Mexico's Gas Liberalization Not Enough: The Need for Furter Reform
Rogelio López-VelardeMexico is one of the few countries that have liberalized their natural gas industry both midstream and downstream without liberalizing and allowing competition in the production and supply of such fuel, or in the generation, transmission, marketing and distribution of electric power.
One may accept that the natural gas liberalization in Mexico has been a success so far; this gas liberalization, however, has highlighted the need to privatize further and allow competition in the energy industry, and to regulate further the government monopolios that control this strategic market. Such liberalization is not only necessary from the economic point of view, but also from the political perspective, since any responsible government would prefer to use scarce government resources on social spending rather than long-term capital investments in an area where the presence of the government is not justified. In particular, two important segments of the industry require immediate reform-is aimed at enticing private participation and competition into the relevant market: the electric power industry, and the exploration and production of oil and gas in Mexico.
This article offers a brief survey of Mexico's natural gas liberalization, and then comments on the status of the liberalization of the electric power industry, and the need to allow private participation in gas production projects in Mexico.
Natural Gas Liberalization
Back in 1995 the Mexican Congress passed a Bill amending the old 1958 Petroleum Law, allowing private participation (national and foreign) in the transportation, storage, distribution and marketing of natural gas in Mexico. Such activities were exclusively reserved to the Mexican State, specifically, to Pemex-Gas y Petroquímica Básica ("PGPB"), one of the four operating subsidiarias of the giant monopoly, Pemex. In that same year, the Natural Gas Regulations were published by the Executive branch implementing this natural gas liberalization. New environmental norms calling for the use of low sulphur fossil fuels became effective as of 1998, making natural gas the best choice for end users, particularly for industrial customers. A new federal agency was created in order to enforce the natural gas and electricity laws and regulations: the Energy Regulatory Commission ("CRE").
After decades of an "oil" mentality, the Mexican Government finally decided to use and consider natural gas as an efficient, safe, readily available, environmentally friendly fuel. The Government decided to encourage the use of natural gas not only through the publication of "clean air" laws and norms, but also through the establishment of local distribution companies (LDCs), legally compelled to "gasify" a specific geographic zone in Mexico. Thus, in exchange for the legal commitment to gasify a predetermined geographic zone through the imposition of a minimum number of end users connected by the fifth year of operation of the relevant LDC, and subject to the compliance of maximum regulated rates, the CRE grants to private LDCs a 30-year distribution permit, renewable for periods of 15 years thereafter, with 12 years of exclusivity as of the issuance of the permit. This exclusivity is only granted in respect of the right of the LDC to distribute the commodity within the pre-determined geographic zone, and not with respect to its marketing. Thus, marketers are entitled to sell gas to end users located in an LDC zone.
The geographic zones where the LDCs are entitled to distribute gas on an exclusive basis are first determined by the CRE; under the Natural Gas Regulations, as a general rule, the first distribution permit for a
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Geographic zone should always be awarded by the CRE through an international bidding process. The CRE has been very successful in granting distribution permits; in less than four years the CRE has awarded 12 LDC permits. Most of the LDCs that have already established operations in Mexico are foreign companies that demonstrated to the CRE their financial clout and longstanding experience in operating gas distribution systems in their countries: Gas Natural from Spain; KN Energy, Inc., Lone Star and Sempra from the United States; Gaz de France from France; Tractebel from Belgium, to name a few.
As a result of this natural gas liberalization, PGPB and CFE (the other state-owned monopoly engaged in providing electric utility services in Mexico, as described below) were required by the Government to spin off and sell their gas distribution assets and companies (e.g. Pemex and CFE distribution assets located in Monterrey, Querétaro and Estado de México). PGPB, alas, was not compelled to dispose of its transportation assets; likewise, CFE kept its small laterals which are tapped into PGPB's lines, and which are not aimed at providing open access services.
Unlike gas distribution permits, transportation companies are not obligated to gasify any pre-determined geographic zone or to connect any given number of users. Thus, gas transportation permits are granted by the CRE on a non-exclusive basis.
There are two types of natural gas transportation permits: open access and self-use. Open access transportation permits are granted to those transmission systems that will serve very much like a utility: they are compelled to grant open access, on a non-discriminatory basis, to any user that requests the service, provided there is available capacity in the system and the parties reach an agreement on the subject matter. For obvious reasons, open access transportation permit holders are heavily regulated and supervised by the CRE. Self-use transportation permits, on the other hand, are exclusively granted to end users or a group of end users organized in a consumption club company, whose transmission systems will not be providing open access services. There are no restrictions in terms of length and width of the pipeline or the capacity of the system, or the number of end users that could form part of a self-use gas consumption club company. Since there are no local utility agencies or commissions in Mexico, the CRE is in charge of granting both interstate and intrastate transportation permits.
Open access gas transportation permits are granted by the CRE for a pre-determined route and capacity to any company that is able to prove the stringent technical, economic and legal requirements set forth in the Natural Gas Regulations and CRE's Pricing and Rates Directive. Like LDC permits, transportation permits are issued for 30 years and renew- able for 15 years. Unlike LDCS, transportation permit holders are not required to post a standby letter of credit in order to guarantee their performance. Further, transportation companies may freely abort their projects and unilaterally cancel their transportation permits; CRE abandonment rules are only applicable, once the open access transportation system has begun operations. As with open access distribution permits, end users are not obliged to acquire gas from the transportation companies. Currently, transportation companies are allowed to undertake the marketing of natural gas, and there are no vertical integration restrictions under Mexican law between transportation and marketing companies. The CRE has not yet adopted any sort of "affiliate-market" rules.
Reputable transmission companies are currently building large transportation systems in Mexico in an effort to compete with the gas transportation-marketer giant, PGPB, such as Tejas Energy from Shell, Enron, TransCanada Pipelines, Williams, MidCon and El Paso Energy.
Despite the fact that PGPB is now heavily regulated by the CRE, unfortunately, PGPB continues to be virtually the only supplier of gas in Mexico, and the largest transporter and marketer of natural gas. Any transportation or marketing company willing to compete with PGPB needs to have a very significant critical mass of clients and volume, unless the Mexican Government wisely decides to prevent PGPB from marketing gas in Mexico, or at least compels PGPB to conduct marketing through a separate entity subject to "Chinese wall" regulations. The CRE has already curtailed, PGPB's substantial power over the natural gas
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Marketing business in Mexico. Unlike private marketers, PGPB's marketing activities will be regulated through a specially-tailored Directive to be issued by the CRE; just recently, the CRE prohibited PGPB from reserving capacity for itself in the gas transportation system owned and operated by PGPB that runs from Naco, at the border with the State of Arizona, downstream to Hermosillo, in the State of Sonora. Although the Naco--Hermosillo trunkline is an isolated transmission system, CRE's ruling is an important precedent that could be used for the other transportation systems currently being operated by PGPB. In another encouraging development, the Mexican Government on August 17, 1999 eliminated the 4 per cent import duty on natural gas from the United States which was originally scheduled to be phased out under NAFTA as of 2003. With this unilateral decision of the Mexican Government, marketing of gas at the border will be significantly increased, particularly if we take into account that most of the important gas-fired power generation projects are being pursued at the northern portion of Mexico (e.g. Hermosillo 225 MW, Rio Bravo 495 MW, Naco-Nogales 258 MW, Monterrey 740 MW).
Open access natural gas distribution and transportation companies are heavily regulated by the CRE. As common carriers subject to open access and unbundling rules, transportation and distribution companies are generally barred from vertical integration if they are serving the same geographic zone. Gas marketers are not subject to permits from the CRE, and gas suppliers, transporters and distributors are free to participate in such marketing companies. Propane and fuel oil are still and will continue to be widely used in Mexico. Therefore, the CRE is keen to maintain transportation and distribution rates at a very competitive level with respect to other competing fossil fuels. Preparation and approval of open access transportation and distribution rates are subject to a "maximum revenue yield cap" methodology, established in the Pricing and Rates Directive. After every five years of operation of the system, the rates are revised by the CRE and the relevant permit holder, based on the Directive (which includes efficiency and correction factors), and pursuant to the terms of the relevant permit.
The price of domestic natural gas (which due to the legal monopoly granted to Pemex can only be produced and supplied by Pemex) is regulated by the CRE pursuant to the Pricing and Rates Directive. Domestic gas is subject to a liquid market price index (Houston Ship Channel), subject to a net back procedure. Imported gas is not subject to any pricing regulation in Mexico.
Natural Gas Production
In light of the growing demand for natural gas in Mexico, the increasing competition in the relevant market, and the legal reforms briefly describes above, Pemex E&P (the most important operating subsidiary of Pemex, exclusively in charge of the exploration and production of oil and gas in Mexico) is currently required to make a rapid increase in the production of natural gas. The Mexican Government, however, is living with the smallest budget in the last 25 years. Needless to say, Pemex is not only subject to these budgetary constraints, but is also subject to a restrictive tailor-made tax regime which takes almost all of its profits. There is insufficient federal funding to cope with Pemex's investment requirements and production programmes. Pemex's surplus on natural gas sup- ply will not last much longer; Pemex E&P needs to be more creative in the implementation of incentive-based service contracts with private companies; otherwise, Mexico will have to start importing significant amounts of natural gas in addition to the importation of refined o¡¡ products from the United States.
Under the 1958 Petroleum Law, performance and incentive-based contracts are permitted to the extent that no ownership rights over the domestic hydrocarbons are contractually granted by Pemex E&P, as consideration for the services rendered by the independent contractor. Thus, production-sharing agreements and oil and gas risk service contracts are forbidden in Mexico if in rem rights over the oil and gas production are
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1 Under the Electricity Law an External Power Producer could be either an IPP, self-consumption company, co-generation or a small-scale production plant.
Given as compensation for the works, The Petroleum Law and its regulations need to be amended in order to facilitate the participation of production companies in the exploration and production of hydrocarbons in Mexico. Some of these amendments would require Congressional action, but for most of them, administrative action would suffice. No Constitutional amendments would be required; Pemex would not need to be privatized.
The Electric Power industry
Pursuant to the Mexican Constitution, the generation, transmission, distribution and marketing of electric power as a utility service is exclusively reserved to the Mexican State (the "Utility Monopoly"). Two public enterprises of the federal Government of Mexico have been entrusted by law to undertake exclusively the Utility Monopoly: the Comisión Federal de Electricidad ("CFE"), and Luz y Fuerza del Centro ("LYFC"). Of the electricity in Mexico 90 percent is produced by CFE; the rest is produced by Pemex, LYFC and private companies, in that order. More than 95 per cent of the transmission, distribution and marketing of power is also controlled by the CFE. These two vertically integrated monopolios are not only protected by Mexican law, but also subject to a significant number of legal constraints under the supervision and control of several federal agencies, including the CRE, the Ministry of Energy, and more importantly, the Ministry of Finance. Like Pemex, CFE and LYFC, as public enterprises of the federal Government, have suffered severe budgetary cuts and constraints. As a result, CFE and LYFC are failing to provide utility services in Mexico.
In 1992 (and very much prompted by the negotiations of Chapter VI of NAFFA), Mexico's Electricity Law was amended to allow private participation in the electric power industry. Implementing regulations were enacted in 1993 expressly allowing private participation in the electric power industry-with no foreign investment restrictions-pursuant to the following power permit regimes (the "Power Permits"): (i) independent power production ("IPPs"); (ii) self-consumption; (iii) co-generation; (iv) small-scale production; (v) import; and (vi) export. The CRE is the agency in charge of granting, supervising and revoking the Power Permits. Power Permits are granted by the CRE to private companies because they do not entail the rendering of a "utility service", which is exclusively reserved to the Mexican State.
Electricity demand is expected to increase 6 per cent each year; thus, Mexico needs to install additional generating capacity of over 13,000 MW during the next six years (close to one-third of the current installed capacity). This entails a capital investment of more than US$25 billion which the Mexican Government does not have. Between 1998 and 2007 Mexico will need to build 21,743 MW in order to satisfy domestic demand, according to government figures. Already, close to 7,000 MW have been or are in the process of being commissioned or under construction by private parties, making the remaining 14,784 MW available for private or government participation.
The Mexican Government has tried to promote private participation in the electric power industry in three different ways: (i) through the promotion of Power Permits; (ii) through the issuance of a significant -number of External Power Producers bids by the CFE[1], whereby the CFE would acquire capacity and associated power output from a power plant to be built, financed and operated by a privately-held producer (the "CFE Bids"); and (iii) through the presentation of a Bill before Congress aimed at allowing private participation in the generation, transmission, distribution and marketing of electricity in Mexico (the "Electricity Bill").
First, the Mexican Government is strongly promoting the participation of private developers through the issuance of Power Permits, particularly under the co-generation and self-consumption Power Permit regimes. Since the regulations of the Electricity Law are not conducive to facilitate these projects, the Mexican Government is currently working to make changes to the electricity regulations by the end of this year. Such changes would not require Congressional action, and would certainly facilitate the implementation of private projects.
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2 In each of the CFE Bids at least six consortiums have participated with cornpanies as Enron, Calpine, Aisthorn, Abengoa, El Paso Energy, Intergen, A.ES Union Fenosa, Electricité de France, Mtsubishi, Destec, Endesa, ABB, Entergy, Wartsila, Iberdrola, among others. In less than two years the CFE has awarded the following bids: the first-Hermosillo 225 MW-was awarded to Union Fenosa; Río Bravo 495 MW to EDF; Bajío 5 1 0 MW to Intergen; Tuxpan 450 MW to Mitsubishi; and Monterrey 740 MW to Iberdrola.
3 lt should be noted that a decentralized public entity in Mexico does not allow private participation.
4 COSEN will control Mexico's electricity market and the transmission lines of REN.
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Second, the Mexican Government and CFE have launched an aggressive programme of CFE bids, under a government procurement programme called "PIDIREGAS". Under the PIDIREGAS programme all of the financing and risk is placed on the private contractors, and payment is made to the contractor on a "throughput basis".
Under the CFE bids, the CFE will sign a 25-year turn-key Power Purchase Agreement with the winning bidder for a predetermined capacity and associated power output (the “CFE PPN”). At the outset, the first CFE bids were "output contracts", where the developer was barred from aggregating loads and building oversized plant. The developers were not able to take advantage of economies of scale, with minimum flexibility regarding the supply of natural gas. The CFE PPA required the construction and operation of gas-fired combined-cycled power plants to be built and operated at a site already predetermined by CFE, with the gas supply already pre-arranged by CFE with PGPB, its sister company. After the lobbying efforts of various companies, CFE changed the structure of the CFE bids, and now bidders are allowed to (i) aggregate loads and propose the construction of an oversized plant, (ii) choose the site and interconnection points subject to certain conditions, and (iii) arrange for their own gas supply, with no restrictions for vertical integration. The first two to take the step of aggregating loads were Intergen with a 645 MW power plant (CFE required between 400 and 510 MW), and Iberdrola with a 740 MW power plant (CFE originally required 495 MW). The next CFE bids under this new bid structure are Altamira (450 MW) and Naco-Nogales (258 MW).
The CFE bids have been a great success so far not only because of the number of refutable power companies participating in such international tenders,' but also because of the rates and competitiveness of the offers. Needless to say, all of the payments under the CFE PPA are being financed by resources of the federal Government.
Third, the CFE bids and the Power Permits are not regarded by the Mexican Government as the solution for the growing demand for power in Mexico. Moreover, the Government has recognized that ¡t is not convenient to maintain the electric power industry subject to a vertically integrated monopoly. As a result of the foregoing, and the increasing demand for energy in Mexico, on February 3, 1999 the Executive branch submitted a Bill before Congress to amend the Constitution. This Bill is aimed at restructuring and expanding the scope of participation of private investment (domestic and foreign), in the generation, transmission, distribution and marketing of power in Mexico.
The most important aspects of the electricity reform are as follows.
1) The electric power industry will no longer remain a monopoly of the Mexican state. The two public utility companies (CFE and LYFC), will be gradually spun off and transformed into various regional state-owned companies, each specializing either in the generation, transmission or distribution of power in Mexico. Such companies "l be subject to a concession or permit to be granted and regulated by the CRE, depending on the type of activity they "l he performing. Private participation will be allowed in these state-owned companies.
2) The electricity reform proposes the creation of three decentralized public entities (i.e. a public enterprise created by law such as Pemex)3: (a) an open access power transmission company exclusively in charge of the National Transmission Grid (known by its Spanish acronym as REN); (b) a public entity exclusively in charge of Mexico's dispatch and operations system to be called the Operation Centre of the National Electric System (known by its Spanish acronym as COSEN)'; and (e) a public enterprise exclusively in charge of the generation of nuclear power.
3) Private companies, domestic or foreign, will be entitled to generate, transmit, market and distribute power. Private generators and marketers will be also entitled to sell capacity and associated power directed to approximately 350 pre-qualified end users.
4) The opening of the electric power industry will be implemented in three phases according to -the Electricity Bill. During the first phase.
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CFE and LYFC will be spun off and transformed into different specialized companies, majority-owned by the Government, and COSEN will be created. The second stage will entail the establishment of a short-term electricity market through which power generators will sell their energy in competitive conditions and the price will be freely determined. Generation and marketing of power will be opened up to foreign and domestic private participation. Power generation will be subject to a permit regime under the supervision and enforcement of the CRE. Power generators entitled to generate electricity will be free to sell capacity and associated power output directly to the new distribution companies and marketing companies, or to pre-qualified
9 companies, o
end users. New concessions will be granted by the CRE to those interested in developing transmission lines that will not be interconnected to the National Transmission Grid to be exclusively owned by REN and exclusively operated by COSEN. Power distribution will be considered a public utility under Mexican law, and such activity will therefore be subject to a 30-year renewable concession to be granted by the CRE. Distributors will be assigned to a specific geographic area, apparently on a non-exclusive basis; there will also be sub- distributors. Finally, during the third stage, the state-owned power companies indicated above will be progressively privatized.
The Electricity Bill may be discussed by Congress in the autumn. The affirmative vote of at least two-thirds of the members of the House of Representatives and the Senate, and the approval by the majority of the legislatures of the 31 States of Mexico and the Federal District, will be required for such Constitutional amendment. Once the Bill has been passed, implementing and enabling legislation will be promulgated by the federal Congress. This legislative process may take between one and three years to be partially implemented, depending on many political factors. Nonetheless, it is expected that the Electricity Bill win be subject to important changes if it is to be passed by Congress.
lt is currently uncertain when the Electricity Bill will be passed, especially since the ruling party requires the support of at least one of the main opposition parties in Congress (evidently PAN), and the fact that next year will be the Presidential elections in Mexico. In the meantime, the Ministry of Energy and the CRE have adopted other measures in order to promote the development of power projects in Mexico, such as restructuring the CFE bids and preparing changes to the implementing regulations of the Electricity Law in order to make this legal framework more flexible.'
5 Only administrative action is required to amend implementing regulations such as the regulations of the Electricity Law; therefore, no Congressional action is required to amend those regulations.
ROGELIO LÓPEZ-VELARDE Lopez Velarde, Heftye y Abogados, S.C. Mexico City
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