REPORT ON STEAM PLANT CONTRACT UNIVERSITY OF RHODE ISLAND

REPORT ON STEAM PLANT CONTRACT UNIVERSITY OF RHODE ISLAND EXECUTIVE SUMMARY The Office of Higher Education (OHE) Internal Audit Department (IAD) reviewed the steam services contract between the University of Rhode Island (URI) and ERI Services, now Energy Infrastructure (EI), to determine if the terms of the contract have been complied with and to evaluate the effectiveness of the university s oversight. Three areas of contract administration could be improved. URI s review proces did not detect anerror in the billing formula and the consumer price index (CPI) used in the vendor s initial invoice. These errors, over time, caused overcharges, including interest, of about $276,000 as of February 2005 on the university s fiscal years 2000-2004 contract billings. URI has since settled the overcharges, including interest, with the contractor. Improved contract language could beter protect the university s interests and should be considered in future contracts. The contractor s audited financial statements have not been reviewed, as required, to monitor the contractor s financial stability. In addition, we believe that it would be advantageous for URI to benchmark steam plant operating costs and procedures against a similar steam plant operated by the Department of Mental Health, Retardation, and Hospitals (MHRH). This would provide a reasonableness check on billings to URI and may identify potential savings and improvements for both operations. We have discussed our findings and recommendations with URI management and believe the improvement actions they have planned or executed should resolve the issues. Full details of the findings, recommendations, and management responses are contained in the DISCUSSION section. OBJECTIVES AND SCOPE The objective of the review was to determine whether EI complied with the contract terms and to evaluate the efectivenes of the university s monitoring system. The scope of the review included reviewing the contract terms, interviewing cognizant personnel, recalculating monthly invoices and support documentation, analyzing financial statements, and evaluating insurance coverage. The focus was on fiscal years 2000 through 2004 transactions. 1

BACKGROUND Prior to November 1999, URI owned and operated its own cogenerated steam plant on the Kingston campus. During 1996, 1997 and 1998, the University was operating the plant using rental boilers, due to the existing plant not meeting EPA emission requirements. In the mid-1990 s the existing plant was deemed inadequate and a decision was made to build a new plant on the existing site and use an outside contractor to operate it. The University requested competitive bids on total costs for the first year of operation for the proposed new plant at an operating level of 380,000 mlbs (thousand pounds) of steam. This provided a common basis of comparison for each bidder on the theoretical annual operating cost. Six qualified bids were received. ERI Services submitted the lowest bid, $4,048,000. The next lowest bid was $4,607,000 with the remaining bids ranging up to $5,500,000. The structure of the bid was subject to expert review and was re-bid three times before a bid was accepted. On May 21, 1998, the university entered into a development and a steam service agreement with ERI Services, now Energy Infrastructure, a subsidiary of EQT Investments, which is in turn a subsidiary of Equitable Resources. Expert outside counsel was consulted during the drafting of the contract. On October 31, 2003, EQT became the guarantor under the contract. Under the agreement, the seller is required to deliver and the university is required to purchase al of the university s steam requirements up to the total operating capacity of the plant for twenty years, through FY 2019. The seller is responsible for the costs of operating the facility and for making such additional repairs to the steam distribution system as directed by the university at a cost of up to $1.5 million. The agreement states that if EI is unable to supply 320,000 mlbs of steam annually, the original anticipated demand, the university may purchase steam from any other source. EI cannot sell steam produced at the facility to any party other than URI without prior consent from the university. Each year, the actual consumption of steam is recorded and a year-end adjustment is made to assure that the operations and maintenance (O&M) costs are addressed. The university is required to pay: A capacity charge to repay steam plant construction bonds For fuel consumed An operations and maintenance charge The capacity charge is fixed at $108,000 per month for the life of the contract. On May 15, 1999, the RI Economic Development Corporation (EDC) issued $16,395,000 in bonds and made the proceeds available to ERI Services to fund the construction of the steam plant. On June 3, 1999, the University, ERI Services, EDC, and the Chase Manhattan Bank, as bond trustee, entered into an agreement obligating the university to 2

make payment of the capacity charge directly to the Trustee for bond repayment. Ownership of the plant reverts to URI after the contract with ERI Services expires. The fuel charge is based on actual consumption at New York Mercantile Exchange (NYMEX) commodity index prices on the 25 th of each month, plus applicable transportation charges. The O&M charge is a fixed charge per mlb of steam, adjusted annually for increases in the consumer price index (CPI), allocated on annual deliveries of 320,000 mlbs of steam. The charge includes actual operating and maintenance expenses such as labor, overhead, services, and supplies as wel as the contractor s profit margin. The tables below show steam consumption and costs for fiscal years 1995 through 2003. Year mlb s of steam used Variable Production Costs (Fuel) Period of ERI Contract O&M costs per the bid formula and CPI Capacity Charge (Debt Service) Total Cost Cost($) per mlb of steam 2003 253,838 $2,568,229 $1,028,153 $1,296,000 $4,892,382 $19.27 2002 230,587 $1,254,849 $1,007,569 $1,296,000 $3,558,418 $15.43 2001 225,217 $2,222,418 $958,472 $1,296,000 $4,476,890 $19.88 2000 246,407 $1,376,726 $818,265 $1,296,000 $3,490,991 $14.17 1999 261,111 0 $1,304,299 0 $1,304,299 $5.00 Year Mlb s of steam used Variable Production Costs (Fuel) Prior to ERI Contract O&M costs Capacity Charge Total Cost Cost($) per mlb of steam 1998 299,151 $1,085,395 $1,067,972 0 $2,153,367 $7.20 1997 290,586 $1,574,572 $915,750 0 $2,490,322 $8.57 1996 250,376 $1,375,098 $936,230 0 $2,311,328 $9.23 1995 257,960 $971,531 $1,022,496 0 $1,994,027 $7.73 Steam consumption grew rapidly during the 1995-1998 period and then dropped during the 1999-2002 period, despite considerable capital expansion on the campus. The prime reasons for this were continuing improvements in the campus steam distribution system and in energy conservation in new and renovated buildings. Steam cost increased from $7.73 per mlb in fiscal year 1995 to $19.27 per mlb in fiscal year 2003. The primary reasons for the increased cost were higher fuel charges, up 264% during the period, and the additional annual capacity charge of $1.3M. O&M costs fell sharply when the new plant went on line in fiscal year 2000. In fiscal year 2003, they were virtually identical to fiscal year 1995, despite inflation over the intervening eight years. The spike in O&M costs in fiscal year 1999 was attributable to ERI operating the plant on a fixed cost basis at $4.40/mlb of steam, including O&M and fuel. Operation of 3

satellite boilers needed at various buildings until the new steam distribution system was functional are also included in the above 1999 O&M costs. DISCUSSION Contract Billings URI s review of EI s steam plant O&M billings for FY2001 did not detect a calculation error that was subsequently carried forward through FY2004. The review process also did not detect the application of an incorrect CPI in FY2000. As a result of these oversights, URI overpaid EI about $276,000, including interest. According to the formula in the contract, the contractor is allowed to charge $2.80 per mlb up to 300,000 mlbs annually and $.25 per mlb for steam above that level to a total of 320,000 mlbs. This convention was adopted to allocate all of the O&M costs in the successful bid in a consistent manner over time. It was not intended to necessarily reflect actual usage in any specific year. EI incorrectly charged the university $2.80 per mlb for 320,000 mlbs of steam for each year. The additional and incorrect charge of $2.55 on the 20,000 mlbs over the 300,000 mlbs base number was not detected by the university s contract review proces. The contract also requires any overpayment to be refunded with interest. During settlement negotiations, both parties agreed to a 5% interest rate on overpayments. As a result, the EI overcharge was $269,422 ($245,158 plus interest of $24,264) as of February 2005. In addition, EI used the July 2000 CPI of 175.3 instead of the contract June 2000 CPI of 174.2 to calculate the O&M charge for fiscal year 2000. This resulted in an overpayment of $6,256 ($5,124 plus interest of $1,132) as of February 2005. Since the completion of our fieldwork, URI has revised its billing review procedures and recovered the value of the FY2004 adjustment overpayment. URI also has a written agreement with EI to repay the remaining overcharges and interest in three equal payments between March 1, 2005 and June 30, 2005. Recommendation None required. URI actions have resolved the issue. Contract Terms Some terms of the steam contract, as curently writen, may not adequately protect URI s interests, appear ineffective, or are unclear. To the extent possible, URI should attempt to renegotiate these terms. Issues noted with current contract terms should be considered when writing future contracts. 4

The bidding process identified the lowest cost vendor for the first year on a lump sum basis given certain operating assumptions. The contract was written based on the winning proposal s first year cost estimates. While two of the three categories of cost in the contract, capacity and fuel charges, are based on actual costs, the third category, O&M costs, is not. The contract reimburses the vendor for O&M, including profit margin, after the first year of operations, based on a CPI figure rather than actual costs and an agreed profit. The intent of this O&M formula was to provide for a mutual assumption of risk between URI and the contractor. If costs exceeded the CPI based figure, URI would be protected. If costs were less than the CPI figure, the contractor profited. Under these terms, it is difficult to determine over a twenty-year contract how reasonable the O&M costs, including contractor profit. A more controlled approach in future contracts would be to define the contractor s profit in the contract separate from actual, reasonable costs and provide a sharing mechanism for any cost savings or overruns. This could be a driver for operational efficiencies and overall lower costs. The contract also allocates O&M charges on an annual base of 320,000 mlbs of steam production. While this was intended to be a consistent convention to allocate O&M charges, questions may arise how O&M charges will be handled when and if actual steam production exceeds the 320,000 mlb figure. Through fiscal 2004, the highest steam production total has been 263,072 mlbs. However, the plant has a capacity to produce 600,000 mlbs of steam annually and capital expansion is driving the university s steam requirements higher. The university should determine how it will handle this contingency and whether it should negotiate any amendment to existing contract language. In addition, for future contracts, the use of actual costs and a fixed profit should be considered in lieu of the current fixed allocation convention. Without a break down of actual O&M costs and a specified definition of allowed contractor profit, URI has only limited means, e.g., market comparisons, to judge the reasonableness of contractor charges after the first year of operations. The University believes that the total O&M costs would have been essentially the same for any level of steam generation up to the 320,000 mlbs of steam pound take point and, therefore, the reduced steam usage did not increase total O&M costs. We did not have the expertise to determine whether this argument is technically correct. However, since the contract already reimburses al of the contractor s operating costs, if a fixed fee profit provision had been included in the contract, there would seem to be no need for the take or pay provision. The contract includes a provision for sharing cost savings on fuel procurements and terms for meter readings for billings. The provisions for cost savings on fuel procurements have been ineffective. EI monthly fuel costs, the major component of its overall billing, are based on NYMEX commodity index prices on the 25 th of each month plus applicable transportation charges, 5

as provided for in the contract terms. The contract also provides that if EI is able to purchase fuel at rates below the NYMEX rate, EI and URI will share in the savings equally. However, EI has never attempted to manage or reduce fuel through hedging, long-term purchasing agreements, etc., despite some apparently favorable market periods. Future contracts of this type should consider requiring the contractor to actively pursue such cost savings and present them to URI for approval. The contract is also unclear about which reading to use when determining the accuracy of meters used to provide billing data. According to EI, the contract requires that each meter s accuracy be within 1% of the actual daily reading instead of the ful range reading of the meter as required by the industry standard. An adjustment is made if a meter is found to be inaccurate by 1% or more. EI found some of the daily readings to be inaccurate by more than 1% between May 2002 and August 2003. As a result, EI believes that URI owes EI for the variances. Recommendation #1 In future, long-term contracts, URI should consider basing all allowable charges on actual, reasonable costs and an agreed upon profit rather than using broad based cost indices such as the CPI. Concur. Recommendation # 2 URI should seek to amend the contract to: Encourage savings in fuel purchasing Require use of the industry standard to determine meter accuracy URI is currently seeking an amendment to the contract to incorporate the ability to pre-purchase fuel in a mutually agreeable arangement with ERI. This amendment will also incorporate the change in wording to use the industry standards for determining meter accuracy. This is currently in draft form and is being reviewed by the University. It is expected to have an amendment in place by July 1, 2005. Financial Statement Review The contract requires EI to provide annual audited financial statements for the university s review. Such a review is a prudent busines practice to monitor the ongoing financial stability of the provider of a critical service. The university has not analyzed EI or its parent financial statements since the inception of the contract. Our analysis of the parent (EQT Investments) financial statements for the year ended December 31, 2003 raised several significant questions. EQT Investments had a weak.73 current ratio, a negative working capital, and no cash on hand. The university needs to determine 6

whether these are symptoms of significant financial problems or can be explained by the financial statements of the ultimate corporate entity, Equitable Resources. Recommendation #3 As part of its contract review process, URI should analyze the financial statements of EQT Investments and Equitable Resources on a yearly basis as a means of monitoring the contractor s financial stability. The university receives annual financial statements from EQT Investments, LLC for the previous operating year, during the month of April. In the future, Facilities Services will copy, review and forward these documents to the University business office for annual financial review by the University. Operational Efficiency URI should consider colecting EI s charges for variable costs (fuel, transportation, and operational and maintenance costs) and benchmarking them against similar charges at MHRH s steam plant, which is similar and is operated by the same contractor. Such a comparison would provide a reasonablenes check on EI s charges and may disclose best practices that could be of value to both plants operations. Recommendation #4 URI should consider benchmarking against MHRH s steam plant. The university has contact with MHRH and the State Energy Office and will exchange information relating to the operation and maintenance of the two facilities to help benchmark activity at both. We also feel this is a reasonable request and should help provide information that will benefit both facilities. ACKNOWLEDGEMENT We would like to express our appreciation to the URI Assistant Vice-President Business Services, the Director of Facility Services, the Utilities Engineer, and to other URI employees for their cooperation and assistance during this review. 7