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entitled 'Defense Infrastructure: Actions Taken to Improve the 
Management of Utility Privatization, but Some Concerns Remain' which 
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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 DODís 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 DODís 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 DODís changes on the concerns noted 
last year. To conduct this review, GAO summarized program status and 
costs, assessed DODís changes to program guidance and in other areas, 
and reviewed the servicesí implementation of the changes. 

What GAO Found: 

DODís progress in implementing the utility privatization program has 
been slower than expected and the estimated completion date has slipped 
from the departmentís target of September 2005 to September 2011. DOD 
attributed the delays to the complexity of the program and to the 
servicesí 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 servicesí 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 GAOís 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. GAOís review of five projects 
awarded prior to DODís 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 programís implementation to know to what 
extent DODís 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, DODís 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, ß 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, ß 2823 (2006) (codified as amended at 10 U.S.C. ß 2688). 

[5] Pub. L. No. 105-85, ß 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, ß 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, ß 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, ß 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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