My Lords, Amendment 18P would have the effect of directing the Secretary of State for Defence to provide Parliament annually with a determination of the contract profit rate and, specifically, the process that is to be used to determine the profit rate. Before considering the amendment, it will be worth while outlining the existing process that the Bill provides for.
Under Clause 17, the contract profit rate is to be determined through six steps. Three of those steps will be determined with reference to rates that are to be calculated annually: step 1, the baseline profit rate; step 4, the SSRO funding adjustment; and step 6, the adjustment for capital employed by the contractor. Two of these steps are not new; steps 1 and 6 have their equivalents under the existing regime. The rates to be used in determining these three steps must themselves be determined annually as they will reflect the most recent accounts of companies and the SSRO in relation to the SSRO funding adjustment.
The process for determining these rates is provided for by Clause 19 and has several stages. First, the Secretary of State will issue statutory guidance containing the principles that should be used in determining the rates. Secondly, the SSRO must recommend rates, having regard to the Secretary of State’s guidance, by 31 January each year. Thirdly, upon receiving the SSRO’s recommendations, the Secretary of State must then determine and publish in the London Gazette no later than 15 March each year the rates to be used. In publishing the rates to be used, the Secretary of State must also publish the reasons for any differences from the SSRO’s recommendations.
I appreciate that at first sight this may appear to be an unnecessarily complicated process, but it has been carefully considered to fulfil a number of requirements: first, for the Secretary of State to be able to set out clear guidance on the principles that should be used in determining the rates; secondly, and crucially, for the SSRO as the independent and impartial body to be free to recommend rates in accordance with its statutory aim to set a framework that delivers a fair and reasonable price. While the SSRO must have regard to the principles established by the Secretary of State, it should also be free to consider any other matters that it considers relevant to the setting of the rates. It must be able to recommend the rates that it considers will provide a fair and reasonable return to contractors and value for money to the Government, even if that means not following the principles set out by the Secretary of State.
The amendment would require that the powers conferred by Clause 19 should be contained in regulations made by statutory instrument and therefore be subject to the same level of parliamentary scrutiny as the
other regulations. While I appreciate that Parliament should exercise an appropriate level of oversight in these matters, I do not think that this proposal is proper in this instance. First, I note that this would form a potentially unhelpful precedent across government, since, as far as I am aware, none of the other regulatory bodies—such as for the railways or water—are subject to this degree of parliamentary scrutiny, even though they deal with issues of great national significance. Secondly, the Secretary of State for Defence is already subject to parliamentary oversight for his powers over the defence budget and is therefore accountable to Parliament for how he discharges these powers. The amendment would add an unhelpful degree of additional and overlapping scrutiny for this specific area of his responsibility.
In addition, this is clearly a very technical and complex issue and there is a risk that making this area subject to parliamentary debate would lead to the politicisation of profit rates which ought to be set through impartial and expert judgment. There would be scope for Parliament to be subjected to lobbying by the various interest groups, a factor that could result in pressure to set the rates either too high or too low.
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Finally, I should point out that the Bill already makes provision for the SSRO to make an annual recommendation to the Secretary of State for the profit rate. The SSRO, as the independent body, is the appropriate body to provide the necessary expert oversight of the Secretary of State’s determination of the profit rates. The Secretary of State will have to publish in the London Gazette the rates to be used and must publish the reasons for any difference from the SSRO recommendations. This therefore provides an appropriate level of oversight and transparency.
Amendment 18Q is similar to Amendment 18P in that it seeks to set out matters in regulations rather than in statutory guidance, in this case relating to allowable costs. Clause 20 deals with allowable costs under the new framework. Those costs will account typically for some £5.5 billion pounds per annum of government expenditure, or 90% of the total cost of single-source procurement, so the rules around determining the allowable costs are important.
There are three principles contained in the Bill for determining whether a cost is an allowable cost, and each of these must be met in order for a cost to be allowable. First, a cost must be appropriate. This relates to the type of cost, such as whether it is for labour or materials, insurance or pensions costs, or rationalisation and redundancy costs. Some types of cost are always appropriate, such as direct labour, and some never. For example, suppliers should never be able to pass on the costs of their charitable donations to the taxpayer. Secondly, a cost must be reasonable. This relates to the quantum of the cost, and a cost may be reasonable if it does not exceed that which would be incurred by a prudent person in the conduct of competitive business. Finally, a cost must be attributable to the contract. This may sound obvious, but without this principle a cost incurred by a supplier could be both appropriate and reasonable, yet be either wholly
or partially related to work other than that under the qualifying contract. The amendment seeks to ensure that the single-source contract regulations will provide the detailed guidance to support these three principles, rather than the SSRO issuing statutory guidance as currently provided for.
As noble Lords are aware, the single-source contract regulations made by the Secretary of State will contain the further detail essential to the operation of the new framework. The Bill also provides for a range of statutory guidance, some to be issued by the Secretary of State, but most to be issued by the SSRO. Like the regulations, the statutory guidance has legal power. However, unlike the regulations, parties subject to Part 2 can deviate from statutory guidance if they have reasonable grounds to do so. Parties must have regard to the statutory guidance. For matters where it is difficult to set out rules that will cater for every possible set of circumstances, statutory guidance provides a means of setting rules that provide for the majority of cases but allow the flexibility to deal with unforeseen circumstances or grey areas. As we developed the framework, we considered whether guidance would be better put into the legally binding single-source contract regulations or whether to use statutory guidance with the greater flexibility that that provides. If statutory guidance is to be used, there is then a secondary question of who should issue that guidance—the Secretary of State or the Single Source Regulations Office.
For allowable costs, we judge that the best approach is to use statutory guidance, and that it should be issued by the SSRO. Using statutory guidance rather than regulations is a matter of practicality, and requiring the SSRO rather than the Secretary of State to issue that guidance is a matter of principle. If we were to specify binding rules for determining allowable costs in regulations, those regulations would need to be very detailed and extensive, catering for every possible scenario that may occur. Such regulations would probably run into many hundreds of pages, perhaps thousands, and it would require an army of people to monitor, police and review them. Noble Lords might be interested to know that this is currently the situation in the United States, where the Defense Federal Acquisition Regulations are more than 3,000 pages long and more than 1,000 accountants are employed to ensure that they are complied with. This may be a suitable approach given the scale of US defence spending, but we do not consider this approach necessary for the scale of our defence budget.
The alternative is to use statutory guidance. As it is possible for a person subject to the statutory guidance to deviate from it if they have sound reason to do so, the guidance can focus upon principles and the rules appropriate for the vast majority of cases. Where there are specific circumstances which reasonably justify an alternative approach, that approach may be taken while still being compliant with the law, although the person must be prepared to justify the approach they have taken. Given the broad nature of activity that will be covered under qualifying contracts—everything from research and development to test facilities, the design and manufacture of complex equipment and the provision of support services—the range of potential costs and accounting issues are innumerable.
I therefore consider statutory guidance to be a far more appropriate mechanism than regulations for dealing with this important, yet complex, area. It can be responsive, for example, to changes in international accounting standards, and flexible to deal with specific accounting complexities. It would not be appropriate to commit the department to using extensive and valuable resources to maintain a complex set of regulations. I hope noble Lords will accept that is a sensible approach.
In terms of who should issue this guidance, as the independent arm’s-length body charged with the dual aim of ensuring value for money and a fair and reasonable price, the Single Source Regulations Office is ideally placed. Were this amendment to be accepted, it would place an inappropriate power with the MoD, since the determination of allowable costs would then rest with one of the parties to the contract.
In summary, I believe that our approach, which is to set out in the Bill the three clear principles for determining whether a cost is an allowable cost, supported by statutory guidance issued by the Single Source Regulations Office, is the best approach to ensure a fair and flexible system that works in the interest of all parties.
I now turn to those amendments that relate to the parliamentary process for the regulations that would be introduced by Amendments 18P and 18Q. The Bill as currently drafted provides for the regulations that would be introduced by Amendments 18P and 18Q to be made by statutory instrument in the single-source contract regulations, or SSCRs, which are introduced under Clause 14(1).
On 20 December 2013, the Delegated Powers and Regulatory Reform Committee published its report on the Bill, which included recommendations on the parliamentary process to be applied to the regulations under Part 2. These included that the SSCRs should be subject to a first-time affirmative procedure and that the regulations to be made under Clause 14, which determine the scope of qualifying defence contracts to which Part 2 and the regulations will apply, should always be made by the affirmative procedure. We have accepted these recommendations, and the government amendments to be discussed later make the necessary changes to the Bill.
A further recommendation noted that Clauses 14(1) and 28(1) could potentially be interpreted as providing for the SSCRs to make general provision, which the committee considered would be too wide and imprecise a power to delegate. We agree that such a power would indeed be inappropriate, but it is the department’s view, based on legal advice, that these subsections are introductory in nature, and must be read in the context of the whole of Part 2, which contains a series of detailed and specific powers, and the usual power to make supplementary or incidental provision which is included in Clause 42(2). It should not be necessary to rely on these general clauses to make provision that is not otherwise permitted by the other powers in Part 2. I hope it is clear from the draft regulations placed in the Lords Library that we have not done so.
The final recommendation was that the determination of rates relevant to the contract profit rate under Clause 19 should be made in the regulations. This
recommendation is the subject of Amendment 18P, which we have already discussed. I shall return to this recommendation shortly as it is also relevant to Amendment 23E.
Amendment 23A provides for the specification of which regulations should be subject to the affirmative process. This has a similar effect to government Amendment 23, which also provides a mechanism for specifying regulations to be made subject to the affirmative process. We therefore agree with the intent of the amendment, but it is not required if government Amendment 23 is accepted. Amendments 23D and 23E provide for regulations under Clause 19, covering rates relevant to determining the contract profit rate, and Clause 20, covering allowable costs to be subject to the affirmative procedure. The current Bill does not provide for regulations under either of these clauses, so the amendments rely upon earlier Amendment 18P for rates relevant to the contract profit rate and Amendment 18Q for allowable costs. The Delegated Powers and Regulatory Reform Committee did not recommend that guidance on allowable costs should be in regulations. It recommended in paragraph 12 of its report that the rates relevant to the contract profit rate should be in regulations, as we have already discussed under Amendment 18P. However, the committee did not recommend that the regulations should be subject to the affirmative procedure. As discussed earlier under Amendments 18P and 18Q, we do not believe that either of these matters should be in regulations, so clearly we do not agree that they need to be subject to the affirmative procedure. However, I will briefly consider each amendment in turn.
Amendment 23D relates to allowable costs. The guidance on allowable costs may need to change on a regular basis, for example, in response to changes in international financial reporting standards. If it was set out in regulations this guidance would be long and technical, and any changes are likely to reflect relatively minor changes in accounting practices. We do not consider that such matters justify the affirmative procedure. Amendment 23E relates to rates relevant to the contract profit rate. Even if in regulations, the Delegated Powers and Regulatory Reform Committee did not recommend that these should be subject to the affirmative procedure. The annual setting of the profit rate has similarities with the determinations made by price regulators, such as those in water, energy and rail. In all these cases, the regulators have considerably more power than the Secretary of State or the Single Source Regulations Office in that they set the overall revenue of the regulated industry, not just the profit rate, which typically accounts for only 10% of the price. However their determinations are not subject to direct parliamentary approval.
Parliament has oversight of the regulators through Select Committees and the Comptroller and Auditor-General, which is also the case for the SSRO. Parliament has already delegated to the Secretary of State overall responsibility for providing strategic direction on acquisition and allocating resources appropriately. The setting of rates relevant to the contract profit rate to apply to single-source contracts falls within this remit. Placing the provisions of Clause 19 in regulations following the negative
procedure would already provide a far greater degree of parliamentary approval than that applied to other similar regulatory powers. To apply the affirmative procedure to these matters would, in the department’s view, be further out of proportion to the nature of the power. We do not consider that these regulations should be subject to the affirmative procedure. I hope this explains our position, and I therefore urge the noble Lord to withdraw his amendment.
I have a couple of further points to make. My noble friend Lord Roper asked whether allowable costs could be addressed in future drafts of the regulations. There is no provision in the Bill for this as it is going to be dealt with in statutory guidance, as set out in Clause 21. It would require an amendment. My noble friend Lord Palmer asked how overhead costs such as directors’ salaries, facilities and so on are spread or allocated to contracts. These are addressed through a process known as cost recovery rates. These are allowable costs which are subject to a requirement to follow the three tests under Clause 20 and are the subject of the reports provided for in Clause 25. These give all the powers and transparency necessary to ensure that overhead costs are fair and reasonable, and that we do not pay more than we should for them.
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