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

UNCLAS SECTION 01 OF 03 BRASILIA 001239 
 
SIPDIS 
 
SENSITIVE 
 
NSC FOR RENIGAR, BREIER 
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: BRAZIL: LATEST ENERGY AUCTION FURTHER REDUCES 
CREDIBILITY OF NEW MODEL 
 
REFS:  A) BRASILIA 0040 
 
       B) SAO PAULO 0134 
       C) 03 BRASILIA 3942 
 
¶1. (SBU) SUMMARY.  On April 2, Brazil held its second auction of 
long-term contracts to supply electric energy under its new 
energy model.  The Minister of Mines and Energy once again 
hailed the auction of energy to be delivered beginning in 2008 
and 2009 as a success because the prices represented what it 
believes to be a fair value for the energy, but were still low 
for consumers.  However, contracts representing only 42% of the 
energy demand offered in this round were auctioned, and no 
energy contracts beginning in 2009 were signed, although some of 
the demand for these years had already been met with contracts 
sold in the December 2004 auction.  Many industry analysts and 
energy producers consider the auction a failure and complained 
about the lack of transparency of the process and rules which 
appear to artificially depress prices.  Although the upcoming 
auction for "new" energy projects is considered to be the real 
test of the Lula administration's energy model, unless the GOB 
reconsiders its auction rules and objectives, the April 2 event 
will cast a cloud over the investment climate in the electricity 
sector. END SUMMARY. 
 
AUCTION RESULTS 
--------------- 
 
¶2. (U) The new energy model was one of the Lula administration's 
early priorities (Ref C), and the April 2 auction constituted 
the second round of electric energy auctioned under this new 
model. (Ref A reports on the first auction.)  The April 2 
auction included two "products," each of which was an eight-year 
contract to supply electric energy beginning in 2008 and 2009. 
In total, only 42% of the energy demand placed up for auction 
was sold (1,325 megawatts) for R$7.7 billion (US$3.1 billion). 
(Note: Because the contracts are for eight years, some of the 
contracts signed during the previous auction will meet demand 
anticipated for these same years. End Note.)  The average price 
for contracts beginning in 2008 was R$83.13 MWh (US$33.25), and 
no energy for contracts beginning in 2009 was sold. 
 
¶3. (SBU) Mauricio Tolmasquim, then Executive Secretary (vice- 
minister) of the Ministry of Mines and Energy (MME), told 
Brasilia EconOffs on April 13 that the goal of the auction was 
to achieve "adequate prices."  (On April 29, Tolmasquim became 
the President of the GOB Energy Research Enterprise (EPE).  The 
new Executive Secretary is Nelson Huber.)  Tolmasquim considered 
the results "good" because the prices matched econometric 
expectations of a reasonable rate of price increases.  In terms 
of contracted energy, Tolmasquim said the glass should be seen 
as half-full, and claimed that Peru and Chile were interested in 
Brazil's energy model.  In those terms, the auction was the 
success that the MME has claimed: prices across the two auctions 
were R$57.71 MWh for 2005, R$67.33 MWh for 2006, R$75.46 MWh for 
2007, and R$83.13 MWh for 2008 -- a smooth curve when graphed. 
Given the limited amounts sold in this round, however, the 
auction itself just barely avoided a total collapse and the 
president of the Brazilian Chamber of Electric Energy Investors 
(CBIEE) is quoted in the press as calling the auction results 
"disastrous." 
 
¶4. (SBU) Tolmasquim told Emboffs that the GoB would have to hold 
new auctions for the unmet 2008 and 2009 demand.  Implicitly 
acknowledging that the auction rules and structures had been 
complex, Tomasquim said that a new auction would be simple, 
focused on meeting demand beginning in a single year.  He also 
noted that the "new" energy auction, planned for June or July, 
would likely have to be postponed until these additional "old" 
energy auctions could be completed. (Note: the MME distinguishes 
between "old" energy -- from generators that came on-line before 
January 1, 2000 --, and "new" energy -- from future generators 
and those that came on-line after January 1, 2000. End Note.) 
 
AUCTION RULES: THROUGH A GLASS DARKLY... 
---------------------------------------- 
 
¶5. (SBU) According to several of our interlocutors, aspects of 
the auction have lead to suspicions of excessive government 
intervention in the process.  For instance, the MME made last 
minute changes to the auction rules, including a decision to 
decrease the demand to be sold by the 700 MW that had not been 
purchased in the December 2004 auction and was held over for the 
April 2 event.  Executive Director Regis Martins of the 
Brazilian Association of Independent Electric Energy Producers 
(APINE) said that this last minute change provoked such an 
outcry by producers and distributors that on April 1, the MME 
reinserted the 700 MW into the demand to be auctioned. 
 
MANIPULATION OF DEMAND 
---------------------- 
 
¶6. (SBU) Echoing concerns first voiced following the December 
2004 auction, personnel in the National Electric Energy 
Regulatory Agency (ANEEL), APINE, representatives of large 
energy generation companies, and energy analysts all told us 
that the auction rules artificially cut the demand during the 
bidding process.  This has the effect of forcing prices down. 
Christiano Vieira da Silva, an advisor in ANEEL's Economic 
Market Studies division, told Brasilia EconOff that a slice of 
the demand was "cut" off the top so that the auction would not 
be aborted because of insufficient supply.  With the demand set 
as lower than the supply, the auction system continued to drop 
the price.  In the end, however, the auction prices were 
considered too low by so many suppliers that they withdrew their 
offers, forcing MME to remove the 2009 contracts from the 
auction altogether.  A JP Morgan analyst reported that the 
decision to cancel the offer for contracts beginning in 2009 
"underscored the complexity of the auction rules, and the 
[energy] pool's vulnerability to alleged government interference 
over prices." 
 
INDUSTRY GRADE?  "F" FOR FAILURE 
-------------------------------- 
 
¶7. (SBU) The industry response to the first auction in December 
2004 was mixed, but with some significant positive sentiment 
(Refs A and B); however, the reaction to this second round 
auction was generally negative.  APINE considers the auction a 
failure.  On the Sao Paulo stock market (BOVEPSA) the Monday 
following the auction, 6 of the 10 stocks with greatest loss of 
value on were in the electric energy sector.  In a meeting with 
Brasilia and Rio EconOffs, Pactual Investment Analyst Pedro 
Batista said he had expected to see more "rational" results in 
the second auction because of tighter supply/demand, more 
involvement of non-state producers, less concern by the GOB 
about the impact on inflation in 2008-09, and significantly less 
pressure for the producers to get cash. (Note: during the 
December 17 auction, the contracts beginning in 2005 were 
effective January 1, meaning a near immediate cash-inflow.  End 
Note.)  Putting a positive, but ironic, spin on the auction's 
near-collapse, Batista argued it meant that the energy producers 
were not yet willing to accept "unrealistically low" prices. 
 
¶8. (SBU) Sao Paulo EconOff spoke with a senior executive of an 
international energy generating firm, who said many energy- 
generating companies, including his own, were unwilling to sell 
at the artificially depressed price the GOB had set.  The 
executive said his firm has been telling the GOB for years that 
the GOB's attempt to manage the market by segregating energy 
into old, interim, and new, is a "disastrous" approach.  He 
lamented the auction's lack of transparency.  While suggesting 
"it's anybody's guess" as to how the GOB should proceed, the 
source said that for the energy sector, which requires long-term 
investment, the lack of transparency and GOB interference in the 
market sends "the worst kind of signal."  In his opinion, 
considering the current environment, no private energy company 
will wish to make new investments in Brazil.  He surmised the 
GOB may soon have to depend on its own funds to finance energy 
supply and related infrastructure projects.  Another executive 
expressed concern about the GOB or parastatals leading 
investment into new energy projects because of their 
fundamentally different perspectives about business operations; 
he also considered additional investments into the country less 
likely if the GOB continues to diminish the value of the 
product. 
 
FEAR AND LOATHING 
----------------- 
 
¶9. (SBU) In particular, private generators and industry analysts 
object to the differentiation between "old" and "new" energy as 
creating artificial price differences for the same product.  An 
executive of a private energy generation company told Brasilia 
EconOff that with multiple rounds of auctions for the same 
product, the GOB may be setting itself up for potential lawsuits 
by companies who sold energy at one (lower) price during an 
early auction, while another company is selling at another 
(higher) price at a subsequent auction.  Eric Westberg, a former 
president of APINE who now represents a private investment firm, 
expressed surprise to Brasilia and Rio EconOffs that the energy 
model had not generated any lawsuits yet, but assumed this was 
because the state-owned generators dominated the first auction 
and were less likely to sue the GOB. 
 
COMMENT: "NEW" WINE IN "OLD" BOTTLES? 
------------------------------------- 
 
¶10. (SBU) Although the Lula administration generally has pursued 
market-oriented and orthodox macroeconomic policies, its energy 
model creates a system in which the State plays a leading role 
in a mixed private-public energy sector.  The lack of 
transparency and apparent GOB manipulation of the auction rules 
to achieve stable, incremental growth in electric energy prices, 
however, has added to widespread doubts about the system and is 
having a negative impact on the investment climate.  The likely 
delay of the new energy auction until the November time-frame is 
bad news, as the GOB needs to get licensing and construction of 
new hydroelectric plants started as soon as possible in order to 
meet expected energy capacity needs beginning in 2009.  And, 
while the GOB model arguably will provide more stability for new 
concession holders than they have chosen to give to existing 
energy producers, the desire by GOB policymakers to reject what 
they view as "unbridled" market forces is clear.  As many 
details of the auctions for new energy remain to be worked out, 
there is still time for the GOB to adjust to a more open, market 
approach.  If this is to indeed happen, pressure from private 
power producers will be key. 
 
¶11. (U) This cable reflects input from Consulates General 
Sao Paulo and Rio de Janeiro. 
 
CHICOLA