Special Presentation

The Energy Crisis in Brazil

American ChamberBusiness Affairs Committee

São Paulo, April 25, 2001

AGENDA

I - What is happening?

II - How did we get to this point?

III - What is the impact of expected

crisis?

IV - What are the proposed solutions?

I - What is happening?

What is happening? In sum: chaos Imminent electric energy rationing Now “officially” accepted - issue is how to do it: when,

quotas, rolling blackouts, how deep, for how long? Doubts being cast on the open, competitive energy

model chosen by Brazil in 95 California crisis adding injury to insult

Is deregulation a failed experiment? Should we go back to the old, state controlled model

as suggested by Mr. Gray Davis (and certainly other to second him in Brazil)

More recently, alarming headlines: “ANEEL has intervened in the Wholesale Market (MAE)”

II - How did we get to this

point?

Physiology of a crisis Usually, a complex interaction of many factors - the

“perfect storm” effect Leading to an absolute lack of control But society and politics need to find a scapegoat,

preferably one single factor to blame on In California, “blame it on deregulation” - This presentation is not meant to be naïve

There are indeed many issues and a web of events The current situation is Brazil is a mixture of the “old”

and the “new” models - Therefore, whose to blame? We can only address a few, key aspects in this limited

timeframe

Facts, not ideas Rationing is a real issue, not a buzzword or a cliché, oftentimes

used by contractors and equipment vendors in the past Reservoirs levels in Brazil have never been so low in the past -

to make things worse, at the very end of the rainy season If nothing is done reservoirs will run dry soon - at some point

between September and December Rationing measures in the past more “niche” based - now most

of the system is in dire conditions (South as a exception?) This is not a result of one single bad season - on the contrary

Secular trend - we have been constantly depleting our reservoirs over the last 3-4 years

An “hoping for the best” - but not “planning for the worse”

Is this surprising? Not for those who have been playing in the electric sector in

Brazil in the last few years Furthermore, the electric system is designed this way

Hydro plants not able to “deliver” 5% of the time And Brazil proudly saying it is predominantly hydro

However, government has not publicly admitted any chance of rationing before - for “legitimate” reasons, not to scare investors or hamper the economy

ONS, who was designed to be “independent” never “translated” the situation in such a way to be understood by society - reality always buried in complex graphs/charts

Besides, probability and “odds” always lead to different interpretations, expectations and levels of “praying”

All of this is happening in the midst of a significant process of restructuring of the energy sectors in Brazil Brazil has embarked since mid 90’s on a significant effort to

restructure its energy sector Hydrocarbons: end of Petrobrás’ monopoly, natural gas as a

new supply source Electric: privatization, competition and deregulation (G/C)

Vision was modern, design detailed - but implementation has been plagued by politics and procrastination Privatization of G assets virtually stopped - no political support Inconsistent messages from “democrats” and “republicans” Implementation of MAE falling behind schedule

Perception of lack of direction and government leadership - some qualifying as “samba do criolo doido” - investors really confused

Why hasn’t anything being done before?

Not a fair statement Since 95 - move towards a private, open model has increased

investments, e.g. doubled in generation - 2,500 MW year, but still not enough

In late 99, an ambitious plan was launched by the Federal Government To expand generating capacity - mostly gas fired plants, between

2000 and 2003 49 Plants - 15,000 MW - supply would catch up demand growth

It was called the “emergency plan” - implying that a crisis was a likely outcome

The plan had its merits To diversify the energy matrix - before, too much hydro and

therefore high risk of rationing To serve as an “anchor” to the Bolivian gas supply TOP contracts Thermal plants much faster to build than hydro Meant to leverage on private resources/capital

Has the Emergency Plan failed?

It depends on how we define success/failure In terms of meeting deadlines and avoiding crisis

Yes, it is a partial failure Only a few plants to be commissioned in late 2001 -

basically on a “merchant” basis, due to the lack of incentives to long term contracting

Those plants are key to alleviate the crisis - but are not enough

In terms of a long term solution to our problems? No Program is here to stay Gas fired plants are a cheap solution - hydro very capital

intensive, capital is an imported commodity Diversification - 15,000 MW not compromising ideal mix

Why has the Emergency Plan “failed”

Certainly easier to answer with the benefit of hindsight

First: continued restructuring of the sector and Emergency Plan should not have been perceived as mutually exclusive goals Of course, there was an issue of priority However, Plan was fundamentally built upon

private capital participation- which requires clear rules and market signals

Why has the Emergency Plan “failed” (continued)

Second: mismatch between the electric and the gas sectors’ cultures - never spoke to each other Electric - mature, moving towards competition Gas - emerging, a de facto monopoly Difficulties for mutual understanding of basic,

technical problems - e.g. dispatch, nomination Let alone agreeing on commercial issues Lack of dialogue between ANEEL and ANP Issues illustrated in Enron Informativo

Regulatorio # 1

Why has the Emergency Plan “failed” (continued) Third: macro-economic and regulatory issues

Gas industry is dollarized; electric tariffs in R$ Who is meant to bear the FX risk? In the midst of a government policy to hold public prices

to avoid an inflation crisis A lot of second-guess and mistrust between government

and investors Cry-babies? Certainly not. Investors willing to take risks,

but too much of a risk to fit within VN Aggravated by the fact that D/Cs are collectively single

buyers - free market still small, VN is essential Statists on call - “Petrobrás and Eletrobrás will fix the

problem” - now defeating the goals of the new model

III - What is the impact of expected crisis?

No one knows - a multi-billion dollar question

Brazil has had two major rationing programs in its recent history South - 3 months in 1986, 20% load cut, via quotas N/NE - 7 months in 1997, 15% load cut, via quotas

We do know how much revenues utilities failed to collect However, no one has ever attempted to quantify the macro-

economic impact of rationing Our best guess for the upcoming rationing

15% to 20% cut over 9 months (quota, not rolling blackouts) 80% of the Brazilian market Social cost: between US$ 10 and US$ 40 billion

Whose to blame? Deregulation? Social cost of procrastination? Benign neglect? Part of the democratic process? Lack of leadership? Will it help knowing?

IV - What are the proposed solutions?

For the time being, let’s try to minimize the impact of rationing - and trust on markets forces Not enough time to fix the supply demand imbalance - neither to be

wasted in finger pointing Leverage (as opposed to destroying) the few market mechanisms already

put in place MAE, spot prices to signal scarcity Put MAE to work - Enron supports ANEEL intervention Honor commercial contracts

Market signals will help alleviate the crisis Merchant, back up, self-generation plants - > 2000 MW in the short run Signal for society to make smart decisions; i.e. - one more MW or more

pollution on Billings

DSB and DSM - badly needed to create demand elasticity Wake up call to a stubborn gas sector: please unbundle !!

Will this suffice? No Electric sector still basically regulated

Ambitious government proposal for retail competition - 50 KW in 2003 and zeroing in 2005

However, now a negligible numbers of free customers, caused by a distorted rate structure, which doe not encourage switching

Regulated world not price responsive Other actions necessary - most importantly

Quota system as a necessary evil Has to be coupled with incentives/penalties for achieving

quotas - e.g. average spot prices Foster regulated demand side management - as part of the

revenue formulae for D/Cs Those actions try to mimic market forces into the regulated world

And after we pass the crisis? What should be done?

First and foremost - acknowledge that the energy sector is now “stuck in the middle” - neither state controlled nor market based ... As a result of a half-way restructuring effort Which lost momentum due to politics and lack of

leadership … And that represents the worse of the two worlds

Public sector not making the necessary investments Private sector reluctant to invest - lack of market

signals, unfair competition with state owned companies

Where should we move to? CERA has offered three options

Giant realized Believe in markets Continue the restructuring process - gas and electric Create real competition at retail and wholesale levels Unbundle gas industry , de-verticalize G/T, privatize Gs

Institutional oligopoly Just a few players acting individually or in association with

dominating SOEs Defend markets - but only until one is part of game

Socialistic chaos State playing a predominant role Private players in minor positions - e.g. sellers to government entities Abundance alternating with scarcity - no market signals at all