A Paper Prepared for ABRACE by Ashley C. Brown, June 10, Advice on the Brazilian Natural Gas Market

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1 A Paper Prepared for ABRACE by Ashley C. Brown, June 10, 2014 Advice on the Brazilian Natural Gas Market The natural gas market in Brazil is largely dysfunctional and constitutes a major barrier to the nation s growth and competitiveness. A well-functioning natural gas market in a modern economy will provide users with a reasonably priced product on a reliable yet flexible basis. To accomplish those objectives, the market should afford its participants with adequate access to the system, ease of entry to the market, a wide variety of products and services, meaningful price signals, enhanced reliability in all energy supply, and transparency in the rules and operations of the system. The Brazilian natural market provides virtually none of these benefits. Reform is absolutely essential. While there are a variety of reasons why the market functions so poorly, the focus in this document is not why things may have occurred in the past, but, rather, what needs to be done on a going forward basis to both better provide users of natural gas with more reasonable prices and a greater range of goods and services and to enable economic growth in Brazil. Concentration of Market Power While the natural gas market depends on a central network, pipelines, the commodity business itself lacks any of the characteristics of a natural monopoly. Nevertheless there is a very high degree of concentration of horizontal and vertical market power in the sector, something which is highly undesirable. To compound the problem, Brazil may be the only major economy in the world that allows a single company to essentially exercise monopoly power in both oil and gas. In most of the world today gas and oil compete and discipline prices and services in each sector. In Brazil, gas and oil products and services are linked and controlled by the same corporate entity. Further hindering development is the fact that the same company has a dominant position in thermal generation. While the company with monopoly power, Petrobras, has many critics, the fundamental problem is not Petrobras itself, nor is it necessarily the fact that it is controlled by the state, but rather the legal and institutional arrangements that have allowed it to dominate the market in ways that may or may not serve its interests, but certainly do not serve either the public interest or the long term well-being of the economy. It is important to note in that regard that Petrobras was created to be the national champion in the global petroleum market. Whether or not one agrees with the national champion model, we can all agree that any advantages offered by such an institution are found in markets such as petroleum, which is truly global in scope. Natural gas markets, by their very nature, are local or regional in scope and scale, and the only aspect that is global, liquefied natural gas, is purely marginal. Thus, there is no economically defensible reason to have a national champion in a market that simply is not global. Liberalizing the Concession Process

2 There is nothing about exploring and drilling for natural gas that has monopoly characteristics. Any financially and socially responsible company with technical competence can engage in the business. It stands to reason that if more companies were engaged in exploration and drilling, more extensive geological study would be carried out and more resources brought to market. That principle has already been recognized by the government is regard to other resources in the new mining law. There is no reason not to do the same in regard to natural gas. While governmental oversight is necessary for environmental and safety reasons, as well as to protect the financial interests of the state in the exploitation of underground resources, that does not require the overly burdensome concession process a company has to go through to obtain rights to explore and drill. As a practical matter that process poses a major barrier to new, perhaps more efficient, players entering the market. In fact, global experience has shown that, more often than not, it is the new players, not comfortable, powerful incumbents, who bring innovation and new products to consumers. It was new entrants, for example, who developed shale gas. As a practical matter, those players cannot do business in Brazil because, under the current process of concessions, if they identify new resources, the result is not economic opportunity for them, but rather a bidding process that is likely to deny them the fruits of their labor. That is because Brazil utilizes a process for granting concessions that was originally designed to protect the financial interests on the Portuguese Crown in colonial times, and which, to be fair, does offer a degree of transparency, but which is out of date in a modern world with rapidly evolving technology, explosive growth, and highly sophisticated ways to protect both the public interest and the financial interest of the state. Interestingly, the Government has clearly recognized the need for such reform in the mining sector where it has liberalized the process for new entry. It needs to do the same in natural gas. Companies with the technical and financial capabilities should be afforded to opportunity, with appropriate regulatory oversight to protect safety and the environment and look out for the state s financial interest in underground resources, to seek out new natural gas resources and to have a fair opportunity to gain from successful exploration and drilling, rather than having to submit the fruits of the labor to the vagaries of an auction process. Pipeline Access Another major barrier to new entry into the market is the lack of open access to the pipeline system. While the current gas law envisions open access in the long run, it does not provide it in ways that assure new entrants of their ability to move what they produce to the market. The pipeline is an essential bottleneck facility, access to which is absolutely essential for every market participant. If a company in the competitive commodity business controls access to the pipeline, unless regulated far more rigorously than is currently being done in Brazil, it has the power to keep competitors out of the market. That is why in so many countries, the pipeline business and the commodity business in one way or another, are unbundled. Indeed, in some jurisdictions, companies are prohibited from being in both businesses. There is no policy or practical reason why Brazil should be any different. Interestingly, in the U.S. the natural gas business vigorously opposed unbundling when it was mandated in the 1980 s, industry participants in both sides of the business have found themselves quite satisfied with the results. While the current Brazilian gas law is premised on the assumption that monopoly pipeline access for a few years is an incentive for exploration and drilling, the North American experience is exactly the

3 opposite. Open access provides an incentive for drilling and exploration and assure more efficient and profitable use of the pipelines. In regard to Petrobras current situation with the pipelines, the easiest thing to do, in theory, is to require the company to sell its pipeline business, or, perhaps exit the gas business altogether. That would result in a win win situation. It is a win for Petrobras because the sale will produce a great deal of capital for investment in Pre Sal and other activities and would permit it to focus more directly on its core mission, the petroleum business. It is a win for consumers and suppliers because open access is very likely to allow more gas as well as more diverse offerings of gas related products and services. Even if Petrobras does not sell its pipeline, it could take, or be compelled to take one or two alternative steps to stimulate the market. The first would be to simply open the pipelines up to full access to everyone and be submitted to strict oversight of its real time operations by regulators in order to assure transparency in pipeline availability. A second step which could be taken is to open a secondary market, where the ownership and operations of the pipeline might remain unchanged, but the rights to use the pipeline could be bought and sold among other parties, much like the leasing and sub-leasing of apartments. The latter step would have two benefits. The first is that it would enable the costs of system expansion to be shared among multiple parties. The second is that it would enable both greater access to the pipelines while at the same time, providing investors with an opportunity to hedge their risks in pipeline expansion. The lack of open access carries with it enormous costs for Brazil. Closed pipeline access has a very negative effect on the terms and conditions for the purchase and sale of natural gas. Those terms and conditions must be put on a far more commercial and flexible basis than they are at present. Essentially, reliable supplies for natural gas must be purchased on a take or pay basis, where the buyer must contract for a specified quantity of gas for which he must pay regardless of whether he uses it or not. It is a very primitive form of contracting that more efficient gas markets have relegated to history. It makes fuel costs for electric generators and for industrial users a fixed, rather than variable cost, which both drives up prices for consumers, increases the risk of inflations, and harms the competitiveness of Brazilian industry in the global economy. Steps need to be taken to add diversity to the products and services available in the natural gas market. Open pipeline access would allow for more free trading of gas, so that even customers with take or pay obligations could easily re-sell the gas they did not use, would ultimately enable the establishment of a hub price that would open the door to swapping and derivative products that would allow both sellers and buyers of gas to mitigate their risks and add liquidity to the commodity market. The types of products that are unavailable in Brazil but are available to competitors in other countries, include not only financial and physical swaps, but gas storage, heat rate contracts, and tolling agreements that facilitate and monetize separation between capacity and energy markets in energy intensive industries as well as electricity. While some of these products may seem, on the surface, to be exotic, they have very practical and beneficial effects in making the market more efficient, cutting costs for the users of gas, reducing inflationary pressures, and making the overall economy more competitive. Brazil can simply no longer afford to have a gas pipeline system that is not open to all market participants. Relationship Between Gas and Electricity

4 It is very important to keep in mind the almost symbiotic relation between natural gas and electricity. The fact that most of Brazil s electricity is generated by hydro resources does not diminish that relationship. There are three reasons for that. The first is that Brazil s hydro system depends on large reservoirs that store energy in order to manage seasonal variations in rain and to deal with drought cycles. For a variety reasons, primarily environmental, Brazil has been unable to build reservoirs. Thus, on a going forward basis, the country will have a shrinking ratio of storage to demand. That means that Brazil will need additional generating capacity to reliably meet demand. While wind and solar will play a role, their intermittent nature limits reliance on their availability, and makes it essential that thermal generation fill much of the gap. The second reason is that thermal generation should set the marginal price for electricity, the essential price signal that signals investors to build new generation and which signal consumers of the need to use energy more efficiently. The third reason is that there is more flexibility in siting thermal plants than hydro facilities. That flexibility can be important in improving the efficiency and reliability of the transmission system by adding voltage support, reactive power, and other types of services necessary to keeping the gird operating effectively. For two important reasons, the most practicable fuel for thermal generators in Brazil is natural gas. The fact that natural gas is available to generators primarily on a take or pay basis means that in Brazil, almost unique among the world s major economies, fuel is a fixed rather than variable cost. Simply stated it means that thermal generating plants, rather than being able to buy fuel as needed, must buy it regardless of need. That automatically translates into both higher costs which are ultimately passed on to consumers. Those higher costs are the result not only of gas being available only on a take or pay basis, but also because the lack of flexibility in supply precludes the development of products and services that reduce both costs and risks in electricity. As noted, those products include tolling arrangements, heat rate contracts, fuel trading and hedging. The high cost and inflexibility of fuel supply also makes the risk of apagao much greater. That is because investment in the thermal generation needed to enhance the country s reserve margin is made very unattractive by the largely dysfunctional natural gas market. One other aspect of the relationship between natural gas and electricity is that Brazil is one of the few major economies in which natural gas regulation is linked to oil. In most countries the regulatory linkage is between gas and electricity not oil and gas. That is in recognition of the largely symbiotic relation between those two markets. It also reflects that fact that gas and oil should be competing with one another rather than operating in the same regulatory framework. Brazil has already suffered consequences from the lack of common regulatory oversight of the electric and gas markets in the derating of some thermal generators. It makes eminent sense to bring the regulation of gas and electricity under the purview of the same regulator. Conclusion In summary, reformation of the natural gas market is absolutely essential for the long term economic health of Brazil. The primitive, dysfunctional nature of that market poses a burden that Brazil need not bear. The reform should, as discussed, focus on the liberalizing the concession process, opening up pipeline access, reducing monopoly power in the market, both horizontally and vertically, tightening the

5 and restructuring the regulatory system, and reforming the organization structure of the market so that barriers to entry are lowered in order to enable more participants to add value and innovation.