The Brazilian Energy Industry Analysis

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Executive summary

The Brazilian energy industry is at crossroads. Decades of planned control by the government have resulted in market inefficiencies. Firms that are dominant in the industry rely on non-innovative approaches to deliver low-cost electricity to consumers. However, the power tariffs in Brazil are among the highest in the world, causing the government to make additional policy interventions, such as putting price ceilings. According to the economic predictions of the effects of a price ceiling, the policy has only served to cut production because it makes businesses less profitable. At the same time, the Brazilian electricity industry structure has two segments. The government controls about 70 percent of the market with companies bidding for long-term contracts, while the other 30 percent is a pure market with no barriers to entry and market equilibrium pricing strategies.

The government-controlled market is an oligopoly, but companies awarded long-term contracts also enjoy some monopolistic powers. Overall, the Brazilian electricity industry is not globally competitive, and it has been a hindrance to the economic performance of the country. Overreliance on hydroelectric power exposes the company to erratic weather patterns. This report also evaluates the business strategies of Electrobras. The discussion reveals that the company is waking up to the fact that government protectionist measures are dwindling in favour of market-based forces. Therefore, Electrobras is looking for expansion and has continued to make internal reforms to improve its overall operations efficiency.

Introduction

Brazil is the tenth largest energy consumer in the world. It takes the number one position in South America and has a regulated energy industry where the government plays a significant role. However, the industry is an oligopoly, with only a few players dominating the market. The structure is shaped by the transition from government only policies to market-based policies that rely on forces of demand and supply, as well as rational economic ideologies on resource allocation. The oligopoly situation is promoted by the dominant nature of two companies, which also happen to be state-owned. They are Petrobas and Electrobras.

The Brazilian economy witnessed rapid growth in the 90s and 2000s decade because of various economic reforms implemented by successive governments. The power sector in the country got a new regulatory framework in 2004 and has since increased its overall electricity generation capacity (IRENA 2011). By 2013, the installed capacity of electricity in Brazil was 127,000 megawatts, with hydroelectric power contributing 86,000 MW, while fossil fuel contributed 37 MW (Saraiva 2012).

Analysis of the structure of the industry

The new structure of the industry is hybrid, which came after the 2004 electricity sector reforms. On one hand, there is a regulated sector where the state influences investments, pricing, and consumptions, while there are producers and consumers relying on the market to deliver and obtain electricity, on the other hand. New public and private companies can come up with power generation and distribution projects under the new structure (Alston 2010).

Despite the significant reforms and the invitation of the private sector to take a major role in the electricity industry, the state still dominates the generation and distribution through its two major state-owned companies. It makes the industry operate like a duopoly, although the existence of smaller players makes it an oligopoly. The biggest electricity company in Brazil is Electrobras, with a market share of 36 percent, while all the private corporations have a combined 36 percent market share. Other state-owned energy companies have about 26 percent of the market for electricity generation (Nielsen 2013).

There is an open access to the power transmission system in Brazil. All players generating electricity have a right to connect to the power grid and be able to sell their electricity to consumers. Therefore, the market is perfectly competitive in terms of distribution access. However, the actual market for electricity operates according to mixed economic conditions. Firms can be either in the regulated market or the single player market. In the first case, there are procured auctions that seek to incorporate all electricity producers to meet the demand for the country in the next five years. The contracted companies are allowed to pass any costs they incur to the consumers. At the bidding stage, all firms have equal chances of becoming electricity generators in the country. However, the winning company takes a monopolistic position for the contractual period after winning the bid, and it can cover the electricity generation needs of a particular segment of the industry.

The following table shows the total installed capacity of megawatts in Brazil, with various power sources.

The conditions of entry into the industry and actual operation parameters are affected by various energy regulating agencies. Brazil has a number of state institutions whose policies and mandates affect the generation, transmission, and pricing of electricity, thereby limiting the ability of market equilibrium forces to influence many aspects of the electricity business. The policies are also responsible for altering the business outlooks of both public and private companies in the industry. In most cases, the institutions work to ensure that the state-owned companies do not abuse their privileges and the private-owned companies have adequate room in the market to exercise their strategic choices and thrive in their business in the long-term (ASTRO 2009).

The regulators support compliance studies regarding different planning criteria. They approve the technical compliances of a particular project and then run the auctions. The central systems operator evaluates the technical compliances regarding bid requirements and grid procedures. It studies and analyses the integration of new installations into the existing transmission system and works on any transmission system reinforcement needs.

The electricity transmission company in Brazil operates as a monopoly. It is controlled by the ministry of mines and energy and plans the transmission systems expansion. However, it relies on input from the private sector companies that bid for transmission system contracts in publicly held auctions. The country mostly follows a build and operate or build and transfer model for particular concession periods. In the end, all transmission assets transfer back to the state, and private companies only act as contractors (Aura 2013).

The use of auctions limits the revenue that firms can earn. It also allocates the duration of contracts for their operation. The industry regularly evaluates the cost of the interconnected system and then sets the rates that companies assisting in interconnection will get and what generators will pay for access to the transmission system. Generating companies pay a fixed access charge, with new generators paying the previously known rate for ten years before moving to a negotiated rate regime. The fixation of rates in the industry ensures that companies have no power to influence electricity pricing, and market equilibrium situations do not persist.

In consideration of the above provisions of the Brazilian electricity industry, many firms evaluate the prospects of joining the industry at auctions. Firms have to take a long-term outlook when considering the return of their investments. They have to be sure that the money invested to win auctions and fund their generating capacity or fulfil their transmission contract obligations will be a considerable fraction of the total payments they expect to receive during the period of their concession (Saraiva 2012).

With the auctions being the only competitive avenue in the industry, firms only innovate to reduce costs, but not to defeat rivals. There is no need to protect market share, as auctions and allocated projects predetermine it. Moreover, there is no explicit choice of products to offer in the market. Firms have to comply with what the regulators and other relevant state agencies seek as part of their auction participation requirements. With agencies placing cap values on actions, there is a tendency to match it with action results as shown in the figure below.

The consequence of a heavily regulated electricity industry has caused various market inefficiencies, leading to rampant power crises in the country. Private and public companies are not able to act fast to meet changing trends in demand. Instead, they have to wait for interventions from regulatory agencies. The project parameters have changed and the companies taking up new contracts have no choice but to limit their strategic actions to the provisions of their contracts by the time auctions are concluded. Beneficiaries of the system have been electricity generators that have no obligation to produce a specified amount of energy, based on their contracts.

On the other hand, distributors feel the most pinch in the inefficient market situation because they have to pay more to get power from companies that have surplus production, despite the fact that regulations place eventual cost caps. They can only pass to consumers in certain circumstances. Overall, the Brazilian electricity industry is imbalanced. The imbalances are the primary source of inefficiencies in firms and across the industry. Consequently, consumers have been experiencing unstable power prices in the last few years, as distributors and producers work on short-term strategies to meet demand and respond to cost challenges.

Unfortunately, only 30 percent of electricity supply in Brazil is sold to the market under free market conditions. The other 70 percent is sold to government agencies, based on long-term contracts that span two to three decades (Rochas & Teixeira 2014). With such contracts and fixed pricing, the industry is mostly unable to influence innovation and cannot enhance efficiencies.

Contribution of the sector to the economy

The structure of the Brazilian electricity industry has been a major hindrance to economic development in recent years. In the past, the overall costs of production remained stable and within the amount stipulated in long-term contracts. However, many of the hydroelectric power sources have been depleted over the years, or they are on their way to depletion. Thus, their electricity production efficiency has diminished substantially. Brazil is facing a situation where marginal increases in power generation only serve to cover the gap related to increasing demand, while existing supply is dwindling due to a lack of innovation. Consequently, new entrants in the market are opting for the short-term market that has become very lucrative, rather than going for the build and operate concessions with the government.

In 2013, the government moved in to cut the cost of electricity for consumers by compelling electricity producers that were operating government-owned power plants to reduce their prices. Eventually, such a move makes economic rationale, given that it will lead to the growth of the economy. Cheap power lowers the cost of production and makes goods manufactured in Brazil cheaper in the export market. With more exports, Brazil can obtain a favourable balance of payments by having exports that exceed import values. Overall, the countrys gross domestic product increases, while its currency gains value because of the increase in foreign exchange inflows.

Eventually, cheap energy contributes to economic growth. Companies pay taxes for their respective inputs, which contribute to the fiscal revenue for the government and fuel government expenditure. However, the strategy pursued by the Brazilian government agencies is flawed. Cheap energy comes at a greater cost to the overall structure of the industry. In the last few years, the companies showing interest in the countrys energy industry have only been looking at the short-term contract. Without prospects for long-term power production investments, Brazil will remain a reactionary country to its power needs. It will be unable to compete favourably with its peers in Latin America or Asia, who are also relying on cheap power to attract investments and grow their economies (Orihuela 2013a).

The reliance on spot power prices to fill the electricity supply gap of low-cost producers hurts the Brazilian economy because it increases the overall cost of power. Unfortunately, government policy is keen on lowering the cost of electricity. In addition, it does not consider market forces and their role in determining production efficiencies. Rather than stimulate competition in the industry and allow the prices take a natural turn, the government initiates monopolistic practices of firms and promotes inefficiencies. Nevertheless, the electricity industry continues to fulfil a crucial role in economic development in Brazil.

Evaluating the contribution of the electricity industry in Brazil to the countrys economy must take into consideration other economic situations prevalent in the last two decades. The lack of competition in the market before the reforms in 2004 ensured that state-owned companies were the largest in the region in size, with various subsidiaries in the electricity industry. Therefore, they played a huge role in determining the energy price inflation in Brazil. For example, Electrobras controlled the biggest share of the electric power generating, distribution and transmission facilities. Unfortunately, years of dominance did not help the company to become more efficient in its production systems or distribution; instead the company was growing into an oligarch, but divesting its interest in other non-energy related endeavours (Mobius 2012). Overall, it was contributing to a loss of competitiveness for the Brazilian economy. However, the situation changed with the introduction of reforms.

Currently, the electricity sector is unable to follow through with its diversification to other sources of power to maintain low costs of production and boost supply. The current volatility in prices has become both a cause and an effect of the industrys inefficiencies. However, the companies that will dominate the short-term production targets and those that will rely on spot prices dominated by the market forces of demand and supply will become very competitive in the coming years.

Volatile prices have caused an adverse impact on many industries in Brazil, with the aluminium industry being one of them. The country is the eighth largest aluminium producer in the world and has to compete with China, USA, and Australia. The production in the Brazilian aluminium industry has been the lowest in the recent years because of high power prices, which worsen an already bad situation of low global metal prices (Anjumohan 2014).

Critical appraisal of sustainability targets of the business plan

Electrobras (Centrais Electricas Brasileiras SA) is a Brazilian state-owned company, which is an important player in the countrys electricity industry. The company was most affected by the government policy that cut the cost of electricity to consumers. It is an important low cost producer of electricity and relies on long-term government contracts in the operation of hydro dams (Reuters 2014). The company has been a beneficiary of the rising demand for electricity caused by increased growth of the Brazil economy in the last decade. The present company that concentrates on generating electricity was also part of the original Electrobras that had an interest in distribution and transmission. The company commands the hydroelectric power market, which contributes about 70 percent of the countrys electricity supply. Currently, the company has to find innovative ways of increasing its revenue because most of its production prospects are tied to long-term government contracts, while new power generation projects rely on the power auction bidding results.

SWOT Analysis of Electrobras

Strengths

Currently, the company operates more than 120 hydroelectric plants. It also has thermal and wind power plants generating more than 40,000 MW of electricity. It has a capable staff of 25,000 employees. The company receives favourable treatment from environmentalists and is unlikely to be affected by environmental policies to cut pollution because a majority of its installed electricity generation capacity is based on hydroelectricity technology. At the same time, the company actively involves itself in environmental sustainability programs in Brazil as part of its corporate social responsibility strategy. A dominant position in the growing market for electricity puts Electrobras in a favourable position to expand and increase its revenues.

Weaknesses

The company only serves the Brazilian market. It relies on the protective measures of long-term government contracts to safeguard itself from market competition. It remains vulnerable to changes in the Brazilian electricity market and government policies. The company has an enormous debt, whose repayment program makes the overall value of the business diminish. The company may not be able to service its debt obligation because it faces a potential need for additional funds in the future for expansion. Another disadvantage for the company is that even with the forced reduction in power tariffs, the Brazilian power remains relatively high in the market, yet the company is still not very profitable with the current rates. This shows that it is quite inefficient in its operations and has made poor strategic choices in the past, which are jeopardizing its ability to turnaround to profitability. The firm made subsequent quarterly losses in 2014 and 2013 (Trevisani 2014).

Opportunities

Expansion beyond the Brazilian market can help the company in diversifying its profit sources. The Brazilian government is looking at the prospects of having consumers pay more for electricity to reverse the adverse effects that a previous policy had on the main low-cost power producers. The companys stock price has been showing investor optimisation in the past few months since the announcement by the Brazilian finance minister. The proclamation that consumers will have to pay more is positive news for the sector because it is the first step of the government to embrace market-based policies, rather than going with populist policies that served to hurt the industry in the past (Edgerton 2014). With a return to market forces, investments and business strategies by Electrobras that have a sound market basis will receive appropriate positive returns and lead the company to long-term profitability.

Threats

Major threats come from increased competition in the private electricity generation market, where independent power producers rely on the market equilibrium. Should the state-controlled face reforms and open up to market forces, Electrobras may be unable to cope up with competitors. Government policy intervention in the price of electricity will continue to create an unfavourable trading environment for Electrobras because the company has limited options for passing on the costs to consumers. The Brazilian government seeks to keep consumer electricity prices low. Therefore, it is forcing the electricity generating companies to absorb costs and cut down on their profits. Forced reductions in prices hurt the companys revenue and make its stock less valuable in the market. Therefore, the company enters into a weak position for seeking funding from external commercial sources (Electrobras System 2010).

Communities around the country are waking up to realize their rights and have increased pressures on the government and companies like Electrobras to renegotiate contracts signed without their involvement, yet projects constructions interfere with their ecosystems (Challenge 2009).

Porters Five Forces Competitive analysis

Power of suppliers

Suppliers have considerable power because they affect the profitability of power generating companies with the pricing of their inputs or services. However, they are not organized; therefore, they are not a major force to influence the business strategies of firms in the industry (Eldring 2009).

Power of buyers

Consumers have limited power, as they have to purchase electricity at specified tariffs. However, they can organize and protest for the government to intervene.

Competitive rivalry

Competition is low in the government-controlled segment of the market, but high in the spot price segment. Firms operating long concessions have security of tenure and fixed prices for their supplies.

Threats of substitution

Power generating companies in Brazil face low threats of substitution when one is observing the market from the perspective of low-cost power generators versus the spot price short-term power generators. The low-cost producers provide distributors with power at lower prices; thus their electricity receives first consideration. When there is a shortage, distributors opt to buy from the short-term power generators whose prices are dictated by market forces (Pearson 2012).

Threat of new entrants

New entrants have to start with low production capacities and cannot compete with established companies in the industry adequately. However, they have the potential of disrupting prices by introducing new technologies to cut production costs. The new entrants pose some threat to the established companies, given that the determination of fixed contract prices relies on market averages in costing. In addition, the entry of new players favouring the short-term electricity market over the long-term contract method may compel the government to change its industrial policy. This may affect the existing players negatively, as they have already defined their business strategies based on the current market situation and their significant size limits their ability to respond to market changes.

Electrobras Business Strategy

The company made plans that would assist it to survive future shocks in price fixing after suffering revenue loss due to government intervention to fix prices in the electricity generation market. The first strategy was to make the company lean so that it could easily respond to changes in market conditions and reduce its costs of production. The move included the voluntary retirement of about 17 percent of its workers to cut down its wage bill (Orihuela 2013b). The company realized that wages were a significant fixed cost for its business, and the only way to reduce them was to have a smaller number of employees. Cutting the number of workers helped the company to shield itself from government labour policies that would compel it to pay more for workers compensation packages (Stringham 2012).

Electrobras has begun divesting out of the Brazilian market by launching a wind power project in Uruguay as a partnership with the countrys national electricity transmission company (Baida 2015). The investment outside Brazil is in line with the companys vision of becoming a multinational with enough capacity to lead the expansion of the Brazilian electricity sector and to leverage the sustainable development of the country (Electrobras System 2010).

The company is increasing its investment in the electricity sector by relying on different funding sources, including the option to renew existing concessions at lower rates. The company is also mulling the possibility of detaching itself from its affiliate distribution businesses that do not align with its core strategy of power generation and transmission. The company is also implementing the national electrical energy conservation program to reduce waste and fight the costs of its investment as a way of ensuring that its business strategic choices are sustainable (Barnes & Pennwell 2012).

Conclusion

Some informed conclusions arise out of the Brazilian energy-sector outlook, with a particular focus on electricity. The market structure is an oligopoly in its government-controlled segment, which makes up about 70 percent of the market. The other segment, which is comprised of the electricity generating companies, is perfectly competitive. Meanwhile, transmission and distribution enterprises in the industry have a monopoly and oligopoly market structure respectively. The power sector is a major contributor to fiscal revenue in the Brazilian economy. Moreover, it sustains business activities that lead to growth in the countrys gross domestic product.

However, the input of the industry is wanting. Brazil strives to compete with other emerging nations, but it faces a challenge of high electricity tariffs caused by rampant inefficiencies in its main electricity generators and populist policies of previous governments. The mixed economy strategies that rely on government interventions in the industry also lead to related inefficiencies in production. Nevertheless, the industry is a major employer and is likely to shift to a free market structure in the future, as the government realizes the need to adopt market-based policies.

Reference List

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Trevisani, P 2014, Brazil power company Electrobras wont need capital increase this year, next. Web.

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