EMCC European Monitoring Centre on Change

Sector Futures: Defence industry

European defence industry - what future?

The defence industry relies on skilled labour and resources in Europe, and has faced a period of considerable change and uncertainty since the end of the Cold War at the beginning of the 1990s. Until now, national governments of EU Member States have had considerable control over the industry while the recent EU Code of Conduct for defence procurement intends to introduce more openness to the market. The first of three articles in the Sector Futures series on this sector delineates the defence industry sector and examines its market size, structure and nature of employment. It also explores the trends and drivers likely to shape the sector’s future, such as changes in demand, in the nature of production and the dominance of the United States.

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). In contrast to most other countries, US spending on defence is projected to grow rapidly. 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, therefore, 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. This is a particular problem for the minor powers that have broader military aspirations, in particular the other permanent members of the Security Council: China, France, Russia and the United Kingdom (UK).

Developments in the industry include the increasing internationalisation of production, growing importance of information technology (IT) companies within the defence sector, and the privatisation of services that were once provided by the military. The most obvious example of this is the role of Halliburton in Iraq. Halliburton supplies products and services to the oil and gas industries, and its subsidiary, KBR, provides a wide range of engineering, construction, operations and maintenance, logistics and project management services. KBR is a major contractor to the US Department of Defense and is heavily involved in reconstruction in Iraq. Thus, Halliburton has become a major beneficiary of the Department of Defense budget.

Defining the defence industrial base

The range of activities that comes within the defence sector is wide, and it is far from being a straightforward matter to describe and delimit the defence industrial base (DIB) in relation to the activities of the sector.

The relevant NACE code, 75.22 Defence activities includes the following:

  1. Administration, supervision and operation of military defence affairs and land, sea, air and space defence forces, such as:
  • combat forces of army, navy and air force;
  • engineering, transport, communications, intelligence, material, personnel and other non-combat forces and commands;
  • reserve and auxiliary forces;
  • provision of equipment, structures, supplies, etc;
  • health activities for military personnel in the field.
  1. Administration, operation and support of civil defence forces.
  2. Support for the working out of contingency plans and the carrying out of exercises in which civilian institutions and populations are involved.

However, this definition excludes an array of further activities, such as the: provision of military aid to foreign countries; activities of military tribunals; provision of supplies for domestic emergency use in case of peacetime disasters; educational activities of military schools, colleges and academies; and activities of military hospitals.

Furthermore, the official definition focuses on support of the armed forces and, thus, it does not cover all of the defence-related activities that a DIB supports. Apart from this difficulty, there are serious and increasing problems in operationalising any definition of the DIB. At first sight, it seems an easy matter to define the DIB as consisting of the companies that provide defence and defence-related equipment to the appropriate authority (e.g. the Ministry of Defence). However, this definition proves problematic.

The range of products involved can be very wide. Weapons differ greatly, from large technologically advanced and expensive weapons systems to inexpensive small arms, and numerous other more general commodities are consumed by the military. The companies that make up the DIB will also differ, both in the degree of their dependence on military production and in their importance to the DIB. There is no reason why these two should be positively related. Some large diversified companies may only consider their DIB activities as marginal but may be vital producers of particular weapons systems, while certain smaller companies may be wholly dependent on military-related orders but are not important suppliers. Key defence contractors are increasingly systems manufacturers integrating a variety of subsystems into a complete final product (Dunne, 1995a).

The definition of what constitutes military production is not always straightforward and can vary between countries. The production and export of weapons components, anti-insurrection and riot-control equipment, razor wire and torture and other such equipment will not necessarily be classified as military. Such problems are exacerbated by the tendency for governments to put considerable emphasis on the development of dual-use technologies, which blur the military-civil distinction. It is also relatively common to find defence-related work under civil headings.

Moroever, it is possible to regard foreign suppliers as part of a country’s DIB, as the UK’s Department of Trade and Industry (DTI) has suggested. For example, the French company, Thales, has become the second largest recipient of UK Ministry of Defence monies, which constitutes a major departure from the attempts at national self-sufficiency across a range of systems that were characteristic of the Cold War period.

In light of the complexities and unavoidable imprecision in attempts to delimit the DIB, it is hardly surprising that researchers usually define the DIB in relation to the questions they are asking about it.

Market size, structure and employment

The problems of clearly delineating the DIB make it difficult to measure its market size, to describe its structure, or to quantify employment within it.

Even if it were clear as to what constitutes the main companies of the DIB, any direct measure of these alone will tend to understate the range of the DIB. This is related to the fact that there are many sub-contractors who are dependent to different degrees on military-related orders, but through the intermediation of other contractors. Indeed, some companies may not know that they are part of the DIB if they make intermediate products or components (such ball bearings). There are also important distributional issues, as many defence producers provide the main industrial presence in outlying regions. Thus, as noted, the extent and economic importance of the DIB is likely to be understated by direct measures of the activities of companies clearly working in the defence field.

Problems of measurement are compounded by the secrecy surrounding information on defence companies in many countries. This secrecy may be the result of government or corporate sensitivity. In the case of companies that are not solely defence producers, it is often difficult to obtain, for example, an exact breakdown of the defence and civil work, and the contribution of the defence side to profits. This may be due to the difficulty of accounting joint costs, but, even in companies where defence divisions are kept separate, any level of subsidies granted to civil production by lucrative defence contracts is likely to be hidden. It is also difficult to obtain data on the employment and skill composition of the labour force, especially on the employment of qualified scientists and engineers, because of the secrecy surrounding research in this field.

For these reasons, analysts tend to use military expenditure in order to get an idea of the size of the sector. In practice, this is the best measure available, but it is by no means perfect. It includes pay for personnel and other fixed costs, and is not limited to expenditure on defence equipment. However, it may also exclude some relevant expenditure.

The Stockholm International Peace Research Institute (SIPRI) produces independent measures in its yearbooks, and these are considered the most reliable. SIPRI estimated that, in 2004, the US accounted for 47% of world military expenditure of $975 billion (€795, all euro equivalents are calculated at a median exchange rate of €0.82 per US dollar). The combined expenditure of the next five largest spenders, UK, France, Japan, China and Germany, was less than half that of the US. The US also has by far the highest per capita spending, followed by the UK and France with just over half the US value. It is common practice to consider the economic cost of defence spending by using the proportion of military spending in gross domestic product (GDP), and this is presented in Table 1.

Table 1: EU military expenditure, in US$ billion
EU military expenditure, in US$ billion
    Military expenditure Growth, in % Proportion of GDP
    1995 2000 2004 1995- 2000 2000- 2004 1995 2003 Change, in %
1 Austria 2,002 2,083 1,925 4.0 -7.6 0.9 0.8 -0.1
2 Belgium 4,216 4,136 4,398 -1.9 6.3 1.6 1.3 -0.3
3 Cyprus 222 249 203 12.2 -18.5 2.3 1.5 -0.8
4 Czech Rep 1,315 1,505 1,741 14.4 15.7 1.8 2.2 0.4
5 Denmark 3,181 3,142 3,228 -1.2 2.7 1.7 1.5 -0.2
6 Estonia 52.8 106 181 100.8 70.8 1 1.9 0.9
7 Finland 1,850 1,954 2,077 5.6 6.3 1.5 1.2 -0.3
8 France 46,100 43,806 46,174 -5.0 5.4 3.1 2.6 -0.5
9 Germany 37,852 36,021 33,882 -4.8 -5.9 1.7 1.4 -0.3
10 Greece 5,450 7,412 - 36.0 -3.9 4.3 4.1 -0.2
11 Hungary 967 1,212 1,485 25.3 22.5 1.6 1.8 0.2
12 Ireland 786 941 1,010 19.7 7.3 1.1 0.7 -0.4
13 Italy 22,425 29681 27,759 32.4 -6.5 1.8 1.9 0.1
14 Latvia 60.7 79.9 204 31.6 155.3 0.9 1.7 0.8
15 Lithuania 54.9 249 336 353.6 34.9 0.5 1.6 1.1
16 Luxembourg 136 168 244 23.5 45.2 0.8 0.9 0.1
17 Malta 34.7 31.2 36.1 -10.1 15.7 1 0.8 -0.2
18 Netherlands 8,104 8,080 8,407 -0.3 4.0 1.9 1.6 -0.3
19 Poland 3,343 3,685 4,149 10.2 12.6 2.1 2 -0.1
20 Portugal 2,887 3,011 3,115 4.3 3.5 2.6 2.1 -0.5
21 Slovakia 909 516 585 -43.2 13.4 3.2 1.9 -1.3
22 Slovenia 350 294 465 -16.0 58.2 1.7 1.5 -0.2
23 Spain 9,160 9,434 9,565 3.0 1.4 1.5 1.2 -0.3
24 Sweden 5,514 5,875 5,439 6.5 -7.4 2.3 1.8 -0.5
25 UK 42,579 40,925 47,401 -3.9 15.8 3 2.8 -0.2
                   
  Total EU 199,551.1 204,596.1 204,009.1 2.5 -0.3      
  Mean 7,982.0 8,183.8 8,160.4     1.8 1.7 -0.1

Note: Military expenditure is in constant US$ billion, 2004 prices, with US$1 equivalent to €0.82.

Source: SIPRI Yearbook, 2005

Table 1 illustrates that, apart from new EU Member States, only Italy increased military spending as a share of GDP between 1995 and 2003. This means that, in other countries, increases in military spending were in line with economic growth over the period. In 2002, the UK had the highest level of government spending allocated to the defence sector, with more than 12%, followed by France and Italy at 10%. The 1995 figures for the UK and France were 15% and 13%, respectively. Overall, the decline in defence share for the EU15 over the period was just above one percentage point.

Table 2 shows that defence as a proportion of government spending varies across the major EU economies and has generally been declining.

Table 2: Growth in defence spending, 1995-2002 (%)
Growth in defence spending, 1995-2002 (%)
  EU15 Germany Spain UK France Italy Czech Republic Poland Slovakia
                   
Total 12.7 8.8 21.5 14.7 13.9 10.0 16.7 11.8 29.1
                   
Defence 0.3 2.2 9.1 -6.5 -5.8 17.6 -7.6 -16.3 -13.4
Education 17.3 13.4 21.9 10.3 22.0 1.1 4.6 17.9 63.8
Health 16.3 10.5 27.9 20.2 17.2 21.4 249.5 2.8 43.9
Other 9.9 4.3 18.8 24.6 12.2 4.5 5.8 13.5 25.3

Note: All growth rates are based on data in 2000 prices.

Source: World Bank, CE Databank, 2003

A further issue in terms of defining sector turnover, and one that is increasing in significance, is ‘hidden’ defence spending. Various expenditures are not registered as defence spending even if they are. Major activities are paid for, for example, from contingency funds, and what was once defence expenditure has been placed under different headings in the new environment of the war on terror. Moreover, civilian companies are increasingly being used to undertake what would once have been the work of the military forces, but would not have -necessarily been recognised as defence, e.g. post-conflict reconstruction in Iraq.

Market structure

The defence industry is a very specific industry. Its size, structure, trade are all determined by government policy, as the national government is the main customer and regulates exports. Thus, it may be termed a ‘monopsony’ in that there are many suppliers (in this case, national arms producers) but only one customer (the national government) - in contrast to a monopoly, where there are many customers but only one supplier. The general characteristics of defence production, resulting from this unusual structure of the market, are:

  • an emphasis on performance of high-technology weaponry rather than on cost;
  • risk borne by government, which often finances R&D and, in some cases, provides investment in capital and infrastructure;
  • elaborate rules and regulations on contracts, to compensate for the absence of any form of competitive market and to assure public accountability;
  • close relations between contractors, procurement executives and military, notably the ‘revolving door’ through which military and civil servants move to working in defence companies with whom they had dealings, and staff from defence companies move into the bureaucracy;
  • the prevalence, outside the US, of companies that are national monopolies or close to it.

These characteristics tend to favour companies that specialise in defence work. They know their way around the formalities and have useful contacts. They become experts at winning government contracts, rather than being successful in commercial markets. Companies are keen to get involved in development programmes for technologically advanced weapons systems as this experience offers the best means of obtaining subsequent production contracts. This process can lead to ‘buy ins’, where companies understate risk or cost to win initial contracts, with a view to making up the losses later. In addition, past programmes have seen ‘gold plating’, where the military continually asks for extras or continuous technological improvements over the contract period. This allows renegotiation of contracts or additional payments, usually to the advantage of the contractor.

As a result of the structure of the market, there are both barriers to entry and to exit, which led to the Cold War defence industrial base (DIB) showing remarkable stability in terms of its composition of main contractors. These barriers - market, technological and procedural - mean that, not only has it been difficult for companies to enter into the defence sector to produce weapons systems, or to upgrade from subcontractor status, but also that it is difficult for defence companies to leave the industry.

For all of these reasons, the monopsony in the defence market has helped to create near-monopolies for certain companies.

National monopolies

One result of the near-monopoly of some companies in national defence markets is that they face no domestic competition, in the sense that there are no other companies making the same product and that it is unlikely of a new domestic company to enter the market. Any competition is going to come from foreign companies which do not necessarily have to be direct competitors to influence the domestic monopolist, they only have to represent a threat. The monopolist has to believe that, if it is worthwhile to the purchaser (e.g. if the domestic monopolist’s profits become too high), foreign companies can and will enter the market. Thus, the influence of foreign firms can be implicit rather than explicit, through the creation of what are called ‘contestable markets’ as a result of potential competition from abroad. For this to work, however, the domestic monopolist has to believe that foreign companies will enter the domestic market and that the government will let them. They need to feel that it is a credible threat, which may not be easy to convince them of.

Unlike most manufacturing industries, which became multinational, the arms industry remained national. Smaller countries that could not afford the large fixed costs of production imported major weapons systems. Following the end of the Cold War in conjunction with a decline in demand, the ability of even the major countries to maintain a domestic DIB was called into question. Governments had to decide whether to allow mergers and acquisitions, which would reduce competition, and in particular whether to allow mergers and acquisitions that involved foreign partners. They were also in a position where the change in the security environment made it harder to justify previous levels of support for the industry, and ‘competitive procurement policies aimed at value for money were introduced in a number of countries’ (Dunne and Macdonald, 2002).

Concentration

The most striking change in sectoral policy occurred in the US. During the Cold War, industry planning was undertaken through the Department of Defense in the Pentagon, but this was only an implicit sectoral planning. In 1993, a merger wave was stimulated by the so-called ‘last supper’ when Pentagon Deputy Secretary, William Perry, told a dinner meeting of defence industry executives that they were expected to start merging. It ended when the Pentagon decided that it had gone far enough and blocked the merger of Lockheed Martin with Northrop Grumman in early 1997 (Markusen and Costigan, 1999). This left the four major contractors shown in Table 3. The only major change since then has been the takeover by Northrop Grumman of the aerospace and information technology company TRW. This made Northrop Grumman the third largest US arms producer after Lockheed Martin and Boeing (SIPRI, 2002).

Table 3: US defence mergers
US defence mergers
Companies in 1993 Year Companies after 1996
Boeing    
Rockwell   Boeing
McDonnel Douglas 1997  
     
Lockheed    
Martin Marietta 1994 Lockheed Martin
GE Aerospace 1992/3  
Loral    
General Dynamics 1992/3  
     
GM Hughes 1998  
E Systems 1995 Raytheon
Raytheon    
Texas Instruments 1997  
     
Northrop    
Westinghouse 1996  
Grumman 1994 Northrop Grumman
TRW 2002  

Source: SIPRI Yearbook, 2002

In Europe, the process was more complicated, since restructuring necessarily involved cross-border mergers which raised political issues. Furthermore, the major European players had different ownership structures, including a substantial degree of state ownership in France. Both factors made a financially-driven merger boom of the US type more difficult. Nevertheless, there was an increase in concentration, culminating in the acquisition of GEC (General Electric Company) defence interests by BAE Systems in the UK and the formation of the EADS (European Aeronautics, Defence and Space) company from DASA (Deutsche Aerospace, a subsidiary of Daimler) of Germany, Aerospatiale-Matra of France and CASA (Construcciones Aeronáuticas SA) of Spain. In 2002, the two largest military vehicle producers merged into one, Alvis.

An important source of information on the industry is the annual SIPRI data on the top 100 arms producing companies. As Table 4 shows, the five largest companies in the SIPRI list accounted for 22% of arms production by the top 100 in 1990, while the shares of the top 10 and the top 15 firms are 37% and 48%, respectively. At the end of the Cold War, the international arms industry was not very concentrated. It is noticeable that the concentration in total sales was higher than in arms sales: commercial markets are more concentrated than military markets, although the commercial markets in which these companies were operating were different to the norm. By 2002, the five largest arms firms accounted for 40% of the total. This large increase in the proportion of the top companies is also shown for the largest 10, 15, and 20 firms.

In addition, there was an increase in concentration for total sales, but not by as much, since it started from a higher base. It is interesting to note that, in terms of total sales, including civil products, concentration was higher in 1990 than it was for arms sales, and then increased by considerably less, leaving arms and total sales measures very similar in 2000. This may well reflect an increasing specialisation on defence sales by the major players.

Table 4: Industry concentration
Industry concentration
  1990 1995 2000 1990 1995 2000

Percentage share:

% Arms % Arms % Arms % Total % Total % Total
Largest five companies 22 28 42 33 34 40
Largest 10 companies 37 42 58 51 53 57
Largest 15 companies 48 53 66 61 65 68
Largest 20 companies 57 61 72 69 73 76

Source: SIPRI Yearbook, 2003

In 2003, the five largest companies accounted for 44% of the market; this, however, is still a low degree of concentration compared with other high-technology markets. It seems likely that major weapons systems would by now have been a very concentrated market, similar to civil airliners or pharmaceuticals, had not national governments inhibited the growth of multinational firms in order to protect their DIB.

Sutton (1998) describes how, until the 1970s, government procurement rules in many countries restricted the purchase of telecommunications equipment from foreign suppliers and determined the number of companies. The easing of procurement rules that followed the liberalisation of the telecommunications market led to rapid concentration in the telecommunications industry worldwide. This is what might be expected to happen if governments ceased to care about market structure in the arms industry.

Table 5 shows the top 30 defence companies in 2003. It illustrates the degree to which the US companies dominate the international market, with BAE Systems the only European company in the top five (BAE has made a successful push into the US market, gaining the status of a US company for the purpose of bidding for US contracts). Nevertheless, European companies are important, with Thales, EADS and Finmeccanica in the top 10. Nearly all companies reported a rise in arms sales between 2000 and 2003 and, apart from the growth of Halliburton, the top 20 companies remain relatively stable.

Table 5: 30 largest arms producing companies, 2003
30 largest arms producing companies, 2003
. 2003 Rank 2002 Company Country/ region Arms sales 2003 Arms sales 2002 Armsas % of total 2003 Employment 2003
1 2 Lockheed Martin US 24,910 18,870 78 130,000
2 1 Boeing US 24,370 22,170 48 157,000
3 4 Northrop Grumman US 22,720 17,800 87 122,600
4 5 BAE Systems UK 15,760 14,070 77 92,500
5 3 Raytheon US 15,450 14,510 85 77,700
6 6 General Dynamics US 13,100 9,820 79 67,600
7 7 Thales France 8,350 6,840 70 57,440
8 9 EADS Europe 8,010 5,630 24 109,140
9 8 United Technologies, UTC US 6,210 5,640 20 203,300
10 10 Finmeccanica Italy 5,290 3,720 57 46,860
11 11 L-3 Communications US 4,480 3,020 89 38,700
12 66 Halliburton US 3,920 480 24 101,380
13 16 Computer Sciences Corp US 3,780 1,980 26 90,000
14 12 Science Applications, SAIC US 3,700 3,000 55 42,700
15 13 Rolls Royce UK 2,970 2,850 32 35,210
16 14 Mitsubishi Heavy Industries Japan 2,430 2,780 12 59,949
17 15 General Electric US 2,400 2,200 2 305,000
18 17 Honeywell International US 2,270 1,830 10 108,000
19 19 United Defense, UD US 2,050 1,730 100 7,300
20 18 GKN UK 2,020 1,800 27 35,480
21 23 DCN France 1,870 1,370 100 12,780
22 30 Groupe Dassault Aviation France 1,810 1,140 49 8,860
23 20 Rheinmetall Germany 1,810 1,580 31 20,890
24 21 ITT Industries US 1,790 1,510 32 39,000
25 29 Groupe SNECMA France 1,750 1,160 24 39,700
26 24 Saab Sweden 1,700 1,310 80 13,320
27 32 CEA France 1,540 1,100 49 15,040
28 26 ATK US 1,460 1,250 62 13,000
29 35 Sukhoi Russia 1,420 960 95 35,000
30 22 Textron US 1,400 1,390 14 43,000

Note: Figures in columns 5 and 6 are in US$ million, at current prices and exchange rates, with US$1 equivalent to €0.82.

Source: SPRI Yearbook 2005

Employment

Employment in the defence sector is difficult to measure. It includes direct military employment, personnel and civilian support staff, ministry staff, direct industry employment in arms contractors and also indirect employment in companies that supply to the defence companies. Finally, there is the indirect employment created by the salaries of those who are employed in the defence sector: the income multiplier effect. This last employment effect is very difficult to measure and is often estimated in an ad hoc way and so is never a particularly reliable estimate.

The Bonn International Centre for Conversion provides some summary statistics on employment in the sector in its annual survey. The data come from a variety of official sources and its own estimates, and include both direct and indirect employment, but do not include the multiplier effect of incomes of the workers. The survey reports that France, the UK and Germany have by far the highest numbers of jobs in the defence sector.

Employment in the defence sector is not simply important in terms of its size in a particular country; it is also:

  • often highly skilled, with a higher proportion of engineers and scientists and higher levels of qualification than on average for industry;
  • often located in areas that are dependent upon it. The location of plants has usually been determined historically by security concerns and was kept away from conurbations. Local communities can, thus, be heavily dependent on defence facilities, factories and bases.

Trends and drivers

World military expenditure and arms exports peaked in the mid 1980s, and then fell gradually with improving East-West relations, followed by a rapid decline with the disintegration of the Soviet Union. In 2000, the Bureau of Verification and Compliance (VCI) estimated that world military expenditure fell at about 6% a year in real terms over the 10 year-period 1987-1997, a fall of 7.3% a year in the developed world and 0.9% a year in the developing world. The most dramatic decline was in the former Soviet Union, where the arms trade dropped by a half between the 1987 high of $81.5 billion and the 1994 trough of $42.2 billion (in 1997 prices), rising again to $54.6 billion in 1997. The Asian crisis of 1997 subsequently hit arms sales, since this was an area where demand had been strong. Procurement of weapons also fell sharply. SIPRI (2000) estimates that arms production (domestic demand plus exports minus imports) in 1997 was 56% of its 1987 level in the US, 77% in France and 90% in the UK. This led to major changes in the structure of the industry, as outlined earlier.

Production for the military is not homogeneous. It consists of a whole range of products, from small arms to large complicated weapons systems, as well as material that is not directly of a military nature.

Much of the information available is on major weapons systems, as these are recognisable, and their particular characteristics over the years have led to particular corporate structures. They involve high fixed R&D costs, financed by governments, and short production runs with steep learning curves. Production is concentrated in relatively few states, in contrast to small arms production, which is relatively standard and widely dispersed (Dunne, 1995a). In addition, many of the components that go into the major weapons systems are ‘commercial off-the-shelf’ (COTS) products, produced by manufacturers who would not see themselves as part of the arms industry. Indeed, the use of standard commercial components is an increasingly common feature of the industry.

The high fixed R&D costs and the steep learning curves, with costs falling sharply with each further unit produced, mean that major weapons producers can gain economies of scale and that their minimum efficient scale is large relative to the size of the market. Thus, on the one hand, governments have been concerned that the drop in demand following the Cold War would drive companies below their minimum efficient scale, but, on the other hand, competition helps to keep down prices and encourages innovation. This tension between the benefits of scale and the benefits of competition has been the central defence industry policy dilemma for the last 40 years.

The end of the Cold War produced not only a quantitative change in the amount of weapons required, but also a qualitative change in the type of weapons required. During the Cold War, planning was straightforward; it was reasonably clear where, how, and with whom war would be fought if it came. After the Cold War, there is much less certainty, although it has become apparent that the Cold War weapons that made up the bulk of the NATO inventory are unlikely to be what is required. Given the long lead times and the commitments made by government bodies, research teams and companies, there are still pressures to continue to produce these weapons systems and to find roles for them. There has, however, been a clear and important qualitative change in the nature of technology. There are two aspects to this.

First, investments in military technology paid off and some, though not all, technologically smart precision-guided weapons actually met the promises that had long been made for them. The power of these, mainly US, technologies was demonstrated in the Gulf War. Second, the relative positions of military and civilian technology were reversed. From the end of World War II to the 1980s, military technology had tended to be in advance of civilian technology, but, by the 1990s, in many areas, particularly electronics, military technology lagged behind the civilian sector. This was largely because the long lead times involved in military procurement meant that much of the technology was obsolete before the system came into service, an example being Eurofighter, a 1980s design, which has only just come into service.

In the past, the spin-off of military technology to the civilian sector was an important argument for the value of military production. However, now the focus is more on passing civilian technology to the military. Many areas of technology that were once the preserve of the military and security services, such as cryptography, are now dominated by commercial applications. Fitting civilian technology into military applications can be difficult, as the UK found in developing a new tactical radio for the army. Fortunately, when in action, UK troops can supplement the heavy 1970s radios issued to them, with their personal mobile phones.

Thus, the trend within the sector is that demand has declined, leading to marked adjustments, but would seem to be rising again. Indeed, on SIPRI’s estimates, world military spending is now only 6% lower in real terms than at the peak of the Cold War. Major changes are taking place for strategic and economic reasons and the predominant actor is the US.

On the supply side, there has been a marked increase in industry concentration. This has now slowed, but the potential exists for further rationalisation at European and international level. There have also been changes in the nature of demand with strategic and technological developments, including an increased civil manufacturing input into weapons production, and changes in the nature of the companies involved in the defence sector, with an increase in information technology (IT) and service contractors. Increasing internationalisation is a further factor, with a growing number of international joint ventures by companies.

Sociological drivers

Changing structure of workforce: The workforce of the defence sector has primarily been male and has been of higher education and skill standard than an average industrial workforce. Now, however, changes are taking place:

  • some defence companies (for example, BAE Systems) have moved their focus more towards work on defence systems and away from production. Consequently, the proportion of production workers in their total staff has fallen, relative to R&D. This is part of a process of ‘hollowing out’, moving to being systems integrators rather than producers;
  • increasing use of civilian technologies has led to increased outsourcing from non-defence companies;
  • some companies have become more specialised and more focused on R&D;
  • new companies tend to be in the civilian sector;
  • peacekeeping roles are changing the nature of the armed forces.

These trends have led to an increasing role for women within the defence sector, though it still remains a male-dominated industry, especially in the core companies.

Changing geographical imperatives: The location of defence industries and facilities has historically reflected security issues, with the result that defence-dependent communities exist in various locations within any country with a large defence industry. The changing nature of the industry and of security means that the geographical pattern is also changing. Company closures cause considerable problems for communities as often the jobs lost are different to other jobs that may be available. While evidence suggests that defence workers - given their high skills - find new jobs relatively easily, it is usually lower-paid work and there is considerable disruption.

Changing international imperatives: Increasing internationalisation of the supply chain is changing the organisation of production. This has implications for levels of employment in contractors and reduces their impact on local economies. Among other examples, BAE Systems has bought US contractors to support its ambitions in that market, and has bought South African contractors to improve its supply chain.

Technological drivers

Technology is extremely important for the defence sector, influencing the sector’s development in several crucial ways.

Barriers to entry: The nature of defence production implies a concern for technological characteristics; consequently, proven capability is important to the buyer and difficult for potential market entrants to establish. Many projects need to be taken through the development stage to production, and this requires a highly skilled workforce and expensive, specialised capital equipment. Management styles also need to be different to those in civil production.

Barriers to exit: Government sponsorship for defence R&D is valuable to companies and not something they would want to lose. Indeed, some firms use government-owned plants and equipment. In addition, the specialist skills and capital equipment are difficult (or impossible) to convert to civil production. The management techniques required in civil production are also different, and managers may find it difficult to forego the emphasis on quality regardless of cost and to direct their attention instead to quantity and low cost.

Although these consequences of high technology have become less pronounced with the changes taking place in the sector, they are still significant.

Changing lead positions: In the Cold War world, a major justification for the defence sector was the spin-off from its technologies to the civilian sector (such as, for example, the internet, computers and transistors). Defence technology was very different to civilian technology. Increasingly today, however, the speed of development in civilian technologies has given them a vital influence in defence systems. This is an important change.

Growth of dual-use technologies: The motive for encouraging dual-use technologies was to allow defence contractors to diversify into civilian markets and make them less dependent on defence procurement, but without losing weapons production capabilities. However, dual-use technologies may simply burden companies with restrictions (because of government regulations and secrecy), which make them less competitive in the civilian market and increase their problems of adjusting to cuts in procurement.

Cooperation: To maintain technological capability, contractors have been turning to licensing, collaboration and joint ventures. This expands the internationalisation of the industry.

Communications technologies: Communication and control technologies are becoming increasingly important in the field of operations. Network-centred warfare, as well as the use of satellites, communications equipment and multi-node networks, are changing the nature of demand and form part of the Revolution in Military Affairs (RMA). While there is no single definition of the RMA, all tend to emphasise the way that improvements in IT, precision targeting and technologically smart munitions create the possibility of a new form of warfare that is network centred.

Internet: This was originally developed by the US military, but has come to play a vital role in the development of communications. However, it also opens up a further area of potential security threats.

Economic drivers

Economic factors have generally not been much to the fore in the defence sector, because of the importance of security concerns. Nevertheless, they create barriers to entry and exit. In addition, changes in demand, globalisation and numerous other factors have had an economic impact.

Barriers to entry: The marketing of military products is different to that of commercial products, as personal contacts and networking are likely to be more important than general advertising. Market demand for arms is also limited by government and is likely to be slow to respond to changing market conditions. This means that entrants cannot rely on an expansion of the market to accommodate them as prices are reduced, but are likely to have to fight against and replace incumbent suppliers. Considerable brand loyalty is also likely, given the nature of the products. Customers may require compatibility with previously purchased weapons systems, or may provide follow-on orders from previous contracts.

Barriers to exit: The marketing of civil products and the need to compete on price make the civil marketplace very different to the world of defence companies. Defence contracts can be safe and profitable and often involve long-term commitments. The market is cyclical and, even in lean periods, it may be worth staying in the market in the expectation of better times, particularly as governments are still likely to bail out major contractors in trouble. Furthermore, even when there are cuts in domestic sales, governments are happy to provide assistance for foreign sales (including providing contacts, organising influential visits, export credits and assistance in the country), and such sales can be lucrative.

Changes in the sector, with the increase in competitive tendering and internationalisation, have reduced these barriers, but they still remain.

Changes in demand: Cuts in military spending that occurred after the Cold War led to considerable restructuring within the international industry. Since then, the decline in demand has reversed and there have been increases in military spending. However, military spending will not return to the heights of the Cold War, particularly if measured as a proportion of GDP (the ‘military burden’).

Changes in the nature of demand: These are mainly political and technological, but are also economic, in view of the increasing costs of high-tech weapon platforms.

Inertia: The military has always been relatively conservative, fighting battles with the weapons of the last war. Large weapons systems take a long time to develop and commit huge resources. Thus, there are still weapons systems coming on stream that were designed for the Cold War, such as the Eurofighter.

Exchange rates: These can be important because of their impact on the cost of imports and exports of arms. The current weakness of the dollar has given the US a greater advantage in terms of exports.

Economic growth: The affordability of defence procurement depends on economic growth. At present, economic growth is sufficient to allow military expenditure to continue at its current levels, except in the US where problems are likely because of government policy and the fiscal deficit.

Linkage to other sectors: Increasingly, civil innovations are being introduced to arms production, increasing the links with the civilian sector and involving new types of company. Companies in the electronics and IT sectors, which in the past had little involvement with arms production, are finding themselves part of the DIB. For example, the software firm, Logica, has become an important contractor for the Ministry of Defence in the UK. This trend could lead to a reduction in the defence specialisation of all but the major contractors. With the growth of privatisation across Europe, it is likely that the financial sector will become increasingly important to defence companies, as it has already become in the UK.

Globalisation: Although defence companies rely on domestic support through procurement and support for exports and are thus not truly ‘transnational’, they have become more international. Governments are more willing to recognise that the costs of high-technology R&D, when combined with smaller national production runs, have made it necessary to make economies of scale through international collaboration and sectoral restructuring. This is very different from the position a few decades ago when governments aimed at maintaining a comprehensive national DIB. Major defence companies from outside the US are also buying defence contractors within the US as a means of entering the market.

Changing supply chain linkages: Companies are changing their supply chains, reflecting internationalisation (for example, BAE Systems and its acquisition in South Africa). They are determining preferred suppliers and using a wider range of them. Companies that survive will do well but there will be casualties.

Privatisation and private finance initiatives: In the UK, most of the defence industry has been privatised in the last two decades, while, in the rest of Europe, the state still owns much of the DIB. This, however, is currently changing. Privatisation is taking place and the UK government’s Public Private Partnerships (PPP) policy, launched in 2000, is having considerable influence. One part of this is the Private Finance Initiative (PFI), where the public sector contracts to purchase quality services on a long-term basis in order to take advantage of private sector management skills, which are heightened and focused by the risk of private financing. PFI can include concessions and franchises, where a private sector partner takes on the responsibility for providing a public service, including maintaining, enhancing or constructing the necessary infrastructure. This initiative is having an important impact on relations between state and industry in the UK, and influences government policy abroad.

Political drivers

Political factors and security concerns have dominated the sector and continue to do so, even though there have been a number of developments. They also create barriers to entry and exit.

Barriers to entry: Political considerations are likely to influence the winning of large contracts and, within the defence industry, personal contacts built up over time remain important. Newcomers are likely to find it difficult to master the detailed procedural regulations and accounting practices that have been developed. In addition, larger contractors may stretch the rules: for example, they may ‘buy in’, by putting in very low bids at the beginning of the contract in the expectation of being able to make more money later, either when specification changes are requested or by winning future contracts. Furthermore, new firms need security clearance, and this can be expensive and time-consuming to obtain.

Barriers to exit: Major defence contractors have become successful at handling the complex procedures of winning government tenders. Having developed these skills, they will not want to give them up. In addition, some companies may also strive to stay in a declining defence market because they have a sense of duty to the nation - in producing the means of defence - rather than for commercial motives.

These factors are less important in today’s defence sector, but they still remain. The industry is very much influenced by political pressures, domestic and international. It is governments that determine the structure of the industry and regulate exports.

Pressure groups and lobbyists: These are an increasingly important group as the European defence industry follows in the footsteps of the US where state ownership and control are reduced.

Government spending: The demand for defence products is dominated by governments and their spending, and their direct influence can determine the structure of the sector.

Changing state policies: These are extremely important. The increasing privatisation of European defence companies, in addition to the tolerance of more foreign ownership and non-domestic procurement, continue to have a major influence on the European industry.

Smart procurement: Governments are involving companies earlier in the development of equipment to meet particular security needs. This is the result of an overhaul of procurement practices to try to deal with the gold plating, cost and time overruns of the Cold War industry. In the UK, in particular, integrated project teams are becoming common. These include specialists responsible for all aspects of acquisition activity, together with industry representatives, except during contract competitions.

Privatisation of defence services and support: This is becoming increasingly apparent, especially in Iraq, as private companies take on the support roles that, in the past, the forces would have held, even in areas of conflict. The big growth area is the provision of security, guarding people and buildings.

EU enlargement: This is linked to NATO enlargement and can lead to increased demand. It also implies that more countries try to benefit from European support for the defence industry.

European Defence Agency: The European Defence Agency (EDA) has been created to help EU Member States to develop their defence capabilities for crisis management operations under the European Security and Defence Policy. It is intended to encourage EU governments to spend defence budgets on meeting future challenges, rather than past Cold War threats, and to help to identify common needs and promote cooperation.

Code of Conduct: In December 2005, the EU Commission outlined plans for an interpretative Communication on the scope of Article 296 of the Treaty establishing the European Community, which restricts cross-border competition by allowing Member States to claim an exemption on national security grounds from normal EU public procurement rules. The Commission also stated that it would propose a specific directive covering defence procurement where Article 296 does not apply. This aims to inject more competition in areas of defence procurement. Where exemptions are invoked - which is the case today for more than 50% of defence equipment purchases - the EDA Code of Conduct is intended to ensure that there is transparent and fair competition.

Arms trade treaty: There is considerable pressure for countries to sign up to an arms trade treaty. Such a treaty would, in future, lead to greater control over the flow of arms and the use of inducements, such as offsets, to support arms exports. Offsets are deals whereby weapons importers are promised compensating economic activity, such as countertrade, licensed production or investment in other industries, as an inducement (see Brauer and Dunne, 2004). The UK supports this non-governmental organisation (NGO) initiative regarding an arms trade treaty, but it is unclear what practical impact it is likely to have.

Strategic drivers

The end of the Cold War changed the nature of the security environment. There was no longer a clear enemy, but the world was still a dangerous place. The strategies and tactics of the Cold War were obsolete and new ones had to be developed. At the same time, changes in technology were having an impact on what could be achieved. The RMA is the catch-all expression for the revolutionary developments taking place in military affairs.

Important strategic aspects include:

Asymmetric warfare: The US and Europe (North Atlantic Treaty Organisation, NATO) are unlikely to face an enemy that can provide a symmetric response. This can change the nature of warfare and lead to more informal guerrilla-type conflicts, with different implications for weapons systems required.

Peacekeeping roles: The increasing involvement of NATO and EU troops in peacekeeping roles around the world is significant. Apart from changing the nature and structure of the forces, it can lead to a change in weapons demand away from Cold War platforms and reinforce the impact of other changes taking place.

War on terror: Uncertainty about the enemy and the intensification of national security are changing the nature of demand. In particular, they make communications and surveillance technologies increasingly important.

NATO enlargement: This requires countries that are joining the alliance to replace old and Warsaw Pact systems with new US and European ones, and has, consequently, increased demand on NATO.

Replacement requirements: Recent commentators have suggested that many fighter aircraft are coming to the end of their life and will need to be replaced.

European collaboration: The Organisation for the Management of Collaborative Armament Programmes (OCAAR) has placed a £2 billion (€2.86 billion) order for about 1,800 missiles and their launch systems with the European missile company MBDA. OCAAR is a jointly-managed procurement alliance formed by France, Germany, Italy and the UK.

Environmental drivers

Given the nature of the industry, environmental concerns are little discussed, but some drivers affect the sector.

Clean-up of facilities: The end of the Cold War left Europe with a number of bases and other facilities that were heavily polluted. This was particularly the case in East Germany following the withdrawal of Russian forces. Some new technologies were developed by companies involved in clean-up that have also been used elsewhere.

Waste and emissions: Military weapons systems are generally designed without concern for fuel efficiency and pollution. There is an increasing awareness of this, but little obvious enthusiasm to deal with it.

Environmental effects of weapons: Concerns have been shown over the impact of weapons systems using depleted uranium and white phosphorous. Increasing concern about the use of landmines and cluster bombs has led to most countries banning landmines.

Environmental security: There is potential for conflict over water and fishery resources.

Uncertainties and issues

All of the drivers are inherently uncertain, both in terms of their future development and their impact upon the sector. While significant changes have occurred in the sector, it is uncertain how well these will serve in predicting future trends. The change from a Cold War to post-Cold War industry was striking, but it had more to do with moving away from a crystallised strategic view of great certainty, towards a world that seems less coherent and less certain. These seem to be the first stages of major changes. For the European industry, the outcome will particularly depend on the role of individual governments, European collaboration and European-US cooperation.

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