Lord Tunnicliffe
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Defence Reform Bill
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Lord Tunnicliffe (Lab)
I hope noble Lords will forgive me if I give a Second Reading introduction to this part of the Bill to make clear the Opposition’s general position. First, I declare an interest, although not a pecuniary one or any interest that I would be required to declare, to show the position I am coming from in terms of experience. I was a non-executive director of the Defence Logistics Organisation, the Defence Procurement Executive and a founder director of DE&S, so I tend to see these matters from the rather more sympathetic viewpoint of those poor professionals who are caught in the middle of the many debates about the efficiency of this process.
I shall speak briefly on Part 2 in general. The view of the Opposition is that this is an admirable attempt at an intractable problem. I commend the creation of Part 2 and congratulate the noble Lord, Lord Currie of Marylebone, on his excellent report and the MoD staff who have turned that report into legislation and regulations. I particularly thank the noble Baroness, Lady Jolly, Philip Dunne, the Permanent Under-Secretary of State for Defence, and their adviser, Jason Petch, for their time in taking me through the Bill line by line. The Opposition’s duty in this sort of legislation, which is largely apolitical—quite honestly, I am scratching around for any political points this afternoon—is to scrutinise the legislation line by line. I assure the Committee that we have done this but mostly off the Floor of the House. Therefore, we have before us a relatively modest number of groups and we hope to finish the Committee stage this afternoon.
My general thrust this afternoon will be to look at the independence and quality of the SSRO, the whole issue of transparency in its operation and its accountability to Parliament. I will also pick up on one or two concerns that have been put to us by industry. Where industry wants assurances, we should like to be able to read them into the record to meet its concerns. It is important to note that, although this debate takes place in the Moses Room with a modest number of us present, words spoken by the Minister will be extremely important to industry.
I should also make a point about procedure. Rather lazily, we have not crafted wickedly clever amendments with which to do our probing but are using the device of a clause stand part debate. I hope to brief the Minister in more detail than I have been able to about the questions that will arise from that. I have given her some briefing but I entirely understand that on some of the questions, which came up just as I made the final run-through, line by line, she may have to write to me. In this important area, it really is better to have accurate and considered responses, rather than hastily cobbled together ones, not that I suggest that the Ministry of Defence would have hastily cobbled together answers anyway. That is quite a useful procedure but if we are not satisfied with the responses and feel that they need to be read into the record, we will use Report to achieve that objective.
I turn now to the Clause 13 stand part debate and Amendments 18G and 18H. I wish to probe the key concept of the SSRO: its independence—not in its role, with which I am comfortable, but in its working. I start with the appointment of the chairman, the rules about which are in paragraph 1(1)(a) of Schedule 4, which states simply that the chair of the SSRO shall be,
“appointed by the Secretary of State”,
and gives no further guidance as to how that chair may be appointed. I first ask the Minister to expand on how the chair will be appointed. I caution her about too much reliance on reference to the Commissioner for Public Appointments, because the commissioner very recently put out a useful press release about appointments in which he clearly stated:
“Ministerial appointments to public bodies regulated by the commissioner must be made in line with the commissioners code of practice which sets out that appointments must follow an open, fair and merit-based process, overseen by a panel. In the case of chair appointments, the panel must be chaired by an independent public appointments assessor appointed by the commissioner”.
That is so far, so good. It goes on:
“The panel’s job is to judge the suitability of candidates and to provide a list of candidates who are ‘above the line’ i.e. they have the ability to do the job. It is then for the relevant Minister to choose which of these candidates to appoint”.
I read that to stress the point that the appointment of the chair is in the discretion of the Secretary of State. It is, in that sense, a political appointment. It is entirely within his discretion.
The complementary area that I shall now explore is the relationship that the chair and the board have with the Secretary of State. I go back to paragraph 2(2) of Schedule 4, which states:
“A person may not be appointed as an executive member without the consent of the Secretary of State”.
The first point is that the executive members will need the consent of the Secretary of State. It is clear from paragraph 1 of Schedule 4 that the Secretary of State appoints not only the chair but the non-executive chair of the SSRO. Moving on, paragraph 3(2) states:
“Appointment as a member of the SSRO is for a term of … not less than three years, and … not more than six”.
Sub-paragraph (6) of the same paragraph states:
“A person who ceases to be a non-executive member is eligible for reappointment”.
Returning to the commissioner’s press release, it states clearly:
“The Public Appointments Commissioner plays no part in a decision not to re-appoint someone at the end of their term of office. That is a matter for Government”.
That makes it very clear that reappointment is a matter for the Government. Looking further at the schedule, paragraph 6 sets out:
“The SSRO may, with the approval of the Secretary of State … pay remuneration and allowances to the non-executive members, and … pay or provide for the payment of pensions, allowances and gratuities to or in respect of a person who is or has been a non-executive member of the SSRO”.
Finally, in pursuance of that point, I move to paragraph 16, on “Finance”, which says:
“The Secretary of State may make to the SSRO such payments out of money provided by Parliament as the Secretary of State considers appropriate”.
Taking all these together, let us suppose, to make it simple, that I was to be appointed—it does not pay enough but we can put that to one side. Let us look at this relationship. The Secretary of State appoints me, reappoints me, determines my remuneration, controls my budget, appoints my non-executives and then approves the appointment of my executives. It is for the Minister to convince me that this is an independent organisation. I have been there; I have been the chairman of a nationalised industry and the chief executive. I have lived under these rules and I have to tell noble Lords that independence was not one of the things I felt. I felt from time to time that I had conversations with the Secretary of State where there was a degree of influence.
I repeat my request to the noble Baroness and invite her to convince the Committee that the SSRO is truly independent. What mechanisms will be put in place to assure us, the world, industry and so on that this independence is real? Can she give us some practical indication: for instance, will the Secretary of State or MoD staff be allowed to communicate with the chairman or SSRO staff?
SSRO staff are covered in paragraph 7 of the same schedule, which says, quite bluntly:
“The SSRO may appoint employees”,
and,
“may pay its employees remuneration and allowances. Employees of the SSRO are to be appointed on such other terms and conditions as the SSRO may determine … The SSRO may pay or provide for the payment of pensions, allowances and gratuities to or in respect of any person who is or has been an employee of the SSRO”.
Finally, paragraph 17(3) says, very clearly:
“Service as a member or employee of the SSRO is not service in the civil service of the State”.
I ask the noble Baroness whether, as it appears from the schedule, the appointment is at the sole discretion of the SSRO. Will there be no interference from the state in any way, from the MoD or the Cabinet Office? Will pay be unfettered and will the SSRO be able to pay what is necessary to achieve the quality of employee necessary? In other words, will it have the sort of freedom—as far as one can see from simply reading this, the complete freedom—to appoint people on terms and conditions that are competitive with industry and, indeed, as good as, if not better than, those that will be allowed to DE&S-plus?
I move on to a straightforward question about procedure. Paragraph 10 of Schedule 4 states:
“The SSRO may determine its own procedure”.
I do not know why draftsmen do that, because it then goes on to say,
“but this is subject to sub-paragraphs (2) to (6)”,
which pretty well say that everything of importance has to be done by a committee. That is what I think it says. Can the Minister confirm that those provisions in sub-paragraph (3) cannot in fact be made by the board of the SSRO itself but will be made through a procedure of the committee as defined in, I think, sub-paragraph (2) and with the particular caveats that are in the subsequent sub-paragraphs?
Finally, I wish to raise an issue that I know we all worry about in public office: revolving door syndrome. I invite the noble Baroness to comment on the extent to which there will be limitations on where the members of the board, the executives of the SSRO, come from or go to. In particular, I am concerned about the extent to which they may be leading lights in the industry and carry their industry heart with them into the SSRO or, conversely, come out of the SSRO into plum jobs in industry. Will there be some limitations?
We have a couple of amendments in this group, which are just to enliven the debate. In the first, I wish to bring some independence to these appointments and suggest that they should be ratified by the House of Commons Defence Select Committee. In the second amendment, I suggest that the committee to which I referred earlier should have a majority of members who are not employees of the SSRO. I beg to move.
Lord Tunnicliffe
While I commend the noble Baroness on her anticipation of my speech, I wonder whether, where she has not answered my direct questions, she will write to me.
Lord Tunnicliffe
Lord Tunnicliffe
My Lords, I am sorry that I did not make a closing speech because the idea of HMT having performance targets and a bonus culture does not fill me with enthusiasm. I may write to the Minister on that.
In moving Amendment 18J I shall speak also to Amendment 18K and to oppose that Clause 25 should stand part of the Bill. The issue here is essentially one of transparency. The offending subsection in Clause 14 is subsection (7), which states:
“The Secretary of State may direct that a particular contract to which subsection (3) applies is not a qualifying defence contract even though the contract otherwise meets the requirements of subsection (2)”.
One loves legislation that contains such clauses because they mean something like, “Never mind the whole of this document because the Secretary of State can decide it does not apply”, which roughly speaking is what this says. Amendments 18J and 18K recognise that there will be circumstances in which, frankly, this whole part of the Bill is excluded by the Secretary of State. It invites the Secretary of State to bring full details to Parliament and explain why the decision has been made. I should like the Minister to set out the circumstances in which subsection (7) would be used. I have asked the question privately and was given a general answer saying, “It is about the peculiarities of government-to-government contracts”. It seems to me that my amendments are entirely reasonable in those circumstances. It is entirely reasonable where there is some other assurance process, such as, “The Americans are going to do it for us” or that there is a treaty with the French which lays out the provisions to do this. That would be when this clause is used.
The Grand Committee is a small group today and we are discussing a very dry subject, but it is one that concerns the moving about of hundreds of millions and, indeed, billions of pounds. If a chunk of money of that order is moving about, Parliament should know under what circumstances it is being moved about, why the SSRO is not involved, and what assurances the public purse can be given by the Government as to what is being done. I expect that in her response the noble Baroness will talk about government-to-government contracts and I look forward to her touching on the detail of that.
The other area that came to light only when I delved into this with more care is the fascinating area of critical industrial capability. I am not sure whether that is the favourite way of referring to the concept these days, but I am sure that my meaning will emerge. Critical industrial capability is a concept whereby the taxpayer shovels out an awful lot of money to various contractors, a substantial part of which goes to BAE Systems, in order to keep workers on the books who are not doing work so that they are available to do work later. I am not even saying that that is wrong. I can see precisely why it makes sense. A more holistic view of the problem might be to schedule one’s procurement in a smoother way so that they are working continuously, but, conceptually, I can see why the former concept is necessary. However, it is important to realise just how substantial this is. We had a recent Statement on aircraft carriers. I read what the Minister said but the BAE Systems press release is in some ways even more interesting in that it is quite revealing. It states:
“BAE Systems has reached agreement in principle with HM Government on measures to enable the implementation of a restructuring of its UK naval ships business”.
The perception of BAE Systems is that this is about the naval ships business. The press release goes on to say:
“In 2009, BAE Systems entered into a Terms of Business Agreement (ToBA) with the Ministry of Defence that provided an overarching framework for significant naval shipbuilding efficiency improvements in exchange for commitments to fund rationalisation and sustainment of capability in the sector. The agreements announced today, together with an anticipated contract for the design and manufacture of the Type 26 Global Combat Ships programme, will progressively replace that ToBA”.
This is about maintaining capability. A couple of paragraphs later, it states:
“Under the new Target Cost contract the industrial participants’ fee will move to a 50:50 risk share arrangement”—
it is talking about carriers—
“providing greater cost performance incentives. The maximum risk to the industrial participants will continue to be limited to the loss of their profit opportunity”.
This clearly—at least in my view—is not compatible with Part 2 of the Bill. Apparently, Part 2 allows risk-sharing only under Clause 16, as far as I can see, and that in no part talks about limiting the loss to the profit component. It implies that the loss would go down the middle and deeper into it.
The press release refers also to the three offshore patrol vessels. Noble Lords may recall that the Secretary of State’s speech made it clear that these were pretty cheap because, frankly, they were being paid for by the industrial capability budget. The press release goes on:
“Following detailed discussions about how best to sustain the long-term capability to deliver complex warships, BAE Systems has agreed with the UK Ministry of Defence that Glasgow would be the most effective location for the manufacture of the future Type 26 ships”.
We should remember that the press release is written for shareholders, not the public, so it re-emphasises:
“The cost of the restructuring will be borne by the Ministry of Defence”.
It seems to me that these sorts of contracts do not come within the proposed framework that Part 2 talks about. In order for such a contract to be completed or negotiated in the future, Clause 14(7) would have to be invoked. Essentially, I am asking whether I am right in those presumptions. I am very happy to be written to because I accept that I have raised rather a new point. If that subsection is to be invoked, and if this capability and that sort of contract is to be involved, costing hundreds of millions of pounds, and probably the odd billion, it seems to me that the public and government should know about it in a rather more open way. Our amendments would require this to happen: the public should know and Parliament should know.
On Clause 25, essentially I am asking the Minister whether I am right that this is the only reference in the Bill to the issue that I have been talking about. Clause 25 seems to stand out as not being cross-referenced anywhere else in the Bill. It suddenly pops up on the subject of overheads and forward planning. I assume that this relates to the reporting structures. I should have said at the beginning that the reporting structures in the Bill are in many ways the essence of it, and the fact that I have no amendments on them is an acknowledgement that I commend the reporting structures and what they do. However, regarding Clause 25, I ask whether this relates to this concept of critical industrial capability and, if it does, in what circumstances Clause 25(8) would apply. Those of us who are required to study legislation always look for this paragraph:
“The Secretary of State may direct that a particular contract is not to be taken into account in determining whether the ongoing contract condition is met in relation to a financial year”.
In other words, if it gets very difficult, the Secretary of State can determine that it shall not be taken account of.
I hope that the Minister will be able to help with these questions and I am content that she may need to write to me. I beg to move.
Baroness Jolly
My Lords, I will consider Amendments 18J and 18K together and then move to the clause stand part debate.
These amendments relate to the Secretary of State’s power to exempt contracts from the new framework, provided for by Clause 14(7). Amendment 18J has no impact in its own right other than to add scope for a limitation to the Secretary of State’s exemption power. That limitation is provided by Amendment 18K. Subsection (7) gives the Secretary of State the power to exempt individual contracts that would otherwise be subject to the new regime. While it is not possible to foresee all future circumstances, this power is considered necessary for a number of reasons.
Before considering the limitation introduced by Amendment 18K, it might be helpful to noble Lords if I outline and give examples of the key circumstances in which we expect this power to be used. The first circumstance is where there is no market failure. The framework addresses the situation where a contract price is not subject to the competitive pressures of the market. If those pressures are evident in the contract price, the framework is not required. An example is the purchase of additional items that are readily available in the civil market, such as computers. To ensure compatibility with our existing infrastructure, we might want to use a particular manufacturer, so the procurement would be a single-source procurement. However, the item might have a price that has been established in a competitive market. In such cases, there would be no requirement for standardised reporting and open book rights to ensure value for money, because it would be self-evident from the marketplace. Applying the framework in such a case would not represent value for money, as the additional costs of making the contract a regulated contract would not be outweighed by the benefits of transparency.
Lord Tunnicliffe
I take it that that was an offer to write to me with the one-and-a-half-page response.
Baroness Jolly
I am more than happy to read it to the noble Lord. Would that help?
Lord Tunnicliffe
It might help, because the noble Baroness will probably have to put it into the record anyway, on Report.
Baroness Jolly
The framework provides for a range of reports to be specified in the single-source contract regulations upon both specific contract costs and upon supplier costs that relate to wider capabilities and capacity. It is estimated that around a third of the costs of single-source contracts relates to so-called overheads. These account for some £2 billion a year of expenditure under single-source contracts. These costs do not relate to any one individual contract but, it is said, represent the costs of providing particular industrial capabilities and capacity. Not all of the costs of this capacity will be reflected in the costs recovered through single-source contracts. Some may be recovered through MoD contracts won competitively, or through non-MoD customers. However, in some sectors where single-source activity is particularly concentrated, these costs may represent the majority, if not all, of the costs of capacity.
The new framework has six reports relating specifically to these costs. These include reports on the estimated costs that are used to price contracts, the assumptions that underpin those estimates and the actual costs that are subsequently incurred. The requirement for suppliers to keep relevant records in relation to costs and the MoD right to examine those records also apply equally to these overhead costs, as they do to any other allowable costs. In addition to these transparency rights, the pricing principles set out in relation to allowable costs also apply to these overhead costs. Such costs must be appropriate in nature and reasonable in value.
The transparency provided by these reports, the access to records supporting them and the requirement to follow the pricing principles will further enhance the ability of the MoD to act as an intelligent customer when considering the cost of the capacity it requires. The single-source contract regulations will also provide for a further report that specifically considers the industrial capacity provided by our key suppliers. This report will supply senior individuals in the department with consistent information across suppliers when considering capacity requirements, contributing to the alignment between requirement and the industrial capacity we have to pay for. I hope that the noble Lord will now consider withdrawing his amendment.
Lord Tunnicliffe
My Lords, I thank the noble Baroness for that response. We have used different terms but I think she has gone half way to meeting my concerns over what I have called the critical industrial capability. I did not of course put down a clause stand part debate in order to not have a clause, but to understand it better.
However, one area still concerns me. The sort of deals that I described from the BAE Systems press release are very large, and I have great difficulty in seeing how you would fit them, in future, into Part 2, which is full of pricing mechanisms, profit share and so on. It is quite detailed and there is a framework. I am happy for the Minister to write to me rather than give me an answer now, but one of the questions is whether she envisages that such deals will be fitted into Part 2 or whether it will be necessary to use Clause 14(7) or some other exception—as the Minister has pointed out, there are other exceptions in that clause. Does the Minister envisage there needing to be an exception for those sort of deals or is it envisaged that future deals of this nature will be somehow compatible with Part 2 in ways that, at the moment, I am incapable of understanding? I would be very grateful for a response to that detailed question, although I would not encourage her to give me one now. With that, I am content to withdraw Amendment 18J.
Lord Tunnicliffe
“(3) Single source contract regulations may provide that, if the achievement of a fair and reasonable contract profit rate for a qualifying defence contract at the time of pricing was frustrated because the information supplied or made accessible by one party to the other at the time of pricing, and on which that contract profit rate was based in whole or in part, was materially inaccurate or incomplete, the SSRO—”
Lord Tunnicliffe
My Lords, in moving Amendment 18L, I will also speak to Amendments 18M and 18N. I find myself in the unusual position of a public sector socialist politician putting forward some amendments nakedly proposed by industry. However, it seemed that the questions being posed deserved a response and a discussion. I hope the Committee will forgive me proposing these amendments as a bunch of probing amendments for the Minister to respond to.
The industry argues that Clause 18(3) creates uncertainty as to the contract price. It enables the contract price to be challenged at any time after it has been agreed if the party considers that adjustments under steps 2, 3 or 6 of Clause 17(2) were not appropriate. When approving or signing a contract, a board of directors will require certainty of income against which it can assess its cost estimates and associated risks. It contends that the sense of uncertainty over price may have unintended consequences for shareholder value, group decisions on where to invest, and the perception in the wider marketplace that the UK remains a good place to invest in and do business. It believes that the parties should have a limited time period in which to challenge the adjustments made in steps 2, 3 or 6 to reduce uncertainty, and that a period of six months from the date of price agreement is more reasonable.
The industry also argues that the grounds for a challenge need to be included in the Bill. There needs to be a material basis for the challenge such as that the adjustment has caused harm or disadvantage to one party. An error or an omission that has caused harm or disadvantage, and if corrected would give rise to a material adjustment, would be a more reasonable basis. Without materiality or a de minimis threshold, challenges could be made for trivial amounts. I beg to move.
Lord Tunnicliffe
My Lords, I thank the Minister for her response, which I will study with great care. I am sure that those outside the House will study it with even greater care. In the mean time, I beg leave to withdraw the amendment.
Lord Tunnicliffe
“(1) The Secretary of State shall by regulations, for each financial year, provide a determination of—”
Lord Tunnicliffe
My Lords, in moving Amendment 18P I will speak to the rest of the amendments in this group. The points I want to make are simple, but I look forward to the reply I shall receive to these simple ideas.
The group essentially refers to Clauses 19 and 20. Clause 19 addresses the issue of the contract profit rate and, essentially, the amendments would require that the rates must be set by regulation each year. Amendments 23A and 23E turn this into an affirmative-procedure process.
More interesting is Clause 20, “Allowable costs”. As the report of the noble Lord, Lord Currie, points out, we have over the years had a lot of debate, effort and negotiation into the contract profit rate which, typically, is 10%—pedantically, it is 9%—of the total price; and too little, one might argue with the benefit of hindsight, into the issue of allowable costs, which represent 90% to 91% of the total price. Therefore, Clause 20 properly addresses this issue.
Subsection (1) states:
“The SSRO must issue guidance about determining whether costs are allowable costs under qualifying defence contracts”.
Subsection (2) attempts to define allowable costs. It is important to emphasise that these are the big bucks. This is where the big money is in the contract. This is 90% or more of the total price. The guidance we get from the primary legislation is that they must be appropriate, attributable to the contract and reasonable in the circumstances. Much as I praise this part of the Bill—and I do as it is a really good attempt to address this extremely difficult issue—I cannot but be amused by these three descriptors of one of the most important elements. I remember that when I was privileged to be in the noble Baroness’s position, whenever an official used the word “appropriate” in my response, it meant we did not have an argument, so I dismiss subsection (2)(a) as pretty well irrelevant. I do not have a lot of time for paragraph (b) either, because if it is not “attributable to the contract”, who would in all conscience try to argue that it should be there? We are left with “reasonable”. Much as I applaud the concept of being reasonable, it is not a very full description. Therefore, inevitably, and quite properly—I am not unhappy about this—it will have to be left to the SSRO to develop guidance about it. However, surely this is so important that it should not be merely guidance but should be in regulations. Regulations of this importance should be exposed to public gaze and debate and should be accountable to Parliament through the affirmative procedure. I beg to move.
Lord Palmer of Childs Hill
My Lords, I, too, am worried about these words. I shall not repeat what the noble Lord, Lord Tunnicliffe, has said. It is really a question about what are allowable costs. As anybody in business knows, allowable costs can be described in so many ways. For instance, Starbucks does not pay any tax in this country because it charges its royalties from overseas against its costs in this country. Would that on a contract for a submarine be allowable costs? If the contractor is producing, let us say, one submarine, can it therefore charge all of its chairman’s, managing director’s and executive board’s salaries against the cost of that one submarine? If it is also producing a group of battleships or carriers, those executive costs, for example, would be spread over all the costs of all those items of equipment.
In her previous reply, the Minister spoke about an audit trail. The noble Lord, Lord Tunnicliffe, used the word “reasonable” and all the other adjectives. A contractor who wished to drive a coach and horses through this could do so by manipulating what could be administrative costs. It is very easy to say that if the mythical submarine requires a widget, that widget is applicable to that submarine. You can see that, but when you are dealing with, let us say, the premises for the submarine, if it is one submarine, is the contractor allowed to charge the whole of the premises costs against the cost of that submarine? If it was also building an aircraft carrier, it could charge some of that premises costs against it. I invite the Minister to come back, perhaps on Report, with some better reassurance about how allowable costs will be allocated and particularly about how to spread large costs if only one item of equipment is produced by that contractor.
Lord Tunnicliffe
My Lords, I thank all noble Lords who have taken part in this debate. I congratulate the Minister on her spirited defence. Unfortunately, it failed. Our concern about the processes is real, and our overwhelming concern is the billions of pounds that are tied up in allowable costs. As we will go on to discuss, the various forms of contract are an important chunk of the real profits of the company. At the end of the day, this is a negotiating game. It is a matter of how much you can legitimately build into your allowable costs, with a profit rate on top of that. Allowable costs are at the centre of what defence contracts cost and what the taxpayer must pay. I do not feel that the Minister, despite her spirited defence, has addressed our concerns—not only my concerns, but those of other Members of the Committee—on allowable costs. I fear that we will be tempted to return to this on Report. As I believe this to be an apolitical issue, I encourage the Minister to ponder today’s debate and to see what she can add to it. We would all enjoy receiving a letter from her that would provide nuance to the Government’s position and I encourage her to do that. It is a matter of real concern to the Committee. In the mean time, I beg leave to withdraw the amendment.
Lord Tunnicliffe
My Lords, I will speak to Clause 21 and to Amendment 23C. I must emphasise that our opposition to Clause 21 standing part of the Bill is not directed at the essence of the clause; it is to explore the clause. However, I fear that we must explore it fairly widely.
The concept in this clause, of a final price adjustment, comes out of the report by the noble Lord, Lord Currie. It addresses the key issue of profit that arises from the outturn. In my view, it is conceptually very sound. It is utterly meaningless without the regulations so I thank the officials and the Minister for sharing the regulations with me. After considerable effort, I think that I understood the early part of the regulations, particularly in relation to Clause 21(2), and they seem very sensible. They have a clawback of excessive profit of up to 75% and they support the supplier in a position of excessive loss at 50%, on the simplistic assumption that the profit rate is 10% of the allowable costs. There is quite a broad band, between 96% and 110%, where all variation falls to the supplier’s bottom line, which is a very strong incentive for the supplier to become more efficient and make more profit. I am not against suppliers increasing profit if that is achieved through efficiency. I am entirely in favour of it in this new open book, multi-reporting regime whereby the MoD can share in that experience through the reporting regime, understand it and help future suppliers understand how they can deliver at lower costs and more efficiently. It is a good regime.
Essentially, Amendment 23C simply argues that the regulations referred to in Clause 21(2) should be approved by Parliament using the affirmative procedure. Having recovered from the effort of understanding subsection (2), I gave up the ghost intellectually at that point and stopped reading the Bill. However, since then, I have started to read it again and I find Clause 21 a little difficult to understand, so I have a series of genuine questions for the Minister.
Clause 21(3) states:
“Provision made under subsection (2) must include provision for the amount of any adjustment to be determined … by agreement between the Secretary of State, or an authorised person, and the primary contractor”.
Does that mean that the regulations set out in subsection (2) may or may not be obeyed? In other words, can the Secretary of State agree to disregard the regulations under subsection (2), in which case it seems that the process of developing and publishing the regulations was valueless; or does it simply mean that the parties agree that the figures are right and so on? Is it a clause which simply invites the parties to agree, and if they do not agree the matter can be referred to the SSRO?
Given the precision of the regulations as I read them—I recognise that many thousands of man hours have gone into crafting them—I had some difficulty in understanding Clause 21(4), which states:
“Provision under this section may be expressed so as to apply … to particular kinds of qualifying defence contracts”.
What would be the differences and how would they apply? I genuinely have trouble envisaging what the different sorts of contracts may be like.
I assume that Clause 21(4)(b) is a simple de minimis provision—namely, that there should be a value below which you do not quibble because it is simply not worth doing so. I was fairly comfortable that it was a de minimis provision until I read Clause 21(5)(a) and (b), at which point I gave up the ghost because I could not understand what subsections (5)(a) and (5)(b) meant if subsection (4)(b) is a simple de minimis provision because subsections (5)(a) and (5)(b) seem to be super de minimis provisions. My general view of Clause 21 is that it is great in so far as I understand it, but I have to confess that I do not fully understand it and I seek enlightenment.
Baroness Jolly
My Lords, this is a crucial element of the Bill because it protects the taxpayer against contractors earning excessive profits while also protecting industry from excessive losses.
The basis of the Bill is that contractors should get a fair return on single-source work, and even better returns if they can drive cost efficiencies which deliver long-term benefits to the MoD. However, they should not be entitled to super-profits just because, despite best intentions and efforts, both parties happened to get the pricing wrong. Likewise, in the same circumstances, suppliers should not be expected to suffer losses. This clause offers protection to both parties. The clause enables a final price adjustment on completion of a contract if the actual costs of the contract turn out to be markedly different from those agreed at the time of pricing. The mechanism will be applied to all qualifying defence contracts priced at the outset on the basis of a firm or fixed price.
At Second Reading in the House of Commons, statements were made to the effect that provisions such as this are undesirable because an agreed contract price should be an agreed contract price and that clauses like this remove pricing certainty and dampen supplier incentivisation. There is some truth in the observation, but I believe the clause strikes a good and proper balance between incentivising suppliers and protecting the public purse in the way that the noble Lord, Lord Currie, recommended it should. It should also be noted that on a number of occasions in the past when suppliers incurred very substantial losses, such as on the Nimrod programme, they have come back to us for more money. Since we need the capability they provide, it is not in our interest to let a supplier go bankrupt by holding it rigidly to its contract price.
I must also tell the Committee that this clause does not introduce a new idea into single-source contracting. Provisions for a final price adjustment have been in place since 1968 under the existing Yellow Book arrangements, and a mechanism very like Clause 21 has been in place since 2004. It is in many of our single-source contracts and has already been successfully used to recover excess profits from our suppliers on some contracts. However, because the existing mechanism is contractual and needs to be negotiated, sometimes suppliers refuse to agree to its terms. This happened on a recent large maritime maintenance contract where commercial officers had to give it up in exchange for another provision we desired. That is why we want to legislate to provide this protection. If Clause 21 falls, a significant protection for both parties falls with it.
Clause 21 also states that any adjustments to the final price will be determined by the Secretary of State and the contractor. However, if an agreement cannot be reached on whether an adjustment is required or on the amount of that adjustment, the clause enables either of the parties to refer the matter to the SSRO for a binding determination. The clause will be used for particular types of contracts—firm and fixed-price contracts, which account for 60% of our single-source contracts—and the SSCRs will set out the minimum value for applying these provisions.
Finally, the clause gives the Secretary of State a power, on a case-by-case basis, to exempt a QDC from any final price adjustment as long as the value of that QDC is within the range to be specified in the SSCRs, which is expected to be between £5 million and £50 million. When deciding whether to make such an exemption, the Secretary of State must have regard to any matters which will be specified in the regulations. The clause is an important element in protecting both parties in defence contracts: the Government against suppliers’ excessive profits and industry from substantial losses, which ultimately would not be in the MoD’s interest. It is therefore crucial that it remains in the Bill.
Amendment 23C is part of a group of amendments which relate to the regulations that are to be made by statutory instrument under Part 2 and the parliamentary procedure by which those regulations will be made. We have previously discussed this in relation to Clauses 19 and 20 and Amendments 23A, 23C and 23D. Amendment 23C would provide for regulations under Clause 21 to be subject to the affirmative procedure. These regulations are for the final price adjustment and are currently subject to the negative procedure. The final price adjustment is expected to apply to around half of qualifying defence contracts—those which are firm or fixed price—and will have effect only when the costs incurred under these contracts are significantly different from those estimated at the time of pricing. The mechanism provided for by the draft regulations under Clause 21 is a relaxation of an existing mechanism that has been in place since 2004 and follows one of the recommendations by the noble Lord, Lord Currie. The Delegated Powers and Regulatory Reform Committee did not recommend that regulations under Clause 21 need be subject to the affirmative procedure and we, too, do not consider that these regulations warrant it. I urge the noble Lord not to move Amendment 23C.
Clause 21(4)(a) applies only to a particular kind of contract. The final price adjustment applies to all firm and fixed-price contracts, but with “pain and gain share” contracts, where the MoD and industry agree sharing provisions such as 50:50, it would not be appropriate to have two sharing mechanisms running simultaneously. Clause 21(4)(a) allows us to exclude “pain and gain share” contracts from the final price adjustment. The noble Lord queried the effect of Clause 21(4)(b). It is only to provide for a de minimis level. I am advised that the effect of Clause 21(5)(a) and 21(5)(b) is complex, and I will write on that.
Lord Tunnicliffe
Lord Tunnicliffe
My Lords, Amendments 18R, 18S and 18T are prompted by industry, which seeks to argue that there should be a mutuality in obligation and a test of materiality. The industry argues that there should be a mutual obligation on the primary contractor and the Secretary of State to notify the other of events, circumstances and information that are likely to have an effect on, or relevance to, a contract. The MoD will have information that is likely to have an effect in relation to a qualifying defence contract, whether that affects its price or performance. The MoD should have a duty to disclose relevant information to the contractor, which must be reflected in the Bill. I understand that this duty was confirmed by the Government in Committee in the House of Commons but I would value further affirmation.
As a result of the broad scope of events and circumstances that are likely to have an effect on, or relevance to, a contract covered by Clause 26(1), it is realistic that the contractor or the Secretary of State should be required to notify only when they believe there is a likely effect or relevance. Without this restriction, the obligation to notify is extremely broad. Further, it is argued that it is not necessary to refer to the effect on costs per se; the important aspect is whether there is an effect on price, such that Clause 26(3)(a) is unnecessary. I beg to move.
Baroness Jolly
My Lords, one of the flaws in the current Yellow Book framework is that it provides little transparency once on contract. A key objective of the new framework is that the MoD should be able to monitor the health of single-source contracts on an ongoing basis, receiving timely information so that it can take fast and effective action. This is very important. There have been too many examples in the past when the MoD has discovered cost or time overruns on single-source contracts far too late for remedial action to be taken. Receiving information throughout the course of a contract will give the MoD the opportunity to work with contractors to take early action to avoid or minimise the impact of issues as they arise. This clause is one of several that provide this transparency.
A supplier will always know more than the MoD about the issues affecting its their delivery of a particular contract. Some of our suppliers share information on an open basis, alerting us as issues arise so that decisions can be taken on a joint understanding of the best information available at the time, but not all of our suppliers do this.
The standardised reports that will be required under Clause 24 will provide periodic snapshots of contract performance. However, for contracts below £50 million in value, a report may be received annually or still less frequently, and even for our largest contracts a standardised report is only required quarterly. These periods are appropriate for standardised reporting, but three months can be a long time in managing a contract, especially complex contracts worth many millions, or billions, of pounds.
Clause 26 therefore supplements the regular contract reporting, placing a duty on contractors to let the MoD know, in a timely fashion, of matters material to the contract. Putting the onus on the contractor in this way means that the new framework can be “lighter touch” than it would otherwise be if the only means by which alarm bells could be sounded on a project was through periodic reporting and the MoD’s monitoring powers.
Amendment 18R would make the Secretary of State subject to the same duty, providing notifications to the contractor. Clause 26 will place a duty upon a contractor to notify the Secretary of State when the contractor becomes aware of the occurrence, or likely occurrence, of “events”, “circumstances”, or “information” that are likely to have a material effect on a qualifying defence contract. Applying this same duty would require the Secretary of State to notify the contractor of events, circumstances or information that are likely to have a material effect on the contractor’s costs—the subject of Amendment 18T—the contract price, or the contractor’s performance.
Let me first be clear that this does not concern changes to our contractual requirements. If the requirements of the MoD change, and this affects an existing contract, then we require a contract amendment to reflect those new requirements. This should be quite separate to the delivery of requirements already contracted for; if we wish to amend the contracted requirement, we will tell the contractor and begin the commercial process of amending the contract, and this is not a matter that requires legislation. The contractor is not forced to make the amendment, and they will charge us for any additional costs that might arise, or amend performance requirements if this is relevant. Until we seek a contract amendment, a contractor should be concerned with managing the existing contract.
For contracts which we are not in the process of amending, this duty would require the Secretary of State to assess the impact of events, circumstances and information across the department upon each contractor’s contracts. This is quite different from the duty placed upon a contractor when they are managing a contract in the normal course of business. It would require the Secretary of State to assess what might, or might not, affect a contractor’s cost or performance, to look beyond the contract and assess whether a contractor’s activities are likely to be affected. This duty would be impossible for any Government to discharge.
We agree that when a contract is being priced, the duty to share information should be reciprocal. Both parties should share their assumptions to ensure that the price agreed for the contract is both fair and reasonable and value for money. However, once a contract has been entered into, it is the contractor who must manage the delivery of the contract, and who is responsible for the performance of its business and costs. It is not the responsibility of the Government to second guess what is likely to have an impact upon how a contractor achieves their contracted requirements. We do not accept that Clause 26 represents an equal duty when placed upon the Secretary of State compared to a contractor. It would be inappropriate to place this duty on the Government and impossible for a Government to fulfil.
Amendment 18S is the second in this group, and it seeks to qualify the duty to notify by adding the requirement that, for each of the three elements under subsection (1), the contractor believes in the existence of the effect or relevance. Each element requiring notification under subsection (1) is expressed as,
“likely to have a material effect”,
or,
“likely to be materially relevant”.
This means that a contractor need only notify the Secretary of State if two tests are met: first, that an effect or relevance is likely; and, secondly, that an effect or relevance is material. If a contractor considers that an effect or relevance is not likely or not material, then no notification is required.
The effect of this amendment would be to add a third test: that an effect must be likely, material, and believed to exist. We do not think that an effect could be considered both likely and material and yet at the same time not be believed to exist. To put it another way, if it were not believed to exist, how could it also be considered likely to have a material effect? Without embarking on a debate on the nature of belief, it is not clear what this third test adds.
Where there is a disagreement between a contractor and the Secretary of State over whether a contractor should have provided a notification under this duty, the Secretary of State may issue a compliance or penalty notice. Ultimately, it will be for the SSRO to determine whether a notification should have been provided and, in doing so, it will consider the two conditions of “likely” and “material”. We consider that the two conditions already required for there to be a duty to notify are sufficient and that the third test of belief proposed by this amendment is unnecessary.
Moving on to Amendment 18T, Clause 26 provides for three matters that are the subject of the duty to notify; these are listed in subsection (3). They are the costs under the contract, the total price payable under the contract, and the contractor’s performance of material obligations under the contract. This amendment seeks to remove the first of these matters—the costs of the contractor under the contract. The effect of this amendment requires some explanation as there is some overlap between the first two matters—the cost and the price payable under the contract. For cost-plus and target-cost contracts, the costs incurred under the contract will directly affect the price payable under the contract, so there is a limited difference between the two matters for these contracts, which represent just under half of the single-source landscape. The rest are firm or fixed-price contracts under which the contractor’s costs may vary while the price payable may not. So it is firm and fixed-price contracts that would primarily be affected by this amendment.
The reason that we wish to be notified in relation to both costs and price under the contract is the same as the overall requirement for Clause 26—to ensure that the MoD receives timely warning of matters affecting contracts. If the costs of a firm or fixed-price contract are likely to materially change, this is still important management information for the MoD. It may indicate a significant risk to the project or signal future performance issues. Just because it may not affect the price payable does not mean that this is not important information. For example, a contractor could manage a contract for a year in between standardised reports being provided to the MoD. In that year, a significant risk could be recognised and material costs could be incurred in trying to manage the risk in the expectation that performance under the contract will not be affected. However, despite the additional costs incurred, it finally becomes apparent that performance is likely to be affected after all, at which point a notification would be required.
It is a characteristic of single-source procurement that there is only one supplier that can provide the capability we require. If the contract fails we lose the capability we need. This has led suppliers in the past to seek price increases even though we have agreed a fixed price. Where the cost increases are very large, this puts the MoD in a difficult position. Seeking to keep to the fixed price can lead a supplier into great financial difficulty, putting not only that contract but others with that supplier at risk. If the supplier fails, then we lose the capability we need. This is a real risk that has arisen in the past, and thus we need the same transparency over the costs of fixed-price contracts as we do for other contract types. We do not see a benefit to applying a different notification requirement to firm and fixed-price contracts, so that for these contracts notification is only required once performance is likely to be affected, while for other contracts notification would be required at the point that costs, and therefore price, are likely to be affected. This is not the early warning that this provision is intended to provide.
For all these reasons, I urge the noble Lord to withdraw the amendment.
Lord Tunnicliffe
My Lords, I thank the Minister for her response, which I will read with great care in Hansard. Others outside the House will read it with even more care. In the mean time, I beg leave to withdraw the amendment.
Lord Roper
My Lords, I welcome the Government’s amendments to these various clauses. They are a very full response to the report of our Delegated Powers and Regulatory Reform Committee of last December, which was responded to by the noble Lord, Lord Astor, in his letter to the committee published earlier this year. It seems that in these amendments the Government have taken fully the points that were made by the report. We are very well served by that committee, which ensures that there is the technical scrutiny to ensure that parliamentary control is maintained when there are questions of delegated powers. I feel that the Government have responded fully to the proposals of the committee. I am not sure whether it has yet had a chance to respond to the letter of the noble Lord, Lord Astor, or if there are any further points that we may need to come back to on Report, but I understand that it is generally satisfied with these amendments.
Lord Tunnicliffe
My Lords, at this point I have no objection to the government amendments, but that may be partly because I do not understand them. I shall find them easier to read when the Bill is reprinted for the Report stage but, as I say, I have no comment or objection at the moment.
I may be about to contradict myself when speaking to Amendments 22A and 23B. Amendment 22A is prompted by the industry, which has argued that the regulations arising as a result of the review should be made and updated in an open and transparent manner. It argues that an industry-wide consultation should be undertaken, the Secretary of State should have regard to that consultation and the regulations should be laid before Parliament. Amendment 23B argues essentially that the penalties regulations should be passed by the affirmative procedure on every occasion. These are penalties which could have dramatic effects.
I think that this is the last time I will speak, so I should like to congratulate the Minister on her marathon performance. I recall from when I occupied her place that it can seem a bit futile, but I know that what she has read into the record will be held to be of great value by both parliamentarians and those outside. I thank her and her officials for their efforts, and I look forward to reading with great care the products of our discussions. I also look forward to her letters.
Baroness Jolly
I thank the noble Lord for his comments and I am sure that I will get my pen out and start writing as soon as I have consulted with the gentlemen sitting behind me. On a slightly more serious note, I am sure that we will have meetings with the Bill team and people from the MoD.
I turn now to the amendments. Amendment 22A would place a statutory duty on the SSRO when performing its review of the single-source framework to consult with industry and to publish the results of the consultation exercise. As noble Lords will be aware, many aspects of the single-source framework under Part 2 will lie in regulations rather than in primary legislation, and many of the clauses in this part give the Secretary of State the power to make those regulations. This is to allow the regulations to be periodically updated to take into account changes in procurement approaches, the defence sector and what is being procured, without the need for primary legislation. I reassure noble Lords that we are aware that the new single-source framework represents an important change to single-source procurement. We have been consulting closely with the industry throughout the development of Part 2, including the Bill and the detail of the regulations.
In October 2011, the noble Lord, Lord Currie, published his report and we subsequently ran a full public consultation which completed in January 2012. In April of that year we started a defence suppliers’ forum subgroup with our top 10 single-source suppliers. These included BAE Systems, Finmeccanica, Rolls-Royce, Babcock, Thales, MBDA, QinetiQ and others. Over the past two years we have met with them more than a dozen times to share our proposed approach and understand their concerns. Beneath this forum we also established a number of technical working groups on specific matters such as confidentiality, the SSRO and risk, and most recently on the regulations themselves. In January alone this year we spent four full days discussing the draft regulations line by line with industry, and we expect further such discussions before the summer. This is a substantial level of consultation, more than is typical for new government policy, and it has resulted in our making some important changes to our framework, such as introducing the new criminal offence to protect industry information.
It is certainly not in our interests to create an unworkable framework. For one thing, we pay for any additional overheads our suppliers will incur, which will be incorporated into their single-source prices, provided that they are reasonable. We also need the capability they provide and have no desire to make it hard to do business with the MoD. Indeed, it is out of a desire to ensure that the framework is as practical as possible that we have consulted with industry to the extent that we have. Industry cannot claim that it has not been consulted prior to the first regulations being made.