BACKGROUND. Operating the freight service; Maintaining the Service Property 1 infrastructure and systems at an agreedupon

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1 To: From: Terry Mitchell, Chair Finance Audit & Administrative Committee Wade Cooper, Member, Finance Audit & Administrative Committee Juli Word, Member, Finance Audit & Administrative Committee Ann Kitchen, Member, Finance Audit & Administrative Committee Caroline Beyer, Vice President, Internal Audit Date: June 10, 2015 Subject: Phase I: Internal Audit Review & Risk Assessment Freight Operations Request for Proposals (RFP) BACKGROUND Capital Metro is the owner of a rail line extending from Giddings to Llano, Texas. As the owner, Capital Metro has the primary common carrier obligation to provide freight services over its line. On December 21, 2010, Capital Metro entered into a lease agreement with Watco dba Austin Western Railroad (AWRR) to provide short-line freight service and to fulfill its primary common carrier obligations. (Capital Metro retains residual common carrier obligation on the line in accordance with Surface Transpiration Board Finance Docket No 35072). This lease expires on September 30, A Request for Proposals (RFP) for a new freight operations contractor was issued on March 6, The updated scope of services for freight operations has been expanded and now includes: Operating the freight service; Maintaining the Service Property 1 infrastructure and systems at an agreedupon level; Making capital investments to support expanded freight service, with potential collateral benefits to passenger service; Generating sufficient income to cover operating and maintenance expenses and capital expenses while providing income to Capital Metro; and Maintaining Capital Metro s right to operate passenger service between existing terminals, along with the possibility of expanding the passenger service operating territory. 1 The Service Property includes right-of-way, tracks, rails, ties, ballast, other track materials, switches, public and private crossings, bridges, culverts, buildings, grade-crossing warning devices and any and all improvements or fixtures affixed to the right-of-way within the in-service territory, along with that portion of the right-of-way that supports these installations. The freight operator will be responsible for maintaining infrastructure and systems exclusive of the Commuter Rail Territory.

2 This proposed contract integrates costs, revenue, and profit responsibilities in a private partner who would be motivated to dedicate more resources to the freight rail business, would take on more of the freight rail business risk, and would provide more business revenue to Capital Metro. Ensuring sound internal controls are in place prior to entering into a long-term partnership will help ensure that public resources are protected and Authority s objectives are met. To that end, Capital Metro has retained external financial and technical experts who have and will continue to advise the Authority during the transition to a new freight rail operations model. AUDIT OBJECTIVE As described in the May 4, 2015, audit planning memo, the objective of the Phase I audit is: To review and perform a risk assessment of the Freight Operations RFP for adequacy and identify potential gaps/enhancements for management s consideration and potential adoption prior to finalizing the contract with the selected operator. PHASE I CONCLUSION Sufficient contractual requirements to limit and/or reduce key operational and financial risks have been included in the Freight Operations RFP. For a detailed analysis of the provision reviewed and the proposed risk mitigation strategies see Appendix I. AUDIT SCOPE The Freight Operations Audit is an approved project from the FY Internal Audit Services Plan. This audit supports Strategic Objective 4.3, Strengthen agency business partnerships: Ensure clear contractual agreements that are fair, measureable and mutually enforceable. Provide opportunities for effective communication between agency and partners. The Phase I project s scope is to evaluate contracting risks, the proposed contractual terms and conditions, and identify whether there are sound risk management protections in place. This information is intended to assist the Capital Metro Board of Directors in their deliberations and approval of a freight operation contract award. The Phase I audit scope does not include an assessment of the following functions or areas: Capital Metropolitan Transportation Authority Page 2 of 9

3 The selected contractor s performance and Capital Metro s oversight and monitoring of new freight operations contract. These will be addressed later in a separate (Phase II) audit. Existing lease with Watco Companies Austin Western Railroad, Inc. (AWRR). This contract is expiring on September 30, 2015, and contractor financial compliance has been periodically reviewed by the Business Manager, Rail Operations. Right-of-Way (ROW) easements and leases. (The RFP does not propose changes in this area. Capital Metro will retain and administer all current leases and licenses.) Rail Dispatch is excluded because the Freight Services Contractor does not perform this service. Positive Train Control in the Commuter Rail Corridor. Capital Metro is responsible for implementing and continues to work with its other contractors to revise the Authority s Positive Train Control Implementation Plan (PTCIP) and implement and design the program. METHODOLOGY This audit was conducted in conformance with the Government Auditing Standards and the Institute of Internal Auditors International Standards for the Professional Practice of Internal Auditing. The purpose of audit planning is to identify and evaluate key risk areas. To accomplish this, auditors: Reviewed the Freight Operations RFP including selected attachments; Obtained and reviewed two previous rail consultant reports prepared for the Authority for use in determining how to improve freight operations: Capital Metro Freight Business Plan, May 2009, AECOM Consult and Capital Metro Freight Business Plan Update, July 3, 2014, LTK Engineering Services; Researched freight rail operations recommended practices and audits from other entities; Identified and assessed related business/operational risks and best practices using an evaluation framework founded on Edward Deming s Plan Do Check Act operations cycle. Facilitated a cross-functional discussion and risk analysis of the proposed freight operations contractual terms. The Deputy CEO/COO, and team members from the Rail, Procurement and Legal Departments provided input during the review. Capital Metropolitan Transportation Authority Page 3 of 9

4 cc: Beverly Silas, Board Vice Chair Ann Stafford, Board Secretary Delia Garza, Board member Rita Jonse, Board member Linda Watson, President/CEO Elaine Timbes, Deputy CEO/COO Gerardo Castillo, Sr. VP, Chief of Staff Kerri Butcher, Chief Counsel Melvin Clark, VP, Rail Operations Scott Phebus, Business Manager, Rail Operations Jason Wolfe, Director of Rail Operations Earl Atkinson, Director of Procurement Capital Metropolitan Transportation Authority Page 4 of 9

5 APPENDIX 1 Business Objective Risk(s) - to Meeting Objective Risk Treatment / Mitigation Strategy Ability to increase commuter rail activity as needed General contract compliance / operator performance General contract compliance / operator performance Growth in freight rail business Competing objectives - Freight obligations constrain the Authority's ability to increase or modify commuter rail operations as needed. Uninsured risks expose the Authority to financial liabilities. Disagreements between parties not resolved. Failure to grow business / reliance / over-reliance on existing customers. Proposed terms included to limit conflict between the requirements of passenger service and freight operations. The Authority may, at any time, by written order, make changes within the general scope of the contract in the services to be performed. The current FRA required temporal separation of commuter rail and freight operations requires that the commuter rail and freight rail operators coordinate, with the commuter rail service windows having precedence. Furthermore, the Freight Services Contractor must request from Capital Metro the use of any midday freight window in advance. Insurance requirements minimums in the RFP are based upon an external risk consultant s recommendations. Capital Metro reserves the right to annually assess the adequacy of the insurance coverage and to make adjustments based upon identified risks. The contract contains a dispute resolution procedure that includes escalation to the President/CEO. While not a contractual requirement, issues that are not resolved by CEO or her designee can be referred for alternative dispute resolution /mediation, if mutually agreed to by both parties. Capital Metro's Strategic Plan includes developing a Freight Rail Business Plan "to improve the financial health of the organization." The selected contractor is required to develop a Business Development and Marketing Plan and provide Capital Metro with a Quarterly Marketing and Business Development Report on marketing and business development activities. Capital Metropolitan Transportation Authority Page 5 of 9

6 Business Objective Risk(s) - to Meeting Objective Risk Treatment / Mitigation Strategy Growth in freight rail business Financial transparency & sustainability Financial transparency & sustainability Financial transparency & sustainability Unreliable locomotive fleet or lack of appropriate resources (e.g., cars) limits business growth opportunities / decreases customer satisfaction. Freight operator is financially unstable / going concern questions. Unclear accounting treatments - A detailed understanding of the proposers' overhead, profit and labor rates is not available or understood. Information needed to validate revenue submissions is not available and/or accurate. Lack of agreement between Authority and Contractor as to acceptable SOGR conditions. Good service means 1) providing reasonably consistent, timely, and reliable car supply, in terms of condition, type and numbers, to meet shipper demand. The Proposer must supply: A description of existing locomotives, rolling stock, and other equipment owned or leased by the Proposer, including locomotives listed by model, and manufacturer / rebuild dates. The Proposer must submit a financial plan which includes Demonstrated financial capacity to provide required services for the length of the contract, including necessary maintenance and capital improvements." Capital Metro has retained external consultants with both financial and rail expertise who will evaluate the proposers' submissions. Unlike the current contract, the proposed contract terms are based upon revenues only. The cost effectiveness of the freight operator does not impact revenue submissions to the Authority. The contract reserves the Authority's right to make a preaward audit of the firm s proposed fees, rates. An external consultant has been retained who will perform a pre-award audit of proposed rate structure/fee. External rail technical expertise is also available to assist with this analysis. Capital Metro shall have the right to audit, reasonably review and copy all records relating to and the payments required under this Contract. Any discrepancy will be provided in writing to the Freight Services Contractor. The Freight Services Contractor shall have thirty (30) days from receipt of the discrepancy notification to respond to such discrepancy. The selected Contractor and Capital Metro will jointly assess the Day One Conditions for the purposes of benchmarking the minimum level of maintenance required to be performed. The "Day One Conditions" assessment establishes the level to which the Service Property must be maintained and the condition in which the Service Property shall be returned at the termination of the Agreement. External technical resources (LTK Consulting) will be used to assist Capital Metro in performing the Day One Condition assessment. Capital Metropolitan Transportation Authority Page 6 of 9

7 Business Objective Risk(s) - to Meeting Objective Risk Treatment / Mitigation Strategy Acts of Nature adversely impact infrastructure. Disagreement between Capital Metro and Contractor on need / performance of Capital projects. Infrastructure falls into disrepair and is not maintained / repaired timely. Financial risk is shared between the Operator and Capital Metro. In the event of damage arising from a natural disaster, the Freight Services Contractor shall be responsible for the payment of the first $50,000 of costs required to restore the railroad to service, and thereafter up to 50% of any additional costs of repairing such damage resulting from such disaster (up to a maximum of $100,000 per occurrence.) The freight contractor is required to maintain rail infrastructure to Day One Conditions. The Freight Services Contractor shall have the right, with the prior written approval of Capital Metro, to make, at its own expense, capital improvements for freight railroad purposes, on the Service Property, exclusive of the Commuter Rail Territory. The contractor s financial plan submission should outline any proposed capital projects that could improve the revenue potential along the line. Capital Metro has the right to review and approve any construction plans prior to commencement of construction. Multiple Strategies are proposed: 1) The Rail Department plans to restructure oversight roles and responsibilities to allow for an enhanced level of internal oversight. A new technical position (Project Manager III) has been requested in the Department's FY2016 operating budget request. 2) The Contractor shall submit a Maintenance Plan and Program for Capital Metro's review and approval. This plan and a related annual program are intended to address all maintenance activities required under this contract. Subsequent revisions to the Annual Maintenance Plan and Program also require Capital Metro's approval. 3) Freight Services Contractor may be declared deficient in its maintenance activities if a deviation from the maintenance requirements of the Freight Services Contract remains uncorrected for more than ninety (90) days. Capital Metro reserves the right to assess and Contractor agrees to pay liquidated damages of Five Hundred Dollars ($500) per day for any delay beyond ninety (90) days after such written notification. Capital Metropolitan Transportation Authority Page 7 of 9

8 Business Objective Risk(s) - to Meeting Objective Risk Treatment / Mitigation Strategy The interests of the Contractor and the Authority diverge nearing end of the contract term which results in inadequate maintenance. Towards the contract end, the contractor faces a commercial risk that the future benefits from its investments may flow to the Authority or to a new contractor, and this can affect the contractor's investment and maintenance decisions. The "Day One Condition" Assessment mitigates disagreements as to "acceptable" infrastructure conditions. Prior to the final solicitation response, Capital Metro added a new requirement for the Contractor to furnish an annual performance bond, in the amount $2,000,000. Freight Operator has history of previous safety violations. requirements and protocols are in place and effective. RFP Evaluation Criteria included to mitigate potential risks. "Qualifications of the Firm" was the most important evaluation factor used when selecting a recommended freight operator. This evaluation factor includes the proposer s: safety record. All proposers were required to provide copies of the past three years of OSHA 300 logs and FRA Injury reports and any other required reporting forms, for work related accidents from all proposed parties and subcontractors. Freight Services Contractor shall develop a Capital Metro approved and Security Program which includes the development of a and Security Plan. An updated and Security Program shall be submitted to Capital Metro for review and approval annually. Untrained or unqualified personnel work for Freight Operator. Hazardous and/or placarded materials are transported without adequate protection. Freight Services Contractor shall implement a training and examination program, subject to advance review and approval by Capital Metro, to qualify the Freight Services Contractor s operating personnel and Capital Metro s rail and security personnel at no cost to Capital Metro. Movement of hazardous and/or placarded materials requires the Authority's prior approval. (Currently, these materials are not moved over the mainline tracks. However, placarded material (hot asphalt) may be transported on the rail line if a facility proposed for Manor, TX is authorized.) Capital Metropolitan Transportation Authority Page 8 of 9

9 Business Objective Risk(s) - to Meeting Objective Risk Treatment / Mitigation Strategy Lack of compliance with FRA required Positive Train Control (PTC) program. Capital Metro is responsible for implementing Positive Train Control in the Commuter Rail Corridor and will work with its other contractors to revise the Authority s Positive Train Control Implementation Plan (PTCIP) and implement and design the program. Once completed, Capital Metro will provide its revised PTCIP to the Freight Services Contractor to provide a better and more detailed understanding of the PTC requirements. PTC implementation the Authority's financial responsibility and funding for PTC is included in Capital Metro's long range financial plan. If PTC enhancements to the rail infrastructure are required outside of the CR corridor, the cost of that would be borne by Capital Metro. This is still begin researched by the Rail Department. Capital Metropolitan Transportation Authority Page 9 of 9