Figure 1. Bank notes of the national currencies of ESA Member States
In October 1995, the ESA Council determined that as of 1 January 1997, ESA should implement an 'All ECU System' with the financial contributions from Member States, the Agency's budget and the contracts placed with industry all to be in European Currency Units (ECU). It was, however, decided to facilitate a smooth changeover by means of a transition period lasting from 1997 to 2000, during which existing contractual commitments in National Currencies (NC) will be phased out.
The ECU is a basket of currencies weighted approximately according to the European Union's (EU) Member States' relative share of the European Community's Gross National Product (GNP) and in intra-community trade.
In 1978, the Heads of State of the European Community decided to introduce a European Monetary System (EMS) with the ECU as its central element. The objective was to establish stability between the currencies of the EU's Member States and, ultimately, to facilitate the introduction of a single European currency, named the EURO, in 1995. The ECU is a precursor of the EURO.
The Maastricht Treaty determined that there would need to be a liberalisation of capital movements in the EU, a coordination of financial policies of Member States and an adherence to certain economic convergence criteria relating to a maximum permitted percentage of public debt, price stability, exchange rate stability and interest rate levels. Subject to meeting these criteria, all EU Member States would enter into European Monetary Union (EMU), with the possible exception of Denmark and the UK who negotiated an opt-out agreement should they choose not to join.
The introduction of a common currency is seen by many as an essential complement to the EU single market.
The European Commission's proposals regarding the changeover to the EURO are contained in its Green Paper 'Practical Arrangements for the Introduction of the Single Currency' which also details the advantages of a single currency, which include cost-savings in currency transactions. The EC estimates that the annual transaction costs relating to currency exchanges within the EU are around 25 billion ECU, or 0.4% of the EU's GNP. It cites the example that if one were to be given 1000 units of any EU Member State's currency and then proceed to visit every Member State, changing the currency at each border but not making any purchases, then one would be left with only 500 units at the end.
The present programme for EMU's introduction is stated in the Green Paper and can be summarised as follows :
In anticipation of the ESA Council decision which had been under discussion for some time, ESA has progressively been placing contracts in ECU, rather than in the NC of each contractor.
Although ESA has acquired substantial experience in placing contracts and sub-contracts in various currencies, the systematic and general use of the ECU constitutes a new challenge which requires the adaptation of a number of specific aspects of the ESA procurement procedure and the way contract prices are established and negotiated with industry.
It must be emphasised that in contrast to ESA's purely internal 'Accounting Unit' (AU), the ECU is a basket of currencies which is tradable and convertible, and which has a recognised value in financial markets. Contracts can consequently be formally and legally concluded in ECU, whereas this was not possible in Accounting Units.
Figure 1. Bank notes of the national currencies of ESA Member States
Using the ECU in industrial contracts is, however, not without its difficulties. One such complication is encountered by ESA contractors who generally incur cost in NC and, consequently, must deal with the ECU as a foreign currency. For pricing purposes the estimated cost in NC must be converted to the ECU in order to submit proposals. Once a contract is negotiated and placed, there is a subsequent time when the ECUs received by the contractor have to be converted into one or more NCs unless the receipts in ECU can be applied to settle some other commitment in ECU of the contractor concerned.
The procedure used for the conversion from NC to ECU and then from ECU back to NC has been a major topic for discussion and negotiation between ESA and its contractors, since the conversion can result in losses or in windfall gains, especially during times of financial turbulence. The aim of ESA in conceiving and developing conversion procedures is to minimise their impact. The most desirable result is that both the negative and positive effects are neutralised for all parties, without an excessive increase in administrative effort. In addition, the nature and extent of financial risk must be defined, the party which will assume it determined and the cost conditions ascertained.
The nature of ESA and its activities is such that there is an inherent and inevitable complexity in its operations which is not applicable to most other organisations. In the context of the introduction of the ECU, the following factors have to be considered:
ESA's preference is to place FFP contracts in ECU if satisfactory prices can be agreed, particularly for smaller contracts of relatively short duration. For such smaller contracts experience has shown that there is no great difficulty in negotiating FFPs. In some cases, FFPs have also been agreed for major programmes.
With all price types, including fixed prices, ESA has full transparency of the detailed estimated cost including the number of hours per labour category, the rates and overheads applied, details of non-labour costs, and the ECU conversion rate applied. The conversion rate and/or any possible provisions in the quoted price relating to exchange rate risks are then subject to assessment and negotiation in the same way as other elements of the price.
Traditionally, there has been a mixture of FPV, FFP and cost reimbursement with cost sharing arrangements for larger programmes of relatively long duration and high values. In a number of such contracts placed in ECU, ESA originally introduced currency adjustment mechanisms with respect to the exchange rates between NC and the ECU at various stages of the contract cycle. However, whilst by this means valuable experience was gained in dealing with large ECU contracts, and significant currency losses or gains were avoided, it was considered that this approach was not consistent with the long-term objectives of placing all contracts in ECU.
In line with ESA Council policy and with the development of a new overall approach for ESA major procurements, it was therefore decided to request total binding commitments in ECUs without such adjustment mechanisms in order to avoid constant uncertainty about the final prices of contracts.
Since it is based on a basket of currencies, the ECU is relatively stable and there is also a damping effect on changes in the exhange rate between the currencies included in the basket and the ECU itself. Furthermore, the fact that many of the currencies included in this basket are also participating in the CMS has an additional stabilising effect.
However, certain of the currencies which are in the ECU basket but outside the EMS have shown significant fluctuations against the ECU. Over the last year some traditionally weak currencies have considerably strengthened against the stronger currencies, reversing the general trend at least temporarily. Thus, whilst a few years ago the concept of fixed prices in ECU could be much more easily accepted by companies from countries with a currency having a tendency to depreciate vis à vis the ECU and less easily accepted by companies in countries with currencies having a tendency to strengthen against the ECU, the situation has become somewhat more complicated.
ESA has investigated this matter in some depth over the years in the context of a working group with industry coordinated through Eurospace, an ESA Council working group, discussions with experts from the European Commission, discussions with banks and other financial institutions, and bi-lateral discussions with contractors.
From the latter, it is evident that large international companies with treasury sections, which have had experience in dealing in foreign currencies, are often able to make satisfactory financial arrangements to protect against currency losses - at least for contracts of relatively short duration. However, this protection is more difficult and expensive to achieve for contracts of longer duration. It has also been noted that in a few cases, international companies find the ECU to be a convenient basis for financial accounting at the corporate level. It is also clear that the overall problem of dealing in ECUs will reduce as its use becomes more widespread, not least because in some cases companies will have financial commitments in ECU which can be met by receipts in ECU, thus avoiding the need for additional ECU/NC conversions.
Figure 2. Proposed EURO coins
Placing contracts in ECU has also raised certain specific issues for ESA some of which, though substantial progress has been made, are not yet fully resolved. These issues include:
Price comparisons
Price comparisons of competitive offers in ECU present no formal or practical problem. Clearly, in principle, industry from countries with a comparatively depreciated currency can present more attractive ECU prices. However, this is simply one element of the overall competition and, in the case of FFPs, not without risk since such a currency can regain comparative value while the contractor remains committed to its total price in ECU. The system is, however, still easier to manage than the previous one based on AU exchange rates.
Price variation formulae and indices
With reference to the more difficult problem of finding appropriate variation formulae and reference indices for price-variation formulae, ESA has initiated an activity with EUROSTAT* to express indices in ECU.
* EUROSTAT is the statistical service of the European Commission based in Luxemburg
As mentioned previously, ESA uses FPVs for most long-running major programmes. This means fixing the price at a defined economic baseline, subject to variation by the application of a price variation formula. Such formulae contain a fixed element not subject to change, a labour element and a material/non-labour element, the coefficients of each reflecting the estimated cost details making up the price.
Historically, ESA's budgets have been updated by applying the appropriate Wiesbaden statistics (as issued by the Wiesbaden Institute). Contract prices, including the target cost for cost-reimbursement with cost-sharing prices, have been updated by applying the appropriate national indices (as issued by various national statistical offices).
However, it is not logical to apply these national indices for prices expressed in ECU because they have a distorting effect. For example, if a country is experiencing a high rate of inflation it can be expected that this will be reflected in both the labour and non-labour indices. It can also be expected that over a period of time the high rate of inflation will have an impact on the exchange rate by weakening the currency. Thus, by applying the national indices as they stand, a company will benefit from a corresponding increase in the price in ECU and then benefit again when converting the ECU into a weakened NC. For companies in countries with low inflation, the reverse situation applies.
The solution would have been to use indices expressed in ECU, but the only official indices of this type in existence were those of consumer prices in Member States issued by EUROSTAT.
ESA therefore initiated discussions with EUROSTAT to investigate the possibility of preparing the indices in ECU. This was achieved without much difficulty. The main tasks involved were some software development, administrative support to obtain the base indices from the national statistical offices, and a final publication of the data.
Applying this method in updating ESA's budget is a relatively simple exercise. The data (comprising about 80 indices) is available electronically and the calculations are required only twice per year (in January for the sketch budget and in June for the budget exercise proper).
For contracts placed with industry, the exercise is much more time consuming. There are more than 200 separate indices which have to be obtained from the different statistical offices and the calculations have to be made and published each month.
Figure 3. The agreed symbol for the EURO
The 1997 ESA budget has been produced using the indices in ECU produced by EUROSTAT. The first publication of the contract indices was in February 1997 and they are now freely available through EMITS**. These indices, in ECU, can now be substituted for the national indices in price-variation formulae which will then be applied to the Milestone Payment Plan or to the Development Cost Plan (DCP). It is expected that these indices will be applied in all new contracts incorporating FPVs, this being considered to be a fair and logical approachfully consistent with ESA's established practices.
** EMITS = ESA's 'Electronic Mail Invitation to Tender System'
Cost reimbursement contracts
It is inevitable that costs will be incurred and monitored in NC. Thus whilst the limit of liability and the target cost will be expressed in ECU, the main points of issue are the means by which the recorded cost in NC is converted to ECU for the purpose of payment, and the method for updating the target cost for the purpose of comparison of total incurred cost against the updated target cost.
The intention with respect to payments is that the contractor will report costs incurred in NC on a monthly or quarterly basis, according to the contract requirements. These costs will be converted to ECU using a predetermined, provisional exchange rate specified in the contract. Payment will be claimed on this basis. Once the final costs in NC have been established (following an audit by ESA), the definitive amount to be reimbursed in ECU will be calculated by applying the monthly average spot rates for the ECU. The amounts derived will be compared to the amounts paid on a provisional basis and any necessary adjustments made.
The target cost in ECU will be updated in the same way as previously - by the addition of the agreed prices for 'class A' changes and by the application of a price variation formula, now incorporating indices in ECU, to the DCP.
Payments in ECU
ESA has given considerable attention to the general problem of delayed payments, especially for SMEs* and lower-level contractors. ESA has traditionally made direct payments to lower level contractors to avoid both exchange rate losses and to speed up the payment process. Given the hierarchy of contractors often found on major programmes, ESA's ETIS** system has made a major contribution in giving visibility on payment claims at all levels of the contractual hierarchy and accelerating payments.
* SME = Small and Medium-sized Enterprises
** ETIS = ESA's 'Tele-Invoicing System'
The removal of possible exchange rate losses to the Prime Contractor as a result of the introduction of the ECU facilitates a delegation to the Prime Contractor to make all payments to his consortium. However, to ensure timely payment, this would require prior agreement of the members of the industrial team on an appropriate internal payment procedure.
Figure 4. Some proposed EURO bank notes of different denominations
Notwithstanding the fact that it has as many as fourteen Member States, each with its own currency, ESA had found the means to be able to place contracts and subcontracts in each participant's NC, thus avoiding the risk of companies losing or gaining significant amounts due to currency fluctuations and without having to accept provisions in contractor prices to cover the risk of currency fluctuations.
Nevertheless, the fact of there being so many different currencies introduced additional complexity in major contracts, often involving the currencies of all Member States, and there was often the need for retroactive adjustments of Member States' contributions as a result of currency fluctuations.
Therefore, both as a European organisation and as a major procurement Agency, it was appropriate for ESA to move towards placing its contracts in ECU as other European Institutions are also doing.
Experience gained over the years in placing a number of contracts in ECU has provided valuable experience and highlighted the issues to be addressed. The presently proposed approach for different price types is considered to be both reasonable and practical.
Thus, when the time comes to make the transition from the ECU to the EURO, ESA should be well prepared and the overall process of placing contracts in EUROs will be more straightforward.
ESA Bulletin Nr. 91