EDTA: New roles for the Defence industry in Europe
Keynote at the 17th NATO LCM
conference, by Jan Wind, president of the EDTA.
Brussels, 18 May 2022
Introduction
In this presentation, I will discuss the changed security environment, recent developments in the European Union and persistent issues related to Small and Medium Enterprises in the Defence sector. I present some of my views on the effects on the Defence industry. In particular, some of the developments and opportunities related to finance.
Security environment
The Defence industry sector will change rapidly
due to political developments within the European Union and also because the
world is getting less secure.
Many foreign policy experts warn already for a long
time for increased tensions. However, it became a clear and present danger in
February when the Russian Federation invaded Ukraine. A steel-on-steel war most
people did not believe would ever happen again. That assessment proved to be
wrong.
Since the start of this war, western nations are
providing Ukraine with capabilities out of their own inventory. These need to
be replaced, while several European Union member states simultaneously increase
their defence budgets. Germany even with a one-time booster of 100 Billion euros.
The industry will have to adapt and quickly ramp up production. I expect the first contracts
will be let for the production of ammunition and existing models. Hopefully, designs
and parts are not outdated, subcontractors still exist and new production runs
are possible. This first wave will be followed by a demand for new technologies
and innovation.
Capabilities
Still, Russia is not the only increasingly relevant
danger, mentions the Strategic Compass of the European Union. Worldwide
tensions grow with the expansionist strategy of China, the nuclear ambitions of
North Korea and more. Therefore, the Strategic Compass also states that Europe
needs more capabilities in all operational domains. High-end naval platforms,
future air combat systems, space-based capabilities, main battle tanks and
more. These should all be next generation systems full of disruptive and other
innovative technologies. In their Strategic Compass, the European Council expresses
the ambition of the European Union to be the security provider for our
citizens. Quite a change!
However, this was written before the war in Ukraine
started. We now need even more. A lot of simple surveillance drones and armed UAVs,
if possible operating autonomously. High energy laser systems against
manoeuvring air targets and also defence against hypersonic and ballistic
missiles. Europe is now completely defenceless against these weapons being
developed by several potentially dangerous adversaries. To become strategically
autonomous, we also may need hypersonic missiles for use by our own forces.
Unfortunately, it appears to be necessary again in the 21st century,
to defend our continent against an adversary in a high-end steel-on-steel war.
Technologies
For these capabilities, we will need technology and
innovation. The European Commission understands this and published their Communication
on Critical Technologies for Defence in February this year. In this
Communication, an urgent need for new technologies is expressed.
The conclusion states: As the race for new technologies continues, the Member
States should reinforce cooperation to reduce strategic dependencies. To
support this, the Commission will establish an Observatory of Critical
Technologies that will lead to technology roadmaps for the Member States to
implement.
In my view and politely said, this bureaucratic process does not sound like a real
quick start in a race for new technologies.
To improve effectiveness, I would propose the
Commission to develop structured interaction with industry. For example in
specialised knowledge networks. Not only with OEMs, but also with innovative SMEs
throughout Europe. Otherwise, interpretation of the roadmaps, budgeting and
contracting of technology and product development may take years, which we
don’t have in a race for new technologies.
To win the race, faster and more effective decision and tendering procedures
are needed to introduce these innovations into our forces.
Funding Innovation
How could the industry assist to speed up this race?
Probably not by taking all the risks themselves, while expecting that
government will pay in the end. That has proven unsuccessful in the past.
However, new concepts are in the making. The Strategic
Compass mentions that the Commission will take measures to promote and
facilitate the access to private funding for the defence industry.
In the Communication on Critical Technologies, an Investment Blending
facility is announced. Believe it or not, this blending machine is intended
to mix 30% public and 70% private funds in a way that intends to be particularly
effective for innovative SMEs.
If private funding indeed could be used effectively,
innovation could speed up. It would not be necessary anymore to wait
several years until national budgets and contracts are approved, coordinated
and implemented.
Similar novel financing methods could also be used for
production and in-service support. The current method of upfront cash payment
for capital goods, like fighter aircraft, navy ships and ground-based combat
systems, is not used anymore in other industries.
All is however dependent on the plans the European
Commission develops in the next 12 months or so. Our EDTA working group on
finance is working with the Commission on this matter, but there are no detailed
plans yet.
Industry
Meanwhile, innovation in the Defence sector is not driven by ambition or great ideas of
engineers and operators, but by carefully manicured risk-free contracts of the
MoD. Likewise, the industry does not demonstrate the broad-minded and unselfish
responsibility for European security as desired by politicians.
Can we blame the industry for that? I don’t think so.
Unselfish behaviour quickly leads to bankruptcy. Certainly for SMEs. This means
that continued requests of the European Commission and National Governments to
co-finance and take risks may not have the desired effect. Even industrialists, like many of you, understand perfectly well how important our
security is. As the Americans say: You cannot take political will to the bank.
A complicating issue is the ever-increasing amount of legal
rules and tendering procedures making life miserable both in government and
industry. Solutions are hard to find and it seems that the European Commission
as a new customer in the defence sector does not make it easier.
I believe that governments, military and politicians
need to understand that a sound and reasonable business model is necessary for the industry to survive.
Moving as much risk as possible to contractors currently is the standard policy of
procurement offices. If possible without compensation. In practice, this
attitude increases the price and decreases flexibility.
I would suggest that governments take those
risks, they can influence themselves. That could save a lot of money and
frustration. Certainly in your domain of Life Cycle Management. Estimating risk
over the lifetime of combat systems takes a lot of assumptions that are hard
to predict with any level of certainty. And any risk will add to the product price.
As an example, over the last 6 years, the Netherlands
MoD tried to force the industry to estimate and contract 30 years of maintenance
for their new submarines. From delivery in 2033 until the scheduled end of life in 2063.
However, the design of the submarines was not even started. As far as we know, the industry refused politely, but persistently.
It seems a smart move that the Netherlands MoD now has decided to take this
risk themselves and postponed contracting of maintenance to a later stage.
Standardisation
At system
level, standardisation has long been an almost unbeatable barrier. Member States and
procurement agencies have their national requirements that lead to unique and
often incompatible systems.
Unexpectedly, the current intentions to spend larger
defence budgets may help here.
Germany and the Netherlands now intend to purchase
exactly the same armoured vehicles. One model is carefully selected and
contracted by the German MoD. The other by the Dutch. No more separate tenders as
they lack the capacity to handle these.
If joint contract handling like this becomes the standard
it will have positive consequences for the industry. Hopefully less dependency on unique
national requirements, fewer differences in design and more effective
competition.
New customer for the defence industry
Still, most companies in the Defence industry are focussing
on their national customer. Maybe not all OEMs, but certainly medium-sized
companies and smaller do so. In other industries, a much broader network exists
throughout Europe and uses regional excellence and capabilities.
Consequently, many research and product development
activities in the Defence industry are duplicated, triplicated or even more. Politicians continue to
urge that this practice should change, but my guess is that it will not be
resolved as long as procurement continues to be conducted on a national level.
Since the European Defence Fund finally started this
year, another player came to the table. The Commission is going to contract
technology and innovation centrally for our Union. Including required
co-financing, the EDF will comprise up to 30 Billion euros for R&T and product
development until 2027. Not just petty money. As MoDs and industries in at
least three Member States have to participate in each proposal, the national
focus will become less and gradually shift to excellence and capabilities.
However, when a company does not participate in a proposal,
it will not win the grant for sure. I have already seen proposals where a
consortium won the contract, while similar technology and systems are already
available in Europe. Manufactured by another company that did not participate
in the tender. Will that company survive?
I believe that the industry should anticipate these changes. Every company, OEM or SME, is aware of their specialisms and level of excellence. They could and should try to use that as their focus area. Within the EDF, focus and excellence in a particular area of activities could lead to a broader customer base than only the national MoD. It will also increase the attractivity of these companies to private investors.
Innovation and participation of SMEs
And now some words on the persistent issues around the involvement of SMEs in the Defence industry.
Already for a few decades, the European Commission is developing
policies to involve SMEs in our industry. Unfortunately, these are not very
effective. As in many economic studies is stated: SMEs are the source of
innovation in modern society. In my analysis: except for the defence industry.
Unfortunately, the EDF policy to involve SMEs for at least 10% of the project
costs usually is only effective for the duration of the project. Upon completion,
participants continue along their own path. In the rules of the European Commission, it is not required or
even permitted to stimulate consortia to stick together after the completion of the
funded project. Usually, prime contractors do not have any reason to do so
either.
In my view three elements are important in the involvement of SMEs in the Defence sector:
- The first is that cross border
involvement of SMEs in Europe often incurs barriers of language, culture and
distance. Business in Spain is different from business in Germany or Bulgaria,
though all three language and cultural areas may have their competitive
advantages. It is hard to manage a Bulgarian subcontractor from Spain. So it imposes a risk
for your company, you better get rid of.
It is hard to manage a Bulgarian subcontractor from Spain. So it imposes a risk for your company, you better get rid of. - The second element is that involvement
of cross border SMEs actually may not be desirable in the defence industry from
a logistical perspective. At the start of the war in Ukraine, we saw that relatively
low tech work like the production of cabling for the automotive industry near Lviv
ceased. Long supply lines may be a risk in times of war. That is unpleasant for
the automotive industry, but could be dangerous for our security.
- The third element is that innovation by SMEs in other sectors thrives because of the ecosystem where venture capital investors invest in multiple start-ups. OEMs purchase the few successful companies for big money. Usually, these start-ups are located near a large OEM. This ecosystem minimises the innovation risk of an OEM. They only adopt and introduce successful products! Yes, they do so for a high price, but don’t forget that 80-90% of the venture capital is not successful. Within the policies of the EDF however, statistically also these 80-90% of failures are fully subsidised.
In my opinion, the European Union policy towards SMEs
in the defence industry should be changed to look like the successful ecosystems
in for instance automotive, healthcare technology and the pharmaceutical
industry. Startups and other SMEs are located relatively close to an OEM or a very
large contractor. They are funded by venture capital en either grow
independently as suppliers, or their technology is purchased by an OEM. If not
successful they will go bankrupt and the venture capital investor loses their
money.
Where the market fails as it did and does in the Defence sector, the government
should not take over risk and fund all innovation, but use other instruments
like guarantees and innovation partnerships.
And indeed, in the recent Communication on Critical Technologies, you will find
the so-called Investment Blending Facility I mentioned before. This is
where the Commission intends to mix private money, government money and
guarantees into a fund, useable for innovative SMEs.
However, from the perspective of the financial sector, this will not be easy. It will remain hard to fund high-risk innovation
projects. It is not likely that investors will take the risk to lose a part of
their investment, even in a blending facility with certain guarantees of the
European Commission.
In my view, it would be more promising to create private financing opportunities
for large projects at low risk. Within such projects, a small part of the funds
could be used for innovations at a higher risk level.
Shakeout in the Defence industry
Meanwhile, according to the Strategic Compass the defence
industry is still scattered over Europe. Is that bad? Other industries like the
automotive sector are just as scattered or even more. Is scattering the reason
for concern, or is it overcapacity, inefficiency and a multitude of overlapping
products?
Maybe industries that receive the majority of their
contracts from their national MoD are not as efficient as they should be. If that
is true, a shakeout could occur during the shift from national procurement to
more influence of the European Commission through the EDF and more cooperation
due to other factors.
The current industrial participation programmes
in Europe do not help to converge and focus either. OEMs are required to build
production plants in Member States purchasing their equipment. When their
initial deliveries have been completed, these subsidiaries will try to find
other customers. This will be hard and probably increases scattering and
overcapacity.
As an example, naval dockyards are currently being built or re-activated in Belgium,
Germany and the Netherlands for their new shipbuilding programmes, while the
existing overcapacity in the shipbuilding industry is well known.
So, no doubt there will be a shakeout of industries over
time. Maybe a bit slower than expected until the beginning of this year, due to
the war in Ukraine.
Which industries will fail in the shakeout we don’t know, but my expectation is
that those who actively participate in a more European approach will have the
best options.
However, a shakeout may not be as bad as it looks. This has happened in many industry sectors in the past. In the end, it led to networks of smaller and more efficient companies. In the Defence sector, companies mainly involved in system development and integration may become the winners.
Environmental, Social and Governance Criteria
About a year ago the issue of Environmental, Social and Governance criteria occurred in the Defence industry. Suddenly, some companies could not attract investors anymore. Others reported they were even refused to get a regular bank account. Why was military equipment suddenly becoming that much unattractive in the financial sector?
It turned out that the change in attitude occurred due to a new expert group of
DG GROW. This Platform on sustainable finance was established in October
2020. It published a draft report on Social Taxonomy in July 2021 and a
final report in February of this year.
The intention of the report is that private investors should no longer invest in companies where more than 5% of their turnover is generated by socially undesirable products, like tobacco, gambling, fossil fuel and Defence. We are in good company!
This limitation is intended to become in effect in
June 2024 and only for a limited set of investors. So, it does not look that
bad. However, the financial sector anticipates this Directive and step by
step discontinues its role in companies involved in defence capabilities.
Even the Thales pension fund in France is not allowed to invest in their own company
anymore.
At this time the European Commission points out that
in the final report of the expert group only controversial weapons like
cluster munitions and chemical weapons are mentioned. So we don’t have to worry.
Our observation however is that financial institutions by their nature use long
term strategies. They already adapted their strategy to fit the new Directive
and will not change that quickly. As soon as the war in Ukraine ends the
financial institutions expect pressure to return to the original intention to ban the
Defence sector from investments.
So, in our sector, we will need to do something else. We
will not be able to change the Directive. Also, we don’t need to tell DEFIS or our
MoDs. They know what is going on.
We need to show the financial sector that Defence is necessary for peace,
security and prosperous society. In fact, it should be considered socially unacceptable
not to invest in the Defence sector.
As EDTA we have established a multinational working group to address this issue, but more help would be appreciated.
Note:
Publication is allowed with notification and acknowledgement of the author and
EDTA. Excerpts only upon prior approval
Jan Wind, jw@fedta.eu