From vision to viability: using microeconomics to implement the Strategic Defence Review

After much anticipation, this month the UK government published its long-awaited Strategic Defence Review (SDR). The SDR is the UK’s response to the challenge facing all European countries: namely, how to protect ourselves in a geo-political climate that has become both riskier and more uncertain. Led by former NATO Secretary General Lord Robertson, retired General Sir Richard Barrons and former US presidential adviser Fiona Hill, the review comes at a time when—in the words of its authors:

• the UK faces multiple, direct threats to its security, prosperity and democratic values;
• the country must once again be ready to deter and prevent a full-scale war by being ready to fight and win;
• the military must pivot to ‘a new way of war’, reflecting rapid advances in technology;
• the armed forces must once again be able to endure in long campaigns, backed by an industry that can scale and sustain innovation and production as required.¹

The government has formally accepted all of the SDR’s recommendations, and—in its recent spending review decision—confirmed that defence spending will rise to 2.6% of GDP from 2027, with an ambition to reach 3% in the next Parliament ‘when economic and fiscal conditions allow’.²

This increase in investment coincides with a broad-based increase in EU defence spending, financed in part through its new €150bn ‘SAFE’ programme.³ It also comes at a time when concerns have been raised about the efficiency of European defence spending, driven by industry fragmentation and a lack of standardisation and interoperability of equipment.⁴

Much has been made about the role that the SDR—and UK defence spending more generally—can play in helping to achieve the government’s growth mission. One of the Review’s stated ambitions is that defence will be an ‘engine for growth—driving jobs and prosperity through a new partnership with industry, radical procurement reforms, and backing UK businesses’.⁵ Given this focus, Ministers have been keen to emphasise the positive impact on jobs arising from individual defence investments.⁶

However, while much attention has been paid to the role that re-armament can play in driving economic growth, there has been almost no commentary on the role that good economics—in particular, microeconomics—can play in making the aims of the SDR a reality.

Ask not what defence can do for your economy—ask what economics can do for your defence!

The SDR rightly recognises the critical role that the private sector must play in delivering its objectives, given the depth of expertise that it provides and the need to ‘crowd in’ private finance.⁷ Getting this right matters: experience in other sectors shows how the design of markets underpinned by robust economic analysis can be the difference between rapid delivery of essential investment, or unnecessary delays and cost overruns. Innovators and investors must be incentivised to produce the outcomes that society needs to face a new geopolitical reality.

Fortunately, there is no shortage of lessons from other sectors on what interventions can incentivise firms and investors to produce socially beneficial outcomes that address significant market failures.

This article examines three aspects of the SDR that immediately highlight the importance of solid microeconomics in securing its objectives. These are:

1. the government’s plan to create ‘always on’ munitions capacity;
2. how to improve procurement outcomes through risk allocation;
3. the regulatory framework for single-source procurements.

We recognise that economics does not have all the answers, and there are real geopolitical and national security constraints which need to be taken into account. This means that ‘first best’ economic outcomes are unlikely to be ‘first best’ defence outcomes. However, economics does provide a useful framework for understanding the trade-offs facing policymakers, including on difficult decisions such as cost vs speed or interoperability vs sovereignty.

1. Paying something for nothing—an ‘always on’ munitions capacity

The war in Ukraine has highlighted serious deficiencies in the West’s ability to produce weapons and munitions. This is perhaps best illustrated by one startling statistic: according to one assessment, at the height of the fighting in Donbas in 2022, Russia was using more ammunition in two days than the entire British military had in stock.⁸

To address this, the SDR recommends that a key priority over the next five years be:

More specifically: the SDR recommends that the UK invests £6bn for munitions in this Parliament, including £1.5bn for an ‘always on’ pipeline for munitions and building at least six new energetics and munitions factories in the UK. The government has accepted this recommendation, with funding confirmed in the latest spending review.¹⁰ However—to our knowledge—the government has so far provided no details regarding the commercial arrangements that would underpin the provision of this capacity.

This raises a question: how should the government pay for something that might never be used?

One option may be to set up a capacity market. Under this approach, the Ministry of Defence (MoD) would hold auctions whereby prospective suppliers would submit bids committing to provide specific amounts of munitions capacity several years into the future. This would be modelled on the approach used by the National Energy System Operator to ensure the UK has sufficient electricity capacity to meet future demand.¹¹

Capacity markets provide a useful tool for policymakers wishing to ensure that supply in future will be available if needed. However, for these markets to function properly, it must be possible for the outputs which will be made available in future to be specified in advance, even if the volumes which will ultimately be needed are uncertain.

Where there is uncertainty regarding both the nature of the outputs to be made available (as well as their volumes), a regulatory model, potentially delivered via RAB financing¹², may be more appropriate. Under this approach, the supplier would be guaranteed the right to recover any costs efficiently incurred in producing and maintaining the munitions capacity, plus a rate of return.

Importantly, under the regulatory model there would be periodic reviews of requirements—including the nature of investment needed and the associated impact on costs—which could more easily accommodate changing circumstances.

However, a potential drawback of the regulatory model is the additional complexity introduced by this approach. This includes the need to establish a reasonable rate of return on investments,¹³ and the need to determine what costs are ‘efficient’ in practice. The latter may be particularly problematic where the firm supplying munitions capacity also provides other services outside of scope of the contract, given the need to allocate common costs across activities.¹⁴

Common to both scenarios is the question of what happens if—when this capacity is not being used by the UK government—it can still be used by other buyers (for example, other governments seeking to purchase munitions). Where this is the case, one might argue that any additional revenues earned from such activities should be ‘netted off’ against the costs incurred in building and maintaining the capacity in the first place (thus resulting in lower payments).

There is precedent in the UK for using commercial revenues to offset costs incurred in the provision of regulated activities. For example, Heathrow Airport is regulated under a ‘single till’ methodology, whereby price caps are determined using a single calculation that considers both aeronautical and non-aeronautical revenues. There may be scope to develop a similar framework for munitions capacity, although careful attention would need to be paid to the impact that such contract structures might have on the contractor’s incentives.¹⁵

2. Improving outcomes through better risk allocation

The SDR focuses extensively on the need to develop a resilient industrial base that can support the UK’s armed forces. It states that:

At the heart of this challenge lies the question of how to allocate risks in defence contracts. Fortunately for the MoD, there is no shortage of research in this area.¹⁷

A large range of contract models are available to governments wishing to purchase goods or services from private providers. However, in very basic terms,¹⁸ the two main options are as follows.

• Cost-plus contracts—these involve the government reimbursing the contractor for all allowable costs incurred during the project, plus an additional fee for profit. The government takes on cost risk under this model.
• Fixed-price contracts—these involve a pre-determined, agreed-upon price for the entire project, regardless of the actual costs incurred by the contractor. The contractor assumes the risk of cost overruns.

The pros and cons of each model are intuitive, even to those with no expertise in public procurement.

For example, cost-plus contracts have the benefit of enabling flexibility, since work can begin without the scope being fully clear at the outset. A key downside however is that the contractor has little incentive to control cost escalation. In contrast, while fixed-price contracts provide strong incentives for cost control, the scope must be well defined at the outset of the project. Fixed-price contracts can also result in higher prices, given the need for suppliers to include a risk margin in their bids.¹⁹

However, while these trade-offs may initially appear obvious, there are some defence-specific complexities that may influence the most appropriate approach to risk allocation. For example:

• Reliance on single suppliers. A large fraction of the MoD’s equipment budget is spent on contracts that are not competed, often either for national security reasons or because the product or service is sufficiently niche that only one specialist supplier is available. This could significantly inhibit the scope for procuring weapons via fixed-price contracts.
• Distortions to the ‘make or buy’ decision. Cost-plus contracts can distort the make-or-buy decision, since any cost-plus profit mark-up on capital employed will usually apply only to what one makes and not to what one buys. This can be problematic in the context of major defence procurements involving multiple contractors, particularly if the main contractor is less efficient at producing certain outputs than potential sub-contractors (since it will have less incentive to sub-contract work to other parties, as it will earn no margin on these activities).
• Challenges with intellectual property rights (IPR). Where programmes are procured in stages, separate contracts for development and production can run into IPR problems. This is because whichever firm wins the design stage contract is likely to also win the production stage, as it will have the IPR and knowledge gained from the early phases of work.²⁰ Under these circumstances, firms may have strong incentives to submit unrealistically aggressive bids for the development phase (particularly under fixed-price contracts), but this may result in sub-optimal outcomes for the buyer through higher prices in the long run.

These unique challenges have driven innovations in the approach to weapons procurement.²¹ For example, the US Department of Defense has increasingly embraced ‘Modular Open Systems Approaches’ (MOSA). This approach—which enables competitive bidding for individual components of contracts—aims to foster competition, accelerate innovation and mitigate vendor lock-in.²²

Ultimately, the optimal form of contract will depend on a wide range of factors that will vary across procurements. However, given the intrinsic challenges with defence procurements and the rapidly evolving geopolitical context, it would be naïve to assume that further developments in procurement models will not be forthcoming.

3. A new framework for single source procurements?

As noted above, a significant proportion of MoD equipment is procured without competitive tendering: over a third (39%) of contracts placed by the MoD in 2022–23 were awarded without competition.²³

Enter the role of the Single Source Regulations Office (SSRO).

The SSRO is a non-departmental public body responsible for overseeing and monitoring the Single Source Procurement Framework. Its role is to ensure that value for money is obtained from MoD contractors when contracts are not tendered competitively.²⁴

The SDR does not focus extensively on the role of the SSRO in defence procurements. However, the reviewers recommend that:

and:

Given that the government has accepted all of the SDR’s recommendations, this suggests that further changes to the single source regime will be forthcoming.

What is interesting however is that the SSRO’s framework was only recently subject to a major overhaul. The new Single Source Contract Regulations—which came into force on 1 April 2024—introduced multiple changes to the original framework, including:

• a new definition of ‘Qualifying Defence Contracts’—bringing a wider range of contracts into scope of the SSRO’s regime;
• the introduction of alternative pricing mechanisms—which can be used instead of the default pricing formula under select circumstances;
• changes to how the Contract Profit Rate is calculated—including amending the original ‘cost risk adjustment’ (i.e. step 2 in the original process) in favour of a wider assessment of financial risk.²⁷

It is unclear, based on the SDR, what further changes might be envisioned to the SSRO’s framework. Regardless, given the speed of developments both on and off the battlefield, it may be wise to revisit certain elements of the regime.

For example, a key input for calculating the baseline profit rate under the SSRO’s framework is the comparator group—made up of financial data from a range of comparable companies, including some from non-defence sectors.²⁸ Given changes to the composition of equipment being procured,²⁹ there may be a case for reviewing the comparator group to ensure that it remains an accurate proxy for the types of activity that it is supposed to represent.³⁰

There is a question of whether changes in the approach to single source procurement can be accommodated within the existing framework, or whether a wider reset of the framework is required. Either way, the message is clear—changes are coming, so watch this space.

A call to (microeconomic) arms

The scale of the task facing the UK is immense. To make the country safe, policymakers must:

• reverse the ‘hollowing out’ of Britain’s armed forces since the Cold War;
• adapt in real time to technology developments on the battlefield; and,
• implement a ‘whole-of-society’ approach to preparations for war, including home defence, resilience, and industrial mobilisation.

No single discipline can address every challenge that defence of the realm will present. In fact, arguably the most important ingredients in making the SDR a success will be political skill and a sense of common purpose among the people of the UK.

But the importance of getting the microeconomics right should not be underestimated. Given the scale of investment needed, the role of private capital in financing it and the productivity improvements demanded, policymakers will need to think very carefully about how the design of markets will incentivise investors and innovators in the real world.