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### Viewing cable 03BRASILIA602, UTILITIES' CONCERNS OVER BRAZIL'S NEW ELECTRICITY

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
03BRASILIA602 | 2003-02-21 15:49 | 2011-07-11 00:00 | UNCLASSIFIED | Embassy Brasilia

`

    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

`