Source: Atlantic Council

10/20/2011 Jonathan Dowdall - defenceiq.com

2011 is proving a momentous year for European militaries, with both spending cuts and new cooperative ties radically shaking-up the defence establishment. Yet whilst the austerity screws continue to tighten in national capitals, in the European Union’s corridors of power, something far more fundamental is coming into force. On the 21^st of August, phase two of the EU’s “Defence Package” passed into binding law, beginning a paradigm shift for European defence industry relations. Indeed to put it simply - and in the words of an executive from one of Europe’s largest defence companies - “this is the biggest thing to happen to European defence ever.”

As always, Defence Dateline will take you through the key points of this landmark policy.

The need to “De-frag” EU defence

The Defence Package seeks to address the fragmentation and un-competitiveness of the EU’s defence industry. The core question is: how has a continent that spends a not-insignificant €200bn a year on defence ended up with so little “bang for its buck”?

The arguments about low overall investment are well known, but in addition, inefficiencies in EU member state defence spending are exasperated by the division of its defence industrial base into 27 national markets. This fragmentation creates additional costs for buyers – i.e. European militaries - in two ways.

Firstly, because nations must acquire and pay for a myriad array of export licenses for even the simplest inter-EU weapons sale, pan-European defence transactions incur significant overheads. In fact, the European Commission has estimated that individual national licensing regimes and a lack of uniformity in application processes generates €400m in costs a year.

Secondly, Europe’s defence industry has for many years remained outside of the EU free market, due to a key component of the EU’s Lisbon Treaty - Article 296. This article allows nations to exempt defence and sensitive military procurement contracts from EU open competition laws - under the banner of “national security interests”.

Unsurprisingly in an industrial sector populated by national champions and niche interests, in practice almost all defence contracts have been declared “Art. 296”, and thus closed to open tender. This has obvious implications for market transparency and supply-discrimination, but it also creates generally disadvantageous market conditions across the EU. In effect, most national companies have guaranteed first access to their government’s contracts, regardless of competitors just across the border. This is not good for market and pricing forces, and it is not good for European military effectiveness.

Leveling the playing field

To address these issues, the EU legislated a “two-for-one” package of laws in 2009 to tackle these systemic problems.

Part 1, which came into force on the 30^th of June 2011, addresses the issue of export licenses. It induces member states to replace their existing individual licences with a general EU certificate for arms transfers between member state markets. If successfully implemented, this should reduce the bureaucratic overhead for inter-EU transfers to a simple and quick “rubberstamp”. Cross-border industrial transfers, as well as military procurement, will both stand to gain from such a move, at a fraction of the current export licensing cost.

Part 2, which entered into force on the 21^st of August 2011, tackles the larger problem of national protectionism. This directive demands that national procurement agencies align their contract tender announcements into a common EU format. Yet more crucially, it also puts additional restrictions on the use of Art. 296, by demanding that most supply or service contracts above €412,000 or procurement contracts above €5.15mmust abide by EU free market laws, meaning that they must be publicly announced and left open to European bids.

It is this second provision which seeks to truly shake-up the old order. By pushing European defence procurement into the open market, the EU is seeking to break monopolistic and protectionist tendencies in the defence sector. Significantly more European defence bids should, under the Defence Package, be open to any company within the EU, without prejudice to their country of origin.

Testing times - theory and practice

Needless to say, this utopian vision of a truly open defence market will not manifest over-night. In fact, huge questions remain about the effectiveness and implementation of the Defence Package.

Firstly, Art. 296 is not dead or buried. Member states retain their sovereign “national security” opt-out, even under the new law, as this is enshrined in the Lisbon Treaty and transcends individual legislation. National capitals will still have the legal right to exempt certain contracts from foreign competition, and thus shield their national industries. The question will be how widely states choose to enact Art. 296 under the new law.

Pre-emptively, the EU has already tried to cover this eventuality. The package contains a specific technical annex categorising the types of defence equipment that can be declared “national security” sensitive. Member states have thus had their legal room for manoeuvre severely curtailed. Gone are the days where everything from ammunition to jeep tyres could be lumped into a safe bid guaranteed to be won by a national arms champion. The onus will now be on member states to justify why a contract is too sensitive to tender openly.

Indeed, should a national government refuse to open a contract to pan-European tender, they could be vulnerable to a legal challenge by member states who feel their defence companies are being discriminated against. The EU Court of Justice could then be asked to adjudicate against a transgression of the free market, with financial penalties if an infraction is deemed to have taken place. It is also likely this would incur a certain amount of political embarrassment for the transgressor.

Yet the above scenario presumes the basic mechanisms of the Defence Package will be observed - and this has also yet to be tested.

At the bottom line, there are political, and not legal, questions about these reforms. Would a smaller member state (Slovakia for example) be willing to risk a public duel on behalf of its national industry with Germany or France over a procurement bid worth, say,  €10m? And would the political fall-out be worth the cost, as recriminations fly and politicians pontificate?

We simply don’t know at this stage how honestly member states intend to deal with the new rules, and how willing others will be to challenge them if they don’t. Art. 296 is ultimately a red-line: something the EU cannot supplant completely through law. It will thus fall to bilateral politics to smooth out the details in practice.

Transatlantic implications?

Interestingly this inter-EU shake-up may also send shockwaves across the Atlantic, as the directive compels a larger number of bids to be tendered on the EU free market - but not necessarily to those outside of it.

For instance, effectively only two “categories” of contract existed in Europe in the past - open to the world (and thus the US) or closed to national champions only. However with the addition of “open EU market” to that list - and the legal compulsion to push more bids into this category it entails - it could transpire that European procurement agencies will, whilst opening up to the EU27, simultaneously reduce the number of truly global open bids. After all, member states have simultaneously been granted cheaper and easier arms export licences to their European neighbours, an advantage the US cannot match.

Thus, whilst strongly denied publicly by the European Commission, the incentives to “buy European” have certainly de facto increased. It is difficult to imagine the US being “locked out”, but these fundamental changes in procurement could certainly alter the buying preferences of EU member states regarding US military equipment.

“The biggest thing to happen to European defence ever”

As this analysis indicates, the sources of Europe’s defence woes have industrial and bureaucratic, as well as spending, roots. The EU has aggressively set out to rectify these deficiencies, highlighting an increased readiness to legislate on defence matters and to introduce greater competitiveness in the last “closed shop” in town.

Yet whether the efficiencies and reduction in fragmentation that lies at the heart of these efforts can realistically be achieved is, as has been explained, an open question. It must also be remembered that a key component of market “de-frag” is a reduction in the number of defence primes. A truly open EU defence market would naturally begin to more closely resemble the national market of the US - with almost all bids fought over by a small number of multi-sector conglomerates.

The loss of national champions this would entail across Europe will almost certainly send governments dashing for the Art. 296 card. It is the biggest potential show-stopper for these reforms.

It will therefore be the willingness of national capitals to negotiate between themselves the loss of national capacities, in the name of greater EU efficiency, that will make or break a truly open European defence market.

Jonathan Dowdell writes for  Defence Dateline Group.