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Sent: Thursday, December 20, 2001 10:02 AM
To: Rohauer, Tanya
Subject: The Road To Competitive Electricity Markets in Mexico



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The Road To Competitive Electricity Markets In Mexico

 

 

Publication date:

 

04-Dec-2001

Analyst:

 

Jeffrey Wolinsky, CFA, New York (1) 212-438-2117; Manuel E Borrajo, New York (1) 212-438-7971; Santiago Carniado, Mexico City (52) 5-279-2013 

 

 

Mexico's much anticipated energy reform seems to have been placed on hold until mid-2002. The delay is due to two crucial factors: The economic slowdown that has led to reduced electricity demand growth, making reform seem less urgent, and the controversial tax reform, which is currently the primary focus of the Mexican Congress. Under the current recession, industrial growth has slowed considerably, resulting in very little growth in electricity demand this year. GDP growth, which is tied to electricity growth, for 2001, is projected at less than 1%, which is a far cry from growth in 2000 of just below 7%. In April 2001, the high electricity demand growth brought reserves down to nearly 0% and led to fears that severe energy shortages were imminent. However, the new plants that came on-line this year as part of the government's independent power producer (IPP) program, combined with much lower demand growth in the later part of the year, reduced the sense of urgency.   

Energy reform is likely to be very controversial and may require a constitutional change to allow greater participation in the sector for private investors. The rival political parties to President Vicente Fox's (National Action Party) PAN are expected to balk at any changes to the constitution, but may accept changes to Mexico's enabling laws to offer openings to private capital. The Mexican Constitution currently requires the state to provide energy services as part of its public service obligations. Enabling laws can be changed, however, to exclude industry and commerce from the definition of public service, which would allow a free market to operate in the electricity sector. Yet, investors got a preview of the opposition to reform in June when Congress blocked a proposal by President Fox to increase the amount of electricity that companies may sell to Comision Federal de Electricidad (CFE). Currently power companies that generate for their own use are permitted to sell up to 20 megawatts (MW) of excess power to CFE. President Fox hoped to allow these companies to sell up to 50% of their capacity to CFE. Mexico's Congress ruled that this proposal was unconstitutional, as it represented a change in law, which cannot be done without first going through Congress. Reform of the electricity sector in Mexico has become more of a political issue than an economic one.   

President Fox faces an uphill battle in devising an energy reform plan that satisfies Congress. Many Mexicans believe that selling off state-owned companies leads to higher prices, worker layoffs, and high profits for the new owners, not improved service as government officials typically promise. Back in February 1999, President Ernesto Zedillo submitted a restructuring proposal to Congress that envisioned the disaggregation, subdivision, and subsequent sale of distribution concessions and generation companies. However, the proposal died in Congress that year. Therefore, any proposal put forward by President Fox will most likely not include plans to privatize the existing generation assets, although there is the potential that the distribution assets could be subdivided and the concessions sold to private investors.   

The resistance to selling a substantial portion of CFE's generation assets creates a great challenge in Mexico's effort to establish a competitive electricity market that will draw private investment into new generation plants. The challenge is unprecedented in that the government would like to create a competitive generation market while retaining ownership of about 90% of generation capacity. There are no global examples of how to accomplish this feat and to make investors comfortable that the market will truly be competitive. The problem Mexico faces is that investors will have to be assured that the government will be prevented from keeping power prices artificially low to stimulate the economy during periods of economic slowdown. The two issues that will have to be addressed are how CFE will determine the pricing for its plants and the form of subsidies to CFE from the Mexican government.   


Market Pricing and Subsidies 

 

 

CFE faces the inverse of the market power issue that has plagued so many other competitive generation systems. When an entity has market power in a given region, that entity can withhold its generation, thereby forcing artificially inflated prices. At this point the entity, having market power, enters the market and makes windfall profits. Standard & Poor's has seen this scenario played out in various markets all around the globe, with the recent California crisis getting a great deal of attention. Mexico would face the opposite problem because the government, through CFE, would own more than 90% of the power generation and could exercise market power to artificially keep prices low by bidding CFE-owned generators below their marginal cost. This might be done to provide an economic stimulus to the economy, and CFE could be reimbursed through some form of a subsidy from the government. Because CFE owns such a substantial portion of the country's generation, one of its plants would likely be the marginal plant for a significant period of time, thereby eroding the profit margins of private generation companies. In order to mitigate this risk for private generators, the government must devise a law that would make it illegal to bid government-owned plants at below their marginal cost and eliminate any loopholes for providing CFE-owned generation plants with government subsidies. Any future government subsidies would have to be made by the Mexican government to CFE's distribution or transmission subsidiary, not to any generation subsidiary.   

Another issue that needs to be addressed is what the government will do about the existing subsidies. In 2000, the government spent about $5.8 billion subsidizing electricity bills, and the estimate for 2001 is slightly higher due to inflation and population growth. In order to highlight these subsidies to the population, the format of electricity bills was changed in July to break out the cost of power and the amount that the government is contributing as a subsidy. As there are no plans to do away with these subsidies, the government must structure them in a way that does not benefit CFE-owned generation plants to the detriment of privately owned plants. One potential indirect subsidy to CFE that has been addressed is the price that CFE pays for its fuel. Under Mexican law, all public entities are forbidden to sell their products or services below market prices. Therefore, Petroleos Mexicanos (PEMEX) cannot legally provide CFE-owned generators with fuel at subsidized prices, unless it offers those prices to all generators. This mitigates the risk of CFE lowering its marginal cost through an indirect fuel subsidy from PEMEX.   

 

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Need For Capital Investment 

 

 

The push toward competitive electricity markets in Mexico is driven by the need for investment in power generation and the reluctance of the Mexican government to continue to add off-balance sheet debt in the form of the IPP contracts. Mexico is forecast to require investments in the power sector of about $5 billion per year during the next 10 years to keep up with demand, most of which is expected to come from private investors. Although the current economic conditions may adjust this forecast downward, substantial investment will still be required in the sector. Even though the IPP program has been successful thus far, Standard & Poor's views these contracts as off-balance sheet debt of CFE, which puts negative pressure on CFE's credit rating. Because the obligations under many of these contracts cross default with CFE's debt, which in turn cross defaults with some of the sovereign debt, these contracts also apply negative pressure to the sovereign rating. While this pressure is not substantial today, if the IPP program continues to be the sole source of new generation in Mexico, these obligations will have a greater affect on the sovereign rating over time. Therefore, a move to a fully competitive electricity market, where private investors take all of the financing risks, will alleviate credit pressure on the sovereign from the electric sector.   

In the interim, the Comision Reguladora de Energia (CRE) is working on creating a framework for the potential liberalization of the industry. CRE envisions the creation of an independent system operator to manage generation commitment, dispatch, and billing. State-owned generators would be divided into regional entities to promote competition. The distribution sector would also be divided into several regional entities, and a concession for the operation and maintenance of these systems could be granted. The transmission network would remain as a single public entity, although concessions for new transmission projects could be granted.   

 

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Liberalization of the Electricity Sector 

 

 

During the past nine years, Mexico has gradually liberalized the restrictions on the power market. CFE enjoyed a monopoly in the electric power sector for many years, although reforms instituted in 1992 allowed IPPs to sell power to CFE and industrial customers under self-supply regulations. In 1996, CFE devised a financing plan to meet projected electric demand growth. The objectives of the plan were to lower the company's debt leverage, finance projects at a lower cost, and extend the maturities of these obligations. As a result, for the first time, several new projects were structured as build-lease transfers (BLT), which are similar to lease transactions. Under this structure, a third party finances and builds a plant (or transmission line, or transformer) and leases the plant to CFE for a period during which the investment is amortized. At the end of this timeframe, ownership of the asset is transferred to CFE. These BLT arrangements indirectly assigned much of the operating risk to CFE, as CFE was required to pay for service even if the asset was unavailable. New facilities are now being constructed under IPP contracts. These arrangements are structured as take-and-pay power purchase agreements whereby CFE will not pay for power if it is not delivered. The next step would appear to be the creation of an open market system where participants are free to buy and sell electricity. Yet, the outlook for the creation of such a system is unclear in Mexico, given the highly politicized tripartisan environment that governs the decision-making process.   

 

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