07-04-00 Unparalleled growth in Brazil's electricity sector is a powerful lure for investors. But the Latin American giant is also home to an exotic collection of pitfalls including buy-back risk, political upheavals, gaps in the regulatory structure, burdensome taxes, and uncertainty about the nation's ability to withstand external shocks.
Brazil's size and growth rate offer potentially phenomenal rewards for those with the courage to invest against a background of such risks. In addition to one of the fastest growing electricity markets in the world, Brazil offers economies of scale and an all-important foothold in Latin America.

According to AT Kearney, in January overall investor confidence in Brazilian utilities, including electricity, ranked above primary investments and financial services, roughly on a par with wholesale and retail trade, and below such sectors as non-financial services and manufacturing.
Risky or not, some $ 8-9 bn will be invested in the sector in 2000 alone, according to Mines and Energy Minister Rodolpho Tourinho. He said electricity consumption will grow at close to 5 % per year through 2004, well above GDP growth, and far beyond other nations with plans for privatisation.
"The biggest risk is for a company not to invest in Brazil," said Merrill Lynch senior international advisor Marcilio Marques Moreira. A former finance minister, Moreira, is also on the board of international advisors for the New York-based risk assessment firm Marsh and McLennan. "If a company wants to be in Latin America, it must invest in Brazil, because if it doesn't, its main competitor certainly will," he said. He pointed out that the Chilean market, for instance, is no bigger than Rio de Janeiro state, and half the size of Sao Paulo state.
Still, Brazil is not for the faint of heart. Hazards ranging from bottomless environmental liabilities and tax costs, to deadlock with powerful local politicians might be too great for some investors. "It all depends on the focus of the company," said Moreira.

Equity analyst Andrea Teixeira of Fleming-Graphus said that investors have to be aware of 2 major sources of risk: unclear normative values for power generation, and the risk associated with "good will" buy-backs in privatisation.
Normative values refer to the generation cost a distributor can pass onto consumers when actual contracted costs are higher. This implies a cap on the wholesale price of power. Since water tables rise and fall, as does the price of natural gas, a generator can go broke unless such values are changed, or allowed to float. Squabbles over those changes translate into risk for distributors and generators alike.
Investors complain that the insistence of the government in keeping inflation low by limiting distributors' rate increases through the system of normative values discourages investment in generation, since generators are prevented from passing the higher costs on to consumers.
Buy-back risk is another concern. In privatisation, bidders pay over book value for the assets. Teixeira said the "good will" buy-back of leftover shares after the privatisation auction offers a way for the winner to dilute the auction price. But, Brazilian law doesn't allow the companies to incorporate debt on the paper company set up to buy the assets, which means the price of the remaining shares could remain overvalued from the perspective of the new owners of the electricity utility.

"Investors need to realise that their investment is at risk, and that it is still unclear whether there is a way for them to protect it," said a Brazilian executive of an independent power producer. He said problems such as the lack of properly defined regulations, inadequate normative values, and sluggish progress toward promised changes make it hard for investors to get their hands around a power project.
While he said changes such as the central bank's recent decision to allow investors to convert part of their revenues into dollars-denominated bank accounts in Brazil will help, he also said that at every step of the way in Brazil, investors must put their money at risk. "For hydroelectric projects, for instance, you need two to three times the investment per MW installed than you need for a thermal plant, and this higher investment doesn't always offer the return you need to make the project viable," said the executive.
Cesar Roland, director of Brazil's Independent Power Producers' Association, agreed. "In this case, what we have as a point of reference is the cost of a deficit and not the cost of expansion, which is terrible," he said.

Finance costs are another difficulty, especially for independent power producers who may lack access to capital available to deep-pockets investors such as the major multinationals. Foreign investors tend to need international turnkey contractors to get financing, driving up the cost of construction.
According to Moreira, the griefs of Brazil's electricity sector are mere growing pains. The market mentality is still being built, and given the spectre of an energy shortfall in Brazil, there was simply not time to implement all the changes needed to placate investors, he said.
The cost of credit in Brazil is still high, but talks are underway between the Brazilian Development Bank (BNDES), state lending agencies and multilateral agencies to improve the outlook. By 2003, the BNDES hopes to secure between 12-14 bn Brazilian real for the sector's expansion, while the Inter-American Development Bank and the World Bank might loan the private sector about 1 bn real each, said National Energy Secretary Benedito Carraro.

Minority shareholder rights continue to concern investors, but new corporate legislation should provide safeguards. According to Teixeira, the new laws could enable investors to merge operations with special purpose companies in privatisation, which would permit a big dilution in the purchase price of the assets for minority shareholders.
Also underway is a project to create the National Waters Agency, a regulator that will help settle once and for all the agonising debate over who controls waterways in Brazil, which will provide more assurances for hydroelectric generators and provide a structure for disputes over environmental liabilities.