Since the beginning of electrification in Brazil, the private sector has played an important role. Hundreds of generation projects and local grids were first developed to supply local businesses, and were later consolidated when Paulo Railway, Light and Power Company and American & Foreign Power Company entered the market in 1889 and 1927.
The 1950s represented a shift from the private paradigm, with new expansions propelled by public investments. Noticeably, federal-controlled Centrais Elétricas Brasileiras SA (Eletrobrás) and several state-controlled companies such as Companhia Energética de Minas Gerais (Cemig) and Companhia Paranaense de Energia (Copel) were established.
The electricity market underwent a major restructuring process and was fully reopened for private investments in the 1990s. Complementary reforms were passed in 2004 to increase the security of supply, regulatory stability and competitiveness among agents. Many assets have been already privatised, including most state electricity companies and some subsidiaries of entities controlled by the federal government. Despite this, enterprises such as Eletrobrás, Cemig and Copel, with US$33 billion, US$4.7 billion and US$3 billion of assets respectively, continue to be within the government's control, but are expected to enter into divestiture programmes in the near future.
Under the existing framework, the federal government maintains the power to grant power transmission, power distribution and large hydropower plant concessions, subject to a competitive process, and to grant authorisations to other power generation projects, under the applicable rules. Through different bodies and entities, the federal government also:
- plans expansions (mainly through the Ministry of Mining and Energy (MME));
- regulates, inspects and enforces regulations (mainly through the National Electricity Agency (ANEEL));
- performs settlements in the electricity trade (mainly through the Electricity Trade Chamber); and
- centrally operates the national electricity grid (mainly through ONS, the national grid operator).
Perhaps particular to Brazil is the fact that the federal government assumes a protagonist role, being responsible for conducting all of the electricity auctions needed to match the demand of privatised power distribution companies with the energy produced by independent power producers. It has successfully encouraged the expansion of the power generation matrix while maintaining a reasonable predictability regarding investments and the bankability of projects. Electricity auctions offer excellent opportunities for mergers and acquisitions (M&A) in greenfield generation, both before and after tenders.
What makes electricity auctions effective in Brazil is the fact that power distribution companies are obliged to acquire the energy required to supply their consumers in these auctions. This is to ensure that the power distribution model is not completely unbundled, in the sense that the large majority of electricity consumers, representing around 70 per cent of the demand, are still not free to select their power supplier, and are bound to their local distribution concessionaire. For this reason, they are called 'captive consumers', as opposed to 'free consumers' who can freely choose their suppliers. However, the proportion of free consumers is increasing so substantially that they will become the majority or even the totality of the market in the next decade or so, which in turn will require changes to the government's role in planning the expansion of the power generation matrix.
ii YEAR IN REVIEW
2018 was an electoral year in Brazil and, as expected, investors initially adopted a wait-and-see approach. As the economic reforms proposed by the President, Jair Bolsonaro, have begun to take off, we have observed intensive activity in transactions resuming in the second semester of 2019.
M&A transactions have been successfully carried out in the past few months, among which we highlight the following:
- Enel's acquisition of the power distribution company Eletropaulo, which holds the concession for the metropolitan area of São Paulo and which was formerly owned by AES Group;
- Votorantim and CPPIB's acquisition of the hydropower generation company CESP, formerly owned by the government of the state of São Paulo;
- Siemens' acquisition from Comerc of minority stakes in MicroPower-Comerc;
- Argo's acquisition of Guaporé Transmissora, which was formerly owned by Cobra Brasil;
- Celeo Redes' acquisition of transmission assets formerly owned by Isolux;
- Statkraft Group's acquisition of hydropower plants formerly held by EDP;
- Kinross Brasil's acquisition of hydropower plants formerly held by Gerdau; and
- the divestiture of six power distribution companies held by Eletrobrás.
iii LEGAL AND REGULATORY FRAMEWORK
M&A in the power sector are subject to the general regime applicable to corporate law, in particular to the Corporations Act,2 and to some extent to the Civil Code.3 In the case of divestiture of government-controlled assets, additional statutes may apply, including the Public Procurement Act,4 the State-Owned Companies Act5 and the State-Owned Divestiture Regime.6 Furthermore, when it comes to power concessions held by the government, specific provisions allow for the extension of the validity of concession agreements when in connection with a privatisation process, such as the one that occurred, for instance, during the privatisation of CESP.
Other acts are applicable in particular to the power sector, such as Law No. 9,074/1995, among others. It is worth highlighting Law No. 13,306/2016, which implemented important changes in the power sector legislation, and created a new mechanism whereby ANEEL may approve a change of control of assets undergoing punitive proceedings as a means to avoid the revocation of the applicable power sector authorisations or concessions. This legal mechanism has already fostered several M&A negotiations relating to hydropower, thermoelectric and wind power plants, as well as to transmission concessions, although due to some excesses it can be expected that ANEEL will take a slightly less permissive approach in the future.
For transactions resulting in a change of control, it should be considered whether ANEEL Normative Resolution No. 484/2012 requires the agency's prior approval, or only a notification after the closing of a transaction. Prior approval will be needed, for instance, when a target involves a concessionaire of a public utility such as power transmission and distribution, or when it relates to hydropower plants or nuclear power plants. There is another hypothesis, not yet applicable, referring to power plants owning a 'relevant level' of supply in regulated electricity auctions, under which the definition of the relevant level by ANEEL is still pending.
The regime applicable to changes of control may be also subject to specific language included in the auction rules of a given concession or in the authorisations and concessions of the relevant power assets, to be assessed on a case-by-case basis. For instance, recent transmission auctions have included in their auction rules the new controller's obligation to evidence compliance with the public tender requirements in the case of a change of control occurring before the commercial operation of the facilities.
iv CROSS-BORDER TRANSACTIONS AND FOREIGN INVESTMENT
Foreign investment in Brazilian power sector companies is considerable. Players in the transmission segment include the Canadian group Brookfield, the Spanish group Cobra, the Chinese group State Grid and, more recently, the Indian group Sterlite Power Grid. In the power distribution segment there are, among others, Italian company Enel, Portugal and China's EDP and China's CPFL. In the field of power generation, France's Engie is one of the largest power producers in Brazil, and China's CTG controls relevant hydropower plants formerly owned by Cemig.
In general, there are no restrictions on foreign investment in the power sector, although there are still certain limitations regarding nuclear power sources and the acquisition or lease of rural properties. Private investors are forbidden from directly providing nuclear power on account of the federal government's operational monopoly as set forth in the Federal Constitution. For this purpose, state-controlled company Eletrobrás has a subsidiary named Eletronuclear, which operates two nuclear power plants and has a third power plant under construction (Angra 1, 2 and 3). The government has, however, included Angra 3 in its investment partnership programme, and recently created a committee to study the legal and operational models necessary to enable a partnership with the private sector.
The acquisition and lease of rural properties also pose some practical challenges for entities controlled by foreign companies, which could be required to obtain the prior approval of the National Institute of Agrarian Reform or the Brazilian National Congress, as the case may be, or to adopt alternative possession structures to avoid any limitations.
Traditionally, when the debt market was dominated by government bonds, the Brazilian development banks Banco Nacional de Desenvolvimento Econômico e Social (BNDES) and Banco do Nordeste do Brasil SA were the largest project finance providers, offering subsidised rates for infrastructure enterprises. Recent changes in the macroeconomic conditions in Brazil, and in particular a decrease in government bond interest rates, have made the issuance of debentures in the power sector an increasingly sought-after alternative. That, along with the decrease in the available funding of BNDES and the increase in BNDES tax rates, have made infrastructure debentures exceed BNDES financing in 2018.
Most infrastructure projects in the power sector can be included in a special regime created by Law No. 12,431/2011 known as the infrastructure debentures regime. This regime allows revenue tax exemptions for individuals and reduced tax rates for entities. According to the Debentures Newsletter prepared by the Ministry of Economy, the power sector is the main driver of infrastructure debentures, representing 89 per cent of the 21.6 billion reais emissions in 2018 and 85 per cent of the 17.3 reais emissions in 2019 (up to September).
The success of debentures in the power generation, transmission and distribution segments can be attributed to the fact that the power sector in general has good credit quality and a low occurrence of external events, which brings comfort to investors and, along with the quality of corporate credits and the predictability of income, offers considerable safety. The long-term profile of power sector projects also strengthens the choices for this type of debt.
vi DUE DILIGENCE
Full due diligence is an essential part of M&A transactions in the power sector. Typical due diligence areas will include:
- financial and operational agreements;
- power sector regulations; and
- real estate, environmental, corporate, litigation, tax, labour, social security, insurance, intellectual property and anti-corruption compliance.
It is overall critical, especially for buyers, to assemble experienced due diligence teams, including:
- legal and regulatory advisers;
- specific technical, engineering and environmental advisers;
- financial advisers; and
- any other advisers that might be necessary in particular cases, such as insurance and employee benefits advisers.
vii PURCHASE AGREEMENTS AND DOCUMENTATION
Representations and warranties will include full compliance with the law and no third-party claims or litigation, or a limitation to those specified in an exhibit. Typical conditions precedent to closing include the waiver or approval of financing parties such as lenders and bondholders, and the prior approval of the competition authorities in Brazil and other applicable jurisdictions. In some cases, the approval of ANEEL and power purchase agreement counterparties will be required.
In the transmission and distribution sector, as well as for some large hydropower plants, regulated tariffs constitute the main source of revenue under the financial models, and, therefore, the prospect of variances may make it relevant to include price adjustment mechanisms in the transaction documents. It is the same in the case of power generation sources subject to the concept of 'physical guarantee', which is a number calculated by the MME that directly affects the energy available for sale.
Depending on the stage of a project, buyers will negotiate to attribute to the seller any risks related to construction or to the additional capital expenditure needed to complete the works. Construction risk is an important factor not only due to the impairment to revenues that it may cause in the event of delays or failures, but also due to the possibility that ANEEL will enforce a performance bond of 5 to 10 per cent of the value of the investments.
viii KEY REGULATORY ISSUES
Key aspects that should be considered when entering into M&A transactions in the Brazilian power sector include energy regulation, real estate, environmental, tax, employment, competition and anti-corruption compliance.
From an energy regulation perspective, it should first be assessed whether targets are under special inspection and administrative punitive proceedings, or if there may be events causing the enforcement of performance bonds, decreases in regulated revenues and other relevant liabilities. Furthermore, litigation related to energy regulation topics is relevant in the sector, and should be fully understood and detailed on a case-by-case basis. Investors may require workshops and memoranda to better understand the current framework and any prospective changes to the applicable framework. This may include an assessment of particular points relevant to the financial models, such as the possibility to extend concessions and authorisations and to grant payment due in these scenarios, or the indemnification criteria and timing in the event of termination.
The real estate situation of projects has also proved to be an important aspect. It is not uncommon in Brazil for projects to be structured by developers without formal agreements with landowners, or with agreements that are not agreements with the lawful landowners. This is important, as it is not always possible to secure declarations of public utility, or to force the expropriation of or a right of way over a project's areas. Furthermore, alternative structures for real estate can be assessed in particular cases, such as in the case of foreign ownership or control.
Environmental aspects pose direct operational risks to projects, as a lack of applicable licences may cause an embargo on works. Delays in the obtainment of such licences are not uncommon on the side of the public authorities, and compliance with deadlines on the side of entrepreneurs is essential to maintain the validity of environmental licences, and also to provide evidence to other public authorities or in financial and operational agreements when needed for extensions or other purposes.
Tax compliance with the federal, state and municipal rules should be assessed just as thoroughly as the full structure of projects, as there may be events where special regimes may be disregarded when projects are considered in their context. Depending on the project, a considerable amount of money can be spent on tax litigation and inspections.
Employment considerations normally relate to the joint and several liability generally applicable by the labour courts in Brazil regarding the purchase of establishments or economic groups, and to vicarious liability regarding employers of third-party providers. It is important to seek legal assistance when changing employees' benefits. In the event of privatisations, particular attention should be given to pension funds, as there may be considerable financial obligations for the employer.
From a competition perspective, the competent authority is the Administrative Council for Economic Defence (CADE). Under Law No. 12,529/2011, certain corporate transactions, including M&A, joint ventures and other association agreements, must be necessarily submitted to CADE for prior approval when at least one of the economic groups involved has registered, in Brazil, revenue of 750 million reais in the previous year, and at least another economic group involved has registered revenue of 75 million reais or more. A lack of prior submission, as well as other integration actions before approval, when required, are considered gun jumping, and can cause the imposition of fines of up to 60 million reais.
Finally, an increasingly important topic in Brazil has been anti-corruption compliance, in view of the many points of contact with public authorities required to develop a project. This due diligence should be carried on by legal advisers and, depending on the case at hand, also with specialised investigation companies.
Although not particularly common in Brazil, some of M&A transaction risks can be mitigated using insurance. In these cases, it is recommended to work with an insurance adviser. Other instruments, such as escrow accounts, holdbacks and deferred payments, have been preferred as risk treatments, as well as the establishment of appropriate closing conditions and the allocation of risks under representation and warranties provisions.
x DISPUTE RESOLUTION
M&A in the power sector usually establish mechanisms to request and respond to transaction provisions such as indemnities and price adjustments. When parties fail to reach a consensus under these mechanisms, most agreements contain arbitration clauses requiring that resolution be provided by a panel of a three arbitrators.
Expansion of the free market is part of an agenda to modernise the Brazilian power sector. It was initiated during 2017 and 2018 under the presidency of Mr Michel Temer, and has continued under the current government of Jair Bolsonaro. This includes technological advancements; digitalisation, decentralisation and de-carbonisation; and changes in the country's electricity consumption profile. Other topics under discussion include the portability of bills, retail electricity traders and hourly tariffs.
In this new technological and regulatory context, we have already noticed an increase in joint ventures and M&A transactions in non-traditional areas, such as distributed solar generation, smart grids, batteries and power supply for electrical cars. There are also challenges arising from the shift towards a free market and the consequential diversification of credit risks, which require creativity in the private sector when creating new arrangements for both debt and equity finance.
Sophisticated corporate partnerships with well-structured corporate governance are already being established between developers, investors and consumers, and should become prominent in the near future. All of this is happening side by side with strong M&A activity in traditional segments, and opportunities in greenfield projects in new transmission and electricity auctions. Between 2019 and 2027, the government expects 27 billion reais to be invested in power transmission and 39 billion reais in power generation as follows:
- 59 per cent in small hydro and wind, biomass and solar power plants;
- 29 per cent in thermal power plants, mainly natural gas;
- 9 per cent in large hydropower plants; and
- 3 per cent in storage.
1 José Roberto Oliva Junior is a partner and Julia Batistella Machado is an associate at Pinheiro Neto Advogados.
2 Corporations Act, Law No. 6,404/1976.
3 Civil Code, Law No. 10,406/2002.
4 Public Procurement Act, Law No. 8,666/1993.
5 State-Owned Companies Act, Law No. 11,303/2016.
6 State-Owned Divestiture Regime, Decree No. 9,188/2017.