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Defence Reform Bill

Volume 753: debated on Monday 24 March 2014

Report (1st Day) (Continued)

Clause 16: Pricing of contracts: supplementary

Amendment 4

Moved by

4: Clause 16, leave out Clause 16

My Lords, I am pleased to see the noble Baroness, Lady Jolly, in her seat. I would feel inhibited in quoting extensively from her letters, as I intend to do, in her absence. As I mentioned earlier, my vision of Part 2 is essentially that it delivers value by forcing the Government into the constraints that the legislation will spell out once it becomes law. Broadly speaking, what it will do, I hope, is to force agreements into a shape whereby a price is set in one form or another and the excesses or losses that actually occur in practice are handled by Clause 21 entitled “Final price adjustment”. The concept seems to be very sound. You have to go into the regulations to understand it but, broadly speaking, if the actual outturn cost goes up, then pound for pound the contractor makes a loss until the cost becomes excessive, and then, by a formula, the loss starts to be shared with the MoD, eventually on a 50:50 basis. Similarly, if the actual cost goes down because of the efficiency of the contractor, initially all that efficiency and improvement falls to the contractor. Only when the profits start to become excessive is there any clawback to the MoD. It looks to be a good idea that contracts can be forced into that by law. We will wait to see whether that comes off but it is a good aspiration, which we support.

As I mentioned earlier, the Government facilitated extensive discussions on the contract. Of course, when everyone sees a formula, one at least takes some interest in how one would get round it, because that is what people will try to do. As an example, I examined the Statement on carriers made by the Secretary of State for Defence on 6 November in the House of Commons, in column 251 of Hansard. He criticised extensively the previous deal, which was for the carrier but then went on to be a deal which I will call a critical industrial capacity deal. In other words, it was a deal, quite complicated in nature, that essentially paid BAE Systems to do nothing if it had nothing to do in order to retain the essential workforce, facilities and so on. It is a very uncomfortable deal but nevertheless you can see the wisdom of it. Our Government made such deals, this Government have made a similar deal, and despite all the wonderful planning in the world I suspect that future Governments may have to make a similar deal. We agreed with BAE on 6 November.

Perhaps I may comment on a sentence or two of the statement. Crucially, under the new agreement, any variation above or below that price—£6.2 billion in the paragraph—will be shared on a 50:50 basis between government and industry. That looks like a good target-cost incentive fee, which is the second big way in which the Bill envisages that business will be done. In other words, if the outturn cost is £100 million higher, then government stump up £50 million and BAE loses £50 million profit. If it is lower, the extra profit or surplus is shared 50:50 with BAE. So far so good. However, the next few words are,

“until all the contractor’s profit is lost”. [Official Report, Commons, 6/11/13; col. 251.]

So suddenly the sharing is 0:100. This means that 100% of the excess cost once the contactor’s profit is lost is paid for by government. This does not seem to fit with any of the models in the Bill.

I raised this issue in Committee and the noble Baroness, Lady Jolly, was kind enough to write to me. In her letter she said, “You speculated that although this agreement”—the agreement to which I have just spoken—“deals with an area concerned with single source procurement, deals of this type could not be covered by the new framework and therefore would be exempted under Clause 14(7)”. That is the clause we were talking about earlier which states that the Secretary of State could exclude contracts but, the Government have assured us, only under exceptional circumstances. The letter continues, “Obviously, in this particular case the new framework has not yet commenced and the provisions are not retrospective”. So the new framework will not cover this agreement. It goes on, “Moreover, although this is a very complex agreement covering a range of issues such as redundancies and policies, were a similar agreement to be reached in the future then there is no reason why such an agreement should not be covered by Part 2 of the Bill. There is no expectation that it will be exempted under Clause 14(7). The principles underlying Part 2 would be as relevant in the application of such an agreement as any other single source contract between MoD and industry”. That is great. That is good. In future we are going to work within the limitations of the new framework.

At a subsequent meeting I said that that was a great assurance but how do we accommodate the point where the deal just concluded goes into a sharing of 100% of the losses being picked up by government and 0% of the losses above that point being the responsibility of BAE Systems? The Government drew breath and said that they would write again. When they wrote again the letter stated, “As I explained to you in my last letter, our initial assumption is that in future any single source contract negotiations will be on the basis that the resulting contract will be a qualifying defence contract as defined in Part 2 of the Bill. It is also our assumption that the Secretary of State will only be required to use his exemption powers on very rare occasions. We do accept that there may be situations, such as where there is a very large element of risk involved in a major project, where it makes sense for the MoD to accept the potential liability for a larger proportion of the costs. In this case, however, there will no requirement to invoke the Secretary of State’s exemption powers. Clause 16”—which is the subject of this debate—“provides the department with the flexibility to make target-cost incentive fee arrangements with industry, allowing us to specify arrangements where we share a greater proportion of potential gains and losses than is the case under the final price adjustment”, which I have previously described.

I do not know about your Lordships, but “target-cost incentive” means that there is an incentive. Every pound that you lose, being wholly paid for by the Government, does not seem to be an incentive at all. This seems to be a complete misuse of Clause 16, which was designed to keep an incentive on the contractor throughout the contract to the very end. I cannot claim that use of this clause in this way is contrary to the wording, but I do claim that it is contrary to the clause’s intention, which was to create a framework for a target-cost incentive fee arrangement—in other words a proper incentive running all the time.

I believe that the use of this clause to legitimise a large and complex deal, whereby all losses are picked by government, is an improper argument. We support the generality of this Bill, but I would like to hear what the Government will do about the use of this clause, which will allow a coach and horses to be driven through this otherwise well crafted part of the Bill; we believe that that is wrong. We would like to hear what the Government are going to do about it and that is why we have put forward this amendment that the clause be deleted. I beg to move.

My Lords, this amendment seeks to remove Clause 16 of the Bill.

The clause is essential to ensure the consistent and widespread application of the new framework to all types of contracts used by the Government in single-source procurement. The purpose of Clause 16 is to allow for qualifying defence contracts that use a target price rather than a fixed price. These target-price contracts include sharing arrangements in the event of cost overruns or underruns. The benefits of any cost reductions are shared by the MoD and the supplier, as are the risks of costs being greater than anticipated. They are usually referred to as target-price incentive fee contracts, as the noble Lord has said. This kind of contracting approach is a model often used in high- value single-source MoD procurements where there is insufficient pricing certainty to make a firm or fixed-price contract a sensible option. In the past they have accounted for approximately 40% of our single-source contracts by value.

The Typhoon-availability contract, which provides support to the RAF’s Typhoon fleet, is one such contract. We want to retain the ability to use these target-cost contracts. We also do not want these contracts to be excluded from all the protections offered to both parties by Part 2. Clause 16 ensures that such target-cost incentive fee contracts, or indeed any other pain/gain share models based on a target price, can benefit from all the protections of the new regime.

Target-cost contracts are typically used when it is not reasonable for either party to take the risk of a firm price at the outset of the contract. This risk may be so great that in order to accept it a supplier would have to price in a very large contingency. This does not represent value for money. In this case, the price at the outset is deemed to be a target price. The final price is determined by comparing actual incurred allowable costs with those used to set the target price. Contractually agreed terms specify the share each party takes, whether 50:50 or some other split. Clause 16 ensures that the allowable costs included in the target price, and the allowable costs later agreed as the actual costs, must conform to all the pricing rules within the Bill. It is possible that there might be a disagreement at the end of a contract over what the actual costs were. In this case Clause 16 allows one or both of the contracting parties to ask the independent SSRO to make an expert determination. This helps ensure that disagreements are not overly prolonged.

Clause 16 also specifies that Clause 21—“Final price adjustment”—does not apply to target-cost incentive fee contracts. This requires a little explanation. The purpose of Clause 21 is to deal with any excessive profits or losses that might apply to firm- and fixed-price contracts. Most of our single-source contracts—approximately 60% by value—are such firm- or fixed-price contracts. A fixed price is typically used for contracts that are not risky enough to justify the use of a target-cost approach. They provide suppliers with the strongest incentive to become more efficient, as any cost reduction will improve their bottom line. This, in turn, will create better value for money for the taxpayer in lower follow-on prices.

However, when profits become excessively high, we do not want to have to wait until we engage in a follow-on contract. Indeed, it is possible that there will not be any follow-on contract at all. That is why we want to ensure that we get a share of these profits even if we have agreed a fixed price. Equally, we do not want to force a supplier to be subject to potentially crippling losses simply because they agreed to a fixed-price contract. For cutting-edge defence equipment, a contract that did not appear risky at first may turn out to be just that, which is why Clause 21 also provides a minimum protection for suppliers in the event of excessive losses. Because Clauses 16 and 21 both include profit-sharing arrangements, they cannot run simultaneously. That is why Clause 21 is excluded from target-price contracts.

Turning back to the amendment, we would like to maintain both options: the option to agree a fixed- or firm-price contract, with suitable protections for excessive profits and losses, as set out in Clause 21; and the option to agree target-price contracts if the contract is clearly high-risk and a fixed-price contract would not give us value for money. Clause 16 is what allows us to do this. The clauses have clearly distinct purposes and will be used in different cases.

Target-price contracts typically account for more than £2 billion worth of contracts per annum. This clause is therefore essential to the overall functioning of the new framework and must remain within the Bill if the substantial financial benefits expected under Part 2 are to be realised. I hope that this explains our position, and I therefore urge the noble Lord to withdraw his amendment.

I thank the noble Baroness for that explanation. But, as she knows, I do not need that explanation because I agree with everything she said. What I am challenging is the use of Clause 16 to explain an agreement where the share is 100% of the losses to the Government and 0% to the contractor. That seems incompatible with the spirit of Clause 16. I do not want Clause 16 to be removed and the noble Baroness knows that I will withdraw my amendment, but I would like at least some assurance that such a deal will not be done in the future. It makes a mockery of the target-price sharing if the so-called share is 0% versus 100%.

I thank the noble Lord for his patience. I would rather not give him inaccurate information. How an agreement works out is very much due to commercial judgment, assured for value for money by the Ministry of Defence or HMT—the Treasury. That is the answer that I have. It is determined as a result of judgment, assured for value for money by the MoD or HMT.

My Lords, there is much agreement between the Opposition and the Government. On this area, I am afraid there is not. Considering the interest that has been shown in this debate by the rest of the House, and my lack of success on a previous occasion, I beg leave to withdraw the amendment.

Amendment 4 withdrawn.

Clause 20: Allowable costs

Amendment 5

Moved by

5: Clause 20, page 14, line 14, leave out subsection (1) and insert—

“(1) The Secretary of State shall set out in regulations the overarching principles governing the treatment of allowable costs under qualifying defence contracts, and such other measures as may be necessary.

(1A) Having regard to the principles set by the Secretary of State under subsection (1), the SSRO shall issue guidance about determining whether costs are allowable costs under qualifying defence contracts.”

My Lords, Amendments 5 and 6 seek to bring out the relative weight given by the Bill to the contract profit rate and allowable costs. The contract profit rate is the subject of Clauses 17, 18 and 19; allowable costs are the subject of Clause 20. The split between profit and allowable costs is typically that more than 90% of the final price will be allowable costs and less than 10% will be profits.

Clause 17(1) states:

“Single source contract regulations must make provision for determining the contract profit rate for a qualifying defence contract”.

Since it is a regulation, it will be made by statutory instrument, with all the parliamentary attention that that will enjoy. Clause 20, which is about much, much more money—nine or 10 times as much money—simply says that the SSRO,

“must issue guidance about determining whether costs are allowable costs under qualifying defence contracts”.

The essence of our concern is that the real potential for profit and loss in a defence contract comes from how the allowable costs are set. They are the much bigger proportion, and once the deal is set—unless it is a profit-sharing contract such as we have just discussed, and even there, the allowable costs are set—every pound by which the contractor is able to produce the goods cheaper than the allowable cost converts to profit on their account. It may not be under the profit part of the pricing deal, but it drops to profit. One has to realise that a substantial amount of the allowable costs—sometimes more than half—are allocated overheads. If you are the finance director of this large conglomerate, you are probably more concerned about making sure that you can—I was about to use a very unparliamentary word—get as much of your overheads into the allowable cost as possible. If one were negotiating this deal, one would not worry about the profit; everybody knows that it is going to be about 10%, as it is laid out by statute and all that sort of thing. The concentration would be to get as much into the allowable costs as possible, both in terms of the original price setting and in terms of taking advantage of some of the price adjustment mechanisms.

It is therefore our contention—and Amendments 5 and 6 give effect to this contention—that the allowable costs rules should be set out in regulations and that there should be a framework of regulations setting out the criteria for allowable costs, recognising that the actual detail of allowable costs will be extensive and that those criteria should go on, as Amendment 6 proposes, to be the subject of guidance from the SSRO. It is a very simple idea, but, we think, a very important one: to give the debate on the most important part of the price a higher profile in the public domain, and to try to persuade the Government that they should be as accountable—indeed, more accountable—for the criteria setting allowable costs as they are for those setting profit.

The Government will no doubt come back and point to Clause 20(2), which sets out criteria. I was somewhat scathing about the criteria in Committee, so I shall try to be less so now. The three criteria are that the cost should be,

“appropriate … attributable to the contract, and … reasonable in the circumstances”.

Working backwards through them, my general understanding of administrative law is that things have to be reasonable in the circumstances. I would not quibble at throwing “reasonable” into the Bill, but it is not a particularly heavy or precise definition.

The next criterion is “attributable to the contract”. It does not seem to me a very exciting idea that the cost should be attributable to the contract; I think that the average lay person would expect allowable costs to be attributable to the contract. Nevertheless, that is what is set down.

The only criterion that seems to have any substance is that the cost should be appropriate. I have a very low opinion of the word “appropriate”. I used to stand on the opposite side of this Chamber and read the stuff that the officials produced for me. Whenever I saw “appropriate”, I knew it meant that they could not find a better argument—I fear that that is what “appropriate” means.

The overarching framework of allowable costs should be set out in regulations so that they can come before Parliament and be widely developed. The SSRO’s guidance should be developed from those fundamentals and should be in the public domain. I beg to move.

My Lords, I will consider Amendments 5 and 6 together. They concern the statutory guidance that the SSRO must issue for determining whether costs are allowable costs under qualifying defence contracts. The allowable costs make up the bulk of the price, and we agree with the noble Lord, Lord Tunnicliffe, that it is important that there should be clear and comprehensive rules that help ensure value for money.

Amendment 5 would introduce an additional step requiring the Secretary of State to set out in the single-source contract regulations principles governing the treatment of allowable costs. The SSRO would be required to have regard to those principles in the regulations when issuing its statutory guidance. Amendment 6 would require the parties to a qualifying contract—that is, the MoD and the supplier—to have regard to those principles as well as to the SSRO’s guidance.

It is in the interests of both the MoD and our suppliers that the rules determining allowable costs should be clear. These costs will typically account for around 90% of the value of a qualifying contract. The SSRO’s guidance must be sufficiently detailed to ensure that inappropriate costs are excluded and to avoid unnecessary ambiguity. The guidance must be enforceable. The Bill provides a strong enforcement mechanism underpinning the SSRO’s statutory guidance on allowable costs. This ensures that its guidance will be adhered to unless there is good reason not to do so, and it is achieved through several provisions.

Clause 20 provides three high-level principles that are binding on the parties to the contract. The noble Lord listed them. Costs must be reasonable in the circumstances, appropriate in nature and attributable to the contract. However, the noble Lord must know that, in the past, costs have not always been attributable to contracts. That has been unavoidable, but it has always been found to be the case after the event. Clause 20 also requires the SSRO to issue statutory guidance.

The guidance issued by the SSRO will have effect in several ways. First, both parties to a qualifying defence contract must have regard to the guidance when agreeing the price. Secondly, the Secretary of State can require a supplier to demonstrate how they have followed the statutory guidance at any time. Thirdly, the SSRO may make a binding determination on the extent to which a cost is or is not allowable.

If either party feels that the guidance was not followed, they can appeal to the SSRO, which can change the price. Any deviation from the SSRO’s guidance carries with it a significant risk. Following an appeal, the SSRO has the power to adjust the price back to what it would have been had the guidance been properly applied—and it is likely to do so unless there were good reasons not to follow its guidance, supported by a robust audit trail. Therefore, although it is called guidance, it is enforceable guidance.

Turning to the content of the guidance, we are confident that the statutory guidance will be substantial. We have agreed with industry that we will jointly recommend to the SSRO that its initial guidance should be heavily based on the existing government accounting conventions. These make up a substantial part of the current “Yellow Book”. For example, there is substantial and detailed guidance on the treatment of costs such as research and development, rationalisation and redundancy, and other such cost categories. These conventions can be imported into the initial statutory guidance, and will be expanded on to include areas not yet covered. Producing this guidance will be one of the first duties of the SSRO, which it will do in consultation with the MoD and industry. MoD officials are already working on the material we intend to provide to the SSRO in support of its consultation, and we know that industry is doing likewise.

The statutory guidance will also continue to evolve as new circumstances are considered. This will happen through the SSRO’s ongoing reviews and consultations on the framework, where the MoD and industry will suggest amendments. The SSRO will also make amendments following opinions or determinations that it is asked to make in relation to allowable costs. For example, if there is any ambiguity in the case of a particular contract, one or other party is likely to raise this with the SSRO for an opinion. After the SSRO has considered the matter, it will be likely to amend the guidance at the next appropriate point so that all parties have the clarity they need. Therefore, the existing provisions of the Bill contain everything required for substantial guidance backed by a strong enforcement mechanism.

In issuing its guidance, the SSRO is acting in its role as an independent expert charged with regulating the framework. The SSRO’s aim is to ensure value for money for the taxpayer and a fair and reasonable price for suppliers. This aim is provided for in the Bill under Clause 13. We do not consider that there is any need to limit the SSRO’s power in relation to providing detailed guidance consistent with that aim. In the event that the MoD objects to the SSRO’s guidance, it can make that case to the SSRO. However, we consider that a strong and independent SSRO will provide the best outcome for the new framework, and it should be fully empowered to fulfil its aim, as with other regulators, without unnecessary constraints.

There may also be an unintended consequence to these amendments. One of the parties to qualifying contracts—the Secretary of State—would be allowed to limit the power of the SSRO to independently set guidance on the allowable costs of those contracts. This may be perceived as introducing a partisan element to the regime, which we do not want.

There is one final point I wish to make. These amendments would lead to there being three tiers to the rules that determine allowable costs: primary legislation, regulations, and statutory guidance. This would add an additional level of complexity to the framework. MoD commercial officers and their industrial counterparts would have to follow and have regard to all three. There are cases where it may be appropriate to have three levels of rules, but clearly it should be avoided unless absolutely necessary. In this case we do not consider it necessary. We have taken the simpler approach of having three high-level principles in primary legislation, supported by substantial detailed guidance issued by the independent SSRO.

In summary, we want a framework that provides clear guidance on allowable costs, supported by a strong enforcement process, and for the SSRO to be able to act as a strong and independent regulator. The Bill as drafted does this, and we do not consider that these amendments are required. They will unnecessarily constrain the power of the SSRO and may introduce uncertainty for contractors. I hope this explains our position. I urge the noble Lord to withdraw his Amendment 5.

My Lords, I am still not convinced by the argument. The essence of my argument is that there should be symmetry of regard for profit and allowable cost. The allowable costs are so intrinsic to how much defence equipment costs the taxpayer, and so much a part of contracts which, over the years, have received massive—perhaps unfair—public criticism. This part of the Bill—which, as I have already said, is a good try and something that we support—will have the biggest impact on cost and profit, and we are not exposing it to the public scrutiny that having the criteria and framework in regulation would allow and, indeed, insist on.

I am incredibly impressed by my arguments but equally seized of the fact that I would not win a vote, so, with enormous reluctance, I beg leave to withdraw the amendment.

Amendment 5 withdrawn.

Amendment 6 not moved.

Consideration on Report adjourned.