Leading the way forward in Latin America

Leading the way forward in Latin America

Tatiana Bruce-da-Silva, Fernanda Delgado, and Bruno Moreno*
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Brazil is experiencing a profound transformation in its energy industry, which has tremendous potential. The government is implementing a series of measures to improve its management and attract new investment

*Researchers at FGV Energia, Center for Energy Studies at Getulio Vargas Foundation.

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Brazil is the largest country and economy in Latin America. Those facts alone explain the country’s relevance in the world energy arena. Moreover, Brazil is rich in energy resources, from fossil fuels to renewable energy. In the last few years, however, the country has experienced the worst recession in its history, a recession that has also affected its energy sector. Although the economic crisis is still ongoing, prospects for the country’s energy sector are optimistic since policy makers are implementing a set of measures that have the potential to improve the sector’s management and attract investments.

The energy potential

In order to better understand how Brazil got here, it may be helpful to examine the country’s energy potential. Brazil and Latin America have substantial energy resources. The region is responsible for 21.3 percent of oil recoverable reserves—behind only the Middle East and North Africa regions. Within the continent, Brazil is home to the second largest oil reserves. Regarding natural gas, Latin America accounts for around four percent of recoverable resources worldwide (not including pre-salt reserves potential). Without the pre-salt reservoirs (not certified until now), this amount is not very substantial, especially taking into account that natural gas is the transition fuel to a lower carbon economy, the principal goal of the countries that have signed and ratified the Paris Agreement in 2016. On the other hand, Latin America is rich in renewable resources. The map below illustrates how well suited Latin America is for solar generation. Additionally, the continent is rich in potential for biomass, wind, and hydropower generation. In Brazil, renewables’ participation in the energy mix accounted for around 41 percent in 2015, while worldwide this participation is 13 percent, placing the country ahead when it comes to energy transition. Considering these factors, Brazil has it all: oil to explore and supply, and renewables to accomplish its energy transition. With the discovery of oil in the pre-salt layer in the mid-2000s, the country was very optimistic about the potential for revenue from royalties and special participation from exploration in this area. However, due to the pre-salt low geological risk, the government at the time made some controversial managerial decisions. The regulatory framework chosen for exploring only the pre-salt layer was production sharing, while exploration in other areas remained in the concession regime. This confusing hybrid system contributed to uncertainty regarding how the area was going to be explored, which is not good for business. Moreover, still in the pre-salt area, Petrobras, the Brazilian National Oil Company, was required to be the operator in all exploration contracts, with a minimum participation of 30 percent. This obligation meant that Petrobras had to invest in areas even if they were not interesting to the company, while other companies had to adjust to Petrobras’ pace if they were interested in exploring an area. Furthermore, requirements for local content —the amount that foreign companies must hire locally in order to explore oil and gas in Brazil —were copious and unclear, and in some areas, the Brazilian industrial sector was not ready to fulfill the explorers’ demands. Finally, Petrobras was the de facto decision maker in the oil and gas sector, a task that should be the responsibility of the Ministry of Mines and Energy, the policy maker for the Brazilian energy sector along with the National Council on Energy Policy (CNPE). Petrobras controlled gas pricing policy, following the government’s directives, when it should have been just another market player. Contrary to what one might think, dictating prices was not an advantage for Petrobras: when gas prices were too high, the company had to keep them at a lower level, chipping in to maintain this subsidy to the population, a scheme that helped increase the company's debt. Further, oil prices plummeted in 2014, and Petrobras got involved in one of the worst corruption scandals in Brazil’s history. Since 2015, there has not been a single auction in the sector. In fact, the last auction for exploration in the pre-salt area was in 2013. Mismanagement also affected the power sector. In 2012, the government passed legislation to reduce electricity prices. In the end, however, it created a mismatch between power offered by independent generators and hired by regulated utilities. As a result, utilities had to buy power in the spot market in order to be able to fulfill their demand, losing money in the process. Moreover, the Brazilian power sector relies heavily on hydropower, and droughts have occurred in the last few years, thus thermal power plants, which are more expensive, are being used to fulfill demand. Therefore, electricity prices have increased and will probably increase even further since consumers will eventually pay for the subsidies given in 2012. After all, there is no free lunch in economics, and structural problems were already in place in the Brazilian energy sector when the economic downturn started. For the power sector, the recession has actually contributed to provide some relief since electricity demand shrank with the decline in economic activity. For the oil and gas sector, the long period without auctions proved to be damaging in a sector where reliability and foreseeability are crucial. Last year, a political crisis to which the decline in commodity prices and the economic crisis contributed greatly, ousted the federal administration.

A more market-oriented government

The new government is more market-oriented and is implementing a series of reforms to bring the energy sector in that direction. In the oil and gas sector, a series of measures aimed at bringing stability were put in place. The local content rules have been revised to become less complicated and to better reflect the Brazilian industry’s capacity to provide goods and equipment needed for exploration. Petrobras is no longer under obligation to be the operator in all pre-salt contracts, which will help to improve its financial situation, and the company is restructuring its portfolio, divesting, and cutting costs in order to reduce its debt. The auctions schedule has been resumed, with ten auctions planned between this year and 2019. The areas to be auctioned are onshore, offshore, and in the pre-salt layer (participating in six auctions). A program to develop mature oil fields called REATE is under development. The natural gas market is also being redesigned, targeting greater competition and liquidity. Market and energy analysts are welcoming these changes, which are expected to attract foreign investment and resources. Meanwhile, government intervention in the power sector has declined, and the government is adjusting its rules and regulations to incorporate new technologies that are already under fast development in other parts of the world, new technologies such as smart grids, electric vehicles, and distributed energy resources (distributed generation, demand response, energy efficiency, and energy storage). Hydropower is becoming more unreliable due to several reasons – change in rain patterns, deforestation on the rivers’ banks, and other issues may be affecting hydropower generation and it is difficult to isolate which one is really causing this observed unreliability. In fact, because of the reduction of storage capacity in the National Grid System, hydropower is turning into an intermittent power source in Brazil. Increasing hydropower production by building new hydro plants is not feasible anymore since the frontier in hydropower generation is in the Amazon region, where reservoirs cannot be built. Building run-of-the-river hydropower plants is too costly and not a solution to the intermittency issue when it does not rain. Since expanding this source is not possible, and the power sector is very dependent on it, fossil fuel thermal power plants are being repeatedly dispatched in order to satisfy the country’s electricity demands. Using more fossil fuel thermal power plants to account for hydropower’s variability will potentially give rise to another problem: an increase in greenhouse gas emissions— an issue that the Brazilian power sector does not need to worry about excessively today. Unlike in other countries, electricity and heating emits only eight percent of Brazilian greenhouse gases—in China, the United States, and the European Union, emissions in this sector amount to, respectively, 42 percent, 38 percent, and 35 percent (according to data from the CAIT Climate Data Explorer, World Resources Institute, 2017). In its Nationally Determined Contribution (NDC), under the Paris Agreement, Brazil has committed to reduce greenhouse gas emissions below 2005 levels by 37 percent in 2025 and by 43 percent in 2030. In order to be able to reach those values, amongst other measures, the share of sustainable biofuels and renewables (other than hydropower) in the energy mix must increase to 18 percent and 45 percent by 2030. Hence, using more fossil fuel thermal power plants will contribute to further emissions and may undermine Brazil’s efforts to decarbonize its economy. The alternative would be to increase wind and solar power production, while using the existing hydropower as “batteries” to compensate for these sources’ variability - along with some smaller amount of thermal power plants to guarantee supply. Investing more in energy efficiency would also be a valid option to decrease power load and the need to build new power plants. This increase in alternative power sources and energy efficiency brings another potential for private sector investments, both from within the country and abroad.

The race of foreign investors

All these changes in the Brazilian energy sector are attracting investors from many countries. Because of the recession, Brazilian state companies like Petrobras and Eletrobras, are selling their participation in energy projects. BNDES, the Brazilian development bank that has historically funded many infrastructure works has had to reduce its financial support for energy projects. Moreover, many Brazilian construction companies are involved in corruption charges, so they are also selling their shares in existing energy plants in the power and oil and gas sectors. Their involvement in new future auctions will be reduced as well. Among those moving to invest in Brazil are Chinese companies, which have already invested in the pre-salt layer in 2013—CNPC and CNOOC hold 20 percent of the shares in the consortium that is exploring the Libra area. In the power sector, China Three Gorges (CTG) is the largest private power generator, while State Grid owns more than seven thousand kilometers in transmission lines and has also acquired a utility company. By the way, although electricity demand declined because of the recession, investments in transmission lines to connect new renewable power plants to the national grid are much needed. A recent transmission auction, in April 2017, was considered a success by the government, and other auctions are expected in the future: two more will probably take place this year, and another one in the first half of 2018. Other countries, like Canada, Japan, France, and Italy are also investing in the Brazilian energy sector. The Italian company Enel Green Power is investing in many wind and solar projects – for instance, the company is responsible for the largest solar plant being built in Latin America, with 292 MW of installed capacity. In order to reduce its debt, Petrobras is selling some of its oil and gas assets, which are attracting several foreign investors. A consortium led by the Canadian asset management company Brookfield purchased gas pipelines in the southeast region, the most populous area of the country, where São Paulo and Rio de Janeiro are located. Other Petrobras' assets, like gas pipelines in the northeast region, thermal power plants, and the fuel distribution company, BR Distribuidora, are also being considered for future sale. All the changes underway in Brazil are occurring at a moment when the world energy arena is also experiencing a transformation. With the ratification of the Paris Agreement, most of the world has consented to modify the way it generates and consumes energy in order to reduce greenhouse gas emissions and fight climate change. Investing in renewable energy is also good for energy security. Every country has access to sun and wind energy. This joint effort is unprecedented, and points to a future where energy integration can become a reality—after all, it makes sense to integrate if goals are similar. In Europe, the Energy Union is taking the continent in this direction. In Latin America, however, countries face individual challenges that make it difficult to focus in a broader plan for integration. The case of Brazil, discussed in detail in this article, exemplifies this dilemma. Political and economic issues must be addressed before the country is prepared to deal with sustainability and energy transition. That is the case for Argentina as well: after years of economic crisis, auctions that include renewables projects took place last year. More auctions, that also include transmission lines, are planned in the future. On the other hand, both countries have recently discovered large reserves of fossil fuels - the pre-salt oil and gas layer in Brazil and the unconventional natural gas reserves in Vaca Muerta, in Argentina. Exploring these reserves can generate income and jobs in countries where they are much needed. Hence, even though emerging countries have potential to dictate trends in the future of energy worldwide—as is the case for China and India - in Latin America other social and economic priorities may come before energy transition.

Future prospects

Prospects for development of the sustainable energy sector in Latin America are positive. Latin American countries may be a few years behind in this energy transition process to a cleaner energy matrix, but they will eventually get there. Most of the countries in the region are young democracies, where citizens are still learning their roles, rights, and what to demand from their governments. There exist some free trade agreements and other diplomacy treaties in the area, but because of economic and institutional problems in the last few years they are not very active. Overall, corruption is still a widespread problem in Latin American countries, wasting income resources in a region where they are scarce. Nevertheless, potential is also immense, especially in the energy arena. Exploring these energy resources sustainably is the next great challenge for Brazil and Latin America, but great opportunities will come from it as well. And, as one of the biggest economies in the area, Brazil is well suited to lead this process.