How Defense Offsets Help Drive the Global Defense Industry

Amid all the talk surrounding the Pentagon’s new Defense Innovation Initiative, also called the “third offset strategy,” we should be mindful of another type of offset that is in the forefront of defense companies’ growth strategies and increasingly becoming a C-suite agenda item. I refer to defense offset agreements, pledges that U.S. defense companies make to foreign entities—usually foreign governments—in order to secure their business.

Offset agreements are complex, the values are often very large, and they raise significant transparency and other concerns. Offsets are increasingly viewed as crucial to securing large defense contracts overseas, but both suppliers and procuring governments should recognize the broader economic development potential in these agreements. Moreover, given the high-value of the obligations they hold, procuring governments should employ comprehensive strategies that leverage these obligations in pursuit of their long-term development goals rather than advancing their local arms-related industries.

What’s an “offset?”

Broadly speaking, offsets encompass a range of compensation arrangements required by foreign governments as a condition of the purchase of defense goods and services from a non-domestic supplier. These arrangements can be local production requirements, investments in local industries, and business relationships with non-defense sectors. Accompanying a detailed analysis of offsets in 2013, the Financial Times provided a timeline on the evolution of offsets from the years following the Second World War—when President Eisenhower coerced Europe to buy American-made defense kits—to the present day marketplace. Steadily increasing since the 1970’s, analysis suggests that the offset market will double within the next five years with much of this growth based on increased defense spending in the developing world.

How large is the offset market?

On the U.S. side, according to the most recent Commerce Department Bureau of Industry and Security (BIS) offset study, in 2012, U.S. defense contractors reported entering into 43 new offset agreements valued at over $10 billion.  The study further reported that those firms executed nearly 700 offset transactions with 30 countries, totaling an actual value of $3.4 billion. While the Department of Commerce submits this annual report on available U.S. offsets data, information on the size and scope of the global market is sparse, as most non-U.S. defense companies do not reveal the value of their offset obligations, which can range from 30 to 100 percent of the value of the deal.

Nevertheless, several examinations of the issue are worthy of note. As mentioned above, in 2013, the Financial Times, using data provided by IHS Jane’s and employing a “very conservative methodology,” calculated the value of outstanding offset obligations for the world’s twelve largest defense firms to be in excess of $75 billion. In the Middle East alone, an estimated $27 billion will be injected into local economies via offset programs by 2020, according to IHS. Analysis by Avascent, a consulting firm, suggests that offset obligations are worth about $250 billion today and could be almost $500 billion by 2016 in their pithily-titled report,”The Half-Trillion Dollar Challenge.” Avascent further notes that while exact figures on the scale of discharged obligations are not publicly available, anecdotal evidence suggests a significant portion remains outstanding.

How do companies fulfill these obligations?

First, one must recognize that different countries have different offset programs and some procuring governments apply “multipliers,” thereby giving “extra credit” to projects they deem particularly beneficial and to target investment at priority areas. IHS Jane’s noted that nearly two dozen countries have introduced formal offset programs between 2000 and 2011, bringing the total number of countries with offset programs to well over 100. As noted above, the values of the obligations range widely.

For example, earlier this year the Indonesian Ministry of Defense announced a new offset policy that imposes a minimum offset requirement of 35 percent, with an emphasis on technology transfers to enable localized production, which will increase by 10 percent every five years until it reaches a full 85 percent in 2039. Indonesia also offers “multipliers,” which serve as an incentive toward certain types of obligations, in this case items that are regarded as important to enhancing Indonesia’s economic development.

In addition,  as offset regimes are becoming more sophisticated and complex, some governments are trying to address the high levels of bureaucracy surrounding defense offsets that no doubt frustrates compliance officers and offset proposal teams. A notable example of this development is India’s creation of an ‘offset facilitation cell’ within their Ministry of Defense’s Defense Offset Management Wing where companies and their Indian offset partners can discuss their obligations and seek clarification about offset guidelines.

As for the underlying question of how companies fulfill these obligations, it can be as simple as financing the creation of a shrimp farm in Saudi Arabia (a creative and award-winning, albeit ill-fated, project sponsored by Raytheon) to advancing domestic civil aerospace industries, to leveraging the obligations of several companies for major infrastructure financing packages. Many governments also channel modernization efforts through their offset strategies. As these deals become increasingly complicated, not only do firms face difficulties finding projects to satisfy their obligations, the calls for transparency become louder.

What are the transparency concerns?

Critics of offsets maintain that the practice fosters corruption. Moreover, they contend that it is difficult to measure the true cost of defense deals, and that as offsets grow increasingly complex, companies can “choose how, or whether, to put them on their balance sheet.” The transparency concerns, therefore, are twofold: potential graft by the procuring government and the fiduciary duty of the contractor to its shareholders.

With respect to the former, while quantitative data on corruption in offsets is lacking, UK-based Transparency International,in a 2012 study titled “Due Diligence and Corruption Risk in Defense Industry Offset Programmes,” cited multiple examples, such as bribes claimed as offsets and high-ranking officials owning or working for the offset-providing company. Moreover, they warned that “offset transactions carry potentially high risks of corruption, not only due to the high level of secrecy within the defence procurement as a whole, but because they usually lack the scrutiny and monitoring of the corresponding acquisition contract…most offset transactions have few, if any, transparency and public accountability requirements.”

For the defense companies, The Economist notes that firms have fought for offsets to remain classified as “proprietary,” so they do not have to disclose their obligations. Additionally, the opacity of offsets, as well as how, and by whom, those obligations are handled, may raise Foreign Corrupt Practices Act concerns.

How does the business community view offsets?

While recognizing that successfully negotiated offset agreements can yield tremendous gains, a recent report by management consulting firm McKinsey & Company also warned that offsets can pose significant “competitive, legal, and reputational risks” if not managed properly. Nevertheless, despite transparency concerns, difficulties in finding offset partners, and the complex nature of offset regimes and associated bureaucracy, companies recognize that offsets are crucial to winning large defense contracts overseas.

Avascent and Fleishman-Hillard, a communications consultancy, followed up the “Half-Trillion Dollar Challenge” report with a survey of practitioners in the aerospace and defense industry on the offset landscape. They found near unanimity on the growing importance of emerging international markets for firms, with many suggesting that offsets would occupy increasing importance in their international business development plans. As markets in America and Europe shrink, defense firms will look increasingly overseas toward less developed countries, where defense spending is rising. In addition to the booming Middle East market previously referenced, another report by McKinsey says that Southeast Asia also presents defense firms with significant opportunities. The latter McKinsey study also notes that offset fulfillment was a critical factor for companies looking to access Southeast Asian markets, with each country requiring a nuanced approach.

A path toward reform

While transparency concerns are significant, with the inherent corruption risks and unrecognized financial liabilities of companies detailed above, both procuring countries and suppliers should acknowledge the broader economic development potential in fulfilling these offset obligations, especially considering that the market growth is concentrated in less developed countries.  In addition to establishing comprehensive strategies for optimizing the growth-producing prospects in the offset obligations they hold, procuring governments could strategically use “multipliers” to drive investment in non-defense sectors to advance public health and social welfare systems, promote agricultural development, and improve their education systems.

Employing such a strategy would assuage the concerns from defense companies that offsets can serve to create a peer competitor and also help foster broader economic and social development in the procuring nation. Whether the outstanding amount of obligations is a “Half-Trillion,” as Avascent maintains, or closer to the $75 billion as put forward by the Financial Times in their admittedly “conservative” analysis, such offsets represent a lot of money—money that could be better leveraged for social good.

This post appears courtesy of CFR.org.