Beauty is in the eye of the beholder
16 Jul 2015|

There’s a degree of cynicism surrounding the government’s Competitive Evaluation Process (CEP) for the future submarine project. That’s to be expected; the process was forced upon the government in the turmoil of an internal leadership contest after all. Be that as it may, it would be a mistake to dismiss the CEP as a smokescreen for a preconceived outcome. Even if the government wished otherwise, the process took on a life of its own from the moment it began and since then the politics of the issue have shifted against a foreign build.

The CEP will evaluate offers from DCNS (a largely government-owned French company), TKMS (a privately-owned Germany company) and the government of Japan. The goal is a submarine similar in range and endurance to the Collins but with superior sensor and stealth performance. Preference will be given to the US combat system and weapons presently on the Collins. To the surprise of many observers, the government excluded the Swedish firm SAAB which owns Kockums, the designer of the Collins class.

The CEP isn’t a conventional tender process. Rather than seeking costed bids from potential suppliers, the contenders have been asked to provide a range of information, including pre-concept designs and positions on commercial issues such as intellectual property release. Critically, potential suppliers have been asked to provide options for ‘design and build overseas, in Australia, and/or a hybrid approach’. In doing so, the door is left open for the government to build the vessels here or overseas. Despite early expectations that Japan wouldn’t support a local build, it now seems that all three contenders are prepared to do so.

In terms of costs, the CEP is asking contenders to provide a ‘rough order of magnitude (ROM)’. Strictly speaking, that means only within a factor of ten. Be that as it may, it doesn’t really matter, as the CEP won’t lead to a construction contract but only to a design phase which, in turn, will lead to a contract. Whether the contract is fixed-price or otherwise remains to be seen. The German’s have indicated that they are willing to work to a fixed price contract, and have even suggested a figure of $20 billion for twelve boats. In effect, the CEP is being used to choose a partner for Defence to work with to refine the design, cost and schedule of the project. We’ll only know what we’re getting and how much it’ll cost once this detailed work is complete.

Probably the best analogy to the CEP is a beauty contest, or perhaps a bragging contest. It’s certainly not without precedent. The AWD project used the same approach to select the shipbuilder (ASC), systems integrator (Raytheon) and preferred designer (Gibbs and Cox). Following these selections, Defence worked with the firms to develop two design options before going to the government for a final decision. Herein lays the risk of choosing partners via beauty contest; commitment occurs before the price is known, which puts the Commonwealth in a disastrous negotiating position.

At the time the firms were selected, the estimated cost of the project was in the range $4.5 billion to $6 billion. By the time the final design was chosen and government approval was gained, the estimated cost of the winning (cheaper) design was $8 billion. While in principle the government could’ve rejected the unexpectedly high price and pursued another option—for example by purchasing ships from overseas—it was too late. The political momentum for a local build was too high, and the 2007 federal election too soon, for the government to do anything other than pass the massive price increase onto the taxpayer. There’s nothing to stop the same situation arising with the future submarine project.

From the bidder’s perspective, a beauty contest is a more like a fishing contest where the goal is to get the Commonwealth on the hook. Once the bait’s taken, the successful bidder has a decisive advantage when it comes to negotiating the price a couple of years later. Its competitors have packed up and gone home, and the government’s left with a monopoly supplier and no credible basis for negotiation.

There’s another way, and it’s fully consistent with the steps presently underway. Rather than select a single firm following the CEP, instead choose the best two firms and proceed in parallel with two funded design studies, leading to fixed price tenders from the firms. That approach will cost more in the short term (you have to pay two firms to undertake design work), but it needn’t take any longer than what’s currently planned and is consistent with previous recommendations to spend more before the approval stage. The advantage is that the two competing firms have strong incentives to plan efficient production strategies and constrain profits.

In contrast, under the present plan, the winner of the CEP has every reason to expand the scale and scope of activity upon which their profits will be based. Open-book accounting and a fixed profit margin doesn’t help—it merely makes transparent the incentive for the firm to build additional costs into the program.

Although the CEP was not the government’s original intention, they’ve crafted a credible next step for the submarine program from the confusion of the February leadership contest. Already, we’ve seen Japan step forward to offer a local build option, and both France and Germany are now firmly in the race. These are all encouraging developments. More importantly, the CEP has the potential to transition into a viable strategy to achieve value-for-money for the taxpayer. Whether that’s what happens depends on what the government does next.