Reworking Regional Benefits (IRBs)
KEN POLE
© 2010 FrontLine Defence (Vol 7, No 1)

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Last summer, three federal departments (PWGSC, IC and DND) commissioned an external study of the federal government’s procurement processes. As we go to press, they continue to play their cards close to the vest, not even acknowledging receipt of the package which was delivered on schedule in December by the Canadian Association of Defence and Security Industries (CADSI).

PWGSC (Public Works and Government Services Canada) would confirm only that it has been collaborating with the departments of National Defence and Industry Canada – the two other sponsors of the CADSI study on improving procurement efficiency. “PWGSC’s commitment to improving the procurement system is not new,” a spokesperson wrote in an anodyne e-mail. “Many of the improvements made over the past few years have made it easier for industry to provide products and services to the government.”

For example, the government moved to “high-level, performance-based specifications, which aim to foster competition to the fullest extent, while respecting operational requirements and government direction and priorities.” She also cited the creation last summer of a forum for “broad input” into development of a long-term sustainable shipbuilding strategy as well as a series of roundtable meetings coordinated by CADSI as part of its study.

“These and other improvements have enhanced our ability to act quickly to acquire new assets,” she continued. “PWGSC intends to continue improving the procurement system in a manner that responds effectively to the evolution of Canadian industry, one that ensures fair, open and transparent procurement processes, and that maintains prudence and probity in the expenditure of public funds.”

CADSI also sought to address those same concerns through “industry engagement,” the results of which are believed central to its still-closely-guarded recommendations to the government.

Janet Thornsteinson, CADSI’s Vice-President of Government Relations, told FrontLine that procurement’s general economic role was a key element. “They’re looking for things such as how many jobs,” she said. “How many jobs in spin-offs? How many jobs under multipliers? How can the Canadian government get an economic return on the investment that they are making in the Canadian military’s readiness?”

Industrial capability was another focus. “What is it that Canada does well? What is it that Canada should be doing well in the future? What’s the gap between those two? What might be done to fill in that gap? Along with that, there are some things where one might say that, ‘well we have been very good at X, perhaps that’s no longer something which is required by the government and you may want to migrate into another area’.”

While all that was going on, Industry Canada had already begun an overhaul of Industrial Regional Benefits (IRBs), a key component of the CADSI study and a long-standing source of frustration for the private sector, particularly large suppliers who feel their opportunities to bank offset credits may be unfairly ­constrained.

Dan Duguay, Industry Canada’s Director of IRB Policy, acknowledged to FrontLine that “not much” had changed since IRBs were instituted in 1986. But an “almost perfect storm” of developments underscored the need for a new or at least revised approach.

The Canada First Defence Strategy, issued in June 2008 and characterized by the government as “a detailed road map for the modernization of the Canadian Forces,” was seminal, particulary with procurement values projected to double and even triple previous years’ baselines. “You’ve got an industry which is largely built on global supply chain arrangements,” says Duguay. “No one builds, in-country, a [complete] military system any more.”

A second development is the increasing robustness of the defence and security sector, which is clearly influenced by U.S. spending and emphasizes the need to support Canadian industry.

The most recent is the urgent need for domestic stimulus resulting from the global economic meltdown. “The IRB policy is sort of the conduit through which a lot of that… would happen,” Duguay says. “Those were sort of the key drivers that came together.”

That set the stage for a series of roundtables a year ago, with companies that had received IRBs (and some that hadn’t). The government utilized these opportunities to solicit private-sector advice on how to make policy recognize those drivers.

“The general message was that the policy framework is robust,” Duguay explains. “In other words, things like 100-percent-of-contract-value as offset is sound. It’s a market-based approach which means the Crown doesn’t tell obligors (companies bound by contracts) who they should work with, what type of work, or how much should they pay.”

There also is the paramountcy of DND’s operational requirements; other departments cannot set military technical specifications. “There are many who feel we should favouring non-compliant technology just because it’s made in Canada,” says Duguay.

The question was, what should the government do? The answer from industry, he says, was that “it was how you apply the policy, the types of instruments, the types of transactions that should be permitted within the policy … the overall policy framework was considered sound and robust.” In short, it was the application that required an update.

That yielded seven “operational enhancements” designed to foster a more flexible business environment, increase the number and types of companies eligible for IRBs, and improve the strategic long-term outcomes of IRB process. But there was a lingering view that the practice of IRB credit banking was selective and focused on high-value contracts.

“There are definitely two aspects to banking,” Duguay agreed. “It gives the companies, the obligors, even potential obligors… an opportunity to do some groundwork with Canadian companies.” They clearly would like to know that they could bank that groundwork against an eventual procurement, even if PWGSC hasn’t even issued a Letter of Intent. ­Current policy requires the credit to be applied against a specific procurement. There generally is no provision for peripheral credits, but Duguay says there can be “one-time transferability in the event, for example, that a procurement is cancelled at no fault of the obligor or there’s a significant delay in that procurement. You want a certain amount of flexibility, but it’s not an open bank.”

There were clearly-defined criteria to meet, and while industry generally was “very comfortable” with this approach, it was looking for an “extended runway up front.” The clock starts ticking only when government gives formal Notice of Intent to procure good or services, but “the bank just extends the runway effect.” It should be noted that most countries that require offsets do have a banking system in place.

Duguay called that “the first half of the banking equation.” The second half is what could be called “over-commitment” banking. If a company such as Boeing, Lockheed-Martin or General Dynamics has a 100% obligation but has been able to identify only 90% of its supply needs, that obviously leaves 10% left unfulfilled. If they then identify another significant transaction that may count for a further 20-30% but are unable to use that 10% leftover.

In some instances, they may walk away from the second transaction because they won’t get the total credit, and opt instead for partners in other countries. Boeing, for example, must juggle offsets in at least 20 countries, therefore it is understandably critical to maximize all credits for their transactions.

The “over-commitment” account most likely comes into play in the case of a high-quality or high-value transaction. “We would be open to providing credit for that over-commitment so that we could secure that transaction in Canada,” Duguay notes. It’s effectively a kind of insurance policy that mitigates the risk of losing high-value jobs in the defence and security sector.

Another key change in IRB policy would ease the original requirement that 60% of a bid price be identified in offset activity when the bid is tendered. That can be huge in a shipbuilding project worth probably $5-6 billion procurement potentially. Bidders would have to dedicate significant resources up-front and with only one winner, it represents a considerable lump to swallow. Accordingly, the government has decided to ask for 30% at bid time and then ask the winner for a further 30% within the first year, reducing initial exposure.

“We believe it also will help to identify more higher-value transactions in the long term because… when you have to find 60% and in some instances maybe in a fairly short period, you tend to reach for low-hanging fruit,” Duguay says. “You’re giving the companies time to identify the right activities and not just sort of scramble as much.”

Other changes to the process are designed to boost the number of suppliers eligible for IRBs. Historically, when Canada set out to fulfill a direct requirement, ­bidders had to “Canadianize” the asset to set percentages, which had created what Duguay allows were “difficulties.”

Some bidders opted out because they couldn’t displace their supply chain to meet the requirement or, if they did, it drove up the unit cost, making it uncompetitive. If they did “Canadianize,” it tended to be only be for that contract. In some instances, facilities were purpose-built for the order with contractors effectively turning off the lights and walking away afterward.

So why not offer equivalent credits against work on foreign orders? An overseas supplier with no Canadian content could bid on a Canadian contract and meet a 20% domestic content requirement on, for example, 1,000 vehicles by committing to 5% on a global fleet of 4,000. Instead of having a large slice of a small pie, Canadian suppliers would have a small slice of a larger pie. “We’ve done this already in the case of the Chinook and we’re looking at it… on a number of other procurements where we feel we’ll really leverage our buying power to access global market opportunities,” Duguay explains.

As for DND’s proclivity to “over-Canadianize” a project, creating problems for IRB planners, Duguay hesitated, clearly wording his reply carefully. “The challenge is always one of the operational requirements of the department versus maximizing the impacts or maximizing the benefits to Canadian industry.”

Why wasn’t it possible to do both? Was it simply having two targets to hit, both of which tend to be moving? “Exactly!” he confirms. “Both are driven by very legitimate requirements.”

Another, and possibly very long-term, result of Industry Canada’s new take on IRBs is its acknowledgement that research and development has obvious multiplier potential.

“If an obligor wishes to invest in a consortium in Canada and partners with a Canadian industrial partner in that consortium, the investment from both parties will be part of the credit equation. There also has to be a post-secondary institution involved, a college or university, which could mean technology transfer out of the university, skills development through a college.”

Major players that have more than $1 billion in outstanding offset obligations – more than half the Canadian total – are being asked to develop a more strategic approach. Boeing, Lockheed-Martin, and General Dynamics have wide-ranging offset activities while Sikorsky’s relate mainly to the Maritime Helicopter Project.

“One of the desires is to elevate the level of discussion with a company like Lockheed because at the moment, all the offsets are identified and achieved project by project. By raising it to a more corporate level, one hopes that we can also engage in discussions around broader, more substantive, levels of activity.” Those could include world product mandates, maybe even a new research centre. “You wouldn’t get those levels of discussion at the project… level because you just don’t have the right people in the companies to talk to… The scope would really have to be elevated much higher up in the department. That’s the objective.”

The cash-for-credit concept remains one of the most challenging issues for the federal government notes Duguay. Some in the private sector feel that “because there’s a $20-billion offset obligation to Canada by all these companies, there’s a $20-billion bag of money somewhere waiting to be picked up.”

Hardly. “Obligors are not in the business of… giving cash in exchange for credit. They only would if that came with a very significant multiplier tied to it. These multipliers can be significantly large, too large for the Crown to accept. What we have acknowledged is that in some instances – when you have a small Canadian company which has a world-leading technology, the right people, the right business plan, and you have, let’s say a Boeing, interested in providing them with some working capital, possibly some in-kind equipment donations, possibly some engineering support, possibly some marketing support and the like – we don’t have a framework around which to determine the level of credit for that kind of activity because of the cash component and some of the other activities… So we’re developing basically an R&D commericalization support framework that says if an obligor wishes to support a Canadian company through these kinds of activities, here’s how we will credit it.”

This approach has largely failed in the past because of the obligors’ preference for large multipliers which Duguay reiterates is something the government cannot afford. “We’re looking at a crediting framework that would figure out how to deal with this because the return could be related as much to what goes into the company as well as the long-term result, the eventual sale, the eventual intellectual property that’s developed.”

Industry Canada has its first working draft of the updated credit approach and Duguay hopes to be ready to “put it into motion” early this year, setting out the principles for providing credit.

“Certain activities would not be recognized for credit, other activities would; some would be recognized for multipliers, others would not; and there would also be a certain due diligence process that has to go with this with respect to how strong the business case is…. These changes will diversify the portfolio of offset activities in Canada. We will see a lot of buying of goods and services, but we will also see more university investment, more business development activities, more development of next-generation products and more purchasing of next-generation products.”

Vigorous growth doesn’t come without its own potential headaches, as the government of Denmark learned to its horror only a few years ago. Its defence procurement created an offset obligation that outstripped the country’s industrial capacity, forcing suppliers to outsource to third countries or find other ways of discharging the obligation.

Canada is far from even being close to that kind of predicament, but Duguay admits that if the system isn’t changed, “we will definitely hit a ceiling at one point, especially at the rate at which we’re looking at the defence spending.”

Industry Canada’s changes, he says, will effectively “redistribute” the types of offset activities. There will still be a lot of the conventional purchasing of goods and services, but he also expects “a more substantive portion of demonstration, product development, applied R&D activity within the portfolio of offsets… These will plant the seeds for those activities which will eventually become the commercial products that they’ll have in six, to eight, to 10 to maybe 20 more years.”

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Ken Pole is a regular writer for FrontLine Defence Magazine.
© FrontLine Defence 2010

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