ENRON WELCOMES

BRAZILIAN JOURNALISTS

CREATING A VIBRANT

ENERGY MARKET IN BRAZIL

Luiz T. A. Maurer

Houston,October 04, 2001

INTRODUCTION

AFTER THIS QUICK TOUR, SOME QUESTIONS IN YOUR MIND MAY POSSIBLY INCLUDE

• Is all this applicable to Brazil?• Has the transformation towards a market based regime led Brazil

into a crisis like in California? Aren’t we following a similar path?• If not, how to explain the existing crisis? Whose to blame?• What should Brazil do to fully get the benefits of markets and

competition? – The “virtuous cycle of contracting”• Other immediate challenges• In conclusion

EACH ONE OF THOSE QUESTIONS WILL BE ADDRESSED IN TURN

IS THIS APPLICABLE TO BRAZIL?• No doubts about it • A vibrant trading market for both gas and electricity is key

to introduce competition both at the wholesale and retail levels

• Enron and multiple other players are market makers, bring liquidity to the market, facilitate new invesments

• Allowing producers and consumers to meet their needs and manage their market risks

• And giving the correct signals for expansion• Who does not want that? All customers deserve it• The new electric sector in Brazil has been designed having

this as an end goal

HAS THIS TRANSFORMATION LED BRAZIL INTO A CRISIS LIKE IN CALIFORNIA? AREN’T

WE FOLLOWING A SIMILAR PATH? NO!

• The energy crisis in Brazil bears strong resemblance with the energy crisis in California [perhaps on the surface]

– Results of at least one demand and supply shock

– Rates to retail customers artificially low

– A regulatory and commercial framework not conducive to new investments

– Both “countries” initiated sector reform in mid 90 - towards a more competitive regime

– Financial imbalances and disputes between buyers and sellers - “Annex V”, Wall Street Journal front page headlines

DESPITE SIGNIFICANT REGULATORY AND MARKET DIFFERENCES, INITIAL VERDICT WAS SIMPLE - “BLAME IT ON DEREGULATION”

BRAZIL

(DURING INITIAL CONTRACTS = CI’s)

CALIFORNIA

RATIONALE CONTRACT AS THE BASIS FOR COMPETITION

CONTRACT PROXY FOR RE VERTICALIZATION

IMPLEMENTATION HALF-WAY THROUGH IMPLEMENTED LEVEL OF CONTRACTING FOR LSE

HIGH MANDATORY

VIRTUALLY NILL HIGHLY RESTRICTED

COMPLEXITY OF WHOLESALE MARKET

LOW – ONE PRODUCT (MWh)

EX-ANTE DECLARATIONS LONG TERM CONTRACTS

FOR ANCILLARY SERVICES

HIGH – SEVERAL PRODUCTS BOTH EX-ANTE AND REAL TIME

DECLARATIONS ANCILLARY SERVICES

PROCURED REAL TIME

ENERGY COST PASS-THROUGH

RESTRICTED TO VN SAME FOR SPOT

PURCHASES

TOTAL, AFTER RECOVERY OF STRANDED COSTS

UNCERTAIN BEFORE NATURE OF SHORTAGE AND MARKET POWER

HIGH PEAKING CAPABILITY – LACKING “FUEL”

MINIMAL UNDER TIGHT POOL REGIME

VERY LOW DURING INITIAL CONTRACTS

BASICALLY SHORT ON CAPACITY (PEAK MW)

ALLEGED AS HIGH FOR G “THIN” MARKET FOR

ANCILLARY SERVICES

WHY USING CALIFORNIA AS THE ONLY EXAMPLE

• Last year, intense press coverage on California – to illustrate the bad things about markets and competition

• A minor fraction of the articles considered California a “botched” deregulation experiment

• However only specialized Journals draw an unbiased comparison between California and other places where markets and competition have worked

• For example, the PJM ISO, which bears strong resemblance to the Brazilian model and has been used as a best practice for the development of other markets in the US– Size comparable to Brazil = 60 GW– Contracts as financial instruments– Central dispatch to optimize power system– Agents free to hedge their risk exposures– Independent Board to run market (COMAE)

BRAZIL AND CALIFORNIA MANAGED THE CRISIS IN A VERY DIFFERENT WAY

• Crisis has long been anticipated (see ONS curves)

• However, it was “officially” acknowledged only on May 03

• “Clock was ticking” - it was necessary to put together, in a few days, a comprehensive plan to cut consumption by at least 20% for 8-9 months

• Brazil had some experience in the past dealing with rationing – but the consumer and the sector have changed

• There were two ways of approaching the problem

– “Rolling black-outs” - leveraging on California’s experience

– Quotas - as it has been done in the past

CRISIS HAS LONG BEING ANTECIPATED

76,3

88,6

81,8

69,9

59,4

32,2

47,5

60,2

43,2

19,7 22,1

12,8

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30,0

40,0

50,0

60,0

70,0

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90,0

100,0

110,0

| | | | | | |1996 1997 1998 1999 2000 2001

Abril Novembro EAR Máx. de 1996 a 2001

BRAZIL AND CALIFORNIA HANDLED THE CRISIS IN A VERY DIFFERENT WAY

• Brazil decided to leverage on market signals– “Quotas” were assigned to all customers, based on 2000 historical average

consumption – Quotas were differentiated by customer group– Economic signals - “penalties” for those exceeding their quotas and

“bonuses” for overachievers (low income) – Economic signals linked to prices in the energy wholesale market– A secondary market for exchanging quotas was established - initially > 3

MW, now more customers– In principle, commercial contracts remain effective

• With a clear, honest perception of crisis– Scarcity does exist - not a result of greedy investors– Fix first, look for scapegoats next– Government is cognizant and will try to fix mistakes which led to

under investment

HOW THE CRISIS HAS BEEN HANDLED• Rolling black-outs were overruled, as they did not seem

to fit into the Brazilian crisis – Contrary to California, it is not a peak shaving issue– Energy rationing is more complex - customers have the ability to

do intra-day “load shifting”– Network is intermeshed, not separating essential loads - besides,

automation is very limited at distribution level– Those factors would entail a disproportionate burden on some

customers (10-16 hours/day) - leading to an urban chaos

• Furthermore, rolling black-outs provided a poor allocation of a scarce resource– Willingness to pay varying within a wide range (1:60)– Some economists: significantly higher GDP reduction

RESULTS SO FAR HAVE MET TARGETS

- MARKET SIGNALS DID WORK- MW Peak Consumption

HOW THE CRISIS HAS BEEN HANDLED• The choice was not an easy one and faced strong opposition• Rolling black-out advocates had several arguments

– Electricity has no elasticity - let alone in the required timeframe – 15% of customers will challenge their quotas– Time required to prepare IT systems and procedures– Uncertainty of achieving desired results – “it may be too

late”…– And California has been using this mechanism…

• With subsequent pressures on the commercial sides– Let’s set a cap on spot prices - California did it– Initial contracts should be suspended– And other disguised mechanisms equivalent to “bail-outs”

• It was not an easy decision to be made and to be implemented in a two week timeframe

IF NOT LIKE IN CALIFORNIA, HOW TO EXPLAIN EXISTING CRISIS? BLAME IT ON MARKETS?

• No. The model was very well designed with a sound implementation plan

• However, demand was catching up supply at a fast pace - supply shortage was well known in advance

• Implementation of the new model has been facing many hurdles and stopped half-way through – an aspect everyone agrees

• In a nutshell, due to lack of “orchestration” among multiple players and initiatives – no doubt, a complex endeavor

• In 1999 – “emergency power program” as the last recourse• Imposing a significant demand on gas-electricity

convergence in multiple fronts• Which, needless to say, did not happen

TWO DIFFERENT CULTURES HAVE CREATED OBSTACLES FOR CONVERGENCE

Natural Gas Electricity Currency * US$ - Business as usual * R$ only - US$ as a blasphemy (except Itaipu)

Lack of mutual understanding * No knowledge on power system operation and impact of artificial contract rigidities

* No knowledge on gas nomination, storage or physical delivery constraints

Supply Dynamics * Monopolistic * Emerging competition

Wholesale Prices * Bundled, unified * Locational signal for load and generation

Attitude towards competition * Averse * Applauded by new entrants; covert opposition by most existing players

Regulatory Oversight * Mix between State and Federal * Basically Federal

Ownership * Basically Federal Government * Mixed - Private, State, Federal

THIS POOR CONVERGENCE, IN TANDEM WITH LACK OF REGULATORY CLARITY, HAS IMPACTED THE ENTIRE SUPPLY CHAIN ...

Domestic Gas

ImportedGas

•No gas competition today•Difficult access to pipelines

Gas SupplierGASLDC IPP D/C

•US$•Contractual Rigidities•High TOP, SOP

•US$•Mirror image•High inflexibility for dispatch

•R$•FX risk•Functioning MAE

Free customer

Captive customer

•Uncertain retail competition•ANEEL’s refusalto deal withstranded costs

•VN•Regulatorylag

… JEOPARDIZING THE SUCCESS OF PPT AND AGGRAVATING THE ENERGY CRISIS

WHAT SHOULD BRAZIL DO TO FULLY GET THE BENEFITS OF MARKETS AND COMPETITION?”

• Will convergence and regulatory clarity suffice?

• Unfortunately no ! There are many other important issues to be addressed

• To create an environment conducive to contracting and expansion - “Virtuous Cycle of

Contracting”

THE SEAMLESS “VIRTUOUS CIRCLE” OF CONTRACTING

REGULATORY/COMMERCIALENVIRONMENT CONDUCIVE

TO CONTRACTING

CULTURE OFCONTRACT“SANCTITY”

RESPONSIBLECONTRACTING

ATTITUDE

THE ELECTRIC SECTOR IN THE LAST TWO YEARS HAS BEEN PLAGUED BY MULTIPLE

CONTRACT DISPUTES - MOSTLY AT MAE LEVEL

DISPUTE/CONTENDERS KEY ISSUES

D/C Concession Contracts –“Parcela A”

Acknowledgement of legitimateregulatory lag for pass-through

Itaipu Excess Energy – Eletrobrásvs. D/Cs

Property rights on [parts] of existingcapacity and generation

MAE Agreement - Gs vs. D/Cs Discussions on basic pillars - e.g."Recompra" (new), Capacity Fee

Imports from Argentina - CIEN vs.Furnas + Gerasul

Should new MAE rules modify agreedcontractual obligations?

IPP - Cuiabá I vs. Furnas Ditto

Annex V - Gs vs. D/Cs Should a particular contractual clausebe applied during rationing?

Angra II - Furnas – Gs - D/Cs: takento COEX for [frustrated] arbitration

Efficacy of capacity contractsregulated by Decree 2.655/98

CONTRACT SANCTITY -

A NAÏVE PROPOSITION? • No. The Electric Sector in Brazil does not have a tradition on contracts for

power - let alone on drafting and honoring them

• Until 1993 - no contracts whatsoever for bulk energy transactions, involving US$ Billions

• “Culture” of GCOI - upsides and downsides offset in a command and control, socialistic fashion

• New model changed rules and procedures, but not ingrained culture

• We still hear things like - “in the rationing, no one is meant to gain or lose”

• This is totally contrary to correct economic signals and to a responsible contracting attitude

• Hernando De Soto - Emerging markets need to enforce property rights to develop a contractual, urban society

CONTRACTS ARE BASIC PILLARS OF THE NEW MODEL

• Basis for– Competition– Risk allocation/pricing– Financial hedge against MAE price volatility– Certainty for investors– Therefore, pre-requisite for expansion

• Most of the contract disputes on previous pages involve Government or SOEs - Is this pure serendipity?

• Angra II disputes very revealing - in essence, multiple Government Agencies challenging contracts under the aegis of “public interest”

• Annex V discussions following similar paths

• Does this attitude create a perception of level playing field for new, badly needed private capital?

COUNTRIES WHERE ELECTRIC SECTOR REFORM WAS UNDERTAKEN HAVE AN OUTSTANDING

PERFORMANCE ON CONTRACTS

01

234

567

89

10

10 9.4 9 8.5 7.9 7.6

AustriaAustraliaDenmarkFinlandGermanyNew ZealandNorwayU.K.U.S.A.

CanadaItaly

PolandPortugal

AlgeriaArgentinaChileChinaMexicoThailandSouth Africa

BrazilPeru

IndiaIndonesiaSri Lanka

Source: The Fraser Institute: Economic Freedom of the World 2000 - Annual Report* Proxy for security of property rights and viability of contracts includes: (i) legal security of private ownership rights (risk of confiscation); (ii) viability of contracts (risk of contract repudiation by the government); (iii) rule of law: legal institutions supportive to principles of rule of law and access to a nondiscriminatory judiciary.

LEGAL STRUCTURE AND PROPERTY RIGHTS INDEX (*) - 1997

- RESPONSIBLE CONTRACTING - REQUIRES ALL COSTS TO BE INTERNALIZED

Gas RigiditiesRegulatory lag

Retail competitionFX RiskLow VN

Cost of deficitMAE priceShort positions

Cost of contracting Costs of not contracting

•Best trade-off•Expectation on beingbailed out?•Rolling black-outsto fix short positions?

Load growth for D/CsAnnex V for Generators

IF BAILOUT IS PERCEIVED AS A POSSIBILITY, THERE WILL BE IRRESPONSIBLE CONTRACTING,

LESS CAPACITY, MORE FREQUENT RATIONING ...

Gas RigiditiesRegulatory lag

Retail competitionFX RiskLow VN

Cost of deficitMAE priceShort positions

Cost of contracting

Costs of not contracting

… AND MORE PRESSURE FOR BAILOUTS ...

IS THIS A DISCOURAGEMENT FOR

NEW INVESTMENTS IN BRAZIL? • No, quite the opposite - just a wake up call

• It shows that contracts are an essential piece of the new model

• The Government should be a guardian, particularly when a SOE is one of the parties involved

• Do not take for granted it is going to happen

• The primary responsibility of a Government Officer is to enforce contracts and respect the Law

• A diffuse, alleged perception of public interest should not override this mission

• We think this is a feasible, achievable proposition

OTHER IMMEDIATE CHALLENGES• Contract Sanctity – from concept to

implementation• Having MAE up and running• Accelerate the implementation of a competitive

model• Align prices to market reality

EACH ONE OF THOSE POINTS WILL BE SUMMARIZED IN TURN

CONTRACT SANCTITY – FROM CONCEPT TO IMPLEMENTATION

• Next weeks will be critical in assigning losses due to rationing – Will government walk the talk?

• How will disputes be solved?– Trying to make everybody happy?– Or adhering to basic guiding principles?

• Key issues on the table– Annex V– MAE price under rationing – R$ 684 or R$ 336?– “ Parcela A”– Angra II settlement

• Perception on contract sanctity will have long lasting effects among investors

HAVING MAE UP AND RUNNING• MAE implementation has been plagued by

multiple delays and procrastination• Angra II dispute was allegedly an important

reason – but not the only one• With 20/20 hindsight

– A stakeholder’s Board was not a good decision– MAE was not mutually exclusive to Emergency Plan –

• Thus far, not a sense of urgency – but now MAE is critical to bring 1000 MW on line and help avoid rolling black-outs !!

• Enron supports the recent changes in MAE Governance – Informativo Regulatorio # 3

ACCELERATE THE IMPLEMENTATION OF A COMPETITIVE MODEL

• The new model contemplates competition– At the wholesale and retail levels– Gradual phase in to the new world

• California and the rationing crisis only prove that we have to accelerate, not reduce the pace

• It is essential to get rid off old energy – that is why “Initial Contracts” were put in place

• And really implement retail competition – Enron support Aneel’s proposal to reduce “ free customer” threshold to 50 kW in 2003, despite fierce opposition

• Wholesale and retail competition have to work harmoniously – rationing plan is a live example

ALIGN PRICES TO MARKET REALITY • Brazil and California crisis had a strong point in common

– A failed attempt to keep prices artificially low– Which becomes explosive when scarcity becomes more severe

• Regulators, in an attempt to “protect”customers, have shielded them from market reality – e.g. Parcela A, cross-subsidies, VN

• Which in the particular case of California has created imbalances between the wholesale and retail markets - with serious financial consequences for incumbent utilities

• The rationing experience in Brazil shows that demand is price responsive and leads to rational allocation

• The California electricity crisis is not really a story about environmentalists going mad, deregulatory details ignored, or unrestrained capitalists running amuck. It is a story about what happens when price controls are imposed on scarce goods” (Taylor and VanDoren – Cato Institute)

IN CONCLUSION ...• A competitive energy model is desirable and feasible not only in the the

US, but also in Brazil• California should not be used as a verdict; but as an experiment to extract

lessons• There is a coherent blueprint for reform in Brazil which needs to be

implemented – and orchestrated with due sense of urgency• Lack of thereof (convergence between gas and electricity) is a real issue

has it has jeopardized the development of the thermal program, aggravating the crisis

• Fundamental question: will this suffice to support expansion?• Simple answer is no: Brazil still has to create a “virtuous” circle of

contracting, which is the basis for expansion• This entails

– Contract Sanctity– Responsible Contracting

• We think it does not happen by default - Government has a key role in

fostering a healthy contracting environment