S&P Global Ratings expects economic conditions in Brazil to worsen as the COVID-19 pandemic spreads in the country, and social-distancing measures and quarantine halt commercial activity. We now expect Brazil to fall into a recession in 2020 with GDP contracting 4.6% and returning to growth in 2021. The unprecedented pandemic will also affect, in our view, the historically resilient utilities sector. This is mainly because of the depth of the economic damage the coronavirus will cause, potential political pressure to provide relief to cash-strapped electricity users, and boost to economic recovery once the lockdown is lifted. Still, we believe electric utilities that we rate will absorb temporarily lower cash flows. This is because most of them have stronger intrinsic repayment capacity (which we refer to as stand-alone credit profiles), while Brazilian sovereign ratings cap those on the companies given the regulated nature of their business.

Moreover, the industry regulator and government already announced several measures to alleviate the burden of utilities bills on residential clients, including billing exemptions for low-income customers and scrapping service disconnections among residential clients. We now expect a series of measures to support the sector players' finances, particularly the distributors because they collect revenues for the entire sector. Nevertheless, despite downside risks of a prolonged crisis, the rated utilities have, in our view, enough financial flexibility. They're cutting costs and expenses, and curtailing investments and dividends to protect their creditworthiness. Many utilities also recently have secured bank loans to preserve liquidity.

The Impact On Distributors Will Be Pronounced

The deep recession and subdued prospects for economic growth for 2021 are dampening power demand, especially among the industrial and commercial segments, while it will rise among residential customers as they spend more time at home.

We expect power demand to decline at least 5% this year. According to the Electricity Commercialization Chamber's (Câmara de Comercialização de Energia Elétrica [CCEE]) data, energy consumption in April was 13% lower than in the same month of 2019. In our view, the demand for power will take two years to recover to pre-pandemic levels. For distributors, the lower demand will also translate into power surpluses this year, given that they have to budget for energy sources in advance. According to the CCEE, energy surplus among distributors is likely to be 111%-113% in 2020, depending on the duration of the quarantine. At this point, the average power purchase agreement (PPA) price is at R$200 per megawatt hour (MWh). Meanwhile, spot prices are trading at the lower end of the regulatory band, at R$39.68/MWh, due to a much weaker demand and robust hydrology conditions, hindering the recovery potential if the energy surplus were to be sold in the spot market. Therefore, we expect the distributors' operating performance to take a hit, because they only have a 5% regulatory buffer to pass through the related costs to end consumers.

Moreover, Itaipu Binacional supplies about 15% of the country's energy generation, rates of which are denominated in dollars according to the Itaipu Treaty. Itaipu Binacional currently supplies the distributors in the southern, southeastern, and midwestern regions of Brazil, which are allowed to pass through the cost of energy purchased, currently at $28.41 per kilowatt (kW). Given that the Brazilian real lost about 40% of its value against the dollar since the beginning of the year, the distributors' working capital needs have increased.

Delinquency Is Increasing

In order to mitigate the hardship caused by COVID-19, the National Electricity Regulatory Agency (Agência Nacional de Energia Elétrica [ANEEL]) announced a series of initiatives, including:

• Distributors are temporarily prohibited from disconnecting from service the residential customers with unpaid bills;
• Low-income customers are exempted from paying electricity bills for a 90-day period; and
• Recent annual rate readjustments were announced, but actual implementation postponed to July.

According to Provisional Measures 949 and 950 that the government announced in early April, low-income clients with electricity consumption of up to 220 kilowatt hours (kWh) are exempted from paying electricity bills between April 1 and June 30 this year. This shouldn't have a significant impact on distributors, because the government will channel up to R$900 million to the electricity sector fund, Conta de Desenvolvimento Energetico (CDE), to cover these bills. We note that the low-income clients represent a minimal portion of the distributors' revenues and margins, even if they represent more of the companies' client base, as shown in the table below. The distributors that operate in the northern and northeastern regions of Brazil have a greater share of such clients. Still, there are risks that these exemptions could be extended and customers falling into the low-income segment if deep economic malaise persists for a longer period.

Table 1

Distributors To Be Compensated For Postponed Rate Hikes

Over the past few weeks, the regulator announced annual rate readjustments for several distributors. But to mitigate the impact from the crisis, the distributors and regulator agreed that readjustments would only come into effect on July 1, 2020, and for the deployment of funds from the CDE in the meantime.

Table 2

Nevertheless, out of ANEEL's abovementioned measures, the one forbidding suspension of services for delinquent customers will have the biggest impact on the distributors, in our view. This, combined with the rapidly deteriorating economic activity, rising unemployment, and depletion of disposable income, is causing delinquency rates to jump. According to the Ministry of Energy and Mines (MME), delinquency levels in April soared to about 12% from the historical average of 3%. Therefore, provisions for unpaid bills may increase significantly, and utilities' inability to collect a portion of the bills could weaken their financial results. The impact will be more severe on the distributors operating in concession areas with historically high delinquency rates, such as Light Servicos de Eletricidade S.A. and Cemig Distribuicao S.A., in our view.

Financial Aid Package Should Shore Up The Sector's Liquidity

The government's recently announced measures also include a provision to provide funding to the distribution segment, financial costs of which will be incorporated into rates in future readjustments. Such funding will be very similar to the one the government deployed in 2014 to support distributors facing high energy costs following a prolonged drought. These entities were grappling with higher working capital needs because the energy cost pass-through only occurs at annual rate readjustments. In 2014, Brazil's largest public and private banks provided a five-year R$21 billion loan to the CCEE, which in turn disbursed the funds to the distributors. The repayment of the loan occurred through an additional rate charge in the monthly consumer bill, which ANEEL approved. As a result, the funds that the distributors received weren't considered as debt.

Therefore, the May 18, 2020, the Presidential Decree 10,350 established the guidelines for a short-term financial package for the electricity distributors, aiming to:

• Cover the drop in cash flows stemming from the sharp reduction in demand and much higher delinquency;
• Monetizing not only existing net regulatory assets (entities that we rate have a combined R$4 billion), but also those that are being formed, for instance due to the higher costs on the portion of the energy denominated in dollars; and
• Address the hit from the lower rate hikes, which the regulator recently approved, but will go into effect in July.

The CCEE will once again manage a specific account, this time called "Conta Covid", which will be funded by a new loan from group of banks led by Banco Nacional de Desenvolviment Economico e Social (BNDES; BB-/Stable/--, brAAA+/Stable/--) and likely to total R$16 billion. The CCEE will disburse funds to distribution companies on a monthly basis until December 2020, based on the severity of cash-flow impact for the period. Repaying this loan will require additional contributions from the distributors to the CDE, incorporated into rates starting in 2021. In our view, the cost of repaying the loan could be lower than that of the one in 2014, thanks to the all-time low interest rates in Brazil of around 3.0%. Certain restrictions would apply to distributors in order to receive the funds, including unilaterally changing the terms of their PPAs and distributing dividends above the regulatory minimum of 25% amid failure to comply with their sectorial financial obligations (such as those to generators and transmission companies, and regulatory fees).

We expect the financial package to be finalized and implemented over the next few weeks, after the preliminary proposal that ANEEL published on May 26 receives comments from market participants through a public hearing between May 27 and June 1, 2020.

Additional Measures Could Be Forthcoming

While we believe the financial package should provide timely short-term liquidity to the sector, the presidential decree doesn't address all the imbalances that distributors are likely to face over the next few years, including delinquency rates much higher than the historical average, exacerbated by the prohibition on disconnecting delinquent customers, which could be seen as above the inherited risk of the business. Still, such issues could be addressed in the future, particularly because the decree allows distributors to request extraordinary rate resets on individual basis.

In addition, further measures could be implemented. In April 2020, the regulator published a study assessing the impact of COVID-19 on the Brazilian electricity sector and proposed some initiatives to cope with the crisis. In addition to the abovementioned liquidity fund and avoiding a significant increase in rates, these include:

• Voluntary amendments of the terms of bilateral power contracts, as in the case of generators remunerated based on their O&M costs, which could delay some of the investments committed to improve assets to prevent such costs to be incorporated into rates; and
• The possibility of revising rules on the use of sector-specific funds, including the ones for R&D and energy efficiency, to provide additional liquidity to the distributors.

In our view, the Brazilian regulatory framework has a solid track record of maintaining the economic and financial sustainability of the electricity market. We expect an economic equilibrium to be negotiated once the pandemic subsides, especially given that the distributors collect revenue that's subsequently distributed to the rest of the participants in the regulated market. We will continue to monitor the situation, because the support could become vital if the pandemic lingers for a longer period, prolonging damage to the sector. Still, in general, we believe that distributors that we rate have enough financial flexibility to maintain higher working capital needs and absorb losses for a prolonged period.

Chart 2

Generators Face Higher Counterparty Risk

Generators usually sell the bulk of their assured energy (defined by the regulator) through long-term, take-or-pay contracts--about 70% in the regulated market. This reduces volume risk and brings stability to cash flows. While the relatively long average term of energy contracts reduces exposure to the currently low price of energy, counterparty risk increased.

We don't expect a significant impact on the regulated market, given that distributors are slated to receive financial support, although changes in some contracts could be mutually agreed upon, especially with generators that are struggling to meet energy delivery requirements. But this is not necessarily the case for the portion of the energy sold in the free market, given the prevailing low spot prices and counterparty risk under bilateral sales agreements. According to CCEE, power consumption in the free market dropped 14% in April 2020 from the same month of 2019. This was particularly so among automakers and auto parts suppliers (down 66%) and textile manufacturers (47%), while consumption among services providers fell 32%.

Chart 3

Contracts in the free market usually contain flexibility and the force majeure clauses. While the amount of the contracted energy consumed could be adjusted (usually within a 5%-15% range), the use of the force majeure clause to cancel a contract could lead to litigations, which could be a time-consuming and costly process, especially because the arbitrage provision is a likely outcome.

We believe the rated generators are overall better protected than distributors to this risk, given that they usually sell energy through long-tenor, take-or-pay contracts with solid counterparties in the regulated and free markets. They also enjoy sufficient financial flexibility to face the situation amid the rising counterparty risk. Therefore, we don't expect rating actions among these entities at this point.

Chart 4

The Transmission Segment Is Least Exposed

The public health crisis will have the least impact on transmission companies, given their operations of availability nature. Their concession contracts operate under a revenue cap model--Receita Anual Permitida (Allowed Annual Revenues). This establishes the annual revenues a transmission concession is entitled to receive, based on the availability of the lines, rather than the actual volume of power transmitted. Nevertheless, the transmission segment could suffer in case of payment delays from both generators and distributors, which can occur especially if liquidity of the latter segment deteriorates.

Liquidity Makes The Difference

Despite the pandemic's pernicious impact on economy and power demand, the rated electric utilities have in general financial flexibility to absorb weaker operating performance until severe social-distancing measures are lifted and an extraordinary liquidity package becomes available. The utilities have taken the following initiatives to preserve cash:

• Tapping new bank loans, although at much shorter tenors and higher costs. Since mid-March, the rated electric utilities raised close to R$6 billion in new credit facilities. In addition, cash position among the sector's players was already relatively robust, covering about 150% of short-term maturities on an aggregate basis.
• Reducing non-mandatory capital expenditures.
• Curtailing or postponing dividend payouts.
• Several of the sector companies that have BNDES loans accepted the lender's offer to postpone principal and interest payments for six months.
• The regulator already authorized the transfer of money from a specific energy reserve fund, consisting of about R$2.4 billion, R$1.9 billion of which was disbursed to the distributors.

We expect the sector's credit metrics to hit a trough in 2020 and recover in subsequent years. However, we don't expect rated entities to be significantly exposed to covenant breaches. But this will also depend on the extent, for instance, the distributors receive financial help: through direct injection of funds or through rate increases. Therefore, covenants for debts of most of the entities that we rate are adjusted for net regulatory assets. These should help diminish the impact on credit metrics.

Table 2

Related Research

• The Spread Of The Coronavirus To Erode Credit Quality Of Latin American Infrastructure Assets, April 7, 2020