9
Acquisition, Financing, and Support

INTRODUCTION

Re-engining (and its inherent fuel savings) has been the focus of several studies of large nonfighter aircraft. Perhaps the most studied aircraft is the B-52, the subject of countless DoD analyses. Despite these studies, no large nonfighter aircraft has ever been re-engined for fuel savings purposes only. Rather, the re-engining of aircraft in this category has been driven by mission requirements. A recent example of this is the decision to re-engine the C-5 to improve its operational performance, thereby increasing its mission capabilities. It is also important to note that even if an aircraft were to be re-engined to save fuel, the projected fuel savings might never materialize. In the case of the re-engining of the KC-135 fleet, for example, the re-engined aircraft were more fuel efficient and produced more thrust, and they could carry more fuel and support more missions. However, the Air Force never actually used any less fuel than it had before, because it flew the aircraft more. In addition, the cost of the re-engining program was increased by the costs of modifying the landing gear and of other modifications that were required to accommodate the increased weight of the new engines and the increased fuel loads that the aircraft became capable of handling.

The committee has concluded, upon review of the specifics of each study, that the aforementioned re-engining (fuel-saving) efforts failed for two main reasons:

  • The requisite large initial investments were difficult to justify within the context of constrained budgets and competition for investments from projects having actual or perceived higher priority and

  • Longer payback periods could not be exploited even if the aircraft was projected to remain in the active inventory for an extended period of time, because of legislative restrictions on obligating the government to expenditures (payback of upfront modification costs) that had not yet been appropriated.

When such issues arise in the private sector, commercial entities are able to finance these large investments through equity investments and bond offerings or by leasing the items in question on a



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Improving the Efficiency of Engines for Large Nonfighter Aircraft 9 Acquisition, Financing, and Support INTRODUCTION Re-engining (and its inherent fuel savings) has been the focus of several studies of large nonfighter aircraft. Perhaps the most studied aircraft is the B-52, the subject of countless DoD analyses. Despite these studies, no large nonfighter aircraft has ever been re-engined for fuel savings purposes only. Rather, the re-engining of aircraft in this category has been driven by mission requirements. A recent example of this is the decision to re-engine the C-5 to improve its operational performance, thereby increasing its mission capabilities. It is also important to note that even if an aircraft were to be re-engined to save fuel, the projected fuel savings might never materialize. In the case of the re-engining of the KC-135 fleet, for example, the re-engined aircraft were more fuel efficient and produced more thrust, and they could carry more fuel and support more missions. However, the Air Force never actually used any less fuel than it had before, because it flew the aircraft more. In addition, the cost of the re-engining program was increased by the costs of modifying the landing gear and of other modifications that were required to accommodate the increased weight of the new engines and the increased fuel loads that the aircraft became capable of handling. The committee has concluded, upon review of the specifics of each study, that the aforementioned re-engining (fuel-saving) efforts failed for two main reasons: The requisite large initial investments were difficult to justify within the context of constrained budgets and competition for investments from projects having actual or perceived higher priority and Longer payback periods could not be exploited even if the aircraft was projected to remain in the active inventory for an extended period of time, because of legislative restrictions on obligating the government to expenditures (payback of upfront modification costs) that had not yet been appropriated. When such issues arise in the private sector, commercial entities are able to finance these large investments through equity investments and bond offerings or by leasing the items in question on a

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Improving the Efficiency of Engines for Large Nonfighter Aircraft long-term basis. The latter mechanism is most popular because the requisite initial investment is not included on the balance sheet as a single item but is spread out over the time during which the items will be used in the form of annual payments that can be appropriately budgeted for. However, long-term leases are seldom used by federal government departments and agencies because Congress is reluctant to approve financial arrangements that would restrict the appropriation prerogative of future congresses (CRS, 2003). However, Congress has overridden this precedent in cases where there are overwhelming benefits. Once such case is Defense Energy Support Center (DESC) long-term contracts for the supply of electrical power to military bases, whereby the government has been allowed to contract for electrical power for as long as 40 to 50 years to allow the amortization of new, more efficient power plants. The current economic and geopolitical situation provides ample justification for the increased use of innovative acquisition, financing, and support mechanisms. The price of oil is forecast to continue to be at or near record highs, swelling the fraction of the DoD budget that is for the purchase of fuel and limiting the funding available for much needed improvements to the military facilities and equipment. Most of the oil that is consumed by the United States comes from locations that are both outside the United States and politically unstable, posing a risk to the U.S. economy and to national security. This economic and security risk is exacerbated by the fact that U.S. refining capacity and oil pipelines are both limited and geographically concentrated and therefore vulnerable to terrorist attacks. Some consequences of this situation were exemplified by the sharp increase in the price of fuel following the devastation of Hurricane Katrina. It is also important to note that more and more refined petroleum products are being imported, with the rate increasing as rapidly as the total amount of oil that is imported, because no refinery has been built in the United States since 1975. The result is that increasing amounts of foreign oil are shipped to foreign refineries before being shipped here, making U.S. energy sources all the more vulnerable. The mechanisms presented in this section are designed to reduce oil consumption by providing innovative ways to acquire, finance, and support the increasing engine improvements or changes. OVERVIEW OF OPTIONS The committee identified 10 options for the acquisition, financing, and support of engine improvements and changes. Each option was categorized as an acquisition, financing, and/or support mechanism. The options then were partitioned into three further groups: In Group 1 are the options the committee believes the Air Force should adopt right away. In Group 2 are the options that the committee believes the Air Force should aggressively evaluate to determine their true utility. In Group 3 are the options that have traditionally not been implemented because they contravene U.S. government acquisition, financing, and support rules; they are included for completeness because they are mechanisms that would be used in the commercial sector. The details of each option are provided below, along with a discussion of its benefits and its implementation challenges. OPTIONS IN GROUP 1 The committee believes the Air Force should adopt the options in Group 1, summarized in Table 9-1, right away. Of the four options in this group, the committee finds that the first (maintain commercial derivative engines to Federal Aviation Administration (FAA) standards) and the second (fully compete

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Improving the Efficiency of Engines for Large Nonfighter Aircraft TABLE 9-1 Group 1: Options That Should Be Implemented Right Away Option Category Expected Benefit(s) Implementation Challenge(s) 1. Maintain all commercial derivative engines to FAA standards. Support Fuel savings. Performance improvements. Potential safety improvements. Reduced maintenance costs. Engines with residual value at the end of the lifetime of the airframe on which they will be mounted because they can be leased or sold in the commercial engine market when the airframe is retired. Bringing the current military commercial derivative engines up to the commercial standards. Obtaining FAA certification for their use on commercial aircraft (since they have not been maintained to a common standard in the past). 2. Compete all maintenance contracts for all commercial derivative engines among all commercial and military maintenance facilities, and do not bundle purchase with maintenance. Support Assures that engine maintenance accounts for a smaller share of LCC. Reduces the net cost of the engines (including acquisition, operation, maintenance), increasing the likelihood of a positive NPV. May result in commercial entities doing more maintenance at Air Force depots, thereby increasing utilization of Air Force facilities.   3. Create line item in the defense budget for the upgrading of engines and for the re-engining of large nonfighter aircraft. Financing Fixed amount available each year that is fenced off from other expenditures. Allows for better scheduling of upgrades and re-engining in relation to mission needs and nominal aircraft maintenance schedules. Facilitates maintenance of Air Force engines to FAA standards. Congress must recognize that this is a proper operating expense rather than a capital expense. Requires significant discipline on the part of those creating and modifying the budget. 4. Implement a fuel savings performance contract strategy similar to the Energy Savings Performance Contract (ESPC) and Share-in-Savings (SiS) contracts currently being used in USAF facilities management and IT management. Financing Air Force benefits from aircraft with more fuel-efficient engines with no up-front capital expenses. Contractor compensated by sharing in the cost savings resulting from the use of more fuel-efficient aircraft. May require specific statutory authority similar to the National Energy Conservation Policy Act for ESPCs and the E-Government Act for SiS contracts. May result in long contract and payback period due to high cost of fuel-efficient engines.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft all maintenance contracts) are perhaps the most important as they are enablers of the subsequent options. To improve the business case for re-engining, the Air Force must have commercial derivative engines maintained to FAA standards if these engines are to be leased or sold after the airframes on which they are mounted have been retired (and also to increase their residual value). It must also ensure that engine maintenance costs contribute less to the life-cycle cost (LCC) by subjecting the maintenance contract to open competition, thereby reducing that particular cost component in net present value (NPV) calculations. Option 1: Maintain All Commercial Derivative Engines to FAA Standards The FAA sets airworthiness certification and safety standards for commercial engines and regulates the maintenance of these engines. To date, the Air Force has chosen to maintain its engines to its own standards. The committee believes that the Air Force should maintain all of its commercial derivative engines to FAA standards rather than to the equally demanding but different government standards currently used. This will allow the Air Force to benefit from the improvements that the FAA deems important based on problems that develop in commercial operation (typically in the area of safety) and the expenditures by commercial entities to improve performance (typically in the area of fuel consumption). Just as it makes good sense to buy commercial derivative engines for large nonfighter aircraft, it makes equally good sense to take advantage of commercial improvements in their engines and maintain military engines to the same standards. Engines in the commercial fleet accumulate flying hours much faster than engines in the military fleet. If the engines in the military fleet were maintained to the same standards as the engines in the commercial fleet, the military would gain invaluable information on failure modes and required maintenance. Safety issues that arise in the commercial fleet could be dealt with much more rapidly and the benefits of commercial modifications realized much more quickly. Commercial users are always interested in fuel savings and typically make several improvements to their engines to reap the fuel consumption benefits afforded by new technology. The Air Force would benefit from having an engine with the same configuration as nonmilitary users. The CFM56-2 engine on the KC-135R serves as an excellent example. When the KC-135 aircraft were re-engined with CFM56-2 engines, commercial users were operating the same engine. Today the KC-135 aircraft are still powered with CFM56-2 engines, while the commercial users are predominantly flying CFM56-7 engines. The CFM56-7 engines are 29 percent more fuel efficient than the CFM56-2 engines, and all of the nonrecurring engineering costs to develop and certify those modifications have been borne by the commercial users. In addition, the Air Force is paying a premium for obsolete CFM56-2 parts, at least for the parts that are not common to the -7 configuration. There are other benefits to a common engine configuration, including the potential for creating a common pool of commercial/military engines and/or engine parts (to be discussed later in this chapter). Such a pool would allow the military to rely on commercial assistance with engines much as it does with transport aircraft through the Civil Reserve Air Fleet (CRAF) program. In addition, a common configuration for military and civilian engines would result in Air Force engines having some residual commercial value when no longer needed by the military, particularly since the military engines would have substantially fewer hours of flight time than commercial engines of comparable age. Finally, common engine fleets would allow the military to take advantage of common training of engine mechanics and facilitate the hiring or placement of needed or excess mechanics as inventories and workloads dictate. The expected benefits include fuel savings, performance improvements, potential safety improvements, reduced maintenance costs, and engines with residual value at the end of the lifetime of the airframe on which they will be mounted.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft The only implementation challenges are related to bringing the current military commercial derivative engines up to commercial standards and obtaining FAA certification for their use on commercial aircraft (since they were not maintained to a common standard in the past). That being said, there is no reason why the Air Force should not adopt a policy of maintaining all newly acquired commercial derivative engines to commercial standards in the future. It should also review the possibility of applying this policy to existing fleets wherever possible. The C-17’s engines, for example, are overhauled in United Airlines’ FAA-approved shops alongside United’s commercial equivalent engines. However, the two engine lines are maintained to different standards, at a considerable cost to the government. Option 2: Compete All Maintenance Contracts Whenever the Air Force determines that the maintenance of an engine is to be contracted out, the maintenance contract should be competed across the entire maintenance, repair, and overhaul industry to maximize the effect of competition on price and to take advantage of economies of scale. When the Air Force decided to re-engine the C-5, each of the original equipment manufacturers (OEMs) proposed an engine and included in its proposal engine depot maintenance for the life of the engine. Thus, although the Air Force got bids for a new engine from virtually all the producers of engines, the competition for maintenance of the engines was by default limited to the OEMs, which maintain only a fraction of the commercial engines that are not under warranty. Most commercial users either maintain their own engines or contract maintenance, repair, and overhaul to a third-party commercial facility. The engine OEMs are the best in the world at designing and producing new engines, but they have proven to be very expensive when it comes to maintaining them. They also have a built-in conflict of interest when it comes to repairing or replacing parts with new parts made by their company unless there is a fixed price for maintenance of the engine. Even with a fixed price there is a problem in that no one knows what the engine will need in the future, and the engine manufacturers must cover all possibilities, making it difficult for them to share potential future savings from innovative production improvements or repair techniques. This fact has led to the development of Production Manufacturing Authorities (PMAs) and Designated Engineering Repairs (DERs) and their use by commercial users. PMAs and DERs are alternative manufacturing sources and repair schemes that are certified by the FAA to be equivalent to or better than the original manufacturer’s parts. The nonuse of PMAs and DERs on military engines is one important reason the overhaul costs for Air Force C-17 engines in United Airlines’ engine shops are higher than the overhaul costs for the Air Force’s commercial equivalent engines in the same shops. In addition, full and open competition may eliminate the middleman and save money. In the case of the C-17, the Air Force contracts for heavy maintenance of the aircraft with Boeing, which in turn contracts for engine overhaul support from Pratt & Whitney (P&W). P&W in turn contracts for engine overhauls from United Airlines. The Air Force should have openly competed the overhaul of the engines or required Boeing to do so and pass the saving to the Air Force. All of these competitions would, of course, be open to the engine OEMs as well, and they would have an equal opportunity to win the maintenance contract. An OEM may be able to offer marginal pricing if it has the engine in question in production or is still producing parts for the engine. In no case should the Air Force be worse off than it is today. Finally, should the competition result in Air Force engines being maintained in a commercial shop or a commercial user teaming with the Air Force to overhaul its engines in an Air Force depot along with Air Force engines, commonality of engine configuration, recommended in Option 1, could more easily be maintained. In summary, the expected benefits include (1) smaller share of LCC goes for engine maintenance,

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Improving the Efficiency of Engines for Large Nonfighter Aircraft (2) reduction in the net cost of the engines (including acquisition, operation, maintenance) and a correspondingly greater likelihood of a positive NPV, and (3) potential for commercial entities doing more maintenance at Air Force depots, thereby increasing the utilization of Air Force facilities. Option 3: Create a Line Item in the Defense Budget While there is common agreement on the benefits of engine modifications or re-engining (lower fuel consumption, better performance, reduced maintenance costs, etc.), such efforts have been stymied by the need for upfront procurement financing and the estimated long times for realizing the financial benefits of so doing. Table 1-1 identifies and prioritizes those nonfighter platforms that are in need of, or would most benefit from, engine modification or re-engining, Those platforms that have more recent engines might benefit from engine modifications or re-engining 10 or more years from now as technology to improve engine performance is developed. Since military airframe lifetimes encompass a number of engine improvement cycles, an ongoing program for engine modification or re-engining should become an operational line in the Air Force budget. To implement this proposal, the Air Force should annually determine the appropriate budget for engine modifications/re-engining for the portion of the nonfighter aircraft fleet that will be taken out of service for heavy maintenance that year. Every year the Air Force should prioritize the needs for that year. On this basis, by the time all the work suggested by Table 1-1 is completed, the platforms not in need of engine modification/re-engining would be ready to benefit from such action and would no longer need to be a line item in the defense budget. This proposal for a line item can be implemented within existing Air Force and congressional budgetary practices. It would hasten lower fuel consumption, better engine and aircraft performance, and reduced maintenance costs. Also, if Option 1 is adopted, the engines might have residual value when they are no longer needed, an additional cost benefit. In summary, the expected benefits include (1) having a fixed amount available each year that is fenced off from other expenditures, (2) better scheduling of upgrades and re-engining in relation to mission needs and nominal aircraft maintenance schedules, and (3) potential residual value as new Air Force engines are maintained to FAA standards as per Option 1. The following implementation challenges have been identified: (1) Congress must recognize that this is a proper operating expense rather than a capital expense and (2) significant discipline is needed on the part of those creating and administering the re-engining budget. Option 4: Implement a Fuels Savings Performance Contract Strategy The financing issues discussed under Option 3 related to the challenges of aircraft re-engining initiatives. They included the lack of up-front funding and the inability to commit to a payback period beyond the congressional funding appropriations. Although these issues continue to hinder aircraft re-engining initiatives, for specific capital investments programs, such as energy and utilities investment projects, Congress has managed to provide specific authorities that overcome the challenges and allow for alternative approaches to financing capital investments. These alternative approaches to financing capital investment contracts do not require up-front congressional appropriations. They include Energy Savings Performance Contracts (ESPCs) and Share-in-Savings (SiS) contracts. Both approaches involve financing arrangements in which the contractor provides the up-front investment and is then compensated out of the resulting accrued savings or revenue.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft The use of an ESPC acquisition strategy is authorized by the National Energy Conservation Policy Act (NECPA) (42 U.S.C. 8287).1 This Act allows the use of an ESPC when it is LCC-effective, to reduce energy use and cost in an agency’s facilities and operations. Executive Order 13123, Section 403, June 3, 1999, Greening the Government Through Efficient Energy Management, requires an agency to make maximum use of the authority provided by NECPA. The NECPA resulted in the establishment of Federal Acquisition Regulation (FAR) 23.204.2 The FAR also states that under an ESPC, an agency can contract with an energy service company for a period not to exceed 25 years to improve energy efficiency in one or more agency facilities at no direct capital cost to the U.S. Treasury. The energy service company finances the capital costs of implementing energy conservation measures and receives, in return, a contractually determined share of the cost savings that result (FAR 23.204). Although this authority seems to be specific to energy and utility systems such as water, sewer, and steam distribution systems as well as electricity and heating, ventilation, and air conditioning systems, the committee sees no reason why the concept should not be applicable to aircraft propulsion systems. The use of an SiS acquisition strategy is authorized under the E-Government Act of 2002, Sections 210 and 317. This Act allows an agency to enter into an SiS contract for information technology (IT), in which the government awards a contract to improve mission-related or administrative processes or to accelerate the achievement of its mission and shares with the contractor savings achieved through contract performance. In addition, Congress has designated the General Services Administration (GSA) to play a leadership role in developing and institutionalizing the share-in-savings concept government-wide. The GSA has listed the following as the most prominent applications of SiS contracts: systems consolidation (e-government, payroll, data centers, reverse auctions), audit recovery (wireless communications, telephone lines), revenue enhancement (fee-based services), and unit price savings for recurring goods and services (reverse auctions).3 Although the SiS acquisition strategy is specifically authorized for IT improvements to administrative processes, the concept might also be successfully applied to aircraft propulsion systems. It should be noted that the congressional authority for ESPCs and SiS contracts is based on the use of an LCC analysis to determine the cost and benefits of the capital investment. Specifically, Executive Order 13123, Section 401, states as follows: Agencies shall use life-cycle cost analysis in making decisions about their investments in products, services, construction, and other projects to lower the Federal Government’s costs and to reduce energy and water consumption. Where appropriate, agencies shall consider the life-cycle costs of combinations of projects, particularly to encourage bundling of energy efficiency projects with renewable energy projects. Agencies shall also retire inefficient equipment on an accelerated basis where replacement results in lower life-cycle costs. (FR, 1999, p. 6) LCCs here are defined as the “sum of the present values of investment costs, capital costs, installation costs, energy costs, operating costs, maintenance costs, and disposal costs, over the lifetime of the project, product, or measure.” (Additional guidance on measuring life-cycle costs is specified in 10 CFR 436.19.) LCC-effective means “the life-cycle costs of a product, project, or measure are estimated to be equal to or less than the base case (i.e., current or standard practice or product).” Additional guidance 1 For additional information on the NECPA, please see http://www.noresco.com/site/pdf/epa1992.pdf. Last accessed on January 22, 2006. 2 For additional information on FAR 23.204, please see http://www1.eere.energy.gov/femp/pdfs/far_rule1201.pdf. Last accessed on January 22, 2006. 3 Available online at http://www.gsa.gov.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft on measuring cost-effectiveness is specified in 10 CFR 436.18 (a), (b), and (c), 436.20, and 436.21 (EO 13123, Sections 707 and 708).4 It would seem feasible, based on the success of ESPC and SiS contracts for energy and utility systems, to request specific congressional authority for aircraft propulsion systems. The use of “fuel savings performance contracts” (FSPCs) would apply the “contractor compensation by savings” concept to aircraft re-engining contracts. If an FSPC acquisition strategy is proven to be LCC-effective (in accordance with the statutes), the Air Force could be allowed to award long-term contracts to aircraft/engine contractors. These contractors, providing their own up-front capital investment, would re-engine the aircraft with more fuel-efficient engines and be compensated by sharing the accrued savings or revenues resulting from the improved fuel efficiency and/or reduced maintenance cost of the aircraft. Of course, the payback period for FSPCs may be significantly longer than the less-capital-intensive ESPCs or SiS contracts. However, this may be offset by the increase in savings and revenues realized by the Air Force and shared with the contractor. With the use of FSPCs, the financial challenges of having no up-front government funding and of Congress’s inability to commit to a payback period beyond the congressional funding appropriations period would appear to be resolved. With this approach, (1) the Air Force benefits from aircraft with more fuel-efficient engines and no up-front capital expenses and (2) the contractor is compensated from the cost savings resulting from the use of more fuel-efficient aircraft. Implementation challenges are twofold: (1) FSPC may require specific statutory authority similar to the NECPA for ESPCs and the E-Government (E-Gov) Act for SiS contracts and (2) it may result in long contract and payback periods owing to the high costs of fuel-efficient engines. Recommendation 9-1. The Air Force should adopt the following options right away: (1) maintaining all commercial derivative engines to FAA standards, (2) competing all maintenance contracts, (3) creating a line item in the defense budget, and (4) implementing a “fuel-savings performance contract” strategy. OPTIONS IN GROUP 2 The committee believes the Air Force should aggressively evaluate the options in Group 2, summarized in Table 9-2, to determine their true utility. Option 5: Re-engine Air Force Aircraft with Commercial Engines and Lease or Resell the Engines When the Airframe Is Retired In this option, the Air Force re-engines its existing aircraft with engines that are expected to be widely used in the commercial fleet beyond the planned retirement date of the Air Force airframes on which they will be mounted, then leases or resells the engines upon airframe retirement. The expectation that an engine will be widely used beyond the planned retirement date of the Air Force airframe is an important component of this approach, as the future demand for an engine type is a key determinant of the residual value for that engine type. Another determinant of residual value is the maintenance history. Thus, as noted under Option 1, the Air Force would be required to maintain its engines to commercial standards. As a variation on this approach, the Air Force could offset a portion of the re-engining cost up 4 Part 436 of the Code of Federal Regulations may be found online at http://www.wbdg.org/pdfs/10cfr436.pdf. Last accessed on January 23, 2007.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft TABLE 9-2 Group 2: Options That Should Be Aggressively Explored Option Category Expected Benefit(s) Implementation Challenge(s) 5. Re-engine Air Force large nonfighter aircraft with commercial engines and maintain these engines to FAA standards in an FAA-certified Air Force depot or in an FAA-certified commercial maintenance facility. Acquisition and support Engines will have residual value at the end of the lifetime of the airframe on which they are mounted because they can be leased or sold in the commercial engine market when the airframe is retired. Residual value of engine can be included in the NPV calculation used to justify the re-engining of the airframe in question, reducing the net cost of the engines and increasing the likelihood of a positive NPV Limits candidate engines to those that are available in the commercial sector, which may (though this is unlikely given the broad capabilities of commercial engines) have an impact onAir Force ability to meet mission requirements. Requires changes to current Air Force maintenance scheduling practices as engine upgrades would need to be done in accordance with FAA airworthiness directives. May require additional training for staff and changes to record-keeping practices at Air Force depots. 6.Create a joint commercial–military spare engine and engine parts pool. Acquisition and support Reduces the number of engines and engine parts that have to be kept in reserve to ensure war readiness due to conflicts between commercial and military needs, as well as the general non-correlation of maintenance failures among a large number of engines. Provides a mechanism for the alternative use of engines when they would otherwise not be used by the Air Force because the airframe to which they are mounted is in the depot for extended overhaul. Increases the effective utilization of the spare engines and parts. Requires Option 1 and therefore has all the implementation challenges of Option 1. Air Force must have priority access to spare engines and parts in times of national need in a similar fashion to CRAF. 7. Long-term (multiyear) lease of commercial engines that are maintained to FAA standards by the lessor in an FAA-certified Air Force depot, or in an FAA-certified commercial maintenance facility. Acquisition, financing,and support Air Force has no significant initial capital outlay. Lessor retains residual value of engine at the end of the lifetime of the airframe on which they will be mounted because they can lease or sell the engines in the commercial engine market when the airframe is retired. Air Force gets best possible leasing rate (equivalent to treasury borrowing rate) because the long-term nature of the lease arrangement ensures that there is negligible expected cost of having to hold the engine in stock while a new lessee is identified. Air Force would still have to pay for any required modifications to the airframe. Air Force would not own the engines, which might be aconcern for Congress. Congressional approval would be required for multiyear leasing arrangement; however, there is a precedent for the granting of a waiver as per the DESC multiyear contracts. Has all the implementation challenges of Option 1 because engines would be commercial engines. Would require coverage for termination liability should the airframe be retired earlier than planned.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft 8. Short-term (yearly) lease of commercial engines that are maintained to FAA standards by the lessor in an FAA-certified Air Force depot, or in an FAA-certified commercial maintenance facility. Acquisition, financing, and support Air Force has no significant initial capital outlay. Does not require a multiyear agreement. Air Force has option to forgo future leasing. Lessor retains residual value of engine at the end of the lifetime of the airframe on which they will be mounted because it can lease or sell the engines in the commercial engine market when the airframe is retired. Air Force would still have to pay for any required modifications to the airframe, Air Force would not own the engines, which might be a concern for Congress. Air Force would incur a premium for having the flexibility to forgo future leasing at the end of each year, but any such premium would be small because the engines would be commercial engines and could therefore be leased or sold in the commercial market should the Air Force exercise the option not to continue leasing them; thus, the premium would be equal to the expected holding cost. Has all the implementation challenges of Option 1 because engines would be commercial engines.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft front by selling a forward contract for the delivery of the engines at a specified future date (the planned airframe retirement date). The primary difference between this approach to purchasing engines and prior approaches is that the engines are treated separately from the airframe on which they will be mounted in recognition of the fact that the engines are themselves commodities that can be traded or resold in the commercial marketplace. It is also interesting to note that the adoption of such an approach could also change the way the Air Force thinks about the retirement of airframes. Specifically, the effects of acquisition decisions on the residual value of the engines in the fleet could become a factor in the decision-making process, as delays in airframe retirement would have a measurable cost. The expected benefits of this approach are as follows: (1) the engines will have residual value at the end of the lifetime of the airframe on which they are mounted because they can be leased or sold in the commercial engine market when the airframe is retired and (2) the residual value of the engine can be included in the NPV calculation used to justify the re-engining of the airframe in question, thereby reducing the net cost of the engines and increasing the likelihood of a positive NPV. Envisioned implementation challenges are these: (1) candidate engines would be limited to those that are available in the commercial sector, which may (though this is unlikely given the broad capabilities of commercial engines) have an impact on Air Force ability to meet mission requirements, (2) current Air Force maintenance scheduling practices would have to be changed so that engine upgrades could be done in accordance with FAA airworthiness directives, and (3) additional training might be required for staff, and changes would be required to record-keeping practices at Air Force depots. Option 6: Create a Spare Engine and Parts Pool With Option 6, the Air Force would re-engine existing aircraft with commercial derivative engines and also participate in a commercial spare engine and parts pool. The benefits of this approach are that (1) an engine that would otherwise be sitting in the shop while the military airframe to which it was nominally attached was being overhauled could be loaned for use on a commercial aircraft that is in need of a spare engine and (2) the Air Force could borrow engines when one of its aircraft needs a spare engine. The net effect of this arrangement is that the total number of spare engines required for both the commercial and military fleet would be reduced because the more effective use of spare engines would reduce the time engines spend off-wing. The committee found examples of this approach in the commercial airline industry. The expected benefits include (1) a reduction in the number of engines and engine parts that have to be kept in reserve to ensure war readiness in the face of conflicting commercial and military needs, as well as the general noncorrelation of maintenance failures in a large number of engines, (2) a potential alternative use of engines when they would otherwise not be used by the Air Force because the airframe on which they are mounted is in the depot for extended overhaul, and (3) an increase in the effective utilization of the spare engines and parts. Envisioned implementation challenges include (1) all the implementation challenges of Option 1, which is required, and (2) the creation of a law or agreement whereby the Air Force, like the CRAF, has priority access to spare engines and parts in times of national need. Option 7: Lease Engines on a Long-Term Basis A lease is an agreement in which one party gains a long-term rental and the other party gains a form of secured long-term debt. That is, the lessee gains a long-term contract for the use of an asset, and the

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Improving the Efficiency of Engines for Large Nonfighter Aircraft lessor is assured of regular payments for a specified number of years. Entering into a simple lease is equivalent to purchasing an asset using secured debt to fund the purchase while simultaneously selling a forward contract to deliver the asset at some specified future date; and a lease with an end-of-term option to buy is equivalent to entering into a simple lease and simultaneously purchasing a European-style call option on the leased asset. A lease with an end-of-term option is also financially equivalent to outright purchase coupled with purchase of a European-style put option on the asset. Long-term leasing is a common commercial practice that is becoming even more prevalent, with many commercial users of aircraft and aircraft engines (the airlines) leasing these assets from manufacturers, leasing agencies, or other nonoperating owners. International Leasing and Finance Corp. and General Electric Commercial Aircraft Services are two of the largest owners of aircraft even though neither is an operator. Leases are used for a variety of purposes beyond simple financing that can include removing debt from a balance sheet and driving an expenditure to be classified as an operating expense rather than a financing cost (Gorton and Souleles, 2005). The committee did not consider these alternative uses. As part of its effort, the committee reviewed the Congressional Research Service’s 2003 report on the KC-767 Tanker Lease Proposal as well as several presentations on the various commercial power-by-the-hour engine leasing programs that it received from industry (CRS, 2003). The KC-767 tanker lease proposal, which would have involved 6-year leases on KC-767 tanker aircraft, with an option to purchase at lease end, ultimately failed to receive congressional approval. While there is no sound economic argument prohibiting long-term leasing as a means of financing a re-engining program, long-term leases have the drawback of obligating future Congresses to commit funds to the lease payments and, in this sense, are similar to multiyear procurement arrangements. However, long-term leasing represents a fair and viable means of financing a re-engining program, and as such should be aggressively evaluated by the Air Force. The expected benefits are threefold: (1) the Air Force has no significant initial capital outlay, (2) the lessor retains residual value of engines at the end of the lifetime of the airframe on which they will be mounted because it can lease or sell the engines in the commercial engine market when the airframe is retired, and (3) the Air Force gets the best possible leasing rate (equivalent to the Treasury borrowing rate) because the long-term nature of the lease arrangement ensures that there is negligible expected cost of having to hold the engine in stock while a new lessee is identified. The following implementation challenges have been identified: (1) the Air Force would still have to pay for any required modifications to the airframe, (2) it would not own the engines, which might be a concern for Congress, (3) congressional approval would be required for a multiyear leasing arrangement (however, there is a precedent for the granting of a waiver as per the DESC multiyear contracts), (4) this approach has all the implementation challenges of Option 1, because the engines would be commercial engines, (5) this approach would require coverage for termination liability should the airframe be retired earlier than planned, and (6) engines might have little or no residual value depending on how extensively they are still being used in the commercial fleets. Option 8: Lease Engines on a Short-Term Basis As an alternative to the long-term lease option described above, the Air Force could consider acquiring engines for re-engined aircraft via short-term leases, fee-for-service arrangements, or other similar rental arrangements. These arrangements could vary from short-term rental agreements under which the Air Force leases the engine but performs all maintenance and repairs organically, to fee-for-service arrangements under which the leasing company is responsible for providing not only the engine but all

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Improving the Efficiency of Engines for Large Nonfighter Aircraft associated maintenance and repair activities. They could even be structured as longer-term leases with an annual option to cancel the lease. Regardless of the particulars, all such arrangements would only require the U.S. government to make yearly spending commitments. Unlike longer-term leases, there would be no multiyear spending requirement. Even if the Air Force took more than a year to decide to cancel a yearly lease, the fact that the lease is yearly would mean that the Air Force would always be able to cancel the lease the same year it finally decided to cancel. The expected benefits of short-term leasing include these: (1) the Air Force has no significant initial capital outlay, (2) no multiyear agreement is needed, (3) the Air Force has the option to forgo future leasing, and (4) the lessor retains residual value of the engines at the end of the lifetime of the airframe on which they are mounted because it can lease or sell the engines in the commercial engine market when the airframe is retired. The last benefit listed above is particularly important. Because Air Force aircraft fly so few hours annually, the engines of re-engined aircraft are likely to significantly outlast the airframes, giving the engines residual value at the end of their use by the Air Force. Even if the Air Force elects to terminate a yearly lease, the leasing company is likely to be able to place the engines in the commercial market and recover their residual value. As a result, a properly structured short-term leasing option would give the Air Force a way to purchase only the fraction of the life of an engine that it actually uses. This could significantly improve the business case for almost all platforms considered in this study. The following implementation challenges have been identified: (1) the Air Force would still have to pay for any required modifications to the airframe, (2) the Air Force would not own the engines, which might be a concern for the Air Force and for Congress, (3) the Air Force would incur a premium for having the flexibility to forgo future leasing at the end of each year, but any such premium would be small—probably equal to the expected holding cost—because the engines would be commercial engines and could therefore be leased or sold in the commercial market should the Air Force choose not to continue leasing them, and (4) this approach has all the implementation challenges of Option 1 because the engines would be commercial engines. Because short-term leases are not commonly used by the Air Force, many of the identified challenges are likely to be cultural challenges more than anything else. For example, while (3) in the preceding paragraph might seem like a challenge, it is simply a reflection of the fact that a short-term lease gives the Air Force more flexibility than any other alternative and that there is financial value in having this option. Similarly, while (2) above might seem like a concern at first, the fact that the Air Force would physically control the engines (they are mounted on the Air Force aircraft to which they are assigned) makes it difficult to imagine that they would not be available in a contingency. Challenge (4), however, does represent a very real challenge. For short-term leases, as envisioned in this chapter, to benefit the Air Force, it would be necessary to ensure that the engines retain their commercial value, and this would lead to the same issues identified earlier. Overall, leasing engines on a short-term basis appears likely to provide the Air Force with all of the benefits of a longer-term lease without forcing it or the Congress to make multiyear purchasing commitments. For this reason, the committee recommends that the Air Force aggressively evaluate this approach further to determine if it would indeed be useful. Recommendation 9-2. The Air Force should aggressively evaluate the following options to determine their true utility: (1) re-engining Air Force aircraft with commercial engines and leasing or reselling the engines when the airframe is retired, (2) creating a spare engine and parts pool, (3) leasing engines on a long-term basis, and (4) leasing engines on a short-term basis.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft OPTIONS IN GROUP 3 In keeping with the statement of task admonition to develop re-engining implementation strategies, including conventional as well as innovative acquisition, financing, and support concepts, the following additional options were identified by the committee. These options were identified because they reflect innovative, outside-the-box thinking, not because the committee has already determined them to have value. Summarized in Table 9-3, they are included here to reflect completeness in the committee’s discussion of the various re-engining approaches. Determining the feasibility of implementing these innovative options in the post-9/11 environment and during the Global War on Terrorism will require additional in-depth analysis and discussion. Option 9: Sale and Leaseback on a Long-Term Basis Under a sale-and-leaseback arrangement, a party sells assets it owns to a counterparty and then leases these same assets back from the counterparty. Typically, the leasing agreement is long-term. Sale-and-leaseback arrangements are often used for a variety of nonfinancing purposes, including removing debt from a balance sheet. The committee did not consider these alternative uses. Rather, it considered the TABLE 9-3 Group 3: Options That Might Be Explored Option Category Expected Benefit(s) Implementation Challenge(s) 9. Sell aircraft that are to be re-engined for a nominal price to a commercial entity with the stipulation that they pay for the new engines and the required changes to the airframe, and then lease the enhanced aircraft to the Air Force on a long-term (multiyear) basis. Acquisition and financing Air Force does not have to pay for any required modifications to the airframe. Air Force has no significant initial capital outlay. Lessor borrows capital at best possible rate (equivalent to Treasury borrowing rate) because of the long-term nature of the lease arrangement. Air Force would not own the aircraft, which might be a concern for the Air Force and for Congress. Congressional approval would be required for multiyear leasing arrangement; however, there is a precedent for the granting of a waiver as per the DESC multiyear contracts. OMB accounting rules may have to be modified so that the money that is borrowed by the lessor does not count against the Treasury borrowing limit. 10. Sell aircraft that are to be re-engined for a nominal price to a commercial entity with the stipulation that they pay for the new engines and the required changes to the airframe, and then lease the enhanced aircraft to the Air Force on a short-term (yearly) basis. Acquisition and financing Air Force does not have to pay for any required modifications to the airframe. Air Force has no significant initial capital outlay. No multiyear agreement is required. Air Force has the option to forego future leasing. Air Force would not own the aircraft, which might be a concern for the Air Force and for Congress. Air Force would incur a premium for having the flexibility to forgo future leasing at the end of each year. This premium would be noticeable because the market for used Air Force large nonfighter aircraft is small. OMB accounting rules may have to be modified so that the money that is borrowed by the lessor does not count against the Treasury borrowing limit.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft approach whereby the Air Force would sell the aircraft to be re-engined to a counterparty, which would then pay for the re-engining of the aircraft (adding value to the asset) and would thereafter lease the upgraded aircraft back to the Air Force. Thus, instead of leasing just the engines, the Air Force would be leasing whole aircraft. As considered in this study, sale-and-leaseback arrangements would involve only transfer of ownership of the aircraft. The Air Force would continue to house and operate the re-engined aircraft and, as such, would retain physical control of the assets. As with a straightforward, long-term leasing arrangement, this approach has the drawback of obligating future Congresses to commit funds to the lease payments and, in this sense, is similar to multiyear procurement arrangements (CRS, 2003). That being said, a sale-and-leaseback arrangement is a fair and viable means of financing a re-engining program. In particular, unlike all other the arrangements considered above, it has the advantage of allowing the Air Force to realize the NPV of positive-NPV re-engining options as up-front cash that could be used to fund other acquisition programs, such as, the F-22, the Joint Striker Fighter, or space radar. The expected benefits include these two: (1) the Air Force does not have to pay for any modifications to the airframe and (2) it has no significant initial capital outlay. Both of these benefits are the result of the fact that the Air Force is “selling” the asset to the counterparty and receiving cash up front in exchange for a commitment to make regular lease payments over a longer term. Any costs to the leasing company associated with modifications to the airframe or purchase of the engines from an OEM would be embedded as a discount in the sale price. In this way, the government would avoid all up-front outlays. Furthermore, the cost savings associated with the improved fuel efficiency of the leased aircraft could be converted into cash up front by attaching a premium to the sale price. This premium would lead to an increase in the lease payment that exactly offsets the dollar savings in fuel and maintenance costs enabled by re-engining. So, in annually paying the sum of the lease cost and the new annual fuel expense, the Air Force would be paying an amount identical to the corresponding annual operating and ownership costs prior to the re-engining, but it would also receive a large cash payment up front equal to the NPV savings associated with re-engining. Three implementation challenges have been identified: (1) the Air Force would not own the aircraft, which might be a concern for it and for Congress, (2) congressional approval would be required for a multiyear leasing arrangement despite the precedent set by the DESC multiyear contracts for the granting of a waiver, and (3) owing to the long-term nature of the lease, OMB accounting rules might have to be modified so that the money that is borrowed by the lessor does not count against the Treasury borrowing limit. The reader will note that this option faces essentially the same challenges faced by the long-term lease option described earlier. This is, of course, because the arrangement is, at its core, a long-term lease. Furthermore, in addition to the challenges listed above, the sale-and-leaseback approach also faces the challenge that it is the most unfamiliar and forward-leaning of the innovative approaches considered in this chapter. As such, it might face significant cultural resistance despite its potential benefits. Overall, the committee determined that sale-and-leaseback arrangements could represent a fair and viable means of financing a re-engining program; and that, uniquely among the options considered, such arrangements allow up-front realization, in cash, of the benefits of re-engining. As such, the committee considered them necessary to a complete discussion of available options. Option 10: Sale and Leaseback on a Short-Term Basis As a variation of Option 9 above, the Air Force could finance re-engining by entering into a sale-and-leaseback arrangement built around an annual lease or other short-term rental of the re-engined

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Improving the Efficiency of Engines for Large Nonfighter Aircraft aircraft rather than a long-term lease. This arrangement would allow the Air Force to reap the benefits of a sale-leaseback arrangement while avoiding a multiyear purchasing commitment. It would, of course, still face the same cultural obstacles described earlier. The specific expected benefits of this approach are four in number: (1) the Air Force does not have to pay for any required modifications to the airframe, (2) it has no significant initial capital outlay, (3) no multiyear agreement is needed, and (4) the Air Force has an option to forgo future leasing. Again, the first two benefits are the result of the fact that the Air Force is selling the asset to the counterparty, so any costs to the leasing company associated with modifications to the airframe or purchase of the engines from an OEM can be embedded as a discount in the sale price. In this way, the government would avoid all up-front outlays. However, by engaging in a rental arrangement rather than a long-term lease, it could be possible to go one step further by embedding all of the leasing payments themselves into a further discount on the sale price. If the leasing company can generate sufficient revenue from the re-engined aircraft when they are not being used by the Air Force, either after termination of the short-term lease or while under lease but not being used by the Air Force, this revenue could offset lease payments. As a result, it is conceivable that the Air Force could embed all airframe modification costs, engine purchase costs, and lease payments into a discount on the sale price of the platform and still end up with a positive sale price. Under such a circumstance, the Air Force would be able to reap the benefits of re-engining with no up-front costs and no recurring costs. The following implementation challenges have been identified: (1) the Air Force would not own the aircraft, which might be a concern for the Air Force itself or for Congress, and (2) it would incur a premium for having the flexibility to forego future leasing at the end of each year, and this premium would be sizable because the market for used Air Force large nonfighter aircraft is small. The reader will note that this option faces essentially the same challenges faced by the short-term lease options described earlier. Furthermore, like sale-and-leaseback on a long-term basis, this option may, due to its unfamiliarity, face cultural resistance despite its potential benefits. Such resistance might be especially strong if the arrangement permits the leasing company to operate the aircraft when it is not being used by the Air Force, it would mean that the aircraft are not under the direct physical control of the Air Force for some period, potentially creating both International Traffic in Arms Regulations issues and the risk of unavailability during a contingency. However, these risks are, of course, no different than those faced by, for example, the United Kingdom in its proposed AirTanker lease.5 Air Force modifications to aircraft leased short term—e.g., communications relay packages and sensor systems—might present an additional logistical challenge as these systems would have to be removed from the aircraft at the end of the leasing period at what might be a significant cost relative to the duration of the lease. This removal cost might be reduced by designing the communication relay packages and sensor systems to be more readily removable. This might require changing the way they are connected together and mounted within the airframe, thus impacting their functionality. Any short-term leasing evaluation must therefore consider the cost of removing such packages and systems, which is likely to be significant. That being said, care must be taken not to overestimate this cost, as there is a nonzero probability that the short-term leases will be renewed and the removal of said equipment will not be necessary. Thus, an expected value for the removal cost must be derived. Despite the potential challenges, the privatization of the Air Force’s depot at Kelly Air Force Base sets a precedent for the approach described here. Furthermore, this option could make a great deal of 5 For additional information on the issues surrounding the AirTanker, please see the following Internet articles: (1) “British AirTanker Deal May Go Private,” available online at http://www.defenseindustrydaily.com/2005/03/british-airtanker-deal-may-go-private/index.php, and (2) “Britain Air Tanker Deal Delayed Until Late 2006: Report,” available online at http://www.defensenews.com/story.php?F=1531164&C=airwar. Articles last accessed on January 22, 2007.

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Improving the Efficiency of Engines for Large Nonfighter Aircraft sense for platforms such as the KC-135, which could be operated part-time by a leasing company as cargo aircraft. By entering into a sale-and-leaseback arrangement with a short-term or cancelable lease, the Air Force would be able to recover value from an asset that it would otherwise place in a boneyard. Overall, the committee determined that sale-and-leaseback arrangements that use short-term leases could represent a fair and viable means of financing a re-engining program and that, of the options considered, they have the best potential to benefit the Air Force because they can enable up-front realization, in cash, of the benefits of re-engining without requiring any up-front or recurring spending. As such, it considered such arrangements a necessary part of a complete discussion of available options. However, the approach is also the most exotic of those considered and would be the most likely to face significant cultural resistance. Recommendation 9-3. The Air Force should analyze the following options in greater depth to determine their feasibility: (1) sale-and-leaseback on a long-term basis and (2) sale-and-leaseback on a short-term basis. REFERENCES CRS (Congressional Research Service). 2003. The Air Force KC-767 Lease Proposal: Key Issues for Congress. Washington, D.C.: Library of Congress. Available online at http://www.globalsecurity.org/military/library/report/crs/rl32056.pdf. Last accessed on January 22, 2007. FR (Federal Register). 1999. Executive Order 13123—Greening the Government Through Efficient Energy Management. Washington, D.C.: Office of the Federal Environmental Executive. June 8. Available online at http://www.ofee.gov/eo/ eo13123.pdf. Last accessed on January 22, 2007. Gorton, G., and N. Souleles, 2005. Special-purpose vehicles and securitization, NBER Working Papers 11190. Cambridge, Mass.: National Bureau of Economic Research, Inc.,