BRAZIL: DISPUTES CAST SHADOW OVER FUTURE ENERGY

UNCLAS SECTION 01 OF 04 BRASILIA 001879

SIPDIS

SENSITIVE

NSC FOR CRONIN
TREASURY FOR OASIA - DAS LEE AND FPARODI
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOL SON
DOE FOR SLADISLAW
USAID FOR LAC/SA

E.O. 12958: N/A
TAGS: EINV ENRG EFIN KIDE OPIC
SUBJECT: BRAZIL: DISPUTES CAST SHADOW OVER FUTURE ENERGY
SECTOR INVESTMENTS

REFS: (A) BRASILIA 1696, (B) BRASILIA 1686


1. (SBU) Summary. Investment disputes between U.S.
investors and Brazil are currently concentrated in the
country's energy sector. The majority of the disputes
involve contracts for thermoelectric plants that were signed
during a period of drought-induced energy shortage (2001-
2002) with guaranteed payments regardless of whether any
energy is produced. When the drought ended and the
hydroelectric plants began to enjoy surpluses of less
expensive energy, however, Petrobras (the GOB's petroleum
sector parastatal) began to reconsider the high costs of
maintaining the contingency energy. Fundamental issue
revolves around the willingness of Petrobras and certain
governors to challenge contracts they don't like and the
inconsistent performance of the judiciary in enforcing these
contracts. Although Brazil is actively encouraging foreign
investment, these disputes with Petrobras and state
governments have negatively impacted the investment climate
in the sector. End Summary.


2. (U) This cable provides additional analysis and
information on the cases submitted for the 2005 Section 527
Report on investment disputes and expropriation claims
report (Ref A). This cable contains business confidential
information and should be handled accordingly.

Background on Petrobras Thermoelectric Contracts
-------------- ---


3. (U) In the context of a 2001-2002 drought-induced energy
shortage in Brazil, Petrobras was called on by the GOB to
partner in several gas-fired power plants, inter alia,
Macae Merchant (with El Paso),Eletrobolt (with former
Enron),TermoCeara (with MPX Energia stakeholders, which are
the U.S. power group MDU and Brazil's EBX),and TermoRio
(with NRG Energy). In all four cases, Petrobras signed
contracts essentially guaranteeing the thermoelectric plants
a minimum payment (to cover operational costs and provide an
investment return) regardless of whether the plants were
called on to produce energy or not. The presence of these
thermoelectric plants has contributed significantly to the
current strength of the energy sector (Ref B).


4. (SBU) Plagued by the heavy contingency payments,
Petrobras began to review some its gas-fired power plant
contracts, particularly those with the private sector, in
search of a way to cut costs. The new Petrobras Director of
Gas and Energy, Ildo Sauer, publicly stated that the company
wanted to "clean up" its thermoelectric portfolio.
Petrobras argued that because market conditions had changed
and it was exclusively bearing the onus of the losses, the
contracts were invalid. The losses to Petrobras have taken
on political overtones as well as the former director of Gas
and Energy at Petrobras, Delcidio Amaral, is currently the
leader of Lula's PT party Senate caucus and the president of
the congressional commission (CPI) installed to investigate
corruption at the Brazilian postal service. Petrobras and
Amaral have been called upon to explain the R$ 2 billion
"losses" incurred by Petrobras during Amaral's tenure due to
the thermoelectric plant contracts.

Deals Gone Sour
--------------


5. (U) As a result of the changed market conditions,
Petrobras has been seeking to either back-out of the
contracts and/or purchase its partners' shares in the
plants. For example, in January 2005, Petrobras ceased
making payments to El Paso's Macae Merchant plant even
though it was under contract to supply gas and buy the power
generated at El Paso's plant, paying a minimum amount even
if no power was generated. Petrobras filed a lawsuit
against El Paso in New York claiming that the contract is no
longer valid. In July an arbitral tribunal decided that
Petrobras must make its contract payments to El Paso into a
judicially administered escrow account pending final
judgment on the case. A decision by the court is expected
in November 2005.


6. (U) In another case, for more than two years Petrobras
refused to pay an arbitral award to NRG Energy, a U.S.-based
independent power producer. In September 2001, NRG acquired
from Petrobras a 50% interest in the TermoRio project in Rio
de Janeiro. Under the terms of the contract, NRG had the
right to require Petrobras to repurchase NRG's interests in
TermoRio under certain circumstances. In April 2002, NRG
exercised that right, but Petrobras refused to pay NRG. In
March 2004, a Brazilian arbitral panel ordered Petrobras to
pay NRG US$80 million (plus interest to date of payment).
Although Petrobras did not challenge the decision in any
forum and assumed full control of TermoRio, Petrobras
delayed paying the award. In September 2004, NRG filed a
lawsuit to enforce the award in a U.S. Federal District
Court. Only on February 25, 2005, did Petrobras pay NRG US$
70 million pursuant to a negotiated settlement of the
dispute.

Thermoelectric Dispute with Parana State
--------------


7. (SBU) The thermoelectric disputes also include another
case involving El Paso and Petrobras, but this time with the
parastatal Parana State Electricity Company (Copel). In
1998, El Paso (60%),Copel (20%),and Petrobras (20%)
created a joint venture (UEG Araucaria) to build a gas-fired-
electricity generation plant at Araucaria, in southern
Parana state. The contract was for El Paso to construct the
plant, and Copel to both operate and maintain the plant.
Although the plant was completed in September 2002, Copel
operated the plant only briefly because of alleged technical
problems. The 20 year contract between Copel and El Paso
was for energy capacity, thus requiring payment to El Paso
whether the plant was in operation or not. Although Copel
made the contracted payments to El Paso for three months,
when new Parana governor Robert Requiao entered into office
in January 2003, he reportedly directed Copel to stop making
payments to El Paso. El Paso claims that the alleged
technical problems are a ruse to enable the state governor
to take over a majority share of the plant. El Paso
initiated arbitration proceedings in Paris and the panel
hearing the case is expected to reach a decision at the
beginning of 2006. As with the Macae Merchant dispute, El
Paso hopes to reach an amicable settlement because the
company wants to continue to work in Brazil's energy sector
-- transitioning from the electricity sector into the oil
and gas sectors -- which would require maintaining good
relations with Petrobras.

More Petrobras Contract Problems
--------------


8. (U) Although many of the thermoelectric plant cases have
resulted in disputes, some have been resolved through
negotiations. The press, however, has reported that the
negotiations involved a bit of "arm twisting" by Petrobras.
For example, in May Petrobras management approved the
purchase of the thermoelectric plant TermoCeara from MPX
Energia for US$ 137 million; MPX Energia was 49% owned by
U.S. Company Centennial Energy in partnership with Brazil's
EBX. In May Petrobras also formally announced its purchase
of the thermoelectric plant Eletrobolt, originally built by
Enron and now belonging to a consortium of banks, for US$
65.1 million. Petrobras has also been in negotiation with
the Neoenergia (formerly called Guaraniana energy company)
regarding the thermoelectric plant Termoacu, whose
construction was halted initially because of a technical
review by the Brazilian Electric Energy Regulatory Agency
(ANEEL). It appears now that Petrobras will increase its
stake in the company from 30% to 80% and may recommence
construction. In short, Petrobras is making a concerted
effort to cut its losses in the thermoelectric sector by
forcing contract negotiations and/or buying out its
partners.


9. (SBU) Banco Pactual's Pedro Batista told Rio and Brasilia
EconOffs that investors have been watching Petrobras'
renegotiation of its thermoelectric plant contracts with
concern. According to Batista, any investors entering the
market will have to calculate in the risk that contracts may
not be fully respected.

Shareholder Agreement Problems
--------------


10. (U) Some of the investment disputes involve state
governments which, following new elections, reneged on
shareholders agreements. As detailed in Ref A, U.S.
companies Mirant and AES, along with a Brazilian partner,
through a joint venture, purchased 33 percent of the voting
shares of the Minas Gerais state electric power company
(CEMIG) for US$ 1.05 billion in 1997. The purchase price
included a shareholders agreement giving the joint venture
certain negative control (i.e., veto) rights over the
management of CEMIG and the ability to nominate some of the
executive officers. However, in 1999, a new state
government took office and overturned the shareholders
agreement in a lower state court. An appeal remains
pending. In a non-energy sector case also detailed in Ref
A, the State of Parana similarly unilaterally terminated the
Shareholders Agreement. The State effectively retook
ownership and management control of its sanitation company
Sanepar, despite having sold a 40% stake in the company with
a shareholders agreement that guaranteed minority
shareholder protections. The courts have not yet ruled
definitively on the case.

Comment
--------------


11. (SBU) The unwillingness of new administrations to honor
contracts signed under a previous federal or state
government makes investors leery of pursuing infrastructure
projects that require a long-term commitment. While
Petrobras' strategy to cut costs makes sense in terms of its
financial bottom line, the end result has been to relegate
the expensive thermoelectric plants to the role a of
contingency source of electric energy, at the additional
cost of reduced investor confidence. Although it appears
that the thermoelectric plants may play an important role in
the next few years because of delays in moving new
hydroelectric plants forward (Ref B),that respite could be
only temporary. Fundamentally, Brazil (whether at the
federal, state, or parastatal level) must decide whether the
security provided by thermoelectric plants is worth the
associated costs, even when they are not in operation.


12. (U) This cable was coordinated with the Foreign
Commercial Service and the Consulates General in Sao Paulo
and Rio de Janeiro.

CHICOLA