Defense Infrastructure
Management Issue Requiring Attention in Utility Privatization Gao ID: GAO-05-433 May 12, 2005Department of Defense (DOD) installations have about 2,600 electric, water, wastewater, and natural gas utility systems valued at about $50 billion. In 1997, DOD decided that utility privatization was the preferred method for improving utility systems and services and the Congress approved legislative authority for privatizing utility systems at military installations with Public Law No. 105-85. Because of the costs and long-term implications of DOD's utility privatization program, GAO reviewed the program to determine (1) the program's status, (2) whether the services' estimates of long-term savings from utility privatization projects are reliable, (3) how DOD implements the fair market value requirement for conveyed utility systems, and (4) whether other issues impact the effectiveness of DOD's execution of the program.
DOD's progress in implementing the utility privatization program has been slower than expected, largely because of the complexities of the solicitation and contracting processes. In 1997, DOD initially expected that the services would privatize or exempt all utility systems by January 2000. Yet, after spending about $248 million on program implementation, the services had privatized only 94 systems and exempted 311 systems of the 1,499 utility systems determined to be available for privatization as of December 31, 2004. Although DOD reset implementation target dates and established September 2005 as the current goal for the services to make decisions to privatize or exempt all systems, DOD officials stated that it was unlikely that the services would meet the revised goal. Utility privatization can provide for quicker system improvements than otherwise might be available; however, there are questions about program savings. Although the services' economic analyses estimate that utility systems privatized to date will reduce the government's costs for utility services, GAO questions the estimates because they give an unrealistic sense of savings to a program that increases ongoing government utility costs in order to pay contractors for enhanced utility services and capital improvements. Other base support services could suffer unless budgets are adjusted to reflect these increased costs. Moreover, GAO found that long-term cost comparisons did not depict actual expected costs of continued government ownership in the event that systems were not privatized and DOD had not taken steps to ensure that the estimates were otherwise reliable. As a result, GAO found in the seven cases it reviewed that the services' analyses included inaccuracies that tended to favor the privatization option over continued government ownership. Although the services are permitted latitude in ensuring that the government receives fair market value for systems conveyed to privatization contractors, in some cases implementation has resulted in higher contract costs for utility services. Contractors normally include the full amounts they paid for conveyances in the associated utility services contracts and, therefore, the government will pay back the amounts received over time. In some cases, contractors also include additional amounts in the contracts to cover costs associated with the fair market value payment. Thus, implementing the fair market value requirement in such cases results in higher contract costs because the government will pay back more than it will receive for conveying the systems. Two additional issues of concern identified by GAO related to limited oversight of privatization contracts and DOD's preferred practice of permanently conveying utility systems to contractors rather than using more limited arrangements which, according to DOD consultant reports, is a more prevalent private sector practice and one which may offer greater safeguards to the government.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director: Team: Phone:GAO-05-433, Defense Infrastructure: Management Issue Requiring Attention in Utility Privatization
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Report to the Subcommittee on Readiness, Committee on Armed Services,
House of Representatives:
May 2005:
Defense Infrastructure:
Management Issues Requiring Attention in Utility Privatization:
GAO-05-433:
GAO Highlights:
Highlights of GAO-05-433, a report to the Subcommittee on Readiness,
Committee on Armed Services, House of Representatives:
Why GAO Did This Study:
Department of Defense (DOD) installations have about 2,600 electric,
water, wastewater, and natural gas utility systems valued at about $50
billion. In 1997, DOD decided that utility privatization was the
preferred method for improving utility systems and services and the
Congress approved legislative authority for privatizing utility systems
at military installations with Public Law No. 105-85.
Because of the costs and long-term implications of DOD‘s utility
privatization program, GAO reviewed the program to determine (1) the
program‘s status, (2) whether the services‘ estimates of long-term
savings from utility privatization projects are reliable, (3) how DOD
implements the fair market value requirement for conveyed utility
systems, and (4) whether other issues impact the effectiveness of DOD‘s
execution of the program.
What GAO Found:
DOD‘s progress in implementing the utility privatization program has
been slower than expected, largely because of the complexities of the
solicitation and contracting processes. In 1997, DOD initially expected
that the services would privatize or exempt all utility systems by
January 2000. Yet, after spending about $248 million on program
implementation, the services had privatized only 94 systems and
exempted 311 systems of the 1,499 utility systems determined to be
available for privatization as of December 31, 2004. Although DOD reset
implementation target dates and established September 2005 as the
current goal for the services to make decisions to privatize or exempt
all systems, DOD officials stated that it was unlikely that the
services would meet the revised goal.
Utility privatization can provide for quicker system improvements than
otherwise might be available; however, there are questions about
program savings. Although the services‘ economic analyses estimate that
utility systems privatized to date will reduce the government‘s costs
for utility services, GAO questions the estimates because they give an
unrealistic sense of savings to a program that increases ongoing
government utility costs in order to pay contractors for enhanced
utility services and capital improvements. Other base support services
could suffer unless budgets are adjusted to reflect these increased
costs. Moreover, GAO found that long-term cost comparisons did not
depict actual expected costs of continued government ownership in the
event that systems were not privatized and DOD had not taken steps to
ensure that the estimates were otherwise reliable. As a result, GAO
found in the seven cases it reviewed that the services‘ analyses
included inaccuracies that tended to favor the privatization option
over continued government ownership.
Although the services are permitted latitude in ensuring that the
government receives fair market value for systems conveyed to
privatization contractors, in some cases implementation has resulted in
higher contract costs for utility services. Contractors normally
include the full amounts they paid for conveyances in the associated
utility services contracts and, therefore, the government will pay back
the amounts received over time. In some cases, contractors also include
additional amounts in the contracts to cover costs associated with the
fair market value payment. Thus, implementing the fair market value
requirement in such cases results in higher contract costs because the
government will pay back more than it will receive for conveying the
systems.
Two additional issues of concern identified by GAO related to limited
oversight of privatization contracts and DOD‘s preferred practice of
permanently conveying utility systems to contractors rather than using
more limited arrangements which, according to DOD consultant reports,
is a more prevalent private sector practice and one which may offer
greater safeguards to the government.
What GAO Recommends:
GAO recommends that DOD take several actions designed to help ensure
the reliability of the economic analyses for proposed utility
privatization projects and improve the guidance and procedures used to
implement and oversee the utility privatization program. DOD did not
agree with the recommendations. GAO believes its recommendations
continue to have merit.
www.gao.gov/cgi-bin/getrpt?GAO-05-433.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Barry W. Holman at (202)
512-5581 or holmanb@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Utility Privatization Implementation Has Been Slower Than Expected:
The Services' Savings Estimates from Utility Privatization Are
Questionable:
Implementation of the Fair Market Value Requirement Can Result in
Higher Contract Costs:
DOD's Execution of the Utility Privatization Program Raises Other
Concerns:
Conclusions:
Recommendations for Executive Action:
Matter for Congressional Consideration:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Scope and Methodology:
Appendix II: Results of GAO's Review of the Services' Economic Analyses
Supporting Seven Utility Privatization Projects:
Appendix III: Comments from the Department of Defense:
Tables:
Table 1: Status of the Utility Privatization Program as of December 31,
2004:
Table 2: Percentage of Systems with Privatization or Exemption
Decision:
Table 3: Implementation Costs for the Utility Privatization Program:
Table 4: Selected Information from Economic Analyses Supporting Utility
Privatization Projects:
Table 5: Amounts to Be Received for Utility System Conveyances for
Projects Reviewed:
Abbreviations:
DOD: Department of Defense:
GSA: General Services Administration:
Letter May 12, 2005:
The Honorable Joel Hefley:
Chairman:
The Honorable Solomon P. Ortiz:
Ranking Member:
Subcommittee on Readiness:
Committee on Armed Services:
House of Representatives:
Department of Defense (DOD) installations have about 2,600 electric,
water, wastewater, and natural gas utility systems valued at about $50
billion. These systems consist of the equipment, fixtures, pipes,
wires, and other structures used in the distribution of electric power
and natural gas, the treatment and distribution of water, and the
collection and treatment of wastewater. According to DOD officials,
many of these systems have become unreliable and in need of major
improvements due to inadequate funding caused by the competition for
funds and DOD's risk management and budget allocation decisions. To
address this issue, DOD decided in 1997 that utility privatization was
the preferred method for improving utility systems and services because
privatization would allow installations to benefit from private sector
financing and efficiencies. With private sector financing,
installations could immediately obtain major upgrades to their utility
systems and pay for these improvements over time. Thus, utility
improvements could be achieved without going through the traditional
military construction budget justification and funding process. Under
DOD's program, utility privatization normally involves two transactions
with the successful contractor--the conveyance of the utility system
infrastructure and the acquisition of utility services for upgrades,
operations, and maintenance under a long-term contract of up to 50
years. DOD estimates that some privatization contracts will cost more
than a hundred million dollars over the contract time frames.
To institute the program at DOD's request, the Congress approved
legislative authority in 1997 for privatizing utility systems at
military installations.[Footnote 1] The authority requires that the
military services meet a number of conditions to privatize a system
including, in part, the following two conditions. First, the services
must demonstrate through an economic analysis that privatization of a
system would reduce the government's long-term costs for utility
services. Second, the services must receive as consideration for
conveying a system an amount equal to the system's fair market
value.[Footnote 2] DOD's program guidance permits the services to
exempt systems from privatization when long-term costs will not be
reduced or for unique security reasons.
In view of these requirements and because of the program's costs and
long-term implications, this report, undertaken pursuant to the
Comptroller General's legislative authorities, determines (1) the
program's status, (2) whether the services' estimates of savings from
utility privatization projects are reliable, (3) how DOD implements the
fair market value requirement for conveyed utility systems, and (4)
whether other issues impact the effectiveness of DOD's execution of the
program. As discussed with your offices, we are addressing the report
to you because of your expressed interest related to your committee's
oversight responsibilities.
To address these questions, we summarized program implementation status
and costs, compared the status to DOD's goals and milestones, and
discussed issues affecting program implementation, such as accounting
for contract termination liabilities. We relied on program status data
provided by the services, confirmed the status data for seven projects,
but did not otherwise test the reliability of the data. We examined
DOD's guidance and methods for performing and reviewing the economic
analyses used to determine whether privatization will reduce the
government's long-term costs and for determining the fair market value
of the systems to be conveyed. We reviewed the economic analyses for
seven projects regarded by DOD as privatization successes to examine
the basis for the estimates and the assumptions used, evaluate
consistency and reliability, and assess the amounts received as
consideration for the conveyances. Finally, we reviewed DOD and service
guidance for utility privatization contract administration, discussed
contract oversight with officials at five installations, and reviewed
information from DOD officials and consultant reports on how DOD's
approach to utility privatization compares with private sector
practices. We conducted our work from July 2004 through March 2005 in
accordance with generally accepted government auditing standards. A
more detailed description of our scope and methodology is included in
appendix I.
Results in Brief:
Although initial goals were aggressive, DOD's actual progress in
implementing the utility privatization program has been slower than
expected. In 1997, DOD initially expected that the services would
privatize or exempt all utility systems by January 2000. Yet, after
spending about $248 million on program implementation, the services had
privatized only 94 systems and exempted 311 systems of the 1,499
utility systems determined to be available for privatization as of
December 31, 2004. Although DOD reset implementation target dates and
established September 2005 as the current goal for the services to make
decisions to privatize or exempt all systems, DOD officials stated that
it was unlikely that the services would meet the revised goal.
According to DOD and service program officials, program implementation
has been slower than expected primarily because the privatization
evaluation, solicitation, and contracting processes were more complex
and time consuming than originally anticipated. Moreover, an issue
surfaced in October 2004 that further slowed the program by placing
pending contract awards on hold for several months while the matter was
evaluated. This issue concerned whether the services were required at
the time of contract signing to obligate sufficient funds to pay a
privatization contractor for costs that had not been recovered under a
contract to date in the event of a future contract termination.
According to service officials, if required, the amounts needed could
be large enough to make many proposed utility privatization projects
financially unfeasible. The DOD Office of General Counsel evaluated the
issue and concluded in February 2005 that the services were not
required to obligate sufficient funds to cover contract termination
liability under the utility privatization program. We agree that
defense services are not required to record obligations for potential
termination liabilities under that authority, unless and until they
decide to terminate.
Although the services' economic analyses estimate that utility systems
privatized to date will reduce the government's costs for utility
services, we found that the estimates give an unrealistic sense of
savings to a program that generally increases government utility costs
in order to pay contractors for enhanced utility services and capital
improvements. DOD's funding obligations will likely increase faster
than they would under continued government ownership as it pays over
time for utility system improvements obtained from private sector
financing. Air Force officials estimated that the Air Force's costs
alone could increase between $100 million and $200 million annually for
the first 5 to 10 years of privatization. Various service officials
expressed concern that unless funding for operation and maintenance
accounts are adjusted to reflect this increase, other support functions
on military bases could suffer as funds are shifted to cover "must pay"
privatized utility costs. Moreover, we found that the services' long-
term savings estimates, required to be developed to support
privatization decisions, were questionable because the estimates did
not depict actual expected costs of continued government ownership in
the event that systems were not privatized and DOD had not taken steps
to ensure that the estimates were otherwise reliable. First, to
determine whether a proposed privatization contract would meet the
statutory requirement for reduced long-term costs, each service
followed DOD guidance and compared the long-term estimated costs of the
contract with the estimated long-term "should costs" of continued
government ownership assuming that the service would upgrade, operate,
and maintain the system in accordance with accepted industry standards
as called for in the proposed contract. This estimating method would be
appropriate if, in the event the system is not privatized, the service
proceeded to upgrade, operate, and maintain the system as called for in
the estimate. However, this generally is not the case. According to DOD
and service officials, if a system is not privatized, then the
anticipated system improvements would probably be delayed because of
DOD's budget allocation decisions, which have limited funds for utility
improvements. Because of the time value of money, a future expense of a
given amount is equivalent to a smaller amount in today's dollars. As a
result, delaying system improvements to future years would reduce the
estimated cost of the government ownership option in today's dollars
and, therefore, affect the results of the economic analyses. At the
same time, it must be recognized that delays in system improvements
could increase government costs due to increased maintenance and
possible changes in system reliability in the long term. Thus, if
reduced costs to the government are expected to be a key factor in
utility privatization decision making, then it would appear more
appropriate for the services to compare the cost of a proposed
privatization contract with the cost of continued government ownership
on the basis of the actual planned expenditures and timing of these
expenditures, with appropriate consideration to the impact of delayed
improvements. Second, largely because DOD does not require that the
services' economic analyses be subjected to an independent review for
accuracy and compliance with guidance, we found in the seven cases we
reviewed that the services' analyses included inaccuracies which tended
to favor the privatization option over continued government ownership.
Although the services are permitted latitude in ensuring that the
government receives fair market value for systems conveyed to
privatization contractors, in some cases implementation has resulted in
higher contract costs for utility services. Guidance and practices for
determining fair market value varied among the services, with Army
guidance stating that fair market value for system conveyances could
range from zero to full replacement cost of the system. For example,
the Army privatized one installation's water distribution system,
consisting of a reservoir, four water towers, and pipelines, and
according to the economic analysis received no consideration from the
contractor for the conveyance. Army officials stated that determining
fair market value was subjective and determined in part by the amounts
contractors were willing to pay. In some cases, the officials stated
that the most beneficial business case was to convey systems at less
than estimated fair market value. Also, although it is a reasonable
concept that the government should receive consideration if an asset is
conveyed to a contractor, the receipt of consideration for conveyances
in the utility privatization program does not typically result in a net
financial payment to the government. To recover their costs,
privatization contractors normally include the full amounts they paid
for conveyances in the associated utility services contracts and,
therefore, the government will pay back the amounts received for the
conveyances in the utility services bills over time. Beyond that, in
some cases, contractors include additional amounts in the utility
services bills to cover the contractors' costs associated with the fair
market value payments. Implementing the fair market value requirement
in such cases will result in increased costs because the government
will pay back more than it will receive for the conveyances. For
example, the economic analysis for the electric distribution system
privatization at Dobbins Air Reserve Base showed that the contractor
will pay $741,000 as the fair market value for the conveyance. The
analysis also showed that the contractor will recover this cost, plus
other associated costs, by charging the Air Force $1,322,000 in the
utilities services bills over time. Thus, implementing the fair market
value requirement in this case will result in the Air Force paying
about $581,000, or 78 percent, more than it will receive for the
conveyance.
In examining DOD's execution of the utility privatization program, we
identified two other areas of concern that could affect program
effectiveness. First, the adequacy of privatization contract oversight
was a concern. Although they intend to do so, the services have not
issued specific contract administration guidance for the program since
it began over 7 years ago. Officials at one installation we visited
stated that they were performing limited oversight because they lacked
sufficient guidance and had not been funded for people to oversee
contractor performance. Also, in its reviews of four utility
privatization contracts, the Army Audit Agency reported that contractor
performance was not adequately monitored and, as a result, there was
little assurance that the installations would receive quality products
and services. Second, according to DOD consultant reports, DOD's
approach to utility privatization differs from typical private sector
practices in that private sector companies may outsource system
operations and maintenance but normally retain system ownership. As a
result, the consultant reports note that DOD's preferred approach of
permanently conveying utility system ownership to contractors may give
the contractor an advantage when negotiating service contract changes
or renewals. This occurs because DOD must deal with the contractor or
pay significant amounts to construct a new utility distribution system
to replace the one conveyed to the contractor, attempt to purchase the
system back from the contractor, or institute legal action to reacquire
the system through condemnation proceedings.
We are making recommendations to help ensure the reliability of the
economic analyses for proposed utility privatization projects and to
improve the guidance and procedures used to implement and oversee the
utility privatization program. In commenting on a draft of this report,
DOD disagreed with our recommendations, characterized our findings as
being outdated and not well founded, and suggested that our report
represented an unwarranted characterization of issues we identified as
being systemic to the program. We believe that our review of the
utility privatization program was objective, balanced, and represented
program conditions existing at the time we completed our review in
March 2005. We disagree with DOD's contention that our findings were
outdated. Of the seven utility privatization projects we reviewed in
detail, the associated contracts for four projects were awarded in
2004, and the contracts for two projects were awarded in 2003.
Additionally, the issues we identified and recommendations we made are
current regardless of the case studies. We remain confident that both
our conclusions and recommendations are soundly based upon the findings
discussed in this report. We address DOD's comments in detail later in
the report. Because of DOD's response to the report, we have added a
matter for congressional consideration.
Background:
At DOD's request, the Congress approved legislative authority in 1997
for privatizing utility systems at military installations.[Footnote 3]
In defining a utility system, the authority included systems for the
generation and supply of electric power; the treatment or supply of
water; the collection or treatment of wastewater; the generation or
supply of steam, hot water, and chilled water; the supply of natural
gas; and the transmission of telecommunications. Included in a utility
system are the associated equipment, fixtures, structures, and other
improvements as well as real property, easements, and rights-of-way.
The authority stated that the Secretary of a military department may
convey a utility system to a municipal, private, regional, district, or
cooperative utility company or other entity and the conveyance may
consist of all right, title, and interest of the United States in the
utility system or such lesser estate as the Secretary considers
appropriate to serve the interests of the United States.
Among other things, the current authority also includes two
requirements for utility privatization. First, the Secretary shall
submit reports to the congressional defense committees on the
conveyances made under the authority each quarter. Previously, the
statute required DOD to submit the report and wait 21 days before
allowing a conveyance.[Footnote 4] For each such conveyance, the report
is to include an economic analysis, based on acceptable life-cycle
costing procedures, demonstrating that (1) the long-term economic
benefit of the conveyance to the United States exceeds the long-term
economic cost of the conveyance to the United States, and (2) the
conveyance will reduce the long-term costs of the United States for
utility services provided by the utility system concerned. Second, the
Secretary shall require as consideration for a conveyance an amount
equal to the fair market value, as determined by the Secretary, of the
right, title, or interest of the United States conveyed. The
consideration may take the form of a lump sum payment or a reduction in
charges for utility services.
Before and after approval of the specific authority for privatizing
utilities, the services have used other authorities for utility
privatization. For example, the Army had privatized some systems after
obtaining congressional authority on each specific case. Also, the
services have privatized systems by modifications to natural gas
services agreements administered by the General Services Administration
and by conveyances of some systems on the basis of authorities related
to base realignment and closure and the military housing privatization
program.
DOD Made Utility Privatization a DOD Policy:
In December 1997, DOD issued Defense Reform Initiative Directive Number
9, which made utility system privatization a DOD policy.[Footnote 5]
The directive instructed the military departments to develop a plan
that would result in privatizing all installation electric, natural
gas, water, and wastewater utility systems by January 1, 2000, unless
exempted for unique security reasons or if privatization would be
uneconomical. Under the program, privatization normally involves two
transactions with the successful contractor--the conveyance of the
utility system infrastructure and the acquisition of utility services
for upgrades, operations, and maintenance under a long-term contract of
up to 50 years. Normally, the conveyances do not include title to the
land underlying the utility system infrastructures.
A year later, in December 1998, DOD issued another directive to
establish program management and oversight responsibilities and provide
guidance for performing economic analyses for proposed projects,
exempting systems from the program, and using competitive procedures to
conduct the program.[Footnote 6] The directive also stated that the
objective was for DOD to get out of the business of owning, managing,
and operating utility systems by privatizing them and that exemptions
from privatization should be rare. The directive reset the
privatization implementation goal to September 30, 2003.
Implementation Goals Reset and Program Guidance Revised:
In October 2002, DOD issued revised program guidance and again reset
implementation goals.[Footnote 7] The guidance noted DOD's contention
that many installation utility systems had become unreliable and in
need of major improvements because the installations historically had
been unable to upgrade and maintain reliable utility systems due to
inadequate funding caused by the competition for funds and DOD's budget
allocation decisions. DOD officials stated that owning, operating, and
maintaining utility systems was not a core DOD function and the
guidance stated that privatization was the preferred method for
improving utility systems and services by allowing military
installations to benefit from private sector financing and
efficiencies. The revised implementation goals directed the military
departments to reach a privatization or exemption decision on at least
65 percent of the systems available for privatization by September 30,
2004, and on all systems by September 30, 2005.
The October 2002 guidance also reemphasized that utility privatization
was contingent upon meeting two requirements contained in the
legislative authority for the program--that the services demonstrate
through an economic analysis that privatization will reduce the long-
term costs to the government for utility services and that the services
receive fair market value for system conveyances. The guidance included
details for conducting the economic analyses stating that the services'
analyses should compare the long-term estimated costs of proposed
privatization contracts with the estimated long-term costs of continued
government ownership assuming that the systems would be upgraded,
operated, and maintained at accepted industry standards, as would be
required under privatization.
Utility Privatization Program Management:
DOD's Office of the Deputy Under Secretary of Defense for Installations
and Environment provides overall policy and management oversight for
the utility privatization program. However, primary management and
implementation responsibility for the program is delegated to the
individual services, their major commands, and individual
installations.
Prior GAO Reports on Utility Privatization and Related Subjects:
Although this is our first detailed report on DOD's utility
privatization program, we have issued four previous reports that
commented on the program. These reports primarily focused on DOD's
progress in implementing DOD's Defense Reform Initiative, which began
in 1997. The initiative represented an important set of actions aimed
at improving the effectiveness and efficiency of DOD's business
operations. One of those actions was the utilities privatization
program. Concerning the utilities privatization program, we reported in
April 1999 and August 1999 that the program was complex, time
consuming, and expensive and that the services would not meet initial
implementation goals.[Footnote 8] In July 2000, we reported that in
December 1998, DOD had issued a program budget decision directing the
services to set aside $243.6 million to complete privatizations between
fiscal years 1999 and 2004.[Footnote 9] The program budget decision
estimated that utility system privatization might begin to provide
about $327 million in annual savings after privatizations were
completed in 2003. However, we also reported that these early budget
estimates of the costs and savings were unrealistic and that in
addition to paying for privatization studies, military service
officials were also concerned that utility bills would increase without
a corresponding increase in operations and maintenance funds. In
December 2002, we again reported that the utility privatization program
was more complex and time consuming than anticipated and DOD planned to
reset the program's completion goal.[Footnote 10]
We have also issued three reports on DOD's program management and
oversight of another privatization program--the military housing
privatization program.[Footnote 11] As noted elsewhere in this report,
information from those reports provides a useful contrast in approach
when compared to the utility privatization program. Finally, we have
issued other reports that identified examples where the services moved
operations and maintenance funds intended to support one functional
area to another functional area and discussed associated
impacts.[Footnote 12]
Utility Privatization Implementation Has Been Slower Than Expected:
The utility privatization program provides DOD with a method to improve
installation utility systems by using private sector financing as an
alternative to traditional military construction funding. Although
DOD's initial goals were aggressive in order to use privatization to
quickly obtain improvements and get the services out of the business of
owning and operating utility systems, actual program implementation has
been slower than expected. In 1997, DOD expected that the services
would privatize or exempt all utility systems by January 2000 and DOD's
current goal is for the services to make decisions to privatize or
exempt all systems by September 2005. Yet, the services had awarded or
exempted only a fraction of the 1,499 systems available for
privatization as of December 31, 2004. Program implementation slowed
further in late 2004 and pending contract awards for all services were
put on hold for several months over an issue related to contract
termination liability. Implementation costs for the program will total
about $296 million for fiscal years 1998 through 2005, according to DOD
and service officials.
Privatization Offers a Method for Obtaining Utility System Improvements
Without Full Up-front Appropriations:
Utility privatization has helped installations achieve major system
improvements which, according to cognizant DOD and service officials,
would not have been otherwise possible due to inadequate funding caused
by the competition for funds and budget allocation decisions. They
report the systems vary among the military services in the extent to
which they have been adequately maintained and upgraded over time. With
private sector financing as an alternative to traditional military
construction funding, installations have obtained system upgrades and
improved operations and maintenance and will pay for the improvements
over time, rather than through full up-front appropriations.[Footnote
13] According to these officials, the improvements have resulted in
increased utility system reliability and efficiencies while reducing
safety and environmental risks. Also, these officials noted that, with
privatization, installations can focus more on their core defense
missions rather than tending to problems caused by outdated utility
systems. These officials further noted that without the privatization
program these benefits would not have been obtained in the short term
but would have been delayed, perhaps for many years.
The Services Have Awarded Contracts for Only a Fraction of the Total
Systems Available for Privatization:
After spending about $248 million on program implementation costs, the
services had awarded contracts for only a fraction of the 1,499 utility
systems available for privatization as of December 31, 2004. Of the 94
total contract awards, the services awarded 68 under the legislative
authorities specifically provided for the program and 26 as part of
other programs, such as DOD's military housing privatization program.
As shown in table 1, the services also had exempted 311 systems for
security or economic reasons and had 979 systems in various stages of
the privatization contract solicitation process.
Table 1: Status of the Utility Privatization Program as of December 31,
2004:
Component: Army;
Systems available for privatization: 320;
Systems pending solicitation or on hold: 67;
Systems in solicitation: 144;
Systems exempted: 40;
Contracts awarded[A]: 69.
Component: Navy;
Systems available for privatization: 645;
Systems pending solicitation or on hold: 23;
Systems in solicitation: 534;
Systems exempted: 73;
Contracts awarded[A]: 15.
Component: Air Force;
Systems available for privatization: 505;
Systems pending solicitation or on hold: 17;
Systems in solicitation: 280;
Systems exempted: 198;
Contracts awarded[A]: 10.
Component: Defense Logistics Agency;
Systems available for privatization: 29;
Systems pending solicitation or on hold: 8;
Systems in solicitation: 21;
Systems exempted: 0;
Contracts awarded[A]: 0.
Total;
Systems available for privatization: 1,499;
Systems pending solicitation or on hold: 115;
Systems in solicitation: 979;
Systems exempted: 311;
Contracts awarded[A]: 94.
Source: DOD.
[A] According to service officials, of the 94 contract awards, 68 were
awarded using 10 U.S.C. 2688 authorities and 26 were awarded using
other authorities. Of the Army's 69 contract awards, 4 were awarded
under the General Services Administration's areawide gas service
agreements and 4 were awarded under authorities related to base
realignment and closure. Of the Navy's 15 contract awards, 14 were
awarded as part of the Navy's military housing privatization program or
other transactions. Of the Air Force's 10 contract awards, 4 were
awarded under the General Services Administration's areawide gas
service agreements.
[End of table]
In comparison to DOD's current implementation goals, only the Air Force
met the September 30, 2004, goal by making a privatization or exemption
decision on at least 65 percent of its utility systems available for
privatization. As shown in table 2, as of September 30, 2004, the Air
Force had made decisions on 70 percent of its systems while the Army,
the Navy, and the Defense Logistics Agency had made decisions on 51
percent, 47 percent, and 55 percent, respectively, of their utility
systems. DOD officials stated that it was unlikely that the services
will meet DOD's September 30, 2005, goal of making a privatization or
exemption decision on every system available for privatization.
Table 2: Percentage of Systems with Privatization or Exemption
Decision:
Component: Army;
Goal for Sept. 30, 2004 (percent): 65%;
Actual as of Sept. 30, 2004 (percent): 51%;
Sept. 30, 2004 goal met? No;
Goal for Sept. 30, 2005 (percent): 100%;
Actual as of Dec. 31, 2004 (percent): 52%.
Component: Navy;
Goal for Sept. 30, 2004 (percent): 65%;
Actual as of Sept. 30, 2004 (percent): 47%;
Sept. 30, 2004 goal met? No;
Goal for Sept. 30, 2005 (percent): 100%;
Actual as of Dec. 31, 2004 (percent): 49%.
Component: Air Force;
Goal for Sept. 30, 2004 (percent): 65;
Actual as of Sept. 30, 2004 (percent): 70;
Sept. 30, 2004 goal met? Yes;
Goal for Sept. 30, 2005 (percent): 100;
Actual as of Dec. 31, 2004 (percent): 71.
Component: Defense Logistics Agency;
Goal for Sept. 30, 2004 (percent): 65%;
Actual as of Sept. 30, 2004 (percent): 55%;
Sept. 30, 2004 goal met? No;
Goal for Sept. 30, 2005 (percent): 100%;
Actual as of Dec. 31, 2004 (percent): 55%.
Component: Total;
Goal for Sept. 30, 2004 (percent): 65%;
Actual as of Sept. 30, 2004 (percent): 56%;
Sept. 30, 2004 goal met? No;
Goal for Sept. 30, 2005 (percent): 100%;
Actual as of Dec. 31, 2004 (percent): 57%.
Source: DOD.
[End of table]
According to DOD and service officials, implementation was slower than
expected primarily because the program proved to be more complex and
time consuming than initially expected. The program represented a new
way of doing business for both the military and the private sector and
it took time to develop guidance for determining fair market values for
system conveyances and for comparing the long-term costs of a proposed
privatization project with the long-term costs of continued government
ownership. Initially, DOD also had to evaluate and make decisions in
many areas such as the role of state laws and regulations on utility
systems located on military installations but with ownership conveyed
to private contractors. Further, to address some private utility
company concerns, DOD made or sought and obtained waivers from some
contracting regulations, but the process to do so was time consuming.
For example, early in the program DOD learned that some private utility
companies were reluctant to submit offers on privatization contracts
because of regulations requiring that contractors follow accounting
standards set by the Cost Accounting Standards Board. The concern was
that the utility industry already had a set of established accounting
practices used by regulatory agencies to set utility rates and to adopt
an additional set of accounting standards would be too costly. DOD
requested the Cost Accounting Standards Board to grant a waiver from
use of the standards in utility privatization contracts under certain
circumstances. Although the matter remained a point of contention for
several years, the waiver was not obtained until September 2004 and DOD
guidance on the matter was not issued until October 2004.
Contract Termination Liability Questions Slowed Implementation Further:
Program implementation slowed further in late 2004 and pending contract
awards for all services were held up over an issue concerning contract
termination liability. In October 2004, the Navy raised a question with
the Office of the Secretary of Defense concerning whether it was
required to obligate funds to cover potential contract termination
expenses should the Navy terminate a utility services contract prior to
the contractor recovering its acquisition and system improvement costs.
Navy officials stated that, if required, the amounts needed could be
very large, making many proposed utility privatization projects
financially unfeasible.
Not all the services shared the Navy's concern regarding termination
liability. The Army, for example, reportedly has entered into a number
of utility privatization agreements without recording an obligation to
cover potential termination liability. The Army's position apparently
was that 10 U.S.C. § 2688 provides the necessary authority to enter
into utility privatization agreements without recording an obligation
for termination liability.
To resolve the differences between the services, the DOD Office of
General Counsel considered the Navy and Army positions and issued
guidance in February 2005 indicating that the services were not
required to obligate funds to cover contract termination liability
under the utility privatization program. In part, the DOD Office of
General Counsel relied on a 1983 GAO decision[Footnote 14] which
addressed the acquisition by the General Services Administration (GSA)
of telephone equipment and related services under 40 U.S.C. §
501(b)(3). That statutory provision, similar to section 2688,
authorizes contracts for public utility services for multiple years (up
to 10 years) without mentioning termination liability. The DOD Office
of General Counsel noted that our 1983 decision stated that under
section 501, GSA did not need to have available budget authority to
obligate the total estimated cost of a contract, "but only sufficient
budget authority to obligate its annual costs under the agreement."
Although the 1983 decision did not directly address termination
liability, the DOD Office of General Counsel maintains that a
requirement to obligate termination costs for such contracts would
directly contradict the conclusion that GSA need only obligate its
"annual costs." According to the DOD Office of General Counsel, the
same result is appropriate under section 2688.
We examined the guidelines issued by the DOD Office of General Counsel
and the authorities they relied on. Given the nature of the section
2688 multiyear authority and the nature of the utility privatization
program, we agree that defense services are not required to record
obligations for potential termination liabilities under that authority,
unless and until they decide to terminate.
During our review of seven privatized DOD systems, we determined that
the services generally are agreeing to reimburse contractors for the
acquisition and system improvement costs of the facilities. To the
extent a particular contract is terminated prior to the contractor
recouping its acquisition and system improvement costs, DOD has agreed
to repay those costs. In the context of the multiyear utility program,
the services have generally entered into contracts with terms of 50
years. During the terms of those contracts, DOD is either going to pay
the annual costs of performance, which includes materials, labor,
overhead, and other costs of the acquisition and system improvements,
or it will pay termination costs, which will cover the contractor's
unreimbursed costs for the acquisition and completed system
improvements.
As DOD's Office of General Counsel notes, our 1983 decision concluded
that GSA may obligate the costs for its utility service contracts on an
annual basis rather than obligating the entire amount of contract costs
for future years in the first year of the contract. Section 2688, the
authority underlying DOD's utility services contracts, is not unlike
GSA's section 501 authority. They both permit contracting for utilities
services for a multiyear period. Just as in 1983, when we viewed
section 501 as a remedial provision to afford GSA flexibility in
contracting, we view section 2688 to similarly afford DOD flexibility.
In our 1983 decision, we noted that the purpose of section 501's
multiyear contracting authority was to "take advantage of discounts
offered under long term contracts" and "to effect economy and improve
services," and, thus, broadly construed the authority conferred to
facilitate achieving these objectives.[Footnote 15] For the same
reasons, we read section 2688 broadly, and agree with DOD's
interpretation of it. To read the statute to require obligating
potential termination costs prior to a decision to terminate could
undermine the economies and improvements in services that the statute
envisions.
The decision to terminate the contracts is DOD's, not the
contractors'.[Footnote 16] If DOD decides to terminate a contract,
those contracts appear to do nothing more than bind DOD to repay
amounts that DOD would otherwise have paid if performance had
continued, rather than additional penalties or charges DOD would not
have paid absent the termination. If DOD decides to terminate, DOD must
either have or obtain sufficient budget authority for the year DOD
becomes liable for termination costs. Because DOD controls whether, and
when, to terminate its contracts (and presumably would not terminate
without sufficient budget authority to cover termination liability),
should DOD in the future decide to terminate, such action does not
expose the government to a financial risk.
Utility Privatization Program Implementation Costs:
For fiscal years 1998 through 2004, DOD and the services estimated that
about $248 million had been spent to implement the utility
privatization program (see table 3). For fiscal year 2005,
implementation costs were expected to be about $48 million, bringing
the total to about $296 million. According to DOD officials, the funds
used to implement the program primarily paid for consultants hired to
help implement the program by assisting the services in inventorying
their utility systems, assessing the systems' condition, preparing
economic analyses, and soliciting and contracting for proposed
projects. Program implementation costs did not include funds used to
pay the costs of awarded privatization contracts.
Table 3: Implementation Costs for the Utility Privatization Program:
Dollars in millions.
Office of the Secretary of Defense;
Fiscal years 1998 through 2004: $3.3;
Fiscal year 2005: $0.0[A];
Total through fiscal year 2005: $3.3.
Army;
Fiscal years 1998 through 2004: $62.5;
Fiscal year 2005: $15.0;
Total through fiscal year 2005: $77.5.
Navy;
Fiscal years 1998 through 2004: $103.3;
Fiscal year 2005: $27.6;
Total through fiscal year 2005: $130.9.
Air Force;
Fiscal years 1998 through 2004: $78.6;
Fiscal year 2005: $5.4;
Total through fiscal year 2005: $84.0.
Total;
Fiscal years 1998 through 2004: $247.7;
Fiscal year 2005: $48.0;
Total through fiscal year 2005: $295.7.
Source: DOD.
[A] At the time of our review in February 2005, Office of the Secretary
of Defense officials stated that they had not yet estimated their
program implementation costs for fiscal year 2005.
[End of table]
According to DOD officials, program implementation costs are expected
to decline rapidly as the services complete their evaluations to
privatize or exempt their utility systems.
The Services' Savings Estimates from Utility Privatization Are
Questionable:
The services' economic analyses supporting utility systems privatized
or near contract award for privatization estimate that the government's
costs for equivalent utility services will be less with privatization.
The amount of the savings is calculated based on the difference between
the estimated costs of two options for improving the utility systems--
privatization and continued government ownership. However, because of
the method used to estimate the costs of continued government
ownership, we found that these estimates give an unrealistic impression
of reduced costs in that the government's costs under privatization
typically increase to pay contractors for enhanced utility services and
capital improvements. Moreover, based on the economic analyses
examined, we question the reliability of the projected differences in
long-term costs between the privatization and government ownership
options. In seven analyses we reviewed, we found inaccuracies and
unsupported cost estimates that tended to favor the privatization
option over continued government ownership. The Army Audit Agency has
reported similar concerns with the reliability of analyses supporting
Army utility privatization projects.
Installation Utility Costs Increase with Privatization:
Installation utility costs under privatization typically increase
significantly above historical levels because the systems are being
upgraded and the contractors recoup their investment costs through the
utility services contracts.[Footnote 17] Essentially, under the
privatization program, the services leverage private sector capital to
achieve utility system improvements that otherwise would not be
feasible in the short term because of limited funding caused by the
competition for funds and budget allocation decisions. The services pay
for the improvements over time through the utility services contracts.
Army officials estimated that the average annual cost increase for each
privatized Army system was $1.3 million. According to the economic
analysis for the electric system privatization at Dobbins Air Reserve
Base, the annual operations and maintenance costs for the system after
privatization were expected to increase by over 500 percent compared to
historical costs.
Air Force headquarters officials stated concerns with the increased
costs from historical levels with utility privatization. The officials
estimated that based on the Air Force systems already privatized and
those systems with the potential to be privatized, the Air Force's
costs could increase between $100 million and $200 million annually for
the first 5 to 10 years of privatization. The officials also stated
their concern that privatized systems present the Air Force with a bill
that must be paid, whereas the Air Force would have more flexibility in
programming and executing improvements for government-owned utility
systems. According to the officials, this flexibility allows the Air
Force to better balance the spending of available funds on utility
improvements and other mission requirements to ensure the best use of
resources.
Officials at each of the five installations we visited also expressed
concern about increased utility costs from privatization. In
particular, installation officials were concerned that other
installation functions might suffer if funding provided for operating
and maintaining their installations were not sufficiently increased to
cover the higher utility costs. They noted that, under privatization,
costs for upgrading, operating, and maintaining the systems are
contract costs that must be paid. As a result, if an installation's
funds were not increased sufficiently, then funds provided for other
installation functions where there was more discretion in spending
might be used to pay the higher utility bills. This, in turn, could
negatively impact those other functions, such as the maintenance of
installation facilities.
The economic analysis for the Fort Campbell water and wastewater
systems privatization illustrates the funding concern expressed by
installation officials. The analysis stated that privatization will
increase installation utility services costs well above levels
previously budgeted for this purpose. The analysis further stated the
concern that "the installation's budget may not be increased to the
level necessary to fund the increase requiring sacrifice of other
installation functions."
Privatization funding was a particular concern at Fort Irwin. Fort
Irwin privatized its electrical system in 2003 and Army headquarters
began providing funds to the installation to pay the monthly utility
services bill. However, when we visited the installation in January
2005, Fort Irwin officials stated that Army headquarters had provided
no funds for the privatization contract from October 2004 through
January 2005 and, as a result, the monthly utility services bills had
not been paid. In March 2005, the officials stated that headquarters
had provided some funding for the project, but the amount provided was
only 34 percent of the amount needed. Fort Irwin officials said that
headquarters officials stated that they would try to provide more
funds; however, if the additional funds are not provided, then the
installation will have to use funds intended for other installation
functions to pay the utility services bills.
Services' Economic Analyses Do Not Depict Actual Expected Costs of
Continued Government Ownership:
We found that the services' savings estimates for utility privatization
projects were questionable because of the assumptions made about
government "should costs" in the economic analyses that compare
predicted costs under the privatization and government ownership
options. DOD guidance directs the military services to compare
estimated privatization costs based on the proposed contract with the
estimated government ownership costs based on what it "should cost" the
government to upgrade, operate, and maintain the system in accordance
with accepted industry standards as called for in the proposed
contract. This estimating method would be appropriate if, in the event
the system is not privatized, the service would proceed to upgrade,
operate, and maintain the system as called for in the government
estimate. However, this generally is not expected to be the case.
According to DOD and service officials, if a system is not privatized,
then the anticipated system improvements would likely be delayed
several years because of DOD's budget allocation decisions, which have
limited the funds available for utility improvements and which caused
DOD to look to privatization as an option in the first place.
Because of the time value of money, a future expense of a given amount
is equivalent to a smaller amount in today's dollars. Thus, delaying
system improvements to future years would reduce the estimated cost of
the government ownership option in today's dollars and, therefore,
affect the results of a proposed project's economic analysis. At the
same time, it must be recognized that delays in system improvements
could increase government costs in the long term. Thus, if savings are
expected to be a key factor in utility privatization decision making,
then it would appear more appropriate for the services to compare the
cost of a proposed privatization contract with the cost of continued
government ownership on the basis of the actual planned expenditures
and timing of these expenditures, with appropriate consideration to the
impact of delayed improvements.
The economic analysis supporting the June 2003 privatization of Fort
Campbell's water and wastewater utility systems illustrates the impact
of using DOD's method for estimating and comparing the long-term costs
of the privatization and government ownership options.[Footnote 18]
Following DOD's guidance, the Fort Campbell economic analysis estimated
the long-term costs of government ownership by assuming that the
installation would upgrade, operate, and maintain the systems in
accordance with industry standards as the contractor proposed to do.
The analysis estimated that over a 50-year period the total cost of
government ownership of the systems would exceed the total cost of
privatization by about $4.3 million in today's dollars. However, Fort
Campbell officials stated that if the contract had not been awarded and
the government continued to own the systems, then the improvements
planned for the systems would not have occurred as indicated in the
economic analysis. The officials stated that the improvements most
likely would have been delayed for several years until the Army
approved funding for the improvements. Based on information in the
economic analysis, we estimated that if the start of improvements to
upgrade the systems planned during the first 10 years under the
government ownership option were delayed by 5 years, which installation
officials stated was a reasonable assumption, then the estimated cost
of the government ownership option would decrease by about $6.5 million
in today's dollars because of the time value of money.[Footnote 19]
Thus, in this case, consideration of the expected costs of continued
government ownership based on a more realistic estimate of the timing
of improvement expenditures could have changed the result of the
analysis and showed that government ownership of the systems would be
less costly than privatization over the long term.
DOD Does Not Require an Independent Review of the Services' Economic
Analyses:
DOD does not require that the services' economic analyses be subjected
to an independent review for accuracy and compliance with guidance, as
a step to help ensure reliability. Normally, the services hire
consultants to prepare the analyses and service officials stated that
completed analyses are reviewed by the service's headquarters office
responsible for the program. However, the reliability of the analyses
is not reviewed by DOD headquarters officials or by an independent
party, such as the services' audit agencies. Further, at the five
installations we visited, installation officials stated that they had
not reviewed the details in the economic analyses supporting their
privatization projects and did not know the basis for some of the
estimates used in the analyses.
In contrast, DOD provides a more rigorous review of the analyses
supporting privatization projects under DOD's military housing
privatization program. Under this program, the service that proposes a
project must provide the responsible DOD headquarters officials with a
detailed briefing that describes the project, its justification, and
whether it meets specific financial criteria. These officials stated
that they review each project's supporting analysis and evaluate the
estimates, assumptions, and methodology used in the analysis for
reasonableness and compliance with guidance. If concerns are
identified, the officials ask the service for additional information
before the project is approved. These top-level review steps provide
additional assurances that supporting analyses are reliable and that
each project is adequately justified before approval.
We reviewed seven utility privatization project analyses and identified
inaccuracies, unsupported cost estimates, and noncompliance with
guidance for performing the analyses. The cost estimates in the
analyses we reviewed generally favored the privatization option by
understating long-term privatization costs or overstating long-term
government ownership costs. In five of the seven analyses, making
adjustments to correct problems we identified would change the outcomes
to show that government ownership, rather than privatization, would be
less costly in the long term. In the remaining two cases, the analyses
were not reliable because they did not reflect the actual utility
system improvements to be performed by the contractor.
The economic analysis for privatizing Fort Lee's water distribution
system illustrates problems we identified. The Fort Lee analysis did
not consider the system's value at the end of the analysis period--the
residual value--under the government ownership option, as required by
DOD guidance.[Footnote 20] Consideration of residual value recognizes
that, under the government ownership option, the government would own
the system and that the system would have some value at the end of the
analysis period. In contrast, under the privatization option, the
contractor, not the government, would own the system at the end of the
analysis period. Not including the residual value in the analysis
resulted in favoring the privatization option by overstating government
ownership costs. We recomputed costs by including a residual value for
the system at the end of the 50-year contract. The result was to change
the outcome of the analysis from estimating that privatization would be
less costly over the long term to estimating that government ownership
would be less costly over the long term.
Table 4 includes selected information on each project we reviewed,
including the savings estimates from the services' analyses and a
summary of the concerns we identified. Also, appendix II contains a
detailed description of our review of each of the seven project
economic analyses.
Table 4: Selected Information from Economic Analyses Supporting Utility
Privatization Projects:
Dollars in millions.
Water system, Fort Lee, Virginia;
Results from services' economic analyses: Estimated total costs of
government ownership option in today's dollars: $10.3;
Results from services' economic analyses: Estimated total costs of
privatization option in today's dollars: $8.8;
Results from services' economic analyses: Estimated savings or cost
avoidance with privatization option: $1.5;
Results from GAO's review of the economic analyses: Were government
ownership costs based on actual expected costs? No;
Results from GAO's review of the economic analyses: Did the analysis
cover the same time period as the privatization contract? No;
Results from GAO's review of the economic analyses: Did the analysis
consider residual value under the government ownership option? No;
Results from GAO's review of the economic analyses: Did the analysis
include errors in estimating costs? Yes;
Results from GAO's review of the economic analyses: Would correcting
the issues identified change the outcome to favor government ownership?
Yes.
Electric system, Fort Lee, Virginia;
Results from services' economic analyses: Estimated total costs of
government ownership option in today's dollars: $31.7;
Results from services' economic analyses: Estimated total costs of
privatization option in today's dollars: $26.9;
Results from services' economic analyses: Estimated savings or cost
avoidance with privatization option: $4.8;
Results from GAO's review of the economic analyses: Were government
ownership costs based on actual expected costs? No;
Results from GAO's review of the economic analyses: Did the analysis
cover the same time period as the privatization contract? Yes;
Results from GAO's review of the economic analyses: Did the analysis
consider residual value under the government ownership option? No;
Results from GAO's review of the economic analyses: Did the analysis
include errors in estimating costs? Yes;
Results from GAO's review of the economic analyses: Would correcting
the issues identified change the outcome to favor government ownership?
Yes[A].
Water and wastewater systems, Fort Campbell, Kentucky;
Results from services' economic analyses: Estimated total costs of
government ownership option in today's dollars: $196.6;
Results from services' economic analyses: Estimated total costs of
privatization option in today's dollars: $192.3;
Results from services' economic analyses: Estimated savings or cost
avoidance with privatization option: $4.3;
Results from GAO's review of the economic analyses: Were government
ownership costs based on actual expected costs? No;
Results from GAO's review of the economic analyses: Did the analysis
cover the same time period as the privatization contract? Yes;
Results from GAO's review of the economic analyses: Did the analysis
consider residual value under the government ownership option? Yes;
Results from GAO's review of the economic analyses: Did the analysis
include errors in estimating costs? Yes;
Results from GAO's review of the economic analyses: Would correcting
the issues identified change the outcome to favor government ownership?
Yes.
Electric system, Fort Irwin, California;
Results from services' economic analyses: Estimated total costs of
government ownership option in today's dollars: $32.1;
Results from services' economic analyses: Estimated total costs of
privatization option in today's dollars: $29.7;
Results from services' economic analyses: Estimated savings or cost
avoidance with privatization option: $2.4;
Results from GAO's review of the economic analyses: Were government
ownership costs based on actual expected costs? No;
Results from GAO's review of the economic analyses: Did the analysis
cover the same time period as the privatization contract? Yes;
Results from GAO's review of the economic analyses: Did the analysis
consider residual value under the government ownership option? Yes;
Results from GAO's review of the economic analyses: Did the analysis
include errors in estimating costs? Yes;
Results from GAO's review of the economic analyses: Would correcting
the issues identified change the outcome to favor government ownership?
Yes.
Electric system, Dobbins Air Reserve Base, Georgia;
Results from services' economic analyses: Estimated total costs of
government ownership option in today's dollars: $5.6;
Results from services' economic analyses: Estimated total costs of
privatization option in today's dollars: $3.8;
Results from services' economic analyses: Estimated savings or cost
avoidance with privatization option: $1.8;
Results from GAO's review of the economic analyses: Were government
ownership costs based on actual expected costs? No;
Results from GAO's review of the economic analyses: Did the analysis
cover the same time period as the privatization contract? No;
Results from GAO's review of the economic analyses: Did the analysis
consider residual value under the government ownership option? Yes;
Results from GAO's review of the economic analyses: Did the analysis
include errors in estimating costs? Yes;
Results from GAO's review of the economic analyses: Would correcting
the issues identified change the outcome to favor government ownership?
Yes.
Water system, Bolling Air Force Base, Maryland;
Results from services' economic analyses: Estimated total costs of
government ownership option in today's dollars: $10.9;
Results from services' economic analyses: Estimated total costs of
privatization option in today's dollars: $6.5;
Results from services' economic analyses: Estimated savings or cost
avoidance with privatization option: $4.4;
Results from GAO's review of the economic analyses: Were government
ownership costs based on actual expected costs? No;
Results from GAO's review of the economic analyses: Did the analysis
cover the same time period as the privatization contract? Yes;
Results from GAO's review of the economic analyses: Did the analysis
consider residual value under the government ownership option? Yes;
Results from GAO's review of the economic analyses: Did the analysis
include errors in estimating costs? Unknown[B];
Results from GAO's review of the economic analyses: Would correcting
the issues identified change the outcome to favor government ownership?
Unknown[B].
Wastewater system, Bolling Air Force Base, Maryland;
Results from services' economic analyses: Estimated total costs of
government ownership option in today's dollars: $7.2;
Results from services' economic analyses: Estimated total costs of
privatization option in today's dollars: $5.7;
Results from services' economic analyses: Estimated savings or cost
avoidance with privatization option: $1.5;
Results from GAO's review of the economic analyses: Were government
ownership costs based on actual expected costs? No;
Results from GAO's review of the economic analyses: Did the analysis
cover the same time period as the privatization contract? Yes;
Results from GAO's review of the economic analyses: Did the analysis
consider residual value under the government ownership option? Yes;
Results from GAO's review of the economic analyses: Did the analysis
include errors in estimating costs? Unknown[B];
Results from GAO's review of the economic analyses: Would correcting
the issues identified change the outcome to favor government ownership?
Unknown[B].
Source: DOD information with GAO analysis.
[A] The outcome of the economic analysis changes if the system's
residual value is assumed to be equal to the system's current
replacement value. Army officials stated that the system's residual
value should equal the system's replacement value less depreciation
and, if this value were used, the outcome of the economic analysis
would not change. However, under privatization, the system is to be
upgraded, operated, and maintained in accordance with industry
standards, which will result in increasing the system's residual value.
[B] We question the reliability of the economic analyses for Bolling
Air Force Base because they did not reflect the actual system
improvements to be performed by the contractor. We did not have
sufficient information to recalculate estimates in the analyses.
However, installation officials stated that they believed that
continued government ownership of the systems would have been less
costly than privatization over the long term.
[End of table]
The Army Audit Agency Identified Concerns about the Reliability of
Economic Analyses:
The Army Audit Agency has issued reports that identified concerns about
the reliability of the economic analyses supporting utility
privatization contracts at four Army installations. These concerns are
similar to the ones we identified in our review. For example, in July
1999, the Army awarded a contract to privatize Aberdeen Proving
Ground's water and wastewater utility system. The Army Audit Agency
reviewed the project and the supporting economic analysis and reported
in April 2004 that the analysis did not include realistic cost
estimates for system improvements to be performed by the privatization
contractor.[Footnote 21] For example, the report stated that the
analysis understated the cost of system improvements by $18.5 million
over the life of the contract. As a result, the audit agency concluded
that there was not a reliable framework for preparing the analysis and
the decision to privatize Aberdeen's water and wastewater system might
result in higher costs to the government in the long term.
Implementation of the Fair Market Value Requirement Can Result in
Higher Contract Costs:
Although DOD is permitted latitude in ensuring that the government
receives fair market value for systems conveyed to privatization
contractors, in some cases implementation has resulted in higher
contract costs for utility services. Guidance and practices for
determining fair market value varied among the services, with Army
guidance stating that fair market value for system conveyances could
range from zero to full replacement cost of the system. Also, although
it is a reasonable concept that the government should receive
consideration if an asset is conveyed to a contractor, the receipt of
consideration for conveyances in the utility privatization program does
not typically result in a net financial payment to the government. To
recover their costs, privatization contractors normally include the
full amounts they paid for conveyances in the associated utility
services contracts and, therefore, the government will pay back the
amounts received for the conveyances through utility services bills
over time. In some cases, the contractors also include additional
amounts in the utility services contracts to cover the contractors'
costs associated with the fair market value payments. Consequently,
implementing the fair market value requirement in such cases will
result in the government paying back more than it will receive for the
conveyances.
Guidance and Practices for Determining Fair Market Value Vary:
The legislative authority for the utility privatization program states
that the Secretary of a military department shall require as
consideration for a conveyance an amount equal to the fair market
value, as determined by the Secretary, of the right, title, or interest
of the United States conveyed. DOD provided general guidance on
implementing this requirement in October 2002. As part of the
negotiation strategy for utility system conveyances, the guidance
directed the services to develop a range of fair market values, taking
into account the business and strategic values of the utility system.
The guidance stated that the services could choose to determine fair
market value through an actual appraisal, a modified cost and income
analysis, or a replacement or original-cost-less-depreciation analysis.
Subsequently, in response to questions at an industry forum in
September 2004, DOD officials stated that the fair market value should
be established through open negotiations, the contractor would recover
the fair market value paid for a conveyance through the service
contract, and the contractor would earn a reasonable return on
investment.
Although service officials stated that they have generally followed
this guidance, the Army issued additional guidance on determining fair
market value in April 2002.[Footnote 22] This guidance basically stated
that a range of values could be considered as fair market value for
utility system conveyances. Specifically, the guidance stated that the
Army had concluded that the fair market value "could be any number of
values such as zero, nominal, appraised, full replacement cost of the
system, or any negotiated amount, but that the [fair market value]
should be determined by an economic analysis applied in planning the
sale of each utility system." Army officials stated that determining
fair market value is subjective and determined in part by the amounts
contractors are willing to pay. In some cases, the officials stated
that the most beneficial business case is to convey systems at less
than their apparent fair market values.
On the basis of information in the services' economic analyses we
reviewed, table 5 shows the amounts that the government will receive
from privatization contractors for utility system conveyances compared
to one measure of fair market value--the system's replacement cost less
depreciation. Whether the amounts received should be considered
sufficient is difficult to gauge because DOD has not adopted objective
standards for determining whether the amounts received meet the fair
market value requirement.
Table 5: Amounts to Be Received for Utility System Conveyances for
Projects Reviewed:
Dollars in millions.
Fort Campbell water and wastewater systems;
System replacement cost less depreciation[A]: $20.0;
Amount to be received for the conveyance[B]: $4.5;
Amount to be received as a percentage of system replacement cost less
depreciation (percent): 23%.
Fort Irwin electric system;
System replacement cost less depreciation[A]: $10.0;
Amount to be received for the conveyance[B]: $8.5;
Amount to be received as a percentage of system replacement cost less
depreciation (percent): 85%.
Fort Lee electric system;
System replacement cost less depreciation[A]: $16.5;
Amount to be received for the conveyance[B]: $9.7;
Amount to be received as a percentage of system replacement cost less
depreciation (percent): 59%.
Fort Lee water system;
System replacement cost less depreciation[A]: Unknown[C];
Amount to be received for the conveyance[B]: $0.0;
Amount to be received as a percentage of system replacement cost less
depreciation (percent): 0%.
Dobbins Air Reserve Base electric system;
System replacement cost less depreciation[A]: $0.9;
Amount to be received for the conveyance[B]: $0.7;
Amount to be received as a percentage of system replacement cost less
depreciation (percent): 78%.
Bolling Air Force Base water system;
System replacement cost less depreciation[A]: $3.1;
Amount to be received for the conveyance[B]: $1.2;
Amount to be received as a percentage of system replacement cost less
depreciation (percent): 39%.
Bolling Air Force Base wastewater system;
System replacement cost less depreciation[A]: $2.9;
Amount to be received for the conveyance[B]: $5.0;
Amount to be received as a percentage of system replacement cost less
depreciation (percent): 172%.
Source: DOD with GAO analysis.
[A] These values are normally determined by an analysis of each
system's replacement cost less depreciation based on an evaluation of
the system's physical condition.
[B] According to the services' economic analyses, the amounts that the
contractors will pay for the conveyances normally will be paid through
credits applied over time to the government's utility services bill.
[C] This project's economic analysis did not include information on the
system's replacement cost. However, an Army analysis of the system,
which included a reservoir, four water towers, and pipelines, performed
about 10 years prior to privatization, stated that the system's
replacement cost was about $11.8 million, and Fort Lee officials stated
that the system was in good condition and was not in need of any
immediate upgrades or improvements at the time of its conveyance to the
contractor.
[End of table]
The Army Audit Agency reported in October 2001 that the Army used
varying methods to handle the fair market value requirement.[Footnote
23] The audit agency reported that in four electric system
privatizations the Army had used an independent contractor to estimate
the fair market values of the systems. However, the fair market value
estimates were not the final negotiated fair market values agreed to by
the parties. For example, in one case the independent fair market value
estimate for the system was $2.2 million and the system was conveyed
for $0.1 million. In another case, the independent fair market value
estimate for the system was $19.5 million and the system was conveyed
for zero dollars.
Implementation of the Fair Market Value Requirement Increased
Privatization Contract Costs in Some Cases:
The services' implementation of the requirement that the government
receive fair market value when conveying utility systems resulted in
increased costs to the government in some cases. The services normally
negotiated with proposed privatization contractors for the fair market
amount that the contractors will pay for system conveyances. However,
to recover their costs, privatization contractors normally factor into
the utility services contracts the full amount paid as fair market
value for the systems. Thus, the government pays back the amounts
received as consideration for the conveyances. However, in some cases,
the contractors also include additional amounts in the utility services
contracts to cover the contractors' costs associated with the fair
market value payments, which increased contract costs.
For example, according to the economic analysis for privatizing Dobbins
Air Reserve Base's electric system, the contractor will pay about
$741,000 as the fair market value for the system conveyance in today's
dollars. However, the analysis stated that the contractor will recover
this cost, plus other associated costs, by charging the Air Force about
$1,322,000 in today's dollars in the utility services bills over time.
Consequently, implementing the fair market value requirement in this
case will result in the Air Force paying about $581,000, or 78 percent,
more than it received for the conveyance.
A similar situation occurred at another installation we visited.
According to the economic analysis for privatizing Fort Lee's electric
distribution system, the contractor will pay about $6.6 million for the
conveyance with a cash down payment and with the remaining balance
financed over 27 years and paid in the form of monthly credits to the
installation's utility services bill. This arrangement will be
equivalent to the contractor paying about $9.7 million for the
conveyance in today's dollars. However, the analysis also stated that
the contractor will recover its costs for purchasing the system,
including added amounts for taxes and other associated costs, through
annual charges added to the installation's utility services bill over
the first 28 years of the contract. Based on the amounts to be charged,
this arrangement will be equivalent to charging the Army about $16.7
million in today's dollars. Consequently, implementing the fair market
requirement in this case will result in the Army paying about $7.0
million, or 72 percent, more than it received for the conveyance.
In a review of the electric distribution system privatization at Fort
Benning, the Army Audit Agency also found that receipt of fair market
value for the conveyance will result in the government paying more
under the contract than if no consideration had been received. The
audit agency's report noted that the contractor agreed to pay $4.8
million for the system and the Army agreed to pay the contractor for
this cost plus additional amounts for profit. The result was that over
the life of the contract the Army will pay about $748,000 more than it
received for the conveyance.[Footnote 24]
DOD's Execution of the Utility Privatization Program Raises Other
Concerns:
In examining DOD's execution of the utility privatization program, we
identified two additional areas of concern that could impact the
overall effectiveness of the program. First, the services have not
issued specific contract administration guidance for the program and,
as a result, the adequacy of privatization contract oversight is a
concern. Second, according to DOD consultant reports, DOD's approach to
privatizing utilities differs from typical private sector practices
and, as a result, privatization contractors may have an advantage when
the time comes to negotiate utility service contract changes and
renewals. Management attention in these areas could help ensure that
best practices are used and the government's interests are adequately
protected.
Adequacy of Privatization Contract Oversight Is a Concern:
The adequacy of privatization contract oversight is a concern. The
services' oversight of utility privatization contracts appeared to be
limited in some cases because of limited guidance and inadequate
provisions for staff to monitor contracts. Inadequate oversight could
result in the services paying contractors for work not performed or for
work performed in an unsatisfactory manner.
The services have not issued specific guidance on utility privatization
contract administration even though the program began 7 years ago and
94 contracts have been awarded. Service officials stated that such
guidance was in preparation and should be issued before the end of
2005. However, the lack of specific guidance for awarded contracts was
a matter of concern at Fort Lee, one of the five installations we
visited. Fort Lee officials stated that they had little guidance from
headquarters on what they should be doing to oversee their water and
electric privatization contracts, other than to pay the bills. The
officials also stated that they did not have sufficient personnel to
perform detailed monitoring of contractor performance because no
additional resources were provided for this purpose after the contracts
were signed. The officials believed that the contractors were
performing adequately but had little documentation to support their
opinions.
The Army Audit Agency also has reported concerns with the adequacy of
privatization contract oversight. As illustrated below, in its reviews
of four Army utility privatization contracts at the Aberdeen Proving
Ground and Forts Hamilton, Benning, and Pickett, the audit agency found
that contractor performance was not adequately monitored, and as a
result, there was little assurance that the installations would receive
quality products and services under privatization.
* In its review of utility privatization at the Aberdeen Proving
Ground, the audit agency found that the Army paid about $3.3 million
during fiscal year 2001 for operating expenses the contractor did not
incur, system improvements the contractor did not perform, and
purchases the contractor did not make.[Footnote 25] These conditions
occurred because the Aberdeen Proving Ground did not develop a
performance monitoring plan, monitor completion of system improvements,
or require detailed expense reporting by the contractor. In response,
the responsible Army officials agreed to develop a contract-monitoring
plan to help track system improvements and require the contractor to
report additional data on expenses.
* In its review of utility privatization at Fort Hamilton, the audit
agency found that the Army's guidance to the installation did not
specify what aspects of the contract required monitoring, the
installation did not have a plan to monitor contractor performance, and
the contractor did not provide the Army with plans and reports as
required by the contract to assist in contract oversight.[Footnote 26]
The audit agency concluded that the Army needed to improve the contract
administration procedures to ensure that the Army would receive quality
products and services. In response, the responsible Army officials
agreed to put procedures in place to address the findings.
* In its review of utility privatization at Fort Benning, the audit
agency found that Fort Benning did not have procedures in place to
effectively monitor the contractor's performance because the contractor
was not required to provide any performance data to the government and
the installation did not have a contract-monitoring plan as required by
guidance.[Footnote 27] In response, Fort Benning officials agreed to
develop a contractor-monitoring plan that included inspection,
verification, and reporting to establish better contract oversight.
* In its review of utility privatization at Fort Pickett, the audit
agency found that Fort Pickett had no contract monitoring plan, the
installation official responsible for the contract did not know that
the contractor had delayed about 50 percent of the improvements planned
in the first year, and tenant organizations at the installation were
not properly charged for reimbursable costs associated with the
privatized electrical system.[Footnote 28] In response, the responsible
Army officials agreed to develop a contract-monitoring plan to help
track system improvements and to ensure accurate charges for tenants.
DOD's Approach to Utility Privatization Appears to Differ from Typical
Private Sector Practices:
DOD has no studies or other documentation showing that its approach to
utility privatization is based on private sector best practices. A
senior DOD official characterized the utility privatization program as
the result of a decision by the Office of the Secretary of Defense that
operating and maintaining utilities was not a core function and that
installation utilities should be privatized. Nevertheless, according to
two reports prepared by Navy and Air Force consultants, DOD's approach
actually differs from typical private sector practices in that private
companies may outsource system operations and maintenance but normally
opt for shorter than 50-year utility service contracts and typically do
not permanently convey ownership of their utility systems. The first
report, prepared by CNA at the request of the Navy and issued in March
2001, noted that while most private sector contracts for utility
services last from 7 to 10 years, most DOD utility services contracts
under privatization are for 50 years.[Footnote 29] The report's concern
was that a contract written today could not adequately anticipate all
possible contingencies over the next 50 years because technologies and
requirements can change in unforeseen ways. CNA also reported that, in
contrast to DOD's preferred approach that utility system ownership be
permanently conveyed to contractors, private sector firms typically
retain ownership of their systems. The report's concern here was that
DOD's preferred approach of permanently conveying ownership may give
the contractor an advantage when negotiating service contract changes
or renewals. For example, generally entering into a long-term services
contract creates a bilateral monopoly where the military must purchase
utility services from one company and that company must sell these
services to the military. The report concluded that such an arrangement
could pose special problems because DOD must deal with the contractor
or face high costs. For example, if DOD and the contractor reached an
impasse over some issue, then DOD might have to pay significant amounts
to construct a new utility distribution system to replace the one that
had been conveyed to the contractor, attempt to purchase the system
back from the contractor, or institute legal action to reacquire the
system through condemnation proceedings.
The second report was prepared by Malcolm Pirnie, Incorporated, at the
request of the Air Force and issued in March 2002.[Footnote 30] This
report included the results of a survey of utility practices at
entities similar to military installations, such as selected industrial
complexes, airport authorities, and universities responsible for
supplying utility services to their complexes. The survey found that in
most cases, these entities owned and operated their utility systems.
The report also noted that under DOD's approach, renegotiating terms
after a contract's 50-year term ends could be a concern because in
instances where alternatives for service were not available, DOD's
negotiating position would be negatively impacted.
Officials at several of the installations we visited also expressed
concerns about the government's negotiating position under
privatization after permanent conveyance of system ownership to a
contractor. For example, Bolling Air Force Base officials stated that
they were concerned that the contractor might obtain larger-than-
expected price increases in future price renegotiations because the
contractor had a monopoly position over the government. As a result,
they believed that a privatization contract could ultimately cost
considerably more than expected. Similarly, the Fort Campbell economic
analysis supporting privatization of the installation's water and
wastewater systems stated that privatization "will give the new owner a
monopoly for the utility service that will require close regulation by
the Army. Staffing of this regulation function will be essential to
insuring that a reasonable price is paid for the service rendered."
A recent situation at Fort Leonard Wood appears to illustrate the
potential problems facing DOD under its approach to privatization when
utility services contracts come up for renewal. About 15 years ago, the
Army awarded a contract to a company to build a natural gas pipeline to
the installation and in 1992 entered into a 10-year utility services
contract with the company. This contract expired in October 2002. From
that time through December 2004, the Army was unable to reach agreement
with the company for a new 10-year contract. According to Army
officials, the impasse was over higher service prices and other
conditions imposed by the company as a condition for renewal. To
continue service, the Army and the company had agreed to short-term 90-
day contracts in which the Army agreed to pay the company higher prices
for utility services. After 26 months, in January 2005, the Army and
the contractor agreed to new terms and entered into a new 10-year
services contract. However, according to Army Audit Agency officials
who were conducting a review of natural gas service contracts at
several installations including Fort Leonard Wood, if negotiations for
renewing the contract at Fort Leonard Wood had not been successful,
then the Army possibly would have started legal efforts to condemn the
system in order to gain ownership.
Of the seven utility privatization projects that we reviewed, all but
one followed DOD's preferred approach and permanently conveyed system
ownership to the contractor. The exception was the privatization of
Fort Campbell's water and wastewater systems. In this case, the
installation conveyed the systems to the contractor, but the contract
provided for reversion of ownership to the government at the end of the
50-year services contract. During the privatization evaluation process,
Fort Campbell officials had noted concerns over the permanent
conveyance of the systems. Specifically, according to the Fort Campbell
economic analysis for the systems, the government will pay the
contractor to upgrade and maintain the systems in good condition over
the 50-year contract term. As a result, by regaining ownership at the
end of the contract, the Army would take ownership of systems worth a
considerable sum of money and would have additional options, such as
taking over operations and maintenance or issuing a competitive
solicitation for a new utility services contract. Conversely, the
analysis noted that by following DOD's preferred approach of permanent
conveyance without reversion, the government would be locked into
procuring utility services from the contractor for as long as the Army
needed the services and this approach might not be in the government's
best interest. Because of its concerns, Fort Campbell sought and
obtained approval from Army headquarters to enter into a privatization
contract that included ownership reversion.
Conclusions:
Utility privatization has helped installations achieve major system
improvements that, according to DOD, would not have been otherwise
possible given competing appropriation priorities. Nevertheless, the
utility privatization program generally increases military utility
costs well above historical levels because the program leverages
private sector capital to achieve utility system improvements. To pay
for these improvements over time, DOD's funding obligations will likely
increase, not decrease, by hundreds of millions of dollars and
operations and maintenance budgets will need to be adjusted, as
necessary. Yet, the services' economic analyses give an unrealistic
sense of savings to this program because they estimate that approved
projects will reduce the government's long-term costs for utility
services. The amount of estimated long-term savings, however, is merely
the services' estimated difference between the costs of two options--
privatization and government ownership--and both options will result in
increased utility costs compared to historical levels, although perhaps
in different time frames. Moreover, as long as selecting the less-
costly option is expected to be a key factor in utility privatization
decision making, it is important that the supporting analyses are
reliable. Unless DOD revises the guidance for preparing economic
analyses for proposed utility privatization projects so that the
analyses are based on actual anticipated costs, the result will
continue to be analyses that could lead DOD to enter into long-term
privatization agreements that result in higher, not lower, costs
compared to continued government ownership. Reliability also will
continue to be an issue until DOD starts requiring an independent
review of the economic analyses supporting proposed privatization
projects. Without such a review, the services' economic analyses could
continue to include inaccuracies and decision makers will be hampered
in their ability to make economically sound choices about which option
should be followed to achieve utility systems improvements.
Unless DOD places greater scrutiny on the implementation of the fair
market value requirement in proposed utility privatization contracts in
order to minimize cases where contractors recover more than the amounts
they paid for system conveyances, some utility privatization contracts
may cost more than necessary. Also, until the services issue specific
utility privatization contract administration guidance including the
clear assignment of responsibilities and ensure that resources are
provided to perform adequate contract oversight, the services'
oversight of utility privatization contracts may continue to be
limited. Inadequate oversight could result in the services paying
contractors for work not performed or for work performed in an
unsatisfactory manner. Also, as long as DOD's preferred approach is for
installations to permanently convey utility system ownership,
contractors may continue to have an advantage when it comes time to
negotiate contract changes and renewals. DOD must deal with the
contractor or pay significant amounts to construct a new utility
distribution system to replace the one that had been conveyed to the
contractor, attempt to purchase the system from the contractor, or
institute legal action to reacquire the system through condemnation
proceedings.
Recommendations for Executive Action:
We recommend that the Secretary of Defense direct the Deputy Under
Secretary of Defense (Installations and Environment) to take the
following six actions:
* As long as savings are expected to be a key factor in utility
privatization decision making, revise the guidance for preparing
economic analyses so that the analyses compare the cost of a proposed
privatization contract with the cost of continued government ownership
on the basis of the actual planned expenditures and the timing of these
expenditures.
* Require an independent review, perhaps by DOD headquarters or the
services' audit agencies, of the economic analyses supporting proposed
privatization projects.
* Provide general program guidance emphasizing the need to consider
increased utility costs under privatization as the military services
prepare their operation and maintenance budget requests.
* Place greater scrutiny on the implementation of the fair market value
requirement in proposed contracts to minimize cases where contractors
recover more than the amounts they paid for system conveyances.
* Issue program guidance, specific to utility privatization,
emphasizing the importance of contract oversight.
* Reassess whether permanent conveyance of utility systems should be
DOD's preferred approach to obtaining improved utility services.
We further recommend that the Secretary of Defense direct the
Secretaries of the military departments to take the following two
actions:
* Ensure that installation operations and maintenance budgets are
adjusted as necessary to reflect increased costs from utility
privatization projects.
* Issue specific utility privatization contract administration guidance
including the clear assignment of responsibilities and ensure that
resources are provided to perform adequate contract oversight.
Matter for Congressional Consideration:
On the basis of DOD's comments on our recommendations, as discussed
below, the Congress may wish to consider requiring DOD to address the
issues and recommendations discussed in this report before proceeding
with further utility privatization efforts.
Agency Comments and Our Evaluation:
In commenting on a draft of this report, the Deputy Under Secretary of
Defense (Installations and Environment) did not concur with our report
findings or recommendations and raised several concerns. DOD stated
that we had a limited understanding of the utilities privatization
program and characterized our findings as being outdated and not well
founded. In addition, DOD suggested that our report represented an
unwarranted characterization of our findings as being systemic problems
of the program. We disagree.
We believe that our review of the utility privatization program was
objective, balanced, and represented program conditions existing at the
time we completed our review in March 2005. We remain confident that
our conclusions and recommendations are soundly based upon the findings
discussed in the report. In response to the comments, however, we
modified two of our recommendations, as noted below, to improve their
clarity and more precisely identify responsible parties. We also added
two recommendations regarding program guidance, as noted below. We
believe it is appropriate to emphasize, as explained in the scope and
methodology section of this report, that we followed our professional
practices and validated the facts and statistics presented in the
report with DOD and service officials prior to preparation of the draft
report.
In its comments, DOD did not provide any information suggesting any
inaccuracies in our report, but rather contended that our case studies
were outdated and related to problems that occurred during the start of
the program in the late 1990s. DOD's contention is incorrect. Of the
seven utility privatization projects we reviewed in detail, the
associated contracts for four projects were awarded in 2004, and the
contracts for two projects were awarded in 2003. The economic analyses
supporting these projects should have been current and reliable at the
time the contracts were awarded; but as noted in this report, they were
not. Further, Office of the Secretary of Defense officials used three
of the projects we reviewed in detail as examples of cost-saving
utility privatization projects in program briefings presented to us in
July 2004. As noted in the scope and methodology section of this
report, we recognize that the limited number of case studies completed
does not make them projectable to the universe of DOD utility
privatization projects. However, given other corroborating information,
including statements of continuing program concerns raised by cognizant
service and installation officials and similar concerns reported by the
Army Audit Agency and more recently by the Naval Inspector General, we
believe the findings of this report have much broader applicability
than the limited number of cases we studied.[Footnote 31] Even the
Deputy Under Secretary recently noted significant challenges in
managing the program. In March 2, 2005, testimony before a House
Appropriations Subcommittee, the Deputy Under Secretary noted
difficulties in conducting long-term economic analyses, determining
fair market value for the government's utility systems, and making
price adjustments to long-term contracts for utility services.[Footnote
32] We make the following observations regarding DOD's comments on the
individual recommendations in the draft report.
DOD disagreed with our recommendation to revise the guidance for
preparing economic analyses so that the analyses would compare the cost
of a proposed privatization contract with the cost of continued
government ownership on the basis of the actual planned expenditures
and the timing of these expenditures. DOD stated that it is impossible
to predict with any measure of accuracy what DOD would spend to
maintain a system, particularly with regard to military construction,
beyond more than a few years. Thus, DOD believes that its current use
of a "should-cost" estimate, based on what a private utility company
would engage in by way of recapitalization, results in an estimate with
some reasonable accuracy. Our issue with DOD's estimates primarily
concerns what DOD would actually spend on the systems over the near
term where, based on its comments, it does know what it plans to spend
with some accuracy. As long as selecting the less-costly option--i.e.,
government ownership or privatization--is expected to be a key factor
in utility privatization decisions, as required by statute, we continue
to believe that the supporting analyses should be based on realistic
anticipated costs, as is the intent of our recommendation. DOD also
commented that use of its current estimating method was consistent with
the underlying rationale of the program--that private industry can
normally provide more efficient utility service than can the
government. As our report makes clear, however, DOD did not provide any
studies or other documentation to support its contention. Given that
the private sector faces higher interest costs than the government and
strives to make a profit whereas the government does not, it is not
certain that utility services provided by the private sector would be
less costly than utility services provided by the government through
the use of up-front appropriations. Thus, as we have recommended, sound
economic analyses based on actual planned expenditures are needed to
determine the most cost-effective option for providing utility services
to DOD installations.
DOD disagreed with our draft recommendation that the Deputy Under
Secretary of Defense (Installations and Environment) ensure that
installation operations and maintenance budgets are adjusted as
necessary to reflect increased costs from utility privatization
projects. DOD properly noted that the Deputy Under Secretary of Defense
(Installations and Environment) does not manage the operations and
maintenance budgets of the installations. Accordingly, we have modified
the recommendation to state that the Secretary of Defense should direct
the Secretaries of the military departments to take this action.
Further, given the magnitude of the program and the fact that many of
these facilities, as well as base operating support budgets from which
utility-related contracting costs are paid, have been historically
underfunded, we believe it would be appropriate for the Deputy Under
Secretary to provide general program guidance emphasizing the need to
consider increased utility costs under privatization as the military
services prepare their operations and maintenance budget requests.
Accordingly, we have added supporting information in the text on this
point and a new recommendation to address this issue.
DOD disagreed with our recommendation to require an independent review,
perhaps by DOD headquarters or the services' audit agencies, of the
economic analyses supporting proposed privatization projects. DOD
stated that the military departments have the authority to ensure a
sufficient review and have adopted processes that conduct such a
review. DOD stated that our concerns, while factual, occurred during
the start of the program. We agree that the military departments have
the authority to ensure sufficient review of the economic analyses, but
we disagree that the military departments have adopted processes that
ensure reliable analysis, as noted by the examples in this report. As
explained above, the case studies we reviewed and their economic
analyses are associated with recent privatization contracts mostly
signed within the past 2 years--not at the beginning of the program in
1997--and thus reflect current concerns. Also, we do not understand
DOD's reluctance to provide additional scrutiny of the economic
analyses for proposed utility privatization projects in view of the
errors we found in the cases we examined and the fact that DOD already
provides for such independent reviews of economic analyses associated
with proposed projects in the housing privatization program. Thus, we
continue to believe, as we have recommended, that an independent review
is needed to help ensure the accuracy and reliability of the economic
analyses supporting proposed privatization projects.
DOD disagreed with our recommendation to place greater scrutiny on the
implementation of the fair market value requirement in proposed
contracts to minimize cases where contractors recover more than the
amounts they paid for system conveyances. DOD again commented that the
examples mentioned in this report happened during the start of the
program and that contracting officers are now aware of the potential
for contractors to recover more than they pay in fair market value and
take steps to minimize the risk. Contrary to DOD's comments, the two
examples of concerns in this area that we reviewed and cite in this
report, Dobbins Air Reserve Base and Fort Lee, were privatized in April
2004 and June 2004, respectively--7 years after the start of the
program in 1997. Also, given that DOD contends that contracting
officers are now aware of the concern and are taking steps to minimize
the risk, we continue to believe, as we have recommended, that it is
appropriate for DOD to place greater scrutiny on the implementation of
the fair market value requirement to ensure that these steps are
successful.
DOD disagreed with our draft recommendation that the Deputy Under
Secretary of Defense (Installations and Environment) issue specific
utility privatization contract administration guidance and provide
funding for personnel to perform contract oversight. DOD commented that
the services are responsible for funding and performing post-award
contract administration of utility contracts, just as with any other
contract. We agree, in part, and therefore clarified and changed our
recommendation to state that the Secretary of Defense should direct the
Secretaries of the military departments to take this action. However,
given the magnitude of the utility privatization program and its use of
50-year service contracts, we believe, as our report makes clear, that
it would be beneficial for the Deputy Under Secretary to issue program
guidance, specific to utility privatization, to emphasize the
importance of contract oversight. We have added a separate
recommendation to address this issue.
DOD disagreed with our recommendation to reassess whether permanent
conveyance of utility systems should be DOD's preferred approach to
obtaining improved utility services. DOD commented that the Deputy
Secretary of Defense determined that owning, operating, and maintaining
utility systems are not core functions of the DOD and that the issue of
title transfer has been reviewed repeatedly during the life of this
program. As noted in this report, DOD has no studies or other
documentation showing that its approach to utility privatization is
based on private sector best practices. On the other hand, the services
have two consultant reports which state that DOD's approach actually
differs from typical private sector practices and raise the concern
that DOD's preferred approach of permanently conveying ownership may
give the contractor an advantage when negotiating service contract
changes or renewals. Moreover, there is not universal agreement within
DOD concerning what is or is not a core function. For example, the
Deputy Assistant Secretary of the Air Force stated in March 2005
congressional testimony that "the Air Force considers utility operation
and maintenance a core competency, without which we could not fly and
fight".[Footnote 33] In its comments, DOD also stated that while there
are compelling arguments on each side, the department continues to
believe that the best practice--i.e., its practice--is to transfer
title to the utility system in line with the statutory intent. We
disagree. First, just because many DOD systems have been conveyed in
that manner does not make it a best practice. As noted, most utility
service contracts are long-term agreements and it may take many years
before DOD knows whether the practice of conveyance is successful or
whether it results in long-term problems and added costs to DOD.
Second, while the utility privatization statute permits title transfer,
it is not clear that the statute's language shows intent for the
services to convey utility ownership. Thus, we continue to believe, as
we have recommended, that DOD should reassess whether permanent
conveyance of utility systems should be DOD's preferred approach to
obtaining improved utility services.
DOD's comments are reprinted in their entirety in appendix III.
We are sending copies of this report to other interested congressional
committees; the Secretaries of Defense, Army, Navy, and Air Force; and
the Director, Office of Management and Budget. We will also make copies
available to others upon request. In addition, the report will be
available at no charge on GAO's Web site at [Hyperlink,
http://www.gao.gov].
If you or your staff has any questions on the matters discussed in this
report, please contact me at (202) 512-5581 or my Assistant Director,
Mark Little, at (202) 512-4673. Gary Phillips, Sharon Reid, Harry
Knobler, and Kenneth Patton were major contributors to this report.
Signed by:
Barry W. Holman,
Director, Defense Capabilities and Management:
[End of section]
Appendixes:
Appendix I: Scope and Methodology:
To determine the status of the Department of Defense's (DOD) utility
privatization program, we reviewed past and present privatization
plans, initiatives, and costs. We reviewed the legislative history of
the privatization program and assessments of the program performed by
service audit agencies and others. We compared current goals and
milestones with previous ones and interviewed DOD and service
headquarters officials responsible for the program to determine reasons
for the changes. We reviewed applicable DOD and military service
policies and procedures. Using data from the services' quarterly
program status reports to DOD, we summarized the program implementation
status by service and compared the status to the current goals and
milestones for the program. We confirmed the quarterly reports' status
data on seven privatization projects but did not otherwise test the
reliability of the data. We discussed with DOD and service officials
issues affecting implementation of the program such as questions
regarding contract termination liability. We visited selected
installations to review and discuss utility privatization projects at
the installations. Specifically, we visited five military
installations--Fort Campbell, Kentucky; Fort Lee, Virginia; Fort Irwin,
California; Dobbins Air Reserve Base, Georgia; and Bolling Air Force
Base, Maryland. The installations were selected because they have
projects that were privatized using the legislative authorities
specifically provided for privatizing military utility systems. In
addition, DOD often cites three of the installations visited as having
financially successful utility privatization projects. We did not
select a Navy or Marine Corps privatization project to review because
the Navy had approved only one project under the legislative
authorities provided for the program and the Marine Corps had approved
none. The Navy project did not involve a typical utility privatization
effort in that it converted a fuel service contract into a
privatization contract.
To determine whether the services' estimates of savings from utility
privatization projects are reliable, we reviewed the services' utility
costs and funding information and discussed with DOD and service
officials how utility costs under privatization compare to historical
utility costs, the reasons for the cost differences, and whether
funding the utility privatization program could affect the funding
available for other installation functions. We also selected and
reviewed the economic analyses for seven privatization projects located
at the five installations visited. We selected three analyses for
review because DOD often cites the associated privatization projects as
examples of successful, cost-saving projects. The other four analyses
were selected because they represented a cross section of typical
utility privatization projects, according to service officials. For
each analysis, we evaluated the basis for the estimates and assumptions
used and assessed consistency and compliance with DOD guidance. We
examined the analyses for the use of appropriate life-cycle
methodologies and accuracy of the calculations. We did not otherwise
attempt to independently determine estimates of long-term costs for the
seven projects. We shared the results of our analyses with DOD and
service officials and incorporated their comments as appropriate. We
discussed with DOD and service officials the procedures they use to
ensure the consistency, reasonableness, and accuracy of the completed
economic analyses. We also reviewed reports from the services' audit
agencies related to utility privatization projects and their
assessments of the reliability of the economic cost analyses.
To determine how DOD implements the fair market value requirement for
conveyed utility systems, we reviewed DOD and service policies and
procedures dealing with implementation of the fair market value
requirement, discussed with officials how receipt of fair market value
is ensured, and assessed the amounts received as consideration for the
seven privatization project conveyances associated with our review of
the economic analyses. For each project, we examined how the fair
market value was determined and reviewed what effect the amounts
received and the associated contract terms had on the government's
costs for privatization. We shared the results of our analyses with DOD
and service officials.
To determine whether other issues might impact DOD's execution of the
utility privatization program, we reviewed DOD and service guidance for
utility privatization contract administration, discussed contract
oversight with DOD and service officials, and discussed and reviewed
the oversight provided at the five installations visited. We also
reviewed reports on utility privatization contract administration from
the Army Audit Agency. In addition, we obtained and reviewed
information from DOD, service, and installation officials and from
service consultant reports on how DOD's approach to utility
privatization compares with private sector practices. We visited one of
the services' consultants, CNA, to discuss details with the authors of
the CNA report on utility privatization.
We conducted our review between July 2004 and March 2005 in accordance
with generally accepted government auditing standards.
[End of section]
Appendix II: Results of GAO's Review of the Services' Economic Analyses
Supporting Seven Utility Privatization Projects:
We reviewed seven utility privatization project analyses and identified
inaccuracies, unsupported cost estimates, and noncompliance with
guidance for performing the analyses. In general, the cost estimates in
the analyses we reviewed favored the privatization option by
understating long-term privatization costs or overstating long-term
government ownership costs. The results of our review are summarized
below.
Fort Lee Water System Privatization:
The economic analysis for privatizing Fort Lee's water distribution
system did not consider the system's value at the end of the analysis
period--the residual value--under the government ownership option, as
required by DOD guidance.[Footnote 34] Consideration of residual value
recognizes that, under the government ownership option, the government
would own the system and that the system would have some value at the
end of the analysis period. In contrast, under the privatization
option, the contractor, not the government, would own the system at the
end of the analysis period. Not including the residual value in the
analysis resulted in favoring the privatization option by overstating
government ownership costs. We recomputed costs by including a residual
value for the system at the end of the 50-year contract. The result was
to change the outcome of the analysis from estimating that
privatization would be less costly over the long term to estimating
that government ownership would be less costly over the long term.
DOD's guidance also requires that a system's economic analysis consider
costs over the proposed project's contract term. However, the analysis
for Fort Lee's water distribution system considered costs over a 25-
year period instead of the contract's 50-year period. Although
information was not available to determine how this discrepancy
affected the results of the analysis, the example demonstrates the need
for independent review to help ensure accuracy and compliance with
guidance.
Fort Lee Electric System Privatization:
The economic analysis for the privatization of Fort Lee's electric
distribution system also did not consider the system's residual value
under the government ownership option. We recomputed costs by including
a residual value for the system at the end of the 50-year contract.
Army officials suggested that the residual value should approximate
$16.5 million, the system's current replacement cost less depreciation.
Using this amount in the analysis would show the privatization option
to still be less costly than government ownership over the long term,
but the estimated cost difference between the options would decrease
from 15.0 percent to 4.6 percent. However, the analysis assumed that
the system would be upgraded and maintained in accordance with industry
standards over the 50-year analysis period and showed that, under the
government ownership option, the Army would spend $17.7 million in
today's dollars for system improvements. As such, we believe that it is
reasonable to assume that the residual value should approximate the
system's current replacement cost of $23.3 million. Using this amount
in the analysis would change the outcome of the analysis and show that
government ownership would be slightly less costly than privatization
over the long term.
Fort Campbell Water and Wastewater Systems Privatization:
The economic analysis supporting privatization of Fort Campbell's water
and wastewater systems contained several errors. First, the analysis
did not follow DOD guidance when estimating contract oversight costs
for the privatization option and as a result, understated these costs.
Second, the analysis included errors in estimating general and
administrative costs under the government ownership option and as a
result, overstated these costs. Third, the analysis used faulty
assumptions in estimating self-insurance costs for potential property
and liability losses under the government ownership option and as a
result, overstated these costs. We recomputed the cost estimates by
making corrections for these errors. The result was to change the
outcome of the analysis from estimating that privatization would be
less costly over the long term to estimating that continued government
ownership would be less costly over the long term.
Fort Irwin Electric System Privatization:
The economic analysis for privatizing Fort Irwin's electric
distribution system overstated annual operations and maintenance costs
under the government ownership option. Specifically, to estimate these
costs, the analysis adjusted the installation's historical operations
and maintenance costs upward to reflect the estimated amount that the
installation should be spending in accordance with industry standards.
However, part of this estimate included predicted future costs for
emergency repairs. Fort Irwin's historical emergency repair costs were
about $175,000 annually and, to adjust for some items that were not
included in the historical costs and estimate the amount that the
installation should be spending for emergency repairs, the analysis
increased the historical amount by over 100 percent to about $357,000
annually. Fort Irwin officials stated that emergency repair costs were
high in the past because the system consisted primarily of old,
antiquated equipment that had not been adequately maintained. However,
under the government ownership option, as under privatization, the
analysis assumed that the system would be quickly upgraded and
maintained to industry standards. As such, the officials stated that
future emergency repair costs should decrease, not increase. To adjust
for the overstated emergency repair cost estimate and to be
conservative, we recalculated the total costs under the government
ownership option assuming that emergency repair costs would not
increase or decrease but remain at the historical level. The result was
to change the outcome of the analysis from estimating that
privatization would be less costly over the long term to estimating
that continued government ownership would be less costly over the long
term.
Changes in the economic analysis supporting the Fort Irwin electric
distribution system privatization also raised questions about
reliability. In October 2000, an Army consultant completed an economic
analysis of the proposed system privatization. The analysis estimated
that the government ownership option would be less costly than
privatization in the long term. Specifically, in today's dollars, the
analysis estimated that the government ownership option would cost
about $14.7 million less over the long term than if the system were
privatized. Yet, about 2 and a half years later in February 2003, the
same consultant completed a new economic analysis for the proposed
project. This analysis concluded the opposite--that privatization would
be less costly than the government ownership option by about $3.6
million in today's dollars. Details explaining the basis for the
significantly changed estimates were not included in the new analysis
and could not be explained by Fort Irwin officials.
Dobbins Air Reserve Base Electric System Privatization:
According to DOD guidance, the economic analyses for proposed
privatization projects should estimate and compare costs assuming that
the government would upgrade and improve the system to industry
standards, as the privatization contractor would be required to do.
However, we questioned whether the analysis for Dobbins Air Reserve
Base's electric system privatization followed this guidance because of
the large cost difference between estimated improvement costs under the
privatization and government ownership options. The economic analysis
estimated that under privatization the contractor's costs to complete
system improvements over the contract period would be about $1.6
million in today's dollars. In contrast, the analysis estimated that
system improvement costs under the government ownership option over the
same period would be about $4.7 million in today's dollars, a
difference of $3.1 million, or 194 percent, more. In response to our
questions, Air Force officials stated that an error had been made in
calculating improvement costs under the government option and that the
improvement costs were overstated by about $2 million. We recomputed
costs to make a correction for the error. The result was to change the
outcome of the analysis from estimating that privatization would be
less costly over the long term to estimating that continued government
ownership would be less costly over the long term.
Bolling Air Force Base Water and Wastewater Systems Privatization:
The economic analyses supporting privatization of the water and
wastewater systems at Bolling Air Force Base were not valid because
they did not accurately reflect system improvements to be performed by
the contractor. Bolling Air Force Base officials stated that the
analyses assumed that the contractor would complete many upgrades and
improvements to the systems during the first 5 years of the contracts.
However, the officials also stated that the privatization contract
process was delayed after the analyses were prepared and that military
construction funding was obtained and used to complete about 90 percent
of the improvement projects that the analyses assumed the contractor
would do. Because the analyses were not updated to reflect the changes
in the planned work, the results of the analyses include estimated
savings from contractor work that will not be performed. We did not
have sufficient information to recalculate estimates in analyses.
However, installation officials stated that they believed that
continued government ownership of the systems would have been less
costly than privatization over the long term.
[End of section]
Appendix III: Comments from the Department of Defense:
OFFICE OF THE UNDER SECRETARY OF DEFENSE:
ACQUISITION, TECHNOLOGY AND LOGISTICS:
3000 DEFENSE PENTAGON:
WASHINGTON, DC 20301-3000:
Mr. Barry Holman:
Director, Defense Capabilities and Management:
Government Accountability Office:
Washington, D.C. 20548:
APR 29 2005:
Dear Mr. Holman:
This is the Department of Defense (DoD) response to the GAO Draft
Report, `DEFENSE INFRASTRUCTURE: Management Issues Requiring Attention
in Utility Privatizations', dated March 31, 2005 (GAO-05-433, Code
350557). Detailed comments on the report are enclosed. Our comments
support my conclusion that the draft report reflects a limited
understanding of the Utilities Privatization program and an unwarranted
characterization of all findings to be systemic problems of the
program.
To the extent that the report characterizes findings which appear to be
outdated and not well founded, I urge your strongest consideration to
revisit this report and to comprehensively address the issues we have
raised prior to issuing this report in final form. My staff is prepared
and willing to assist your team to more accurately assess the program.
We would also appreciate an additional opportunity for review prior to
any final publication.
Signed by:
Philip W. Grone:
Deputy Under Secretary of Defense (Installations and Environment):
Enclosure: As stated:
GAO DRAFT REPORT-DATED MARCH 31, 2005 GAO CODE 350557/GAO-05-433:
"DEFENSE INFRASTRUCTURE: Management Issues Requiring Attention In
Utility Privatization:"
DEPARTMENT OF DEFENSE COMMENTS TO THE RECOMMENDATIONS:
RECOMMENDATION 1: The GAO recommended that the Secretary of Defense
direct the Deputy Under Secretary of Defense for Installations and
Environment to revise the guidance for preparing economic analyses so
that the analyses compare the cost of a proposed privatization contract
with the cost of continued government ownership on the basis of the
actual planned expenditures and the timing of these expenditures. (pp.
33/GAO Draft Report):
DOD RESPONSE: Nonconcur. In establishing the economic costs to be
compared for purposes of meeting the statutory requirements of 10
U.S.C. § 2688, the DoD effectively had two choices: (1) it could assume
that future costs of ownership by DoD would be the equivalent of the
level of maintenance that would occur if owned by private industry,
i.e., "should-cost"; or, (2) it could assume that future costs of
ownership by DoD would reflect the likely levels of actual expenditures
that DoD would invest in the system. In either case, the resulting
numbers would be, at best, an estimate of future costs. The more
accurate estimate, however, is the "should-cost" estimate. This is
because it is impossible to predict with any measure of accuracy what
the DoD would itself spend to maintain a system, particularly with
regard to military construction, beyond more than a few years. DoD does
not effectively budget beyond that for purposes of utility system
capitalization. On the other hand, using the "should-cost" estimate is
substantially more accurate since it represents what a private utility
company would engage in by way of re-capitalization. This is an
estimate the DoD can ascertain with some reasonable accuracy. Given the
choice between a reasonably accurate number and a number that would be
unreliable, the DoD chose the more reliable number-the "should-cost"
estimate.
This is also consistent with the underlying rationale of the program,
that private industry can normally provide more efficient utility
service than can the Government. It is reasonable to assume that the
comparison, for purposes of the economic evaluation, should be between
equivalent operations. To do this, the DoD has to assume that the
utility system will be maintained at essentially the same level whether
privately or Government owned. The alternative-assuming little or no
Government investment, but very large private investment-would result
in the authority of section 2688 never being used for the simple reason
that the costs of not maintaining a system, even if it doesn't perform,
is always going to be less expensive than the costs of maintaining the
system.
RECOMMENDATION 2: The GAO recommended that the Secretary of the Defense
direct the Deputy Under Secretary of Defense for Installations and
Environment to adjust installation operations and maintenance budgets
as necessary to reflect increased costs from utility privatization
projects. (p. 34/GAO Draft Report):
DOD Response: Nonconcur. The Deputy Under Secretary of Defense for
Installations and Environment does not manage the operations and
maintenance budgets of the installations. The Military Departments are
responsible for funding the utility services contracts resulting from a
system conveyance. The Services make the required adjustments for these
must-pay contract costs as part of their programming and budgeting
responsibilities.
The example on page 18 concerning funding of the Fort Irwin electrical
distribution services contract illustrates how the Services prioritize
requirements in a rational manner. The Army centrally programs and
budgets for the increased cost of utilities due to privatization for a
period of two years following contract award. By that time, the
increased cost becomes part of the historic data and is captured by the
Army's programming and budgeting system.
RECOMMENDATION 3: The GAO recommended that the Secretary of the Defense
direct the Deputy Under Secretary of Defense for Installations and
Environment to require an independent review, perhaps by DoD
headquarters or the services audit agencies, of the economic analyses
supporting proposed privatization projects. (p. 34/GAO Draft Report):
DOD Response: Nonconcur. The Military Departments have authority to
ensure a sufficient review and have adopted processes that conduct such
a review. The Service Secretary is responsible for ensuring that a
proper economic analysis is conducted per guidance that has been in
effect since October 10, 2002. While some of the GAO concerns are
factually correct, they occurred during the start of the program. The
Services have implemented program improvements (standard RFPs and
economic analysis models) to achieve uniform and consistent processes
and have shared lessons on a regular basis. The Services achieve
independent review of the economic analysis by using the Defense
Contract Audit Agency and consultants to conduct reviews at all stages
of the procurement process. DUSD(I&E) will continue to monitor progress
in this area in it's oversight role.
RECOMMENDATION 4: The GAO recommended that the Secretary of the Defense
direct the Deputy Under Secretary of Defense for Installations and
Environment to place greater scrutiny on the implementation of the fair
market value requirement in proposed contracts to minimize cases where
contractors recover more than the amounts they paid for system
conveyances. (p. 34/GAO Draft Report):
DOD Response: Nonconcur. 10 U.S.C § 2688 states that the Secretary
concerned shall require as consideration for a conveyance an amount
equal to the fair market value of the right, title, or interest of the
United States conveyed. This requires that the contractor make an
investment in the system. It also avoids issues related to taxes for
contributions in aid of construction. Business practices will normally
yield some return on that investment, as does any investment in capital
plant by a business. The form of that return and the cost of the
transaction are highly variable depending on the industry sector. The
examples mentioned in the GAO report happened during the start of the
program. Contracting Officers are now aware of the potential for
contractors to recover more than they pay in Fair Market Value and take
steps to minimize the risk.
RECOMMENDATION 5: The GAO recommended that the Secretary of the Defense
direct the Deputy Under Secretary of Defense for Installations and
Environment to issue specific utility privatization contract
administration guidance and provide funding for personnel to perform
contract oversight. (p. 34/GAO Draft Report):
DOD Response: Nonconcur. The Services are transitioning their emphasis
from pre-award functions to post award contract administration. The
Services are responsible for funding and performing post-award contract
administration of utility contracts just as with any other contract.
Specific utility privatization guidance is best developed by Service
contracting authorities as a regular order of business using
established contract administration procedures and best business
practices.
RECOMMENDATION 6: The GAO recommended that the Secretary of the Defense
direct the Deputy Under Secretary of Defense for Installations and
Environment to reassess whether permanent conveyance of utility systems
should be DOD's preferred approach to obtaining improved utility
services. (p. 34/GAO Draft Report):
DOD Response: Nonconcur. The Deputy Secretary of Defense determined
that owning, operating, and maintaining utility systems are not core
functions of the Department of Defense. When conveyance with full title
transfer is uneconomical, the Military Services are already able to
consider if conveyance of a lesser estate will result in long-term
savings. As an example, the Army determined that full title transfer of
the water and wastewater systems at Fort Campbell is uneconomical. The
Army then determined that conveyance of the systems at a lesser estate
is economical and completed the transaction.
The issue of title transfer has been reviewed repeatedly during the
life of this program. While there are compelling arguments on each
side, the Department continues to believe, supported by numerous
completed actions, that the best practice is to transfer title to the
utility system in line with the statutory intent. This effectively gets
the Department out of a non-core mission and makes the Department a
utility customer instead of a utility provider. As of 2nd quarter FY
2005, the Services have issued RFPs or made privatization decisions for
most of DOD's utility systems. A re-assessment of DOD's policy at this
point would create confusion without adding value to the few remaining
solicitations.
[End of section]
(350557):
FOOTNOTES
[1] The National Defense Authorization Act for Fiscal Year 1998, Pub.
L. No. 105-85, § 2812, (1997).
[2] The conveyance may consist of all right, title, and interest of the
United States in the utility system or such lesser estate as the
Secretary of a military department considers appropriate to serve the
interests of the United States.
[3] See note 1.
[4] See National Defense Authorization Act for Fiscal Year 2004, Pub.
L. No. 108-136, § 1031(a)(12), which changed the timing of the
reporting requirement. The seven utility privatization projects we
reviewed were under the earlier requirement.
[5] See Deputy Secretary of Defense, Memorandum for Secretaries of the
Military Departments and others, Subject: Department of Defense Reform
Initiative Directive #9--Privatizing Utility Systems (Department of
Defense: Washington, D.C., Dec. 10, 1997).
[6] See Deputy Secretary of Defense, Memorandum for Secretaries of the
Military Departments and others, Subject: Department of Defense Reform
Initiative Directive #49--Privatizing Utility Systems (Department of
Defense: Washington, D.C., Dec. 23, 1998).
[7] See Deputy Secretary of Defense, Memorandum for Secretaries of the
Army, Navy, and Air Force and Director of the Defense Logistics Agency,
Subject: Revised Guidance for the Utility Privatization Program
(Department of Defense, Washington, D.C., Oct. 9, 2002).
[8] GAO, Defense Reform Initiative: Organization, Status, and
Challenges, GAO/NSIAD-99-87 (Washington, D.C.: Apr. 21, 1999) and
Defense Infrastructure: Improved Performance Measures Would Enhance
Defense Reform Initiative, GAO/NSIAD-99-169 (Washington, D.C: Aug. 4,
1999).
[9] GAO, Defense Management: Actions Needed to Sustain Reform
Initiatives and Achieve Greater Results, GAO/NSIAD-00-72 (Washington,
D.C.: July 25, 2000).
[10] GAO, Defense Management: New Management Reform Program Still
Evolving, GAO-03-58 (Washington, D.C.: Dec. 12, 2002).
[11] See GAO, Military Housing: Privatization Off to a Slow Start and
Continued Management Attention Needed, GAO/NSIAD-98-178 (Washington,
D.C.: July 17, 1998); Military Housing: Continued Concerns in
Implementing the Privatization Initiative, GAO/NSIAD-00-71 (Washington,
D.C.: Mar. 30, 2000); and Military Housing: Management Improvement
Needed As the Pace of Privatization Quickens, GAO-02-624 (Washington,
D.C.: June 21, 2002).
[12] See GAO, Defense Budget: DOD Should Further Improve Visibility and
Accountability of O&M Fund Movements, GAO/NSIAD-00-18 (Washington,
D.C.: Feb. 9, 2000); and Defense Infrastructure: Changes in Funding
Priorities and Strategic Planning Needed to Improve the Condition of
Military Facilities, GAO-03-274 (Washington, D.C.: Feb. 19, 2003).
[13] Because the budget does not reflect up front the full costs of the
improvements to be obtained through utility privatization, it may be
more difficult for decision makers to consider the full financial
commitment that the government undertakes when it enters into long-term
privatization contracts. This could lead to a situation in which budget
decisions favor utility privatizations over programs that include their
full costs up front in the budget.
[14] 62 Comp. Gen. 569 (1983).
[15] 62 Comp. Gen. at 572 and 575, n.8.
[16] We do not presume the government will default on its contractual
obligations.
[17] System improvements normally include capital equipment upgrades
and enhanced operations and maintenance to increase utility system
reliability and reduce safety and environmental risks.
[18] Fort Campbell privatized its water and wastewater systems under
one contract and prepared one economic analysis for the project.
[19] Under the government ownership option, the Fort Campbell economic
analysis assumed that operations and maintenance levels would be
enhanced and a series of capital projects would be undertaken to
upgrade the systems. Our estimate was based on delaying the planned
capital projects, not the enhanced operations and maintenance levels,
for 5 years.
[20] See DOD Instruction 7041.3, Subject: Economic Analysis for
Decisionmaking, November 7, 1995.
[21] U.S Army Audit Agency, Potable Water and Wastewater Utility
Systems Contract, Aberdeen Proving Ground, Maryland, A-2004-0186-IMO
(Alexandria, Va.: Apr. 27, 2004).
[22] See Memorandum for Distribution, Subject: Utility Systems
Privatization--Fair Market Value, the Army Assistant Chief of Staff for
Installation Management (Washington, D.C.: Apr. 30, 2002). Navy and Air
Force officials stated that their guidance on fair market value was
consistent with DOD's general guidance.
[23] U.S. Army Audit Agency, Memorandum for the Assistant Chief of
Staff for Installation Management, Subject: Review of the Fair Market
Value for Privatized Electrical Distribution Systems, AA 02-701
(Alexandria, Va.: Oct. 5, 2001).
[24] U. S. Army Audit Agency, Electrical Distribution System Contract,
U.S. Army Infantry Center and Fort Benning, A-2002-0395-IMO
(Alexandria, Va.: May 23, 2002).
[25] See note 21.
[26] Army Audit Agency, Privatization of Utility Distribution Systems,
Fort Hamilton, New York, A-2003-0216-IMO (Washington, D.C.: Apr. 11,
2003).
[27] See note 24.
[28] U.S. Army Audit Agency, Electrical Distribution System Contract,
Virginia Army National Guard Maneuver Training Center, Fort Pickett,
Virginia, A-2003-0337-IMO (Alexandria, Va.: June 27, 2003).
[29] CNA, Utility Privatization Initiatives: Concerns, Metrics,
Priorities, CRM D0003236.A2 (Alexandria, Va.: March 2001).
[30] Malcolm Pirnie, Inc., Program Assessment for Utilities
Privatization in the U.S. Air Force (March 2002).
[31] See notes 21, 23, 24, 26, and 28, and Naval Inspector General,
Utilities Privatization Study (Washington, D.C.: Mar. 15, 2005).
[32] See Statement of Deputy Under Secretary of Defense (Installations
and Environment) before the Subcommittee on Military Quality of Life
and Veterans' Affairs, Committee on Appropriations, United States House
of Representatives, March 2, 2005.
[33] See Statement by the Deputy Assistant Secretary of the Air Force
(Installations) before the Subcommittee on Military Quality of Life and
Veterans' Affairs, Committee on Appropriations, United States House of
Representatives, March 2, 2005.
[34] See DOD Instruction 7041.3, Subject: Economic Analysis for
Decisionmaking, Nov. 7, 1995.
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