A Report on the Brazil Energy Roundtable

THE CHANGING BRAZILIAN ELECTRICITY MARKET

By: Professor Adilson de Oliveira Administrative Director Instituto de Economia, Univ. Federal do Rio de Janeiro.

ROUNDTABLE HIGHLIGHTS
To assess the current situation of the Brazilian electricity supply industry (BESI) the Institute of the Americas structured a dialogue between Brazilian authorities and academics, private investors, and utilities. The reform of the BESI had moved smoothly until the beginning of 1999 and the devaluation of the real. The Federal government is confronting political difficulties as it moves to privatize the remaining state owned generation companies, especially with few investments in new power plants. This situation is increasing the risk of electricity rationing in the near future. Private investors' perception of risk has increased substantially since the devaluation. Tariffs are not in line with utilities' costs, while the normative value introduced by Aneel is not sufficient to attract private investment. Moreover, tariffs for transmission are not yet fixed, and the tax regime discourages deverticalization. Government officials indicated that they understand the situation. They reported several measures intended to remove risks and increase the attractiveness of power projects. They are also evaluating the indexation of tariffs to the dollar and a triggering mechanism for cost increases. Incentives already exist for small hydropower plants, and an emergency plan introduced several incentives for a list of thermal power plants. The government stressed its commitment to privatization throughout the roundtable. A clear sign of this commitment is the profound change in Eletrobras' role as declared by Dr. Sampaio Neto: Eletrobras is energetically implementing the government's policies. It was announced that the spot market would be created in three phases. In the first, beginning October 1999, monthly prices will be fixed for the purchase of shortterm electricity; the second, in January 2000, involves the fixing of three weekly prices; and finally, hourly prices will be introduced in November 2000. Participants were gladdened by the news that Aneel had formed joint groups with the environment and water regulatory agencies to find mechanisms reducing the environmental and water use risks of power plants. Similarly, it was encouraging to see that BNDES, Aneel, Eletrobras, and the Energy Secretariat are coordinating their actions to move on the reform of the Brazilian electricity supply industry.

BACKGROUND
In the early 1990s, Brazilian macro-economic policies changed radically. The abandonment of import substitution policies made room for an open economy where competition could play the central role instead of government planning. As part of this process, it was decided that the provision of services by public utilities should be reformed. This meant that private investors would replace state owned companies as providers of these services and independent regulatory agencies would be created to induce utilities to supply these services to consumers fairly and efficiently. The Federal government began the reform of the Brazilian electricity supply industry (BESI) at the end of 1993 with the abandonment of the concept of cost-plus pricing. Soon after, it opened the grid to large energy consumers and a new regulatory agency (Aneel) assumed the responsibility of overseeing the economic and technical performance of the industry. Then, the government established a system operator to dispatch power plants and guarantee the quality of service provided by the grid. Currently, a wholesale market for power is being developed, as well as a planning agency (CCPE) that will decide the expansion of the transmission system and produce an indicative plan for new power plants. Privatization is a key aspect of the BESI reform. Privatization will help the government reduce its fiscal deficit and, more importantly, eliminate political interference in the day-to-day management of the industry. Most distribution utilities are already privately owned, with only two relevant, large distribution areas (COPEL and CEMIG) remaining to be privatized. Privatization of the generation companies started in 1998 but, in contrast to the privatization of distribution utilities, is not moving smoothly. Political problems related to water use led the Federal government to postpone privatization of Furnas and, consequently, delay the privatization of two other Eletrobras subsidies, CHESF and Eletronorte. More importantly, although critically needed, investments in new power plants are not materializing. Several projects have not been able to find their way to the market place. This situation is rather surprising. Elsewhere, similar reforms provoked rapid privatization and the erection of several new power plants. How can we explain this situation? What actions are necessary to remove the obstacles that are blocking the movement ahead of the BESI? The Institute of the Americas organized the Brazil

The Changing Brazilian Electricity Market

Energy Roundtable 99 to provide some answers to these questions.

THE ROUNDTABLE
A framework paper identified the main problem: investors face too many uncertainties in the new Brazilian electricity market. Indeed, the regulation of the wholesale market for power has not yet been settled and the computer model that will be used to fix the spot price is still in the development stages. Moreover, initial contracts were signed between incumbent generators and distribution utilities at prices much below the costs of new power plants, and many constraints in the grid are likely to produce high transmission tariffs, increasing electricity prices substantially over marginal costs. It becomes very difficult to reliably assess the future price of electricity in such conditions, a piece of information essential to the process of contract negotiation. To make the situation even more complex, the Federal government's ten-year plan for the BESI suggests that new hydropower plants should be built to supply the growing demand while private sector analyses indicate investments should flow towards thermal power plants. These uncertainties raise investor risks above reasonable levels, making it very difficult to organize a financial package for any power project in Brazil. The government should act to remove uncertainties and reduce risks. So far, Eletrobras considers the BESI privatization program (one of the largest in the world) to be successful. Several utilities have already been privatized, frequently at large premiums over minimum bid prices. The Treasury collected about R$ 22.2 billion, helping to reduce the country's fiscal deficit. Distribution utilities were privatized first to reduce the perceived risk of financial disruption of contracts by public utilities. Although the privatization of some federal generation companies are facing difficulties, the president of Eletrobras emphasized that the Federal government's commitment to privatization of these companies must not be underestimated: their privatization will be carried out during the year 2000. Eletrobras is actively working in that direction. Indeed, the company played a key role in the privatization of distribution utilities and was able to sell Gerasul, a large generation company in the south of Brazil. Eletrobras is facing legal and political obstacles in keeping the process moving in the case of Furnas and CHESF; but all efforts are to have these problems solved by the beginning of 2000. Meanwhile, Eletrobras is giving up its qualified personnel for the organization of a system operator, a private utility essential to the privatization of the generation companies. The planning committee of the BESI (GCPS) forecasts substantial growth in Brazilian electricity consumption in the near future. About 3500 MW of capacity will be needed each year in the next decade; most of it being 2

expected to come from hydropower plants. However, environmental protection is reducing the scope for hydropower plants, and Aneel is having some trouble attracting private investors to hydropower projects. In the short term, the Federal government wants to develop substantial thermal power capacity in each one of the main load centers to reduce the risk of blackouts. The government has been surprised to find, however, that private investors are not rushing in. A detailed review of the situation in the isolated systems (mainly in Amazonia) was presented. Although these systems are a small share of BESI, they represent a market of 7.7 TWh (2.2 GW of installed capacity) and they supply 2.5 million consumers. There are 333 isolated systems in Brazil and, although the service they provide is poor, the electricity they produce is very expensive. Each year, roughly R$ 670 million is expended with subsides, despite the fact that the tariff is R$ 130/MWh. This is due to the high costs of transporting the 1.4 billion liters of diesel oil a year that must be supplied to power plants. Government subsides in this area should remain in place until the year 2013. Only half of the Brazilian population in Amazonia has electricity supply; but government policy is to rapidly increase supply in the near future. To accomplish this, it is essential to reduce both subsides and costs. A plan exists for the use of natural gas available in the region and the exploitation of the substantial hydropotential at competitive prices. Privatization of Amazonian utilities is planned for 2000. Dr. SAMPAIO NETO, president of Eletrobras, noted that there is growing concern among government officials regarding the little to no private investment in new power plants. He suggested that the main difficulty seems to lie in the Power-purchase Agreement (PPA) negotiations between public utilities and private generators, forcing Eletrobras to sit in on these negotiations. Eletrobras has no intention of competing with the private sector in this area. Rather, it will take on risks that private investors are reluctant to assume to make projects otherwise doomed to remain on paper financially viable. Referring to transmission lines, he indicated that until now, most of the new lines had been built by Eletrobras subsidiaries (Furnas, CHESH, Eletronorte and Eletrosul). From now on, however, Eletrobras subsidiaries will only participate as a minority investor, once again with the objective of reducing private investor risks. He clearly presented the new role of Eletrobras in the reformed electric sector. Eletrobras will continue to hold two generation companies (Eletronuclear and the Brazilian share of Itaipu) and will market their electricity to distribution companies or large consumers. Moreover, it will use its considerable financial capacity to support government policies such as: (i) the development of transmission lines that private investors are not interested in; (ii) taking a minority share in power plants to stimulate needed investments; (iii) supporting research and development for the electricity business (private investment in CEPEL was welcomed); (iv) rural

The Changing Brazilian Electricity Market

electrification (government intends to provide electricity to at least 1 million rural producers in the coming years); and (v) attracting private investment to the isolated systems of Amazonia. Dr. Sampaio Neto indicated that Eletrobras has increasing interest in diversifying its business scope, adding value to the very large infrastructure already owned by the company (212,000 km of transmission lines) that connects all large urban centers of Brazil. Eletrobras created a subsidiary (Eletronet) that has forged an association with a strategic partner (AES corp.) to develop the use of its network for telecommunications. Eletrobras considers this moment particularly exciting because the Brazilian telecommunications industry has been opened to competition, creating a window of opportunity for investors to develop and explore Eletrobras' existing network. The company's objective is to capture 11% of the total Brazilian flow of long distance telecommunications by 2008. In contrast to Eletrobras, CESP (the state electric company of So Paulo) is not facing major difficulties with the privatization of its generation subsidiaries. The company was split into three generation companies and their privatization is proceeding: the first (Paranapanema) was privatized in September 1995, and Tiet soon followed suit in October of the same year. A clear political commitment to privatization from the government of So Paulo and a careful arrangement for the pension fund of the utilities' employees are possible keys to the success of these endeavors. Nevertheless, it is clear that the government of So Paulo does not intend to privatize the transmission companies created as result of the split up of CESP and Eletropaulo. Indeed, they will soon be merged to create a regional state owned transmission company. Participants reacted to this point with concerns that Eletrobras is increasing its role in the BESI, therefore leaving less room for private investors. This is likely to prolong the transition to a competitive, private BESI. They indicated that government should play a more effective role in reducing risks (such as the back up for thermal power plants and the exchange rate for the tariff) and clarifying aspects that produce uncertainties (such as transmission tariffs and the gas price index). Government officials rebutted, stating that the Federal government is paying attention to these problems, but expects that investors will take on some risk. Eletrobras will step in only when private investors are not developing the needed additional capacity. A privatized utility reviewed the situation and highlighted that the lack of investments in new generation capacity significantly increased the risk of a power deficit over the next two years. This could keep the electricity spot price at a very high level during that period. However, if the planned expansion happens, the spot price will drop sharply after 2003. To redress the situation, substantial investments are needed in the short term, despite the 3

reality that investors are facing a difficult macroeconomic and regulatory context. The devaluation of the real reduced the actual average tariff for consumers from US$ 80/MWh to US$ 56/MWh and increased the regulatory risk as well. Indeed, utilities were not allowed to immediately pass on the devaluation of real to their tariffs (this is especially important in the case of electricity supplied by Itaipu because it is priced in dollars) while Aneel is passing additional costs on to utilities, reducing their profitability. Figures presented suggested that the current average tariff (US$ 56) leaves a margin for distribution utilities (US$ 29) that is insufficient to pay their costs and finance the needed expansion of the network (US$ 40). Moreover, the average price distribution utilities pay for their power supply (US$ 27) is not enough to cover the cost of a combined-cycle gas turbine power plant (US$ 35) and the transmission costs (US$ 5). It appears the distribution companies are hesitating to sign the PPA's for expensive new power because they already have cheap power contracts that are adequate to supply their captive consumers. Therefore, they can cover their contractual obligations with captive consumers, leaving large, potentially free consumers with the potential necessity to sign PPAs for their needed power. The presentation concluded by proposing a few measures to put the system back on its feet: first, increasing the average tariff for consumers to at least US$ 67; second, requiring the regulatory agency (Aneel) to provide conditions for PPA contracting by allowing any additional cost to be immediately passed on to consumers; third, coordinating natural gas and electricity policies, which would have particular importance for the normative value formula. Independent power producers are finding it difficult to develop a power project for several reasons. First, distribution companies prefer to develop their own power plants because they are allowed to self-supply 30% of their consumers. Second, the potentially free consumers (30% of total consumption) are finding it difficult to buy from independent power producers, mainly because distribution utilities are not making it easy to gain access to their grid. Third, tariffs for transmission are not yet fixed and so it is impossible to know what the value of the electricity produced by the power plant is exactly. Fourth, the taxation regime penalizes deverticalization by taxing each transaction that takes place--taxes, which cannot be recovered, in the following transactions. Fifth, there are no funds available in Brazil to structure project financing, and foreign suppliers of funds are extremely averse to a devaluation risk. To further complicate things, gas turbines will not be available in the market until the year 2002. A group of speakers reviewed the situation from the perspectives of the system operator, Aneel, and the wholesale market for power. They pointed out that coordination is essential in the case of the BESI because

The Changing Brazilian Electricity Market

efficient coordination of water use produces substantial economic benefits (estimated at US$ 3.1billion each year). The system operator is working hard to have all new procedures, models, and contracts in place by December 2002, when the initial contracts terminate. Aneel indicated that private investors are hesitant to build new power plants and distribution utilities are apprehensive with the factor X (of the price cap formula) in the review of their tariffs, as well. The regulatory agency is working on both issues. For instance: (i) incentives were given for small hydropower plants that have already begun attracting private investors; (ii) a recent resolution from the Brazilian Central Bank allowed utilities to have maintain their accounts in dollars to reduce their devaluation risk; (iii) Fundao Getulio Vargas is evaluating the factor X. Currently, the joint group of Aneel and IBAMA (the environmental agency) is working on the procedures for licensing power plants. Another joint group with the ANA (the water regulatory agency) is assessing the issue of river water use. Regarding the normative value, Aneel expects that there will be no captive consumers and, therefore, there will be no need of a normative value. The speakers highlighted that, in contrast to other reforms, the government left the organization of the power market to Brazilian market players. The achievement of consensus among the players will require time. Thus, the spot market will be introduced in three phases: the first in October 1999, fixing monthly prices for the purchase of short-term electricity; the second in January 2000, with the fixing of three weekly prices; and, finally, the introduction of hourly prices in November 2000. Despite the difficulties pointed out earlier, there are many gas-fired power projects currently under consideration. There is plenty of gas available in the region and Petrobras intends to have a minority stake in several projects. The company priority is for cogeneration plants, in which case Petrobras will buy the steam eventually produced and a share of the electricity, as well. Petrobras will provide natural gas with financing from its equipment suppliers and BNDES. It was pointed out that development of an interruptible market for gas is fundamental for the economic viability of thermal power plants in Brazil. After supporting privatization of distribution utilities, BNDES is actively offering financial support for private investors interested in the generation business. Toward this end, BNDES is seeking partnership with foreign banks. It is difficult for BNDES to accept pure project finance--at the end of the day, some corporate guarantees are necessary. Internationally, financing power projects becomes more difficult because the risk premium has increased, the amount of funding available has decreased, and investors are looking for short-term opportunities. The government's role in risk management is fundamental, as is that of Aneel. It was suggested that particular attention should be given to the 4

fact that projects will be financed in dollars while the revenue will be in reals. Attention should also be focused on the way in which the regulatory agency intends to deal with the inflation rate. The seminar concluded with the Secretary of Energy, Dr. Benedito Carraro informing the audience that government has decided launch an emergency plan in order to remove the likelihood of electricity shortage until the year 2002. It is the government's plan to arrive at that year, when the wholesale power market will be fully operational, with electricity supply and demand in balance. To achieve this objective, full support will be given to the development of a group of power plants (7000 MW hydro, 7000MW thermal, and 2000MW imported): 1. Eletrobras will act as a buyer of last resort, meaning Eletrobras will sign PPAs with independent power producers unable to find buyers for their power; Aneel was asked to demand distribution utilities to use their contracts to prove that they are able to supply their markets; Aneel was requested to analyze a full passthrough of any devaluation of the real to tariffs; Aneel should assess the possibility of immediate passthrough of any increase in costs to tariffs; The natural gas price for electricity generation was fixed at an average US$ 2.26/million Btu for the period 2002 to 2021; BNDES will offer credit under special conditions to the limit of 80% of the total investment; Eletrobras can offer some guarantees to make these projects viable; Transport tariffs for this electricity will be soon fixed by Aneel; Aneel will soon finalize the public hearing concerning backup costs for these power plants;

2.

3. 4. 5.

6. 7. 8. 9.

10. The Secretary of Energy will soon design and distribute a model for the PPA.

CONCLUSIONS
The roundtable produced a fruitful dialogue between private investors and government authorities. There was general agreement that there are still uncertainties in the Brazilian electricity market that must be removed to reduce risks and create an adequate environment for investment. This is essential to avoiding electricity shortages in the near future. Private investors had the opportunity to present their main concerns and to suggest measures to enhance the attractiveness of power projects. Clearly, the January

The Changing Brazilian Electricity Market

1998 devaluation has had a profound impact on investor perception of risk. In addition, actual tariffs (both for generation and transmission) are far below the figures the market believes are reasonable. Moreover, investors are unhappy with the normative price Aneel has fixed: its value is not close to what the market believes is the actual cost of additional power in Brazil, nor is the formula proposed for its indexation considered acceptable. It was indicated that the current tax regime does not favor deverticalization. Government representatives and the regulatory agency indicated that they are acting to solve these problems. A triggering mechanism is under consideration for both inflation and currency devaluation; the normative price will be used only during the transition period. In the long term, competition will fix electricity prices in the wholesale market for power. The Federal government is particularly concerned with the possibility of an electricity shortage in the coming years. The emergency plan announced during the roundtable is intended to keep supply and demand balanced until the year 2002, when the wholesale market will be fully in place. Eletrobras will play an important role in the emergency plan, but government officials stressed that this should not be perceived as intended to reduce the scope for private investors in the BESI. Eletrobras was called in only to make viable private investment projects that otherwise would not materialize. The government reiterated its commitment to privatization of the remaining stateowned generation companies. It was good news to hear that Aneel had formed joint groups with the environmental and water regulatory agencies to devise mechanisms reducing the environmental and water use risks of power plants. Similarly, it was encouraging to see that BNDES, Aneel, Eletrobras, and the Energy Secretariat are coordinating their actions to move on the reform of the Brazilian electricity supply industry.

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