30 September 2002 – Brazil’s recent power shortage, fears of potential contagion from the Argentine financial crisis, growing risk aversion and tightening budgets among international power developers add up to a major economic and strategic challenge for the next Brazilian administration, according to the authors of “Brazil: Market Rules and Power Plays 2002,” an update of a 2001 multi-client study by Cambridge Energy Research Associates (CERA).

“Although Brazil’s fractured Congress and multitude of political parties will limit any successful candidate’s room to maneuver, the direction taken by the new president, elected in October 2002, will be an important signpost for the future direction of the Brazilian power sector,” said Jed Bailey, CERA’s Director in charge of Latin American power markets. “The new president will have a strong influence on the priorities of the Ministry of Energy, the implementation of proposed regulatory changes and progress in the stalled privatization program in the power sector.”

Brazil’s incomplete regulatory regime is at a crucial stage of development, says Bailey. The country’s hydro generation resources have been overextended for years, and an abnormally short rainy season in 2000-01 left hydro reservoir levels critically low entering the dry season. While blackouts were averted as the result of a strict rationing program, the crisis prompted the government to propose a 33-point revitalization plan designed to streamline the power sector’s regulations, operations and institutional framework.

The plan has been debated extensively, but key measures have not yet been implemented and may not be completed before the new administration is in power.
These include:
* Further unbundling the sector and setting new limits on cross-ownership and self-contracting among generators and distributors
* Finalizing the revision of distribution tariffs, including reduction of cross-subsidies and setting a new, lower ‘social’ tariff for low-income consumers
* Clarifying the role of the wholesale market, planned power auctions, and bilateral contracts
Calculating locational transmission tariffs to provide stronger signals for the location of new generation capacity relative to demand centres.

Because of the delayed development of a competitive market in Brazil and increasing financial pressure on international power companies, individual companies’ responses to current conditions in the sector have ranged from tightening costs, limiting new expenditures and waiting out the storm to portfolio shuffling involving asset swaps, partner buy-outs and increasing focus on geographical (vertical) or functional (horizontal) integration. Some have also reduced their overall exposure in Brazil, the report indicated.

These new strategies can allow companies to minimize and even overcome the difficulties posed by the current market environment and position companies to best take advantage of the new sector structure as it emerges, according to the authors.

“Brazil remains the largest power market in Latin America, with strong growth potential that will require substantial investment to meet its power development needs. A significant level of private-sector capital will be necessary if major service disruptions are to be prevented. It remains to be seen if the market rules and institutions needed to support that level of participation can be developed in a timely manner,” Bailey said.

According to the CERA analysis, Brazil’s ability to attract investment for electric power will depend on:
* Whether the transition to a market-oriented regulatory structure and greater private-sector participation continues
* Whether prospective investors in generation capacity perceive that a sufficient return will be available, or whether they perceive the risks to be prohibitive
* Whether the Brazilian energy infrastructure can successfully include thermal generation technologies and the requisite expansion of natural gas supplies within a system that relies heavily on hydro power
* Whether Brazil will be perceived as able to maintain political and economic stability in the context of a poor global economy and the rapid economic deterioration in Argentina.

“There is no clear future course right now for the Brazilian electric power market,” says Bailey.
The report defines three scenarios to describe plausible paths forward for Brazil and the electric power sector:

* Giant Realized ( Under this scenario, there is economic stability and outward orientation supported by the government. The government pursues business relations that promote growth for the country. Economic growth and cross-border trade are central to the government’s agenda. Protectionist policies are implemented initially to allow the growth of evolving industries but rapidly phased out to allow for free trade and economic integration.

On the energy regulatory side, Brazil over time moves toward a fully competitive market, and the role of the remnant monopolist is significantly reduced. Economic growth is strong and stable, averaging 4 percent per year, supported by high trade flows. Brazil has strong ties with the international trade community, and foreign direct investment flows are strong, backed by strict monetary and fiscal policies.

Overall energy demand growth is strong, outpacing economic growth in the initial years. The regulatory framework and revitalization measures are completed, and competition is encouraged among a number of players. The market agents and players work smoothly and are able to develop the capacity needed to support economic growth.

Institutional Oligopoly ( Under this scenario, there are a few big players in the energy sector and other key markets influencing major regulatory decisions. There is weak accountability on the government’s side, and politics are backed by relationships between government and a few groups of investors. The regulatory process moves more slowly, with these few groups influencing the market. There is a bipartisan government with a moderate president. A few strong labour unions hinder the reform process. Government and business communities have good relations, but there is little effort on the government’s part to break trade barriers.

There is slower GDP growth, averaging 3 percent per year. Investment flows are slow as investors wait for clearer regulations. High debt levels continue to be a problem. The absence of clear regulations, together with compromised monetary and fiscal policies, leads to limitations on economic growth and energy demand.

Initial regulations promote increasing generation capacity over developing a competitive market. The presence of a few big players supporting the regulatory environment leads to a gradual break-up in monopoly, and these few players dominate the power market. An oligopoly market is formed, and few new companies enter. This prevents the development of a truly competitive market.

Volatile Stagnation ( Under this scenario, there is strong opposition to market reforms, and traditional populist policies prevail. The government establishes regulations based on political interests without considering investors’ needs. Traditional opposition exists, and all political forces remain focused on their core constituencies.

There is no commitment to open market competition, and the short-term political orientation leads to weak economic and trade policies. Exports remain based on core commodities, and there is little effort to diversify exports. Trade levels between Brazil and other countries remain low. On the regulatory side, the government follows its own pace, and little or no change occurs. Strong labor forces compromise the reform process.

Once serious energy and economic crises affect voters, the government attempts to institute radical change but runs into continued resistance in Congress and at the state level. Economic growth is volatile and constrained by under-investment in the energy sector. The power generation mix in this scenario continues to be dominated by hydro, with most new thermal capacity driven by industrial self-generation needs. The lack of investments, combined with slower but continuing economic growth, will contribute to brownouts and periodic rationing. The regulatory framework remains incomplete, and the energy sector is not the government’s priority.

Signposts
The report identified a number of signposts likely to signal movement from the current situation toward one of the scenarios. Monitoring these signposts will make it possible to assess the intentions of the new administration and determine which scenario best approximates future trends at any given time.

According to CERA, key signposts to watch following the October elections include:
* Progress of the reform process and energy liberalization
* Resumption of power generation asset privatization
* Roles of Petrobras & Eletrobras
* Role of market agents (Agencia Nacional do Petroleo, Agencia Nacional de Energia Eletrica and others)
* Currency stability
* Pace of Brazilian inflation
* U.S. and Brazilian interest rates
* U.S. economic growth
* Status of the Mercosur Trade Agreement.

Brazil is facing a difficult international environment and undergoing profound changes, says Bailey. The key challenge for current and potential investors is to understand the dynamics, unique characteristics and future market scenarios and adopt solid strategies for navigating this complex marketplace, Bailey concluded.

Cambridge Energy Research Associates (CERA) is the leading international research and consulting firm providing independent analysis and insight into the energy future. CERA’s focus is on energy markets, geopolitics, industry trends and strategy. CERA’s expertise covers major energy sectors – oil, refined products, natural gas, and electric power – on a regional and global basis. CERA’s Southern Cone team is based in Cambridge, Mass., S?o Paulo, Buenos Aires and Santiago.

Copies of the full report can be purchased and information obtained about CERA’s Southern Cone Gas & Power Advisory Services by contacting Alberto Bullrich at +1617 498 9191.