The European defence industry urgently needs investment | In Principle

For years, the European defence industry has been oriented towards peacetime production, resulting in low capacity. The war in Ukraine quickly exposed this, as well as the severe underinvestment which the EU’s defence sector has suffered from for years. Optimistically, the growing demand for defence equipment has also quickly raised the awareness that production capacity needs to be increased. But now this conviction must translate into action, first of all in the form of increased financial support.

In the current geopolitical situation, there is no need to cite arguments for increasing investments in national security. The security and defence sectors are key for protecting the state from external threats such as terrorism, foreign states’ aggression, and cyberattacks.

Increasing national defence capabilities requires investment in modern technologies and armaments, but the benefits will extend beyond raising the state’s level of security against conflicts or threats. The defence industry generates thousands of jobs for specialists, engineers, and workers on the production line and in logistics. In turn, this contributes to economic growth and stability. Additionally, defence companies often research new technologies that end up being applied not only in the military, but also in fields such as telecommunications, medicine or transportation. Considering the necessary aspect of international cooperation, investing in the defence sector can also foster the exchange of knowhow and technology.

Investing in the defence industry also carries certain risks. This sector is exposed to political winds, regulatory changes, and volatile market conditions, which may affect the stability of investments. In recent years, like other industries, defence companies have experienced disruptions in their global supply chain, delaying projects and exposing contractors to penalties.

But despite years of neglect, positive changes are also discernible, such as:

• Implementation of advanced digital technologies, such as the internet of things and artificial intelligence, to optimise production processes, predict machine failures, or personalise production
• Use of big data analytics combining operational data with IT for more effective analysis
• Use of augmented reality and virtual reality technologies in production processes, e.g. for employee training or design visualisation, for the purpose of increasing production efficiency and adapting to changing operational conditions
• Export growth—in 2022 in Poland the value of exports and intra-EU transfers of armaments and military equipment reached EUR 1,180 million, an increase of more than EUR 681 million over 2021 levels, according to a report issued in 2023 by the Ministry of Foreign Affairs. According to the same report, the top eight countries buying Polish defence products were Ukraine (e.g. for high-calibre artillery systems), the United States, Thailand, Brunei, Norway, Spain, Germany and Algeria. The most sought-after Polish armaments are those that have already proven themselves during the war in Ukraine.

Mobilisation for the defence industry

The difficulties revealed by the war in Ukraine and years of backlogs in the defence sector have raised the level of mobilisation, also on an international scale. The limits of this increased activity within the European Union are set by treaty provisions, as Art. 41(2) of the Treaty on European Union prohibits charging the EU budget for “expenditure arising from operations having military or defence implications and cases where the Council acting unanimously decides otherwise.” However, as the European Commission’s latest legislative initiatives described below show, a legal basis (although controversial) may be Art. 173(3) of the Treaty on the Functioning of the European Union, i.e. promoting the competitiveness of European industry, along with Art. 322 TFEU with regard to finances.

Considering the legal possibilities for supporting the defence industry, in light of Russia’s aggression against Ukraine, the Commission adopted the first-ever European Defence Industrial Strategy (EDIS). The objectives enshrined there are ambitious, as they assume that by 2030 the EU member states will:

• Procure at least 40% of defence equipment collaboratively
• Spend at least half of their defence procurement budget on products made in Europe (60% by 2035)
• Ensure that at least 35% of trade in defence-related goods takes place between EU states and not with other states.

The European Defence Industry Programme (EDIP), which has been presented in the form of a proposed regulation, is to be the method for implementing the EDIS. The main task of the EDIP is to ensure the readiness of the defence industry by transitioning from the short-term emergency measures adopted in 2023 and ending in 2025 (such as EDIRPA [the European Defence Industry Reinforcement through Common Procurement Act—Regulation (EU) 2023/2418] and ASAP [the Act in Support of Ammunition Production—Regulation (EU) 2023/1525]) to a more structural, long-term approach. Under the proposal, the EDIP will enter into force at the beginning of 2025 and remain in effect until the end of 2027 with regard to financial measures (with appropriations made from 2026 to 2033).

The means provided for in the budget in the amount of EUR 1.5 billion for the EDIP will be distributed mainly by the European Investment Bank and the European Investment Fund. Financial support for the defence industry sector will be provided in the form of grants, awards, public procurement and financial instruments (i.e. in one of the forms specified in Regulation (EU, Euroatom) 2018/1046), in operations combined with the InvestEU programme (a guarantee mechanism for financial institutions aimed at providing financing guarantees for high-risk investment projects).

The EDIP would facilitate access to financing for SMEs and small mid-caps involved in defence technologies and product manufacturing, through the dedicated Fund to Accelerate defence Supply chains Transformation (FAST). The fund will offer debt or equity financing to SMEs (including startups and scaleups) and small mid-caps across the EU which are struggling to access financing and which (i) industrialise defence technologies or manufacture defence products or have plans to do so, or (ii) are part of the defence industry supply chain or plan to become part of it in the near future.

EU funds to enhance security in the 2021–2027 perspective

The legislative procedures and formal arrangements mean that in practice the funds provided under the EDIP and FAST will be available in about a year’s time. In contrast, it is already possible to obtain EU funding in the 2021–2027 financial perspective for the security and defence sectors.

Funding for the security sector from the Internal Security Fund (ISF)

The ISF is an EU financial mechanism that supports security-related activities, with the objectives including:

• Preventing and combating terrorism and radicalisation, serious and organised crime and cybercrime, and assisting and protecting victims of crime
• Preparing for, protecting against and effectively managing security-related incidents, risk and crises.

The fund supports a broad range of actions, including:

• Procurement of information and communications technology systems and associated training and testing, as well as upgrading interoperability and data quality
• Monitoring implementation of EU law and policy objectives in member states in the area of security information systems
• Operations implementation, or facilitating implementation of the EU policy cycle (European Multidisciplinary Platform Against Criminal Threats—EMPACT)
• Support for thematic or cross-theme networks of specialised national units to improve mutual confidence, exchange and disseminate knowhow, information, experiences and best practices, and pool resources and expertise in joint centres of excellence
• Education and training for relevant law enforcement and judicial authorities and administrative agencies.

(The description here omits the Nuclear Decommissioning (Lithuania) programme, exclusively for Lithuania, and the Nuclear Safety and Decommissioning programme exclusively for Bulgaria and Slovakia.)

Currently, as part of the ISF, the following calls for proposals and invitations to tender for procurement procedures are now open on the EU’s Funding & Tenders Portal: 

• Three calls for proposals organised directly by the European Commission:
  • Projects dedicated to support efforts to fight corruption (deadline 26 September 2024)
  • Common operational partnerships to prevent and combat migrant smuggling, with competent authorities of third countries (deadline 4 September 2024)
  • Digital investigation projects (e.g. solutions to increase and enhance the reporting of cybercrime to law enforcement, increase the capacity of law enforcement or judicial authorities to investigate cyberattacks and cyber-enabled crime, or increase the capacity of law enforcement to support victims during investigations—deadline 5 September 2024).

These calls are open to a wide range of entities from the security sector, i.e. police, customs and other specialised law enforcement agencies (including national cybercrime units and anti-terrorism units). Proposals can also be submitted by local public bodies, NGOs, international organisations, trade unions, private and public-law companies, research institutes and universities.

• Four calls to suppliers to tender for specific goods or services (data as of 9 July 2024):
  • Provision of nuclear analysis services (deadline 23 August 2024)
  • Provision of general engineering support services (deadline 2 September 2024)
  • Provision of logistics services for transportation of any conventionally-sized package within Europe, from Europe to Japan and from Japan to Europe under the Broader Approach Agreement (deadline 6 September 2024)
  • Delivery of parts of nuclear reactor vessels (deadline 9 September 2024).

In Poland, the ISF is being implemented through the 2021–2027 Internal Security Fund Programme, and its budget is more than EUR 87 million, of which more than EU 70 million is contributed by the EU. The programme includes measures to raise the effectiveness of law enforcement agencies and other relevant institutions in countering and combating serious and organised crime with a cross-border dimension through the pursuit of three specific objectives:

• Information exchange (CS1) between various authorities and institutions
• Cross-border cooperation (CS2), supporting security cooperation between member states
• Countering and fighting crime (CS3).

Funding for the defence sector from the European Defence Fund (EDF)

Established in 2017, the European Defence Fund is a key initiative to boost competitiveness by encouraging joint research and development of defence capabilities, with a budget of EUR 8 billion, which in February 2024 was raised by EUR 1.5 billion in the mid-term review of the multiannual financial framework.

The results of the EDF calls for proposals for 2021, 2022 and 2023 show strong interest in this support. For example, in 2022, EUR 832 million was invested in 41 defence projects, with an average of 22 entities from nine EU member states and Norway participating in each project.

The Polish Ministry of Defence website lists the current calls launched for:

• Industry and science consortia (deadline 5 November 2024)
• Research projects (deadline 11 October 2024)
• Development projects (deadline 27 September 2024).

Applications should be submitted to the Department of Innovation at the Ministry of Defence, on forms available at the website. The objectives of the project must be consistent with the National Security Strategy of the Republic of Poland and the priority directions of scientific research at the Ministry of Defence in 2021–2035, and/or other strategic Polish, NATO and EU documents on security and defence.

The details regarding existing opportunities and conditions for applying for EDF support can be found in the informational materials for Polish scientific and research entities published by the Ministry of Defence in April 2024.

NATO Innovation Fund (NIF)

Unlike the European Union, NATO is not associated with providing financial support to companies. However, this changed with establishment of the NATO Innovation Fund, which aims to support companies from the defence sector. The NIF makes direct investments in science and technology startups located in any of 24 NATO countries, as well as indirect investments in deep tech with a transatlantic impact.

The NIF is a EUR 1 billion standalone venture capital fund supporting entities developing new and critical technologies in the areas of AI, biotech, energy, manufacturing, space, and quantum technology.

In June 2024, the NIF announced its first investments in the high-tech area, in four companies: ARX Robotics, Fractile AI, iCOMAT, and Space Forge. They offer innovative solutions in the fields of new materials and manufacturing, AI and robotics.

In July 2024, the NIF signed a memorandum of understanding with the European Investment Fund aimed at jointly providing financial support to SMEs and mid-caps in the defence and security sectors in Europe. Under this agreement, the NIF and the EIF, as part of the European Investment Bank Group, will seek to encourage private equity funds to invest in defence and security. This cooperation will include resolving difficulties arising in practice in the interpretation of investment criteria. This is because banks, other financial institutions, and private investors do not use the same criteria when taking decisions to invest in certain activities, including defence. This lack of a common understanding often leads to uncertainty and differences in treatment. The NIF’s cooperation with the EIF is also aimed at preparing new methods to channel resources to the defence industry.

Defence Equity Facility (DEF)

Another form of support for companies from the defence sector is the Defence Equity Facility, created at the beginning of 2024 by the European Commission and the European Investment Fund. Under the DEF, the EIF invests as a limited partner in private funds (such as VC/PE funds) whose investment strategies are targeted to European companies developing innovative defence technologies with potential for dual use (civilian and defence).

In 2024–2027, the DEF plans to invest EUR 175 million to stimulate the development of an ecosystem of private funds investing in defence innovation. This aim is ambitious, as it will mobilise some EUR 500 million in support for European companies. As a key investor, the EIF is expected to help attract additional investors.

The funds receiving DEF investments will be able to invest in SMEs (including startups), small mid-caps, special-purpose vehicles, joint ventures, spin-offs, spin-outs, technology transfer projects or technology rights.

As a condition for obtaining DEF support, the end users must have their registered office in a member state or Norway. Participation in such a venture will exclude acquisition of control over the participant by a third country or entities from a third country (although the control requirement may be waived if a guarantee is provided, based on the European Defence Fund Regulation—2021/697).

Challenges for entities from the security and defence sectors

Defence spending

NATO member states are guided by a defence spending target of 2% of gross domestic product, which was formalised at the 2014 NATO summit in Wales. In practice, NATO estimates that in 2023, 11 NATO countries reached this target, with another seven expected to reach it in 2024.

The EU member states participating in Permanent Structured Cooperation (PESCO) under Council Decision (CFSP) 2017/2315 also agreed to regularly increase their defence budgets as part of their PESCO commitments.

But despite these declarations, EU member states have not seriously increased their share of defence investments for years. According to a Joint Communication from the Commission in May 2022, if all member states had spent 2% of their GDP on defence (with 20% earmarked for investments) from 2006 to 2020, this would have yielded an additional EUR 1.1 trillion for defence, of which some EUR 270 billion would be spent on defence investments.

The procurement system

In the same joint communication, the European Commission and the High Representative of the Union for Foreign Affairs and Security Policy pointed out that severe underinvestment in defence has resulted in gaps in the EU’s defence industry and defence capabilities. This is exacerbated by the European defence industry’s reliance on the “built-to-order” principle—European defence contractors, especially for high-tech projects, avoid production without having pre-orders in place, due to the very high price of production. In practice, this means that for the defence industry to invest large amounts in production, solid, long-term orders are needed to make it economically feasible.

Shortcomings in the Defence Technological and Industrial Base

The EU’s Defence Technological and Industrial Base (EDTIB) is a key component of the defence industry strategy at the EU level. It encompasses a number of large multinationals, mid-caps, and more than 2,000 SMEs. The European Commission estimates its annual turnover at EUR 70 billion. While the EDTIB is dominated by companies based in France, Germany, Italy, Spain and Sweden, industry mapping shows that the prime manufacturers of the 46 most urgently needed items are located in 23 different member states.

Financing and bureaucracy

Development of new technologies and products in the defence sector requires significant financial outlays. Often companies need to find sources of funding, such as grants, loans or private investors. In practice, the European defence industry faces serious difficulties in accessing financing, especially private financing.

A survey by the European Commission shows that SMEs from the defence sector also face greater barriers to accessing financing than companies in other sectors. Based on investors’ experience, this results from such factors as:

• The complexity and length of procurement procedures in the defence sector significantly limiting the sense of market potential
• Sector-specific administrative procedures and requirements related to security, exports, certification and licensing, which entail higher costs
• Controls on foreign direct investment in conjunction with a limited investor market and an overly rigorous and cautious interpretation of environmental, social and governance criteria.

Consequently, in 2021–2022 two-thirds of the defence SMEs surveyed did not take advantage of equity financing, and almost half of them did not seek debt financing.

Although there are notable examples of VC/PE investors actively participating in the defence industry in France, Germany and Spain, this financing market in the EU is still relatively small compared to the US or the UK.

Conclusion

The main criticisms of initiatives to organise financial support for the defence and security sector at the international level are usually insufficient funds and unclear procedures. This is also the case with this year’s initiatives, i.e. the EDIS and the EDIP. All parties involved in these initiatives, including companies and administrators from member states, the EU and the US, dampen the Commission’s enthusiasm by pointing out that:

• The EUR 1.5 billion for the European investment programme should be considered only the beginning, in the face of actual, ongoing needs
• Financial as well as political support will be key, although the EDIS objectives of solving the major defence funding problem and emphasis on interoperability are promising
• The aim of achieving greater European defence autonomy is hampered or threatened by procedural, financial and implementation issues
• There are ongoing problems of jurisdiction in security and defence (the question is whether the member states will even consider allowing the Commission’s proposed role in the highly sensitive area of national security, which remains the sole prerogative of each member state).

In principle, the recent initiatives for additional financing of companies in the defence and security sector have been warmly welcomed internationally. The European Defence Industrial Strategy and the European Defence Industry Programme are regarded as an important contribution to strengthening Europe’s capacity to protect its citizens, territory, and core values. Their aims of increasing Europe’s defence readiness and developing Europe’s defence industry to achieve full readiness are crucial, but will require international (intra-EU) and transatlantic cooperation to promote the EU’s competitiveness and its ability to be an effective guarantor of security.

But in practice, time is now of the essence for all parties involved. To meet the short-term needs arising from the current geopolitical challenges for companies, clear procedures are necessary that will directly translate into rapid action and release of financing. In turn, new and existing companies in the defence and security sector also need operational certainty and a clear long-term perspective. This perspective will rest primarily with national governments and their readiness to raise defence spending, as the 2% of GDP target formalised 10 years ago at the NATO summit in Wales has already proved to be far too low, and will be completely out of step with reality in another decade.

Dr Anna Kulińska, Tax practice, Wardyński & Partners