FIRST TEST OF BRAZIL'S NEW ENERGY REGULATORY MODEL

UNCLAS SECTION 01 OF 04 BRASILIA 000040

SIPDIS

SENSITIVE

NSC FOR RENIGAR, DEMPSEY
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

E.O. 12958: N/A
TAGS: ENRG EINV ECON PGOV BR
SUBJECT: FIRST TEST OF BRAZIL'S NEW ENERGY REGULATORY MODEL
GENERATES CONCERN

REFS: A) 04 BRASILIA 2834 NOTAL

B) 04 RIO DE JANEIRO 518
C) 04 SAO PAULO 591


1. (U) This cable reflects input from Consulates General
Sao Paulo and Rio de Janeiro.


2. (SBU) SUMMARY. The GoB took a long-awaited first step
towards implementing its new energy regulatory model with a
December 7 auction of electricity supply futures. The
Ministry of Mines and Energy (MME) trumpeted the auction as
an unqualified success, but analysts, investors and
regulators have criticized both the conduct and results of
the auction, which resulted in unexpectedly low energy
prices. While some observers see the results simply as a
function of current excess supply and other market factors,
many analysts are concerned that the low prices will
decapitalize existing power producers and fail to generate
sufficient investments to match future energy needs.
Although the auction was the first real test of the GoB's
new energy regime (reftels),additional auctions to be held
in early 2005 should more clearly indicate the new model's
fate. END SUMMARY.

BACKGROUND: FINALLY A NEW ENERGY MODEL
--------------


3. (U) Since 1995, GoB energy policy has acknowledged the
need for reliance, to some degree, on market forces and
private sector involvement, including some privatization of
the sector. Upon taking office in 2002, however, the Lula
administration was determined to establish a new model for
the sector (reftels). While the Lula administration did
not want to pursue further privatization of existing power
companies, which are primarily parastatal, it recognized
that it still needed to bring in new private investment
into the sector. The result was a new hybrid model,
enacted in March 2004, designed to stabilize the energy
sector by increasing state control while maintaining
aspects of market competition.


4. (U) To account for the differences in cost structures
among older, already-amortized power plants and new
investment, the complicated new model divides power
generators into two competition groups: "old energy"
(generators that came on-line before January 1, 2000) and
"new energy" (future generators and those that came on-line
after January 1, 2000). (Note: existing generators whose
projects came on-line after the cut-off date for "old
energy" are sometimes referred to as "Energia de Botox" -
i.e., old energy, but with a new face. End Note.)

THE FIRST TEST OF THE NEW MODEL
--------------


5. (U) The December 7 "old energy mega-auction," run by the
newly-created Electrical Energy Commercialization Chamber
(CCEE),was widely seen as the first real test of the new
GoB energy model. The 17,000-megawatt auction was for the
"captive" consumers -- primarily households and small
businesses -- who represent a little over 60% of current
power demand, and who purchase energy through the large
distributors. (Note: Large industrial and commercial power
consumers may negotiate power-supply contracts directly
with the energy producers, including some private companies
who did not sell their energy at the auction, through the
Free Contract Market (ACL). End Note.)


6. (U) Brazilian Minister of Mines and Energy Dilma
Rousseff publicly called the auction a "success," and
declared it would bring stability to the energy sector
through longer-term contracts and lower consumer prices.
The national average price for energy at the time of the
auction was R$61/MWh. For the 8-year contracts auctioned,
the average results were as follows:

Year Price %-of-Demand Contracted
-------------- -------------- --------------
2005 R$57.51/MWh 98.9%
2006 R$67.33/MWH 91.7%
2007 R$75.46/MWh 100%


7. (U) Although there is currently a surplus of energy --
in part because recent rains have replenished the country's
hydro reservoirs -- the auction resulted in even lower
prices than either analysts or the GoB expected. Investors
and analysts responded negatively immediately after the
auction and stock prices for many energy companies plunged;
in the three days after the auction, the stock of
Eletrobras (a parastatal and also the country's largest
electricity generator) fell 21.5% and the electric power
index on the Bovespa stock exchange fell 7.9%. Many
analysts expressed concern that the prices were too low for
the state-owned companies to invest in future generating
capacity and that the low prices would not attract private
sector investment. Other analysts believe, however, that
the Bovespa's quick return to pre-auction levels indicates
that the market initially over-reacted to the results.
They note that the prices were still substantially higher
than the current spot price (Reais 18.59),and that, when
adjusted for inflation, 2007 prices approach the lower
bounds of the system's marginal cost of expansion (at
current exchange rates).

TWEAKING THE AUCTION RULES
--------------


8. (SBU) One of the Directors of ANEEL (the Brazilian
Electricity Regulatory Agency),Isaac Averbuch, told
Brasilia EconOff the low prices were the result of GoB
rules for the auction. Averbuch does not consider it to
have been a true auction since the rules created a
"permanent imbalance" between supply offered by generators
and demand. Indeed, by separating the auction of "old
energy" from "new energy", the initial auction benefited
the primarily state-owned companies whose debts were
amortized and could thus offer lower prices.


9. (U) The state-owned companies also did not face the same
pressure as private companies in terms of bottom-lines and
investment returns. During the auction itself, 6 of the 18
participating producers reportedly dropped out after the
first round of bids. We are not aware of any state-owned
companies that withdrew from the pool even as the prices
continued to drop. To the contrary, Eletrobras
subsidiaries were reportedly responsible for 65% of the
energy auctioned. Although the GoB plays a central role in
the auction, the distributors ultimately sign contracts
directly with the generators.


10. (SBU) During the auction, when the prices dropped below
a certain level, the energy companies participating could
withdraw their energy offer from the auction. Under more
traditional rules, supply would have been below demand,
forcing the price to rise again until enough power was
offered to meet the demand. However, the GoB created a
mechanism that allowed it to keep forcing prices down.
According to Averbuch, the GoB could adjust the demand to
keep demand less than the supply so that prices would
continue to drop. The energy demand removed from the
auction would then be met with power sold on the spot
market rather than the long-term contract auction.
PRIVATE SECTOR PERSPECTIVE
--------------


11. (SBU) U.S.-owned energy firms Duke Energy and AES told
Sao Paulo EconOff they believe the GoB conducted the
auction in a manner that favored state-owned generators and
distributors. Duke Energy Director for Regulatory Affairs
Paulo Born lends support to Averbuch's assertion of GoB
manipulation of the auction rules. Born said that, in the
second phase of the auction, the GoB lowered forecasted
demand while state-owned generating firms offered a
consistent supply. This resulted in a downward pressure on
bid prices that private companies found difficult to match.
(Note: Although it is not clear how much of the energy
demand was removed from the auction through this method,
many companies withdrew their energy supplies from the
auction as the prices dropped and not all of the demand was
met for contracts beginning in 2005 and 2006. End Note.)
Born described the auction as a GoB play for political
advantage and "popular support" by holding energy prices
down. AES Vice President for Business Development Ricardo
Lima told us that, although the auction resulted in lower
than anticipated prices, the outlook for energy
distributors has improved, citing guarantees provided for
distribution companies under the new energy model. He said
the prospects for energy generation firms were still
worrisome, and that it will likely be several years before
the country will be able to attract new investment.

SHORT-TERM VS. MID-TERM PROGNOSIS
--------------


12. (SBU) The Minister of Mines and Energy has publicly
stated that the auction results will mean lower prices for
the consumer. Many reporters have repeated the same
prediction, at least for the short-term. Lima from AES
predicts that prices may drop 2.5%. Averbuch, however,
says the prices will probably not go down so much as they
may just not rise as quickly.


13. (SBU) Averbuch, Born, Lima and other energy analysts
predict that Brazil faces a possible shortage of energy in
the short-term (2008-2009) similar to the crisis the
country suffered in 2001. This may be the case given the
approximately 4 years a new hydroelectric plant -- the
GoB's preferred type of power plant -- takes to progress
from concession to operation, especially if a future
drought leads to water shortages at the main reservoirs.
The GoB did not solicit bids for the construction of new
power plants during 2003 and 2004, and the press reports
that of the 45 hydroelectric plant concessions auctioned
between 1997 - 2002, only 21 have begun construction. Many
projects are delayed because of environmental licensing
problems. While a new thermal power plant can be built in
2 to 3 years, the GoB policy views thermal power primarily
as emergency back-up.


14. (SBU) In the medium-term (2010-2012),however, Averbuch
predicts precisely the opposite problem, because in the new
model the GoB has reserved for itself the role of
predicting how much new generation capacity is needed.
These predictions will be made by a newly formed and
purportedly independent Energy Research Enterprise (EPE).
The GoB plans to auction concessions for new power plants
to supply energy based on the EPE energy consumption
projections. Averbuch fears that because the GoB will
likely over-estimate the energy needs based on overly
optimistic economic growth projections, Brazil may have an
energy surplus by 2010 that will lead to a ballooning bill
for contracted energy.

UPCOMING "NEW ENERGY" AUCTION
--------------


15. (U) Although there is considerable concern over the
results of the December auction, investors are watching the
upcoming auction of "new energy" even more closely. The
"new energy" auction is expected in March or April for
contracts beginning in 2008 and 2009, and the GoB will
conduct up to four additional auctions during 2005 for
contracts to supply estimated new future demand. Wary of
the timeframe to bring new generation capacity on-line, in
the new auction the GoB will only solicit bids from
companies with already-approved environmental licenses.
However, according to news sources, even among companies
with approved licenses, such as Tractebel, the decision
whether to construct the new plants is pending the results
of the next auction.

COMMENT
--------------


16. (SBU) While the results of the December "old energy"
auction were less than encouraging, existing generators had
little option but to minimize their losses and make their
peace with the new model. Beyond the lower than expected
prices, of perhaps greater concern is the apparent GoB
manipulation of the auction rules and the influence of the
large, state-owned energy producers. That said, the
outlook for private investment hinges more on the results
of the "new energy" auction, which should show starkly how
much confidence private investors have in the new model.

DANILOVICH