Articles by " Mark Thomson"

On economics and submarines

A lesson for submarines

According to the South Australian government, the Australian economy will be better off by $21 bn if our next generation of submarines is built in-country rather than purchased from overseas. With the Abbott government likely to make a decision about the submarines soon, the claim deserves close examination.

The underlying analysis is set out in a paper from the SA Economic Development Board  based upon commissioned work done by the official-sounding National Institute of Economic and Industry Research. It’s a short paper, running to only nine pages, and sparse in detail. Read more

The paper compares two options:

  • purchasing 12 submarines from overseas and performing only light maintenance on the boats in Australia;
  • building 12 submarines in Australia and performing both light and heavy maintenance in Australia.

The options posited immediately skew the analysis by assuming that with the foreign build option, heavy maintenance would be done offshore. It fact it would be feasible and advantageous to perform heavy maintenance in-country. In case there’s any doubt, we successfully executed an extensive mid-life upgrade of the British-built Oberon class boats.

As a starting point, the paper assumes that it would cost $20 bn to acquire 12 boats irrespective of where they are built at the baseline exchange rate of 92c to the US dollar. Thus, at today’s exchange rate of 88c, we already face a $900 million premium for a foreign build.

But recent experience demonstrates that there’s a substantial premium associated with building ships in-country (albeit one that depends on the prevailing exchange rate). As Andrew Davies put it, in the case of the $8.1 bn Air Warfare Destroyer (AWD) project, we’re getting three ships for the price of four, not counting recent cost blowouts and the lost value of increasingly delayed delivery. Estimates of the effective rate of assistance for the Landing Helicopter Dock and AWD programs come in at 70% and 33% respectively.

Not only is the higher up-front cost of local construction ignored, but the analysis unreasonably privileges future spending by omitting a net-present-value calculation of costs—which matters a lot given the unrealistic assumption about off-shore heavy maintenance and the 40-year time-horizon of the model.

The SA paper also ignores the ‘agency’ problems of local build. First, it can be desperately hard to get acceptable productivity from a domestic monopoly—as our sorry experience with submarine maintenance shows. Second, and as we’ve seen, an incumbent local supplier will form a natural alliance with unions and the state government to shift risk and cost increases back to taxpayers.

The SA paper then makes matters worse by modelling the economic impact via an input–output model. One of us has already blogged about the shortcomings, but the essential features are easy to recount.

The problem’s best explained by thinking of a ship built in Australia. The workers and local subcontractors will receive income, which they will largely spend on other locally-produced goods. By using data on the inputs and outputs of Australian producers of those goods, it’s possible to trace the direct and ‘multiplier’ effects of the spending on GDP and tax revenue.

That’s fine, but such an analysis ignores the alternative use of the labour and other inputs—it assumes they’ll sit idle if our hypothetical ship isn’t built. In reality, market forces will redeploy them elsewhere in the economy where they will contribute to GDP and pay taxes. That’s especially true in any long-run scenario—and this modelling stretches over 40 years.

The unreality of input–output modelling is well understood, so more sophisticated general equilibrium modelling is the standard approach for addressing long-run ‘what if’ questions about policy. The SA paper rejects general equilibrium modelling on the grounds that ‘no capacity constraints are anticipated in the labour market’. That is, it assumes that there will be a pool of unemployed in Australia for the next 40 years who, but for the opportunity, have the aptitude to become highly skilled engineers and trades persons. Indeed, as there are no ‘ramp up’ costs in the model, it assumes all these skills and resources already exist—in obvious contrast to the findings of the RAND study.

If the economy really was as static and unresponsive as assumed in input–output modelling, we could never have absorbed the resource boom. Nor would we ever have recovered from the removal of tariffs on cars, footwear and clothing. But we did, and the economy responded with new jobs in new areas. More importantly, consumers came to enjoy cheaper prices. There’s a lesson here about buying submarines. The economic argument for mandating local construction is ultimately no different to the neo-mercantilist arguments which sought to hold back productivity-boosting reforms of the 1980s and 90s. Then as now, the focus should be on the overall benefits rather than those concentrated in the hands of a few.

Henry Ergas is a senior economic adviser, Deloitte Access Economics, and professor of Infrastructure Economics, University of Wollongong. Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Flickr user sea turtle.

Graph of the week

Graph - salary increase comparatorsThe government’s offer of a 1.5% p.a. pay rise for each of the next three years in exchange for a reduction in leave entitlements and other allowances has been met with dismay. This is one of those issues where the facts speak for themselves. So here are some facts:

According to the government’s own figures, inflation is projected to be 2.25% in 2014-15 and 2.5% for the three years after. With a little arithmetic, this means that the government’s offer of 1.5% per annum would result in a cumulative reduction of 2.66% in real terms over the next 36 months. Compared with the remainder of the labour force, the picture is worse still. The government projects that the Wage Price Index will run at 3% over the next two years.

Two things are noteworthy in this regard. First, the Defence budget is indexed at 2.5% per annum to take account of inflation. Second, the ADF workforce has been quarantined from efficiency dividends under the current and previous governments. It follows that an inflation-matching salary increase of 2.5% per annum could be afforded from within existing funding without redirection from other programs (consistent with the government’s 2014 Public Sector Workplace Bargaining Policy). Read more

Current ADF salary rates and allowances can be found here. For those without the time to work through the labyrinth of numbers, a benchmark is as a follows. The salary plus service allowance for a sergeant in the army roughly equates with average adult full-time earnings in Australia (~$78,000). Higher ranks get paid more, lower ranks less—though specialist skills can make a significant difference.

Looking over time (see chart above), ADF salary increases have consistently outpaced inflation; and growth in average weekly full-time ordinary earnings has done the same, but by a wider margin. The latter is presumably a reflection of a structural shift in the Australian economy to higher productivity jobs.  Defence APS salaries and ADF salaries are bootstrapped onto each other, thereby explaining their overlapping trajectories.

Finally some context is worth taking into account. The government has frozen the pay of parliamentarians and senior public servants as of July 1 2014, so they’ll experience an even higher percentage real loss of salary than ADF members if the present offer goes through. However, this needs to be seen in the context of the 31% pay increase awarded to parliamentarians in 2012 (along with the 27% increase in remuneration awarded to the Chief and the Defence Force and a similar rise for departmental secretaries over the period 2012 to 2014).

As I said, the facts speak for themselves.

Mark Thomson is senior analyst for defence economics at ASPI. Image (c) ASPI 2014.

Submarines: the value of Option B

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Brendan Nelson will be remembered as the defence minister who pushed through the Super Hornet purchase as a hedge against further delays in the long-troubled F-35 Joint Strike Fighter program. While Air Force held tight to the increasingly forlorn hope that the F-35 would be delivered on schedule—resisting any suggestion of a 4th-generation interim fighter lest it become the final capability—Nelson moved decisively to mitigate the risk of a capability gap. In doing so, he saved the RAAF from itself.

Fast-forward eight years, and another capability gap looms. This time it’s Australia’s submarine capability. It’s now widely known that the Abbott government is working hard to secure a submarine deal with Japan. A great many concerns have been raised about so-called Option J, from the suitability of the Soryu-class boats to the difficulty of dealing with a first-time exporter. Perhaps most vocally, Australia’s shipbuilders are crying foul that the longstanding promise of a local build has been broken. Read more

Even without my ambivalence to local shipbuilding, I’d have sympathy for the government’s approach. Upon coming to power last year, they inherited a risky DIY scheme to design and build an ab initio Australian-designed submarine (cue: stirring speech about nation building and the Snowy Mountains Scheme). So they grasped Option J as a realistic alternative and they’ve been running hard with it ever since.

Good on them. It’s easy to raise legitimate questions about the suitability of the Soryu-class. Nonetheless, in broad terms, it appears to be the closest thing to what we need that’s available off the shelf. But what happens if, upon closer examination, our engineers and submariners conclude that the Soryu won’t cut it? Or what if the difficulties of working with a first-time exporter prove too daunting? There are surely significant cultural, language and commercial differences to be carefully weighed.

Perhaps most importantly, there’s the question of how achievable and durable a deal with the current Japanese government will be. For the moment, there appears to a real willingness at the highest level in Tokyo. But like any democracy, the Abe administration’s ability to do a deal depends on Japan’s parliament, the Diet, and thereby on Japanese public support. And make no mistake; the sale of subs to Australia would be a substantial strategic move for Japan which would quite properly elicit domestic debate.

So if things don’t work out, what’s Option B? As with the F-35, there are inherent risks to putting all your eggs in one basket—especially when time is running out to get production underway. The Collins isn’t going to last forever.

There are at least three other credible partners who could help us maintain our submarine capability—France, Germany, and Sweden—and perhaps a fourth in Spain. I’ve argued previously, as have others, that we should run a design competition to select the best supplier and secure the best deal. The benefits of doing so are many and obvious—and akin to why most people shop around rather than grab the first item that catches their eye.

Setting aside the myriad intrinsic advantages of competition, in our current situation a competition would allow Option J to be progressed in tandem with one or more alternatives. Thus, not only would we be able to secure the best deal the market can offer, but we’d be mitigating the risk inherent with pursuing a single source. Better still, and in contrast to the Super Hornet purchase, rather than shouldering the cost of an interim capability we’d be able to proceed expediently with a long-term solution.

Of course, it would take a little extra time to run a contest. But the delay wouldn’t have to be extensive. Everything that a competition would ask of potential suppliers would need to be asked of Japan before a sole source deal could be struck. Activity would be concurrent rather than sequential. Alternatively, if Option J is the only option being developed, we’ll have to start over if things don’t work out.

Perhaps it’s time for Defence to return the favour they owe Brendan Nelson and take forward a submarine acquisition strategy to the Abbott government that builds in an Option B to ensure no submarine capability gap emerges.

Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Flickr user Kate Hiscock.

Defence and the diarchy

The diarchy: butting heads on occasion

If the First Principles Review of Defence goes back to first principles, it’ll have to examine the diarchy wherein Defence is jointly headed by the Secretary and CDF. That’s likely to occur given that one Review panel member—retired Army chief Peter Leahy—is on the record arguing that the Minister should ‘ask himself why Defence is the only department or agency in the country run by a diarchy’.

In a speech in 2000, then departmental secretary Allan Hawke said that the diarchy was ‘about bringing together the responsibilities and complementary abilities of public servants and military officials’. In terms of responsibilities this is undoubtedly true, but only in a circular sense because legislation has been drafted consistent with a diarchy. The fact that the Australian Federal Police (AFP) is headed by a uniformed commissioner shows that there’s no underlying legal impediment to putting the CDF in sole charge. Read more

What about complementary abilities? Is Defence really so large and complex that it requires two leaders with different backgrounds to manage the enterprise effectively? Of course not; the largest of corporations and even entire countries get by with a single head. Where specialist advice is needed, specialists can provide it. Whatever expertise a departmental secretary has could easily be relegated to a subordinate reporting to the CDF—as effectively occurs in the AFP.

So why have a diarchy? Although such an arrangement is almost unheard of in the business world, Australia’s defence diarchy isn’t unique; the United Kingdom for one has a similar arrangement. Other countries, such as Canada and New Zealand, maintain civilian defence departments in parallel with their defence forces. The common and essential element is that the government has dual sources of advice on military affairs. In its own way, the United States achieves the same thing within its system.

The involvement of civilian officials in defence matters is an essential part of the elected government maintaining effective control of the military. The risk is not of insubordination; the ADF’s obedience to the government of the day is beyond reproach—as tends to be the case wherever the rule of law prevails. Rather, civilian involvement is needed to ensure a level of objectivity in defence administration that can’t realistically be expected from the military.

The Army, Navy and Air Force, and the ADF as a whole, are institutions with strongly ingrained identities. That’s as it should be; the fighting coherence of our forces is as dependent on their distinct institutional characteristics as it is on their equipment. But with ingrained identities come ingrained aspirations that can put institutional desires above the needs of Australia’s defence. In a classic RAND study from the 1980s, Carl Builder captured the idiosyncratic ways that the US Army, Navy and Air Force each approach the problem of force planning—all largely divorced from strategy. The three Australian military services are little different today.

Moreover, the senior ADF leadership have dual responsibilities: upward to the minister, and downward to its members and to the institution(s). What service chief doesn’t argue for the best equipment, best facilities and best conditions of service for their members? I don’t expect them to do otherwise, but neither do I want an inefficient and gold-plated defence force. As in any other area of government activity, spending should be disciplined by the cold, dispassionate balancing of costs and benefits.

For exactly the same reasons that the Australian Medical Association wouldn’t be given control of health administration, or teachers control over education administration, neither should the military be the government’s sole source of advice about itself. The diarchy (or something like it) is needed to temper the institutional introspection of the military in favour of the objective interests of Australia’s defence and the taxpayer.

How can that best be done? The pros and cons of having a diarchy, as opposed to having a separate defence department and defence force, have been discussed by Derek Quigley (ex-NZ MINDEF) and Neil James (ADA Executive Director). However, the differences between the two options are ultimately of practicality rather than principle. For what it’s worth, I’m firmly in favour retaining the diarchy. When it comes to civilian involvement in military matters, the closer and more integrated the better.

While civilian bureaucratic involvement in Defence is desirable, its present implementation remains imperfect. Today’s plans for the ADF are little more than the sum total of single-service wish-lists, and defence efficiency remains a distant hope. The diarchy may be necessary but it’s manifestly insufficient. Otherwise why would the government have turned—yet again—to external advisors to tell them how to fix Defence?

Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Flickr user Marin.

First principles review: one more round of external oversight

Aerial photograph of Russell Offices. Mark Thomson writes that while it might be politically expedient to quarantine military personnel from scrutiny, they represent more than three-quarters of the Defence workforce and are the most expensive on a per-capita basis. The multiple military headquarters maintained by the ADF are likely to be every bit as overstaffed as those on Russell Hill.On 5 August, eleven months after coming to office, the government finally announced its long-promised First Principles Review of Defence. Although the review’s terms of reference have not been formally released, the minister effectively outlined them in a recent speech saying that the review would make recommendations to:

  • ensure that the Department of Defence’s business structures support the ADF’s principal tasks, as determined by the 2015 Defence White Paper, and other whole of government responsibilities out to 2030
  • ensure a commercially astute, focused and accountable materiel acquisition and sustainment capability
  • improve the efficiency and effectiveness of Defence
  • guide the implementation of recommendations from the Commission of Audit not otherwise covered above, and
  • ensure the ongoing delivery and reporting of agreed recommendations

It’s probably not wise to read too much into the points above. For example, it’s hardly likely that the Review will uncritically accept the recommendations of the National Commission of Audit (or let’s hope not). Nevertheless, the government’s goals are clear: make Defence efficient and effective, reform the Defence Materiel Organisation, and ensure that any recommendations are carried out. Read more

The review will be headed by David Peever, ex-managing director of mining powerhouse Rio Tinto Australia (and newly appointed Cricket Australia Deputy Chairman). Assisting him will be ex-chief of army Peter Leahy, BAE Systems executive Jim McDowell, ex-defence minister Robert Hill and ex-finance minister Lindsay Tanner.

In the weeks ahead, I will post on many of the issues that fall within the terms of reference (along with a few that don’t). With a major review underway, it would be good to see a public discussion about how best to structure and manage the multi-billion dollar Defence enterprise. In the remainder of this post, however, I want to reflect on the practice of having external reviews of Defence and provide some background.

As the following timeline shows, successive governments have brought in outsiders to assist in the quest to create a more efficient and effective Department of Defence.

In 1989, Kim Beazley tasked ex-ASIO head Alan Wrigley to review civil support to the defence force. The result was the Commercial Support Program (CSP), which saw thousands of uniformed and civilian positions outsourced from Defence through the 1990s.

In 1996, Ian MacLauchlan initiated the Defence Efficiency Review (DER) chaired by CSIRO head Sir Malcolm McIntosh. The result was the Defence Efficiency Program (DRP) which accelerated the outsourcing of jobs, rationalised the defence estate, and established the current ‘shared services’ business model within Defence. The goal was to generate $1 billion dollars a year in savings.

In 2007, Brendan Nelson launched the Defence Management Review in the wake of the failed repatriation of Pte Jacob Kovco from Iraq. Headed by ex-state government bureaucrat and businesswoman Elizabeth Proust, the Review led to some additional deputy-secretary positions but not much more.

In 2008, Joel Fitzgibbon hired management consultant George Pappas to undertake the Defence Budget Audit (DBA). The result was the Strategic Reform Program (SRP), which made widespread but largely incremental reforms to Defence from 2009 to 2012 in an attempt to generate more than $20 billion in savings over a decade.

In 2011, Stephen Smith commissioned a raft of ‘cultural reviews’ following the Skype scandal at the Australian Defence Force Academy, all but one of which was headed by an external party. In the same year, Smith also commissioned a Review of the Defence Accountability Framework headed by ‘ethicist, theologian and strategic advisor’ Rufus Black.

Why has government after government felt it necessary to use external people to recommend changes to Defence? It’s not that the organisation lacks high-paid talent; on the contrary, the past decade has seen strong growth in civilian and military executive positions. More importantly, Defence often impresses; it routinely executes complex military operations at short notice, and is capable of formulating innovative policies such as the recently announced enhanced workforce model. So why doesn’t the government rely upon its principal advisors—the Secretary and Chief of the Defence Force—to sort things out.

To start with, there’s inherent value in seeking outside perspectives. The specialised nature of the work means that many people in Defence—especially in the military—have limited experience of the world beyond. External reviews bring external perspectives unavailable from within the organisation.

But to my mind the real advantage of an outside review is that it brings a degree of objectivity impossible for those engaged in the internecine politics of Defence. Everyone, by position or past, has a vested interest in protecting their part of the organisation. More generally, when it comes time to trim the accumulated fat from the body bureaucratic, there’s no point handing the scalpel to the patient. Let’s hope the newly appointed review team has a steady hand.

Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Department of Defence.

The British are coming

The British are coming!

Last week, The Australian broke the story of BAE Systems potentially being brought in to fix the troubled Air Warfare Destroyer project. The three-ship build is already well underway in Adelaide, and the project is currently managed through an industrial alliance contract involving government-owned ASC Pty Ltd, Raytheon Australia and Defence.

Approved at a cost of $8.5 billion dollars in 2007, the project has accumulated nearly two years of delays and $300 million in additional costs. A government-initiated review of the project by ex-US Secretary of the Navy Don Winter and former Transfield boss John White recommended a range of measures, including ‘the urgent insertion of an experienced shipbuilding management team into ASC’.

But while the summary of the Winter/White report was announced by government just two months ago, the AWD Alliance had taken steps before that to remedy some of the project’s shortcomings. One of us (Andrew) visited the site at Osborne last week, and it was clear that some good work has been done. Read more

When the Australian National Audit Office reported on the project in March, many of the identified problems related to the transfer of the design from Spain to Australia, and the inexperience of the Australian workforce after more than a decade without a build project. Those factors contributed to a poor start to the project. Low productivity was the inevitable result, due to reworking of both the design and often the hardware. As a result, the first-of-class HMAS Hobart took shape fitfully and inefficiently.

A critical question is whether the existing project management and workforce can retrieve the situation. The answer seems to be a ‘qualified yes’. The Alliance has recruited some experience in production engineering and is seeing positive results. Visits to the yard at about the same stage of progress on ships 1 and 2 revealed a huge difference between the two. The blocks for ship 2 in the yard are more complete (with internal piping, painting, insulation etc) and are constructed to tighter tolerances than the first. For example, when the upper blocks were first lowered into position on ship 1, a substantial gap resulted. On ship 2, the parts fitted neatly together. The already in situ features in the modules mean there’s less need for work in tight and cramped spaces (in particular, the need for difficult overhead work is greatly reduced). The reduction in labour hours required from the first to second of class will be well over 20%, with further improvements expected for ship 3.

The ‘yes’ has to be qualified because there’s still substantial work to be done before a functional warship is delivered. In particular, the capability of the vessels will depend critically on how the Aegis combat system and other sensors and weapons function together. The job of building integrated systems into the hulls is yet to come, although land-based integration is well advanced.

Perhaps because of those improvements, news of BAE’s putative role has taken many by surprise, even though the government showed its cards by appointing a team of corporate lawyers and investment bankers as strategic advisors back in June. By seeking out mergers and acquisition specialists (rather than shipbuilders), the government revealed its inclinations.

So what might we expect if BAE is brought in? At a minimum, BAE could provide individuals with shipbuilding expertise to assist ASC. More likely, BAE would be asked effectively to take charge of the project. It’s even possible that BAE would take an equity stake in ASC’s shipbuilding arm—perhaps contingent on completing the AWD project. (There are good reasons to retain ASC’s submarine maintenance role in government hands, at least for the time being.)

BAE taking charge of the AWD project—if that’s indeed what’s to happen—would bring benefits and risks. On the positive side, BAE could reach back to the UK for help. Of course, BAE’s own problems with module construction for the AWD, and their trials and tribulations with the LHD project, show that they’re capable of overestimating their own abilities. If nothing else, however, BAE would bring the commercial focus that the government-owned ASC lacked. And they’d have every incentive to do so; not only will their reputation be on the line, but success with the AWD would likely secure them the massive eight-vessel Future Frigate Anzac replacement next decade.

On the other hand, the disruption that’s an inevitable result of a change of management would have to be carefully handled. While BAE has experience as a subcontractor, there’d still be a lot for them to learn about the project. The challenge would be to ensure continuity of effort concurrent with the introduction of new blood. As we’ve seen, ASC hasn’t been sitting on its hands. A lot would depend on the attitudes taken by the parties involved and cooperation will be critical. If it happens, let’s hope that the intervention adds more than it subtracts from the project’s likelihood of success.

As ever, the devil’s in the details, and another post will discuss the intricacies of third-party intervention and what the alternatives might look like.

Andrew Davies is senior analyst for defence capability and director of research at ASPI. Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Flickr user Kayla Casey.

The elephant in the conference room

Is that an elephant in the room?

The worst-kept secret at the DMO Defence and Industry conference this week was the government’s active consideration of buying submarines from Japan. Although it was never mentioned in any presentation, Option J, as it has come to be known, was discussed in every corner and corridor of the Adelaide convention centre.

Good policy rarely results from secret deliberations shielded from public scrutiny, so I think it’s time to discuss Option J directly, at a level beyond passing media speculation.

As recently as a month ago, the Abbott–Abe strategic cozying up seemed likely to deliver little more than access to Japanese submarine technologies—in particular, the propulsion system. But today it appears that the government is actually considering having replacements for the Collins built in Japan. Read more

Before going any further, it’s worth noting that would be a move laden with geopolitical consequences. The export of Japanese submarines to Australia would represent a much more rapid normalisation of Japan’s defence posture than anyone has anticipated so far. It would alarm China and heighten Beijing’s fears of containment by the United States and its US allies. Those are serious first-order strategic considerations not to be dismissed lightly or as somehow secondary to the reasons for acquiring submarines in the first place.

But for the moment, at least, I’ll leave it to others to argue the strategic merits and risks of the proposal and focus instead on the question of whether Option J represents a credible path to the cost-effective delivery of submarines to meet Australia’s needs.

It’s commonly believed that Japan builds and operates capable submarines of a displacement commensurate with Australia’s needs. Moreover, they do so through a mature industrial arrangement that exploits dual sourcing to deliver efficient construction and maintenance. So far, so good. The trouble is that, at least in the public domain, we know little about the range, endurance, sensor effectiveness and acoustic properties of the vessels.

Even on the basis of what we do know, if Japan is willing to sell us submarines, we should be looking closely at what they have to offer to see if it meets our needs, or might meet our needs with some modification. For example, we’d almost certainly want to equip the vessels with US weapons and combat systems.

The option of building submarines offshore will alarm Australia’s domestic shipbuilders who have been waiting patiently to play a role in what was long promised to be a domestic program. I’m largely agnostic about building offshore, provided that appropriate steps are taken to ensure the availability of cost-effective and strategically necessary in-country support the fleet will need.

The fear among many people I’ve spoken to, and which I share, is that Option J is being driven at the political level in the absence of the due diligence needed for a multi-billion dollar critical defence acquisition. Japan isn’t the only country that builds submarines. France, Germany and Sweden all have credible products and a declared interest in helping Australia fulfill its submarine needs.

We need something more than a beauty contest—which appears to be all that’s currently planned—that rushes to a decision. With three or four credible contenders we need to see what’s on offer and use competitive mechanisms to secure the best possible deal for the Australia taxpayers.

The bare bones of what we should do is straightforward:

Step One would be to seek formal expressions of interest from prospective suppliers for both in-country and foreign-build boats, based around a clear statement of what Australia wants in terms of platform performance, US-system compatibility and, critically, efficient through-life support in Australia.

Step Two would be to select the two best contenders, or three if absolutely necessary, and conduct funded preliminary design studies. Preliminary design studies would allow decisions to be made on the basis of reasonable estimates of the cost and capability available from the selected firms.

Of course, the conduct of the second stage would be more complex than the simple picture I’ve painted. For example, for domestic construction, the involvement of local firms complicates matters somewhat. But the principle underlying my proposal is simple: in the absence of competitive pressure to contain costs and negotiate affordable through-life support we’ll find ourselves at the mercy of the supplier for the next thirty years.

Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Flickr user Justin Elson.

Defence projects, jobs and economic growth

HMAS Anzac under tow as it prepares to re-enter the water from Henderson Naval Base where it spent twelve months undergoing an upgrade.

In a recent post, Andrew Davies explained how the government ignored Defence’s advice and chose the MRH90 over the Black Hawk helicopter—presumably because the former offered more for local industry.

There’s nothing intrinsically wrong with considering industry factors in defence procurement. As John Harvey reminded us, a local preference can legitimately be based on defence self-reliance and/or broader economic benefits. Consistent with this, government announcements routinely tout the economic benefits of defence projects. For example, this year’s F-35 announcement said:

The acquisition of F-35 aircraft will bring significant economic benefits to Australia, including in regional areas and for the local defence industry with more jobs and production for many locally-based skilled and technical manufacturers.

The message is clear; the more work that’s done in Australia the better. In the case of the F-35, it’s likely true. Rather than rely on offsets, Australian firms compete with foreign manufacturers to supply the global F-35 program so that only internationally competitive firms thrive. In other instances, local sourcing occurs absent foreign competition and at a sizable cost premium, such as the troubled Air Warfare Destroyer Project where we are getting three vessels for the price of four. Read more

What’s the lure of having work done locally? Apart from expectations of achieving greater self-reliance and more cost-effective through-life support (each a canard for another post), decision-makers probably believe that there’s a net economic benefit from having work done in Australia even at a premium.

The notion that local production delivers an economic benefit has been cultivated by those eager to avoid foreign competition. DefenceSA, the South Australia Government’s defence lobbying arm, has produced two glossy publications (here and here) that extol the economic and industry benefits of local shipbuilding.

The DefenceSA reports quote an economic analysis of the Anzac Ship project commissioned by the Australian Industry Group in 2000. The scanned copy of report can be found here (PDF) and its companion report on the Huon minehunter project is here (PDF). The reports employ two methodologies to estimate the economic impact of projects: input-output multiplier analysis and general equilibrium modeling.

Multiplier analysis estimates the gross economic impact of spending, and the table below summarises the key results from the Anzac and Huon reports:

Input-Output Multiplier analysis of recent major naval construction projects

Project

Cost

National output

Jobs

Anzac frigates

$5.6 billion

$10.9 billion

57,000

Huon minehunters

$1.0 billion

$1.7 billion

9,250

Impressive numbers indeed! If only the world was so simple; multiplier analysis overestimates economic impacts by ignoring (along with much else) constraints on, and alternative uses of, inputs to production. For example, multiplier analysis assumes that each and every person employed by the project would be unemployed had the project not occurred. The Productivity Commission released a paper on the uses and missuses of multiplier analysis in 2013.

Mindful of the limitations of multiplier analysis, the Anzac and Huon reports also used general equilibrium modeling to estimate the economic impact taking account of input constraints on the Australian economy as a whole.

General equilibrium modeling of recent major naval construction projects

Project

Cost

GDP increase

Jobs increase

Anzac frigates

$5.6 billion

$3 to 7.5 billion

7,850

Huon minehunters

$1.0 billion

$887 million

1,860

Unlike the input-output analysis, the estimated boosts to GDP and employment in the table above are net increases across the entire economy. How much confidence can we have in those estimates? Comparison with analogous estimates in a 1994 Industry Commission report are informative. Depending on the assumptions made—none of which were unreasonable—an increase in local defence sourcing could result in either an increase or decrease in GDP and employment. Confused yet?

As best I can tell (not being an economist) two assumptions drive the results. First, the extent to which employment is held as a fixed constraint in the model. Second, the assumed productivity enhancement arising in firms engaged in the project. Weak employment constraints and higher productivity yield greater benefits, and vice-versa.

Given ongoing strong competition for skilled labour and the low productivity of (at least) the naval shipbuilding sector, recent local purchases such as the AWD have probably not had anything like the bountiful impact claimed by the Anzac and Huon analyses—certainly nothing like what would be needed to cover the substantial premium being paid.

Nonetheless, we should be wary of definitive claims either way about the economic impact of buying defence equipment locally. But with $78 million already committed to progress a local build of frigates to replace the Anzacs (wastefully early), the government needs to get some evidence-based advice on the economic costs and benefits of local construction sooner rather than later. As I’ve suggested in the past, the Productivity Commission would be a good place to start.

Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Department of Defence.

How to buy a submarine – part 2

The building of a replacement for Australia’s Collins class submarines will be the country’s most expensive and complex defence project to date. There are a myriad of capability, commercial and industrial issues to be managed: the expertise for the design and construction of conventional submarines resides in Europe and Asia while Navy’s preference is for American combat and weapon systems. Pulling those elements together while managing the technical risks is no easy task.

Local construction of the future submarine has been a bipartisan position for several years, and it has the support of industry and the bureaucracy. But there’s no simple or fast way to produce a unique Australian submarine. If the government decides to go down that path, it will have to do so in the knowledge that it’s a high-stakes venture.

In April 2014, ASPI held a two-day conference called ‘The Submarine Choice’. At the conclusion, we were left with three disquieting impressions. Read more

First, pursuing an entirely new design will be risky. Conference presenters drove home the message that Australia currently lacks two key prerequisites for success: ongoing collective experience and a highly-trained design, engineering and submarine-specific building workforce.

Second, there’s a worrying disconnect between Defence’s plans and the government’s thinking (to the extent that either are public knowledge).

Third, it was clear that Defence’s thinking on the submarine acquisition strategy was simultaneously prescriptive and vague— prescriptive about the sort of commercial entity it wanted to undertake the submarine project but vague about how to create it.

With those impressions in mind, we decided that it was time to revisit ASPI’s 2009 paper ‘How to buy a submarine’, written when the enterprise was formally instigated. Our paper released today is our attempt to do so.

Sorting out fact from folklore wasn’t easy. Once we thought we had a consistent picture we sent a draft out to most of the stakeholders and interested commercial entities. We received a wealth of feedback and were struck (though not entirely surprised) by the diverse views expressed. It proved impossible to include, let alone reconcile, all of the disparate and sometimes diametrically-opposed opinions.

For example, several respondents told us that a European firm wouldn’t get the permissions required to integrate sensitive US subsystems and submarine technologies onto vessels they designed, while others told us that the issue was entirely manageable. One possible explanation for the apparent disconnect is commercial interest—for a number of players circling the submarine program, it’s a convenient story. We’re not sure which version is true, but there’s little doubt that the merger of a European design and American combat system is possible under some circumstances—after all, that’s what the Collins is. Our recommendation as a sensible early step in the process would be for Australia to have government-to-government discussions with the potential players—especially in Washington—to determine what the actual constraints are, and what’s merely unsubstantiated folklore.

Conventional submarine design capability with the experience required is found in France, Germany, Japan and Sweden. The UK hasn’t designed or built a conventional submarine for decades, but the trusted nature of the ‘five eyes’ intelligence relationship and its ongoing nuclear submarine programs means that it’s also a potential partner if access to American technology is the issue some claim it to be.

Of the Europeans, France and Germany have established export markets, and have exported designs for construction elsewhere. The Swedish submarine industrial base is currently undergoing significant changes, but the close relationship between the Swedish and US Navy submarine arms makes them a credible contender. Japan’s an established builder of large conventional submarines and there’s high-level political support on both sides for a collaborative effort—and this is rapidly developing into one of the more likely options.

Then there’s the Australian end of the arrangement. The most recent public statements from officials suggest that their preferred approach is similar to the Collins project: the creation of a commercial entity specifically to execute the design and build. The advantage would be that a purposely-created Australian-based entity could manage the interplay of participating European and American firms and their intellectual property. However, having gone in this direction, the government would carry the majority of risk associated with the project from the start.

Other approaches are possible. Most simply, the government could test the market and contract an existing international submarine designer/builder to undertake the project. Not only would this result in a cleaner commercial relationship, it would also give the Commonwealth a commercial counterpart with sufficient financial depth to shoulder a share of the risk in the project.

Finally, there’s always the possibility that the government will weigh up the issues we describe in this paper and decide that it’s all too difficult. In that case it’d need to decide whether offshore procurement options are able to deliver the required capability—or find an acceptable compromise between capability and risk.

Andrew Davies is senior analyst for defence capability and director of research at ASPI. Mark Thomson is senior analyst for defence economics at ASPI. Strategic Insight ‘How to buy a submarine: part 2′ is available free to download hereImage courtesy of Flickr user n1ct4yl0r

Shipbuilding—Australian style

Anzac class frigate HMAS Perth at the International Fleet Review,  October 2013. Minister for Defence, Senator David Johnston, has announced the government would 'bring forward preliminary engineering and design work necessary to keep open the option of building the future frigate in Australia'.Last Friday, the defence minister announced no fewer than three shipbuilding initiatives.

First, to the dismay of the Australian Manufacturing Workers Union (PDF) and the indignation of the opposition, the government announced that it would seek bids from Spain and Korea to build two new replenishment vessels for the RAN. The new vessels will replace the ageing replenishment vessel HMAS Success (18,000 tonnes) and the modified commercial tanker HMAS Sirius (47,000 tonnes).

Although the vessels could’ve been built in Australia, it makes sense to go offshore. Not only would a local build require new infrastructure, but the low productivity of local yards would further drive up the cost. Given the benchmark of the AWD, where we’re getting three vessels for the price of four (and counting), the local premium would be upwards of 33%.

Nonetheless, the vessels won’t come cheap. The Spanish spent around A$350 million dollars to build SPS Cantlarbia (19,000 tonnes), while the British have ordered four Tide Class vessels (37,000 tonnes) from Korea for around A$240 million each. Defence’s 2012 estimate for the two vessels (PDF) was above $1 billion, so the taxpayer is at least a couple of hundred million dollars ahead. Read more

The government also announced plans to build more than 20 steel-hulled patrol boats in Australia. These vessels will replace the 22 boats currently operated with Australia’s assistance by 12 Pacific island states under the Pacific Patrol Boat Program. The specification of steel hulls will disappoint Australia’s highly-capable aluminum shipbuilders, but it has probably been justified by the need for robust, easily-maintained vessels.

The local sourcing of the patrol boats looks to be a sop to Australian industry; Asian shipyards could undoubtedly build the vessels much more cheaply. What’s more, the small size and simple design of the vessels will do nothing to nurture the high-end skills needed for future local projects such as the new submarines.

To make matters worse, the Minister has said the project will ‘generate additional work for yards around Australia’. Thus, rather than capturing economies of scale at a single site, work will be shared around the country, resulting in duplicated fixed costs and multiple company overheads. The only consolation is that the slug to the taxpayer from the patrol boats will likely be less than the saving on the replenishment vessels. Viewing the former as the political quid pro quo for the latter, there’s still a net gain.

Without doubt, the most interesting announcement was that the government would ‘bring forward preliminary engineering and design work necessary to keep open the option of building the future frigate in Australia’. Taken at face value, that announcement is difficult to fathom. A replacement for the Anzac frigates has long been planned for the end of the 2020s, and the prevailing assumption has always been that the vessels would be built locally. To achieve that, the 2012 Defence Capability Guide (PDF) planned on first-pass approval around 2019-20 and second-pass around 2022-23. So there’s plenty of time for a local build.

Rather, the option that’s being kept open now is a specific proposal that industry has been pushing quietly behind the scenes. The suggestion is to take the combat system and radar developed for the Anzac frigates by the Australian companies CEA Technologies Australia and SAAB Combat Systems, and to incorporate them into hulls like those currently being built by ASC for the new destroyers.

As well as leveraging the highly successful work done on the Anzac frigate upgrade, the proposal has the potential to provide continuity of work for ASC and its subcontractors. By doing so, it’s argued, hard-won productivity gains on the AWD project (assuming they eventually materialise) can be used to reduce the cost of the future frigates. What could be better—the incumbent firms each get a piece of the pie and the taxpayer saves some money?

But wait a second. On known plans, substantive work on AWD fabrication will end long before it’s necessary to start work on building the Anzac replacements. Even after the two-year delay to the AWD, fabrication will have ended by 2018 and work on the new frigates isn’t due to start until post 2022. So what’s going on?

A hint can be found in Defence’s 2013 Future Submarine Industry Skilling Plan (PDF) (subtitled A Plan for Australia’s Naval Ship Building Industry). Turn to page 170 and look at Scenario 7. There’s the solution: we can achieve continuity by retiring the Anzacs early. The previous government confirmed this when it talked about ‘bringing forward the replacement of the current Anzac Class frigates’.

There’s no way that marginal productivity gains from continuity will offset the cost of recapitalising the frigate fleet four or five years early. While other nations are looking at how to keep their vessels in service for longer, we’re doing the opposite just to keep our shipbuilders in profit for longer. I despair.

Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Wikimedia Commons.

The cost of Defence: eighty million, two hundred & eighty-one thousand, three hundred & ninety-one dollars & seventy-eight cents per day

MarkThomson_CoDJust as humour is good provided it’s funny, promises are good provided they’re kept. This year’s defence budget was about a promise; the Prime Minister’s election promise to boost defence spending to 2% of GDP within a decade.

I reported the headline figures for Defence the morning after the budget. Briefly, defence spending will increase by $2.3 billion next financial year to an all-time high of $29.3 billion amounting to 1.8% of GDP. On current plans, spending will remain more or less at that level in real terms for the next three years before increasing in the fourth. In a federal budget dominated by fiscal consolidation, it was as good an outcome for defence as could have been expected. Read more

There’s no doubt the government demonstrated a strong commitment to defence in this budget. Although much of the year-on-year increase reflects a combination of pre-existing funding programmed by the previous government and foreign exchange supplementation, it was always open to the government to add Defence to the list of portfolios reeling under cuts. But aside from a $75 million efficiency dividend spread over four years, the promise of no further cuts to the defence budget was kept.

Apart from helping to alleviate near-term budget pressures, the funding granted to Defence provides a credible path to achieving 2% of GDP in 2023-24 as promised. The path isn’t an easy one; to meet the target on the basis of the funding disclosed for the next four years, expenditure will have to increase at a rate of 5.3% above inflation for the six years after that. But with three to four years to plan and prepare, it would be learned helplessness to suggest that it can’t be done.

In the meantime, there are some serious challenges for Defence to surmount. To start with, the recovery in defence spending next year will deliver a surge in major equipment investment (because that’s the part of the budget that accommodated most of the cuts of the past few years). Equipment investment will grow from around $3.5 billion this year to $6.1 billion next year.

Normally, such a massive year-on-year increase would be unachievable but the high number of off-the-shelf purchases will help make it manageable. And even if money ends up being handed back, it will have been worth the risk to regain momentum in the investment program.

At the same time, Defence needs to get its workforce numbers into better health. There’s no point buying equipment if there are insufficient people to crew the assets. For three years in a row, permanent numbers in the ADF have fallen despite plans to the contrary. Numbers for this year stand at around 56,400, with a target of 59,600 four years hence.

Assuming that those near-term hurdles can be surmounted, the path to spending 2% of GDP is clear—provided the government makes good on its promise. Sometime in the next several years the imperative to return the federal budget to surplus has the potential to perturb but not necessary derail progress. If the government wants to spend 2% of GDP on defence, there’s no fundamental economic reason it can’t. From a fiscal perspective, however, it’ll have to find a way to convince taxpayers to accept the higher taxes and/or reduced services necessary to fund the venture.

If it can, the question is where the path leads in terms of the future development of the ADF. 2% of projected GDP in 2023-24 is a lot of money; around $42 billion in today’s terms. Extrapolating current trends in personnel and operating costs, there’ll be around $112 billion available for capital investment in the forthcoming decade as a consequence, compared with only $66 billion for the decade just past (both measured in today’s dollars). It appears, therefore, that the ADF will need to grow to accommodate the additional money that’s been promised.

If capital investment is capped at 30% of the budget (compared with a historical average of 27%) there’ll be enough money in 2023-24 to increase the size of the ADF by around 10,000 people.

The risk in providing such generous funding to Defence is that proposals of progressively diminishing merit will be brought forward in coming years—for both new equipment and personnel. The challenge for the government will be to ensure that generous funding doesn’t translate into wasteful spending.

Our first insight into what the government has in mind is likely to be the 2015 Defence White Paper, which hopefully will tell us why it’s necessary to spend so much money, and explain what sort of defence force it will buy.

You can read the Cost of Defence here.

Mark Thomson is senior analyst for defence economics at ASPI. Image (c) ASPI 2014.

The 2014 Defence budget—as good as it gets!

Defence Budget 2014In two weeks’ time, ASPI’s annual Cost of Defence will hit the streets, detailing the ins and outs of the 2014 Defence budget. For those who can’t wait, here’s a preliminary analysis of the key points.

In the current fiscal environment, it was a surprisingly good budget for Defence. Spending will rise to $29.3 billion next financial year, a nominal increase of $2.3 billion on what was spent this year and a real (corrected for inflation) increase of 6.1%. As a share of GDP, defence spending will rise from 1.7% this financial year to 1.8% next year.

The key initiatives in this year’s defence budget was the reprogramming of $2 billion from 2017–18 which resulted in an additional $500 million this year (2013–14) and an additional $300 million, $550 million and $150 million respectively across the next three years. Yes, that’s right; despite the government’s fiscal consolidation, Defence will get extra money four years in a row. Read more

On the savings front, there’s $1.2 billion to be saved over the next four years from ‘back office’ reforms, all of which will be available for reinvestment in capability—ie Defence will retain the money generated. Consistent with this, the number of civilians employed will fall from 20,900 today to 18,600 in four years’ time.

Over the next three years, defence spending is slated to remain largely static in real terms before rising to $30.6 billion in 2017–18. Beyond that, we don’t have visibility of what’s planned. But for the government to make good on its promise to boost defence spending to 2% of GDP by 2023–24, they would need to increase defence spending by around 5.3% every year for the six years following the forward estimates period.

On past experience, a sustained 5.3% rate of growth will be challenging to achieve. During the 2000s, when defence spending was growing at around 3% a year, Defence and defence industry had trouble absorbing the increase—to the extent that substantial sums of money were handed back. However, this time, there are 3–4 years available to prepare for the ramp-up so we can perhaps be more optimistic. Moreover, there’s nothing to stop the government from using future budgets to ease the task by commencing growth towards 2% of GDP prior to 2017–18. Indeed, one of the critical decisions for the forthcoming white paper will be the funding envelope from 2015 onwards.

A potential complication is that the government plans to return the Commonwealth to surplus around 2018–19, just after it looks as though defence spending will take off. If the government’s fiscal projections turn out to be overly optimistic, there’ll be pressure for further savings in order to preserve the surplus. If this happens, defence spending can’t expect to be immune.

Notwithstanding that risk, this year’s defence budget is about as good as it gets in an environment dominated by fiscal concerns. Not only has Defence received more money in the near term, but a credible path to 2% of GDP has been established.

Mark Thomson is senior analyst for defence economics at ASPI. Graph (c) ASPI 2014.