they have a valuable contribution to make to the success of the enterprise. The sharpening up of the UK industry which has come about through competitive procurement policies has not just meant much better value for money for the taxpayer when buying the equipment our Armed Forces require; it has also meant that the UK defence industry has also become much more competitive internationally. 1993 was a record year for UK defence export orders which amounted to more than £6 billion. Turning to strategic capability, we must not confuse loss of capacity with loss of capability. The UK is not in the business of using scarce resources to fund overproduction or inefficiency in the defence sector - private or public. By keeping suppliers informed, we aim to ensure that our needs will be accommodated. We have not lost any strategic capability as a result of the reduction in capacity which has been a commercial decision taken by the managers of these enterprises. To summarise, the UK has found that industry performs more efficiently, effectively and economically if companies are left to run their businesses without the interference of government. There has been a cultural change from "cost-plus to cost-conscious". Government will continue to give high priority to maintaining an effective range of well equipped forces. In a time of change it is important to provide industry with as much visibility as possible of our requirements. We have taken a number of steps to ensure that industry are provided with all the information necessary to enable them to make sound commercial judgements so that they can remain competitive and successful in both domestic and overseas markets. By setting up a customer-supplier relationship with the Department, industry is able to make commercial decisions which will enable us to obtain best value for money for the taxpayer when buying the equipment our Armed Forces require. By giving companies the freedom to exercise their commercial judgement on how to adapt to changing market circumstances, they are in a position to ensure that they have a strong basis for future growth. ---------------------------------------------------------- Copyright 1994 NATO All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means: electronic, electrostatic, magnetic tape, mechanical, photocopying, recording or otherwise, without permission in writing from the copyright holders. Authorization may be requested for redistribution of the text on a non commercial base by research and educational services. Requests should be addressed to the Economics Directorate, NATO, via e-mail 'scheurweghs@hq.nato.int'. First edition 1994 ISBN 92-845-0079-6 This is the latest in a series bringing together papers presented at the NATO colloquia organised by the NATO Economics Directorate and Office of Information and Press on economic issues in the former USSR and Central and East European countries. For further information please write to the Director, Office of Information and Press, 1110 Brussels, Belgium. The articles contained in this volume represent the views of the authors and do not necessarily reflect the official opinion or policy of member governments or NATO.