The slow liberalisation of Mexico’s
energy industry
Rogelio López-Velarde, Jorge Jiménez and Amanda Valdez, López Velarde, Heftye, Abogados SC
The Mexican energy industry has been closed for decades, with most of its activities being exclusively reserved for state-owned companies.
That has changed in the past five years, with further liberalization strongly indicated.
This article is aimed at providing readers with a general overview of the Mexican oil and gas industry and electric power sector.
The oil and gas sector
The exploration and production of crude oil and natural gas is exclusive to the Mexican state; such activities are conducted by Pemex-Exploración y Producción (Pemex E&P), the most important operating subsidiary of Pemex. Under the current framework, no concessions are allowed for the exploration and production of oil and gas, although the Mexican government is currently considering a bill to amend the Constitution, aimed at allowing the granting of concessions to private parties for the exploration and production of dry gas (see note 1).
Pemex E&P substantially develops its activities through private contractors, which contracts are awarded pursuant to international treaties (eg Chapter X of NAFTA), and Mexico's Government Procurement Laws and Regulations.
In addition to prohibiting risk contracts, production sharing agreements, or other contracts or concessions, Mexico's 1958 Petroleum Law went even further than the Constitution by prohibiting Pemex E&P from making payments in kind (ie paying with oil or gas) for its E&P contracts. Many sectors consider that this restriction should be eliminated, and thus production companies would have a greater incentive to participate in the sector, and the cost of the services would be lower for Pemex. In addition, it is said that this abolition would be very beneficial for Pemex, which would be able to pay with its most available currency its oil or gas rather than having to pay important financing costs to obtain hard currency and pay its service providers. The possibility of eliminating this statutory restriction is currently being discussed, so Pemex may have the ability to attract private investment and increase upstream activities, particularly with respect to the production of unassociated natural gas (see note 2). In the meantime, and in light of its severe budgetary constraints, Pemex E&P is currently developing a new type of incentive-based E&P contract aimed at allowing the participation of international production companies in increasing Mexico's production levels (see note 3).
Refining is another sector where Mexico may see a change in the mid-term. Currently, Mexico's refining capacity is very limited, and Pemex imports a large percentage of the gasoline and other derivatives sold in the Mexican market. The successful venture it has had in a refinery located in Texas may set a precedent, favoring the establishment of similar structures in Mexico (see note 4).
Midstream and downstream natural gas activity has been successfully opened up since 1995. While the transportation and storage of petroleum remain within the realm of the state monopoly, natural gas transportation, distribution, storage and marketing were opened up to private undertakings, with no limit on foreign participation. To this end, Congress excluded such activities from the state monopoly, and in the same year, the president issued the Natural Gas Regulations. One of their main purposes is to regulate the participation of the government, through Pemex-Gas y Petroquímica Básica (PGPB), in the transportation, distribution, storage and marketing of natural gas, and to foster, implement and regulate the participation of private companies in the same activities. As a result of the new framework, PGPB became, among others, a transporter of gas, subject to the same market rules as new private transporters coming into the market, and subject to the regulation and scrutiny of the Energy Regulatory Commission (CRE), when PGPB acts as marketer of gas (see note 5). By the same token, also in 1995, the Law of the Energy Regulatory Commission vested this federal agency with broad powers to regulate and enforce the natural gas and electric power industry regulations, including the authority to issue directives (see note 6).
Pursuant to the Natural Gas Regulations, natural gas services became subject to a federal permit granted by the CRE. Permits operate as 30-year renewable quasi-concessions, and impose to the service providers a series of regulatory obligations, including the granting of open access, safety restrictions, and the regulation of rates.
Important steps have been taken to encourage the use of natural gas, not only through the publication of 'clean air' laws and standards, but also through the establishment of local distribution companies (LDCs), legally compelled to 'gasify' a specific geographical area in Mexico. Thus, in exchange for the legal commitment to 'gasify' a predetermined geographical 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, with 12 years of exclusivity as of the issue of the permit. This exclusivity is only granted in respect of the right of the LDC to distribute the commodity within the predetermined geographical zone, and not with respect to its marketing. Accordingly, other marketers are entitled to sell gas to end-users located in an LDC zone.
As a general rule, the first distribution permit for a geographical zone should always be awarded by the CRE through an international bidding process. The CRE has been very successful in granting LDC permits; in less than five years the CRE has awarded 21 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 own countries: companies such as Gas Natural from Spain; KN Energy, Lone Star and Sempra from the United States; Gaz de France from France; and Tractebel from Belgium.
Unlike gas distribution licensees, transportation companies are not obliged to 'gasify' any predetermined geographical 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. For obvious reasons, open access transportation permit-holders are heavily regulated and supervised by the CRE.
* Self-use transportation permits are exclusively granted to end-users or a group of end-users organised 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, nor the number of end-users that could form part of a self-use gas consumption 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 predetermined route and capacity to any company that is able to satisfy the stringent technical, economic and legal requirements set out in the Natural Gas Regulations and the CRE's Pricing and Rates Directive. Reputable transmission companies are currently developing large transportation systems in Mexico in an effort to compete with the gas transportation-marketer giant, PGPB, such as Williams, MidCon, Gaz de France 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; however, the CRE has been keen to regulate PGPB's marketing activities in order to limit its substantial power over the natural gas marketing business. Unlike private marketers, PGPB's domestic gas marketing activities are regulated by a CRE directive, and a set of rules contained in the General Terms for Natural Gas First-Hand Sales. Moreover, domestic gas prices are regulated by the CRE pursuant to the Pricing and Rates Directive, being subject to a liquid market price index (Houston Ship Channel), and a net back procedure.
Additionally, in another effort to promote competition in gas marketing activities in Mexico, on August 17 1999 the Mexican government eliminated the 4 per cent import duty on natural gas from the United States, which was originally scheduled to be phased out under NAFTA in 2003. With this unilateral decision by the Mexican government, marketing of gas at the border has significantly increased, particularly if we take into account the important share of gas-fired power generation projects being pursued in the northern region of Mexico. Imported gas is not subject to any pricing regulation in Mexico.
The increasing demand for natural gas transportation services (which is primarily a result of the large number of gas-fired power generation projects being developed in the country), and Pemex's budgetary constraints on expanding its own capacity, have led gas marketers and end-users to explore innovative business structures through investment agreements with Pemex aimed at increasing Pemex's transportation capacity through compression. Under these investment agreements, the relevant marketer or end-user owns and operates the compression facilities, providing compression services either to Pemex or to the end-user that ultimately benefits from the increased capacity.
During the last few months, several major natural gas companies have expressed their interest and started taking action to deliver liquefied natural gas (LNG) terminal projects in Mexico. The purpose of such projects is twofold: (i) to bring gas into Mexico to supply the increasing demand created by the construction of gas-fired power plants, as well as the increasing demand in the industrial sector in general, and (ii) to be a source of supply for the US market. In both cases, the LNG projects will mitigate the inability of Mexico to dramatically increase its gas production with the currently restrictive legal framework, and therefore be able to meet its internal requirements. The plan of development of this type of project is focused in certain delimited areas, such as Altamira, Baja California, Manzanillo and Michoacán. As the time of writing this overview, amendments to the Natural Gas Regulations are being finalized and would be ready to be implemented before the end of 2001. Such amendments will be aimed at regulating LNG terminals, imposing open access obligations and safety standards (such a the requirement for full containment technology, based on European standards).
The electricity power industry
Under Article 27 of the Constitution the generation, transformation, distribution and marketing for public utility purposes of electricity is a state monopoly, and no concessions to private parties are allowed. This vertically integrated monopoly is currently and mainly entrusted to a government-controlled company, the Comisión Federal de Electricidad (CFE).
In 1992 the Mexican electricity industry was partially opened up by Congress through an amendment to the Electric Power Public Utility Law (LSPEE), allowing private investment with no foreign investment restrictions in certain power generation projects that had been expressly excluded from being considered part of the "electric power public utility service" restricted to the state. The projects are: (i) independent power production (IPPs); (ii) self-consumption; (iii) co-generation; (iv) small-scale production; (v) generation for export purposes. Likewise, the amendment to the LSPEE allowed private parties to import power. These activities are subject to permit by the CRE. IPPs, co-generation and self-consumption permits have been the most common vehicles used by private developers of electricity.
IPP entails the generation of electric power with the sole purpose of selling the capacity and associated power output to CFE, whereas self-consumption entails the generation of power with the sole purpose of satisfying the electricity needs of the permit-holder, or the electricity needs of a defined group which collectively owns the relevant generation facilities or creates a self-consumption company to hold the relevant permit (consumption clubs). A co-generation permit allows the generation of power along with steam or other secondary thermal energy, or the generation of power using the thermal energy or fuels produced as a result of other industrial processes. Under a recent amendment to the Regulations of the Electricity Law, CFE has been authorized to enter into power purchase agreements (PPAs) (without the need of awarding such contracts through a bidding process), comprising the payment for both capacity and associated power output, with self-use permit-holders and co-generation permit-holders, in order to purchase such licensees' power surpluses. Under this scheme, CFE may purchase up to 50 per cent of installed capacity in the case of self-supply, and 100 per cent of installed capacity in the case of co-generation. Export permits, of course, allow the generation of power for export purposes, while import permits allow the permit-holder to import power to satisfy its own needs only, without the possibility of selling such power on to third parties.
As a result of the bidding processes launched by CFE during the past five years, the most important private power generation scheme, in terms of the generation capacity being installed, is the IPP (see note 7). In these cases, the IPPs are responsible for building, owning, operating and maintaining the corresponding power plant, and in exchange, they are awarded a 25-year PPA for the supply of power to CFE. At the outset, the first CFE bids were 'output contracts', where the developer was barred from aggregating loads and building an 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 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.
Some IPPs have sized their power plants to exceed CFE's power-generation requirements. The excess capacity of an IPP may be used to satisfy the requirements of a consumption club that has become a partner of the IPP company, or used for export purposes. These projects entail having a power plant operated under a dual-permit structure, which is permitted under the applicable legal provisions.
Despite the absence of sufficient infrastructure to supply natural gas to the power plants being developed, and the intensive negotiations between the IPPs and PGPB to achieve an adequate gas supply, the IPPs have been successful in making their projects suitable for project finance structures (see note 8). The lack of infrastructure (which is worsened by PGPB's budgetary constraints on expanding the national pipeline system), is being handled through private gas marketing and transportation companies which have undertaken the development of complementary gas transportation systems and/or the expansion of PGPB's available gas transportation capacity through compression facilities, whereas the negotiations between the IPPs and PGPB to improve the terms of PGPB's gas supply services are still taking place, in many instances, with the intervention and assistance of the Mexican energy authorities.
Co-generation projects and self-consumption power plants are also being developed, but the installed capacity under these schemes is still small. On the other hand, only a few import and export permits have been granted. One reason why power import projects have not been very attractive is the restrictions imposed by the LSPEE and its regulations for import permit-holders to share transmission facilities and the requirement of having one permit per company, without the possibility of creating consumption clubs (see note 9). Alternatives to eliminate or mitigate these restrictions, however, are currently being analyzed as a result of the proactive participation of private developers. The amendments to the regulations of the LSPEE being analyzed would not require congressional action, and would certainly facilitate the implementation of private projects.
The power generation and power import permits granted by the CRE give the permit-holders the option to either build, own and operate the transmission facilities required to deliver the associated power output to the authorized users, or request transmission services from CFE for such purpose. Most permit-holders requiring transmission as part of their projects have resorted to CFE's transmission services (see note 10). CFE's transmission services, along with back-up power supply services, also available from CFE, are also regulated by the CRE; the Ministry of Finance, on the other hand, has also jurisdiction in the regulation of some of these services, mainly with respect to the consideration payable to CFE by the permit-holders.
Demand for electricity in Mexico is expected to increase at a rate of over 6 per cent a year. Coping with such demand will require additional generating capacity of over 21,000 MW within the next eight years, coupled with an expansion of the national electric grid by approximately 20,000 miles, and 70,000 MV Amperes in substations for the 20002008 period. This entails capital investments of more than US$51 billion.
No public budget is capable of meeting these requirements, so despite the fact that the IPP scheme has been successful, there is no doubt about the need to promote other investment structures that further enhance the participation of private capital in the Mexican electricity industry, and ultimately, the need to amend the applicable legal provisions (including the inevitable amendment to the Mexican Constitution), to create a market that is attractive for national and foreign private investors.
As a result, President Fox has submitted a bill to amend the Constitution in an effort to further liberalize the power industry.
The most important aspects of the electricity reforms are as follows:
* The electric power industry will no longer remain a state monopoly. The two public utility companies will be gradually spun off and transformed into various regional state-owned companies, each specializing either in the generation or distribution of power.
* The electricity reform proposes the creation of an independent system operator to be in charge of the national transmission system and the wholesale electricity market to be called COSIME (Electric Market and Operational System Center), where generators, marketers, distributors and qualified users will participate in the wholesale market to be operated by COSIME.
* Private companies, domestic or foreign, will be entitled to generate, transmit, market and distribute power subject to permit and/or concession to be granted by the CRE.
The electricity bill is expected to be discussed by Congress in autumn 2001. Once the bill has been passed, implementing and enabling legislation will be introduced. This legislative process could take between one and three years, depending on many political factors. In the meantime, private sponsors would continue to generate power through the IPP, co-generation and self-consumption projects.
Notes
1 A Constitutional amendment would require the supra-majority vote of federal Congress, and the simple majority approval of the 32 local legislatures in Mexico.
2 Unlike a Constitutional amendment, this statutory amendment would only require the simple majority vote of the federal Congress.
3 There are no foreign investment restrictions for E&P companies in Mexico except for drilling; prior authorization is required from the National Commission on Foreign Investments in order to increase a 49 per cent foreign investment participation in companies engaged in providing E&P drilling services.
4 Pemex-Refinación has a refinery with Shell in Deer Park, Texas, through a joint venture, and currently sells its product both in Mexico and in the US markets.
5 Marketing of natural gas in Mexico is not regulated except when Pemex is acting as marketer.
6 The CRE is an autonomous administrative agency of the Ministry of Energy, and regulates the players of both natural gas and electricity industries, including private entities, PGPB and CFE.
7 14 IPP projects have been awarded by CFE. The companies to which such IPP projects have been awarded are Iberdrola, AES, Unión Fenosa, EDF, Transalta, Mitsubishi and Intergen.
8 As mentioned before, the terms and conditions in which PGPB is allowed to offer gas supply are regulated by the Natural Gas Regulations, the Directive on Prices and Rates for Natural Gas Regulated Activities, and more specifically, the Directive on Natural Gas First Hand Sales and the General Terms for Natural Gas First Hand Sales, approved by the CRE and published on August 23 2000.
9 The holder of a power import permit is required to either (i) build, own and operate, on its own, the transmission facilities used to import power; or (ii) interconnect to the national electric grid owned and operated by CFE; however, power importers are not allowed to share any transmission facilities, nor create consumption clubs, which prevents them from obtaining the benefits of economies of scale.
10 It has been only a few years in which CFE has acted as common carrier for private power generation companies using CFE's transmission services. Last year, for example, a subsidiary of Enron Corp obtained a co-generation permit for a 245 MW power plant in Monterrey, NL, which will be serving a consumption club of more than 30 users located all over Mexico using CFE's wheeling services.