Defense Infrastructure: Management Issue Requiring Attention in  
Utility Privatization (12-MAY-05, GAO-05-433).			 
                                                                 
Department of Defense (DOD) installations have about 2,600	 
electric, water, wastewater, and natural gas utility systems	 
valued at about $50 billion. In 1997, DOD decided that utility	 
privatization was the preferred method for improving utility	 
systems and services and the Congress approved legislative	 
authority for privatizing utility systems at military		 
installations with Public Law No. 105-85. Because of the costs	 
and long-term implications of DOD's utility privatization	 
program, GAO reviewed the program to determine (1) the program's 
status, (2) whether the services' estimates of long-term savings 
from utility privatization projects are reliable, (3) how DOD	 
implements the fair market value requirement for conveyed utility
systems, and (4) whether other issues impact the effectiveness of
DOD's execution of the program. 				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-433 					        
    ACCNO:   A24017						        
  TITLE:     Defense Infrastructure: Management Issue Requiring       
Attention in Utility Privatization				 
     DATE:   05/12/2005 
  SUBJECT:   Cost analysis					 
	     Defense cost control				 
	     Defense economic analysis				 
	     Economic analysis					 
	     Fair market value					 
	     Military facilities				 
	     Privatization					 
	     Program evaluation 				 
	     Strategic planning 				 
	     Electric utilities 				 
	     Contract oversight 				 
	     Performance measures				 
	     Program goals or objectives			 

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GAO-05-433

                 United States Government Accountability Office

GAO	Report to the Subcommittee on Readiness, Committee on Armed Services, House
                               of Representatives

May 2005

DEFENSE INFRASTRUCTURE

         Management Issues Requiring Attention in Utility Privatization

                                       a

GAO-05-433

[IMG]

May 2005

DEFENSE INFRASTRUCTURE

Management Issues Requiring Attention in Utility Privatization

  What GAO Found

DOD's progress in implementing the utility privatization program has been
slower than expected, largely because of the complexities of the
solicitation and contracting processes. In 1997, DOD initially expected
that the services would privatize or exempt all utility systems by January
2000. Yet, after spending about $248 million on program implementation,
the services had privatized only 94 systems and exempted 311 systems of
the 1,499 utility systems determined to be available for privatization as
of December 31, 2004. Although DOD reset implementation target dates and
established September 2005 as the current goal for the services to make
decisions to privatize or exempt all systems, DOD officials stated that it
was unlikely that the services would meet the revised goal.

Utility privatization can provide for quicker system improvements than
otherwise might be available; however, there are questions about program
savings. Although the services' economic analyses estimate that utility
systems privatized to date will reduce the government's costs for utility
services, GAO questions the estimates because they give an unrealistic
sense of savings to a program that increases ongoing government utility
costs in order to pay contractors for enhanced utility services and
capital improvements. Other base support services could suffer unless
budgets are adjusted to reflect these increased costs. Moreover, GAO found
that longterm cost comparisons did not depict actual expected costs of
continued government ownership in the event that systems were not
privatized and DOD had not taken steps to ensure that the estimates were
otherwise reliable. As a result, GAO found in the seven cases it reviewed
that the services' analyses included inaccuracies that tended to favor the
privatization option over continued government ownership.

Although the services are permitted latitude in ensuring that the
government receives fair market value for systems conveyed to
privatization contractors, in some cases implementation has resulted in
higher contract costs for utility services. Contractors normally include
the full amounts they paid for conveyances in the associated utility
services contracts and, therefore, the government will pay back the
amounts received over time. In some cases, contractors also include
additional amounts in the contracts to cover costs associated with the
fair market value payment. Thus, implementing the fair market value
requirement in such cases results in higher contract costs because the
government will pay back more than it will receive for conveying the
systems.

Two additional issues of concern identified by GAO related to limited
oversight of privatization contracts and DOD's preferred practice of
permanently conveying utility systems to contractors rather than using
more limited arrangements which, according to DOD consultant reports, is a
more prevalent private sector practice and one which may offer greater
safeguards to the government.

United States Government Accountability Office

Contents

  Letter

Results in Brief
Background
Utility Privatization Implementation Has Been Slower

Than Expected The Services' Savings Estimates from Utility Privatization
Are Questionable Implementation of the Fair Market Value Requirement Can
Result in Higher Contract Costs DOD's Execution of the Utility
Privatization Program Raises

Other Concerns Conclusions Recommendations for Executive Action Matter for
Congressional Consideration Agency Comments and Our Evaluation

1 3 7

11

17

25

29 34 36 37 37

Appendixes

Appendix I: Scope and Methodology 43

Appendix II:	Results of GAO's Review of the Services' Economic Analyses
Supporting Seven Utility Privatization Projects 45

Appendix III: Comments from the Department of Defense 49

Tables	Table 1: Table 2: Table 3: Table 4: Table 5:

Status of the Utility Privatization Program as of
December 31, 2004 13
Percentage of Systems with Privatization or Exemption
Decision 13
Implementation Costs for the Utility Privatization
Program 17
Selected Information from Economic Analyses Supporting
Utility Privatization Projects 23
Amounts to Be Received for Utility System Conveyances
for Projects Reviewed 27

Contents

Abbreviations

DOD Department of Defense
GSA General Services Administration

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A

United States Government Accountability Office Washington, D.C. 20548

May 12, 2005

The Honorable Joel Hefley Chairman The Honorable Solomon P. Ortiz Ranking
Member Subcommittee on Readiness Committee on Armed Services House of
Representatives

Department of Defense (DOD) installations have about 2,600 electric,
water, wastewater, and natural gas utility systems valued at about $50
billion. These systems consist of the equipment, fixtures, pipes, wires,
and other structures used in the distribution of electric power and
natural gas, the treatment and distribution of water, and the collection
and treatment of wastewater. According to DOD officials, many of these
systems have become unreliable and in need of major improvements due to
inadequate funding caused by the competition for funds and DOD's risk
management and budget allocation decisions. To address this issue, DOD
decided in 1997 that utility privatization was the preferred method for
improving utility systems and services because privatization would allow
installations to benefit from private sector financing and efficiencies.
With private sector financing, installations could immediately obtain
major upgrades to their utility systems and pay for these improvements
over time. Thus, utility improvements could be achieved without going
through the traditional military construction budget justification and
funding process. Under DOD's program, utility privatization normally
involves two transactions with the successful contractor-the conveyance of
the utility system infrastructure and the acquisition of utility services
for upgrades, operations, and maintenance under a long-term contract of up
to 50 years. DOD estimates that some privatization contracts will cost
more than a hundred million dollars over the contract time frames.

To institute the program at DOD's request, the Congress approved
legislative authority in 1997 for privatizing utility systems at military
installations.1 The authority requires that the military services meet a
number of conditions to privatize a system including, in part, the
following two conditions. First, the services must demonstrate through an
economic analysis that privatization of a system would reduce the
government's longterm costs for utility services. Second, the services
must receive as consideration for conveying a system an amount equal to
the system's fair market value.2 DOD's program guidance permits the
services to exempt systems from privatization when long-term costs will
not be reduced or for unique security reasons.

In view of these requirements and because of the program's costs and
longterm implications, this report, undertaken pursuant to the Comptroller
General's legislative authorities, determines (1) the program's status,
(2) whether the services' estimates of savings from utility privatization
projects are reliable, (3) how DOD implements the fair market value
requirement for conveyed utility systems, and (4) whether other issues
impact the effectiveness of DOD's execution of the program. As discussed
with your offices, we are addressing the report to you because of your
expressed interest related to your committee's oversight responsibilities.

To address these questions, we summarized program implementation status
and costs, compared the status to DOD's goals and milestones, and
discussed issues affecting program implementation, such as accounting for
contract termination liabilities. We relied on program status data
provided by the services, confirmed the status data for seven projects,
but did not otherwise test the reliability of the data. We examined DOD's
guidance and methods for performing and reviewing the economic analyses
used to determine whether privatization will reduce the government's
long-term costs and for determining the fair market value of the systems
to be conveyed. We reviewed the economic analyses for seven projects
regarded by DOD as privatization successes to examine the basis for the
estimates and the assumptions used, evaluate consistency and reliability,
and assess the amounts received as consideration for the conveyances.
Finally, we

1 The National Defense Authorization Act for Fiscal Year 1998, Pub. L. No.
105-85, S: 2812, (1997).

2 The conveyance may consist of all right, title, and interest of the
United States in the utility system or such lesser estate as the Secretary
of a military department considers appropriate to serve the interests of
the United States.

reviewed DOD and service guidance for utility privatization contract
administration, discussed contract oversight with officials at five
installations, and reviewed information from DOD officials and consultant
reports on how DOD's approach to utility privatization compares with
private sector practices. We conducted our work from July 2004 through
March 2005 in accordance with generally accepted government auditing
standards. A more detailed description of our scope and methodology is
included in appendix I.

Results in Brief	Although initial goals were aggressive, DOD's actual
progress in implementing the utility privatization program has been slower
than expected. In 1997, DOD initially expected that the services would
privatize or exempt all utility systems by January 2000. Yet, after
spending about $248 million on program implementation, the services had
privatized only 94 systems and exempted 311 systems of the 1,499 utility
systems determined to be available for privatization as of December 31,
2004. Although DOD reset implementation target dates and established
September 2005 as the current goal for the services to make decisions to
privatize or exempt all systems, DOD officials stated that it was unlikely
that the services would meet the revised goal. According to DOD and
service program officials, program implementation has been slower than
expected primarily because the privatization evaluation, solicitation, and
contracting processes were more complex and time consuming than originally
anticipated. Moreover, an issue surfaced in October 2004 that further
slowed the program by placing pending contract awards on hold for several
months while the matter was evaluated. This issue concerned whether the
services were required at the time of contract signing to obligate
sufficient funds to pay a privatization contractor for costs that had not
been recovered under a contract to date in the event of a future contract
termination. According to service officials, if required, the amounts
needed could be large enough to make many proposed utility privatization
projects financially unfeasible. The DOD Office of General Counsel
evaluated the issue and concluded in February 2005 that the services were
not required to obligate sufficient funds to cover contract termination
liability under the utility privatization program. We agree that defense
services are not required to record obligations for potential termination
liabilities under that authority, unless and until they decide to
terminate.

Although the services' economic analyses estimate that utility systems
privatized to date will reduce the government's costs for utility
services, we

found that the estimates give an unrealistic sense of savings to a program
that generally increases government utility costs in order to pay
contractors for enhanced utility services and capital improvements. DOD's
funding obligations will likely increase faster than they would under
continued government ownership as it pays over time for utility system
improvements obtained from private sector financing. Air Force officials
estimated that the Air Force's costs alone could increase between $100
million and $200 million annually for the first 5 to 10 years of
privatization. Various service officials expressed concern that unless
funding for operation and maintenance accounts are adjusted to reflect
this increase, other support functions on military bases could suffer as
funds are shifted to cover "must pay" privatized utility costs. Moreover,
we found that the services' long-term savings estimates, required to be
developed to support privatization decisions, were questionable because
the estimates did not depict actual expected costs of continued government
ownership in the event that systems were not privatized and DOD had not
taken steps to ensure that the estimates were otherwise reliable. First,
to determine whether a proposed privatization contract would meet the
statutory requirement for reduced long-term costs, each service followed
DOD guidance and compared the long-term estimated costs of the contract
with the estimated long-term "should costs" of continued government
ownership assuming that the service would upgrade, operate, and maintain
the system in accordance with accepted industry standards as called for in
the proposed contract. This estimating method would be appropriate if, in
the event the system is not privatized, the service proceeded to upgrade,
operate, and maintain the system as called for in the estimate. However,
this generally is not the case. According to DOD and service officials, if
a system is not privatized, then the anticipated system improvements would
probably be delayed because of DOD's budget allocation decisions, which
have limited funds for utility improvements. Because of the time value of
money, a future expense of a given amount is equivalent to a smaller
amount in today's dollars. As a result, delaying system improvements to
future years would reduce the estimated cost of the government ownership
option in today's dollars and, therefore, affect the results of the
economic analyses. At the same time, it must be recognized that delays in
system improvements could increase government costs due to increased
maintenance and possible changes in system reliability in the long term.
Thus, if reduced costs to the government are expected to be a key factor
in utility privatization decision making, then it would appear more
appropriate for the services to compare the cost of a proposed
privatization contract with the cost of continued government ownership on
the basis of the actual planned expenditures and timing of these
expenditures, with

appropriate consideration to the impact of delayed improvements. Second,
largely because DOD does not require that the services' economic analyses
be subjected to an independent review for accuracy and compliance with
guidance, we found in the seven cases we reviewed that the services'
analyses included inaccuracies which tended to favor the privatization
option over continued government ownership.

Although the services are permitted latitude in ensuring that the
government receives fair market value for systems conveyed to
privatization contractors, in some cases implementation has resulted in
higher contract costs for utility services. Guidance and practices for
determining fair market value varied among the services, with Army
guidance stating that fair market value for system conveyances could range
from zero to full replacement cost of the system. For example, the Army
privatized one installation's water distribution system, consisting of a
reservoir, four water towers, and pipelines, and according to the economic
analysis received no consideration from the contractor for the conveyance.
Army officials stated that determining fair market value was subjective
and determined in part by the amounts contractors were willing to pay. In
some cases, the officials stated that the most beneficial business case
was to convey systems at less than estimated fair market value. Also,
although it is a reasonable concept that the government should receive
consideration if an asset is conveyed to a contractor, the receipt of
consideration for conveyances in the utility privatization program does
not typically result in a net financial payment to the government. To
recover their costs, privatization contractors normally include the full
amounts they paid for conveyances in the associated utility services
contracts and, therefore, the government will pay back the amounts
received for the conveyances in the utility services bills over time.
Beyond that, in some cases, contractors include additional amounts in the
utility services bills to cover the contractors' costs associated with the
fair market value payments. Implementing the fair market value requirement
in such cases will result in increased costs because the government will
pay back more than it will receive for the conveyances. For example, the
economic analysis for the electric distribution system privatization at
Dobbins Air Reserve Base showed that the contractor will pay $741,000 as
the fair market value for the conveyance. The analysis also showed that
the contractor will recover this cost, plus other associated costs, by
charging the Air Force $1,322,000 in the utilities services bills over
time. Thus, implementing the fair market value requirement in this case
will result in the Air Force paying about $581,000, or 78 percent, more
than it will receive for the conveyance.

In examining DOD's execution of the utility privatization program, we
identified two other areas of concern that could affect program
effectiveness. First, the adequacy of privatization contract oversight was
a concern. Although they intend to do so, the services have not issued
specific contract administration guidance for the program since it began
over 7 years ago. Officials at one installation we visited stated that
they were performing limited oversight because they lacked sufficient
guidance and had not been funded for people to oversee contractor
performance. Also, in its reviews of four utility privatization contracts,
the Army Audit Agency reported that contractor performance was not
adequately monitored and, as a result, there was little assurance that the
installations would receive quality products and services. Second,
according to DOD consultant reports, DOD's approach to utility
privatization differs from typical private sector practices in that
private sector companies may outsource system operations and maintenance
but normally retain system ownership. As a result, the consultant reports
note that DOD's preferred approach of permanently conveying utility system
ownership to contractors may give the contractor an advantage when
negotiating service contract changes or renewals. This occurs because DOD
must deal with the contractor or pay significant amounts to construct a
new utility distribution system to replace the one conveyed to the
contractor, attempt to purchase the system back from the contractor, or
institute legal action to reacquire the system through condemnation
proceedings.

We are making recommendations to help ensure the reliability of the
economic analyses for proposed utility privatization projects and to
improve the guidance and procedures used to implement and oversee the
utility privatization program. In commenting on a draft of this report,
DOD disagreed with our recommendations, characterized our findings as
being outdated and not well founded, and suggested that our report
represented an unwarranted characterization of issues we identified as
being systemic to the program. We believe that our review of the utility
privatization program was objective, balanced, and represented program
conditions existing at the time we completed our review in March 2005. We
disagree with DOD's contention that our findings were outdated. Of the
seven utility privatization projects we reviewed in detail, the associated
contracts for four projects were awarded in 2004, and the contracts for
two projects were awarded in 2003. Additionally, the issues we identified
and recommendations we made are current regardless of the case studies. We
remain confident that both our conclusions and recommendations are soundly
based upon the findings discussed in this report. We address

DOD's comments in detail later in the report. Because of DOD's response to
the report, we have added a matter for congressional consideration.

Background	At DOD's request, the Congress approved legislative authority
in 1997 for privatizing utility systems at military installations.3 In
defining a utility system, the authority included systems for the
generation and supply of electric power; the treatment or supply of water;
the collection or treatment of wastewater; the generation or supply of
steam, hot water, and chilled water; the supply of natural gas; and the
transmission of telecommunications. Included in a utility system are the
associated equipment, fixtures, structures, and other improvements as well
as real property, easements, and rights-of-way. The authority stated that
the Secretary of a military department may convey a utility system to a
municipal, private, regional, district, or cooperative utility company or
other entity and the conveyance may consist of all right, title, and
interest of the United States in the utility system or such lesser estate
as the Secretary considers appropriate to serve the interests of the
United States.

Among other things, the current authority also includes two requirements
for utility privatization. First, the Secretary shall submit reports to
the congressional defense committees on the conveyances made under the
authority each quarter. Previously, the statute required DOD to submit the
report and wait 21 days before allowing a conveyance.4 For each such
conveyance, the report is to include an economic analysis, based on
acceptable life-cycle costing procedures, demonstrating that (1) the
longterm economic benefit of the conveyance to the United States exceeds
the long-term economic cost of the conveyance to the United States, and
(2) the conveyance will reduce the long-term costs of the United States
for utility services provided by the utility system concerned. Second, the
Secretary shall require as consideration for a conveyance an amount equal
to the fair market value, as determined by the Secretary, of the right,
title, or interest of the United States conveyed. The consideration may
take the form of a lump sum payment or a reduction in charges for utility
services.

3 See note 1.

4 See National Defense Authorization Act for Fiscal Year 2004, Pub. L. No.
108-136, S: 1031(a)(12), which changed the timing of the reporting
requirement. The seven utility privatization projects we reviewed were
under the earlier requirement.

Before and after approval of the specific authority for privatizing
utilities, the services have used other authorities for utility
privatization. For example, the Army had privatized some systems after
obtaining congressional authority on each specific case. Also, the
services have privatized systems by modifications to natural gas services
agreements administered by the General Services Administration and by
conveyances of some systems on the basis of authorities related to base
realignment and closure and the military housing privatization program.

DOD Made Utility Privatization a DOD Policy

In December 1997, DOD issued Defense Reform Initiative Directive Number 9,
which made utility system privatization a DOD policy.5 The directive
instructed the military departments to develop a plan that would result in
privatizing all installation electric, natural gas, water, and wastewater
utility systems by January 1, 2000, unless exempted for unique security
reasons or if privatization would be uneconomical. Under the program,
privatization normally involves two transactions with the successful
contractor-the conveyance of the utility system infrastructure and the
acquisition of utility services for upgrades, operations, and maintenance
under a long-term contract of up to 50 years. Normally, the conveyances do
not include title to the land underlying the utility system
infrastructures.

A year later, in December 1998, DOD issued another directive to establish
program management and oversight responsibilities and provide guidance for
performing economic analyses for proposed projects, exempting systems from
the program, and using competitive procedures to conduct the program.6 The
directive also stated that the objective was for DOD to get out of the
business of owning, managing, and operating utility systems by privatizing
them and that exemptions from privatization should be rare. The directive
reset the privatization implementation goal to September 30, 2003.

5 See Deputy Secretary of Defense, Memorandum for Secretaries of the
Military Departments and others, Subject: Department of Defense Reform
Initiative
Directive #9-Privatizing Utility Systems (Department of Defense:
Washington, D.C.,
Dec. 10, 1997).

6 See Deputy Secretary of Defense, Memorandum for Secretaries of the
Military Departments and others, Subject: Department of Defense Reform
Initiative
Directive #49-Privatizing Utility Systems (Department of Defense:
Washington, D.C.,
Dec. 23, 1998).

    Implementation GoalsReset and Program Guidance Revised

In October 2002, DOD issued revised program guidance and again reset
implementation goals.7 The guidance noted DOD's contention that many
installation utility systems had become unreliable and in need of major
improvements because the installations historically had been unable to
upgrade and maintain reliable utility systems due to inadequate funding
caused by the competition for funds and DOD's budget allocation decisions.
DOD officials stated that owning, operating, and maintaining utility
systems was not a core DOD function and the guidance stated that
privatization was the preferred method for improving utility systems and
services by allowing military installations to benefit from private sector
financing and efficiencies. The revised implementation goals directed the
military departments to reach a privatization or exemption decision on at
least 65 percent of the systems available for privatization by September
30, 2004, and on all systems by September 30, 2005.

The October 2002 guidance also reemphasized that utility privatization was
contingent upon meeting two requirements contained in the legislative
authority for the program-that the services demonstrate through an
economic analysis that privatization will reduce the long-term costs to
the government for utility services and that the services receive fair
market value for system conveyances. The guidance included details for
conducting the economic analyses stating that the services' analyses
should compare the long-term estimated costs of proposed privatization
contracts with the estimated long-term costs of continued government
ownership assuming that the systems would be upgraded, operated, and
maintained at accepted industry standards, as would be required under
privatization.

Utility Privatization DOD's Office of the Deputy Under Secretary of
Defense for Installations

Program Management	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.

7 See Deputy Secretary of Defense, Memorandum for Secretaries of the Army,
Navy, and Air Force and Director of the Defense Logistics Agency, Subject:
Revised Guidance for the Utility Privatization Program (Department of
Defense, Washington, D.C., Oct. 9, 2002).

    Prior GAO Reports on Utility Privatization and Related Subjects

Although this is our first detailed report on DOD's utility privatization
program, we have issued four previous reports that commented on the
program. These reports primarily focused on DOD's progress in implementing
DOD's Defense Reform Initiative, which began in 1997. The initiative
represented an important set of actions aimed at improving the
effectiveness and efficiency of DOD's business operations. One of those
actions was the utilities privatization program. Concerning the utilities
privatization program, we reported in April 1999 and August 1999 that the
program was complex, time consuming, and expensive and that the services
would not meet initial implementation goals.8 In July 2000, we reported
that in December 1998, DOD had issued a program budget decision directing
the services to set aside $243.6 million to complete privatizations
between fiscal years 1999 and 2004.9 The program budget decision estimated
that utility system privatization might begin to provide about $327
million in annual savings after privatizations were completed in 2003.
However, we also reported that these early budget estimates of the costs
and savings were unrealistic and that in addition to paying for
privatization studies, military service officials were also concerned that
utility bills would increase without a corresponding increase in
operations and maintenance funds. In December 2002, we again reported that
the utility privatization program was more complex and time consuming than
anticipated and DOD planned to reset the program's completion goal.10

8 GAO, Defense Reform Initiative: Organization, Status, and Challenges,
GAO/NSIAD-99-87 (Washington, D.C.: Apr. 21, 1999) and Defense
Infrastructure: Improved Performance Measures Would Enhance Defense Reform
Initiative, GAO/NSIAD-99-169 (Washington, D.C: Aug. 4, 1999).

9 GAO, Defense Management: Actions Needed to Sustain Reform Initiatives
and Achieve Greater Results, GAO/NSIAD-00-72 (Washington, D.C.: July 25,
2000).

10 GAO, Defense Management: New Management Reform Program Still Evolving,
GAO-03-58 (Washington, D.C.: Dec. 12, 2002).

We have also issued three reports on DOD's program management and
oversight of another privatization program-the military housing
privatization program.11 As noted elsewhere in this report, information
from those reports provides a useful contrast in approach when compared to
the utility privatization program. Finally, we have issued other reports
that identified examples where the services moved operations and
maintenance funds intended to support one functional area to another
functional area and discussed associated impacts.12

  Utility Privatization Implementation Has Been Slower Than Expected

The utility privatization program provides DOD with a method to improve
installation utility systems by using private sector financing as an
alternative to traditional military construction funding. Although DOD's
initial goals were aggressive in order to use privatization to quickly
obtain improvements and get the services out of the business of owning and
operating utility systems, actual program implementation has been slower
than expected. In 1997, DOD expected that the services would privatize or
exempt all utility systems by January 2000 and DOD's current goal is for
the services to make decisions to privatize or exempt all systems by
September 2005. Yet, the services had awarded or exempted only a fraction
of the 1,499 systems available for privatization as of December 31, 2004.
Program implementation slowed further in late 2004 and pending contract
awards for all services were put on hold for several months over an issue
related to contract termination liability. Implementation costs for the
program will total about $296 million for fiscal years 1998 through 2005,
according to DOD and service officials.

11 See GAO, Military Housing: Privatization Off to a Slow Start and
Continued
Management Attention Needed, GAO/NSIAD-98-178 (Washington, D.C.: July 17,
1998);
Military Housing: Continued Concerns in Implementing the Privatization
Initiative,
GAO/NSIAD-00-71 (Washington, D.C.: Mar. 30, 2000); and Military Housing:
Management
Improvement Needed As the Pace of Privatization Quickens, GAO-02-624
(Washington, D.C.: June 21, 2002).

12 See GAO, Defense Budget: DOD Should Further Improve Visibility and
Accountability
of O&M Fund Movements, GAO/NSIAD-00-18 (Washington, D.C.: Feb. 9, 2000);
and
Defense Infrastructure: Changes in Funding Priorities and Strategic
Planning Needed
to Improve the Condition of Military Facilities, GAO-03-274 (Washington,
D.C.:
Feb. 19, 2003).

    Privatization Offers a Method for Obtaining Utility System Improvements
    Without Full Up-front Appropriations

Utility privatization has helped installations achieve major system
improvements which, according to cognizant DOD and service officials,
would not have been otherwise possible due to inadequate funding caused by
the competition for funds and budget allocation decisions. They report the
systems vary among the military services in the extent to which they have
been adequately maintained and upgraded over time. With private sector
financing as an alternative to traditional military construction funding,
installations have obtained system upgrades and improved operations and
maintenance and will pay for the improvements over time, rather than
through full up-front appropriations.13 According to these officials, the
improvements have resulted in increased utility system reliability and
efficiencies while reducing safety and environmental risks. Also, these
officials noted that, with privatization, installations can focus more on
their core defense missions rather than tending to problems caused by
outdated utility systems. These officials further noted that without the
privatization program these benefits would not have been obtained in the
short term but would have been delayed, perhaps for many years.

    The Services Have Awarded Contracts for Only a Fraction of the Total Systems
    Available for Privatization

After spending about $248 million on program implementation costs, the
services had awarded contracts for only a fraction of the 1,499 utility
systems available for privatization as of December 31, 2004. Of the 94
total contract awards, the services awarded 68 under the legislative
authorities specifically provided for the program and 26 as part of other
programs, such as DOD's military housing privatization program. As shown
in table 1, the services also had exempted 311 systems for security or
economic reasons and had 979 systems in various stages of the
privatization contract solicitation process.

13 Because the budget does not reflect up front the full costs of the
improvements to be obtained through utility privatization, it may be more
difficult for decision makers to consider the full financial commitment
that the government undertakes when it enters into long-term privatization
contracts. This could lead to a situation in which budget decisions favor
utility privatizations over programs that include their full costs up
front in the budget.

Table 1: Status of the Utility Privatization Program as of December 31,
2004 Component

Systems available for privatization

Systems pending solicitation or on hold

                            Systems in solicitation

Systems exempted

Contracts awardeda

                Army                   320         67        144       40     
                Navy                   645         23        534       73     
              Air Force                505         17        280       198    
      Defense Logistics Agency          29          8        21         0     
                Total                 1,499        115       979       311    

Source: DOD.

aAccording to service officials, of the 94 contract awards, 68 were
awarded using 10 U.S.C. 2688 authorities and 26 were awarded using other
authorities. Of the Army's 69 contract awards, 4 were awarded under the
General Services Administration's areawide gas service agreements and 4
were awarded under authorities related to base realignment and closure. Of
the Navy's 15 contract awards, 14 were awarded as part of the Navy's
military housing privatization program or other transactions. Of the Air
Force's 10 contract awards, 4 were awarded under the General Services
Administration's areawide gas service agreements.

In comparison to DOD's current implementation goals, only the Air Force
met the September 30, 2004, goal by making a privatization or exemption
decision on at least 65 percent of its utility systems available for
privatization. As shown in table 2, as of September 30, 2004, the Air
Force had made decisions on 70 percent of its systems while the Army, the
Navy, and the Defense Logistics Agency had made decisions on 51 percent,
47 percent, and 55 percent, respectively, of their utility systems. DOD
officials stated that it was unlikely that the services will meet DOD's
September 30, 2005, goal of making a privatization or exemption decision
on every system available for privatization.

Table 2: Percentage of Systems with Privatization or Exemption Decision
Component

Goal for Sept. 30, 2004 (percent) Actual as of Sept. 30, 2004 (percent)
Sept. 30, 2004 goal met?

       Goal for Sept. 30, 2005 (percent) Actual as of Dec. 31, 2004 (percent)

          Army             65        51 No                             100 52 
          Navy             65        47 No                             100 49 
       Air Force           65        70 Yes                            100 71 
Defense Logistics                        
         Agency            65        55 No                             100 55 
         Total             65        56 No                             100 57 
                       Source: DOD.         
                            Page 13         GAO-05-433 Defense Infrastructure 

According to DOD and service officials, implementation was slower than
expected primarily because the program proved to be more complex and time
consuming than initially expected. The program represented a new way of
doing business for both the military and the private sector and it took
time to develop guidance for determining fair market values for system
conveyances and for comparing the long-term costs of a proposed
privatization project with the long-term costs of continued government
ownership. Initially, DOD also had to evaluate and make decisions in many
areas such as the role of state laws and regulations on utility systems
located on military installations but with ownership conveyed to private
contractors. Further, to address some private utility company concerns,
DOD made or sought and obtained waivers from some contracting regulations,
but the process to do so was time consuming. For example, early in the
program DOD learned that some private utility companies were reluctant to
submit offers on privatization contracts because of regulations requiring
that contractors follow accounting standards set by the Cost Accounting
Standards Board. The concern was that the utility industry already had a
set of established accounting practices used by regulatory agencies to set
utility rates and to adopt an additional set of accounting standards would
be too costly. DOD requested the Cost Accounting Standards Board to grant
a waiver from use of the standards in utility privatization contracts
under certain circumstances. Although the matter remained a point of
contention for several years, the waiver was not obtained until September
2004 and DOD guidance on the matter was not issued until October 2004.

    Contract Termination Liability Questions Slowed Implementation Further

Program implementation slowed further in late 2004 and pending contract
awards for all services were held up over an issue concerning contract
termination liability. In October 2004, the Navy raised a question with
the Office of the Secretary of Defense concerning whether it was required
to obligate funds to cover potential contract termination expenses should
the Navy terminate a utility services contract prior to the contractor
recovering its acquisition and system improvement costs. Navy officials
stated that, if required, the amounts needed could be very large, making
many proposed utility privatization projects financially unfeasible.

Not all the services shared the Navy's concern regarding termination
liability. The Army, for example, reportedly has entered into a number of
utility privatization agreements without recording an obligation to cover
potential termination liability. The Army's position apparently was that
10 U.S.C. S: 2688 provides the necessary authority to enter into utility

privatization agreements without recording an obligation for termination
liability.

To resolve the differences between the services, the DOD Office of General
Counsel considered the Navy and Army positions and issued guidance in
February 2005 indicating that the services were not required to obligate
funds to cover contract termination liability under the utility
privatization program. In part, the DOD Office of General Counsel relied
on a 1983 GAO decision14 which addressed the acquisition by the General
Services Administration (GSA) of telephone equipment and related services
under 40 U.S.C. S: 501(b)(3). That statutory provision, similar to section
2688, authorizes contracts for public utility services for multiple years
(up to 10 years) without mentioning termination liability. The DOD Office
of General Counsel noted that our 1983 decision stated that under section
501, GSA did not need to have available budget authority to obligate the
total estimated cost of a contract, "but only sufficient budget authority
to obligate its annual costs under the agreement." Although the 1983
decision did not directly address termination liability, the DOD Office of
General Counsel maintains that a requirement to obligate termination costs
for such contracts would directly contradict the conclusion that GSA need
only obligate its "annual costs." According to the DOD Office of General
Counsel, the same result is appropriate under section 2688.

We examined the guidelines issued by the DOD Office of General Counsel and
the authorities they relied on. Given the nature of the section 2688
multiyear authority and the nature of the utility privatization program,
we agree that defense services are not required to record obligations for
potential termination liabilities under that authority, unless and until
they decide to terminate.

During our review of seven privatized DOD systems, we determined that the
services generally are agreeing to reimburse contractors for the
acquisition and system improvement costs of the facilities. To the extent
a particular contract is terminated prior to the contractor recouping its
acquisition and system improvement costs, DOD has agreed to repay those
costs. In the context of the multiyear utility program, the services have
generally entered into contracts with terms of 50 years. During the terms
of those contracts, DOD is either going to pay the annual costs of
performance, which includes materials, labor, overhead, and other costs of

14 62 Comp. Gen. 569 (1983).

the acquisition and system improvements, or it will pay termination costs,
which will cover the contractor's unreimbursed costs for the acquisition
and completed system improvements.

As DOD's Office of General Counsel notes, our 1983 decision concluded that
GSA may obligate the costs for its utility service contracts on an annual
basis rather than obligating the entire amount of contract costs for
future years in the first year of the contract. Section 2688, the
authority underlying DOD's utility services contracts, is not unlike GSA's
section 501 authority. They both permit contracting for utilities services
for a multiyear period. Just as in 1983, when we viewed section 501 as a
remedial provision to afford GSA flexibility in contracting, we view
section 2688 to similarly afford DOD flexibility. In our 1983 decision, we
noted that the purpose of section 501's multiyear contracting authority
was to "take advantage of discounts offered under long term contracts" and
"to effect economy and improve services," and, thus, broadly construed the
authority conferred to facilitate achieving these objectives.15 For the
same reasons, we read section 2688 broadly, and agree with DOD's
interpretation of it. To read the statute to require obligating potential
termination costs prior to a decision to terminate could undermine the
economies and improvements in services that the statute envisions.

The decision to terminate the contracts is DOD's, not the contractors'.16
If DOD decides to terminate a contract, those contracts appear to do
nothing more than bind DOD to repay amounts that DOD would otherwise have
paid if performance had continued, rather than additional penalties or
charges DOD would not have paid absent the termination. If DOD decides to
terminate, DOD must either have or obtain sufficient budget authority for
the year DOD becomes liable for termination costs. Because DOD controls
whether, and when, to terminate its contracts (and presumably would not
terminate without sufficient budget authority to cover termination
liability), should DOD in the future decide to terminate, such action does
not expose the government to a financial risk.

15 62 Comp. Gen. at 572 and 575, n.8.
16 We do not presume the government will default on its contractual
obligations.

    Utility Privatization Program Implementation Costs

For fiscal years 1998 through 2004, DOD and the services estimated that
about $248 million had been spent to implement the utility privatization
program (see table 3). For fiscal year 2005, implementation costs were
expected to be about $48 million, bringing the total to about $296
million. According to DOD officials, the funds used to implement the
program primarily paid for consultants hired to help implement the program
by assisting the services in inventorying their utility systems, assessing
the systems' condition, preparing economic analyses, and soliciting and
contracting for proposed projects. Program implementation costs did not
include funds used to pay the costs of awarded privatization contracts.

Table 3: Implementation Costs for the Utility Privatization Program

                              Dollars in millions

Component

Fiscal years 1998 through 2004

Fiscal year 2005

Total through fiscal year 2005

              Office of the Secretary of                          
                                 Defense     $3.3        $0.0a           $3.3 
                                    Army     62.5        15.0     
                                    Navy    103.3        27.6           130.9 
                               Air Force     78.6         5.4     
                                   Total    $247.7       $48.0         $295.7 

Source: DOD.

aAt the time of our review in February 2005, Office of the Secretary of
Defense officials stated that they had not yet estimated their program
implementation costs for fiscal year 2005.

According to DOD officials, program implementation costs are expected to
decline rapidly as the services complete their evaluations to privatize or
exempt their utility systems.

  The Services' Savings Estimates from Utility Privatization Are Questionable

The services' economic analyses supporting utility systems privatized or
near contract award for privatization estimate that the government's costs
for equivalent utility services will be less with privatization. The
amount of the savings is calculated based on the difference between the
estimated costs of two options for improving the utility
systems-privatization and continued government ownership. However, because
of the method used to estimate the costs of continued government
ownership, we found that these estimates give an unrealistic impression of
reduced costs in that the government's costs under privatization typically
increase to pay

contractors for enhanced utility services and capital improvements.
Moreover, based on the economic analyses examined, we question the
reliability of the projected differences in long-term costs between the
privatization and government ownership options. In seven analyses we
reviewed, we found inaccuracies and unsupported cost estimates that tended
to favor the privatization option over continued government ownership. The
Army Audit Agency has reported similar concerns with the reliability of
analyses supporting Army utility privatization projects.

    Installation Utility Costs Increase with Privatization

Installation utility costs under privatization typically increase
significantly above historical levels because the systems are being
upgraded and the contractors recoup their investment costs through the
utility services contracts.17 Essentially, under the privatization
program, the services leverage private sector capital to achieve utility
system improvements that otherwise would not be feasible in the short term
because of limited funding caused by the competition for funds and budget
allocation decisions. The services pay for the improvements over time
through the utility services contracts. Army officials estimated that the
average annual cost increase for each privatized Army system was $1.3
million. According to the economic analysis for the electric system
privatization at Dobbins Air Reserve Base, the annual operations and
maintenance costs for the system after privatization were expected to
increase by over 500 percent compared to historical costs.

Air Force headquarters officials stated concerns with the increased costs
from historical levels with utility privatization. The officials estimated
that based on the Air Force systems already privatized and those systems
with the potential to be privatized, the Air Force's costs could increase
between $100 million and $200 million annually for the first 5 to 10 years
of privatization. The officials also stated their concern that privatized
systems present the Air Force with a bill that must be paid, whereas the
Air Force would have more flexibility in programming and executing
improvements for government-owned utility systems. According to the
officials, this flexibility allows the Air Force to better balance the
spending of available funds on utility improvements and other mission
requirements to ensure the best use of resources.

17 System improvements normally include capital equipment upgrades and
enhanced operations and maintenance to increase utility system reliability
and reduce safety and environmental risks.

Officials at each of the five installations we visited also expressed
concern about increased utility costs from privatization. In particular,
installation officials were concerned that other installation functions
might suffer if funding provided for operating and maintaining their
installations were not sufficiently increased to cover the higher utility
costs. They noted that, under privatization, costs for upgrading,
operating, and maintaining the systems are contract costs that must be
paid. As a result, if an installation's funds were not increased
sufficiently, then funds provided for other installation functions where
there was more discretion in spending might be used to pay the higher
utility bills. This, in turn, could negatively impact those other
functions, such as the maintenance of installation facilities.

The economic analysis for the Fort Campbell water and wastewater systems
privatization illustrates the funding concern expressed by installation
officials. The analysis stated that privatization will increase
installation utility services costs well above levels previously budgeted
for this purpose. The analysis further stated the concern that "the
installation's budget may not be increased to the level necessary to fund
the increase requiring sacrifice of other installation functions."

Privatization funding was a particular concern at Fort Irwin. Fort Irwin
privatized its electrical system in 2003 and Army headquarters began
providing funds to the installation to pay the monthly utility services
bill. However, when we visited the installation in January 2005, Fort
Irwin officials stated that Army headquarters had provided no funds for
the privatization contract from October 2004 through January 2005 and, as
a result, the monthly utility services bills had not been paid. In March
2005, the officials stated that headquarters had provided some funding for
the project, but the amount provided was only 34 percent of the amount
needed. Fort Irwin officials said that headquarters officials stated that
they would try to provide more funds; however, if the additional funds are
not provided, then the installation will have to use funds intended for
other installation functions to pay the utility services bills.

Services' Economic We found that the services' savings estimates for
utility privatization Analyses Do Not Depict projects were questionable
because of the assumptions made about Actual Expected Costs of government
"should costs" in the economic analyses that compare

predicted costs under the privatization and government ownership
options.Continued Government DOD guidance directs the military services to
compare estimated Ownership privatization costs based on the proposed
contract with the estimated

government ownership costs based on what it "should cost" the

government to upgrade, operate, and maintain the system in accordance with
accepted industry standards as called for in the proposed contract. This
estimating method would be appropriate if, in the event the system is not
privatized, the service would proceed to upgrade, operate, and maintain
the system as called for in the government estimate. However, this
generally is not expected to be the case. According to DOD and service
officials, if a system is not privatized, then the anticipated system
improvements would likely be delayed several years because of DOD's budget
allocation decisions, which have limited the funds available for utility
improvements and which caused DOD to look to privatization as an option in
the first place.

Because of the time value of money, a future expense of a given amount is
equivalent to a smaller amount in today's dollars. Thus, delaying system
improvements to future years would reduce the estimated cost of the
government ownership option in today's dollars and, therefore, affect the
results of a proposed project's economic analysis. At the same time, it
must be recognized that delays in system improvements could increase
government costs in the long term. Thus, if savings are expected to be a
key factor in utility privatization decision making, then it would appear
more appropriate for the services to compare the cost of a proposed
privatization contract with the cost of continued government ownership on
the basis of the actual planned expenditures and timing of these
expenditures, with appropriate consideration to the impact of delayed
improvements.

The economic analysis supporting the June 2003 privatization of Fort
Campbell's water and wastewater utility systems illustrates the impact of
using DOD's method for estimating and comparing the long-term costs of the
privatization and government ownership options.18 Following DOD's
guidance, the Fort Campbell economic analysis estimated the long-term
costs of government ownership by assuming that the installation would
upgrade, operate, and maintain the systems in accordance with industry
standards as the contractor proposed to do. The analysis estimated that
over a 50-year period the total cost of government ownership of the
systems would exceed the total cost of privatization by about $4.3 million
in today's dollars. However, Fort Campbell officials stated that if the
contract had not been awarded and the government continued to own the

18 Fort Campbell privatized its water and wastewater systems under one
contract and prepared one economic analysis for the project.

systems, then the improvements planned for the systems would not have
occurred as indicated in the economic analysis. The officials stated that
the improvements most likely would have been delayed for several years
until the Army approved funding for the improvements. Based on information
in the economic analysis, we estimated that if the start of improvements
to upgrade the systems planned during the first 10 years under the
government ownership option were delayed by 5 years, which installation
officials stated was a reasonable assumption, then the estimated cost of
the government ownership option would decrease by about $6.5 million in
today's dollars because of the time value of money.19 Thus, in this case,
consideration of the expected costs of continued government ownership
based on a more realistic estimate of the timing of improvement
expenditures could have changed the result of the analysis and showed that
government ownership of the systems would be less costly than
privatization over the long term.

    DOD Does Not Require an Independent Review of the Services' Economic
    Analyses

DOD does not require that the services' economic analyses be subjected to
an independent review for accuracy and compliance with guidance, as a step
to help ensure reliability. Normally, the services hire consultants to
prepare the analyses and service officials stated that completed analyses
are reviewed by the service's headquarters office responsible for the
program. However, the reliability of the analyses is not reviewed by DOD
headquarters officials or by an independent party, such as the services'
audit agencies. Further, at the five installations we visited,
installation officials stated that they had not reviewed the details in
the economic analyses supporting their privatization projects and did not
know the basis for some of the estimates used in the analyses.

In contrast, DOD provides a more rigorous review of the analyses
supporting privatization projects under DOD's military housing
privatization program. Under this program, the service that proposes a
project must provide the responsible DOD headquarters officials with a
detailed briefing that describes the project, its justification, and
whether it meets specific financial criteria. These officials stated that
they review each project's supporting analysis and evaluate the estimates,
assumptions,

19 Under the government ownership option, the Fort Campbell economic
analysis assumed that operations and maintenance levels would be enhanced
and a series of capital projects would be undertaken to upgrade the
systems. Our estimate was based on delaying the planned capital projects,
not the enhanced operations and maintenance levels, for 5 years.

and methodology used in the analysis for reasonableness and compliance
with guidance. If concerns are identified, the officials ask the service
for additional information before the project is approved. These top-level
review steps provide additional assurances that supporting analyses are
reliable and that each project is adequately justified before approval.

We reviewed seven utility privatization project analyses and identified
inaccuracies, unsupported cost estimates, and noncompliance with guidance
for performing the analyses. The cost estimates in the analyses we
reviewed generally favored the privatization option by understating
long-term privatization costs or overstating long-term government
ownership costs. In five of the seven analyses, making adjustments to
correct problems we identified would change the outcomes to show that
government ownership, rather than privatization, would be less costly in
the long term. In the remaining two cases, the analyses were not reliable
because they did not reflect the actual utility system improvements to be
performed by the contractor.

The economic analysis for privatizing Fort Lee's water distribution system
illustrates problems we identified. The Fort Lee analysis did not consider
the system's value at the end of the analysis period-the residual value-
under the government ownership option, as required by DOD guidance.20
Consideration of residual value recognizes that, under the government
ownership option, the government would own the system and that the system
would have some value at the end of the analysis period. In contrast,
under the privatization option, the contractor, not the government, would
own the system at the end of the analysis period. Not including the
residual value in the analysis resulted in favoring the privatization
option by overstating government ownership costs. We recomputed costs by
including a residual value for the system at the end of the 50-year
contract. The result was to change the outcome of the analysis from
estimating that privatization would be less costly over the long term to
estimating that government ownership would be less costly over the long
term.

Table 4 includes selected information on each project we reviewed,
including the savings estimates from the services' analyses and a summary

20 See DOD Instruction 7041.3, Subject: Economic Analysis for
Decisionmaking, November 7, 1995.

of the concerns we identified. Also, appendix II contains a detailed
description of our review of each of the seven project economic analyses.

    Table 4: Selected Information from Economic Analyses Supporting Utility
                             Privatization Projects

                              Dollars in millions

Results from services' Results from GAO's review of the economic analyses
economic analyses

Utility privatization project Did the analysis consider residual value
under the government ownership option? Did the analysis include errors in
estimating costs? Would correcting the issues identified change the
outcome to favor government ownership?

                                                    Did the   
                                                    analysis  
                             Estimated Were        cover the  
Estimated total Estimated savings or government  same time 
        costs of total costs        cost ownership period as  
    government of privatiza- avoidance costs based the        
       ownership tion option    with on actual     privatiza- 
option in today's in       privatiza-expected   tion       
today's                                         
             dollars dollars tion option costs?     contract? 

        Water                                                          
     system, Fort                                                      
    Lee, Virginia    $10.3    $8.8      $1.5  No     No    No    Yes      Yes 
       Electric                                                        
     system, Fort                                                      
    Lee, Virginia     31.7    26.9       4.8  No    Yes    No    Yes     Yesa 

Water and
wastewater
systems,
Fort
Campbell,
Kentucky 196.6 192.3 4.3 No Yes Yes Yes Yes

Electric
system, Fort
Irwin,
California 32.1 29.7 2.4 No Yes Yes Yes Yes

Electric
system,
Dobbins Air
Reserve
Base,
Georgia 5.6 3.8 1.8 No No Yes Yes Yes

Water
system,
Bolling Air
Force Base,
Maryland 10.9 6.5 4.4 No Yes Yes Unknownb Unknownb

(Continued From Previous Page)

Dollars in millions

Results from services' Results from GAO's review of the economic analyses
economic analyses

                                                    Did the   
                                                    analysis  
                                 Estimated Were    cover the  
                  Estimated   savings or            same time 
                              government           
                  total costs       cost ownership period as  
                      of      avoidance costs         the     
                  privatiza-  based                
                  tion option    with on actual    privatiza- 
                  in today's   privatiza-expected     tion    
                      dollars  tion option costs?   contract? 

Did the analysis consider residual value under the government ownership
option?

Did the analysis include errors in estimating costs?

Would correcting the issues identified change the outcome to favor
government ownership?

      Estimated total costs of government ownership option in today's dollars

Utility privatization project

Wastewater
system,
Bolling Air
Force Base,
Maryland 7.2 5.7 1.5 No Yes Yes Unknownb Unknownb

Source: DOD information with GAO analysis.

aThe outcome of the economic analysis changes if the system's residual
value is assumed to be equal to the system's current replacement value.
Army officials stated that the system's residual value should equal the
system's replacement value less depreciation and, if this value were used,
the outcome of the economic analysis would not change. However, under
privatization, the system is to be upgraded, operated, and maintained in
accordance with industry standards, which will result in increasing the
system's residual value.

bWe question the reliability of the economic analyses for Bolling Air
Force Base because they did not reflect the actual system improvements to
be performed by the contractor. We did not have sufficient information to
recalculate estimates in the analyses. However, installation officials
stated that they believed that continued government ownership of the
systems would have been less costly than privatization over the long term.

    The Army Audit Agency Identified Concerns about the Reliability of Economic
    Analyses

The Army Audit Agency has issued reports that identified concerns about
the reliability of the economic analyses supporting utility privatization
contracts at four Army installations. These concerns are similar to the
ones we identified in our review. For example, in July 1999, the Army
awarded a contract to privatize Aberdeen Proving Ground's water and
wastewater utility system. The Army Audit Agency reviewed the project and
the supporting economic analysis and reported in April 2004 that the
analysis did not include realistic cost estimates for system improvements
to be performed by the privatization contractor.21 For example, the report
stated that the analysis understated the cost of system improvements by
$18.5 million over the life of the contract. As a result, the audit agency

21 U.S Army Audit Agency, Potable Water and Wastewater Utility Systems
Contract, Aberdeen Proving Ground, Maryland, A-2004-0186-IMO (Alexandria,
Va.: Apr. 27, 2004).

concluded that there was not a reliable framework for preparing the
analysis and the decision to privatize Aberdeen's water and wastewater
system might result in higher costs to the government in the long term.

  Implementation of the Fair Market Value Requirement Can Result in Higher
  Contract Costs

Although DOD is permitted latitude in ensuring that the government
receives fair market value for systems conveyed to privatization
contractors, in some cases implementation has resulted in higher contract
costs for utility services. Guidance and practices for determining fair
market value varied among the services, with Army guidance stating that
fair market value for system conveyances could range from zero to full
replacement cost of the system. Also, although it is a reasonable concept
that the government should receive consideration if an asset is conveyed
to a contractor, the receipt of consideration for conveyances in the
utility privatization program does not typically result in a net financial
payment to the government. To recover their costs, privatization
contractors normally include the full amounts they paid for conveyances in
the associated utility services contracts and, therefore, the government
will pay back the amounts received for the conveyances through utility
services bills over time. In some cases, the contractors also include
additional amounts in the utility services contracts to cover the
contractors' costs associated with the fair market value payments.
Consequently, implementing the fair market value requirement in such cases
will result in the government paying back more than it will receive for
the conveyances.

    Guidance and Practices for Determining Fair Market Value Vary

The legislative authority for the utility privatization program states
that the Secretary of a military department shall require as consideration
for a conveyance an amount equal to the fair market value, as determined
by the Secretary, of the right, title, or interest of the United States
conveyed. DOD provided general guidance on implementing this requirement
in October 2002. As part of the negotiation strategy for utility system
conveyances, the guidance directed the services to develop a range of fair
market values, taking into account the business and strategic values of
the utility system. The guidance stated that the services could choose to
determine fair market value through an actual appraisal, a modified cost
and income analysis, or a replacement or original-cost-less-depreciation
analysis. Subsequently, in response to questions at an industry forum in
September 2004, DOD officials stated that the fair market value should be
established through open negotiations, the contractor would recover the
fair market

value paid for a conveyance through the service contract, and the
contractor would earn a reasonable return on investment.

Although service officials stated that they have generally followed this
guidance, the Army issued additional guidance on determining fair market
value in April 2002.22 This guidance basically stated that a range of
values could be considered as fair market value for utility system
conveyances. Specifically, the guidance stated that the Army had concluded
that the fair market value "could be any number of values such as zero,
nominal, appraised, full replacement cost of the system, or any negotiated
amount, but that the [fair market value] should be determined by an
economic analysis applied in planning the sale of each utility system."
Army officials stated that determining fair market value is subjective and
determined in part by the amounts contractors are willing to pay. In some
cases, the officials stated that the most beneficial business case is to
convey systems at less than their apparent fair market values.

On the basis of information in the services' economic analyses we
reviewed, table 5 shows the amounts that the government will receive from
privatization contractors for utility system conveyances compared to one
measure of fair market value-the system's replacement cost less
depreciation. Whether the amounts received should be considered sufficient
is difficult to gauge because DOD has not adopted objective standards for
determining whether the amounts received meet the fair market value
requirement.

22 See Memorandum for Distribution, Subject: Utility Systems
Privatization-Fair
Market Value, the Army Assistant Chief of Staff for Installation
Management
(Washington, D.C.: Apr. 30, 2002). Navy and Air Force officials stated
that their guidance on
fair market value was consistent with DOD's general guidance.

  Table 5: Amounts to Be Received for Utility System Conveyances for Projects
                                    Reviewed

Dollars in millions

        Amount to be received as a percentage of system replacement cost less
                                                       depreciation (percent)

                         Utility privatization project

System replacement cost less depreciationa

Amount to be received for the conveyanceb

           Fort Campbell water and                             
             wastewater systems                   $20.0             $4.5      
         Fort Irwin electric system               10.0              8.5       
          Fort Lee electric system                16.5              9.7       
            Fort Lee water system               Unknownc            0.0       
          Dobbins Air Reserve Base                             
               electric system                     0.9              0.7       
        Bolling Air Force Base water                           
                   system                          3.1              1.2       
           Bolling Air Force Base                              
              wastewater system                    2.9              5.0       

Source: DOD with GAO analysis.

aThese values are normally determined by an analysis of each system's
replacement cost less depreciation based on an evaluation of the system's
physical condition.

bAccording to the services' economic analyses, the amounts that the
contractors will pay for the conveyances normally will be paid through
credits applied over time to the government's utility services bill.

cThis project's economic analysis did not include information on the
system's replacement cost. However, an Army analysis of the system, which
included a reservoir, four water towers, and pipelines, performed about 10
years prior to privatization, stated that the system's replacement cost
was about $11.8 million, and Fort Lee officials stated that the system was
in good condition and was not in need of any immediate upgrades or
improvements at the time of its conveyance to the contractor.

The Army Audit Agency reported in October 2001 that the Army used varying
methods to handle the fair market value requirement.23 The audit agency
reported that in four electric system privatizations the Army had used an
independent contractor to estimate the fair market values of the systems.
However, the fair market value estimates were not the final negotiated
fair market values agreed to by the parties. For example, in one case the
independent fair market value estimate for the system was

23 U.S. Army Audit Agency, Memorandum for the Assistant Chief of Staff for
Installation Management, Subject: Review of the Fair Market Value for
Privatized Electrical Distribution Systems, AA 02-701 (Alexandria, Va.:
Oct. 5, 2001).

$2.2 million and the system was conveyed for $0.1 million. In another
case, the independent fair market value estimate for the system was $19.5
million and the system was conveyed for zero dollars.

    Implementation of the Fair Market Value Requirement Increased Privatization
    Contract Costs in Some Cases

The services' implementation of the requirement that the government
receive fair market value when conveying utility systems resulted in
increased costs to the government in some cases. The services normally
negotiated with proposed privatization contractors for the fair market
amount that the contractors will pay for system conveyances. However, to
recover their costs, privatization contractors normally factor into the
utility services contracts the full amount paid as fair market value for
the systems. Thus, the government pays back the amounts received as
consideration for the conveyances. However, in some cases, the contractors
also include additional amounts in the utility services contracts to cover
the contractors' costs associated with the fair market value payments,
which increased contract costs.

For example, according to the economic analysis for privatizing Dobbins
Air Reserve Base's electric system, the contractor will pay about $741,000
as the fair market value for the system conveyance in today's dollars.
However, the analysis stated that the contractor will recover this cost,
plus other associated costs, by charging the Air Force about $1,322,000 in
today's dollars in the utility services bills over time. Consequently,
implementing the fair market value requirement in this case will result in
the Air Force paying about $581,000, or 78 percent, more than it received
for the conveyance.

A similar situation occurred at another installation we visited. According
to the economic analysis for privatizing Fort Lee's electric distribution
system, the contractor will pay about $6.6 million for the conveyance with
a cash down payment and with the remaining balance financed over 27 years
and paid in the form of monthly credits to the installation's utility
services bill. This arrangement will be equivalent to the contractor
paying about $9.7 million for the conveyance in today's dollars. However,
the analysis also stated that the contractor will recover its costs for
purchasing the system, including added amounts for taxes and other
associated costs, through annual charges added to the installation's
utility services bill over the first 28 years of the contract. Based on
the amounts to be charged, this arrangement will be equivalent to charging
the Army about $16.7 million in today's dollars. Consequently,
implementing the fair market requirement in

this case will result in the Army paying about $7.0 million, or 72
percent, more than it received for the conveyance.

In a review of the electric distribution system privatization at Fort
Benning, the Army Audit Agency also found that receipt of fair market
value for the conveyance will result in the government paying more under
the contract than if no consideration had been received. The audit
agency's report noted that the contractor agreed to pay $4.8 million for
the system and the Army agreed to pay the contractor for this cost plus
additional amounts for profit. The result was that over the life of the
contract the Army will pay about $748,000 more than it received for the
conveyance.24

  DOD's Execution of the Utility Privatization Program Raises Other Concerns

In examining DOD's execution of the utility privatization program, we
identified two additional areas of concern that could impact the overall
effectiveness of the program. First, the services have not issued specific
contract administration guidance for the program and, as a result, the
adequacy of privatization contract oversight is a concern. Second,
according to DOD consultant reports, DOD's approach to privatizing
utilities differs from typical private sector practices and, as a result,
privatization contractors may have an advantage when the time comes to
negotiate utility service contract changes and renewals. Management
attention in these areas could help ensure that best practices are used
and the government's interests are adequately protected.

    Adequacy of Privatization Contract Oversight Is a Concern

The adequacy of privatization contract oversight is a concern. The
services' oversight of utility privatization contracts appeared to be
limited in some cases because of limited guidance and inadequate
provisions for staff to monitor contracts. Inadequate oversight could
result in the services paying contractors for work not performed or for
work performed in an unsatisfactory manner.

The services have not issued specific guidance on utility privatization
contract administration even though the program began 7 years ago and 94
contracts have been awarded. Service officials stated that such guidance
was in preparation and should be issued before the end of 2005. However,

24 U. S. Army Audit Agency, Electrical Distribution System Contract, U.S.
Army Infantry Center and Fort Benning, A-2002-0395-IMO (Alexandria, Va.:
May 23, 2002).

the lack of specific guidance for awarded contracts was a matter of
concern at Fort Lee, one of the five installations we visited. Fort Lee
officials stated that they had little guidance from headquarters on what
they should be doing to oversee their water and electric privatization
contracts, other than to pay the bills. The officials also stated that
they did not have sufficient personnel to perform detailed monitoring of
contractor performance because no additional resources were provided for
this purpose after the contracts were signed. The officials believed that
the contractors were performing adequately but had little documentation to
support their opinions.

The Army Audit Agency also has reported concerns with the adequacy of
privatization contract oversight. As illustrated below, in its reviews of
four Army utility privatization contracts at the Aberdeen Proving Ground
and Forts Hamilton, Benning, and Pickett, the audit agency found that
contractor performance was not adequately monitored, and as a result,
there was little assurance that the installations would receive quality
products and services under privatization.

o 	In its review of utility privatization at the Aberdeen Proving Ground,
the audit agency found that the Army paid about $3.3 million during fiscal
year 2001 for operating expenses the contractor did not incur, system
improvements the contractor did not perform, and purchases the contractor
did not make.25 These conditions occurred because the Aberdeen Proving
Ground did not develop a performance monitoring plan, monitor completion
of system improvements, or require detailed expense reporting by the
contractor. In response, the responsible Army officials agreed to develop
a contract-monitoring plan to help track system improvements and require
the contractor to report additional data on expenses.

25 See note 21.

o 	In its review of utility privatization at Fort Hamilton, the audit
agency found that the Army's guidance to the installation did not specify
what aspects of the contract required monitoring, the installation did not
have a plan to monitor contractor performance, and the contractor did not
provide the Army with plans and reports as required by the contract to
assist in contract oversight.26 The audit agency concluded that the Army
needed to improve the contract administration procedures to ensure that
the Army would receive quality products and services. In response, the
responsible Army officials agreed to put procedures in place to address
the findings.

o 	In its review of utility privatization at Fort Benning, the audit
agency found that Fort Benning did not have procedures in place to
effectively monitor the contractor's performance because the contractor
was not required to provide any performance data to the government and the
installation did not have a contract-monitoring plan as required by
guidance.27 In response, Fort Benning officials agreed to develop a
contractor-monitoring plan that included inspection, verification, and
reporting to establish better contract oversight.

o 	In its review of utility privatization at Fort Pickett, the audit
agency found that Fort Pickett had no contract monitoring plan, the
installation official responsible for the contract did not know that the
contractor had delayed about 50 percent of the improvements planned in the
first year, and tenant organizations at the installation were not properly
charged for reimbursable costs associated with the privatized electrical
system.28 In response, the responsible Army officials agreed to develop a
contract-monitoring plan to help track system improvements and to ensure
accurate charges for tenants.

26 Army Audit Agency, Privatization of Utility Distribution Systems, Fort
Hamilton, New York, A-2003-0216-IMO (Washington, D.C.: Apr. 11, 2003).

27 See note 24.

28 U.S. Army Audit Agency, Electrical Distribution System Contract,
Virginia Army National Guard Maneuver Training Center, Fort Pickett,
Virginia, A-2003-0337-IMO (Alexandria, Va.: June 27, 2003).

    DOD's Approach to Utility Privatization Appears to Differ from Typical
    Private Sector Practices

DOD has no studies or other documentation showing that its approach to
utility privatization is based on private sector best practices. A senior
DOD official characterized the utility privatization program as the result
of a decision by the Office of the Secretary of Defense that operating and
maintaining utilities was not a core function and that installation
utilities should be privatized. Nevertheless, according to two reports
prepared by Navy and Air Force consultants, DOD's approach actually
differs from typical private sector practices in that private companies
may outsource system operations and maintenance but normally opt for
shorter than 50year utility service contracts and typically do not
permanently convey ownership of their utility systems. The first report,
prepared by CNA at the request of the Navy and issued in March 2001, noted
that while most private sector contracts for utility services last from 7
to 10 years, most DOD utility services contracts under privatization are
for 50 years.29 The report's concern was that a contract written today
could not adequately anticipate all possible contingencies over the next
50 years because technologies and requirements can change in unforeseen
ways. CNA also reported that, in contrast to DOD's preferred approach that
utility system ownership be permanently conveyed to contractors, private
sector firms typically retain ownership of their systems. The report's
concern here was that DOD's preferred approach of permanently conveying
ownership may give the contractor an advantage when negotiating service
contract changes or renewals. For example, generally entering into a
long-term services contract creates a bilateral monopoly where the
military must purchase utility services from one company and that company
must sell these services to the military. The report concluded that such
an arrangement could pose special problems because DOD must deal with the
contractor or face high costs. For example, if DOD and the contractor
reached an impasse over some issue, then DOD might have to pay significant
amounts to construct a new utility distribution system to replace the one
that had been conveyed to the contractor, attempt to purchase the system
back from the contractor, or institute legal action to reacquire the
system through condemnation proceedings.

29 CNA, Utility Privatization Initiatives: Concerns, Metrics, Priorities,
CRM D0003236.A2 (Alexandria, Va.: March 2001).

The second report was prepared by Malcolm Pirnie, Incorporated, at the
request of the Air Force and issued in March 2002.30 This report included
the results of a survey of utility practices at entities similar to
military installations, such as selected industrial complexes, airport
authorities, and universities responsible for supplying utility services
to their complexes. The survey found that in most cases, these entities
owned and operated their utility systems. The report also noted that under
DOD's approach, renegotiating terms after a contract's 50-year term ends
could be a concern because in instances where alternatives for service
were not available, DOD's negotiating position would be negatively
impacted.

Officials at several of the installations we visited also expressed
concerns about the government's negotiating position under privatization
after permanent conveyance of system ownership to a contractor. For
example, Bolling Air Force Base officials stated that they were concerned
that the contractor might obtain larger-than-expected price increases in
future price renegotiations because the contractor had a monopoly position
over the government. As a result, they believed that a privatization
contract could ultimately cost considerably more than expected. Similarly,
the Fort Campbell economic analysis supporting privatization of the
installation's water and wastewater systems stated that privatization
"will give the new owner a monopoly for the utility service that will
require close regulation by the Army. Staffing of this regulation function
will be essential to insuring that a reasonable price is paid for the
service rendered."

A recent situation at Fort Leonard Wood appears to illustrate the
potential problems facing DOD under its approach to privatization when
utility services contracts come up for renewal. About 15 years ago, the
Army awarded a contract to a company to build a natural gas pipeline to
the installation and in 1992 entered into a 10-year utility services
contract with the company. This contract expired in October 2002. From
that time through December 2004, the Army was unable to reach agreement
with the company for a new 10-year contract. According to Army officials,
the impasse was over higher service prices and other conditions imposed by
the company as a condition for renewal. To continue service, the Army and
the company had agreed to short-term 90-day contracts in which the Army
agreed to pay the company higher prices for utility services. After 26
months, in January 2005, the Army and the contractor agreed to new terms

30 Malcolm Pirnie, Inc., Program Assessment for Utilities Privatization in
the U.S. Air Force (March 2002).

and entered into a new 10-year services contract. However, according to
Army Audit Agency officials who were conducting a review of natural gas
service contracts at several installations including Fort Leonard Wood, if
negotiations for renewing the contract at Fort Leonard Wood had not been
successful, then the Army possibly would have started legal efforts to
condemn the system in order to gain ownership.

Of the seven utility privatization projects that we reviewed, all but one
followed DOD's preferred approach and permanently conveyed system
ownership to the contractor. The exception was the privatization of Fort
Campbell's water and wastewater systems. In this case, the installation
conveyed the systems to the contractor, but the contract provided for
reversion of ownership to the government at the end of the 50-year
services contract. During the privatization evaluation process, Fort
Campbell officials had noted concerns over the permanent conveyance of the
systems. Specifically, according to the Fort Campbell economic analysis
for the systems, the government will pay the contractor to upgrade and
maintain the systems in good condition over the 50-year contract term. As
a result, by regaining ownership at the end of the contract, the Army
would take ownership of systems worth a considerable sum of money and
would have additional options, such as taking over operations and
maintenance or issuing a competitive solicitation for a new utility
services contract. Conversely, the analysis noted that by following DOD's
preferred approach of permanent conveyance without reversion, the
government would be locked into procuring utility services from the
contractor for as long as the Army needed the services and this approach
might not be in the government's best interest. Because of its concerns,
Fort Campbell sought and obtained approval from Army headquarters to enter
into a privatization contract that included ownership reversion.

Conclusions	Utility privatization has helped installations achieve major
system improvements that, according to DOD, would not have been otherwise
possible given competing appropriation priorities. Nevertheless, the
utility privatization program generally increases military utility costs
well above historical levels because the program leverages private sector
capital to achieve utility system improvements. To pay for these
improvements over time, DOD's funding obligations will likely increase,
not decrease, by hundreds of millions of dollars and operations and
maintenance budgets will need to be adjusted, as necessary. Yet, the
services' economic analyses give an unrealistic sense of savings to this
program because they estimate that approved projects will reduce the
government's long-term costs for

utility services. The amount of estimated long-term savings, however, is
merely the services' estimated difference between the costs of two
options-privatization and government ownership-and both options will
result in increased utility costs compared to historical levels, although
perhaps in different time frames. Moreover, as long as selecting the
lesscostly option is expected to be a key factor in utility privatization
decision making, it is important that the supporting analyses are
reliable. Unless DOD revises the guidance for preparing economic analyses
for proposed utility privatization projects so that the analyses are based
on actual anticipated costs, the result will continue to be analyses that
could lead DOD to enter into long-term privatization agreements that
result in higher, not lower, costs compared to continued government
ownership. Reliability also will continue to be an issue until DOD starts
requiring an independent review of the economic analyses supporting
proposed privatization projects. Without such a review, the services'
economic analyses could continue to include inaccuracies and decision
makers will be hampered in their ability to make economically sound
choices about which option should be followed to achieve utility systems
improvements.

Unless DOD places greater scrutiny on the implementation of the fair
market value requirement in proposed utility privatization contracts in
order to minimize cases where contractors recover more than the amounts
they paid for system conveyances, some utility privatization contracts may
cost more than necessary. Also, until the services issue specific utility
privatization contract administration guidance including the clear
assignment of responsibilities and ensure that resources are provided to
perform adequate contract oversight, the services' oversight of utility
privatization contracts may continue to be limited. Inadequate oversight
could result in the services paying contractors for work not performed or
for work performed in an unsatisfactory manner. Also, as long as DOD's
preferred approach is for installations to permanently convey utility
system ownership, contractors may continue to have an advantage when it
comes time to negotiate contract changes and renewals. DOD must deal with
the contractor or pay significant amounts to construct a new utility
distribution system to replace the one that had been conveyed to the
contractor, attempt to purchase the system from the contractor, or
institute legal action to reacquire the system through condemnation
proceedings.

  Recommendations for Executive Action

We recommend that the Secretary of Defense direct the Deputy Under
Secretary of Defense (Installations and Environment) to take the following
six actions:

o 	As long as savings are expected to be a key factor in utility
privatization decision making, revise the guidance for preparing economic
analyses so that the analyses compare the cost of a proposed privatization
contract with the cost of continued government ownership on the basis of
the actual planned expenditures and the timing of these expenditures.

o 	Require an independent review, perhaps by DOD headquarters or the
services' audit agencies, of the economic analyses supporting proposed
privatization projects.

o 	Provide general program guidance emphasizing the need to consider
increased utility costs under privatization as the military services
prepare their operation and maintenance budget requests.

o 	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.

o 	Issue program guidance, specific to utility privatization, emphasizing
the importance of contract oversight.

o 	Reassess whether permanent conveyance of utility systems should be
DOD's preferred approach to obtaining improved utility services.

We further recommend that the Secretary of Defense direct the Secretaries
of the military departments to take the following two actions:

o 	Ensure that installation operations and maintenance budgets are
adjusted as necessary to reflect increased costs from utility
privatization projects.

o 	Issue specific utility privatization contract administration guidance
including the clear assignment of responsibilities and ensure that
resources are provided to perform adequate contract oversight.

Matter for On the basis of DOD's comments on our recommendations, as
discussed

below, the Congress may wish to consider requiring DOD to address
theCongressional issues and recommendations discussed in this report
before proceedingConsideration with further utility privatization efforts.

  Agency Comments and Our Evaluation

In commenting on a draft of this report, the Deputy Under Secretary of
Defense (Installations and Environment) did not concur with our report
findings or recommendations and raised several concerns. DOD stated that
we had a limited understanding of the utilities privatization program and
characterized our findings as being outdated and not well founded. In
addition, DOD suggested that our report represented an unwarranted
characterization of our findings as being systemic problems of the
program. We disagree.

We believe that our review of the utility privatization program was
objective, balanced, and represented program conditions existing at the
time we completed our review in March 2005. We remain confident that our
conclusions and recommendations are soundly based upon the findings
discussed in the report. In response to the comments, however, we modified
two of our recommendations, as noted below, to improve their clarity and
more precisely identify responsible parties. We also added two
recommendations regarding program guidance, as noted below. We believe it
is appropriate to emphasize, as explained in the scope and methodology
section of this report, that we followed our professional practices and
validated the facts and statistics presented in the report with DOD and
service officials prior to preparation of the draft report.

In its comments, DOD did not provide any information suggesting any
inaccuracies in our report, but rather contended that our case studies
were outdated and related to problems that occurred during the start of
the program in the late 1990s. DOD's contention is incorrect. Of the seven
utility privatization projects we reviewed in detail, the associated
contracts for four projects were awarded in 2004, and the contracts for
two projects were awarded in 2003. The economic analyses supporting these
projects should have been current and reliable at the time the contracts
were awarded; but as noted in this report, they were not. Further, Office
of the Secretary of Defense officials used three of the projects we
reviewed in detail as examples of cost-saving utility privatization
projects in program

briefings presented to us in July 2004. As noted in the scope and
methodology section of this report, we recognize that the limited number
of case studies completed does not make them projectable to the universe
of DOD utility privatization projects. However, given other corroborating
information, including statements of continuing program concerns raised by
cognizant service and installation officials and similar concerns reported
by the Army Audit Agency and more recently by the Naval Inspector General,
we believe the findings of this report have much broader applicability
than the limited number of cases we studied.31 Even the Deputy Under
Secretary recently noted significant challenges in managing the program.
In March 2, 2005, testimony before a House Appropriations Subcommittee,
the Deputy Under Secretary noted difficulties in conducting long-term
economic analyses, determining fair market value for the government's
utility systems, and making price adjustments to long-term contracts for
utility services.32 We make the following observations regarding DOD's
comments on the individual recommendations in the draft report.

DOD disagreed with our recommendation to revise the guidance for preparing
economic analyses so that the analyses would compare the cost of a
proposed privatization contract with the cost of continued government
ownership on the basis of the actual planned expenditures and the timing
of these expenditures. DOD stated that it is impossible to predict with
any measure of accuracy what DOD would spend to maintain a system,
particularly with regard to military construction, beyond more than a few
years. Thus, DOD believes that its current use of a "should-cost"
estimate, based on what a private utility company would engage in by way
of recapitalization, results in an estimate with some reasonable accuracy.
Our issue with DOD's estimates primarily concerns what DOD would actually
spend on the systems over the near term where, based on its comments, it
does know what it plans to spend with some accuracy. As long as selecting
the less-costly option-i.e., government ownership or privatization-is
expected to be a key factor in utility privatization decisions, as
required by statute, we continue to believe that the supporting analyses
should be based on realistic anticipated costs, as is the intent of

31 See notes 21, 23, 24, 26, and 28, and Naval Inspector General,
Utilities Privatization Study (Washington, D.C.: Mar. 15, 2005).

32 See Statement of Deputy Under Secretary of Defense (Installations and
Environment) before the Subcommittee on Military Quality of Life and
Veterans' Affairs, Committee on Appropriations, United States House of
Representatives, March 2, 2005.

our recommendation. DOD also commented that use of its current estimating
method was consistent with the underlying rationale of the program-that
private industry can normally provide more efficient utility service than
can the government. As our report makes clear, however, DOD did not
provide any studies or other documentation to support its contention.
Given that the private sector faces higher interest costs than the
government and strives to make a profit whereas the government does not,
it is not certain that utility services provided by the private sector
would be less costly than utility services provided by the government
through the use of up-front appropriations. Thus, as we have recommended,
sound economic analyses based on actual planned expenditures are needed to
determine the most cost-effective option for providing utility services to
DOD installations.

DOD disagreed with our draft recommendation that the Deputy Under
Secretary of Defense (Installations and Environment) ensure that
installation operations and maintenance budgets are adjusted as necessary
to reflect increased costs from utility privatization projects. DOD
properly noted that the Deputy Under Secretary of Defense (Installations
and Environment) does not manage the operations and maintenance budgets of
the installations. Accordingly, we have modified the recommendation to
state that the Secretary of Defense should direct the Secretaries of the
military departments to take this action. Further, given the magnitude of
the program and the fact that many of these facilities, as well as base
operating support budgets from which utility-related contracting costs are
paid, have been historically underfunded, we believe it would be
appropriate for the Deputy Under Secretary to provide general program
guidance emphasizing the need to consider increased utility costs under
privatization as the military services prepare their operations and
maintenance budget requests. Accordingly, we have added supporting
information in the text on this point and a new recommendation to address
this issue.

DOD disagreed with our recommendation to require an independent review,
perhaps by DOD headquarters or the services' audit agencies, of the
economic analyses supporting proposed privatization projects. DOD stated
that the military departments have the authority to ensure a sufficient
review and have adopted processes that conduct such a review. DOD stated
that our concerns, while factual, occurred during the start of the
program. We agree that the military departments have the authority to
ensure sufficient review of the economic analyses, but we disagree that
the military departments have adopted processes that ensure reliable
analysis,

as noted by the examples in this report. As explained above, the case
studies we reviewed and their economic analyses are associated with recent
privatization contracts mostly signed within the past 2 years-not at the
beginning of the program in 1997-and thus reflect current concerns. Also,
we do not understand DOD's reluctance to provide additional scrutiny of
the economic analyses for proposed utility privatization projects in view
of the errors we found in the cases we examined and the fact that DOD
already provides for such independent reviews of economic analyses
associated with proposed projects in the housing privatization program.
Thus, we continue to believe, as we have recommended, that an independent
review is needed to help ensure the accuracy and reliability of the
economic analyses supporting proposed privatization projects.

DOD disagreed with our recommendation to place greater scrutiny on the
implementation of the fair market value requirement in proposed contracts
to minimize cases where contractors recover more than the amounts they
paid for system conveyances. DOD again commented that the examples
mentioned in this report happened during the start of the program and that
contracting officers are now aware of the potential for contractors to
recover more than they pay in fair market value and take steps to minimize
the risk. Contrary to DOD's comments, the two examples of concerns in this
area that we reviewed and cite in this report, Dobbins Air Reserve Base
and Fort Lee, were privatized in April 2004 and June 2004, respectively- 7
years after the start of the program in 1997. Also, given that DOD
contends that contracting officers are now aware of the concern and are
taking steps to minimize the risk, we continue to believe, as we have
recommended, that it is appropriate for DOD to place greater scrutiny on
the implementation of the fair market value requirement to ensure that
these steps are successful.

DOD disagreed with our draft recommendation that the Deputy Under
Secretary of Defense (Installations and Environment) issue specific
utility privatization contract administration guidance and provide funding
for personnel to perform contract oversight. DOD commented that the
services are responsible for funding and performing post-award contract
administration of utility contracts, just as with any other contract. We
agree, in part, and therefore clarified and changed our recommendation to
state that the Secretary of Defense should direct the Secretaries of the
military departments to take this action. However, given the magnitude of
the utility privatization program and its use of 50-year service
contracts, we believe, as our report makes clear, that it would be
beneficial for the Deputy Under Secretary to issue program guidance,
specific to utility

privatization, to emphasize the importance of contract oversight. We have
added a separate recommendation to address this issue.

DOD disagreed with our recommendation to reassess whether permanent
conveyance of utility systems should be DOD's preferred approach to
obtaining improved utility services. DOD commented that the Deputy
Secretary of Defense determined that owning, operating, and maintaining
utility systems are not core functions of the DOD and that the issue of
title transfer has been reviewed repeatedly during the life of this
program. As noted in this report, DOD has no studies or other
documentation showing that its approach to utility privatization is based
on private sector best practices. On the other hand, the services have two
consultant reports which state that DOD's approach actually differs from
typical private sector practices and raise the concern that DOD's
preferred approach of permanently conveying ownership may give the
contractor an advantage when negotiating service contract changes or
renewals. Moreover, there is not universal agreement within DOD concerning
what is or is not a core function. For example, the Deputy Assistant
Secretary of the Air Force stated in March 2005 congressional testimony
that "the Air Force considers utility operation and maintenance a core
competency, without which we could not fly and fight".33 In its comments,
DOD also stated that while there are compelling arguments on each side,
the department continues to believe that the best practice-i.e., its
practice-is to transfer title to the utility system in line with the
statutory intent. We disagree. First, just because many DOD systems have
been conveyed in that manner does not make it a best practice. As noted,
most utility service contracts are longterm agreements and it may take
many years before DOD knows whether the practice of conveyance is
successful or whether it results in long-term problems and added costs to
DOD. Second, while the utility privatization statute permits title
transfer, it is not clear that the statute's language shows intent for the
services to convey utility ownership. Thus, we continue to believe, as we
have recommended, that DOD should reassess whether permanent conveyance of
utility systems should be DOD's preferred approach to obtaining improved
utility services.

33 See Statement by the Deputy Assistant Secretary of the Air Force
(Installations) before the Subcommittee on Military Quality of Life and
Veterans' Affairs, Committee on Appropriations, United States House of
Representatives, March 2, 2005.

DOD's comments are reprinted in their entirety in appendix III.

We are sending copies of this report to other interested congressional
committees; the Secretaries of Defense, Army, Navy, and Air Force; and the
Director, Office of Management and Budget. We will also make copies
available to others upon request. In addition, the report will be
available at no charge on GAO's Web site at http://www.gao.gov.

If you or your staff has any questions on the matters discussed in this
report, please contact me at (202) 512-5581 or my Assistant Director, Mark
Little, at (202) 512-4673. Gary Phillips, Sharon Reid, Harry Knobler, and
Kenneth Patton were major contributors to this report.

Barry W. Holman, Director Defense Capabilities and Management

Appendix I

Scope and Methodology

To determine the status of the Department of Defense's (DOD) utility
privatization program, we reviewed past and present privatization plans,
initiatives, and costs. We reviewed the legislative history of the
privatization program and assessments of the program performed by service
audit agencies and others. We compared current goals and milestones with
previous ones and interviewed DOD and service headquarters officials
responsible for the program to determine reasons for the changes. We
reviewed applicable DOD and military service policies and procedures.
Using data from the services' quarterly program status reports to DOD, we
summarized the program implementation status by service and compared the
status to the current goals and milestones for the program. We confirmed
the quarterly reports' status data on seven privatization projects but did
not otherwise test the reliability of the data. We discussed with DOD and
service officials issues affecting implementation of the program such as
questions regarding contract termination liability. We visited selected
installations to review and discuss utility privatization projects at the
installations. Specifically, we visited five military installations-Fort
Campbell, Kentucky; Fort Lee, Virginia; Fort Irwin, California; Dobbins
Air Reserve Base, Georgia; and Bolling Air Force Base, Maryland. The
installations were selected because they have projects that were
privatized using the legislative authorities specifically provided for
privatizing military utility systems. In addition, DOD often cites three
of the installations visited as having financially successful utility
privatization projects. We did not select a Navy or Marine Corps
privatization project to review because the Navy had approved only one
project under the legislative authorities provided for the program and the
Marine Corps had approved none. The Navy project did not involve a typical
utility privatization effort in that it converted a fuel service contract
into a privatization contract.

To determine whether the services' estimates of savings from utility
privatization projects are reliable, we reviewed the services' utility
costs and funding information and discussed with DOD and service officials
how utility costs under privatization compare to historical utility costs,
the reasons for the cost differences, and whether funding the utility
privatization program could affect the funding available for other
installation functions. We also selected and reviewed the economic
analyses for seven privatization projects located at the five
installations visited. We selected three analyses for review because DOD
often cites the associated privatization projects as examples of
successful, cost-saving projects. The other four analyses were selected
because they represented a cross section of typical utility privatization
projects, according to service

Appendix I Scope and Methodology

officials. For each analysis, we evaluated the basis for the estimates and
assumptions used and assessed consistency and compliance with DOD
guidance. We examined the analyses for the use of appropriate life-cycle
methodologies and accuracy of the calculations. We did not otherwise
attempt to independently determine estimates of long-term costs for the
seven projects. We shared the results of our analyses with DOD and service
officials and incorporated their comments as appropriate. We discussed
with DOD and service officials the procedures they use to ensure the
consistency, reasonableness, and accuracy of the completed economic
analyses. We also reviewed reports from the services' audit agencies
related to utility privatization projects and their assessments of the
reliability of the economic cost analyses.

To determine how DOD implements the fair market value requirement for
conveyed utility systems, we reviewed DOD and service policies and
procedures dealing with implementation of the fair market value
requirement, discussed with officials how receipt of fair market value is
ensured, and assessed the amounts received as consideration for the seven
privatization project conveyances associated with our review of the
economic analyses. For each project, we examined how the fair market value
was determined and reviewed what effect the amounts received and the
associated contract terms had on the government's costs for privatization.
We shared the results of our analyses with DOD and service officials.

To determine whether other issues might impact DOD's execution of the
utility privatization program, we reviewed DOD and service guidance for
utility privatization contract administration, discussed contract
oversight with DOD and service officials, and discussed and reviewed the
oversight provided at the five installations visited. We also reviewed
reports on utility privatization contract administration from the Army
Audit Agency. In addition, we obtained and reviewed information from DOD,
service, and installation officials and from service consultant reports on
how DOD's approach to utility privatization compares with private sector
practices. We visited one of the services' consultants, CNA, to discuss
details with the authors of the CNA report on utility privatization.

We conducted our review between July 2004 and March 2005 in accordance
with generally accepted government auditing standards.

Appendix II

Results of GAO's Review of the Services' Economic Analyses Supporting Seven
Utility Privatization Projects

We reviewed seven utility privatization project analyses and identified
inaccuracies, unsupported cost estimates, and noncompliance with guidance
for performing the analyses. In general, the cost estimates in the
analyses we reviewed favored the privatization option by understating
long-term privatization costs or overstating long-term government
ownership costs. The results of our review are summarized below.

Fort Lee Water System Privatization

The economic analysis for privatizing Fort Lee's water distribution system
did not consider the system's value at the end of the analysis period-the
residual value-under the government ownership option, as required by DOD
guidance.1 Consideration of residual value recognizes that, under the
government ownership option, the government would own the system and that
the system would have some value at the end of the analysis period. In
contrast, under the privatization option, the contractor, not the
government, would own the system at the end of the analysis period. Not
including the residual value in the analysis resulted in favoring the
privatization option by overstating government ownership costs. We
recomputed costs by including a residual value for the system at the end
of the 50-year contract. The result was to change the outcome of the
analysis from estimating that privatization would be less costly over the
long term to estimating that government ownership would be less costly
over the long term.

DOD's guidance also requires that a system's economic analysis consider
costs over the proposed project's contract term. However, the analysis for
Fort Lee's water distribution system considered costs over a 25-year
period instead of the contract's 50-year period. Although information was
not available to determine how this discrepancy affected the results of
the analysis, the example demonstrates the need for independent review to
help ensure accuracy and compliance with guidance.

Fort Lee Electric 	The economic analysis for the privatization of Fort
Lee's electric distribution system also did not consider the system's
residual value under

System Privatization	the government ownership option. We recomputed costs
by including a residual value for the system at the end of the 50-year
contract. Army

1 See DOD Instruction 7041.3, Subject: Economic Analysis for
Decisionmaking, Nov. 7, 1995.

                                  Appendix II
                    Results of GAO's Review of the Services'
                   Economic Analyses Supporting Seven Utility
                             Privatization Projects

officials suggested that the residual value should approximate $16.5
million, the system's current replacement cost less depreciation. Using
this amount in the analysis would show the privatization option to still
be less costly than government ownership over the long term, but the
estimated cost difference between the options would decrease from 15.0
percent to 4.6 percent. However, the analysis assumed that the system
would be upgraded and maintained in accordance with industry standards
over the 50-year analysis period and showed that, under the government
ownership option, the Army would spend $17.7 million in today's dollars
for system improvements. As such, we believe that it is reasonable to
assume that the residual value should approximate the system's current
replacement cost of $23.3 million. Using this amount in the analysis would
change the outcome of the analysis and show that government ownership
would be slightly less costly than privatization over the long term.

  Fort Campbell Water and Wastewater Systems Privatization

The economic analysis supporting privatization of Fort Campbell's water
and wastewater systems contained several errors. First, the analysis did
not follow DOD guidance when estimating contract oversight costs for the
privatization option and as a result, understated these costs. Second, the
analysis included errors in estimating general and administrative costs
under the government ownership option and as a result, overstated these
costs. Third, the analysis used faulty assumptions in estimating
selfinsurance costs for potential property and liability losses under the
government ownership option and as a result, overstated these costs. We
recomputed the cost estimates by making corrections for these errors. The
result was to change the outcome of the analysis from estimating that
privatization would be less costly over the long term to estimating that
continued government ownership would be less costly over the long term.

  Fort Irwin Electric System Privatization

The economic analysis for privatizing Fort Irwin's electric distribution
system overstated annual operations and maintenance costs under the
government ownership option. Specifically, to estimate these costs, the
analysis adjusted the installation's historical operations and maintenance
costs upward to reflect the estimated amount that the installation should
be spending in accordance with industry standards. However, part of this
estimate included predicted future costs for emergency repairs. Fort
Irwin's historical emergency repair costs were about $175,000 annually
and, to adjust for some items that were not included in the historical
costs and estimate the amount that the installation should be spending for
emergency

                                  Appendix II
                    Results of GAO's Review of the Services'
                   Economic Analyses Supporting Seven Utility
                             Privatization Projects

repairs, the analysis increased the historical amount by over 100 percent
to about $357,000 annually. Fort Irwin officials stated that emergency
repair costs were high in the past because the system consisted primarily
of old, antiquated equipment that had not been adequately maintained.
However, under the government ownership option, as under privatization,
the analysis assumed that the system would be quickly upgraded and
maintained to industry standards. As such, the officials stated that
future emergency repair costs should decrease, not increase. To adjust for
the overstated emergency repair cost estimate and to be conservative, we
recalculated the total costs under the government ownership option
assuming that emergency repair costs would not increase or decrease but
remain at the historical level. The result was to change the outcome of
the analysis from estimating that privatization would be less costly over
the long term to estimating that continued government ownership would be
less costly over the long term.

Changes in the economic analysis supporting the Fort Irwin electric
distribution system privatization also raised questions about reliability.
In October 2000, an Army consultant completed an economic analysis of the
proposed system privatization. The analysis estimated that the government
ownership option would be less costly than privatization in the long term.
Specifically, in today's dollars, the analysis estimated that the
government ownership option would cost about $14.7 million less over the
long term than if the system were privatized. Yet, about 2 and a half
years later in February 2003, the same consultant completed a new economic
analysis for the proposed project. This analysis concluded the
opposite-that privatization would be less costly than the government
ownership option by about $3.6 million in today's dollars. Details
explaining the basis for the significantly changed estimates were not
included in the new analysis and could not be explained by Fort Irwin
officials.

  Dobbins Air Reserve Base Electric System Privatization

According to DOD guidance, the economic analyses for proposed
privatization projects should estimate and compare costs assuming that the
government would upgrade and improve the system to industry standards, as
the privatization contractor would be required to do. However, we
questioned whether the analysis for Dobbins Air Reserve Base's electric
system privatization followed this guidance because of the large cost
difference between estimated improvement costs under the privatization and
government ownership options. The economic analysis estimated that under
privatization the contractor's costs to complete system improvements over
the contract period would be about $1.6 million in

                                  Appendix II
                    Results of GAO's Review of the Services'
                   Economic Analyses Supporting Seven Utility
                             Privatization Projects

today's dollars. In contrast, the analysis estimated that system
improvement costs under the government ownership option over the same
period would be about $4.7 million in today's dollars, a difference of
$3.1 million, or 194 percent, more. In response to our questions, Air
Force officials stated that an error had been made in calculating
improvement costs under the government option and that the improvement
costs were overstated by about $2 million. We recomputed costs to make a
correction for the error. The result was to change the outcome of the
analysis from estimating that privatization would be less costly over the
long term to estimating that continued government ownership would be less
costly over the long term.

                             Bolling Air Force Base
                              Water and Wastewater
                             Systems Privatization

The economic analyses supporting privatization of the water and wastewater
systems at Bolling Air Force Base were not valid because they did not
accurately reflect system improvements to be performed by the contractor.
Bolling Air Force Base officials stated that the analyses assumed that the
contractor would complete many upgrades and improvements to the systems
during the first 5 years of the contracts. However, the officials also
stated that the privatization contract process was delayed after the
analyses were prepared and that military construction funding was obtained
and used to complete about 90 percent of the improvement projects that the
analyses assumed the contractor would do. Because the analyses were not
updated to reflect the changes in the planned work, the results of the
analyses include estimated savings from contractor work that will not be
performed. We did not have sufficient information to recalculate estimates
in analyses. However, installation officials stated that they believed
that continued government ownership of the systems would have been less
costly than privatization over the long term.

                                  Appendix III

                    Comments from the Department of Defense

Appendix III
Comments from the Department of Defense

Appendix III
Comments from the Department of Defense

Appendix III
Comments from the Department of Defense

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