Washington, May 13, 2005

Power Sector Reform in Brazil

Luiz MaurerEnergy and WaterThe World Bank

Objectives of this presentation

THIS SESSION HAS FIVE MAIN OBJECTIVES

• Provide an overview of power sector reform in the world

• Summarize the key points about power sector reform in Brazil

• Discuss the good aspects and accomplishments• Discuss the not so good aspects and why reform fell

short of expectations• Present challenges ahead – Is reform complete?

Overview of power sector reform in the world

Challenges in the power sector …

Universal access 1.6 billion people without access to modern energy Undisputable linkage – access and poverty reduction

Expansion – how to raise U$ 120 billion per year? Private capital brought efficiency and investments Many took advantage of the euphoria for private

participation in the 1990s In Latin America – a mix of privatization and new generation Some places in Asia – only new generation via IPPs

Other countries literally “missed the boat” – and are now in worse off

Africa Middle East

Challenges in the power sector – reliability and adequacy of power systems…

Table 1 – Recent Scarcity and Power Shortage Episodes

System Year

Chile 1998-1999 Tanzania, Kenya 2000 Yugoslavia 2000-2001 New Zealand 2001 Brazil 2001-2002 Venezuela 2002 Ivory Coast, Ghana, Togo and Benin 1998 California 2000-2001 Norway 2001 and 2003 Russia 2001 Dominican Republic 2002-present Marahashtra – India China

2002 2003- present

Source: Implementing Energy Rationing in a Sensible Way – The Brazilian Case – Luiz Maurer – EWDEN – Washington, January 2003, and World Bank analysis

Challenges in the power sector – What about the future?

Challenges in the power sector …

SustainabilityAbility to live with its own means If tariffs are not cost reflective – sooner or later problems will

emerge, system will fall apart, or public debt escalateHow to provide services to those with low willingness to pay?Subsidies for access and lifeline rates necessary, but others

should be closely examined – e.g. subsidies that foster wasteful consumption Sooner or later will hamper affordability and quality Poor will be the first to suffer consequences

Subsidies in countries with low access – regressive taxationSustainability also encompasses consumption of natural

resources and deterioration of the environment

Major challenge – who will invest?

3

Financing Required for the Power Sector In Emerging Markets 1990-2020

Cumulative Sum ($Bn)

$4,300 Bn

$3,800 Bn

Historic Future

0.0

50.0

100.0

150.0

200.0

250.0

19

90

19

92

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94

19

96

19

98

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20

02

20

04

20

06

20

08

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10

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12

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14

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16

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20

Private Investmentin the Power Sector

Sourc e: World B ank , IE A , Deloitte T ouc he T ohm ats u E merging M arkets G roup

Low InvestmentDemand Scenario (2%)

E merging M ark ets G roup

High Investment DemandScenario (3%)Gap covered by public financing

self-financing, donor funding, and rationing

20 years of power sector reform - what have we learned? Initial considerations

First and foremost - the need for a baseline Greatest roadblock to evaluate the effectiveness of power sector

reform and privatization “What would have happened if nothing had been done?”

“Tell me a place where reform has worked perfectly” Misstated question - where has regulation worked perfectly? If regulations were flawless, why have reforms started?

Failures get [a lot] more publicity All of us know about the failure in California. What about press

coverage on other functioning pools? Recent WB seminar on energy

Crowded auditorium to see the movie “Power Trip” (Georgia) A few interested in the Peruvian BOT successes in transmission

Failures get [a lot] more publicity with distorted cause-effect relationships

California was not deregulation – a “botched deregulation” How many know about the virtues of other pools in the USA, such as

NEPOOL, NYISO, PJM and more recently Texas And abroad such as Alberta, Nordel, Australia, New Zealand, Argentina, Chile,

… Black-out in the US was due to miscommunication and lack of control in the

MISO “loose pool,” not a good example of deregulation - with geographical spillover effects

The most “liberals” advocate “security constrained, centralized, price bid, least cost dispatch,” with demand response – MISO is far away from what may be called a market

Black-outs in countries which embarked on reform are always in the headlines – but how many of us know the number of countries where black-outs are a fact of life or “business as usual” ?

Tinkering with reform and rules. Does is suffice?

No. Well crafted rules are essential to get competition “in” and “for” the market, as well as operating and investment efficiencies

Despite its uniqueness, electricity has elements of a private good If I consume one MWh, my neighbors will have one less MWh A very expensive good to produce – devours capital and environment Give it for free – creates wasteful consumption and bankrupts providers

Success of any reform – back to the basics in the cash register Energy has to be metered (always), billed and paid Supply side orientation overshadowed the importance of those

Governments have to “walk the talk” Pay their bills Enforce contracts, treat theft as a crime

Economic and financial sustainability Not even touted single buyer model is “bullet proof”

Summarize the key points about power sector reform in Brazil

Power sector reform in Brazil – a long process

• Settlement of arrears in 1993 – taxpayer absorbing > U$ 30 billion as a result of the “old regime”

• Concession Laws paving the road for reform and private capital participation (1995)

• RE-SEB – first comprehensive effort to create a new institutional, commercial and regulatory model – ANEEL, ONS, MAE (1997-1998) – half-way implemented

• Priority program of natural gas fired power plants (1999)• Rationing – challenge everything from scratch (2001)• Lula’s government – despite initial fears, new, good ideas - e.g.

auctions for new energy, strict purchasing requirements, EPE• Never ending process – still a lot to be done

Complex and not always linear process – web of Laws, Decrees, Portarias, Regulations

Discuss the good aspects and accomplishments

Brazil was the country who took most advantage of the privatization euphoria

Total Investments (*)

% Worldwide

Brazil $56,672 21%Argentina $25,988 10%China $22,316 8%Philippines $14,214 5%India $12,688 5%Malaysia $11,120 4%Indonesia $10,737 4%Thailand $10,274 4%

Total $269,874 100%

Period 1990-2003 - US$ MillionPrivate Investments in the Power Sector

(*) Includes Divestiture, Concessions, Greenfield, Management Contracts and Leases

What about the criticism – resources were not invested in new assets?

Greenfield & Concessions (*)

Divestiture

Brazil 17,689 38,983China 16,861 5,455Philippines 12,610 1,604India 12,126 563Indonesia 10,547 188Malaysia 8,525 2,595Thailand 8,098 2,176Argentina 6,765 19,223

Total 160,392 109,464

Private Investments in the Power Sector

(*) Excludes Management Contracts and Leases

Period 1990-2003 - US$ Million

Generation installed capacity – jumped from 1,100 MW to about 3,100 MW per year post 95

Annual Growth of Installed Capacity

0500

100015002000250030003500400045005000

1988 1990 1992 1994 1996 1998 2000 2002 2004

Year

MW

Ditto for transmission assets

Annual Increase of Basic Grid

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500

1000

1500

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3000

3500

1985 1990 1995 2000 2005

Year

km

of

Tra

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mis

sio

n L

ine

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Quality of service increased significantly

20 years of power sector reform - “Assessment is in the eyes of the beholder” – the bright side of Brazil

Brazil – Created a competitive business model for G 10 GW MW of hydro concessions granted, 19 GW commissioned Significant reduction in time and cost of construction

• Consolidated a business model for power system operation similar to the most advanced pools in the US – (cost bid, not price bid)

• Created a new business model in transmission (BOO)– 12,600 km of HV and 23 GVA in sub-stations built, mostly by the private sector

• Created a Wholesale Energy Market – now in full operation

• Privatized 85% of D and 26% of G with significant improvements in quality, and electrified 400,000 rural households

• Managed successfully a 20%, 8 month, country wide rationing program – market based, with no black-outs (an international best-practice)

• End of 2002 – 8,500 MW of capacity available – during rationing, end-customer learned how to use energy effectively

• Consolidate a competitive procurement process via energy auctions

Not so good aspects and why reform fell short of expectations

If everything so rosy, why rationing?

• Long term trend of depleting the reservoirs Independence of operator questioned Culture of not giving “bad news first”

• Half way implementation of the power sector reform• Privatization of G interrupted – the “worse of the two worlds”• Lack of planning, particularly gas-electricity convergence• Spot exposure – not perceived as a credible bankruptcy threat

by Gs or Ds – in the end, a “bail out” was necessary Gs – disregarded potential exposure of Annex V Ds – “penny-wise” in discussing +- adjustments of VN with ANEEL

• For all those reasons Increase in G and T investments But not sufficient

• Aggravated by bad weather – system is designed to have rationing one in every twenty years – but the scope and extent of 2001 beyond any expectations

New model more evolutionary than revolutionary

FEATURE TODAY LULA'S CAMPAIGN NEW MODEL

Industry StructureProposed deverticalization of G, T, D and C, partially implemented - missing D and C

Deverticalization not an issue

Prohibits cross ownership and self-dealing. Separation between D and C postponed. State companies challenging restrictions.

Trading ArrangementsMultiple buyers and sellers negotiating in the same environment

Single Buyer (SB), responsible for buying and selling all energy

"Soft Single Buyer" (pool) allocating contracts and coordinating auctions. But no title for the energy. Contracts outside of the pool are allowed (IPPs and free customers)

Primary Nature of Contracts

Bilateral, of financial natureTo be transferred to SB, possibly physical

As today

Generation Pricing

Vesting contracts = regulated New contracts = freely negotiated for IPPs and auction for public generators

All generation to have regulated prices

Freely negotiated if outside of the pool; Result of a competitive process (auction) if within the pool

Status of Generation

New = IPP. Old gradually moving from public service towards IPP, as plants are privatized

All generation has to be public service

Status remain as today. However, if energy from public service generators is sold via competitive auction, status becomes irrelevant

Operation of the Power System

Independent System Operator (ONS), security constrained, least cost centralized dispatch

Change trading arrangements to allow optimal operation of the power system. Trading arrangements interfere in the optimal dispatch

As today, but government indends to appoint most ONS executives

Retail competitionTo be reduced below 3 MW in 2003 - proposed 1 MW

Allowed only for large customers

Delayed the reduction in the threshold

Tariff to large customers

Subsidized. Idea to gradually eliminate cross subsidies as initial contracts expire, reflecting a commodity cost of US$ 30/MWh. Unbundle D and C to give visibility

Reduce cross-subsidies immediately

Idea is still to eliminate cross subsidies, but special deals being cut with large customers @ US$ 20/MWh

(*) Contracts between Gs and Ds are de facto capped at the normative value for pass through purposes

BASIC CHARACTERISTICS OF THE NEW MODEL FOR THE POWER SECTOR

Present challenges ahead – Is reform complete?

Power sector reform is never complete

• Power sector reforms have to be predictable, but never a finished product

• Current administration knows there is still a lot to be doneUniversalizationBetter targeting of subsidies for the poorIsolated systems and renewablesAssure expansion via new energy auctionsUntangle the “taxation web” – see next page

The power sector became a tax collector

Other aspects for the government to consider

• If we want a market – we need strong price signals in time and spaceMore on “dynamic pricing” and demand response – customer

to perceive when the energy is scarce or abundantLocational signals – current sub-market pricing scheme is

flawed, auctions have to take into account where new plants are to be located

• Rationing was a tough experience – but we learned that price signals do work If properly designed are the best way to allocate scarce

resourcesGood design includes, inter alia, safety nets for the poor

In a nutshell

• Power sector reform is a challenge everywhere• So far Brazil has developed so far a promising power sector

model – we are now much better than when we started• Leveraging on international capital – which is still badly needed• A lot of criticism in the last years has been more a result of

perception than reality – reform has been an evolutionary process• Current administration has commitment and important items in

the agenda • We can always improve – other areas include

Better targeting of subsidiesSimplification of taxation schemes If we need a market, we need good prices in time and spaceDemand response and energy conservation – still orphans