Background

1. The fleet oiler HMAS WESTRALIA was a key element of the Royal Australian Navy (hereafter referred to as ‘Navy') Maritime Operations Support Capability (MOSC) from 1989 until September 2006. WESTRALIA provided logistic support to naval operations and exercises and contributed to Defence international engagement through these activities. The new vessel to replace WESTRALIA is called HMAS SIRIUS and was commissioned by Defence in mid September 2006, which was concurrent with the formal decommissioning of WESTRALIA. This approach was adopted by Defence to ensure that Navy maintained a continuous afloat support capability.

2. The WESTRALIA Replacement Project requirements and delivery schedule were influenced by Navy's intent to continue to comply with Australia's international obligations as set under the International Maritime Organisation's Maritime Pollution (MARPOL) agreement. This agreement is the main international convention covering the prevention of pollution of the marine environment by ships, but provides an exemption for naval vessels.

3. Under MARPOL, WESTRALIA was classified as a single hull tanker. Project SEA 1654 Phase 2A (hereafter referred to as ‘the Project') was aimed at delivering an environmentally compliant, double hull, tanker to the Navy. The Project, which proposed the purchase and modification of a commercial vessel, was approved by Government in March 2004. In the Defence Portfolio Budget Statements 2006 07, Defence reported that the approved Project budget at that time was $143 million, with $102 million expended and $32 million to be expended in 2006 07. The total reported Project expenditure to 31 October 2006 amounted to $118.74 million.

4. Based on the initial Base Ship Specification and List of Modifications, Defence and the Defence Materiel Organisation (DMO),¹ supported by a number of contractors, conducted a worldwide search of operating tankers to produce a short list of vessels that were compliant with the Base Ship Specification. Detailed inspections of three vessels were conducted, with a decision made to purchase the preferred vessel in late May 2004. The Commonwealth purchased an environmentally compliant, double hull commercial ‘off-the-shelf'² product tanker named Merchant Tanker DELOS for $US35.7 million,³ which was delivered to DMO in mid June 2004.

5. Following the purchase of the DELOS, DMO entered into the Navion Timecharter Agreement (known as the ‘Navion Contract'), for the commercial time charter⁴ of the DELOS, with Teekay Chartering Limited Marshall Islands (hereafter referred to as ‘Teekay Chartering') in early July 2004. The initially agreed rate of hire was US$15 000 per day, payable monthly in advance. DMO reported that it principally entered into the time charter arrangement to provide the Navy with sufficient operational experience on the DELOS to inform the design and modification process. For the charter period of July 2004 to August 2005, DMO reported total charter revenue of $8.22 million.

6. During the period of the charter of the DELOS, the Commonwealth signed a fixed-price, milestone based contract with Tenix Defence Pty Ltd (hereafter known as the ‘Prime Contractor') to modify the DELOS, as envisaged, in order to provide Navy with a vessel capable of conducting underway replenishment of fuel (diesel and aviation) and water. The initial Contract value was $63.055 million. The Contract value was initially to be paid in 14 milestone payments over 18 months, ending with the scheduled delivery and acceptance of the modified vessel on 15 September 2006.

7. The audit examined the purchase of a commercial ‘off-the-shelf' oil product tanker in June 2004, its chartering from July 2004 to August 2005, and its subsequent modification to fulfil the role as the Navy's new fleet oiler. The modification of the purchased vessel was conducted at the Henderson Common User Facility, located south of Fremantle, Western Australia. The DMO provided the ANAO with an overview assessment of the Project in October 2006 (see Table 1).

Table 1: DMO assessment of the HMAS WESTRALIA Replacement Project

Source: DMO advice to ANAO, 23 October 2006

Key findings

Project approval and ship purchase (Chapter 2)

8. The Defence White Paper 2000 (the ‘White Paper') had identified the requirement to replace WESTRALIA upon its anticipated retirement from service in 2009.⁵ Between 2003 and 2006, Defence implemented operational limitations, including limiting the maximum amount of fuel to be carried, which resulted in WESTRALIA being reclassified to ensure continued compliance with MARPOL. Defence's management strategy for WESTRALIA was highly adaptive to recent MARPOL developments in that it extended WESTRALIA's operational life to over 27 years, maintaining class certification and MARPOL compliance until retirement in September 2006.

9. In early March 2004, Government accepted a proposal of the September 2003 Defence Procurement Review (also known as the ‘Kinnaird Report') that Defence Capability Plan Projects with a 2003 04 or 2004 05 year of decision should progress directly to Government second pass approval consideration. The Project was identified by Government in March 2004, on advice from DMO, as falling into this category. The strengthened two-pass approval system was to be fully implemented for projects with a 2005 06 year of decision or later. With Government second pass approval achieved in late March 2004, the Project was authorised to purchase a commercial tanker as the Base Ship and modify it for Navy service.

10. The Evaluation Plan for the Base Ship purchase identified that a tiered set of performance-based selection criteria would be used to evaluate the suitability of short listed vessels.⁶ Final suitability assessments were made against criteria for vessel performance (50 per cent), program (30 per cent)⁷ and commercial (20 per cent) aspects. The ANAO observed that while the DELOS and the 2nd Ranked Ship⁸ were assessed as being equivalent against the performance and commercial criteria, the overall assessment was determined by the program criteria, where the DELOS achieved a significantly higher rating due to it being available for sale prior to 30 June 2004.⁹ DMO subsequently advised the ANAO that the purchase of the DELOS was the correct decision as the purchase of a new ship meant that DMO received both a warranty period for defects, and access to the Shipbuilder's design information, which may not have been available had it purchased an older vessel.

11. Defence capability guidance of June 2002 had identified that WESTRALIA, because of its maximum speed of 16 knots, was not able to fully integrate with any Task Group that required flexibility to operate at higher speeds. The capability guidance also stated that ships within the maritime operations support capability should have a maximum speed in excess of 18 knots. The original capability objective was lowered to 14 knots in November 2003, in line with the reduction in the forecast Project budget from $450 million to $150 million, and Defence's decision to pursue a commercial tanker as a base ship which was a ship design with a maximum economical speed of around 14.5 knots.¹⁰ Against the revised capability guidance, DMO acquired the DELOS for US$35.7 million in June 2004, following which the DELOS regularly achieved sustained speeds of between 15 and 16 knots during its commercial charter.

DMO chartering of the DELOS (Chapter 3)

12. The decision to charter the vessel for a short period following its purchase was taken once an assessment was made of the design data available for the DELOS. DMO entered into a Ship Management Agreement (hereafter known as the ‘Shipman Contract') with Teekay Marine Pty Ltd (hereafter known as ‘Teekay Marine') in early June 2004. Through the Shipman Contract, the DMO outsourced the commissioning and operation of the DELOS, which included crew, technical and commercial management, to Teekay Marine.

13. The DMO construct for the commercial charter of the DELOS provided for the cost of Teekay Marine's services to be covered by the time charter hire charges earned by DMO under the Navion Contract with Teekay Chartering. DMO permitted the charter of the DELOS to operate on this basis after concluding that the charter monies did not become public funds until the Shipman Contract had been reconciled and monies were due and payable to the Commonwealth.

14. Under the Shipman Contract (Clause 7.1), all funds collected by Teekay Marine, and any interest thereon, were to be held to the credit of the Commonwealth in a separate bank account.¹¹ Between July 2004 and September 2005, hire charges of $8.22 million were paid by Teekay Chartering to Teekay Shipping as agent of the Commonwealth under the Navion Contract. Teekay Shipping advised that these public funds were banked and maintained in a Teekay Shipping working bank account on behalf of the Commonwealth.¹² Over the charter period, and in accordance with the payment construct agreed by DMO, Teekay Marine acquitted its commercial charter expenses of $7.60 million against the public money charter receipts held in the Teekay Shipping bank account.¹³

15. Teekay Shipping advised the ANAO in December 2006 that:

According to standard industry practice, this clause [Clause 7.1] does not infer a DMO or a specific Commonwealth bank account but implies the funds are held in a separate account to ensure they are held to the credit of the Commonwealth. This was the case in this situation where funds were held in an account where Teekay were able to differentiate the DMO funding. There is hence no requirement in the Shipman Contract to deposit funds into a Commonwealth Bank Account.¹⁴

16. A separate, Official bank account for the Commonwealth was not established by DMO until June 2006. The remaining balance of the charter revenues, an amount of $683 547, was paid to the DMO on 29 June 2006.¹⁵ Technically, DMO should have received at least monthly invoices to support and acquit the withdrawal of public funds, and issued Teekay Marine with a validly authorised drawing right to expend these public funds, which have been assessed by the Australian Government Solicitor to be part of Defence's and DMO's appropriations. Teekay Shipping advised the ANAO in December 2006 that the customer [DMO] had agreed to a budget at the start of the period (the commissioning phase) and any funds thereafter would be used during the next phases if in surplus.¹⁶ It is standard industry practice, and in accordance with the Shipman Agreement, that the ship manager should have funds in advance.

17. Defence advised the ANAO in December 2006 that:

An informed business decision was made by the DMO to use innovative methods to reduce risk and to achieve a positive outcome for the Commonwealth. The DMO and Commonwealth do not usually undertake the role of leasing vessels to commercial operators and for the Commonwealth to adopt anything other than commercial practices for the contracting and operations of the vessel would have placed a much higher risk upon the Commonwealth than was the case in this lease. The audit by the DMO Financial Investigation Service found that the Commonwealth was paid all the revenue that it was owed.

18. Based on an audit by DMO's Financial Investigation Service in mid 2006, DMO advised the ANAO that it was satisfied that all commercial charter revenues and expenses were correctly reported. In the course of the ANAO's audit, the ANAO had observed administrative weaknesses relating to the chartering of the DELOS to Teekay Chartering by the DMO, and issues concerning adherence with elements of the Financial Management and Accountability Act 1997 (FMA Act), concerning the custody and banking of public funds and the authority for the withdrawal of appropriated public funds, and requirements of the Goods and Services Tax legislation (GST Act). This highlights that the risk of contravention of the Commonwealth Financial Framework can increase with transactions that are unusual or infrequent. The ANAO considers that, in such circumstances, a higher level of analysis or review often assists in mitigating risks.

Modification of the DELOS (Chapter 4)

19. The vessel modification design and production program, which was approved at the time of the Project's approval in late March 2004, was allocated $76 million. The elements of the modification work included: accommodation, communications and sewerage treatment plant upgrades; and the installation of a solids cargo container deck; replenishment at sea equipment, flight deck and rigid hull inflatable boats.

20. The Modification Contract included an incentive payment regime to provide an additional incentive for the Prime Contractor to deliver the modified vessel to DMO on or before the scheduled completion date of 15 September 2006. The maximum incentive payment of $1 million was to be payable to the Prime Contractor in the event that the modified vessel be delivered to the DMO on or before 31 July 2006 and was subsequently accepted in the delivered state.¹⁷ With the exception of some Contract Change Proposals and items of Government Furnished Equipment, the DMO reported that the Prime Contractor offered the modified vessel to DMO for acceptance on 7 August 2006.

21. The DMO contractually accepted the modified vessel on the same day, which was prior to the completion of its test and evaluation activities. On this basis, the Prime Contractor may have been entitled to an incentive payment of $0.75 million for the early delivery and DMO contractual acceptance of the ship. Defence advised the ANAO in early August 2006 that Initial Operational Release¹⁸ was planned for October 2006, with full Operational Release¹⁹ expected in mid 2007. Defence advised the ANAO in December 2006 that:

At acceptance what was actually accepted were the modification work packages to the base ship, not the ship itself. The incomplete test and evaluation activities related solely to these modification packages and at no fault of the Contractor, the Contractor could not complete the required test at that time. The DMO had directed the Contractor not to conduct a small number of tests until a later date to harmonise Tenix's work with that of other contractors working on the ship at the same time.²⁰ … Also to be fair and equitable to Tenix, any test or evaluation that was delayed at the direction of the Commonwealth could not legally reduce the Commonwealth obligation to pay the early delivery bonus of $750 000 to Tenix.

22. The Modification Contract provided for any potential liquidated damages to be available for payment to DMO at two of the original 14 contract milestones. The milestones were for the Critical Design Review and Acceptance. As at Contract signature on 15 March 2005, the Critical Design Review milestone date was 15 July 2005. The Critical Design Review milestone was not submitted for final DMO acceptance until 8 May 2006. Defence has advised the ANAO that the slippage in Critical Design Review approval was due to the DMO seeking the assurance of an expert third party regarding the integrity of Structural Design Analysis. Against the revised milestone date for the Critical Design Review of 15 September 2005, 235 days of liquidated damages at $7 000 per day, or $1.65 million in total, was available as a debt payable to the Commonwealth.²¹ Under the Contract, the early delivery of the modified vessel on 7 August 2006 reduces the amount of accrued liquidated damages to $1.38 million. Defence advised the ANAO in December 2006 that the DMO is assessing the circumstances surrounding the Commonwealth's right to liquidated damages, including seeking legal advice.

23. The new fleet oiler Modification Contract required that the Prime Contractor deliver the final Safety Case Report to DMO by 15 October 2005, 11 months prior to anticipated delivery of the modified ship. The DMO advised the ANAO in August 2006 that elements of the Safety Case Report relating to the major work packages were complete but that the Safety Case Report²² would not be finalised until February 2007. It is desirable, from a risk management perspective, that Safety Cases for major capital assets are finalised to schedule so that system hazards are adequately identified and any exposures managed to acceptable levels.

24. Defence advised the ANAO in December 2006 that:

The safety baseline for this ship, as required to meet the Navy safety framework, comprised the Tenix Safety Case Report, the Rexroth Safety Case Report and the Lloyds Register certificate suite provided with the base ship. This suite of documents has met the Navy's safety requirements as demonstrated through Chief of Navy granting Initial Operational Release after careful consideration of, amongst many other things, safety compliance. The Whole Ship Safety Case Report is an initiative of the Project to enhance through life support of the ship. This report seeks to consolidate all other safety case reports and documentation so as to provide a comprehensive configuration baseline for in-service management of the ship. By capturing the design intent contained in these reports, the overall integrity of the design can be maintained and configuration changes can be embodied in accord with this design integrity. The Navy safety framework does not require this to be in place for Initial Operational Release but it is certainly required for full Operational Release, which is expected to be granted mid 2007. The Whole Ship Safety Case Report will be finalised by February 2007.

25. The ANAO notes that the Naval Operational Test and Evaluation Manual²³ (ABR 6205) does not align with the framework outlined above with regard to the Safety Case. This may therefore create misleading expectations of what capability is required at the milestone of Initial Operational Release. The Navy manages gaps in the safety framework by placing limitations on the vessel's operations to effectively manage the relevant capability risks. Generally such risks are managed through limiting the operational use of the vessel.

Overall audit conclusions

26. The Defence Capability Plan 2001-2010 initially proposed that the replacement for WESTRALIA be introduced into service by 2009. With the release of the revised Plan 2004-2014 in early November 2003, Defence formally brought forward the retirement of WESTRALIA to 2006. To achieve this revised timetable, DMO developed and implemented an acquisition approach to advance the delivery of a replacement vessel for WESTRALIA by purchasing a commercial off-the shelf product tanker.

27. In less than three months from Government approval of the Project in March 2004, the DMO successfully completed the identification, evaluation and purchase of an existing product tanker that was suitable for modification to fulfil the role as the Navy's new fleet oiler. The ANAO notes that the capability is likely to be delivered within the approved Project budget, which was reported by DMO as $143 million in May 2006.

28. The modified vessel was delivered by the Prime Contractor and contractually accepted by DMO five weeks ahead of schedule on 7 August 2006, following which the vessel was commissioned as HMAS SIRIUS on 16 September 2006. The ANAO notes that at the time of delivery of the vessel, contractual deficiencies identified by the Prime Contractor included incomplete and untested modification work. At the time of delivery and acceptance, the Report of the Material and Equipment Performance State for the contracted work noted that the Commonwealth had not identified any issues of concern. DMO advised that it considered that a number of the deficiencies related to the late delivery of Government Furnished Materiel, which was outside the control of the Prime Contractor. ²⁴

29. The ANAO observed weaknesses in the administrative processes associated with the financial arrangements implemented by Defence and DMO, which included requirements under both the Commonwealth Financial Framework and the GST legislation. With respect to the Commonwealth Financial Framework, administrative weaknesses included adherence to the provisions for: public funds to be deposited into and held in Official bank accounts; the prompt banking of public funds; and the requirement for authority to be given for the receipt and custody of public funds by non-public servants. Also, improvements were required in the processes to ensure there is a valid authorisation to approve payments from public funds and to debit amounts against an appropriation.²⁵

Agency Response

30. The Department of Defence provided a response (see Appendix 1) on behalf of the DMO and Defence. Defence agreed with the recommendation made in this report. The Defence response stated that:

Project SEA1654 Phase 2A (HMAS WESTRALIA Replacement) has provided Defence with an unprecedented opportunity to demonstrate the successful application of Kinnaird Review principles. The DMO has applied innovative techniques to the solution of a complex problem and met, or exceeded, all capability, safety, budget and schedule requirements.

Innovation in this Project has included the use of commercial standards (classification society rules) where appropriate, commercial contracting templates and contracting incentive arrangements. This has resulted in achievement of the desired capability ahead of schedule and within budget.

The DMO's business-like approach to the use of different methods of contracting has been vindicated. The DMO continues to be innovative and look for the best contracting method based on the risk profile of each project. In this case, knowing that there would be obstacles if our identity as a government organisation was disclosed, we decided to purchase the vessel on the open market using a standardised commercial contract format that met all international standards. The DMO then continued to be innovative by leasing the vessel back to the market while it undertook the competitive tender process for the refit activity.

In this Project, the DMO was highly responsive to Government. The requirement under the original Defence Capability Plan was for a vessel to be delivered in 2009 and a project budget of about A$450 million. That plan was substantially revised by Government following the Defence Capability Review (November 2003). Changes to international regulatory standards have led to an accelerated timetable for the withdrawal of single hull oil tankers like WESTRALIA. Although warships are not strictly bound by these regulations, the environmental impacts and the risk of limited future access to international waters were key factors in the Government decision to bring forward the replacement of WESTRALIA from 2009 to 2006.

The Project has also been an excellent example of achieving results in partnership with industry. The contract for the refit and modification of the tanker was awarded to Tenix, with the majority of work completed in Western Australia. The contract included incentives for completing the work ahead of schedule. Over a period of 18 months, and with a number of difficult issues to resolve along the way, Tenix completed the work on budget and have received incentives for completing the work ahead of schedule.

Defence regrets that it might be inferred from this report that there are shortcomings in the safety program. Any such suggestions have now been proven baseless through a rigorous test and evaluation process. The delivery of safe capabilities and the safe operation of those capabilities in service is an absolutely key focus for Defence.

Footnotes

1 On 1 July 2005, the DMO was established as a Prescribed Agency under the Financial Management and Accountability Act 1997.

2 The 2005 Defence Capability Development Manual states that an ‘off-the-shelf' product is defined as one that is available for purchase, and will have been delivered to another military or government body or commercial enterprise in a similar form to that being purchased at the time of the approval being sought (first or second pass).

3 The amount recorded by Defence's financial management system is $52.2 million but the amount actually paid was $51.1 million due to currency recording.

4 The time charter involved the ‘wet lease' of the DELOS where DMO was responsible for covering all costs including crew, provisions and supplies, maintenance and insurance, but excluding charter related fuel costs, port charges and associated fees which were generally borne by the Teekay Chartering.

5. Prior to the initiation of the Project to replace WESTRALIA, Defence had identified a number of shortcomings in WESTRALIA's capability that limited the vessels utility in supporting operational deployments.

6. The total performance rating for each ship was compared to the prospective purchase price to produce a value for money rating (quotient).

7. The program criterion was based on sub-criteria for availability (60 per cent), owner's reason for sale (10 per cent) and spend profile (30 per cent).

8. The Base Ship Selection Report, produced by DMO immediately prior to the Base Ship's selection and purchase, identified that the price of the 2nd Ranked Ship was approximately US$3 million less than the DELOS.

9. By comparison, DMO reported that the 2nd Ranked Ship was under charter and that this may restrict delivery with a consequent impact on the short term spend profile requirement of spending the money in that financial year.

10. Alternative ship designs that may have permitted higher operational speeds, such as container ships, were eliminated from consideration at an early stage as their subsequent modification was considered a high risk in terms of Australian industry ability, cost and schedule.

11. The Shipman Contract Clause 7.1 requires that: All moneys collected by the Managers under the terms of this Agreement (other than moneys payable by the Owners to the Managers) and any interest thereon shall be held to the credit of the Owners [Commonwealth] in a separate bank account.

12. DMO documentation of February 2006 notes that Teekay does not/has not maintained a separate bank account for the management of the DELOS on behalf of the Commonwealth. All the ships they manage are covered under the one bank account.

13. From September 2005 to mid 2006, Teekay Marine acquitted further expenses of $1.34 million, relating to its services to DMO in respect to its ongoing management of the DELOS, from the Teekay Shipping bank account.

14. Teekay Shipping advised the ANAO in December 2006 that:

When the most recent audit commenced, a full reconciliation of the Advance Account (basic summary including receipted and expensed amounts and full backup of bank statements where requested) were forwarded to the audit team – the balance was agreed to be correct and all interest and funds were subsequently transferred to the new account opened by the DMO. At no stage prior to the ANAO/DMO audit, did the DMO advise that a separate Commonwealth bank account would be required.

15. On 4 July 2006, DMO transferred $546 723 into the new Official bank account, which was $683 547 less the $136 794 interest earned on the net charter revenues.

16. Teekay Shipping advised the ANAO that:

The DMO requested ‘health checks' and audits (which in fact occurred three times prior to the most recent audit) to ensure that the accounts were prepared in a true and correct manner and there was in fact minimal requests for monthly accounts from the DMO, apart from various progress reports that were made available on ad-hoc basis and some financial reports that were sent to the DMO at various intervals. Although the DMO required infrequent reports, Teekay have stringent reporting requirements and completed a full set of accounts for the DELOS each month – these reports were available to the DMO at any point in time. It was always emphasized, even during prior audits, that our books are always open for inspection if required. In fact at various intervals during the prior audits, full sets of the Operating expenditure reports were sent to the DMO.

17. The incentive payment reduced by $0.25 million for each week that delivery occurred after this date.

18. Initial Operational Release is defined by Defence as the milestone at which Navy is satisfied that the operational and materiel state of the equipment, including deficiencies, training and supportability elements, are such that it is safe to proceed into Naval Operational Test and Evaluation.
19. Operational Release is the milestone which represents the in-service date, at which, Navy is satisfied that the equipment is safe and fit for operational service and that its current operational capability has been clearly defined.

20. Defence advised that an example of why the Government directed a change to the testing procedures relates to the ship's sewage treatment plant. The new system was fully tested to the manufacturers standards but could not be fully completed until the full ship's crew were on board and the ship was at sea with the normal motions of a vessel underway.

21. Section 47 of the FMA Act requires that a Chief Executive must pursue recovery of each debt for which the Chief Executive is responsible unless:

•  the debt has been written off as authorised by an Act;
•  the Chief Executive is satisfied that the debt is not legally recoverable; or
•  the Chief Executive considers that it is not economical to pursue recovery of the debt.

22. The HMAS SIRIUS Safety Case Report (SCR) is to consist of the following five parts: Part 1: Introduction; Part 2: Capability Description; Part 3: Formal Safety Assessment; Part 4: Safety Management System; and Part 5: Emergency / Contingency Plan.

23. The Naval Operational Test and Evaluation Manual (ABR 6205) notes that:

The Initial Operational Release process must ensure that all safety aspects are addressed and that at the appropriate milestones it is demonstrably safe to proceed to the next stage of the process. The Materiel Certification Plan is a key document used to support this process. A documented Safety Case will be required for Initial Operational Release.

24. Defence advised the ANAO in December 2006 that:

In the period leading up to Tenix offering delivery of the five capability packages, a number of other contractors and Defence agencies were conducting parallel activities onboard the ship. A number of these parallel activities presented minor conflicts with Tenix's activities leading the Project to direct Tenix to defer a number of test and acceptance activities to a later date. In many cases testing had already been completed and witnessed by Commonwealth personnel and the issue was simply one of completing and rendering reports.

25. An appropriation is defined in the Department of Defence Annual Report 2005-06 as an authorisation by the Parliament to spend money from the Consolidated Revenue Fund (the principal working fund of the Commonwealth) for a particular purpose.