Changing Tides

The energy crisis and underinvestment has prompted the Brazilian government to introduce a new raft of reforms to the electricity sector. Can it develop the clear and stable market that it needs?

Brazil’s power market is undergoing a much-needed overhaul in the aftermath of last year’s energy crisis, when a severe drought led to power shortages throughout large chunks of the country. A raft of reforms to the electricity sector announced in early February consisting of 33 measures, aims to lay the ground for further investments, particularly private investment, while attempting to mitigate the impact of tariff hikes on consumers.

“The ultimate objective [introducing improvements] in the regulatory model of the electricity sector is precisely that of defining clear, transparent, stable and predictable rules,” said Pedro Parente, head of the Energy Crisis Management Committee in a speech before members of the American Chamber of Commerce in Sao Paulo in mid-February. The announcement of the reforms broadly coincided with a final lifting of energy rationing on 1 March, further boosting optimism for recovery and expansion in the power sector.

The changes are effectively a pragmatic response to a series of regulatory inconsistencies and setbacks that have stifled investment over the past couple years. Added to this has been the reduction in companies’ earnings as a result of the implementation of a 20 per cent power rationing in June last year. The energy crisis in itself contributed to a weakening currency, affecting costs dominated in the local currency. And finally the collapse of Enron, while not of direct impact in terms of the failed energy trader’s interests in Brazil, has forced US power firms to concentrate on consolidating their domestic reputations.

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Investor response to the reforms has generally been positive. “Initially the feeling was that changing the rules in the middle of the game was a bad sign,” says Subhojit Daripa, associate at the Sao Paulo offices of investment bank Credit Suisse First Boston. However, he also admits there was recognition that the government was “trying to address concerns of investors in terms of supply of energy.”

The right priorities

The 33 measures will be gradually introduced over the course of the next few months. There will first be a priority on eight of the measures, which essentially concern rules defining the sale of so-called ‘old energy’, that is power provided by state generators. While the electricity model had previously envisaged the eventual total liberalization of the market and privatization of all remaining (mainly generating) assets, failure to proceed has forced the government to create a dual-market system in the wake of a dispute between private distributors and Electrobras, responsible for the state-run generators.

The new system will prevent federal gencos from participating in the wholesale market. This, it is hoped, will allay potential investors’ fears that the generators would use lower operating costs to trade power at cheaper prices. Prices will be fixed for the federal gencos at a level close to the marginal operating costs. This situation will effectively remain in place while the generators remain in state hands. At present, the new electricity regulations have ruled out genco privatization for the foreseeable future.

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Efforts to sell two of the largest generators in 2001, Chesf and Furnas, eventually ground to a halt amid the energy crisis and lack of regulatory clarity. Moreover, few in the political establishment were willing to risk votes backing an unpopular process so close to the October presidential and legislative elections.

Following repeated postponements, the sale of Furnas, which supplies power to the southeast, had been due to go ahead in March this year. However, as far back as December, the President of state oil firm Petrobras, Francisco Gros, said that “it will not be possible to carry out the privatization [of Furnas] in March or on any date in 2002. The current international turbulence does not create an opportune moment for this and, currently, there is no more available time to prepare the sale of this scale.” Government estimates of the value of the gencos, both of which have an installed capacity of about 9200 MW, amounts to more than $3 billion.

A previous attempt to introduce a wholesale market had failed. Introduced in 2000, the mercado atacista de energia (MAE) was designed to trade surplus power at market-oriented prices. However, a legal dispute between Electrobras and private investors prevented the sale of any electricity. In response the government decided to abandon the MAE and introduce a new wholesale market, which will be more closely regulated (the MAE was self-regulatory). Although free-market advocates have criticised the move, tighter government supervision is actually intended to uphold private investors’ interests. Importantly, Electrobras and its genco interests will not be able to participate in the wholesale market.

Economic growth

The government is eager that the new rules will provide the basis for an expansion in capacity in order to meet energy needs over the next few years. A resumption in economic activity following the downturn in 2001 is likely to fuel a five per cent annual rise in demand. Industry experts translate this to an extra 3500 MW generating capacity annually.

While such needs are likely to be met in the near term, there appears to be some concern as to whether demand can be met beyond that. Government officials have insisted that there will be no recurrence of the power crisis during 2002 and 2003 but have not made any assurances beyond that point. Independent analysts concur. “I would say that over the next 24 months the possibility of scarcity of supply is very low,” says CSFB’s Daripa. Reservoir levels have been rising substantially since the end of the drought in 2001 and could rise to as high as 70 per cent. However, the need for extra investment is paramount: “Even if you have supply in excess, if you don’t invest you will have problems,” he adds.

Brazil remains heavily reliant on hydroelectric generation for its domestic and non-domestic electricity requirements. Hydroelectric power accounts for about 90 per cent of electricity supply. While there have been efforts to increase capacity from thermal generators, the relative scarcity of domestic natural gas reserves mean that there is unlikely to be any significant reduction in dependence on hydroelectric supply within the next few years.

Despite the improved optimism, many investors are adopting a ‘wait-and-see’ policy with regards to the new direction of the electricity sector. The effective functioning of the new rules, especially regarding pricing has yet to be established. Additionally, the investment climate in Latin America has been gloomy, a problem that goes back to the emerging markets crisis of 1998.

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The general economic downturn in the region has been compounded by specific problems affecting the power sector. US power firms have been drawing back from the region.

Arlington-based AES Corp. has been steadily reducing its exposure in Latin America. Essentially, its acquisitive strategy towards the region, including non-core areas such as telecommunications, was exposed as a burden on share prices, which took a beating in the aftermath of September 11. Subsequently, the Enron scandal has forced AES to concentrate on its domestic activities and, as with other US power firms, reassure investors over its accounting practices. AES’s contraction in Latin America could affect its distribution operations in the south of Brazil, although a spokesperson for the company has indicated no official decision has been made in relation to Brazil.

Political will

While the downturn in investor confidence will not prevent the Brazilian government from awarding further concessions for new generating plants, it may act to slow it down. Moreover, in Brazil, investor interest for 2001 is being stifled not only by continuing lack of certainty over the new electricity rules, but also by the October elections.

Observers point out that political risk is inbuilt into any overall risk assessment of Brazil. However, it has been a constant and debilitating factor in energy reforms during the Cardoso administration. Although the government has been committed to liberalizing the sector, there have been overriding political concerns that have placed reforms further down the agenda.

“The government term began with maxi-devaluation and ever since crisis management rather than structural reform has defined policy,” says John Bowler, regional director for Latin America at the Economics Intelligence Unit (EIU) in London. Consequently, he expresses strong doubts that many concessions or privatizations will be implemented prior to the elections.

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