All Eyes Are On Renewal Terms

Following the privatization wave of Brazilian electricity discos in the early 2000s, 20 concession contracts are set to expire between 2025 and 2031 (see table 1). The renewal process has gained significant attention not only from large industry players but also from investors and creditors, given longstanding discussions and uncertainty over its final form. The Federal Audit Court's (Tribunal de Contas da União [TCU]) Jan. 24, 2024, endorsement of the preliminary terms that the Ministry of Mines and Energy (MME) proposed for the renewal of distribution concessions for additional 30 years has provided some clarity. This is a favorable development, considering that the 20 distributors listed in the table below account for 62% of the country's power distribution market (see chart 1), representing a significant portion of the electricity market. We expect renewals will follow the general conditions, but we also anticipate some variations based on each concession's characteristics.

Table 1

Chart 1

Endorsed Guidelines Without Renewal Fees

In late January 2024, the TCU ratified the preliminary renewal terms. Originally published on June 22, 2023, the terms signal the government's commitment to continuity and stability in the power distribution sector. More specifically, discos, which are complying with not only minimum services quality metrics but also with economic-financial regulatory requirements, would be eligible to extend their contracts without renewal fees. However, we believe the granting authority may require compliance with stricter quality metrics. (Minimum service quality metrics are duration and frequency of service interruption [known by their Portuguese acronyms of DEC and FEC, respectively]).

In line with our base-case assumptions, which exclude the payment of renewal fees, we don't anticipate the concession extension process to affect credit metrics or liquidity of the rated discos and their respective groups. Moreover, we believe the renewal process increases the medium- and long-term visibility. It also confirms our view of Brazil's adequate regulatory framework for the electricity industry, while supporting the companies' refinancing efforts beyond concession expirations, diminishing overall uncertainties and credit risks.

The new distribution concessions will also incorporate the consumer price inflation index (IPCA) to adjust costs for which discos are responsible (parcel B or manageable costs, including employee salaries, for instance). Currently, concessions use the IGP-M inflation index, which has a higher weight of wholesale prices and has been more volatile than IPCA, resulting in higher electricity bills. This modification will increase the predictability, in our view, of rate adjustments. Moreover, it will align the index adjustment with concession renewals in 2015-2017. These include Cemig Distribuicao S.A. (BB-/Stable/--; brAA+/Stable/--), and some concessions of CPFL Energia S.A. (brAAA/Stable/--) and Energisa S.A. (BB/Stable/--; brAAA/Stable/--).

Added Flexibility For More Investments

We believe that the formalization of the exclusion of renewal fees will free up discos' liquidity for investments in grid improvements and enhancement of service quality metrics, especially across subregions within concession areas. Therefore, we don't anticipate significant increases in discos' debt as most of the rated groups generate stable cash flows, and have solid balance sheets and adequate liquidity. Moreover, several groups performed significant capex in the past few years to expand and upgrade their distribution networks, connect new clients, improve service quality metrics, and lower the percentage of energy losses. These investments are incorporated in the groups' regulatory asset bases that are reassessed during their rate reviews, which occur every three to five years (depending on the concession contract).

Overall, we assess liquidity of the rated integrated electricity groups as adequate, as they benefit from ample access to credit markets, allowing them to fund additional investments without jeopardizing their credit quality. The exception is Light S.A., as it is currently under judicial reorganization.

Service Quality Matters

Chart 2

Chart 2 shows that discos invested roughly R$115 billion in 2015-2023, which contributed to a gradual improvement of the overall service quality metrics (see table 2). We have aggregated service quality metrics of all distribution concessions expiring in the next several years, and divided the reported ratios by each respective regulatory threshold.

Table 2

As of Sept. 30, 2023, service quality metrics of the majority of the rated discos with expiring concessions were within regulatory limits with a comfortable cushion. Discos have also complied with the regulatory economic-financial requirements. There are a few exceptions though, such as Equatorial Maranhao Distribuidora de Energia S.A. (brAAA/Stable/--), quality metrics of which eroded in 2021 due to adverse weather conditions and lower investments during the pandemic. As a countermeasure, the company has expanded its maintenance staff and increased investments to strengthen the reliance and redundancy of its distribution networks after 2021.

According to concession terms, the Electricity Regulatory Agency (ANEEL) may intervene and recommend the termination of the concession, if the concessionaire fails to comply with service quality metrics for more than three years or with the economic-financial requirements for more than two years. This was the case for Amazonas Energia (not rated), given that ANEEL recommended the termination of the company's concession due to cash burn and high debt. In turn, the concession renewal terms for Light--currently under judicial reorganization--and Enel Rio (both not rated) are in a separate category, as they operate concessions in areas with high levels of energy theft and crime.

Potential Bottlenecks

Although we view the recent developments as positive, the renewal process is advancing slower than expected. For instance, EDP Espirito Santo Distribuicao de Energia S.A., the first disco in line to renew its concession, should have received a reply from the MME in early January 2024, according to the timetable outlined in Chart 3. However, the TCU endorsed the proposed terms for concession renewals only on Jan. 24, 2024, and the MME has yet to announce the final terms. Nevertheless, our base-case scenario continues to incorporate concession extensions without renewal fees, and in general, the rated groups have sufficient liquidity to cope with higher refinancing needs in case the process takes much longer.

Chart 3

Dynamic Energy Landscape Will Still Require High Investments

As the Brazilian electricity distribution segment evolves rapidly, more investments in energy efficiency will be needed, guidelines for which the MME will establish. We believe initiatives could include investments in energy efficiency for low-income regions/customers and the public sector, upgrading metering systems, and reducing nontechnical losses in challenging concession areas. We don't expect meaningful cash outflows for discos due to these potential investments, because the proceeds would come from mechanisms already in place, such as energy efficiency contributions (R&D programs) and ancillary revenue.

We believe investments in the maintenance and upgrade of distribution networks will remain substantial, as a result of the surge of decentralized generation that disrupts the existing networks by integrating numerous small-scale energy sources spread across the grid. For instance, the installed capacity of decentralized photovoltaic panels in Brazil jumped to more than 26 gigawatts (GW) as of December 2023 from 1 GW in 2019. The National Power System Operator forecasts the addition of 14 GW through 2027. The bidirectional flow of electricity in decentralized systems demands advanced technologies such as smart grids to monitor and control the network effectively, which will require additional investments in digitalization and automation to ensure grid stability and accommodate the inherent intermittent power output from renewable sources. As a result, we expect investments for upgrading distribution networks to be incorporated under each disco's regulatory asset base.

Also, recent extreme weather events—such as severe wind gusts, heavy rains, and floods--have damaged distribution grids and caused prolonged periods of disconnections across Brazil. That has generated discussions among ANEEL, discos, and municipalities about the necessity for additional investments to strengthen the network infrastructure against these climate-induced challenges. We believe discos will have incentives to upgrade distribution networks if such investments are incorporated into their asset bases and passed through to electricity rates. Still, we will continue monitoring the developments of those requirements.

In addition, the increased liberalization of Brazil's energy market adds a layer of complexity to distribution concession renewals, because we expect the migration from captive clients to the free market will shrink the discos' client base. Since the beginning of 2024, industrial and commercial clients that consume less than 500 kilo volts are allowed to choose their energy suppliers. This was the last step of the opening of the market to high voltage clients initiated in 2019. As a result, energy trading companies and large integrated power groups can offer new types of services, like discount on short- to medium-term energy contracts, which increases market competition. In this environment, discos may have to invest heavily in digitalization of networks, as advanced technologies like smart grid and digital meters empower suppliers with real-time information on consumers' energy usage, enabling them to offer tailored services to clients.

Bright, Although Challenging, Prospects For Discos

The renewal of distribution concessions is advancing at a slower-than-expected pace. However, we believe there are grounds for a smooth process—including the exclusion of renewal fees--given discos' sizable investments in the past years, which contributed to a gradual improvement in quality standards, as well as due to the companies' expertise in operating their concession areas. Moreover, the overarching financial-economic balance of the majority of concessions, supported by the ownership of large integrated energy groups that enjoy wide access to debt markets, lends stability to the renewal process. We incorporate this factor into the stable outlooks on the rated integrated electricity groups and discos in Brazil. This is because we don't expect significant cash burns during the concession extension process, which will also raise visibility and support discos' refinancing beyond the concession expirations. We also believe that the electricity groups have capacity to continue investing in the power distribution segment in Brazil in light of the evolving dynamics of the sector.