Department of Energy: New Loan Guarantee Program Should Complete Activities Necessary for Effective and Accountable Program Management
Released: 2008-07-07T00:00:00

Letter

Background

Title XVII of EPAct 2005—Incentives for Innovative Technologies— authorized DOE to guarantee loans for projects that satisfy all three of the following criteria: (1) decrease air pollutants or man-made greenhouse gases by reducing their production or by sequestering them (storing them to prevent their release into the atmosphere); (2) employ new or significantly improved technologies compared with current commercial technologies; and (3) have a “reasonable prospect” of repayment. Title XVII identifies 10 categories of projects that are eligible for a loan guarantee, such as renewable energy systems, advanced fossil energy technologies, and efficient end-use energy technologies. Appendix II provides a list of these categories.

The LGP office is under DOE’s Office of the Chief Financial Officer. LGP’s actions are subject to review and approval by a Credit Review Board. The Board met for the first time in April 2007; it approves major policy decisions of the LGP, reviews LGP’s recommendations to the Secretary of Energy regarding the issuance of loan guarantees for specific projects, and advises the Secretary on loan guarantee matters. DOE first received appropriated funds for the LGP’s administrative costs in early 2007 and began processing preapplications—in response to the August 2006 solicitation—and at the same time began to obtain staff and take other steps to initiate the program. During 2007, it reviewed preapplications for 143 projects and in October 2007 invited 16 of the preapplicants to submit full applications for loan guarantees. Appendix II includes information on the 16 projects invited to submit full applications. In general, according to DOE, the processing of full applications will require DOE to have numerous interactions with the applicants and private lenders. It will also require financial, technical, environmental, and legal advisors to assist with underwriting, approving, and issuing a loan guarantee. DOE estimated that the time between receiving an application and completing negotiations for a loan guarantee contract would range from 9 to 25 months, with additional time at the beginning to prepare and issue the solicitation and at the end to close the loan.

On April 11, 2008, DOE issued a fiscal year 2008 implementation plan for $38.5 billion in solicitations, to respond to a requirement that DOE provide Congress information about future solicitations 45 days prior to issuing them. On June 30, 2008, DOE simultaneously issued three solicitations that total $30.5 billion—on (1) efficiency, renewable energy, and electric transmission ($10 billion), (2) nuclear power facilities ($18.5 billion), and (3) nuclear facilities for the “front end” of the nuclear fuel cycle ($2 billion). DOE plans to subsequently issue a fourth solicitation in late summer 2008 for advanced fossil energy projects ($8 billion). DOE is also required to annually provide Congress a report on all activities under Title XVII and issued the first report on June 15, 2007. Figure 1 shows a timeline of these and other key program events since 2005 that illustrate the status of the LGP through June 2008.

DOE Issued Regulations That Contained Required Elements, but One Key Aspect Is Not Clear

On October 23, 2007, DOE’s final regulations for the LGP were published in the Federal Register. DOE had previously issued program guidelines in August 2006. The final regulations contain requirements for preapplication and application submissions; programmatic, technical and financial evaluation factors for applications; and lender eligibility and servicing requirements. The regulations incorporate and further clarify requirements of Title XVII related to eligibility, fees, default conditions, and audit documentation. The regulations also generally incorporate requirements set forth in OMB Circular A-129 Policies for Federal Credit Programs and Non-Tax Receivables, which prescribes policies and procedures for federal credit programs, such as applicant screening, lender eligibility, and corrective actions. Because loan guarantee programs pose significant financial risks, it is important to include appropriate mechanisms to help protect the federal government and American taxpayers from excessive or unnecessary losses.

DOE changed some key aspects of the initial program guidelines in its final regulations to help make the program more attractive to lenders and potentially reduce financing costs for projects. These changes included increasing the maximum guarantee percentage, allowing the lender to separate or “strip” the nonguaranteed portion of the debt, and revising its interpretation of a Title XVII requirement that DOE have superior right to project assets pledged as collateral. Other important changes relate to increased specificity in key definitions and a requirement for independent engineering reports. Specifically, we found the following: Guarantee percentage. The final regulations allow for loan guarantees of up to 100 percent of the loan amount, which is limited to no more than 80 percent of the project costs, provided that, for a 100 percent guarantee, the loan must be disbursed by the Federal Financing Bank (FFB). The use of the FFB is required, in part, because a private lender may exercise less caution when underwriting and monitoring a loan with a 100 percent guarantee. The guidelines stated that DOE preferred not to guarantee more than 80 percent of the loan amount, which was limited to no more than 80 percent of the project costs. Because the regulations increased the maximum guarantee percentage, this change increases the risk that the government is willing to assume on a project by project basis.

Stripping the nonguaranteed portion. When DOE guarantees 90 percent or less of a loan, the final regulations allow the nonguaranteed portion of a loan to be separated or “stripped” from the guaranteed portion. This change allows lenders greater flexibility in selling portions of a loan on the secondary market and could reduce overall funding costs for projects. In contrast, the guidelines and the proposed regulations did not allow stripping.

Superiority of rights. Title XVII requires DOE to have superior rights to project assets pledged as collateral. In the proposed regulations, DOE interpreted this provision to require DOE to possess first lien priority to assets pledged as collateral. Therefore, holders of nonguaranteed portions of loans would be subordinate to DOE in the event of a default. In the final regulations, DOE changed its interpretation to allow proceeds received from the sale of project assets to be shared with the holders of nonguaranteed portions of loans in the event of a default. As noted in public comments on the proposed regulations, this practice is an established norm in project lending. DOE stated that it retains superiority of rights, as required by Title XVII, because DOE has sole authority to determine whether, and under what terms, the project assets will be sold at all.

Key definitions. In the context of “innovative technologies,” the final regulations added a definition that clarified the definition of what constitutes a “new or significantly improved” technology, considerably expanded the definition of “commercial” technology already in use, and clearly linked the definitions to each other. According to the regulations, a new or significantly improved technology is one that has only recently been developed or discovered and involves a meaningful and important improvement in productivity or value in comparison with the commercial technology in use. DOE’s regulations define a commercial technology as being in general use if it is employed by three or more commercial projects in the United States for at least 5 years.

Independent engineering report. The final regulations require the applicant to provide an independent engineering report on the project, which was not required under the guidelines. According to the regulations, the engineering report should assess the project, including its site information, status of permits, engineering and design, contractual requirements, environmental compliance, testing and commissioning, and operations and maintenance.

Although the final regulations generally address requirements from applicable guidance, we identified one key aspect related to equity requirements that is not clear. The final regulations state that DOE will evaluate whether an applicant is contributing significant equity to the project. The regulations define equity as “cash contributed by the borrowers and other principals.” Based on this definition, it appears that non-cash contributions, such as land, would not be considered equity. However, the LGP director told us that land and certain other non-cash contributions could be considered equity. As a result, the regulations do not fully reflect how DOE is interpreting equity and potential applicants may not have a full understanding of the program’s equity requirements.

DOE Has Not Fully Implemented Activities Necessary for Effective and Accountable Program Management

DOE may not be well positioned to manage the LGP effectively and maintain accountability because it has not completed a number of management and internal control activities key to carrying out the program. As a result, DOE may not be able to process applications efficiently and effectively, even though DOE has begun to review its first application, and officials told us they will begin reviewing other applications as soon as they are submitted. The key activities that DOE has not sufficiently completed include (1) clearly defining its key milestones and its specific resource needs, (2) establishing policies and procedures for operating the program, and (3) agreeing upon key measures to evaluate program progress. The nature and characteristics of the LGP expose the government to substantial inherent risk; implementing these management and internal control tools is a means of mitigating some risks.

DOE Has Begun Its Application Review Process before Clearly Defining Program Milestones and Specific Resource Needs

According to our work on leading performance management practices, agencies should have plans for managing their programs that identify goals, strategies, time frames, resources, and stakeholder involvement in decision making. In January 2008 DOE completed a “concept of operations” document that contains, among other things: information on the LGP’s organizational structure; mission, goals, and objectives; and timelines, milestones, and major program activities that must be accomplished and their sequence. However, LGP officials told us they do not consider the concept of operations a strategic or performance planning document. In addition, it is unclear whether LGP plans to set other timelines and milestones that would be available to stakeholders, such as applicants and Congress. Without associating key activities with the time frames it aims to meet, it is unclear how DOE can adequately gauge its progress or establish and maintain accountability to itself and stakeholders.

As of March 2008, 14 of the 16 companies invited to submit full applications reported that they plan to submit their applications to DOE by the end of September 2008, and the other 2 plan to submit by the end of January 2009. DOE received one application in April 2008, which it has begun to review, and DOE officials told us they will begin reviewing other applications as soon as they are submitted. This influx of applications could cause a surge in workload, but it is not clear that DOE has obtained the resources it needs to carry out its application review activities. Although it is critical for agencies to determine the timing and type of resources needed, DOE has not determined the number and type of contractor resources it will need to review the applications, which could lead to delays. For example, DOE expects to need legal, engineering, environmental, and financial contracting expertise but has not completed plans describing the types of expertise needed, estimated when the expertise will be required, or determined to what extent each type of expertise will be needed. According to the LGP director, much of this expertise will have to be acquired through new contracts that DOE must negotiate and that generally take some months to put into place. To the extent that these resources are not available when needed, DOE could experience delays in reviewing the applications. In early April 2008, the LGP director said that his office is working with other DOE offices to develop these contracts and considers this activity high priority; while the completion date for an acquisition and contract vehicles strategy was initially set for the end of April, the timetable DOE includes in its agency comments letter indicates an August 2008 completion date. In addition, as of April the LGP office was 7 staff short of its authorized level of 16 for fiscal year 2008; the director told us it has faced delays in hiring permanent staff, although he indicated that the office has enough permanent staff to review the first 16 applications. He also said that the permanent and contractor staff LGP has hired have many years of project finance or loan guarantee experience at other institutions.

DOE Has Not Completed Key Policies and Procedures

Management has a fundamental responsibility to develop and maintain effective internal controls to help ensure that programs operate and resources are used efficiently and effectively to achieve desired objectives and safeguard the integrity of their programs. As of May 2008, DOE had not completed policies and procedures to select loans, identify eligible lenders and monitor loans and lenders, estimate the costs of the program, or account for the program, despite reporting to Congress in June 2007 that it would have completed most of these activities by the end of fiscal year 2007.

Selecting Loans

OMB Circular A-129 calls for agencies to develop policies and procedures to select loans, including appropriate applicant screening standards to determine eligibility and creditworthiness. In this regard, from August 2006 through October 2007, DOE conducted a preapplication process to help it develop final regulations; develop and test policies, criteria, and procedures for reviewing preapplications; and determine which projects it would invite to apply for loan guarantees. Conducting the preapplication process also enabled DOE to respond to congressional interest in launching the program, according to DOE officials.

We found that, during its preapplication review process, DOE did not always sufficiently document why it ultimately selected projects that reviewers did not score highly or recommend initially. DOE documented the results of the selection process, including its technical and financial reviews for individual projects, its joint technical-financial reviews for categories of projects, and its decisions made during its secondary review process. However, we found that DOE’s documentation for deciding which projects to recommend to the Credit Review Board did not always provide sufficient justification. While our discussions with DOE officials helped clarify the documentation for 6 of the 16 invited projects, they did not for 2 of those projects. According to DOE officials, they gave greater weight to the technical merit than the financial merit of the projects during the preapplication selection process. In addition, a consultant DOE hired to review the preapplication process found that although the files were in “good working order,” DOE did not consistently conduct and document its technical evaluations and did not document financial evaluations in depth. The consultant recommended that DOE take steps to establish standards for these evaluations and increase the level of transparency in the preapplication evaluation process.

We also found that the financial and technical criteria DOE used to review the preapplications were not sufficiently defined in some cases. For example, a requirement that is central in considering projects’ overall eligibility—whether it is “innovative,” also known as “new and significantly improved”—was difficult to determine, according to several program managers and reviewers. After the initial review process was completed, DOE further defined what it considers “new and significantly improved” in its final regulations, but has not correspondingly updated the review criteria. In addition, when DOE conducted its financial reviews, it evaluated projects by assigning scores between zero and four—with zero being the weakest score and four being the strongest score. However, DOE did not define what the possible scores signified. Moreover, 60 percent of a preapplicant’s financial score was based on creditworthiness; yet, DOE did not require preapplicants to submit pertinent financial and credit information such as audited financial statements or credit histories.

DOE has not fully developed detailed internal policies and procedures, including criteria, for selecting applications. To review the first 16 projects, DOE officials told us they will use criteria developed for the preapplication process. For projects that apply in response to future solicitations, DOE plans to amend current preapplication criteria and develop additional evaluation factors that will be specific to certain technology areas or sectors. According to DOE officials, as of May 2008, DOE has also hired one staff person to develop credit policies and procedures specific to LGP, and to fully establish its credit policy function. They also said that these credit policies and procedures would provide internal guidance related to some aspects of application review.

DOE officials told us they also expect the application process guidance they developed for companies to also serve as internal review policies and procedures. This guidance provides instructions on the content and format applicants should adhere to when applying for a guarantee, such as background information; a project description; and technical, business, and financing plans. The guidance generally aligns with information in the final regulations on the factors DOE plans to review and should make it easier for companies to develop applications. However, in some cases the guidance lacks specificity for applicants. In addition, when considering the guidance for use as internal policies and procedures, as DOE has indicated it will be used, we determined that it does not contain criteria or guidance that would be sufficient for DOE reviewers. Specifically, it lacks instruction and detail regarding how DOE will determine project eligibility and review applications, such as roles and responsibilities, criteria for conducting and documenting analyses, and decision making. For example, we found the following: Project eligibility. DOE does not delineate how it will evaluate project eligibility—that is, how each project achieves substantial environmental benefits and employs new or significantly improved technologies. The guidance requires applicants to submit background information on the technologies and their anticipated benefits but does not require enough detail for DOE to assess the information. Without such detail, it is unclear how DOE will measure each project’s contribution to the program.

Independent engineer’s report. DOE’s guidance does not provide sufficient detail on the technical information applicants should submit in this report, even though the guidance requires that the report comprehensively evaluate five technical elements as well as contractual requirements and arrangements. DOE officials told us that applicants generally develop this report for investors and that the reports will likely be of varying quality and detail. DOE officials also expect that, in developing a separate report that assesses this information, they will likely need to fill considerable gaps and conduct additional analyses. While DOE recognizes these reports serve an important due diligence function, DOE has not provided applicants with specific instructions on what to include. As a result, DOE is likely to lose efficiency and effectiveness when it uses the reports to aid in evaluating loan guarantee applications.

Creditworthiness. For a company to be eligible for a loan guarantee, a reasonable prospect of repayment must exist and the applicant cannot have delinquent federal debt, which is critical to determine at the beginning of the review process to assess whether an applicant is even eligible. Therefore, a sound assessment of creditworthiness is essential. However, the criteria DOE has established to evaluate creditworthiness— which it used during the preapplication process and plans to use for future applications—did not take into account the more meaningful and thorough information required for the full application process. In addition, while DOE’s guidance requests applicants to submit more complete information, such as a credit assessment, it does not provide details regarding how DOE will evaluate the information to determine creditworthiness.

Project cost information. DOE’s guidance for the application process instructs applicants to indicate if their cost estimates are firm or subject to change, but it does not request applicants to report a level-of-confidence in their total project estimates. GAO has reported that for management to make good decisions and determine if a program is realistically budgeted, the estimate must quantify the uncertainty so that a level of confidence can be given about the estimate. For example, an uncertainty analysis could inform DOE management that there is a 60 percent chance that a project’s cost will be greater than estimated. Without requiring information on the uncertainty in project cost estimates and specifying how it will assess that information, DOE may not be able to appropriately determine a project’s feasibility and identify projects that could eventually require substantially more investment or loans for completion.

Without sufficient internal policies and procedures that correspond to application components, DOE’s application review process will lack transparency and it will be difficult for DOE to consistently, thoroughly, and efficiently evaluate project applications.

Identifying Eligible Lenders and Monitoring Loans and Lenders

OMB Circular A-129 calls for agencies to establish policies and procedures to identify eligible lenders and to monitor loans and lenders. DOE has hired a director of monitoring and, according to DOE officials, is currently developing policies and procedures that will include (1) processes for identifying eligible lenders through a competitive process, as well as an associated checklist and guide for evaluating potential lenders, and (2) loan servicing and monitoring guidelines. These policies and procedures may build upon the monitoring policies of the Overseas Private Investment Corporation (OPIC). Implementing rigorous monitoring policies and procedures will help DOE ensure the success of the loan guarantee program. According to DOE officials, these policies and procedures will be completed before DOE issues the first loan guarantees.

Estimating Subsidy Costs

As required by the LGP’s fiscal years 2007 and 2008 appropriation, DOE plans to charge borrowers fees to cover subsidy costs, as permitted by Title XVII. However, estimating the subsidy cost for the LGP will be difficult because of inherent risks due to the nature and characteristics of the program. To the extent that DOE underestimates the costs and does not collect enough fees from borrowers, taxpayers will ultimately be responsible for any shortfall. Therefore, it is critical that DOE have a sound and comprehensive methodology to develop its cost estimates. Guidance on preparing subsidy cost estimates lists procedures necessary to estimate subsidy costs, such as the development of a cash flow model; the review and approval process; and documentation of the cash flow model and underlying assumptions. OMB Circular A-129 requires agencies to develop models to estimate subsidy costs before obligating direct loans and committing loan guarantees. According to LGP officials, DOE has submitted a draft subsidy cost model to OMB for approval and has drafted documentation for the subsidy calculation process.

Estimating Administrative Costs

Title XVII requires DOE to collect fees from borrowers to cover applicable administrative costs. Such costs could include costs associated with evaluating applications; offering, negotiating, and closing guarantees; and servicing and monitoring the guarantees. The federal accounting standard for cost accounting states that cost information is an important basis for setting fees and reimbursements and that entities should report the full cost of programs, including the costs of (1) resources the office uses that directly or indirectly contribute to the program, and (2) identifiable supporting services other offices provide within the reporting entity. While DOE has prepared a schedule of fees to be charged for the first solicitation, it could not provide support for how it calculated the fees. DOE officials stated that they used professional judgment as a basis for the fee structure. However, DOE has not developed polices and procedures to estimate administrative costs, including a determination of which costs need to be tracked. For example, DOE has not tracked administrative costs associated with the time general counsel staff have spent working on issues related to the LGP. Therefore, DOE lacks assurance that the fees it collects will fully cover applicable administrative costs, particularly support costs from offices outside of the LGP office, such as the general counsel. According to DOE officials, some element of judgment must be used at this time in the determination of fees and as more experience is gained they will be able to develop policies and procedures designed to ensure that adequate fees are collected to cover administrative costs.

Accounting for the Loan Guarantee Program

In April 2008, DOE officials told us that policies and procedures to account for the LGP are nearly complete. Under the LGP regulations, DOE may issue loan guarantees for up to 100 percent of the loan amount as long as FFB disburses the loan. OMB Circular A-11, Preparation, Submission and Execution of the Budget, calls for credit issued by FFB to be budgeted for as a direct loan. Because the accounting treatment mirrors the budgeting, DOE would also account for such loans as direct loans. Accordingly, DOE has indicated that the policies and procedures will cover accounting for both direct loans and loan guarantees.

DOE Has Not Completed Its Framework for Evaluating Program Progress

DOE has also not completed the measures and metrics it will use to evaluate program progress. DOE included some of these in its fiscal year 2009 budget request and its concept of operations document, but LGP’s director told us the measures and metrics have not been made final because DOE and OMB have not yet agreed on them. In assessing the draft measures and metrics, we observed the following shortcomings: DOE intends to measure outcomes directly tied to overall program goals—installing new capacity, reducing greenhouse gas emissions, and reducing air pollution—and has said it will develop baselines or benchmarks for these outcomes. However, it has not yet gathered and analyzed the necessary data on, for example, existing capacity or current emission levels for categories of LGP project technologies.

DOE included a measure for the recovery of administrative costs but not one for the recovery of subsidy costs, which will most likely be the more significant program cost.

DOE’s metric to assess the effectiveness of financing decisions— containing the loss rate to 5 percent—may not be realistic; it is far lower than the estimated loss rate of over 25 percent that we calculated using the assumptions included in the fiscal year 2009 president’s budget.

Inherent Risks Will Make Estimating Subsidy Costs Difficult and May Introduce Self- Selection Biases in the Projects That Ultimately Receive Loan Guarantees

The nature and characteristics of the LGP will make estimating the program’s subsidy costs difficult even if DOE develops a sound and comprehensive methodology. Evaluating the risks of individual projects applying for loan guarantees will be difficult because the LGP targets innovative energy technologies and because projects will likely have unique characteristics—varying in size, technology, and experience of the project sponsor. For the first solicitation alone, the technologies range from a modest energy efficiency project to multiyear advanced coal projects, and estimated project costs range from around $25 million to more than $2 billion. In fiscal year 2008, DOE plans to further diversify the types of technology projects that it will consider for its loan portfolio, including nuclear power facilities, whose project costs may be more than $5 billion for each facility. Further, DOE will not gain significant experience in each technology because the program’s objective is to commercialize a limited number of each type of innovative technologies. Therefore, the types of projects will, by design, evolve over time, and the experience and data that DOE gains may not be applicable to evaluating the risks of projects applying in the future.

The composition of DOE’s eventual portfolio will even further limit the data available to help DOE evaluate project risks. Unlike an agency that provides a high volume of loan guarantees for relatively similar purposes, such as student loans or home loans, DOE will likely approve a small number of guarantees each year, leaving it with relatively little experience to help inform estimates for the future. In addition, DOE’s loan guarantees will probably be for large dollar amounts, several of which could range from $500 million to more than $1 billion each. As a result, if defaults occur, they will be for large dollar amounts and will likely not take place during easily predicted time frames. Recoveries may be equally difficult to predict and may be affected by the condition of the underlying collateral. In addition, project risks and loan performance could depend heavily on regulatory and legislative actions, as well as future economic conditions, including energy prices and economic growth, which generally can not be predicted accurately. These factors combine to make it difficult for DOE to prepare reliable estimates of subsidy costs. To the extent that DOE underestimates the costs of the LGP and does not collect enough fees from borrowers, taxpayers will ultimately have to pay for any shortfalls. Under FCRA, DOE is required to update, or reestimate, the subsidy costs of LGP to reflect actual loan performance and changes in expected future loan performance. Shortfalls identified in annual reestimates are automatically funded by the federal government under the terms of the FCRA and are not subject to congressional scrutiny during the annual appropriation process.

The likelihood of misestimates and the practice of charging fees to cover all the estimated costs may lead to biases in the projects that ultimately receive loan guarantees and tilt the portfolio of loan guarantees toward those that will not pay for themselves. In general, potential borrowers will know more about their projects and creditworthiness than DOE. As a result, borrowers will be more likely to accept loan guarantee offers if they believe DOE has underestimated the projects’ risks and therefore set the fee too low, than if they believe DOE has overestimated risks. Underestimated fees amount to an implicit subsidy. The CBO reported that such a bias in applicants’ acceptance of loan guarantees increases the likelihood that DOE’s loan guarantee portfolio will have more projects for which DOE underestimated the fee. CBO evaluated the cost of the LGP and estimated that DOE would charge companies, on average, at least 1 percent lower than the likely costs of the guarantees. To the extent that DOE underestimates the fee, and does not collect enough fees from borrowers to cover the actual subsidy costs, taxpayers will bear the cost of any shortfall.

Even if DOE estimates the subsidy cost with a reasonable degree of accuracy and charges the applicants fees to cover the true costs, there is a potential for a self-selection bias in the companies participating in the program toward those for which the fee is small relative to the expected benefits of the loan guarantee (such as more favorable loan terms or a lower interest rate). As CBO recently reported about the LGP, a loan guarantee would improve a project’s financial viability if the cost of the guarantee is shifted to the federal government. However, when the borrower pays a fee to cover the subsidy cost, as is the case with the LGP, the cost and most of the risk stay with the project and the viability of the project may not be substantially improved. Therefore, for such projects, there is a practical limit to how large the fee can be without jeopardizing the project’s financial prospects; these constraints add to the challenge of setting fees high enough to compensate for uncertainties. To the extent that some projects targeted by Title XVII are not financially viable without some form of federal assistance or favorable treatment by regulators, these projects will not pursue loan guarantees even though they are otherwise eligible. As a result, if this financial viability is not distributed evenly across technologies targeted by Title XVII, the projects that ultimately receive loan guarantees may not represent the full range of technologies targeted by Title XVII.

DOE officials noted that the borrower pays option may cause the more risky potential borrowers that would be required to pay a higher fee to either (1) contribute more equity to their projects to lower the fee or (2) abandon their projects and not enter the program. If potential borrowers contribute more equity, this could decrease default risk or improve potential recoveries in the event of a default.

Conclusions

More than a year has passed since DOE received funding to administer the LGP and we recommended steps it should take to help manage the program effectively and maintain accountability. We recognize that it takes some time to create a new office and hire staff to implement such a program. However, instead of working to ensure that controls are in place to help ensure the program’s effectiveness and to mitigate risks, DOE has focused its efforts on accelerating program operations. Moreover, because loan guarantee programs generally pose financial risk to the federal government, and this program has additional inherent risks, it is critical that DOE complete basic management and accountability activities to help ensure that it will use taxpayer resources prudently. These include establishing sufficient evaluation criteria and guidance for the selection process, resource estimates, and methods to track costs and measure program progress. Without completing these activities, DOE is hampering its ability to mitigate risks of excessive or unnecessary losses to the federal government and American taxpayers.

The difficulties DOE will face in estimating subsidy costs could increase LGP’s financial risk to the taxpayer. If DOE underestimates costs, the likely end result will be projects that do not fully pay for themselves and an obligation to taxpayers to make up the difference. Furthermore, the inherent risks of the program, along with the expectation that borrowers will cover the costs of their loan guarantees, may lead to self-selection bias that tilts the portfolio of projects toward those for which costs have been underestimated. Neither we nor DOE will be able to fully evaluate the extent or magnitude of the potential financial costs to the taxpayer until DOE has developed some experience and expertise in administering the program. Expanding the LGP at this juncture, when the program’s risks and costs are not well understood, could unnecessarily result in significant financial losses to the government. Self-selection bias may also—under certain conditions—lead to less than the full range of projects of technologies targeted by Title XVII represented in the LGP. The likely costs to be borne by taxpayers and the potential for self-selection biases call into question whether the program can fully pay for itself; they also call into question whether the program will be fully effective in promoting the commercialization of a broad range of innovative energy technologies.

It is important to note that, while we found that inherent risks and certain features of the program may lead to unintended taxpayer costs and that self-selection biases may reduce the scope of participation in the program, this is not an indication that the overall costs of the program outweigh the benefits. Rather, it simply means that the costs may be higher and the benefits lower than expected. Finally, the extent to which these costs and benefits will differ from expectations over the life of the program is something that cannot be reasonably estimated until DOE gains some experience in administering the LGP. Even at the current planned pace of the program, it will take a number of years before we can observe the extent to which unintended taxpayer costs are incurred or the benefits of innovative energy technologies emerge.

Matter for Congressional Consideration

To the extent that Congress intends for the program to fully pay for itself, and to help minimize the government’s exposure to financial losses, we are suggesting that Congress may wish to consider limiting the amount of loan guarantee commitments that DOE can make under Title XVII until DOE has put into place adequate management and internal controls. We are also making recommendations to assist DOE in this regard.

Recommendations for Executive Action

To improve the implementation of the LGP and to help mitigate risk to the federal government and American taxpayers, we recommend that the Secretary of Energy direct the Chief Financial Officer to take the following steps before substantially reviewing LGP applications: complete detailed internal loan selection policies and procedures that lay out roles and responsibilities and criteria and requirements for conducting and documenting analyses and decision making; clearly define needs for contractor expertise to facilitate timely amend application guidance to include more specificity on the content of independent engineering reports and on the development of project cost estimates to provide the level of detail needed to better assess overall project feasibility; improve the LGP’s full tracking of the program’s administrative costs by developing an approach to track and estimate costs associated with offices that directly and indirectly support the program and including those costs as appropriate in the fees charged to applicants; further develop and define performance measures and metrics to monitor and evaluate program efficiency, effectiveness, and outcomes; and clarify the program’s equity requirements to the 16 companies invited to apply for loan guarantees and in future solicitations.

Agency Comments and Our Evaluation

We provided a draft of this report to the Secretary of Energy for review and comment. DOE generally disagreed with our characterization of its progress to date in implementing the LGP. DOE stated two of our six recommendations were inapplicable to the LGP, indicated it has largely accomplished the remaining four recommendations, and disagreed with our matter for congressional consideration. DOE further stated that our report contains flawed logic, significant inaccuracies, and omissions; however, DOE did not provide evidence to support these assertions. Our evaluation of DOE’s comments follows. A more detailed analysis is presented in appendix III.

In particular, DOE stated that we placed disproportionate emphasis on activities that should be completed for a fully implemented loan guarantee program rather than one that is currently being implemented, and that we overlooked DOE’s accomplishments to date. We disagree. We believe that our report accurately assesses the LGP in its early development stage and focused our report’s analysis and recommendations on activities that should be completed before DOE begins to substantively review any applications. DOE states that it will have completed many of these activities before it issues loan guarantees, but we continue to believe these activities should be completed before DOE reviews applications and negotiates with applicants so that it can operate the program prudently. In several cases, DOE cites as complete documents and activities that were, and still are at the time of this report, in draft form. For example, in several instances DOE states that it has “implemented” its credit subsidy model. However, as of June 24, 2008, DOE indicated that OMB has not approved its model. Further, DOE illustrates in an updated timetable it provides in its appendix B of its comment letter that a majority of these activities are not yet complete and that several will not be complete until the end of the calendar year 2008. DOE’s entire letter, including its appendixes, is reproduced as appendix III of this report.

Regarding our recommendation on policies and procedures for conducting reviews, DOE cites policies and procedures that it believes are adequate for continuing program implementation. We disagree. DOE is developing credit policies and procedures, but it does not have complete internal application policies and procedures, which it should have as it begins to review and negotiate its first loan guarantee applications. DOE also lacks any substantive information in its external application guidance on how it will select technologies. DOE has indicated that some of this information will be included in future solicitations.

DOE partially agreed with our recommendation to define the expertise it will need to contract for and stated that it is developing descriptions of necessary contractor expertise on a solicitation-specific basis. Although DOE may plan to complete such descriptions and other preparatory work for future solicitations, DOE did not provide us with any information for contractor expertise for the 2006 solicitation. DOE’s timetable provided in Appendix B indicates an August 2008 completion date for its acquisition strategy and contract vehicles; this target may be in time for future solicitations but it is not in time for the applications that companies are now submitting and DOE is reviewing. DOE also states that it is not possible to develop generic definitions of needed contractor expertise because the department’s needs will vary from solicitation to solicitation. We continue to believe it is both reasonable and feasible for DOE to develop estimates for the timing and type of resources the department will require. To be transparent and consistent in its review and negotiation processes, DOE’s statements of work within sectors and across sectors should have similar frameworks and rationale. Specifically, DOE may need assistance in areas common to all technologies, such as cost and risk analysis, project management, and engineering and design reviews. DOE should be able to start defining these and other areas on the basis of past experience.

DOE disagreed with our recommendation to provide more specific application guidance on the content of independent engineering reports. DOE stated that this specificity is not required, necessary, or appropriate for LGP implementation. We disagree. Providing more specificity to companies on DOE’s expectations for an application’s content—and basic information about how it will review the projects—will help companies develop higher quality application materials and help ensure thorough, consistent, and efficient evaluations. Taking this step is also likely to decrease the number of requests for more analyses or information from the applicant. We also continue to believe it is reasonable for DOE to provide more specificity on how to develop project cost estimates, including a level-of-confidence estimate, so that it can better evaluate project cost estimates.

DOE disagreed with our recommendation that it track the administrative costs associated with the LGP. DOE stated it is appropriate to track the costs of the LGP office and that it plans to develop a methodology for doing so, but there is no reason to track the costs of certain support activities. We disagree. Title XVII requires DOE to charge and collect fees that the Secretary determines are sufficient to cover applicable administrative expenses. The federal accounting standard for managerial cost accounting requires agencies to determine and report the full costs of government goods and services, including both direct and indirect costs associated with support activities. Therefore, we believe it is appropriate for DOE to consider costs associated with support activities, such as costs associated with the time general counsel staff spend working on issues related to the LGP, to be “applicable administrative costs.” If DOE does not consider support costs when setting fees, it cannot be assured that the fees it collects will fully cover all administrative costs incurred to operate the LGP.

Regarding our recommendation to further develop and define performance measures and metrics before substantially reviewing LGP applications, DOE stated it has developed initial draft performance measures and metrics with the aim of completing them by the end of calendar year 2008. We continue to believe such measures and metrics should be developed as soon as possible for the 16 projects DOE invited to apply for guarantees. In addition, DOE has emphasized its focus on selecting technologies and projects that will produce significant environmental benefits, in particular the avoidance of air pollutants and greenhouse gases. However, it is unclear how DOE will do so without gathering data to establish baseline measures and metrics associated with these benefits.

DOE stated that it did not need to take additional action to implement our recommendation that it clarify the LGP’s equity requirements with the 16 companies invited to apply and in future solicitations because it informed the 16 companies invited to apply of DOE’s equity position. However, DOE officials told us that they communicated this information orally and did not provide specific documentation to the 16 companies. We believe it is reasonable to provide potential applicants with key information, such as the LGP’s equity requirement, in writing to help ensure that all potential applicants receive the same information. Furthermore, we continue to believe that this is appropriate information to include in future solicitations.

In commenting on our matter for congressional consideration, DOE disagreed with our findings that LGP does not have adequate management and internal controls in place to proceed and that it is well on the way to implementing the accepted recommendations contained in our report. We disagree. DOE has been slow to recognize the inefficiencies and inconsistencies it may face in not having key activities, policies, and procedures completed or in place before proceeding with its operations. While it is important that DOE make meaningful progress in accomplishing its mission under Title XVII, it is also important to operate the program prudently, given that billions of taxpayer dollars are at risk.

DOE also made minor technical suggestions, which we incorporated as appropriate. DOE’s written comments and our more detailed responses are provided in appendix III.

We are sending copies of this report to congressional committees with responsibilities for energy and federal credit issues; the Secretary of Energy; and the Director, Office of Management and Budget. We are also making copies available to others upon request. This report will be available at no charge on GAO’s Web site at http://www.gao.gov.

If you or your staff have any questions about this report, please contact Frank Rusco at 202-512-3841 or ruscof@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Key contributors to this report are listed in appendix IV.

Appendix I: Scope and Methodology

To assess the Department of Energy’s (DOE) progress in issuing final regulations that govern the loan guarantee program (LGP), we reviewed and analyzed relevant provisions of Title XVII of the Energy Policy Act of 2005; the LGP’s August 2006 guidelines and solicitation; its 2007 notice of proposed rulemaking; public comments on the proposed rulemaking; and final regulations published in the Federal Register. We compared the final regulations to applicable requirements contained in Title XVII and OMB Circular A-129 Policies for Federal Credit Programs and Non-Tax Receivables, which prescribes policies and procedures for federal credit programs. We also discussed the final regulations with DOE officials.

To assess DOE’s progress in taking actions to help ensure that the program is managed effectively and to maintain accountability, we reviewed documentation related to DOE’s implementation of the LGP. Specifically, we reviewed and analyzed the LGP’s “concept of operations,” technical and financial review criteria for the preapplication process, DOE’s Application Process Overview Guidance, Preapplication Evaluation Procedural Guidance, minutes of Credit Review Board meetings held between April 2007 and February 2008, and other relevant documents. As criteria, we used our Standards for Internal Control in the Federal Government and budget and accounting guidance. Further, to assess DOE’s progress to develop measures and metrics, we applied GAO’s Government Performance and Results Act guidance and analyzed information in Title XVII, DOE’s budget request documents and other relevant documents.

When DOE had completed its preapplication review process, we obtained documentation from DOE’s decision files related to the 140 preapplications for 143 projects. We reviewed all decision files DOE provided to us and analyzed the documentation for the preapplications that DOE considered responsive to the August 2006 solicitation to determine if DOE conducted its review process consistently and documented its decisions sufficiently. Responsive decision files generally contained a summary of the technology; separate technical and financial review scoring sheets; minutes documenting results of joint technical- financial meetings; and a DOE summary of its secondary review process. We also reviewed other preapplication materials that DOE provided to us. We did not evaluate the financial or technical soundness of the projects that DOE invited to submit full applications.

Further, we interviewed cognizant DOE officials from the LGP office, detailees from the Department of the Treasury, and contractor personnel assisting DOE with the preapplication process, the development of policies and procedures, and the implementation of the program. In addition, we interviewed officials from DOE’s Office of General Counsel; Office of the Chief Financial Officer; and program offices that participated in the technical reviews of the preapplications, including the Office of Energy Efficiency and Renewable Energy, the Office of Fossil Energy, the Office of Nuclear Energy, and the Office of Electricity Delivery and Energy Reliability. We also spoke with officials from the Departments of Agriculture and Transportation to discuss policies and procedures for managing their loan guarantee programs.

To examine the inherent risks associated with the LGP, including the “borrower pays” option of Title XVII, we reviewed our prior work on federal loan guarantee programs, including programs under the Maritime Administration, the Federal Housing Administration, and the Small Business Administration. We interviewed officials at and reviewed reports by the Congressional Budget Office. We also discussed risks with DOE officials.

We conducted this performance audit from August 2007 through June 2008 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix II: Title XVII Categories, DOE’s First Solicitation, and Projects DOE Invited to Submit Applications for Loan Guarantees

The Energy Policy Act of 2005 (EPAct 2005) listed 10 categories of projects that would be eligible to apply for loan guarantees under Title XVII. In August 2006, DOE issued a solicitation inviting companies to submit preapplications for projects eligible to receive loan guarantees under Title XVII. The solicitation listed categories falling within 8 of the 10 Title XVII categories. The solicitation did not invite projects for two Title XVII categories: advanced nuclear energy facilities, and refineries, meaning facilities at which crude oil is refined into gasoline. Table 1 shows the 10 categories.

On October 4, 2007, DOE announced that it had invited 16 projects to submit full applications for loan guarantees. Table 2 includes the projects’ sponsors, types, descriptions, and their current proposed locations.

Appendix III: Comments from the Department of Energy

The following are GAO’s comments on the Department of Energy’s letter dated June 13, 2008.

GAO Comments

1. See “Agency Comments and Our Evaluation,” pages 27-30 of this report. 2. DOE’s comments incorrectly cite GAO’s finding. We specifically refer to DOE’s determination of the type or timing of contractor resources. As we stated in the draft report, LGP’s director told us he has enough resources for reviewing and negotiating the loan guarantee applications related to the 2006 solicitation that companies are submitting. 3. We recognize DOE is in the process of hiring experienced staff.

Nevertheless, the nature of the program may not allow DOE to develop significant expertise for any particular technology. 4. DOE has not yet developed final metrics and measures or gathered the data necessary to establish meaningful sector-specific baselines for its 2006 solicitation, from which it formally invited 16 solar, biomass, advanced fossil energy coal, and other projects to apply for loan guarantees. 5. We do not imply that DOE may be biased toward underestimating the subsidy costs of the program. Rather, we point out that the LGP’s inherent risks due to its nature and characteristics could cause DOE to underestimate its subsidy costs and therefore not collect sufficient fees from borrowers. 6. We do not believe that our report creates the impression that DOE could choose not to develop a methodology to calculate the credit subsidy cost. On the contrary, we state that it is critical that DOE develop a sound and comprehensive methodology to estimate subsidy costs because inherent risks due to the nature and characteristics of the program will make estimating subsidy costs difficult. 7. DOE did not provide us with a detailed presentation of the LGP’s credit subsidy model. On several occasions, the LGP director told us that we would be given a detailed presentation once the Office of Management and Budget (OMB) approved the credit subsidy model. As of June 24, 2008, DOE stated that OMB had not approved the model. 8. We believe that our report and the Congressional Budget Office (CBO) report DOE cites adequately explain the rationale for potential biases in applicants’ acceptance of loan guarantees that may increase the likelihood that DOE’s loan portfolio will have more projects for which DOE underestimated the fee. 9. The fiscal year 2009 President’s budget states that the assumptions related to the LGP reflect an illustrative portfolio; that is, the assumptions do not apply to a specific loan. Nevertheless, the 25- percent loss rate assumption from the budget does call into question whether the 5-percent loss rate draft metric DOE established to assess the effectiveness of financing decisions is realistic. 10. We have not inaccurately characterized the operation of the Federal Credit Reform Act of 1990 (FCRA). Instead, we specifically discuss reestimates to explain that even though DOE is proceeding with LGP under the provision that borrowers pay for the subsidy cost of the program, taxpayers will bear the cost of any shortfall, depending on the extent to which DOE underestimates the risks (subsidy cost) and therefore does not collect sufficient fees from borrowers. DOE correctly states that reestimates that increase the subsidy costs are funded by permanent indefinite budget authority, but DOE does not explain that these funds come from taxpayers. Furthermore, because of the nature and characteristics of the program, we believe it is unlikely that the program as a whole will result in savings associated with the subsidy cost because, to the extent that any loans default, the cost of the default will likely be much larger than the fee collected. Lastly, we did not discuss modifications under FCRA because DOE has not completed its policies and procedures on estimating subsidy costs. We would expect one component of these policies and procedures to explain how DOE will identify, estimate the cost of, and fund modifications. 11. If a project defaults, the cost of the default will likely be greater than the fee collected, thus creating a shortfall. Under FCRA, this shortfall would be identified during the reestimate process and would ultimately be subsidized by taxpayers. 12. OMB Circular A-11, Preparation, Submission and Execution of the Budget, describes the budgetary treatment for credit programs under FCRA requirements. While DOE explains that the financing accounting is nonbudgetary (its transactions are excluded from the budget totals), DOE fails to explain the sources of the financing account funds. According to OMB Circular A-11, “an upward reestimate indicates that insufficient funds had been paid to the financing account, so the increase is paid from the program account to the financing account to make it whole.” The program account is a budgetary account, and its transactions do affect the deficit and may require Treasury to borrow from the public. 13. We recognize that DOE plans to take steps to assess risk and develop mitigation strategies; however, we continue to believe that the nature and characteristics of the LGP result in certain inherent risks that, by definition, DOE is unlikely to be able to mitigate or accurately quantify. As a result, there are likely to be many cases in which the risks will not be covered by the borrower fee or a risk reserve. In addition, even in instances where DOE’s estimates of subsidy costs are reasonably accurate, the “borrower pays” option may cause some potential borrowers to not pursue loan guarantees because the fee is too high relative to the benefits to the borrower of the loan guarantee. 14. As stated in the report, the inherent risks of the program, along with the expectation that borrowers will cover the costs of their loan guarantees, may lead to self-selection bias that tilts the portfolio of projects toward those for which costs have been underestimated. To the extent that some projects targeted by Title XVII are not financially viable without some form of federal assistance or favorable treatment by regulators, these projects will not pursue loan guarantees even though they are otherwise eligible. As a result, if this financial viability is not distributed evenly across technologies targeted by Title XVII, the projects that ultimately receive loan guarantees may not represent the full range of technologies targeted by Title XVII. 15. We changed “clearly” to “sufficiently.” We distinguish between the technical and financial reviews that staff conducted, and the rational and clarity of documentation that management provided for its decision-making processes. We observed from our file review that, when preapplications contained sufficient information, reviewers applied the criteria LGP provided, and in some cases applied additional criteria in their assessments. These assessments were specific to the preapplication process, not the application process. At times the preapplications lacked meaningful information for reviewers to assess. The cases we highlight in our report are those in which the LGP office did not provide sufficient justification for inviting projects.

GAO welcomes the LGP’s office efforts to establish formal standards and procedures. In recommending that LGP complete its measures and metrics associated with achieving benefits and employing new and significantly improved technologies, we believe this effort will also help inform future selection processes. 16. DOE did not require preapplications to include proforma “financial statements.” Rather, preapplicants were required to submit financing plans, estimated project costs, and a financial model detailing the projected cash flows over the life cycle of the project. We believe that audited financial statements and credit ratings would be more useful in assessing creditworthiness. In addition, when evaluating preapplications, DOE did not combine technical and financial scores. Therefore, it is accurate to state that creditworthiness comprised 60 percent of the preapplicant’s financial score. 17. DOE erroneously refers to the preapplication process here. This analysis on project evaluation is specific to our discussion of project eligibility, and DOE’s use of external guidance as a proxy for internal policies and procedures for applications. 18. The statement DOE cites is in context with the prior sentence, “While DOE recognizes these reports serve an important due diligence function, DOE has not provided applicants with specific instructions on what to include.” This sentence is also prefaced with “as a result” in the draft report. We changed the word “underwriting” to “evaluating” and added “applications” after “loan guarantees” to clarify our statement. 19. We generally agreed with the consultant’s finding. Specifically, we found that DOE program offices used Credit Review Board-approved criteria as well as other criteria. In one case, these criteria were appropriate to differentiate projects in accordance with Title XVII. We could not fully determine whether the use of these additional criteria had any impact on the selection process. 20. See also comment 17. DOE’s response does not address our report’s analysis; specifically, we are referring to DOE’s application guidance. In addition, while DOE’s final rule states what applicants should submit, it and the application guidance do not indicate how DOE will evaluate these submissions. 21. Federal loan guarantees do help borrowers obtain more favorable terms than they may otherwise obtain. For example, a borrower may be able to get a lower interest rate, an extended grace period, or a longer repayment period when the loan is guaranteed by the federal government. 22. For clarification, we revised the report to indicate that DOE needs to “identify eligible lenders.” 23. For clarification, we incorporated DOE’s suggested revision. 24. We revised the report to reflect this update of information. 25. We revised the report to state “According to DOE, as of May 2008, DOE has hired one staff person to develop credit policies and procedures specific to LGP, and to fully establish its credit policy function.”

Appendix IV: GAO Contact and Staff Acknowledgments

Staff Acknowledgments

In addition to the individuals named above, Marcia Carlsen and Karla Springer, Assistant Directors; Abe Dymond; Richard Eiserman; Jeanette M. Franzel; Carol Henn; Jason Kirwan; Kristen Kociolek; Steve Koons; Sarah J. Lynch; Tom McCool; Madhav Panwar; Mehrunisa Qayyum; Carol Herrnstadt Shulman; Emily C. Wold; and Barbara Timmerman made key contributions to this report.