Share-in-Savings IT Contracts Requires Close Look

Both Rep. Tom Davis, R-Va., and Sen. Joseph Lieberman, D-Conn., have said they are examining new inducements to federal agencies to engage in share-in-savings IT service contracts as part of an additional round of acquisition reform legislation. The House Government Reform subcommittee on technology and procurement policy, chaired by Davis, held a hearing late last month that included testimony from Steven Kelman, former Office of Federal Procurement Policy administrator, and others who support share-in-savings service contracts. Kelman urged Congress to establish share-in-saving contracts as a contract type under federal acquisition regulations and to allow multiyear information technology outsourcing contracts without requiring previous funding of government termination liabilities. Both steps are necessary to induce vendors to incur the start-up costs and to provide vendors the opportunity to earn a share of promised savings benefits. The goal of share-in-savings contracts is laudable: provide government agencies with a stake in the savings that may be achieved when vendors supply commercial IT services to government agencies. The assumption is that outsourcing government IT services to contractors using commercial practices will save IT dollars. Whether such savings actually are achieved in implementing share-in-savings contracting is a complex issue. As OFPP Administrator Angela Styles said in her confirmation hearing last month, there has not been any serious examination of whether the implementation of commercial-like procurement practices in the last decade actually has improved competition and fairness in government procurement. An instructive analog to share-in-savings IT service contracts may be found in the energy demand reduction services contracts that have been awarded by the General Services Administration, Defense Department and other agencies for many years. Under these agreements, agencies may enter into contracts for up to 25 years with public utilities to obtain energy conservation engineering services, energy conserving machinery, energy control upgrades and facilities improvements. The improvements provided by public utilities must generate monthly cost savings that are greater than the amortized cost of the improvements over the term of the contract. The public utilities also may participate in the savings achieved. On the surface, this would appear to be a bargain for the government. The agency reduces its energy consumption and obtains facilities upgrades at a total cost less than its current energy consumption cost. In actual practice, the cost savings may be illusory. First, it is common for the public utility to fund the conservation services and improvements by discounting its government payment stream to a commercial bank or factor, a company that purchases accounts receivable. In order to recover a respectable profit on the services and improvements, the public utility increases the cost of the services to cover the discount. This financing cost is included in the price of the goods and services sold to the agency, and is included in the government's monthly payment over the 10-year term of the contract. Thus, in effect, the government ends up financing its purchase of energy conservation goods and services at commercial bank lending rates, rather than at the government's much lower cost of funds. The government's monthly payment for energy plus energy demand reduction services may be less than it's old monthly bill for energy alone, but not necessarily less than it would be if the government had simply purchased the demand reduction services outright using government debt. Second, to obtain commercial financing of long-term government demand reduction services contracts, the commercial lender must be satisfied that its payment stream is secure. Because the contracts require that the services be paid out of the energy cost savings, it is essential for the contractor to lock in the imputed savings, and thus the government's payment obligation, in order to give the lender the security that it demands. The only way this can be accomplished is to base the government's savings on a variety of engineering calculations and assumptions about energy costs that may or may not prove out in practice. To my knowledge, there has never been a careful study made to determine whether the imputed energy cost savings that underlie these long-term contracts actually are achieved. The General Accounting Office studied energy demand reduction programs several times in the last 10 years and concluded that cost-effectiveness of the programs was difficult to determine because the data was difficult to correlate. The point here is not that share-in-savings IT services contracts are a bad idea. They may, in fact, produce significant savings for government agencies and powerful incentives for service providers to improve the efficiency of their IT services to government customers. The challenge is to design share-in-savings IT contracting methods that adequately quantify real savings achieved by efficient outsourcing contractors over a lengthy contract term in the real world and do not rely on ephemeral savings assumptions. Jonathan Cain is a member of the law firm Mintz Levin Cohn Ferris Glovsky & Popeo PC in Reston, Va. The opinions expressed in this article are his. He can be reached by e-mail at jcain@mintz.com.