OP-ED

by David Perry

Canadian Naval Review
Volume 12, No. 1 (2016)

The most necessary outcome of the 2016 Defence Policy Review is to align the current acquisition plans of the Department of National Defence (DND) with the defence budget. During the 2015 federal election, the Liberal Party of Canada rightly recognized that the previous government’s defence policy, the 2008 “Canada First Defence Strategy” (CFDS), was “underfunded and out of date.”1 The single biggest policy problem facing the Canadian military is an inadequate supply of funding to recapitalize.

The broad policy contours of the CFDS remain largely valid today. The three defined roles for the armed forces (defending Canada, defending North America and contributing to international peace and security) are unlikely to change, although how they are interpreted by the new government could. Similarly, the six articulated mission types (conduct daily domestic and continental operations, support a major event in Canada, respond to a terrorist attack, support civilian authorities during a crisis in Canada, lead or conduct a major international operation for an extended period of time, and deploy forces elsewhere in the world for shorter periods) are similarly so generic that there is little need of revision.2 Defence policy will, however, need some updating to account for new threats and technologies and  changed geostrategic circumstances, particularly a different relationship with Russia.

Addressing these policy issues – the prose of our defence policy – is less fundamental than resolving an inadequate supply of capital funding to move forward with military procurement. For the Royal Canadian Navy (RCN) this is a major problem, given the extensive requirements for capital investment needed to keep naval technology current. The navy faces two broad types of funding pressures. First, the adequacy of the project budgets for those major projects that have been approved and included in DND’s Investment Plan (the long-term planning document required by the Treasury Board Secretariat), but which are not yet into contract, has been repeatedly called into question.3 Second, the future of the submarine fleet is in jeopardy because neither a life-extension of the existing Victoria-class nor a replacement submarine is funded in the Investment Plan.4 All of these projects are jeopardized by the inadequate supply of funding for the capital program as a whole. Resolving this recapitalization dilemma is therefore the most pressing concern for future naval policy.

The Capital, Operations and Personnel Mix

The distribution of the defence budget among the major components of defence spending (Personnel, Operations and Maintenance, and Capital) is just as important as its size. The first category includes pay, allowances and benefits for the military and civilian members of the defence organization. The second category includes the costs associated with operating and maintaining equipment and facilities, conducting deployed operations, routine missions and training exercises. Finally, the third category comprises the costs of acquiring or making major upgrades to equipment or infrastructure.5

Maritime power is heavily dependent upon major investments in a naval fleet which means that, like the Royal Canadian Air Force (RCAF), the navy places much more significant demands on the capital share of the defence budget than it does on personnel. Figure 1 includes all of the projects and potential projects in the 2015 Defence Acquisition Guide, DND’s list of future capital equipment purchases. Th at document itemized planned projects with their costs estimated across a likely range. Supplemented with known information about actual project budgets (such as those for the Canadian Surface Combatant and the Joint Support Ship) that data is presented in Figure 1. It shows that both the RCN and RCAF have capital requirements significantly larger than those for the Canadian Army, Special Operations Forces (SOF) or other joint capabilities.

The RCN employs far fewer people than the RCAF and especially the army – the RCN has less than 9,000 Regular Forces personnel, the army has roughly 23,000, and the RCAF has roughly 13,500.6 As a result, the RCN depends significantly more on the capital budget and less on the personnel budget to generate capability than does the army and, to a lesser extent, the RCAF. The share of the defence budget allocated to capital is therefore an important determinant of future naval capabilities as they rely disproportionately on significant capital spending.7

For decades, DND has established targets for how large a share of its budget should be allocated to capital. This occurred fi rst in the 1964 White Paper which set a target of 25% of the budget being devoted to capital equipment.8 The same target was endorsed in the 1987 White Paper,9 and Defence Policy 1992 increased it to 26% immediately, with a long-term objective of 30%.10 During the 1990s as the Chrétien government wrestled the deficit into submission, though, defence funding was slashed and spending on capital especially so. By the early 2000s, the Canadian military was facing a recapitalization crisis, with many major platforms extremely advanced in age.

Efforts to correct this started with the 2005 budget which provided DND with a significant increase in funding for capital, followed by the 2006 budget which did the same. Then the CFDS provided a unique funding arrangement to provide long-term funding for capital. Despite all of the additional capital funding promised in the mid-2000s, the CFDS curiously set the 20-year spending target for this sector at only 20%. Given the signifi cant backlog of recapitalization that accrued during the 1990s, this was surprising, and several analysts questioned early on whether the funding for individual acquisitions was adequate.11 More broadly, Eric Lerhe argued presciently in 2010 that the overall CFDS allocation of only 20% of the total funding to capital was inadequate to provide funding for recapitalization. In particular, he noted that the

plans to increase troop strength to 70,000 were unaffordable, leaving insufficient funds allocated for major fleet procurement, and thus argued that the size of the military should be held at 64,000 Regular Forces to allow for proper recapitalization.12 This assessment was remarkably apt, as significant shortfalls in the overall availability of capital funding have become clear. The funding gap has also been exacerbated by the inability of the Canadian procurement system to obtain needed equipment on schedule.

The 2016 Budget Context

The portions of the defence budget devoted to personnel and operations and maintenance are subject to different rules than the portion for capital. The most significant of these is that DND’s personnel and operations and maintenance funds (both denoted as Vote 1 in the Estimates) are automatically increased every year. DND is unique for having a built in ‘escalator’ applied to its Vote 1 baseline funding. Under the terms of the CFDS, in 2011/2012 the amount of this annual increase rose to 2% annually. In its final budget, in 2015, the Harper government committed to increase the escalator to 3% a year between 2017/2018 and 2026/2027.13 Beyond this escalator, like other federal departments, DND also benefits from additional funding that off sets the impact of wage increases for its personnel. 14

In its 2015 campaign platform, the Liberal Party of Canada pledged to “maintain current National Defence spending levels, including current planned increases,”15 a commitment that presumably refers to the existing escalator arrangements. While the 2016 federal budget made no mention of the escalator specifi cally, offi cials from the Department of Finance confirmed that those arrangements were left untouched in the budget. Consequently, DND will receive an additional $361M in Vote 1 funding for 2016/2017.

Despite these built-in funding mechanisms, governments can, and recently have, cut defence funding while still providing DND with its annual escalator. Starting in 2010, two separate operating budget freezes obviated the normal off setting funding increases to compensate for rising wages. Further, DND’s Strategic Review and the Deficit Reduction Action Plan cut a combined $2.1B in defence funding.16 These measures resulted in significant reductions to DND’s operations and maintenance funds. The effects of some measures taken as a result, including cuts to DND’s national procurement funds (those for equipment repair and overhaul), are still being felt. But because of the automatic annual increase through the escalator, the pressures on the operations and maintenance budget as a whole are no longer acute.

In contrast, there are real funding shortfalls with respect to capital funds, largely because these have not benefited from automatic annual increases. DND actually has two separate types of capital funding. The first is roughly $1.5B annually in A-base Vote 5. These funds are intended to provide for the replacement of existing capabilities. Finance officials state that DND could choose to apply some of its annual escalator increase to its A-base Vote 5, but to date this has not happened.

In addition to its A-base Vote 5, DND also has a second source of capital funding. As the 2016 budget stated, “funding to support large-scale capital projects for defence, including the associated operating and sustainment costs, is set aside in the fiscal framework and managed on an accrual basis.”17 Th is funding is known colloquially in National Defence Headquarters as the ‘accrual space.’This funding mechanism was introduced with the CFDS which set aside the long-term funds needed for the new capabilities promised in that policy document.18 The size of the accrual space is fixed, as the defence escalator does not apply to that portion of DND’s funding.

For projects funded in the accrual space, DND requests the funds it needs for procurements as ‘Investment Cash,’ the money required to make payments for a procurement on an annual basis. Th is is denoted as Vote 5 funding in the Estimates. The full value of the Investment Cash used annually is not counted against the defence budget, however. Instead, the full costs of capital projects are amortized over their expected life, and only an annual amortization expense is accounted for in DND’s accrual space.19 Even though the funding for these purchases is set aside in the fiscal framework for defence purchases, DND does not actually have any amortization expenses to account for in the accrual space unless it actually procures something. This, however, has been problematic.

The ongoing problems with the defence procurement system in Canada are well documented. For multiple reasons beyond the scope of this article, the pace of procurement has fallen well short of the existing supply of capital funding. Because of this, procurements for which funding is allocated have not proceeded on schedule and, as a result, billions of dollars set aside to account for their amortization expenses have not been needed. The 2016 budget marked the third time in four years that a federal budget has made a statement along the lines of “[t]o ensure that funding is available when key capital acquisitions will be made, funding that is not yet allocated to specific projects, or that cannot be spent due to unforeseen delays in planned projects, can be moved forward into future years when it will be needed.”20 Due to the inability to procure funds on the needed schedule, $3.7B worth of accrual space was reprofiled into the future. Combined with similar measures in 2012 and 2014, more than $10B in fiscal room allocated for defence purchases between 2011 and 2021 has been shift ed into the future. Th is inability to spend the allocated funding has meant that, since 2008, DND has fallen well short of its goal of spending a fifth of its budget on capital. As Figure 2 shows, the percentage of the defence budget devoted to capital has dropped to levels not seen since the late 1970s.

The chronic delays in the procurement system present an ongoing problem, particularly because the accrual space is unprotected from the impact of inflation. While the RAND Corporation has estimated that the costs of naval surface combatants escalate at a rate of almost 11% a year, the funds budgeted for Canada’s next surface combatant are fixed.21 Improving the procurement process must be a focus of the Defence Policy Review to preserve the purchasing power of the capital budget.

This is particularly the case because the unallocated funding room in DND’s Investment Plan for new purchases is vastly outstripped by the demands for new acquisition. The left -hand column in Figure 3 denotes the available room left in the Investment Plan. It also provides estimates for both the low and high ranges of total capital expenditures outlined in the 2015 Defence Acquisition Guide (DAG). The latter estimates were calculated by taking the total data presented in the DAG, including known project budgets, and removing those projects known to be funded

in the Investment Plan.22 Th e remaining list of projects represents potential acquisitions for which funding in the Investment Plan may not be assured, ranging from a low estimate of roughly $42B to a high estimate of $69B. The midpoint between these upper and lower ranges would be roughly $55B in future demand for capital.

At present, there is less than $18B in available Investment Plan room, comprised of both A-base Vote 5 and accrual space. The accrual space portion must also account for operating and sustainment costs of the capital projects funded from within it, and the remaining Investment Plan as a whole must reserve some space to account for possible cost escalation due to inflation, exchange rate fluctuations and other contingencies. As a consequence, there is more than three times more demand for capital funding than room in the Investment Plan.

Ways Forward

Three options exist for rectifying this problem: (1) increase the funding available for capital; (2) reallocate the balance of funding within DND’s overall budget; or (3) reduce the ambition of Canada’s defence policy, thereby reducing the demands for capital purchases.

The first option could be achieved in three ways: (a) increase the overall defence budget above the planned escalator increases; (b) apply the escalator to DND’s A-base Vote 5, thereby increasing it over time; or (c) allow DND to expand its useful budgetary room for capital by converting some of its A-base Vote 5 capital into its accrual space, thus allowing for long-term amortization of more of its program. Any one of these three options could have a benefit by increasing the capital share immediately, increasing it slowly over time, or applying more favourable accounting rules to the budget it has at present.

The second option would be to reallocate funding internally within DND. One such plan is underway, through Defence Renewal, which is implementing a range of efficiency, cost-saving and cost-avoidance measures to improve the operation of the defence business enterprise. This effort could produce a recurring reinvestment potential of between $500-600M by 2019/2020.23 This would help address the shortfall, but likely not resolve it completely, and achieving this will take concerted action by senior departmental leaders.

An additional means of reallocating funds internally would be to adjust the overall distribution of spending between personnel and capital. Reducing the size of the Canadian Armed Forces is an option that would allow for an internal reallocation of the defence budget, to shift funds from personnel, to devote them to capital. Former Chief of Defence Staff Rick Hillier recently argued that scaling back the size of the military should be considered as a means of ensuring proper recapitalization.24 However, when asked whether he would examine such an option, the Minister of National Defence replied “[w]e are not looking at reducing our personnel…. In fact, the conversation I’m having right now is about where do we need to increase some of the personnel.”25

If DND cannot otherwise increase its capital funding, reducing the size of the armed forces should be given careful consideration. At present, the annual cost of each 1,000 members of the Regular Forces is approximately $105M. To place that in perspective, the annual amortization cost of a $3B capital asset with a 30-year lifespan would be $100M. Reducing the size of the armed forces by just a few thousand people could therefore free up the fiscal space needed for an additional $10B in capital spending.

The third option available for rectifying the mismatch between the capital budget and capital demand would be for the policy review to indicate policy changes from which a reduced set of capabilities could be produced. The existing plans in the DAG emanate from the existing interpretations of defence policy. If no further funding is forthcoming, and no reallocations can be made, this would be the only remaining choice.

Conclusion

The most significant defence policy problem from a naval perspective is a lack of funding for capital in the defence budget. Whatever else the policy review accomplishes, bringing the mismatch between funding and capital plans into closer alignment must be a priority. While the inclination to perfect the defence policy prose will be strong, the real emphasis needs to be on finding the money to get on with the procurement.

Notes

1. Liberal Party of Canada, “A New Plan for a Strong Middle Class,” 2015.

2. Canada. Department of National Defence (DND), “Canada First Defence Strategy,” 2008.

3. Canada, Office of the Parliamentary Budget Officer, “Feasibility of Budget for Acquisition of Two Joint Support Ships,” 2013; James Cudmore, “Warship Cost Could Rise to $30B, Vice-Admiral Mark Norman Confirms,” CBC, 2 December 2015.

4. A life extension has been identified as one of 18 investment priorities for the net version of the Investment Plan all of which have been identified as important, but none of which are actually funded.

5. Lieutenant Colonel Ross Fetterly, “Budgeting within Defence,” in Craig Stone (ed.), Th e Public Management of Defence in Canada (Toronto: Breakout Education Network, 2009), pp. 53-91.

6. DND Public Aff airs email to the author, 4 April 2016.

7. John M. Treddenick, “Distributing the Defence Budget,” in Douglas Bland (ed.), Issues in Defence Management (Kingston: School of Policy Studies, Queen’s University, 1997), pp. 57-82.

8. Canada, White Paper on Defence (Ottawa: Queen’s Printer, 1964).

9. Canada, DND, Challenge and Commitment (Ottawa: 1987).

10. Canada, DND, Canadian Defence Policy (Ottawa: 1992).

11. Elinor C. Sloan, “Stretched to the Breaking Point,” National Post, 17 June 2008; Lieutenant-General (Ret’d) George Macdonald, The Canada First Defence Strategy: One Year Later (Calgary: Canadian Defence and Foreign Affairs Institute, 2009).

12. Commodore (Ret’d) Eric Lerhe, “Getting the Capital and Personnel Mix Right,” in Ann Griffiths and Eric Lerhe (eds), Naval Gazing (Halifax: Centre for Foreign Policy Studies, 2010), pp. 54-95.

13. Canada, Department of Finance Canada, “Economic Action Plan 2015,” 2015.

14. Unless the government invokes an operating budget freeze.

15. Liberal Party of Canada, “A New Plan for a Strong Middle Class,” p. 69.

16. David Perry. Th e Growing Gap Between Defence Ends and Means (Ottawa: Conference of Defence Associations Institute, 2014).

17. Canada, Department of Finance Canada, “Growing the Middle Class,” Budget Plan 2016.

18. Funding for an expansion of the military, and the funds to operate, sustain and make it ready was also set aside in the accrual space.

19. Other project expenses such as the cost of the Project Management Office, Initial Logistics Setup and Initial Spare Parts are also counted in the accrual space in the year these expenses are incurred.

20. Canada, Department of Finance Canada, “Growing the Middle Class,” Budget Plan 2016.

21. Mark V. Arena, Irv Blickstein, Obaid Younossi and Cliff ord A. Grammich, Why Has the Cost of Navy Ships Risen? (Pittsburgh: RAND Corporation, 2006).

22. This removed the following projects from the total: the Arctic Off shore Patrol Ship; Canadian Surface Combatant; Fixed Wing Search and Rescue Aircraft ; Future Fighter Capability; Joint Support Ship; Joint Unmanned Surveillance and Target Acquisition System; Point Defence Missile System Upgrade; Underwater Warfare Suite Upgrade.

23. Canada, DND, “Defence Renewal Annual Report 2014-2015,” 2016; David Perry, Doing Less with Less (Ottawa: Conference of Defence Associations Institute, 2014). Th is amount was calculated by subtracting the dollar value equivalent of the full-time equivalent efficiencies the original Defence Renewal Plan intended to realize from the revised reinvestment target published in the 2014-2015 Defence Renewal Annual Report (which appear to include potential efficiencies with respect to full-time equivalents expressed as a dollar value). Th e Liberal campaign platform had committed to “implement the recommendations made in the Canadian Forces’ Report on Transformation,” which proposed more significant savings. Th e Minister of National Defence’s mandate letter did not direct him to do so, however, and this objective appears to have been abandoned.

24. Andrea Janus, “Canada ‘Just Can’t Get Around’ Army Cuts, Hillier Says,” CTV News, 23 September 2013.

25. Lee Berthiume, “Liberals Reject Cutting the Size of Canadian Military. Instead, They’re Looking to Expand,” National Post, 18 February 2016.

Dr. Dave Perry is the Senior Analyst and Fellow at the Canadian Global Affairs Institute. 

Image: Leading Seaman Dan Bard, Formation Imaging Services Halifax