How the Idea of Localization in Procurement Turned into an Unsolvable Problem

We all know that it is very difficult to solve an equation when there are multiple variables.  But the Cabinet of Ministers seems to think otherwise.

The idea of localization in Prozorro was promoted for almost a year and a half. Eventually, in December 2021, MPs approved this law — thus, the Law of Ukraine “On Public Procurement” was supplemented with a list of goods subject to localization and its minimal required percentage. Ultimately, this idea was formalized as the Procedure for Confirming the Degree of Localization of Production of Goods. It was published by the Cabinet last week.

In terms of the legislative bureaucracy, the process of introducing localization is complete. In terms of math and logic, we have an unsolvable problem on our hands.

When localization needs to be confirmed

According to the defined list of goods, the requirement of minimum localization applies to goods of the machine building industry: in particular, buses, freight transport, transformers, generators, rolling stock of railways, fire trucks, garbage trucks, helicopters, airplanes.

There will be a separate list of localized products for all these goods. It will be monitored and updated by the Ministry of Economy. Only goods from this list will be available for competitive public procurement.

Domestic manufacturers will apply to have their goods included into this list, along with calculations of the required degree of localization. This year it is set at 10%, but will gradually increase to 40%.

This rule will not apply to alternatives that are manufactured in countries with which we have signed trade agreements: The EU, the USA, the UK, Japan, South Korea, Canada and others.

That is, not all foreign manufacturers will be screened out, but only those to whom we do not have obligations in the field of free trade.

At this stage, it seems that there should not be any particular problems. Of course, apart from the fact that procuring entities will have to educate themselves on the thresholds and terms of agreements with various countries. But then the question arises as to how to confirm the localization.

Localization formula

While applying to be included into the list of localized goods, the manufacturer must submit the calculation of said localization.

It looks like a simple arithmetic ratio of the cost of imported components and the cost of the product. In addition, the calculation includes not only those components imported from abroad by the final manufacturer, but also imported parts used by manufacturers of individual parts of the product.

DL (degree of localization) = (Cost of important components for manufacturing of the product + cost of imported goods within parts purchased from domestic manufacturers) / Cost price of the product

In case of simple homogenous goods, like metal, flour, concrete, food products, it is generally possible to calculate localization based on this formula. But for complex engineering goods, it is almost impossible to check whether this calculation makes sense:

• The calculation includes the concept of cost price, which includes all production and administrative costs. Formally, your product can fully consist of imported parts, but you can always indicate a different figure of other expenses — depreciation, salaries, administrative expenses — and the result will be what you need it to be.
• Who guarantees that the supplier of individual product components will provide the manufacturer with reliable information about the cost of imported components, and whether this is not a violation of trade secrets?
• How is it possible to investigate the entire chain of co-manufacturers if the suppliers of parts have other suppliers of parts, and it goes on from the smallest components to the finished product?
• What to do if the manufacturer has several potential suppliers of components for this specific product, including foreign and domestic suppliers, or if there is a need to change the supplier at a certain point?
• Can depreciation of imported equipment be considered local costs in the cost structure?
• If parts from countries with whom we have trade agreements were used for production of the final product, are such goods considered localized?

All responsibility for the reliability of calculations rests with the product manufacturer. The Ministry of Economy will check the correctness of mathematical calculations and add the product to the list. Basically, what is checked is the formula itself, rather than whether the manufacturer indicated correct data. They are not required to file any documents confirming the calculations. Essentially, any information at all can be entered. In addition, the Ministry of Economy is supposed to monitor localization once per six months — this will be done with the use of Prozorro system data. That is, again, they will only be using documents and doing calculations — no confirmation needed.

In most cases, even supervisory bodies will not be able to check these calculations. If the manufacturer of goods produces more than one type of product, or has a complex network of suppliers, it is almost impossible to understand the import share in a particular product. There needs to be a big investigation with a bunch of cross-checking of different companies.

The complexity of this task is corroborated by the fact that back in the day, Ukrzaliznytsia (Ukrainian Railway) had to actually purchase services for calculation of the localization degree during the production of ТЕ33А locomotives under a contract with General Electric. At that time, according to the terms of the contract with the American manufacturer, 10% localization of production in Ukraine was foreseen. The auditing company PAT KPMG Audit had to evaluate the localization and produce an analysis based on its results. But there is no report on the execution of this contract, and there is no information how the audit ended.

More questions than answers

So, what is the result?

Procuring entities get a lot of additional work:

• write tender documentation for purchases with localization;
• figure out who can be admitted without localization and who cannot;
• publish the winner’s documents on the calculation of the actual localization together with the report on the execution of the contract.

And this is just what we can already predict.

Participants will be dependent on manufacturers. It is the manufacturers who will put data on their goods on the “localization list.” The winners will also obtain the documents on the actual localization calculations from them as well. And if the manufacturer does not provide these documents upon request? They can just as well provide them to one participant but not the other. There is a lot of space for manipulations and corruption here.

Can localization be calculated in engineering goods in the first place? Doing it once a year for all products is definitely unrealistic. On the other hand, if no one is actually validating the data, localization information can be filled out just formally, not necessarily truthfully.

Help or harm

We remind you that the Law on Localization is the one that made changes allegedly to create prerequisites for sustainable development and modernization of domestic industry.

Right now, it appears that localization is creating more problems during implementation than benefits. Ukrainian goods will continue to compete with foreign goods in most tenders, in particular for the most expensive contracts.

Manufacturers will receive certain benefits. They will be able to control who sells their goods to the state, issuing the necessary documents for tenders or refusing to do so.

However, it is not apparent how this will help to develop and modernize industry, particularly during the war.

And what about the American localization?

The Buy American Act and the Buy America Act do exist in the USA. However, they provide localization for relatively simple goods such as steel, cast iron, steel and cast iron components, and others.

Requirements of the Buy America Act:

The phrasing “must be American” or “US-made” should also be used with a caveat, since goods from countries with free trade agreements with the US are considered equivalent to American goods.

Also, localization in the US is not a mandatory requirement if there is no competition, or when the procuring entity believes that such a requirement leads to a significant overestimation of the cost of the purchase and is contrary to the public interest.

But it is worth noting that the US legislation is highly different from the EU legislation, and we are trying to integrate with the EU. All attempts at localization in the EU were unsuccessful and fell apart in European courts. EU legislation is more strict with the issue of limiting competition and free access to the market of participants from different countries.

Thus, if we need to harmonize Ukrainian legislation with the EU requirements, we will still have to come back to the issue of localization and, perhaps, it is better to cancel it now if it is not going to work anyway.

Ivan Lakhtionov, deputy executive director for implementation of innovative projects, Transparency International Ukraine

Volodymyr Datsenko, project manager, Transparency International Ukraine