Defense Infrastructure
Actions Taken to Improve the Management of Utility Privatization, but Some Concerns Remain Gao ID: GAO-06-914 September 5, 2006Department 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 privatization was the preferred method for improving utility systems, and Congress approved legislative authority for privatizing DOD's utility systems with Public Law No. 105-85. DOD estimates that some utility privatization contracts will cost over $100 million. In a May 2005 report, GAO identified several management weaknesses in DOD's implementation of the program. The Fiscal Year 2006 National Defense Authorization Act required GAO to evaluate and report on changes to the utility privatization program since May 2005. Accordingly, this report updates the status of the program and discusses the effect of DOD's changes on the concerns noted last year. To conduct this review, GAO summarized program status and costs, assessed DOD's changes to program guidance and in other areas, and reviewed the services' implementation of the changes.
DOD's progress in implementing the utility privatization program has been slower than expected and the estimated completion date has slipped from the department's target of September 2005 to September 2011. DOD attributed the delays to the complexity of the program and to the services' decision to suspend and reassess the management of the program between October 2005 and March 2006. Since May 2005, the services privatized 14 utility systems under the legislative authority for the program, bringing the total number of awarded projects to 81. However, the services have awarded no projects since DOD issued new program guidance in November 2005. Meanwhile, the services' total estimated program implementation costs through fiscal year 2006 have increased to $285 million, and more funds will be required before the program is completed in 2011. Since GAO's May 2005 report, DOD has issued new guidance and required changes in procedures. If fully implemented, these changes should result in more reliable economic analyses, improved budgetary consideration of increased utility costs, enhanced oversight of privatization contracts, and reduced instances where contractors recover more than the fair market value paid for system conveyances. However, a number of concerns from the May 2005 report remain. For example, although DOD made changes to improve the reliability of project economic analyses by requiring independent reviews, GAO reviewed 10 economic analyses and found reliability issues that had not been identified during the independent reviews. DOD directed the services to adequately consider in their budgets the increased costs resulting from utility privatization. However, questions remain over the availability of the funds needed to complete the program because the services estimate that they will need $453 million more than is currently programmed to pay costs associated with remaining utility systems that might be privatized. Although DOD made many changes to improve contract administration and oversight, it may take some time to fully implement the changes as new privatization contracts are awarded. GAO's review of five projects awarded prior to DOD's changes found continuing questions about the adequacy of resources provided to perform oversight and the lack of required plans for overseeing contractor performance. It is too early in the program's implementation to know to what extent DOD's efforts will be successful in ensuring equitable periodic contract price adjustments and limiting long-term cost growth in the utility privatization program. However, GAO found indications that cost growth may become a challenge. DOD did not change its guidance to require that project economic analyses depict the actual expected costs of continued government ownership if the systems are not privatized. Therefore, DOD's reported $650 million in long-term cost reductions is unrealistic.
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-06-914, Defense Infrastructure: Actions Taken to Improve the Management of Utility Privatization, but Some Concerns Remain
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Report to Congressional Committees:
United States Government Accountability Office:
GAO:
September 2006:
Defense Infrastructure:
Actions Taken to Improve the Management of Utility Privatization, but
Some Concerns Remain:
Defense Infrastructure:
GAO-06-914:
GAO Highlights:
Highlights of GAO-06-914, a report to congressional committees
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 privatization was the preferred
method for improving utility systems, and Congress approved legislative
authority for privatizing DOD‘s utility systems with Public Law No. 105-
85. DOD estimates that some utility privatization contracts will cost
over $100 million. In a May 2005 report, GAO identified several
management weaknesses in DOD‘s implementation of the program.
The Fiscal Year 2006 National Defense Authorization Act required GAO to
evaluate and report on changes to the utility privatization program
since May 2005. Accordingly, this report updates the status of the
program and discusses the effect of DOD‘s changes on the concerns noted
last year. To conduct this review, GAO summarized program status and
costs, assessed DOD‘s changes to program guidance and in other areas,
and reviewed the services‘ implementation of the changes.
What GAO Found:
DOD‘s progress in implementing the utility privatization program has
been slower than expected and the estimated completion date has slipped
from the department‘s target of September 2005 to September 2011. DOD
attributed the delays to the complexity of the program and to the
services‘ decision to suspend and reassess the management of the
program between October 2005 and March 2006. Since May 2005, the
services privatized 14 utility systems under the legislative authority
for the program, bringing the total number of awarded projects to 81.
However, the services have awarded no projects since DOD issued new
program guidance in November 2005. Meanwhile, the services‘ total
estimated program implementation costs through fiscal year 2006 have
increased to $285 million, and more funds will be required before the
program is completed in 2011.
Since GAO‘s May 2005 report, DOD has issued new guidance and required
changes in procedures. If fully implemented, these changes should
result in more reliable economic analyses, improved budgetary
consideration of increased utility costs, enhanced oversight of
privatization contracts, and reduced instances where contractors
recover more than the fair market value paid for system conveyances.
However, a number of concerns from the May 2005 report remain. For
example:
* Although DOD made changes to improve the reliability of project
economic analyses by requiring independent reviews, GAO reviewed 10
economic analyses and found reliability issues that had not been
identified during the independent reviews.
* DOD directed the services to adequately consider in their budgets the
increased costs resulting from utility privatization. However,
questions remain over the availability of the funds needed to complete
the program because the services estimate that they will need $453
million more than is currently programmed to pay costs associated with
remaining utility systems that might be privatized.
* Although DOD made many changes to improve contract administration and
oversight, it may take some time to fully implement the changes as new
privatization contracts are awarded. GAO‘s review of five projects
awarded prior to DOD‘s changes found continuing questions about the
adequacy of resources provided to perform oversight and the lack of
required plans for overseeing contractor performance.
* It is too early in the program‘s implementation to know to what
extent DOD‘s efforts will be successful in ensuring equitable periodic
contract price adjustments and limiting long-term cost growth in the
utility privatization program. However, GAO found indications that cost
growth may become a challenge.
* DOD did not change its guidance to require that project economic
analyses depict the actual expected costs of continued government
ownership if the systems are not privatized. Therefore, DOD‘s reported
$650 million in long-term cost reductions is unrealistic.
What GAO Recommends:
GAO is making seven recommendations to improve the management of the
utility privatization program. DOD generally agreed with six and
indicated disagreement with one recommendation. Still, GAO believes
this recommendation continues to have merit.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-914].
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 Milestones Have Slipped and Implementation Costs
Continue to Climb:
DOD's Changes to Improve Utility Privatization Implementation Have
Addressed Many Areas but Have Not Eliminated All Program Concerns:
Conclusions:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Comments from the Department of Defense:
Appendix III: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Percentage of Systems with Privatization or Exemption Decision
and Estimated Program Completion Date:
Table 2: Status of the Utility Privatization Program as of March 31,
2006:
Table 3: Implementation Costs for the Utility Privatization Program:
Table 4: Potential Additional Privatization Contracts and Associated
Costs:
Table 5: Service Estimates of Potential Utility Privatization Program
Funding Shortfall:
Table 6: DOD's Estimated Cost Avoidance from Utility Privatization:
United States Government Accountability Office:
Washington, DC 20548:
September 5, 2006:
Congressional Committees:
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 are in need of major
improvements. 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 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 $100 million over the contract time frames.
To institute the program, at DOD's request, 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 condition: the services must
demonstrate through an economic analysis that privatization of a system
would reduce the government's long-term costs for utility services.
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 May 2005, we issued a report that identified management weaknesses
in DOD's implementation of the utility privatization program.[Footnote
2] The report noted a number of concerns, such as the reliability of
the economic analyses associated with privatization decisions and the
adequacy of contract oversight, and made several recommendations to DOD
to improve the guidance and procedures used to implement and oversee
the utility privatization program. Although DOD initially disagreed
with the report's findings and recommendations, after further review of
the report, the department subsequently reported to Congress that it
generally agreed with our findings and recommendations and decided to
issue new guidance on November 2, 2005, to address the key issues in
our prior report.[Footnote 3] Among other things, this guidance
required the services to complete remaining evaluations of utility
system potential for privatization in a timely and efficient manner,
perform an independent review of the economic analyses supporting
proposed projects, consider and plan for increased costs for utility
services resulting from potential privatization projects, and take
steps designed to improve the administration and oversight of awarded
privatization projects. Even before DOD issued the new guidance, the
services had implemented several program improvements including the
requirement for independent reviews of project economic analyses.
In January 2006, the National Defense Authorization Act for Fiscal Year
2006[Footnote 4] made several modifications to the legislative
authority for the utility privatization program, restricted the number
of utility systems that DOD could privatize during fiscal years 2006
and 2007, and required the Secretary of Defense to submit a report to
congressional defense committees by April 1, 2006, addressing program
issues and many of the concerns noted in our May 2005 report. The act
also directed us to evaluate and report on the changes made by DOD to
the program since May 2005 and their effects. Accordingly, this report
(1) updates the status of the utility privatization program, and (2)
discusses the effect of DOD's changes on the program management and
oversight concerns noted in our May 2005 report.
To address these objectives, we summarized program implementation
status and costs and compared the status to DOD's past and current
goals and milestones. To determine the effect of DOD's changes on the
program management and oversight concerns noted in our prior report, we
interviewed DOD and service officials and reviewed pertinent policies,
guidance, memorandums, and reports to document the changes made, and we
compared those changes with our previously identified concerns to
assess whether the issues had been fully addressed. Further, we
reviewed the reliability of the economic analyses supporting 10
privatization projects that were awarded after our prior report and had
been subjected to the services' new independent review process. We also
visited four installations to assess contract administration and
oversight issues and reviewed contract price changes in six ongoing
utility privatization contracts. Although we generally relied on
program status data provided by the services, we confirmed the status
data for five utility privatization projects and did not otherwise test
the reliability of the data.
We conducted our review from March through July 2006 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:
DOD's progress in implementing the utility privatization program has
been slower than expected, and implementation costs have continued to
climb. Since our previous report, the estimated program completion date
has slipped from the department's target of September 2005 to September
2011. DOD officials have attributed delays in program implementation to
privatization evaluation, solicitation, and contracting processes that
were more complex and time-consuming than originally anticipated.
Service officials also stated that additional delays resulted from the
services' decision to suspend and reassess the management of the
program between October 2005 and March 2006. The officials stated that
the suspension allowed DOD and the services time to review concerns
noted in our prior report, develop and issue supplemental guidance for
the program, and implement program changes necessitated by
modifications in the program's legislative authority. Between May 31,
2005, and September 30, 2005, the services privatized 14 utility
systems under the legislative authority for the program, bringing the
total number of awarded projects to 81. However, the services have
awarded no projects since September 2005 and, therefore, no projects
have been awarded since DOD issued supplemental program guidance in
November 2005. With program delays, the services' total estimated
program implementation costs through fiscal year 2006 have increased
from $268 million to $285 million and additional amounts will be
required before the program is projected to be completed in 2011.
Program delays also caused the Defense Energy Support Center to cancel
solicitations to privatize 42 Army utility systems in May 2006. These
solicitations had been closed from 1 to 4 years with no award decision
and there were concerns that conditions, such as the accuracy of the
inventory and needed improvements, had changed or might change before
an award decision would be made. The Army plans to resolicit these
systems over the next few years.
DOD has issued new program guidance and required changes in program
procedures to improve the management and oversight of the utility
privatization program since our May 2005 report. For example, DOD
implemented a requirement for an independent review of economic
analyses for proposed privatization projects and has imposed greater
emphasis on contract oversight. If fully implemented, the changes
should result in more reliable economic analyses supporting proposed
privatization projects, improved budgetary consideration of increased
utility costs from privatization, enhanced oversight of privatization
contracts, and reduced instances where contractors recover more than
the amounts they paid as the fair market value for system conveyances.
However, we noted a number of limitations in implementation of the new
procedures. Moreover, a number of concerns noted in our prior report
remain, at least to some degree, because DOD's changes to address some
issues were not implemented effectively, some changes were not
sufficient to fully eliminate some concerns, and DOD did not make
changes to address some concerns. For example:
* First, although DOD made changes to improve the reliability of
project economic analyses by requiring independent reviews, we found
issues with the implementation of this change. Specifically, we
reviewed the economic analyses supporting 10 privatization projects
that had been subjected to independent review and found reliability
issues that had not been identified during the independent review.
* Second, although DOD directed the services to adequately consider in
their budgets the increased costs resulting from utility privatization,
questions remain over the availability of the funds needed to complete
the program. The services have estimated that they will need $453
million more than is currently programmed for continuing government
utility operations to pay implementation and contract costs associated
with the remaining number of utility systems that might be privatized
through 2010 for the Air Force and the Navy and Marine Corps and
through 2011 for the Army. In view of competing needs and budget
priorities, the Air Force stated that it will not solicit additional
utility privatization contracts until further resources are identified
to cover the potential increase in costs. DOD had not made any
decisions on the funding availability issue at the time of our review
in June 2006.
* Third, it may take some time to fully implement DOD changes to
improve utility privatization contract administration and oversight as
new privatization contracts are awarded. Our review of five projects
awarded prior to DOD's changes found continued oversight concerns,
including questions about the adequacy of resources provided to perform
oversight and the lack of required plans for overseeing contractor
performance.
* Fourth, DOD reported to Congress in March 2006 that, although
privatization may limit the government's options during contract
negotiations, the department continues to prefer privatization with
permanent conveyance and believes that safeguards are in place to
adequately protect the government's interests. It is too early in the
program's implementation to know to what extent DOD's efforts will be
successful in ensuring equitable periodic contract price adjustments
and limiting long-term cost growth in the utility privatization
program. However, we found cost growth in three of six privatization
projects we reviewed. In one case, the government's annual costs for
utility service were expected to increase by 92 percent as a result of
the contract's first periodic price adjustment.
* Fifth, DOD did not change its guidance to require that project
economic analyses depict the actual expected costs of continued
government ownership in the event that the systems are not privatized.
Therefore, although DOD reported to Congress that the 81 contracts
awarded under the utility privatization authority will result in about
$650 million in long-term cost reductions to the government, the amount
is unrealistic because it was not calculated based on the actual
expected cost differences between continued government ownership and
privatization, and because privatization generally results in
increased, not decreased, utility service costs to the government.
We are making a number of recommendations designed to ensure that DOD
improves the reliability of the economic analyses for proposed utility
privatization projects, addresses potential program funding shortfalls,
ensures adequate oversight in utility privatization contracts awarded
prior to DOD's program changes, monitors potential contract cost
growth, and clearly depicts the increased costs resulting from proposed
utility privatization projects. In comments on a draft of this report,
DOD generally agreed with six of our seven recommendations and outlined
a plan of action to address each recommendation. Where it indicated
disagreement, we continue to believe our recommendation has merit. We
discuss DOD's comments in detail later in this report.
Background:
At DOD's request, Congress approved legislative authority in 1997 for
privatizing utility systems at military installations.[Footnote 5] 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 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 1997 authority also included two requirements
for utility privatization. First, DOD was required to submit a report
to congressional defense committees and wait 21 days before allowing a
conveyance. For each conveyance, the report was 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 was required to
receive 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 could 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 for 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'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. In addition, Defense Logistics Agency's Defense Energy
Support Center is responsible for providing the military services with
utility privatization contracting, technical, and program management
support.
DOD Made Utility Privatization a Department Policy:
In December 1997, DOD issued Defense Reform Initiative Directive Number
9, which made utility system privatization a DOD policy.[Footnote 6]
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 beneath 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 7] 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 8] 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 all
systems available for privatization by September 30, 2005. The October
2002 guidance also reemphasized that utility privatization was
contingent upon the services demonstrating through an economic analysis
that privatization will reduce the long-term costs to the government
for utility services. 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.
GAO Report Identified Weaknesses in Program Implementation:
In May 2005, we issued a report that identified management weaknesses
in DOD's implementation of the utility privatization program.[Footnote
9] The report noted that utility privatization implementation had been
slower than expected, the services' economic analyses supporting
utility privatization decisions provided an unrealistic sense of
savings to a program that generally increases government utility costs,
DOD's funding obligations would likely increase faster than they would
under continued government ownership, DOD did not require that the
services' economic analyses be subjected to an independent review for
accuracy and compliance with guidance, implementation of the fair
market value requirement in some cases resulted in higher contract
costs for utility services, the services had not issued specific
contract administration guidance for the program, and 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. The report made several
recommendations for DOD to address these concerns.
Program Legislative Authority Modified:
The National Defense Authorization Act for Fiscal Year 2006,[Footnote
10] enacted in January 2006, made several modifications to the
legislative authority for the utility privatization program. The act
did the following:
* Reinstated a requirement that the Secretary of Defense must submit to
congressional defense committees an economic analysis and wait 21 days
after the analysis is received by congressional defense committees, or
14 days if in electronic form, before conveying a utility
system.[Footnote 11] The economic analysis must demonstrate among other
things that the conveyance will reduce the long-term costs to the
United States of utility services provided by the utility system. The
report and wait requirement had been replaced with a requirement for a
quarterly report of conveyances by the National Defense Authorization
Act for Fiscal Year 2004.[Footnote 12]
* Added a requirement that the economic analyses incorporate margins of
error in the estimates, based upon guidance approved by the Secretary
of Defense, that minimize any underestimation of the costs resulting
from privatization or any overestimation of the costs resulting from
continued government ownership.
* Eliminated the requirement that DOD must receive as consideration for
a conveyance an amount equal to the system's fair market value.
* Limited contract terms to 10 years, unless the Secretary concerned
determines that a longer term contract, not to exceed 50 years, will be
cost-effective and provides an explanation of the need for the longer
term contract, along with a comparison of costs between a 10-year
contract and the longer term contract.
* Placed a temporary limitation on conveyance authority stating that
during each of fiscal years 2006 and 2007, the number of utility
systems for which conveyance contracts may be entered into under this
authority shall not exceed 25 percent of the total number of utility
systems determined to be eligible for privatization under this
authority as of January 6, 2006.
* Required DOD to submit, not later than April 1, 2006, to
congressional defense committees a report describing the use of section
2688 of title 10, United States Code (10 U.S.C. 2688), to convey
utility systems. The report was to address several specified aspects of
the utility privatization program.
DOD's Response to GAO's Report and Modifications to the Program's
Authority:
Although DOD initially disagreed with our May 2005 report, after
further review of the report, it subsequently reported to Congress that
the report had brought some significant issues to light and that the
department had decided to issue new guidance to address the key issues
in the report in order to improve program management. On November 2,
2005, DOD issued the new guidance, which among other things required
the services to complete the remaining evaluations of utility system
potential for privatization in a timely and efficient manner, perform
an independent review of the economic analyses supporting proposed
projects, consider and plan for increased costs for utility services
resulting from potential privatization projects, and take steps to
improve the administration and oversight of awarded privatization
projects.[Footnote 13] DOD issued additional supplemental
guidance[Footnote 14] on March 20, 2006, to implement the modifications
to the legislative authority made by the Fiscal Year 2006 National
Defense Authorization Act; and on March 31, 2006, DOD submitted to
congressional defense committees the utility privatization report
required by the act.[Footnote 15] Even before DOD issued new guidance
to improve the program in November 2005, the services had implemented
several program improvements, including the requirement for independent
reviews of project economic analyses.
Utility Privatization Milestones Have Slipped and Implementation Costs
Continue to Climb:
DOD's progress in implementing the utility privatization program has
been slower than expected and implementation costs have continued to
climb. None of the services met DOD's September 2005 implementation
goal and the program's estimated completion date has now slipped to
September 2011. In addition to increasing implementation costs, program
delays have also resulted in the cancellation of privatization
solicitations because of concern that conditions had changed or might
change before a decision would be made whether to privatize.
Services Did Not Meet Program Implementation Milestone:
None of the services met DOD's goal of making a privatization or
exemption decision on all systems available for privatization by
September 30, 2005. Since the program began, DOD officials have
attributed delays in program implementation to privatization
evaluation, solicitation, and contracting processes that were more
complex and time consuming than originally anticipated. Service
officials stated that additional delays occurred because the services
decided to suspend the program between October 2005 and March 2006.
According to the officials, the suspension was provided to allow DOD
and the services time to review concerns noted in our May 2005 report,
develop and issue supplemental guidance for the program, and implement
program changes necessitated by modifications in the program's
legislative authority made by the National Defense Authorization Act
for Fiscal Year 2006. The services now estimate that their program
completion dates--the date when a privatization or exemption decision
has been made on all available systems--are October 2007 for the Navy
and Marine Corps, December 2008 for the Air Force, and September 2011
for the Army. Among other things, the Army attributed the extension in
its completion date to the privatization process being more complicated
than envisioned and a recognition that the Army's past estimates for
completing the program were unrealistic. Table 1 shows progress as of
March 31, 2006, compared to DOD's goal, as well as the current
estimated program completion dates.[Footnote 16]
Table 1: Percentage of Systems with Privatization or Exemption Decision
and Estimated Program Completion Date:
Component: Army;
Goal for September 30, 2005 (percent): 100;
Actual as of March 31, 2006 (percent): 75;
Estimated completion date: September 2011.
Component: Navy and Marine Corps;
Goal for September 30, 2005 (percent): 100;
Actual as of March 31, 2006 (percent): 78;
Estimated completion date: October 2007.
Component: Air Force;
Goal for September 30, 2005 (percent): 100;
Actual as of March 31, 2006 (percent): 82;
Estimated completion date: December 2008.
Component: Defense Logistics Agency;
Goal for September 30, 2005 (percent): 100;
Actual as of March 31, 2006 (percent): 86;
Estimated completion date: December 2007.
Source: DOD.
[End of table]
Services Have Awarded Contracts for a Fraction of the Total Systems
Available for Privatization:
After spending about $268 million on program implementation costs
through fiscal year 2005, the services had awarded contracts for a
fraction of the 1,496 utility systems available for privatization.
Between May 31, 2005, and September 30, 2005, the services privatized
14 utility systems using 10 U.S.C. 2688 authority bringing the total
number of awarded projects to 81. However, the services have awarded no
projects under this authority since DOD issued supplemental program
guidance in November 2005. In addition to the projects awarded under 10
U.S.C. 2688 authority, DOD privatized 36 systems under other programs,
such as DOD's housing privatization program. The services also have
exempted 147 additional systems, bringing the total systems exempted
from privatization to 458. Table 2 shows program status as of March 31,
2006.
Table 2: Status of the Utility Privatization Program as of March 31,
2006:
Component: Army;
Systems available for privatization: 320;
Systems pending solicitation or under reassessment: 0;
Systems in solicitation: 202;
Systems exempted: 38;
Total contract awards: 80;
Contract awards using 10 U.S.C. 2688 authority: 70.
Component: Navy and Marine Corps;
Systems available for privatization: 645;
Systems pending solicitation or under reassessment: 13;
Systems in solicitation: 411;
Systems exempted: 200;
Total contract awards: 21;
Contract awards using 10 U.S.C. 2688 authority: 1.
Component: Air Force;
Systems available for privatization: 502;
Systems pending solicitation or under reassessment: 4;
Systems in solicitation: 262;
Systems exempted: 220;
Total contract awards: 16;
Contract awards using 10 U.S.C. 2688 authority: 10.
Component: Defense Logistics Agency;
Systems available for privatization: 29;
Systems pending solicitation or under reassessment: 0;
Systems in solicitation: 29;
Systems exempted: 0;
Total contract awards: 0;
Contract awards using 10 U.S.C. 2688 authority: 0.
Component: Total;
Systems available for privatization: 1,496;
Systems pending solicitation or under reassessment: 17;
Systems in solicitation: 904;
Systems exempted: 458;
Total contract awards: 117;
Contract awards using 10 U.S.C. 2688 authority: 81.
Source: DOD.
[End of table]
Program Delays Have Resulted in Increased Implementation Costs:
With program delays, the services' estimated program implementation
costs have increased from about $268 million through fiscal year 2005
to about $285 million through fiscal year 2006. Additional
implementation funds will be needed before the services complete their
programs between October 2007 and September 2011. According to service
officials, the funds used to implement the program primarily paid for
consultants hired to help the services in conducting an inventory of
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 shows program
implementation costs by service and the Office of the Secretary of
Defense.
Table 3: Implementation Costs for the Utility Privatization Program:
Dollars in millions.
Component: Army;
Implementation costs for fiscal years 1998 through 2005: $62.5;
Estimated implementation costs for fiscal year 2006: $4.0;
Total estimated implementation costs through fiscal year 2006: $66.5.
Component: Navy and Marine Corps;
Implementation costs for fiscal years 1998 through 2005: 109.7;
Estimated implementation costs for fiscal year 2006: 4.4;
Total estimated implementation costs through fiscal year 2006: 114.1.
Component: Air Force;
Implementation costs for fiscal years 1998 through 2005: 92.6;
Estimated implementation costs for fiscal year 2006: 8.0;
Total estimated implementation costs through fiscal year 2006: 100.6.
Component: Office of the Secretary of Defense;
Implementation costs for fiscal years 1998 through 2005: 3.6;
Estimated implementation costs for fiscal year 2006: 0.3;
Total estimated implementation costs through fiscal year 2006: 3.9.
Total;
Implementation costs for fiscal years 1998 through 2005: $268.3;
Estimated implementation costs for fiscal year 2006: $16.8;
Total estimated implementation costs through fiscal year 2006: $285.1.
Source: DOD.
Note: Totals may not add due to rounding.
[End of table]
Program delays also caused the Defense Energy Support Center to cancel
solicitations to privatize 42 Army utility systems in May 2006. These
solicitations had been closed from 1 to 4 years with no award decision
and there were concerns that conditions, such as the accuracy of the
inventory and needed improvements, had changed or might change before
an award decision would be made. The Army plans to resolicit these
systems over the next few years. Further, Defense Energy Support Center
officials stated that program delays and the resulting decrease in
assistance requested by the services have made it difficult to retain
qualified staff to support the utility privatization program.
Consequently, the center will need to train new staff once the
program's pace begins to increase again.
Services Have Estimated the Number and Cost of Potential Privatization
Contracts:
In addition to revising their program completion dates since our
previous report, the services also estimated the additional number of
systems that might be privatized by the completion of their programs
and the funds needed to pay the costs of these anticipated contracts.
The Army estimated that 41 additional systems might be privatized with
the associated contract costs totaling about $212 million; the Navy and
the Marine Corps estimated that 40 additional systems might be
privatized with the associated contract costs totaling about $139
million; and the Air Force estimated that 210 additional systems might
be privatized with the associated contract costs totaling about $602
million (see table 4). Air Force officials stated that its estimated
210 additional systems was a "worst case" estimate used to determine
the maximum funding needed for possible additional privatization
contracts. The officials stated that the more likely number of systems
that might be privatized was about 105 systems. However, the officials
did not provide an estimate of the contract costs associated with the
smaller number of systems.
Table 4: Potential Additional Privatization Contracts and Associated
Costs:
Dollars in millions.
Component: Army;
Number of additional systems that potentially could be privatized: 41;
Potential program costs if the additional systems are privatized:
$212.4.
Component: Navy and Marine Corps;
Number of additional systems that potentially could be privatized: 40;
Potential program costs if the additional systems are privatized:
139.3.
Component: Air Force;
Number of additional systems that potentially could be privatized: 210;
Potential program costs if the additional systems are privatized:
602.0.
Total;
Number of additional systems that potentially could be privatized: 291;
Potential program costs if the additional systems are privatized:
$953.7.
Source: DOD.
[End of table]
DOD's Changes to Improve Utility Privatization Implementation Have
Addressed Many Areas but Have Not Eliminated All Program Concerns:
DOD has made many changes to improve the management and oversight of
the utility privatization program since our May 2005 report. To improve
the reliability of the economic analyses supporting privatization
decisions, DOD now requires that the analyses undergo an independent
review to assess the inputs and assumptions, ensure that cost estimates
for the government-owned and privatization options are treated in a
consistent manner, and verify that all relevant guidance has been met.
Also, in supplemental program guidance issued in November 2005, DOD
reminded the services to consider and plan for increased costs for
utility services contracts resulting from potential privatization
projects and prepare operation and maintenance budgets based upon the
expected costs under privatization. The guidance also emphasized the
importance of contract oversight and directed a number of actions
designed to ensure adequate contract administration and oversight.
Among other things, the guidance directed the Defense Energy Support
Center to develop specific preaward and postaward procurement
procedures for the effective management of utilities services
contracts, directed contracting agencies to adequately train and
prepare personnel involved in the utility privatization contracts,
noted that DOD components are responsible for ensuring that the
acquisition plan adequately addresses cost growth control, and stated
that DOD components are responsible for ensuring that resources
required to properly administer the contracts have been identified and
provided. In March 2006, DOD also issued guidance implementing
modifications in the program's legislative authority made by the Fiscal
Year 2006 National Defense Authorization Act, which among other things
addresses our concern that some utility privatization contracts had
allowed contractors to recover more than they paid as the fair market
value for system conveyances. If fully implemented, the changes should
result in more reliable economic analyses supporting proposed
privatization projects, improved budgetary consideration of increased
utility costs from privatization, enhanced oversight of privatization
contracts, and reduced instances where contractors recover more than
the amounts they paid as the fair market value for system conveyances.
Although DOD has made many changes to improve implementation of the
utility privatization program, the changes have addressed some concerns
but have not eliminated all concerns noted in our prior report, such as
ensuring the reliability of project economic analyses and ensuring
effective contract oversight. We found that changes to address some
issues have not been effectively implemented, some changes were not
sufficient to totally eliminate the concerns, and DOD did not make
changes to address some concerns causing continued questions about the
reliability of the economic analyses, the availability of funds to pay
for the remaining projects that might be privatized, the adequacy of
contract oversight in projects awarded prior to DOD's changes, and the
control of long-term cost growth in utility privatization contracts. We
also have concerns that the program may continue to provide an
unrealistic sense of savings and decision makers may have incomplete
information on the financial effect of privatization decisions.
DOD Has Taken Steps to Improve the Reliability of Project Economic
Analyses but Implementation Is a Concern:
Although DOD has made changes to improve the reliability of the
analyses supporting proposed utility privatization projects, we found
issues with the services' implementation of the changes. In November
2005, DOD issued supplemental program guidance requiring DOD components
to ensure that independent reviews were conducted for all economic
analyses supporting a proposed conveyance. The guidance stated that the
independent review should verify that all relevant guidance has been
met and that privatization is in the best interest of the government.
In March 2006, DOD reported to Congress that the independent review
included procedures to review the general inputs and assumptions,
verify that the inventory in the economic analysis is identical to the
inventory in the solicitation, and ensure that the government and the
contractor treat the renewal and replacement cost estimates in a
consistent manner.[Footnote 17] Even before DOD issued the guidance
requiring independent reviews, Army and Air Force officials stated that
they had implemented such reviews to help ensure reliability of their
project analyses. The officials stated that independent reviews were
performed on the analyses supporting 12 utility privatization projects
that were awarded in September 2005--after our previous report--but
before DOD's issuance of the guidance requiring independent reviews.
As an additional step to help ensure reliable economic analyses, DOD's
March 2006 report to Congress stated that the services must conduct
postconveyance reviews that compare actual project costs with the
estimated costs included in the projects' economic analyses. DOD stated
that the postconveyance reviews are conducted 2 to 3 years after
contract award, or 1 year after the first periodic price adjustment,
whichever is later, and that the results of these reviews will be
compiled until such time as the analysis of all conveyances is
complete. DOD stated that the reviews are to include an analysis of the
system's inventory, changes in requirements and contract costs, and a
comparison of actual contract costs with estimates from the economic
analyses.
Although DOD's changes are key steps in the right direction to improve
the reliability of the economic analyses, we found issues with the
implementation of the changes. First, we reviewed the analyses
associated with 10 Army and Air Force projects awarded in September
2005. Although these analyses were prepared prior to the issuance of
DOD's supplemental guidance, the services had already implemented an
independent review process and these analyses underwent an independent
review. Service officials noted that the independent reviews had just
begun and expected that the thoroughness of the reviews would improve
as experience was gained and DOD's supplemental guidance was
implemented. We found that the reviews did identify some questionable
items and that some changes were made to improve the reliability of the
economic analyses. Yet, we also found questionable items in each
analysis that were not identified during the independent review. For
example:
* The economic analysis for the natural gas system privatization at
Minot Air Force Base did not treat estimates of renewal and replacement
costs for the government-owned and privatization options in a
consistent manner. The analysis estimated that the Air Force would
spend $7.1 million on renewals and replacements during the first year
of continued government ownership. Under the first year of
privatization, the analysis estimated that the contractor would spend
about $0.2 million on renewals and replacements. When we asked about
this difference, Air Force officials stated that the contractor is not
required to perform the same renewals and replacements identified in
the government estimate and that the government found the contractor's
proposal to be acceptable. Because the analysis was not based on
performing the same work, the cost estimates were not consistently
developed and resulted in favoring the privatization option. This issue
was not identified in the independent review.
* The economic analyses for the water and wastewater privatization
projects at Andrews Air Force Base were based on the systems' inventory
(i.e., the wells, pumps, water treatment equipment, valves, fire
hydrants, water distribution mains, meters, storage tanks, reservoirs,
and other components that constitute the systems) and condition 2 years
prior to contract award. The Air Force stated that adjustments to the
contract could be made after contract award, if needed, to reflect
changes in the inventory. However, because the analyses were not
updated to reflect inventory changes before contract award, the
reliability of the analyses is less certain. This issue was not noted
in the independent review.
* The economic analyses for privatization of the electric distribution
system at Fort Leavenworth and the water and wastewater systems at
three Army installations in the Tidewater Virginia area incorrectly
included financing costs under the government option. Although this
favored the privatization option, the amount was not enough to change
the outcome of the analyses. This issue was not identified in the
independent review. However, Army officials told us that they would
ensure that this did not occur in future analyses.
Second, although DOD noted in its March 2006 report to Congress the
importance of postconveyance reviews as an additional measure to help
ensure reliable economic analyses, DOD has not issued guidance that
requires the services to perform the reviews. Service officials stated
that they had performed only a limited number of postconveyance reviews
and do not have plans to perform the reviews in the manner or frequency
described in DOD's report to Congress. Also, DOD's report cited seven
Army Audit Agency postconveyance reviews, four additional Army
postconveyance reviews, and one Air Force postconveyance review.
However, only three of the Army Audit Agency reviews included a
comparison of actual contract costs with estimates from the economic
analyses.
DOD Has Taken Steps to Address Some Funding Issues but Concerns Remain:
Although DOD has taken steps to help ensure that the services
adequately consider the increased costs from utility privatization
projects during budget preparation, questions remain over the
availability of the additional funds needed to complete the program.
The services estimate that they potentially will need $453 million more
than is currently programmed for continuing government utility
operations to pay implementation and contract costs associated with the
remaining number of utility systems that might be privatized through
2010 for the Air Force, the Navy, and Marine Corps, and through 2011
for the Army. As a result, in view of competing needs and budget
priorities, the Deputy Assistant Secretary of the Air Force
(Installations) stated in an April 2006 memorandum that the Air Force
could not afford to award further utility privatization contracts
unless additional resources are provided.
Utility Costs Increase with Privatization:
Our May 2005 report noted that 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. 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,
which are "must pay" bills. 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 affect those other functions, such as the maintenance of
installation facilities. We recommended that DOD provide program
guidance emphasizing the need to consider increased utility costs under
privatization as the military services prepare their operation and
maintenance budget requests and that DOD direct the service Secretaries
to ensure that installation operations and maintenance budgets are
adjusted as necessary to reflect increased costs from utility
privatization projects.
In November 2005, DOD issued supplemental program guidance that
reminded DOD components to consider the increase in utility costs from
privatization. Specifically, the guidance directed the components to
consider and plan for increased costs for utility services contracts
resulting from potential privatization projects and system conveyance
and prepare operation and maintenance budgets based upon the expected
costs under privatization.
Funds Not Programmed for All Potential Utility Privatization Projects:
DOD's guidance addresses the recommendations from our May 2005 report
and, if implemented, should result in the increased costs from utility
privatization projects being adequately considered during budget
preparation. However, in view of competing needs and budget priorities,
questions remain over availability of the additional funds needed to
complete the program. To illustrate, DOD's November 2005 supplemental
guidance also directed DOD components to advise the Deputy Under
Secretary of Defense (Installations and Environment) if significant
shortfalls are anticipated that will affect utilities privatization
efforts. In response to that direction, each service estimated the
remaining number of utility systems that might be privatized,
calculated the associated implementation and contract costs, compared
these costs with the funds already programmed for continued government
operation of the systems that might be privatized, and determined
whether any potential funding shortfalls existed. The Army's estimate
was through fiscal year 2011 and the other services' estimates were
through fiscal year 2010. As a result of this review, each service
determined that funding shortfalls existed to pay for potential future
privatization contracts (see table 5).
Table 5: Service Estimates of Potential Utility Privatization Program
Funding Shortfall:
Dollars in millions.
Component: Army;
Number of systems that potentially could be privatized: 41;
Potential program costs if the systems are privatized: $212.4;
Total funds programmed: $90.3;
Total unfunded requirement (shortfall): $122.1.
Component: Navy and Marine Corps;
Number of systems that potentially could be privatized: 40;
Potential program costs if the systems are privatized: 139.3;
Total funds programmed: 103.2;
Total unfunded requirement (shortfall): 36.1.
Component: Air Force;
Number of systems that potentially could be privatized: 210;
Potential program costs if the systems are privatized: 602.0;
Total funds programmed: 306.9;
Total unfunded requirement (shortfall): 295.1.
Total;
Number of systems that potentially could be privatized: 291;
Potential program costs if the systems are privatized: $953.7;
Total funds programmed: $500.4;
Total unfunded requirement (shortfall): $453.3.
Source: DOD.
[End of table]
Air Force May Not Award Some Additional Privatization Projects Due to
Funding Issues:
Air Force officials stated that the increased costs from potential
future utility privatization contracts had reached a critical point.
The officials stated that because funds are limited and funding needs
for some Air Force programs are greater than the funding needs for
utility upgrades, the Air Force has concluded that it will not solicit
new utility privatization contracts until additional resources are
identified to specifically cover any potential increase in future
costs. Air Force officials further explained that privatization results
in improving utility systems to an industry standard level by creating
"must pay" contracts. However, without additional resources, funding
these contracts must come from other base operating support funds,
which would result in diverting critical resources from remaining
facilities and infrastructure. Also, the officials noted that the
utility privatization program drives system recapitalization to an
industry standard level that may be questionable when compared to
historical Air Force requirements and, furthermore, reflects a funding
level that is not affordable in light of current fiscal constraints and
differing Air Force modernization priorities.
When we questioned a cognizant DOD official in June 2006 about the
potential funding shortfall, the official stated that each service has
competing priorities and the cost of awarding contracts to privatize
utility infrastructure is just one of many. However, the official also
stated that the funding issue and alternatives were under discussion
but conclusions had not yet been reached.
DOD Directed Actions to Improve Utility Privatization Contract
Oversight but Some Concerns Remain:
DOD has made a number of changes designed to improve utility
privatization contract administration and oversight since our May 2005
report. However, it may take some time for the improvements to be fully
implemented as the changes are applied to new privatization contract
awards and efforts may be needed to ensure that the changes are
applied, where needed, to previously awarded contracts.
DOD Has Taken Steps to Address Oversight Concerns:
To address privatization contract oversight concerns, DOD issued
supplemental program guidance in November 2005 that emphasized to the
services the importance of contract oversight and directed a number of
actions designed to ensure adequate contract administration and
oversight. Among other things, the guidance:
* directed the Defense Energy Support Center to develop specific
preaward and postaward procurement procedures for the effective
management of utilities services contracts resulting from a utility
conveyance, and coordinate with the Defense Acquisition University to
develop a training program for all contracting officers and DOD
components involved in utilities privatization efforts;
* directed contracting agencies to adequately train and prepare
personnel involved in the administration of the utilities services
contracts resulting from a utilities conveyance;
* stated that contracting officers must be able to use guidance for
postaward contract management and contract provisions to ensure that
the government's interests are protected in the long-term utility
service contracts and associated real estate documents;
* stated that prior to awarding a services contract resulting from a
utility conveyance, DOD components are responsible for ensuring, among
other things, that resources required to properly administer the
contract have been identified; and:
* directed that transfers of contract administration responsibilities
from the procuring contract office to the contracting administration
office should include an on-site transfer briefing with government and
contractor personnel that includes, among other things, a clear
assignment of responsibilities.
During our visit to the Defense Energy Support Center in April 2006,
officials stated that in accordance with the guidance, the center had
already issued the preaward and postaward procurement procedures that
would help ensure the effective management of utilities services
contracts. The officials stated that they had also begun developing a
training program for all contracting officers and other DOD personnel
involved in utilities privatization efforts and had developed
procedures for transferring contract responsibilities that should help
ensure effective contract oversight. During our visits to the services,
officials stated that, in addition to working with the Defense Energy
Support Center, further efforts were underway to ensure that postaward
management is effective. For example, Air Force officials stated that
they had developed their own postaward plan, which defines the
responsibilities and standards by which the government could ensure
that utility services are provided in accordance with requirements.
Navy officials stated that the Navy plans to prepare a quality
assurance plan for each utility privatization contract awarded.
Some Contract Oversight Concerns Identified at the Four Installations
We Visited:
Although the steps taken by DOD, the Defense Energy Support Center, and
the services are significant improvements, implementation will be the
key to ensuring effective oversight of all utility privatization
contracts, and it may take some time to fully implement improvements as
new privatization contracts are awarded. From the time DOD's
supplemental guidance was issued and other improvement measures were
put into place through the time of our review in June 2006, the
services awarded no new utility privatization contracts. Thus, to
assess contract oversight, we were unable to visit installations with
utility privatization contracts awarded after DOD's changes were
implemented. Instead, we assessed contract oversight at four
installations with five utility privatization projects that were
awarded prior to our May 2005 report. We found continuing concerns
about the adequacy of oversight because no additional resources were
provided to oversee the contracts at all four installations and
mandatory written plans for overseeing contractor performance were not
prepared at two installations.
For example, officials at each of the four installations we visited
noted that no additional resources were provided at the installation
level to perform contract oversight once their utility systems were
privatized. The contract officials stated that the extra work
associated with the contracts was added to their workload of overseeing
other contracts. Some officials stated that they did not have
sufficient personnel to perform the level of detailed monitoring of
contractor performance that they believed was needed. According to Fort
Eustis officials, when the electric system was privatized, they
requested three additional people to oversee the contract based on the
magnitude of the workload associated with this contract. Yet, no
additional people were provided and the extra workload was added to the
workload of the staff responsible for overseeing other contracts.
Also, our review of the electric distribution system privatization
projects at Fort Eustis and the Army's Military Ocean Terminal Sunny
Point found that neither installation had a quality assurance
surveillance plan in place for overseeing contractor performance. Such
plans are required by the Federal Acquisition Regulation. Officials at
both installations stated that although a formal surveillance plan had
not been prepared, they were performing oversight to ensure that the
contractors met contract requirements. Nevertheless, formal contractor
performance monitoring plans are an important tool for ensuring
adequate contract oversight.
Containing Utility Privatization Contract Cost Growth May Be a
Challenge:
Because contractors own installation utility systems after
privatization and, therefore, may have an advantage when negotiating
contract changes and renewals, containing utility privatization
contract cost growth may become a challenge as contracts go through
periodic price adjustments and installations negotiate prices for
additional needed capital improvement projects and other changes. In
March 2006, DOD stated that although it recognizes that privatization
may limit the government's options during contract negotiations, the
department continues to prefer privatization with permanent conveyance
and believes that safeguards are in place to adequately protect the
government's interests. Although it is too early in the program's
implementation to know to what extent DOD's efforts will be successful
in ensuring equitable contract price adjustments and limiting long-term
cost growth in the utility privatization program, our review found
indications that containing cost growth may become a concern.
DOD Continues to Prefer Permanent Conveyance but Has Taken Steps to
Control Costs:
In our prior report, we noted that, 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.
Because of concern that contractors may have an advantage when it comes
time to negotiate contract changes and renewals, we recommended that
DOD reassess whether permanent conveyance of utility systems should be
DOD's preferred approach to obtaining improved utility services.
DOD stated that it has reassessed its position and continues to believe
that owning, operating, and maintaining utility systems is not a core
mission of the department and that permanent conveyance of systems
under utilities privatization enables the military installations to
benefit from private sector innovations, economies of scale, and
financing. Although DOD contends that private industry can normally
provide more efficient utility service than can the government, DOD has
not provided 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.
Although DOD continues to prefer privatization with permanent
conveyance of the utility systems, DOD has recognized that
privatization may limit the government options during contract
renegotiations and has taken steps to help control contract cost
growth. First, DOD stated in its March 2006 report to Congress that a
contractor also may have limited options under privatization because
the contractor typically cannot use the installation's utility system
to service other customers. DOD reported that privatization creates a
one-to-one relationship between the installation and the contractor. In
this relationship, DOD stated that both parties must work together to
execute fair and equitable contract changes, both parties have
significant vested interests in successful negotiations, and both
parties retain substantial negotiation leverage.
Second, DOD noted that service contracts awarded as part of a
privatization transaction are contracts subject to the Federal
Acquisition Regulation and applicable statutes. Because it is
recognized that privatization will as a practical matter limit future
opportunities to recompete this service, DOD stated that all contracts
will include appropriate provisions to protect the government's
interest while allowing the contractor reasonable compensation for the
services provided. DOD's report further stated that fixed price
contracts with prospective price adjustment provisions have been
determined to be the most appropriate contract in most situations and
that this type of a contract will mitigate cost risk and hopefully
result in a satisfactory long-term relationship for both the contractor
and the government.
Third, DOD noted that utility services contracts resulting from a
utility conveyance may include a contract clause that provides an
option for the government to purchase the system at the end of the
contract period. According to Defense Energy Support Center officials,
the center has developed language for future Army and Air Force
contracts that would provide an option for the government to buy back a
system at the end of the contract period. Center officials stated that
this clause may help the government in negotiations at the end of the
contract term. Navy officials stated that the Navy does not plan to
include a buy back clause in its future utility contracts because a
system could be taken back, if necessary, through condemnation
procedures.
Fourth, in its November 2005 supplemental guidance, DOD emphasized the
importance of controlling contract cost growth. Specifically, the
guidance noted that prior to awarding a services contract resulting
from a utility conveyance, DOD components are responsible for ensuring
that the acquisition plan adequately addresses cost growth control,
which includes specifying the appropriate price adjustment methodology
and postaward contract administration.
Cost Growth in Utility Privatization Contracts May Become a Concern:
Although DOD has policies, guidance, and procedures to help control
contract costs and ensure that price adjustments are equitable, cost
growth may still become a concern as utility privatization contracts go
through periodic price adjustments and, in some cases, installations
negotiate changes for additional capital improvement projects or other
needs. According to DOD, most utility privatization contracts include
provisions for periodic price adjustments. The price adjustment process
allows contract price changes based on changes in market prices,
generally to cover inflation, and changes to the service requirement
from system additions or modifications resulting from capital upgrades.
Under this process, the contractor is required to submit sufficient
data to support the accuracy and reliability of the basis for service
charge adjustments. If the contractor's data is determined to be fair
and reasonable, the contracting officer negotiates a service charge
adjustment. Utility privatization contracts normally provide for price
adjustments after an initial 2-year period and every 3 years
thereafter. In addition to cost increases from service charge
adjustments, contract costs can also increase as a result of contract
modifications to pay for additional capital improvement projects not
included in the initial contract.
According to the services, utility privatization contracts for 22
systems are currently undergoing, or will be subject to, their first
periodic price adjustment before the end of calendar year
2007.[Footnote 18] Although it is too early to know the extent of cost
changes that might occur in these contracts, our review of six
contracts--one that completed a periodic price adjustment, one that was
undergoing periodic price adjustment, and four that had not yet
undergone a periodic price adjustment--found conditions that indicate
that cost growth in utility privatization contracts may become a
concern. Changes in contract costs could result in privatization costs
increasing above the levels estimated in the economic analyses. To
illustrate:
* The Fort Rucker natural gas distribution system privatization
contract was issued on April 24, 2003. The contract provided for a
price adjustment after the initial 2 years of the contract and then
every 3 years thereafter. In February 2005, the contractor submitted a
proposal for a price adjustment and requested an increase in the price
paid to the contractor for operations and maintenance, associated
overhead, and renewals and replacements. According to a government
memorandum that summarized the results of the price adjustment process,
the requested increases were based on the contractor's actual labor
hours and material costs and additional overhead costs which resulted
from a change in the way the contractor calculated overhead costs. The
change in overhead calculations included costs that were not included
in the original proposal submission or in the contract. When queried,
the contractor responded that the costs were not originally submitted
but should have been. After review, the government team responsible for
the price adjustment process determined that the requested increases
were allowable and reasonable and approved the price increase. The
change increased the government's annual utility service charge costs
from about $87,000 to about $124,000, an increase of about $36,000, or
41 percent. In approving the increase, the government team noted that
although the estimated cost avoidance from privatization would be
reduced, the contract was still economical compared to the estimated
costs of government ownership.
* The Sunny Point electric distribution system privatization contract
was issued on September 30, 2003. In January 2006, the contractor
submitted a proposal for a price adjustment and requested an increase
in the utility service charge based on the contractor's actual labor
hours and material costs associated with operating and maintaining the
system, including the installation's emergency generators. According to
installation officials, the costs to operate and maintain the system
were significantly higher than originally anticipated by the contractor
because of errors in the system's inventory used to develop the
solicitation, such as not including all of the installation's emergency
generators. When queried about the requested price increase, the
contractor responded that the initial contract bid would have been
higher if the true inventory of the system had been known. Although the
price adjustment process was not final at the time of our visit in June
2006, installation officials stated that the government team
responsible for the process had determined that the requested increases
were allowable and reasonable and had approved the price increase. As a
result of the price adjustment, the government's annual utility service
costs are expected to increase from about $415,000 to $798,000 in the
third year of the contract, an increase of about $383,000, or 92
percent.
* The Fort Eustis electric distribution system privatization contract
was issued on June 24, 2004. While this contract is not scheduled for a
periodic price adjustment until December 2006, the contract costs have
increased by about $431,000, or 26 percent, since the contract was
signed. The increase is the result of two factors. First, the annual
service charge was increased by about $73,000 as the result of
correcting errors to the system's inventory described in the
privatization solicitation. Second, the contract's cost was increased
by about $358,000 to pay for capital improvement projects that were
added to the original contract. Fort Eustis officials stated that
funding for the capital improvement projects added to the contract did
not have to compete for funding against other needed installation
improvement projects because project costs were added to the
privatization contract. The officials stated that it was unclear
whether these projects would have been approved for funding had the
privatization contract not been in place.
The remaining three contracts we reviewed--the water and wastewater
privatization contracts at Bolling Air Force Base and the electric
distribution system privatization contract at Dobbins Air Reserve Base-
-were not yet eligible for, or not subject to, a periodic price
adjustment. At the time of our visits in May 2006, actual contract
costs in these cases approximated the estimates in the projects'
economic analyses.
DOD Has Not Made Changes to Provide More Realistic Savings Estimates
from Utility Privatization:
Because DOD has not changed the guidance for performing the economic
analyses or taken any other steps to change the perception that the
utility privatization program results in reduced costs to the
government, the program may continue to provide an unrealistic sense of
savings for a program that generally increases annual government
utility costs in order to pay contractors for enhanced utility services
and capital improvements. The concern was caused by the methodology DOD
uses to determine whether a proposed privatization contract would meet
the statutory requirement for reduced long-term costs. In our previous
report, we noted that DOD's guidance directs the services to compare
the estimated long-term 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.
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.
Since May 2005, DOD has not changed the guidance for performing the
economic analyses nor has DOD taken other steps, such as showing
current utility system costs in the economic analyses, to change the
perception that the utility privatization program results in reduced
costs to the government. DOD's November 2005 supplemental program
guidance directed the services to continue to prepare economic analyses
based on the "should costs," which is defined as an independent
government estimate of the costs required to bring the system up to and
maintain it at current industry standards. Further, DOD's March 2006
report to Congress stated that the "should cost" estimate is the
government's best tool for predicting the future requirement for
individual systems and is the most realistic methodology. Yet, the
report also acknowledged that the department had done an inadequate job
of defining industry standards and then subsequently programming,
budgeting, and executing to that requirement. Because DOD has not
programmed funds to do the work described in the "should cost" estimate
if the system is not privatized, DOD's estimates of the reduced costs
to the government that would result from privatization are not based on
realistic cost differences.
Information that DOD reported to Congress in March 2006 illustrates our
concern. DOD's report stated that the department's total cost avoidance
from utility conveyances is expected to exceed $1 billion in today's
dollars and, as shown in table 6, the report included information
showing that the 81 contracts awarded under 10 U.S.C. 2688 will result
in about $650 million in reduced costs to the government in today's
dollars compared to DOD's "should cost" estimate.
Table 6: DOD's Estimated Cost Avoidance from Utility Privatization:
Dollars in millions.
Component: Army;
Number of systems privatized: 70;
Estimated costs under government ownership: $2,377.0;
Estimated costs under privatization: $1,867.5;
Estimated cost avoidance with privatization: $509.5.
Component: Navy and Marine Corps;
Number of systems privatized: 1;
Estimated costs under government ownership: 308.1;
Estimated costs under privatization: 215.4;
Estimated cost avoidance with privatization: 92.7.
Component: Air Force;
Number of systems privatized: 10;
Estimated costs under government ownership: 220.5;
Estimated costs under privatization: 173.0;
Estimated cost avoidance with privatization: 47.5.
Total;
Number of systems privatized: 81;
Estimated costs under government ownership: $2,905.6;
Estimated costs under privatization: $2,255.9;
Estimated cost avoidance with privatization: $649.7.
Source: DOD.
Note: Estimates are totals in today's dollars over the contract terms
(50 years for most projects).
[End of table]
DOD's reported cost avoidance amounts provide an unrealistic sense of
savings for several reasons:
* First, as previously stated, the estimated costs under government
ownership are not based on the actual expected costs if the system is
not privatized but rather on a higher "should cost" amount. As a
result, estimated costs under government ownership are overstated and,
therefore, DOD's estimated cost avoidance is overstated, at least in
the short term.
* Second, the government's costs for utility services increase with
privatization. Army officials estimated that average annual cost
increase for each privatized Army system was $1.3 million. Also, the
services estimate that they will need $453 million more than is
currently programmed for continuing government ownership to pay for the
contract and other costs associated with the remaining number of
utility systems that might be privatized through 2010 for the Air Force
and the Navy and Marine Corps, and through 2011 for the Army.
* Third, DOD's reported cost avoidance does not consider the program's
one-time implementation costs. Through fiscal year 2005, about $268
million was spent to implement the program.
* Fourth, the economic analyses used to estimate the cost avoidance
between the government-owned and privatization options for several of
the 81 projects included in DOD's report to Congress are unreliable. As
noted in our previous report, our review of seven project analyses
identified inaccuracies, unsupported cost estimates, and noncompliance
with guidance for performing the analyses. The cost estimates in the
analyses generally favored the privatization option by understating
long-term privatization costs or overstating long-term government
ownership costs. When we made adjustments to address the issues in
these analyses, the estimated cost avoidance with privatization was
reduced or eliminated. Also, as discussed in another section of this
report, although DOD has taken steps to improve reliability, we found
questionable items in 10 economic analyses supporting projects awarded
after our May 2005 report.
* Fifth, cost growth in privatization contracts might reduce or
eliminate the amount of the estimated cost avoidance from
privatization. We reviewed the analysis supporting the Navy's one
privatization project under 10 U.S.C. 2688, awarded in 1999, and
compared actual contract costs to the estimated contract costs included
in the analysis. The analysis showed that if contract costs continue to
increase at the same rate experienced since the contract was awarded,
then the project's estimated cost avoidance would be reduced from about
$92.7 million to about $18 million. This analysis also did not include
consideration of privatization contract oversight costs. Consideration
of these costs would further reduce the estimated cost avoidance to
about $4 million. As discussed in another section of this report, we
found contract cost growth concerns in 3 of 6 additional utility
privatization projects we reviewed, which will reduce the estimated
cost avoidance for those projects.
In addition to providing an unrealistic sense of savings by providing
only the "should cost" estimates, the economic analyses do not include
other information that would provide decision makers with a clearer
picture of the financial effect of privatization decisions. If the
analyses included information showing the amount that the government
currently spends on operating, maintaining, and upgrading the utility
systems being evaluated for privatization, decision makers could better
consider the increase in costs that will result from privatization as
they assess the merits of proposed projects. However, DOD's guidance
does not require that the services' economic analyses include current
utility system cost information.
The National Defense Authorization Act for Fiscal Year 2006 modified
the program's legislative authority by requiring that project economic
analyses incorporate margins of error in the estimates that minimize
any underestimation of the costs resulting from privatization of the
utility system or any overestimation of the costs resulting from
continued government ownership and management of the utility system.
This step could help improve the reliability of the cost differences
between the government-owned and privatization options. The modified
authority stated that incorporating margins of error in the estimates
was to be based upon guidance approved by the Secretary of Defense.
However, as of June 2006, DOD had only issued general guidance in this
area with no details on how the services were to comply with the new
requirement. Specifically, on March 20, 2006, DOD issued guidance
directing the services to include in the economic analysis an
explanation as to how margin of error considerations were addressed in
developing the independent government cost estimate and carried forward
in the price analysis report and cost realism report. Although the
guidance referenced Office of Management and Budget Circular A-94,
dated October 29, 1992; DOD Instruction 7041.3, dated November 7, 1995;
and Deputy Secretary of Defense memorandum and guidance dated October
9, 2002; none of these documents provide details on how margins of
error should be incorporated into the economic analyses. At the time of
our review in June 2006, Army and Navy officials stated that they were
evaluating how to include margins of error into future economic
analyses. Air Force officials stated that their economic analyses
already included margins of error calculations but that no formal rules
existed on how to use the results of the calculations. Without detailed
DOD guidance, there is little assurance that the services will include
margins of error considerations in an appropriate and consistent manner
in future project economic analyses.
Changes in Legislative Authority and DOD's Implementation of the Change
Address Fair Market Value Concerns:
DOD's changes to implement a modification to the legislative authority
for the utility privatization program have addressed the fair market
value concerns discussed in our May 2005 report. Our report noted that
in some cases implementation of a previous legislative requirement that
the government receive fair market value for systems conveyed to
privatization contractors had resulted in higher contract costs for
utility services. To address this concern, we recommended that DOD
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.
Subsequent to our report, in January 2006, the National Defense
Authorization Act for Fiscal Year 2006 was enacted.[Footnote 19] The
act changed the legislative language from stating that fair market
value from a conveyance must be received to stating that fair market
value from a conveyance may be received.
In March 2006, DOD issued guidance to implement modifications in the
legislative authority made by the act. With regard to fair market
value, DOD's guidance to the services noted that military departments
are no longer required to obtain fair market value exclusively through
cash payments or rate credits. The military departments now have the
flexibility to seek consideration in a manner other than a payment of
the fair market value when the economic analysis demonstrates it is in
the best interest of the government. The guidance also stated that the
military departments may not dispose of the government's property
without receiving an appropriate return, but the amount and nature of
that return may be determined and represented in a number of ways,
depending on the negotiated deal.
The change in legislative authority and the additional guidance issued
by DOD address our concern with receipt of fair market value for system
conveyances. Our review of 10 economic analyses for projects awarded
after our May 2005 report showed that the fair market value paid by the
contractor and the amount recovered were the same. Thus, according to
these analyses, the receipt of the fair market value for the
conveyances in these cases did not result in any increased costs to the
government.
Conclusions:
DOD has made many changes to improve the management and oversight of
the utility privatization program since our previous report. If fully
implemented, the changes should result in more reliable economic
analyses supporting proposed privatization projects, improved budgetary
consideration of increased utility costs from privatization, enhanced
oversight of privatization contracts, and reduced instances where
contractors recover more than the amounts they paid as the fair market
value for system conveyances. However, a number of program concerns
remain because DOD's changes to address some issues noted in our
previous report have not been effectively implemented, some changes
were not sufficient to totally eliminate the concerns, and DOD did not
make changes to address some concerns. Specifically, implementation of
DOD's changes to improve the reliability of the economic analyses, such
as requiring independent reviews and noting the importance of
postconveyance reviews to compare actual contract costs with estimates
from the analyses, could be improved. The reliability of the analyses
could continue to be questionable until DOD requires independent
reviewers to report to decision makers on the thoroughness of the
economic analyses and any significant anomalies between the ownership
options, estimated costs, inventories, and assumptions and also issues
guidance requiring the services to perform the postconveyance reviews
as noted in its March 2006 report to Congress. An additional concern is
the services' estimated shortfall in the funds needed to pay contract
costs associated with the remaining number of utility systems that
might be privatized by the end of their programs. Unless DOD addresses
the potential funding shortfall in view of all DOD and service funding
and priority needs, questions will remain over the availability of the
additional funds needed to complete the program. Also, although DOD's
changes designed to improve utility privatization contract
administration and oversight are key steps in the right direction, it
may take some time to fully implement improvements as new privatization
contracts are awarded and oversight of older contracts is assessed.
Until DOD ensures that the contracts awarded prior to the program
changes have adequate resources and contractor performance surveillance
plans, the adequacy of contract oversight will remain a concern.
Further, because contractors own installation utility systems after
privatization, they may have an advantage when negotiating contract
changes and renewals. Unless DOD places additional emphasis on
monitoring contract cost growth as utility privatization contracts
undergo periodic price adjustments and other changes are negotiated,
concern will continue that containing utility privatization contract
cost growth may become a challenge.
Because DOD did not change guidance to require that project economic
analyses show the actual costs of continued government ownership if the
system is not privatized, or take any other steps to change the
perception that the utility privatization program results in reduced
costs to the government, DOD continues to provide 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. Until DOD requires that each economic analysis
includes information on the system's current costs and the actual
expected costs if the system is not privatized, decision makers will
have incomplete information on the financial effect of privatization
decisions. In addition, unless the Secretary of Defense issues detailed
guidance explaining how the services should incorporate margins of
error in the economic analyses, as required by the National Defense
Authorization Act for Fiscal Year 2006, there is little assurance that
the full benefit from this requirement will be achieved.
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 seven actions:
* require independent reviewers to report to decision makers on the
thoroughness of each economic analysis and any significant anomalies in
the assumptions used and estimated costs for each ownership option;
* issue guidance requiring the services to perform the postconveyance
reviews as noted in DOD's March 2006 report to Congress;
* address the utility privatization program potential funding shortfall
in view of all DOD and service funding and priority needs;
* ensure that utility privatization contracts awarded prior to the
November 2005 supplemental guidance have adequate resources and
contractor performance surveillance plans;
* place additional emphasis on monitoring contract cost growth as
utility privatization contracts undergo periodic price adjustments and
other changes are negotiated;
* require, in addition to the "should cost" estimate, that each project
economic analysis include the system's current annual costs and the
actual expected annual costs if the system is not privatized; and:
* issue detailed guidance explaining how the services should
incorporate margins of error in the economic analyses.
Agency Comments and Our Evaluation:
In comments on a draft of this report, the Deputy Under Secretary of
Defense (Installations and Environment) generally agreed with six of
our seven recommendations and outlined a plan of action to address each
recommendation. The Deputy Under Secretary noted that the utility
privatization systems evaluated in our report were approved prior to
DOD's November 2005 program guidance and that the guidance will be
fully implemented prior to awarding additional contracts. We recognize
that issues identified in this report pertain to contracts awarded
before supplemental program guidance was issued in November 2005.
Nevertheless, we believe the issues identified in this report highlight
areas that merit increased attention as the program continues--and this
is reflected in the department's response to each recommendation.
The Deputy Under Secretary indicated disagreement with our
recommendation to require, in addition to the "should cost" estimate,
that each project economic analysis include the system's current annual
costs and the actual expected annual costs if the system is not
privatized, and also stated that full implementation of DOD's November
2005 guidance will provide further reassurance that every conveyance
will reduce the long-term costs of the department compared to the costs
of continued ownership. However, as noted in our May 2005 report and
again in this report, we believe that in the short term it is clear
that the utility privatization program increases annual costs to the
government where contractors make system improvements and recoup their
costs from the department through their service contracts. DOD's sole
use of "should costs" as a basis for comparing its long-term costs with
those contained in contractor proposals provides a less clear picture
of savings to the government since, as our reports have shown, the
government's "should costs" do not provide a realistic portrayal of the
planned government expenditures. Accordingly, we believe our
recommendation continues to have merit.
DOD's comments and our detailed response to specific statements in
those comments are presented in appendix II.
We are sending copies of this report to other interested congressional
committees; the Secretaries of Defense, the Army, the Navy, and the 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 have any questions about this report, please call
me at (202) 512-5581 or e-mail at holmanb@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. The GAO staff members who made key
contributions to this report are listed in appendix III.
Signed by:
Barry W. Holman, Director:
Defense Capabilities and Management:
List of Congressional Committees:
The Honorable John Warner:
Chairman:
The Honorable Carl Levin:
Ranking Minority Member Committee on Armed Services:
United States Senate:
The Honorable Ted Stevens:
Chairman:
The Honorable Daniel K. Inouye:
Ranking Minority Member:
Subcommittee on Defense:
Committee on Appropriations:
United States Senate:
The Honorable Duncan L. Hunter:
Chairman:
The Honorable Ike Skelton:
Ranking Minority Member:
Committee on Armed Services:
House of Representatives:
The Honorable C. W. Bill Young:
Chairman:
The Honorable John P. Murtha:
Ranking Minority Member:
Subcommittee on Defense:
Committee on Appropriations:
House of Representatives:
[End of section]
Appendix I: Scope and Methodology:
To update the status of the Department of Defense's (DOD) utility
privatization program, we summarized program implementation status and
costs and compared the status to DOD's past and current goals and
milestones. We discussed with DOD and service officials issues
affecting implementation of the program, such as the services'
suspension of the program between October 2005 and March 2006, and
inquired about the effects of implementation delays on program
completion plans. Using data from the services' quarterly program
status reports to DOD, we summarized the program implementation status
by service and compared the status to program status reported in our
prior report. We confirmed the quarterly reports' status data on five
privatization projects at the four installations we visited but did not
otherwise test the reliability of the data. We also reviewed and
summarized the services' estimates of the additional number of systems
that might be privatized by the completion of their programs and the
funds needed to pay the costs associated with these anticipated
projects.
To assess the effect of DOD's changes on the program management and
oversight concerns noted in our May 2005 report, we documented the
changes made by interviewing DOD and service officials and reviewing
pertinent policies, guidance, memorandums, and reports, discussed with
DOD and service officials the intended objective for each of the
changes, and compared the changes with the concerns identified in our
prior report. To assess the effect of DOD's changes on the reliability
of the economic analyses supporting privatization decisions, we
reviewed the economic analyses supporting 10 privatization projects
that were awarded after our May 2005 report and that had been subjected
to the services' new independent review processes. The analyses were
judgmentally selected to obtain examples from both the Army and the Air
Force. For each analysis, we evaluated the basis for the estimates and
assumptions used and assessed consistency and compliance with DOD
guidance. We did not otherwise attempt to independently determine
estimates of long-term costs for the projects. We shared the results of
our analyses with service officials and incorporated their comments as
appropriate. To assess the effect of DOD's changes on consideration of
increased costs from utility privatization, we summarized the services'
estimates of the additional funds that would be needed to pay costs
associated with the remaining number of utility systems that might be
privatized and inquired about DOD's plans for dealing with a potential
program funding shortfall. To assess the effect of DOD's changes on the
administration and oversight of utility privatization projects, we
visited four installations with five utility privatization projects
awarded prior to our May 2005 report: Fort Eustis, Virginia; the Army's
Military Ocean Terminal Sunny Point, North Carolina; Bolling Air Force
Base, Maryland; and Dobbins Air Reserve Base, Georgia. These
installations were judgmentally selected because they represented a
cross section of typical utility privatization projects, as
corroborated with service officials. At each installation, we discussed
resources available for contract oversight and plans for contractor
performance monitoring. Also, to assess the effect of DOD's changes on
controlling cost growth in utility privatization contracts, we reviewed
cost changes in the five utility privatization contracts at the
installations we visited, discussed the reasons for the changes with
local officials, and compared the actual contract costs with estimates
from the projects' economic analyses. We also reviewed cost changes in
the Fort Rucker natural gas privatization contract because, according
to the services, it was the only contract awarded under the legislative
authority specifically provided for utility privatization that had
completed a periodic price adjustment. To assess the effect of DOD's
changes on cost avoidance estimates from privatization, we reviewed the
estimates DOD reported to Congress to determine whether the estimates
reflected the actual changes expected in the government's utility
costs.
We conducted our review from March through July 2006 in accordance with
generally accepted government auditing standards.
[End of section]
Appendix II: Comments from the Department of Defense:
Note: GAO comments supplementing those in the report text appear at the
end of this appendix.
Office Of The Under Secretary Of Defense:
3000 Defense Pentagon:
Washington, DC 20301-3000:
Acquisition, Technology And Logistics:
Mr. Barry Holman:
Director, Defense Capabilities and Management:
Government Accountability Office:
441 G Street, N.W.
Washington, D.C. 20548:
Aug 21 2006:
Dear Mr. Holman:
This is the Department of Defense (DoD) response to the GAO draft
report, GAO-06-914, `Defense Infrastructure: Actions Taken to Improve
the Management of Utility Privatization, but Some Concerns Remain,'
dated July 17, 2006 (GAO Code 350812). I have enclosed a detailed
response and plan of action for each recommendation.
As noted in your report, no Department utility systems have been
privatized since the issuance of new guidance in November 2005. As
such, the systems evaluated within the report were not subject to that
guidance. The guidance will be fully implemented prior to the
Components awarding any further contracts providing further reassurance
that every conveyance will reduce the long-term costs of the Department
compared to the costs of continued ownership.
I appreciate the opportunity to comment on the draft report.
Signed by:
Philip W. Grone:
Deputy Under Secretary of Defense:
(Installations and Environment):
Enclosure: As stated:
GAO Draft Report - Dated July 17, 2006 GAO CODE 350812/GAO-06-914:
"Defense Infrastructure: Actions Taken to Improve the Management of
Utility Privatization, but Some Concerns Remain"
Department Of Defense Comments To The Recommendations:
Recommendation 1: The GAO recommended that the Secretary of Defense
direct the Deputy Under Secretary of Defense (Installations and
Environment) to require independent reviewers to report to
decisionmakers on the thoroughness of each economic analysis and any
significant anomalies in the assumptions used and estimated costs for
each ownership option.
DOD Response: Concur with this recommendation. As stated in the report,
guidance issued by the Department on 2 November 2005 requires an
independent review for all analyses supporting a proposed conveyance.
While there are clearly some areas for concern in the independent
reviews that were studied, the report also states that these reviews
were conducted prior to the Department issuing guidance requiring them.
Additionally, these reviews were the first ones conducted and were
learning experiences for all involved. Since these reviews, lessons
learned have been shared through the Utilities Privatization Working
Group to improve the quality of later reviews.
GAO noted specific concerns identified with three of the reviews, but
does not make a compelling case that the issues would have changed the
proposed outcomes. The estimated cost of recapitalizing a utility
system is a judgment call on the part of the estimator. There are a
number of factors, including acceptance of risk, which affect the
decision. In the case where a contractor proposes a lower amount of up
front capital improvement than the government estimate, it is not
legitimate for the government to drop the government estimate to match
that input. Beyond the concern that this may constitute bid leveling,
the contractor may be willing to accept a higher risk of costly
emergency repairs to decrease the initial capital improvement costs.
Regardless of this difference in philosophy, the contractor would still
be required to provide the specified level of service, which is the
basis for the comparison.
Plan of Action:
1. Continue to require independent reviews as per current guidance.
2. Through the Utilities Privatization Working Group, emphasize the
scope of the reviews and continue to share lessons learned to improve
the quality of future reviews.
Recommendation 2: The GAO recommended that the Secretary of Defense
direct the Deputy Under Secretary of Defense (Installations and
Environment) to issue guidance requiring the Services to perform the
post conveyance reviews as noted in DoD's March 2006 report to
Congress.
DOD Response: Concur with this recommendation. As stated in the March
2006 report to Congress, the Department recognizes the value of post
conveyance reviews. The report expresses concern over the limited
number and scope of the reviews that have been conducted. While the
Department agrees that the scope of some of the reviews may be less
than adequate, it is important to note that conducting these reviews at
a time before the contractor has reached steady state operations is not
conducive to reliable and realistic results.
Plan of Action:
1. Issue guidance requiring Service officials to perform post
conveyance reviews in a manner and time frame consistent with the March
2006 report to Congress.
Recommendation 3: The GAO recommended that the Secretary of Defense
direct the Deputy Under Secretary of Defense (Installations and
Environment) to address the utility privatization program potential
funding shortfall in view of all DoD and Service funding and priority
needs.
DOD Response: Partially concur with this recommendation. The guidance
issued 2 November 2005 directs Components to consider and plan for all
costs associated with utility privatization before and after
conveyance. GAO reports that without identifying additional resources
for utility privatization costs, funding for these contracts must come
from other base operating support funds. In reality, it has been the
utility sustainment funds that have been used in the past for other
base support operations that has led to the need and desire to
privatize. Components must continue to prioritize competing interests
within the constraints provided by budgets and guidance.
Plan of Action:
1. Reiterate guidance through the Utilities Privatization Working Group
2. Monitor progress and respond to program reviews and waiver requests.
Recommendation 4: The GAO recommended that the Secretary of Defense
direct the Deputy Under Secretary of Defense (Installations and
Environment) to ensure that utility privatization contracts awarded
prior to the November 2005 supplemental guidance have adequate
resources and contractor performance surveillance plans.
DOD Response: Concur with this recommendation. The GAO report states
that written performance evaluation plans as required by Federal
Acquisition Regulations were not in place at two installations.
Additionally, the report points to concerns that adequate personnel
resources have not always been identified. It is the responsibility of
the requiring activity and the contracting officer to ensure that both
of these items are adequately addressed prior to award. In those cases
where that was not done prior to award, it is imperative that the
problem be corrected. There is sometimes a difference of opinion in the
level of detailed oversight that is necessary and in the adequacy of
the workforce to handle the workload in a particular office. These
issues should be resolved under the purview of the Service and not at
the DoD level.
The Defense Energy Service Center, in cooperation with Defense
Acquisition University, recently provided a new online course for
Utilities Privatization Contract Administration. This module will be
used in a continuing education environment to help ensure adequate
training for personnel involved with privatized utilities contracts.
Plan of Action:
1. Reiterate through the Utilities Privatization Working Group that
Federal Acquisition Regulations require a written performance
evaluation plan and these plans are valuable and essential components
of government oversight.
2. Advertise availability of the new Utilities Privatization Contract
Administration module through Defense Acquisition University.
Recommendation 5: The GAO recommended that the Secretary of Defense
direct the Deputy Under Secretary of Defense (Installations and
Environment) to place additional emphasis on monitoring contract cost
growth as utility privatization contracts undergo periodic price
adjustments and other changes are negotiated.
DOD Response: Partially concur with this recommendation. The GAO report
identifies cost growth in several contracts, some of which appear to be
excessive at first look, but the report does not classify the growth as
warranted or unwarranted. Cost growth may occur in utility service
contracts due to many factors, including but not limited to, increased
labor costs, increased energy costs, and the addition of infrastructure
that needs to be covered by the contract. Much of the cost growth
discussed in the report occurred in the first year of a contract due to
inventory adjustments that were made after award. GAO only looked at
the contract cost and did not review the impact to the government
estimate. In most cases, while there is cost growth, it would have
affected both estimates and as such, the savings delta remains valid.
The Component's necessity to prioritize budget constraints is an
inherent driver toward emphasizing and controlling unwarranted cost
growth. As such, the Department does not consider that there is
anything to gain by issuing guidance on this topic.
Plan of Action:
1. Continue to emphasize the requirement to implement procedures to
control cost growth in privatized utility contracts.
Recommendation 6: The GAO recommended that the Secretary of Defense
direct the Deputy Under Secretary of Defense (Installations and
Environment) to require, in addition to the "should cost" estimate,
that each project economic analysis include the system's current annual
costs and the actual expected annual costs if the system is not
privatized.
DOD Response: The Department can include the current annual costs in
the economic analysis but cannot provide the expected annual cost if
the system is not privatized.
The current annual cost, alone, would be of limited use because it
could only be compared to the "should cost," which is what we should be
spending, as opposed to what we are or will be spending to maintain the
system. At most, only a handful of systems currently being considered
for privatization would have reasonably projected recapitalization
projects that could be included to formulate the future annual costs if
not privatized. Without inclusion of such recapitalization costs, the
projected annual costs would be essentially the same as current annual
costs. The projection, therefore, would be of no real value except in
those very few cases with pending projects, and then only if the
project was essentially a complete recapitalization of the entire
system, in order to be comparable to the cost of privatization.
Plan of Action:
1. Considering the intent to provide reliable utility services support,
continue to use the appropriate industry standard in determining the
long-term costs of the United States for utility services provided by
the utility system concerned.
Recommendation 7: The GAO recommended that the Secretary of Defense
direct the Deputy Under Secretary of Defense (Installations and
Environment) to issue detailed guidance explaining how the Services
should incorporate margins of error in the economic analyses.
DOD Response: Concur with this recommendation. Although the March 2006
guidance directs Components to include an explanation as to how margin
of error considerations were addressed, there is no clear guidance on
how margin of error should be addressed.
Plan of Action:
1. The Department will work with the Components to identify the best
method for considering margin of error and will issue guidance
directing that method be used in future analyses.
The following is our detailed response to the Department of Defense's
(DOD) comments provided on August 21, 2006.
GAO's Response to the Department of Defense's Comments:
Our responses to DOD's comments are numbered below to correspond with
the department's various points.
1. As noted in this report, we identified concerns with the independent
review performed on each of the 10 economic analyses we reviewed. We
did not attempt in this report to prove that the questionable items we
identified with each analysis would have changed the proposed outcomes
but noted that improvements are needed in the thoroughness of the
independent reviews that will be performed on future projects. Until
DOD requires independent reviewers to report to decision makers on the
thoroughness of the economic analyses and any significant anomalies, we
continue to believe the reliability of the analyses could be
questioned. As outlined in our May 2005 report and this report, to
ensure a valid comparison of costs we continue to believe that the
government's "should cost" estimate should be closely based on
performing the same work that the contractor would perform.
2. Our report does not suggest that postconveyance reviews should be
conducted prematurely as indicated by DOD in its comments. The fact is
that the utility privatization contracts under 10 U.S.C. 2688 authority
began to be awarded in 1999, about 7 years ago, and postconveyance
reviews do not appear to have been performed on many ongoing utility
privatization contracts since that time. Although DOD noted in its
March 2006 report the importance of postconveyance reviews as an
additional measure to help ensure reliable economic analyses, it has
not issued guidance to require the services to perform such reviews.
3. Our report clearly shows that Air Force officials, not GAO, stated
that without additional resources, funding for utility privatization
contracts must come from other base operating support funds, which
would result in diverting critical resources from remaining facilities
and infrastructure.
Furthermore, DOD's comment that utility sustainment funds have been
used for other base support operations in the past only reinforces the
need to address the utility privatization program potential funding
shortfall. We have completed a number of reviews in which we have
identified examples where the shifting of operation and maintenance
funds from one account to other accounts to fund must-pay bills and
other priorities contributes to management problems and funding
shortfalls. For example, in February 2003, we reported that the
services withheld facilities sustainment funding to pay must-pay bills,
such as civilian pay, emergent needs, and other nonsustainment
programs, throughout the year and transferred other funds back into
facilities sustainment at fiscal year's end.[Footnote 20] Still, the
amounts of funds spent on facilities sustainment were not sufficient to
reverse the trend in deterioration. In June 2005, we reported that
hundreds of millions of dollars originally designated for facilities
sustainment and base operations support had been redesignated by the
services to pay for the Global War on Terrorism.[Footnote 21] While
installations received additional funds at the end of the fiscal year
to help offset shortfalls endured during the year, the timing made it
difficult for the installations to maintain facilities and provide base
support services efficiently and effectively. Similarly, unless the
potential funding shortfall in the utility privatization program is
addressed, funding will likely have to be redesignated to fund the
utility privatization program rather than be used for its intended
purpose.
4. Our report raises concerns about the adequacy of the services'
oversight of several privatization contracts that were awarded prior to
DOD's November 2005 supplemental guidance. Given that the Office of the
Deputy Under Secretary of Defense (Installations and Environment) has
overall policy and management oversight responsibilities for the
utility privatization program, we continue to believe that this office
is the appropriate level for providing direction and assurance that
utility privatization contracts awarded prior to the supplemental
guidance have adequate resources and contractor performance
surveillance plans, as we recommend.
5. Our report highlights the importance of monitoring cost growth
because contractors have ownership of the utility systems after
privatization and, therefore, may have an advantage when negotiating
contract changes and renewals. In addition, controlling the potential
growth in the cost of ongoing utilities privatization contracts is
important to the services in their planning for the adequate funding of
the program. We did not review the effect of contract cost growth on
the government estimate because the government estimate is not a
relevant factor in controlling costs once a system has been privatized.
Although a comparison of actual costs of a privatization project with
the estimates included in the project's economic analysis is a useful
tool to help improve the reliability of analyses of future
privatization projects, it is unlikely that such comparisons would
assist in controlling cost growth.
Furthermore, DOD's comment refers to a "savings delta." As noted in our
May 2005 report and again in this report, in the short term it is clear
that the utility privatization program increases annual costs to the
department where contractors make system improvements and recoup their
costs through the service contracts.
[End of section]
Appendix III: GAO Contact and Staff Acknowledgments:
GAO Contact:
Barry W. Holman, (202) 512-5581 or (holmanb@gao.gov):
Acknowledgments:
In addition to the person named above, Susan C. Ditto, Harry A.
Knobler, Katherine Lenane, Mark A. Little, Gary W. Phillips, Sharon L.
Reid, and John C. Wren also made major contributions to this report.
FOOTNOTES
[1] National Defense Authorization Act for Fiscal Year 1998, Pub. L.
No. 105-85, § 2812 (1997).
[2] GAO, Defense Infrastructure: Management Issues Requiring Attention
in Utility Privatization, GAO-05-433 (Washington, D.C.: May 12, 2005).
[3] DOD, Under Secretary of Defense, Memorandum for Secretaries of the
Military Departments and Director, Defense Logistics Agency, Subject:
Supplemental Guidance for the Utilities Privatization Program
(Washington, D.C.: Nov. 2, 2005).
[4] National Defense Authorization Act for Fiscal Year 2006, Pub. L.
No. 109-163, § 2823 (2006) (codified as amended at 10 U.S.C. § 2688).
[5] Pub. L. No. 105-85, § 2812 (1997).
[6] DOD, Deputy Secretary of Defense, Memorandum for Secretaries of the
Military Departments and others, Subject: Department of Defense Reform
Initiative Directive #9--Privatizing Utility Systems (Washington, D.C.:
Dec. 10, 1997).
[7] DOD, Deputy Secretary of Defense, Memorandum for Secretaries of the
Military Departments and others, Subject: Department of Defense Reform
Initiative Directive #49--Privatizing Utility Systems (Washington,
D.C.: Dec. 23, 1998).
[8] DOD, Deputy Secretary of Defense, Memorandum for Secretaries of the
Army, Navy, and Air Force and Director, Defense Logistics Agency,
Subject: Revised Guidance for the Utilities Privatization Program
(Washington, D.C.: Oct. 9, 2002).
[9] See footnote 2.
[10] Pub. L. No. 109-163, § 2823 (2006).
[11] Prior to November 2003, section 2688 of title 10 stated that the
Secretary of Defense was not permitted to make a conveyance until he
submitted a report that demonstrated two specific factors and a period
of 21 days had elapsed from the date at which the analysis was
submitted.
[12] National Defense Authorization Act for Fiscal Year 2004, Pub. L.
No. 108-136, § 1031(a)(32)(2003).
[13] See footnote 3.
[14] DOD, Under Secretary of Defense, Memorandum for Secretaries of the
Military Departments and Director, Defense Logistics Agency, Subject:
Supplemental Guidance for the Utilities Privatization Program
(Washington, D.C.: Mar. 20, 2006).
[15] DOD, Deputy Under Secretary of Defense (Installations and
Environment), Report to Congress on Use of Utility System Conveyance
Authority and Temporary Suspension of Authority Pending Report
(Washington, D.C.: Mar. 31, 2006).
[16] Although this report includes Defense Logistics Agency program
status information, the report does not include any additional Defense
Logistics Agency program information because the agency has few systems
available for privatization compared to the military services and has
awarded no utility privatization contracts.
[17] Renewals and replacements is a term used to describe the normal
replacement of, or repairs to, a system's components or parts as needed
to keep the system functioning in accordance with industry standards.
[18] Air Force officials stated that four additional utility
privatization contracts were previously eligible for periodic price
adjustment but no adjustment was made because neither the contractor
nor the government requested an adjustment.
[19] Pub. L. No. 109-163, § 2823 (2006).
[20] GAO, 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).
[21] GAO, Defense Infrastructure: Issues Need to Be Addressed in
Managing and Funding Base Operations and Facilities Support, GAO-05-556
(Washington, D.C.: June 15, 2005).
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