New obstacles to private power projects in Mexico

New obstacles to private power projects in Mexico

February 05, 2021 | By Raquel Bierzwinsky in New York|Mexico City, Hernán González Estrada and Carlos Campuzano in Mexico City

Publication of a bill to roll back energy reforms in Mexico has industry participants, specialists and experts crying foul.

A Supreme Court decision on February 3 sets an important precedent that may require some changes in the bill before it is enacted.

The bill would strengthen the position of the state-owned electric utility, Comisión Federal de Electricidad or CFE, as the dominant player in the Mexican electricity market at the expense of private generators.

Mexican President Andrés Manuel López Obrador sent the measure to the Mexican Congress on February 1 with a request to Congress to approve it on a 30-day fast-track basis. It would reform the Mexican Electric Industry Law (Ley de la Industria Eléctrica or LIE).

Until now, the Mexican government has tried to favor the CFE by modifying existing administrative regulations or creating new ones. The new bill goes one step further by rewriting parts of the main law governing the electricity sector.

It is an open and frontal attack on the interests of all private generators in Mexico for the exclusive benefit of the CFE.

In the past week, private business councils, industry experts and associations, private institutes and opposition political parties have issued strongly-worded statements against the bill, accusing the government of ignoring the Mexican legal system.

Mexico's President has been clear about his goals for the sector. A July 2020 memorandum sent to energy regulators laid out the basic guidelines of the government’s energy policy. At the core of the policy is the undoing of several 2013 reforms that have brought in more than $15 billion in private investments in the power sector.

The memorandum suggested the government should stop issuing electricity generation permits to private generators due to an alleged oversupply of electricity in the mid- and long term, and suggested power plants should be dispatched not based on economic or efficiency merit, but rather on a basis that gives preference to power plants owned by the CFE. The principles in the memorandum are very similar to those reflected in a failed reliability policy issued by the Mexican Ministry of Energy (Secretaría de Energía or SENER) in May 2020 that has been the subject of numerous court challenges by private generators and non-governmental groups. (For previous coverage, see "New policy in Mexico puts dagger in private sector participation in the electricity sector.")

The Mexican Federal Competition Commission (Comisión Federal de Competencia Económica or COFECE), the only remaining fully independent regulator, challenged the reliability policy on constitutional grounds.

The Mexican Supreme Court resolved the constitutional dispute on February 3.

Although the court did not invalidate the policy in its entirety, it rendered several provisions void that the court said violate constitutional principles.

The parts of the policy with which the court found fault grant the CFE competitive advantages over other market participants, discriminate against renewable power projects, or create additional barriers to access for private projects. For example, the policy gives the CFE a right to propose priority projects that would have preferential interconnection rights. It provides, among other things, that private parties must obtain interconnection feasibility studies from CENACE before they will be issued generation permits; for CENACE to dispatch power plants out of economic merit order; and that  CENACE can reject interconnection requests submitted by renewable power projects simply because of their intermittent nature and the alleged adverse effects of the projects on grid reliability.

The Supreme Court decision may require rewriting parts of the new bill before it is enacted. The bill is an attempt to codify the policies in the July 2020 memorandum. Some of those policies have now been struck down on constitutional grounds.

The bill in the form presented to Congress would contravene a number of Mexican constitutional and legal principles, including a right to non-discrimination, no retroactivity of laws, legal certainty, legitimate expectations in investments, economic dispatch, antitrust principles, and the right to a healthy and clean environment, among others.

Changes to dispatch rules

The bill would erode the position of private generators.

It would modify the order of dispatch for power projects by giving priority to power plants that enter into power purchase agreements for the physical delivery of energy with CFE Basic Supply, the CFE subsidiary responsible for supplying electricity to customers who require less than one megawatt.  

These physical delivery agreements are a new type of agreement proposed in the bill and may only be entered into by CFE Basic Supply, as offtaker, with selected generators. The bill offers no details on the content of the agreements. However, the intention is for CFE Basic Supply to enter into physical delivery agreements only with generators that are owned by the CFE, setting up CFE power plants to be dispatched ahead of other power plants. The CFE hydroelectric fleet would end up being dispatched first, followed by all other power plants owned by the CFE, regardless of their technology, including power plants owned by independent power producers that have power purchase agreements to sell most of their output to the CFE.

Thereafter, private wind and solar photovoltaic plants would be allowed to deliver power to the grid. Combined-cycle projects owned by private parties would be dispatched last.

Although existing economic dispatch rules in the Mexican energy law would remain on the statute books, the dispatch priority granted to projects with physical delivery agreements with CFE Basic Supply would in practice revoke the principles of economic dispatch by allowing all of the CFE's fleet, with more expensive generation costs and dirtier technologies, to be dispatched ahead of any private renewable project or any gas-fired project not selling power to CFE under a legacy independent power producer contract.

The bill is silent about whether the rules for determining local marginal prices would change as a consequence of changing the dispatch merit order. This makes it difficult to anticipate the effects on prices in the wholesale electricity market. It will probably create a perverse pricing system that, depending on whether renewable and gas-fired private generators are in fact dispatched, will either increase prices for consumers (if only CFE plants are dispatched) or will manipulatively reduce prices (if the cheaper, privately-owned plants set the local marginal price). In the latter case, the CFE will not be able to recover its generation costs.

These changes in the dispatch rules are clearly an attempt to discriminate against private generators for the benefit of the CFE.

Power generation permits

The bill would establish new roadblocks to issuance of new power generation permits and access to the transmission and distribution grids.

New permits would be granted by the Energy Regulatory Commission (Comisión Reguladora de Energía or CRE), taking into consideration the planning guidelines of the National Electric System issued by SENER.

Also, access to the transmission and distribution grids will be permitted only if technically feasible. This new language opens the door to the creation of subjective criteria by the CFE -– as owner of the national grid -- and SENER.

The federal government argues that renewable energy projects reduce grid reliability. This argument will be used to deny new generation permits or interconnection to private generators.

Clean energy certificates

The bill incorporates the principles of a now debunked SENER ruling from October 2019 that would have entitled all clean energy power plants owned by the CFE to receive clean energy certificates or "CELs" for the renewable energy generated, regardless of whether the power plants commenced operation before or after implementation of the energy reform on August 11, 2014. (For previous coverage, see "Mexican CEL Ruling Roils Market.") 

Implementation of this provision will increase the supply of CELs, thereby reducing the market price for them. It will affect all projects that sell CELs in the wholesale electricity market or through private contracts and that made pricing decisions based on earlier rules. It also creates a disincentive to build new renewable projects.

Physical delivery agreements

The bill would also release CFE Basic Supply from its statutory obligation to purchase electricity and associated products exclusively through power auctions.

The existing regulations were supposed to drive down electricity prices by creating a competitive market and allow CFE Basic Supply to buy energy, CELs and capacity at the lower prices.

In the bill’s explanatory statements, the Mexican government now suggests that the auctions are “a perverse scheme devised with the purpose of guaranteeing the profitability of investments by private generators to the detriment of CFE.”

This could not be further from the truth. The three power auctions conducted between 2015 and 2017 resulted in record low prices for the benefit of CFE Basic Supply and its customers. Some of the prices were the lowest in the world at the time.

Instead, the bill proposes to let CFE Basic Supply sign power purchase agreements for physical delivery with the CFE's generation companies. No competitive process is contemplated for these agreements, thus leading one to believe that the award criteria will not be based on competitiveness or price efficiency for the benefit of CFE Basic Supply and its customers, but rather on the ownership of the power plants, the type of technology or other discretionary criteria, regardless of whether this makes economic sense.

A frontal attack

The bill is openly hostile toward self-supply projects that obtained permits before the 2013 energy reforms and that retain, as grandfathered projects, the rights and obligations pursuant to the rules prevailing prior to the energy reforms.

The CRE will be “obligated” under the bill to revoke any self-supply permits that were obtained “fraudulently” in the sole opinion of the federal government.

Self-supply permits are legacy permits that allow a generator to sell power exclusively to its shareholders for self-consumption. These generators are not permitted to sell under post-2013 reform rules, unless they are issued new generation permits or acquire such permits for expansion of their current projects. These projects benefit from stamp-tax transmission tariffs and an energy banking system.

In the government's view, most self-supply permit holders engaged in fraud by creating a secondary electricity market by accepting unaffiliated third parties as partners in their self-supply companies for the sole purpose of selling power to them. The right of permit holders to supply electricity to their partners was recognized in the Law of Public Service of Electric Energy (Ley del Servicio Público de Energía Eléctrica or LSPEE) that was in force before the 2013 energy reforms. It spurred the growth of the electricity market, allowing many commercial and industrial customers to buy power from private generators at significant discounts from the prices offered by the CFE.

Revocation of permits that were legally issued violates the constitutional principles of no retroactive application of the law, legal certainty, legitimate expectations in investments and acknowledgement of acquired rights.

Review of IPP contracts

The bill also requires agreements entered into between the CFE and independent power producers pursuant to the LSPEE to be reviewed to verify they are profitable for the federal government.

All existing independent power producer contracts entered into by the CFE over the past 20 years were awarded through public international auctions, and the contracts reflect terms and conditions that were evaluated based on the circumstances and information prevailing when they were signed. Most of these projects are large CCGT projects with international financings in place. They have been supplying the CFE with stable, base-load generation since the mid-1990s. Since the current administration took office in December 2018, the CFE has critized and renegotiated private contracts for the construction of natural gas pipelines to transport gas to CFE power plants and, more recently, it has targeted IPPs.

The bill suggests that if IPP agreements are not profitable for the government, then they must be renegotiated or terminated at the CFE’s discretion. This provision creates a unilateral right for the CFE to force companies into negotiations to revise the commercial terms of agreements that may have been in place for over a decade or, even worse, to terminate the agreements, presumably without any liability to the CFE.

This also clearly violates Mexican constitutional principles, as well as international investment treaties, as it attacks the principles of legal certainty and legitimate expectations in investments.

Implementation

The bill gives SENER, CRE and CENACE, the independent system operator, six months to amend the existing regulations to conform them to the principles in the bill.

A coherent and reasonable legislative process should lead to rejection of the bill or at least to a thorough debate to identify its flaws and revise provisions of the current law that can be improved on, to make it consistent with principles embedded in the Mexican constitution and obligations acquired by Mexico through international treaties, including the US-Mexico-Canada trade treaty or USMCA, that came into force on July 1, 2020 (and, for investments with legacy claims pre-dating USMCA, its predecessor, NAFTA), as well as multiple trade and investment treaties.

However, given the strong influence that the current President has on Mexican politics and the allegiance of the majority of members of Congress to him, the bill is expected to pass with few changes, regardless of its legal and technical deficiencies.

Following an uproar by the media, industry players and opposition parties, Mexico’s Senate majority leader –-a member of the President's ruling party –- indicated that the bill requires dialogue with companies to ease their concerns and avoid lawsuits. He has pledged to work with private energy companies to ensure the proposal does not clash with international treaties, including the USMCA.

If the bill is passed, the negative effects are likely to be felt throughout the economic supply chain.

The dispatch of power plants with higher operating costs will lead to higher electricity prices to the detriment of customers, most of whom are commercial and industrial. Residential tariffs will continue to be subsidized.

The attack on self-supply permit holders could inflate prices for goods and services, as many of the biggest companies in the country, such as metallurgy, glass, manufacturing, food, retail, information technology companies, have historically used self-supply contracts to reduce electricity costs and enhance their competitiveness, expand their operations and create jobs.

The revocation of their permits in an attempt to force them to enter into supply agreements with the CFE or to migrate to a generation permit under the LIE, with new and uncertain dispatch rules, can be expected to increase their electricity costs and increase, in turn, the prices of the products they produce or the services they provide.

On the contractual side, the bill will require private generators and offtakers to review the changes in law and force majeure provisions in their power purchase agreements. The change in the dispatch rules will probably affect the expected output of several power projects, forcing them to renegotiate their commitments for delivery of energy and associated products.

Financing facilities in place for power projects will require review on a case-by-case basis. For example, financial models will have to be re-run to reflect the effects of the bill on specific power plants. These vary by location, electricity demand and the current or future presence of CFE power plants in the zone and node where they interconnect. Generators will have to understand the risk of being displaced in the order of dispatch and the effects on projected revenue. Self-supplied projects risk having their permits revoked. IPP projects risk having their contracts canceled or renegotiated.

This is not the end of the road for private generation in Mexico.

Mexican law gives potentially affected companies different legal avenues to challenge the bill. Affected parties may seek constitutional injunctions, known as amparos, to claim the unconstitutionality of the modified provisions. An amparo ruling could suspend implementation of the reforms. This is where the recent Supreme Court's decision invalidating the SENER reliability policy plays a critical role, as undoubtedly all legal challenges will cite the Court's decision.

The Mexican Federal Competition Commission will probably also open an investigation into the creation of barriers to competition by the Mexican authorities in a sector involving the provision of essential goods and services.

International investors may have important additional extra-contractual protections under bilateral or multi-lateral investment treaties. These instruments typically set out substantive protections that foreign investors are entitled to from the host state and, if breached, the investor has a right to bring a claim directly against the host state. They may consider filing claims under the treaties that, if successful, could lead to payment of indemnities by the Mexican government to the affected parties.

Common substantive protections offered under investment treaties include: fair and equitable treatment, full protection and security, national treatment, most-favored-nation treatment, no expropriation without full (and prompt) compensation and free transfer of capital. The bill falls foul of a number of these. Key treaties that are likely to be applicable include the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), the USMCA and NAFTA, the Free Trade Agreement between Mexico and the European Union, as well several bilateral investment treaties with other countries. Depending on the investor’s home jurisdiction, there may be rights under other treaties.

The most common remedy for breach of an investment treaty is monetary compensation. However, in certain cases, other remedies, including declaratory relief and restitution, may be available. Interim relief while proceedings are ongoing may also be available, including interlocutory measures to compel or restrain the host state from certain conduct (such as might aggravate the dispute or render the dispute nugatory). In recent years, regulatory changes in international domestic energy markets, particularly in the renewables sector, have proved fertile ground for investment treaty disputes between foreign investors and host states. Significant damages awards have been handed down in favor of investors in some cases. Similar outcomes could result if the bill is passed in its current form.