Pearls and Irritations

I think this is an outstanding article on naval shipbuilding, industry policy and economic prospects in South Australia. Jon Staford suggests that in terms of industry policy, ‘continuing to prop up the car industry … would probably have been a much cheaper way of [creating jobs]’. In case you have missed it, I have decided to repost.  John Menadue

The recent statement by the Prime Minister on the naval shipbuilding industry is highly problematic. By committing up to $89 billion to a continuous warship-building program in Adelaide, the government’s largesse knows no bounds. This policy seems irresponsible, not just financially but also in terms of both industry policy and defence requirements. Yet, in political terms, it may seem a masterstroke, not just in shoring up the Coalition vote in South Australia but because none of the other political parties will oppose it.

1. National security argument for building warships locally

In the current debate over naval shipbuilding it is taken for granted that there is a strong defence argument in favour of building naval platforms in Australia, almost regardless of cost. Not only do politicians and trade unions assert this, but it goes generally unchallenged in the media. Yet it is simply not correct.

From a Defence policy perspective, the role of industry is to provide through life support for military assets, to upgrade them as required and, in any conflict, to repair combat damage and return the asset to the front line as expeditiously as possible. It is not necessary to have built a warship in the first place to be able to undertake these tasks. Local industry has always provided through life support to the RAN fleet, irrespective of whether the ships were built locally or procured offshore. In recent times, for example, the Oberon class submarines were built in the UK but were both sustained and upgraded to challenging RAN specifications in Australia.

More recently, the US origin Perry class FFGs have been upgraded very substantially to a local design. But the contract went not to the Williamstown shipyard that built the two Australian sourced ships but to Thales/ADI in Sydney, which had played no part in constructing the ships. The current leading-edge upgrade to the Anzac class frigates is being undertaken not in the Williamstown yard that built them, but in Western Australia. Indeed, the Navy prefers to have maintenance and upgrades undertaken at the fleet bases in Sydney and Henderson (WA), while construction generally takes place elsewhere.

In practical terms, when we consider Air Force and Army assets the national security argument for building naval platforms locally is soon shown to be false. The Mirage was the last RAAF fighter to be assembled locally in the 1960s and there was no argument from Defence that the F-35 Joint Strike Fighter should be built here. The RAAF and defence industry have done a fine job in maintaining and upgrading the fleet of Hornets, which were bought off the shelf from the US. Although some helicopters are being assembled in Australia, it is not clear what the benefits are and there have been some significant costs. While the Army was keen to acquire the Abrams Main Battle Tank (to what end has never been entirely clear), there never seemed to be any suggestion that it was necessary to build the platforms in Australia.

It is also notable that the Prime Minister appears to support the RAN’s next submarine being sourced from Japan. While he may compromise on this position, it does suggest that he does not accept that there is a national security argument for building naval platforms locally.

From a Defence perspective, there can also be significant downside in building warships in Australia. First, they are likely to cost more (30-40 per cent more according to the RAND Corporation). Within a constrained defence budget, this reduces the ‘bang for the buck’ very significantly. For example, for the eventual cost of three locally built air warfare destroyers, we would probably have been able to buy off the shelf from the US five larger and more capable Arleigh Burke class destroyers or, more realistically, buy three and divert the savings into other defence priorities. Secondly, delays in delivering locally built ships can lead to significant problems and costs for the RAN where obsolescent ships that were due to be replaced have to be kept in service for longer.

Continuous build: the tail wagging the dog?

Establishing a local industry to build warships for a small navy leads to major problems in terms of maintaining a skilled workforce. If there is no new build program on the horizon to take over from another program that is nearing completion, there is no alternative but to discharge the shipyard’s workforce and put some of the capital on care and maintenance. This leads to a major loss of skills in the workforce that can pose substantial risks to a new build program and take years to rebuild.

The Prime Minister’s solution to this problem is to establish a continuous build program for warships. Note that this will not commence in this decade; the Anzac ships with their current upgrade are among the most capable frigates in the world and do not need replacing yet. This means that most naval shipyards will need to pay off most of their current workforce. Some shipyards, such as Williamstown, may even close permanently as a result.

Given that the sole purpose of a local naval shipbuilding industry is to service the requirements of Defence, what are the benefits to Defence of a continuous build program in the future? The answer, surely, is very few. The Navy needs to retain maximum flexibility in its future requirements. It may need a new class of vessel quickly that does not accord with continuous build. Given rapid changes in IT and systems as technology advances ever more quickly, it may be much more efficient to upgrade existing platforms rather than prematurely replace them with new ones. The RAN is not the US Navy; it may not require a new ship every two years. The only benefit is to the industry, which should be a servant of the Navy. This is truly a case of the tail wagging the dog.

2. Industry policy perspective

Apart from national security, the main argument for building warships locally is that it creates jobs for Australians rather than for foreigners if the same ships were built overseas. Given Australia’s commitment to free trade, it is curious to see this mercantilist argument, which takes no account of comparative advantage, proposed by a Coalition government that supposedly supports a market economy, as well as by an Opposition that surely retains in its veins some of the competitive blood from the Hawke/Keating years.

It is also particularly odd to witness a government that virtually shooed the car industry out of the country on the basis of the subsidy it required as being so keen to pay enormous sums of money for locally built warships in order to create jobs. If job creation in South Australia’s engineering industries is the policy objective, continuing to prop up the car industry (particularly under a much lower exchange rate) would probably have been a much cheaper way of achieving it.

The inconvenient truth is that, with two exceptions, Australia has never been very good at building warships. We have a long history of building copies of overseas designs in government-owned shipyards. Often these have taken twice as long to build as they should have done and have come at a significant cost premium compared with overseas acquisition. Notably, it was Gough (“I am a Rattigan man”[1]) Whitlam who brought the party to an end by rejecting a proposal for a locally designed and built frigate in favour of acquiring the cheap, off the shelf Perry FFG class from the US.

Two successes: Anzacs and Littoral Combat Ships

The one outstanding domestic shipbuilding success story is the Anzac frigate program. Eight ships of German design were built at Williamstown for the RAN (and two more for New Zealand) and delivered over ten years from 1996 on time and on budget. Although cost comparisons are difficult because of differences in specifications, it is generally agreed that the ships were procured for much the same cost as if they had been acquired from Germany. Even the German shipbuilder conceded that they could not have delivered the frigates for a lower cost.

So what was the secret of this success and how did the government exploit it? The main reasons for the success were that:

• The Williamstown shipyard had been privatised by the Hawke government and had developed its experience in both management and the workforce in building the last two FFGs immediately before the Anzac program commenced
• The company had a visionary leader in John White, who was highly committed to the idea that Australia possessed the engineering and manufacturing skills to build warships competitively
• The shipyard maintained highly productive industrial relations protocols
• The ships were built on the basis of a fixed price contract, so that the company had extensive skin in the game and the risk to government was much reduced
• The terms of the fixed price contract virtually precluded Defence from making costly and time consuming changes to the design during the build
• The design of the Anzac class was both mature and simple – to justify an eight ship acquisition, the frigates were ‘built for but not with’ a number of weapons systems and associated sensors that were added later
• A ten ship program allowed considerable economies of scale to be exploited as well as moving a long way down the learning curve – the last ship, HMAS Perth, cost far less to build than the first one.

As to how government exploited this success, the short answer is extraordinarily badly. As the Anzac program reached completion, the three ship air warfare destroyer program was put to tender and was being pursued by both Victoria (at Williamstown) and Adelaide, where the government-owned ASC had largely paid off its workforce from the Collins class submarines and had never built a surface warship. With an experienced workforce available and at the peak of its game, it seemed obvious that Tenix at Williamstown should be awarded the contract.

But this didn’t happen. Defence was not enamoured of Tenix, which tended to keep them at arm’s length, and it had developed its own plan to concentrate naval shipbuilding in Adelaide. The risks of not awarding the project to an experienced builder were ignored. The membership of the Cabinet committee that made the decision had a majority of South Australians, including the Ministers for Defence, Foreign Affairs and Finance (who also happened to be the shareholder for ASC). The shipbuilder itself inevitably had a conflict of interest, being both owned by the government and with the government as the client. The alliance-based contract was not based on a fixed price and the cost blew out significantly as design changes were brought in, while accountability was not always clear. Inexperience in the workforce, including at sub-contractors such as Williamstown where the Anzac workforce had been paid off, led to costly mistakes and blow-outs both to the budget and the delivery schedule.

The other success story is Austal, an entrepreneurial Western Australian shipbuilder that was one of the pioneers of fast aluminium ferries in the global market.[2] Austal opened a shipyard in Alabama, which enabled it to get around the protective Jones Act in the US and compete to build ships for the US Navy. As well as other high speed aluminium warships, Austal is completing a contract to build ten Littoral Combat Ships for the US Navy, with an objective of upgrading future ships to frigates. According to the Western Australian government, Austal is currently building 15 per cent of the US fleet.

Yet the Prime Minister could find no room for Austal in his announcement last week. While the RAN, with some justification, has reservations about aluminium warships (as do all navies since the Falklands War), it is worth considering whether Austal’s highly competitive offerings could meet some of its future needs. It is worthy of note that Austal also built the RAN’s current patrol boat fleet, the Armidale class.

The PM also failed to mention BAE Systems at Williamstown, one of the world’s largest defence contractors with a very significant naval shipbuilding business.

Current situation

As of now, therefore, all the benefits of the Anzac program have been lost. Australia is left with a dominant government-owned shipbuilder and, according to the RAND Corporation a cost disability of 30-40 per cent vis-à-vis best practice overseas. Assuming a materials to output ratio of 50 per cent, the effective rate of protection (or assistance to value added), for naval shipbuilding comes out at around 70 per cent, a figure far higher than that for the car industry.[3]

With no significant defence benefits from a local build, it is impossible for the government to justify providing massive contracts to an industry that requires an effective rate of protection of 70 per cent. To do so is totally contrary to the thrust of industry policy since the Whitlam government and implies a considerable misallocation of highly skilled labour resources that could be used much more productively elsewhere. Indeed, this government was not able to tolerate the car industry’s subsidy requirements, which would have equated to an effective rate of protection of around 10 per cent.

Conclusion

The government’s announcement appears to give an open-ended commitment continuously to build future warships in Australia, or more specifically in Adelaide. There is no mention of how great a cost disability the government is willing to tolerate, how it plans to make ASC more efficient or why the Navy needs a continuous build program. There is no explanation as to why a government-owned shipyard, which is yet to deliver a surface warship, is being preferred over privately-owned shipyards in Victoria and Western Australia that have a record of success. In particular, the government has not enlightened us as to why the naval shipbuilding industry should be accorded a much higher level of assistance than it was prepared to provide to the car industry, which generates many more jobs throughout the economy, particularly in South Australia and Victoria. The justification for the taxpaying community to support a massive entitlement to the naval shipbuilding industry has yet to be explained.

However, there may well be a good case for reforming the naval shipbuilding industry. Such a program would involve:

• Ensuring the industry is in a fit state to undertake its major Defence functions, ie the efficient provision of through life support of assets, upgrades and swift repair of combat damage
• Privatising ASC in Adelaide in the context of a comprehensive rationalisation of the industry to reduce excess capacity
• Making no commitments about building future warships locally unless cost competitiveness can be achieved
• In future programs local procurement would only occur if competitive (within, say 5 per cent) with offshore acquisition
• A continuous build program would be undertaken only on the basis of a rigorous cost/benefit assessment
• All acquisitions would be on the basis of a fixed price contract, albeit with possible increases in the budget for new or unforeseen changes.

Given that the government’s announcement appears to satisfy none of these criteria, there is an opportunity for the Opposition to propose a rational industry policy more in accord with its approach under the Hawke and Keating governments. Unfortunately there are no signs that this will happen. Indeed, Bill Shorten wants to outdo the government in pork barrelling by going totus porcus (as the British Admiral Jackie Fisher used to say) and committing, cost unseen, to building the submarines in Adelaide as well.

The current ALP leadership might usefully pause to remember that they are walking in the shadows of giants in these critical areas of public finance and industry policy. The legacy of Peter Walsh and his helper and friend John Button should not lightly be cast aside.

As a consultant, Jon Stanford has undertaken significant work on Australia’s naval shipbuilding industry, for both government and defence contractors. Previously he worked on industry policy in the Department of the Prime Minister and Cabinet.

[1] Alf Rattigan was the Chairman of the Tariff Board, which became the Industries Assistance Commission, under the Whitlam government, and took a strong position in favour of low industry protection.

[2] Austal has often flown under the radar. When Prime Minister Thatcher commissioned the first Australian-built Austal fast ferry on the cross-Channel route in the 1980s, she called it “a triumph for British technology”.

[3] Even if we assume a materials to output ratio of 30 per cent, an implausibly low figure given the cost of modern missiles, sensors and systems such as Aegis, on the basis of RAND Corporation figures the effective rate of protection comes out at 50 per cent.

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