developing the natural gas market in sÃo paulo,...

DEVELOPING THE NATURAL GAS MARKET IN SÃO PAULO, BRAZIL –THE COMGÁS EXPERIENCE

World Gas Conference 2003

SG10.2. The development of gas markets in developing & transitional countries

EXECUTIVE SUMMARYAs the world’s sixth most populous country possessing large and well-developed agriculture, mining,manufacturing and service sectors, Brazil accounts for almost half of Central and South America’seconomic output. Hydroelectricity and oil fuel the economy accounting for over 80% of the nation’sprimary energy requirements.

Natural gas has played a minor role in the energy matrix to date, partially as a consequence of therelatively small indigenous resources, but chiefly because more attractive alternative sources of powerhave been available. The accumulation of a number of factors including an ever increasing demand forenergy, the unreliability of the existing power grids, governmental pursuit of a more balanced energysupply portfolio and pipeline access to the immense Bolivian gas fields have provided a massive stimulusto the natural gas industry.

In 1999, as part of the Brazilian’s government’s National Privatisation program, a gas concession area inthe south eastern state of Sao Paulo was granted to a consortium comprising of BG Group and Shell. Theconcession area captured an existing gas distribution network in Metropolitan Sao Paulo together withsome of the most industrialised areas within Brazil. The existing gas supply area served only a fraction ofthe potential market and under new ownership with a new outlook, the new company has set out totransform this potential into market share.

The marketing of natural gas is set against the background of a regulated environment and a country andculture unfamiliar with the product. Comgás faces not only the challenge of developing the market acrossall sectors but simultaneously animating the gas industry as a whole. The dynamics of each marketsegment vary considerably and there are some distinctly Brazilian challenges that need to be addressed.

This paper describes the specific experiences of Comgás in cultivating the natural gas market in SãoPaulo and reviews some of the key issues, challenges, strategies and lessons learned.

WS10-2_Siegel_text.doc 1 29/01/2003

BACKGROUNDThe Brazilian Energy Market

Brazil has one of the largest energy markets in the world and by far the largest in South America, with theBrazilian Total Primary Energy Consumption (TPEC) being twice as large as the aggregated TPEC ofArgentina, Bolivia, Chile, Paraguay and Uruguay.

The 1990’s witnessed a significant growth in demand with a 48.2% increase in energy consumption to anannual demand of 177.1 MTOE (million tonnes of oil equivalent) in 19991. This rate of increase was one ofthe highest in the world and in material terms only exceeded by the United States and some of the AsianTiger Economies.

The risk associated with the country’s continuing dependence on hydroelectric power generation wasexposed during 2001, when Brazil experienced a severe energy crisis. A power-rationing programme wasenforced from June 2001 through to March 2002 and was successful in that it averted rolling blackouts,but inevitably seriously hindered economic confidence and advancement. The principal cause wasindisputably severe droughts that depleted the nation’s reservoirs; however, other significant factorsincluding inadequate long term planning, lack of investment, the indecision and uncertainty bred by theenergy sector privatisation process also conspired to bring about the crisis. The advent of this powershortage was ill timed, coinciding as it did with the global economic slow down and the well documentedproblems within its Latin neighbour, Argentina.

However, Brazil has fared significantlybetter than all its Latin neighbours anddespite negative economic growth in thefirst quarter of 2002, has shown recentpromising signs of recovery. Theoutlook for energy growth in Brazil isextremely positive over the medium tolong term – a 2002 study by theAmerican Energy InformationAdministration (EIA) is forecasting, evenon a low growth case basis, a TPECgrowth of 50% over the next 20 years to300 MTOE.2

With current demand matching existinginstalled energy capacity and a further130 MTOE required over the next twodecades, Brazil continues to offer aninviting challenge and an excitingopportunity for energy companies.

Natural Gas in Brazil

Natural Gas has, to date, played only a minor role in meeting the energy requirements of the country, buthas steadily grown in importance over the last decade and in 2000 accounted for 4.6% of the TPEC1. Thispaucity in market share is due to the relatively modest indigenous natural gas resources (reserves in 2000were estimated at 228.7 billion cubic metres3) and the fact that more attractive alternatives existed to meetthe developing needs of the country.

The role of natural gas will become increasingly more prominent in the future, driven by: -

• The pursuit of a more balanced energy supply portfolio to offset the risk of future energy shortages• The construction of pipeline links to the huge gas fields of Bolivia.• The environmental advantages offered by natural gas

Energy Share of TPEC in 2000

Nuclear

1%

Coal

7%

Oil

48%

Natural

Gas

5%

Hydro

Electric

39%


São Paulo & Comgás

The South Eastern state of São Paulo is the most affluent and industrialised state within Brazil. It hasbeen nicknamed the “Locomotive State” as it is acknowledged to be the driving force of the country. It isan attractive proposition for investment, especially for energy companies. São Paulo generates 35% of theBrazilian GDP (US$94 billion in 1998), has a population exceeding 37 million4 and is home to some of theCountry’s largest industrial energy consumers.

The history of Companhia de Gás de São Paulo (Comgás) began officially in 1872 with the granting of aconcession to provide publiclighting in the city of São Paulo.Over the next 127 years,through numerous changes ofname and ownership, theCompany evolved into a stateowned natural gas distributioncompany concentrated withinthe metropolitan area of the citysupplying 300,000 customerswith 1.2 bcm (billion cubicmetres) of gas per annum

In 1999, in line with the BrazilianGovernment’s privatisationstrategy, Comgás was offeredfor sale as part of a concessionwhose boundariesencompassed the metropolitanarea of São Paulo, the Valley ofParaíba, Baixada Santista andthe Campinas region. One of

three concession areas in São Paulo state, it is by far the largest with 65% of the state population and80% of the GDP. The potential and scale of the opportunity appealed to many international oil and gascompanies, but it was the combination of BG (formerly British Gas) and Shell that emerged as thesuccessful bidders.

On the May 31st 1999 at the Governor’s Palace the concession agreement was signed and a new eradawned for both the Company and for natural gas in Brazil.

CONSTRAINTSThe competitive nature of the bid recognised the huge potential within the concession, but equally thefailure of the existing company to tap into this potential. As part of the due diligence process and duringthe take over phase, a critical task was the identification of effective ways to remove the barriers to growthwhich had precipitated Comgas’ stagnation since the 70’s. There were numerous and complex reasonswhy the market growth had plateaued, including the relative strengths of competing fuels at various stagesin the Company’s history, but at the time of the public offering, three principal inhibitors were recognised: -

ß Supply Constraint

ß Cash Constraint

ß Company Culture

Supply Constraint

Ambitions of major gas market development in the past have been limited by the availability of the naturalresource. Although São Paulo is sited close to the largest indigenous gas fields in the Campos and

Interior

São Paulo Metropolitan area (Population -16 million)

Vale deParaiba

1999 GasSupply Area

Gas fromSantos Basin

Gas fromCampos Basin

Gas fromBolivia

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Santos basins, their development, which remained in the hands of the federally controlled PetroleoBrasileiro AS (Petrobrás), has been conservatively pursued in favour of oil exploitation. The majority ofnational gas production continues to be exploited as associated gas, as the importance of oil remains pre-eminent.

The dynamics in the region have been altered by the discovery of huge gas fields in Bolivia and the desireof major oil & gas companies to exploit these resources and export gas to the most attractive market. Thefirst pipeline to connect Brazil to these fields was the 3,000 km long Bolivia – Brazil pipeline,commissioned in July 1999 and linking Santa Cruz in Bolivia to São Paulo. The completed pipeline has aninitial delivery capacity capable of shipping 6.2 billion cubic metres per annum (17mmcmd) and this isscheduled to be increased in 2003 to 10.9 billion cubic metres per annum. Petrobrás have a controllinginterest in the pipeline and Shell and BG have shareholdings, together with significant upstream interestsin the Bolivian gas fields.

This has invigorated the gas industry in Brazil and stimulated renewed interest in natural gas. Explorationactivity in the hydrocarbon rich, but as yet under explored, Atlantic Ocean off the South Eastern coast ofBrazil has increased and large discoveries in this area in June 2001 and April 2002 have positiveimplications for the future of Brazilian gas production.

The prospect of long-term secure and plentiful resources has enabled gas distributors such as Comgás tobroaden the horizons of their market development ambitions. The balance between national and importedgas resources will be important to the overall competitivity of natural gas, as the transportation componentin the Bolivian gas is significant in the unit commodity cost.

Cash Constraint

As with many of the Brazilian utilities, Comgás had suffered from under investment and with an ageinginfrastructure the focus was on maintaining the existing network rather than seeking new growthopportunities.

In 1995, the Brazilian government commenced a privatisation programme (which was one of the largestever carried out anywhere), but during this process federal and state utility investment dwindled.

The advent of new owners in BG and Shell paved the way for access to capital. Investment wasconditional as part of the concession agreement, but to realise the undoubted potential in the Companyand to meet corporate strategic gas chain objectives, significant additional investment was essential.

[c1]The international standing and the credit worthiness of the principal shareholders has allowed Comgásto secure favourable debt financing from the European Investment Bank (EIB) and Banco Nacional deDesenvolvimento Econômico e Social (BNDES) - The National Bank of Economic and SocialDevelopment.

Company Culture

A successful transition from an archetypal state owned utility to a modern, progressive private companywas a fundamental prerequisite to meeting the aspirations of the new shareholders and realising thepotential of the company and its market. The entire corporate structure of the company was re-engineeredintroducing streamlined work processes, improved planning and cost control procedures, cohesive marketdevelopment programmes, optimised manning (in terms of numbers, skills and employment type) togetherwith an over-arching governance framework. Inevitably this transformation resulted in a large turnover ofstaff and a reskilling of the existing workforce to meet the future direction of the company. Whereverpossible Comgás has drawn resources from the local market, but inevitably recruitment of experiencedgas industry personnel from outside Brazil has been necessary and to this end Comgás has leveraged theadvantages afforded to it by its principal shareholders.

BG and Shell are two top performing international oil and gas companies with vast experience in operatinggas businesses across the world. They have brought not only financial acumen, but also technical,business and marketing skills together with previous experience in buying into and successfullydeveloping existing gas enterprises. The new shareholders have high expectations with respect to theperformance and returns from their investment in Comgás.


REGULATIONComgás operates under the terms of the concession agreement and under the auspices of the stateregulator, Comissão de Serviços Públicos de Energia (CSPE).

The Regulator provides a framework in which Comgás pursues the Brownfield development inmetropolitan São Paulo, the semi Greenfield development in the Vale de Paraíba and the Greenfielddevelopment of the Interior.

The basic features of this framework include: -

• The granting of a 30-year concession with a 20 year extension option.

• 30-year residential and commercial customer commodity and transportation exclusivity.

• 12-year exclusivity on commodity for industrial customers.

• Revenue control through a price cap mechanism with a review every 5 years.

• Annual inflation adjustment of the distribution margin.

• Pass through of the cost of gas directly to the end users.

• The establishment of a current (suspense) account to absorb and control the fluctuating cost of gasand the tariff adjustment lag. This mechanism ensures that pass through is managed equitably andany inflation and interest payments are applied appropriately.

• An RPI – X review formula based on the return from asset to incentivise continually improvingoperational performance.

A major strategic challenge is anticipating and shaping the future of this regulatory framework. Althoughthe pass through arrangements apply across all market segments, the difference in margins is substantial.This regime, however, does constitute a relatively simplified basis on which to form a marketing strategyand allows the company to prioritise market sector development based on the relationship between unitmargin and volume.

It has been known from the outset that the second regulatory cycle (2004-2009) would impose a verydifferent tariff structure. From 2004, the tariffs will be based on connection cost, commodity charges andcapacity charges for all market segments. Tariffs will be set from a single parameter – maximum averagemargin across all sectors. This will allow the company to set tariffs appropriate to the competitive marketconditions prevailing for each sector but must demonstrate to the Regulator that these costs are non-discriminatory and cost reflective. Comgás must transparently show the true cost of providing gas serviceto each category of end user. This will impose a requirement to determine fully loaded unit costs for eachsupply type and this will demand strict control and monitoring of cost and activity.

73,6%

2,4%2,8%10,9%3,5% 6,6%

1,8%

11,1%

31,5%

1,9%0,7%

53%

% Volumes Sold by MarketSector 2002

% Gross Margin by MarketSector 2002

ResidentialCommercial

NGVIndustrial

Co-GenIPP


Following the implementation of SAP and cost modelling techniques that have nurtured a greaterunderstanding of cost components and overall cost control, Comgás is well placed to meet the newregulatory demands. This will allow Comgás to redefine its marketing strategy and adopt a moresophisticated analysis of true gross margins for each market segment (rather than gross margins whichreflect only the cost of gas). The outcome will be a redefining of market priorities and a change in themargins in each sector appropriate to the competition.

Another example of the uncertainty and impact regulation will have on market strategy may be found inthe loss of exclusivity clause, whereby Comgás will lose exclusive right of supply to large customers from2011. The opening up of third party access and the uncertainty of customer retention need to be reflectedin net present value project evaluations of new capital investment decisions.

The Brazilian government and by implication the Regulator are keen to support the development of thegas industry and relations between the company and Regulator have been positive and encouraging; butit is an aspect that needs to be managed as part of the overall market development strategy.

THE RESIDENTIAL SECTORBackground

At the end of 2002, Comgás had approximately 370,000 residential customers, all within Metropolitan SãoPaulo. Traditionally gas utilisation is restricted to cooking loads and as a consequence the loads arecomparatively low – averaging 230 m3 per annum. However, because of the tariff structure the marketsegment is extremely important to the company. The segment accounts for only 2.8% of the volume butprovides 31.5% of the gross margin. There is extremely strong competition in the residential marketsegment from liquid petroleum gas (LPG) and electricity.

There are 6 million residential electricity customers within the boundaries of the concession area and ithas been postulated that the terminal potential natural gas market could be as high as 2 million residentialclients.

Skills

One of the impediments to developing this market for natural gas has been the lack of skills in the sector –from sales personnel, to installers through to retailers. Comgás has encouraged professional accreditationand training through its membership of ABEGÁS (Associação Brasileira das Empresas Distribuidores deGás Canalizado) and its relationship with training bodies such as SENAI (Serviço Nacional deAprendizagem Industrial). The scarcity of qualified, dedicated natural gas installers has manifested itself inadditional costs of supervision and quality control. The impact of any high profile natural gas relatedincident due to faulty workmanship or installation malpractice could have serious consequences for whatis essentially a fledgling industry. To assist in managing this risk, Comgás has employed external qualitycontrol companies to independently verify and assess the performance of all contractors involved in thisactivity and to support in house managers.

Capacity

The cost of connection is an impediment to exploiting this sector. To make as much gas available to thissector (and other sectors) as economically as possible, Comgás have re-engineered traditionalapproaches to network design and construction.

The terms of the Concession Agreement oblige Comgás to replace 250 km of cast iron main in the first 5years and a further 150 km in years 6 – 10. Taking advantage of the flexibility in the selection of the mainsfor replacement, but still adhering to the principle of risk reduction, Comgás have implemented a strategicmains replacement process, whereby judicious selection of mains has allowed the progressive elevationof distribution pressures from the traditional operating pressures of 25mb to new operating pressures of 4bar. This has enabled mains to be replaced at a lower cost – permitting the insertion of smaller diameterpolyethylene mains inside the existing cast iron mains as opposed to employing more costly open cut


installation methods. In addition, the pressure elevation has significantly increased network capacity in theurbanised areas where the cast iron mains predominate, paving the way for greater utilisation andfacilitating co-generation opportunities. The capacity increases have been achieved at incremental costand are significant; for example a 63mm polyethylene main operating at 4 bar has a capacity over 40times as great as that of 4” cast iron main operating at 25 mbar (into which it could be inserted).

A large proportion of the residential housing is high rise and from the early 1970’s all new constructionshave been compelled to have gas infrastructure installed, irrespective of whether the properties wereinitially supplied with gas or not. Penetration of this market has been impeded by some of the installationsbeing inadequately sized for typical natural gas delivery pressures (25 millibar). LPG has the advantage ofhigher delivery pressures. A study is currently underway to evaluate the feasibility and assess the safetyimplications of using elevated natural gas delivery pressures (75 -100 mbar) in high-rise buildings.Dependent on the outcomes of this study, another 1 million residential premises could become viablecustomers.

Displacing LPG

The growth of the residential natural gas market is partly dependent on challenging the LPG marketposition. LPG, assisted by continuing but diminishing governmental subsidies, currently has theadvantage of a lower commodity price, but the marketing message from Comgás has been centred onsafety and convenience.

As natural gas is unfamiliar to much of the population it is important to ensure that the safer fuel messageis communicated successfully. This theme plays a pivotal role in selling gas to condominiums.

In the higher social class condominiums, LPG is supplied in bulk, stored below ground in tanks anddistributed to individual apartments through risers and laterals. Individual clients pay their respective fuelcosts through the condominium charges. The Comgás marketing message targets the respective safetyperformance of both fuels, the lower distributed pressure of natural gas, the dangers inherent during theLPG filling process and the space taken up by the bulk tanks and the hazard that these tanks represent.Even with respect to commodity costs, natural gas has a positive message – each apartment will only payfor their own use and not subsidise others. In the case of late or default payments, with LPG these costsare passed through to all the customers in the condominium, whereas with natural gas the consumer isprotected from these pass through costs (effectively Comgás takes on the risk). The combination of thesafety message and fair cost apportionment has been well received and natural gas continues to displaceLPG in these markets, even in the face of higher (apparent) unit costs.

In lower social class condominiums, individual apartments have their own bottled LPG supply and thecapture of this market is more difficult both technically and commercially. The benefit of natural gas safetyremains equally valid for this market and the convenience of not having to renew and replace bottles ofLPG in favour of continuous supply is attractive. The more modern blocks may have gas infrastructureinstalled (although not in use); Comgás experience to date has shown that these riser systems are nolonger gas tight and are often unsuitable for adoption. The cost of installing new riser systems in thesecircumstances is often prohibitive and consequently penetration of this sector has been difficult., Throughits shareholders (principally BG) and via its own efforts, Comgás is evaluating innovative riser repair &renovation techniques. If a technology can be identified that can cost effectively resurrect the integrity ofthe installed riser systems, then the conversion and sales potential in this area will be greatly enhanced.

Gas Water Heater Program.

There is very little potential for space heating, but an utilisation opportunity that remains under-exploited isthat of water heating. A concerted effort has been made to introduce natural gas water heating as the firstchoice amongst consumers. This initiative has been targeted at both new and existing customers with thekey message to consumers that gas water heating provides improved water heating performance at loweroperating costs than electricity. This initiative has been supported by the technical and marketingexpertise within BG, who have used their experience in the UK and their relationships with appliancesuppliers to source competitively priced appliances. Comgás has in turn supported external installers andhelp foster the secondary service market to support retailing and installation activities.


Targeting New Residential Housing Sector

Comgás has had significant success in the new residential housing sector and has increased penetrationto over 80% (with the water heaters achieving penetration rates in excess of 50%). The new residentialmarket also affords the opportunity to supply gas heating for swimming pools – this is an attractiveproposition for developers keen to entice clients in a highly competitive housing market.

Improved performance in this sector has been achieved by deploying 2-3 marketing developmentmanagers to work full time with the major constructors in São Paulo.

Expanding to other Cities

The residential customer base has, to date, been confined to metropolitan São Paulo but substantialnetwork expansion into the Interior and the Vale of Paraíba anchored by industrial loads has placedinfrastructure adjacent to major population centres. Campinas for example, with a population in excess of2.5 million is one of the fastest growing cities in South America with a vibrant economy and one of thehighest GDPs per capita in Brazil.

To successfully develop these areas, it will be vital to leverage the experience, skills and knowledgeharvested over the last few years. Barriers such as customer intransigence and unsuitable (for naturalgas) building infrastructure will undoubtedly feature equally prominently in these Greenfield markets.

THE COMMERCIAL SECTORAt the end of 2002, this sector comprised of over 7,600 supply points and accounted for 2.4% of the salesvolume but over 11% of the gross margin for the company. There is tremendous potential in this marketbecause of the favourable tariff and the fact that there are 50,000 potential customers in the MetropolitanSão Paulo area alone.

This segment of the energy market place is highly price sensitive but also places some value onconvenience and reliability. The smaller commercial enterprises share similar characteristics to thoseexhibited by the residential customers whereas the larger customers tend to share the characteristicsdisplayed by industrial customers.

This is a high growth sector but also extremely competitive and to date utilisation has been based upontraditional uses. Market segmentation and analysis has been completed to identify high utilisationcustomers and high growth segments. This has evolved into a targeted market plan for this sector,enabling gas sales packages to be constructed to meet specific customer aspirations, e.g. thedisplacement of electric heating in bakeries. Resources can be concentrated on meeting the needs of anindividual group of consumers with the assurance that the sales packages, the technical know how andthe hardware are all available and proven.

To stimulate this market, Comgás have developed a take, pay and transfer scheme. Comgás havefostered relationships with commercial gas appliance manufacturers to identify best-fit appliances/suppliers for specific areas of the commercial market. Leveraging these relationships, Comgás havetargeted particular segments of the market where natural gas has demonstrable advantages overcompeting fuels. Comgás will then procure the equipment on behalf of the customer, install and convertand the customer will sign a take or pay contract that will guarantee Comgás a monthly return that willoffset the equipment, installation and gas costs and include a small margin. The term of these contracts istypically 5 years, after which time the equipment reverts to the client’s ownership.

This has been a successful approach and enterprises with good stability such as bakeries have beentargeted initially. There remains plenty of scope to broaden the customer type, appliances and flexibility ofthe contract in the future.


THE INDUSTRIAL SECTORGreenfield Network Expansion

The industries of São Paulo state have underpinned the major network expansion projects to date andessentially provided the platform for the development of the business. This sector represents substantialshareholder investment and the anticipated volume growth has been reflected in the terms and conditionsof newly negotiated upstream gas supply contracts. Any failings to meet volume growth in this sector willbe reflected, not only in lower NPV project returns, but also in exposure to sizeable take or pay liabilities.

Driven in part by environmental pressures, there has been, over the last decade, a migration of largerindustries away from the city of São Paulo to more favourable sites, (in terms of land cost and space), inthe Interior and the Vale of Paraíba. The Bolivia-Brazil pipeline dissects the Interior and a Petrobrastransmission pipeline passes through the Vale of Paraíba providing a backbone for high pressureexpansion. There has been a successful expansion into the Interior in the face of competition from heavyfuel oils, and industrial gas volumes outside of the São Paulo metropolitan area now exceed 0.55 billioncubic metres per annum.

The growth of the high pressure gas network has presented one of the greatest technical challenges forthe newly privatised company. Unprecedented levels of high pressure steel gas pipeline constructiondemanded internationally recognised standards of technical, HS&E and quality management. As acompany, industry and a country unfamiliar to this intensity of activity, external support of experiencedengineers, suppliers, manufacturers and managers was vital. Comgás have been able to tap into the vastcommercial and technical acumen of its shareholders through mechanisms such as operating andtechnical support agreements. These allow Comgás to access technical and managerial support and toachieve fast track knowledge enablement of its engineers, managers and contractors. In the absence ofsuch support, the gestation period for this massive infrastructure development would have beensignificantly greater.

São Paulo Industrial Market

Comgás supplies almost 700 industrial customers with more than 2.1 billion cubic metres of gas perannum (73% of the total sales volume in 2002) and there is an upside potential within the concession areafor 4,000 industrial customers with an aggregated gas load of 5.3 billion cubic metres per annum5. Thissector has high expectations towards gas with respect to quality, reliability and especially price. Theindustrial customer is generally well informed with an appreciation of the energy market, regulation andthe monopoly represented by the concession.

The major energy consumers by segment in São Paulo state are the food & beverage industry, whichaccounts for 35% of the total state industrial energy consumption, Iron & Steel (12.6%), Pulp & Paper(10.7%), Chemicals (10.6%) and Non Ferrous metal industries(9.3%).

Displacing Existing Fuels

There is fierce competition in this market segment from heavy fuel oils, which are able to wield significantcompetitive advantage through comparatively lower commodity prices. Historically, Brazilian refinerieswere established on imported light crude but as these feedstocks have been supplanted by heavier crude(including indigenous production) the output of heavy fuel oils (HFO) has risen. The current market placeis saturated and consequently margins for the oil companies are extremely small or even non-existent andthis is reflected in the market price. A major modernisation programme for the refineries is underway tointroduce secondary refining processes to extract greater proportions of higher value distillate products.This will incidentally reduce the HFO production and permit market prices to normalise. The impact of thismodernisation process will only become apparent in 5 – 10 years and in the meantime natural gas willcontinue to face stiff competition.

The largest industrial segment energy load - the food and beverage industry - will not necessarily translateinto the largest natural gas load. The sugar and alcohol industries continue to use organic sugar canewaste as their primary fuel source (equivalent to 4.4 MTOE in 2000) and this provides a very inexpensive,readily available, functional (although low quality), fuel source. The displacement of these fuels by natural


gas is likely to be very limited as premium fuel quality and positive environmental benefits are more thanoffset by the higher commodity price

Discounting the bias introduced by sugar cane as a fuel source with the acceptance that its marketposition is virtually unchallengeable, the major industrial segments in the competitive energy market areiron & steel (17.3%), pulp & paper (14.7%), chemicals (14.6%), non-ferrous metals (12.6%) and the food& beverage industry (10.7%). Other competing fuels for the industrial market include liquefied petroleumgases, diesel and coke. The use of imported, low quality coke from the United States has grown insignificance over recent years and has displaced HFO in the cement industry in particular, impacting atarget area for Comgás in the process.

A number of market studies have been carried out to identify the factors that will influence a decision byan end user to substitute his primary energysource. The dominating factor for eachindividual enterprise will be dependent on theindustry type, its location and the competitivity ofits market. The principle driver may be purelyeconomic (cost of the energy commodity) inenergy intensive industries or may be more gastechnology based (where energy substitutionaffords reduced expenditure on personnel andraw materials); or security of supply may becritical for industries where energy cost isrelatively low with respect to production cost, butcontinuity of supply is all-important.

These studies have provided a basis fordeveloping action plans to secure contracts andencourage conversion from other fuels andallowed Comgás to develop packages tailored tomeet the aspirations of particular customer

groups. One of the challenges facing full market development of this sector is the dearth of gas utilisationskills, knowledge, equipment in country and the cost of importing these technologies. In the case of small-scale co-generation for which this is equally true, the way forward has been to forge an alliance with amanufacturer and develop a joint venture company. This approach facilitates quicker access to the marketbut maintains the commercial focus on building the load. The prospect of joint ventures in a widerindustrial context is under constant review.

The market approach has not been based solely on the commercialisation of natural gas as a commoditybut as a fuel to facilitate the modification and enhancement of industrial processes that realise indirectbenefits in the cost of production; as well as environmental and process control benefits. Recognising thatindustrial customers may have difficulties in accessing financing for conversion, a fully flexible, customerspecific approach has been adopted and markets have been secured by offering the optimum solution fora particular customer, whether this is discounted commodity prices, direct investment in equipment orassistance in financing. Trade associations and industrial federations have been approached to highlightthe advantages and also to assess interest and co-develop sectorial pricing policies. Individual potentialhigh yield customers have been offered free energy use audits and support has been offered to tertiarygas industry service companies and organisations.

The widening of the industrial load base is critical to reducing risk in the business. At the beginning of2002, the top ten customers consumed over 32% of the entire industrial volume. This concentration ofvolumes has increased the company’s exposure to specific market fluctuations.

The high pressure Greenfield network expansion programme has been founded to date on the industrialcustomer base. Residential and commercial loads have generally been excluded from the projectevaluations on the basis that these marginal loads would not in themselves sway the project economics.However, once the major transmission infrastructure is in place, a cohesive and structured expansion planto serve these markets is being developed to leverage maximum value from the investment.

NATURAL GAS ENERGY MARKET SHARE (%) BY INDUSTRIAL SECTOR

0

5

10

15

20

25

30

Food

&B

ever

age

Iron

&St

eel

Pape

r

chem

ical

s

Oth

erM

etal

s

Bri

cks

&C

eram

ics

Tex

tiles


NATURAL GAS VEHICLESSão Paulo has experienced increasing air pollution problems as a consequence of rapid urbandevelopment and increased motor vehicle emissions. A 1999 study determined that 10% of the city’spollution derived from industry and 90% was generated by motor vehicles6. Environment has emerged asa more potent political issue over the last decade, although paling in significance when compared to thesocial problems of poverty, homelessness, crime, health and education. São Paulo has followed othermajor cities such as Santiago and Mexico City by introducing vehicle use restrictions, where each vehiclemust remain idle during certain parts of a week.

Although Brazil is classified as a developing country under the Kyoto protocol and therefore not requiredto reduce carbon emissions, there is state and federal support for environmentally friendly energysolutions.

Against this background, the environmental benefits that result from the conversion of vehicles to naturalgas are welcomed. Natural gas powered vehicles offer the promise of higher efficiency, less carbondioxide emission and fewer nitrous and sulphurous particulates. A favourable tax regime in comparison tocompetitive vehicular fuels is somewhat offset by relatively small permitted margins, however, the growthin natural gas vehicle (NGV) demand to date has outstripped internal projections, and sales volumes inthis sector now exceed the aggregated combined sales volumes for residential and commercial customers.

This market sector will become increasingly more important to Comgás in the second regulatory cycle withthe prospect of greater margins and the sizeable volumes supporting the company’s take or paycommitments. The current tariff has resulted in the NGV market price being very aggressively priced – thecost of gas fuelled car travel per kilometre being approximately 30% of that for petroleum. Fleet targetinghas been an obvious and successful tactic and over 90% of all cars converted to date have been taxis.The main areas of resistance revolve around the cost of converting the vehicles, the perceived safetyimplications and the loss of space within the vehicle itself. Comgás plays an active role in promoting thesafety of this form of transport. Following the regulatory review in 2004, consideration may be given tostimulating the market further by subsidising the conversion costs of its own or partner garages fundedfrom higher margins from the gas sales.

Initially, this market sector was catered for from within the business, with Comgás seeking clients andattempting to energise the market. The acquisition and provision of gas compression equipment is a keycomponent to the introduction of compressed natural gas on the forecourt. This was facilitated byComgás on behalf of its clients, but it was recognised that this was incidental rather than core business.As a result, NGV compression services were effectively spun off and a 100% BG subsidiary – Iqara –assumed responsibility of attracting independent and franchised fuel outlets to participate in this sector.Comgás benefits from the additional gas volumes sold, while Iqara are a stand alone commerciallysuccessful entity focused on expanding the NGV market. Iqara are one of a number of participants in themarket place and have contributed to a doubling of NGV outlets in the concession area from 67 to 140 in2002.

The development of this market has imposed additional technical challenges for the company and pipelineconstruction, quality control, risk assessment and management improvements have been essential toensure that NGV stations are supplied safely with 7 & 17 bar gas in urban environments. The market hasbeen enhanced by Comgás employing holistic market identification strategies to transform sub-economicNGV projects into commercially viable projects by identifying other sectors with complementary loads thatcould take advantage of any proposed network extension.


CO-GENERATIONThe emergent market of co-generation is prospectively one of the most important sectors for Comgás andone that is particularly suited to the São Paulo market place. It is a sector that shares some commonground with NGV in that it possesses high volume potential but under the current tariffs the margins arerelatively small. One marked difference, however, is the cost of gas to this market sector – the NGV sectorhas been stimulated by the large differential between compressed natural gas and conventional fuels andthis has been reinforced by the allocation of cheaper ´National Gas´ by the Brazilian government to thissector. Co-generation, although offering similar environmental advantages, has not received the sameencouragement and its commodity gas price, including gas from Bolivia is 35 – 50% higher than that forNGV.

The major stimuli for investment in co-generation are the unreliability of the energy grid combined with thegeneral poor quality of the electrical supplies, which exposes commercial and industrial customers tooutages, voltage drops and impacts production and efficiency. Although many end users have invested instandby or peak shaving private generation to reinforce the security of their supplies, the additionaloperating and maintenance costs are undesirable.

Natural gas powered co-generation faces substantial competition from grid electricity in the commercialand industrial markets; this is reflective of the influence of hydroelectric generation but also significantlythe cross–subsidies that exist in the electricity market (commercial and industrial customers are effectivelysubsidised by the residential sector).

Continuing deregulation of the electricity sector should assist in diminishing these cross subsidies and thecompetitivity of natural gas in the medium term is anticipated to rise. Electricity commodity prices areexpected to gradually rise as cross subsidies are eliminated, while the increased capacity in the BrazilBolivia pipeline and more national gas production will help in reduce the unit commodity prices for naturalgas.

In the existing market conditions, natural gas co-generation has a small competitive advantage in terms ofR$/kWh in a relatively small sub-sector approximating to the larger commercial and smaller industrial endusers. The identification of this niche market has spawned a business opportunity that has manifesteditself as a joint venture company.

BG has agreed to fund the development of a small number of co-generation units to establish the viabilityof the approach. This initiative has been undertaken with a UK based power generation solutionscompany that manufactures 1.3-MW co-generation units that can conceivably be banked to serve up to 6MW of electrical demand (beyond this the economics would favour the construction of purpose built co-generation plant). The nascent company has attracted plenty of interest and revenues from energy salescovers both commodity costs and the capital costs of the plant infrastructure. In commercial environmentsthe customer purchases the gas under a tolling arrangement but in industrial projects the joint venturecompany is the gas purchaser – this allows tax efficiency with respect to sales tax and maintainscompetitivity in both sectors.

Power generation through co-generation transcends some of the problems that have been encounteredby the conventional power markets. The thermal generation program has encountered obstacles in thelack of regulatory clarity, the poor creditworthiness of utility companies and the uncertainty over whetheror not sustained demand will persist over the lifetime of the asset. Co-generation is more manageable inthat it is sponsored by a substantial private enterprise, the loads are predictable and committed, thefunding requirements are much lower and a power purchase agreement of 15 years is normally sufficientto guarantee returns on the investment.

The market in general would benefit from a greater differential in commodity price and will undoubtedly beassisted with electricity price reforms. However, the environmental benefits should continue to bepromoted and Comgás has a key role in continuing to lobby the nation’s decision makers. The allocationof less expensive gas, favourable tax treatment, preferential financial support from government supportedinstitutions and the Kyoto Protocol’s Clean Development Mechanism (CDM) should all be pursued in theinterests of the environment and the fledging natural gas market.


POWERThe 2001 Energy crisis was the catalyst for the Brazilian government’s Thermoelectric Priority Programwith the very ambitious target of increasing the installed electricity capacity by 25% on 2000 levels by2005, mainly through the construction of natural gas fuelled power plants.

A long term strategy developed by Electrobrás (the national power generation holding company) and theWorld Bank at the end of the 1990’s identified that a mix of hydroelectric and thermoelectric plantsprovided the optimum cost and supply solution to Brazil’s power requirements for the next 30 years. Gasfired plants have the advantage of lower capital costs and increase the proportion of energy available forsecondary markets. Hydroelectric plants are characterised by the installed capacity being far in excess ofthe minimum guaranteed delivery capacity - as this will be set by the lowest water levels in the reservoir.The hydro-thermal generation power mix allows a block of secondary energy with low economic value tobe converted to firm energy of a higher economic value.

The commodity value of despatched electricity from a thermoelectric plant is less than that for ahydroelectric plant when the capital costs of construction are included in the evaluation. Additionally,thermoelectric power stations can be sited near to the centres of demand and thereby reducetransmission costs. The construction and operation of a thermoelectric power station is an economicallyviable solution to meet new energy demand – gas for power is competitive against new hydroelectricalternatives but cannot compete with the existing hydroelectric plants.

Nonetheless, when hydroelectric availability is greater than market demand, this is preferentiallydispatched. Only during the periods where demand outstrips installed hydroelectric capacity, willthermoelectric power plants be called upon.

Conventionally thermoelectric plants operate at high load factors but in the Brazilian context for a largeproportion of the year these plants will stand idle; but operate at full capacity during periods of drought. Tofacilitate the development of the gas power market a flexible and unique energy trading environment mayneed to be developed to allow both the power generator and the gas distributor to operate commercially.With the power generators committed to paying pipeline capacity and gas commodity charges irrespectiveof whether or not the plants are running, a secondary (industrial) market could be created. This marketwould differ from the conventional interruptible contracts used across World gas markets. These contractsdo not conventionally include reserved pipeline capacity within the gas price, however Brazil offers a novelopportunity for the secondary market to share this charge with the power plants. A possible contractscenario envisages the power plants being charged a small priority fee when they are idle and the levyingof a charge to the secondary consumers equal to the full firm gas price less the priority fee. Power plantswould be given priority in using the supply and industrial users would be incentivised to accept interruptionif required. When the power plants were running they would incur the full firm cost of the gas supply andindustrial customers would switch to an alternative fuel. Comgás could work with the regulator andpoliticians to help develop this secondary market which will in turn support the market, increasethermoelectric viability and maximise utilisation of the gas infrastructure.

In the Comgás concession area, one new thermoelectric power station has been constructed under theprogram at Interlagos, São Paulo City (the original Thermoelectric Priority Program envisaged a total of 19new plants within the Comgás concession area alone). Power plants are usually seen as anchor loads inGreenfield developments but in the Brazilian context where tariffs are regulated and the thermoelectricplants are competing against the economics of hydroelectric plants, volumes and revenues areconsiderably diminished.

The plant was scheduled for operation by the end of 2002, but an easing of the power shortage and thefalling exchange rates have moderated the rate of progress. Although the physical construction of bothphases is substantially complete neither phase is currently in full commercial operation. The principalreason for this being the readily available hydroelectric power which is capable of meeting current levelsof demand. Contractual concerns have also been encountered due to the conflict between the impositionof ICMS (sales tax) on the Bolivian gas and the ICMS exemption of power plants constructed under theThermoelectric Priority Program.

Petrobrás is the major shareholder of the Piratininga plant at Interlagos and has effectively underwrittenthe construction. Petrobrás is also the gas supplier and under the terms of the concession, Comgás isobliged to buy the gas and then re-sell at the point of sale (this is an extremely unusual obligation for a


local distribution company under regulation). The upstream and downstream counter parties areeffectively identical and the back-to-back upstream and downstream gas sales agreements are fullycomplementary in respect of take or pay, ship or pay and other key terms and conditions. An importantissue in negotiating the contracts was the recognition that the potential risk to Comgás was vastlydisproportionate to the gross margin. Mitigation needs to be built into the terms and conditions of thecontracts to limit the exposure – failure to do so, could result in Comgás being liable for very largedamages in the event of failure of its network with the value of these damages outstripping any margin.

THE COMGÁS EXPERIENCEBetween privatisation in May 1999 to the end of 2002, annual sales volumes have increased 245% (from1.2 to 2.95 bcm per annum) and the total number of customers across all sectors has increased by 28%(from 295,000 to 378,500). These statistics represent significant market development success and thecompany are rightfully proud of many of its achievements in São Paulo. However, there have beennumerous obstacles to overcome (none more so than the scale of the economic down turn in LatinAmerica) and some profound lessons learned.

Incumbent Energy Players

The dominance of major energy companies in the Brazilian market place has presented a major challengefor a new entrant into the energy market . Competitive behaviour is inevitable as Comgás endeavour tosecure new markets and displace competing fuels. However, the dominant position of large verticallyintegrated energy companies has allowed them tosupport horizontally and vertically across respectiveenergy markets and to wield considerable political influence.

Comgás have employed a number of strategies to meet this challenge including fostering a positiverelationship with the Regulator, participating in industry related institutional forums and lobbying thenation’s decision makers. Undertaking a detailed analysis of competitors’ profile, strategies and businessculture corporately and not just from a gas industry perspective has been invaluable. This analysis hasimparted an understanding of motives, drivers, prospects, areas of weakness and even areas of potentialco-operation. This has allowed future behaviour of these enterprises to be more predictable and facilitatedintuitive interface with competitors, the Regulator and the Government.

Legal & Regulatory Framework

The absence of a Brazilian gas law has created some uncertainty and insecurity in the investment. Anoverarching legal structure would formally set out the regulatory powers, develop the concept of utility andestablish the obligations, powers and rights of the industry stakeholders. This has manifested itself inpractical issues concerning rights of way, statutory rights and from a consumer’s perspective the right tobe supplied.

The relationship with the Regulator is all the more important in the absence of a legislative framework andComgás have made every effort to foster a positive atmosphere and engender mutual respect and trust.Regular contact is maintained and the approach has been one of positive engagement, professionalism,technical competence, transparency and the avoidance of conflict. The current regulated environmentlacks some clarity, especially with respect to the new tariff structure and the loss of exclusivity in 2011.Comgás is working with the Regulator in a constructive way to bring definition to the concession and withit reduce uncertainty and business risk.

Licensing & Permitting Issues

The absence of statutory status has contributed to problems encountered in securing permits andenvironmental licences for network expansion both inside and outside of Metropolitan São Paulo. Severedelays in securing licences have impacted project phasing, costs and the commissioning of new networks,especially in the first two years of the concession. The problems were of a greater magnitude than was


anticipated at the time of the public offering. A major obstacle to securing the licences in a timely andexpeditious manner is that submissions must be made to the various local authorities in whose jurisdictionthe proposed gas infrastructure is to be installed. A major project can spawn as many as 50 separatelicences, authorisations or permits. There is little consistency in the information, the data, the format ofsubmission, the detail or even in the timescales demanded by these authorities.

Comgás have been diligent in capturing all the experience gained in obtaining these licences and permits,so that repeat submissions can be made with a degree of certainty that all the requirements of eachspecific authority will be met. The intricacies involved have encouraged Comgás to contract a specialistthird party to act on its behalf and secure the necessary authorisations. This has proven to be extremelybeneficial and significant improvements have been made to the entire process. This has enabled forwardplanning of projects to be carried out with a greater degree of confidence and gas availability to be moreaccurately forecast.

Natural Gas Culture

The Brazilian economy has no significant history of natural gas in any market sector. This has created alack of gas related skills to support market growth. There is a dearth of gas appliance manufacturers,retailers, installers, contractors, engineers, sales personnel and managers. There is a pervading lack ofunderstanding of natural gas, its applications and advantages.

In developing the gas market, Comgás has simultaneously needed to energise the gas industry. The needto inform and educate prospective clients is implicit, but the forging of relationships with manufacturershas been important in extending the value proposition to the customer. Growing the market is more thansimply supplanting an alternative fuel but ensuring that there is service and technology back up.

Comgás have actively encouraged external gas industry service providers to invest in and extend theiroperations into Brazil. An example of this is the support afforded to feasibility studies carried out byAdvantica, a gas technology solutions company that evolved from the research & development arm ofBritish Gas. Comgás provided logistical, office and market intelligence support to assist Advantica indetermining the potential for establishing a new business in Brazil.

Comgás has awarded a period-type contract with a Brazilian Company that is backed and supported byestablished European gas contractors. The work force is Brazilian but the management, technologies andgovernance are to the highest international gas industry standards. This has reaped the benefits of highlevels of technical and health and safety performance in the construction of new and replacementinfrastructure.

To ensure sustainable quality in construction, Comgás have been the catalyst for the creation of a gasengineering training programme through the training body, SENAI. This has established a gas distributionspecific engineering training scheme that will help support the growing industry and swell the number ofskilled contractors in the market.

Technological & Health and Safety Improvements

To enable Comgás to satisfy its market development ambitions, it has been crucial that new technologieshave been introduced and that health and safety standards have been raised. This was fundamental inassuring; asset integrity; the safety and security of company and contract personnel; the well being ofmembers of the public; the preservation of the environment and for protecting the reputation of thecompany and the product.

New technologies have been introduced across all activities and their value has been augmented by theimplementation of complementary planning and project management processes and techniques.

The improvement in health and safety performance has been impressive; as an example, the lost timeinjury frequency (LTIF) immediately before privatisation was averaging 16 occurrences per annum, butduring January 2003 the company completed 1,000 days without a single LTIF. This has not onlyeliminated the distress of an injured party and their families, but also generated a positive atmosphereamongst the company’s employees who take pride in the achievements and are made to feel highlyvalued; this permeates into all realms of the company’s activities and enhances the company’s standing in


the community. Comgás believes that the quality in managing health and safety is a barometer of thequality in managing the overall business.

This commitment to high technical and safety standards, together with investments in new informationsystems and technology, has inevitably been reflected in increased construction and connection costs. Itwas important to factor in these additional costs during the early stages of network development. Thetypical construction costs that existed at the time of acquisition reflected lower expectations andconsequently a lesser cost. Comprehending the incremental costs of revised standards of operation andconstruction was essential in the formulation of forward-looking market development plans.

Funding the Business

Securing debt financing to grow the business has encountered a lack of sophistication in the Brazilianfinancial sector, which has limited the options available. Brazilian based funding is, relative to the globalmarket, expensive and tends to be comparatively short-term.

The advent of September 11th, the economic problems in Argentina and the falling exchange rate havemade balanced financing absolutely critical to the success of the business. A great deal of effort has beenexpended to forge secure, cost effective hedging against continued volatility in the foreign exchangemarkets.

Understanding the Market

The structuring of the company with departmental responsibilities for the industrial, commercial, vehicular,residential and power markets is designed to recognise the very different characteristics of each marketsegment. However, it is critical that any network development within any one sector is assessed to identifyany complementary plays that may be invoked in any or all of the others. This could make the differencebetween a sub-economic and an economic project. The organisation of the company must allow free flowof information and permit a holistic market development strategy. The processes, procedures and ITinfrastructure must promote cohesive decision-making.

The growth of residential and commercial markets in particular, has not been as great as anticipated bythe preliminary business plans. A significant impediment to realising projected volume growth was thelack of suitable marketing tools and strategies. The introduction of modern geomarketing tools and thecarrying out of extensive market studies have coincided with increased rates of customer acquisition andvolume growth. The Brazilian market has some unique characteristics and is critical that these areidentified and recognised – marketing strategies that have worked in other parts of the world (even otherparts of South America) will not necessarily be successful in São Paulo.

Long Term Planning and Sustainability

The future of the gas industry in Brazil depends upon securing long-term, reliable and competitive gascommodity and transportation prices. This is critical, particularly with a changing balance betweenimported and indigenous gas supplies, where the competitivity of natural gas in Brazil is extremelysensitive to gas transportation charges from Bolivia. It is the role of the government and the regulators toensure that a keenly contested competitive environment exists upstream of the City Gates. In a Braziliancontext there are further complexities in that there is one regulator for transportation and import (AgênciaNacional do Pétroleo) and one for downstream activities (for São Paulo State this is Comissão deServiços Públicos de Energia, CSPE).

Conflicts with Associated Businesses

It is important that any associated gas growth businesses, such as NGV compression services, which arespun off have their business drivers and objectives carefully aligned with those of the core business of gasdistribution. The potential for commercial conflicts must be minimised. The example that could be cited isthat Iqara NGV Compression services receive their revenues from rental of compression equipment,whereas Comgás receive their revenues through gas throughput. There is, therefore, a potential conflict


that in a fixed market, Iqara would seek to saturate the area with NGV outlets but this would not add anyadditional volumes for Comgás. Controls and balances need to be imposed so that both companiesachieve their objectives symbiotically.

Phasing of Regulatory Targets

Regulatory targets can provide incidental opportunities to support market growth. The temptation hasbeen to initiate activities to meet these targets early within the regulatory period. However, in some casesit has been prudent to defer, so that any opportunities to add value and grow the market incidentally canbe evaluated.

Legal & Financial Support

The value of best available legal and financial advice should not be underestimated. The Brazilianeconomy and context is unique and gas sales and other agreements should be compiled with duedeference to the characteristics of this market.

1 BP - Statistical Review of World Energy June 20022 Energy Information Administration - Annual Energy Outlook 20023 US Department of Energy - an Energy Overview of Brazil4 Instituto Brasileiro de Geografia e Estatística – Regional Accounts5 FGV Consulting – Potential for Natural Gas Consumption January 20026 Fossil energy international – An Energy Overview of Brazil

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