Empowering a nation

As it throws open the door to allow private capital to invest in an oil and gas sector that has been off limits since 1938, it is no surprise that Mexico has been in the spotlight and in investors’ sights since President Enrique Peña Nieto announced his energy reform plans. It is also one of the main reasons Mexico found itself in the number two spot of our “Hot Markets” ranking in April.

But what has perhaps attracted less attention is the country’s power sector which, thanks to the new electric industry law (Ley de la Industria Eléctrica) that went into effect last August, is undergoing a transformation of its own.

The expected changes are profound, leading one source Infrastructure Investor spoke with to characterise electricity reform as possibly having an even “more dramatic” impact than the liberalisation of the oil and gas industry.

“From a competitive and a strategic standpoint, electricity is a major, major aspect of the country’s well-being and its ability to attract further investment, to further expand its manufacturing capabilities and the like,” Juan Francisco Torres Landa, a partner at law firm Hogan Lovells, comments.

While Jose Valera, a partner at law firm Mayer Brown, stops short of predicting that power market reform will upstage that relating to oil and gas, he concedes that both are equally significant.

“The more people move from poverty into the middle class, the more they can afford better housing, appliances and so economic growth generates greater energy demand. For people to move into the middle class, they need the power to fuel that which makes a middle class,” Valera explains.

Javier Chavarria is senior vice president of private infrastructure for the Americas at Switzerland-based Partners Group, a private markets investment management firm that has already tested the waters in Mexico with the acquisition on behalf of its clients of a majority stake in Fermaca, a natural gas pipeline owner and operator, in February 2014. He believes electricity reform will have a slightly more limited impact. The reason for this “is the fact that that sector has been open for private investment for about 20 years [although] not quite in the way it will be with reform,” he acknowledges.

“With reform it’s going to be a more transparent market with the opportunity to sign power purchase agreements with the ultimate consumers,” he says.

INTERPRETING CHANGE

The electricity law will establish a new wholesale power market that will be operated by CENACE (Centro Nacional de Control de Energía. Until the law went into effect, CENACE was a division within the Comisión Federal de Electricidad (CFE) – Mexico’s equivalent to the US Federal Energy Regulatory Commission (FERC). Now it is the independent system operator for the national electricity grid.

According to a market update released by law firm Chadbourne & Parke last September, CFE will become a “productive state enterprise”. It will be allowed to participate across the range of activities in the power market, which includes generation, transmission, distribution, power marketing and supply of electricity through its subsidiaries.

Private sector entities will also be able to participate in these activities, but in order to safeguard competition, a single company will not be allowed to be active in more than one segment of the market. However, one parent company can have multiple activities provided it does so through separate subsidiaries.

“The idea is that there is no over-concentration of dominant players that may have excessive control of the market,” Torres Landa explains. Another safety measure is appointing CFE the last supplier of record. “If anyone wants to arbitrarily increase prices, CFE can step in supplying cheaper electricity and thus preventing any company from profiteering,” he notes, adding that this does not apply to residential consumers since those rates will be controlled with caps and other measures to prevent abuse.

While control of the national grid as well as of transmission and distribution will remain with the Mexican government, “the private sector will be able to participate in transmission and distribution of electricity through agreements and joint ventures with state-owned agencies,” according to Chadbourne & Parke’s report.

NEEDS AND OPPORTUNITIES

The need to modernise and decongest the existing transmission network as well as expand it is where some of the opportunities for private investment will arise.
“One of the limiting factors under the pre-existing legal framework, which had some opportunities for the private sector to participate but never took off as envisioned, was that the transmission network was too congested and insufficient,” Valera comments.

By expanding the network, parts of Mexico that are not adequately served in terms of transmission capacity will be, Valera says, referring to those parts of the country that are served only by one or two facilities and are therefore more vulnerable to power outages.

But the opportunities don’t stop there. Mexico also needs to increase its generation capacity.

“In terms of electric generation, there are investment opportunities mainly for two reasons,” Valera remarks. “The first reason is that some of the existing generation capacity is old, inefficient and dirty,” he says, referring to coal and diesel.

But in addition to the need for modernising and “cleaning up” existing power generation, there is also a requirement to create additional generation capacity “and that’s where the second class of opportunities comes in,” according to Valera.

Taking into consideration that a good portion of Mexico’s economy relies on mining, cement and manufacturing, it is easy to understand the need for additional generation capacity.

A key sector is the country’s auto manufacturing industry, which according to Torres Landa is currently the world’s seventh largest and poised to become number four within the next two years, outranking Germany.

“What is the connection between that and electricity?” Torres Landa asks. “Imagine what will happen to that sector when electricity costs are reduced by 30, 40 or even 50 percent. That will be a direct result of the energy reform because we will have access to cheaper gas, new sources of natural gas – the main fuel used for electricity generation,” he says.

Chavarria is slightly more reserved in his optimism. “I think any opinion at this time depends quite a bit on the details of the rules and the secondary laws that are still in the process of being approved,” he points out.

“Assuming that these are implemented in an investor-friendly way with the changes that are expected, I think that both reforms – the oil and gas and electricity – will bring significant changes,” he continues.

Because the changes are significant or, as Valera describes them, “so fundamental and deep”, they will take time to implement. According to Valera, a functioning wholesale market is one or two years away.

“But the law is there; they’re working on its implementation,” he says, highlighting the progress made to date.

Torres Landa describes it in a different way. “The fact that we’re talking about these issues is nothing short of a miracle. Two years ago someone would have said ‘that’s not going to happen in my lifetime; maybe it will 20 years from now,’” he says. “But discussions about private investment, private generation, loss of monopoly – all these things being done in such a short time is amazing.”

Should Mexico successfully implement its reform agenda as planned then investors could be in store for some compelling opportunities.