EMCC European Monitoring Centre on Change

Defence industry - visions of the future

This article builds on the discussion in the first article on the trends and drivers likely to shape the future of the sector and the challenges it faces since the end of the Cold War. In particular, it looks at developments in the industry, such as the increasing internationalisation of production, the growing importance of IT companies within the defence sector, and the privatisation of services that were once provided by the military. The article also explores three alternative scenarios for the defence industry illustrating the decisions that need to be made, as well as the implications of these.

The global military economy has been transformed over the last decade by trends in military expenditure and technology that have reinforced the dominance of the United States (US). The fixed costs of research and development (R&D) for major systems continue to grow, both for platforms and for the infrastructure (such as satellites, strategic air assets) and information systems needed to support network-centred warfare. All countries except the US face structural disarmament as they are unable to afford the fixed costs needed to replace conventional military capability with modern systems comparable to those of the US.

At the end of the Cold War, the international arms industry was not as consolidated as some other high-technology industries, such as commercial aerospace or pharmaceuticals. The main reason for this was probably the tendency for the major military powers to prefer to procure from national defence industries. The decline in the total size of the market and the growing R&D requirements for major weapons systems produced an increase in consolidation. If governments allow it, this tendency will continue.

Trends and drivers of change

External environment

The following tables summarise the factors expected to affect the defence industry. The relative importance of each factor is indicated in Column 3 on a scale of one to three stars. A more detailed description of each driver can be found in Article 1.

Sociological drivers

Driver

Summary

Importance

Changing gender distribution of the workforce This will continue to evolve towards a greater participation of women. Part of the explanation lies in the changing nature of the major contractors, but the main reasons are due to the overall change in the nature of the supply chain and the greater involvement of civil and international companies. *
Changing geographical imperatives Changes in the nature of defence companies and the increasing use of global outsourcing make it likely that defence-dependent communities will suffer as facilities are relocated. **
Changing international imperatives Increasing internationalisation of the supply chain will continue to bring about changes in the organisation and location of production. ***

Technological drivers

Driver

Summary

Importance

Barriers to entry These remain for major contracts, but they will become less important because of the increase in joint ventures and in the use of COTS (commercial off-the-shelf) products, and because of the growth of outsourcing. *
Barriers to exit These are likely to remain for the major contractors. *
Changing lead positions The direction of technological innovations and transfer is already from civilian to defence technology. This trend will continue, except in a few areas where the technological initiative lies with defence equipment, e.g. stealth technology. **
Growth of dual-use technologies This once seemed to be a significant development, but in reality it has not become important and is unlikely to do so in future, given the increased use of civilian technology. *
Cooperation Licensing, collaboration and joint ventures will continue to grow in importance for the production of major weapons systems, especially for the first-tier producers. **
Communications technologies Communications and control technologies are becoming increasingly important in the field of operations. Network-centred warfare is changing the nature of demand and leading to what has been called the Revolution in Military Affairs. ***
Internet This was originally developed by the US military, but now plays an important role in the development of communications. However, it is also an area of potential security threats. **

Economic drivers

Driver

Summary

Importance

Barriers to entry These will remain because of the nature of the market and the role of governments. **
Barriers to exit These will remain because of the role of governments, but will become less important. **
Changes in demand Military spending is unlikely to increase greatly and there is still potential for cuts in many European countries. **
Changes in the nature of demand These are political and technological mainly, but also economic, because of the increasing cost of high-tech weapons platforms. ***
Inertia Military conservatism will not vanish, but, increasingly, the new security environment will lead to budgets being directed away from legacy weapons systems. *
Exchange rates Strengthening of the dollar against the European currencies, or vice versa, could have important implications for the European defence industry. *
Economic growth Growth seems to be slow in Europe and unlikely to change in the short to medium term, but there is still enough growth to prevent an affordability crisis for current levels of defence spending. *
Linkage to other sectors This will continue to grow in importance and lead to a reduction in the defence specialisation of all but the major contractors. The growth of privatisation will bring about an increasing influence of financial capital in the defence industry across Europe. ***
Globalisation Companies will remain dependent on their home markets, but internationalisation will continue to be an important force in the sector, exercising its influence in particular through supply chain expansion and joint ventures and partnerships. ***
Changing linkages in the supply chain These will continue to be an important force in domestic and international markets. ***
Privatisation and private finance initiatives The UK has been at the forefront of these initiatives, but they have not become prominent in the rest of Europe. Their development throughout Europe would represent a major policy change. **

Political drivers

Driver

Summary

Importance

Barriers to entry Political considerations will remain important in winning contracts, despite attempts to introduce competition. **
Barriers to exit These will remain important for the increasingly few companies that are heavily dependent on defence contracts, but will become less significant in general. **
Pressure groups and lobbyists These will continue to grow in importance in Europe if privatisation and cross-border restructuring develop as expected. ***
Government spending This will continue to be the main source of demand for the sector. It is unlike to grow much, but is also unlikely to fall much. **
Changing state policies These will increase in importance with the increasing privatisation of European defence companies, as well as the increasing tolerance of foreign ownership and non-domestic procurement. ***
Smart procurement (involving companies earlier in the development phase) This will become yet more common and will alter relations between states and the defence industry; but it is still not clear how successful it will be at improving performance and price of large contracts. *
Privatisation of defence services and support This will continue to be important, and new companies will provide service support. It is changing the way in which security, e.g. guarding people and buildings, is provided. ***
EU enlargement This will have some impact on demand, but probably not very much. However, enlargement could increase industry capacity, especially if Turkey joins the EU. **
European Defence Agency This is likely to be increasingly important in policymaking. ***
Code of Conduct This will be of great importance. If it is effective, it is likely to lead to more cross-border restructuring in Europe and will probably increase concentration within the European market. ***
Arms trade treaty There is likely to be increasing pressure to deal with the arms trade, but it is unclear what impact this pressure will have. **

Assessment of major trends and drivers

Sociological drivers

Clearly, changes are taking place in the structure and location of the workforce in the defence sector, and these are likely to continue. In the present conditions of declining demand and the resulting industry concentration, companies that specialised more in defence have maintained defence-type employment structures of highly skilled, predominantly male employment; while companies that have reduced their defence share are likely to become more similar in their employment structure to other industrial sectors. The defence specialists that remain tend to have higher proportions of R&D work than they had before. Against this, the decline in value-added service in defence companies, due to outsourcing for example, has changed the nature of the firms involved, and has made the geographical distribution of the supply chains more dispersed. Moreover, the closure of bases and facilities in the aftermath of the Cold War added to the problems. This has impacted significantly on local defence-dependent communities, and is likely to remain an issue across the EU; it could lead to specialist regions for different types of weapons system.

Technological drivers

Technology is extremely important for the defence sector. As argued in Article 1, European defence industry - what future?, it provides barriers to both entry and exit and, although these are becoming less pronounced with the increasing use of civilian technologies and of COTS, they remain significant. It is difficult to see new entrants in the production of major weapons systems. However, market entrants may be found in the new areas that are opening up within the sector, due to the increasing importance of network-centred warfare and of communications and control technologies in the field of operations. This so-called Revolution in Military Affairs is likely to continue to influence future developments in the sector.

With the growth of technology and costs, contractors are likely to turn increasingly to licensing, collaboration and joint ventures, thereby stimulating further internationalisation of the industry. The implications for the EU are clear: the European defence industry will need to restructure to remain competitive internationally and increasingly take advantage of licensing, joint ventures, mergers and cross-ownership. This will be true, above all, for the first-tier producers, and this fact will further strengthen the position of the US. European companies have already been buying US companies to gain an entry into this market.

Economic drivers

Economic factors have generally taken a back seat in the defence sector because of security concerns. Nevertheless, they still provide effective barriers to entry and exit, mainly because of the nature of the market and the role of the national state in each market. Though competition may be growing in some areas, the bottom line is that the state controls the size and nature of the market, the number of companies in it, and the role of foreign producers.

The escalating calls on their defence budgets, because of rising costs of weapons systems and advances in technology, continue to put pressure on governments, and they respond by putting pressure on companies. The economic imperative to reduce costs is leading to increases in competitive tendering, outsourcing and internationalisation, and this will continue to be an important trend. With the growth of privatisation, the influence and importance of financial capital will increase throughout the European defence industry.

The changing nature of demands and the growth in importance of the US market will continue to lead to changes in the structure of the industry. European companies will need to restructure further across borders, and joint ventures and partnerships with US companies are likely to increase in importance, especially at first-tier level. While defence companies rely on domestic procurement and support for exports, they are likely to continue to internationalise, particularly in their supply chains. Changes in the exchange rate could have important impacts; a strengthening of the dollar against sterling, the euro and the Swedish krona would assist price competition, but increase the costs of imports and purchases from US companies.

Political drivers

Political factors and security concerns have dominated the sector and will continue to do so, even though there have been changes. They create barriers to entry and exit. The role of the state remains paramount in determining the nature of the market, but international agreements are likely to increase in importance as relationships between companies strengthen across borders. The role of international governance structures could become increasingly important. The European Defence Agency will probably change the nature of demand and the EU Code of Conduct, if it is taken seriously, will be an important driver of change in the industry. Linked to changes in the nature of demand is the increasing willingness of governments to allow the private sector to provide combat-related services that previously would have been provided by the defence forces, e.g. security/bodyguard and support roles. This is a significant change.

Trend and driver linkages

The best way to consider the linkages between the drivers is to recognise the nature of the market and the structure of the forces operating on it. A useful schematic representation shows regulation (Level 1) affecting the overall nature of the sector and, through feedback, influencing in a dynamic way the perception of the Level 2 imperatives. The interaction of these two levels affects the structure, conduct and performance of the industry, and also affects interactions and the distribution of activities in the industry (Level 3).

Level 1: Regulation

Governance: role of the national state; procurement; international bodies

Level 2: Specificities of economics and security

Economic imperative: pressures on budgets; pressures on costs; internationalisation; costs of new systems

Security imperative: changing threats and changing perceptions of threats; war on terror; asymmetric conflict; peacekeeping

Technological imperative: changing technology; advancement of civilian technology; network-centred warfare

Level 3: Effects and implications

Structure: number of companies and other aspects of market structure

Conduct: based on the market structure, levels of competition and hence behaviour of companies

Performance: how efficiently the industry manages to produce its output

Interaction: the strategic interaction of companies within the market structure, their competitive rivalries and agreements

Distribution: the spatial distribution of economic activity across Europe and beyond - both defence and related non-defence activities

Scenarios for the defence sector

Scenario overviews

There are three stylised scenarios illustrating the sort of strategic decisions that the defence industry has to make and the implications of these. As has been emphasised, in a market like defence, the role of national governments is of paramount importance.

Scenario 1: European status quo - failure of ongoing initiatives

In this scenario, the EU-level initiatives fail and the defence sector remains dominated by national concerns. Governments attempt to retain their domestic defence industrial base across a range of systems with high levels of state ownership and control. There are limited joint ventures. Important overcapacities remain in the industry and exports will be heavily subsidised.

Demand: Military spending will be under pressure to increase with a continuous level of subsidies of national industries to maintain chronic overcapacity. Numbers of weapons systems purchased will be reduced as prices go up. Pressures will be on governments to support arms exports and resist arms controls. This could lead to an increase in the ‘military burden’ (military expenditure as a proportion of GDP).

Supply: Some companies will internationalise - they were already doing so even before governments looked more favourably on it. It is likely that the major players in the UK will align themselves with the key US defence companies, develop clear transatlantic structures, and reduce their involvement with Europe. The US connection is likely to be the most successful commercially, given the size of the US market and the problems in cutting costs and gaining economies of scale within Europe.

Implications: Military spending in Europe will be high and subject to persistent upward pressure; there will be several types of major weapons systems across Europe - all expensive and all subsidised.

Employment: There would be little effect upon employment, although the main contractors, such as systems integrators, are likely to reduce employment and have a more technologically advanced workforce through availing of outsourcing.

Scenario 2: European restructuring: success of ongoing initiatives

In this scenario, the ongoing initiatives are successful and pan-European defence policies are enacted. Privatisation of producers would be complete.

Demand: There would be a European defence force along with centralised procurement and defence budgets would probably not rise above their present levels as a proportion of GDP. The size of the European market would not be enough to generate sufficient economies of scale to compete with US companies, as a result, export subsidies would continue, even if the pressure for them would be weaker than at present.

Supply: There would be a marked restructuring of the defence sector, with a great deal of concentration within countries and across Europe. Mergers and takeovers would occur to produce larger defence companies. These companies would be recognisably European and multinational, but they would still have a home base, as in the present example of BAE Systems.

Employment: The restructuring of the industry across Europe would lead to reductions in employment, with significant regional implications.

Scenario 3: EU-US collaboration

In this scenario, Europe aligns itself with the US. In essence, this creates a joint market, although the independence of the major contractors in both Europe and the US is likely to be maintained. This means that they would be protected from takeover.

Demand: Numbers of new weapons systems would be reduced and costs would be kept down. There would be less pressure on the defence budget and a general reduction in spending would be possible. Given the size of the joint markets, it will not be as important for companies to push exports, and security concerns may limit the export of major weapons systems beyond reliable allies. Certainly, arms export controls would be possible.

Supply: It is unlikely that European companies would take over or be allowed to take over major US companies. Europe would restructure to create large companies that would buy US second-stream companies to gain a presence in the US market. There would also be a rise in joint ventures and internationalisation of supply chains would continue as before. There may be a move of production away from Europe. A concern would be that the European defence industry might simply become a secondary partner of the US industry, producing lower technology products and losing the capability for high-technology development and production.

Employment: It is likely that there would be a reduction in employment in Europe, though, if the European companies are particularly successful in the US market, this may not be by much. It is more likely, however, that losses will be greater as US firms are likely to be more successful in the joint market, given their present advantages.

Scenario evaluation

The stylised scenarios provide a valuable illustration of the kinds of forces at work. Given pas and current developments, the expectation would be that the industry would end up in a situation somewhere between Scenario 2 and Scenario 3. In this case, the European defence industry sector is undergoing restructuring, though not entirely, while attempting to integrate with the US industry, but not with complete success. There are benefits of scale, but not fully, and there is an increasing amount of joint ventures, cross-border mergers and licensed production. Russia and China will increasingly compete in export areas but, given the size of the US and EU markets, this need not unduly concern the major contractors. It is likely that there will be more international consolidation as US and European contractors expand their international operations to gain cost savings and to win orders in other countries.

Implications

The implications are that changes should be expected in the sector, but not as much as would occur if the governments were to allow restructuring to proceed freely.

Geographical

It is likely that certain regions in Europe will start to specialise in certain weapons systems, such as shipbuilding, located around the Baltic region but dominated by Germany. The industry overall will continue to internationalise and will outsource increasingly to new industrialising economies. It is likely that high-skill intensive production, design and R&D will remain with major companies (the systems integrators) but inputs and components will be outsourced. These trends could make the production of major weapons systems feasible only through cooperation between specialist companies.

Inter-sectoral

Concentration will take place among the major European contractors and some countries may lose production facilities as a result of rationalisation. Some weapons system production capabilities may be lost or prove impossible without cooperation between the EU and the US. The links between civil companies and defence contractors will grow, as will the number of entrants to certain new components of the defence market. The internationalisation of the industry will continue, with the main contractors increasingly focusing on systems integration, R&D, marketing and lobbying. Civil companies will become part of the supply chain without having to take on the appearance of being defence contractors.

Social relations

The main issue here is the reduced degree of dependence of some localities on defence contractors. Already, companies have reduced employment, and outsourcing has weakened their links with local communities. Many defence companies are no longer producers in the old sense, but systems integrators (e.g. BAE Systems, in its effort to return to financial health in the 1990s, reduced production and halved its workforce). The new structures, as well as the increased involvement of the civilian sector in new areas of defence production and service provision, will make the defence industrial base much less visible and distinctive. It will also mean a decline in the number of local and regional economies dependent on arms producing facilities.

Employment

Identifiable employment in the defence industry - those employed directly in producing weapons - will decline, but those employed in other sectors producing goods and services for the defence sector will increase. Consequently, the defence industry is likely to have a smaller and more highly qualified workforce than in the past, with the less technologically advanced inputs coming from non-defence specialist firms employing a less qualified workforce. Overall, the higher productivity of the non-defence sector is likely to lead to reductions in total (direct and indirect) employment but, given current trends, not by a significant amount. Moreover, any future reductions in demand for arms will not have as great an impact on employment as they would have done in the past, because fewer employees will directly work on arms (in the major contractors) and more will work in companies that can easily adjust to increasing their production for the civilian market.

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