National Shipbuilding Procurement Strategy technical briefing (January 16, 2015)

Ladies and Gentlemen,

Good day.

Rear admiral Pat Finn, Kevin McCoy and I are pleased to be here today to provide you with an update on the implementation of the National Shipbuilding Procurement Strategy. As you know, we have provided you with regular updates at key milestones of the program.

Today, we are pleased to inform you that we have reached agreement with Irving Shipbuilding on the build contract for the Arctic Offshore Patrol Ships (AOPS). This is a significant milestone. Our briefing this morning will therefore focus on the AOPS build contract.

Before we get to the AOPS, let me do a quick run through on a few of the other elements of the program. I'll start with the shipyard transformations and modernizations. These have been remarkable.

Over the last three years, Vancouver Shipyards and Irving Shipbuilding have planned, demolished, reconfigured and rebuilt their yards so that they could construct Canada's large vessels efficiently.

Vancouver completed its $170 million transformation a few months ago, ahead of schedule. Irving will complete its $340 million modernization this year, on schedule. It is important to reiterate that these renovations are at zero cost to Canada.

These major reconfigurations had to be completed before any build activities could take place; they are a condition of the selection of the yards to build Canada's fleets; and the state of readiness and completion will be validated by First Marine International, our independent third party expert on shipbuilding.

As a result, both the combat and the non-combat packages will begin vessel construction this year. In fact, construction of the two initial blocks for the Canadian Coast Guard's Offshore Fisheries Science Vessels began last October in Vancouver.

We are moving forward on the build contract for the Offshore Fisheries Science Vessels and on purchasing long lead items for the Joint Support Ships.

Each of the ships in the National Shipbuilding Procurement Strategy (NSPS) program is advanced through a design-then-build approach which we've briefed you on previously. The design-then-build approach allows for the exercise of design-cost trade-offs to ensure affordability, while ensuring delivery of the Navy's and the Coast Guard's requirements and capabilities.

More to the point, getting this approach right is key to addressing the questions of cost, capability and schedule that seem to get asked most often in relation to AOPS.

I will address each of these in turn in relation to the AOPS build contract. The initial AOPS design was provided to Irving Shipbuilding in June 2012. Since then, the shipyard has been maturing the design through multiple reviews. The shipyard is now at the final stages of completing the design process and moving to a build-ready state.

Throughout the design-cost-capability reviews, construction estimates are refined until substantive costs are provided. These are not based on benchmarks from other countries or computer estimates or parametric models. This is a costing model that is informed by data directly related to the shipyard, the ship and its capabilities. It includes five elements:

1. A three dimensional model that provides a full understanding of the design and construction elements—and Kevin will demonstrate a sample of that modeling in his presentation
2. A supply chain established by the shipyard where the major equipment has been selected through competitive processes
3. A design that has been reviewed, scrutinized, refined and costed for both labour and material
4. A number of detailed reviews by the Government of Canada and the shipyard to ensure risk elements are known, assessed and mitigated
5. And finally, review and validation by an independent third party—the American Bureau of Shipping—which included a review of costs

The design-then-build approach also includes construction of the first sections of the vessels, known as initial blocks or production test modules. The shipyard will test its new infrastructure, environment and production processes with these initial blocks.

As the design work progressed, we negotiated the build contract. For the last 14 months, we have been working with Irving Shipbuilding to structure an innovative incentive-based build contract. We started the contract negotiations from a principles perspective. We identified risk elements such as the liabilities and warranties, and discussed ways to ensure that the funds expended would be maximized on ships as opposed to contingencies for "what-ifs".

From there, we focused on interest-based negotiations, the "why" behind each of the cost elements. The end result is in the best interest of Canadian taxpayers and the shipyard as both parties will focus on the efficient management of the contract so as to deliver cost savings to the Crown while ensuring the Navy receives the ships it requires.

As an example, it is in Irving's best interest to keep costs down so as to receive an increased fee based upon our negotiated incentivized fee structure.

Concurrent to these discussions, we conducted cost and profit discussions with the focus on cost containment and value for money.

The culmination of these efforts is a contract that delivers the Arctic Offshore Patrol Ships that the Royal Canadian Navy requires within a contract that provides best value for taxpayers.

The AOPS is a new design and a new class of ship, being built in a brand new shipyard. These factors bring risks with them.

As for any complex program, the challenge is to find the appropriate balance between risk and cost certainty.

The contract with Irving Shipbuilding is for six ships. It is structured to include incentives to keep costs down and to deliver six ships, within a ceiling price. Should costs increase, due to unforeseen factors, the contract will guarantee the delivery of five ships within the same ceiling price.

However, building five ships will negatively impact the shipyard as the incentives to build six ships turn into significant disincentives if only five ships are built.

The AOPS contract is a Cost Reimbursable Incentive Fee or CRIF based contract. This assigns risk-sharing of some key elements, such as liabilities and warranties, to either the shipyard or the Crown, whichever is better equipped to manage it. It also includes contingencies for fluctuations in exchange rates, inflation and labour rates.

The President of Irving Shipbuilding, Mr. Kevin McCoy, will speak to the contract incentives, and the strategies the shipyard has put in place with regard to the number of ships to be built in just a few minutes.

The total potential value of the build contract is $2.3 billion.

The original AOPS budget of $3.1 billion was established in 2007. This included acquisition costs such as ship design and construction, infrastructure costs (jetties), spares, logistics, project office operations and contingencies. As the Auditor General noted in his report, and the government acknowledged, a number of factors such as cost-of-living and exchange rates will impact budgets that are set far in advance. Generally, these factors affect the amounts set aside for contingencies. And that is the case for the AOPS project.

As a result, the overall AOPS project budget was recently increased to $3.5 billion, to re-establish an appropriate contingency. This additional funding comes from DND's existing accrual envelope and does not affect other DND acquisitions or operational activities.

Capability

While a design-then-build approach with several design reviews allows for cost capability trade-offs, no major capability reductions were identified during the design process. Let me repeat that: no major capability reductions were identified during the design process. Admiral Finn will provide additional details on the capability issues in a moment.

Schedule

When the shipyard selection process was completed in 2011, we established a schedule to begin the AOPS construction in 2015. And I am pleased to say that the construction of an initial block will commence this summer, and full production will begin in September, as planned and scheduled after the shipyard selection process. This will see delivery of the first AOPS vessel in 2018 and a further vessel approximately every 9 months thereafter.

I will now ask Admiral Finn to speak to how the AOPS vessels meet the Navy’s requirements.

Pat Finn: Thank you Tom. As designed, the new class of ships, now called the Harry DeWolf class, will meet the requirements of the Canadian Armed Forces. These ships are capable of operating in the Arctic, providing a greater presence in the north and an operational capability further into the season. The NSPS has enabled an approach that allowed us to complete a rigorous design review. It also provides insight into the implications of various requirements. This has resulted in some changes to the ship design, none of which have resulted in the elimination of major capability or affected the ability to meet all operational requirements.

Examples of the changes include lengthening the ship to make it simpler to produce and simplification of some of the communications systems.

Through our design-then-build approach we have reviewed, refined, and matured the AOPS ship design to get all the production details right, factor in the potential risks, and finalize costs.

Our cost estimates are informed by real data, real prices, and real quotes from industry.

The Parliamentary Budget Officer's report was based on a parametric model of the AOPS ship that utilizes high-level technical and performance parameters such as displacement and speed as primary inputs.

Parametric modelling is typically used during the very early stages of a project when critical design details are not known. As such, parametric models are subject to a wide range of uncertainty.

It is for these reasons that we are confident in the delivery of six ships as opposed to the PBO estimate that there would still only be a 50% probability of getting six ships after a budgetary increase.

Importantly for Canadians, AOPS will better enable the Navy to assert and enforce sovereignty in Canadian waters, including in the Arctic. The ships are fundamentally designed to meet the Canadian Armed Forces requirements.

I will now turn the floor over to Kevin McCoy who will speak to the measures taken by the shipyard that will drive the shipyard's production and number of ships.

Kevin McCoy: With this contract, Irving is planning to build six ships. We are heavily incentivized to do so and we expect to deliver six ships for the Royal Canadian Navy.

As Tom mentioned, this is a new design and class of military ship that will be constructed in a brand new shipyard. These things bring risks with them—that is a fact of life.

What we have done here is try to understand and manage these risks and provide for what will happen if they occur.

The AOPS contract is a balanced and fair contract, with appropriate levels of risk being taken by all parties.

In the event that risks materialize and increase costs, there is a pre-agreed mechanism to deal with them in a simple, well understood way.

Around the world the best performing shipbuilding programs are those where the design of the ship is complete before construction begins.

The rigorous approach laid out by Canada to fully design the ship before cutting first steel—maximizes production efficiency and reduces overall program risk.

Canada and Irving are working closely together to avoid these risks; the best example being the design-then-build approach being taken. Let me show you a few images of what the 3D model looks like.

The contract is innovative, well thought out, appropriate and balanced. It ensures an effective partnership and collaboration between the Government of Canada and Irving Shipbuilding.

It will also create jobs. We estimate that over 1,000 jobs will be sustained at the yard at the peak of construction. We will also be generating work across Canada. To date, even before we start construction on the AOPS, Irving Shipbuilding has issued contracts worth $331 million to suppliers across Canada.

Tom Ring: As Mr. McCoy just emphasized, we are expecting that the cost reimbursable incentive fee-based contract creates the right incentives for the shipyard to construct six AOPS vessels.

In conclusion, we are pleased that the men and women of the Navy and Coast Guard will get the equipment they need to do the important work we ask of them.

As stated by the Auditor General, the National Shipbuilding Procurement Strategy is well managed and will help the Government of Canada to procure ships in a "timely and affordable manner".

In addition, the Canadian economy is benefiting, and will continue to benefit from this strategy. This is a 30-year program that is creating an estimated 15,000 jobs across Canada and generating over $2 billion a year in economic benefits.

To date, 197 companies in Canada have already benefited from NSPS work.

We are available to take your questions.