ELECTRIC INDUSTRY PRIVATIZATION AND RESTRUCTURING: LESSONS FROM BRAZIL Ashley C. Brown

1. Collaborative Field Course ENERGY, WATER AND THE ENVIRONMENT ELECTRIC INDUSTRY PRIVATIZATION AND RESTRUCTURING: LESSONS FROM BRAZIL Ashley C. Brown Executive Director, Harvard Electricity Policy Group John F. Kennedy School of Government, Harvard University Of Counsel, Dewey & LeBoeuf January 20, 2010 Harvard University School of Engineering & Applied Sciences (SEAS) Universidade de São Paulo Escola Politécnica (Poli-USP) Harvard University David Rockefeller Center for Latin American Studies (DRCLAS) www.drclas.harvard.edu/brazil/seas-poli-usp-2010

2. Overview of Power Sector • 65,134 MW Installed Capacity (1998) • 95%+ Hydro • Need for Thermal Expansion • National Ownership of generation and transmission • State owns distribution companies • Nationalization completed in 1970’s • 5% Demand Growth (1999)

3. Overview, con’t • Three Systems: • South / South-Central • Northeast • Isolated Systems • Heaviest Load in South / South-Central region • Hydro facilities located on only a few rivers

4. Overview, con’t • Many hydro plants are multiple use: • Electricity • Water / irrigation • Navigation • Generating resources far from load centers • Procel Efficiency Program

5. Overview, con’t • Generating and Transmission Sectors well planned and operated • Deteriorated distribution networks • High non-technical losses • Some vertical integration at State levels • 45% Rural Electrification • 1 Nuclear unit; 2 others planned • 1 Huge Bi-national plant

6. Socio/Economic Context • Massive Government Debt • Real Plan • Inflation declining • Pressing social needs • Skewed demographic and geographic distribution of wealth • Partly first world / partly third world

7. Motivation For Privatization • Macro-Economic Considerations - Primary • Government Debt • Recover Debts Owed by States to National Government • Pressing Social Needs • Satisfy Loan Conditions • Micro-Economic Considerations - Secondary • Improve Performance of Distribution Sector • Inability to Raise Capital Needed to Meet Growing Demand

8. Goals of Privatization • Primary Objective: Maximize Revenues from Sale of Assets • Part of Overall Economic liberalization • Finance System Expansion

9. Sector Considerations • Secondary or Tertiary • Delayed Creation of Regulatory Structure • Delayed Consideration of Market Structure and Rules • Inadequate Attention to Need for Promoting Thermal Development

10. The Plans • Distribution Sector Entirely Privatized (Where BNDES Controlled) • Generating Sector Privatized (Where BNDES Controlled) • State retention of Transmission + Itaipu and Angra

11. Flaws in the Plans • Complexity of Unbundling and Privatizing Hydro Generation • Water Rights and Priorities of use • Upstream/Downstream Issues • Asymmetry in Hydro-Thermal Competition • High Productivity of the Generation and Transmission Sector • Privatization Before Creation of Regulatory and Market Institutions

12. Flaws in the Plans, Con’t • Lack of Balance Between Micro and Macro Economic Considerations • Underestimate of Currency Risks • Asymmetry Between Fuel Market and Electric Sector Needs • Emphasis on Short Term Results • Inadequate Consideration of Transition Problems

13. Institutional Responsibility For Privatization • BNDES Given Main Responsibility • Ministry of Mines and Energy Only to Coordinate Sector • State Owned Companies Precluded from Obtaining Independent Advice • Role of State Governments

14. Incentives for Investors • Price Caps Without Productivity Expectations • General Absence of Social Expectations Mandate • Pre-existing Contracts for Generators with Distributors • Annex V Throughput Assurances for Distributors

15. Course of Privatization • Revenues from Sale of Distribution Companies Generally Exceeded Minimum • Average Premium over Minimum = 45% • Sale of Generators Generally Required Long Term Sales Contracts to Attract Investors • State Financing Central to Many Transactions (26% from BNDES alone) • Most of Distribution Sector Privatized • (17 companies)

16. Course of Privatization, Con’t • Generation Largely Not Privatized (4 companies) • Inability to Privatize FURNAS, CHESF, and Eletronorte • Inability to Attract Significant Thermal Investment • CEMIG Controversy • Current Inability to Attract Private Investors (e.g. COPEL, CELG) • Increasing Concentration of Private Investors

17. Results from Consumer Perspective • Shortage of Supply and Rationing • Service Quality Problems • Prospect of Huge Increases in Rates (33-50% over Next Few Years) • No Appreciable Expansion of Service

18. Reasons for Consumer Disappointments • Drought • Failure to Diversify Resource Portfolio • Disincentives for Private Investment • Perversity of Incentives • Lack of Productivity Expectation • Inability to Distinguish Between Cost Cutting and Productivity Gains • Ex Post Creation of Regulatory Regime • Lack of Coherent Market Structure

19. Results from Investor Perspective • Substantial Financial Losses • Assumption of Uncontrollable Risks • Fuel Market • Currency Fluctuation • Artificial Price Constraints (Unlinked to costs) • Inability to Enforce Contracts • e.g. Annex V

20. Results from Investor Perspective, Con’t • Asymmetrical Market • Privatization before Regulation • Skewed and Uncertain Market Rules and Conditions • Distributors Unwilling to take Long Term Contract Risks in Face of Uncertainty • Generators Unwilling to Risk Capital in Absence of Contracts or Market Rules

21. Reasons for Investor Disappointment • Unreal Expectations Created by Initial Incentives • Decline in Value of Real • Drought • Macro-Economic and Political Concerns Trump Micro-Economic Considerations • Inflation Fears • Opposition to Any Form of Indexing • Unwillingness to Impose New Obligations on State-Owned Companies (e.g. Annex V) • Lack of Regulatory Independence • Mismatch Between Gas and Electric Markets

22. Reasons for Investor Disappointment, Con’t • Failure to Break Monopoly in Natural Gas Market • Imbalance Between Incentives and Regulatory Rules (e.g. Rio Light) • Legal Uncertainties Regarding Contracts (e.g. CEMIG) • Uncertain Relationship Between License Conditions and Subsequent Regulations • Service Quality Standards • Expansion of Service Availability • Technology Transfer • Affiliate Transactions • Unknown Market Rules With Full Market Opening in 2003

23. Government Responses to Problems • Ad Hoc Socialization of Risks, Not Clarification of Market • Socialization of Annex V and Angra II Liabilities (BNDES + Tariff Increases) • State Owned Generators Relieved of Obligation • Socialization of Fuel Risks • Petrobras Assumption of Risk for 12 Month Periods • Socialization of Thermal Investment • Petrobras as Strategic Investor in Sector

24. Government Response to Problems • Creation of Crisis Management Chamber (CGC) • Mandatory 20% Curtailment of Use & Rationing • Disbanding of MAE • Strengthen ANEEL’s Jurisdiction over Market Design • Mandate that 95% of all Generation Output be Sold Long Term • Segregation of “ Old Energy” from Thermal Energy • Make Dispatch Protocols more Thermal Friendly

25. Government Responses to Problems, con’t • Dispatch Regime changed from Cost Based to Bid Based • Reinforce Independence of ONS • Subsidize Gas Imports from Bolivia • Implementation of LMP Transmission Pricing • New Incentive to Promote Use of Renewables • Promotion of Rural Electrification