Investment implications of Brazil’s gubernatorial elections

Core Case

In this election year investors have rightly focused on the presidential race and the outlook for the post-Lula economy. However the gubernatorial elections taking place simultaneously with the presidential election will also have a significant impact on the business climates in Brazil. The fate of state-controlled companies, for better or worse, turns on the outcome of these elections. Likewise, the operations of private firms are also at stake. Below we examine in detail the political outlook of the three states most represented in equity portfolios: Parana, Minas Gerais and Sao Paulo.

PARANA: Good news ahead

Perhaps the most egregious example of the investment climate risk inherent in the gubernatorial elections has been posed by Roberto Requiao, a populist of the ideologically nebulous Democratic Movement Party (PMDB) who took office in 2003 in the southern state Parana following two-term Governor Jaime Lerner. During his eight years in office Lerner, a progressive and dynamic governor who was recognized globally for his innovative city planning policies, had pushed ahead with a privatization programme that included the sale of state bank Banestado, state telecommunications company Telecomunicacoes do Parana (TELEPAR), railway Ferroeste, several state highways and a controlling stake in sanitation company Companhia de Saneamento do Parana (SANEPAR).

But Requiao, who ran on an anti-privatization platform, made good on his promises to increase the state’s role in the economy. Within months of taking office, he deposed Vivendi of its controlling position in SANEPAR, tried to void concession contracts held by the highway management company Companhia de Concessoes Rodoviarios (CCR) and intervened in the railway concession controlled by America Latina Logistica (ALL). Requiao also left his mark on state electric company Companhia Paranaense de Energia (COPEL), which adopted a policy of discounting electric bills that has eroded shareholder value and reduced dividends.

In addition to his assault on state-controlled companies and concession holders, Requiao also caused huge losses for soy exporters when he illegally banned genetically modified (GM) soybeans from Brazil’s main grain port of Paranagua, which was managed by his brother Eduardo Requiao. Between 2003 (when the prohibition on GM soy was first issued) and 2005, Paranagua’s total soy complex exports dropped by 4.2 per cent to 12.2 million metric tonnes while soy export volumes at the state’s biggest port, Santos, climbed 22.2 per cent and volumes at the southern port Sao Francisco do Sul surged by 112 per cent. Export volumes of soy leaving Paranagua sank by a further 20 per cent year on year in 2006. Parana’s ban on GM exports was struck down by the Supreme Court in April 2006, but delays in integrating GM exports back into the activities of the port continued for over a year, as Eduardo Requiao succeeded in holding part of the port off limits to GM soy producers until July 2007.

The next governor is likely to be pro-business.

With Requiao ineligible to run for a third consecutive term, a new governor will take office in 2011. Currently Carlos Alberto “Beto” Richa of the main opposition Social Democrat party (PSDB) is the clear leader in the race and could win in the first round. Before stepping down to run for governor, Richa had been the extremely popular mayor of Parana’s capital city Curitiba since 2004. He was re-elected in 2007 with 77 per cent of the vote and his government still has a 90 per cent approval rating.

Richa is likely to implement the PSDB’s business-friendly approach to governing, in the tradition of Jaime Lerner, Aecio Neves (the former PSDB Governor of Minas Gerais) and the PSDB’s presidential candidate Jose Serra (the former Governor of Sao Paulo). Richa himself has already given an idea of how he would govern Parana if elected. In recent declarations to the press he pointed out that Curitiba has maintained a primary surplus for five consecutive years without compromising investments in infrastructure, which he claims have been equivalent to 9 per cent of municipal revenues. Moreover, in an editorial published in several local newspapers in early May, he said that he would not privatize SANEPAR, COPEL or the port of Paranagua and that he envisions an “efficient state that works closely with the private sector”. He echoed the PSDB party platform, which defends “the strengthening and professionalization of state-controlled companies”. Richa also pointed to his promotion of public-private partnerships (PPPs).

We believe that Richa’s election would be positive for SANEPAR and COPEL, which have been punished by Requiao’s populist management. Private companies in the state, such as road concession operators and soybean exporters will also directly benefit from Richa’s professional governing style. Environmental licensing delays, which have significantly impeded construction of small hydroelectric dams and other projects, could be streamlined under his administration.

The only candidate who has any chance of successfully challenging Richa – we believe this chance to be small – is Osmar Dias of the Democratic Workers Party (PDT), who lost to Requiao in the 2006 gubernatorial election by a razor-thin margin of 0.2 per cent. Dias, who is running on an anti-privatization platform, is likely to continue in Requiao’s footsteps, with negative implications for the management of COPEL and SANEPAR if he wins. However there is a strong possibility that Dias may abandon the gubernatorial race and run instead for the Senate with PSDB support, thus leaving the way completely open for Richa’s victory. Dias’ chances to win the gubernatorial race are limited, given that the PDT is a small party and he would need to form an alliance with a larger party in order to have a successful campaign. According to local press reports, Serra himself has got involved and has offered to help Dias in his bid for Senate and has reportedly agreed to make Dias the Minister of Agriculture in the event that Serra wins his bid for president.

SAO PAULO: Pro-business policy continuity very likely

Former Sao Paulo state Governor Geraldo Alckmin (2001–06) of the PSDB is ahead in the polls, with 53 per cent of voters’ preference compared to 13 per cent for Sao Paulo Senator Aloizio Mercadante of the Workers’ Party (PT). An Alckmin victory would secure continuity for the management of state sanitation utility SABESP and other state-run companies, such as power generation company CESP. As governor, Alckmin was responsible for a major restructuring of CESP in 2006, when he sold its controlling stake in Sao Paulo power transmission company Companhia de Transmissao de Energia Eletrica Paulista (CTEEP) for R$1.193 billion (US$547 million).The capital raised through this sale was used to reduce CESP’s debt, which totaled R$10 billion (US$4.6 billion) at that time, in order to lay the groundwork for the sale of a controlling stake in the company to private investors.

Alckmin would also continue the PSDB policy of auctioning off new road concessions and working closely with the private sector in infrastructure projects, topics we shall discuss in depth in upcoming reports. We believe that Alckmin, if elected, will hit the ground running in terms of structuring projects that will attract private sector interest. He would also continue Serra’s policy of working closely with Sao Paulo’s Mayor Gilberto Kassab of the Democrat Party, in pushing through much-needed infrastructure projects, particularly in the inter-municipal transportation and sanitation sectors.

MINAS GERAIS: The wild card

The outcome of the Minas Gerais gubernatorial election is less clear, and therefore, so is the future of its state-controlled companies Companhia Energetica de Minas Gerais (CEMIG) and Companhia de Saneamento de Minas Gerais (COPASA). Both companies have become models of sound management during Aecio Neves’ two terms as state governor.

A victory for PSDB candidate Antonio Anastasia (Neves’ chosen successor) would help to continue to strengthen these two companies, which have improved dramatically since Neves took office in 2003. At that time he appointed a new management team to COPASA, which began the process of optimizing management that included massive cost cutting and improvements in corporate governance. This allowed the company to list on the BOVESPA in 2006. The company has also been able to increase investments while maintaining a profit, as illustrated by Chart 1.

Important improvements also took place at CEMIG during the Neves administration. When Neves took office, he negotiated the massive debt that the state of Minas Gerais had with the company. He also began a programme of expansion through acquisition that has taken CEMIG outside Minas Gerais state. The company also saw its EBITDA increase by 90 per cent between 2004 and 2009.

For Minas Gerais, an Anastasia victory would also guarantee the continuity of fiscally responsible policies. Anastasia has worked closely with Neves in putting the state’s finances in order. Minas has been a pioneer in PPPs and has used the model for investments in a broad range of sectors, including prisons and highways. For example the state government is hoping to use the PPP model to renovate the Belo Horizonte football stadium ahead of the 2014 World Cup. The state has also announced plans to sell concessions for as many as 7,000km of state highways.

Although Anastasia has gained rapidly according to the 1–4 May Instituto Sensus poll, he is still behind the other potential candidates, with only 16 per cent of voters’ preference. The current leader is the former Telecommunications Minister and Senator Helio Costa of the PMDB, with 38.8 per cent, followed by the PT's unofficial candidate, the former Mayor of Belo Horizonte, Fernando Pimentel, with 19.5 per cent. Anastasia could benefit from political infighting between the PMDB and the PT in Minas Gerais: the Lula administration promised to support Costa, but local PT officials want to run Pimentel. Costa has threatened to support PSDB presidential candidate Jose Serra in the event that Pimentel runs for governor.

Based on Costa’s proposals as Telecommunications Minister, which included reviving nearly defunct federally controlled telecommunications holding company Telebras in order to spearhead the expansion of Brazil’s broadband programme, we expect him to take a far less private sector-friendly approach to the management of CEMIG and COPASA than Neves if he wins the election. Although Pimentel was a competent leader in Belo Horizonte, he would probably reverse some of the spending cuts implemented by the Neves administration – particularly by increasing the number of state workers.

CESP and CEMIG could be big beneficiaries of a Serra victory

State-run Brazilian power companies currently face significant regulatory uncertainty in the medium term owing to the expiration of the concession contracts of key generation, transmission and distribution assets in 2015, a topic we explored in depth in this December 2008 note. The uncertain fate of these concessions has hit CESP hardest. An attempt in March 2008 to sell a controlling stake in the company failed because of investor concern over the 2015 expiration date of two-thirds of its generation capacity, supplied by Ilha Solteira (Brazil’s third-largest hydroelectric plant) and Jupia. Other state utilities – notably the subsidiaries of federal power holding company Eletrobras (FURNAS and CHESF) and, to a lesser extent, CEMIG – face the same regulatory uncertainty as the countdown to 2015 continues.

If Serra wins we believe that he will throw his support behind the extension of the 2015 concessions, with positive implications for these companies. Once this happens, and if Alckmin wins the gubernatorial race in Sao Paulo state, CESP is likely to go back on the auction block despite cautious electoral rhetoric this year from Alckmin regarding privatization.

If Dilma wins we expect her to eventually support the extension of the 2015 concessions owing to strong backing from both the private and public sectors on this front. However the Lula administration has tarried in supporting a bill of this type for the past two years, despite forceful lobbying from industry executives. Moreover Dilma, who has never been elected to public office, would probably have her hands full in her first year of governing, which could leave this legislative action on the back burner until 2012.

Conclusion

Although the outcome of the presidential election will have a greater impact on investor sentiment regarding Brazil, the results of the gubernatorial elections will nonetheless have a significant impact on the management of state-owned companies as well as on the overall business environment in the states. The winners of the gubernatorial races will directly affect the sale of infrastructure concessions to the private sector over the next four years. This is especially important as the 2014 World Cup approaches and host cities struggle to meet FIFA deadlines.

Barring a major campaign disaster for Alckmin, the outcome of the election in Sao Paulo should be favourable for investors. In Parana the chances continue to look good for Beto Richa, the market-friendly candidate. The outcome is less clear in the state of Minas Gerais, the second-largest state in Brazil in terms of population and GDP. Although it is still too early to call, PMDB Senator Helio Costa is the clear leader. Anastasia, the market-friendly candidate, will face an uphill battle to get elected.

Relevant Companies

Parana

Minas Gerais

Sao Paulo