Mexico Institute
Line of duty: Mexico has 50,858 km of transmission lines
Credit: Mexico Institute

Sweeping reforms to Mexico’s energy sector could unlock at least $60 billion worth of business to new players in the country, writes Ivan Castano.

When Mexico approved a sweeping energy reform last December, global experts applauded the move, calling it ‘transformative’ for a country that had kept its huge power industry shuttered to foreign investors for eight decades.

As the news percolated through the global electricity markets, a slew of international players announced plans to expand in Latin America’s second-largest economy, saying that the game-changing overhaul of the country’s lucrative yet highly inefficient power sector could boost their fortunes.

Even some countries have joined the fray, with Poland’s new Mexican ambassador Beata Wojna recently saying the rejig could help her country curb its Russian energy dependence. Polish firms, she believes, are interested in helping Mexico develop its abundant shale gas reserves to boost energy trade between the two nations.

As global energy executives rush to distil the reform’s business opportunities, analysts say there is at least $60 billion up for grabs as Mexico City moves to open the electricity generation and distribution sectors for the first time in 80 years.

Huge infrastructure projects to expand and modernize the country’s power grid, as well as to build new gas pipelines and other infrastructure, are also expected to provide new and exciting business opportunities for foreign firms interested in growing in Mexico.

However, the highly controversial market overhaul, which triggered huge protests across Mexico, is not for the faint of heart. Lawmakers are working to draft a slew of secondary legislation that experts say will spell out the new power game’s rules. Depending on their fine print, some foreign utilities may bypass Mexico. However, most observers are confident that the rules will be attractive enough to usher in an investment bonanza.

One risk looming on the horizon is the spectre of a planned appeal by the leftist PRD party, which hopes to strike down the reform in a referendum coinciding with next year’s mid-term elections. That move, however, is not expected to kill the initiative, observers concur.

Generation boom

Mexico’s economy is forecast to grow around 4 per cent annually in the next ten years, sharply boosting energy demand. To meet this need, electricity production will have to soar a whopping 70 per cent to 95 GWh, according to PWC’s infrastructure and energy director Juan Carlos Rojas.

At the same time, Mexico has begun working on a goal to generate 35 per cent of its electricity from ‘cleaner’ energy sources – mainly natural gas, renewables and hydropower – by 2024. It has not, however, been clear about how exactly it plans to achieve this.

Because natural gas is cheap and increasingly abundant, observers predict the majority of the next decade’s new generation capacity will be met by a slew of planned combined-cycle power stations.

In fact, Rojas expects the facilities could eventually account for 40 per cent of the 32 GW production hike expected by 2024, while the other 20 per cent could stem from a mix of renewables – most likely led by wind – and the other 10 per cent from large hydropower projects.

Based on a $1 million cost estimate per plant, the 25 GW of new combined-cycle capacity would cost around $25 billion, Rojas says, adding that the renewable and hydro projects needed to make up for the remainder could have a $15 billion price tag, bringing the total investment needed to enlarge the power grid to $40 billion.

This is on top of Mexico’s recent announcement that it intends to plough $63 billion to build 10,000 km of new gas pipelines and 27 new combined-cycle thermoelectric power plants to phase out older fuel-running stations.

In making the announcement, Francisco Rojas, president of state-run electricity supplier Comision Federal de Electricidad (CFE), said that roughly $23 billion of the pipelines and the majority of the new power stations will be built by private companies. The pipelines are expected to be ready in five years while the new power stations will be constructed in a 15-year horizon and will boost combined-cycle generation capacity to 23,700 MW from the current 3750 MW.

PWC’s Rojas welcomes the move, saying it is necessary to build a “cheaper and cleaner” electricity generation matrix to boost the power sector’s competitiveness.

The pipelines are of course needed to bring gas to the CFE’s future combined-cycle stations. The plants will import the gas, mainly from the US, but also from the Middle East. To bring in all this gas, new regasification facilities and a series of pipelines will be built. State-oil giant Pemex is in charge of building two of the new major pipelines, including Los Ramones and Gasoducto del Pacifico, which are set to be come on stream in the near to medium term.

Loss-making CFE also plans to spend around $7 billion per year by 2021 to expand, upgrade and maintain its transmission and distribution network, observers say.

“They have to improve transmission and distribution lines to reduce technical power losses,” says Marisol Gonzalez, S&P Latam Utilities and Infrastructure Ratings’ director, adding that the firm has failed to achieve this during past expansion efforts.

By inviting private firms to participate in the process, Gonzalez is hopeful the CFE will be able to cut its technical power losses which have in recent years jumped to account for 15 per cent of all power reaching the grid. The CFE could earmark around 50 per cent of the planned expenditures to transmission and distribution improvements, Gonzalez adds.

A CFE control room: the government could plough $125 billion into Mexico’s power sector by 2014
Credit: Grupocovix

CFE’s plans

Mexico has 50,858 km and 715,717 km of transmission and distribution lines respectively, Gonzalez says, adding that 97.6 per cent of the power network is wired up.

The CFE’s $35 billion investment scheme, coupled with the $40 billion capacity expansion and the $50 billion earmarked for new gas infrastructure, means the government could plough around $125 billion into expanding Mexico’s power sector by 2024. Experts say roughly half of that sum will come from private firms, both local and international, putting the reform’s business opportunity at a conservative $60 billion.

Rojas expects that future combined-cycle plants will be built through public-private partnership (PPP) concessions spanning 20-25 years. The overhaul will enable private firms to build, maintain and operate transmission lines whereas before they were only allowed to operate them.

“To bolster transmission efficiencies, the CFE will have to allow private enterprise to build, operate and maintain,” Rojas says. The new PPP schemes will also benefit renewable energy plants that have faced trouble evacuating their output because of poor and limited transmission infrastructure.

Observers also expect a handful of operating concessions to be launched in 2015. Cenace, a new regulator tucked under the Energy Secretariat, will be in charge of managing the auctions, which could be ready as early as the first quarter of next year.

Lucas Aristizabal, an energy analyst at Fitch Ratings in Mexico City, says private firms will also be invited to bid for projects to develop Mexico’s shale gas sector, which the state is keen to do to sharply bolster its gas output to build a cheaper and cleaner energy matrix. Mexico is believed to have the world’s sixth largest recoverable shale gas reserves, hovering at around 15.4 trillion cubic metres.

It currently produces 57 million cubic metres of gas per day, an amount analysts say it wants to sharply expand to cut its dependence on increasingly expensive US imports.

Federico Robinson, energy analyst at Mexican stockbroker Actinver, expects the reforms will open up deepwater shale gas exploration and production to private firms, a crucial step to develop the resource and a process for which Mexico lacks the know-how.

Observers say it is too early to tell how much the government will invest to flesh out the shale gas industry. This is partly due to suggestions that the government could limit the amount of water needed for fracking in the drought-prone north of the country where many reserves lie. Observers hope that question will be clarified when the secondary legislation is issued.

Mexican officials have said, however, that Mexico hopes to become a leading Latin American producer of the ‘transition fuel’,ahead of Brazil and second to Argentina.

Opening up competition

The energy reshuffle will open the power generation and distribution market to private enterprises, something that has until now remained a CFE stronghold.

Currently, independent power producers (IPPs) sell the bulk of the electricity CFE buys from private suppliers, estimated at 30 per cent of total generation. Mexican corporates, notably cement major Cemex and bakery giant Bimbo, also market excess output to the CFE. IPPs and corporations will now be able to sell directly to the grid’.

“Under the new rules, IPPs will no longer have to sign contracts with the CFE to sell their power,” Aristizabal says. “They will be able to sell to others including industrial consumers through bilateral contracts.”

Private firms, however, will continue to pay CFE a tolling or wheeling rate to use its transmission network. The amount of power they will be able to commercialize will also be capped to enable the state firm to meet Mexico’s booming energy demand.

An electricity spot market is also in the cards, observers say, though how exactly it will work will be detailed when the secondary legislation is ready in April.

All said, 30-40 per cent of the industrial power market could be unlocked to private generators, up from around 20 per cent now, they add.

Emboldened by the prospect of handsome profits, a string of global utility firms have announced plans to bolster their Mexican foothold or enter the market for the first time. Spain’s Iberdrola, which has the biggest market share of any foreign utility in Mexico, has reiterated it is on track to plough in $120 million by 2014, while Italy’s Enel in January signed a deal to co-operate with the Mexican government to boost the development of geothermal power and smart grids.

Rojas says PWC has received interest from several companies looking to grow their Mexican franchise. They include Spain’s Abengoa and Isolux Corsan, Mexico’s ICA and even Cemex, which he says is interested in expanding in the renewables market. Rojas adds several Japanese firms including Mitsubishi and Mitsui are also interested in muscling in on Mexico, while Korean rivals LG and Samsung, as well as Siemens, Alstom, GE and Brazil’s Odebrecht are also eager to expand in the market. The firms’ interests span generation, distribution, technology projects and other business surrounding the whole value chain, Rojas says.

Despite the wide interest, experts concur that Spanish firms, many of which have been operating in Mexico for decades, stand to gain the most from the reform because of their strong presence in the generation and renewables market. These companies include large firms such as Iberdrola and Gas Natural but also smaller ones. Isolux Corsan, for example, recently won a $90 million tender to build 26 km of new power transmission and 10 power substations in Mexico.

Mexico has 3400 MW of wind capacity
Credit: Alstom

Industry wishlist

Despite their zeal, many global utilities are keen to see what the secondary regulations will look like before committing their cash to Mexico.

“It’s clear that many sectors in the energy markets will open up but no one really knows to what degree,” Rojas says. “That will be clearer in the secondary legislation.”

Observers, however, are confident that the regulations will enable private firms to use long-term power purchase agreements (PPAs) guaranteeing high returns. Investors also want more certainty on wheeling prices, which experts say the CFE calculates in an opaque manner, leaving many wondering if they are overpaying transmission charges.

“Today, if you want to sell your energy to Queretaro, the CFE determines and tells you the wheeling price,¨ says one analyst in Mexico City. “You cannot determine this price independently.”

Therefore, electricity suppliers hope secondary legislation will explain how the CFE calculates this tariff so that a more reliable and competitive price benchmark can be established.

The CFE must also become more transparent about how it bills business and residential consumers. “If you look at a Mexican power bill, you will see it only breaks down generation costs,” adds the analyst, who asked to remain anonymous. “In other countries these costs are itemized, but so are transmission, administration and other costs so that consumers know what they are paying for exactly.”

Jorge Castilla, Deloitte’s leading Mexican energy partner, agrees, adding that investors hope the secondary laws will include business-friendly environmental regulation in line with international standards, especially as new combined-cycle plants are put on the block.

Regarding renewables, observers say a more detailed plan specifying which segments the government plans to develop, and how and to what degree, must also be presented in the secondary legislation.

“There is no plan that states wind, solar or geothermal will be developed by this much or in this way,” Rojas says. “Private enterprise needs a clearer definition so they can determine where and how much they want to invest.” A renewable energy bank is also necessary, he adds.

Mexico currently has 9701 MW of installed renewable energy capacity. This includes 4100 MW of cogeneration capacity, followed by 3400 MW of wind, 1260 MW of geothermal, 600 MW of biomass, 300 MW of small hydro and 41 MW of solar photovoltaic.

Mexico also so has carbon dioxide emission reduction targets of 30 per cent below anticipated growth levels by 2020 and 50 per cent below 2000 levels by 2050.

In a sign that the government is serious about meeting its renewable energy goals, it recently launched a Renewable Energy Council that will pursue eight broad strategic initiatives.

Apart from more clarity on renewables, the process to grant interconnection permits should also be hastened, observers say. “If you want to connect your plant to the network you have to get permission from the CFE, which can take as long as 15 months,” adds the analyst. “Such a process should normally take a maximum of three months.”

Gonzalez is confident that the state will make the secondary laws as attractive as possible to lure much-needed foreign investment into the sector.

According to Gonzalez, the inclusion of mid and long-term PPA contracts is pivotal to bringing foreign investors into the picture.

“If the secondary laws say you can come here and sell power but you have to do so without long and mid-term contracts and depending on fluctuating market prices, fewer people will be interested in coming to Mexico,” Gonzalez says.

Actinver’s Robinson expects that the secondary legislation will be as ambitious as the reform itself. This is because the ruling and opposition PRI and PAN parties respectively are keen to see the reform thrive.

President Enrique Pena Nieto, who has made the overhaul the cornerstone of his new administration, said recently that the rewrite’s secondary regulations will come in line with the spirit of the reform.

“The reform had a high political cost for the PRI and the PAN [in terms of concessions they had to provide to gain Congressional approval] so the secondary laws will have to be as ambitious as the reform itself – or what would be point of the reform,” Robinson says.

The PRD party has vowed to strike down the overhaul through a popular referendum coinciding with mid-term elections in 2015. However, observers do not expect the action to kill the proposal. This is because Mexico’s charter bans referendums on matters that could negatively impact tax revenues or the budget. The Supreme Court, which will rule on the matter, is also unlikely to want to overturn an action that will significantly boost Mexico’s economic growth and international competitiveness, they add.

Robinson hopes the market’s liberalization will happen quickly, adding that a gradual ‘energy revolution’ should then ensue. The market, however, must understand that this will not happen overnight, he adds.

Impact on Prices

Another thing that will take some time is the expectation that the overhaul will help trim Mexico’s soaring power prices.

According to Aristizabal, the CFE currently charges industrial customers as much as $9.1 cents/kWh. This tariff is high in part because the CFE has to offset subsidies to residential prices. The firm currently charges home customers $7 cents/kWh, below the $7.8 cent average generation cost, according to Aristizabal.

Other Latin American countries such as Chile have an opposite dynamic, he says. There, residential power tariffs are higher than industrial ones. This is because the market is liberalized and generators can sell to customers directly.

As competition increases in the yet-to-be-opened market, Aristizabal says the CFE will need to be more competitive or lose industrial customers to a plethora of new rivals. This means the firm will have to invest to boost its network efficiency and curb technical power losses.

“If they can’t improve their network to cut these losses, they will not be able to reduce their prices to compete,” Aristizabal says. Lowering its operating costs will be crucial and challenging. This is because the CFE will not be able to hike residential tariffs without fuelling a political hot potato in Mexico where half of the population lives in poverty.

Castilla says the CFE will have a hard time lowering prices in the short term. This is because Mexico’s energy matrix is still heavily reliant on fuel oil, which is in turn dependent on global crude prices.

Currently, 34 per cent of Mexico’s electricity generation comes from natural gas, 24 per cent from fuel oil, 15 per cent from coal, 20 per cent from hydro, 2 per cent from nuclear, 2 per cent from geothermal, 1 per cent from wind and 1 per cent from biofuels and biomass.

However, as the country boosts its combined-cycle power plant network, these pressures will gradually subside as natural gas replaces much of the fuel oil currently used to power the country. This will enable the CFE to lower prices and become more competitive.

However Castilla says: “This won’t be a fast business. It’s going to take at least four to five years for the matrix to change.”

In the meantime, Castilla hopes the government will take some of the subsidies burden from the CFE to help it survive in the new competitive landscape. He hopes secondary legislation will spell out how these subsidies will be redistributed across government institutions and Mexican states.

Castilla says heavy industrial producers are hoping power prices will fall to the levels seen in the US. However, he adds that will be very difficult to achieve in Mexico.

“The US employs more coal and has a higher nuclear generation mix which makes generation cheaper, so I don’t think our prices will fall to that level with the reform,” he notes.

Despite that, Castilla is confident that the secondary legislation will encourage private firms to jump onto Mexico’s energy wagon and that the first phase of a string of profitable projects will likely be launched early next year.

Bill Adams, a Mexico economist at PNC Bank, says the pending launch of the secondary laws “has left many open questions”. However, he adds: “I think the energy reform has the potential to turn a part of the Mexican economy that has been a laggard into a new engine of growth.”

Whether that will actually come true and to what degree is something industry watchers far and wide hope will be answered in the spring.

Ivan Castano is a Mexico-based freelance journalist, specialising in energy matters.

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