Defense Infrastructure: Actions Taken to Improve the Management  
of Utility Privatization, but Some Concerns Remain (05-SEP-06,	 
GAO-06-914).							 
                                                                 
Department of Defense (DOD) installations have about 2,600	 
electric, water, wastewater, and natural gas utility systems	 
valued at about $50 billion. In 1997, DOD decided that		 
privatization was the preferred method for improving utility	 
systems, and Congress approved legislative authority for	 
privatizing DOD's utility systems with Public Law No. 105-85. DOD
estimates that some utility privatization contracts will cost	 
over $100 million. In a May 2005 report, GAO identified several  
management weaknesses in DOD's implementation of the program. The
Fiscal Year 2006 National Defense Authorization Act required GAO 
to evaluate and report on changes to the utility privatization	 
program since May 2005. Accordingly, this report updates the	 
status of the program and discusses the effect of DOD's changes  
on the concerns noted last year. To conduct this review, GAO	 
summarized program status and costs, assessed DOD's changes to	 
program guidance and in other areas, and reviewed the services'  
implementation of the changes.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-914 					        
    ACCNO:   A60206						        
  TITLE:     Defense Infrastructure: Actions Taken to Improve the     
Management of Utility Privatization, but Some Concerns Remain	 
     DATE:   09/05/2006 
  SUBJECT:   Contract oversight 				 
	     Defense budgets					 
	     Energy costs					 
	     Military budgets					 
	     Privatization					 
	     Program evaluation 				 
	     Program management 				 
	     Electric utilities 				 
	     Wastewater management				 
	     Economic analysis					 

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GAO-06-914

     

     * Results in Brief
     * Background
          * DOD Made Utility Privatization a Department Policy
          * Implementation Goals Reset and Program Guidance Revised
          * GAO Report Identified Weaknesses in Program Implementation
          * Program Legislative Authority Modified
          * DOD's Response to GAO's Report and Modifications to the Prog
     * Utility Privatization Milestones Have Slipped and Implementa
          * Services Did Not Meet Program Implementation Milestone
          * Services Have Awarded Contracts for a Fraction of the Total
          * Program Delays Have Resulted in Increased Implementation Cos
          * Services Have Estimated the Number and Cost of Potential Pri
     * DOD's Changes to Improve Utility Privatization Implementatio
          * DOD Has Taken Steps to Improve the Reliability of Project Ec
          * DOD Has Taken Steps to Address Some Funding Issues but Conce
               * Utility Costs Increase with Privatization
               * Funds Not Programmed for All Potential Utility Privatization
               * Air Force May Not Award Some Additional Privatization Projec
          * DOD Directed Actions to Improve Utility Privatization Contra
               * DOD Has Taken Steps to Address Oversight Concerns
               * Some Contract Oversight Concerns Identified at the Four Inst
          * Containing Utility Privatization Contract Cost Growth May Be
               * DOD Continues to Prefer Permanent Conveyance but Has Taken S
               * Cost Growth in Utility Privatization Contracts May Become a
          * DOD Has Not Made Changes to Provide More Realistic Savings E
          * Changes in Legislative Authority and DOD's Implementation of
     * Conclusions
     * Recommendations for Executive Action
     * Agency Comments and Our Evaluation
     * Appendix I: Scope and Methodology
     * Appendix II: Comments from the Department of Defense
          * GAO's Response to the Department of Defense's Comments
     * Appendix III: GAO Contact and Staff Acknowledgments
          * GAO Contact
          * Acknowledgments
               * Order by Mail or Phone

Report to Congressional Committees

United States Government Accountability Office

GAO

September 2006

DEFENSE INFRASTRUCTURE

Actions Taken to Improve the Management of Utility Privatization, but Some
Concerns Remain

GAO-06-914

Contents

Letter 1

Results in Brief 3
Background 6
Utility Privatization Milestones Have Slipped and Implementation Costs
Continue to Climb 11
DOD's Changes to Improve Utility Privatization Implementation Have
Addressed Many Areas but Have Not Eliminated All Program Concerns 14
Conclusions 32
Recommendations for Executive Action 33
Agency Comments and Our Evaluation 34
Appendix I Scope and Methodology 37
Appendix II Comments from the Department of Defense 39
Appendix III GAO Contact and Staff Acknowledgments 47

Tables

Table 1: Percentage of Systems with Privatization or Exemption Decision
and Estimated Program Completion Date 12
Table 2: Status of the Utility Privatization Program as of March 31, 2006
12
Table 3: Implementation Costs for the Utility Privatization Program 13
Table 4: Potential Additional Privatization Contracts and Associated Costs
14
Table 5: Service Estimates of Potential Utility Privatization Program
Funding Shortfall 20
Table 6: DOD's Estimated Cost Avoidance from Utility Privatization 29

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United States Government Accountability Office

Washington, DC 20548

September 5, 2006

Congressional Committees

Department of Defense (DOD) installations have about 2,600 electric,
water, wastewater, and natural gas utility systems valued at about $50
billion. These systems consist of the equipment, fixtures, pipes, wires,
and other structures used in the distribution of electric power and
natural gas, the treatment and distribution of water, and the collection
and treatment of wastewater. According to DOD officials, many of these
systems have become unreliable and are in need of major improvements. To
address this issue, DOD decided in 1997 that utility privatization was the
preferred method for improving utility systems and services because
privatization would allow installations to benefit from private sector
financing and efficiencies. With private sector financing, installations
could immediately obtain major upgrades to their utility systems and pay
for these improvements over time. Thus, utility improvements could be
achieved without going through the traditional budget justification and
funding process. Under DOD's program, utility privatization normally
involves two transactions with the successful contractor-the conveyance of
the utility system infrastructure and the acquisition of utility services
for upgrades, operations, and maintenance under a long-term contract of up
to 50 years. DOD estimates that some privatization contracts will cost
more than $100 million over the contract time frames.

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

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

In May 2005, we issued a report that identified management weaknesses in
DOD's implementation of the utility privatization program.2 The report
noted a number of concerns, such as the reliability of the economic
analyses associated with privatization decisions and the adequacy of
contract oversight, and made several recommendations to DOD to improve the
guidance and procedures used to implement and oversee the utility
privatization program. Although DOD initially disagreed with the report's
findings and recommendations, after further review of the report, the
department subsequently reported to Congress that it generally agreed with
our findings and recommendations and decided to issue new guidance on
November 2, 2005, to address the key issues in our prior report.3 Among
other things, this guidance required the services to complete remaining
evaluations of utility system potential for privatization in a timely and
efficient manner, perform an independent review of the economic analyses
supporting proposed projects, consider and plan for increased costs for
utility services resulting from potential privatization projects, and take
steps designed to improve the administration and oversight of awarded
privatization projects. Even before DOD issued the new guidance, the
services had implemented several program improvements including the
requirement for independent reviews of project economic analyses.

In January 2006, the National Defense Authorization Act for Fiscal Year
20064 made several modifications to the legislative authority for the
utility privatization program, restricted the number of utility systems
that DOD could privatize during fiscal years 2006 and 2007, and required
the Secretary of Defense to submit a report to congressional defense
committees by April 1, 2006, addressing program issues and many of the
concerns noted in our May 2005 report. The act also directed us to
evaluate and report on the changes made by DOD to the program since May
2005 and their effects. Accordingly, this report (1) updates the status of
the utility privatization program, and (2) discusses the effect of DOD's
changes on the program management and oversight concerns noted in our May
2005 report.

2GAO, Defense Infrastructure: Management Issues Requiring Attention in
Utility Privatization, GAO-05-433 (Washington, D.C.: May 12, 2005).

3DOD, Under Secretary of Defense, Memorandum for Secretaries of the
Military Departments and Director, Defense Logistics Agency, Subject:
Supplemental Guidance for the Utilities Privatization Program (Washington,
D.C.: Nov. 2, 2005).

4National Defense Authorization Act for Fiscal Year 2006, Pub. L. No.
109-163, S: 2823 (2006) (codified as amended at 10 U.S.C. S: 2688).

To address these objectives, we summarized program implementation status
and costs and compared the status to DOD's past and current goals and
milestones. To determine the effect of DOD's changes on the program
management and oversight concerns noted in our prior report, we
interviewed DOD and service officials and reviewed pertinent policies,
guidance, memorandums, and reports to document the changes made, and we
compared those changes with our previously identified concerns to assess
whether the issues had been fully addressed. Further, we reviewed the
reliability of the economic analyses supporting 10 privatization projects
that were awarded after our prior report and had been subjected to the
services' new independent review process. We also visited four
installations to assess contract administration and oversight issues and
reviewed contract price changes in six ongoing utility privatization
contracts. Although we generally relied on program status data provided by
the services, we confirmed the status data for five utility privatization
projects and did not otherwise test the reliability of the data.

We conducted our review from March through July 2006 in accordance with
generally accepted government auditing standards. A more detailed
description of our scope and methodology is included in appendix I.

                                Results in Brief

DOD's progress in implementing the utility privatization program has been
slower than expected, and implementation costs have continued to climb.
Since our previous report, the estimated program completion date has
slipped from the department's target of September 2005 to September 2011.
DOD officials have attributed delays in program implementation to
privatization evaluation, solicitation, and contracting processes that
were more complex and time-consuming than originally anticipated. Service
officials also stated that additional delays resulted from the services'
decision to suspend and reassess the management of the program between
October 2005 and March 2006. The officials stated that the suspension
allowed DOD and the services time to review concerns noted in our prior
report, develop and issue supplemental guidance for the program, and
implement program changes necessitated by modifications in the program's
legislative authority. Between May 31, 2005, and September 30, 2005, the
services privatized 14 utility systems under the legislative authority for
the program, bringing the total number of awarded projects to 81. However,
the services have awarded no projects since September 2005 and, therefore,
no projects have been awarded since DOD issued supplemental program
guidance in November 2005. With program delays, the services' total
estimated program implementation costs through fiscal year 2006 have
increased from $268 million to $285 million and additional amounts will be
required before the program is projected to be completed in 2011. Program
delays also caused the Defense Energy Support Center to cancel
solicitations to privatize 42 Army utility systems in May 2006. These
solicitations had been closed from 1 to 4 years with no award decision and
there were concerns that conditions, such as the accuracy of the inventory
and needed improvements, had changed or might change before an award
decision would be made. The Army plans to resolicit these systems over the
next few years.

DOD has issued new program guidance and required changes in program
procedures to improve the management and oversight of the utility
privatization program since our May 2005 report. For example, DOD
implemented a requirement for an independent review of economic analyses
for proposed privatization projects and has imposed greater emphasis on
contract oversight. If fully implemented, the changes should result in
more reliable economic analyses supporting proposed privatization
projects, improved budgetary consideration of increased utility costs from
privatization, enhanced oversight of privatization contracts, and reduced
instances where contractors recover more than the amounts they paid as the
fair market value for system conveyances. However, we noted a number of
limitations in implementation of the new procedures. Moreover, a number of
concerns noted in our prior report remain, at least to some degree,
because DOD's changes to address some issues were not implemented
effectively, some changes were not sufficient to fully eliminate some
concerns, and DOD did not make changes to address some concerns. For
example:

           o  First, although DOD made changes to improve the reliability of
           project economic analyses by requiring independent reviews, we
           found issues with the implementation of this change. Specifically,
           we reviewed the economic analyses supporting 10 privatization
           projects that had been subjected to independent review and found
           reliability issues that had not been identified during the
           independent review.
           o  Second, although DOD directed the services to adequately
           consider in their budgets the increased costs resulting from
           utility privatization, questions remain over the availability of
           the funds needed to complete the program. The services have
           estimated that they will need $453 million more than is currently
           programmed for continuing government utility operations to pay
           implementation and contract costs associated with the remaining
           number of utility systems that might be privatized through 2010
           for the Air Force and the Navy and Marine Corps and through 2011
           for the Army. In view of competing needs and budget priorities,
           the Air Force stated that it will not solicit additional utility
           privatization contracts until further resources are identified to
           cover the potential increase in costs. DOD had not made any
           decisions on the funding availability issue at the time of our
           review in June 2006.
           o  Third, it may take some time to fully implement DOD changes to
           improve utility privatization contract administration and
           oversight as new privatization contracts are awarded. Our review
           of five projects awarded prior to DOD's changes found continued
           oversight concerns, including questions about the adequacy of
           resources provided to perform oversight and the lack of required
           plans for overseeing contractor performance.
           o  Fourth, DOD reported to Congress in March 2006 that, although
           privatization may limit the government's options during contract
           negotiations, the department continues to prefer privatization
           with permanent conveyance and believes that safeguards are in
           place to adequately protect the government's interests. It is too
           early in the program's implementation to know to what extent DOD's
           efforts will be successful in ensuring equitable periodic contract
           price adjustments and limiting long-term cost growth in the
           utility privatization program. However, we found cost growth in
           three of six privatization projects we reviewed. In one case, the
           government's annual costs for utility service were expected to
           increase by 92 percent as a result of the contract's first
           periodic price adjustment.
           o  Fifth, DOD did not change its guidance to require that project
           economic analyses depict the actual expected costs of continued
           government ownership in the event that the systems are not
           privatized. Therefore, although DOD reported to Congress that the
           81 contracts awarded under the utility privatization authority
           will result in about $650 million in long-term cost reductions to
           the government, the amount is unrealistic because it was not
           calculated based on the actual expected cost differences between
           continued government ownership and privatization, and because
           privatization generally results in increased, not decreased,
           utility service costs to the government.

           We are making a number of recommendations designed to ensure that
           DOD improves the reliability of the economic analyses for proposed
           utility privatization projects, addresses potential program
           funding shortfalls, ensures adequate oversight in utility
           privatization contracts awarded prior to DOD's program changes,
           monitors potential contract cost growth, and clearly depicts the
           increased costs resulting from proposed utility privatization
           projects. In comments on a draft of this report, DOD generally
           agreed with six of our seven recommendations and outlined a plan
           of action to address each recommendation. Where it indicated
           disagreement, we continue to believe our recommendation has merit.
           We discuss DOD's comments in detail later in this report.

           Background
			  
			  At DOD's request, Congress approved legislative authority in 1997
           for privatizing utility systems at military installations.5 In
           defining a utility system, the authority included systems for the
           generation and supply of electric power; the treatment or supply
           of water; the collection or treatment of wastewater; the
           generation or supply of steam, hot water, and chilled water; the
           supply of natural gas; and the transmission of telecommunications.
           Included in a utility system are the associated equipment,
           fixtures, structures, and other improvements as well as easements
           and rights-of-way. The authority stated that the Secretary of a
           military department may convey a utility system to a municipal,
           private, regional, district, or cooperative utility company or
           other entity and the conveyance may consist of all right, title,
           and interest of the United States in the utility system or such
           lesser estate as the Secretary considers appropriate to serve the
           interests of the United States.

           Among other things, the 1997 authority also included two
           requirements for utility privatization. First, DOD was required to
           submit a report to congressional defense committees and wait 21
           days before allowing a conveyance. For each conveyance, the report
           was to include an economic analysis, based on acceptable
           life-cycle costing procedures, demonstrating that (1) the
           long-term economic benefit of the conveyance to the United States
           exceeds the long-term economic cost of the conveyance to the
           United States, and (2) the conveyance will reduce the long-term
           costs of the United States for utility services provided by the
           utility system concerned. Second, the Secretary was required to
           receive as consideration for a conveyance an amount equal to the
           fair market value, as determined by the Secretary, of the right,
           title, or interest of the United States conveyed. The
           consideration could take the form of a lump sum payment or a
           reduction in charges for utility services.

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

           DOD's Office of the Deputy Under Secretary of Defense for
           Installations and Environment provides overall policy and
           management oversight for the utility privatization program.
           However, primary management and implementation responsibility for
           the program is delegated to the individual services, their major
           commands, and individual installations. In addition, Defense
           Logistics Agency's Defense Energy Support Center is responsible
           for providing the military services with utility privatization
           contracting, technical, and program management support.

           DOD Made Utility Privatization a Department Policy
			  
			  In December 1997, DOD issued Defense Reform Initiative Directive
           Number 9, which made utility system privatization a DOD policy.6
           The directive instructed the military departments to develop a
           plan that would result in privatizing all installation electric,
           natural gas, water, and wastewater utility systems by January 1,
           2000, unless exempted for unique security reasons or if
           privatization would be uneconomical. Under the program,
           privatization normally involves two transactions with the
           successful contractor-the conveyance of the utility system
           infrastructure and the acquisition of utility services for
           upgrades, operations, and maintenance under a long-term contract
           of up to 50 years. Normally, the conveyances do not include title
           to the land beneath the utility system infrastructures.

           A year later, in December 1998, DOD issued another directive to
           establish program management and oversight responsibilities and
           provide guidance for performing economic analyses for proposed
           projects, exempting systems from the program, and using
           competitive procedures to conduct the program.7 The directive also
           stated that the objective was for DOD to get out of the business
           of owning, managing, and operating utility systems by privatizing
           them and that exemptions from privatization should be rare. The
           directive reset the privatization implementation goal to September
           30, 2003.

           Implementation Goals Reset and Program Guidance Revised
			  
			  In October 2002, DOD issued revised program guidance and again
           reset implementation goals.8 The guidance noted DOD's contention
           that many installation utility systems had become unreliable and
           in need of major improvements because the installations
           historically had been unable to upgrade and maintain reliable
           utility systems due to inadequate funding caused by the
           competition for funds and DOD's budget allocation decisions. DOD
           officials stated that owning, operating, and maintaining utility
           systems was not a core DOD function and the guidance stated that
           privatization was the preferred method for improving utility
           systems and services by allowing military installations to benefit
           from private sector financing and efficiencies. The revised
           implementation goals directed the military departments to reach a
           privatization or exemption decision on all systems available for
           privatization by September 30, 2005. The October 2002 guidance
           also reemphasized that utility privatization was contingent upon
           the services demonstrating through an economic analysis that
           privatization will reduce the long-term costs to the government
           for utility services. The guidance included details for conducting
           the economic analyses, stating that the services' analyses should
           compare the long-term estimated costs of proposed privatization
           contracts with the estimated long-term costs of continued
           government ownership assuming that the systems would be upgraded,
           operated, and maintained at accepted industry standards, as would
           be required under privatization.

           GAO Report Identified Weaknesses in Program Implementation
			  
			  In May 2005, we issued a report that identified management
           weaknesses in DOD's implementation of the utility privatization
           program.9 The report noted that utility privatization
           implementation had been slower than expected, the services'
           economic analyses supporting utility privatization decisions
           provided an unrealistic sense of savings to a program that
           generally increases government utility costs, DOD's funding
           obligations would likely increase faster than they would under
           continued government ownership, DOD did not require that the
           services' economic analyses be subjected to an independent review
           for accuracy and compliance with guidance, implementation of the
           fair market value requirement in some cases resulted in higher
           contract costs for utility services, the services had not issued
           specific contract administration guidance for the program, and
           DOD's preferred approach of permanently conveying utility system
           ownership to contractors may give the contractor an advantage when
           negotiating service contract changes or renewals. The report made
           several recommendations for DOD to address these concerns.

           Program Legislative Authority Modified
			  
			  The National Defense Authorization Act for Fiscal Year 2006,10
           enacted in January 2006, made several modifications to the
           legislative authority for the utility privatization program. The
           act did the following:

           o  Reinstated a requirement that the Secretary of Defense must
           submit to congressional defense committees an economic analysis
           and wait 21 days after the analysis is received by congressional
           defense committees, or 14 days if in electronic form, before
           conveying a utility system.11 The economic analysis must
           demonstrate among other things that the conveyance will reduce the
           long-term costs to the United States of utility services provided
           by the utility system. The report and wait requirement had been
           replaced with a requirement for a quarterly report of conveyances
           by the National Defense Authorization Act for Fiscal Year 2004.12 
           o  Added a requirement that the economic analyses incorporate
           margins of error in the estimates, based upon guidance approved by
           the Secretary of Defense, that minimize any underestimation of the
           costs resulting from privatization or any overestimation of the
           costs resulting from continued government ownership.
           o  Eliminated the requirement that DOD must receive as
           consideration for a conveyance an amount equal to the system's
           fair market value.
           o  Limited contract terms to 10 years, unless the Secretary
           concerned determines that a longer term contract, not to exceed 50
           years, will be cost-effective and provides an explanation of the
           need for the longer term contract, along with a comparison of
           costs between a 10-year contract and the longer term contract.
           o  Placed a temporary limitation on conveyance authority stating
           that during each of fiscal years 2006 and 2007, the number of
           utility systems for which conveyance contracts may be entered into
           under this authority shall not exceed 25 percent of the total
           number of utility systems determined to be eligible for
           privatization under this authority as of January 6, 2006.
           o  Required DOD to submit, not later than April 1, 2006, to
           congressional defense committees a report describing the use of
           section 2688 of title 10, United States Code (10 U.S.C. 2688), to
           convey utility systems. The report was to address several
           specified aspects of the utility privatization program.

           DODï¿½s Response to GAOï¿½s Report and Modifications to the Programï¿½s
			  Authority
			  
			  Although DOD initially disagreed with our May 2005 report, after
           further review of the report, it subsequently reported to Congress
           that the report had brought some significant issues to light and
           that the department had decided to issue new guidance to address
           the key issues in the report in order to improve program
           management. On November 2, 2005, DOD issued the new guidance,
           which among other things required the services to complete the
           remaining evaluations of utility system potential for
           privatization in a timely and efficient manner, perform an
           independent review of the economic analyses supporting proposed
           projects, consider and plan for increased costs for utility
           services resulting from potential privatization projects, and take
           steps to improve the administration and oversight of awarded
           privatization projects.13 DOD issued additional supplemental
           guidance14 on March 20, 2006, to implement the modifications to
           the legislative authority made by the Fiscal Year 2006 National
           Defense Authorization Act; and on March 31, 2006, DOD submitted to
           congressional defense committees the utility privatization report
           required by the act.15 Even before DOD issued new guidance to
           improve the program in November 2005, the services had implemented
           several program improvements, including the requirement for
           independent reviews of project economic analyses.

           Utility Privatization Milestones Have Slipped and Implementation
			  Costs Continue to Climb
			  
			  DOD's progress in implementing the utility privatization program
           has been slower than expected and implementation costs have
           continued to climb. None of the services met DOD's September 2005
           implementation goal and the program's estimated completion date
           has now slipped to September 2011. In addition to increasing
           implementation costs, program delays have also resulted in the
           cancellation of privatization solicitations because of concern
           that conditions had changed or might change before a decision
           would be made whether to privatize.

           Services Did Not Meet Program Implementation Milestone
			  
			  None of the services met DOD's goal of making a privatization or
           exemption decision on all systems available for privatization by
           September 30, 2005. Since the program began, DOD officials have
           attributed delays in program implementation to privatization
           evaluation, solicitation, and contracting processes that were more
           complex and time consuming than originally anticipated. Service
           officials stated that additional delays occurred because the
           services decided to suspend the program between October 2005 and
           March 2006. According to the officials, the suspension was
           provided to allow DOD and the services time to review concerns
           noted in our May 2005 report, develop and issue supplemental
           guidance for the program, and implement program changes
           necessitated by modifications in the program's legislative
           authority made by the National Defense Authorization Act for
           Fiscal Year 2006. The services now estimate that their program
           completion dates-the date when a privatization or exemption
           decision has been made on all available systems-are October 2007
           for the Navy and Marine Corps, December 2008 for the Air Force,
           and September 2011 for the Army. Among other things, the Army
           attributed the extension in its completion date to the
           privatization process being more complicated than envisioned and a
           recognition that the Army's past estimates for completing the
           program were unrealistic. Table 1 shows progress as of March 31,
           2006, compared to DOD's goal, as well as the current estimated
           program completion dates.16

           Table 1: Percentage of Systems with Privatization or Exemption
           Decision and Estimated Program Completion Date

           Source: DOD.

           Services Have Awarded Contracts for a Fraction of the Total Systems
			  Available for Privatization
			  
			  After spending about $268 million on program implementation costs
           through fiscal year 2005, the services had awarded contracts for a
           fraction of the 1,496 utility systems available for privatization.
           Between May 31, 2005, and September 30, 2005, the services
           privatized 14 utility systems using 10 U.S.C. 2688 authority
           bringing the total number of awarded projects to 81. However, the
           services have awarded no projects under this authority since DOD
           issued supplemental program guidance in November 2005. In addition
           to the projects awarded under 10 U.S.C. 2688 authority, DOD
           privatized 36 systems under other programs, such as DOD's housing
           privatization program. The services also have exempted 147
           additional systems, bringing the total systems exempted from
           privatization to 458. Table 2 shows program status as of March 31,
           2006.

                                   Background

5Pub. L. No. 105-85, S: 2812 (1997).

DOD Made Utility Privatization a Department Policy

6DOD, Deputy Secretary of Defense, Memorandum for Secretaries of the
Military Departments and others, Subject: Department of Defense Reform
Initiative Directive #9-Privatizing Utility Systems (Washington, D.C.:
Dec. 10, 1997).

7DOD, Deputy Secretary of Defense, Memorandum for Secretaries of the
Military Departments and others, Subject: Department of Defense Reform
Initiative Directive #49-Privatizing Utility Systems (Washington, D.C.:
Dec. 23, 1998).

Implementation Goals Reset and Program Guidance Revised

GAO Report Identified Weaknesses in Program Implementation

8DOD, Deputy Secretary of Defense, Memorandum for Secretaries of the Army,
Navy, and Air Force and Director, Defense Logistics Agency, Subject:
Revised Guidance for the Utilities Privatization Program (Washington,
D.C.: Oct. 9, 2002).

9See footnote 2.

Program Legislative Authority Modified

10Pub. L. No. 109-163, S: 2823 (2006).

11Prior to November 2003, section 2688 of title 10 stated that the
Secretary of Defense was not permitted to make a conveyance until he
submitted a report that demonstrated two specific factors and a period of
21 days had elapsed from the date at which the analysis was submitted.

12National Defense Authorization Act for Fiscal Year 2004, Pub. L. No.
108-136, S: 1031(a)(32)(2003).

DOD's Response to GAO's Report and Modifications to the Program's Authority

13See footnote 3.

14DOD, Under Secretary of Defense, Memorandum for Secretaries of the
Military Departments and Director, Defense Logistics Agency, Subject:
Supplemental Guidance for the Utilities Privatization Program (Washington,
D.C.: Mar. 20, 2006).

15DOD, Deputy Under Secretary of Defense (Installations and Environment),
Report to Congress on Use of Utility System Conveyance Authority and
Temporary Suspension of Authority Pending Report (Washington, D.C.: Mar.
31, 2006).

Utility Privatization Milestones Have Slipped and Implementation Costs Continue
                                    to Climb

Services Did Not Meet Program Implementation Milestone

16Although this report includes Defense Logistics Agency program status
information, the report does not include any additional Defense Logistics
Agency program information because the agency has few systems available
for privatization compared to the military services and has awarded no
utility privatization contracts.

                       Goal for September Actual as of March  Estimated       
Component           30, 2005 (percent) 31, 2006 (percent)  completion date 
Army                               100                 75  September 2011  
Navy and Marine                    100                 78  October 2007    
Corps                                                      
Air Force                          100                 82  December 2008   
Defense                            100                 86  December 2007   
Logistics Agency                                           

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

Table 2: Status of the Utility Privatization Program as of March 31, 2006

                                                                        Contract 
                                Systems                                   awards 
                                pending                                 using 10 
                   Systems solicitation                          Total    U.S.C. 
             available for     or under   Systems in  Systems contract      2688 
Component privatization reassessment solicitation exempted   awards authority 
Army                320            0          202       38       80        70 
Navy and            645           13          411      200       21         1 
Marine                                                              
Corps                                                               
Air Force           502            4          262      220       16        10 
Defense              29            0           29        0        0         0 
Logistics                                                           
Agency                                                              
Total             1,496           17          904      458      117        81 

Source: DOD.

Program Delays Have Resulted in Increased Implementation Costs

With program delays, the services' estimated program implementation costs
have increased from about $268 million through fiscal year 2005 to about
$285 million through fiscal year 2006. Additional implementation funds
will be needed before the services complete their programs between October
2007 and September 2011. According to service officials, the funds used to
implement the program primarily paid for consultants hired to help the
services in conducting an inventory of their utility systems, assessing
the systems' condition, preparing economic analyses, and soliciting and
contracting for proposed projects. Program implementation costs did not
include funds used to pay the costs of awarded privatization contracts.
Table 3 shows program implementation costs by service and the Office of
the Secretary of Defense.

Table 3: Implementation Costs for the Utility Privatization Program

Dollars in                                          
millions                                            
                                             Estimated        Total estimated 
                 Implementation costs   implementation   implementation costs 
                     for fiscal years costs for fiscal    through fiscal year 
Component        1998 through 2005        year 2006                   2006 
Army                         $62.5             $4.0                  $66.5 
Navy and                     109.7              4.4                  114.1 
Marine Corps                                        
Air Force                     92.6              8.0                  100.6 
Office of the                  3.6              0.3                    3.9 
Secretary of                                        
Defense                                             
Total                       $268.3            $16.8                 $285.1 

Source: DOD.

Note: Totals may not add due to rounding.

Program delays also caused the Defense Energy Support Center to cancel
solicitations to privatize 42 Army utility systems in May 2006. These
solicitations had been closed from 1 to 4 years with no award decision and
there were concerns that conditions, such as the accuracy of the inventory
and needed improvements, had changed or might change before an award
decision would be made. The Army plans to resolicit these systems over the
next few years. Further, Defense Energy Support Center officials stated
that program delays and the resulting decrease in assistance requested by
the services have made it difficult to retain qualified staff to support
the utility privatization program. Consequently, the center will need to
train new staff once the program's pace begins to increase again.

Services Have Estimated the Number and Cost of Potential Privatization Contracts

In addition to revising their program completion dates since our previous
report, the services also estimated the additional number of systems that
might be privatized by the completion of their programs and the funds
needed to pay the costs of these anticipated contracts. The Army estimated
that 41 additional systems might be privatized with the associated
contract costs totaling about $212 million; the Navy and the Marine Corps
estimated that 40 additional systems might be privatized with the
associated contract costs totaling about $139 million; and the Air Force
estimated that 210 additional systems might be privatized with the
associated contract costs totaling about $602 million (see table 4). Air
Force officials stated that its estimated 210 additional systems was a
"worst case" estimate used to determine the maximum funding needed for
possible additional privatization contracts. The officials stated that the
more likely number of systems that might be privatized was about 105
systems. However, the officials did not provide an estimate of the
contract costs associated with the smaller number of systems.

Table 4: Potential Additional Privatization Contracts and Associated Costs

Dollars in millions                              
                       Number of additional systems   Potential program costs 
                          that potentially could be if the additional systems 
Component                             privatized            are privatized 
Army                                          41                    $212.4 
Navy and Marine                               40                     139.3 
Corps                                            
Air Force                                    210                     602.0 
Total                                        291                    $953.7 

Source: DOD.

  DOD's Changes to Improve Utility Privatization Implementation Have Addressed
            Many Areas but Have Not Eliminated All Program Concerns

DOD has made many changes to improve the management and oversight of the
utility privatization program since our May 2005 report. To improve the
reliability of the economic analyses supporting privatization decisions,
DOD now requires that the analyses undergo an independent review to assess
the inputs and assumptions, ensure that cost estimates for the
government-owned and privatization options are treated in a consistent
manner, and verify that all relevant guidance has been met. Also, in
supplemental program guidance issued in November 2005, DOD reminded the
services to consider and plan for increased costs for utility services
contracts resulting from potential privatization projects and prepare
operation and maintenance budgets based upon the expected costs under
privatization. The guidance also emphasized the importance of contract
oversight and directed a number of actions designed to ensure adequate
contract administration and oversight. Among other things, the guidance
directed the Defense Energy Support Center to develop specific preaward
and postaward procurement procedures for the effective management of
utilities services contracts, directed contracting agencies to adequately
train and prepare personnel involved in the utility privatization
contracts, noted that DOD components are responsible for ensuring that the
acquisition plan adequately addresses cost growth control, and stated that
DOD components are responsible for ensuring that resources required to
properly administer the contracts have been identified and provided. In
March 2006, DOD also issued guidance implementing modifications in the
program's legislative authority made by the Fiscal Year 2006 National
Defense Authorization Act, which among other things addresses our concern
that some utility privatization contracts had allowed contractors to
recover more than they paid as the fair market value for system
conveyances. If fully implemented, the changes should result in more
reliable economic analyses supporting proposed privatization projects,
improved budgetary consideration of increased utility costs from
privatization, enhanced oversight of privatization contracts, and reduced
instances where contractors recover more than the amounts they paid as the
fair market value for system conveyances.

Although DOD has made many changes to improve implementation of the
utility privatization program, the changes have addressed some concerns
but have not eliminated all concerns noted in our prior report, such as
ensuring the reliability of project economic analyses and ensuring
effective contract oversight. We found that changes to address some issues
have not been effectively implemented, some changes were not sufficient to
totally eliminate the concerns, and DOD did not make changes to address
some concerns causing continued questions about the reliability of the
economic analyses, the availability of funds to pay for the remaining
projects that might be privatized, the adequacy of contract oversight in
projects awarded prior to DOD's changes, and the control of long-term cost
growth in utility privatization contracts. We also have concerns that the
program may continue to provide an unrealistic sense of savings and
decision makers may have incomplete information on the financial effect of
privatization decisions.

DOD Has Taken Steps to Improve the Reliability of Project Economic Analyses but
Implementation Is a Concern

Although DOD has made changes to improve the reliability of the analyses
supporting proposed utility privatization projects, we found issues with
the services' implementation of the changes. In November 2005, DOD issued
supplemental program guidance requiring DOD components to ensure that
independent reviews were conducted for all economic analyses supporting a
proposed conveyance. The guidance stated that the independent review
should verify that all relevant guidance has been met and that
privatization is in the best interest of the government. In March 2006,
DOD reported to Congress that the independent review included procedures
to review the general inputs and assumptions, verify that the inventory in
the economic analysis is identical to the inventory in the solicitation,
and ensure that the government and the contractor treat the renewal and
replacement cost estimates in a consistent manner.17 Even before DOD
issued the guidance requiring independent reviews, Army and Air Force
officials stated that they had implemented such reviews to help ensure
reliability of their project analyses. The officials stated that
independent reviews were performed on the analyses supporting 12 utility
privatization projects that were awarded in September 2005-after our
previous report-but before DOD's issuance of the guidance requiring
independent reviews.

As an additional step to help ensure reliable economic analyses, DOD's
March 2006 report to Congress stated that the services must conduct
postconveyance reviews that compare actual project costs with the
estimated costs included in the projects' economic analyses. DOD stated
that the postconveyance reviews are conducted 2 to 3 years after contract
award, or 1 year after the first periodic price adjustment, whichever is
later, and that the results of these reviews will be compiled until such
time as the analysis of all conveyances is complete. DOD stated that the
reviews are to include an analysis of the system's inventory, changes in
requirements and contract costs, and a comparison of actual contract costs
with estimates from the economic analyses.

Although DOD's changes are key steps in the right direction to improve the
reliability of the economic analyses, we found issues with the
implementation of the changes. First, we reviewed the analyses associated
with 10 Army and Air Force projects awarded in September 2005. Although
these analyses were prepared prior to the issuance of DOD's supplemental
guidance, the services had already implemented an independent review
process and these analyses underwent an independent review. Service
officials noted that the independent reviews had just begun and expected
that the thoroughness of the reviews would improve as experience was
gained and DOD's supplemental guidance was implemented. We found that the
reviews did identify some questionable items and that some changes were
made to improve the reliability of the economic analyses. Yet, we also
found questionable items in each analysis that were not identified during
the independent review. For example:

17Renewals and replacements is a term used to describe the normal
replacement of, or repairs to, a system's components or parts as needed to
keep the system functioning in accordance with industry standards.

           o  The economic analysis for the natural gas system privatization
           at Minot Air Force Base did not treat estimates of renewal and
           replacement costs for the government-owned and privatization
           options in a consistent manner. The analysis estimated that the
           Air Force would spend $7.1 million on renewals and replacements
           during the first year of continued government ownership. Under the
           first year of privatization, the analysis estimated that the
           contractor would spend about $0.2 million on renewals and
           replacements. When we asked about this difference, Air Force
           officials stated that the contractor is not required to perform
           the same renewals and replacements identified in the government
           estimate and that the government found the contractor's proposal
           to be acceptable. Because the analysis was not based on performing
           the same work, the cost estimates were not consistently developed
           and resulted in favoring the privatization option. This issue was
           not identified in the independent review.
           o  The economic analyses for the water and wastewater
           privatization projects at Andrews Air Force Base were based on the
           systems' inventory (i.e., the wells, pumps, water treatment
           equipment, valves, fire hydrants, water distribution mains,
           meters, storage tanks, reservoirs, and other components that
           constitute the systems) and condition 2 years prior to contract
           award. The Air Force stated that adjustments to the contract could
           be made after contract award, if needed, to reflect changes in the
           inventory. However, because the analyses were not updated to
           reflect inventory changes before contract award, the reliability
           of the analyses is less certain. This issue was not noted in the
           independent review.
           o  The economic analyses for privatization of the electric
           distribution system at Fort Leavenworth and the water and
           wastewater systems at three Army installations in the Tidewater
           Virginia area incorrectly included financing costs under the
           government option. Although this favored the privatization option,
           the amount was not enough to change the outcome of the analyses.
           This issue was not identified in the independent review. However,
           Army officials told us that they would ensure that this did not
           occur in future analyses.

           Second, although DOD noted in its March 2006 report to Congress
           the importance of postconveyance reviews as an additional measure
           to help ensure reliable economic analyses, DOD has not issued
           guidance that requires the services to perform the reviews.
           Service officials stated that they had performed only a limited
           number of postconveyance reviews and do not have plans to perform
           the reviews in the manner or frequency described in DOD's report
           to Congress. Also, DOD's report cited seven Army Audit Agency
           postconveyance reviews, four additional Army postconveyance
           reviews, and one Air Force postconveyance review. However, only
           three of the Army Audit Agency reviews included a comparison of
           actual contract costs with estimates from the economic analyses.

           DOD Has Taken Steps to Address Some Funding Issues but Concerns Remain
			  
			  Although DOD has taken steps to help ensure that the services
           adequately consider the increased costs from utility privatization
           projects during budget preparation, questions remain over the
           availability of the additional funds needed to complete the
           program. The services estimate that they potentially will need
           $453 million more than is currently programmed for continuing
           government utility operations to pay implementation and contract
           costs associated with the remaining number of utility systems that
           might be privatized through 2010 for the Air Force, the Navy, and
           Marine Corps, and through 2011 for the Army. As a result, in view
           of competing needs and budget priorities, the Deputy Assistant
           Secretary of the Air Force (Installations) stated in an April 2006
           memorandum that the Air Force could not afford to award further
           utility privatization contracts unless additional resources are
           provided.

           Utility Costs Increase with Privatization
			  
			  Our May 2005 report noted that installation utility costs under
           privatization typically increase significantly above historical
           levels because the systems are being upgraded and the contractors
           recoup their investment costs through the utility services
           contracts. Essentially, under the privatization program, the
           services leverage private sector capital to achieve utility system
           improvements that otherwise would not be feasible in the short
           term because of limited funding caused by the competition for
           funds and budget allocation decisions. The services pay for the
           improvements over time through the utility services contracts,
           which are "must pay" bills. As a result, if an installation's
           funds were not increased sufficiently, then funds provided for
           other installation functions where there was more discretion in
           spending might be used to pay the higher utility bills. This, in
           turn, could negatively affect those other functions, such as the
           maintenance of installation facilities. We recommended that DOD
           provide program guidance emphasizing the need to consider
           increased utility costs under privatization as the military
           services prepare their operation and maintenance budget requests
           and that DOD direct the service Secretaries to ensure that
           installation operations and maintenance budgets are adjusted as
           necessary to reflect increased costs from utility privatization
           projects.

           In November 2005, DOD issued supplemental program guidance that
           reminded DOD components to consider the increase in utility costs
           from privatization. Specifically, the guidance directed the
           components to consider and plan for increased costs for utility
           services contracts resulting from potential privatization projects
           and system conveyance and prepare operation and maintenance
           budgets based upon the expected costs under privatization.

           Funds Not Programmed for All Potential Utility Privatization Projects
			  
			  DOD's guidance addresses the recommendations from our May 2005
           report and, if implemented, should result in the increased costs
           from utility privatization projects being adequately considered
           during budget preparation. However, in view of competing needs and
           budget priorities, questions remain over availability of the
           additional funds needed to complete the program. To illustrate,
           DOD's November 2005 supplemental guidance also directed DOD
           components to advise the Deputy Under Secretary of Defense
           (Installations and Environment) if significant shortfalls are
           anticipated that will affect utilities privatization efforts. In
           response to that direction, each service estimated the remaining
           number of utility systems that might be privatized, calculated the
           associated implementation and contract costs, compared these costs
           with the funds already programmed for continued government
           operation of the systems that might be privatized, and determined
           whether any potential funding shortfalls existed. The Army's
           estimate was through fiscal year 2011 and the other services'
           estimates were through fiscal year 2010. As a result of this
           review, each service determined that funding shortfalls existed to
           pay for potential future privatization contracts (see table 5).

           Table 5: Service Estimates of Potential Utility Privatization
           Program Funding Shortfall
           
           Dollars in                                                  
millions                                                    
                                         Potential                            
                  Number of systems  program costs             Total unfunded 
                   that potentially if the systems Total funds    requirement 
Component    could be privatized are privatized  programmed    (shortfall)
Army                          41         $212.4       $90.3         $122.1 
Navy and                      40          139.3       103.2           36.1 
Marine Corps                                                
Air Force                    210          602.0       306.9          295.1 
Total                        291         $953.7      $500.4         $453.3 

           Source: DOD.

           Air Force May Not Award Some Additional Privatization Projects Due
			  to Funding Issues
			  
			  Air Force officials stated that the increased costs from potential
           future utility privatization contracts had reached a critical
           point. The officials stated that because funds are limited and
           funding needs for some Air Force programs are greater than the
           funding needs for utility upgrades, the Air Force has concluded
           that it will not solicit new utility privatization contracts until
           additional resources are identified to specifically cover any
           potential increase in future costs. Air Force officials further
           explained that privatization results in improving utility systems
           to an industry standard level by creating "must pay" contracts.
           However, without additional resources, funding these contracts
           must come from other base operating support funds, which would
           result in diverting critical resources from remaining facilities
           and infrastructure. Also, the officials noted that the utility
           privatization program drives system recapitalization to an
           industry standard level that may be questionable when compared to
           historical Air Force requirements and, furthermore, reflects a
           funding level that is not affordable in light of current fiscal
           constraints and differing Air Force modernization priorities.

           When we questioned a cognizant DOD official in June 2006 about the
           potential funding shortfall, the official stated that each service
           has competing priorities and the cost of awarding contracts to
           privatize utility infrastructure is just one of many. However, the
           official also stated that the funding issue and alternatives were
           under discussion but conclusions had not yet been reached.

           DOD Directed Actions to Improve Utility Privatization Contract
			  Oversight but Some Concerns Remain
			  
			  DOD has made a number of changes designed to improve utility
           privatization contract administration and oversight since our May
           2005 report. However, it may take some time for the improvements
           to be fully implemented as the changes are applied to new
           privatization contract awards and efforts may be needed to ensure
           that the changes are applied, where needed, to previously awarded
           contracts.

           DOD Has Taken Steps to Address Oversight Concerns
			  
			  To address privatization contract oversight concerns, DOD issued
           supplemental program guidance in November 2005 that emphasized to
           the services the importance of contract oversight and directed a
           number of actions designed to ensure adequate contract
           administration and oversight. Among other things, the guidance

           o  directed the Defense Energy Support Center to develop specific
           preaward and postaward procurement procedures for the effective
           management of utilities services contracts resulting from a
           utility conveyance, and coordinate with the Defense Acquisition
           University to develop a training program for all contracting
           officers and DOD components involved in utilities privatization
           efforts;
           o  directed contracting agencies to adequately train and prepare
           personnel involved in the administration of the utilities services
           contracts resulting from a utilities conveyance;
           o  stated that contracting officers must be able to use guidance
           for postaward contract management and contract provisions to
           ensure that the government's interests are protected in the
           long-term utility service contracts and associated real estate
           documents;
           o  stated that prior to awarding a services contract resulting
           from a utility conveyance, DOD components are responsible for
           ensuring, among other things, that resources required to properly
           administer the contract have been identified; and
           o  directed that transfers of contract administration
           responsibilities from the procuring contract office to the
           contracting administration office should include an on-site
           transfer briefing with government and contractor personnel that
           includes, among other things, a clear assignment of
           responsibilities.

           During our visit to the Defense Energy Support Center in April
           2006, officials stated that in accordance with the guidance, the
           center had already issued the preaward and postaward procurement
           procedures that would help ensure the effective management of
           utilities services contracts. The officials stated that they had
           also begun developing a training program for all contracting
           officers and other DOD personnel involved in utilities
           privatization efforts and had developed procedures for
           transferring contract responsibilities that should help ensure
           effective contract oversight. During our visits to the services,
           officials stated that, in addition to working with the Defense
           Energy Support Center, further efforts were underway to ensure
           that postaward management is effective. For example, Air Force
           officials stated that they had developed their own postaward plan,
           which defines the responsibilities and standards by which the
           government could ensure that utility services are provided in
           accordance with requirements. Navy officials stated that the Navy
           plans to prepare a quality assurance plan for each utility
           privatization contract awarded.

           Some Contract Oversight Concerns Identified at the Four Installations
			  We Visited
			  
			  Although the steps taken by DOD, the Defense Energy Support
           Center, and the services are significant improvements,
           implementation will be the key to ensuring effective oversight of
           all utility privatization contracts, and it may take some time to
           fully implement improvements as new privatization contracts are
           awarded. From the time DOD's supplemental guidance was issued and
           other improvement measures were put into place through the time of
           our review in June 2006, the services awarded no new utility
           privatization contracts. Thus, to assess contract oversight, we
           were unable to visit installations with utility privatization
           contracts awarded after DOD's changes were implemented. Instead,
           we assessed contract oversight at four installations with five
           utility privatization projects that were awarded prior to our May
           2005 report. We found continuing concerns about the adequacy of
           oversight because no additional resources were provided to oversee
           the contracts at all four installations and mandatory written
           plans for overseeing contractor performance were not prepared at
           two installations.

           For example, officials at each of the four installations we
           visited noted that no additional resources were provided at the
           installation level to perform contract oversight once their
           utility systems were privatized. The contract officials stated
           that the extra work associated with the contracts was added to
           their workload of overseeing other contracts. Some officials
           stated that they did not have sufficient personnel to perform the
           level of detailed monitoring of contractor performance that they
           believed was needed. According to Fort Eustis officials, when the
           electric system was privatized, they requested three additional
           people to oversee the contract based on the magnitude of the
           workload associated with this contract. Yet, no additional people
           were provided and the extra workload was added to the workload of
           the staff responsible for overseeing other contracts.

           Also, our review of the electric distribution system privatization
           projects at Fort Eustis and the Army's Military Ocean Terminal
           Sunny Point found that neither installation had a quality
           assurance surveillance plan in place for overseeing contractor
           performance. Such plans are required by the Federal Acquisition
           Regulation. Officials at both installations stated that although a
           formal surveillance plan had not been prepared, they were
           performing oversight to ensure that the contractors met contract
           requirements. Nevertheless, formal contractor performance
           monitoring plans are an important tool for ensuring adequate
           contract oversight.

           Containing Utility Privatization Contract Cost Growth May Be a Challenge
			  
			  Because contractors own installation utility systems after
           privatization and, therefore, may have an advantage when
           negotiating contract changes and renewals, containing utility
           privatization contract cost growth may become a challenge as
           contracts go through periodic price adjustments and installations
           negotiate prices for additional needed capital improvement
           projects and other changes. In March 2006, DOD stated that
           although it recognizes that privatization may limit the
           government's options during contract negotiations, the department
           continues to prefer privatization with permanent conveyance and
           believes that safeguards are in place to adequately protect the
           government's interests. Although it is too early in the program's
           implementation to know to what extent DOD's efforts will be
           successful in ensuring equitable contract price adjustments and
           limiting long-term cost growth in the utility privatization
           program, our review found indications that containing cost growth
           may become a concern.

           DOD Continues to Prefer Permanent Conveyance but Has Taken Steps
			  to Control Costs
			  
			  In our prior report, we noted that, according to DOD consultant
           reports, DOD's approach to utility privatization differs from
           typical private sector practices in that private sector companies
           may outsource system operations and maintenance but normally
           retain system ownership. As a result, the consultant reports note
           that DOD's preferred approach of permanently conveying utility
           system ownership to contractors may give the contractor an
           advantage when negotiating service contract changes or renewals.
           This occurs because DOD must deal with the contractor or pay
           significant amounts to construct a new utility distribution system
           to replace the one conveyed to the contractor, attempt to purchase
           the system back from the contractor, or institute legal action to
           reacquire the system through condemnation proceedings. Because of
           concern that contractors may have an advantage when it comes time
           to negotiate contract changes and renewals, we recommended that
           DOD reassess whether permanent conveyance of utility systems
           should be DOD's preferred approach to obtaining improved utility
           services.

           DOD stated that it has reassessed its position and continues to
           believe that owning, operating, and maintaining utility systems is
           not a core mission of the department and that permanent conveyance
           of systems under utilities privatization enables the military
           installations to benefit from private sector innovations,
           economies of scale, and financing. Although DOD contends that
           private industry can normally provide more efficient utility
           service than can the government, DOD has not provided any studies
           or other documentation to support its contention. Given that the
           private sector faces higher interest costs than the government and
           strives to make a profit whereas the government does not, it is
           not certain that utility services provided by the private sector
           would be less costly than utility services provided by the
           government through the use of up-front appropriations.

           Although DOD continues to prefer privatization with permanent
           conveyance of the utility systems, DOD has recognized that
           privatization may limit the government options during contract
           renegotiations and has taken steps to help control contract cost
           growth. First, DOD stated in its March 2006 report to Congress
           that a contractor also may have limited options under
           privatization because the contractor typically cannot use the
           installation's utility system to service other customers. DOD
           reported that privatization creates a one-to-one relationship
           between the installation and the contractor. In this relationship,
           DOD stated that both parties must work together to execute fair
           and equitable contract changes, both parties have significant
           vested interests in successful negotiations, and both parties
           retain substantial negotiation leverage.

           Second, DOD noted that service contracts awarded as part of a
           privatization transaction are contracts subject to the Federal
           Acquisition Regulation and applicable statutes. Because it is
           recognized that privatization will as a practical matter limit
           future opportunities to recompete this service, DOD stated that
           all contracts will include appropriate provisions to protect the
           government's interest while allowing the contractor reasonable
           compensation for the services provided. DOD's report further
           stated that fixed price contracts with prospective price
           adjustment provisions have been determined to be the most
           appropriate contract in most situations and that this type of a
           contract will mitigate cost risk and hopefully result in a
           satisfactory long-term relationship for both the contractor and
           the government.

           Third, DOD noted that utility services contracts resulting from a
           utility conveyance may include a contract clause that provides an
           option for the government to purchase the system at the end of the
           contract period. According to Defense Energy Support Center
           officials, the center has developed language for future Army and
           Air Force contracts that would provide an option for the
           government to buy back a system at the end of the contract period.
           Center officials stated that this clause may help the government
           in negotiations at the end of the contract term. Navy officials
           stated that the Navy does not plan to include a buy back clause in
           its future utility contracts because a system could be taken back,
           if necessary, through condemnation procedures.

           Fourth, in its November 2005 supplemental guidance, DOD emphasized
           the importance of controlling contract cost growth. Specifically,
           the guidance noted that prior to awarding a services contract
           resulting from a utility conveyance, DOD components are
           responsible for ensuring that the acquisition plan adequately
           addresses cost growth control, which includes specifying the
           appropriate price adjustment methodology and postaward contract
           administration.

           Cost Growth in Utility Privatization Contracts May Become a Concern
			  
			  Although DOD has policies, guidance, and procedures to help
           control contract costs and ensure that price adjustments are
           equitable, cost growth may still become a concern as utility
           privatization contracts go through periodic price adjustments and,
           in some cases, installations negotiate changes for additional
           capital improvement projects or other needs. According to DOD,
           most utility privatization contracts include provisions for
           periodic price adjustments. The price adjustment process allows
           contract price changes based on changes in market prices,
           generally to cover inflation, and changes to the service
           requirement from system additions or modifications resulting from
           capital upgrades. Under this process, the contractor is required
           to submit sufficient data to support the accuracy and reliability
           of the basis for service charge adjustments. If the contractor's
           data is determined to be fair and reasonable, the contracting
           officer negotiates a service charge adjustment. Utility
           privatization contracts normally provide for price adjustments
           after an initial 2-year period and every 3 years thereafter. In
           addition to cost increases from service charge adjustments,
           contract costs can also increase as a result of contract
           modifications to pay for additional capital improvement projects
           not included in the initial contract.

           According to the services, utility privatization contracts for 22
           systems are currently undergoing, or will be subject to, their
           first periodic price adjustment before the end of calendar year
           2007.18 Although it is too early to know the extent of cost
           changes that might occur in these contracts, our review of six
           contracts-one that completed a periodic price adjustment, one that
           was undergoing periodic price adjustment, and four that had not
           yet undergone a periodic price adjustment-found conditions that
           indicate that cost growth in utility privatization contracts may
           become a concern. Changes in contract costs could result in
           privatization costs increasing above the levels estimated in the
           economic analyses. To illustrate:

           o  The Fort Rucker natural gas distribution system privatization
           contract was issued on April 24, 2003. The contract provided for a
           price adjustment after the initial 2 years of the contract and
           then every 3 years thereafter. In February 2005, the contractor
           submitted a proposal for a price adjustment and requested an
           increase in the price paid to the contractor for operations and
           maintenance, associated overhead, and renewals and replacements.
           According to a government memorandum that summarized the results
           of the price adjustment process, the requested increases were
           based on the contractor's actual labor hours and material costs
           and additional overhead costs which resulted from a change in the
           way the contractor calculated overhead costs. The change in
           overhead calculations included costs that were not included in the
           original proposal submission or in the contract. When queried, the
           contractor responded that the costs were not originally submitted
           but should have been. After review, the government team
           responsible for the price adjustment process determined that the
           requested increases were allowable and reasonable and approved the
           price increase. The change increased the government's annual
           utility service charge costs from about $87,000 to about $124,000,
           an increase of about $36,000, or 41 percent. In approving the
           increase, the government team noted that although the estimated
           cost avoidance from privatization would be reduced, the contract
           was still economical compared to the estimated costs of government
           ownership.
           o  The Sunny Point electric distribution system privatization
           contract was issued on September 30, 2003. In January 2006, the
           contractor submitted a proposal for a price adjustment and
           requested an increase in the utility service charge based on the
           contractor's actual labor hours and material costs associated with
           operating and maintaining the system, including the installation's
           emergency generators. According to installation officials, the
           costs to operate and maintain the system were significantly higher
           than originally anticipated by the contractor because of errors in
           the system's inventory used to develop the solicitation, such as
           not including all of the installation's emergency generators. When
           queried about the requested price increase, the contractor
           responded that the initial contract bid would have been higher if
           the true inventory of the system had been known. Although the
           price adjustment process was not final at the time of our visit in
           June 2006, installation officials stated that the government team
           responsible for the process had determined that the requested
           increases were allowable and reasonable and had approved the price
           increase. As a result of the price adjustment, the government's
           annual utility service costs are expected to increase from about
           $415,000 to $798,000 in the third year of the contract, an
           increase of about $383,000, or 92 percent.
           o  The Fort Eustis electric distribution system privatization
           contract was issued on June 24, 2004. While this contract is not
           scheduled for a periodic price adjustment until December 2006, the
           contract costs have increased by about $431,000, or 26 percent,
           since the contract was signed. The increase is the result of two
           factors. First, the annual service charge was increased by about
           $73,000 as the result of correcting errors to the system's
           inventory described in the privatization solicitation. Second, the
           contract's cost was increased by about $358,000 to pay for capital
           improvement projects that were added to the original contract.
           Fort Eustis officials stated that funding for the capital
           improvement projects added to the contract did not have to compete
           for funding against other needed installation improvement projects
           because project costs were added to the privatization contract.
           The officials stated that it was unclear whether these projects
           would have been approved for funding had the privatization
           contract not been in place.

           The remaining three contracts we reviewed-the water and wastewater
           privatization contracts at Bolling Air Force Base and the electric
           distribution system privatization contract at Dobbins Air Reserve
           Base-were not yet eligible for, or not subject to, a periodic
           price adjustment. At the time of our visits in May 2006, actual
           contract costs in these cases approximated the estimates in the
           projects' economic analyses.

           DOD Has Not Made Changes to Provide More Realistic Savings
			  Estimates from Utility Privatization
			  
			  Because DOD has not changed the guidance for performing the
           economic analyses or taken any other steps to change the
           perception that the utility privatization program results in
           reduced costs to the government, the program may continue to
           provide an unrealistic sense of savings for a program that
           generally increases annual government utility costs in order to
           pay contractors for enhanced utility services and capital
           improvements. The concern was caused by the methodology DOD uses
           to determine whether a proposed privatization contract would meet
           the statutory requirement for reduced long-term costs. In our
           previous report, we noted that DOD's guidance directs the services
           to compare the estimated long-term costs of the contract with the
           estimated long-term "should costs" of continued government
           ownership assuming that the service would upgrade, operate, and
           maintain the system in accordance with accepted industry standards
           as called for in the proposed contract. This estimating method
           would be appropriate, if in the event the system is not
           privatized, the service proceeded to upgrade, operate, and
           maintain the system as called for in the estimate. However, this
           generally is not the case. According to DOD and service officials,
           if a system is not privatized, then the anticipated system
           improvements would probably be delayed because of DOD's budget
           allocation decisions, which have limited funds for utility
           improvements. Because of the time value of money, a future expense
           of a given amount is equivalent to a smaller amount in today's
           dollars. Thus, if reduced costs to the government are expected to
           be a key factor in utility privatization decision making, then it
           would appear more appropriate for the services to compare the cost
           of a proposed privatization contract with the cost of continued
           government ownership on the basis of the actual planned
           expenditures and timing of these expenditures.

           Since May 2005, DOD has not changed the guidance for performing
           the economic analyses nor has DOD taken other steps, such as
           showing current utility system costs in the economic analyses, to
           change the perception that the utility privatization program
           results in reduced costs to the government. DOD's November 2005
           supplemental program guidance directed the services to continue to
           prepare economic analyses based on the "should costs," which is
           defined as an independent government estimate of the costs
           required to bring the system up to and maintain it at current
           industry standards. Further, DOD's March 2006 report to Congress
           stated that the "should cost" estimate is the government's best
           tool for predicting the future requirement for individual systems
           and is the most realistic methodology. Yet, the report also
           acknowledged that the department had done an inadequate job of
           defining industry standards and then subsequently programming,
           budgeting, and executing to that requirement. Because DOD has not
           programmed funds to do the work described in the "should cost"
           estimate if the system is not privatized, DOD's estimates of the
           reduced costs to the government that would result from
           privatization are not based on realistic cost differences.

           Information that DOD reported to Congress in March 2006
           illustrates our concern. DOD's report stated that the department's
           total cost avoidance from utility conveyances is expected to
           exceed $1 billion in today's dollars and, as shown in table 6, the
           report included information showing that the 81 contracts awarded
           under 10 U.S.C. 2688 will result in about $650 million in reduced
           costs to the government in today's dollars compared to DOD's
           "should cost" estimate.

           Table 6: DOD's Estimated Cost Avoidance from Utility Privatization
			  
			  Dollars in                                          
millions                                            
                             Estimated                                        
                 Number of costs under Estimated costs         Estimated cost 
                   systems  government           under         avoidance with 
Component    privatized   ownership   privatization          privatization
Army                 70    $2,377.0        $1,867.5                 $509.5 
Navy and              1       308.1           215.4                   92.7 
Marine Corps                                        
Air Force            10       220.5           173.0                   47.5 
Total                81    $2,905.6        $2,255.9                 $649.7 

           Source: DOD.

           Note: Estimates are totals in today's dollars over the contract
           terms (50 years for most projects).

           DOD's reported cost avoidance amounts provide an unrealistic sense
           of savings for several reasons:

           o  First, as previously stated, the estimated costs under
           government ownership are not based on the actual expected costs if
           the system is not privatized but rather on a higher "should cost"
           amount. As a result, estimated costs under government ownership
           are overstated and, therefore, DOD's estimated cost avoidance is
           overstated, at least in the short term.
           o  Second, the government's costs for utility services increase
           with privatization. Army officials estimated that average annual
           cost increase for each privatized Army system was $1.3 million.
           Also, the services estimate that they will need $453 million more
           than is currently programmed for continuing government ownership
           to pay for the contract and other costs associated with the
           remaining number of utility systems that might be privatized
           through 2010 for the Air Force and the Navy and Marine Corps, and
           through 2011 for the Army.
           o  Third, DOD's reported cost avoidance does not consider the
           program's one-time implementation costs. Through fiscal year 2005,
           about $268 million was spent to implement the program.
           o  Fourth, the economic analyses used to estimate the cost
           avoidance between the government-owned and privatization options
           for several of the 81 projects included in DOD's report to
           Congress are unreliable. As noted in our previous report, our
           review of seven project analyses identified inaccuracies,
           unsupported cost estimates, and noncompliance with guidance for
           performing the analyses. The cost estimates in the analyses
           generally favored the privatization option by understating
           long-term privatization costs or overstating long-term government
           ownership costs. When we made adjustments to address the issues in
           these analyses, the estimated cost avoidance with privatization
           was reduced or eliminated. Also, as discussed in another section
           of this report, although DOD has taken steps to improve
           reliability, we found questionable items in 10 economic analyses
           supporting projects awarded after our May 2005 report.
           o  Fifth, cost growth in privatization contracts might reduce or
           eliminate the amount of the estimated cost avoidance from
           privatization. We reviewed the analysis supporting the Navy's one
           privatization project under 10 U.S.C. 2688, awarded in 1999, and
           compared actual contract costs to the estimated contract costs
           included in the analysis. The analysis showed that if contract
           costs continue to increase at the same rate experienced since the
           contract was awarded, then the project's estimated cost avoidance
           would be reduced from about $92.7 million to about $18 million.
           This analysis also did not include consideration of privatization
           contract oversight costs. Consideration of these costs would
           further reduce the estimated cost avoidance to about $4 million.
           As discussed in another section of this report, we found contract
           cost growth concerns in 3 of 6 additional utility privatization
           projects we reviewed, which will reduce the estimated cost
           avoidance for those projects.

           In addition to providing an unrealistic sense of savings by
           providing only the "should cost" estimates, the economic analyses
           do not include other information that would provide decision
           makers with a clearer picture of the financial effect of
           privatization decisions. If the analyses included information
           showing the amount that the government currently spends on
           operating, maintaining, and upgrading the utility systems being
           evaluated for privatization, decision makers could better consider
           the increase in costs that will result from privatization as they
           assess the merits of proposed projects. However, DOD's guidance
           does not require that the services' economic analyses include
           current utility system cost information.

           The National Defense Authorization Act for Fiscal Year 2006
           modified the program's legislative authority by requiring that
           project economic analyses incorporate margins of error in the
           estimates that minimize any underestimation of the costs resulting
           from privatization of the utility system or any overestimation of
           the costs resulting from continued government ownership and
           management of the utility system. This step could help improve the
           reliability of the cost differences between the government-owned
           and privatization options. The modified authority stated that
           incorporating margins of error in the estimates was to be based
           upon guidance approved by the Secretary of Defense. However, as of
           June 2006, DOD had only issued general guidance in this area with
           no details on how the services were to comply with the new
           requirement. Specifically, on March 20, 2006, DOD issued guidance
           directing the services to include in the economic analysis an
           explanation as to how margin of error considerations were
           addressed in developing the independent government cost estimate
           and carried forward in the price analysis report and cost realism
           report. Although the guidance referenced Office of Management and
           Budget Circular A-94, dated October 29, 1992; DOD Instruction
           7041.3, dated November 7, 1995; and Deputy Secretary of Defense
           memorandum and guidance dated October 9, 2002; none of these
           documents provide details on how margins of error should be
           incorporated into the economic analyses. At the time of our review
           in June 2006, Army and Navy officials stated that they were
           evaluating how to include margins of error into future economic
           analyses. Air Force officials stated that their economic analyses
           already included margins of error calculations but that no formal
           rules existed on how to use the results of the calculations.
           Without detailed DOD guidance, there is little assurance that the
           services will include margins of error considerations in an
           appropriate and consistent manner in future project economic
           analyses.

           Changes in Legislative Authority and DODï¿½s Implementation of the
			  Change Address Fair Market Value Concerns
			  
			  DOD's changes to implement a modification to the legislative
           authority for the utility privatization program have addressed the
           fair market value concerns discussed in our May 2005 report. Our
           report noted that in some cases implementation of a previous
           legislative requirement that the government receive fair market
           value for systems conveyed to privatization contractors had
           resulted in higher contract costs for utility services. To address
           this concern, we recommended that DOD place greater scrutiny on
           the implementation of the fair market value requirement in
           proposed contracts to minimize cases where contractors recover
           more than the amounts they paid for system conveyances. Subsequent
           to our report, in January 2006, the National Defense Authorization
           Act for Fiscal Year 2006 was enacted.19 The act changed the
           legislative language from stating that fair market value from a
           conveyance must be received to stating that fair market value from
           a conveyance may be received.

           In March 2006, DOD issued guidance to implement modifications in
           the legislative authority made by the act. With regard to fair
           market value, DOD's guidance to the services noted that military
           departments are no longer required to obtain fair market value
           exclusively through cash payments or rate credits. The military
           departments now have the flexibility to seek consideration in a
           manner other than a payment of the fair market value when the
           economic analysis demonstrates it is in the best interest of the
           government. The guidance also stated that the military departments
           may not dispose of the government's property without receiving an
           appropriate return, but the amount and nature of that return may
           be determined and represented in a number of ways, depending on
           the negotiated deal.

           The change in legislative authority and the additional guidance
           issued by DOD address our concern with receipt of fair market
           value for system conveyances. Our review of 10 economic analyses
           for projects awarded after our May 2005 report showed that the
           fair market value paid by the contractor and the amount recovered
           were the same. Thus, according to these analyses, the receipt of
           the fair market value for the conveyances in these cases did not
           result in any increased costs to the government.

           Conclusions
			  
			  DOD has made many changes to improve the management and oversight
           of the utility privatization program since our previous report. If
           fully implemented, the changes should result in more reliable
           economic analyses supporting proposed privatization projects,
           improved budgetary consideration of increased utility costs from
           privatization, enhanced oversight of privatization contracts, and
           reduced instances where contractors recover more than the amounts
           they paid as the fair market value for system conveyances.
           However, a number of program concerns remain because DOD's changes
           to address some issues noted in our previous report have not been
           effectively implemented, some changes were not sufficient to
           totally eliminate the concerns, and DOD did not make changes to
           address some concerns. Specifically, implementation of DOD's
           changes to improve the reliability of the economic analyses, such
           as requiring independent reviews and noting the importance of
           postconveyance reviews to compare actual contract costs with
           estimates from the analyses, could be improved. The reliability of
           the analyses could continue to be questionable until DOD requires
           independent reviewers to report to decision makers on the
           thoroughness of the economic analyses and any significant
           anomalies between the ownership options, estimated costs,
           inventories, and assumptions and also issues guidance requiring
           the services to perform the postconveyance reviews as noted in its
           March 2006 report to Congress. An additional concern is the
           services' estimated shortfall in the funds needed to pay contract
           costs associated with the remaining number of utility systems that
           might be privatized by the end of their programs. Unless DOD
           addresses the potential funding shortfall in view of all DOD and
           service funding and priority needs, questions will remain over the
           availability of the additional funds needed to complete the
           program. Also, although DOD's changes designed to improve utility
           privatization contract administration and oversight are key steps
           in the right direction, it may take some time to fully implement
           improvements as new privatization contracts are awarded and
           oversight of older contracts is assessed. Until DOD ensures that
           the contracts awarded prior to the program changes have adequate
           resources and contractor performance surveillance plans, the
           adequacy of contract oversight will remain a concern. Further,
           because contractors own installation utility systems after
           privatization, they may have an advantage when negotiating
           contract changes and renewals. Unless DOD places additional
           emphasis on monitoring contract cost growth as utility
           privatization contracts undergo periodic price adjustments and
           other changes are negotiated, concern will continue that
           containing utility privatization contract cost growth may become a
           challenge.

           Because DOD did not change guidance to require that project
           economic analyses show the actual costs of continued government
           ownership if the system is not privatized, or take any other steps
           to change the perception that the utility privatization program
           results in reduced costs to the government, DOD continues to
           provide an unrealistic sense of savings to a program that
           generally increases government utility costs in order to pay
           contractors for enhanced utility services and capital
           improvements. Until DOD requires that each economic analysis
           includes information on the system's current costs and the actual
           expected costs if the system is not privatized, decision makers
           will have incomplete information on the financial effect of
           privatization decisions. In addition, unless the Secretary of
           Defense issues detailed guidance explaining how the services
           should incorporate margins of error in the economic analyses, as
           required by the National Defense Authorization Act for Fiscal Year
           2006, there is little assurance that the full benefit from this
           requirement will be achieved.

           Recommendations for Executive Action
			  
			  We recommend that the Secretary of Defense direct the Deputy Under
           Secretary of Defense (Installations and Environment) to take the
           following seven actions:

           o  require independent reviewers to report to decision makers on
           the thoroughness of each economic analysis and any significant
           anomalies in the assumptions used and estimated costs for each
           ownership option;
           o  issue guidance requiring the services to perform the
           postconveyance reviews as noted in DOD's March 2006 report to
           Congress;
           o  address the utility privatization program potential funding
           shortfall in view of all DOD and service funding and priority
           needs;
           o  ensure that utility privatization contracts awarded prior to
           the November 2005 supplemental guidance have adequate resources
           and contractor performance surveillance plans;
           o  place additional emphasis on monitoring contract cost growth as
           utility privatization contracts undergo periodic price adjustments
           and other changes are negotiated;
           o  require, in addition to the "should cost" estimate, that each
           project economic analysis include the system's current annual
           costs and the actual expected annual costs if the system is not
           privatized; and
           o  issue detailed guidance explaining how the services should
           incorporate margins of error in the economic analyses.

           Agency Comments and Our Evaluation
			  
			  In comments on a draft of this report, the Deputy Under Secretary
           of Defense (Installations and Environment) generally agreed with
           six of our seven recommendations and outlined a plan of action to
           address each recommendation. The Deputy Under Secretary noted that
           the utility privatization systems evaluated in our report were
           approved prior to DOD's November 2005 program guidance and that
           the guidance will be fully implemented prior to awarding
           additional contracts. We recognize that issues identified in this
           report pertain to contracts awarded before supplemental program
           guidance was issued in November 2005. Nevertheless, we believe the
           issues identified in this report highlight areas that merit
           increased attention as the program continues-and this is reflected
           in the department's response to each recommendation.

           The Deputy Under Secretary indicated disagreement with our
           recommendation to require, in addition to the "should cost"
           estimate, that each project economic analysis include the system's
           current annual costs and the actual expected annual costs if the
           system is not privatized, and also stated that full implementation
           of DOD's November 2005 guidance will provide further reassurance
           that every conveyance will reduce the long-term costs of the
           department compared to the costs of continued ownership. However,
           as noted in our May 2005 report and again in this report, we
           believe that in the short term it is clear that the utility
           privatization program increases annual costs to the government
           where contractors make system improvements and recoup their costs
           from the department through their service contracts. DOD's sole
           use of "should costs" as a basis for comparing its long-term costs
           with those contained in contractor proposals provides a less clear
           picture of savings to the government since, as our reports have
           shown, the government's "should costs" do not provide a realistic
           portrayal of the planned government expenditures. Accordingly, we
           believe our recommendation continues to have merit.

           DOD's comments and our detailed response to specific statements in
           those comments are presented in appendix II.

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

           If you or your staff have any questions about this report, please
           call me at (202) 512-5581 or e-mail at [email protected] . Contact
           points for our Offices of Congressional Relations and Public
           Affairs may be found on the last page of this report. The GAO
           staff members who made key contributions to this report are listed
           in appendix III.

           Barry W. Holman, Director Defense Capabilities and Management

           List of Congressional Committees

           The Honorable John Warner Chairman The Honorable Carl Levin
           Ranking Minority Member Committee on Armed Services United States
           Senate

           The Honorable Ted Stevens Chairman The Honorable Daniel K. Inouye
           Ranking Minority Member Subcommittee on Defense Committee on
           Appropriations United States Senate

           The Honorable Duncan L. Hunter Chairman The Honorable Ike Skelton
           Ranking Minority Member Committee on Armed Services House of
           Representatives

           The Honorable C. W. Bill Young Chairman The Honorable John P.
           Murtha Ranking Minority Member Subcommittee on Defense Committee
           on Appropriations House of Representatives

           Appendix I: Scope and Methodology
			  
			  To update the status of the Department of Defense's (DOD) utility
           privatization program, we summarized program implementation status
           and costs and compared the status to DOD's past and current goals
           and milestones. We discussed with DOD and service officials issues
           affecting implementation of the program, such as the services'
           suspension of the program between October 2005 and March 2006, and
           inquired about the effects of implementation delays on program
           completion plans. Using data from the services' quarterly program
           status reports to DOD, we summarized the program implementation
           status by service and compared the status to program status
           reported in our prior report. We confirmed the quarterly reports'
           status data on five privatization projects at the four
           installations we visited but did not otherwise test the
           reliability of the data. We also reviewed and summarized the
           services' estimates of the additional number of systems that might
           be privatized by the completion of their programs and the funds
           needed to pay the costs associated with these anticipated
           projects.

           To assess the effect of DOD's changes on the program management
           and oversight concerns noted in our May 2005 report, we documented
           the changes made by interviewing DOD and service officials and
           reviewing pertinent policies, guidance, memorandums, and reports,
           discussed with DOD and service officials the intended objective
           for each of the changes, and compared the changes with the
           concerns identified in our prior report. To assess the effect of
           DOD's changes on the reliability of the economic analyses
           supporting privatization decisions, we reviewed the economic
           analyses supporting 10 privatization projects that were awarded
           after our May 2005 report and that had been subjected to the
           services' new independent review processes. The analyses were
           judgmentally selected to obtain examples from both the Army and
           the Air Force. For each analysis, we evaluated the basis for the
           estimates and assumptions used and assessed consistency and
           compliance with DOD guidance. We did not otherwise attempt to
           independently determine estimates of long-term costs for the
           projects. We shared the results of our analyses with service
           officials and incorporated their comments as appropriate. To
           assess the effect of DOD's changes on consideration of increased
           costs from utility privatization, we summarized the services'
           estimates of the additional funds that would be needed to pay
           costs associated with the remaining number of utility systems that
           might be privatized and inquired about DOD's plans for dealing
           with a potential program funding shortfall. To assess the effect
           of DOD's changes on the administration and oversight of utility
           privatization projects, we visited four installations with five
           utility privatization projects awarded prior to our May 2005
           report: Fort Eustis, Virginia; the Army's Military Ocean Terminal
           Sunny Point, North Carolina; Bolling Air Force Base, Maryland; and
           Dobbins Air Reserve Base, Georgia. These installations were
           judgmentally selected because they represented a cross section of
           typical utility privatization projects, as corroborated with
           service officials. At each installation, we discussed resources
           available for contract oversight and plans for contractor
           performance monitoring. Also, to assess the effect of DOD's
           changes on controlling cost growth in utility privatization
           contracts, we reviewed cost changes in the five utility
           privatization contracts at the installations we visited, discussed
           the reasons for the changes with local officials, and compared the
           actual contract costs with estimates from the projects' economic
           analyses. We also reviewed cost changes in the Fort Rucker natural
           gas privatization contract because, according to the services, it
           was the only contract awarded under the legislative authority
           specifically provided for utility privatization that had completed
           a periodic price adjustment. To assess the effect of DOD's changes
           on cost avoidance estimates from privatization, we reviewed the
           estimates DOD reported to Congress to determine whether the
           estimates reflected the actual changes expected in the
           government's utility costs.

           We conducted our review from March through July 2006 in accordance
           with generally accepted government auditing standards.

Appendix II: Comments from the Department of Defense

Note: GAO comments supplementing those in the report text appear at the
end of this appendix.

See comment 1.

See comment 4.

See comment 3.

See comment 2.

See comment 5.

             GAO's Response to the Department of Defense's Comments

           The following is our detailed response to the Department of
           Defense's (DOD) comments provided on August 21, 2006.

           Our responses to DOD's comments are numbered below to correspond
           with the department's various points. 
			  
                        1. As noted in this report, we identified concerns
                        with the independent review performed on each of the
                        10 economic analyses we reviewed. We did not attempt
                        in this report to prove that the questionable items
                        we identified with each analysis would have changed
                        the proposed outcomes but noted that improvements are
                        needed in the thoroughness of the independent reviews
                        that will be performed on future projects. Until DOD
                        requires independent reviewers to report to decision
                        makers on the thoroughness of the economic analyses
                        and any significant anomalies, we continue to believe
                        the reliability of the analyses could be questioned.
                        As outlined in our May 2005 report and this report,
                        to ensure a valid comparison of costs we continue to
                        believe that the government's "should cost" estimate
                        should be closely based on performing the same work
                        that the contractor would perform.
                        2. Our report does not suggest that postconveyance
                        reviews should be conducted prematurely as indicated
                        by DOD in its comments. The fact is that the utility
                        privatization contracts under 10 U.S.C. 2688
                        authority began to be awarded in 1999, about 7 years
                        ago, and postconveyance reviews do not appear to have
                        been performed on many ongoing utility privatization
                        contracts since that time. Although DOD noted in its
                        March 2006 report the importance of postconveyance
                        reviews as an additional measure to help ensure
                        reliable economic analyses, it has not issued
                        guidance to require the services to perform such
                        reviews.
                        3. Our report clearly shows that Air Force officials,
                        not GAO, stated that without additional resources,
                        funding for utility privatization contracts must come
                        from other base operating support funds, which would
                        result in diverting critical resources from remaining
                        facilities and infrastructure.

                        Furthermore, DOD's comment that utility sustainment
                        funds have been used for other base support
                        operations in the past only reinforces the need to
                        address the utility privatization program potential
                        funding shortfall. We have completed a number of
                        reviews in which we have identified examples where
                        the shifting of operation and maintenance funds from
                        one account to other accounts to fund must-pay bills
                        and other priorities contributes to management
                        problems and funding shortfalls. For example, in
                        February 2003, we reported that the services withheld
                        facilities sustainment funding to pay must-pay bills,
                        such as civilian pay, emergent needs, and other
                        nonsustainment programs, throughout the year and
                        transferred other funds back into facilities
                        sustainment at fiscal year's end.1 Still, the amounts
                        of funds spent on facilities sustainment were not
                        sufficient to reverse the trend in deterioration. In
                        June 2005, we reported that hundreds of millions of
                        dollars originally designated for facilities
                        sustainment and base operations support had been
                        redesignated by the services to pay for the Global
                        War on Terrorism.2 While installations received
                        additional funds at the end of the fiscal year to
                        help offset shortfalls endured during the year, the
                        timing made it difficult for the installations to
                        maintain facilities and provide base support services
                        efficiently and effectively. Similarly, unless the
                        potential funding shortfall in the utility
                        privatization program is addressed, funding will
                        likely have to be redesignated to fund the utility
                        privatization program rather than be used for its
                        intended purpose.

                        4. Our report raises concerns about the adequacy of
                        the services' oversight of several privatization
                        contracts that were awarded prior to DOD's November
                        2005 supplemental guidance. Given that the Office of
                        the Deputy Under Secretary of Defense (Installations
                        and Environment) has overall policy and management
                        oversight responsibilities for the utility
                        privatization program, we continue to believe that
                        this office is the appropriate level for providing
                        direction and assurance that utility privatization
                        contracts awarded prior to the supplemental guidance
                        have adequate resources and contractor performance
                        surveillance plans, as we recommend.
                        5. Our report highlights the importance of monitoring
                        cost growth because contractors have ownership of the
                        utility systems after privatization and, therefore,
                        may have an advantage when negotiating contract
                        changes and renewals. In addition, controlling the
                        potential growth in the cost of ongoing utilities
                        privatization contracts is important to the services
                        in their planning for the adequate funding of the
                        program. We did not review the effect of contract
                        cost growth on the government estimate because the
                        government estimate is not a relevant factor in
                        controlling costs once a system has been privatized.
                        Although a comparison of actual costs of a
                        privatization project with the estimates included in
                        the project's economic analysis is a useful tool to
                        help improve the reliability of analyses of future
                        privatization projects, it is unlikely that such
                        comparisons would assist in controlling cost growth.

                        Furthermore, DOD's comment refers to a "savings
                        delta." As noted in our May 2005 report and again in
                        this report, in the short term it is clear that the
                        utility privatization program increases annual costs
                        to the department where contractors make system
                        improvements and recoup their costs through the
                        service contracts.
			  
Appendix III: GAO Contact and Staff Acknowledgments

           GAO Contact
			  
			  Barry W. Holman, (202) 512-5581 or ( [email protected] )

           Acknowledgments
			  
			  In addition to the person named above, Susan C. Ditto, Harry A.
           Knobler, Katherine Lenane, Mark A. Little, Gary W. Phillips,
           Sharon L. Reid, and John C. Wren also made major contributions to
           this report.

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18Air Force officials stated that four additional utility privatization
contracts were previously eligible for periodic price adjustment but no
adjustment was made because neither the contractor nor the government
requested an adjustment.

19Pub. L. No. 109-163, S: 2823 (2006).

1GAO, 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).

2GAO, Defense Infrastructure: Issues Need to Be Addressed in Managing and
Funding Base Operations and Facilities Support, GAO-05-556 (Washington,
D.C.: June 15, 2005).

(350812)

www.gao.gov/cgi-bin/getrpt? GAO-06-914 .

To view the full product, including the scope and methodology, click on the link above.

For more information, contact Barry W. Holman at (202) 512-5581 or
[email protected].

Highlights of GAO-06-914 , a report to congressional committees

September 2006

DEFENSE INFRASTRUCTURE

Actions Taken to Improve the Management of Utility Privatization, but Some
Concerns Remain

Department of Defense (DOD) installations have about 2,600 electric,
water, wastewater, and natural gas utility systems valued at about $50
billion. In 1997, DOD decided that privatization was the preferred method
for improving utility systems, and Congress approved legislative authority
for privatizing DOD's utility systems with Public Law No. 105-85. DOD
estimates that some utility privatization contracts will cost over $100
million. In a May 2005 report, GAO identified several management
weaknesses in DOD's implementation of the program.

The Fiscal Year 2006 National Defense Authorization Act required GAO to
evaluate and report on changes to the utility privatization program since
May 2005. Accordingly, this report updates the status of the program and
discusses the effect of DOD's changes on the concerns noted last year. To
conduct this review, GAO summarized program status and costs, assessed
DOD's changes to program guidance and in other areas, and reviewed the
services' implementation of the changes.

What GAO Recommends

GAO is making seven recommendations to improve the management of the
utility privatization program. DOD generally agreed with six and indicated
disagreement with one recommendation. Still, GAO believes this
recommendation continues to have merit.

DOD's progress in implementing the utility privatization program has been
slower than expected and the estimated completion date has slipped from
the department's target of September 2005 to September 2011. DOD
attributed the delays to the complexity of the program and to the
services' decision to suspend and reassess the management of the program
between October 2005 and March 2006. Since May 2005, the services
privatized 14 utility systems under the legislative authority for the
program, bringing the total number of awarded projects to 81. However, the
services have awarded no projects since DOD issued new program guidance in
November 2005. Meanwhile, the services' total estimated program
implementation costs through fiscal year 2006 have increased to $285
million, and more funds will be required before the program is completed
in 2011.

Since GAO's May 2005 report, DOD has issued new guidance and required
changes in procedures. If fully implemented, these changes should result
in more reliable economic analyses, improved budgetary consideration of
increased utility costs, enhanced oversight of privatization contracts,
and reduced instances where contractors recover more than the fair market
value paid for system conveyances. However, a number of concerns from the
May 2005 report remain. For example:

           o  Although DOD made changes to improve the reliability of project
           economic analyses by requiring independent reviews, GAO reviewed
           10 economic analyses and found reliability issues that had not
           been identified during the independent reviews.
           o  DOD directed the services to adequately consider in their
           budgets the increased costs resulting from utility privatization.
           However, questions remain over the availability of the funds
           needed to complete the program because the services estimate that
           they will need $453 million more than is currently programmed to
           pay costs associated with remaining utility systems that might be
           privatized.
           o  Although DOD made many changes to improve contract
           administration and oversight, it may take some time to fully
           implement the changes as new privatization contracts are awarded.
           GAO's review of five projects awarded prior to DOD's changes found
           continuing questions about the adequacy of resources provided to
           perform oversight and the lack of required plans for overseeing
           contractor performance.
           o  It is too early in the program's implementation to know to what
           extent DOD's efforts will be successful in ensuring equitable
           periodic contract price adjustments and limiting long-term cost
           growth in the utility privatization program. However, GAO found
           indications that cost growth may become a challenge.
           o  DOD did not change its guidance to require that project
           economic analyses depict the actual expected costs of continued
           government ownership if the systems are not privatized. Therefore,
           DOD's reported $650 million in long-term cost reductions is
           unrealistic.
*** End of document. ***