Message-ID: <2862306.1075840833279.JavaMail.evans@thyme> Date: Thu, 20 Dec 2001 08:35:50 -0800 (PST) From: tanya.rohauer@enron.com To: louise.kitchen@enron.com Subject: FW: The Road To Competitive Electricity Markets in Mexico Mime-Version: 1.0 Content-Type: text/plain; charset=us-ascii Content-Transfer-Encoding: quoted-printable X-From: Rohauer, Tanya X-To: Kitchen, Louise X-cc: X-bcc: X-Folder: \ExMerge - Kitchen, Louise\'Americas\ESVL X-Origin: KITCHEN-L X-FileName: louise kitchen 2-7-02.pst =20 -----Original Message----- From: SandPUtil@StandardAndPoors.Com [mailto:SandPUtil@StandardAndPoors.Com= ] Sent: Thursday, December 20, 2001 10:02 AM To: Rohauer, Tanya Subject: The Road To Competitive Electricity Markets in Mexico Standard and Poor's RatingsDirect Link This report was reproduced from Standard & Poor's Web-based credit ratings = and research service, RatingsDirect. Click here to get a FREE 30-day trial! Your Connection to Standard & Poor's Utilities, Oil & Gas, and Project Finance Ratings Team Standard & Poor's is pleased to provide ongoing service to the investment c= ommunity. Research: =20 The Road To Competitive Electricity Markets In Mexico =20 =20 Publication date: =20 04-Dec-2001 Analyst: =20 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 =20 =20 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 =20 =20 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 =20 Need For Capital Investment=20 =20 =20 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 Liberalization of the Electricity Sector=20 =20 =20 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 =20 RatingsDirect Link is a FREE service provided by Standard & Poor's. If you = do not wish to receive further E-mails related to this topic only, please s= end a blank E-mail to leave-projfin@ratingslist.standardandpoors.com .=20 If you do not wish to receive further E-mails on any topic, please click he= re or send an E-mail with the subject "Unsubscribe" to rati= ngs_customerrelations@standardandpoors.com =20 If you would like to be added to this list, please send an E-mail to join-= projfin@ratingslist.standardandpoors.com . You will be asked to confirm your request. This report was reproduced from Standard & Poor's RatingsDirect, the premie= r source of real-time, Web-based credit ratings and research from an organi= zation that has been a leader in objective credit analysis for more than 14= 0 years. 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