What on earth is going on with the Air Warfare Destroyer program?

Three weeks ago, the finance minister announced the third delay, and the fourth get-well initiative, for the beleaguered Air Warfare Destroyer program. In case you’ve lost track, delays and remediation initiatives were announced in 2011 and 2012, and a ‘reform strategy’ was announced in 2014. The vessels will now be delivered between 30 and 33 months late and cost ‘at least’ $1.2 billion more than planned.

According to the finance minister, ‘these ships are costing $3 billion a ship’ which implies a total project cost of $9 billion. Looking at the budget papers released just prior to the announcement, the pre-existing cost of the project was $7.9 billion. Adding $1.2 billion to $7.9 billion yields $9.1 billion—a 15% cost blow out. That’s bad enough, but those aggregate figures conceal the true state of affairs.

Under the alliance, Defence, Raytheon and ASC share the pain and gain relative to a Target Cost Estimate (TCE) for the alliance part of the project. If the target is met, industry participants receive a pre-determined ‘fee’ to cover profits and corporate overheads. If the project’s under-budget, participants share the unspent funds up to the amount of twice the fee. If the project’s over-budget, additional direct costs are shared by all three participants up to twice the fee. Thereafter, the Commonwealth pays all additional direct costs.

Consistent with the alliance contract, the current approved cost of $7.9 billion has four components:

$5.1 billion corresponding to the TCE (including a management reserve)
an undisclosed amount to cover ‘government furnished’ inputs including the Aegis combat system
the ‘fee’ to be paid to the alliance partners if the TCE is met or improved upon (and a ‘procurement fee’ for Raytheon that’s not at risk)
a further financial contingency.

Although the latter three amounts haven’t been disclosed, estimates are possible.

While there’s no hard and fast rule for how large contingency should be for a defence project, the Department of Finance suggests 10%-15% for non-developmental defence IT projects. With this as a benchmark, and noting the manifestly developmental components of the AWD project, contingency of around $1 billion seems reasonable—split between the management reserve in the TCE and the contingency held by DMO. Based on commercial margins, the fee for industry participants is probably around 10% of the TCE or $500 million, leaving around $1.6 billion to cover government furnished inputs.

Everything the government says points to cost blowouts in the alliance component of the project. If there are problems elsewhere they have not been disclosed. This means that the alliance part of the project is in deep trouble. For the overall cost to have blown out by $1.2 billion, the $1.0 billion contingency has been depleted and the ‘at risk’ component of the $500 million originally set aside to pay the industry partners fees has been redirected to cover emergent costs.

Assuming one-third of the contingency was embedded in the TCE, and that Raytheon’s not-at-risk procurement fee was 20% of the overall industry fee, the TCE has been exceeded by an eye-watering $2.3 billion (= $1.2 billion + $0.66 billion + $0.4 billion).

Actually, the situation is probably not that bad. For reasons I’ll explain in a future post, a change to the indexation arrangements for all defence projects back in 2010 gave rise to a funding shortfall that’s embedded into the foregoing estimate. The indexation shortfall—which is beyond the project’s control—could be in the vicinity of $0.5 billion.

But even taking that into account, there’s still been a massive cost blowout, for which the taxpayer will bear 90% of the pain because ASC is government-owned. Every dollar spent directly on the project will continue to be recompensed 100% by the taxpayer, and Raytheon will still receive its ‘procurement fee’ irrespective of performance.

In theory, ‘liquidated damages’ are owed for late delivery. On the basis of the latest reschedule, the Commonwealth could seek damages of around $557 million. Bizarrely, however, under the alliance contract, Defence is liable for 50% of the liquidated damages and the rest is only recoverable against the already forgone ‘fee’. As elsewhere under the alliance, the taxpayer has once again been left carrying the can.

The forgoing analysis raises a number of questions.

First, why did it take so long to understand the extent of the problems? As recently as mid-2014, Defence assessed that there was ‘sufficient budget remaining for the project to complete against the agreed scope’. How can the project’s prospects have deteriorated so dramatically in less than 12 months? Serious questions need to be asked about the level of oversight exercised by Finance (as owner of ASC) and Defence (as both customer and alliance member).

Second, what’s going to motivate the industry partners now that the incentive fee is no more? The Commonwealth has neither carrots nor sticks. Moreover, what assurance do we have that the line between ‘direct costs’ and ‘fee’ has been properly maintained? Ultimately, the demarcation is an accounting exercise that’s open to interpretation.

Although the details of the AWD alliance’s finances aren’t publicly disclosed, we can get a feel for the sorts of big dollars that arise in the shipbuilding sector by looking at Defence’s handling of the future submarine IPT (Integrated Project Team). As explained in Chapter 7 of the 2015-16 ASPI Budget Brief, there are 35 separate contracts at an average annual per-capita cost of $513k for industry participants in the IPT. For example, the services of a combat system sonar engineer cost $778k a year and an industry and business analyst costs $703k. Either the profits and overheads charged by the firms are egregious, or the direct costs being attributed to personnel are egregious—or both. In any case, the payment of such astronomical fees erodes confidence in Defence’s commercial acumen.

Third, and most importantly, how can the taxpayers’ interests be better protected in future domestic shipbuilding projects? According to the Finance Minister, ‘the Government will release an enterprise-level naval shipbuilding plan later this year, which will provide for the long-term future of the Australian naval shipbuilding industry’. Before we double down on domestic shipbuilding, we need something better than the approach taken for the AWD—which, among other shortcomings, made provision for Defence to sue itself.