Brazil: A sporting chance

Author: | Published: 1 Sep 2010
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Many people would say that there has never been a better time to invest in infrastructure in Brazil. Economic development in Brazil over the past decade has stimulated internal consumption, and the growth in Asian countries and closer commercial relationships between Brazil and these countries has increased demand for Brazilian agricultural products and commodities such as iron ore.

With growing demand for Brazilian products both to supply the domestic market and international trade, the demand for ports, roads, railways, pipelines and other logistics solutions has also increased dramatically. There is also a greater call for energy supply to power Brazilian industry and consumers.

After the Brazilian financial crises of the 1980s and early 1990s, major infrastructure investments in Brazil stalled. With the economic stability provided by the real, the economy started growing again but subsequent investment programs did not keep up with this growth, causing bottlenecks in a number of areas that are now becoming critical to the country's continued and sustained development.

Adding to this, Brazil has been chosen to host the 2014 World Cup, and Rio will host the Olympic Games in 2016.

If this were not already enough, Brazil has also made significant oil discoveries in the past few years and has identified potentially massive offshore oil reserves in the ultra deep waters of the pre-salt layer that could turn Brazil into one of the largest oil producers in the world.

However, this conjunction of very positive factors and excellent prospects for Brazilian economic development also entails some difficult challenges: how to build the infrastructure required to solve the bottlenecks that impair Brazil's growth? How to ensure that the investments required for the World Cup and the Olympics are available and on time? How to take advantage of the offshore oil exploration opportunities?

For all of these, Brazil will need to attract more private investment. Major financing is required and a stable regulatory framework to attract long-term investment is a must. However, in some of the affected areas, regulation is changing, and private investors may have to chart troubled waters until the new regulations are sufficiently clear and tested, because these novel frameworks are evolving as we speak and yet market pressures demand that investments be made now. Deep-water oil exploration in the pre-salt layer looks set to alter Brazil's role in the global energy economy dramatically, and many players want to be part of that process.

Investment opportunities

The federal administration launched a major investment program called the Growth Acceleration Programme (Programa de Aceleração do Crescimento – PAC) two years ago, and, even before the first phase of the program has been fully disbursed, a second phase has already been announced, with planned investments of approximately $546 billion from 2011 to 2014. Post-2014, the government plans to invest a further $360 billion in infrastructure, totalling more than $900 billion. In addition, the energy infrastructure expansion plan recently released by the Brazilian Ministry of Mines and Energy has planned investments of $542 billion until 2019, aiming to achieve production of 429.9 million tonnes of oil equivalent.

According to estimates from the Brazilian Ministry of Mines and Energy, the power sector will require an additional $122 billion in investment by 2019.

The private sector is also targeting oil and gas, power generation, telecommunications, transportation and water and sanitation services. According to a recent BNDES (the Brazilian development bank) survey, the private sector plans to invest $176 billion in infrastructure over the next four years.

World Cup

For the World Cup, it is estimated that $46 billion of investment is required in infrastructure, and for the Rio Olympic Games the forecast is that an additional investment of $16.5 billion will be required to overcome deficiencies in logistics, transportation, sanitation and power. Except for the power sector, which the government has been actively stimulating over the past few years through regular energy auctions, those other areas have been lacking significant investments for many years.

To meet FIFA requirements and stimulate the investments required for the World Cup, a special tax regime has recently been introduced that exempts the renovation, expansion or construction of football stadia from a number of taxes in Brazil until 2014, including those levied on the importation of machinery, equipment and materials to be used in building new arenas or renovating existing stadia.

Housing

The government's Minha Casa Minha Vida low-income housing initiative should receive $40 billion in investments. This program aims to help reduce the housing deficit that lower income families have been facing. In addition to this official investment program, the private construction sector has been investing heavily in new housing developments and demand is huge in all economic classes, as the changes in long-term housing financing have made it possible for many more families to become home owners.

Transportation

Airports, in turn, are set to receive $3.5 billion in investments over the next four years in renovations, expansions and new construction. There is already a severe strain on the main airports of Brazil not only in terms of passenger capacity but also in import and export terminals.

Many private sector analysts believe that the only way to solve the airport issue before the World Cup would be to hand over at least some airports to private initiative but, as yet, the Brazilian government seems unwilling to surrender government control of Brazilian airports.

Another concern for the World Cup is what is being dubbed the mobility blackout. Most Brazilian cities do not have reliable and efficient public transportation systems. To deal with this problem, the Brazilian government has launched another investment program called the Mobility Acceleration Growth Program (PAC da Mobilidade), with planned investments of $4.5 billion for 47 projects in the 12 cities that will be hosting World Cup games.

There are additional $10.3 billion investments planned for urban transportation solutions such as subways, light rail transit (LRT) and bus rapid transit (BRT) systems . BRTs are seen as an especially viable short-term solution for the public transportation problems that most large Brazilian cities face, as they can be quickly implemented and are cheaper to build than LRT or subways. However, many analysts point out that subways are the only long-term solution for mass transportation in large cities, despite the higher costs and technical complexity. The Rio government has announced its intention to expand the city's subway system in time for the 2016 Olympics, and other cities such as São Paulo are also investing heavily in subway expansion projects.

Water and sanitation

Even though a law was passed in 2007 defining rules for investments in sanitation to help promote private investment in this sector, implementing sanitation programs is still a challenge and most sanitation services are still performed by state-owned companies rather than by private investors. In order to auction sanitation projects to private players, the municipalities need to develop and approve their sanitation plans, which not all major cities have done.

To approve these plans, they need to carry out technical studies, develop projects, hold public hearing sessions and approve the plans in the local legislative body. This process is difficult, especially for the smaller and poorer municipalities that are most in need of sanitation investments. As a result, auctions have been delayed and in 2009 only four concession contracts for sanitation services were signed. As additional barriers to private investment, private companies, as opposed to public entities, are not allowed to receive government funds for sanitation projects, and not all Brazilian states allow private companies to hold sanitation service concessions.

However, the push to have the country ready for these major international events should help the implementation of sanitation projects, at least in the 12 states that will be hosting the World Cup. The PAC program reserved $23 billion for investments in sanitation, and multilaterals such as the IDB and the ICF have been looking at sanitation projects with interest. These factors should help overcome some of the hurdles mentioned above.

Nuclear energy

The Brazilian government has also been setting its sights on nuclear power plants as a way to diversify the Brazilian energy matrix, which is still heavily dependent on hydroelectric power. Although Brazil is proud to boast one of the most renewable energy matrices in the world, the concentration on hydropower leaves the country exposed to power shortages in case of droughts, especially since the more recent hydropower projects have been planned as run-of-the-river plants due to environmental concerns and, therefore, have smaller reservoirs.

Uranium exploration and nuclear energy generation are state monopolies in Brazil, and to implement the Brazilian government's plans for nuclear power, the government has revived Nuclep, a state-owned company which will be in charge of the Angra 3 nuclear power plant. However, there is increasing pressure for the state monopoly on nuclear to be made more flexible to allow private investment in this sector.

Other energy sources

In addition to this renewed government interest in nuclear energy, other alternative energy sources, such as wind power and biomass, are also being promoted with sector-specific auctions. The current back-up energy of Brazil is still being provided mostly by heavy fuel, coal and more recently natural gas-powered plants, but increased investment in alternative energy, especially wind power, for which a national industry is being created, should alter this mix in the long run.

Ethanol and biofuels

Brazilian ethanol, produced from sugar cane, is more efficient and less polluting than corn-based ethanol. According to the US Environmental Protection Agency (EPA), sugar cane ethanol reduces carbon emissions by up to 61% as compared to gasoline, a significantly higher reduction level than for corn ethanol, which is responsible for an average 20% reduction only. In February 2010, the EPA designated sugar cane ethanol as an advanced biofuel. It is expected that this formal recognition should help boost exports of Brazilian ethanol to the US and other countries.

The Brazilian government, in its turn, has been sponsoring the expansion of the local ethanol market for a number of years now, with the result that over 90% of new cars manufactured in Brazil are flex-fuel and can run on ethanol, gasoline or any combination of the two.

Green fuel policies in a number of countries portend huge potential for the ethanol trade and the ability to use sugar cane bagasse, which would otherwise go to waste, to run co-generation facilities is an excellent way to reduce production costs, create extra revenues for ethanol and sugar producers with the sale of any energy surpluses, reduce waste and generate energy from a renewable source.

To foster this growing sugar cane bagasse energy generation business, the Brazilian government has been hosting power purchase actions specifically targeting biomass sources. As a result, a large number of sugar and ethanol producers have started to invest in energy generation as a significant element of their business plans, not just as a sideline activity.

A by-product of sugar cane ethanol may also attract significant investments over the next two to three years. Researchers are developing a green substitute for naptha, which is oil-based, as a material for production of chemical by-products and plastics. Ethanol supply to chemical industries may rise from the current one billion to 10 billion litres over the next five years.

With excellent prospects for ethanol exports, growing internal consumption, and developing markets for sugar cane by-products, there has been significant activity in the ethanol business in Brazil.

The international financial crisis delayed some new projects and the rise in sugar prices in the international market had a negative impact on ethanol production in 2009. However, by 2019, Brazilian ethanol production should reach 64 billion litres.

With the global economy picking up there has been a flurry of activity in the sugar and ethanol sector, with foreign investors acquiring stakes in the local sugar cane industry and a consolidation of the sector with larger players acquiring smaller businesses. Some examples are the acquisition of Brenco by ETH, which is part of the Odebrecht group, and the acquisition by Cosan of Exxon assets in Brazil and more recently an announced joint venture with Shell. This consolidation trend is changing the face of the ethanol business in Brazil, moving from a small, mostly family owned industry to a sector that is slowly being taken over by large corporations.

Project finance for the sugar and ethanol business is still challenging due to the peculiarities of the business, but, with larger players involved, it is becoming easier to structure project finance for the sugar and ethanol businesses.

Financing of projects

It is believed that this volume of investments may help Brazil recover from a 30-year slump in infrastructure investments. Nevertheless, the specific challenge facing the country and outside investors lies heavily in structuring and financing these projects.

The role of BNDES

Due to the credit crunch of the past two years, liquidity in the international markets dried up and Brazilian infrastructure projects had to rely mostly on funding from BNDES, the national development bank, and other regional development banks and development funds such as the Marine Merchant Fund (FMM) administered by BNDES, which finances projects in the shipping industry, a sector that has been experiencing a recent boom to cater to the offshore oil and gas business.

Over 50% of BNDES loan disbursements from January to October 2009 were made for infrastructure projects. For instance, BNDES will finance 80% of the investment for construction of the 11,000 MW Belo Monte Power plant auctioned earlier this year to a consortium comprising private investors, state-owned companies and pension funds, at an expected cost of approx. $11 billion as of August 2010. BNDES should also play a major role in the financing of the $19 billion high-speed train that will link Rio, São Paulo and Campinas, which is expected to be auctioned in 2010.

With the increased liquidity of commercial banks, the tendency is that for future projects there will be a natural balancing out of BNDES lending with commercial bank lending.

PPPs

One of the ways in which infrastructure projects may be structured is the creation of public-private partnerships (PPPs), which serve as an alternative to the more traditional concession and authorisations regimes via auctions that have been the norm in Brazil where public sector investments are concerned.

Even though PPPs were introduced into the Brazilian legal system as long ago as 2004, and despite the PPP law being meant to facilitate project finance, for example, by introducing into the Brazilian legal system the concept of step-in rights (which did not exist under Brazilian law until the federal PPP Law (Law 11,079 of 2004) was enacted), a number of difficulties have hindered the implementation of PPPs in Brazil.

There were difficulties in providing government guarantees, until guarantee funds were created, although the rules for some of these funds are still rather unclear. Also, a lack of public officials within the local and federal government levels with the experience to structure this type of project was perceived, a problem which the financial sector is now trying to address, to which we shall return.

Another difficulty has been that federal PPP law prohibited the federal government from providing guarantees or making voluntary transfers of resources to Brazilian states and municipalities in case the sum of payments under PPPs contracted by such states or municipalities exceeded 1% of the current expenses of the state or municipality in the previous year. For poorer states and municipalities, this threshold was very low and effectively prevented them from entering into PPPs that exceeded this limit. In recognition of this problem, in August 2009, the PPP Law was amended to raise the threshold to 3%.

In an attempt to facilitate the process of structuring PPP projects, BNDES, Banco do Brasil and seven private financial institutions formed the Estruturadora Brasileira de Projetos – EBP, the Brazilian Project Structuring Company. EBP's mandate is to structure PPP projects and bring together government representatives and private investors. In August 2010, the EBP has worked successfully on structuring the project to auction the renovation and management of the Mineirão football stadium in Belo Horizonte, Minas Gerais, one of the stadia where World Cup games are to take place.

Nine Brazilian states are developing 43 projects worth $6.7 billion. One of these is a $970 million sanitation project in Rio. The first federal PPP project is also being launched this year, a $114 million irrigation project in the state of Pernambuco.

It is expected that, with the World Cup and Olympic Games ahead and with a change in the culture of public services in Brazil, PPPs may finally take off as a means to realise some of the potential for infrastructure investment over the coming years.

Changes in regulatory regimes

Even though there are investment opportunities in infrastructure in Brazil that have not been seen for many decades, some challenges still await investors seeking to tap into these markets.

As Brazil explores market expansion opportunities, the Brazilian government has been reviewing the regulatory regimes of certain sectors in Brazil and, while some changes may benefit foreign investors, others bring concerns, as they imply greater state control and unknown consequences.

Aviation

Among the changes that are being discussed, one that may benefit foreign investors is the potential easing of restrictions in the domestic aviation market to foreign investors. Currently, foreign investors are not allowed to hold more than a 20% interest in Brazilian aviation companies. The local market has been attracting significant interest from foreign players. The domestic market is currently dominated by a handful of companies with very little competition among them. There is, however, a bill of law in the Brazilian Congress that would allow foreign investors to hold a stake of up to 49% of domestic airlines.

Allowing international investors to enter the Brazilian market with more significant shares in local companies could improve services and stimulate competition. LAN Chile airlines has recently purchased a stake in TAM, the Brazilian airline. Other international airlines have expressed an interest in the local market and if the bill of law is approved, which is expected to occur in 2011, the domestic aviation market could face significant changes.

Mining

Another regulatory change that is being discussed is a change in the Brazilian Mining Code that could alter the mining exploration regime quite significantly. The government has not yet released the bill of law that the Ministry of Mines and Energy is preparing for public review but, from presentations that the Ministry has made to introduce the new plans, some of the highlights of the new proposal are that (i) individuals would no longer be able to obtain exploration licences; (ii) some areas would be treated as relevant national interest areas and would be subject to special tender procedures; (iii) the concept of a minimum investment requirement would be introduced in exploration licences, and the licence holder would be subject to fines if the requirement were not met; and (iii) a standard concession contract would be adopted which, among other changes, would include minimum local content requirements, a similar policy to the minimum local content requirements of the oil and gas industry, and would limit exploitation for up to 35 years (possibly extendable).

The government had also initially proposed the increase of governmental royalties (Compensação Financeira pela Exploração Mineral – CFEM) but, for the time being, this proposal has been lifted, presumably to facilitate passing the new law in Congress, although this issue has been a recurring subject in debates among government representatives and the mining industry.

Ports

Although there is huge interest from private players in investing in ports and terminals, the development of this sector has been negatively affected by uncertainties in the current regulatory framework, which is very new and as yet incomplete.

Pre-salt layer oil exploration

Recent discoveries in ultra-deep waters off the Brazilian coast in what is called the pre-salt layer indicate that there may be massive oil deposits in offshore basins. Brazil could, as a result, become one of the largest oil producing countries in the world, but the investments required to exploit the pre-salt layer are estimated to range from $400 billion to $1 trillion.

Despite the size of the investments required to exploit the pre-salt layer, the Brazilian government has decided to adopt a new exploration regime for this zone, in order to give the government greater control and a larger share in the exploration of the pre-salt, which are considered low risk investments.

After significant debate over alternatives for exploration regimes, the government has decided to support the production-sharing model but the law approving the new pre-salt regulations has not yet been approved in the Brazilian Congress. The debates over the new law have been heated and politicians have decided to wait until after the presidential elections of October 2010 to approve the new regulations.

With the production sharing model, the federal government will retain ownership of the oil extracted from the pre-salt zone and will compensate the exploration companies in oil. While this regime gives the government greater control over the exploration of the pre-salt layer, the government also bears the risks of exploration. With disasters such as the Gulf of Mexico oil leak, this could represent a substantial liability for the Brazilian government to take on.

Although the law introducing the new regime has not yet been approved, the state-owned company that will manage the federal government's interests in pre-salt oil production has already been created. The new entity will manage the production-sharing agreements and monitor the exploration activities.

Many private sector companies have complained that the new exploration regime reduces incentives for private investment in the exploration of the pre-salt layer, however, determining what the incentives are going to be for private investors and whether they will be sufficient to entice them to take part in the pre-salt exploration venture will depend on the details of the new regulation.

In the meantime, Petrobras has announced a $224 billion capital expenditure investment program for 2010 to 2014, of which the bulk is dedicated to deep-sea oil exploration.

Natural gas

For many years, the exploitation of natural gas is Brazil was of secondary concern. Brazil relied heavily on an abundant and cheap natural gas supply from Bolivia but, with increased demand for gas and political instability in Bolivia, the Brazilian government has decided to promote investments in the natural gas sector in Brazil.

However, in order to foster investments, a regulatory regime was required that set out clear rules on which private investors could rely. In order to attract such private investment, a law was passed in the Brazilian Congress in 2009 to regulate the treatment, processing, storage, liquefaction, regasification, commercialisation and transportation of natural gas (Law 11,909 of 2009, the Gas Law).

The Brazilian Gas Law has established a regulatory framework for the natural gas industry in Brazil, but this framework is as yet incomplete. The Gas Law established an innovative concession regime which coexists with the authorisation regime under the Brazilian Oil Law (Law 9478 of 1997) that has been used until now, in order not to alter existing contracts. Under the new Gas Law, the concession contracts will be subject to bidding procedures and the original owners of the transportation infrastructures will be entitled to an exclusivity period.

There is, however, a constitutional issue that has not yet been resolved: pursuant to the Brazilian Federal Constitution, Brazilian states have monopoly over piped-gas distribution within state boundaries. However, the new Gas Law has liberalised access to gas transmission and distribution, which will reduce the states' exclusive right to regulate distribution through pipelines. This conflict will undoubtedly generate some discussions and may hinder projects due to the legal uncertainty surrounding this issue.

In any event, the new Gas Law is a significant step forward to promote the natural gas sector in Brazil, and renewed private sector interest in this area is starting to pay off: OGX, one of the companies in Eike Batista's group, has recently announced the discovery of natural gas inland reserves in the state of Maranhão which may hold 10 to 15 trillion cubic feet of natural gas.

Significant investments and a change in public policies will be required to effectively distribute this natural gas throughout Brazil and create consumer markets for all this natural gas production. Nevertheless, the prospects for the natural gas industry in Brazil are very bright.

About the author

Ana Carolina Barretto is a lawyer at Veirano Advogados based in Rio de Janeiro, Brazil. She has been a member of the firm since 1997, and coordinates the energy and infrastructure practice group. Ana specialises in project development and finance, focusing mainly on the energy and infrastructure sector. She has represented sponsors, lenders, EPC contractors and equipment suppliers in connection with the acquisition, development, financing, construction and operation of a number of energy and infrastructure projects in Brazil, including wind, ethanol and hydro power in the renewables sector, heavy oil, gas and coal power plants, shipyard and vessel construction, mining and logistics projects. Ana holds a law degree from the Pontifícia Universidade Católica do Rio de Janeiro, a Magister Juris degree and a Master of Studies in Legal Research degree, both from the University of Oxford. While at Oxford, Ana was a Chevening/FCO scholar.

Contact information

Ana Carolina Barretto
Veirano Advogados

Av. Presidente Wilson, 231 / 23º andar
Rio de Janeiro - RJ - Brasil
CEP: 20030-021
Tel: +55 21 3824-4747
Fax: +55 21 2262-4247
Web:www.veirano.com.br

About the author

Pedro Aguiar de Freitas is a senior partner at Veirano Advogados. He came back to Veirano in 2009 after more than 20 years, returning to the firm where he started his career. Before joining Veirano he held the position of general counsel and secretary to the board of directors of Companhia Vale do Rio Doce, one of the largest business conglomerates in Latin America, for six years. Pedro also held the positions of general counsel of Brasil Telecom, general counsel of Organizações Odebrecht and senior counsel at the International Finance Corporation. He started his career with Veirano (which was then the Rio de Janeiro office of Baker & McKenzie), having also practiced in Chicago at the B&M headquarters. Pedro is a board member of several organisations, including the Mining Committee of the International Bar Association, where he serves as a secretary, the Latin American Forum of the International Bar Association, Fundação Getúlio Vargas, and the Office of the President of Brazil’s Council of Economic and Social Development. Pedro practices in the corporate, arbitration, natural resources, mining and project financing areas.

Contact information

Pedro Aguiar de Freitas
Veirano Advogados

Av. Presidente Wilson, 231 / 23º andar
Rio de Janeiro - RJ - Brasil
CEP: 20030-021
Tel: +55 21 3824-4747
Fax: +55 21 2262-4247
Web:www.veirano.com.br