Brazilian Energy Tariffs and Regulation Issues “Like changing tires on a moving vehicle”

1. Brazilian Energy Tariffs and Regulation Issues“Like changing tires on a moving vehicle” Jose Bestard Vice President, Enron South America Institute of the AmericasLa Jolla, May 15-16, 2000

2. Main message of Presentation • The overall speed of change in the Brazilian energy sector has been breath-taking. But, recently we have been paralyzed searching a way to harmonize conflicting policies. • A current snap-shot shows… • Still a number of institutional barriers to the expansion of power plants • Distribution companies have been financially impacted by regulatory lags and devaluation -- not in a position to sign long-term contracts • There has been delays and tension between the actors at the MAE (electricity market). • Recent efforts to attract investment for EXPANSION (NOT PRIVATIZATION), are trying in vain to circumvent the realities: • For the near future, energy is an imported commodity and the currency of payments is the US$ • 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.

3. Road Map of Presentation • Background leading the September 1999 announcements by the Ministry of Mines and Energy of an Action Plan to make viable gas thermo-electric plant. • What was presented at the APINE meeting by MME and Aneel. -- Precursor of the Priority Plan • The still present barriers (April 2000) to the Priority Plan 17,000 MW, 49 projects, by 2003. • Concentrate my remarks in four factors. • I.- Distribution Company tariffs - Financial impacts. - Ability to sign contracts • II.- Delays at the MAE • III. The increasingly higher marginal cost of electricity and the tension that it creates between those that have a “long” or “short” position in their contracts. • IV. The Valor Normativo and the tie to the current Gas Price policy.

4. Background - Institutional delays in Brazil • Scope and speed of the restructuring were very challenging • Electrical Sector restructuring - de-verticalization and full competition • Gas Sector regulations • Privatizations -- Done under concession contracts -- Regulation still under development • New Laws, Institution, Rules • New actors and newer roles • …. creating a problem of synchronism and harmony of different policies …. • Across each link in the energy production and delivery chain • and between the energy and the financial governmental sectors. • … .creating delays in new investments • …. creating the need of government intervention through the “Priority Plan” • Root causes- • 1) Resistance to dollarization of energy tariffs - Real Plan • 2) Convergence of gas and electricity markets - Monopoly or Open Markets? • 3) in search for a “soft landing”- winners and loosers - consensus • 4) complexity - the “devil” is in the details

5. Ten measures announced by MME in September 1999 - Priority Plan Background- February regional outages. Period of reevaluation. Announced at the APINE meeting to resolve the barriers to IPP development 1.- Eletrobras as buyer of last resort • Electricity Distributors not in a position to buy. 2.- Distributors to demonstrate that they can supply captive markets • What is the captive market when customers leave? For how long? 3.- Change of the Valor Normativo (VN) to allow a project specific US$ indexation • Formula not reflecting the high US$ component of gas power plants 4.- Automatic pass-through procedure for gas price/currency fluctuations • Neither IPP, nor distribution off-taker capable of taking this risk. 5.- Petrobras - Nation-wide gas price for 8000 MW . • Change the gas price to fit the VN, not the other way around????

6. Ten measures announced by MME in September 1999 - Priority Plan Background- February regional outages. Period of reevaluation. Announced at the APINE meeting to resolve the barriers to IPP development 6.- BNDES - Project Financing • No international financing available. Limited scope and expensive 7.- Eletrobras guarantees of Electric Distribution Co. PPAs • To patch-up the concerns that Distribution Co were not financially strong 8.- Clarification of Transmission open access rules and tariff impacts • Included in VN? What cost? Stability? 9.- Rules for Back-up purchases when generators are unavailable. • High exposure in an illiquid market 10.- Model PPA with international project financiable clauses. • FM, International arbitration, Enforceability, lenders covenants and assignments

7. Aneel Announcements -Measures underway - Sept 1999 Announced at the APINE meeting to support the energy policy measures while fostering competition.-- Too many rabbits?? • Valor Normativo - Exchange correction of up to 100% for of the price for gas power plants • Tariff pass-through of gas prices. • Verification of contracting for at least of 85% of the distribution market • Regulatory buffer - “Buyer of last resort” • Definition of Capacity Charge - Wholesale Market Rules.(MAE) • Definition on new limits for Free Consumers after 2003 • Reduction of terms to release Free Consumers with Contracts for undetermined periods • Information release of potential Free Consumers • Cogeneration qualification Rules • Study over the rational use of natural gas (Aneel/ANP) • (Re)Definition of the Cost of Outages • Initial Contract - Free Contracting

8. Aneel Announcements -Measures underway - Sept 1999 Announced at the APINE meeting to support the energy policy measures while fostering competition -- Too many rabbits??? • Mergers constraints • Revision of Resolution 094/98 - Market Concentration • Defense of Competition - Covenant CADE/SDE • Segmentation of the “D” (distribution) and “C” (commercialization) Functions of distributors • Eletrobras as a energy marketing co (authorized) • Free Access of the T&D Network • Nodal tariffs- locational signals - better competition in generation • Nodal methodology down to 69 KV ( Installation for T&D) • Simplification on the contracting (total cost at the connection bus-bar) • 100% discount for PCH -- up to 2003 • Mechanism to provide stability (reduction of variability) in transmission use tariffs • Tariff for D (wires access) depending with the costs of service • Generation charges depending on maximum connecting capacity (not nominal) • Possibility of negative tariffs for generation

9. April 2000 - Still facing significant barriers 1) Find a buyer with the financial capacity to pay you. 2) Overcome the constraints and uncertainties of the system Principal Barriers to Thermoelectric Projects • Uncertainties due market in transition between the old system and the market system. • Capacity of Electric Distributors to sign a long-term PPAs • Valor Normativo and Pass-through • MAE/ONS Exposure • Capacity of Free consumers/Marketers to sign long-term PPA • Competition for limited resources. • Legal/Institutional concerns with international project financing • Issues with Gas supply Contracts

10. Principal Barriers to Thermoelectric Projects • Uncertainties due market in transition between the old system and the market system. • Stability/Predictability of electric transition rules. • Delays in the working of the MAE. • Lack of liquidity in the MAE • Opening of the gas market to competition (Convergence of gas and electricity) • Capacity of Electric Distributors to sign a long-term PPAs • Weak Financial Position – Regulatory Lag and Devaluation impact.- (EBIDAT Recovery ?) • Separation of Distribution and Commercial Functions – Limited margins ? • Progress to allow more free customers – size of the captive market?

11. Principal Barriers to Thermoelectric Projects • Valor Normativo and Pass-through • Level and indexation formula (One for all Brazil – does not reflect projects differences) • Formula does not reflects the US$ obligations • Mechanisms to harmonize gas indexation and other US$ obligations with electricity indexation (tracking account) • MAE/ONS Exposure • Influence of other projects on future transmission costs • Influence of back-up costs. • Frequency response requirements requested by ONS for gas turbines • Capacity of Free consumers/Marketers to sign long-term PPA • Free customer not leaving until initial contracts are renegotiated and future more clear

12. Principal Barriers to Thermoelectric Projects • Competition for limited resources. • Limited amount of turbines • Human resource constraints in institutions to process simultaneous projects. (Banks, Regulators, Environmental Agencies) etc. • Obtaining Financing in an uncertain regulatory environment • Legal/Institutional concerns with international project financing • Dispute resolution- International Forum, Enforceability • Central Bank rules for US$ account transfers. • Issues with Gas supply Contracts • Requires more flexible TOP obligations – Hydro matching • International Financing clauses • Disputes with concessionaires and specific projects - Exclusivity. • “Preferential pricing” for certain projects – Competition on the market • Taxation – ICMS deferral to final consumer • Central Bank- TOP payments for imported gas. – Economic dispatch different from dedicated supply

13. Distribution Companies have been affected by devaluation impact and regulatory lag. Are they able to guarantee long term PPAs?… EBITDA(Earnings before Interest, Taxes, Depreciation,Amortization) — actual vs expected • Change in exchange policy • Regulatory lag - pass-through • Regulatory uncertainty Discontinuity Median up to Dec/98 Median up to Dec/98 Actual data from the companies Expected progression Source: CIEE, analysis A.T. Kearney Expected progression of initial distribution margins Departure EBITDA US$/MWh Tariff Revision (illustrative) 01/97 07/97 01/98 07/98 01/99 07/99 01/00 07/00 01/01 07/01 01/02 07/02 01/03 07/03 01/04 07/04 01/05 07/05

14. What is happening at the MAE (Energy Wholesale Market) • Initial Contracts.- Rate-shock due was to be avoided by delaying and gradually allowing the “old-energy” contracts (best hydro - depreciated facilities) to eventually converge to the new energy prices (new plants) -- 1998-2005 transition • Little trading liquidity until 2003 -2005 gets near. • Free customers do not want to take the plunge and get exposed to higher marginal prices. Exceptions Tariff Cross-subsidies. • Temporary rules are in place (compromise) to trade the Initial Contracts - They are to be replaced by new rules (already agreed) • Delays (Impasse) between generators and consumers to agree to the new rules • Agreement reached in Feb 00 - Targeted implementation in Sep 00. • Due to Furnas legal challenges, submittal to Aneel approval delayed. • Aneel has called for Public Hearings in July 00.. Aneel may not approve the new agreement in its entirety. Delay to 2001 very likely • The Furnas legal challenge, and threats of counter legal challenges, has consumed the MAE leadership for months • Confluence of Angra II delays (Claims of FM ) plus High Spot prices (Model-driven “Value of Water”) due to poor hydrology and no existing gas power options.

15. Market Liquidity: Function of Initial Contracts

16. MAE IMPLEMENTATION - WHEN? YEAR 2000 ? 1998 1999 2000 2001 2002 IntialPlan Aproved ASMAE By theCOEX Regras do Mercado (January 99) Contabilidade + Sistemas de Liquidação Medição Provisória Revision during MAE budget (February 99) Absorption of GCOI by MAE Fase I Fase II Provisional Rules (Revocation da MP1819) (Abril 99) Delays to adopt the definitive Rules Fase I Fase II Forecast (July 99) (*) Revised Estimates Fase I.0 + Fase I.1 Fase II (September 99) Evolução a Mercado (*) “ Pseudo Mercado ” Final Approval of Core Rules (February 2000) (*) “ Pseudo Mercado ” Delays in Submission to Aneel AP 2/2000 da ANEEL (Abril 2000) Evolução a Mercado (*) Assumes definitive metering Fim da resolução 222

17. Situation As of September 1999 High short term marginal costs INTERCONNECTED SYSTEM SHORT TERM MARGINAL COST US$/MWHR Source: Eletrobrás/GCPS - Sep 1999

18. Updated Information - Getting Worse before it gets better Marginal Cost (US$/MWh) Preliminary Source : Plano Decenal de Expansão 2000/2009

19. 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 of 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.

20. Valor Normativo and Gas pricing • The national commodity piece is 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 CPI ?) has been 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. Policy Implication.- Petrobras monopoly control of the gas supply. Impact on MAE competition

21. Conclusion -- What is next??? WHO KNOWS??? Tune-in for the next Chapter. Very active interchange to make this transition work. Soon!!! I expect more transition rules