Investors Feel Squeeze

Brazil is failing to engage the private sector in infrastructure development by undermining returns. This is a drag on its ambitious and urgent growth program.
The fact that revitalizing Brazil’s rotten infrastructure is a centerpiece of the second Lula administration has raised investor hopes for progress before his term runs out in 2010. Toll roads and energy are the two areas to watch because the government already has experience and a successful track record managing such projects. But it has dropped the ball in other priority areas like sewage and sanitation.

Industry experts attending a LatinFinance roundtable in São Paulo in August said they were seeing movement on the PAC, an ambitious program to kick-start Brazil’s anaemic growth with a strong emphasis on infrastructure projects. But they increasingly worry about the meddlesome instincts of the administration. Part of the problem is the belief within many parts of the government that it manages projects more cheaply, quickly and efficiently than the private sector. Politicians see their role as controlling returns rather than incentivizing the private sector, says Daniel DeVito, minister counsellor for commercial affairs at the US Department of Commerce in São Paulo. He adds that the US buyside is keen to invest but wary of falling foul of cumbersome legislation, while also deterred by the reluctance of the government to offer long-term guarantees. And investors are concerned about interference with contracts at the state level.

The idea that the government knows best, coupled with much improved levels of country risk and access to cheaper financing, make the state trim all the fat from contracts, say industry participants. Recent road bids have low implied rates of return that may repel large international players. Rogério Graziottin, a manager at Espirito Santo Investment, says the government is behind the times in its thinking, probably because until 15-20 years ago it was the only investor in the area. This explains an excessively detailed regulatory framework. “They know the private sector is needed. They just haven’t decided what its role should be,” he reasons.

Government Shifts on Road Program
In the latest round of concessions for roads, with bids expected by the end of November, the government’s indicative toll provides an implied rate of return of 8%-9%. Roberto Deutsch, executive director of Infrastructure Business Development at construction and engineering conglomerate Camargo Corrêa, fears this is unrealistic. This and limited pre-conditionality will ensure low-quality applicants, he says. “We’ll see new players come in from very different sectors including investors that don’t have the experience or skills to operate in a concession of this size,” Deutsch cautions.

And because these projects require 20-25-year commitments, even if the government finds bidders, getting financing when margins are so thin could prove difficult, notes Angélica Wiegand, head of structured and corporate finance at WestLB in São Paulo. That is likely to push up the need for sponsor equity to more than 60% to get projects to fly, estimates Silvana Bianco, manager of structured and corporate finance for energy and infrastructure at WestLB. That is high even by Brazilian standards, where projects already require more equity than elsewhere. “We have seen ratios of 90% debt to 10% equity in other parts of the world on our projects. In Brazil, typically at least 30% equity is needed,” notes Fernando Luiz Santos-Reis, director of Odebrecht Infrastructure Investments.

Isaac Averbuch, program director in the Economic Assessment of PPPs unit at the Federal Ministry of Planning, Budget and Management, counters that the individual circumstances and strategy of each bidding company dictates their pitch. Factors that may induce a low bid include a desire to build market share or a tightly-controlled cost structure, he adds. Bidders’ reluctance to reveal their hand makes the auction process complicated for the government, which must also balance two opposing forces: customers wanting the cheapest tolls and concessionaires demanding the highest returns, he says.

Deraldo Mesquita, manager in the PPP unit in the government of the state of São Paulo, says there is no magic, fixed number per project. “Focusing too hard on the return could unnecessarily harm the process all for the sake of a political number,” he adds.

Airport Needs
If there is agreement that roads are in pole position, there is a big question mark over the future of airport infrastructure. The fatal TAM accident in July shone a spotlight on the area and Reis is optimistic that the government will seek private sector help as the need for investment has become so pressing. “We will start to see airport infrastructure and privatization. This will represent a great opportunity and may even come through PPP schemes,” he predicts. Deutsch believes, however, that because the government has neither experience nor plans from which to work in the area, it will be difficult to make up lost time and jump start the process.

The port sector is also contentious, albeit for other reasons. Development of most ports falls under federal government entities, which oversee the development of key infrastructure, such as deepening of channels. A new special secretariat of ports has been announced to put in place plans. It is likely that private investment will be confined to building container terminals for companies and the infrastructure surrounding the port, such as access roads.

PPPs Blocked
The latest round of road projects also show that the government is moving away from using a PPP program in favor of straight concessions. The federal government is no longer sure it even wants PPPs, says Graziottin. “We were more optimistic on this a year ago,” says Wiegand.

That makes all the more important the success of state-level PPP projects, including one to operate a new São Paulo metro line and a road deal in Minas Gerais. São Paulo’s Mesquita notes that the state is also considering a water treatment plant, a train to Guarulhos city with a spur to the international airport, and several projects to improve the capital city’s metropolitan rail systems and service, all through PPPs. Even at the state level there are many limitations, Mesquita cautions. São Paulo is limited to using just 1% of net revenues for PPPs, which need to be considered in the context of the fiscal responsibility law, he notes.

Other states are considering PPPs too. Reis sees opportunities in sewage and sanitation and says the Federal District (Brasilia) and the north-eastern state of Pernambuco are considering PPPs. He is optimistic that progress will be made by those states with room in the budget to accommodate PPPs, but doubts the federal government will take a leaf out of their book. Averbuch notes that that the political make-up of São Paulo and Minas Gerais are very different to the federal government.

Energizing Investment
After a painful crisis in 2001, the consensus is that the government is focused on energy. Averbuch stresses that the administration is determined to push ahead with generation projects – particularly three key hydro projects, two on the Rio Madeira at Santo Antônio and Jirau, and one at Belo Monte – as well as on gas projects. In the interim, the trend is for the development of small scale power generation. This includes hydro as well as an array of alternatives, including offshore wind power and biomass.

Despite the will, the consensus is that the probability of another energy crisis is high. It is a very regulated sector, partly because returns are established in the bidding process and also because of bureaucracy and licensing, says Bianco. That has deterred new investors and leaves energy as the preserve of state-owned companies. She believes the situation could come to a head in the next two to three years, though if smaller projects are completed fast, crisis might be averted. “[If not] this time will be worse because we don’t even have gas because of the Bolivian situation,” she notes. Bolivia has nationalised the hydrocarbon sector, including confiscating Petrobras assets.

Reis sees the possibility of either a downturn in consumption – as occurred in the previous blackout following punitive government consumption taxes – or a full-blown energy crisis. He is not optimistic that the small projects will be a viable stop-gap. They face many of the same licensing and procedural difficulties of the bigger plants but do not have the political clout to be fast-tracked, he adds.

Even if mega dam projects get the green light, there is widespread acknowledgement of the challenges ahead. These include distances from consumer centers, the country’s continued over-reliance on hydro power and licensing. Distance means long, complex and expensive distribution chains need to be built and the generation matrix is still skewed, Deutsch believes. The 2001 crisis and its aftermath showed that Brazil was far too dependent on hydro power and thus rain, he says. Back then some 90% of Brazilian energy was hydro, the highest level in the world.

Not much has changed. “The risk is still the same – if it’s not raining we’ll face the same problems as 2001,” says Deutsch. The takeover by Petrobras of gas and thermal plants highlights the vulnerability of other sectors to hydro competition and regulations.

The sector is also dogged by some strict stipulations, adds Reis. Obtaining environmental and other licenses is exceptionally time consuming. “Environmental licensing is a big problem,” Averbuch admits. “The government is trying to simplify the process.” Under Brazilian law, the person who approves a license can be held personally responsible and face criminal trial. That is why survey after survey is requested, he points out. Foreign NGOs, particularly European, aggravate the problem. “They have double standards. While they acclaim hydro power as clean and renewable at home, they condemn it as environmentally destructive in Brazil,” he says.

BNDES Catalyst
The catalytic role that national development bank BNDES should play in big projects is underdeveloped, panellists agreed. The bank faces specific structural issues although it is making a determined effort to get to grips with project financing. It is very difficult for the BNDES to get involved without corporate guarantees, particularly during the construction phase, points out Bianco. They are likely to work on energy and road projects where they have experience, but will be hard pressed to operate in other areas where they are newcomers, she adds.

The only solution would be to change the operating policies of the bank, allowing the legal department to accept project finance type guarantees in place of corporate guarantees, adds Deutsch. He believes the BNDES will get increasingly involved in projects once the construction is completed and after projects have been successfully tested.

Reis reasons that internal change at BNDES will be driven by the government’s ardent desire to get very large energy projects off the drawing board. “The government’s need to finance its favoured projects will instigate change at the institution,” he says. The BNDES is flexible and it played a decisive role in privatizations, notes Averbuch. As the government needs the BNDES to adjust its role in project financing, it will move in that direction, he predicts.

The other driver for BNDES involvement is likely to be a heating up of competition as interest rates continue to trend lower, with Brazil on the cusp of investment grade. That will close the gap between financing rates from the BNDES and commercial banks, which are slowly achieving the same tenors as BNDES and offering more competitive pricing. “We have seen 12-years in projects and even 13-year loans by banks,” says Bianco.

Wiegand adds that the IDB and IFC, which have both been deterred by currency risk, are looking at ways of mitigating that risk and re-entering Brazil. The ideal would be for all the institutions to work together.
Legal Hassles
Even if projects do attract interest, longer-term difficulties that dog Brazil have not been addressed. Investors’ particular bugbears continue to be bureaucracy and legislation. “In Brazil, we see an excess of regulation. There are just too many rules and legal frameworks which other countries don’t have,” says Reis. There is also complacency in Brazil about its hidebound rules because of the size of the economy. Brazil believes investors should adapt to its rules.

Domestic investors may stay the course, but long waits for project approval means that foreigners do not want to get involved until late in the day and projects look certain, says Stephen Hood, managing partner of Clifford Chance’s São Paulo office. The deadening culture of political consensus means that there’s an “inability for tough decisions to be taken quickly. A multitude of parties gets involved while corruption and the unfaithfulness of parties lead to too much horse-trading and not enough action,” he says.

In addition, international investors have plenty of rich pickings elsewhere in Latin America, says Wiegand. Mexico has a very large concession program and is aggressively raising money, for example. Even within Brazil, there is competition for investment, she adds. The Brazilian state road system needs financing and individual states could well end up competing with the federal government.

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