DEPUTY SECRETARY OF DEFENSE 1010 DEFENSE PENTAGON WASHINGTON, DC 20301-1010

23 DEC 1998

SUBJECT: Department of Defense Reform Initiative Directive #49 - Privatizing Utility Systems

      As you know, Defense Reform Initiative Directive (DRID) #9 directed the Military Departments to develop plans for privatizing electric, water, waste water, and natural gas utility systems, and required the Under Secretary of Defense for Acquisition and Technology (USD(A&T)) to develop uniform criteria for the Military Departments to apply in determining security and economic exemptions from this directive. The purpose of this DRID is to reset the goal for this initiative, establish the approach to its management and oversight, and convey guidance for assessing exemptions, conducting the divestiture of utility assets using competitive procedures, and performing economic analyses of the transactions.

      Since issuing DRID #9, both the number of utility systems available for consideration and the complexity of issues surrounding these transactions have multiplied. As a result the Military Departments should now revise their plans to accommodate award of privatization contracts for all utility systems no later than September 30, 2003 (except those exempted in accordance with the attached guidance). To ensure progress towards the new utility privatization goal, these new plans should also adhere to two interim milestones. The first requires the completion by September 30, 2000 of a determination for all systems of whether or not to pursue privatization. The second interim milestone requires all solicitations to be released no later than September 30, 2001.

      The Military Departments shall submit revised plans for utility privatization to the USD(A&T) no later than December 23, 1998. These plans shall provide an inventory of all utility systems, including those proposed for exemption, as well as a management plan that indicates the schedule on which each system will reach key milestones - synopses/Notice of Intent, study complete, solicitation, and contract award. The USD(A&T) will complete and submit to me an initial assessment of those plans no later than January 22, 1999.

      Thereafter, the Military Departments will submit quarterly reports to the USD(A&T) describing each system's progress through the milestones. The first will be due April 15, 1999 with data as of March 31, 1999. The reports should also address to the USD(A&T) issues identified during privatization studies conducted in the previous quarter. These issues should include proposals to improve efficiency and eliminate barriers to effective privatization.

      Success in this initiative will require innovative business approaches. To foster one such innovation, I encourage the Military Departments to work with one another and the Defense Energy Support Center (DESC) to initiate during 1999 at least one joint, regional utility privatization plan. The purpose of this pilot will be to provide the Military Departments an opportunity to utilize DESC services while exploring the promise of some alternative approaches to conducting these divestitures.

      The attached guidance governs the privatization of electric, water, waste water, and natural gas utility systems as directed by the DRI. It sets forth the criteria for exempting systems from the privatization program, for using competitive procedures, and for conducting the economic analyses. Utility privatization will be pursued at all major and minor installations worldwide not previously designated for closure by the Base Realignment and Closure Act. While some exemptions may be necessary, they should be rare and taken only under the authority of the Secretaries of the Military Departments. The use of competitive procedures, which already is required by statute (CICA and Section 2688), is reiterated in the guidance. The guidance establishes how the economic analyses should account for the costs of operations, maintenance, and system improvements that would be incurred by the Department if the systems were operated and maintained at accepted industry standards.

      Finally, the USD(A&T) should work with the Military Departments to determine the necessity of legislative relief from two obstacles: the 10-year limitation on utility service contracts and the tax treatment of utility system conveyances.

      While utility privatization presents several tough challenges it also offers great opportunities. I expect the Military Departments to work privatization hard, finding those business innovations that will garner the maximum benefit for the Department and the American taxpayer.

John J. Hamre

Attachment

Attachment

PRIVATIZATION OF DEFENSE UTILITY SYSTEMS

I. PURPOSE

Section 2688 of title 10, United States Code, provides to the Secretary of a Military Department authority to convey all Defense utility systems, including electric, water, waste water, and natural gas, as well as steam, hot and chilled water, and telecommunications systems. The Defense Reform Initiative (DRI) stated that the Department of Defense (DoD) would privatize all electric, water, wastewater, and natural gas utility systems, except where privatization is uneconomical or where unique security reasons require ownership by the Department. While the DRI did not specifically direct the privatization of steam, hot and chilled water, and telecommunications at this time, it does not prohibit such privatization. The DRI's objective is to get DoD out of the business of owning, managing, and operating utility systems by privatizing them. Defense Reform Initiative Directive (DRID) #9 required the Under Secretary of Defense (Acquisition and Technology) to establish guidance for the privatization of electric, water, waste water, and natural gas utility systems. This document provides that guidance.

II. SCOPE

A. Definitions

1. A "utility system" means any system for the generation and supply of electric power, for the treatment or supply of water, for the collection or treatment of wastewater, and for the supply of natural gas. For the purpose of this definition, supply shall include distribution. A utility system includes equipment, fixtures, structures, and other improvements utilized in connection with the systems described above, as well as the easements or rights-of-way associated with those systems. A utility system does not include any projects constructed or operated by the Army Corps of Engineers under its civil works authorities nor does it include any interest in real property other than an easement or right-of-way associated with the utility system.

2. "Secretary" refers to the Secretary of the Military Department that has jurisdiction over the utility system.

3. "Military Department" or "Department" refers to the Department that has jurisdiction over the utility system.

B. The Military Departments are authorized to convey a utility system to any municipal, private, regional, district or cooperative utility company or to any other entity under this authority in accordance with applicable state and local laws. In the case of overseas utility systems, privatization will comply with appropriate agreements and applicable host nation laws.

C. The privatization of utilities and utility systems is to be conducted at all installations, both in the United States and overseas, that have utility systems available to convey. All Active Duty, Reserve, and Guard installations, both major and minor, not currently designated for closure under the Base Realignment and Closure (BRAC) Act, will be considered candidates for utility system privatization. BRAC closure constitutes privatization of the entire installation to include utility systems. All BRAC designated installation closures will be transferred/privatized in accordance with appropriate closure laws and agreements.

D. While 10 U.S.C. 2688 governs the privatization of the utility system, the acquisition of utility services, even when a part of the privatization, is governed by 40 U.S.C. 481 and FAR Part 41.

III. EXEMPTIONS FROM PRIVATIZATION

A. The DRI exempts from privatization those utility systems that would be uneconomical to privatize, or those for which unique security reasons exist not to privatize.

B. Unique Security Reasons

1. A utility system is exempt from the privatization requirement set out in DRID #9 when either the Secretary concerned or the Principal Staff Assistant for a Defense Agency certifies to the Under Secretary of Defense (Acquisition & Technology) that unique security reasons require that the United States own the system.

2. "Unique security reasons" are situations in which:

a) ownership of the utility system by a private utility or other entity would substantially impair the mission of the Department concerned; or

b) ownership of the utility system by a private utility or other entity would compromise classified operations or property

C. Privatization is Uneconomical

1. A utility system is exempt from the privatization requirement set out in DRID #9 when either the Secretary concerned or the Principal Staff Assistant for a Defense Agency certifies to the Under Secretary of Defense (Acquisition & Technology) that privatization is uneconomical.

2. Privatization may be considered "uneconomical" only when:

a) there is a demonstrated lack of market interest, as indicated by a lack of response from any utility company or other responsive and responsible entity to an announcement of the intention to privatize; or

b) the long-term cost to the Department as a result of privatization would be greater than the long-term benefits; or

c) the long-term cost to the Department for utility services provided by the utility system concerned will not be reduced.

IV. COMPETITIVE PROCEDURES

Competitive procedures will be used in conducting the privatization of utility systems. In advance of issuance of the solicitation, the Military Departments must determine whether there is market interest in acquiring the utility system. The Departments should synopsize in the Commerce Business Daily (normally by publishing a notice of intent) and other available public media. The synopses shall indicate that the Department is considering privatizing its utilities, state the type and location of those utilities, and request that interested parties communicate their interest to a specified point of contact within the Department concerned. The synopses' results will form the basis of the competition analysis necessary for the Department to determine the proper competition strategy.

     If the installation resides in an area served by a franchised and regulated utility, that franchise holder shall not be considered the presumptive conveyee, nor shall another responsible and responsive utility or entity that expresses interest be excluded from the competition. State law and regulatory policy should be considered when determining the form of competition for franchised and regulated utilities. Where state law and regulatory policy specifically prohibits competition, a sole-source negotiation may be pursued after evaluating response to the synopses. The Military Department, however, may not rely on the assertions of the franchised or regulated utility in this regard. Rather, it must make an independent legal finding that the franchised or regulated utility is the only entity authorized to own and operate the utility system to be privatized.

A. The competitive procedures must ensure that the utility services resulting from privatization are sufficient to support installation missions in a reliable and resource efficient manner.

B. Military Departments should consider how different regulatory environments might affect the determination of rate structures for any utility service contracts entered into beyond the end of the initial utility service contract. Special consideration should be given when contracting with a utility or other entity that is not subject to price regulation or that is price self-regulated. The non- or self- regulated environment may present considerable barriers to ensuring the strength of the Department's negotiation position for the follow-on service contract. The Department shall contract in a manner that will mitigate the risk it bears in subsequent contracts. Some risk mitigation methods to consider include: contractually establishing a regulatory scheme in the initial conveyance/service contract, retaining actual land ownership, and conveying a lesser estate as considered appropriate by the Secretary and as authorized by Section 2688.

C. The solicitation shall require that if the utility system under consideration for privatization will continue in operation after conveyance, the recipient shall take all actions necessary to ensure that the system complies with all applicable legal and regulatory requirements. If the utility system under consideration for privatization will instead be replaced, the new system must also comply with the above requirements.

D. The solicitation shall contain a provision plainly stating that the Department cannot guarantee that it will enter into a contract at the end of the solicitation process. The provision must express that the success of the solicitation is contingent upon the ability to certify to Congress that the long-term economic benefit of the conveyance exceeds the long-term economic costs, and that the conveyance will reduce the long-term costs to the Department concerned for utility services provided.

E. The Military Departments shall conduct all utility privatizations consistent with all other applicable legal and regulatory requirements, including any environmental analysis requirements.

F. After determining that privatization is uneconomical or is precluded by security considerations, efforts should be made to award an Energy Savings Performance Contract (ESPC), to competitively source the operation of those systems, or pursue other cost savings measures.

V. CONGRESSIONAL NOTIFICATION REQUIREMENTS

Section 2688 of title 10 requires that the Secretary concerned submit to the Defense Committees of Congress an analysis that demonstrates that the long-term economic benefit of the conveyance exceeds the long-term economic cost, and that the conveyance will reduce the long-term costs to the Department concerned for utility services provided by the subject utility system. The Secretary concerned shall not proceed with conveyance of the utility system until 21 days have elapsed after the committees receive the economic analysis.

A. The economic analysis must take into account the costs for operation, maintenance, and system improvements that would be incurred by the Department if the systems were operated and maintained in accordance with accepted industry practice and all applicable legal and regulatory requirements. The direct proceeds (if any) from a conveyance and the future cost of utility services to be obtained if the conveyance is made must also be considered.

B. Methodological Assumptions and Parameters

1. The basic parameters involved in the economic analysis, such as economic life and period of analysis, are those specified in DOD Instruction 7041.3. Other parameters shall also be included in the analysis, if necessary. All parameters should be clearly explained and justified.

2. For the purposes of the economic analysis, "long-term" refers to the economic life of the utility system under consideration for privatization. (Note: Economic life of the utility system under consideration for conveyance need not be the same as the life of the contract for utility services.)

3. Life-cycle cost analysis shall be treated/conducted as specified in OMB Circular A-94.

a) Should a general inflation assumption be necessary, the inflation rate specified in section 7 of Circular A-94 is recommended. This shall be the rate used in converting costs and benefits from real to nominal values, and vice versa.

b) The discount factor utilized in the economic analysis shall be as described in section 8 of Circular A-94 and as specified in Appendix C of the circular. While the real discount rate is usually preferable, if future benefits and costs are given in nominal terms, then the nominal rate shall be used. Real and nominal values may not be combined in the same analysis.

4. Since the actual costs that the Department concerned incurs in operating and maintaining its utility systems may reflect inadequate maintenance and condition, the economic analysis must include the costs that should be incurred if the systems were operated and maintained in accordance with all applicable legal and regulatory requirements. The object of this approach is to bring a degree of parity to the costs reflected in the proposals and the economic baseline survey developed by the Department.

VI. FINANCIAL MANAGEMENT

A. Section 2688 of title 10 requires the recipient utility or entity to pay fair market value, as determined by the Secretary concerned, for the utility system. This consideration for the conveyance may be accepted in the form of a lump sum payment or a reduction in charges for utility services provided by the utility being conveyed to the military installation at which the system is located. The treatment of a lump sum payment received in consideration for the sale of a utility system should be handled in accordance with procedures described in the Financial Management Regulations (FMR).

B. If the Secretary concerned elects to receive consideration through a reduction in charges for utility services provided to the military installation, the time period for reduction in charges for services provided by the privatized utility shall not be longer than the life of the contract for utility services.

C. When structuring an arrangement for privatization of a utility system, the Secretary concerned may require additional terms and conditions as a part of the sale of the utility system as he or she considers appropriate to protect the interests of the United States.