1. THE OFFSET ENVIRONMENT

1.1. Introduction

Defence and Security programs constitute a very large capital investment on the part of a nation and are also associated with heavy follow-on costs and investments in terms of maintenance and support. Throughout the last thirty years, nations have been trying to use such investments to establish a local capability of support and develop military and security systems. The means that were used for such goal were called “Offsets”.

Offset are generally associated with major Aerospace and Defence (A&D) contracts from foreign suppliers. Programs are negotiated between prime contractors and governments, usually the ministry of defence or the ministry of economy and in some case directly with the Procurement Authorities of the Armed Forces (e.g. Brazil).

Usually offsets are required as a condition of purchase of “defence equipment purchases” and “defence services” but in certain countries (e.g. South Africa, Israel, UAE, GCC countries, etc.) offsets are also applied to civil contracts such as large civil infrastructure projects. Offsets come in different shapes and forms but can generally be divided into two main categories:

• Direct Offsets: Transactions directly related to the defence contract, which usually come in the form of co-production, subcontracting, technology transfer, training, production, licensed production, or financing activities.
• Indirect Offsets: Transactions not directly related to the defence contract, which aim to trigger other technological and industrial advancement in the defence or other sectors like IT or Telecommunication by drawing on the multiple areas of knowledge and technology capabilities of the prime contractors or its subcontractors. Indirect offsets can include purchases, investment, training, financing activities, marketing/exporting assistance, and technology transfer.

The objectives of Offset programs in general terms are:

• Boost the domestic economy by channelling activity to local companies. This can be done through co-production agreements, subcontracting or direct purchases.
  
• Enhance local skills and technological know-how through the transfer of advanced technology to local companies and training of the local workforce.
  
• Import substitution in order to minimize the balance of payments impact generated by military purchases.
  
• Create Sustainable Business Partnerships, which would never have occurred without the impact of Offsets.
  
• Increase the country’s self sufficiency and independence from foreign suppliers by acquiring maintenance, support or even production capabilities of the purchased equipment.
  
  

1.2. The Offset Market

The offset industry representing an estimated $10bn market per annum is large but highly fragmented. Prime contractors currently have 20bn+ US$ of unfulfilled offset obligations around the world and in some cases face difficulties in finding projects to satisfy their offset liabilities due to complicated or badly adapted offset guidelines.

While every country has different Offset guidelines due the different economic, defence and industrial environment, a number of countries apply offsets on a case-by-case basis without providing official guidelines. Experience has shown however limited success due to reduced bargaining power and the lack of strategic planning.

Countries with coherent and well adapted offset guidelines seem to harvest the greatest benefits out of offsets. Here, differences can be seen in the types of transactions that are eligible for offsets, in the differing multipliers and eligible industries (military, civilian), in the structure of the Offset approval authorities and the processes as well as in the credit release procedures.

1.3. Offset Particulars

1.3.1. Structuring an Offset

Offset agreements are usually negotiated and signed in parallel with the main supply contract, however often enough agreements are only partially agreed or describe only broadly the offset related activities with the details being agreed upon after the contract award. In certain countries, companies are required to perform offsets prior to the contract award (pre-offsets) as part of the selection process.

The value of an offset agreement is calculated based on the contract value of the procurement times a percentage. Each offset policy specifies the minimum percentage of offset that is acceptable, while usually contractors have the right to offer a greater percentage as part of their offer.

Based on the offset value, a number of projects are structured by the contractor that will be negotiated with the authorities and be approved with a specific credit value assigned to each one of them.

Finally, other terms and conditions are included in an offset agreement, such as term of implementation, banking guarantee, penalties, applicable law etc.

1.3.2. Types of Offset projects

Apart from the general distinction between direct and indirect offsets, projects are usually classified according to the type of the performed activities. The most common types are:

• Purchases: Procurement of off-the-shelf items from the offset recipient. Often, but not always, purchases are indirect by nature. Indirect purchases are similar in definition to countertrade, while direct purchases are analogous to buy-backs.
• Subcontract: local production of a part or component of foreign defence and in some cases civil equipment. In most cases, the subcontracting is directly related to the purchased equipment (direct offset).
• Technology Transfer: Transfer of technology that occurs as a result of an offset agreement and that may take the form of research and development conducted abroad, technical assistance provided to the subsidiary or joint venture of overseas investment, or other activities under direct commercial arrangement between the defence prime contractor and a foreign entity.
• Training: Generally includes training related to the production or maintenance of the exported defence item. Training, which can be either direct or indirect, may also be required in unrelated areas, such as computer training, foreign language skills, or engineering capabilities.
• Investment: Investment arising from the offset agreement, taking the form of capital invested to establish or expand a subsidiary or joint venture in the foreign country.
• Licensed Production: local production of foreign defence equipment based upon transfer of technical information under direct commercial arrangements between the foreign manufacturer and the local government or producer. Licensed production is usually restricted to parts or components of a defence system, rather than the complete system. These transactions can be either direct or indirect.
• Co-production: local production of the complete or of part of the defence equipment that is being supplied under the procurement contract. This is classified as direct offsets and can involve licensed production.
• Credit Assistance: Credit assistance includes direct loans, brokered loans, loan guarantees, assistance in achieving favourable payment terms, credit extensions, and lower interest rates. Credit assistance is nearly always classified as an indirect offset transaction but can be either direct or indirect.

1.4. Future Developments

Offsets have been following an upward trend over the last two decades. With about twenty (mostly NATO) countries applying official offset policies in the ’80s, the figure has more than doubled to almost 50 countries today.

Out of the large number of countries that apply offsets on a case by case basis, more and more countries seem to realise the benefits of a structured and strategic approach to offsets and are in the process of establishing official offset policies and guidelines such as Pakistan, Libya and Qatar.

Offset demands as a percentage of export contracts are increasing as the supply of defence systems greatly exceeds demand, the worldwide defence expenditures are shrinking and the competition for defence sales becomes more intense. The volume of Offsets still remains within two main geographical areas, Europe and Asia and this is expected to continue for at least the next ten years.

Based on the analysis of the Defence and Aerospace market, Europe will remain a steady large market, while Asia will be the major force for development. The same principle applies to Offsets, as European and Asian countries will remain the top Offset generators but also the main focus on requirements. With a number of major procurements expected in Latin America, the number offset agreements is expected to rise in this region over the coming years.