This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 05 BRASILIA 000602 
 
SIPDIS 
 
STATE FOR WHA/BSC AND EB/ESC/IEC, NSC FOR JOANNA WALLACE, 
DEPT OF ENERGY FOR PI/GARY WARD, USDOC FOR MAC/WH/BRAZIL, 
USDOC FOR 4332/ITA/MAC/OLAC/TSHIELDS, DEPT OF TREASURY 
OASIA/BACKES FOR GEOFFREY GOTTLIEB 
 
E.O. 12958: N/A 
TAGS: ECON EFIN BR ENGR
SUBJECT: UTILITIES' CONCERNS OVER BRAZIL'S NEW ELECTRICITY 
MODEL 
 
REF: A. RIO 00160 
     ¶B. 02 BRASILIA 04567 
     ¶C. 02 BRASILIA 04364 
 
¶1. (SBU)  Summary.  On February 6, Embassy hosted a 
Roundtable on Electricity Regulation in Brazil with 
participation by 16 executives from 8 U.S. and European 
companies from both the generation and distribution sides. 
Companies' main concerns were short-term liquidity issues, 
continued low electricity demand, and the upcoming periodic 
review of tariff rates.  Companies were clearly anxious over 
the new GoB's impending reformulation of sector regulation, 
and most attendees noted that their companies have halted 
further investments in Brazil pending the emergence of a 
clear regulatory model.  Nonetheless, all company 
representatives termed their access to GoB officials as 
"good" and their initial impressions of Minister of Mines and 
Energy (MME) Dilma Roussef as positive.  Groundwork was laid 
for a continuing dialogue between the private sector and the 
Mission.  End Summary. 
 
¶2. (SBU)  As part of a mission-wide strategy to coordinate 
our policy approach in Brazil's energy sector, on February 6 
the Ambassador hosted a diverse group of electric utilities 
including U.S. companies Alliant, Duke, Enron, AES, Mirant, 
and PSEG, as well as European companies EDP (Portuguese), and 
Tractebel (Belgian).  Grupo Cataguazes (Brazilian) and Endesa 
(Spanish) were last minute no-shows.  Ambassador and CG Rio 
had already hosted a similar event for hydrocarbon companies 
in ConGenRio during the last week of January (ref A). 
Ambassador and CGs have also been meeting frequently with 
U.S. companies on a one-on-one basis.  Econ and commercial 
officers followed-up the February 6 roundtable by making a 
courtesy call on MME Secretary for Energy Marcelo Poppe. 
Ambassador expects to make her initial call on Roussef during 
the week of February 24. 
 
Background to a Mess 
-------------------- 
¶3. (U)  The timing and concerns of the roundtable reflect the 
current confusion and uncertainty surrounding the electricity 
sector.  In the mid-90s, the Cardoso administration embarked 
on an ambitious privatization program to attract much-needed 
investment to the state-dominated energy sector.  The process 
was poorly implemented from the start, as Congress failed to 
pass comprehensive sector reform legislation similar to that 
created for the telecommunications sector via the General Law 
of Telecommunications.  Instead, Congress carried out the 
process piece-meal.  Congress first legalized the sale of 
states' distribution companies.  In 1995, Espirito Santo sold 
its distribution company ESCELCA to a group of foreign 
investors.  U.S. companies, led by AES, began investing in 
¶1996. 
 
¶4. (U)  Reform legislation continued to trickle through 
Congress, resulting in the creation of the national 
electricity regulator ANEEL in 1997, and the creation of the 
wholesale energy market (MAE) in 1998.  Although the National 
Council for Energy Policy (CNPE), a committee within the MME, 
was given responsibility for long-term policy planning, the 
weakness of the MME as an institution encouraged ANEEL to 
step into the policy realm and complete the sector reform 
process de facto through regulation.  CNPE has met only three 
times to discuss long-term policy.  Roussef has commented on 
various occasions that the MME will "recapture the policy 
role" from ANEEL. 
 
¶5. (U) Devaluation at the beginning of 1999 presented the 
first warning signal for foreign companies whose debts were 
dollar-dominated, but whose revenue streams were in Brazilian 
reals.  Since 1999 the dollar has appreciated approximately 
200 percent in nominal terms against the real.  For 
distribution companies, this has been partially compensated 
by annual GoB tariff adjustments based on a broad-based 
inflation index -- 87 percent over the same period.  Currency 
risk has also put a damper on thermal-generation investment, 
as the cost of turbines, fuel, and natural gas are 
dollar-linked. 
 
¶6. (U)  The privatization process met growing political 
resistance in 2000 when the government's plan to privatize 
state generator giant FURNAS faltered amidst popular 
discontent.  The process then stalled-out completely with the 
electricity shortage and subsequent government-mandated 
rationing in 2001.  Although the outgoing government received 
high marks for managing the rationing crisis, it was unable 
to make progress on a comprehensive reformulation of the 
regulatory model, leaving this major headache for the new 
government. 
 
¶7. (U)  The GoB also failed to provide permanent fixes to 
institutions such as the MAE (see ref C), the CNPE, and 
ANEEL.  Although the GoB ended rationing in February 2002, 
deleterious after-effects continue to affect generators and 
distributors as electricity end-users have rolled back their 
consumption to 1999 levels.  Lower demand, combined with 
abundant rains that have filled reservoirs in Brazil's 90 
percent hydro-dominated system, has led to an electricity 
surplus depressing spot prices to their regulated price floor 
- approximately 1.15 dollars per megawatt hour.  This is 
unfortunate timing as a pre-planned phased liberalization of 
the market freed 25 percent of the market's bilateral 
electricity contracts held between generators and 
distributors on January 1, 2003.  This electricity, estimated 
to be between 3,500 to 5,000 megawatts of capacity, remains 
unsold.  Generators have begun to assert that the government, 
or distributors, must find a way to share the pain for the 
depressed prices. 
 
¶8. (U)  In summary, the new government of President Lula has 
inherited an electricity sector mess.  Dollar-linked debt, 
depressed supply prices, institutional gridlock, 
macroeconomic constraints (i.e., inflation-target and 
fiscal-surplus limits), and the supposed left-leaning 
platform on which the new government rode into power all 
raise doubts among investors for the long-run viability of 
the electricity sector. 
 
¶9. (SBU)  In addition to putting out some of the fires above, 
the new government must now define a sector model, 
principally deciding what role private finance, current and 
future, will play. Roussef, a former 1970s guerilla (ref B), 
spent the first month putting her team together, and from all 
accounts is serious, frank, and intelligent. Despite these 
positive attributes, industry anxiety regarding her plans for 
the sector and the outcome of the new model is running high. 
 
Distributors Focus on Tariff Reviews 
------------------------------------ 
¶10. (U)  Not surprisingly, distributors at the roundtable 
seemed most focused on short-term issues.  First on their 
mind was this year's periodic tariff reviews, which are 
conducted every four to five years depending on the date of 
each distributor's concession contract.  This year, ANEEL 
will conduct 17 tariff reviews with the goal to restore 
"financial equilibrium" to distributors, and split 
productivity gains between distributors and consumers. 
During the event distributors lamented that financial 
equilibrium remains an undefined term. 
 
¶11. (U) In November 2002, ANEEL announced it would use 
companies' current asset values as the basis for calculating 
the capital value of each distributor, a key component in the 
methodology for conducting the 2003 tariff reviews.  This 
announcement came as a surprise to industry as the GoB had 
used an altogether different basis to determine the capital 
value of each distributor when seeking minimum bid prices 
during privatization in the late 90s.  During that period, 
ANEEL determined the capital value of the company on the 
projected discounted revenue stream of the distributor. 
 
¶12. (U)  ABRADEE (the primary distributors' association in 
Brazil) immediately objected to ANEEL's proposed use of 
current asset value to determine capital value, and has since 
led the charge against its implementation.  ABRADEE asserts 
that the depreciation in the Brazilian real since 1998 has 
eroded the asset value of sector companies, and that the use 
of this methodology would result in an insufficient increase 
in tariffs.  ABRADEE has proposed instead that the capital 
value of the company be computed as it was for the minimum 
bid prices used during privatization.  An estimated 26 
billion reals over the next five years industry-wide are in 
play in this decision that will lead to either an average 20% 
to 25% tariff increase, if ANEEL's methodology is used, or an 
average 40% increase, if ABRADEE's is. 
 
¶13. (U)  ABRADEE has already been dealt an initial defeat as 
two successive federal judges have declined the association's 
request for an injunction on the current tariff reviews.  On 
February 17, ANEEL released its formula for the first three 
reviews for public comment.  The agency also stated that 
distributors receiving high tariff adjustments following the 
review would have them implemented in "parcels", starting 
this year and continuing into the future in order to lessen 
the impact on consumers. 
 
Short-term Liquidity Crunch 
--------------------------- 
¶14. (SBU)  For some distributors, short-term liquidity 
problems rank ahead of tariff concerns.  AES, for example, 
has a total Brazil-related debt running into the billions, 
with a large percentage of it short-term and dollar-linked. 
With a depreciated real and 1999 levels of electricity 
demand, AES simply cannot make the receipts to cover its 
debt.  The company also continues to experience large losses 
from municipal government non-payment.  AES told Ambassador 
in a private meeting that municipalities owe 400 million 
reals to AES distributor Eletropaulo alone. 
 
¶15. (SBU)  Distributors told us that short-term fixes, i.e., 
90-day debt rollovers, are not helpful, and that most 
important is GoB acceptance of companies' rights to a 
reasonable level of return.  One of their suggestions is to 
increase tariffs on industrial consumers.  Currently, 
Brazil's residential consumers pay rates several times that 
of industrial consumers.  While such increases may seem, at 
first glance, more politically acceptable to the new 
left-leaning GoB than increasing the electricity bill of the 
average consumer, roundtable participants told Embassy 
officers that the GoB was not likely to increase rates on 
industrial consumers for fear of reducing their own campaign 
funds. 
 
¶16. (SBU)  Another option highlighted was a reduction in 
taxes.  Distributors commented that approximately 27 percent 
of consumers' electricity bills are tax.  The great majority 
of this is ICMS, a state tax.  Distributors told us that the 
corresponding tax burden in the United States was about six 
to seven percent.  However, roundtable participants were 
pessimistic on the prospects of the GoB reducing taxes. 
 
Generators Not Overly Concerned by Single-Buyer Concept 
--------------------------------------------- ---------- 
¶17. (U)  As mentioned above, government-mandated rationing, 
abundant rains, and the phased liberalization of 25 percent 
of bilateral electricity contracts has depressed wholesale 
electricity prices.  A longer-term problem facing the 
government is how to diversify Brazil's electricity mix.  The 
majority of policy-makers concede that some non-hydro 
generation is desirable to avoid dramatic fluxes as seen 
during the 2001 drought when dry reservoirs in three out of 
Brazil's four regions combined with inadequate transmission 
infrastructure to push prices to 650 reals per megawatt on 
the spot market.  However, new thermal plants with higher 
amortization and fuel costs simply cannot compete with older 
hydro plants in normal conditions. 
 
¶18. (U)  One idea for dealing with price fluctuations and 
creating incentives for future generation investment is MME's 
vaguely stated proposal to create a single buyer to trade 
energy between a pool of generators and individual 
distributors.  Theoretically, such a trader would pay thermal 
generators higher prices than amortized hydro plants, thus 
arriving at an unified average cost of energy.  This would 
maintain profitability for thermal generators who face 
difficulties covering their costs when abundant rains make 
hydro cheap.  Going into the roundtable, we had expected to 
hear vehement industry objections to this proposal, but were 
surprised to see generally neutral attitudes on the subject. 
More GoB specifics on this proposal should emerge in upcoming 
months. 
 
Opinions on Current Government Guarded; Access to GOB Good 
--------------------------------------------- -------------- 
¶19. (SBU)  Companies told Ambassador that their access to the 
new government has been "good."  They report that Roussef 
appears to be direct, strong-willed, and opinionated, but 
also fair and intelligent.  This echoes what we've been 
hearing in private one-on-one meetings with U.S. companies, 
and reinforces the commonly-held notion that it was Roussef's 
drive that achieved the partial resolution wholesale 
electricity market (MAE) accounts in early January.  Roussef 
spent most of her first four weeks in office placing trusted 
advisors in key positions throughout the energy sector.  Now 
that her team is built, Roussef appears to be moving directly 
to reformulation of the electricity sector model.  A 
Brazilian weekly quipped that if the GoB followed the 
McDonald's best practices, Roussef would be "Minister of the 
Month." 
 
¶20. (U) Diligent performance in her first 30 days has raised 
industry expectations of Roussef's capabilities, as well as 
industry hope that the GoB "shares the pain."  The GoB does 
indeed appear willing to accept that it has some 
responsibility toward finding a solution for the sector 
crisis.  In a February 6 meeting with econoff and commercial 
officers, Secretary for Energy Marcelo Poppe said the MME has 
formed a working group to present a reformulated model by 
July, with a period of public comment to follow. A report in 
national daily Estado de Sao Paulo on February 13 quoted MME 
Executive Secretary Mauricio Tolmasquim as saying that the 
MME would introduce a package of refinancing intended to 
assist companies to survive until the new model is 
implemented sometime near the end of the year. 
 
Conclusion and Comment 
---------------------- 
¶21. (SBU)  The future role of private finance in the 
Brazilian electricity sector is unclear, and likely to remain 
so until at least July.  The GoB has already said its future 
model will be a mixed model of public and private investment. 
 It may be that the future MME plan will trade large 
potential profits, private investment, and efficiency gains 
for a less efficient, but more stable sector with lower 
returns.  Eletrobras President Pinguelli Rosa has been quoted 
as saying 15 to 20 percent returns are "unrealistic," and 
praised the French system as more reliable with 5 to 10 
percent returns. 
 
¶22. (SBU)  Pending the new model's definition, the GoB must 
find a way to deal with distributors' short-term liquidity 
problems.  Many of these private investors are requesting 
that the government (i.e., development bank BNDES, 
Eletrobras, and the state generators) "take a haircut" on a 
portion of the distributors' outstanding debts, some of which 
predate privatization. However, convincing the current GoB to 
write down debts created by its predecessor is an unlikely 
prospect.  Eletrobras has its own stockholders who will balk 
at big bailouts, and though new BNDES President Carlos Lessa 
originally called his organization a "hospital for sick 
companies," his sentiment has been publicly rebutted by 
Minister of Finance Antonio Palocci. 
 
¶23. (SBU)  The primary alternative to refinancing deals is 
reversion of concessions to the GoB.  Such a move would 
result in long legal challenges, and one also wonders if the 
GoB would really wish to manage these utilities.  Our 
earliest indications are that Roussef herself, despite her 
original extreme-left ideology, now does not want to 
"refederalize" companies. 
 
¶24. (SBU)  Mission will continue to engage U.S. business, and 
maintain open dialogue with the GoB as it formulates its 
model.  We will lend support to ABRADEE's proposal for tariff 
revision methodology, and urge options to improve companies' 
financial health while limiting cost increases to residential 
consumers.  GoB options, in this context, include urging 
local governments to pay up, reducing taxes on electricity, 
and redressing the imbalance between residential and 
industrial tariffs.  Over the longer-term we will seek 
opportunities to strengthen institutions such as ANEEL and 
the MAE, and promote cooperation between policy planning 
organizations such as the Brazilian CNPE (National Council 
for Energy Policy) and the United States Energy Information 
Administration. 
 
HRINAK