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Cablegate: Utilities' Concerns Over Brazil's New Electricity

This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 05 BRASILIA 000602

SIPDIS

STATE FOR WHA/BSC AND EB/ESC/IEC, NSC FOR JOANNA WALLACE,
DEPT OF ENERGY FOR PI/GARY WARD, USDOC FOR MAC/WH/BRAZIL,
USDOC FOR 4332/ITA/MAC/OLAC/TSHIELDS, DEPT OF TREASURY
OASIA/BACKES FOR GEOFFREY GOTTLIEB

E.O. 12958: N/A
TAGS: ECON EFIN BR ENGR
SUBJECT: UTILITIES' CONCERNS OVER BRAZIL'S NEW ELECTRICITY
MODEL

REF: A. RIO 00160
B. 02 BRASILIA 04567
C. 02 BRASILIA 04364

1. (SBU) Summary. On February 6, Embassy hosted a
Roundtable on Electricity Regulation in Brazil with
participation by 16 executives from 8 U.S. and European
companies from both the generation and distribution sides.
Companies' main concerns were short-term liquidity issues,
continued low electricity demand, and the upcoming periodic
review of tariff rates. Companies were clearly anxious over
the new GoB's impending reformulation of sector regulation,
and most attendees noted that their companies have halted
further investments in Brazil pending the emergence of a
clear regulatory model. Nonetheless, all company
representatives termed their access to GoB officials as
"good" and their initial impressions of Minister of Mines and
Energy (MME) Dilma Roussef as positive. Groundwork was laid
for a continuing dialogue between the private sector and the
Mission. End Summary.

2. (SBU) As part of a mission-wide strategy to coordinate
our policy approach in Brazil's energy sector, on February 6
the Ambassador hosted a diverse group of electric utilities
including U.S. companies Alliant, Duke, Enron, AES, Mirant,
and PSEG, as well as European companies EDP (Portuguese), and
Tractebel (Belgian). Grupo Cataguazes (Brazilian) and Endesa
(Spanish) were last minute no-shows. Ambassador and CG Rio
had already hosted a similar event for hydrocarbon companies
in ConGenRio during the last week of January (ref A).
Ambassador and CGs have also been meeting frequently with
U.S. companies on a one-on-one basis. Econ and commercial
officers followed-up the February 6 roundtable by making a
courtesy call on MME Secretary for Energy Marcelo Poppe.
Ambassador expects to make her initial call on Roussef during
the week of February 24.

Background to a Mess
--------------------
3. (U) The timing and concerns of the roundtable reflect the
current confusion and uncertainty surrounding the electricity
sector. In the mid-90s, the Cardoso administration embarked
on an ambitious privatization program to attract much-needed
investment to the state-dominated energy sector. The process
was poorly implemented from the start, as Congress failed to
pass comprehensive sector reform legislation similar to that
created for the telecommunications sector via the General Law
of Telecommunications. Instead, Congress carried out the
process piece-meal. Congress first legalized the sale of
states' distribution companies. In 1995, Espirito Santo sold
its distribution company ESCELCA to a group of foreign
investors. U.S. companies, led by AES, began investing in
1996.

4. (U) Reform legislation continued to trickle through
Congress, resulting in the creation of the national
electricity regulator ANEEL in 1997, and the creation of the
wholesale energy market (MAE) in 1998. Although the National
Council for Energy Policy (CNPE), a committee within the MME,
was given responsibility for long-term policy planning, the
weakness of the MME as an institution encouraged ANEEL to
step into the policy realm and complete the sector reform
process de facto through regulation. CNPE has met only three
times to discuss long-term policy. Roussef has commented on
various occasions that the MME will "recapture the policy
role" from ANEEL.

5. (U) Devaluation at the beginning of 1999 presented the
first warning signal for foreign companies whose debts were
dollar-dominated, but whose revenue streams were in Brazilian
reals. Since 1999 the dollar has appreciated approximately
200 percent in nominal terms against the real. For
distribution companies, this has been partially compensated
by annual GoB tariff adjustments based on a broad-based
inflation index -- 87 percent over the same period. Currency
risk has also put a damper on thermal-generation investment,
as the cost of turbines, fuel, and natural gas are
dollar-linked.

6. (U) The privatization process met growing political
resistance in 2000 when the government's plan to privatize
state generator giant FURNAS faltered amidst popular
discontent. The process then stalled-out completely with the
electricity shortage and subsequent government-mandated
rationing in 2001. Although the outgoing government received
high marks for managing the rationing crisis, it was unable
to make progress on a comprehensive reformulation of the
regulatory model, leaving this major headache for the new
government.

7. (U) The GoB also failed to provide permanent fixes to
institutions such as the MAE (see ref C), the CNPE, and
ANEEL. Although the GoB ended rationing in February 2002,
deleterious after-effects continue to affect generators and
distributors as electricity end-users have rolled back their
consumption to 1999 levels. Lower demand, combined with
abundant rains that have filled reservoirs in Brazil's 90
percent hydro-dominated system, has led to an electricity
surplus depressing spot prices to their regulated price floor
- approximately 1.15 dollars per megawatt hour. This is
unfortunate timing as a pre-planned phased liberalization of
the market freed 25 percent of the market's bilateral
electricity contracts held between generators and
distributors on January 1, 2003. This electricity, estimated
to be between 3,500 to 5,000 megawatts of capacity, remains
unsold. Generators have begun to assert that the government,
or distributors, must find a way to share the pain for the
depressed prices.

8. (U) In summary, the new government of President Lula has
inherited an electricity sector mess. Dollar-linked debt,
depressed supply prices, institutional gridlock,
macroeconomic constraints (i.e., inflation-target and
fiscal-surplus limits), and the supposed left-leaning
platform on which the new government rode into power all
raise doubts among investors for the long-run viability of
the electricity sector.

9. (SBU) In addition to putting out some of the fires above,
the new government must now define a sector model,
principally deciding what role private finance, current and
future, will play. Roussef, a former 1970s guerilla (ref B),
spent the first month putting her team together, and from all
accounts is serious, frank, and intelligent. Despite these
positive attributes, industry anxiety regarding her plans for
the sector and the outcome of the new model is running high.

Distributors Focus on Tariff Reviews
------------------------------------
10. (U) Not surprisingly, distributors at the roundtable
seemed most focused on short-term issues. First on their
mind was this year's periodic tariff reviews, which are
conducted every four to five years depending on the date of
each distributor's concession contract. This year, ANEEL
will conduct 17 tariff reviews with the goal to restore
"financial equilibrium" to distributors, and split
productivity gains between distributors and consumers.
During the event distributors lamented that financial
equilibrium remains an undefined term.

11. (U) In November 2002, ANEEL announced it would use
companies' current asset values as the basis for calculating
the capital value of each distributor, a key component in the
methodology for conducting the 2003 tariff reviews. This
announcement came as a surprise to industry as the GoB had
used an altogether different basis to determine the capital
value of each distributor when seeking minimum bid prices
during privatization in the late 90s. During that period,
ANEEL determined the capital value of the company on the
projected discounted revenue stream of the distributor.

12. (U) ABRADEE (the primary distributors' association in
Brazil) immediately objected to ANEEL's proposed use of
current asset value to determine capital value, and has since
led the charge against its implementation. ABRADEE asserts
that the depreciation in the Brazilian real since 1998 has
eroded the asset value of sector companies, and that the use
of this methodology would result in an insufficient increase
in tariffs. ABRADEE has proposed instead that the capital
value of the company be computed as it was for the minimum
bid prices used during privatization. An estimated 26
billion reals over the next five years industry-wide are in
play in this decision that will lead to either an average 20%
to 25% tariff increase, if ANEEL's methodology is used, or an
average 40% increase, if ABRADEE's is.

13. (U) ABRADEE has already been dealt an initial defeat as
two successive federal judges have declined the association's
request for an injunction on the current tariff reviews. On
February 17, ANEEL released its formula for the first three
reviews for public comment. The agency also stated that
distributors receiving high tariff adjustments following the
review would have them implemented in "parcels", starting
this year and continuing into the future in order to lessen
the impact on consumers.

Short-term Liquidity Crunch
---------------------------
14. (SBU) For some distributors, short-term liquidity
problems rank ahead of tariff concerns. AES, for example,
has a total Brazil-related debt running into the billions,
with a large percentage of it short-term and dollar-linked.
With a depreciated real and 1999 levels of electricity
demand, AES simply cannot make the receipts to cover its
debt. The company also continues to experience large losses
from municipal government non-payment. AES told Ambassador
in a private meeting that municipalities owe 400 million
reals to AES distributor Eletropaulo alone.

15. (SBU) Distributors told us that short-term fixes, i.e.,
90-day debt rollovers, are not helpful, and that most
important is GoB acceptance of companies' rights to a
reasonable level of return. One of their suggestions is to
increase tariffs on industrial consumers. Currently,
Brazil's residential consumers pay rates several times that
of industrial consumers. While such increases may seem, at
first glance, more politically acceptable to the new
left-leaning GoB than increasing the electricity bill of the
average consumer, roundtable participants told Embassy
officers that the GoB was not likely to increase rates on
industrial consumers for fear of reducing their own campaign
funds.

16. (SBU) Another option highlighted was a reduction in
taxes. Distributors commented that approximately 27 percent
of consumers' electricity bills are tax. The great majority
of this is ICMS, a state tax. Distributors told us that the
corresponding tax burden in the United States was about six
to seven percent. However, roundtable participants were
pessimistic on the prospects of the GoB reducing taxes.

Generators Not Overly Concerned by Single-Buyer Concept
--------------------------------------------- ----------
17. (U) As mentioned above, government-mandated rationing,
abundant rains, and the phased liberalization of 25 percent
of bilateral electricity contracts has depressed wholesale
electricity prices. A longer-term problem facing the
government is how to diversify Brazil's electricity mix. The
majority of policy-makers concede that some non-hydro
generation is desirable to avoid dramatic fluxes as seen
during the 2001 drought when dry reservoirs in three out of
Brazil's four regions combined with inadequate transmission
infrastructure to push prices to 650 reals per megawatt on
the spot market. However, new thermal plants with higher
amortization and fuel costs simply cannot compete with older
hydro plants in normal conditions.

18. (U) One idea for dealing with price fluctuations and
creating incentives for future generation investment is MME's
vaguely stated proposal to create a single buyer to trade
energy between a pool of generators and individual
distributors. Theoretically, such a trader would pay thermal
generators higher prices than amortized hydro plants, thus
arriving at an unified average cost of energy. This would
maintain profitability for thermal generators who face
difficulties covering their costs when abundant rains make
hydro cheap. Going into the roundtable, we had expected to
hear vehement industry objections to this proposal, but were
surprised to see generally neutral attitudes on the subject.
More GoB specifics on this proposal should emerge in upcoming
months.

Opinions on Current Government Guarded; Access to GOB Good
--------------------------------------------- --------------
19. (SBU) Companies told Ambassador that their access to the
new government has been "good." They report that Roussef
appears to be direct, strong-willed, and opinionated, but
also fair and intelligent. This echoes what we've been
hearing in private one-on-one meetings with U.S. companies,
and reinforces the commonly-held notion that it was Roussef's
drive that achieved the partial resolution wholesale
electricity market (MAE) accounts in early January. Roussef
spent most of her first four weeks in office placing trusted
advisors in key positions throughout the energy sector. Now
that her team is built, Roussef appears to be moving directly
to reformulation of the electricity sector model. A
Brazilian weekly quipped that if the GoB followed the
McDonald's best practices, Roussef would be "Minister of the
Month."

20. (U) Diligent performance in her first 30 days has raised
industry expectations of Roussef's capabilities, as well as
industry hope that the GoB "shares the pain." The GoB does
indeed appear willing to accept that it has some
responsibility toward finding a solution for the sector
crisis. In a February 6 meeting with econoff and commercial
officers, Secretary for Energy Marcelo Poppe said the MME has
formed a working group to present a reformulated model by
July, with a period of public comment to follow. A report in
national daily Estado de Sao Paulo on February 13 quoted MME
Executive Secretary Mauricio Tolmasquim as saying that the
MME would introduce a package of refinancing intended to
assist companies to survive until the new model is
implemented sometime near the end of the year.

Conclusion and Comment
----------------------
21. (SBU) The future role of private finance in the
Brazilian electricity sector is unclear, and likely to remain
so until at least July. The GoB has already said its future
model will be a mixed model of public and private investment.
It may be that the future MME plan will trade large
potential profits, private investment, and efficiency gains
for a less efficient, but more stable sector with lower
returns. Eletrobras President Pinguelli Rosa has been quoted
as saying 15 to 20 percent returns are "unrealistic," and
praised the French system as more reliable with 5 to 10
percent returns.

22. (SBU) Pending the new model's definition, the GoB must
find a way to deal with distributors' short-term liquidity
problems. Many of these private investors are requesting
that the government (i.e., development bank BNDES,
Eletrobras, and the state generators) "take a haircut" on a
portion of the distributors' outstanding debts, some of which
predate privatization. However, convincing the current GoB to
write down debts created by its predecessor is an unlikely
prospect. Eletrobras has its own stockholders who will balk
at big bailouts, and though new BNDES President Carlos Lessa
originally called his organization a "hospital for sick
companies," his sentiment has been publicly rebutted by
Minister of Finance Antonio Palocci.

23. (SBU) The primary alternative to refinancing deals is
reversion of concessions to the GoB. Such a move would
result in long legal challenges, and one also wonders if the
GoB would really wish to manage these utilities. Our
earliest indications are that Roussef herself, despite her
original extreme-left ideology, now does not want to
"refederalize" companies.

24. (SBU) Mission will continue to engage U.S. business, and
maintain open dialogue with the GoB as it formulates its
model. We will lend support to ABRADEE's proposal for tariff
revision methodology, and urge options to improve companies'
financial health while limiting cost increases to residential
consumers. GoB options, in this context, include urging
local governments to pay up, reducing taxes on electricity,
and redressing the imbalance between residential and
industrial tariffs. Over the longer-term we will seek
opportunities to strengthen institutions such as ANEEL and
the MAE, and promote cooperation between policy planning
organizations such as the Brazilian CNPE (National Council
for Energy Policy) and the United States Energy Information
Administration.

HRINAK

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