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Slow progress towards power sector reform in Mexico

The energy sector is one that is drawing an increasing amount of attention among investors. And in Mexico the government has recently indicated its willingness to permit privatization of electricity supply, providing new opportunities for those prepared to take the risk. Monica Restrepo of Coudert Brothers gives an overview of the reforms.

After decades of providing electricity through a state monopoly, the Mexican government is taking incremental steps to permit private participation in the sector. This reform is being driven by increases in demand for electricity that have outpaced the government's ability to finance necessary expansion and modernization. (The Mexican government's concern to fund economic expansion has also led it to enact revisions to its tax laws which could have significant ramifications for energy and other project economics - see sidebar).

However,a recent decision by the Mexican Supreme Court has cast doubts on the constitutionality of the law that began to liberalise the energy sector in 1992. The decision might press Congress to become proactively involved in the long-awaited power sector reform.

The State Monopoly

The role of the Mexican government in the electricity sector is rooted in the Mexican Constitution, which provides that the State has a monopoly over the public service of electricity, including the generation, transmission, distribution and commercialization of energy. Under this monopoly structure, as managed by two state-owned electric utilities, the Comisión Federal de Electricidad ("CFE") and Luz y Fuerza del Centro ("LFC"), Mexico was able to supply electricity to 94.7 per cent of its population by 2000.

To achieve these results, however, the state was obliged to assume an enormous financial burden. In addition, during the last ten years demand for electrical energy has outpaced the growth of the Gross Domestic Product, and the Mexican Government lacks the resources to build the generation infrastructure required to meet future energy demands.

According to the 2001-2006 Energy Program developed by the Mexican Government, demand for electricity is expected to grow at 6 per cent annually for the next ten years, which will require an additional 27,357 MW of generation capacity. While 10,854 MW of that capacity will be covered by existing contracts or commitments, the 16,503 MW shortfall must be made up by additional generation projects that have not yet been committed.

Steps Towards Liberalisation

In 1992,the Mexican Congress amended the Electric Power Public Utility Law (the "Law") to allow, or the first time, some private investment in power generation.

That law allowed private investment in the following types of generation facilities:

(i)    self-generation or self-consumption (generation dedicated to the exclusive use of the generator and its owners);

(ii)   co-generation (generation using steam or other thermal energy produced by industrial processes);

(iii)   independent power production (generation by plants greater than 30 MW for the sole purpose of selling the energy and capacity produced to CFE and LFC);

(iv)   small production (generation by plants of less than 30 MW for the sole purpose of selling the energy and capacity produced to CFE and LFC); and

(v)    generation exclusively for import (to satisfy the permit holder's own needs)and for export purposes.

The Law also provided that permit holders (i.e., the private generators described above) could enter into contracts with CFE and LFC for

(a)    the sale of up to 20 MW of their excess capacity and associated energy or

(b)    the sale of excess energy (i.e., energy other than that required to meet the permit holder's needs).

This reform has not been as successful as had been hoped, however. While permits for nearly 18,000 MW of co-generation, independent production and import and export had been granted by January 2002, only a small fraction of projects (other than projects built under CFE's IPP program) have been constructed. A principal reason for this shortfall has been uncertainty regarding the tariffs that private parties can charge, as well as the relatively low level of tariffs that resulted from calculating the tariff on the basis of delivered energy only.

A related issue affecting tariff uncertainty in the current market is that the dispatch center (Centro Nacional de Energía or "CENACE") is a functional division of CFE. Although in a monopoly environment the regulator may control the dispatch center, in a system based on open access and cost-based dispatch the dispatch center is typically an independent, autonomous unit.

To address the issue of tariff uncertainty, the Comisión Reguladora de Energía ("CRE") has proposed a methodology for determining rates (currently pending final approval) based on the short-term marginal cost of energy for permit holders that sell excess energy and capacity to CFE and LFC. (CRE is the regulatory agency tasked with approving tariff regulations and protecting private parties from the use of market power by CFE and LFC,as well as increasing transparency and stability in the energy sector.) CRE's agreements. If the CRE's proposed methodology is approved,it will resolve some of the present tariff uncertainties, but additional clarifications will be required as it is applied to individual generators.

A step back

In order to boost private investment, the President decreed in May,2001, that the amount of excess energy and capacity that permit holders could sell to CFE and LFC would be increased:

(a)    to 50%of total capacity for self- generators with more than 40 MW installed capacity; and

(b)    to 100 per cent of excess generation for co-generators.

However, that decree was not implemented as its constitutionality was subsequently challenged in Mexican courts on grounds that the President lacked the requisite authority to issue the decree.

In dicta, the Supreme Court indicated that the Law and "certain other legal provisions" might be unconstitutional, without, however, providing any further explanation other than noting that such issues were beyond the scope of their actual review and that it would be up to the Mexican Congress to take action to amend the Law. Although the effect of the Supreme Court's judgment cannot be predicted at present, according to our Mexican sources, future constitutional challenges to the Law -even if successful -should not pose any risks to permit holders with vested rights under Mexican law. However,it is at the moment uncertain how parties applying for new permits in the future or seeking amendments to their existing permits might be impacted.

Energy Reform Proposals

One outcome of the Supreme Court's decision, according to our Mexican sources, is that the Mexican Congress may be prompted to undertake an active role in the general reform of the energy sector but within existing constitutional guidelines. The Mexican Congress has so far rejected three of at least five energy reform bills submitted by diverse political parties. The rejected bills advocated constitutional reform to allow the entry of private investment in the rendering of the public service of electricity.

From both public and non-public Mexican sources we understand that President Fox is progressing towards submitting a compromise energy bill to Congress, which will necessarily be watered-down based on the need for consensus among the political parties regarding the main elements of reform. Among the likely elements of such a consensus are the following:

• CFE and LFC will not be privatized;
  
  
• The transmission network and the dispatch system will be operated by a newly-created government agency, to be independent of CFE, under open access rules;
  
  
• Government subsidies will be retained, but will be itemized in monthly bills;
  
  
• Retail tariffs will be increased gradually;
  
  
• Hydroelectric generation will be opened to private investment;
  
  
• Co-generation and self-generation projects will be fostered by easing existing restrictions;
  
  
• Measures, including creation of a wholesale energy market will be introduced to enhance private participation in generation and 
  
• Measures will be introduced to improve the efficiency of CFE and LFC, including allowing certain activities now under their responsibility to be outsourced.

If passed, this bill will likely chart the course of liberalization in Mexico's energy sector, as well as demonstrate Mexico's plan for responding to the threat of future power shortages.

Copyright © 2003 Coudert Brothers

For updates regarding the progress of the reform of the Mexican energy sector and the effects of the recent Supreme Court decision, please contact Monica Restrepo or visit our website at www.coudert.com.

Information for this article was also provided by Francisco Treviño of our Associated Office in Mexico, Rios Ferrer y Guillén-Llarena. Mónica Restrepo is an associate in Coudert Brothers' energy practice in the Washington, D.C. office. Her experience includes four years with a leading Colombian law firm, where she concentrated on the development and financing of energy, water and infrastructure facilities and related transactions.