RE: Feedback Requested During Meeting with AIDN Board Conducted 15 August 2024

Executive Summary
In the following, practical and implementable steps are offered by AIDN in response to the four issues raised, together with (at the Appendix) additional recommended steps to better foster successful outcomes for defence industry policy.

Issue 1, Prime/SME Relationship. Defence is increasingly using prime contracts, with AIDN members’ opportunities now primarily as subcontractors via primes. The AIC construct is intended to encourage primes to use Australian subcontractors, but many countervailing factors undermines its effectiveness. To address these, AIDN recommends modifying AIC from a “best endeavours” model to contractually obligatory, binding levels of Australian content.

Issue 2, GSC Limitations. The GSC does not address commercial factors that constrain the nature of supply that the primes’ overseas businesses would consider being fulfilled by Australian companies. Different mechanisms, including leveraging Australia’s power as a large buyer, will be needed to increase and/or broaden export sales from Australian defence industry.

Issue 3, DIDS Grants. Defence support to development of industry capability is sought across a broader range of industrial capabilities, and at a higher level of support, to bring Australia in line with the practice of our primary alliance partner.

Issue 4, Development of Mid-Tier. Mechanisms are identified to increase the range of procurement opportunities that would enable existing tier 3 businesses to naturally develop into tier 2 businesses; through identification of capability procurements suited to the prospective suppliers, and by enabling those capabilities to be defined at a genuine minimum viable capability level at which the supplier will be able to realistically bid for as prime.

Item 1: The Prime/SME Relationship
Context – The topic arose during the discussion around Defence’s progressive move away from direct contracting, with more work contracted via prime contractors. This leads to questions on the prime/SME relationship, on which you commented: “further work is needed on”.

Response:
A primary concern of AIDN members is that channeling work through the primes (which are predominantly foreign owned/controlled) may block SME access to potential opportunities.

The policy framework relies on the AIC construct to incentivise primes to include SMEs, by creating a commercial incentive (attaining advantage in tendering) to offer work to SMEs.
Unfortunately, the AIC construct is encumbered by multiple systemic weaknesses:
• It ignores significant countervailing commercial incentives acting on the primes. These include the commercial desire of primes to:
• Provide work to themselves first,
• maintain control over the more IP-intensive parts of programs (which have comparatively greater potential to attract commercially attractive variations over the life of type of the capability) by avoiding subcontracting out supply of such elements,
• seek favour with their primary customer in their ‘home’ market, who will desire that suppliers in their domestic markets are used wherever possible, and exert pressure on ‘their’ suppliers to assure that outcome,
• meet offsets obligations arising from the prime’s contracted works in other territories; leading to desire to contract suppliers from those countries.
• The AIC mechanism seeks to influence primes’ behavior via incentive. For this to be effective, primes must have the perception that a strong AIC package is an important element of evaluation. Where primes perceive that Defence program offices are not interested in the AIC package, AIC has minimal influence. The perception in the current market is that AIC packages are not an important influence on Defence tender evaluation.
• It is a “best endeavours” construct, which allows primes to argue that they have tried their best and cannot find suitable local suppliers – without any independent channel for Australian suppliers to challenge such assertions.
• AIC is “policed” through Defence checking AIC activity only on the basis of reports provided by the prime itself – making it easy for primes to break tendered AIC commitments and avoid any adverse commercial outcomes.

It is AIDN’s view that the time has come for Defence to accept that the existing AIC approach has not and will not deliver the desired levels of engagement of Australian industry.

AIDN recommends that the AIC construct be modified as follows:
• The prime contract to contain contractually binding obligations for specified minimum levels of Australian Industry Content (AIC), and for specific mandated items to be sourced in-country, from the outset of the program tendering, planning and product design/procurement, including for FMS suppliers, with independent audits and contractual penalties/remedies for non-compliance.

Item 2: GSC Limitations
Context – The discussion highlighted that GSC operates by having (taxpayer funded) prime personnel interact with programs conducted by their parent company in their ‘home’ territory.

The perspective of a Program Manager (PM) of a US or European prime was discussed, when interacting with an Australian GSC person seeking opportunities for Australian businesses to bid for.

It was canvassed that such a PM would not consider allowing any non-domestic supplier bid for any program elements that are technology/IP rich and/or involve highly advanced manufacturing – as the “crown jewels” have strategic industrial value and must remain in-country. However, such a PM might be willing to have overseas suppliers (e.g. Australians) bid for commodity or manufacturing work where that work does not have a strategic industrial value to the foreign prime (or their primary customer). In such cases the foreign prime is not overly concerned about where (or who) does the work; rather what matters is simply getting the lowest cost/ lowest risk source of supply.

In consequence, while GSC may be effective in gaining workshare for Australian businesses supplying commodity or manufacturing type work, the GSC will not generally be effective in attaining work share for Australian suppliers of IP-rich technology and highly-advanced manufacturing.

During the discussion you expressed that you sought perspectives from industry.

Response:
Defence will need to utilise mechanisms other than GSC to gain export markets for Australian industry offering IP-rich technology or highly-advanced manufacturing supplies.

Examples may be for Defence to utilise the leverage it has as customer to seek exports for Australian businesses offering IP-rich technology or highly-advanced manufacturing supplies, by requiring as a tender condition primes bidding for Australian Defence work, to find a mandated level of exports for Australian businesses offering IP-rich technology or highly-advanced manufacturing supplies.

Item 3: DIDS Grants
Context – This arose during the discussion of DIDS grants. The discussion highlighted that none of the DIDS Grant streams provides grant assistance for internal staff expenses for IP development or the development of advanced manufacturing processes (i.e. R&D conducted by SMEs into developing new technology or manufacturing processes).

For example, the “Sovereign industrial priorities” stream provides only for support for purchasing of manufacturing plant and equipment.

The discussion also canvassed that grants only cover 50% of project costs, and the desirability of allowing grants for smaller entities to provide a greater % of costs than 50%.

During the discussion the existence of technical or legal constraints on grant funding (possibly related to treaty commitments) was suggested, with feedback sought on these matters.

Response:
Defence related grants need to be much broader in the scope of allowable costs. In addition to capital equipment, technology R&D, business governance and productivity improvements are areas that need funding support, particularly in the areas of SDIP and AUKUS pillar 2 aligned technology, standards/certification/accreditations compliance; software purchase and implementation; jig, mould and tool development; production qualification; and consultancy support for process improvement, defence contract submissions, and other improvements in business processes, safety, compliance or productivity.

The current ‘Defence Industry Development Grant’ and other Defence industry grants are too restrictive in their definition of eligible expenditure, with internal salary expenditure in the areas outlined above needing to be included, and the timelines associated with submission windows and assessment periods, means that for most businesses, the funding is not responsive enough to be truly effective. Industry would prefer a 4 week turnaround from the date of submission to the determination and notification date, with no set submission window cut off dates.

Industry acknowledges the 50% grant co-contribution rate; however this is still insufficient funding support for most businesses when producing outcomes for Defence, particularly when the Department of Defence is the only consumer for that product or service, and in many cases the outcome is being initiated by the Department of Defence with specific companies. If the intent is there to aid Defence industry at a greater level, then the solution is to not use grant mechanisms, but instead use direct sole source procurement contracts to fund the activity, whilst avoiding the administrative and contractual burden of going to the broader market through open tender. It is noted that our senior ally, the US, takes this path for its SBIR program through which US industry is paid to develop much of the US’s new Defence technology and/or manufacturing processes.

Item 4: Development of Mid-Tier Australian Businesses
Context – The discussion highlighted two key priorities of the government:
• The development of Defence industry exports; and,
• The development of mid-tier Australian businesses.

During the discussion, you described that you are open to input on how both of these can be achieved.

The issue of exports has been addressed at item 2 above.

Regarding the development of mid-tier businesses, the conversation canvassed that such businesses will be considered as both potential prime contractor and subcontractor suppliers.

Response:
The development of tier 2 businesses requires allowing tier 3 businesses (i.e. SMEs) to grow adequately to become tier 2 businesses.

AIDN offers the following approaches that will foster the growth conditions for SMEs necessary to enable the emergence of tier 2 businesses:
• Identify growth opportunities. Defence to identify cases where (current) SMEs have capabilities that align well to key elements of upcoming major programs. This process should be contestable by industry, in a manner independent of the program offices involved.
• Align procurement strategy. The procurement strategy for the applicable upcoming programs should be selected to promote the likelihood of the identified SME gaining work on the program. This may mean any of:
o Set the MVC level for the program at a level small enough (i.e. at the “minimum viable” capability level) that allows the SME to bid directly to Defence
o Where the MVC level must be larger than the scale of functionality able to be provided by the SME, Defence must assess whether there is a genuine need for a private sector integrator, or whether Defence will be able to itself integrate components. This will be determined by an assessment of the technical complexity of the integration involved, which, if not significant, should allow separate items to be contracted directly by Defence, allowing the SME to contract directly with Defence.
o Both of the elements above must be able to be contested by industry, to preclude Defence always setting “high” MVC and always stipulating the need for a prime system integrator
o Where it is unavoidable that a prime system integrator is required, Defence to either mandate that the relevant supplies are acquired from the SME; or impose fully transparent and separate “supplier evaluation” obligations onto the prime to enable the SME to bid fairly for the opportunity – without SME bid data being leaked by the prime to the SME’s competitors
• Where all of the steps above are not possible, the prime contract to contain contractually binding obligations for specified minimum levels of Australian Industry Content (AIC), and for specific mandated items to be sourced in-country, from the outset of the program tendering, planning and product design/procurement, including for FMS suppliers, with independent audits and contractual penalties/remedies for non-compliance.

Appendix One – General Feedback on Industry Development Strategy

The body of this letter has provided responses to questions addressing very specific issues raised with Defence industry policy.

Nevertheless, it is recognised that governments of both persuasions have sought broad goals for the development of Australian defence industry capability, and have developed policy positions crafted with the intent of achieving those aims; yet in general have not succeeded in doing so.

AIDN wishes to offer for consideration both additional information on why this occurs, and additional policy constructs that AIDN considers offers a more likely prospect of achieving the outcomes sought by the government and Australian-owned industry.

To that end, it is AIDN’s view that a number of factors arise which consistently lead to the results being achieved falling well short of the intended outcomes for Australian industry’s participation in Australian Defence programs.

These include, in no particular order the following factors:
• Widespread use of FMS procurement, which removes much opportunity for Australian industry involvement in the acquisition phase.
• Procurement rules that do not distinguish between genuinely Australian-owned and controlled businesses and those that are local subsidiaries of foreign owned and/or controlled entities.
• A procurement culture that by default engages prime contractors to manage Defence programs, and usually large foreign-owned primes.
• The scarcity of genuinely Australian prime contractors, resulting in the widespread default utilisation of foreign owned and controlled prime contractors to manage Defence programs.
• The existence of commercial pressures on these foreign-owned and controlled prime contractors that serve to bias against that prime selecting Australian suppliers. Commercial pressures may include defence policy obligations arising in their home market, meeting their primary customer’s expectations of utilisation of their domestic supplier base, and/or offset obligations arising in other export markets they may have. These commercial conflicts serve to exclude Australian component suppliers, irrespective of their competitive merits.
• The existence of commercial affiliations between foreign-owned and controlled prime contractors and non-Australian component suppliers, with such affiliations serving to bias against that prime selecting Australian component suppliers. Commercial affiliations may include existing relationships with suppliers in the prime’s domestic market, and in extreme cases may even include shared ownership with in-house business units that may act as component suppliers. These commercial conflicts serve to exclude Australian component suppliers, irrespective of their competitive merits.
• The pressure applied to foreign-owned and controlled prime contractors conducting programs in their domestic market to ensure that the supply of technology-rich components occurs from suppliers located in that country – which as a general rule precludes the possibility of Australian businesses from gaining export opportunities in those programs for any IP-rich technologies, irrespective of their competitive merits.
• The practice of having a foreign-owned and/or controlled prime contractor to supply the “first-of-type” of a particular platform or system from their existing facility located overseas, with the intent of having subsequent platforms or systems manufactured in Australia. Experience indicates that the
“right time” to transfer the production to Australia never arises, and that commencement of design and production overseas precludes Australian industry from opportunities to participate, irrespective of their competitive merits.
• That positions that are captured as “policy” are less likely to be consistently adhered to by the Department, than those items that are captured as legislative requirements.
It is for these reasons that AIDN considers that “best endeavours” policy constructs such as the AIC and GSC policies will not ultimately deliver the desired industrial outcomes, and that the following policy positions are required:
• Adopt a definition of sovereignty that captures where a business is owned and controlled.
• Modify Commonwealth Procurement Rules to require purchase officers to:
o mandate a minimum design content to be undertaken in Australia;
o assess the benefits to the ADF of Australian industrial self-reliance;
o disallow the punishment of Australian entities for development risk where Australian entities can demonstrate a good record of relevant development; and,
o consider risks to the availability of support during wartime associated with use of non-Australian entities.
• Mandate local content % on all majors >60-70% Australian, to be achieved both during acquisition and support (Note – the US Jones Act stipulates 75%); with such content able to include export contracts for sovereign Australian businesses, particularly in SDIP areas.
• Mandate that all Defence work on SDIPs must be contracted to sovereign Australian entities.

It is AIDN’s view that all of the items set out above should be captured in legislation, a Defence Industry Strategic Resilience Act. The scale of the Defence procurement budget over the next decades, and the imperative to establish a sovereign defence industry capability/capacity, means that a Defence Industry Strategic Resilience Act could arguably provide a highly cost-effective alignment with this Government’s other policy commitments to establish future manufacturing capacity and development of sustainable skilled employment.