The specificities of defence industries
Defence industries operate in a highly regulated, monopsonic market where governments play a unique role. As sole customers, sponsors and regulators, they put orders, specify operational and technical requirements, fund research and development, define the regulatory framework and authorise exports. In contrast to commercial markets, new products are not developed unsolicited, but only on the specific demand of governments.
Since their purpose is to provide military advantage over potential adversaries, defence systems are based on cutting-edge, high-end technologies. They are often as complex as cost-intensive and have very long lifecycles. It can take years, sometimes decades, for a system to enter into service, and companies face significant technological and financial risks during the research and development phase. Operational needs may change, governments adjust their requirements or even cancel a project altogether. Given the monopsonic nature of the market, these risks and uncertainties necessitate specific procurement rules and funding schemes.
The European defence industry is highly competitive and provides a major contribution for European economy. However, today’s competitiveness of defence systems made in Europe is the fruit of investments of the past. Over the last decades, defence investment and R&D funding in Europe have been strongly reduced. This has led to a lack of new defence programmes, which affects negatively Europe’s military capabilities and put at risk industry’s competitiveness of tomorrow.
At the same time, the shrinking of home markets has increased the importance of exports for European industries. In fact, given the high R&D costs of many defence systems, certain production volumes are necessary to maintain the industrial capabilities that are needed to equip European armed forces at affordable prices and maintain a certain degree of strategic autonomy for critical technologies.
Defence exports are always subject to restrictions that are defined by the government of the country in which the company is located. The main purpose of these restrictions is to ensure the operational superiority of the national armed forces over potential adversaries and to align defence exports with the host country’s foreign policy.
The structure of defence industries
After the end of the Cold War, cuts in defence budgets and the downsizing of armed forces reduced defence markets in Europe and worldwide. This reinforced global competition, triggered a consolidation process that often spans across national borders, and led to an important reduction of workforce. Still, in 2017, defence companies in Europe supported as many as 436,000 jobs.
Industry’s structure varies between sectors. In general, however, it resembles a pyramid with a limited number of large system integrators, or ‘original equipment manufacturers’ (OEM), at the top, and an extensive supply chain with several tiers composed of mid-caps and small- and medium-sized enterprises (SMEs). OEMs integrate components and sub-systems produced by sub-suppliers. They have the industrial leadership and the responsibility for the defence system as a whole and act as prime contractors vis-à-vis governments.
Source: Cauzic et al.
Defence spending in Europe is highly concentrated in a few Member States. The six so-called “Letter of Intent (LoI) countries” - France, Germany, Italy, Spain, Sweden and the UK – account together for more than 80% of defence spending and 95% of defence R&D investment in the EU. These differences find direct expression in the geographical distribution of industry: The main European system integrators are located in the LoI countries; smaller platform builders, sub-suppliers and niche producers can be found across Europe. In 2017, European defence industry generated a revenue of €98bn; out of this total, €80bn were generated by companies established in the LoI countries.
Defence industry sectors
The defence industry has been traditionally organised in three sectors (aeronautics, land, naval) which mirror the structure of the armed forces (air, land, sea). At the same time, electronics companies are active in all sectors as suppliers, but sometimes also as OEMs. The increasing importance of cyber and space for defence adds additional layers of complexity. Across all sectors, most defence companies have also important civil activities. This is the case in particular for lower-tier suppliers.
Air power superiority is a key success factor for defence. Air power capability constitutes a key-enabler to support the EU and its Member States in complex operational scenarios with a prompt and fast response also in remote geographical areas. It must be able to support all types of missions and to operate in a joint and collaborative environment with naval, land and space assets. To develop the required air power capabilities, a strong industrial base is needed and must be constantly sustained to remain at the technological edge.
The military aeronautics industry in Europe is able to produce a broad range of manned and unmanned aerial systems, from combat aircraft and drones to transport aircraft and helicopters. It consists of companies of all size: At the top, a small number of prime contractors deliver complete ‘System of System’ solutions and services; tier-1 suppliers develop and produce complete sub-systems (i.e. engine, radar, structure, etc.); tier-2 suppliers deliver equipment or special technologies included at product top level or sub-systems (i.e. electronics, software, mechanical components, etc.); tier-3 suppliers provide components and raw material.
Since the end of the Cold War, most European Armies have been downsized and restructured for the specific needs of out-of-area operations. This came along with a lack of investment in major land defence systems. Today, European land forces are required to improve their protection and reactiveness in operations. This implies enhanced mobility and agility of movement, interconnectivity of systems, energy management and support to decisions in an increasingly digitalized environment.
The European land industry has a long tradition of supporting Member States’ armies and is key to deliver a new generation of land military capabilities. Its product portfolio is diverse, spanning from main battle tanks to families of armored vehicles, artillery, guided ammo, integrated systems and components for the battlefield, protection of soldiers and infrastructures, etc.
European navies find themselves at a crossroads: fleets are reaching obsolescence and many replacements have been delayed for financial reasons. At the same time, potential adversaries have developed new capabilities which may contest European control of its neighboring maritime areas. High intensity threats are re-emerging, whilst areas of operation extend to extreme climate zones.
The European naval industry produces platforms of all sizes as well as embedded systems such as electronics and armaments. The sector encompasses the full spectrum of vessels, including aircraft carriers and nuclear submarines. In Europe, there are six prime contractors which have the full responsibility to design, integrate and build naval ships. For the design and development of combat systems and combat management systems, most of them rely on tier-1 suppliers. The lower tiers of the supply chain consist of a broad range of companies of different size and activities. Many of them generate only a small part of their revenues on the defence market.
Future warfare will be characterised more and more by a system architecture approach, which takes advantage of new and emerging cross-functional technologies (e.g. 5G or Cyber) and uses platforms as nodes or components of a system. This approach includes non-platform related capabilities, such as information superiority, command and control, cyber, space, as well as cross-sector capabilities like training, simulation and autonomy.
This development is driven by changes in both threat scenarios and technology advances. In the future, there will be an increasing need for armed forces to be able to operate in an integrated manner across all domains, supported by the necessary technologies. The latter will be influenced strongly by emerging technology trends that are driven mainly by huge investments in the commercial sector (such as Artificial Intelligence, Quantum computing, etc.). Whilst defence industry will not be at the forefront of developments in such technologies, it will have the responsibility to develop the means of applying these technologies to military systems and military operations. New technologies, more pervasive and transversal, are likely to have consequences also for the structure of the defence industrial and technological base. It will bring new entrants into the military sector and cause defence companies to adapt their strategies to meet the need to incorporate these new technologies into the products they develop.
It will be increasingly difficult for Member States to cope with these challenges individually. Consequently, Europeans will have to cooperate more and better than in the past. Recent initiatives like EDF, PesCo and CARD can make a major contribution to fostering European cooperation. However, defence cooperation between Member States is always complex and faces systemic challenges. It is therefore crucial to draw lessons from the past and establish mechanisms that help enhance efficiency and effectiveness of collaborative defence projects.