Privatization of Public Utilities: Three Lessons from the Brazilian Experience

June 2008-- Please do not cite or quote. Comments appreciated –

Abstract: Privatization in developing countries has to be fundamentally different from developed countries. This is especially true for infrastructure sectors. In designing this type of privatization in a developing country, policymakers need to be aware of three possible obstacles to reform: broader institutional environment (or deficiencies in it), higher complexity of policy goals, and the intensity of political economy problems. Lack of judicial independence or unstable political systems are problems related to the broader institutional environment. Sometimes countries manage to circumvent these problems, finding alternative ways to protect investors against expropriation and to signal commitment to reforms. But even when these broader institutional problems are addressed, policymakers might still face significant obstacles in dealing with conflicting policy goals. Many privatization processes are motivated by two core goals: raising revenues and increasing efficiency in the delivery of services. In developing countries, a third issue often came into the mix: macroeconomic stabilization plans. These plans influenced the pace and sequencing of privatization in ways that were detrimental to the other two objectives. This type of tradeoffs makes the work of policymakers more complex. Finally, even with the broader institutional environment problem solved, and the tradeoffs between different policy goals worked out, policymakers need to deal with one of the most significant obstacles for reform in developing countries: the resistance of interest groups that benefit from the status quo, and the apathy or lack of power from groups who would support reforms. This political economy obstacle can determine what is feasible and what is not. These three aspects (broader institutional environment, complexity of policy goals, and intensity of political economy problems) are particularly relevant in the developing country context. To illustrate, I discuss the privatization experience in Brazil, and provide some anecdotal evidence from Latin America.

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TABLE OF CONTENTS

Introduction

1. The decision to privatize: three core concerns

2. The Broader Institutional Environment

2.1 The Judiciary a) Judicial Independence

i) Structural Independenceii) De Facto Independenceiii) Behavioral Independence

b) Functionality and Efficiencyc) Corruption

2.2 Lack of Protection against Indirect Expropriationa) Presidential Systems in Latin Americab) Regulatory Agencies in Brazil

2.3 Alternative Ways of Securing Credible Commitmenta) Public Financing of Privatizationb) Alternative Ways of Securing Commitment and their Costs

3. The Rationales and Goals of Privatization: Complex Tradeoffs

3.1 Increasing Efficiency in a Developing Country

3.2 Raising Revenues in a Developing Country

3.3 Raising Revenues for What? a) Paying Outstanding Debtb) Fighting Fiscal Deficitsc) Promoting Macroeconomic Stabilization

4. Political Economy Obstacles

4.1 The Problem of Sequencing

4.2 Establishing a Regulatory Framework

4.3 Establishing Regulatory Institutions

Conclusion

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Introduction

The 30-year process of widespread privatization in Latin America’s infrastructure

sectors has been closely examined in the specialized literature. Since these sectors are

not fully competitive, they require a structure of incentives to ensure that service quality

and prices are similar to what they would be in a free and competitive market. Scholars

and other analysts, therefore, have placed particular emphasis on examining the design

of appropriate regulatory frameworks to ensure the efficient and affordable delivery of

services. This focus on the design of regulatory frameworks, however, seems to have

overshadowed the need to analyze the actual implementation of privatization policies in

the region. This paper will assess a series of factors that motivate or serve as obstacles

to a successful privatization process. I will explain how the broader institutional

environment, coupled with the need to manage conflicting policy goals and political-

economy concerns, can affect the implementation of privatization policies. My

examination will mainly rely on the privatization of the electricity industry in Brazil,1 but

will be supplemented by assessing other countries and infrastructure sectors.

1 Francisco Anuatti-Neto et al., “Costs and Benefits of Privatization: Evidence from Brazil”, Inter-American Development Bank, Latin American Research Network, Working Paper R-455. Available at http://www.iadb.org/res/publications/pubfiles/pubR-455.pdf. (Saying that Brazil has not only one of the most important privatization processes conducted in Latin America, but also one of the largest in the world.)

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1. The decision to privatize: three core concerns

The sale of state-owned companies has often been perceived as a strategy that

should help solve two problems at once: reducing the government’s fiscal deficit by

generating revenues, and improving the efficiency and quality of services delivered by

transferring state-owned companies to private hands.2 Sometimes these two goals can

be pursued simultaneously without significant tradeoffs. In these circumstances, even if

one of the goals is regarded as the prevailing concern, the other may help enhance the

case for privatization.3

Successfully pursuing these goals largely depends on credible commitments by

the government. The government needs to assure private investors that there will be no

expropriation of their investments. If there is no such commitment, efficiency might be

negatively affected because investors are less likely to make investments to improve

services, expand infrastructure services networks or bring new technologies to these

sectors. This commitment is also relevant for the goal of raising revenues – without a

credible commitment against expropriation, investors will apply a discount rate and pay

less for the companies. The broader institutional environment (which includes the

political system, the legal system, and other institutions) largely determines a country’s

ability to provide a credible commitment against expropriation to investors.

Sometimes the goals of promoting efficiency and raising revenues cannot be

pursued simultaneously, despite a credible commitment to privatization reforms. In these

cases, policymakers need to deal with significant tradeoffs: raising more revenues can

come at a cost of undermining efficiency, and vice-versa. The most basic example, and

a rather simplistic one, is when a government needs to choose between either

2 John Vickers and George Yarrow, Economic Perspectives on Privatization, p. 118.3 Id.

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privatizing infrastructure sector companies as monopolies to maximize the sale price, or

breaking up the company and creating competition that improves the quality of the

services delivered, though potentially reducing the revenues collected by the state at the

time of the sale. What will determine which rationale will prevail is the pace, sequencing,

and manner in which privatization is conducted.

Even in an institutional environment in which credible commitments can be made

and tradeoffs between different goals can be worked out, there is still no guarantee of

success. Policymakers are likely to face resistance to privatization from interest groups

that will be preceded by changes in the status quo. This is the problem of political

economy, which can significantly affect decisions on whether and how to conduct

privatization.

In sum, a successful implementation of a privatization plan needs to be designed

with three core concerns in mind:

(i) the broader institutional environment, and how it affects credible governmental commitments;

(ii) the policy goals tradeoff, and how they might force the government to pursue one goal at the expense of the other;

(iii) the political economy obstacles, and how they might not only block reforms, but also foreclose some reform options.

These concerns have already been identified and explored in the specialized

literature on privatization in infrastructure sectors. In this paper, I will show how these

concerns are particularly acute in developing countries. Section 2 will start by discussing

background institutional factors, which are common to many developing countries,

especially in Latin America. I show that there are some ways to mitigate the problems

with the broader institutional environment in developing countries. However, these

solutions are imperfect because under these alternative mechanisms, any reduction to

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an investor’s expected rate of return, no matter how justifiable or needed it is, provides

grounds for compensation. As a consequence, they may come at a high cost for

developing countries.

Given the concerns that institutional factors create for investors, section 3 then

considers the policy goals tradeoff confronted by the Brazilian state. Finally, the last

section discusses how the broader political-economic environment created additional

obstacles that affected the timing of privatizations and their relation to the creation of

regulatory agencies. I will show how in implementing privatization the executive was not

only responding to concerns of investors, but also domestic political realities. This

discussion will lead to the conclusion that in developing countries these three concerns

are closely interconnected, and generally more complex to manage than in developed

countries. I will use the privatization experience in Brazil, with some anecdotal evidence

from other Latin American countries, to illustrate this.

2. The Broader Institutional Environment

One of the biggest fears of private investors participating in privatization

processes is expropriation. Expropriation can happen in a number of different ways.

Takings are the direct from of expropriation. The government takes complete control and

ownership of the privatized company, and does not pay proper compensation. Latin

America has a long history of direct expropriation against foreign companies, with the

most recent episodes taking place in Venezuela. Governments can also expropriate

investors indirectly by reducing or simply freezing consumer utility rates (known as

regulatory takings). While these measures may often benefit consumers of public utilities

(who are, at the end of the day, voters), these reduced rates entail lower rates of return

to investors. This is called the problem of the “predatory ruler”. Another way in which the

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government might expropriate investors is by increasing taxes, which also reduce

investors’ rate of return.

A country that makes a credible commitment against expropriation of private

investments has a better chance of success in using privatization to collect revenues

and improve the efficiency in the delivery of infrastructure services. The risk of

expropriation can affect efficiency by discouraging improvements in the infrastructure

network and assets. If we consider that most investments in infrastructure are “sunk

investments”, we can assume that private investors will be more willing to put their

money in the actual network, or in technology or in employee training, if they have a

guaranteed rate of return in the long term that justifies such investment in the short term.

If the rate of return is not guaranteed, some investors might be deterred from

participating, and others might bid a lower price. For instance, an investor might be

willing to replace an obsolete technology in the landline network if the one-time fixed

cost to do so will eventually pay for itself with the increased profits in the next few years.

This investor, however, may resist doing so if there is a risk that this investment will be

lost at any moment because the government can arbitrarily reduce the expected rate of

return. The same applies to the price paid for the company. If there is any risk that the

company might be taken back, investors might not buy it or they are likely to place a

lower bid. Similarly, if there is risk of indirect expropriation, investors might discount this

risk in the price paid for the company. At the end of the day, lack of commitment will

have a negative impact on both privatization goals.

What is necessary to secure a credible commitment? The literature points to the

enforcement of contracts and protection of property rights. These are the two pillars of

the credible commitment for private investment in general. In the specific case of

infrastructure sectors, which are regulated, there is another layer of protection required:

stability of the regulatory framework. This means that in addition to not breaching

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contracts opportunistically or taking control of companies by fiat, governments will not

arbitrarily or unexpectedly change regulations that determine utility rates (or statutes

governing taxes) in regulated sectors. This does not mean that the regulatory framework

should not allow for changes. Of course, flexibility might allow the government to adjust

to unexpected changes in the market, and might even favor investors if the rates happen

to be very low. The problem, instead, is when this flexibility creates room for

opportunism or arbitrary changes, which can happen if governments decide to cater to

consumers when election time approaches.4

The feasibility of credible commitments lies largely in the broader institutional

environment of a country. To protect property rights, enforce contracts, and guarantee

regulatory commitments, a country needs a robust set of legal and political institutions. A

functioning judiciary is one of the most important institutions to secure these goals. In

addition, a stable political system, with strong checks and balances, can help further

secure these commitments. In developing countries, however, it is generally the case

that neither of these institutions is able to secure a strong commitment to private

investors. On the one hand, courts do not have high levels of independence from the

government (section 2.1). On the other, political systems are unstable or do not have

strong checks and balances or other mechanisms to solve or mitigate the problem of the

“predatory ruler” (section 2.2).

If this is so, what then explains the fact that Brazil and other Latin American

governments were able to sell their utilities and attract private investment with very little

institutional and legal protection? I suggest that there were at least two mechanisms that

were used to decrease the risk to investors. One, used in Brazil, is public financing of

4 Levy and Spiller explore in more detail the complex tradeoff between security and flexibility in infrastructure regulation. On one hand, flexible frameworks allow for necessary adjustments, they also increase the risk of opportunism. On the other hand, inflexible frameworks reduce the risk of opportunism but also reduce the government’s ability to implement necessary regulatory improvements and adapt to unexpected circumstances. For more details, see Levy & Spiller, cit., supra note ___, p. ___.

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privatization. The other, used in Argentina, for instance, is the use of arbitration clauses,

which delegate conflict resolution to a third (supposedly independent) party (section 2.3).

Each of these will be explored in more detail below.

2.1 The Judiciary

There seems to be some consensus in the academic literature on the importance

of judicial independence and competence in attracting private investment to

infrastructure sectors. Scholars and policymakers claim that without effective and

reliable law enforcement mechanisms, contracts will be breached and assets

expropriated.5 This is particularly true with regard to infrastructure sectors. Unlike other

sectors of the economy, electricity, telecommunications, water and other utility services

require large investments in non-salvageable assets.6 In these cases, parties cannot rely

on personal ties, ethnic connections, or other self-enforcing mechanisms,7 and investors

may be unwilling to put their money in these sectors unless a formal third-party

enforcement mechanism is available, or significant risk premiums are offered. These

unique characteristics of the sector suggest that to attract private investment, and at the

same time promote the goals of efficiency and revenue-raising, an independent and

functional judiciary is necessary.8

What is the connection between judicial independence and protection against

expropriation? Investors fear that lack of judicial independence will lead to uncertainty.9

5 To be sure, there are circumstances in which reputation, social norms and other self-enforcing mechanisms will be enough to provide the security required by investors. However, as I explain below, these mechanisms are much less likely to apply in the privatization of infrastructure sectors. For a review of the literature, see Michael Trebilcock and Jing Leng, “The Role of Formal Contract Law and Enforcement in Economic Development”, 92 VA. L. R., n. 7 (November, 2006), 1517-1580, 1537-1573. 6 REGULATIONS, INSTITUTIONS AND COMMITMENT: COMPARATIVE STUDIES OF TELECOMMUNICATIONS (Brian Levy & Pablo T. Spiller eds., 1998) at 5-7.7 Trebilcock and Leng, supra n. 4, at 1575.8 Levy & Spiller, supra n. 5 at 5-7. 9 Such perception is reinforced by a number of studies that found correlations between judicial independence and countries’ economic performances. See Hommes, Rudolf. “Institutional Reliability and Development” in Justice Delayed: Judicial Reform in Latin America, eds. Edmundo Jarquin and Fernando Carrillo. Washington: Inter-American Development Bank and John Hopkins University Press, 1998, at p.48. (“[i]f judges can be random and arbitrary, the legal system becomes a disincentive for private investment decisions, as it compounds economic uncertainty considerably.”).

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Contracts, regulations and statutes will not be enforced in a predictable way, and will

therefore impose unanticipated costs on their investments, thereby reducing expected

rates of return.10

Judicial independence, however, is not all that matters. A dysfunctional judiciary

can increase transaction costs by increasing enforcement costs.11 This suggests that in

addition to judicial independence, effectiveness is also required to attract investment.

Even with an independent judiciary, if cases take too long to be resolved, this might

impose costs on investors, like losing businesses, or having a portion of their assets

unavailable for a long period of time. In addition to judicial independence and

effectiveness, there is also manifest concern with corruption in the justice system. The

specialized literature indicates that corruption can deeply undermine the ability of courts

to protect investors. In fact, empirical evidence shows a negative correlation between

judicial corruption and levels of investment.12

How Latin American countries in general, and Brazil in particular, fare in regard

to these three elements (judicial independence, effectiveness, and corruption) is

explored in the following sections. The general conclusion is that these countries in

general, and Brazil in particular, do not fare very well.

a) Judicial Independence

Despite the consensus over the importance of judicial independence, there is

little agreement as to what it refers to and how it should be measured.13 One commonly

discussed concept is structural independence, which refers to institutional or statutory

guarantees of independence that insulate the judiciary from governmental influence or

10 Klerman, Daniel M., "Legal Infrastructure, Judicial Independence, and Economic Development". USC CLEO Research Paper No. C06-1 Available at SSRN: http://ssrn.com/abstract=877490 11 Douglass North [CITE]. 12 And this seems to be also related to predictability. See Dakolias, M. and K. Thachuk, “Attacking Corruption in the Judiciary: A Critical Process in Judicial Reform” (2000) 18 Wis. Int’l L.J. 353 at p.364. 13 Ron Daniels and Michael Trebilcock, The Rule of Law and Development (forthcoming Edward Elgar), chapter 2.

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manipulation. For example, if a judge depends on a certain political actor to obtain salary

increases, promotions and other career benefits, she would have the incentive to foster

governmental policy preferences to enjoy these benefits.14 Structural independence

indicates which institutional guarantees ensure that judges are insulated from these or

any other types of influence. A second concept is de facto independence, which

considers “the degree of independence that the courts factually enjoy.”15 This concept

considers not only the letter of the law (as structural independence does), but how

effective it is. For instance, in addition to asking whether justices of the Supreme Court

have tenure, it also inquiries into how long justices actually remained in their positions.

Finally, a third concept is behavioral independence, which focuses on the actual

behavior of courts.16 In some instances, courts have behaved as independent bodies

without having the aforementioned institutional guarantees of independence. 17 The

reverse is also true: courts might not behave as independent bodies despite the

existence of institutional guarantees.18 Thus, despite being a good proxy, institutional

guarantees might not be sufficient to measure judicial independence.

i) Structural Independence

With the exception of Chile, structural independence of the courts is not very high

in Latin America.19 Courts in the region rank poorly in most judicial independence studies 14 Daniel Brinks, Judicial Reform and Independence in Brazil and Argentina: the beginning of a new millennium?, 40 TEX. INT’L L.J. 595 (2005) at 597. 15 Lars Feld & Stefan Voigt, 2003. "Economic growth and judicial independence: cross-country evidence using a new set of indicators," European Journal of Political Economy, vol. 19(3), pages 497-527.16 The term behavioral independence was coined by Kenneth Dam who recognizes that “some – thought not all – characteristics that determine how judges act cannot be traced to legal safeguards.” Dam indicates that education, values, prestige of the judicial profession and non constitutional factors that encourage judges to act independently can be considered as possible causes of this behavior. Dam [CITE] at 21.17 The British judiciary is frequently cited as lacking institutional guarantees of independence. Yet, it is generally recognized as an example of independence. See Kenneth Dam, “Institutions, History and Economic Development” (January 2006). U of Chicago Law & Economics, Olin Working Paper n. 271. Available at ssrn.com/abstract=875026. Kenneth Dam, “The Judiciary and Economic Development”, U of Chicago Law & Economics, Olin Working Paper n. 287 (March 2006), p. 22-23. Available at www.law.chicago.edu/Lawecon/index.html. See also Daniel Klerman and Paul Mahoney, “ The Value of Judicial Independence”, 7 American Law & Economics Review 1 (2005). 18 The Asian Development Bank has shown that this is the case for a number of its members. Asian Development Bank, Law and Policy Reform at the Asian Development Bank (2003). [PAGE]19 [CITE]. This is explored in more detail in Prado [CITE] 1.

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that focus on institutional guarantees such as lifetime tenure, no removal without cause,

irreducible salaries, etc.20 In the only study in which some Latin American countries

seem to be performing well on standard measures of structural independence, the

authors are quick to point out that this finding in no way determines whether there is (or

there was at the time when privatizations took place) effective investment protection in

Latin America.21 This is what I turn to next.

ii) De Facto Independence

If structural judicial independence in Latin America is not very good in principle, it

is even worse in practice. Take for instance life tenure for higher court judges. “Lifetime

tenure is desirable for judges because it gives them economic security and frees them

from undesirable pressures, whether from government, politicians or private parties.”22

Nevertheless, in addition to verifying whether the law in Latin American countries

establishes lifetime tenure or not, it is also important to ask what the actual tenure period

is for judges.23

Feld and Voigt, who examined the concept of de facto independence, have

addressed the problem in a systematic fashion, creating eight variables to determine

independence. When measured over the period between 1960 and today, these

variables show that among 62 countries around the world, Latin Americans courts had a

less than stellar performance.24 In the final ranking, Costa Rica was fifth, Mexico was

20 Id. 21 Feld and Voigt, supra n. 15. The authors used twelve variables to rank 36 countries and determine their levels of de jure judicial independence. Latin American courts perform quite well in Feld and Voigt ranking, where the most independent judiciary is the Colombian and the third most independent is the Brazilian. However, the authors themselves are quick in dismissing the importance of these findings by claiming that the relevant variable for economic development is de facto independence. 22 Dam, supra p. 113-114.23 As the Argentinean case shows, often the letter of the law is already not ideal, but the reality is even worse: “When Juan Peron came to power in the 1940s, he arranged for the impeachment of Supreme Court justices from the earlier period. Later presidents followed suit. By 1994 the Argentinean Supreme Court had been completely replaced six times since 1946. And peronist president Carlos Menem in the 1990s expanded the Court from five to nine justices, so that he could “pack” the court with a majority.” Dam, supra n. 16 at 114.24 Feld and Voigt, supra n. 15 at 503.

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twenty-fourth, Paraguay was twenty-ninth, Chile was thirty-first, Colombia was thirty-

second, and Guatemala was thirty-fourth. Brazil ranked fortieth, which is a lower level of

de facto independence than many Latin American countries.

iii) Behavioral Independence

Behavioral independence is notably hard to assess. Even if we reached a

consensus about the definition of “actual independent behavior,” it is difficult to regard

any past trends as conclusive evidence that the judiciary will uphold contracts and

enforce property rights in the future.25 As Joel Verner puts it, “even those courts which

have had long histories of judicial independence can lose their enviable status very

quickly as a result of the actions of an untoward executive during a period of severe

national crisis.”26 Given these difficulties in determining behavioral independence, it is

hard to rely on this measure to predict the levels of investor protection. Notwithstanding

these difficulties, many authors have argued that the Latin American judiciaries lack a

strong tradition of contract enforcement and protection of property rights and for this

reason are regarded as less able to protect investors than courts in developed

countries.27 But this is far from conclusive. Studies about the Brazilian judiciary, for

instance, offer conflicting assessments: some researchers find that the judiciary is

25 In order to measure it, we would need to account for the actual decisions of courts. In infrastructure sectors it would be particularly relevant to assess the actual behavior of courts in enforcing contracts and protecting property rights, especially against the government. Assessing the existence of such behavior is however a challenging endeavor. Can we say that there is effective protection if, over the past 20 years, 51% of judicial decisions enforce contracts against the government? What if the majority of cases brought to courts were not actually strong cases in favor of private investors? See Bernardo Mueller, Institutions for Commitment in the Brazilian Regulatory System, QUARTERLY REVIEW OF ECONOMICS AND FINANCE 41, 621-643. 26 Joel G. Verner, The Independence of Supreme Courts in Latin America: a Review of the Literature, JOURNAL OF LATIN AMERICAN STUDIES, v. 16, n. 2 (Nov. 1984), pp. 463-506, p. 484.27 One exception would be Chile. But even the perceived long standing “tradition” of independence of the Chilean judiciary was severely attenuated after the military coup in 1973. Thomas Skidmore and Peter Smith, Chile: Democracy, Socialism, and Repression, MODERN LATIN AMERICA, (1984).

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independent from the other two branches of government28 and has been able to enforce

contracts and protect property rights,29 while others find the opposite.30

b) Effectiveness and Competence

In terms of effectiveness, Latin American courts are again not doing very well.

Consider that there is already a significant difference in time lag to solve disputes

between developed and developing countries.31 In Latin American and Africa, delays are

longer and backlogs are greater than in the rest of the world.32 There are, of course

significant differences within Latin America, Chile being one important exception.33 But

even if one accounts for these differences, there seems to be no country in the region

with courts as functional as those in developed countries.

Within Latin America, Brazil is one of the most problematic cases of an

ineffective judiciary. A survey indicates that the average period from the filing of an initial

petition to a final court decision is 46 months (3 years and 10 months) in the federal

justice system and 38 months (3 years and 2 months) in the state justice system.34 This

significantly impairs the protection that the judiciary can grant to private investors.35

There are also significant problems with backlog. One of the causes is that Brazil has,

28 William C. Prillaman, The Judiciary and Democratic Decay in Latin America: Declining Confidence in the Rule of Law (Westport: Praeger, 2000), p. 94. Subscribing to Prillaman’s view, Matthew Taylor, “Veto and Voice in the Courts: Policy Implications of Institutional Design in the Brazilian Judiciary”, Comparative Politics, CITE, footnote 13. 29 2006 Index of Economic Freedom. Citing the Economist Intelligence Unit: "Contracts in Brazil are generally considered secured (…) although it is important to specify the jurisdiction for any disputes.…" (http://www.heritage.org/research/features/index/country.cfm?id=Brazil). 30 Dalmo de Abrey Dallari, 1996. NEV, Prado [CITE] IV, item 2.3 (citing interviews with judges). See also Carlos Santiso, Economic reform and judicial governance in Brazil: balancing independence with accountability, Democratization, Volume 10, Number 4, November 2003, pp. 161-180(20).31 Dam, note 15 at 103, citing Islam (2003). 32 Kenneth Dam, The Law Growth Nexus [REF] p. 102.33 [CITE].34 According to empirical research developed by Bolivar Lamounier, Maria T. Sadek, Armando Castelar Pinheiro, O judiciario brasileiro: a avaliacao das empresas, p. 85.35 Take the average three-year decision period, for instance. A toll road company facing an arbitrary reduction on its tariffs by 50% would have significant losses while waiting for a resolution of the dispute, even if the final decision ended up being in the company’s favor. Bolivar Lamounier, Maria T. Sadek, Armando Castelar Pinheiro, O judiciario brasileiro: a avaliacao das empresas, p. 79.

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on average, a higher number of cases filed per judge than most other countries.36

Although the clearance rate is fairly high, the judiciary simply cannot cope with the

number of cases filed. As a result, the number of pending cases per judge is also high.37

Estimates of the total number of pending cases in Brazil vary from 6 million in 1997 to 50

million in 1999.38

c) Corruption

Studies show that, compared to developed countries, perceptions of corruption in

Latin America are fairly high,39 and this is likely to affect investors’ decisions to allocate

money to infrastructure assets in that region. Furthermore, anecdotal evidence about

corruption does not provide any assurance that investors are properly protected in Latin

America. On the contrary, stories of corruption scandals are common. The Brazilian

judiciary, for instance, was recently involved in a series of corruption scandals related to

nepotism, sale of habeas corpus orders by judges in the second highest federal court in

the country (STJ), and embezzlement in the construction of a court in São Paulo.40

These scandals suggest that Brazil might not be able to offer a judicial system that

protects investors and is capable of securing efficient investments in infrastructure.

In sum, due to lack of independence, delays, backlogs and corruption, courts in

Latin America in general and Brazil in particular seem ill-equipped to guarantee effective

protection of property and enforcement of contracts.

36 Between 1995 and 1996, for instance, Germany had 175 cases filed per judge, whereas in São Paulo this number was 2,157.37 Only in São Paulo there were 3,129 cases pending per judge in 1995-1996. [Cite data on Sadek (2005)].38 Dam, supra note 30 at [PAGE]. 39 Daniel Kaufmann et al., Measuring Corruption: Myths and Reality, Global Corruption Report, Transparency International, 2007. See also, Johann Lambsdorff [CITE]. Although largely used and cited, these indexes rely on perceptions of corruption and for this reason are controversial. See, for instance, Mark Philp, Corruption Definition and Measurement, in MEASURING CORRUPTION, p. 51; Peter Langseth, Measuring Corruption, in Charles Sampfor et al., MEASURING CORRUPTION (2006), p. 35.40 As described by the NIS Country Report (2001) of Transparency International: “The ex-president of the São Paulo Regional Labour Court (a branch of the Judiciary) (…) was implicated in an US$ 80 million scam involving the construction of one single building (the US$ 80 million correspond only to the disappeared amount). A senator charged with complicity had his mandate revoked. A former close aid to the President was under investigation on the same charges.”(available at http://www.transparency.org/policy_research/nis/regional/americas).

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2.2 Lack of Protection against Indirect Expropriation

As I mentioned above, one of the reasons why a credible commitment is

important is because investors fear indirect expropriation, that is, an unforeseen and

unexpected reduction in investors’ rate of return caused by changes in the norms

governing the regulated sector. There are two main ways in which governments can

indirectly expropriate investors. One is by modifying statutory or constitutional

provisions. The other is by changing non-statutory rules applicable to the sector. To

protect investors from these forms of indirect expropriation and thus secure credible

commitments, there are basically two mechanisms: lock-in actions and delegation. Lock-

in actions reduce or eliminate the possibility of changes, whereas delegation transfers

the responsibility to an entity that is not subject to the same incentives to act

opportunistically or arbitrarily as the government. This section explores how effective

lock-in mechanisms and delegation have been used in Latin America. I analyze the

Brazilian presidential system as an example of a lock-in mechanism, and its regulatory

agencies as examples of delegation, and suggest that neither has been very effective in

producing credible commitments.

a) Presidential Systems in Latin America

One of the possible lock-in mechanisms against expropriation in infrastructure

sectors is the structure of the political system. According to Levy and Spiller, a political

system with checks and balances that guarantee to the executive branch veto power

over legislation, such as the American presidential system, offers more obstacles to

legislative changes than a system in which the executive and legislative powers are

unified, as in many parliamentary systems.

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Despite having divided governments, the particular characteristics and

functioning of Latin American presidential systems may prevent them from offering high

levels of protection to investors. It is fairly easy for the executive government to change

legislation when it has substantial influence in the normal legislative process and when

presidents have legislative powers of their own.41

Take, for instance, the normal legislative process in Brazil. In contrast to the

United States, the President has strong dominance over the Brazilian legislative

process. Brazil is among the five countries granting the most budgetary power to the

President.42 Congressional influence on the appropriations process is strongly limited by

constitutional and statutory provisions that allow for significant presidential control over

the final outcome of the bill that is approved by Congress.43 In addition, and perhaps

most importantly from an investor perspective, the President controls the legislative

agenda – and therefore the final content of substantive laws -- in many ways. First, the

President enjoys a veto power that is not easily overridden by Congress, as party

fragmentation in Congress makes it difficult for opposition parties to assemble the

required majority to override a veto.44 Second, the President has the exclusive right to

initiate legislation on a number of matters, including public sector and budgetary

matters.45 In this regard, the Brazilian case is in a category of its own: very few

constitutions grant Presidents such sweeping powers to initiate legislation.46

41 In addition to the differences in the normal legislative process, the constitutional powers of Latin American Presidents include executive decrees with force of law. These decrees grant legislative powers to the president, with significant impacts on the relationship between the legislative and the executive branches. Scott Mainwaring and Matthew Shugart, “Presidentialism and Democracy in Latin American: Changing the Terms of the Debate”, in Presidentialism and Democracy in Latin America (1997), p. 13-14. John Carey and Mattew Shugart, Executive Decree Authority (1998).42 Scott Mainwaring, “Multipartism, Robust Federalism, and Presidentialism in Brazil” in Mainwaring and Shugart, Presidentialism and Democracy in Latin America (1997), p. 64.43Argelina Figueiredo and Fernando Limongi, Incentivos Eleitorais, Partidos e Política Orçamentária, Dados 45(2) (2002), pp. 303-44. 44 Scott Mainwaring, “Multipartism, Robust Federalism, and Presidentialism in Brazil” in Mainwaring and Shugart, Presidentialism and Democracy in Latin America (1997), p. 61.45 Constitution 1988, art. 61 (Brazil).46 Mainwaring, supra n. 41 at 62.

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As a consequence of these unique structural features, the normal legislative

process in Brazil is largely dominated by the president. Since 1988, Brazilian presidents

have been successful in enacting their legislative agendas. Presidents introduced 86%

of the bills enacted since 1988 and the rate of approval of the bills introduced by the

executive was 78%.47 In addition to these structural features, the Brazilian president

uses coalition-building strategies, like those of parliamentary systems,48 and relies on

party discipline and loyalty.49 As a result, “[Brazilian Presidents] have been able to

reliably obtain the support of the parties that belong to the government coalition in

approving its legislation: the average discipline of the presidential coalition, defined as

the act of voting in accordance with the public recommendation of the government

leader in the floor, was 85.6%”.50

Credible commitment is undermined not only by the president’s dominance of the

regular process of the legislature, which makes the Brazilian system less divided than

the American, but also by the president’s direct legislative power. In Brazil, like in most

of its Latin American counterparts, the President has the power to enact decrees with

the force of law (known as medidas provisórias or “provisional measures”). These

decrees have force of law and come into effect immediately. Unlike regulations that are

subordinated to statutory provisions, the decrees have the same status of a statute

approved by Congress. Thus, the President can use these decree to overrule statutory

provisions. To be sure, the President is not granted unlimited legislative powers: the

Brazilian Constitution has provisions severely restricting the use of these decrees with

47 Fernando Limongi, Institutions, Presidents and Agencies, Revista Direito GV, Vol. Especial 1 (2005), p. 47. 48 For the seminal study that considered this possibility, see Sergio Abranches, Presidencialismo de coalizão: O Dilema Institucional Brasileiro, Dados 31, v. 1, pp. 5-34. 49 For a study that shows how party discipline is produced by the centralized organization of Congress and the control the Executive has over the legislative agenda, see Argelina Figueiredo and Fernando Limongi, Presidential Power, Legislative Organization and Party Behavior in the Legislature, COMPARATIVE POLITICS 32 (2000), pp.151-70. But see Scott Mainwaring, “Robust Federalism, and Presidentialism in Brazil”, in Mainwaring and Shugart, Presidentialism and Democracy in Latin America (1997), p. 74.50 Limongi, supra at 45. For the complete analysis, see Figueiredo and Limongi, supra.

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force of law by the President.51 However, historically these restricting provisions have not

been very effective.

For instance, for these decrees to become actual statutes, they need to be

approved by Congress within 60 days of their enactment, but in the meantime they

produce effects and are fully enforceable.52 According to the constitution, if Congress

does not convert the decree with force of law into a statute within the 60-day period, the

decree is no longer valid, and it stops producing effects. However, in practice, there was

no constitutional provision forbidding the President to reenact the decrees and

Presidents have largely benefited from this loophole. From 1988 to 2001, due to the

practice of reenactment, decrees had been in force for years despite the lack of

congressional approval.53 A constitutional amendment passed by Congress in 2001

severely limited the re-enactment of these decrees. Despite that limitation, the possibility

of reenactment was very present at the time of privatization. And even today, if we

consider that they are unilateral acts of the executive branch, these decrees are still

probably the highest threat to the credibility of the statutory provisions that govern the

regulatory system.

The most important mechanism to protect investors against executive decrees is

a constitutional provision forbidding the President from changing the statutes that

regulate infrastructure sectors by a decree with force of law. Shortly before privatization

started, the Constitution was modified to include this provision.54 Since its enactment,

however, provisional measures were used in the regulatory scenario a number of

51 See footnote 51 above, and accompanying text. 52 After enacting a decree with force of law the President has to submit it to Congressional approval. The decree will be valid and will produce effects for a limited period of time. In the original provision, the period was 30 days, but in 2001 the constitution was amended to turn it into 60 days (Amendment 32/2001). Another important restriction is that the decree with force of law can only be used in cases of relevance and urgency. 1988 Constitution, article 62. Additional limitations were imposed by Amendment 32/2001.53 For a more detailed analysis, see Mariana Prado, “Credible Commitments and Political Systems: When Presidentialism does not Protect Private Investment” unpublished manuscript (on file with the author).54Constitutional Amendment n. 7/1995.

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times.55 Thus, notwithstanding constitutional restrictions, provisional measures still

represent a device that could be (and in fact is) used by the President to strike down

regulations enacted by regulatory agencies and congressional statutes relating to

regulatory issues.56

b) Regulatory Agencies in Brazil 57

Another way of protecting investors is for the executive branch to delegate its

regulatory powers to independent regulatory agencies (IRAs).58 The assumption is that

IRAs59 enjoy “autonomy” from elected politicians, thereby reducing the risks of

expropriation, political manipulation, or short-term considerations related to the electoral

cycle that could adversely affect private investment incentives in relevant sectors.60 As a

result, the creation of IRAs became one of the central institutional issues in the context

of privatization reforms worldwide.61 In fact, the World Bank and the Organization for

Economic Cooperation and Development (OECD) recommend that countries promoting

regulatory reforms and privatizations should create IRAs.62 Advocates of these reforms

55 Provisory measure no. 2.147/01 (setting up an ad-hoc committee to deal with the electricity crisis). Provisory measure n.1531/98 also altered the statutory provisions governing the electricity sector (Statute 9472/96) and was eventually converted in Statute n.9648/98 by Congress. Provisory measure n.29 (February, 2002) authorized the creation of the Wholesale Market of Electricity and was eventually approved by the Congress and enacted as Statute n. 10.433/02. 56 There was only one instance in which the Supreme Court used the constitutional provision mentioned above to veto these changes. Provisory measure n.1819-1 (April, 1999) altered the provisions of the Statute 9427/96 but was declared unconstitutional by the Supreme Court.57 This section is based on another article of mine. “The Challenges and Risks of Creating Independent Regulatory Agencies: A Cautionary Tale from Brazil”, Vanderbilt Journal of Transnational Law (Forthcoming 2008). 58 Jon Elster, Constitutional Courts and Central Banks: Suicide Prevention or Suicide Pact?, E. EUROPEAN CONST. REV. , Summer 1994, at 66, 67. Marcus André Melo, A Politica da Ação Regulatória: Responsabilização, Credibilidade e Delegação [The Politics of Regulation: Responsibility, Credibility and Delegation], 16 REVISTA BRASILEIRA DE CIENCIAS SOCIAIS 55, 55–68 (2001). 59 The terms IRAs, agencies, and regulatory agencies will be used interchangeably in this paper. 60 Giandomenico Majone, From the Positive to the Regulatory State: Causes and Consequences of Changes in the Mode of Governance, 17 J. PUB. POL’Y 139, 152–55 (1997).61 See generally Jacint Jordana & David Levi-Dafur, The Diffusion of Regulatory Capitalism in Latin America: Sectoral and National Channels in the Making of a New Order, 598 ANNALS AM. ACAD. POL. & SOC. SCI. 102 (2005) (analyzing the “restructuring of the state in Latin America and the consequent institutionalization of a new regulatory order”)62 See, e.g., ORG. FOR ECON. COOPERATION & DEV. [OECD], THE OECD REPORT ON REGULATORY REFORM: SYNTHESIS (1997) (recommending regulatory reform and setting forth the reasons for this solution). Also, see OECD, THE OECD REPORT ON REGULATORY REFORM: VOLUME II: THEMATIC STUDIES (1997); OECD, REGULATORY POLICIES IN OECD COUNTRIES: FROM INTERVENTIONISM TO REGULATORY GOVERNANCE (2002); WORLD BANK, CONCESSION FOR INFRASTRUCTURE: A GUIDE TO THEIR DESIGN AND AWARD: WORLD BANK TECHNICAL PAPERS N. 399 (1998), available at http://rru.worldbank.org/Documents/Toolkits/concessions_fulltoolkit.pdf; WORLD BANK, THE WORLD’S BANK ROLE IN THE ELECTRIC POWER SECTOR: WORLD BANK POLICY PAPER (1993), available at http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/1999/09/17/

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believed that IRAs create credible regulatory commitments,63 thereby increasing the

value of the state-owned companies to investors and attracting more private

investment.64

During the 1990s, U.S.-style IRAs were adopted in many European and Latin

American countries,65 becoming one of the primary means of regulatory governance

worldwide.66 Following this trend, between 1996 and 2002, the Brazilian government

established IRAs for electricity, telecommunications, oil and gas, transportation, and

other infrastructure sectors as part of a very ambitious privatization program.67 Following

the formulas advocated internationally, Brazilian IRAs were designed to have fixed terms

of office for commissioners, Congressional approval of presidential nominations, and

alternative sources of funds to ensure their financial autonomy.68 These and other

institutional features were implemented to guarantee that these agencies were not

subordinated to the President’s directive authority or to any other branch of government.

000178830_98101911183588/Rendered/PDF/multi_page.pdf; OECD, Independent Regulators in South East European Countries (2003), available at http://www.investmentcompact.org/pdf/9thPTMtgIndependentRegulators.pdf; World Bank, How to Strengthen Regulatory Framework/Agencies, Document presented at the Water Forum (2002), available at http://siteresources.worldbank.org/EXTWSS/Resources/337301-1147283821774/0508_framework.pdf; World Bank, Regulatory Governance Background Note presented at the African Forum for Utility Regulation (2002). At quite an early stage in the debate, the idea was also supported by WTO. World Trade Organization [WTO], Negotiating Group on Basic Telecommunications: Reference Paper (Apr. 1996), available at http://www.wto.org/english/tratop_e/serv_e/telecom_e/tel23_e.htm.63 For an exploration of the idea of regulatory commitment, see DAVID NEWBERY, PRIVATIZATION, RESTRUCTURING, AND REGULATION OF NETWORK UTILITIES 62 (2001); Levy & Spiller supra n. 4; Pablo T. Spiller, Institutions and Regulatory Commitment in Utilities’ Privatization, 2 INDUS. & CORP. CHANGE 317 (1993); Pablo T. Spiller, A Positive Political Theory of Regulatory Instruments: Contracts, Administrative Law or Regulatory Specificity?, 69 S. CAL. L. REV. 477 (1996).64 Newbery, id. at 73 (noting that the “costs [of prívate ownership] may take the form of a high rate of return required to reward investors for the high perceived regulatory risk”). 65 JACINT JORDANA & DAVID LEVI-FAUR, HACIA UN ESTADO REGULADOR LATINOAMERICANO? LA DIFUSIÓN DE AGENCIAS REGULADORAS AUTÓNOMAS POR PÁISES Y SECTORES [Towards a Latin American Regulatory State? The Diffusion of Independent Agencies in Countries and Sectors] (2005); Giandomenico Majone, The Rise of the Regulatory State in Europe, 17 W. EUR. POL. 77 (1994).66 See OECD, REGULATORY POLICIES IN OECD COUNTRIES – FROM INTERVENTIONISM TO REGULATORY GOVERNANCE (2002) (“One of the most widespread institutions of modern regulatory governance is the so-called independent regulator. . . . ”). 67 In this period, nine regulatory agencies were implemented in Brazil: Agência Nacional de Energia Elétrica – ANEEL (Electricity); Agência Nacional do Petróleo – ANP (Oil and Gas); Agência Nacional de Telecomunicações – ANATEL (Telecomunications); Agência Nacional de Vigilância Sanitária – ANVISA (Sanitary Vigilance/ Health Inspectors); Agência Nacional de Saúde Suplementar – ANS (Private Health Care Services); Agência Nacional de Águas – ANA (Water); Agência Nacional de Transportes Aquaviários – ANTAQ (Water Transportation); Agência Nacional de Transportes Terrestres – ANTT (Ground Transportation); Agência Nacional do Cinema – ANCINE (Cinema).68 See Warrick Smith, Utility Regulators – The Independence Debate, PUB. POL’Y PRIVATE SECTOR (World Bank Group, Wash., D.C.) Oct. 1, 1997, at 3, available at http://rru.worldbank.org/documents/publicpolicyjournal/127smith.pdf (providing a summary of the “strong consensus on the formal safeguards required [by independent agencies]”).

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These features aimed to provide a high level of independence to Brazilian agencies.69

But the aim went unfulfilled.

Brazilian IRAs’ design was inspired by the American experience, but the

effectiveness of IRA guarantees of independence in Brazil was very different from the

United States. In particular, IRAs are not very independent in Brazil for three reasons.

First, some institutional features of the U.S. agencies were not implemented or fully

transplanted to Brazil. Second, some successful institutional features of the U.S. political

and legal system were unsuccessful in Brazil. Finally, some problematic features of the

U.S. system were transplanted to Brazil, replicating many of the problems that have long

existed in the United States.70 As a result, despite delegating regulatory powers to

independent agencies, the government was still able to influence their decisions.

Institutional guarantees that characterize IRAs in developed countries, especially the

United States, were not sufficient to insulate Brazilian IRAs from the political sphere.71

In addition, the regulatory agency for the Brazilian electricity sector has a lower

level of independence than the agency for the telecommunications sector. The details of

the institutional design of these two agencies are very different, and secure different

levels of independence. One potential explanation for these differences is the fact that

the bureaucracy in the electricity sector resisted the privatization reforms. This did not

happen in the telecommunications sector. In addition, the Minister that conducted the

reform process in the telecommunication sector was much more powerful than the two

Ministers who conducted the process in the electricity sector, and therefore was able to

obtain congressional approval without substantive modifications to the original

69 See GESNER OLIVEIRA, DESENHO REGULATÓRIO E COMPETITIVIDADE: EFEITOS SOBRE OS SETORES DE INFRA-ESTRUTURA [Regulatory Design and Competition: Impact on Infrastructural Sectors] (2005), available at http://www.eaesp.fgvsp.br/AppData/GVPesquisa/P00338_1.pdf (designing an index to measure the independence of agencies, and indicating that Brazil has one of the highest levels of independence in the world).70 I explore this in more detail in Mariana Mota Prado, “The Challenges and Risks of Creating Independent Regulatory Agencies: A Cautionary Tale from Brazil”, Vanderbilt Journal of Trasnational Law (forthcoming).71 Id.

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proposal.72 Thus, there were some political economy obstacles to the implementation of

even stronger guarantees of independence in the electricity sector.

The Brazilian experience illuminates the difficulties that many developing

countries face in trying to realize the ideal of regulatory independence and the benefits

that would supposedly flow from this. Also, it replicates many of the challenges and

obstacles in implementing institutional reforms around the world. The Brazilian case

illustrates the need and the difficulty to adapt transplants to the local conditions and

particularities of the reforming country.

2.3 Alternative Ways of Securing Credible Commitment

When the broader institutional environment does not secure credible

commitment, from the point of view of investors, a country may have to resort to other

options. One is to replace the jurisdiction of national courts over certain issues with

international dispute resolution mechanisms. This is what Bilateral Investment Treaties

(BITs) with arbitration clauses have done.73 Other alternatives include broad distribution

of share ownership and sequenced privatization.74 These mechanisms increase the

costs for any breach of previous commitments made by the government. Broad

distribution of share ownership means that a large portion of the electorate will be

negatively affected by expropriations (reducing the government’s incentives to proceed

with it), and sequenced sale of assets entails that expropriation of early privatized

companies can undermine future sales and the viability of the entire privatization

process.

Another option, which in contrast to BITs has been far less explored in the

specialized literature, is public financing of privatization. The Brazilian government is one 72 Id. 73 Graham Mayeda, “Playing Fair: The Meaning of Fair and Equitable Treatment in Bilateral Investment Treaties”, Journal of World Trade 41(2):273-291 (2007).74 Levy and Spiller, pp. 34-35.

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of the few in the world that decided not to sign investment treaties. Instead, it used the

alternative mechanism to of publicly financing privatization to protect investors. I will

discuss this in more detail in section (a) below.

Alternative ways of securing credible commitments do exist, but they come at a

cost. BITs and public financing of privatization, for instance, reduce flexibility and might

impair policy modifications, even when they are fully justifiable. The macroeconomic

crisis in Argentina is one such example.75 The currency devaluation in 1999 in Brazil

shows that public financing of privatization can impose similar costs, also due to

inflexibility. I will discuss this example in more detail in section (b) below.

a) Public financing of privatization

Brazil has used public financing of investments in privatization. The Brazilian

Development Bank (BNDES), a state-owned bank, granted loans to private investors

purchasing privatized companies and bought debentures of these companies or their

buyers. This financing was available to all participants in the privatization process,76 and

provided two lines of credit. First, the buyer could take up to 50% of the minimum price

of its bid as a loan.77 The maturity period of BNDES loans was normally from five years

to eight years, but in some cases was as long as ten. Second, part of the remaining

price could be financed with debt issued by an investor’s subsidiary firms. This debt was

purchased by BNDES Participações (BNDESPAR), an arm of BNDES. If both lines of

credit were combined, investors could have their investments largely financed by

BNDES. In fact, in 1997 alone BNDES financed R$ 3.11 billion out of R$ 13.18 billion

75 [CITE PAPER ON ARGENTINA]76 The only exception occurred when the BNDES refused to provide a loan to one of the bidders, because the bidder was itself a state-owned company. Celso Pinto, Tasso, o BNDES e o BB, FOLHA DE S. PAULO, April 5, 1998.77 BNDES, Resolution n. 254/97 and 314/98. These loans were granted under the Program to Foster State Privatization (Programa de Estímulo a Privatização Estadual –Pepe).

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(23.6%) as fourteen companies were privatized. Out of these, loans represented R$

1.74 billion and debentures represented R$ 1.37 billion.78

There was more to this process than simple financing. The government was

certainly making privatized firms more attractive to investors because it decreased the

initial amount of money required for their purchase.79 Moreover, the way in which these

loans were structured made them a very important mechanism to protect investors

against the risks of expropriation. Basically, BNDES secured its loans with shares of the

privatized companies and did not require any additional guarantees. Upon a default, this

lack of sound guarantees makes it difficult for BNDES to negotiate payment. As a

consequence, public financing has actually been a mechanism to force the government

to return a portion of the price paid for privatized companies in case of expropriation.80

Two concrete cases in the electricity sector show how public financing played a

role in protecting the interests of private investors.81 Both involve AES, an American

company that became the biggest foreign investor in Brazil’s electricity sector. The first

case is related to the acquisition of Eletropaulo, one of the biggest electricity distribution

companies (also known as discos) of the country, in April 1998.82 In the first months of

2003, AES had defaulted on a US$ 415 million payment to the BNDES group, declaring

78FOLHA DE S. PAULO, BNDES financia 23,6% das privatizações, December 18, 1997.79 This same effect could be obtained if payments for the privatized utilities were made in installments (a portion of the payment was made at the time of the sale, and the remaining portions paid thereafter). These installments reduced the initial investment, like a loan. In the Brazilian case, installments were used in the telecommunications sector, but much less so in electricity. 80 A similar mechanism is international investment guarantees programs. Multilateral institutions, such as the World Bank, offer insurance against noncommercial risk (such as governmental expropriation). The host country is obliged to repay for the guarantee if it is called in. On the one hand, this increases the financial costs of expropriation from the point of view of the government. On the other hand, if the government refuses to pay the guarantee, the refusal might damage its reputation not only with investors, but also with an important international institution. 81 I discuss this case in more detail in Mariana Prado, “Financial Strategies to Attract Private Investment”, unpublished manuscript, January 2008 (on file with the author).82 The consortium acquired 74.8% of the voting shares of Eletropaulo. Eletropaulo distributes 14% of the total energy that is consumed in Brazil, in a region where most of the industrial activity of the country is concentrated. VALOR ECONÔMICO, BNDES pode ter prejuízo este ano por causa da inadimplência das elétricas. March 13, 2002. Through a subsidiary, AES received US$ 888 million to buy Eletropaulo. BNDES, Decision n. 163/98. I explain the financing structure and later corporate restructurings in more detail in Prado [CITE] 4.

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that the devaluation of the Brazilian currency in 1999 was the reason.83 BNDES was

forced to reach an agreement that was largely beneficial to AES.

The second case relates to Cemig, a disco in the state of Minas Gerais. In May

1997, AES and other companies (a consortium eventually called SEB) bought 33% of

the voting capital of Cemig and signed a shareholders’ agreement according to which

the consortium would be entitled to nominate 4 of the 11 members of the board of

directors, and also three of eight executives of Cemig.84 In September 1999, the newly

elected governor of the State of Minas Gerais and former President of the Republic,

Itamar Franco, obtained an injunction temporarily cancelling the terms of the agreement

and gave complete control of Cemig back to the state government.85 A few days after

the injunction, the governor changed the bylaws of the company canceling the veto

power granted to the nominees of SEB, so that the state government could recover full

corporate control of Cemig.86 SEB’s response was a default on its debts to BNDES,

which is controlled by the Federal government. Allegedly, it would not pay for the loan

since its shares had lost part of their value when the shareholders’ agreement was

cancelled.87 In 2007 an agreement was reached, and AES attained another reduction in

its debt.

These cases show that whenever these investors felt that the government had

expropriated anything by changing the initial deal (i.e. based on the existing rules to

protect investors, and considering the risk premiums received) they would simply reduce

the amount invested by defaulting and/or renegotiating their debts. The cases illustrate

83 FOLHA DE S. PAULO, O Caso envolvendo AES e BNDES, February 25, 2003. Marcio Moreira Alves, O caso Eletropaulo, O GLOBO, February 28, 2003. FOLHA DE S. PAULO, AES deveria quitar em abril última parcela de empréstimo com BNDES, January 13, 2003. 84 FOLHA DE S. PAULO, Minas vende 33% da Cemig por R$ 1,3 bi, May 29, 1997.85FOLHA DE S. PAULO, Justiça suspende acordo entre Cemig e acionistas estrangeiros, September 29, 1999. 86FOLHA DE S. PAULO, Itamar muda Cemig e descontenta EUA, October 26, 1999. 87FOLHA DE S. PAULO, Entenda a nova dívida da AES com o BNDES, January 19, 2004.

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that public financing can give investors the opportunity to reduce the amount initially

invested if they feel that there was expropriation.

I suggested earlier that the lack of appropriate guarantees reduced the

bargaining power of the government in these negotiations. To be sure, the government’s

bargaining power was also reduced by institutional factors. The higher risk of lending

money in developing countries, due to limitations in the broader institutional scenario,

specially the judiciary, makes it more cumbersome to recover unpaid debts.88 This can

create incentives for the government to settle disputes in terms that are not as favorable

as they could be.

In sum, the Brazilian development bank provided loan that had only the shares of

privatized companies as guarantees. This tied up the risks associated with the loans with

the performance of these companies, which was in turn associated with their efficiency

in private hands but, most importantly, was associated with a regulatory framework that

could secure the expected rates of return to these investors. In case of expropriation

and arbitrary changes in the regulatory framework, investors had the option of defaulting

on the loans, leaving the bank with a difficult choice between enduring a long and

potentially ineffective judicial battle and negotiating a not so favorable settlement.

b) Alternative ways of securing commitment and their costs

One of the problems with these alternative mechanisms of protection to investors

is that they not only reduce the government’s ability to change norms opportunistically,

but they change the government’s ability to change norms under any circumstances.

Thus, instead of dealing with the “predatory ruler”, which is an arbitrary or opportunistic

government that might benefit from the fact that investors are locked in due to

irrecoverable investments, these mechanisms might instead simply tie the government’s 88 Luiz Ricardo Cavalcante, Desenvolvimentismo, Crise e Desestatização: A Atuação do BNDES entre 1952 e 2002, Revista Desenbahia nº 1 / set. 2004, p. 197.

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hands and not allow any modifications in the contract. This can have disastrous

consequences.

While public financing offers a form of protection from the point of view of

investors, the lack of appropriate guarantees for BNDES loans made the executive

branch assume some risks of the investment. In the privatizations of the electricity

sector, Brazil did not protect itself against this risk by using better guarantees for the

loans, such as collateral assets from other companies within the same corporate group,

which were used in the telecommunications sector.89 Instead, BNDES secured its loans

with shares of the privatized companies and did not require any additional guarantees.

Also, it did not spread the risks of the sector among other financial institutions. The

discos profiting from the government's vulnerability have avoided some of the risks they

otherwise would have had to bear and have shifted many of their costs to the

government. For instance, in the first case discussed in the previous section, AES was

able to transfer to the federal government many of its losses with the devaluation of the

currency. In the second case, AES and the other companies in the consortium might

end up transferring to the Federal government their losses caused by a state governor’s

breach of the shareholders’ agreement. Unlike the macroeconomic risk, this could be

considered a case of opportunism and one could consider that investors should not bear

this type of risk as they did. The different risks in these two cases show that the peculiar

structure of BNDES financing for the electricity sector functions not only as an additional

mechanism to protect investors against opportunism but a mechanism to shift risks back

to the government. More specifically, it provides protection both against business risks

and opportunistic changes in the regulatory framework by granting investors the option

of reducing the amount of their initial investment.

89 Diário Oficial da UniãoSeção 1, March 18, 2005, at 126.

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This raises questions not only about desirability of adopting such mechanisms,

but also about the broader purposes of privatization. Why would governments agree to

sell their companies under schemes that allocate substantial risks to themselves? More

importantly, why would the government agree to schemes that could deplete public

accounts of valuable financial resources? If the Development Bank of Brazil is forced to

take back companies that now have less value than they used to at the time of

privatization, the government is simply losing money. The purpose of raising revenues,

as a consequence, can be seriously impaired by these mechanisms. As the next section

will indicate, the concern with macroeconomic stabilization plans can explain much of

the rationale behind this seemly irrational decision of using public financing in

privatization processes.

Often, it is not hard to find easy and quick solutions to the problems with the

broader institutional environment in developing countries. BITs and arbitration clauses in

Argentina, and public financing in Brazil are two examples. However, these solutions are

not perfect substitutes because they deal in a rather simplistic way with the problem of a

private investors’ fear of expropriation by “the predatory ruler”. Under these alternative

mechanisms, many reductions in the expected rate of return, even those not caused by

a predatory ruler, are grounds for compensation. This contrasts with a situation in which

contractual provisions guarantee a certain consumer tariff, which in turn generates a

certain rate of return. If the currency was devaluated during a major macroeconomic

crisis, investors could have reduced returns if they need to pay back loans in foreign

currency. That would, however, not necessarily trigger any protection under a court of

law – a number of considerations could be brought before a court ruling on the matter.

The simplistic mechanisms, in turn, fail to have the sophistication that a fully functional

legal system would have. As a consequence, they may come at a high cost for

developing countries.

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In sum, we need to be aware that it is difficult to find mechanisms to replace an

entire judicial and political system, and that governments may resort to easy and quick

solutions even if they come at a high cost.

3. The Rationales and Goals of Privatization: Complex Tradeoffs

As I mentioned earlier, privatization of state-owned companies is often justified in

terms of efficiency, The idea is that privatized companies will operate more efficiently

than state-owned companies. Another oft-cited rationale for privatization is to raise

revenues. Developing countries may face two major tradeoffs involving these rationales.

Although not intrinsically incompatible, there are circumstances in which governments

might need to choose between raising revenues and promoting efficiency. As I will show

below, these circumstances are quite common in a developing country context. The

second tradeoff involves two different reasons to raise revenues: reducing fiscal deficits

and promoting macroeconomic stability. As I argue below, macroeconomic stability has

played an important role in Brazil, and oftentimes came at a cost to efficiency and to

addressing fiscal deficits.

3.1 Increasing Efficiency in a Developing Country

Privatization might increase efficiency in the delivery of infrastructure services.

Two basic factors are thought to contribute to this. One is ownership, i.e. the assumption

that the principal-agent relationship is more effective in pressing managers for results

when there are shareholders, instead of a diffuse body of taxpayers who do not

necessarily press the government for results. The other factor is competition. The

assumption is that under a competitive market structure, companies have to show

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results in order to survive and this would create incentives for them to be more

efficient.90

On the one hand, it is questionable whether developing countries have promoted

privatization under the belief that by merely changing hands these companies would shift

from an inefficient enterprise to an efficient one. In fact, there is little evidence that

ownership has any impact on levels of efficiency.91 On the other hand, selling state-

owned companies in infrastructure sectors to private investors does not necessarily

promote competition. Some of these sectors are natural monopolies, and cannot operate

with more than one player (electricity distribution is a clear example). In other

infrastructure sectors it is possible to have competition, but this is dependent upon an

effective regulatory framework that sets up conditions for competition, replicates

competitive outcomes, or imposes restrains on companies, thereby increasing efficiency

in the service provision. In sum, in infrastructure sector privatizations a regulatory

framework is important either to regulate natural monopolies or to set up a framework

that fosters competition.

If efficiency was a concern at all, it did not translate into incentives to promote

increased efficiency by putting an effective regulatory framework in place. If any

efficiency benefits were foreseen by those promoting privatizations, they were linked

with the fact that by transferring infrastructure sector companies to private hands would

removed previous fiscal constraints stemming from the government’s inability to invest in

state-owned companies for decades. Many developing countries have imposed strict

limitations on governmental investment in state-owned enterprises (SOEs). When these

limitations exist, state ownership negatively affects companies not through management,

but due to the lack of necessary investments for technological innovation, expansion of

90 Trebilcock and Smith [CITE]91 Vicker & Yarrow supra n. 3. See also Fitzpatrick [CITE].

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the network, or even necessary repairs and equipment replacement. In these cases,

perhaps levels of efficiency in SOEs could be increased simply with financial

restructuring and appropriate levels of investment, instead of outright sales.92 But in the

context of privatization what it meant was that simply releasing companies from these

constrains was likely to generate improvements.

Brazil is a good example of how fiscal constrains reduced governmental

investment in SOEs, impairing the companies’ efficiency. The Brazilian government

adopted a methodology to calculate public spending in which state-owned companies’

debt is treated like any form of government debt.93 When Brazil adopted this

methodology, state-owned companies were being used

as an extension of the government’s short term economic policy. (…) For instance, on the verge of the 1982 debt crisis Brazil’s government led several healthy state-owned companies to make hard currency debts to improve the country’s dollar inflow. However, although Brazil was in need of hard currency at that moment, these debts did not have any business motivation. Even worse: state-owned companies were soon to suffer the impact of both local currency devaluation and soaring international interest rates. These debts rose to the point of compromising their companies’ financial health.94

The methodology, at the cost of reducing investment in state-owned companies,

was implemented to stop the political use of SOEs. While it might have been a solution

to that problem, the subsequent lack of investment in state-owned companies left some

infrastructure sectors in dire straits.95 This had a negative impact on the necessary

92 Joseph Stiglitz, MAKING GLOBALIZATION WORK (2006), at [PAGE]. 93 In 1982, an agreement with the IMF obliged the government to design a program of economic adjustment that should include the reduction of public deficit. In order to monitor the deficit, Brazil adopted a method based on the Public Sector Borrowing Requirements, Necessidades de Financiamento do Setor Público (NFSP). Within this method, the any debt incurred by state-owned companies is considered government’s debt. Brazil not only adopted the method, but it also adapted it to the Brazilian reality. The most relevant adaptation is distinctions between different types of spending incurred by the Brazilian state: expenses that the government can actually manage (resultado primário) are separated from those that are not manageable, namely interests and oscilation of currency exchange rate, for the debt in hard currency. Nivalde Castro and Roberto Brandão, “Why do Brazilian state-owned Companies Refrain from Investing?”, [REF], footnote 2. 94 Id. at 4.95 Hermes de Araújo, João Lizardo R., “The Case of Brazil: Reform by Trial and Error?”

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technological improvements and the necessary maintenance of infrastructure, which in

turn impaired the SOEs’ efficiency.

Due to historical patterns of political use (and abuse) of SOEs, these constraints

are more likely to be present in developing countries than in developed ones. In fact,

developed countries have not adopted such methodology to control their public

accounts.96 The European Union, for instance, excludes productive SOEs from public

deficit and public debt calculation.97 More recently, the IMF said it would be wiling to

consider the exclusion of productive SOEs, but Brazil is not yet ready. In a 2005 report,

the IMF acknowledged that several Brazilian SOEs have a strong commercial

orientation, but none meet the complete set of criteria to be excluded from the budget

because they are still subject to governmental approval of wages policies, Congressional

approval of investment plans, changes in management that are linked with changes in

government (not with performance-related reasons), and have a history of loss-making

and/or noncommercial pricing policies.98

Recalling the rationales for privatization, one of the claims is that with

restructuring (i.e. proper investment and a revamped corporate environment) some of

the SOEs could be profitable again. In fact, Brazilian companies – many of which remain

today state-owned – were much more profitable after going through restructuring.99

Thus, there are reasons to believe that inefficiency did not come primarily from state

ownership, but instead from constraints on public investment in state-owned companies.

The conclusion is that developing countries might promote privatization to

release utility companies from the investment constraints imposed by this methodology

96 To be sure, there is one developed country that adopted a similar measure: England imposed limits on governmental investment in state-owened enterprises, but it did not change the methodology according to which public debt is calculated. Vicker & Yarrow supra n.97 Nivalde de Castro and Roberto Brandão, supra p. 4 (citations ommited). 98 Fiscal Affairs Department, "Public Investment and Fiscal Policy – Summaries of the Pilot Country Studies", International Monetary Fund, April 2005, p. 7.99 Carvalho, [REF] p. 72.

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of controlling public accounts. This does not create, however, any incentives for these

countries to invest in regulatory frameworks. If budgetary constraints are the reason

behind inefficiency, these countries might be more concerned with only guaranteeing

that investors will bring much needed investments to infrastructure sectors, which were

blocked by other governmental policies and concerns. After a decade without proper

investments, the threshold to promote necessary improvements can be quite low. So, if

the efficiency rationale plays any role in this context, it is a limited one and it might not

yield incentives for governments to implement regulatory frameworks and promote

competition where it is feasible to do so.

One could certainly argue that investors are more likely to invest if the regulatory

framework is well defined ex ante, because this reduces uncertainties. This is especially

true if there is a broader institutional framework to secure a credible commitment to

reforms. If that is the case, then countries might be willing to adopt regulatory

frameworks before privatization takes place. This will only happen, however, if the

government has time to wait until the regulatory framework is defined and implemented

(and in cases of major macroeconomic crisis and rampant fiscal deficits they might not

be able to wait) and if there are no major obstacles to the implementation of this

regulatory framework. One of these obstacles is opposition by interest groups, as

discussed in more detail below (section 4). If any of these circumstances are not present

(i.e. the government does not have time or is facing major obstacles), governments

might be willing to move forward with privatization without a proper regulatory

framework, and just cash in the efficiency benefits generated by the transfer of

ownership.

3.2 Raising Revenues in a Developing Country

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If a company needs money, it can sell bonds, get loans from financial institutions

or sell assets. The same applies to governments: if they need more revenues, they can

sell bonds or privatize. Thus, the first question related to the revenue raising rationale is

under what circumstances privatization prevails. One answer is that under certain

circumstances selling bonds or obtaining loans is not feasible. As Vickers and Yarrow

explain, “governments constrained in their ability to sell bonds, like some Latin American

countries facing debt crises, might nevertheless favor equity sales.” 100 This is more likely

to happen in a developing country than in a developed one. Another answer is because

bonds are available, but selling them is more costly than privatization due to high

transaction costs and under-pricing.101 Here, again, this is more likely to happen in a

developing country context. In developed countries, where there are liquid bond

markets, selling bonds is likely to be less costly than selling equity due to reduced

transaction costs (prospectus, advertisement, underwriting is more costly for equity

sales) and the lower risk of under-pricing.102 Developing countries might not only lack

liquid bond markets, but they might also have substantial discount rates applied to their

bonds, given the risk of default.103 If this is the case, privatization might be preferable. In

sum, developing countries are more likely to privatize simply because they need the

resources badly, and privatization is either the only or the cheapest way of raising them.

If privatization is the only or the best way to raise revenues, this goal might offset

other privatization goals such as promoting efficiency in privatized sectors. As suggested

100 John Vickers and George Yarrow, Economic Perspectives on Privatization, p. 111. (“What holds for a developed, market-based economy in Western Europe may not hold for a developing country with a thin domestic capital market or severe debt problems, still less for an economy emerging from decades of state control.”) 101 Id. p. 118. 102 Id. 103 Id. Both in cases of bonds and privatization, investors are afraid of expropriation. In the case of bonds, governments might withhold interest payments, or default on the payment of the principal. In the case of privatization, governments can nationalize private companies without paying proper compensation, or it can indirectly expropriate investors by not granting the agreed increased for the prices paid for utility services once investment is no longer recoverable (sunk investments). In both cases, inflation can also function as a form of expropriation (unless the bonds or the tariffs are indexed). As a consequence, the discount rate applicable to both bonds and privatization will be determined by macroeconomic stability, the credibility and reputation of the country internationally, and any mechanisms that can secure protection to investors.

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below (section 4), if there are political economy obstacles to implementing reforms that

will create an effective regulatory framework, and the government needs the money

immediately, it might decide to sell its companies without a regulatory framework in

place. The lack of an effective regulatory framework can negatively impair the

functioning of the sector, and undermine improvements in the efficiency and delivery of

services. If the relative cost of raising revenues by selling bonds is a determinant in the

privatization decision, a developing country is more likely to be in the position of deciding

to privatize primarily to raise revenues. Whenever this happens, the goal of raising

revenues can undermine the goal of increasing efficiency in the delivery of infrastructure

services.

An urgent need for resources may also make developing countries adopt costly

strategies to protect investors, so as to increase the price paid for the companies. As

discussed earlier (section 2), countries that could not count on their legal and political

systems to offer protections against outright or indirect expropriation adopted costly

mechanisms. Argentina, for instance, adopted BITs with arbitration clauses in order to

protect investors. Brazil, on the other hand, has done so by providing public financing to

private investors, shifting the risk of default to the government.104

In addition to being more likely to privatize to raise revenues than developed

nations, developing countries also have unique necessities that need to be satisfied.

This is discussed in the next section.

3.3 Raising Revenues for What?

Privatization is merely an exchange of an asset for cash. Although this increases

liquidity, there are no clear benefits for the government from the sale of state-owned

companies. In other words, the financial situation of the government remains the same,

104 This is as illustrated by the cases involving AES in Brazil. See supra notes __ and accompanying text.

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after companies have been privatized. So, what kind of benefits could countries realize

by selling their state-owned companies? I mentioned earlier that raising revenues is

often cited as a privatization goal. This section provides at least three different

hypotheses on how governments might raise revenues through privatization.

a) Paying Outstanding Debt

The first hypothesis is that countries might recover the investment made in SOEs

and put it to more profitable uses. Thus, the revenue raising effect comes from the

investments made, instead of the sale of SOEs in and of themselves. For instance,

governments can use these resources to pay outstanding debt, if the debt service cost is

higher than the rate of return in these companies.105 In Brazil, for instance, at the time of

privatization the rate of return of state-owned companies was very low, and the debt

service cost was high.106 In 1995, it was estimated that the capital invested in state-

owned companies in Brazil would provide a rate of return of 1.08% a year. At that time, if

this capital was used to pay the public debt, which then had interest rates of 20% to 25%

a year, the government would realize major fiscal benefits. For each R$ 10 billion of

assets sold, it would be possible to save anywhere from R$ 1.9 billion to R$ 2.4 billion a

year.107 Considering that in 1994 the Federal government had 55 state-owned

companies totaling US$ 88 billion in assets, and the average rate of return on this capital

in the period from 1988 to 1994 was 0.4% a year, the sale of these companies could

generate significant savings for the government.108 These 1995 predictions came true: it

is estimated that the government gained an amount equivalent to 25.5% of the total

revenues of privatization by using it to reduce the public debt.109 In sum, the savings

105 Camargo, “Privatização, Dívida e Déficit Público no Brasil”, [REF], citing Wright (1994). (Using the revenues from sale of state-owned companies to reduce public debt is recommended).106 Nunes [REF], p. 58-9. 107 Campos, cited by Nunes p. 55 (this is a free translation of Campos). 108 Nunes, supra p. 55109 Camargo, supra p. 57.

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incurred by reducing debt service were much higher than the dividends generated by the

companies privatized.

If we assume that developing countries are more likely to have high debt services

due to the risk of default, and that they are more likely to have inefficient SOEs due to

fiscal constraints, as suggested in the previous sections, we can assume that using

privatization revenues to pay outstanding debt will be particularly attractive to them. In

fact, the differences between developed and developing countries are clear. While

Argentina, Brazil, Chile and Mexico used privatization revenues to pay outstanding

debts,110 England and France used the receipts from privatization to finance current

expenses.111

Even if SOEs are profitable, as they were in Chile in 1970s, developing countries

can benefit from privatization in another way: they can use the revenues to pay

outstanding debt and issue new debts under terms and conditions that are more

favorable to the government. 112 The argument here is that new financing conditions are

only available because privatization changed the expectations and perceptions of

creditors, increasing their willingness to offer more favorable terms than they would

without privatization. In other words, a major debt restructuring might be only possible

due to privatization. In this context, privatization is considered better than the other

option, which is to issue new debt to finance old debt under less favorable terms.113

110 Although these key Latin American countries used privatization revenues were mostly used to reduce public debt, there are relevant differences among them regarding the type of debt reduced. While Chile and Argentina used most of the revenues from privatization to reduce external debt, Brazil and Mexico employed these resources to reduce internal debt. The reasons for these differences vary. Countries might be tempted to reduce the most pressing debt in the moment in which privatization is occurring. In this case, the external crises of Chile and Argentina in the 1980s might explain their choice to reduce external debt. Another possible reason is simplicity: one debt might be more homogeneous than other and it is easier to deal with it. Camargo, supra p. 42.111 Nunes, supra p. 19. 112 This certainly happened in Brazil. Without these favorable conditions, the government would have increased its debt even more. For instance, Macedo estimates that, without privatization, and assuming a constant share of their debt, total debt would have reached 66.5 per cent of GDP by 1999, rather than 49.5 per cent. Macedo, Roberto, “Privatization and the Distribution of Assets and Income in Brazil,” (2000) Carnegie Endowment Working Papers: Global Policy Program, No. 14. Available at http://www.carnegieendowment.org/publications/index.cfm?fa=view&id=368 at p.22. but see Camargo supra p. 73 (indicating that without privatization the public debt would be 58.1% of the GDP by 1999, not 66.5%).113 Camargo supra, p. 60.

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b) Fighting Fiscal Deficits

Another reason to raise revenues is to reduce fiscal deficits: if the government’s

fiscal revenues do not cover its current expenses, privatization might fill the gap.

However, some authors have argued that sales do not generate fiscal benefits.114 If the

government does not increase revenues and reduce expenses with tax, administrative

and pension reforms, it will need more money to finance its current expenses and will

incur new debts.115 “Selling SOEs to cover current expenses, a path followed by some

countries, is financially irresponsible; it is analogous to an individual who sells his house

in order to maintain his habit of eating at expensive restaurants. The house will be soon

gone, but the bills will not.”116 Thus, it seems reasonable to assume that if countries are

privatizing because they are facing fiscal deficits, and selling equity is preferable to

selling bonds, these countries should (i) only proceed with privatization if they can also

proceed with other reforms that will reduce governmental expenditures and (ii) use the

revenues to pay outstanding debt. In sum, privatization alone would not solve fiscal

crises or reduce fiscal deficit.

Possible evidence that developing countries seek privatization as a solution for

fiscal crises and public deficits is the fact that they tend to use the proceeds from

privatization to pay outstanding debt, as many Latin American countries did.117 I

suggested above, however, that to successfully tackle fiscal deficits a country needed to

promote a series of reforms along with privatization, including tax and pension reforms,

which many countries do not do. In Brazil, for example, privatization allowed for the

114 Ricardo da Costa Nunes and Selene Peres Nunes, “Privatization e Ajuste Fiscal: A Exeriência Brasileira”, Planejamento e Políticas Públicas, n. 17 (June 1998) p. 57. See also Hemming e Mansoor(1988), Builter(1983) e Mansoor(1987) e Walters (1992).115 Nunes supra, p. 57. 116 Simonsen (1995,p.13), cited by Nunes. 117 Tooraj Jamasb et al., Core Indicators for Determinants and Performance of the Electricity Sector in Developing Countries, WORLD BANK POLICY RESEARCH WORKING PAPER 3599, May 2005.

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immediate reduction of debt levels, but the government did not reduce expenses, and

new debts needed to be incurred in order to finance these expenses. As a result, the net

increase in public debt offset the beneficial effect of privatization. In the end, privatization

had no positive fiscal impact.118

The conclusion is that if privatization was meant to raise revenues that were

needed due to fiscal crises, it should be accompanied by reforms to deal with the causes

of the crises (such as tax and pension reforms). If these reforms do not take place, there

would be little reason to go forward with privatization. The privatization revenues would

just go down the drain to cover uncontrollable expenses by the government, as they did

in Brazil.

If this is true, it is intriguing that a country with a massive fiscal deficit at the time,

decided to go ahead with privatization despite the absence of such reforms. The next

section will suggest that this is largely because there was another concern in play:

macroeconomic stabilization.

c) Promoting Macroeconomic Stabilization

Developing countries might be tempted to use privatization to support

macroeconomic plans, even when the sale of state-owned companies will not foster

efficiency or help reduce fiscal deficits. The Brazilian case illustrates this: privatization

was mainly conceived as a mechanism to deal with the urgent need for immediate cash,

which was intrinsically linked to a macroeconomic stabilization plan. This might explain

why the government went ahead with privatization, despite knowing of its limited positive

impact (if any) on the infrastructure sectors, the public debt and fiscal deficit. The

macroeconomic concern may also help explain why Brazil offered public financing for

privatization.

118 Marcel (1989) cited by Nunes, p. 57.

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In 1993, Brazil implemented a macroeconomic stabilization plan (Plano Real) 119

that relied on an exchange rate anchor to stabilize inflation. 120 An overvalued currency

put pressure on domestic producers not to increase the prices, but it also generated a

current account deficit, which led to borrowing.121 Borrowing at high interest rates in turn

generated a rising public debt, rising debt interest payment, and an increasing current

account deficit.122 Although the anchored exchange rate mechanism proved effective at

halting inflation in the short-run, in the longer-run a more fundamental fiscal adjustment

was required.123 Nevertheless, fiscal adjustment did not come until 1998.124

Between 1995 and 1998, over 80 state-owned enterprises were sold, providing

revenues of US$ 60.1 billion, and a transfer of debt to the private sector of US$ 13.3

billion.125 These revenues from privatization played a role in temporarily tackling the

119 The plan contained: US$ 6 billion cut to government spending (9% of federal government spending), a tightening of tax collection, and a recasting of financial relationships with state governments, which owed US$ 36 billion to the federal government in 1993, and were approximately US$ 2 billion in arrears. Edmund Amann and Werner Baer, “The Illusion of Stability: The Brazilian Economy Under Cardoso,” (2000) 28:10 World Development 1805 at p. 1806. Valdir Ramalho, “’Plano Real:’ The End of Hyperinflation in Brazil,” in Economic Reform in Latin America, eds. Harry Costin and Hector Vanolli, (1998) Toronto: The Dryden Press, at p.175. (indicating that unlike either the Collor or Cruzado Plans, the changes would be gradual, and the Plan would not involve prize freezes, seizures of assets, or government-imposed breaches of private contracts). Fernando Ferrari-Filho and Luiz Fernando de Paula, “The Legacy of the Real Plan and an Alternative Agenda for the Brazilian Economy,” Investigación Económica, Vol. LXII, n.244, abril-junio, 2003, pp.57-92 at p.61. (In the original version of the plan, these two elements (fiscal adjustment and indexing system) were implemented in three phases. First, the government adjusted the short-term fiscal deficit. Second, the central bank introduced a price index, the URV, to stabilize inflation. Third, monetary reform was implemented, introducing the real as legal tender, and disindexing the currency).120 The system operated as follows. The value of the real was kept artificially high, and trade restrictions were lessened. This increased the ability of the country to import, and by doing so put pressure on domestic producers to limit price increases. A subsequent result of an overvalued exchange rate is a current account deficit: the country imports more than it exports. To cover up the current account deficits that resulted from an overvalued exchange rate, Brazil needed capital inflows (i.e. money to pay for the increased imports). This capital came from two primary means: borrowing and foreign investment. Borrowing was done by keeping domestic interest rates higher than their foreign counterparts throughout 1994-1998. Investment came due to the end of inflation, ongoing economic liberalizations (including privatizations), and a president who encouraged markets and private investment.121 Id. at p.1811.122 Anuatti-Neto, Francisco, Milton Barossi-Filho, Antonio Gledson de Carvalho, and Roberto Macedo, “Costs and Benefits of Privatization: Evidence from Brazil,” in Privatization in Latin America: Myths and Reality, eds. Alberto Chong and Florencio López-de-Silanes, (2005) Stanford University Press, at p.169.123 Id. at p.1807. Amaury de Souza, Amaury, “Cardoso and the Struggle for Reform in Brazil,” (1999) 10:3 Journal of Democracy 49 at p.54. (…keeping interest rates attractively high for foreign investors required balanced public accounts lest the internal debt explode. Thus the core strategy was to reform public finance through reforming social security, the civil service, and the tax system, through privatizing state owned companies and eliminating deficit spending at all levels of government. Over the long haul, the stability of the real hinged on the credibility of fiscal policy.)124 Amann and Baer, supra n. 114 at p.1811. (The failure of the government to secure rapidly badly needed fiscal reforms…resulted from deep divisions within Congress. Discipline among pro-government parties was weak while the exercise of local as opposed to national interests over members of Congress remained strong….Congress in general proved very reluctant to accede to thoroughgoing fiscal reform, especially that which would have restricted the fiscal autonomy of the states and municipalities or would have adversely affected…employment in the public sector.)125 Armando Castelar Pinheiro, Regis Bonelli e Ben Ross Schneider, “Pragmatic Policy in Brazil : the political economy of incomplete market reform”, Texto para discussão 1035, Rio de Janeiro, 2004, p. 21. Available at http://www.ipea.gov.br/pub/td/2004/td_1035.pdf.

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current account and the fiscal deficits in two ways. First, they helped fund the deepening

current account deficit by attracting private investment.126 Second, they helped reduce

fiscal deficit and thus public debt (which increased but would have been much higher by

1999 in the absence privatization).127 In sum, by increasing investment flows,

privatization served as a short-term adjustment mechanism for the economy.128

The main conclusion is that the primary reason for the strong privatization efforts

from 1995-1998 was the need to sustain the Plano Real. 129 The pace of privatization is

evidence that privatization was intrinsically connected with the plan. To be sure, Brazil

privatized some SOEs from 1991 to 1994, but the bulk of privatization was from 1995 to

1998 (a period in which privatization was broadened and expedited) and as such

intrinsically connected to the need to sustain the Plano Real. Specifically, in 1997, after

the Asian financial crisis, privatization assumed a vital role in the survival of the plan. It

was between 1997 and 1998 that a significant number of companies were sold,

particularly in the electricity and telecommunications sectors. Similarly, after the

exchange rate was allowed to float freely in 1999 the priority ascribed to privatization

declined,130 and the revenues from privatization decreased significantly, until the

privatization program was officially abandoned by the Lula government in 2002.

126 Roberto Macedo, “Privatization and the Distribution of Assets and Income in Brazil,” (2000) Carnegie Endowment Working Papers: Global Policy Program, No. 14. Available at http://www.carnegieendowment.org/publications/index.cfm?fa=view&id=368 at p.20. (“Although not an official objective, the privatization program [of the mid 1990s] was…assigned the role of financing a major part of the external disequilibrium, by means of the foreign direct investment it was to attract.”) From 1997-2000, the ratio between FDI inflows associated with privatization and the current account deficit averaged approximately 25 per cent. Pinheiro, supra at p.21. In fact, net portfolio investment rose from US$ 0.62 billion/year from 1990-1992 to US$ 4.5 billion/year from 1995-1997. Also, net direct investment rose from US$0.3 billion/year from 1990-1992 to US$ 16.3 billion/year from 1996-1998. Amann and Baer, supra at p.1806-12.127 Pinheiro, Giambiagi, and Moreira, [REF] at p.11.128 André Averbug and Fabio Giambiagi, “The Brazilian Crisis of 1998-1999: Origins and Consequences,” BNDES Discussion Paper, at p. 10. Available at http://www.bndes.gov.br/english/studies/td77i.pdf (“[I]t seemed reasonable, therefore, to imagine that the sum of ‘pure’ direct investment plus privatization would suffice to finance a substantial part of the current account deficit in the following years, while the country ‘saved time’ to promote a graduate real devaluation of its currency and stimulate exports through non-exchange rate mechanisms…”)129 Pinheiro, Armando Castelar, “The Brazilian Privatization Experience: What’s Next?” University of Oxford Centre for Brazilian Studies Working Paper Series, CBS-30-02 (2002). Available at: http://www.brazil.ox.ac.uk/workingpapers/CastelarPinheiro30.pdf at pp.22, 26. See also Pinheiro et al, supra n. 120.130 When the exchange rate was allowed to float freely in 1999, the result was to reduce the twin deficits: the primary fiscal balance went from a deficit to a surplus and the current account deficit fell, while at the same time flows of non-privatization FDI went up. This “[reduced] the importance of privatization finance of the external deficit.” Pinheiro (2002) supra note 124, p. 26.

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The idea that privatization was undertaken to promote macroeconomic stability

can be seen as irreconcilable with public financing of privatization (section 2, item c).

More specifically, the argument that privatization provided the revenues to cover the

current account and the fiscal deficits generated by the Plano Real might seem

contradicted by the fact that the Brazilian Development Bank provided public financing to

investors. If Brazil needed the money so badly, why did it not take it directly from its own

Bank? The reason is that there were advantages to do otherwise. Financial institutions

are off-budget, according to the accounting method adopted in Brazil. As a

consequence, BNDES is an off-budget account and BNDES financing was not deducted

from the government account, while the payment by private investors was added to it.

Thus, public financing helped attract private investment, while at the same time not

depleting the government’s financial resources. The only question that remains is

whether there was any real financial improvement in the public accounts in Brazil, or

whether it was merely an improvement in appearances.

The conclusion of this section is that when macroeconomic considerations are

added to the picture, the goal of raising revenues to deal with fiscal deficits changes

radically and tradeoffs become even more complex. The concern with macroeconomic

instability also had an impact on the regulatory framework, i.e. on the goal of improving

efficiency and quality in the delivery of infrastructure services. This impact was relevant,

but it was rather different in distinct moments of the privatization process, i.e. after the

implementation of the Real plan (1995-1996), after the Asian crisis (1997-1998), and

after the devaluation of the Brazilian currency (post-1999). In some of these moments,

macroeconomic concerns were aligned with efficiency concerns and in other moments

they were not. One important variable in this dynamic was political economy problems,

especially the resistance of certain interest groups to privatization and regulation, as

discussed below.

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4. Political Economy Obstacles

The section uses the case of the Brazilian electricity sector to illustrate how

political economy concerns (resistance to reforms by interest groups that benefit from

the status quo) may complicate the already complex privatization picture discussed in

the previous sections of the paper.

4.1 The Problem of Sequencing

In the Brazilian electricity sector, there was a delay in setting up regulation and

sectoral institutions. While the specialized literature recommends regulating before

privatizing, in the Brazilian electricity sector privatization preceded regulation and

regulatory institutions. A considerable number of the companies were in private hands

before there was a regulatory agency and a stable regulatory framework settled. In fact,

the privatization process started only one week after a first and rough statute regulating

the sector (Statute 9.074/95) was enacted. The first company to be privatized, Escelsa,

was in the hands of investors two years before the creation of the regulatory agency

Agência Nacional de Energia Elétrica (ANEEL). After the creation of ANEEL, a total of

18 companies were sold before the system operator and the electricity exchange for the

wholesale energy market (MAE) were legally established.131

This sequencing is one of the causes for the failure of implementing a fully

competitive environment in the Brazilian electricity sector. Selling companies without a

regulatory framework has had negative effects on the functioning of the market, slowing

the process to establish the new regulatory framework, compromising the credibility of

the regulatory agency (ANEEL), and helping to make regulation more ad hoc.132 There

131 Pinheiro (2003).132 See Pinheiro (2003), footnote 12.

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was no clear separation of competences between ANEEL, the Ministry of Mining and

Energy, the system operator and the state-owned electricity holding company

(Eletrobrás), which led to much confusion in the regulation of the sector.133 One of the

consequences of this confusion was that privatized discos preferred to have bilateral

contracts with generation companies as opposed to buying electricity from new plants in

a free-market, and the transition to a free market was never completed.

This sequencing is especially puzzling if we consider that the Brazilian

telecommunications sector had the opposite experience. The main reason for the

difference relates to political economy problems. In the electricity sector, there were

many conflicting interests involved: the holding company Eletrobrás has been a

consistent opponent of privatization and of increased competition in the sector and

technocrats from the Ministry of Mines and Energy and the National Department of

Water and Energy (DNAEE) have remained committed to a strong state role in the

sector.134 On the other hand, BNDES has been a proponent of privatization on

pragmatic, fiscal grounds.

As a result of these conflicts of interest, and outright resistance to the reforms,

the government decided not to privatize all at once, as it did in the telecommunications

sector. Instead, it started with the sector that faced less resistance: electricity

distribution. The government also decided to sell companies before setting up a

regulatory framework. This sequencing was not an oversight. Instead, it was a strategy

of the government to overcome resistance to the regulatory reforms. There was strong

resistance to the implementation of a competitive market in electricity generation (not in

133 PIRES, J. C. Os desafios da reestruturação do setor elétrico brasileiro. BNDES, 2000(Discussion Paper, 76).134 Kingstone, Peter, “The Long (and Uncertain) March to Energy Privatization in Brazil,” (2004) Baker Institute Energy Forum: Critical Issues in Brazil’s Energy Sector, at p.38. Available at: http://www.rice.edu/energy/publications/brazilenergysector.html.

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distribution or transmission, which are natural monopolies), and the government saw

privatization as a way of forcing these changes to be implemented.135

The idea that sequencing was not merely an oversight is well supported in the

Brazilian literature. However, it fails to explain how the government was able to

overcome resistance to privatization. One possible response is that selling companies is

easier than changing legislation. Another possible response is that the government was

being pulled in different directions in terms of its own interests. On the one hand,

resistance to changes in the sector (privatization and regulation) would greatly increase

the political costs of reforms. On the other hand, the government was pressed to sell its

companies for macroeconomic reasons. The response of the Brazilian government to

these pressing but conflicting concerns was to do what was feasible to minimize costs

while addressing the most pressing need at the time.136

Thus, political economy problems can help explain the overall sequencing of

privatization of electricity companies in Brazil. But it does not account for the entire

history. It is only when we look at these political economy problems in the context of

macroeconomic concerns that we can explain how regulation was implemented in Brazil.

In fact, as I will explain in more detail below, starting in 1997, the government needed a

substantial amount of revenues, and privatizing the distribution sector was feasible at the

time. Thus, the regulatory efforts focused on the distribution sector, where they could

generate even more revenues for the government, without impinging on entrenched

interests.

4.2 Establishing a Regulatory Framework135 See Pinheiro (2003), footnote 12 (mentioning that this resistance also absent in the telecommunications sector, where regulatory reform preceded privatization). 136 Kingstone, Peter, “The Long (and Uncertain) March to Energy Privatization in Brazil,” (2004) Baker Institute Energy Forum: Critical Issues in Brazil’s Energy Sector, at p.39. Available at: http://www.rice.edu/energy/publications/brazilenergysector.html (In addition to opposing interests “[i]f we add to the mix the government’s exceptionally complex reform agenda,…a series of macro-economic shocks, and an energy crisis, it is not hard to understand that the government has largely reacted to circumstances.”)

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The essence of macroeconomic concerns changed at least three times in Brazil

between 1995 and 2000. These changes are connected with three different phases of

the privatization of the electricity sector in Brazil. In some of these moments,

macroeconomic goals and regulatory reforms were aligned. For example, promoting

regulatory reforms would help the government to achieve its macroeconomic goals.

Whenever that was the case, reforms were promoted. In contrast, when regulatory

reforms and macroeconomic concerns were not aligned, reforms did not take place. In

some periods, these goals were convergent and in others divergent. The regulatory

reforms that took place in Brazil largely coincide with the points of convergence.

In the first period of the Brazilian electricity sector privatization, 1995 and 1996,

two federal distribution companies, Escelsa and Light, were privatized. What is peculiar

about these initial privatizations is that the companies were sold with regulatory

uncertainty: neither the regulatory framework nor the independent regulator was defined

at the time of the sale. Instead, the government designed concession contracts that

were tailored to the specific conditions of each sale in order to compensate for the lack

of a regulatory framework. In the case of Escelsa (1995), the concession contracts did

not provide security to investors, especially due to the lack of clarity, transparency and

predictability of the rate setting mechanism.137 As a consequence, there were only two

bidders at the auction. It is estimated that the government could have sold Escelsa for a

higher price, if it had waited to sell the company until after the regulatory framework of

the sector was set up. Unlike Escelsa, there was only one bidder in the auction to sell

Light (1996). Not only did it attract only one consortium, but the “bid reached the

reservation price only after the development bank BNDES joined the consortium with

additional funding.”138 Unlikely, Escelsa, when Light was privatized, these uncertainties

137 Baer, Werner and Curt McDonald, “A Return to the Past? Brazil’s Privatization of Public Utilities: The Case of the Electric Power Sector,” (1998) 38:3 Quarterly Review of Economics and Finance 503, at p.517.138 Hennemeyer, Paul, “Energy Reform and Privatization: Distilling the Signal from the Noise,” in Can Privatization Deliver? Infrastructure for Latin America, eds. Federico Basañes, Evamaría Uribe, and Robert Willig, (1999) Washington:

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were addressed in its concession contract through a price cap scheme.139 Many clauses

are argued to have been added simply to encourage investment.140 But still the clauses

were deemed to be ill conceived. The presence of regulatory risk is particularly salient if

one consider that Light (barely) sold for the minimum asking price, despite it being

“considered a relatively well-managed utility” and having an expected rate of return on

investment of at least 14 per cent.141

The decision to privatize these companies under these conditions can be linked

with macroeconomic concerns. More specifically, signaling is a key reason why Light

and Escelsa were privatized with regulatory uncertainty. Signaling the government’s

seriousness to liberalize its economy might be a strong reason that Escelsa and Light

were privatized with regulatory uncertainty (and thus at a reduced value). Because the

electricity industry had historically been used directly by the government as a

macroeconomic tool (e.g. keeping rates low to prevent inflation), by privatizing it the

government made a strong statement about changes in economic policy.

Interestingly, in the macroeconomic context of those years, fiscal concerns were

not all that important.142 Nevertheless, macroeconomic concerns can still help explain

why Light and Escelsa were privatized before a regulatory framework was established.

These privatizations signaled a commitment to fiscal austerity; recall that around 1995

the government was still making an effort to balance the budget.143 It also signaled a

policy change toward encouraging a reduced public sector, and the newly elected

Cardoso administration’s serious approach to a strong privatization program (and in Inter-American Development Bank, at p.292.139 Baer, Werner and Curt McDonald, “A Return to the Past? Brazil’s Privatization of Public Utilities: The Case of the Electric Power Sector,” (1998) 38:3 Quarterly Review of Economics and Finance 503, at p.517.140 Hermes de Araújo, João Lizardo R., “The Case of Brazil: Reform by Trial and Error?” [REF] at p.545 .141 de Oliveira, Adilson, “Reforming the Brazilian Energy System: Challenges and Opportunities,” (Winter, 1996) 2:4 Journal of Project Finance 13 at p.21.142 Pinheiro, Armando Castelar, and Fabio Giambiagi, “The Macroeconomic Background and Institutional Framework of Brazilian Privatization,” in Privatization in Brazil: The Case of Public Utilities, eds. Armando Castelar Pinheiro and Kiichiro Fukasaku, OECD/BNDES at p.20. Available at: http://www.bndes.gov.br/english/studies.asp (“[I]t was not until the 1997 Asian crisis that privatization truly became a crucial issue to the government, assuming a vital role in the very survival or the Real Plan.”)143 Hermes de Araújo, João Lizardo R., “The Case of Brazil: Reform by Trail and Error?” at p.545.

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doing so, helped to attract investments to offset the growing current account deficit). In

contrast, the need for revenues to offset the fiscal deficit deeply affected privatization in

1997 and 1998.

In the second phase of the privatization process, differently from the privatization

of Light and Escelsa, new macroeconomic circumstances forced the government to be

more pro-active in establishing regulation for the sector so as to increase the sale prices

of state-owned companies. Starting in 1997, a series of consistent and coordinated

reforms were implemented.144 Here the political economy problems become relevant.

While the government needed financial resources to support its macroeconomic plan, it

also faced obstacles in selling electricity generators. It was only feasible to proceed with

privatization if the government started with the distribution sector. This obstacle largely

determined the way in which the government proceeded with regulatory reforms: it

rushed into a regulatory framework for rate revisions for distribution companies.

Regulation related to other features of the market were flawed and poorly implemented,

since they were not the government’s top priority at the time. More specifically, the

government’s concern over the existence and implementation of rate regulation for

distribution services stands in sharp contrast to its concern over a general regulatory

framework for transmission and generation services, and to establish competition in the

sector as a whole, as explored below. The conclusion is that the regulation preceded

privatization only to the extent that it would increase the sale price of companies; that is,

only to the extent that regulatory concerns were aligned with macroeconomic concerns.

The price paid for electricity utilities arguably increased after this regulatory framework

was established.145 144 João Pires, The Reform Process within the Brazilian Electricity Sector, available at www.bndes.gov.br/english/studies/studie01.pdf. (“The progress of reforms within the sector (…) only acquired a more generalized, consistent and coordinated character from 1997 onwards, when a series of regulatory policies were implemented, many of which had been proposed by the consulting firm, Coopers and Lybrand, through various provisional measures that gave rise to Law 9,648, and that promoted the privatization of several electricity distributors.”)145 Bakovic, Tonci, Bernard Tenenbaum, Fiona Woolf, “Regulation by Contract: A New Way to Privatize Electricity Distribution?” (2004) World Bank Working Paper 14. p. 22. (“the average price of US$1,400 per customer obtained by

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Earlier in this paper, I claimed that there was no strong regulatory commitment

and security for investors in Brazil. How can I reconcile this claim with the fact that

investors paid more for the companies after the regulatory framework was established?

These impressive results may reflect the fact that the Brazilian Development Bank

increased security to investors by offering public financing for privatization (section 2

above). This, together with a regulatory framework, enhanced investors’ confidence in

the Brazilian privatization process. Nevertheless, my central point still holds: the

government quickly implemented regulation for distribution rates when it needed to

maximize the sale price of these companies. This maximization, in turn, was directly

related to the government’s macroeconomic concerns at the time.

The privatization process lost steam in early 1999.146 This third phase of the

process was intrinsically connected with the devaluation of the currency and the new

exchange rate regime adopted in Brazil. With the devaluation, the fiscal and current

account deficits became less pressing for the government, reducing also the need for

revenues. The devaluation impacted negatively on consumers and private investors. For

consumers, there were significant increases in electricity rates. But “[i]nvestors were not

happy either, because, measured in dollars, revenues did fall somewhat against their

expectations. And some utilities, most notably Light/EDF in Rio and Eletropaulo/AES in

São Paulo, had contracted substantial overseas loans before devaluation, and were

consequently in financial difficulties.”147 Because of a rate pass through, some of these

costs could be directly imposed on consumers, but not all of them.148 At least one of the

BNDES debt restructurings described earlier is partially related to this currency

devaluation. Brazil’s distribution privatizations beat all previous world records. AES paid a 93 percent premium to acquire CEEE in October 1997 and Enron acquired Elektro at a 99 percent premium in July 1998. In less than five years, private investors invested more than US$27 billion in the Brazilian power sector.”)146 Pinheiro (2003, p.10)147 Hermes de Araújo, João Lizardo R., ibid., at p.552 148 Resende, Marcelo, “Relative efficiency measurement and prospects for yardstick competition in Brazilian electricity distribution,” (2002) 30 Energy Policy 637, at note 4.

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In 2002, Lula was elected as the new president and the privatization process was

officially abandoned. Macroeconomic concerns with fiscal austerity, however, are still

affecting the arrangements for investment in infrastructure in Brazil. In fact, SOEs are

now authorized to participate in auctions for transmission and generation concessions,

after being banned from them. But they are not allowed to compete with private

companies on equal terms. This restriction is due to SOEs’ subordination to the need to

cut the public deficit.149 Most interestingly, the new arrangements for private investment

in infrastructure, public-private partnerships (PPPs), are very attractive from a fiscal

perspective. The PPPs allow the government to have a minority share in the new

infrastructure projects. “By having a minority share, the project’s debt remains off

balance sheet and, therefore, public debt, as measured by the Brazilian definition, is not

affected.”150 The increase of PPPs in Brazil is largely due to the fact that the state

remains a capital investor, without affecting the fiscal balance – due to the continued

focus on macroeconomic stability and public deficit reduction.151

In sum, privatization in Brazil was largely an instrument of macroeconomic

adjustment; but, it would be too simplistic to say that macroeconomic concerns trumped

regulatory concerns. Instead, I argue that there was a complex interaction between two

goals: promoting macroeconomic stability and increasing the efficiency and quality of the

services through regulatory reforms. These two goals were not aligned in the first phase

of privatization (1995 and 1996). Signaling a commitment to liberalization and fiscal

austerity might be the reason why the government proceeded with the privatization of

Escelsa and Light despite lacking a regulatory framework. In the second phase of

privatization (1997 and 1998), the deteriorating conditions of the current account and

fiscal deficits generated a need for substantial amounts of cash revenues. In this case, 149 Nivalde de Castro and Roberto Brandão, p. 12. 150 Id.151 D. R. Almeida, A. C. A. Negrão, “A Expansão sustentada do setor elétrico brasileiro: desafio para a regulação e espeaço para a empresa estatal. Rio de Janeiro: Eletrobrás, 2005.

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the macroeconomic and regulatory concerns were aligned because regulation could

increase the sale price of the companies, generating more revenues for the government.

In 1999, after the devaluation of the currency, privatization itself was no longer aligned

with macroeconomic concerns and the entire process was abandoned shortly thereafter,

but macroeconomic concerns still play a role in investments in infrastructure.

These shifting relationships between privatization’s different goals explain why

privatization reforms in Brazil do not seem especially planned or focused, but rather

appear to be policy changes implemented on a somewhat ad hoc, reactionary basis.

4.3 Establishing Regulatory Institutions152

Political economy problems also determined different institutional designs of

Brazilian independent regulatory agencies, especially in the telecommunications and

electricity sectors. Earlier in this paper (section 2), I indicated that there is a common

belief that independent agencies can create a secure environment for private investment

in infrastructure sectors. This belief seems to be the predominant reason why Brazil

implemented IRAs in both sectors, but circumstantial factors caused the design of these

two agencies to be quite different. And among all the factors playing a role, political

economy problems were especially relevant.

President Cardoso (1995-2002) assigned to the ministry of each sector the task

of formulating the new regulatory agency’s structure for that particular sector.153 In each

of the sectoral ministries, the specialized bureaucrats managed the process of creating

IRAs differently, leading different outcomes in the telecommunications and electricity

sectors. In the electricity sector, where there was strong resistance to privatization and

regulatory reforms, bureaucrats in charge of designing the agency rejected any external

152 This section is based on another article of mine. “The Challenges and Risks of Creating Independent Regulatory Agencies: A Cautionary Tale from Brazil”, Vanderbilt Journal of Transnational Law (Forthcoming 2008).

153 Id.

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advice,154 and the bill prepared by them did not include measures to secure the new

regulatory agency’s independence.155 Instead, the bill would replace the existing

regulatory body (Departamento Nacional de Águas e Energia Elétrica or DNAEE) with

another non-independent entity.156

The President did not want to implement a non-independent body, and to avoid

confronting the specialized bureaucracy he decided to transfer the debate to

Congress,157 sending them a bill that included no guarantees of independence.158 Before

that, however, the President negotiated the bill’s revision with party leaders and

assembled a coalition in Congress to implement the changes that would make the

regulatory agency independent.159 Thus, the Congressional changes in the bill were

actually a Presidential initiative.160 The bill was enacted as Statute 9,427/96, creating

ANEEL, which regulated the electricity sector.

In contrast to electricity, the telecommunications bill submitted to Congress

already guaranteed a very high level of independence for the regulatory agency.161 Two

154 Despite the fact that external consultants were involved, they were not able to influence the proposed design, and the bureaucracy retained the final word in the process. For instance, the consulting firm Coopers and Lybrand was formally involved in the process and it highlighted its disagreement with the institutional design proposed by the Ministry but was not able to implement changes. E-mail interview with Edvaldo Alves de Santana, Director of ANEEL (Feb. 3 & July 20, 2006) (on file with author). Also, some independent consultants were invited to discuss the proposal informally, but again, their suggestions were not taken into consideration. The most influential players in this process were the bureaucrats of the previous regulatory body, DNAEE. Three of them (José Mario Miranda Abdo, Luciano Pacheco, and Eduardo Henrique Ellery Filho) became the first directors of ANEEL. Other people who were very influential in the process were José Said Brito (former director of DNAEE, before Abdo), Peter Greiner (National Secretary of Energy), and Reginaldo Medeiros (Chief of Staff of Greiner). Id. 155 Representative Aleluia declared that the original bill proposed by the executive branch was “timid” in guaranteeing independence. Nunes, supra at 192.156 It would be an autarquia. Different from DNAEE, this new body would be located outside of the Minister, but would not necessarily have institutional guarantees of independence to avoid political influence.157 Interview with Sergio Abranches (Nov. 2005). 158 Projeto de Lei No. 1.669/96 (Mensagem n. 234/96). 159 See Interview with Sergio Abranches, supra note 152 (reporting a private conversation with Fernando Henrique Cardoso in 1996). 160 Representative José Carlos Aleluia, from one of the parties of the governing coalition, drafted the new version that would guarantee the agency's independence. The reports of the discussions in the House of Representatives show that the author of the reforms, Representative Aleluia, was in close consultation with the Cardoso Administration. DIÁRIO DA CÂMARA DOS DEPUTADOS, July 25, 1996, at 21155–61 available at http://www2.camara.gov.br/publicacoes. ; see also José Carlos Aleluia, Speeches at the House of Representatives, July 9 & 24, 1996, in DIÁRIO DA CÂMARA DOS DEPUTADOS, July 10, 1996, at 19647; July 25, 1996, at 21177, 21185, available at http://www2.camara.gov.br/publicacoes. 161 The bill proposed by the executive branch was PL 2,648/96, which was incorporated into an existing legislative proposal (PL 821/96) and later became Statute 9,472/97. Interview with Carlos Ari Sundfeld, Former Legal Advisor for the Cardoso Administration on the Privatization of Telecommunication Companies, and Member of the Commission that Designed the Regulatory Agency (Jan. 2006).

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circumstantial conditions largely contributed to this. First, the telecommunications

Minister took a strong leadership position in promoting the reforms.162 Second, the

telecommunications bureaucracy was not only more open to international trends and to

external advice,163 but the bureaucracy’s leadership was actually supportive of the

privatization reforms and advocated for an IRA in the sector.164

The differences in the bill sent to Congress, which later translated into actual

differences in the institutional design of agencies, can be largely ascribed to political

economy problems. More specifically, the bureaucratic resistance to reforms in the

electricity sector radically changed the way in which institutional reforms were

conducted. The outcome has been the creation of two regulatory agencies, whose

creation can be ascribed to the same governmental concern with attracting private

investment, but that have fundamentally different institutional designs.

In conclusion, the case of privatization in the Brazilian electricity sector shows

that political economy problems might affect privatization reforms in at least three ways.

First, it can serve as an obstacle to privatization altogether, barring or excluding certain

sectors, or companies from the sales. In the case of Brazil, the generation sector was

excluded from the privatization program. Second, it can interact with some of the

rationales or goals of privatization, making some of the tradeoffs discussed in section 3

even more complex and reducing the options available to governments. In the case of

162 Roger Marinzoli et al., Lessons of Telebras: The Leadership of Sergio Motta (on file with the author). 163Interview with Renato Guerreiro, Former Secretary of the Ministry of Telecommunications, Former President of ANATEL, and Mentor of the Privatization Reforms in the Telecommunications Sector (Feb. 2006). 164 Interview with Carlos Ari Sundfeld, Former Legal Advisor for the Cardoso Administration on the Privatization of Telecommunication Companies and Member of the Commission that Designed the Regulatory Agency (Jan. 2006); Interview with Renato Guerreiro, Former Secretary of the Ministry of Telecommunications, Former President of ANATEL, and Mentor of the Privatization Reforms in the Telecommunications Sector (Feb. 2006). Guerreiro himself is the clearest example of that because he was supportive of privatization reforms. See supra note 22 and accompanying text. In the telecommunications sector, the bureaucrats not only had a lot of contact with international institutions and were aware of international trends in the sector, but they also knew that a process of privatization would not threaten their jobs. Interview with Sergio Abranches, supra. This was not necessarily the same in the electricity sector. Privatization brought the threat of a potential shift from hydro generation to thermo generation, a technology that was not the expertise of the specialized bureaucracy. Also, in the pre-privatization period, these bureaucrats, who alternated between periods in government offices and periods in state-owned companies, dominated the regulatory bodies. Many resisted privatization and independent agencies because both would cause them to lose power in the sector. The Author is grateful to Sergio H. Abranches for calling her attention to this point.

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Brazil, the interaction between political economy problems and macroeconomic

concerns determined a piecemeal and scattered implementation of the regulatory

framework. Third, political economy problems might also impair institutional reforms that

are implemented in connection with the privatization process to deal with problems

related to the broader institutional environment. This shows that privatization reforms in

developing countries need to deal with three core concerns (the broader institutional

environment, the complexity of policy goals, and political economy problems) and that

these three concerns are quite interconnected.

Conclusion

This paper addressed three important variables that might impact the success of

privatization policy: pre-existing conditions for its success (attracting private investment),

the motivation of the policymakers and decision makers to adopt the policy, and the

obstacles to its implementation. I have explored these variables in developing countries

(lack or instability in the broader institutional environment, complex policy tradeoffs, and

political economy problems caused by entrenched interests), and argued that they are

fundamentally different from developed countries. Policymakers, therefore, need to be

aware of these differences when advocating privatization in a developing country

context. As I hope to have shown, these three variables will largely determine what is

likely to be adopted, what is feasible, and what may be successful. In the realm of

privatization policies, the answers to these three issues are likely to be widely different in

developed and developing countries. Following the same principle, it is reasonable to

assume that there will be significant differences among developing countries

themselves. Middle-income countries (like most Latin American countries) face a

number of problems that are significantly different from low income countries (like most

African nations). Policymakers need also to take these differences into consideration.

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***

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