Single source defence contracting in the UK
The current procurement regime in England and Wales requires most Government contracts to be procured by a competitive process to select the most economically advantageous tender. In the defence sector, procurement is regulated mainly by the Defence and Security Public Contracts Regulations 2011. However, there are exemptions from this competitive framework, such as where disclosure of information under the regulations would be contrary to essential national security interests. “Single source” procurements are also permitted where there is only one possible contractor, such as where specialist military equipment can only be maintained (or replacement parts provided) by one contractor, or if a contractor has the unique engineering capability or intellectual property rights to perform the contract.
Around 50% of the annual expenditure of the Ministry of Defence (the “MoD”) on equipment and services is incurred through such “single source” procurements. This proportion is likely to increase, as the Defence and Security Industrial Strategy in March 2021 announced a move away from a “global competition by default” policy to a “more sophisticated and nuanced approach”, which uses competition where appropriate but gives greater consideration to the markets concerned, technology sought, national security requirements, international partnerships and socio-economic factors.
The Defence and Security Industrial Strategy also announced that the Government would reform the legislation governing single source procurement to “simplify the regime, speed up the contracting process, and introduce new ways of incentivising suppliers to innovate, take risk and support government objectives”. In April 2022, the MoD published a Command Paper outlining its proposed reforms, and the Procurement Bill currently before Parliament will make the necessary changes to the Defence Reform Act 2014 (the “Act”) to implement those reforms.
In this article we take a look at what can be expected from the reforms, based on the MoD’s published proposals and the draft Bill.
Regulation of single source defence contracts
Single source contracts in the defence sector are regulated by the Single Source Contract Regulations (the “SSCR”), made under Part 2 of the Act. The SSCR seek to ensure that value for money is achieved, and that contractors are paid fair and reasonable prices, where the MoD does not have the benefit of competition. The legislative regime is overseen by the Single Source Regulations Office (the “SSRO”).
In general, the Act and the SSCR apply to any contract under which the MoD procures goods, works or services for defence purposes, where the value of the contract is £5 million or more and the contract award is not the result of a competitive process (known as “Qualifying Defence Contracts” or “QDCs”). The Act also allows for contracts to be converted to QDCs on amendment by the agreement of the contracting parties. A non-competitive sub-contract to a QDC may itself be subject to the regime if has a value of £25 million or more (known as a “Qualifying Sub-Contract” or “QSC”).
Certain contracts are excluded from the regulatory framework, such as contracts with foreign governments, contracts for the acquisition of land, and contracts made within the framework of a cooperative international defence programme.
Previous Reforms
Under the Act, the Secretary of State for Defence is required to review the legislative regime every five years, with the first review carried out in 2017. The SSRO is also required to keep the regime under review and may recommend changes to the Secretary of State that it considers appropriate.
Following the 2017 review, the SSCR were amended by three separate statutory instruments in 2018 and 2019. The first made changes to the categories of contracts that are excluded from being QDCs or QSCs. The second changed the way in which the MoD and contractors are required under the SSCR to re-determine the price payable under a QDC or QSC when it is amended. The third changed the reporting requirements on contractors and made a range of clarificatory amendments. Our series of articles on these reforms sets out further details.
Proposed Reforms to the SSCR
The MoD began the next review process in mid-2019, with the SSRO submitting its initial recommendations in 2020 and its final recommendations in 2021. The MoD confirmed its intention to reform the Act and the SSCR and outlined the broad parameters of its proposals in the Defence and Security Industrial Strategy published in March 2021. The Command Paper published by the MoD in April 2022 set out more detail of the proposed reforms. Our blog at the time summarised the MoD’s proposals.
The Procurement Bill, which is before Parliament and in its ‘Second Reading’ in the House of Commons at the time of writing this article, will make the necessary changes to the Act to implement the proposed reforms. By changing primary legislation, the reforms are in one sense more fundamental than the 2018 and 2019 reforms, which only amended the SSCR themselves. Although most of the details of the reforms will be set out in changes to the SSCR, which have not yet been published, the Bill provides an indication of how Government intends to give effect to the changes proposed in the Command Paper. We have set out below a brief analysis of the key changes.
(1) Introducing alternative ways of determining the contract price
Central to the regulatory framework is a requirement that the price payable under a QDC or QSC, and any amendments to the price made during the contract term, are determined using a prescribed formula – (CPR x AC) + AC – in which AC means the contractor’s allowable costs under the contract and CPR means a contract profit rate calculated using six steps set out in the Act and the regulations.
The MoD has stated that whilst this pricing formula works well for many “traditional” contracts for the acquisition or support of defence equipment, it is less suited to an increasing number of contracts. These include contracts where the costs of production per unit are low but suppliers need to recoup significant initial investment costs (such as software licences), or contracts with suppliers who have tariffs for both their commercial and defence businesses.
As proposed by the MoD in its Command Paper, the Procurement Bill will amend the Act to allow the SSCR to specify circumstances in which the price payable under a QDC or QSC is determined in accordance with another method instead of the pricing formula. What exactly those circumstances or methods are will not be known for certain until the revised SSCR are published, but the MoD has proposed that the regulations will allow for value money to be demonstrated by reference to open market prices, and may also include cases where prices are already regulated.
The MoD has also proposed to introduce a new regulation allowing for the pricing formula not to be applied to pre-agreed scopes and prices when a contract is converted into a QDC on amendment. There is no provision of the amended Act that specifically enables this change, so it appears likely that it is intended to be enabled by the general change above which allows for the pricing formula to be disapplied from components of a contract. This change will remove a barrier to converting contracts where it would be impracticable to re-price the whole of the contract, but there are likely to remain practical challenges to conversion of long-term or complex contracts.
(2) Changing the profit rate calculation
Under the Act and the SSCR, the profit rate used to determine the price under a QDC or QSC must be calculated in accordance with a six-step process. The first step is to take a baseline profit rate published by the Secretary of State each year. The following adjustments are then made in order:
- a “cost risk adjustment” (at step 2) to reflect the risk of the contractor’s actual costs incurred differing from estimated costs;
- a “profit on cost once (POCO) adjustment” (at step 3) to ensure that profit is only paid once where a contractor enters into single source group sub-contracts;
- an “SSRO funding adjustment” (at step 4), which is a minor deduction to reclaim some of the funding of the SSRO from contractors;
- an “incentive adjustment” (at step 5) which allows up to an additional 2% to be paid as an incentive for enhanced performance under the contract; and
- a “capital servicing adjustment” (at step 6) to ensure that the contractor receives an appropriate and reasonable return on the fixed and working capital employed for the purposes of the contract.
As proposed by the MoD in its Command Paper, the Procurement Bill will reduce the six-step process to a four-step process, by abolishing the POCO adjustment and the SSRO funding adjustment.
However, the abolition of the POCO adjustment is a simplification of the mechanism rather than a substantive change in policy. The MoD intends that the principle of ‘profit on cost once’ will continue to apply and will be addressed where intra-group profits arise in costs. The Bill will amend the allowable costs provisions of the Act to enable the SSCR to provide in law that costs arising from intra-group profits are disallowable. It is expected that the regulations will also close a perceived loophole in relation to joint ventures that allows profit to be paid on costs more than once where the prime contractor does not have a controlling stake in the sub-contractor.
The Bill will make a more significant change to the cost risk adjustment at step 2. The existing adjustment is limited to financial risks that are directly related costs, so cannot be used to reflect broader financial risks, such as in relation to quality or schedule performance. The new step 2 will be broadened in scope to reflect all financial risks taken by the contractor under the contract, and make specific reference to the type of activities being carried out under the contract. This should provide a more versatile and useful mechanism, particularly for cost-plus and estimate-based fee contracts where cost risk is held by the customer but the parties may reasonably wish to compensate the contractor for taking on other risks. However, there remains no indication that the range of adjustments permitted by the regulations under the cost risk adjustment (plus or minus 25% of the baseline profit rate) will be changed.
As expected, the Bill will allow for the SSCR to set out how and when the fee under the incentive adjustment at step 5 may be used. This is currently addressed only in the statutory guidance issued by the SSRO. In keeping with the MoD’s proposals in the Command Paper, there remains no indication that the maximum amount of the incentive adjustment will be changed from 2%. Whilst the changes to the cost risk adjustment are designed to increase flexibility in its use, the changes to the incentive adjustment are more likely to limit the way it is used. With no changes being made to the permitted ranges of the adjustments, the changes to the profit rate mechanism can rightly be perceived as refinements rather than fundamental reforms.
The revised legislation will also expressly allow contracts to be split into segments, each of which has its own pricing method, profit rate and final price calculation. Whilst the existing legislation already permits the use of different pricing types within contracts (and many QDCs and QSC already do this in practice), the changes are intended to clarify how profit is calculated, how segmented prices are aggregated, and how final pricing is carried out. In that sense the changes are more corrective than transformational, but they will have knock-on effects on reporting, and may impose new constraints on the way on which segmentation is applied.
(3) Widening the scope of SSRO referrals and guidance
The functions of the SSRO include providing binding determinations and advisory opinions on certain matters referred to it by parties (or prospective parties) to QDCs and QSCs, and publishing guidance on certain matters relating to the regulatory regime.
In practice, the powers to provide opinions and determinations have rarely been used because few matters have been referred to the SSRO by the MoD and contractors. The MoD has proposed that the reforms will address this in part by broadening the range of matters that can be referred to the SRRO for determinations, and in part by changing the referral process for opinions.
The additional matters on which the SSRO will be able to make binding determinations are
- the incentive adjustment,
- whether a contract or proposed contract meets the conditions to be a QDC or QSC, and
- the agreement of rates used in the pricing of QDCs or QSCs.
There are two key changes to the referrals process for opinions:
- SSRO will have the power to give an opinion on any matter relating to the regulatory regime, rather than matters relating to a specific contract or proposed contract, and
- This power may be exercised following a request by one party (or prospective party) to a contract, rather than (as is currently the case) jointly by both parties.
The MoD’s stated aim of these changes is to speed up and simplify the acquisition process by making better use of the referrals process through an increased number and breadth of referrals. Time will tell whether parties take the increased opportunity to obtain SSRO opinions on matters under negotiation, or indeed to obtain binding determinations on commercially agreed matters such as the profit rate adjustments, but the right to make unilateral referrals for opinions will undoubtedly add a new dimension to those negotiations. Another interesting factor is the expansion of the SSRO’s role in answering legal questions as well as commercial questions.
The Bill will amend the Act to give the SSRO the power to issue such guidance as it considers appropriate in relation to “the application or interpretation” of the regime. This guidance will not (it appears) have the same legal status as the existing guidance that the SSRO is required to issue on allowable costs, profit rate adjustments and reporting, which parties have an obligation to “have regard” to, but in practice additional published views of the SSRO can be expected to influence how the MoD and contractors interpret and apply the legislation themselves.
(4) Changing the scope of Qualifying Defence Contracts (QDCs)
The regime currently applies to single source contracts under which the Secretary of State procures goods, works or services for defence purposes.
The MoD proposed in its Command Paper to amend the legislation to ensure that, where appropriate, single source contracts which are partially for defence purposes may also become subject to the regime (for example cross-Government contracts used by the MoD and other departments). The way this proposal is reflected in the Bill is to expand the definition of a QDC to encompass contracts under which the Secretary of State procures goods, works or services “wholly or substantially” for defence purposes. Although it is clear that contracts will continue to qualify only where the MoD is a customer, the impact of this change will not be apparent until the amended regulations are published, as the Bill will give the Secretary of State the power specify in the regulations when a contract is to be treated as “substantially” for defence purposes.
Perhaps more significantly in practice, the Bill will also provide for the SSCR to specify circumstances in which a contract entered into by the Secretary of State and a contractor is or is not to be treated as amending an existing contract. This distinction is important; a new contract falls within the scope of the regime by law if the qualifying criteria are met, whereas an existing non-QDC (such as a competitively procured contract) only falls within the scope of the regime if the parties agree to convert it to a QDC on amendment. Depending on the approach taken in the SSCR, this change has the potential to significantly extend the reach of the regulatory regime.
(5) Incentivising Innovation
The Defence and Security Industrial Strategy announced that the reforms to the single source regime would introduce new ways of incentivising suppliers to innovate. The MoD has proposed in the Command Paper that this will include ensuring that costs incurred in pursuit of the Government’s innovation and technology aim are allowable, and allowing the MoD and contractors to enter into joint funding for innovation without quantifying the financial benefits each party expects to accrue.
The MoD indicated that it expected these aims to be achievable through updates to the SSRO’s statutory guidance, and accordingly the Bill does not make any specific legislative changes in this area. However, the Command Paper indicates that changes to the legislation may be made in future to ensure there is sufficient flexibility to take account of new ways of funding innovation. Innovation may be an area addressed in the new SSCR provision on use of the incentive fee at step 5 of the profit rate calculation, but it is unlikely that those provisions will create any new ways of incentivising innovation on their own.
(6) Refining Contract Reporting
The MoD has proposed to reduce and refine the requirements for industry to provide contract and supplier reports so that the MoD receives only information that is tailored to what it needs. These changes are expected to include requiring the use of a Defined Pricing Structure only for certain contracts, and use of contractors’ own work breakdown structures in Interim Contract Reports, but the substance of these changes will be dealt with in the revised SSCR rather than the Act.
What happens next
At the time of writing, the Procurement Bill is still before Parliament and may yet change before it progresses into law, but there is a high degree of consistency between the proposals in the MoD’s Command Paper and the draft Bill as it stands. The revised SSCR – which will set out most of the detail and substance of the proposed reforms – have not yet been published, but the MoD has said that it expects to introduce the regulations in two tranches: the first to “implement key flexibilities such as alternative pricing methods” and the second to make the remaining changes.
Whilst the reforms are undoubtedly further reaching than the 2018 and 2019 reforms, they are more incremental than fundamental. The impact of the more significant changes – such as the alternative pricing methods, the financial risk adjustment when calculating profit rates, and the increased scope of SSRO referrals – will depend largely on the way they are reflected in the revised regulations and the way in which contracting parties choose to use the options available to them. We will follow up this article with a further analysis when the draft regulations are published.
This article was written by Chris Chesterman and Mark Gwilt.