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Cablegate: Brazil's Electricity Supply in Precarious Equilibrium

VZCZCXRO5186
RR RUEHRG
DE RUEHSO #0260/01 1491424
ZNR UUUUU ZZH
R 281424Z MAY 08
FM AMCONSUL SAO PAULO
TO RUEHC/SECSTATE WASHDC 8243
INFO RUEHBR/AMEMBASSY BRASILIA 9370
RUEHRG/AMCONSUL RECIFE 4109
RUEHRI/AMCONSUL RIO DE JANEIRO 8724
RUEHBU/AMEMBASSY BUENOS AIRES 3150
RUEHAC/AMEMBASSY ASUNCION 3398
RUEHMN/AMEMBASSY MONTEVIDEO 2702
RUEHSG/AMEMBASSY SANTIAGO 2398
RUEHLP/AMEMBASSY LA PAZ 3809
RUCPDOC/USDOC WASHDC 3089
RUEATRS/DEPT OF TREASURY WASHDC
RHEHNSC/NATIONAL SECURITY COUNCIL WASHDC

UNCLAS SECTION 01 OF 04 SAO PAULO 000260

STATE PASS USTR FOR KDUCKWORTH
STATE PASS EXIMBANK
STATE PASS OPIC FOR DMORONSE, NRIVERA, CMERVENNE
DEPT OF TREASURY FOR JHOEK
DEPT OF ENERGY

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ENRG ECON ENV PREL BR
SUBJECT: BRAZIL'S ELECTRICITY SUPPLY IN PRECARIOUS EQUILIBRIUM


SENSITIVE BUT UNCLASSIFED--PLEASE PROTECT ACCORDINGLY

REF: A: Brasilia 0593; B: Brasilia 672; C: Sao Paulo 0031; D: La Paz
0462; E: 06 Sao Paulo 1059

1. (U) SUMMARY: Brazil's 2008 electricity supply will just cover
demand, leaving the county in a state of precarious equilibrium.
President Lula is lucky that it has been raining sufficiently over
the last six years to feed Brazil's hydroelectric reservoirs (which
account for approximately 80 percent of Brazil's electricity
production), but he may not be as lucky next year. In addition, the
GOB's improvements to the electrical system since 2001 have not
overcome the fundamental problems of lagging investment in
electricity production and an energy matrix that is heavily skewed
towards this one source of power. Government investment to expand
the electricity supply has been insignificant compared to growth in
electricity demand, and prospects for private sector investment
appear limited given the regulatory framework. Political
uncertainties in neighboring Bolivia and Paraguay also may limit
Brazil's supply of electricity. In addition, several large domestic
hydroelectric generation projects are years from becoming
operational. In short, Brazil's static energy balance shows a very
tight picture between supply and demand through 2012 when new gas
and oil discoveries could potentially come on-line. Brazil's
options for strengthening the electricity balance in the near term
are biomass generation, securing reliable sources of natural gas,
conservation, and better energy efficiency. In the meantime, Brazil
should expect higher electricity tariffs until it can develop a
consistent supply of natural gas and get several large generation
projects off the ground. END SUMMARY.

Current Dynamics
----------------

2. (U) The Brazilian government appears to have averted an
electricity crisis due in large part to pure luck. Because
approximately 80 percent of Brazil's electricity supply is from
hydroelectric power, rainfall is the most important determinant in
avoiding an electricity shortage. (Note: See Ref A for more
detailed look at breakdown of Brazil's generation capacity. End
Note.) In December 2007, industry insiders were preparing for
shortages because rainfall was 50 percent below normal; however,
heavy rains in early 2008 have saved the GOB from the potential
crisis in the short-term. The medium-term threat of an electricity
crisis, however, is far from over.

3. (U) According to statistics from Brazil's National Agency for
Electric Energy (Aneel) from March, Brazil had an installed capacity
for electric power generation of 100,700 megawatts (MW), an increase
of 3,400 MW over 2007. Although generating capacity vastly exceeds
the demand of 64,000 MW (Ref B), it is theoretical because many
gas-fired generators do not have adequate supplies of natural gas,
and hydroelectric capacity is dependent on rainfall to fill
reservoirs. Shortages in Brazil's natural gas supply (Ref C)
limited gas-fired plants to producing only 35 percent of their
11,600 MW capacity in 2007. On the demand side, electricity demand
growth tracks well with economic growth. According to the Energy
Research Company (EPE), electricity consumption was up 5.7 percent
in 2007 (GDP growth was 5.4 percent), the largest increase since the
electricity rationing of 2001. Consumption was up across the
various consumers: commercial consumption was up 6.6 percent,
residential consumption up six percent, and industrial consumption
up five percent.

4. (SBU) Government investment to expand the electricity supply has
been lagging growth in electricity demand and prospects for private
sector investment appear limited. The largest state-owned
electricity company Electrobras' investment was down by seven
percent last year in real terms from 2006 despite the GOB's promises
for increased investment in the sector. Total public investment in
the sector reached R$ 3.11 billion in 2007 (approximately USD 1.83
billion). David Waltenberg, an expert in legal and regulatory
energy issues, told Econoff that distortions within the distribution
system discourage investment and skew the electricity pricing
structure. The President of AES Brasil, Britaldo Soares, told

SAO PAULO 00000260 002 OF 004


Econoffs that new firms are unwilling to invest without more stable
investment rules, availability of financing instruments, clearer
environmental licensing procedures, and better pricing terms. AES
Electropaulo's CFO Alexandre Innecco underscored this point by
noting that from his point of view, only existing foreign companies
who have established themselves in Brazil are liable to increase
investments in electricity generation in the short-term. (Note:
While acknowledging the significant problems in the sector, private
industry group representatives Luiz Fernando Leone Vianna of the
Independent Energy Producers Association (APINE), and Paulo Pederosa
of the Brazilian Association of Commercial Agents of Electrical
Energy, both feel the positives outweigh the negatives, and believe
there are some good opportunities for investment in this sector in
Brazil. End Note.)

Better System than 2001 but Not Enough
--------------------------------------

5. (SBU) The GOB's improvements to the electricity system since
2001, primarily increasing installed electricity generation capacity
and interconnecting regional electricity transmission lines, have
not solved Brazil's fundamental electricity problems and have not
been enough to assuage the fears of renewed crises. For example on
interconnectivity, AES's Innecco pointed out to Econoff that
reservoirs have different generation capacities that limit the
effectiveness of the interconnectivity of the grid. He noted that
in some cases reservoirs in one region cannot substitute for a lack
of water in another. Despite this imperfect substitution, Dilton da
Conti Oliveira, President of the San Francisco River Hydroelectric
Company (CHESF), told the Principal Officer in Recife that he was
not worried about electricity shortages in the Northeast despite the
lack of rain because CHESF was already "importing" electricity from
other parts of the country thanks to the interconnected grid.
(Comment: This comment by the head of CHESF illustrates the lack of
understanding of imperfect substitution. Interconnectivity alone
will not resolve electrical shortages. End Comment.)

Supply Uncertainties Abound
---------------------------

6. (U) According to GOB figures, the static energy balance
(assuming five percent growth in demand and a guaranteed natural gas
supply) shows a very tight picture between supply and demand through
2012. On the supply side, the uncertainties are enormous. To
increase the installed generation capacity by 4.5 percent per year,
Brazil needs to make investments of R$ 18 billion per year
(approximately USD 10.6 billion), according to the Federation of
Industries of Sao Paulo (FIESP). New electricity generation
projects such as the auction of the Rio Madeira mega-project Santo
Antonio in December 2007 are an important step for the GOB, but are
a far cry from solving the country's energy problems, and would not
alleviate the intrinsic uncertainty of hydroelectric generation to
meet future demand. Brazil would need to build one mega-complex per
year from 2012 to 2016 to sustain five percent GDP growth.
Furthermore, project delays are certain to occur due to
environmental licensing concerns and financing. Currently, the
Brazilian law requires multiple environmental impact assessments and
the Brazilian Environmental Agency (IBAMA) employees are held
personally liable for mistakes. The GOB initiated studies six years
ago on the Rio Madeira projects and it will take a minimum of seven
years to reach full operating capacity. Even privatizing existing
generation facilities has been difficult in recent months. The Sao
Paulo state government canceled its third attempt to auction
Brazil's third largest generation companies Companhia Electrica de
Sao Paulo (CESP) on March 26 because potential bidders balked when
the GOB was unwilling to consider an extension of its generation
contracts, which would have been the largest electricity
privatization ever in Brazil.

7. (U) International pressures also could contribute to possible
electricity shortages. The ongoing discussions between Bolivia,
Argentina, and Brazil (Ref D) to divide up Bolivian natural gas
production will probably limit Brazil's supply of Bolivian natural
gas to power its gas-fired plants. Another of Brazil's power
suppliers, its neighbor Paraguay, is also threatening Brazil's

SAO PAULO 00000260 003 OF 004


electricity supply in the coming months. President-elect Fernando
Lugo wants to raise the tariff on electricity Paraguay sells to
Brazil from the Itaipu Dam by 700 percent. Itaipu is the world's
largest hydropower plant (14,000 MW), from which Brazil gets 20
percent of its energy supply.

Biomass, Conservation, and Efficiency to the Rescue
--------------------------------------------- ------

8. (SBU) The timeframe for large projects and for further
development of Brazil's natural gas resources provide opportunities
for biomass generation to fill some of the gap. Most experts point
to biomass electricity generation via bagasse, the biomass remaining
after sugarcane stalks are crushed to extract their juice for
ethanol and sugar production. The Director of the National
Operating System (ONS) Hermes Chipp told Econoff that biomass
projects and small hydro plants are fundamental for guaranteeing
Brazil's energy needs through 2012. Separately, ABRACEEL's Pederosa
also cited these as the two areas with the most growth potential for
the Brazilian energy matrix in the near term.

9. (SBU) According to the Brazilian Sugar Cane Industry Association
(UNICA), Brazil's sugar/ethanol facilities have an installed
capacity of 1,800 MW, of which 780 MW was sold to the grid during
sugar cane harvest last year. With increased use of biomass from
sugarcane and the implementation of high pressure boilers, UNICA
estimates biomass could produce up to 15 percent (11,500 MW) of
Brazil's energy needs by 2015. Cogeneration can be as inexpensive
as the incremental cost of installing a more efficient boiler up to
an investment-intensive technology overhaul to maximize electricity
generation. General Electric (GE) Regional Manager Guillermo Brooks
told Econoff that GE and others are interested in developing better
technology to improve efficiency, but that sugar/ethanol facilities
would need economies of scale in order for the investments to be
economically viable. Cogeneration is a complimentary power source
to hydroelectric generation (wet vs. dry seasons), the construction
time for a cogeneration plant is about two years (five years for
hydro), and provides a natural hedge for sugar/ethanol production.
(Note: In order for bagasse plants to supply electricity to the
grid, either the state or federal government will need to ensure
access from these plants to the grid either through building the
transmission lines or providing economic incentives for the
companies to do so. End Note.)

10. (U) Another short-term option is energy conservation and
efficiency. Because conservation was so successful in 2001,
however, Innecco told Econoff that rationing would be less effective
because many consumers have maintained their conservation efforts.
Brazil would unlikely see a comparable drop if residential rationing
measures were instituted again; instead, he said that the savings
would have to come from industry, which would result in a larger
economic impact. Despite Innecco's skepticism, the National Program
of Electricity Conservation (Procel) estimated that if consumers
reduced consumption by five percent, Brazil would conserve about
2,500 MW. Brazil has an estimated USD 2.5 billion in untapped
energy efficiency improvements every year despite having had an
energy efficiency program since 1985. A recent World Bank study
showed that Brazil is a difficult place to promote energy efficiency
because of the lack of available financing for energy efficiency
projects and high interest rates. The main source of funding
instead comes from a federally mandated fee charged to utility
companies for efficiency measures. Although the fee encourages some
efficiency projects, Brazil needs to create other incentives to fund
energy-saving projects.

11. (SBU) Illegal connections to the electricity grid cost
distributors approximately R$ 5 billion (USD three billion) per year
and Brazil's average commercial losses exceed five percent of
generated electricity, compared with the worldwide average of one
percent. AES started a program in June 2005 to formalize illicit
electricity connections in Sao Paulo. In 2007, AES Electropaulo
estimated more than 300,000 illegal connections in its operating
area. These consumers abuse the system and have no incentives to
reduce their consumption. AES' pilot program working with USAID to
formalize illegal connections showed a 30 percent consumption

SAO PAULO 00000260 004 OF 004


reduction (Ref E) by bringing participants into the formal system
and educating them how to conserve and to be accountable for their
electricity consumption.

COMMENT
-------

12. (SBU) The tight supply and demand picture for electricity
undoubtedly means higher electricity tariffs for residential and
industrial consumers until bigger projects come online in 2012.
Financial interlocutors point to higher energy costs as one of the
major inflationary concerns in the Brazilian economy in 2008.
Although generators will initially bear the brunt of some of the
up-front costs of higher generation costs, eventually they will pass
them on to consumers. Brazil's electricity generation capacity in
2008 depends on a number of external factors largely out of the
control of the government such as weather, the results of Paraguay's
attempts to renegotiate the Itaipu contract, and supplies of natural
gas from Bolivia and Argentina. Brazil needs to start advancing
innovative ideas to bridge the gap and increase electricity supply.
The GOB is beginning to recognize biomass as a viable alternative
and the private sector is beginning to finance these ventures. As
the 10th largest energy consumer in the world, the World Bank
expects Brazil to double its energy usage by 2030, but without the
right government incentives for production, conservation, and/or
efficiency, Brazil will have a hard time doing this. Barring much
larger investments in the energy sector, the Brazilian economy could
face a significant constraint on its growth. The next cable in this
series will focus on regional influences on Brazil's energy sector.
END COMMENT.

13. (U) This cable was coordinated and cleared by Embassy
Brasilia.

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