[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 5.12.2007

SEC(2007) 1598

COMMISSION STAFF WORKING DOCUMENT

Accompanying document to the Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the coordination of procedures for the award of certain public works contracts, public supply contracts and public service contracts in the fields of defence and security IMPACT ASSESSMENT

{COM(2007) 766 final}{SEC(2007) 1599}

COMMISSION STAFF WORKING DOCUMENT

Annex to theProposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the coordination of procedures for the award of certain public works contracts, public supply contracts and public service contracts in the fields of defence and security

1. Introduction 5

2. Procedural issues and consultation 5

3. Problem definition 9

3.1. Background information on defence and security markets 9

3.1.1. The blurred dividing line between defence and security 12

3.2. Specific Problem: "mismatch" between theory and practice in defence and security procurement in the EU 13

3.2.1. Defence procurement: Article 296 (1) (b) between theory and practice 13

3.2.2. Security procurement: between Article 296 (1) (a) and Article 14 Directive 15

3.3. Cause of the problem: EC rules are ill-suited to sensitive security and defence procurement 16

3.3.1. The need for flexibility 16

3.3.2. Ensuring security of supply and security of information 18

3.4. Patchwork of national regulations and practices 21

3.4.1. Publication 21

3.4.2. Technical specifications 22

3.4.3. Procedures 22

3.4.4. Selection of suppliers 23

3.4.5. Security of supply 23

3.4.6. Offsets 24

3.5. Implications on transparency, non-discrimination and openness 25

3.5.1. Transparency 25

3.5.2. Non-Discrimination 27

3.5.3. Lack of openness 28

3.6. Effects on stakeholders 29

3.7. Problem summary 30

3.8. How would the problem evolve, all things being equal? 31

3.9. Is the EU best suited to act? 31

4. Objectives 32

4.1. General objective 32

4.2. Specific objective 32

4.3. Operational objective 32

5. Policy options 33

5.1. No further EU-action 33

5.2. Non-legislative Measures 33

5.2.1. Explaining the use of Article 14 of the Directive 33

5.2.2. Developing a more proactive infringement policy 33

5.2.3. Training of national authorities and Commission staff 34

5.3. Legislative measures 34

5.3.1. The nature of the instrument 34

5.3.2. The field of application 35

5.3.3. The content 35

5.4. Discarded Options 35

5.4.1. Non-legislative Measures 35

5.4.2. Legislative Measures 36

5.5. Retained Options 39

6. Analysis of Impact 39

6.1. Option 1: Do nothing 39

6.2. Option 2: Introducing new rules for the procurement of defence and sensitive non-military security equipment 40

6.2.1. Choice of the legal instrument [LI] 41

6.2.2. Field of application [Scope] 42

6.2.2.1. List or general definition? 43

6.2.2.2. Exemptions 44

6.2.2.3. Thresholds 44

6.2.3. Content of Legislation 45

6.2.3.1. Security of Supply [SoS] 45

6.2.3.2. Security of information [SoI] 47

6.2.3.3. Offsets 49

6.2.3.4. Procedures [Proc] 49

6.2.4. Wider impacts: costs and benefits for stakeholders 51

6.2.4.1. Legal Impacts 52

6.2.4.2. Administrative Impact 53

6.2.4.3. Economic impacts 53

6.2.4.4. Social and Environmental Impacts 56

6.2.4.5. Consistency/coherence with other measures 57

6.2.4.6. International impacts 57

7. Monitoring and evaluation arrangements 58

7.1. Annual monitoring 58

7.2. In the mid term: interim evaluation 59

7.3. In the long term: comprehensive evaluation 59

8. Conclusion 59

1. INTRODUCTION

For more than 40 years after the failure of the European Defence Community project in 1954, defence and security matters were excluded from the process of European integration. This was true not only of European defence policies and armed forces, but also for market and industry issues. As a consequence, defence markets in the European Union remained de facto outside the Internal Market and fragmented at the national level.

Since the end of the Cold War, this fragmentation has become increasingly problematic. Facing a combination of budget constraints, rising costs for military equipment and the restructuring of the armed forces, national markets in Europe have often become too small to produce and procure high quality equipment at affordable prices. This is the case in particular for complex equipment which involves high costs for research and development. Far-reaching reforms have thus become indispensable for Europe to maintain a viable European Defence Industrial and Technological Base (EDITB) and equip its armed forces adequately. In this context, the establishment of a competitive European Defence Equipment Market (EDEM) is recognised as particularly important.

Following the development of the European Security and Defence Policy (ESDP), the EU has become the main framework for action to achieve this objective. A major step forward was the establishment of the European Defence Agency (EDA) in 2004. As an agency of the EU Council, EDA is supporting Member States' efforts to develop the military capabilities needed for ESDP. Focussing on the demand side of the market, EDA tries in particular to harmonise military needs, pool research efforts and foster European armaments cooperation.

Complementing Member States' efforts, the Commission also launched an initiative to support the establishment of an EDEM. In its Communication “Towards a European Defence Equipment Policy” of March 2003[1], the Commission presented a series of proposals for action in areas related to defence industries and markets (standardisation, EDITB monitoring, intra-community transfers, procurement rules, dual-use exports and research). This Communication was thus the starting point for the Commission's activities in the field of defence procurement.

2. PROCEDURAL ISSUES AND CONSULTATION

From January to April 2004, the Commission organised several workshops with representatives from governments and industry to collect information on current defence procurement practices and to identify the expectations of stakeholders vis-à-vis possible Community action in this field[2].

These workshops prepared the ground for the Green Paper on defence procurement, adopted in September 2004[3]. The Green Paper invited all stakeholders to comment on how to improve the legal framework for defence procurement in the EU. At the end of the consultation period in May 2005, the Commission had received 40 written contributions from 16 Member States, institutions and industry[4]. Given the sensitivity of the issue and the relatively small number of actors involved, this was considered a good level of participation.

The Green Paper consultation confirmed that the existing legislative framework for defence procurement in Europe is deficient. At the EU level, the Public Procurement (PP) Directive applies to public contracts awarded by contracting authorities in the field of defence, subject to Article 296 of the Treaty establishing the European Communities (TEC). According to stakeholders, this framework is not functioning properly, mainly for two reasons:

- Uncertainties persist regarding the use of Article 296 TEC, which allows Member States to derogate from EC rules laid down in the PP Directive if this is necessary for the protection of their essential security interests. Since the scope and the conditions for the use of the exemption are vague, the application of Article 296 TEC to defence procurement remains problematic and varies considerably between Member States.

- The current PP Directive, even in its revised version (2004/18/EC), is generally considered ill-suited to many defence contracts, since it does not take into account some special features of those contracts. As a result, many Member States are reluctant to use the PP Directive for defence procurement and try to interpret Article 296 TEC as broadly as possible in order to exempt defence contracts from EC rules.

To tackle these two problems, the Commission announced in December 2005 two initiatives[5]:

1) Adoption of an "Interpretative Communication on the application of Article 296 TEC in the field of defence procurement";

2) Preparation of a possible new directive on defence procurement, adapted to the specificities of defence contracts.

This two stage approach, which was also supported by the European Parliament[6], allowed a measured reaction to the issues raised. Within a fairly short time period, the Commission would be able to consult on and produce guidance for Member States on the use of Article 296 TEC, which could then be put to immediate use. A longer time frame would be needed to give appropriate consideration and discussion before taking deciding about further legislative action, which, if proposed, would itself require time to prepare, adopt and transpose.

The Interpretative Communication was adopted on 6 December 2006, after intensive consultation of industry and Member States.[7] Explaining the conditions for the use of Article 296 TEC, the Communication gives guidance to national contracting authorities for their assessment of whether procurement contracts can be exempted or not.

In order to cope with the second problem identified in the Green Paper consultation, the Commission has continued in parallel to prepare a possible new directive adapted to the specificities of defence. Again, stakeholders have been closely involved at every stage. Between December 2006 and April 2007, Member States gave their input on the scope and the content of a possible Directive, in particular via the Advisory Committee on Public Procurement (ACPP). Discussions in the ACPP helped to identify why current EC rules were deemed ill-suited to defence procurement, what the field of application of a possible new Community instrument should be, what the main problematic issues are and how they should be dealt with. After each meeting, Member States were invited to give detailed written contributions. On top of this, the Commission had numerous bilateral discussions with Member States and EDA. Industry was also involved, in particular via meetings with national and European Associations (see Annex 20). Throughout this consultation, stakeholders have contributed in a constructive way to the Commission's work, giving valuable input both for this impact assessment and for the proposal itself. No stakeholder, and in particular no Member State, has shown opposition on the principle itself of the exercise.

Governments and industry were also consulted in the framework of the Impact Assessment. In this context, five studies were commissioned, in particular to collect more quantitative information. Three studies were commissioned from the College of Europe (BE) to: 1) analyse the defence budgets of ten Member States, categorising spending by sectors and products; 2) examine the “Tenders Electronic Daily” (TED)[8] in order to assess the extent to which contracting authorities use the Official Journal of the European Union (OJEU) for the publication of defence contract notices, 3) assess how many and which defence contract notices are published only at the national level[9].

Two further studies dealt with economic and market aspects. The first one, conducted by Rambøll Management (DK), provides facts and figures on the supply base in Europe, examines procurement practices in the EU and attempts to measure the administrative burden of new procurement rules for both companies and contracting authorities. The second study, by Yellow Window (BE), is a market study which establishes a categorisation of defence products and tries to measure the economic impact of the new procurement rules on defence markets and in particular on cost-savings for each type of product.

The present report is based both on the findings of the five above-mentioned studies and on the consultation the Commission has organised with Member States and industry since the beginning of 2004[10]. The dialogue the Commission has carried out with stakeholders for several years has made it possible to collect a great deal of qualitative information on defence markets and procurement practices. The studies outsourced in order to obtain economic and financial information, by contrast, could not always deliver the expected results.

There are a number of reasons for this, which are related to the specificities of defence markets: since there is no commonly agreed terminology and categorisation of “arms, munitions and war material”, it has been difficult to exploit economic and industrial databases. Member States defence budgets have also been hard to analyse and compare, since they are structured and organised in very different ways. Moreover, many defence suppliers have both military and civil activities, making it difficult to clearly identify “defence market operators” and the importance of defence activities for their overall business. An additional problem is the lack of reliable information aggregated at the EU level. Existing sources are disparate, often incomplete and differ considerably. Even at the national level, the political and strategic sensitivity of these markets makes any quantitative analyse a difficult exercise.

Facing such challenges, it has proved to be very difficult to provide precise quantitative data. Even market operators with important international activities often have only an incomplete picture of defence markets in the EU and remain extremely cautious about market forecasts. Consequently, the following analysis is based mainly on qualitative data.

The present report addresses both defence procurement (military equipment, namely arms, munitions and war material, procured for armed forces) and sensitive security procurement (equipment with similar features as military equipment, but procured for non-military security forces). However, the focus of the analysis is on defence. There are several reasons for this: Most of all, since the beginning of the process, the Commission's initiatives in this field have been driven by a specific demand of stakeholders for community action in defence procurement; sensitive non-military security came up, at Member States' request, only at a later stage as an additional facet of the debate. (This also accounts for the fact that the five outsourced studies only concern defence, not security equipment.) Moreover, before the emergence of asymmetric security threats (catastrophic terrorism in particular), sensitive non-military security procurement attracted little attention, and public expenditure in this area has not been monitored in a systematic, detailed way. This, together with the complexity of the demand side of the non-military security market (see section 4.2.), makes it particularly difficult to gather financial and economic data in this area.

However, the specific focus on defence seems justified: 1) It is procurement in the field of non-military security which has developed in recent years specificities similar to defence procurement (not the other way around). In many respects, a qualitative analysis of the latter therefore covers automatically the former. 2) The focus of the Commission’s initiative remains on defence. With regard to non-military security, the question is "merely" whether a possible community instrument for defence should also become applicable to certain particularly sensitive non-military security procurements.

As part of the Commission’s commitment to improving the quality of Impact Assessments, an independent internal Impact Assessment Board (IAB) has been set up. This Impact Assessment was reviewed by the IAB at a meeting on 27 June 2007, and shortly after the IAB published its opinion. In general, the opinion was positive, and the IA was praised for its well structured problem analysis; making good use throughout the document of feedback from the extensive stakeholder consultation and proposing appropriate monitoring and evaluation arrangements. The recommendations for improvements are detailed below, with a short commentary indicating how and where these recommendations have been accommodated within the current version of the report:

1) The presentation of the impact analysis should be organised in a clearer and more coherent way : as discussed in the IAB meeting steps were already in hand to address this issue. Sections 6 and 7 have been reworked, summary tables have been added and the logical flow of the “screening” of the sub-options has been reviewed;

2) Provide better explanation as to why the proposed new rules can effectively cover both defence and sensitive security procurement : references drawing comparisons between the two different markets have been added throughout the text (in particular sections 3.7, 6.2.4.);

3) The problem statement should be more focused and concise : in recognition of this request, some editing has been done to shorten this section (e.g. section 3.1, 3.2.1 and 3.3). However, we feel it is important to communicate the detail of this issue to a wider audience, and thus have not moved to annexes sections which might be considered as less relevant;

4) The objectives should be better linked to broader policy agendas: more explanation has been added in section 4.1 where the general objectives are presented and, where reasonable, references are made in the impact section (e.g. competitiveness);

5) The longer term aspects of the social impact analysis should be reinforced: some short additional statements (drawing on general theory) have been added to the section discussing the impacts on employment (6.2.4.4).

3. PROBLEM DEFINITION

3.1. Background information on defence and security markets

This section provides an overview of the operation of (1) defence and (2) security markets in the EU. Without being exhaustive, it aims at describing some of the main features of these markets in order to put the procurement issue into perspective and facilitate the understanding of the problems encountered in this specific area.

4.1.1. Defence Markets – specificities and problems

Defence markets cover a broad spectrum of products and services, ranging from non-war material, such as office equipment and catering, to complex weapon systems (tanks, fighter aircraft, aircraft carriers, etc.) and highly sensitive material, such as nuclear, biological and chemical equipment. The sensitivity of defence equipment (arms, munitions, war material) for Member States' security interests can vary depending on political and military circumstances. In general, however, its sensitivity is proportional to its technological and strategic importance. At the upper end of the technological spectrum, weapon systems are often developed for the specific demands of a very small number of customers. Such systems normally have long development and life cycles and high non-recurring costs. This, in turn, makes it necessary for governments of producing countries to bear a large share of research and development (R&D) costs.

Given the importance of defence equipment for Member States’ security, national governments play a predominant role in the organisation and operation of defence markets. As sole clients, they determine the demand for products and thus define both the size of the market and the technological portfolio of the industry. As regulators, they control arms trade via export licences and shape the way companies operate and organise themselves. State control can also include industrial restructuring and ownership. In many cases, States are still shareholders in defence companies and/or hold "golden shares", which provide influence over strategic business decisions.

It is very difficult, if not impossible, to produce accurate figures about the total number of firms operating in defence markets, the number of staff they employ and the types of products they produce[11]. The figures we have been able to collect are presented in Annex 7 and relate to firms operating in the areas of land and naval defence and military aerospace. These indicate that in 2005, the turnover of firms in these sections of the defence market was just over €52 bn with exports totaling around €17 bn. In terms of employment, these sectors provided jobs for around 614,000 people.

In 2005, combined defence expenditure in the EU-25 was worth about €174 bn, which includes €85 bn for defence procurement. This, in turn, includes about €30 bn for the acquisition of new military equipment, €10 bn for R&D, €20 bn for maintenance and €5 bn for infrastructure, with an additional €15 bn for (mostly non-military) operating expenditures[12]. European defence expenditure was in constant decline throughout the 1990s and has stabilised recently at a lower level (on average 1.7% of GDP in 2005). Moreover, this expenditure remains split into relatively small and closed national markets, with the six major arms producing Member States (the so-called LoI countries) representing 83% of it[13].

On the other hand, development costs of new weapon systems have increased dramatically, starting to exceed the financial means of even the big EU Member States[14]. The discrepancy between flat, stagnating budgets and increasing costs has had a damaging effect in two respects. First, it has resulted in obvious gaps in Europe’s military capabilities[15]. Second, the lack of funding is damaging the European Defence Industrial and Technological Base (EDITB). Lack of investment in research in particular is jeopardising industry’s capacity to prepare for the future and to remain competitive vis-à-vis U.S. counterparts[16].

Even (highly unlikely) defence budget increases would not resolve these problems: since most European armed forces have been streamlined and downsized, national markets are in general too small today to generate adequate economies of scale[17]. For complex weapon systems in particular, per-unit costs will simply be too high if the production run is limited to the needs of a single European country[18].

The relatively small size of European defence markets makes the existing fragmentation along national lines increasingly problematic. This fragmentation persists at all levels:

1) On the demand side, 27 national customers have great difficulties in harmonising their military requirements and pooling their purchasing power into common procurement projects. In 2005, EU Member States spent only 18% of their equipment expenditure on cooperative projects, whereas 82% was spent nationally[19]. Consequently, numerous duplications exist. In total, 89 different weapon programmes exist in the EU compared to only 27 in the US (although the US spend three times as much on equipment as the EU combined)[20].

2) The regulatory framework consists of 27 different sets of national rules and procedures for all relevant areas (exports, transfers, procurement, etc.), plus specific arrangements for cooperative programmes; this regulatory patchwork is a major obstacle to both competition and cooperation and creates considerable extra-costs[21];

3) On the supply side, defence industries remain fragmented along the lines of (national) market structures. Some transnational companies exist in aerospace and electronics, but market fragmentation hinders them from rationalising their organisation and exploit potential economies of scale. In naval and land armaments, consolidation is less advanced and cross-border industrial ties remain an exception.

If this situation persists, Member States will increasingly face difficulties to maintain a sound and viable EDTIB and to develop the military capabilities necessary for implementing the ESDP.

3.1.1. The blurred dividing line between defence and security

The evolution of the international context and the emergence of a new security environment have had market implications as well. Today’s transnational and asymmetric threats, such as international terrorism or organized crime, necessitate special security measures not only at the borders, but also inside the EU. Against these threats, non-military security forces increasingly use equipment which is, from a technology point of view, similar to defence equipment used by the armed forces. Such security equipment is often a slightly different (and less performing) application of the same technology and produced by the same suppliers as defence equipment. At the same time, certain security equipment must be interoperable with defence equipment, since non-military and military forces increasingly operate together to fulfill the same missions (for example border control). There is thus a growing market for security equipment, which has in many ways similar features as defence equipment and can be equally sensitive (in terms of technical complexity, but also in terms of confidentiality).

Given these similarities and commonalities, the public market for such sensitive non-military security equipment can be considered as an appendix to the traditional defence market. However, major differences persist: most importantly, the demand side of the market is much more complex for security than for defence, concerning not only national governments, but also regional and local authorities, as well as great variety of end users (police, customs services, intelligence agencies, civil protection agencies, etc.).

The great variety of security customers makes it also difficult to identify the expenditures for this kind of security equipment and thus measure the size of the market. In 2005, security (public order and safety) expenditure in the EU-25 was worth about €195 bn, which includes about €57 bn for security procurement in general[22]. These expenditures cover procurements for a broad range of security services (police, fire-protection, law courts, prisons, etc.) and include both sensitive and non-sensitive security procurement.

3.2. Specific Problem: "mismatch" between theory and practice in defence and security procurement in the EU

The previous section has shown that fragmentation of defence markets in the EU creates problems with major financial and economic consequences in a variety of areas. The following sections will focus on one area – procurement law – and one specific problem, namely the extensive use of the exemptions from Community Law provided by Article 296 TEC and Article 14 of the PP Directive.

The Court’s case law gives quite clear indication for how to use these exemptions. Moreover, the recent Interpretative Communication on the application of Article 296 TEC in the field of defence procurement clarified remaining uncertainties. The problem thus does not lie with the theory, but with a mismatch between theory and practice.

3.2.1. Defence procurement: Article 296 (1) (b) between theory and practice

- Theory

At the Community level, it is the PP Directive (2004/18/EC) on the procurement of goods, works and services which applies to " contracts awarded by contracting authorities in the field of defence, subject to Article 296 of the Treaty " (Article 10 of the Directive). Article 296 TEC reads as follows:

(1) The provisions of this Treaty shall not preclude the application of the following rules:

(a) no Member State shall be obliged to supply information the disclosure of which it considers contrary to the essential interests of its security;

(b) any Member State may take such measures as it considers necessary for the protection of the essential interests of its security which are connected with the production of or trade in arms, munitions and war material; such measures shall not adversely affect the conditions of competition in the common market regarding products which are not intended for specifically military purposes.

(2) The Council may, acting unanimously on a proposal from the Commission, make changes to the list, which it drew up on April 1958, of the products to which the provisions of paragraph 1(b) apply.

The non-application of the PP Directive is a measure “ connected with the production of or trade in arms, munitions and war material ”. Member States can therefore use Article 296(1)(b) TEC to exempt the award of defence contracts from EC rules, provided the conditions laid down in the Treaty as interpreted by the Court of Justice are fulfilled. At the same time, the scope of Article 296(1)(b) TEC is limited by the concept of "essential security interests" and the list of military equipment mentioned in paragraph 2 of that Article.

Article 296(1)(a) TEC goes beyond defence, aiming in general at protecting information which Member States cannot disclose to anyone without undermining their essential security interests. This can also concern the public procurement of sensitive equipment, in both the defence and the (non-military) security sector.

The Court of Justice has consistently made it clear that any derogation from the rules intended to ensure the effectiveness of the rights conferred by the Treaty must be interpreted strictly. Moreover, it has confirmed that this is also the case for derogations applicable " in situations which may involve public safety ". In Commission v Spain , the Court ruled that articles in which the Treaty provides for such derogations " deal with exceptional and clearly defined cases . Because of their limited character, those articles do not lend themselves to a wide interpretation "[23]. On the basis of the Court's judgement, the Commission has specified in its Interpretative Communication of December 2006 that both the field and the conditions of application of Article 296 TEC must be interpreted in a restrictive way[24].

- Practice

In contrast to the Court’s ruling, many Member States have used Article 296 TEC extensively, exempting from EC rules almost automatically the procurement of military equipment. During the consultation process, stakeholders confirmed that many contracting authorities in the field of defence normally do not apply the PP Directive to the procurement of arms, munitions or war material, and often not even to the procurement of non-war material. In other words: what should be the exception is, de facto, often the rule.

The relatively low publication rate in the OJEU for public procurement by awarding authorities in the field of defence confirms the extensive use of Article 296 TEC[25]: Between 2000 and 2004, the (then) 15 EU Member States published in the OJEU contract notices for on average 13% of their overall defence procurement (in value terms). This figure includes both the procurement of non-war material and military procurement. Moreover, these publication rates differ greatly between Member States, ranging from 1% to more than 20%. On average, however, the publication rate was in decline from 16% in 2000 to 8 % in 2004[26].

The publication rate is low for defence procurement in general, but it is particularly low for arms, munitions and war material. In their responses to the Yellow Window study, half of the EU Member States who participated in the survey declared to "generally" publish in the OJEU contract notices for non-military procurement in the field of defence, such as uniforms or certain services. Only one fourth, by contrast, declared to use the OJEU generally also for the procurement of military goods, as well as services and works related to them. In these cases, Member States publish mainly contract notices for the procurement of "simple", low value equipment, such as busses or trucks, as well as non-sensitive works and services[27].

3.2.2. Security procurement: between Article 296 (1) (a) and Article 14 Directive

A similar, albeit more recent problem exists with regard to the procurement of sensitive equipment for non-military purposes. Such contracts do not fall in the field of application of Article 296(1)(b) TEC. However, security interests may justify their exemption from EC rules on the basis of Article 14 of the PP Directive, provided that the conditions for its application are met[28], or on the basis of Article 296(1)(a), if the application of EC rules would oblige a Member State to disclose information prejudicial to the essential interests of its security.

In theory, the Court’s ruling on the exceptional character of exemptions applies also to procurement of sensitive non-military security equipment, whether the exemption is based on Article 296 (1)(a) or Article 14 of the PP Directive. In practice, however, Member States deal with these contracts as they do with defence contracts, i.e. exempt them systematically.

Moreover, contracting authorities often mix up Article 296 (1)(a), (1)(b) and Article 14 of the Directive to justify exemption of non-military security procurements. This confusion of legal arguments is due to the above-mentioned developments in the field of security and defence, with the distinction between external and internal security, military and non-military security becoming increasingly blurred. This is true not only at the conceptual, but also at the operational and technological levels:

- Facing transnational and asymmetric threats, non-military security services sometimes use equipment which is technologically similar to defence equipment;

- In today’s strategic environment, military forces and security forces often operate closely together to fulfill the same missions;

- In some Member States, parts of the armed forces have both military and non-military tasks for which they often use the same equipment.

This constitutes an additional challenge for the current legal framework in the EU, which is still based on the traditional distinction between defence and non-military security.

3.3. Cause of the problem: EC rules are ill-suited to sensitive security and defence procurement

Consultations with stakeholders have pointed out to one salient root cause for the extensive use of the exemptions provided by Article 296 TEC and article 14 of the PP Directive: the ill-suitability of EC rules to most defence and sensitive non-military security procurements.

Although EC public procurement law applies to contracts awarded in the fields of defence and security (subject to Article 296 TEC and Article 14 of the Directive), it was drafted for and suited to the procurement of civil supplies, works and services. Defence and sensitive non-military security procurement, however, is different by its very nature. It can decide on life or death of (European) soldiers and citizens, is directly related to the security of Member States and therefore often influenced by political and strategic considerations. At the same time, technical, financial and time-related complexities make many of these procurement processes extremely challenging. To deal with these specificities effectively, contracting authorities need both flexibility (to formulate and meet their needs adequately) and specific safeguards (to protect Member States security's interests), which the PP Directive does not provide.

3.3.1. The need for flexibility

Stakeholders consistently expounded that the complexities of defence programmes revolve around three main elements: the technological intricacies of defence equipment (which make it difficult for procurement authorities to ‘translate’ at the outset a functional requirement into detailed technical specifications), their long life cycles and the sophisticated architecture their financing requires. In order to manage effectively such complexities, stakeholders explained, project managers need flexible procedures.

Defence equipment is procured to obtain a specific military capability and to gain superiority over potential enemies. It often includes state-of-the-art technologies , which are integrated at various levels into complex architectures (components into products, products into systems, systems into systems of systems, the whole lot into national armed forces). On top of that come interoperability requirements with the armed forces of other NATO and EU members. Procurement authorities must make sure that every single technical detail of the equipment they wish to procure is fitting in the overall architecture and at every level. One of the ways to ensure standardisation and interoperability is resorting to defence-specific standards[29].

In order to meet their military capability needs, procuring authorities either ask a producer to develop new equipment tailor-made to their specific requirements, or purchase off-the-shelf equipment which will then be customized to their requirements. In particular in the first, but to a lesser degree also in the second case, they need to discuss with potential suppliers all characteristics of the equipment they wish to procure in order to manage intricate trade-offs between costs, efficiency and technological superiority.

Moreover, defence equipment often has extremely long life cycles . The time between the expression of an operational need and the end of a weapon system's life may be as long as 50 years. Throughout its in-service life, regular maintenance and technological upgrades are necessary to ensure the performance of a system. Such needs are met in various ways across the EU. In any case, arrangements for maintenance and upgrading, which remain into effect for many years, normally imply in-depth negotiations between contracting authorities and potential suppliers on numerous technical and financial aspects.

The development of new technologies, complex system integration and long-life cycles can imply high financial risks and make it often impossible to assess from the start the price of a defence programme, even more its life cycle costs. The financial set-up of such contracts is thus highly complex, with Member States asking companies to share the financial risks. In order to tailor the necessary financial arrangements for each specific programme, again, awarding authorities need to negotiate thoroughly with potential suppliers.

A similar degree of flexibility can be necessary for the procurement of sensitive non-military security equipment. The latter is often developed from the same technology base and / or constitutes modified versions of defence applications. Facing non-military threats, non-military security applications are often less performing than their military counterparts. However, in many areas, they are technologically very sophisticated (IT security). They can also be integrated in complex system of system architectures (for example for the protection of vital infrastructures). Moreover, modern security concepts, be it for border protection, crisis management or disaster relief, often foresee close cooperation between different security forces (police, fire brigades, etc.) and between security and military forces. In these cases, interoperability can become as important for security equipment as for defence equipment. For certain types of security equipment, technological complexity and interoperability can thus raise similar needs for flexible awarding procedures as in defence.

Scrutinizing EC law with these observations in mind, it seems that existing Community rules hardly offers the degree of flexibility which is necessary to meet such complexities.

First, it does not recognize standards specifically developed for defence purposes within national or regional defence-specific standardizing bodies[30].

Secondly, the standard procedures of the PP Directive – the open and restricted procedures – are based on two assumptions: 1) The contracting authority is able to specify from the outset not only all technical specifications, but also all the other features of the contract: whether or not it needs training packages, maintenance and upgrade provisions - for how long-, the costs and risks-sharing arrangements associated with them, etc. 2) The tenders can meet from the outset each and every one of the needs of the contracting authority and indicate the prices without any changes or adjustments. For the reasons outlined before, both assumptions are hardly ever met for the procurement of defence and sensitive non-military security equipment.

The competitive dialogue procedure introduced by the new PP Directive can be resorted to when a contracting authority does not know the technical and/or financial solution to its need, or which one of a number of solutions is the best. This can happen in defence procurement, but does not cover all complexities which necessitate negotiations between awarding authorities and potential suppliers (lead times, costs, risk-sharing, IPR, maintenance, upgrading, subcontracting, etc.). The competitive dialogue may therefore be an option for some cases, but not a satisfactory solution to the shortfalls identified above.

The PP Directive allows also more detailed negotiation between contracting authorities and economic operators, but only in exceptional cases. According to Article 30 of the Directive, the negotiated procedure with prior publication is justified (a) " in the event of irregular tenders" and (b) "in exceptional cases, when the nature of the works, supplies, or services or the risks attaching thereto do not permit prior overall pricing " (which does not mean though that only negotiations on price are permitted). However, in the field of defence procurement, instances where "prior overall pricing" is impossible are but one of the many cases where negotiations are necessary. Above all, resorting to this possibility is explicitly circumscribed to "exceptional" cases, whereas the need to negotiate is rather the rule for the procurement of defence and sensitive security equipment.

In a few, even more exceptional cases, the PP Directive also allows to negotiate contracts without publication of a contract notice. Some of these cases can apply to defence and sensitive security contracts (protection of IPR), but others appear ill-suited to the specificities of the latter: this is the case in particular for " reasons of extreme urgency brought about by events unforeseeable by the contracting authority in question ", the circumstances of which are " not in any case [..] attributable to the contracting authority ". Yet, where defence and security are concerned, situations of "extreme urgency" may very well have been foreseeable.

To sum up , the standard procedures of the current PP Directive appear too rigid for the award of many sensitive defence and security contracts. Cases where it is possible to use the negotiated procedure (with or without prior publication) seem both too limited and ill-defined for such procurement. Of course, other types of procurement may well be complex as well, and more flexible rules might come in handy in these cases too. However, for defence and sensitive non-military security procurement, such flexibility is not just "handy", but literally vital for the security of States, their soldiers and citizens.

3.3.2. Ensuring security of supply and security of information

- Security of supply

The security of supply imperative was unanimously pinpointed by all stakeholders as one of the major specificities of defence procurement[31]. This does not come as a surprise, since the adequate and timely supply of defence equipment is crucial for the effectiveness of military power. In military operations, supply problems can cost the lives of European soldiers, lead to military defeat and have major negative consequences for Member States security.

Security of supply in defence has various aspects. From an industrial point of view, suppliers must have the capacity to deliver defence equipment (including spare parts, maintenance and upgrades) over a long period of time (because of the long life cycles of many defence systems). In addition, in times of crisis or war, suppliers must be able to meet urgent additional demands for incremental or accelerated deliveries.

From a political point of view, security of supply becomes particularly challenging if the supplier is established outside the territory of the buying country. In this case, security of supply depends not only on the technical capacity of the supplier, but also on the political decision of the country where the supplier is established to grant an export authorisation. This is the case also within the EU, since intra-Community defence transfers are still subject to export licenses and cannot circulate freely between Member States. Some intergovernmental agreements exist to facilitate such transfers, but they are limited to certain Member states and cover only specific products or companies. The bulk of defence transfers between Member States depend on individual export licences, be it for the delivery of the main equipment, spare parts or incremental supplies in case of crisis. What is more, many defence systems made in Europe contain US components and sub-systems. In these cases, the transfer from one Member State to the other necessitates also approval from US authorities (ITAR system).

Consequently, contracting authorities cannot simply take it for granted that a supplier established in another Member state will obtain the necessary authorizations, including in times of emergency (not to mention bureaucratic delays). A current Commission initiative is aiming to at least facilitate the transfer of defence products, but for the time being, security of supply remains a major obstacle for cross-border defence procurement in the Union[32].

In general, security of supply is less important for non-military security equipment, because technologies are often dual-use (and therefore do not always depend on export licences), but also because production increase in times of crisis is less relevant. However, this does not mean that, in certain areas, security of supply cannot be crucial: urgent additional deliveries of equipment may become necessary, for example, when Gendarmerie forces participate in crisis management operations outside the EU, or when a major terrorist attack takes place on the territory of an EU Member State. In other areas, such as the protection of critical infrastructures, security systems are often technologically complex and tailor-made to the specific needs of individual customers, which makes the long-term security of supply for maintenance, upgrades and spare parts particularly important.

C urrent EC rules do not take into account security of supply imperatives to such a comprehensive extent . The ECJ has recognized security of supply as a legitimate award criterion within the context of the PP Directive[33], which keeps the range of award criteria fully open as long as they are "linked to the subject-matter of the contract in question (Article 53)". But the multiplicity of facets security of supply takes on in defence and security are difficult to embrace by an award criterion.

- Security of information

Security of information has also regularly been brought up as one of the major specificities of defence and sensitive non-military security procurement. This does not come as a surprise, since many of these contracts involve classified information which must, by definition, be protected against unauthorised access.

Security of information comes up at various levels of a procurement procedure. During the publication phase, Member States might not want to disclose all technical specifications of the product, service or work they want to procure in order to protect their security interests. For example, an accurate description of a maintenance service might reveal sensitive information about the weapons needing maintenance; an infrastructure work might as well expose information on the capabilities needing storage. Some information may even be so sensitive that it can only be given to the company to which the contract is awarded in the end[34].

Security of information is also important during the performance of the contract. Given the sensitivity of most defence equipment, potential suppliers must have the capacity to store and handle confidential information in a proper way. This capacity – which is usually referred to as "industrial security" – concerns both the infrastructure and the personnel involved in the execution of the contract.

Here again, the requirements for contracts in the field of non-military security can be very similar to those in defence. In many cases, the procurement of equipment for non-military security forces involves sensitive information which needs protection against unauthorised access. This may be the case in areas where defence and security services cooperate (for example communication systems for border control or crisis management operations abroad). Security of information is also important for the procurement of equipment used for the protection of critical infrastructures or the fight against terrorism and / or organised crime.

Article 6 of the PP Directive deals with "confidentiality", but only as regards disclosure by the contracting authority of " information forwarded to it by economic operators which they have designated as confidential" including "in particular, technical or trade secrets and the confidential aspects of tenders ". This may indeed happen during the procurement procedure and performance of a contract for defence and sensitive non-military security equipment. Yet, this provision only protects confidential information originated by economic operators, not by the contracting authority. Moreover, it does not deal with industrial security requirements. Current EC rules fail to take account of this specificity of defence and security [35] .

3.4. Patchwork of national regulations and practices

In the absence of suited EC rules, Member States have used the exemptions provided in Article 296 TEC and Article 14 of the PP Directive extensively. This allows them to cope with the specificities of defence and sensitive security procurement contracts. At the same time, they do so in a completely non-coordinated manner, on the basis of their own national inherited traditions: some Member States have specific legislative rules, in particular for defence procurement covered by Article 296 TEC, when others rely only on non-legislative guidance for project managers. In any case, each Member State follows different rules as regards publication, technical specifications, procedures, and address the specificities of defence procurement in its own way. This diversity results in a fragmentation of defence and sensitive non-military security procurement rules across the EU.

3.4.1. Publication

The chief question as regards publication is to publish or not to publish a contract notice . For obvious reasons of national security, no Member State publishes all its defence and security contract opportunities. However, the extent to which contract notices are published (either at the EU or at the national level) differs widely. Thresholds for publication play a significant part in this context. Those thresholds vary from less than 100.000€ to 1M€, i.e. by more than 1000%. They may vary even within Member States, according to the nature of the equipment procured or the different types of publication media used. Finally, in some Member States, defence contract notices are not published at all as a rule[36].

National practices differ also with regard to the advertisement of contract award notices . In many Member States, no contract award notices are published in the field of defence. In others, all award notices are published in order to foster competition down the supply chain, and even when no contract notice was published in the first place. Between those two extremes, all situations co-exist across the EU.

Many more questions yet arise as regards how, when, where and for who contract notices are published and, here again, the sole common point between Member States is diversity. Contract notices can be published through various publication media : official journals, public procurement bulletins, and/or defence-specific procurement bulletins. Despite a current trend to publish contract opportunities online, contract notices are often (also) published in paper format or on CD-ROM. Moreover, the model used for the publication also varies. Even within one Member State, different models can be used depending on the contracting authority.

The frequency of publication is also a diverging point. In some countries procurement portals are updated daily (for example FR), in others, publication may be on a weekly, quarterly basis, or at variable intervals (for example SW). Contract notices are also unevenly accessible . Whereas some Internet portals are accessible to anyone, free of charge, others are only accessible to paying subscribers (UK) or authorised ones (PT). Finally, publication is most of the time in the national language , except in a few countries where notices are (also) published in English (in particular in Scandinavia).

3.4.2. Technical specifications

Member States resort to different sorts of defence standards to detail the technical specifications of the subject-matter of the contract. Some have developed their own national defence standards, drafted and maintained either within Ministries of Defence or national standardisation bodies. In addition, Member States which are part of NATO, have signed standardisation agreements which, when ratified and implemented, become compulsory. These standardisation agreements define minimal common requirements in order to guarantee interoperability between armed forces. They must sometimes be specified and/or adapted to national specificities and, to this end, transposed into (different) national defence standards[37].

In the face of this plethora of standards, project managers themselves face difficulties when setting out technical specifications in contract documents. This is why Member States have often developed hierarchies of standards [38]. These hierarchies vary significantly from one Member State to the other. Some take up the hierarchy set up in EC law, even when applying Article 296 TEC: European standards are then the first choice for defence procurement, and a defence standard is mentioned only when no equivalent civil standard exists[39]. Other Member States on the contrary consider defence standards to have priority[40].

3.4.3. Procedures

It is generally stated that the usual procedure for defence procurement is the negotiated procedure. This may however be overly simplistic, applying an EC law category (the "negotiated procedure") to practices that have remained preserved from European legislative coordination. In fact, though defence procurement procedures normally allow for negotiation at some point, they may take on differing national characteristics which wander more or less far from European procedures.

A few Member States actually do use the negotiated procedure as a "standard" procedure for defence procurement, either with or without publication. Most Member States, however, adapt other sorts of procedures to the negotiation requirements of defence procurements, or even use their very own types of procedures[41].

3.4.4. Selection of suppliers

Member States pointed out during consultation processes that candidates are often evaluated on the basis of their "reliability". This highly subjective concept may, in part, rest on long-term relationships and trust which, in turn, can be, materialized through framework agreements or lists of agreed suppliers . Here again, Member States set up and manage their lists their own way. Such lists may simply include all previous suppliers of the Ministry of Defence whereas, at the other extreme, in some Member States, registration is based on very selective criteria and may pre-condition the admission of suppliers to negotiations.

In addition, many Member States use security of information as a selection criterion, usually evidenced by the facility security clearance (FSC) granted to candidates by their national security authorities (NSA). In this case, diversity lies less with the type of evidence requested (FSCs), than with the diversity of mutual recognition arrangements of national FSCs between Member States. In the absence of a Community security of information regime, Member States resort to agreements of various nature: general, sectional or ad hoc security agreements for specific products or contracts. Finally, Member States which belong to NATO also use NATO's procedures for security of information.

3.4.5. Security of supply

Security of supply is a complex issue which pervades defence procurement procedures from start to finish. It is thus impossible to classify in one category such as “selection criteria”, “award criteria”, or contractual requirement. Though the concern is common among Member States, they address it their own way. For the sake of clarity though, two stages can be distinguished: the selection of suppliers, and the putting together of tenders.

- Security of supply as a selection criterion

Some Member States use security of supply as a criterion to select suppliers and request to this end different types of evidence. The first type of evidence is connected to the industrial aspects of security of supply. Some contracting authorities ask, for example, information on the candidate's industrial capacity and the skills of its personnel, or its capacity to rapidly increase supplies in case of emergency. The second type of evidence relates to political factors. In some Member States, contracting authorities may ask, for example, information on the composition of shareholding, the location of technological assets (including patents), the value created on the national territory and an export licence.

- Security of supply as an aspect of tenders

Security of supply is also a key negotiation topic, whether it is considered as condition for the performance of the contract or whether used as award criterion. Here again, the double facet (industrial and political) of security of supply is addressed in various ways.

In many Member States, contracting authorities ask for export licences at this stage of the procedure. Industrial and technological factors play again a role. Contracting authorities may include in the contract documents provisions on the nature of the technologies and the industrial means used by the economic operator, or on rights of use in technical information to reconstitute national supply facilities in the case of an interruption of supplies. Security of supply may also be examined along the supply chain. As an award criterion, some Member States evaluate the management of the supply chain and the location of subcontractors. As a condition for the performance of the contract, in other Member States, contractual clauses may include rights of the contracting authority to establish a control over subcontracting.

3.4.6. Offsets

Offsets are compensations that many governments require when they procure defence equipment from non-national suppliers. The principle is to ensure an economic return on defence investment. Offsets can take various forms: they can be directly related to the subject-matter of the contract (for example industrial participation of local companies in the production of the procured equipment), indirect but limited to the military sphere (for example sub-contracts awarded by the supplier to local defence companies for other military products), or indirect non-military (for example the supplier’s commitment to mobilise foreign investments in civil sectors of the buying country’s economy).

Offset policies and practices vary tremendously among Member States[42]. Some of them do not require offsets at all, for others, offsets are compulsory above certain thresholds, in some cases, they are decided upon on an ad-hoc basis. Those Member States who require offsets do so on different legal basis : some have laid down the obligation to provide offsets in national law, others have “only” specific guidelines.

The thresholds for the contract value above which offsets become mandatory differ also (from less than 1M€ to 15M€). In some Member States, these thresholds vary, depending on the origin of the company or on the type of procedure used. The volume of offset requirements hinges around a minimum of 80 to 100% of the contract value, but they can reach up to 200 %. Member States often set specific obligations connected to the lead times , sector or business activity in which offsets must be provided.

Offsets are also handled differently in the procurement process . They can come as a condition for the performance of the contract, with offsets packages negotiated between the tenderers and Ministries of Defence or of Economy, either before or after the contract is awarded. In other Member States, they are considered as an award criterion. After the contract is awarded, the offset deal is either included in the main contract, or forms a separate agreement which comes into force simultaneously with the procurement contract.

3.5. Implications on transparency, non-discrimination and openness

The consequence of the non-application of EC rules and the use of diverse national procurement procedures is often the non-compliance with the principles of the Treaty, in particular transparency and non-discrimination. This hampers openness and fair competition on European defence markets.

3.5.1. Transparency

Transparency is a crucial aspect of fair and open competition and one of the founding principles of the Treaty as regards public procurement. In the field of defence, exemption from EU law hampers transparency in many ways:

- Publication

For public procurement to be public -ised , it must usually be preceded by the publication of a contract notice or an invitation to tender, which is accessible to the general public or at least potential bidders and contains all information necessary for the submission of pertinent tenders. As described above, this is at best partially the case for defence and security:

* Publication in the OJEU offers the highest degree of publicity EU-wide, but is used only in a minority of defence and sensitive non-military security contracts[43];

* Publication rates and practices at the national level differ greatly, in particular with regard to thresholds for publication;

* Since July 2006, EDA offers its Electronic Bulletin Board (EBB) as an additional forum to post notices for defence contracts. However, the EBB is only open to Member States subscribing to the Code of Conduct[44]. Moreover, the threshold for publication is high (1 M€), publication is not mandatory and only concerns procurement exempted from EC rules on the basis of Article 296 TEC (thus a different market segment than the one the EC has jurisdiction over).

The industry experts working group gathered for the preparation of the Green Paper emphasized that, for larger enterprises the lack of publication is less problematic as they have contacts in Member States to identify contract opportunities. For SMEs however, it is not always easy to obtain contract notices. In this context, the relatively high thresholds for publication are particularly problematic, since smaller contracts – which are particularly interesting for SMEs – are often not published. However, even when contract notices are published, great difficulties persist: in the absence of a centralised publication media with standardised forms, companies must monitor a multitude of information sources, which differ greatly from each other and are often extremely user-unfriendly. All this creates considerable administrative and financial burden, which is again particularly difficult to bear for SMEs.

In this context, industry has identified the language barrier as the most important problem both for SMEs and larger companies. There are a variety of reasons for this: for publications in the OJEU, the Common Procurement Vocabulary (CPV)[45] provides for a system of standardised codes which helps market operators to spot relevant contract notices from all awarding authorities throughout the Union, independently of the language of origin. Similar systems do not exist at the national level. Moreover, when contract notices are published in national media, they are mostly published only in the national language and therefore difficult to access for many foreign companies. Last but not least, limitation to the national language significantly increases the costs for the elaboration of the tender itself and hinders direct communication (Q&A and negotiations) between contracting authorities and candidates.

- Procedures

Transparency in public procurement relies not only on publication, but also on the setting out in advance of the rules of procurement procedures, such as deadlines, selection/award criterion and conditions for the performance of the contract. Such rules must be public and not change during the procedure. This allows market operators to know how to tender for a contract and how they will be evaluated.

Such transparency is not necessarily the rule in all Member States. It happens, for example, that contracting authorities merely state that the "most economically advantageous tender" will be selected, without specifying by which factors (price, quality, lead time, etc.) economic advantages will be assessed. In that case, tenderers can but draft their tenders in the dark. At the end of the procedure, they do not know why their tender was selected or not and, in the latter case, cannot challenge the contracting authority’s decision in court. In practice, contracting authorities have full room to evaluate bids in a discretionary way.

Given all that, it is not astonishing that the Study conducted by Rambøll confirmed that lack of transparency is a significant issue that adversely affects open and fair competition. Out of 116 companies who replied to the questionnaire, 44 stated that lack of transparency of local procedures is a barrier to cross-border transfer "to some extent", and 29 "to a high extent": in total thus, 62% of those companies identify lack of transparency as a problem in defence markets. This is particularly true for SMEs[46].

3.5.2. Non-Discrimination

The principle of non-discrimination of non-national companies within the EU is at the heart of the Treaty and the European project. In defence markets, however, extended use of exemptions from the Treaty have made it possible for Member States to perpetuate practices which result (and sometimes aim at) discriminating non-national companies.

- National preference regulations

Some Member States’ legislation provide for explicit national discrimination, with obligations to procure from national suppliers when possible or when the price difference between a national and a non-national tender is below a certain percentage.

Other Member States use selection or award criteria which may also have discriminatory effects. This is the case, for example, for the value created on the national territory, or provisions on the location of the execution of the contract. Such provisions may not systematically exclude companies without production activities on the territory of the contracting authority, but they undoubtedly discriminate against them.

- Misuse of security of supply

It is fully legitimate for contracting authorities to endeavour to guarantee the security of their supply, in particular in areas as sensitive as defence and security. It is also true that the absence of a Community-wide security of supply regime presents an additional problem to cross-border awards of defence contracts. However, this problem can also serve as a pretext to discriminate non-national suppliers. One should not forget that Member States de facto hardly ever refuse licences for military sales to governments of other EU countries[47]. On top of that, the growing economic difficulties of many defence firms, which often lead to changes of ownership or in industrial organisation, may become a bigger risk to long-term security of supply than political interference of an exporting Member State.

The Rambøll Study confirms that many defence companies face the misuse of security of supply: "According to interviewed company representatives, national procurement agencies use the argumentation of security of supply to limit the entrance of non domestic competition. Some companies have experienced that local presence was to some extent a prerequisite for being competitive in the tender process. Some companies have then taken the consequence and established a local presence while others have avoided these types of tenders. Security of supply is thus used as a logistic barrier, and companies in such cases need to have local presence /local office/ local employment in the purchasing Member State in order to tender"[48].

Among the 116 companies which answered Rambøll’s questionnaire, 48 considered "lack of fairness towards foreign companies", in particular through invocation of security of supply requirements, as a barrier to cross-border procurement to “some extent”, and 25 to “a high extent”. In total, 63% of the companies who participated to the survey stated that “lack of fairness towards foreign companies” was a problem in defence markets.

- Negative effects of offsets

Depending on their nature, offsets can have different discriminating effects:

First, they discriminate non-national suppliers, since their local competitors are by definition not required to provide offsets. Given the financial importance of most offset deals, it is an enormous advantage not to bear this burden.

Second, even if all competitors are required to provide offsets (i.e. no local producer participates), the latter have discriminating effects:

* They give a considerable advantage to big prime contractors, which normally have better means than smaller competitors to arrange offset deals (broader portfolio, more programs for sub-contracting, large networks of industrial partnerships);

* If military offsets are required, prime contractors have to sub-contract to companies located in the buying country. Consequently, they cannot use the most competitive sub-contractors to organize their supply chain, but must give preference to sub-suppliers of a certain nationality. This practice, which is particularly harmful to SMEs, is clearly against the founding principles of the Internal Market.

* If non-military offsets are required, which is normally the case, the same effect spills over into civil markets: non-military contracts are then awarded on the basis of nationality rather than competitiveness. This practice stands in contrast even with Article 296 TEC itself, which clearly states that measures taken under that Article " shall not adversely affect the conditions of competition in the common market regarding products which are not intended for specifically military purposes ."

3.5.3. Lack of openness

Lack of transparency and the existence of discriminatory rules and practices inevitably hamper the openness of defence markets between EU Member States.

The annual reports of the EU Code of Conduct on Arms Exports confirm the low level of intra-European trade[49]. For 2005, the value of intra-European arms transfers can be estimated at around €3.4 bn, whereas the total value of the public procurement of military equipment in the EU was €26.4bn[50]. This means that, at EU level, only about 13% of military equipment (in value) is procured from other European suppliers[51].

This does not mean that defence contracts in general would be awarded without competition. On the contrary, according to Member States responding to the Yellow Window questionnaire on current procurement practices, about three quarters of Member States "normally" open defence contracts to international competition (average based on all defence product types), but only one quarter usually publish these contracts in the OJEU (and thus award them according to EC rules)[52].

Most of the time, however, Member States give preference to domestic suppliers even when competition “officially” takes place. A study published at the end of the 1990s demonstrated that contracts published in the WEAG bulletin were won most of the time by national companies[53]. For example, in 1996/97 in the UK, 95% of procurement opportunities conducted in the framework of the WEAG was awarded to domestic companies. In France, the percentage was 100% for the same period. There is no indication that this situation has significantly improved since the demise of the WEAG. Between 1st July 2006 and 1st March 2007, for example, 14 Member States published more than 130 contract opportunities on the EBB of EDA. However, only one single cross-border contract was awarded by April 2007, nine months after the launch of the EBB.

3.6. Effects on stakeholders

The widespread exemption of defence and sensitive non-military security procurement, and its implications for transparency, non-discrimination and openness of these markets create a situation which, in the long run, is disadvantageous for all stakeholders:

- Taxpayers pay extra-costs with governments not (always) buying the most competitive equipment; Armed forces may not get the best value (equipment) for money;

- Industries face discrimination and pay extra overhead costs (if they participate in foreign bids), suffer from short production runs (if they stick to their home markets) and see their competitiveness compromised (in both cases);

- Contracting authorities act on difficult grounds, since they must either use ill-suited EC procurement rules or ignore the Court’s ruling and the Commission’s Interpretative Communication;

- The Commission's role as Guardian of the Treaty is handicapped, with infringement policy caught in a dilemma of either tolerating non-compliance of procurement practices with the Court’s case law or imposing the use of ill-suited EC rules.

3.7. Problem summary

In contrast to the Court’s case law, Member States use Article 296 (1)(b) TEC extensively to exempt the procurement of defence equipment from EC rules. The same problem, albeit less prominent, exists for sensitive non-military security procurement, where Member States use either Article 296 (1)(a) TEC or Article 14 of the PP-Directive to evade from EC rules.

In both cases, the cause of the problem lies in the lack of EC rules suited to the specificities of these contracts. The main features of defence and sensitive non-military security procurement are: complexity, special requirements for security of supply and security of information. Since current EC procurement rules have been developed for non-military and non-sensitive procurement, they do not sufficiently take into account these features.

As a consequence of the non-application of EC rules, most defence and sensitive non-military security equipment is procured on the basis of national rules and procedures. The latter differ greatly in terms of publication, tendering procedures, selection and award criterion, offsets, etc. This regulatory patchwork is a major obstacle on the way towards a common European defence equipment market and opens the door to non-compliance with the Treaty principles in important parts of defence markets in Europe. Lack of transparency and widespread discrimination of suppliers from other Member States lead to a lack of openness of these markets, with negative effects for all stakeholders.

The problem is more difficult to identify and to quantify for security than for defence procurement. The main reason for this is that defence is more “visible” (one single customer – Ministry of Defence, one user – armed forces – and one clearly identifiable budget in each Member State; big procurement programmes with high costs; political debate on military capability shortfalls, etc.). Sensitive non-military security, by contrast, is a more diverse and “discrete” phenomenon, in particular because of the multitude of customers, users and budgets at national, regional and local levels.

Each security service has its own specific equipment which has different similarities with defence equipment. The protection of public transport infrastructures, for example, can be technologically complex and involve highly confidential information. Interoperability with the equipment of armed forces, by contrast, is probably less important than in other contexts, such as the surveillance of maritime borders, where navies and coast guards often operate together. In all these cases, security and defence equipment have features in common, which lead to similar challenges in the field of procurement. Consequently, the problem (widespread exemption from EC rules), its cause (contract specificities to which EC rules are ill-suited), and its consequences (lack of openness) are often the same.

3.8. How would the problem evolve, all things being equal?

If no action was taken, the widespread exemption of defence and sensitive non-military security equipment from EC procurement rules would probably continue. The bulk of defence and sensitive non-military security equipment would still be procured via un-coordinated national procedures, which is unsatisfactory in terms of transparency, allows for discrimination and limits the openness of the market for intra-European competition. The specificities of these procurements would make it extremely difficult for contracting authorities to comply with the Court’s case law and implement the principles of the Commission’s Interpretative Communication. Public procurement in these markets would thus continue on a legally problematic basis and in an economically unsatisfactory way.

3.9. Is the EU best suited to act?

The widespread use of the exemption from EC law in the field of defence and sensitive non-military security procurement is incompatible with the Treaty and the Court’s case law. In this case, the Commission, as Guardian of the Treaty, has the duty to act to solve the problem.

The specific problem results from the inefficiency of the EC legal framework. Article 296 TEC and Article 14 of the PP-Directive cannot be applied in accordance with the Court’s case law, since current EC procurement rules are ill-suited to defence and sensitive non-military security procurement contracts. In this case, the EU is not only the best suited, but the only possible actor to address this problem: EDA, as an intergovernmental agency of the EU Council, has no competence on Community rules and can only put forward non-binding arrangements outside the scope of EU law. Consequently, only the Commission can take an initiative to cope with the cause of the problem.

4. OBJECTIVES

4.1. General objective

The Commission's general objective is to establish an open and competitive European Defence Equipment Market (EDEM) in support of the EU's Security and Defence Policy (ESDP). Following the Union's comprehensive security approach, such an EDEM would cover both military segments (arms, munitions and war material) as its core, and non-military, sensitive segments.

Ideally, such an EDEM would allow suppliers established in one Member State to serve without restriction public customers in all Member States. The advantages for both the supply and the demand side are evident: European companies would obtain a much larger ‘home’ market, could restructure across national boundaries to reduce duplication, create centres of excellence and take advantage of longer production runs. At the same time, competition would encourage suppliers to optimise production capacity and help to lower costs, thus saving scarce public finances.

All this is generally recognised today, and there is a growing consensus on the necessity to act towards the establishment of an EDEM[54]. As sole customers of defence equipment, it is for Member States to reform the demand side of the market, and the establishment of the EDA in 2004 illustrates their political determination to do so. The Commission can support Member States' efforts, in particular via the establishment of a more coherent regulatory framework.

In its Communication from 2003[55], the Commission put forward proposals for action and further reflection in several areas where the Community can contribute to the establishment of an EDEM. In some of these areas concrete results have already been achieved (e.g. research), in others, initiatives are still on-going (e.g. standardisation and monitoring). The current initiative on procurement rules goes hand in hand with a simultaneous initiative on intra-community transfers. Both initiatives aim, in particular, at enhancing open and fair competition on defence markets between EU Member States. This contributes also to the competitiveness of European industries and is in line with the Lisbon Strategy.

4.2. Specific objective

In the field of public procurement, the general objective of an EDEM implies a properly functioning regulatory framework at the EU level for the award of contracts in the field of defence and security. This means that EU procurement law must effectively implement the principles of the Treaty for the Internal Market in the field of defence and security and, at the same time, ensure Member States security interests.

4.3. Operational objective

The operational objective is to limit the use of the exemptions provided in Article 296 TEC and Article 14 of the PP-Directive to exceptional cases, in accordance with the Court's case law. The majority of contracts in the field of defence and security, including those for the procurement of arms, munitions and war material, should thus be awarded on the basis of EC rules. This would limit the use of uncoordinated national rules and facilitate the implementation of the principles of the Treaty. The realisation of this objective, however, must not conflict with Member States’ security interests.

5. POLICY OPTIONS

5.1. No further EU-action

Without further EU action, EDA’s Code of Conduct and the Commission's Interpretative Communication would remain the only instruments in the field of defence procurement.

Interpretative Communication on the use of Article 296 in the field of defence procurement

The Interpretative Communication does not change EU procurement rules, but explains the conditions for the use of Article 296 for the exemption of defence contracts from the Treaty. It respects Member States' prerogatives in defence, but also highlights the exceptional character of the exemption and the Commission's right to verify, if necessary, whether the use of Article 296 is justified. The Communication does not determine ex ante which contracts can be exempted from EC rules, but gives guidance to national contracting authorities for their assessment of whether procurement contracts fulfil the conditions to be exempted or not. At the same time, it serves as a reference for the Commission’s infringement policy.

Code of Conduct

The Code of Conduct on defence procurement, administered by EDA, entered into force on 1 July 2006. Its aim is to foster competition for (certain) defence contracts exempted from EC rules on the basis of Article 296 (EDA and the Commission's remit therefore do not overlap).

To achieve this objective, the Code suggests a set of general principles applicable on a voluntary basis. These principles are non-binding, very general, and not all EU Member States have subscribed to them (27 minus HU, DK). Member States can publish contracts to which they want to apply the Code’s principles on the EBB, a common electronic platform. These contracts are then awarded on the basis of national rules and procedures. Particularly important military procurement (cooperative projects, research, NBC equipment) is exempted from the Code, and sensitive non-military security equipment is not covered at all.

5.2. Non-legislative Measures

With the adoption of the Interpretative Communication, the Commission took already the most prominent non-legislative measure which is at its disposal. On top of that, three further non-legislative measures are conceivable.

5.2.1. Explaining the use of Article 14 of the Directive

The Commission could also issue an Interpretative Communication specifically on the use of Article 14 of the PP Directive for sensitive non-military security procurement. Following the example of the Communication on defence procurement, such a document could try to explain the conditions for the exemption of such procurement in the light of the Treaty principles and relevant case law.

5.2.2. Developing a more proactive infringement policy

Up until now, the number of infringement cases in the defence sector has been limited. The reason for this is twofold: first, very few market operators have complained about procurement decisions of contracting authorities, second, the Commission’s infringement policy in this field has been rather lenient. Now that the Interpretative Communication has spelt out the conditions for the use of Article 296, the Commission could develop a more active infringement policy in the field of defence procurement. It could do the same for procurement in the field of security, although the conditions for the exemption of these contracts have not been explained (the Interpretative Communication does not cover security).

5.2.3. Training of national authorities and Commission staff

The Interpretative Communication on defence procurement gives guidance to national contracting authorities for their assessment of the applicability of Article 296. However, this guidance remains inevitably general and must be applied to individual procurement contracts. To make such case-by-case assessment effective, it would make sense to organise specific training courses for national authorities, explaining the Commission's interpretation on the basis of concrete cases. As a natural complement, training courses could be organised for Commission staff to explain the specificities of defence procurement. The same could be done in for sensitive non-military security procurement.

5.3. Legislative measures

The Commission could take a legislative measure to introduce into EC procurement law specific rules for the award of defence and sensitive non-military security contracts to which the existing PP Directive is ill-suited. In this case, different options exist at three levels: the nature of such a legislative measure, its field of application and its content.

5.3.1. The nature of the instrument

Different types of legislative instruments can be used to introduce specific rules into EC law:

* A regulation would set detailed rules exhaustively for the award of defence and sensitive non-military security contracts. It would be binding in its entirety and directly applicable in all Member States. This means that (in contrast to public procurement rules in other sectors) the procedures for the award of such contracts would be precisely defined at EU level, and strictly identical throughout the EU.

* A Directive would content itself with setting binding results to be achieved by Member States. Its rules would be transposed into national legal orders and thus adapted to Member States’ specificities. Consequently, national procedures for the award of defence and sensitive non-military security contracts would not be strictly identical throughout the EU, but coordinated around a set of core dispositions. Three different types of Directives could be envisaged in order to introduce into EC law specific rules for the award of defence and sensitive non-military security contracts:

a) A defence sector directive, applying to all contracts awarded by contracting authorities in the field of defence and security (mainly Ministries of Defence and Interior). In this case, the field of application would not be defined by the type of equipment procured, but by the nature of the contracting authority.

b) A directive applying to sensitive contracts for defence and security specifically. In this case, the field of application of the new rules would not be defined by the nature of the contracting authority, but by the type of equipment procured. This means that contracting authorities would have to ask themselves whether the equipment they wish to procure is a defence or sensitive non-military security equipment (in which case they would be covered by the new directive) or not (in which case the PP Directive applies).

c) An amending directive, inserting specific rules suited to the specificities of defence and sensitive non-military security contracts into the PP Directive (which currently applies to all public procurement except in the water, energy, transport and postal services sectors, covered by Directive 2004/17/EC).

5.3.2. The field of application

The definition of the field of application of the new rules is crucial, since it determines for which contracts exemption from EC law could at least potentially be avoided: at the same time, the notions “defence procurement” and "sensitive non-military security procurement” must be specified in order to clearly distinguish those contracts which could come under the new rules from those which would remain under the current PP Directive and those which could still be exempted. In this context, different options exist at three different levels:

* General approach: should the scope be defined via a list or a general definition?

* Exclusions versus exemptions: should certain contracts be explicitly excluded, or would a general reference to the possible use of Article 296 (for the exemption of defence contracts) and Article 30 (for security contracts) be enough?

* Thresholds: Should new specific thresholds be introduced or the thresholds of the current PP Directive apply?

5.3.3. The content

Consultations with stakeholders confirmed that EC rules for defence and sensitive non-military security procurement would have to take into account the specific needs for flexibility and security (of information and of supply). This concerns in particular the use of the negotiated procedure, guarantees as regards confidentiality, special provisions for security of supply and interoperability, and offsets. For each of these issues, various options exist, with different impacts on transparency and non-discrimination:

* How to ensure security of supply: via a generic selection criterion or as part of the technical capacity of the market operator (industrial dimension)? Via the requirement for export licences or a more flexible formula, taking into account the close political relationship between Member States (political dimension)?

* How to ensure security of information: via possible restrictions during the publication and negotiation phases? Via a generic selection criteria, or as part of the technical capacity of the market operator (industrial security)?

* What to do with offsets: should the new rules allow offsets, for example as an award criterion? Should they try to regulate offsets?

* How to gain flexibility in the award process: using the negotiated procedure when necessary or as a standard procedure? Would non-publication be an open choice or limited to specific cases?

5.4. Discarded Options

5.4.1. Non-legislative Measures

- Explaining the use of Article 14 of the PP- Directive

Explaining the conditions for the exemption of non-military sensitive procurement via a new Interpretative Communication would be a difficult task: Article 14 of the PP Directive is based on Treaty Articles 30, 45 and 46. The latter, however, are more generic than Article 296 and therefore less suited as a basis for detailed interpretation. An additional difficulty lies in the lack of relevant case law. Besides these difficulties, this measure would face the same limits as the Interpretative Communication on Defence Procurement: it would clarify the conditions for the use of the exemption, but not do away with the main problem, i.e. the fact that current rules are ill-suited for sensitive non-military security procurement.

- Developing a more proactive infringement policy

A rigorous infringement policy can certainly reinforce the impact of the Interpretative Communication. In fact, merely explaining the principles for the use of Article 296 may be insufficient to change well-established habits of contracting authorities which have lived for 50 years with the general assumption that all defence- and security-related procurement is automatically exempted.

However, in the current legal framework, infringement policy has its limits. For non-military procurements, it may convince Member States to use current community rules. This would limit the worst cases of misuse of Article 296. For the procurement of most military equipment, however, even a rigorous infringement policy would probably have little impact. As long as ill-suited community rules are the only alternative to the use of Article 296, Member States will certainly interpret the field of application of the exemption as broadly as possible. In consequence, a strict infringement policy can easily increase the number of legal disputes between Member States and the Commission. This can be problematic, in particular when contracts exempted from EC rules are posted on EDA’s EBB. At the same time, the absence of suited EU procurement rules makes it easy to use the specificities of military equipment as justification for the exemption. The same is true for the procurement of sensitive non-military security equipment under Article 14 of the PP Directive.

Consequently, a rigorous infringement policy can reinforce the impact of the Interpretative Communication mainly on non-military procurement. However, under current circumstances, it would probably have a very limited impact on the procurement of military and sensitive non-military security equipment.

- Training of national authorities and Commission staff

The same is true for training courses for staff members of the Commission and national awarding authorities. Both measures would help to establish a better understanding of existing law and avoid implementation problems. However, such measures would again have limited impact. They would not overcome the structural deficiencies of the existing legal framework and, at best, only help to limit the worst cases of misuse of Article 296.

To conclude , non-legislative measures are useful, and the Commission should indeed both develop a more proactive infringement policy and envisage special training courses. However, such measures do not eliminate the cause of the specific problem and are therefore by themselves insufficient to achieve the objective of reducing the use of the exemptions provided by Article 296 of the Treaty and Article 14 of the Directive They may be able to cope with the worst cases of misuse, i.e. cases where current EC rules are in fact suited. However, EC rules would still remain difficult to apply to the bulk of defence and sensitive non-military security contracts. The mismatch between current practice and the Court's case law would thus persist.

Non-legislative measures were therefore set aside early on in the consultation process, in favour of a legislative instrument. Being aware of the legal problems which arise from the widespread use of the exemptions, Member States have supported the Commission in this choice. Caught between the difficulties of using ill-suited procurement rules, on the one hand, and the risk of being challenged by the Commission for abuse of the exemption, on the other, the vast majority of Member State's have recognized the advantage of new Community rules that would make it easier for them to respect the Court's case law.

5.4.2. Legislative Measures

The limits of non-legislative measures confirm that the main cause of the problem is the absence of EC rules suited to defence and sensitive non-military security equipment. Consequently, the use of the exemption in this sector can only be limited to exceptional cases if EU procurement law contains rules and provisions which take into account the specificities of defence and sensitive non-military security contracts. Since such rules and provisions currently do not exist, they must be created. This, in turn, necessitates a legislative measure.

Nevertheless, certain legislative measures can also be discarded:

- Regulation

A regulation would automatically limit the field of application of the new rules to the award of defence and sensitive non-military security supply contracts[56]. The objective of limiting the use of Article 296 could thus only be achieved in part – as works and services would remain covered by ill-suited rules, and thus probably exempted more often than not. Secondly, a regulation is the strictest Community instrument. Defence and sensitive non-military security supply contracts would thus be awarded with a more limiting and stricter legislative framework than all other public contracts. This seems inappropriate, because defence and security are particularly sensitive sectors, and would be in contradiction with the objective of providing Member States with greater flexibility.

A directive thus seems better-suited: it would be applicable to supply, services and works contracts, and content itself with coordinating national procedures, therefore leaving Member States some flexibility to take into account their national specificities. This seems particularly important in an area where Member States have very different defence spending levels, industrial capabilities and hence, different procurement practices and interests. However, not all types of possible Directives are equally suited.

- Defence sector directive

A defence sector directive applying to all contracts awarded by contracting authorities in the field of defence and security would also include rules for the procurement of “civil” and non-sensitive equipment. For the latter, the new sector Directive would then either repeat the rules of the existing PP Directive or contain new specific rules. The former option represents an unnecessary duplication of existing law and is incompatible with the Commission's Better Regulation policy. The second option would result in a situation where similar equipment (for example, office furniture) would be procured through different rules depending on the identity of the contracting authority (the Ministry of Defence or the Ministry of Education, for example). Not only would this be unjustified (as the new rules would partly apply to contracts to which existing rules are currently suited) but it would also bring considerable legal uncertainty within EC and national law.

Screening of policy options against specific and operational objectives

Policy options\ Objectives | Specific objective: establishment of a functioning defence and sensitive non-military security procurement regulatory framework | Operational objective: limitation of the use of derogations from EC rules |

No further EU action | not achieved – does not address root causes of problem | partially achieved – worst cases of misuse of Article 296 reduced (due to IC) |

Non-legislative measures |

IC on Article 14 | partially achieved – 1) improved clarity on appropriate use of Article 14 2) longer and more complex legal exercise than the IC on Article 296 3) no improvement to the current regulatory framework – cannot address root causes of problem | partially achieved – 1) worst cases of misuse of Article 14 reduced; 2) worst cases of misuse of Article 296 reduced as result of related IC; 3) no/minor impact on derogations as a whole |

Proactive infringement policy | partially achieved – 1) enforces conclusions of the IC on Article 296 (and Article 14 if IC written) 2) case law could over time increase understanding and application 3) does not address root causes of problem | partially achieved – 1) worst cases of misuse reduced; 2)