Private Finance for  Infrastructure Projects in Brazil

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Private Finance for Infrastructure Projects in Brazil

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1. Private Finance for Infrastructure Projects in Brazil Paulo Correa Senior Economist, ECSPF Europe and Central Asia Region

2. 2 Brazil benefited significantly from the flow of PPI during the 1990s…

3. 3 Mainly in divestiture projects in telecom and energy sectors.

4. 4 But while economic returns have not been commensurate to economic costs in the short term…

5. 5 … they seem adequately profitable when the full term of concession is taken into account (long-turn).

6. 6 …which increases the component related to regulatory risk. Brazil has one of the highest opportunity costs of investing in infrastructure among Latin American countries (9 percentage points higher than Mexico and 10 percentage points higher than Chile, in 2004).

7. 7 What is regulatory risk? Investments in infrastructure industries have large sunk costs and a high degree of asset specificity (i.e., their assets cannot be easily transferred to other lines of business (Williamson, 1985). There are also important economies of scale involved and a high political content as infrastructure investments involve a large numbers of consumers, stakeholders and voters. Because investments are sunk and politically sensitive, politicians may see a chance to act opportunistically, requiring new targets or imposing extra costs to regulated firms after investments are made. Given that assets are not easily transferred to alternative activities, investors imperfectly adjust to this new business environment and the new conditions translate into lower returns to investment or, simply put, into capital expropriations. Faced with the risk of administrative expropriation by future governments, private investors are discouraged from financing infrastrastructure projects (Henisz, 2001; Henisz and Zelner, 2002).

8. 8 Delegation of powers as an attempt to curb regulatory risk Governments have thus to credibly committing to secure property rights inter-temporally. One solution to this dilemma involves the delegation of authority to independent regulators. By delegating powers to independent regulatory agencies, the executive assures private investors that it will not be able to arbitrarily intervene in the market and expropriate rents, once investments are sunk (lowering interest rates or administratively expropriating investors through lower tariffs). By relinquishing short-term interests, political actors can minimize the risk of expropriation (regulatory risk), reduce the costs and increase the availability of private capital. Stability of rules and credibility are key ingredients of this environment.

9. 9 What should be delegated ? The degree of delegation reflects the degree to which the executive and or the legislative seek to bind their hands in order to acquire credibility (Levy and Spiller, 1996; Spiller and Tiller, 1997). To be effective, delegation should involve most or all those attributes that directly affect returns to private investments or the cost of capital (e.g. One clear attribute is the management of tariff setting and tariff readjustment). The contents of delegation are embedded in sector laws and/or concession contracts. Attributes and rules should be clearly defined.

10. 10 How should delegation be enforced ? The content of regulatory enforcement is important if the objective is to reduce the risk of expropriation. Some flexibility in sector laws and concession contracts is also inevitable and desirable (not all contingencies can be anticipated) and the use of sound regulatory reasoning is necessary. Effective enforcement of concession contracts and sector laws will require some pre-conditions to be met (structure of regulatory governance) The risk of expropriation reduces when four pre-conditions are in place: Autonomy (political and financial) for decision making; Decision-making rules that promotes technical decisions and stability; Access to regulatory tools; and Accountability (to reduces the chances of continued legal battles from unhappy stakeholders).

11. 11 Summary/Framework

12. 12 Legal Framework and Policy The power sector, private investment is often hindered by unsolved legal loopholes, incentives embedded in the design of energy auctions, and stranded costs generated by recurrent changes in sector legislation. T The current legal framework for natural gas is unable to generate supply contracts suitable for thermal plant operation in a predominantly hydropower system and it was ineffective in curbing anticompetitive behavior – two needed steps to unleash opportunities for private investments in the sector. In logistics, factors deterring private investment in the sector include the five-year delay of the second phase of the federal road concession program, a paralysis of the non-truck highways decentralization process, and an interruption of the port reform. In water and sanitation, regardless of the solution for the allocation of awarding rights in the sector (i.e., the “poder concedente” problem). Despite recent progress, the remaining obstacles in environmental licensing should be further reduced; the impact of courts’ revision of regulatory decisions on regulatory risk should be mitigated; Collaboration among public institutions involved in the concessioning/regulatory process should be improved, especially the roles of Ministério Público and Tribunal de Contas da União.

13. 13 Contract Design Recent history of contract renegotiation of infrastructure concessions in Brazil shows evidence of “excessive” government-generated renegotiations. Brazil had a greater proportion of concession contracts renegotiated (41 percent) than the LAC region (30 percent). Roughly three-fourths of the renegotiations were initiated by the government, compared to one-quarter in LAC. The average time until the first renegotiation occurs is also lower in Brazil than in LAC. Renegotiations were initiated because of tariff revisions and changes in investment plans or needs. The probability of renegotiation increased when regulation was embedded in a contract (not in a sector law), management of contract was not done by an independent regulator; and the use of the lowest tariff as the concession awarding criterion.

14. 14 Contract Design Concession contracts is further complicated by the definition of concession objectives and risk allocation. The 1999 exchange rate devaluation contributed to lower returns on infrastructure services in 1998-2003 as prices of telecommunications, energy, and water services in Brazil declined in real terms (when measured in U.S. dollars), contrary to most LAC countries. A second factor was weak enforcement of tariff policies caused by an incomplete regulatory framework or political interference. A third factor may be the persistence of non-technical losses, particularly in the electricity and water sectors. Another important cause of the low profitability of infrastructure concessions was the high investment levels in the initial years. Appropriate allocation of risk, particularly exchange rate and coverage objectives consistent with adequate rates of return (with cost-effective subsidies used to cover more ambitious social objectives) are central issues.

15. 15 Regulatory Enforcement: overview Without adequate regulatory governance, good sector laws and well-designed contracts will be poorly enforced, increasing regulatory risk and the cost of capital. A survey of 21 regulatory agencies in Brazil in early 2005 showed that most of the general elements for good governance transferable by law seem to have been put in place (Correa et al 2006) The challenge, then, is to develop the more detailed attributes that could not be covered by law, and create the appropriate conditions to effectively enforce them (improve regulatory goverance).

16. 16 Regulatory Enforcement: Autonomy Def. The appropriate delegation of legal attributes would be irrelevant if enforcement is not isolated from short-term political influence. Insulation from private sector interests, however, also plays a role as decisions by captured regulators tend not to be sustainable overtime. Two devices (i) tenure and staggered mandates for regulators [not-coincident with the executive]; (ii) financial independence. (Smith, 1997c). In the majority of cases, directors’ positions are tenured but in a surprisingly high number of agencies (7 out of 21), directors can be dismissed for a vague reasons (such as “threatening the agency’s integrity”). In most agencies directors’ terms do not coincide with that of the executive; the exception is three state agencies (AGERBA, ARCE, and ARPE). Despite the existence of legal attributes providing for autonomy, 13 agencies declared that the executive (ministry or governor) made very highly” or “highly” effective attempts to intervene in the agency, with direct interventions being reported in the case of 8 agencies (2 federal and 6 state agencies). 17 agencies declared they had financial autonomy to control their own expenses throughout the year and in only 2, the government was the single source of revenues.

17. 17 Regulatory Enforcement Decision-making rules Def. Procedural requirements or pre-existing rules limit the range of feasible choices available for the regulator’s, protecting private investors from the abuse and misuse of discretionary power (Smith 1997b). Procedural requirements may also contribute to induce deliberative rationality, strengthening coherence and predictability of law and contract enforcement (Stern and Holder 1999 and Noll 2001). Compliance with “due process” reduces the risk that regulator’s decision be reversed by court, increasing the sustainability of the regulatory system (Berg 2001). In assessing the decision making process, the decision-making rules (how decisions are reached -- majority rules or consensus) are a key aspect (Smith 1997c). How much precedent binds future decisions, inducing deliberative rationality and strengthening coherence and predictability of law and contract enforcement, is also of importance (Berg 1998). Equal relevance can be placed on the extent to which it is required that decisions be explained in written documents, as it helps to establish a record that sets a foundation for consistent implementation of the law (Guasch and Spiller 1999). Finally, the legitimacy of regulatory decisions requires that the stakeholders have equitable access to the decision-makers.

18. 18 Regulatory Enforcement: Decision --Making Rules The main voting rule used by regulatory agencies to make a decision is simple majority. Only two agencies (ANATEL and ARTESP) rely mostly on qualified majority, while two other agencies (AGEPAN and CSPE) use both rules for different types of decisions. Directors have veto power over the board’s decisions in only two agencies. Most agencies allocate cases among their directors on the basis of either their areas of specialization or the decision of the director-general. In almost all cases any director can obstruct a case after it has been assigned. For almost all agencies formal documentation is legally required, decisions should be documented in writing and supported by technical analysis. Among the 18 agencies that are formally required to document their final decisions, only 7 regulators are additionally required to cite jurisprudence. Only in the case of six regulators, decisions are taken without previous communication and discussion among board members. In addition, only in 3 (out of 18) agencies, a legal apparatus prohibits informal meetings of directors with stakeholders . Legislation provides for public participation in the case of 17 agencies and 15 regulators reported that such participation has led to changes in the agencies’ decisions.

19. 19 Regulatory Enforcement: Tools and Personnel The large majority of regulators declared to have the appropriate legal means to enforce the regulation and request information. The majority of agencies declared to have access to basic regulatory tools while Mmore sophisticated tools specially related to economic regulation (i.e. models for benchmarking firm performance) were less frequently available In terms of staff, approximately only 20 percent of the agencies’ personnel had been admitted by public examinations. Salaries offered by agencies for top technical and managerial positions were considered to be much lower (at least 25 percent lower) than the salary of the attorney general or the state finance secretary by 12 of the 21 surveyed agencies. In 18 agencies, the average employment time of technical staff was superior to two years, indicating a relatively low turnover. 9 agencies employed personnel with master’s degrees, in which case they represented, on average, 4 percent of the staff members in that category. Only 6 agencies had employees with PhDs (representing 2 percent of their staff).

20. 20 Regulatory Enforcement: Accountability Congress and state legislatures exert some control over 17 agencies, Via: requiring public hearings, summoning the directors, and making official requests for explanations. Public hearings do affect agencies’ decisions, as they have caused changes in decisions at least once in 15 agencies. In one-forth of the agencies, at least one case has been settled by the Supreme Court.

21. 21 Regulatory Governance Index The federal agencies ANATEL, ANEEL, and ANP are the three best-ranked regulators, while three state regulatory agencies (ARSEP-RN, AAGISA, and ARTESP) presented the lowest indexes. The ranking changes when only questions related to actual practices (as opposed to formal attributes) are used .

22. 22 Regulatory Governance: Decomposing attributes by agency characteristics Older agencies have on average better access to regulatory tools and accountability mechanism. However, no statistically significant difference was found between old and young agencies for the autonomy and decision-making attributes. One possible explanation is that autonomy and decision-making are defined at the inception of the delegation process while the other two may “evolve” as a result of learning and adaptation.

23. 23 Regulatory Governance (final) In sum, most of the general elements for good governance transferable by law were put in place and the challenge is related to the development of those more detailed attributes that could not be transferred by law, as well as to their effective enforcement. Despite the fact that regulatory independency is granted by almost all sector laws, more than half of the regulators reported that the Executive branch interfered at least once in their final decision. Also, the majority of regulators (eighteen) were formally required to document their decision-making process but few (seven) were required to cite jurisprudence in support of their decisions, which affects the consistency of their decisions over time. Few agencies provided for legal sanctions against informal meetings between directors and stakeholders, which may also affect the fairness of the decision-making process. Only one-fifth of the agencies’ personnel, on average, were admitted by public exams. Salaries offered by agencies for top technical and managerial positions were considered to be much lower (at least 25 percent) than the salary of the attorney-general or the state finance secretary (used as benchmarks) by 12 of the 21 surveyed agencies.

24. 24 Conclusions Reinvigorating private investment in infrastructure in Brazil requires transforming infrastructure needs into private opportunities by reducing the cost of capital and allowing long-term returns commensurate to these costs In attracting back private capital, this report argues that Brazil needs to: eliminate remaining regulatory bottlenecks and policy uncertainties in selected sectors, design infrastructure concessions to avoid “excessive” renegotiations, simultaneously guaranteeing an adequate rate of return for investors and protecting consumers’ welfare, and strengthen the quality of the regulators for technically sound and coherent decision-making processes.

25. 25 In addition, Brazil should improve the process through which public investments in infrastructure are selected, implemented and evaluated. Brazil could fully explore existing opportunities for private participation by: advancing the second phase of highway concession program (2,700 km and an expected flow of resources estimated in US$ 9.3 billion); aligning the incentives of the energy auctions with possibilities of private participation; and, streamlining the awarding process in railways, given that most of the fundamentals for private participation seems to be in place in that sector. Policy Implications

26. 26 Innovations? PPPs? Buying credibility through PRG?

27. 27 Improve Regulatory Governance ? “Lei das Agências”: good initiatives (separating policy formulation from regulatory enforcement); some risks (performance contract) and some important missing points (improving the quality and consistency of decisions). (See Correa and Pereira Neto, 2005) Other Controversial aspects: How much formality should be imposed? Information asymetries; informal meetings and the quality of decision. The revision of regulatory decisions by the judiciary: at which level?

28. 28 Further questions (and research) How regulatory inputs affect regulatory outputs? (Modeling reguators’ decision) Regulatory inputs and industry performance (regulatory governance and private investment in infrastructure). Simplify and update the survey periodically.

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