Volume 6, Number 4, Page 1

Reforms to Allow Foreign Investment in Mexico's Electricity Sector

By Bradford S. Nixon

At the end of January, the Secretary of Energy announced that Mexico will need an investment of at least US $25 billion in order to meet the expected demand of 13,000 additional megawatts of power by 2005 (approximately a third of Mexico's currency generating capacity). The investment is needed in order to meet an expected 6 percent yearly increase in demand for electricity. By way of comparison, Mexico's electricity consumption has grown at a rate of about five percent per year for the last ten years, while growth in the U.S. has been approximately two percent. There are two main reasons for the increase. First, the economic recovery which followed the 1994 peso crisis. Second, industrialization is expanding exponentially in the Northern border regions.

In order to address the need for increased electric generation, the constitution was amended in 1992 to allow minimal foreign investment in the electric sector (excepting nuclear generation). These amendments allowed private entities to import and export electricity for their own consumption and permitted the sale of excess generation to the Federal Electric Commission (CFE). Under NAFTA, private companies from Canada or the U.S., or their Mexican subsidiaries, are allowed to operate or invest in self-generation facilities for their own use, generation facilities that produce less than thirty megawatts, co-generation facilities which produce both electricity and thermal energy or independent power producing facilities (IPPs) of more than thirty megawatts for sale to the CFE. These amendments also provide for build-lease-transfer (BLT) arrangements. The conditions placed upon Mexico by the U.S. and the International Monetary Fund in connection with the $50 billion "bailout" following the peso devaluation of 1994 were also a cause of this slight opening up of the market.

A major obstacle to increased private investment has always been the national pride of the Mexican State. This nationalism is enshrined in Articles 27 and 28 of the Mexican Constitution, where the State's right to control the generation, transmission and sale of electricity is explicitly stated. Although several studies have affirmed that foreign investment is the most viable solution to Mexico's energy needs, the political will has not been sufficient to make the necessary constitutional changes in order to allow for this investment. Reasons for this lack of political will are numerous and complex; however, the strength of Mexican labor unions, Pemex (the State run oil monopoly) and the recent introduction of vocal political opposition parties have all played a major role.

A major turning point was President Ernesto Zedillo's January proposal to Congress to make the constitutional changes necessary for increased private investment in the electric sector. Not only did the Executive branch show the political will to address the issue, but Leonardo Rodriguez Alcain, head of the powerful Confederation of Mexican Workers and leader of the Electrical Workers of the Mexican Republic supported the sale of State assets provided that workers are protected. Also, the conservative National Action Party (PAN), one of the main opposition parties, also supported the proposal. The President has tried to sway public opinion in favor of his proposal by broadcasting official statements explaining the need for the reforms. Political cover has been provided by arguing that with foreign investment, the government will not have need to divert funds from much needed social spending. The process has also been bolstered by the appointment of Alfredo Elias Ayub to the position of Director of Federal Electricity Commission. Mr. Elias wrote the 1992 rules allowing private companies to generate, transport and distribute natural gas in Mexico.

Currently, Mexico's system is comprised of two vertically integrated state owned companies, the Federal Electric Commission (CFE) and Central Light and Power (LFC). The reform envisions a three step process towards achieving an open wholesale market. First, the CFE and LFC will be dissolved and their assets grouped into several independent generation and regional distribution companies. The national transmission grid (REN ) will be a separate freestanding entity. There will also be a decentralized state owned entity Center of Operations of the National Electric System (COSEN) which will be responsible for system operation, dispatch and the wholesale electricity market. There will also be a new governmental entity to control the generation of nuclear power (currently there is one nuclear plant located in Laguna Verde, Veracruz which generates 4 percent of Mexico's electricity). Second, the wholesale market will be developed; generation and marketing opened to domestic and foreign investment and generators will now be able to contract with new distribution companies and qualified users (large private consumers). Third, the new generation, REN and distribution companies created from State owned assets will be privatized through sales or concessions.

Due to their natural monopolistic characteristics, REN and distribution companies will remain regulated. For-profit private companies under 30 year renewable concessions will run REN and independent regional distribution companies. These entities will also be responsible for the expansion and maintenance of the transmission and distribution systems. The Regulatory Energy Commission (CRE) will regulate the tariffs, service quality and investment of the concessioned distribution companies responsible for delivery, metering, billing and collections. Tariffs for the transmission and distribution will be subject to a "price-cap tariff regime" determined every five years based on cost, investments, maintenance and a reasonable rate of return and will be subject to control through strict performance agreements. It will also be possible to obtain concessions for distribution in specific areas as a sub-distributor or to a construct new transmission infrastructure not connected to the national grid. In other words, the distribution concessions may not be absolutely exclusive.

Under the new reform, generators will sell their output in the Wholesale Electric Market (MEM) operated by COSEN, through contracts with distribution companies or directly to qualified users and marketers. All generators will be required to obtain a permit from the Energy Regulatory Commission (CRE). State assets will be privatized through three mechanisms: the transfer of controlling interest through public bidding (trade sale); the placement of stock in the market (float); or a combination of the two. Therefore, the entire non-nuclear generation aspect of the industry is to be privatized and competing on the wholesale market in order to encourage efficiency and new investment in technology. Ultimately, it is hoped that private investment will help construct new generating facilities needed to meet Mexico's future energy demand.

COSEN will physically operate the system and control its financial aspects. It will be a non-profit entity acting independently of all other participants, including REN , to ensure open and non-discriminatory practices. To guarantee independence, COSEN will have a board of nine members selected by the Secretary of Energy, including representatives from each segment of the industry. COSEN will oversee the creation of MEM and run its operations. MEM will set prices to be paid every generator and charged every customer based on the "last accepted offer" in each generation hour; the price will be set by the highest bid from the group of lowest bidders needed to meet capacity demand.

Transmission congestion and location pricing, with COSEN setting the generation schedule for the following day by which generators will bid will also affect the price. The price fixed by the MEM will also contain a "cost of failure and probability" element in order to promote incentives to invest in more generation for periods when the possibility of shortages is highest.

Other aspects to pricing include price hedging mechanisms to be introduced in order to protect the consumers against price fluctuations in unusual climatic years. COSEN will also be responsible for contracting for ancillary services for the system such as voltage control and black-start services. A form of vested contracts between the newly created generation and distribution companies will be introduced in order to ensure stability during the transition to the MEM.

Customers will buy bundled service from their local distributor; the price determined by the cost of generation, regulated transmission and distribution tariffs. Qualified users (those who can demonstrate to the CRE that they consume over 5.0 GWh annually) must register with the CRE in order to contract directly with the generators or the local distribution company, to buy on the wholesale market or through a marketer. Marketers will be able to buy electricity directly from generators or the wholesale market and sell to distribution companies or qualified users under special conditions. The existence of the marketers will provide more flexibility in purchases and payment plans and allow for better risk management.

To attract investment, the Mexican Government must ensure transparency and avoid market dominance and unfair practices. In other words, it must guarantee the integrity of the process. Therefore, the Government plans to introduce certain restrictions in the new industry. Generation and distribution companies may market electricity but generators must operate through independent subsidiaries and distribution companies must market outside of their concession area. Generation companies will be restricted to minority ownership of distribution companies and vice versa. The Federal Competition Commission will also guard against any dominant player manipulating the MEM.

It must be stressed that the above is a summary of the proposal sent to the Congress by the Executive Branch. This proposal is currently being discussed in subcommittee and should be amended. However, it is apparent that Mexico needs a substantial infusion of private capital into its electric industry; this proposal signifies that the Government has finally decided to address the issue. Therefore, if the Executive Branch succeeds in passing some form of the above proposal, there will be substantial investment opportunities for foreign and domestic companies.

Bradford S. Nixon is an Attorney with the Law Firm of Capin, Calderon, Ramirez Y Gutierrez-Azpe, S.C. Mexico City, Mexico