My Lords, we are considering in this group of amendments three related changes to the power under Clause 18 for a referral to be made to the SSRO for a determination to adjust the price of a contract. On a minor drafting point, the proposed amendments address only the SSRO’s adjustment of the profit element of the price and, indeed, to only three of the six steps that set contract profit rate. However, I shall assume in my response that the intent of the amendments is also to limit the ability of the SSRO to adjust the cost element of the price as outlined in Clause 20 rather than the profit element alone.
The contention behind these amendments is, I believe, that this price determination introduces an unacceptable degree of uncertainty to the price of a contract, and so they seek to restrict the scope of the determination in three ways: by restricting the grounds on which a referral may be made, as set out in Amendment 18L; by restricting the period in which a referral may be made, as set out in Amendment 18M; and finally by restricting the determination that the SSRO may make. We do not consider that any of these restrictions are
necessary or desirable, and placing such restrictions on the determination will significantly weaken compliance with the pricing rules of the new framework. I think it will be helpful if I outline the purpose and scope of the SSRO’s price determinations before we consider the individual amendments.
The new single-source framework is essentially a deal between suppliers and the Government. Suppliers get a fair and reasonable price and we get the protections we need to ensure value for money. This is a good deal for both parties. We have a duty to ensure taxpayer value for money and an efficient and thriving defence sector that gets a fair price, which is good for defence as a whole. It means that our Armed Forces get the equipment and support they need and the wider economy benefits from an efficient defence sector that can drive innovation and exports. Determining a fair price is thus a key component of Part 2, and Clauses 15 to 21 set out how this is to be done. They set out, for example, that the price must be determined on the basis of allowable costs—costs that are reasonable, appropriate and relate to the contract. They also set out that on top of these costs, the supplier is entitled to a fair and reasonable profit rate. Following these pricing rules will result in a price that is fair and reasonable. The rules on profit ensure that suppliers are adequately compensated for their expertise, and the rules on costs ensure that taxpayers do not pay more than they should. There would be no point in having these rules if they were not enforceable. Indeed, it would undermine the deal that is central to the framework.
This is the situation we have at the moment. Even though the current Review Board for Government Contracts annually recommends a profit rate, there is no obligation to use it, and it is being used less and less on our larger contracts. It may be asked why we need price enforcement provisions at all. Why would anyone sign a contract with a price that is not fair and reasonable? The answer stems from the market failures inherent in single-source procurement. This form of procurement is used when there is no alternative supplier. It means that we cannot walk away from the supplier without also walking away from the essential military capability that that supplier provides. This is not a strong negotiating position, as our suppliers are only too aware. In addition, we are sometimes under time pressures, so that any delay to signing the contract puts lives at risk. This compounds the problem, and partly explains why we may not always get the best deal.
Another reason why we might sign a contract with a price that is not fair and reasonable stems from the fact that in single-source procurement there is only one supplier pricing the work. The knowledge that there is no one who can put forward a cheaper, more competitive price puts a supplier in a highly unusual and privileged position. Instead of a healthy market incentive to price keenly, our single-source suppliers are under a direct financial incentive to do just the opposite, and the current framework encourages this. This is not to say that our suppliers always, or even routinely, do this. However, it cannot be denied that an
environment where suppliers are rewarded for inflating their price is hardly conducive to getting value for money.
The MoD, of course, has a duty to challenge a supplier’s price estimates. As a brief aside, I will note that this price challenge has not been a level playing field historically. Suppliers’ commercial staff, for whom financial incentives are paramount, typically outnumber our commercial staff, and they employ specialist consultants to help them—which, under the current system, they can often charge back to us. Returning to the market failures of single-source procurement, a substantial difficulty in challenging suppliers’ costs is that they always know more about them than we do. Clearly we need to see their cost assumptions before we agree a price. This is what we should get under the current system, although it is not legally binding. Under the current system we can also challenge their price up to two years after the contract has ended, if we can prove that they did not show their assumptions to us.
This brings me to Amendment 18L. This seeks to introduce a single and specific ground for a price referral to the SSRO—namely, that the SSRO can amend the price only if the initial pricing assumptions were not shown to the MoD. However, seeing suppliers’ price assumptions is not sufficient. Suppliers are in a strong position and can present a convincing case—for example, by showing that their costs forecasts are aligned to historic expectations even if these represent poor value. It requires specialist knowledge and experience to challenge this. It is not enough for a supplier to show us their assumptions, and to put all of the duty on to the MoD to check that each and every one is reasonable, as with the current approach. This encourages a supplier to add extras to their price and hope that the MoD does not find them all. This is an appalling pricing incentive, far removed from a healthy market, and we must address it if we want to get value for money. Again, I do not say that this always happens but I am sure that it is not conducive to getting value for money.
We want suppliers to be encouraged to use good quality pricing assumptions in the first place; assumptions that are fit for purpose. If the cost is worth hundreds of millions of pounds, then they should do a certain amount of due diligence to support this estimate. If they do not, they should be at risk of a future price change when it transpires that outturn costs bear little resemblance to the original estimates. Equally, and just as importantly, I accept that the MoD has a duty to check these estimates. If we fail in our duty, any SSRO-determined price change will take this into account.
The SSRO price referrals, in the way that they are currently drafted, will replace the current misaligned pricing incentives with incentives that act as a proxy for the missing competitive pressures. We have chosen to give the SSRO, in its role as an independent expert of single-source procurement, the function of acting as an independent adjudicator in the event that these pricing rules are not followed. One alternative might have been the courts. However, the technical and specialist nature of single-source procurement means
that this route might be more complicated and time consuming for both parties, and probably much more expensive.
So the SSRO, under Clauses 18 and 20, can make a determination that the price of the single-source contract must be adjusted. It will make this assessment if it considers, for example, that a contractor’s assumptions were misleading or not fit for purpose at the time of pricing; in other words, that they were not fair and reasonable.
The SSRO will not penalise either party for getting an assumption wrong—no one can be expected to know the future—but if it considers that a party provided misleading assumptions or withheld crucial information known to that party at the time, such as, for a supplier, known efficiency measures, then the SSRO can adjust the price. If the SSRO considers that the MoD should have asked more questions, it will also take this into account in its determination. Industry has raised concerns that this adds uncertainty into single-source procurement. My challenge back is that it is an uncertainty that can easily be mitigated. If you follow the pricing rules and keep an audit trail of your assumptions, then any uncertainty will be minimal.
Amendment 18L would reduce the grounds for referral to the SSRO. A referral could be made only if inaccurate or incomplete information had been provided by either party to the contract. If information was provided but was misleading or not fit for purpose, this amendment would prevent the SSRO reviewing and, potentially, adjusting the price of a contract. Similarly, if the adjustments had been determined without regard to the statutory guidance or there was an error of calculation, there would also be no ability to refer the matter. This amendment puts all the duty back on to the MoD to ensure that all the details of a price are fair and reasonable; all the supplier has to do is show its assumptions to us. It takes away from the supplier the duty to do its own due diligence and ensure its estimates are reasonable. This amendment is not an equitable arrangement, particularly given that suppliers have greater knowledge about their costs, and it frustrates our intent to put a proxy for market pressures back on to our single-source suppliers. I therefore urge the noble Lord to withdraw Amendment 18L.
Having provided a great deal of background for the first amendment, I will be brief with the next two amendments in this group. Amendment 18M seeks to restrict the ability of either party to a contract to make a referral to the SSRO for a determination. This amendment would limit the period in which such a referral could be made to the first six months after the price of a contract has been determined. As I discussed earlier, there are a number of reasons why an SSRO price determination might be appropriate: whether information was withheld from one party at the time of pricing, whether due regard was given to statutory guidance, whether the detailed calculations were performed correctly, or any other reason why the pricing assumptions may not have been fit for purpose. In all these scenarios, information will continue to emerge throughout the course of the contract. For example, the supply chain employed may be significantly different from that
assumed at the time of pricing, and this may be a prompt to investigate whether information was appropriately shared or whether the pricing assumptions were fit for purpose. If a contract is for the design, manufacture and initial in-service support of equipment, this kind of information may not become apparent until several years into the contract. To restrict the period for this determination to six months is to restrict the ability to consider information that later comes to light, conduct investigations and assess whether an adjustment might be appropriate. We consider this an artificial and unnecessary restriction upon the SSRO’s aim of ensuring that the contract price is fair and reasonable and that good value for money is obtained. As before, any uncertainty can easily be mitigated by a contractor following the pricing rules and keeping an audit trail of its assumptions.
We however recognise that it is appropriate clearly to specify the periods in which opinions and determinations, including this determination under Clause 18, may be made. It was for this reason that we introduced in the House of Commons what is now Clause 41. This provides that the single-source contract regulations may specify time periods for all referrals to the SSRO, and the draft regulations do just that. The draft regulations are the subject of the ongoing consultation with industry, so we do not consider it necessary to single this one referral out to specify a period in the Bill rather than in the regulations.
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Amendment 18N is the final amendment in this group. Unlike the previous two amendments, which would restrict the basis upon which a referral to the SSRO may be made, this amendment seeks to limit the determination that the SSRO is able to make by introducing the requirement for a price adjustment to be material. In most circumstances, the requirement for materiality is implicit in the overall process for this referral and determination. In order to arrive at a price adjustment, parties must first have recognised an issue, failed to reach agreement through discussion and negotiation, referred the matter to the SSRO, and the SSRO must consider that an adjustment is appropriate. The SSRO is not under a duty to make an adjustment in response to a referral. It may do so if it considers that the existing price is not appropriate. We would not expect to arrive at a referral to the SSRO over an immaterial matter, and would not generally expect the SSRO to determine a price adjustment if it were immaterial.
However, while in most cases any adjustment would be naturally expected to be material, there is also the important matter of compliance with the regime. Part 2 introduces a civil penalty compliance process, which deals with contraventions relating to the duties of a contractor once they have entered into a qualifying defence contract—duties such as keeping records and providing reports. That process does not directly address the pricing of a contract. That is dealt with by the determinations under Clauses 18 and 20 that allow for the SSRO to determine a price adjustment.
These determinations play an essential role in ensuring that a contract is priced in accordance with the principles set out in the Bill and regulations, and with regard to statutory guidance. Without these determinations, there would be rules relating to the pricing of these contracts, but no compliance process.
To limit this determination to material price adjustments would limit the power of the SSRO to make determinations based upon principle, irrespective of value, and in doing so to award appropriate costs. The determination may deal with important matters of principle but, based upon the balance of circumstances, the SSRO may consider that a nominal adjustment is appropriate, setting out its reasons for doing so. To prevent the SSRO from making such determinations would be an unfortunate restriction upon its freedom to make determinations in such cases. I therefore urge the noble Lord to withdraw Amendment 18L, and not to move Amendments 18M and 18N.