Petrobras (PBR)

Power

Brazil currently has an installed electricity generation capacity of approximately 80,000 MW. More than 97% of this capacity is interconnected to form one single integrated system, with approximately 86% of the electricity supplied to that system coming from hydroelectric sources. Annual consumption of electricity grew annually at a rate of 4.5% during the 1990s. As a result of the rapid growth in electricity demand, combined with the limited investment in the sector during the last two decades and a high dependency on hydroelectric power (and consequently susceptibility to a prolonged drought), we believe substantial additional generation capacity needs to be developed in Brazil. In recognition of the need for such capacity and in order to promote the development of thermoelectric plants, the Brazilian government established the Thermoelectric Priority Program (PPT).

History of the PPT

The PPT, as originally envisioned in February 2000, prioritized the development of 49 new thermoelectric plants to meet Brazil’s growing electricity demand requirements. These PPT thermoelectric plants were to have increased Brazil’s generation capacity by approximately 17,000 MW by 2003. Despite a number of incentives introduced by the Brazilian government to promote the PPT, those thermoelectric power plants under development have been slow to progress. Developers have faced numerous difficulties, including inability to pass on financial and operating costs in U.S. dollars following a devaluation of the Brazilian Real in each of 2001 and 2002, the reluctance of many distribution companies to sign power purchase agreements because of existing supply contracts and lower consumer demand for thermoelectric power as a result of excess supply of hydroelectric power. In light of these difficulties, the Brazilian government reviewed the PPT and reduced the program to 39 projects, representing a planned 13,500 MW of additional capacity.

In line with our strategies in this segment, we decided to participate in the PPT either as a minority shareholder, offtaker or both, in a number of strategically important thermoelectric plants. Initially, we were planning to participate in 26 of the PPT projects, with total capacity of approximately 10,500 MW, of which 4,500 MW corresponds to our purchase commitments at that time.

Current Status of PPT

Due to decreased rainfall in 2000 and 2001 in Brazil and the subsequent shortfall of hydroelectric power to meet Brazilian demand, the Brazilian government implemented a rationing program from the beginning of June of 2001 until the end of February 2002. This created a permanent reduction in demand of approximately 7%, according to recent Brazilian government estimates, resulting from the more rational use of electricity achieved during this period. Additionally, since the end of the rationing program, heavy rains have filled the main reservoirs of the country. As a result, in the short term, existing hydroelectric capacity is sufficient to meet the energy needs of the

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country. The combination of exceptional hydrological conditions and demand reduction has limited, in the short-term, the price and volume at which we can sell electricity from thermoelectric plants.

New Regulatory Model

A new regulatory model for the power sector was introduced on March 16, 2004 with the enactment of the New Industry Model Law. Under the new model, energy may be sold under regulated contracts or free contracts. Energy sold under regulated contracts must be acquired by means of public auctions and energy sold under the free market is negotiated freely through bilateral contracts. The new regulatory model also creates incentives for the investment in power generation.

The first energy auction for existing power plants occurred in December 2004. The first auction for new power plants will occur in 2005. We may participate in such auction to sell energy from our thermo power plants with the intention of securing long-term contracts under prices that will generate good returns.

The effects of the new regulatory model on our operations are still uncertain, since most of the changes introduced by the new law have yet to be tested.

Status of our Investments

We believe our participation in the construction and development of thermoelectric plants has strategic benefits for our business for several reasons:

Although our Strategic Plan calls for an increase in capacity, our plans will ultimately depend upon the level of demand for electricity in general and the success of our electricity marketing efforts. Nonetheless, we intend to acquire a significant number of thermoelectric plants in 2005, especially thermoelectric plants to which we owe contingent payments in order to reduce our financial exposure.

Following this strategy, on April 29, 2005, we acquired Sociedade Fluminense de Energia (SFE), the owner of the Eletrobolt thermoelectric plant, a plant with a capacity of 388 MW located in Seropédica in the State of Rio de Janeiro. We acquired SFE from a group of banks for a purchase price of US$65 million. We have also signed a term sheet on March 24, 2005 for the acquisition of the Termoceará thermoelectric plant from MPX for US$137 million (including the assumption of indebtedness). The execution of a definitive acquisition agreement is subject to certain conditions precedent, including the conclusion of a due diligence of the company. Finally, we also own 100% of TermoRio S.A, an independent power producer under construction. We initially owned 50% of TermoRio S.A., and the remaining 50% was owned by NRG. In April 2002, NRG exercised a put option requesting us to buy its shares and credits in TermoRio. The put option was subject to an arbitration proceeding that ended in February 2005 and required us to purchase NRG’s interest in TermoRio for approximately U.S. $83 million.

The main purpose of these acquisitions was to reduce our financial exposure in connection with these merchant thermal power plants. See “—Financial Exposure.”

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Financial Exposure

To encourage the development of some of the thermoelectric power plants in which we participate with an equity interest, or to which we sell our natural gas, we have entered into agreements to provide economic support to such thermoelectric power plants. Our obligations under these agreements are either structured as:

We have only entered into tolling arrangements with thermoelectric plants in which we have an equity interest. Our power commitments under merchant and tolling agreements are as follows: