The Risk of Reform: Privatisation and Liberalisation in the Brazilian Electric Power Industry by Sunil Tankha Master in Public Affairs The University of Texas at Austin, 1997 Submitted to the Department of Urban Studies and Planning in Partial Fulfilment of the Requirements for the Degree of DOCTOR OF PHILOSOPHY IN ECONOMIC DEVELOPMENT at the MA SSACHUSETTS INSTITUTE MASSACHUSETTS INSTITUTE OF TECHNOLOGY OF TE February 2006 JUL 2 0 2006 C 2005 Sunil Tankha. All rights reserved. LIBRA RIES The author hereby grants to MIT permission to reproduce and to distribute publicly paper and electronic copies of this these document in whole or in part. Signature of A uthor ................................................ Department of Urban Studies and Planning August 22, 2005 C ertified by ......................................... / Ali'e AmNden Professor of Political Economy Dissertation Chair Accepted by ................ Frank Levy Chair, Ph.D. Program The Risk of Reform: Privatisation and Liberalisation in the Brazilian Electric Power Industry by Sunil Tankha Submitted to the Department of Urban Studies and Planning in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in Political Economy ABSTRACT In 1996, when Brazil was well-underway to privatising and liberalising its electric power industry, few would have predicted that within five years the reforms would be a shambles. Like its nighbours Argentina and Chile, Brazil based its electricity reforms on the orthodox therapies of privatisation and liberalisation. The industry was well-positioned to benefit from the reforms: it was technically sophisticated, relatively efficient, and attractive to both domestic and foreign investors. Electricity rates had been suppressed for a long time, but they were not populist and it was the residential customer who cross-subsidised industry. As such, political backlash to increasing electricity prices was unlikely and, in fact, Brazil had successfully begun to raise electricity rates as early as 1993. Despite these fortuitous circumstances, the reforms did not induce sufficient investment and Brazil suffered a massive electricity rationing in 2001. For ten months all classes of consumers had to cut consumption by 20%. By 2002, the electricity reforms were politically dead and none of the candidates in Brazil's presidential elections that year, not even the incumbent administration's nominee, favoured continuing with them. My dissertation explains why the reforms failed, approaching the issue from three different perspectives-the policy, the economic and the industrial. Collectively, these essays explain why sectoral neoliberal reforms had a short shelf-life. Dissertation Chair: Alice Amsden Title: Professor of Political Economy ACKNOWLEDGEMENTS My thanks go to: My dissertation committee: Alice Amsden, Jose Antonio Gomez-Ibafiez, and Ashley Brown. Judith Tendler, my constant mentor. Marty Rein, for brainstorming. Antonio Magalhies, for Brazil. All those who shared their couches and beds with me on my random reappearances in Boston- Bilal, Robin, Yanni, Sarah, Jill, Sarah P., Laura, Ariel, Genna, Jean, Uri, Nadya, Malo, Boyd, Leigh, Ian, Annie and the anonymous person who left the camp bed in the DUSP Common Room. And of course, Tenzing, for facilitating most of those couches. I would also like to take this opportunity to acknowledge the financial support of the Social Science Research Council, the John D. and Catherine T. MacArthur Foundation, the Center for International Studies and the Center for Energy and Environmental Policy Research at MIT. Special thanks go to Jose Antonio Puppim de Oliveira and the Brazilian School of Public and Business Administration (EBAPE) at the Getulio Vargas Foundation (FGV) in Rio de Janeiro for hosting me during my field research. Finally, I thank all the politicians, public officials, academics, consultants, and public and private energy company executives in Brazil for helpful discussions. CONTENTS Paper One Muddling Means and Ends: The Short and Unhappy Era of Electric Power Privatisation in B razil............................................................................................................7 Paper Two The Risk of Reform: Analysing the Effects of Privatisation on Costs of Capital and Prices in the Brazilian Electric Pow er Industry..........................................................................61 Paper Three Mischievous Markets: An Exploration of the Potential Effects of Deregulation on Investment in Brazil's Electric Power Industry........................................................................ 97 6 Paper One MUDDLING MEANS AND ENDS The Short and Unhappy Era of Electric Power Privatisation in Brazil All serious reflection about the ultimate elements of meaningful human conduct is oriented primarily in terms of the categories 'end' and 'means' - Max Weber (1949) 1. Introduction Like its neighbours Argentina and Chile, Brazil based its electric power reform on the orthodox therapies of privatisation and liberalisation. The Brazilian federal government initiated the reforms in 1993 and persevered with them until a lack of private investment in power generation led to a crippling energy crisis and forced the nation into mandatory power rationing in 2001. By 2002, the idea of persisting with privatisation was politically dead. None of the four major candidates in Brazil's 2002 presidential elections favoured continuing the process; not even the incumbent administration's nominee. The results of the first seven years of electric power reform in Brazil are anomalous. Of all the Latin American countries, Brazil was one of the best-placed to benefit from orthodox reforms. First, many Brazilian power companies, especially the generation companies, were technically well-managed even under state control. By enabling a more supportive economic and commercial environment, orthodox reforms should have facilitated even more efficiency and investment. Second, power rates in Brazil were never populist in the traditional sense. Cross- subsidies in the electric power sector favoured large industrial consumers at the expense of residential and commercial customers. Political resistance to price rationalisation-which is generally one of the key barriers to implementing orthodox reform-was therefore unlikely. Third, the Brazilian federal government had already completed the basic and politically difficult reforms before initiating privatisation. Power rates had been raised and many of the state-owned power companies had begun streamlining their workforce, forcing hundreds of employees into retirement. Fourth, Brazil was one of the most important economies in Latin America, which should have facilitated the foreign investment necessary to cement orthodox reforms. Finally, the Brazilian government and policymakers had a wide range of experiences of orthodox reform implemented in other countries in Latin America and Europe from which to learn. Given these favourable factors, orthodox reform should have delivered immediate and self-reinforcing benefits. Indeed, in the first few years of the reforms, it did appear that the reforms were headed in the right direction. Between 1993 and 1995, with the elimination of electricity rate controls, the conditions were set for the recovery of the financial health of the power companies. Subsequently, between 1995 and early 1998, most of the power distribution companies were privatised, many at substantial mark-ups over their minimum reserve prices. By 1998, however, serious problems had begun to appear in the Brazilian electric power reforms programme. Privatisation of generation companies stalled in response to a combination of macroeconomic difficulties, political opposition and investor disinterest. Subsequently, the government's attempts to induce private investment in independent power projects (IPPs) also failed. In 2000, but for some providential rains and an economic slowdown caused by the collapse of the currency peg, Brazil would certainly have suffered power rationing. The administration did not take much advantage of this temporary relief and in May of the following year, warned by the Brazilian National Electric Systems Operator (ONS) that the hydropower reservoirs in most of the country were practically depleted, President Fernando Henrique Cardoso was forced to declare an emergency power rationing. All except the smallest residential customers were instructed to reduce their power consumption by at least 20%. The rationing lasted 10 months and cost the industry at least US$ 5 billion in lost revenue. Estimates of the loss in GDP caused by power rationing varied between 1.5 and 2 percent, which indicates a further loss of about US$ 10 billion to the Brazilian economy. Given the tremendous losses caused by the flawed electric power reform programme, one could logically expect that the government would have used all available means to avoid the rationing. Indeed, the Cardoso administration in Brazil began electric power privatisation with the objective of ensuring sufficient and efficient investment in electric power generation. Yet, by the end of Cardoso's second term, investment in electric power was neither sufficient nor efficient, despite the fact that there was ample warning of an impending power shortage, despite the fact that resources were available to the federal government to promote investment in electric power and despite the fact that state-owned power generation companies were enjoying historically high