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Subject: FW: The Road To Competitive Electricity Markets in Mexico
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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

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Publication date:

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04-Dec-2001

Analyst:

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Jeffrey Wolinsky, CFA, New York (1) 212-438-2117; Manuel E Borrajo, New Yor=
k (1) 212-438-7971; Santiago Carniado, Mexico City (52) 5-279-2013=20

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Mexico's much anticipated energy reform seems to have been placed on hold u=
ntil mid-2002. The delay is due to two crucial factors: The economic slowdo=
wn that has led to reduced electricity demand growth, making reform seem le=
ss urgent, and the controversial tax reform, which is currently the primary=
 focus of the Mexican Congress. Under the current recession, industrial gro=
wth has slowed considerably, resulting in very little growth in electricity=
 demand this year. GDP growth, which is tied to electricity growth, for 200=
1, 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 re=
serves 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 t=
he government's independent power producer (IPP) program, combined with muc=
h lower demand growth in the later part of the year, reduced the sense of u=
rgency.  =20

Energy reform is likely to be very controversial and may require a constitu=
tional change to allow greater participation in the sector for private inve=
stors. The rival political parties to President Vicente Fox's (National Act=
ion 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 e=
nergy 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 electr=
icity sector. Yet, investors got a preview of the opposition to reform in J=
une when Congress blocked a proposal by President Fox to increase the amoun=
t of electricity that companies may sell to Comision Federal de Electricida=
d (CFE). Currently power companies that generate for their own use are perm=
itted 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 rep=
resented 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 p=
olitical issue than an economic one.  =20

President Fox faces an uphill battle in devising an energy reform plan that=
 satisfies Congress. Many Mexicans believe that selling off state-owned com=
panies leads to higher prices, worker layoffs, and high profits for the new=
 owners, not improved service as government officials typically promise. Ba=
ck in February 1999, President Ernesto Zedillo submitted a restructuring pr=
oposal to Congress that envisioned the disaggregation, subdivision, and sub=
sequent sale of distribution concessions and generation companies. However,=
 the proposal died in Congress that year. Therefore, any proposal put forwa=
rd by President Fox will most likely not include plans to privatize the exi=
sting generation assets, although there is the potential that the distribut=
ion assets could be subdivided and the concessions sold to private investor=
s.  =20

The resistance to selling a substantial portion of CFE's generation assets =
creates a great challenge in Mexico's effort to establish a competitive ele=
ctricity market that will draw private investment into new generation plant=
s. The challenge is unprecedented in that the government would like to crea=
te a competitive generation market while retaining ownership of about 90% o=
f generation capacity. There are no global examples of how to accomplish th=
is feat and to make investors comfortable that the market will truly be com=
petitive. The problem Mexico faces is that investors will have to be assure=
d that the government will be prevented from keeping power prices artificia=
lly low to stimulate the economy during periods of economic slowdown. The t=
wo issues that will have to be addressed are how CFE will determine the pri=
cing for its plants and the form of subsidies to CFE from the Mexican gover=
nment.  =20


Market Pricing and Subsidies=20

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CFE faces the inverse of the market power issue that has plagued so many ot=
her competitive generation systems. When an entity has market power in a gi=
ven region, that entity can withhold its generation, thereby forcing artifi=
cially inflated prices. At this point the entity, having market power, ente=
rs the market and makes windfall profits. Standard & Poor's has seen this s=
cenario 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. Be=
cause 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 o=
f 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-own=
ed generation plants with government subsidies. Any future government subsi=
dies would have to be made by the Mexican government to CFE's distribution =
or transmission subsidiary, not to any generation subsidiary.  =20

Another issue that needs to be addressed is what the government will do abo=
ut the existing subsidies. In 2000, the government spent about $5.8 billion=
 subsidizing electricity bills, and the estimate for 2001 is slightly highe=
r due to inflation and population growth. In order to highlight these subsi=
dies 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 contr=
ibuting 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-own=
ed generation plants to the detriment of privately owned plants. One potent=
ial indirect subsidy to CFE that has been addressed is the price that CFE p=
ays for its fuel. Under Mexican law, all public entities are forbidden to s=
ell their products or services below market prices. Therefore, Petroleos Me=
xicanos (PEMEX) cannot legally provide CFE-owned generators with fuel at su=
bsidized prices, unless it offers those prices to all generators. This miti=
gates the risk of CFE lowering its marginal cost through an indirect fuel s=
ubsidy from PEMEX.  =20

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 <http://rd-digex.ratings.com/cgi-bin/gx.cgi/#TOP>




Need For Capital Investment=20

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The push toward competitive electricity markets in Mexico is driven by the =
need for investment in power generation and the reluctance of the Mexican g=
overnment 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 cur=
rent economic conditions may adjust this forecast downward, substantial inv=
estment will still be required in the sector. Even though the IPP program h=
as 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 ra=
ting. Because the obligations under many of these contracts cross default w=
ith CFE's debt, which in turn cross defaults with some of the sovereign deb=
t, these contracts also apply negative pressure to the sovereign rating. Wh=
ile this pressure is not substantial today, if the IPP program continues to=
 be the sole source of new generation in Mexico, these obligations will hav=
e 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.  =20

In the interim, the Comision Reguladora de Energia (CRE) is working on crea=
ting a framework for the potential liberalization of the industry. CRE envi=
sions the creation of an independent system operator to manage generation c=
ommitment, dispatch, and billing. State-owned generators would be divided i=
nto regional entities to promote competition. The distribution sector would=
 also be divided into several regional entities, and a concession for the o=
peration and maintenance of these systems could be granted. The transmissio=
n network would remain as a single public entity, although concessions for =
new transmission projects could be granted.  =20

=20

 <http://rd-digex.ratings.com/cgi-bin/gx.cgi/#TOP>




Liberalization of the Electricity Sector=20

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During the past nine years, Mexico has gradually liberalized the restrictio=
ns 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 p=
ower to CFE and industrial customers under self-supply regulations. In 1996=
, CFE devised a financing plan to meet projected electric demand growth. Th=
e 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 bu=
ild-lease transfers (BLT), which are similar to lease transactions. Under t=
his structure, a third party finances and builds a plant (or transmission l=
ine, 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 mu=
ch of the operating risk to CFE, as CFE was required to pay for service eve=
n if the asset was unavailable. New facilities are now being constructed un=
der IPP contracts. These arrangements are structured as take-and-pay power =
purchase agreements whereby CFE will not pay for power if it is not deliver=
ed. 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 f=
or the creation of such a system is unclear in Mexico, given the highly pol=
iticized tripartisan environment that governs the decision-making process. =
 =20

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