Case Study: Power Reforms in Brazil

During the 1980s, Brazil’s economy was characterized by low growth and macroeconomic imbalances. Growth averaged about 3 percent and inflation was high, averaging 272 percent. Fiscal policy was expansionary, with the overall budget deficit averaging 5 percent of GDP during the period and reaching 7 percent in 1989. The weak fiscal performance led to an increase in net public debt from 24 percent of GDP in 1981 to almost 40 percent in 1989. These deteriorating conditions put pressure on the authorities to alter Brazil‘s import-substitution policies and liberalize the economy (Giambiagi and Moreira, 1999).

Privatizing the power sector was part of the authorities’ reform efforts in this area and was attractive for three reasons. First, privatizing some of the assets of the sector held out the promise of raising substantial revenues for the treasury and clearing debt due to the federal government off the books. In 1993, this external debt contracted by the electricity companies amounted to almost 25 percent of Brazil‘s external debt. Second, selling off the state-owned distribution companies meant that a significant amount of state-level debt owed to the national government would be paid. Third, the federal government believed that it would be difficult to raise sufficient amounts of capital on its own to invest in the facilities needed to meet growing demand. Electricity investment dropped by almost half, in the 1990s, relative to the decade before.

Other sector-specific factors also motivate the privatization. These included high construction costs incurred because of cartels among contractors; excessive employment; and high power losses the system. Finally, private distribution companies would establish tariff structures that were more reflective of costs.

The performance of the sector in the 1980s was poor and provided the primary impetus for structural change. A number of factors contributed to this weak performance, including the regulatory framework for determining prices. This was determined by the Planning Secretary of the President‘s Office. Price adjustments were influenced by the desire to contain inflation and were unrelated to developments in costs and the need to ensure an adequate rate of return to capital. This approach to pricing resulted in declining electricity tariffs in real terms and undermined incentives for improving productivity. It led to a worsening of the companies‘ financial position and an increase in external debt to finance expansion of the electricity supply. As a result, by 1993 debt accumulated in the CRC (Conta de Resultados a Compensar) reached US$26 billion in 1993, which was absorbed by the central government in the same year. Assuming this represented the accumulation of losses over the preceding five years, the subsidy to the electricity sector had averaged 0.7 percent of GDP per year in 1987.

Figure 1: Brazil-Key Macro-Economic Indicators

Source: Sources: International Energy Agency; World Development Indicators, World Bank; and World Economic Outlook, IMF.

Reforms of electricity pricing

The overall plan devised for the power sector was for all assets to be privatized to the fullest extent possible. In order to remove constraints for privatization, in 1993 the requirements of uniform national tariffs and of a mandated 10 percent rate of return on capital were removed. Significant pricing reforms were also undertaken. To increase the transparency of the pricing system in the electricity sector, a law was enacted in 1998 unbundling the electricity sector system.

The government decided to begin the electricity sector privatization with the distribution companies. This was motivated by the fact that substantial productivity gains could be realized in these activities. In addition, the financial problems in these companies had ripple effects in the entire sector, since financially insolvent distribution companies were not paying electricity generation companies. Fixing the finances of the distribution companies and making them creditworthy buyers of energy had a positive effect on the power generation sector and helped pave the way for privatizing these assets.

The privatization program took place over a 10-year period from 1993 to 2003 and resulted in a competitive generation market with a number of private companies competing. The distribution sector was privatized under a series of monopoly licenses although over time the end users could obtain third-party access to the grid and the industry was under regulatory jurisdiction.

The 1993 reforms were successful, from a fiscal point of view, in eliminating subsidies. However, the privatization of the sector was not accompanied by a strong regulatory framework. This led to an uncertain investment climate and the suspension in the construction of some distribution lines. The lack of investment in electricity generation, combined with a drought in 2001, caused Brazil‘s hydroelectricity reservoirs to become dangerously depleted. In order to avoid a larger energy supply crisis, the government introduced regulations that forced producers to ration the electricity they supplied to consumers, and allowed distributors to raise their tariff levels to compensate for their losses during the rationing period. These decisions produced a sudden drop in GDP, and a steep increase in tariff levels. This undermined public support for privatization and contributed to a slowdown in progress in liberalizing the energy sector.

Even after the privatization, cross subsidies were maintained. They were designed to support rural electrification and establish special rates for low-income households. But no uniform method to implement these cross subsidies was developed and each concessionaire was at liberty to fashion its own. The result is a potpourri of subsidies whose targeting efficiency is almost impossible to measure.

In summary, the electricity market reform in Brazil was successful in many respects. It eliminated government subsidies to the sector, depoliticized tariff increases, secured the expansion of electricity generation (post-2001), and reduced vulnerabilities associated with the external debt acquired by electricity-sector companies. Mota (2003) evaluated the effects of the electricity sector privatization on supply quality and cost and found that the efficiency gains due to cost reduction were substantial. These were obtained through the reduction, by half, in the number of employees from 1994 to 2000. With respect to the impact of privatization on quality, there has been an improvement in security and availability of energy supply.

Figure 2: Brazil- Macroeconomic Developments and Electricity Subsidy Reforms

Source: IMF World Economic Outlook database and IMF staff estimates.

Mitigating measures

·    Even after the liberalization of the sector, regional cross subsidies remained.

·  A levy on electricity tariffs was introduced in 1993 to subsidize the supply of fuels to the inefficient thermal power plants of Amazonia, a politically sensitive region, and was maintained for an extended period.

·     In 1995, legislation was approved to provide lower electricity tariffs for low-income households.

·     In 2003, the government introduced a program to finance free electricity to 10 million rural people, which is funded by levies on electricity tariffs.

Lessons

The need to correct macroeconomic imbalances can provide political support for reforms. The low economic growth, hyperinflation, and high external debt burden of Brazil in the 1980s forced politicians to react and consider subsidy reform as an option to confront these imbalances.

Controlling increases in electricity prices as an anti-inflationary tool can have adverse fiscal consequences. The adoption of this policy in the 1980s resulted in financial losses for the sector, the accumulation of debt, and underinvestment.

Reforms have a better chance of success with a popular government. After controlling the hyperinflation, which had been chronic for over a decade, President Cardoso‘s administration was able to capitalize on this political support to undertake his agenda for energy sector liberalization.

Targeted social programs can reduce opposition to subsidy reform and assist the poor. Brazil has adopted a policy to reduce the electricity tariffs for low income people and has adopted a conditional cash transfer program, which facilitated the implementation of the subsidy reforms.

Privatization of electricity companies without a strong regulatory framework can have serious consequences and undermine popular support for energy reform. The unclear rules in the first years of the privatization process resulted in low levels of investment and contributed to the energy crisis in 2001.