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Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs (2017)

Chapter: 4. Appendix C: OWNERSHIP AND OPERATING MODELS

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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
×
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
×
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
×
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
×
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
×
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
×
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
×
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Suggested Citation:"4. Appendix C: OWNERSHIP AND OPERATING MODELS." National Academies of Sciences, Engineering, and Medicine. 2017. Acquisition and Operation of Polar Icebreakers: Fulfilling the Nation’s Needs. Washington, DC: The National Academies Press. doi: 10.17226/24834.
×
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25 Appendix C OWNERSHIP AND OPERATING MODELS The first consideration with regard to the lease–purchase and ownership decision for the U.S. Coast Guard (USCG) is whether the polar icebreaker is a USCG cutter. A USCG cutter must be a public vessel to perform many of USCG’s statutory missions (GAO 2016). Under federal law, a public vessel must be owned by the United States or on a demise charter [46 USC 2101(24)], which USCG would crew, operate, and maintain, but not own (46 CFR 169.107). In the past, the U.S. government has obtained vessels through direct purchase or with lease financing (demise chartered). Most USCG and Navy vessels have been obtained through direct purchase. There are several examples of the use of lease financing for noncombatant vessels by the Navy’s Military Sealift Command (MSC), which is responsible for the chartering or leasing of auxiliary vessels20 for the Department of Defense: • In 1982, the Navy entered into long-term leases for five T-5 replacement tankers. They were to be purpose-built for MSC and chartered for a 5-year base term with three 5-year options (total term charter with all options of 20 years for each vessel). Civilian mariners operated all five tankers. • Also in 1982, the Navy awarded 13 contracts for the building and chartering of maritime prepositioning ships (MPS). Each vessel had a term charter between the operating company and MSC with a 5-year base term plus four 5-year options (total term charter with all options of 25 years for each vessel). The MPS program included five purpose- built ships (General Dynamics or Bobo class), three converted U.S.-built ships (Waterman class), and five converted (in a U.S. shipyard) foreign-built ships (Maersk class). Civilian mariners operated all 13 of the prepositioning ships. There was a significant contingent of Navy personnel (mostly Marines) on each MPS to maintain the prepositioned warfighting equipment on board. These leases were reviewed by the Government Accountability Office (GAO) in a June 25, 1999, report. The report reached the following conclusions (GAO 1999, 12): The Navy’s decisions in the early 1970s and early 1980s to enter into long-term ship leases were based primarily on the decision to acquire ships without a large up-front obligation of procurement funds. The Navy also believed leasing was more cost-effective than purchasing the ships. These decisions were supported by certain assumptions that were used in the absence of clear guidance. Different economic assumptions would have supported purchasing, rather than leasing, these ships. Our legal opinions clarified requirements for such leases, and current budgetary legislation and scoring guidance now emphasize up-front budgeting for such leases. The elimination of tax advantages for leasing, together with more detailed guidelines for conducting lease versus purchase analyses, will make it more difficult to support long-term leasing on a cost-effectiveness basis. 20 Auxiliary vessels are supply, research, or other noncombatant vessels.

26 As suggested in the 1999 GAO report, long-term leasing under more detailed guidelines can make the option less cost-effective. Current guidelines from the Office of Management and Budget (OMB) under Circular A-94 indicate that the acquisition of a polar icebreaker through a lease requires a separate lease–purchase analysis to prove that it is a less costly option than direct purchase. In addition, in accordance with OMB Circular A-11, lease–purchase and capital leases of an asset are to be scored up front, which makes avoidance of the up-front budget impact of a purchase through leasing unattractive as a budget strategy. A polar icebreaker under a long-term lease would fall under one of those leasing options as opposed to a short-term operating lease, which would not require up-front budgeting. A GAO report from 2016 on USCG’s Arctic capability included Figure C-1, which shows the factors affecting the decision to lease a polar icebreaker. FIGURE C-1 Factors affecting the decision to lease a polar icebreaker. (Source: GAO 2016, 40.) The committee’s assessment of the lease-versus-buy decision is based on the following: • Identification of the various options available under the lease-versus-buy decision; • The ability to meet USCG’s operational requirements, as stated in the Polar Icebreaker Operational Requirements Document (Industry Version, November 2015); • The comparative cost to the government of leasing versus buying a polar icebreaker; and • Operating cost impacts of the identified manning options (civilian or USCG personnel). Each of the above items is covered in the balance of this appendix. Leasing Options Leasing options were identified from two perspectives, as follows: • Capital costs: Use of leasing as a form of 100 percent financing for a ship. Lease financing is typically done with a financing company (known as the lessor) purchasing and owning the ship. The lessor then arranges for a bareboat charter (also known as a demise charter) of the vessel to the ship operator (the lessee), typically for a term of 15 to

27 25 years. With changes in the tax laws, leases can now include a fixed end-of-lease purchase price. Previously, leases could only include fair market value purchase clauses. • Manning options: While lease financing is not required for this option [numerous Navy- owned noncombatant vessels, such as the large, medium speed roll-on/roll-off ships (LMSRs), are manned by civilian mariners], the following two manning options for polar icebreakers are examined: o Civilian mariners only (or the “MSC model”). Only licensed civilian mariners are employed on board the polar icebreaker. The civilian mariners are contracted by MSC with a private “ship manager” (such as General Dynamics’ American Overseas Marine Division or Crowley Marine) to provide a civilian crew for the icebreaker. This is usually done through a competitive bidding process. o USCG only (or the “USCG model”). Only USCG personnel are employed in operating the vessel. The existing USCG polar icebreakers (the Polar Star and the Healy) use this manning model. The committee also considered the option of a long-term lease of a polar icebreaker to perform the annual McMurdo Station break-in in Antarctica and to support other national, nonmilitary activities. The acquisition process would be similar to the National Science Foundation’s (NSF’s) agreement for the Nathaniel B. Palmer and Laurence M. Gould vessels, which were built and are owned privately by Edison Chouest Offshore. The original contract included a 10-year lease by NSF for the Palmer and a 5-year base lease with an option for a 10- year extension for the Gould (ABS Consulting 2012). Construction costs for the vessels were partially amortized over the lease life (ABS Consulting 2012). NSF uses the vessels under a service contract agreement with Lockheed Martin (previously Raytheon Polar Services Company), which charters the vessels from their owner (NRC 2007). This type of lease would be an operating lease, and in accordance with OMB Circular A-11, budget authority only covers up to 5 fiscal years after the authority expires unless there is specific language in the appropriation stating otherwise (OMB 2016a). Comparative Cost of Leasing Versus Buying a Polar Icebreaker The cost of leasing versus buying a polar icebreaker was analyzed from a financial perspective. A “scoring analysis” using OMB Circular A-11 was not conducted. The committee’s cost analysis examined the likely annual lease payment for a polar icebreaker and is described in detail below. Weighted Average Cost of Capital The weighted average cost of capital (WACC) is the rate at which a company expects to pay its security holders to finance assets and is used as the discount rate in calculating the net present value of the assets. WACC is calculated as shown in Equation C-1. The parameter values are included in Table C-1.

28 WACC (%) = 𝑟𝑟𝐷𝐷 ∗ �𝐷𝐷𝑉𝑉� ∗ (1 − 𝑇𝑇) + 𝑟𝑟𝐸𝐸 ∗ �𝐸𝐸𝑉𝑉� (Equation C-1) where 𝑟𝑟𝐷𝐷 = current market rate for debt, 𝐷𝐷 𝑉𝑉 = debttotal value, 𝑇𝑇 = tax rate, 𝑟𝑟𝐸𝐸 = cost of equity, and 𝐸𝐸 𝑉𝑉 = equitytotal value. Cost of Equity The cost of equity was calculated as the sum of the risk-free rate of return and the equity risk premium, as shown in Equation C-2. The equity risk premium is the Ibbotson value, adjusted up to account for currently low interest rates on the basis of the Saint Louis Federal Reserve’s high- quality corporate bond interest rate (Ibbotson 2017; Federal Reserve Bank of Saint Louis 2017).21 Parameter values are shown in Table C-1. Cost of equity (%) = 𝑟𝑟𝐸𝐸 = 𝑟𝑟𝑓𝑓 + 𝑟𝑟𝑝𝑝 (Equation C-2) where rf is the risk-free rate of return and rp is the equity risk premium. For this analysis, the cost of equity is 10.61 percent and the WACC is 4.6 percent. The result was an after-tax WACC of 4.6 percent. A 4.6 percent WACC after tax is considered a conservative discount rate for this analysis (i.e., it results in a lower expected lease payment to the lessor than would the use of less conservative input).22 21 The unadjusted historical equity risk premium is 6.9 percent (from Ibbotson 2017) and is based on the average equity risk premium from 1926 through 2015. However, in the current low interest rate environment, the security market line “misses” the zero beta risk-free Treasury bond rate or the expected return on an investment. This indicates that either the equity risk premium is too low or the risk-free return on U.S. Treasury bonds is too low. The estimated adjustment to the slope of the security market line results in an adjustment of 80 to 100 basis points in the equity risk premium. The committee used a 90–basis point (0.9 percent) adjustment to the historical equity risk premium to account for this phenomenon. That adjustment is based on work by the Brattle Group with regard to returns on securities in the current low interest rate environment. That research showed that as interest rates decreased, the targeted return on equity increased. 22 The development of the WACC (after tax) was informed by a discussion with Michael Vilbert of the Brattle Group, a recognized expert on this topic.

29 TABLE C-1 WACC Parameters, Values, and Sources Parameter Value Source rD 4.68% U.S. Department of the Treasury, 30-year high quality market corporate bond spot rate, from Federal Reserve Economic Data, Federal Reserve Bank of Saint Louis D/V 0.80 Committee member expertise with leveraged lease financing. This is a highly leveraged percentage that is related to the risk of a U.S.-backed lease. T 0.35 Internal Revenue Service rE 10.61% Calculated as shown in Equation C-2 rf 2.8% OMB Circular A-94 rp 6.9% 7.8% (adj.) Ibbotson 2017, adjusted up by 0.9 from historical equity risk premium rate E/V 0.20 Calculated as 1 – (D/V) SOURCE: Generated by the committee. The committee calculated the cost of leasing for a company and to the government on the basis of commonly used cash flow analysis techniques accounting for depreciation, taxes, asset life, and the time value of money. Table C-2 gives the main parameter values. Table C-3 gives the cash flow analysis. Figure C-2 shows a flowchart of the calculations, which are described by column. TABLE C-2 Cash Flow Analysis: Main Parameters, Values, and Sources Parameter Value Source Vessel capital cost $791 million In accordance with committee’s estimate (average cost of a series of four heavy polar icebreakers) Asset life 30 years In accordance with the statement of task Scrap value $2.33 million LWT of 11,650 tons (same as Healy) and $200 per LWT MACRS % Varies 10-year MACRS in accordance with IRS Publication 946, How to Depreciate Property, Section 4.10 Corporate tax rate 35% Internal Revenue Service WACC 4.6% Calculated as shown in Equation C-1 Government discount rate 2.8% OMB Circular A-94, Appendix C (revised November 2016) NOTE: LWT = lightweight tonnage. MACRS = modified accelerated cost recovery system (system used for tax depreciation in the United States). SOURCE: Generated by the committee.

30 The basic calculations between columns in Table C-3 are described as follows. Calculations cover the 30-year asset life unless noted otherwise. Negative cash flows are identified with parentheses in the spreadsheet and are shown with a “–” symbol here. The purpose of this calculation is to estimate the bareboat charter rate and therefore the after-tax bareboat cash flow that would set the sum of net present value of the cash flow (Column I) equal to zero—in other words, the annual payment that the federal government would need to make to the charter company for the company to achieve its risk-adjusted after-tax rate of return on its investment in the vessel. FIGURE C-2 Flowchart of cash flow analysis for leasing. (Source: Generated by the committee.) Column A Year 0—vessel capital cost = –$791,000,000.

31 Year 31—scrap value = $2,330,000. Column B Years 1 to 11—MACRS % depreciation. Column C Pretax bareboat cash flow = charter day rate * 365 days. Charter day rate = value calculated in the spreadsheet so that the net present value over 30 years is zero. Column D Vessel depreciation = –vessel capital cost * vessel MACRS % (Column B). The vessel is fully depreciated after 12 years. Column E Bareboat income = pretax cash flow (Column C) + vessel depreciation (Column D). Column F Corporate tax = –bareboat income (Column E) * corporate tax rate. Column G After-tax bareboat cash flow: Year 0 = –$791,000,000. Other years = pretax cash flow (Column C) + corporate tax (Column F). Column H Discount factor = 1(1+WACC)𝑛𝑛−0.5 where n is the number of years (any number between 1 and 30); 0.5 accounts for payments at midyear. Column I Bareboat cash flow present value = after-tax bareboat cash flow (Column G) * discount factor (Column H). Column J Discount factor, calculated with the formula used for Column H but for the federal government [with n = 30 and rate (used in place of the WACC) = 2.8 percent; 0.5 accounts for payments at midyear]. Column K Tax flow to government present value = corporate tax (Column F) * discount factor (Column J). Column L Bareboat less tax, net government cash flow = –pretax bareboat cash flow (Column C) – corporate tax (Column F). This is the cost to the government for leasing, with account taken of the tax that the government will receive from the charter company.

32 Column M Present value of lease = bareboat less tax, net government cash flow (Column L) * discount factor (Column J) This is the present value of the lease. The sum of the values in this column is the net present value, $939 million (shown above Column M). Finally, the committee used the Goal Seek feature in Excel (Table C-3)23 to estimate the bareboat charter day rate by setting the net present value (sum of Column I) equal to zero and varying the bareboat charter day rate cell. The result was a bareboat charter day rate of $142,605, which is $52 million per year (the value shown in Column C) after multiplication by 365 days per year. The committee then calculated the corporate tax owed in Column F (at 35 percent; the leasing company was assumed to have other income to offset early year losses, which reduces the lease rate). The corporate tax (Column F) cash flow was reduced by the “discount factors” calculated with a rate of 2.8 percent (the OMB 2016b designated discount rate) to estimate the after-tax net present value of $123 million. There may also be a small tax payment due to the government on the interest received by a lending institution providing funds to the leasing company (the lease was assumed to be leveraged). TABLE C-3 Cash Flow Analysis NOTE: The spreadsheet is available at http://onlinepubs.trb.org/onlinepubs/sp/IcebreakerLeaseBuycalculation2.xlsx. SOURCE: Generated by the committee. The net present value of the cost to the government of leasing a $791 million asset with a 30-year life (through use of a capital lease that is based on the committee’s assumptions and 23 The spreadsheet is available at http://onlinepubs.trb.org/onlinepubs/sp/IcebreakerLeaseBuycalculation2.xlsx. Capacity Difference in cost to the U.S. of direct buy versus lease financing -19% 365 Present Value of Lease Cost to U.S. (after tax) ($938,984,627) Newbuild Cost $791,000,000 0.5 GOAL SEEK: 0.5 Cost of Direct Purchase to U.S. $791,000,000 $142,605 35.00% 4.60% $0 2.80% $123,036,160 Added cost of leasing ($147,984,627) A B C D E F G H I J K L M Vessel Vessel Pre-Tax Bareboat Charter Vessel Bareboat Corporate After-Tax Bareboat Leasing Firm Bareboat CF U.S. Govt. Tax flow to Govt. BB less Tax Year Capital MACRS % Cash Flow Depreciation Income Tax Cash Flow Discount Factor Present Value Discount Factor Present Value Net Govt CF Present Value 0 ($791,000,000) ($791,000,000) 1.0000 ($791,000,000) 1.0000 1 17.50% $52,050,774.08 ($138,425,000) ($86,374,226) $30,230,979 $82,281,753 0.9778 $80,452,157 0.9863 ($29,816,431) ($82,281,753.15) ($81,153,448) 2 16.50% $52,050,774 ($130,515,000) ($78,464,226) $27,462,479 $79,513,253 0.9348 $74,326,211 0.9594 ($26,348,146) ($79,513,253) ($76,286,879) 3 13.20% $52,050,774 ($104,412,000) ($52,361,226) $18,326,429 $70,377,203 0.8937 $62,893,070 0.9333 ($17,103,897) ($70,377,203) ($65,682,431) 4 10.56% $52,050,774 ($83,529,600) ($31,478,826) $11,017,589 $63,068,363 0.8544 $53,882,863 0.9079 ($10,002,549) ($63,068,363) ($57,257,932) 5 8.45% $52,050,774 ($66,839,500) ($14,788,726) $5,176,054 $57,226,828 0.8168 $46,741,979 0.8831 ($4,571,195) ($57,226,828) ($50,539,467) 6 6.76% $52,050,774 ($53,471,600) ($1,420,826) $497,289 $52,548,063 0.7809 $41,032,922 0.8591 ($427,215) ($52,548,063) ($45,143,433) 7 6.55% $52,050,774 ($51,810,500) $240,274 ($84,096) $51,966,678 0.7465 $38,794,397 0.8357 $70,278 ($51,966,678) ($43,427,988) 8 6.55% $52,050,774 ($51,810,500) $240,274 ($84,096) $51,966,678 0.7137 $37,088,334 0.8129 $68,364 ($51,966,678) ($42,245,125) 9 6.56% $52,050,774 ($51,889,600) $161,174 ($56,411) $51,994,363 0.6823 $35,476,188 0.7908 $44,609 ($51,994,363) ($41,116,372) 10 6.55% $52,050,774 ($51,810,500) $240,274 ($84,096) $51,966,678 0.6523 $33,897,990 0.7692 $64,690 ($51,966,678) ($39,975,174) 11 0.82% $52,050,774 ($6,486,200) $45,564,574 ($15,947,601) $36,103,173 0.6236 $22,514,520 0.7483 $11,933,495 ($36,103,173) ($27,015,790) 12 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.5962 $20,170,942 0.7279 $13,260,943 ($33,833,003) ($24,627,466) 13 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.5700 $19,283,883 0.7081 $12,899,750 ($33,833,003) ($23,956,679) 14 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.5449 $18,435,835 0.6888 $12,548,395 ($33,833,003) ($23,304,163) 15 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.5209 $17,625,081 0.6700 $12,206,610 ($33,833,003) ($22,669,419) 16 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.4980 $16,849,982 0.6518 $11,874,134 ($33,833,003) ($22,051,964) 17 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.4761 $16,108,969 0.6340 $11,550,714 ($33,833,003) ($21,451,327) 18 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.4552 $15,400,544 0.6168 $11,236,103 ($33,833,003) ($20,867,049) 19 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.4352 $14,723,274 0.6000 $10,930,062 ($33,833,003) ($20,298,686) 20 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.4160 $14,075,787 0.5836 $10,632,356 ($33,833,003) ($19,745,804) 21 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.3977 $13,456,776 0.5677 $10,342,759 ($33,833,003) ($19,207,980) 22 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.3802 $12,864,986 0.5523 $10,061,049 ($33,833,003) ($18,684,806) 23 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.3635 $12,299,222 0.5372 $9,787,013 ($33,833,003) ($18,175,881) 24 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.3475 $11,758,339 0.5226 $9,520,440 ($33,833,003) ($17,680,818) 25 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.3323 $11,241,242 0.5084 $9,261,129 ($33,833,003) ($17,199,239) 26 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.3176 $10,746,885 0.4945 $9,008,880 ($33,833,003) ($16,730,778) 27 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.3037 $10,274,268 0.4810 $8,763,502 ($33,833,003) ($16,275,075) 28 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.2903 $9,822,436 0.4679 $8,524,808 ($33,833,003) ($15,831,785) 29 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.2776 $9,390,475 0.4552 $8,292,614 ($33,833,003) ($15,400,570) 30 $52,050,774 $0 $52,050,774 ($18,217,771) $33,833,003 0.2653 $8,977,509 0.4428 $8,066,745 ($33,833,003) ($14,981,099) Scrap $2,330,000 $2,330,000 $0 $2,330,000 ($815,500) $1,514,500 0.2594 $392,933 0.4367 $356,148 BB Charter Rate/day

33 analysis, including tax payments by the lessor to the U.S. Treasury, and OMB’s 2.8 percent discount rate) would be $939 million. The $939 million is $148 million, or 19 percent, more than the $791 million direct purchase cost. On the basis of the committee’s calculations, an increase in the WACC applied to the analysis (after tax) to 6 percent would raise the cost of leasing to 35 percent more than the cost of buying. Historically, the WACC (after tax) for leasing firms has been on the order of 10 to 15 percent higher than the current WACC for maritime assets. The committee would expect the cost of leasing to increase with higher WACC assumptions and thus make the leasing option even less attractive for the federal government. At a 35 percent corporate tax rate, the leasing cost is 19 percent higher than the cost of direct purchase. A reduction in the corporate tax rate from 35 percent to 0 percent would result in the cost of the lease being approximately 24 percent higher than the cost of direct purchase. The following are among the reasons for the higher cost of leasing as opposed to buying: • The U.S. government is considered the lowest-risk borrower (U.S. government securities are considered “risk free”). Therefore, it can borrow funds at a lower cost than any other organization. The 30-year high quality market corporate bond spot rate in March 2017 was 4.68 percent (Federal Reserve Bank of Saint Louis 2017). • Leasing companies require a return on equity (the current equity risk premium over the risk- free rate is on the order of 7.8 percent) that would meet the profit expectations of the lessor on the transaction. Leasing costs the government more than buying because the rate that leasing firms pay to borrow funds exceeds the rate at which the government can borrow (GAO 2016). In addition, leasing firms use equity (which costs more than debt) and require a return (profit) on the equity used (GAO 2016). This analysis does not consider the “transaction” costs inherent in a leveraged lease transaction (leveraged lease transaction costs involve legal and financial adviser fees that significantly increase the cost to the government). The conclusion that purchasing a USCG cutter for icebreaking is less costly to the government than leasing would also apply to a non-USCG option. Such an option would be to lease a U.S.-owned heavy icebreaker solely for breaking out McMurdo and supporting other scientific missions in the Antarctic. For the federal government, regardless of an asset’s use, buying is less expensive than leasing for a long-term asset life of 30 years for the two reasons described above. Under the Palmer–Gould model of a shorter-term service contract, the lease would be an operating lease as long as it met the OMB-defined requirements (OMB 2016a). The lease would be for a maximum of 5 years unless a longer term was written into the appropriation (OMB 2016a). A polar icebreaker is more of a specialty vessel than the Palmer or the Gould. Thus, there may not be as high a demand for its use, and attracting a private company with a 5-year (perhaps longer) lease term for an expensive vessel may be more difficult. Another option to consider is the lease or purchase of a “retired” foreign polar icebreaker to support icebreaking during scientific missions in the Antarctic. This option is only possible if there are other polar icebreakers available having the required capability and meeting the requirements of U.S. law. According to USCG, none are available (GAO 2016). With regard to the possibility of purchasing a “retired” foreign polar icebreaker at a low capital cost, the

34 committee is aware of the sale of only one vessel in the past 10 years that could be considered a polar icebreaker (the Botnica), but it has insufficient power to break out McMurdo.24 Operating Costs of the Various Manning Models As stated previously, the manning model is not dependent on the lease-versus-buy decision. The manning of a leased polar icebreaker by a USCG crew is conceptually possible. A previous National Academies report presented a table showing the difference in crewing costs between a USCG and a civilian crew (NRC 2007, 94, Table 10.1). The 2007 report suggested that the overall crew size would decrease with newer ships and upgrades in technology, as was the case with the Polar Star and the Healy (NRC 2007). The crewing model assumptions from the 2007 report included the following: • 300 annual operating days including days under way and working port calls; • 65 days annually for maintenance, sustainment, and preparation; • Current proven technology; • An integrated electric power plant for propulsion and hotel services; shaft horsepower capabilities between the Healy and the Polar Star; • Design to incorporate labor-saving features; • Sailing crew that operates up to 4 consecutive months and supports an additional 60 personnel; • Ship capable of round-the-clock operations; maximum 12-hour workday; • No major installed weapons systems; and • Use of U.S. citizens as crew members. The crewing estimate in the 2007 report assumed that USCG would be able to operate the ship, winches, cranes, boats, and any helicopters included on board. Additional crew would be required for some missions, such as major oil spill cleanup, but most missions would be met by the base crew of 60 billets. On-the-job training would occur on shore rotations, with less reliance on training while under way (NRC 2007, 94). Among the additional assumptions from the 2007 report are inclusion of standard personnel cost (pay, allowances, transfer, medical, and training) and use of the 2006 industry standard personnel costs schedule (NRC 2007, 94). The current committee used assumptions from the 2007 report to develop four alternative crew and manning combinations and the associated operating costs (see Table C-4). The commercial crew type costs are derived from industry input, and the USCG options are estimated on the basis of assumptions from the 2007 report listed above. The commercial estimates are for the current costs for crews on commercial Jones Act tankers and MSC auxiliary vessels. The annual cost for a commercial crew on a U.S.-flag vessel (e.g., tanker, containership) with 21 to 25 billets is on the order of $6 million to $7 million. MSC contracts for vessel 24 The Botnica was sold by Arctia Shipping, Finland’s government-owned icebreaker operator, to the Tallinn Port Authority in late 2012 for a reported $64.2 million. The Botnica is 317 feet long, has a beam of 78.7 feet, has a gross tonnage of 6,370 (a volumetric measure), and is diesel powered, with total installed power of 15,000 kilowatts.

35 TABLE C-4 Comparison of Alternative Crewing Models Crew Type Commercial Commercial USCG USCG Manning basis MSC modela Jones Act tankerb Lower crewing model PIBc Higher crewing model PIBd Billets 31 21–25 60 120 Cost per day ($) 20,500–28,000 12,000–17,000 17,721 28,800 Annual cost ($ millions) 7.5 to 10.2 6.0 to 7.0 6.5 10.5 NOTE: PIB = polar icebreaker. a MSC model crew cost input provided by MSC contractors under confidentiality agreement. b Jones Act tanker costs obtained from Jones Act tanker owners–operators under confidentiality restriction; cost range is due to differences in maritime union agreements and experience of specific crew members. c The lower USCG crewing model is based on an analysis from the 2007 National Academies study, and costs are inflated from 2006 to 2017 dollars (approximately 3 percent inflation per year). d The higher PIB crewing size is an estimate of the likely number of billets on the new polar icebreaker that also allows USCG to meet all of its statutory missions. Estimated annual crew costs were not available from USCG for either the lower or the higher crewing models. SOURCE: Generated by the committee. operations (crewing and maintenance) for full-service deployment range from $20,500 to just over $28,000 per day for a variety of operations ($7.5 million to $10.2 million per year) of different types of ships, including LMSRs, MPS, and other auxiliaries (e.g., remote radar systems).25 Estimated crew costs per day of USCG vessels are similar to or slightly more than those for non-USCG crew costs. USCG-manned vessels have larger crew sizes, the primary factor in the higher costs. For a smaller USCG polar icebreaker crew of 60, crew operating costs are less than the MSC option even with double the crew size. For a new polar icebreaker, USCG could consider smaller crew sizing, which could reduce annual crew operating costs. The committee did not examine crew size for the performance of USCG missions. An option for one of the new polar icebreakers (not necessarily the first of its class) is a U.S.-government-purchased polar icebreaker that is crewed privately and used solely for the McMurdo break-in. The private crew costs could be similar to the MSC or Jones Act tanker models given in Table C-4. This polar icebreaker would not be able to perform USCG missions but could conduct science or other nonmilitary activities. Summary The lease-versus-buy analysis indicates that, with its large capital cost and a 30-year life, a polar icebreaker is less expensive for the government to buy than to lease, regardless of whether the option is for a USCG cutter or a privately owned or operated polar icebreaker. This essentially rules out the option of leasing rather than buying. 25 See MSC Summary of Charters spreadsheet, available at http://www.procurement.msc.navy.mil.

36 • USCG cutters must be manned by USCG crews to perform their missions, which rules out privately crewed USCG vessels. • The options for crewing of a vessel for the breaking out of McMurdo Station depend on the crew size that USCG determines to be necessary for the polar icebreakers. A USCG crew size double that of a private crew is feasible with comparable cost. The operating cost of the higher crewing size would exceed the costs of a private crew. However, the non-USCG crew would be unable to perform any USCG statutory missions while the vessel was in the Southern Hemisphere. • A government-purchased polar icebreaker with a private crew could be a feasible option for breaking out McMurdo Station. In view of the requirement for government purchase and the lack of foreign vessels available for lease, this could be a cost-effective option for supporting science missions at the South Pole once USCG has a fleet of at least four polar icebreakers. References Abbreviations ABS American Bureau of Shipping GAO Government Accountability Office or Government Accounting Office NRC National Research Council OMB Office of Management and Budget ABS Consulting. 2012. Leasing Options for U.S. Polar Icebreaker Capability. Arlington, Va. Federal Reserve Bank of Saint Louis. 2017. 30-Year High Quality Market (HQM) Corporate Bond Spot Rate (HQMCB30YR). https://fred.stlouisfed.org/series/HQMCB30YR. Accessed April 21, 2017. GAO. 1999. Defense Acquisitions: Historical Analyses of Navy Ship Leases. Report B-281374. Washington, D.C. GAO. 2016. Coast Guard: Arctic Strategy Is Underway, but Agency Could Better Assess How Its Actions Mitigate Known Arctic Capability Gaps. GAO-16-453. Washington, D.C. Ibbotson, R. 2017. Stocks, Bonds, Bills, and Inflation (SBBI) Yearbook. John Wiley and Sons. http://cosmofilmes.com/pdf/2017-stocks-bonds-bills-and-inflation-sbbi-yearbook. NRC. 2007. Polar Icebreakers in a Changing World: An Assessment of U.S. Needs. National Academies Press, Washington, D.C. OMB. 2016a. Circular A-11 Capital Programming Guide, Version 3.0. Washington, D.C. OMB. 2016b. Circular A-94 Appendix C Discount Rates for Cost-Effectiveness, Lease Purchase, and Related Analyses. Revised Nov. Washington, D.C.

Next: 5. Appendix D: Icebreaker Acquisition Strategy, Design and Cost Projections,and Operating Costs »
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On July 11, 2017, the National Academies of Sciences, Engineering, and Medicine Committee on Polar Icebreaker Cost Assessment released a letter report that advises the U.S. Congress on strategies to minimize life-cycle costs of polar icebreaker acquisition and operations. The Committee recommends the number and type of polar icebreakers to fund and an acquisition strategy that achieves a lower cost.

The Committee developed an independent cost estimate using available concept designs to determine if the U.S. Coast Guard’s existing cost estimates for heavy and medium icebreakers are reasonable. It also compared operating costs of the current fleet to the prospective operating costs of new vessels. The Committee recommends a science-ready design for the new icebreakers and the use of an enhanced maintenance program to ensure continuity of operations for existing icebreakers.

This letter report is mandated by the Coast Guard Authorization Act of 2015, and sponsored by the USCG. View the press release.

View a video summarizing the report findings:

On July 25, 2017, the U.S. House of Representatives Transportation and Infrastructure Committee Subcommittee on Coast Guard and Maritime Transportation held a hearing that examines the U.S. Coast Guard’s infrastructure and acquisition needs, and includes the testimony of Rear Admiral Richard D. West (Navy Ret.) who served as Chair for the Committee on Polar Icebreaker Cost Assessment. Witness statements are available online, and the video of the hearing is below:

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