Offsets, Local Content, and Supplier Information Management

I’ve written — but at no great length — in the past about issues around “local content” and how this appeared to be a growing area of interest for procurement leaders. One discussion that stimulated my interest a year or so back was a presentation from a very large mining firm, which explained that it had to demonstrate how its activities would drive the local economy if it hoped to win mining rights in developing countries.

So the government of that country would expect the company to show how its activities would help local people, including the development of a local supply base — the “local content,” in other words, in their supply chain. And this wasn’t merely window dressing: the company was expected to produce tangible data and evidence that this was happening.

It was only recently though that I made a connection between this example and the world of offsets, used most commonly perhaps in procurement of military equipment. They are used in other industries, but a number of trade agreements ban their use, except in the case of defence expenditure.

The principle of offsets is this: assume a country doesn’t have its own indigenous capacity or capability to manufacture, say, fighter aircraft, so it has to buy from foreign suppliers. But the government making the purchase will (not unreasonably) wish some of that purchase price to be reinvested back into its country.

So the government will define “offsets” — either specific spend areas, or a general amount of money — that the supplier contractually agrees to spend with firms in the country making the purchase. The offsets can be:

• Direct spend, in which the investment is directly related to what is being bought (in our example, components of the fighter planes)
• Indirect spend, which can be defense or civil and are not related to what is being bought

Besides being used to develop the country’s defence capabilities, offsets are frequently used as industrial (sometimes even social or economic) policy tools to improve balance-of-payments accounts and compensate the purchaser’s economy (and tax payers) for a large public investment not directly beneficial to the population.

At first sight, that all sounds quite reasonable and positive. Yet in practice, it has been one of the most significant sources of corruption in defense procurement.

If you haven’t come across Transparency International, they are a superb organization that campaigns against corruption globally, including publishing global corruption indices that tend to get a lot of press. They have carried out significant research into corruption in the military sector, and recommended change in the world of defense procurement in general, making them experts on the topic of offsets. (Here is an example of their take on the topic.)

Offset contracts are usually under-scrutinised and under-monitored in comparison to the corresponding acquisition contract. In fact, these contracts usually are not audited by the court of accounts. Offsets can therefore give rise to two different kinds of corruption risks:

• Those involved in the definition, negotiation, management and monitoring of offset programs can receive undue benefits from the offsets themselves; and
• …to complete a corruption cycle within an acquisition.

The contractor (the manufacturer of the fighter planes) may have over-promised in order to win the contract, offering a level of offsets that it’s not sure how to actually deliver. And of course, it isn’t easy to suddenly substitute a proven supplier for one in the buying country: “OK, we won’t use the Rolls Royce aero engine we’ve used for the last 10 years, we’ll buy a local engine manufactured in Mozambique.”

No offense to Mozambique, but that’s not going to happen. So the supplier may struggle to meet the terms of the offset agreement. And that’s where various players can get involved, all offering to “help” the supplier spend their money and meet the offset requirement. Some may be genuine, assisting the supplier to find genuine local suppliers. Others will channel the money in various directions to give the impression of success, or even buy-off politicians or officials so that the need to show offsets being achieved is somehow forgotten.

Then we have the more direct corruption, where the offset money is channelled into a company controlled by individuals who were able to influence the contract award — the defense minister, the senior official, the ruling family.

Moving back now to our original discussion of non-defense firms who need to show their support for local economies, we can see the potential parallels with the world of defense procurement. Even if the situations are not perhaps quite as politically sensitive, and corruption may not be quite such a problem, there are still significant questions and issues.

How does the organization find the right sort of suppliers who can both genuinely meet their needs and satisfy the local content type aims? And do that without money being creamed off into the wrong hands along the way? When do you take a risk on the basis that you’ll be able to develop a supplier to an acceptable level quickly, even if they’re not quite there yet? How do you verify that they really are “local” or satisfy other requirements (perhaps criteria related to the size of the firm, minority/ethnic ownership etc.)? Indeed, that is an issue even in the USA, where we’ve seen instances of suppliers “cheating” — claiming minority ownership falsely to tick various boxes and win more business.

And fraud is still an issue. As soon as we move away from purely objective decisions in terms of how to choose suppliers, that opens up the possibility of fraud. When we award a contract to a supplier who does not offer the clear best value for money, but satisfies other “softer” criteria, then the door is open to the fraudster.

In Part 2, we will take a look at how procurement can work in this environment, and in particular the sort of information and systems that are useful or even essential to manage these situations effectively.