Brazil and the Means of Production: A Dilemma

Recent events in Brazil's run-up to the October presidential elections have been a combination of the tragic and the astounding. A month ago, in a three-way race between incumbent Dilma Rousseff of the ruling Worker's Party (Partido dos Trabalhadores or PT), opposition party candidates Aecio Neves (Democratic Socialist Party of Brazil or PSDB) and Eduardo Campos (Brazilian Socialist Party or PSB), it appeared that Dilma and Aecio would face off in a second round of the election (a candidate must win at least 51% of the vote in the first round to be declared president; otherwise, there must be a run-off between the top two candidates).

Then last month, tragedy struck in the form of a plane crash, killing Eduardo Campos. Shortly thereafter, Campos' vice presidential running mate, Marina Silva, was nominated to take his place at the top of the PSB ticket. When Eduardo Campos died he was ranked a distant third by all posters. Most people assumed that Eduardo Campos, would throw his support to Aecio Neves after the first round in October, joining forces in an attempt to unseat Dilma in the second round November run-off.

As this article goes to publication the polls currently show Marina Silva as the leading candidate to become the next president of Brazil. Not only is Brazil faced with the unprecedented circumstance of two women facing off for president, it is also facing the prospect of electing the world's first green president.

This year's World Cup in Brazil overshadowed two important announcements during the tournament. The first was made by Petrobras, Brazil's state owned oil company, which celebrated a production milestone of having exceeded 500,000 barrels of oil per day, from its pre-salt areas in the Santos and Campos Basins some 300 kilometers off the coast of Rio de Janeiro. These pre-salt areas (over 4000 meters below the ocean floor) represent the deepest offshore oil drilling in the history of global oil exploration and extraction.

The second announcement during the World Cup came from Germany, where the country set a new record with solar power providing more than 50% of its spot electricity demand.

These contrasting energy scenarios, one celebrating fossil fuels (with their unstated but attendant risks and pollution potential) and the other clean renewable solar energy, represent more than economically driven approaches to a given country's energy needs.

The real contrast between Germany and Brazil has to do with interpretations of global energy trends, and political thinking focused on the betterment of society over the long-term, versus Brazilian party politics. Controlling future oil royalties via politically controlled Petrobras is the ruling party's priority -- even if ultimately that could come at a cost to Brazil itself.

This is especially egregious when we compare Germany's solar potential with Brazil's. The simple fact of the matter is this -- just because Brazil has found huge oil deposits offshore (some estimate pre-salt reserves on a par with Saudi Arabia), does not mean that it is in Brazil's best interest to exploit those reserves.

Increasingly, and worldwide, preservation of the environment is being viewed as a central part of the quality of life equation, particularly for urban living. This means gearing up to transition to a more sustainable energy future.

Rethinking the future of energy is important for several reasons:

• Fossil fuel costs are continually rising as global demand requires exploration of ever more difficult locations and feedstocks (e.g., heavy oil, shale oil, tar sands and ultra-deep offshore drilling like the pre-salt area)

• Most oil reserves are now controlled by government owned companies, which means that the global regulation and distribution of energy can be used as a political tool (Putin's Russia is a classic example)

• The centralization of control contributes to price volatility and frustratingly imprecise long-term planning

• New energy technologies are being discovered and adopted at an accelerated pace, making the price of oil over the long-term unpredictable

• Climate change is a real concern not to be passed on to future generations

Some countries like Germany have stepped ahead of the curve and made big bets on renewable energy. The decision to go green required foresight, and led Germany to create strong incentives for wind and solar technology development and implementation, well before it was economically feasible. This has enabled both technologies to mature and enter the mainstream.

Today, Germany's solar and wind industry has the highest penetration in the world. The price of energy is trending downward, while other countries with high fossil fuel generation and reliance are seeing price growth.

In contrast, Brazil was well ahead of this clean energy curve in the past and used to be a world leader in sustainable energy with hydropower from the 1960s through the 1980s, and ethanol's development in the 1980s into 1990s and early 2000s. Today, however, Brazil is backtracking and heading towards a model that the rest of the world is desperately trying to get away from; a model focused on increasing thermal (carbon-driven) electricity generation and oil exploration.

With its pre-salt exploration, Brazil is making a massive bet on the future of oil while some of the large suppliers of the Middle East, such as UAE, Kuwait and Saudi Arabia, are already preparing for a future without oil. At the same time, given all the difficulties already alluded to, many large oil consumers (such as U.S. and China) are focused on reducing consumption (efficiency) and moving to renewable alternatives (electric vehicles)..

Brazil's government is betting all of their energy chips on global long-term strong oil demand. We do not believe that that is a good bet.

At first glance the pre-salt discovery appears to be a positive development for the country. In taking a step back, the real potential risks of going full steam in this direction give pause.

Here are some key pre-salt figures:

• R&D costs already incurred by Petrobras of US$100B

• Petrobras has the highest debt ratio of any major oil company and has lost half of its market value since the pre-salt discovery

• Additional estimated capital costs of US$ 250B to access the oil over the next 5 years (more than the entire national education or health budgets for the same period)

• Current production of 2 million barrels/day and plans for 3.5 million by 2020

Given current long-term oil price estimates of US$85/barrel that would result in an incremental free cash flow of approximately US$ 25 billion -- creating a payback of about 8 years. If prices fall short of this prediction, the payback could increase significantly (US$70/Barrel would mean 15+ years). In other words, Brazil would not breakeven on this massive bet until 2030 or 2035 at the earliest.

In the past, Brazilian hydropower capacity was a huge success and the country's clean energy matrix was a shining example globally.

However, in the last 10 years, the installed capacity of hydro has dropped from over 80% of the matrix to about 65%, - with fossil fuel driven thermal generation making up the difference.

Electricity prices in Brazil have risen dramatically in the last decade partly due to thermal generation's increasing market share, along with infrastructure issues and taxes. Brazilian energy prices used to be some of the lowest in the world and now are some of the highest.

Given the recent drought and even higher thermal use than expected, the price of electricity is expected to rise at least 15-20% by our estimate. The current government has been artificially keeping prices contained ahead of the election. Utilities are currently being subsidized with government-backed loans with high interest that will also need to be paid by the consumers when prices come due next year.

The International Energy Agency (IEA) forecasts that Brazil will need to invest US$300B in generation and US$250B in transmission to meet expected demand (doubling current capacity by adding roughly 120 GW of capacity). This translates into a capital cost of approximately US$4.5/Watt (excluding any operational costs).

Accounting for different efficiency ratios and decreasing solar capital costs, Brazil could accomplish nearly the same result at the same capital cost with solar (giving solar a clear advantage since it has no operational costs).

Additionally, because Brazil has a large hydro reservoir capacity, with proper planning that natural storage can accommodate solar generation variability, making the deployment of solar easier and cheaper than in most other countries.

Ironically, Germany's best geographic regions for solar, are on par or below half the capacity of Brazil's average areas for solar.

Given Brazil's natural advantages, solar should be a large and growing market:

• High solar insolation across the country (higher than most other countries)

• High electricity costs (the higher the cost, the more attractive solar becomes)

• Large flexible hydropower base that can accommodate solar variability

• The ability to decrease transmission and distribution costs with solar distributed generation (installed solar capacity at point of consumption)

• Solar is the fastest growing source of energy globally with a better than 40% compound annual growth rate, and it is the only source of renewable energy with a thirty plus year record of 15% annual decreasing costs

Lamentably, and contrary to common sense, there is currently no solar market in Brazil. There are two key issues preventing solar deployment.

First, solar is different from most other energy sources, in that nearly all costs are upfront, occurring on installation. As a result, typical energy consumers prefer to finance these costs and pay over time instead. However, interest rates in Brazil are too high and financial institutions such as banks are not structured to finance these kinds of assets.

Typically, specialized solar finance firms perform this function. But, given the overly complex tax system and limited availability of consumer finance in Brazil, this market has not yet materialized.

Second, the decentralized distributed network approach to energy, which is already a global trend, and the hallmark of solar energy and all things digital, runs aground of the current government's propensity for energy centralization and control.

The 7 - 1 thrashing of Brazil in the World Cup semi-final was not only symbolic of Germany's global leadership role in renewable energy, it was also symptomatic of a larger challenge in Brazil -- the turning away from a mental framework of being a follower, which dates back to colonial times, and a turn toward a more mature nation that recognizes its natural leadership role in a new global clean energy future.

All of this may be in the hands of a woman from the Amazon.

Robert Wilson is the founder of Gaia Labs, a venture capital firm. Enrique Glotzer is CEO and co-founder of EnergyCO, a start-up promoting solar project finance. Both are based in Rio de Janeiro.

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