Brazilian Consolidation of Energy Reforms “Brazil -- The Energy Crisis is here”

1. Brazilian Consolidation of Energy Reforms“Brazil -- The Energy Crisis is here” Jose Bestard Vice President, Enron South America Institute of the AmericasLa Jolla, May 15-16, 2000

2. Last year’s Presentation about Brazil • We are running out of time to avert an energy crisis. The policy choices for the sector will have a lasting effect much more beyond 2003 to direct the energy market towards either... • The current vision of a market-based energy economy, or…. • Back to a more regulated, administered-price economy. Brazilian Energy Tariffs and Regulation Issues“Like changing tires on a moving vehicle” Institute of the AmericasLa Jolla, May 15-16, 2000

3. Brazilian Power Market: - Shortages Expected • Expected energy shortages during the next three to five years due to: • Significant demand growth • Delayed investment in new generation • Hydro-intensive market experiencing severe depletion of reservoirs as a result of very little rain.

4. ONS -Probability forecast of level of cuts in the South/SE Target for end of Rainy Season - 49% Starting Level in February - 33% 10% Required by ONS to maintain transfer capabilities

5. Rain Required to avoid Cuts ……. 2) Had to rain at least 75% of the yearly average rainfall May through December 1) Had to rain 100% of the yearly average rainfall through April Note: These levels are not seasonally adjusted

6. Last week’s Report -- Stored Energy being depleted faster than expected due to lack of rain …. Shows the downward revision to the original May’s forecast in the SE where 68 % of the reserves are located Water flow at 56 % of Average End of month at 27% Level

7. Main message of Last year’s Presentation • Change in the Brazilian energy sector was breath-taking. But, last two years searching ways to harmonize conflicting policies betweenenergy expansion and inflation control. • A current snap-shot shows… • Institutional barriers to the expansion of power plants • Distribution companies financially impacted by regulatory lags and devaluation -- not in a position to sign uncertain long-term contracts • Long delays and tension between the actors at the MAE (electricity market). • Efforts to attract investment for EXPANSION (NOT PRIVATIZATION), are trying in vain to circumvent the realities: • For the short term, the incremental energy supply is an imported commodity and the currency of payments is the US$ for that increment. • There is a convergence between the gas and electric markets. Cannot attain the vision of a competitive electric market without open access to gas supplies • We are running out of time to avert an energy crisis. The policy choices for the sector will have a lasting effect much more beyond 2003 to direct the energy market towards either... • The current vision of a market-based energy economy, or…. • Back to a more regulated, administered-price economy with heavy dependence on Government owned companies.

8. Brazilian Power Market: Hurdles - Liquidity Initial Contracts: • Established in 1998 as a transitory solution to avoid rate shocks • Contract prices do not reflect current market dynamics • Expire gradually between 2003 -2005 • Free customers are free on paper. In practice, they are discouraged to do so given subsidized tariffs from LDCs. Limited New Capacity Available: • Outside initial contracts, there is little supply currently available • New supply is limited given delays in Thermal IPP Program • Major new plants scheduled are: • Hydro: Lajeado, Machadinho, Tucurui • Thermo: Eletrobolt, Macae, Araucária

9. Valor Normativo and Gas pricing • A nation-wide price cap (Valor Normativo), an administered price, was established for “competitive supplies” with an indexation formula. • “Black-box” model. Irrespective of location, size, dispatch factor, transmission system charges, simple or combined cycle, peaking or base plant duty, hard currency obligations AND GAS PRICING. • The Imported gas price was “too high” to fit under the VN and therefore “made gas-fired plants not viable”. Thus the solution was to force the gas to be lower by having Petrobras mix “cheaper” national gas with more “expensive” imported gas. • Imported gas (with transportation) US$2.55 -- BBPL + Bolivian GSA indexing • National gas (with transportation) US$1.94 -- Lots of discussion about indexing! • Mixed gas (with transportation) US$2.26 -- Different indexing. • The National gas (administered level) was unbundled into commodity and transport. • It is the policy of the government to gradually sent stronger transportation locational signals • But the commodity piece turned out to be more expensive than the imported counterpart.

10. Valor Normativo and Gas pricing • The national commodity piece was higher. A note from MME indicates that • it is not directly comparable to the imported commodity • it is still consistent with the US$1.94/MMBtu starting base • it provides a good signal to encourage domestic exploration. • A new price US$ 2.475 indexed annually (US PPI) was announced, as an option to eliminate the disparity between quarterly gas indexation and annual electric tariff corrections. Remaining is the issue of R$ to US$ tracking. • A “Global Gas fund” has been studied as a way to provide a currency hedge. Idea has not advanced. The hedge cost, once calculated, would have to be added to the VN. • New VN issued in Jan 01; ANP advanced the idea to price gas in Reais. Latest discussion is that Petrobras will “bank” the currency differences during yearly periods

11. Spot Prices Expected to rise significantlyCap is the “Cost of deficit” -- Unless artificially constrained The Price Cap will converge to the “Cost of Deficit” . This average level was adapted year’s ago

12. Methodology Used by the Long Term System Planners Cost of Deficit varied depending on the gravity of the cuts. For simplicity, the average was used in the models that determine the current spot prices.

13. Retail Tariffs are constrained while generation costs are mounting High Gross receipt taxes. Efficient tax collector FX risks Currently 2.20+ not 1.83 Elektro Average 2000 Various rate subsidies different classes Buy High! Sell Low ??

14. News and events BEFORE the acknowledgement of CRISIS …. • Electricity rationing expected to start soon • Changed Leadership at MME.- Needs time to determine strategies • Various proposals in front of the Agencies and the Government for over a year • Expansion of Power plants.- Petrobras sponsored projects. Other projects awaiting resolution of issues • CNPE was finally formed to deal with sector policy issues that are impeding the expansion. • Furnas/ MAE,- The Angra issue still unsettled. • Furnas Privatization?. Keeping it intact still under Government Control? • Federal Generators.- Initial Contracts not to be renegotiated at this time. • Cesp Privatization. - Delayed until first half next year • Bolivian Pipeline Access.- First case by Enron. Pending Case by BG. Expansion possibilities

15. Finally, the CRISIS has been officially recognized • A high-level group -- “Chamber to Manage the Energy Crisis” formed in May • Law - “Medida Provisoria” - Gives the organization wide powers to deal with the emergency. • Curtail Use by sector; Expand supply; Suspend or modify regulations • First Priority -- “Rationing Formulas” • Usage restrictions; Price Signals; before adopting rolling circuit cuts • Resolution #1 - restricts uses night events, temporary services, new services to non-residential and non-rural customers. • Plan announced May 18 - Try to achieve customer class targets cuts before resorting to black outs. • Residential Customer reduction target of 20% from last year’s consumption • Penalties (higher tariff) and Bonus (credits) vary depending with each individual customer prior years usage level (May, June, July) • Customers may request review if the historical period is not appropriate • In addition to higher tariffs, individual customers may have their service cut. 3 days for first occurrence, 6 days for second occurrence.

16. Concerns with practical aspects of implementation …... • Distribution Companies acting as agent-of -the-state to do something 100% opposite to what they are in business to do -- to serve the customer! • High legal exposure • Dealing with customer dissatisfaction • Developing and getting approvals for detailed procedures. • Capacity to handle individual customer cases • to set targets • To cut individual services for non-compliance. 27% !! Scary number!!!! Every day delay worse!! • Possibility of losing operating control at by ONS wholesale level is chaotic!! • Alternative of feeder-level rolling black out is very concerning-- Several hours every day

17. Reflection-- Integrated Planning Models always are iterative CLOCKWISE Demand Supply Constraining the Price is the OTHER way to RESTRICT demand Price Finance

18. Conclusion Market solutions took a back-seat two years ago. Half-measures do not work. Heavy dependence of Petrobras for project sponsorship and risk mitigation High danger of abandoning reforms under stress; going back to the old public sector model. Higher danger of a shift to “populist” political paradigms in the future if this crisis is not well managed.

19. Brazilian Consolidation of Energy Reforms“Brazil -- The Energy Crisis is here” Jose Bestard Vice President, Enron South America Institute of the AmericasLa Jolla, May 15-16, 2000