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May 26, 2021

Regulatory Developments in the Mexican Power and Oil & Gas Sectors — Protecting Private Investment

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REGULATORY DEVELOPMENTS IN THE MEXICAN POWER AND OIL & GAS SECTORS — PROTECTING PRIVATE INVESTMENT

Throughout the past year, Mexican President Andrés Manuel López Obrador (AMLO) and his administration (the “AMLO Administration”) have vigorously pursued regulatory changes in favor of the state-owned companies the Federal Electricity Commission (Comisión Federal de Electricidad—CFE) and Mexican Petroleum (Petroleos Mexicanos—PEMEX), culminating in the past few months in the submission of amendments to existing law that, if fully implemented, would reorder these sectors in the Mexican economy. We recently explored the AMLO Administration’s amendments to the Oil & Gas Law (Ley de Hidrocarburos—LH) (such amendments, the “LH Amendments”) and their potential impacts on private investment in a client alert dated May 18, 2021.[1]

In this note, we will discuss the main provisions of the AMLO Administration’s amendments to the Electric Industry Law (Ley de la Industria Eléctrica—LIE) (such amendments, the “LIE Amendment”) and likely impacts on private investment in the power sector in Mexico. We will also analyze the potential options available to investors that are likely to suffer the economic consequences of the LIE Amendment and/or the LH Amendments.

On March 9, 2021, the Mexican Ministry of Energy (Secretaría de Energía—Sener) published the LIE Amendment in the Official Gazette.[2] The LIE Amendment is, hopefully, the conclusion to a series of governmental actions taken by the AMLO Administration to tip the scales of regulatory power in favor of the CFE, and to reverse the private-investment-friendly Constitutional energy reforms of 2013 and ensuing legislation that was enacted in 2014 (collectively, the “Energy Reform”). For further discussion of the regulatory actions of the AMLO Administration in the Mexican power sector leading up to the LIE Amendment, please see our prior three chapters in this series: Chapter 1, Chapter 2 and Chapter 3.

Key changes in the LIE Amendment include: (i) modifying the dispatch order of power plants to prioritize power produced by CFE irrespective of economic or efficiency merit; (ii) permitting legacy, including in particular CFE, power plants (i.e., those operating before the Energy Reform) to qualify for clean energy certificates (Certificados de Energía Limpia—CELs) for power generated; (iii) allowing CFE (as residential supplier) to purchase power directly from market participants and not exclusively from public energy auctions administered by the National Energy Control Center (Centro Nacional de Control de Energía—CENACE); (iv) mandating that the Energy Regulatory Commission (Comisión Reguladora de Energía—CRE) terminate all existing legacy self-supply permits; (v) mandating that new generation or supply permits by CRE only be granted if the relevant generation activities are consistent with the planning criteria outlined by SENER for the National Electric System (Sistema Eléctrico Nacional—SEN); and (vi) allowing CFE to renegotiate or terminate existing long-term power purchase agreements (PPAs) executed with independent power producers (IPPs) for certain legacy projects, to ensure adherence to law and profitability for the State.[3]

The LIE Amendment may have serious adverse impacts on existing private investment in the Mexican power sector, while also jeopardizing the development of future projects and any appetite for investment therein.[4] [5] Some of the main consequences of the LIE Amendment include:

  • Curtailment of privately-owned power generation facilities: As a result of the new dispatch priority outlined under the LIE Amendment, private generation facilities may suffer a substantially increased risk of curtailment from the risk that was originally envisioned and included in the financial models prepared in connection with the investments in these generation facilities. This will adversely impact not only their rate of return but also their ability to honor their other obligations. Most of these projects sized their projected generation output considering the “cost efficiency” dispatch preference in force before the enactment of the LIE Amendment. However, with the shift of the dispatch preference in favor of CFE’s power plants (including coal-fired and fuel-oil facilities), certain privately-owned renewable generation projects may no longer be able to generate enough revenues to pay their operational costs and/or to service their debt under their financing arrangements. The new dispatch priority policy would particularly discriminate against private renewable power projects with the prior preferred dispatch of more expensive and polluting CFE-sponsored power projects.
  • CELs for CFE’s legacy power plants: Under the Energy Reform, CELs were designed to promote the clean energy transition by forcing energy suppliers to comply with a minimum clean energy consumption requirement to be increased on a yearly basis.[6] By tying CELs to clean energy generation, CELs have an associated market value, which served as a way to promote the development of renewable projects throughout the country. Consistent with such policy, CFE’s existing facilities were precluded from receiving CELs, which acted as a de facto booster for CEL prices based on their scarcity. However, following the enactment of the LIE Amendment, market experts have forecasted that the CEL prices will suffer a significant decrease in market value,[7] dropping below even the most conservative prior estimates. This situation could present a huge challenge for developers who relied on the additional revenue generated by the previously projected CEL prices in their financial models, causing potential cash shortfalls, impacts on rates of return and defaults under their financing arrangements and assumptions.
  • CFE’s option to acquire energy directly from the market: Considering that the Mexican Energy Market (Mercado Eléctrico Mayorista—MEM) is still incipient and historical information on Marginal Local Prices (Precio Marginal Local—PML) is quite limited, auctions administered by CENACE for mid-term and long-term PPAs for CFE (as residential supplier) resulted in bankable PPAs that helped project sponsors obtain financing for their projects by providing fixed energy rates and revenues. The auctions held by CENACE were highly competitive and resulted in attractive rates for CFE—with one of the lowest average rates per MWh in the world—while acting as an effective catalyst for Mexico’s clean energy transition.[8] The auctions proved to be a viable way for developers and sponsors to secure bankable PPAs through transparent, competitive processes. By allowing CFE to purchase energy outside of the auction process, potential developers interested in investing in Mexico’s renewable resources may face additional challenges for developing new projects as it will likely be difficult to obtain bankable PPAs. In addition, it is not clear whether CFE will be subject to the same transparency rules in contracting with third parties as it did through the auctions, which may prove to be an additional obstacle for parties interested in supplying energy to CFE.

    Furthermore, if the trend to develop new renewable projects halts, Mexico’s ability to benefit from cleaner and cheaper energy offered by renewable projects will be compromised. With the Energy Reform requirement that energy be dispatched on the most economic basis being discarded, power prices are likely to rise, with those costs ultimately being passed down to the Mexican consumer either directly or through the funding of subsidies.
  • Termination of existing legacy self-supply permits: In the explanatory statements (exposición de motivos) of the LIE Amendment bill sent by AMLO to Congress (which was ultimately enacted with almost no changes), the AMLO Administration claims that the legacy self-supply (auotabastecimiento) regime was “abused” by private companies because third-party offtakers became minority shareholders of the generator with the sole purpose of purchasing energy under that regime.[9] The so called “fraudulent” (or “socios de paja”) scheme was, according to the AMLO Administration, against the spirit of the law, which was intended to limit such purchasers to actual or genuine affiliates.[10] Notwithstanding such claims, the corporate structure of each self-supply legacy permit holder was analyzed and authorized on a case-by-case basis by the CRE before the permit was granted. Therefore, terminating existing permits under the AMLO Administration’s interpretation of the law could be deemed a retroactive application of the law and unduly discriminatory.

    In any event, any such revocation of permits by CRE will be devastating for permit holders as it would render it impossible for them to comply with their energy commitments with offtakers, causing them to default on their existing contractual arrangements across the board, stranding generation assets in the industry and throwing the entire self-supply regime into disarray. Financings in place for these assets will face setbacks from the reduced or limited revenue generating potential.
  • Conditions for granting new permits: Power generation regulations in Mexico provide for a permit-based regime (i.e. all participants meeting certain requirements are entitled to obtain a permit) as opposed to a concession-based regime (where the Mexican State would grant discretionary concessions to private parties for the use of public goods).[11] The Energy Reform laws required the CRE to authorize permits to applicants that complied with the relevant requirements. CENACE was, in turn, charged with independently verifying if the interconnection of the project was feasible or not and, if not feasible, recommending technical improvements that the permit holder could complete in order to be able to interconnect the project to the grid.[12] Under the LIE Amendment, CRE may now deny a power generation permit on a discriminatory basis to any given applicant ex ante, determining that the power generation project is not consistent with the SEN’s planning. This could be a significant bottleneck for any new private generation project in Mexico that would compete with the CFE. The less transparency in the SEN planning, the riper the possibilities for projects to not get off the ground.
  • Renegotiation and termination of existing PPAs executed with IPPs: Before the enactment of the Energy Reform, CFE was permitted under an exception available pursuant to the Electrical Power Public Service Law (Ley del Servicio Público de Energía Eléctrica) to acquire energy from private producers known as IPPs.[13] Under the IPP structure, power generation projects were auctioned by CFE and a long-term IPP PPA was executed between CFE and the awarded party.

    With the enactment of the LIE Amendment, CFE is now able to renegotiate existing IPP PPAs with the relevant sponsors to ensure adherence to (i) law and (ii) “profitability principles” for the Federal Government. Therefore, CFE may now seek to replicate the de facto renegotiations that occurred last year in connection with several gas transportation agreements executed by CFE with private entities—such as the Sempra-TransCanada project to transport natural gas from Texas to Tuxpan through a submarine pipeline.[14] Unlike the natural gas contract renegotiations, which occurred on an ad hoc basis and not on the basis of any legal regime, all IPP project sponsors will now be legally required to sit down and renegotiate their IPP PPAs with CFE or otherwise face potential termination. Such renegotiations pose a serious threat to the economics of such IPPs and their ability to honor their other contractual and financial commitments. They further bring into question the Rule of Law and principles surrounding sanctity of contract.

Considering these potential risks associated with the LIE Amendments, several industry players have expressed concern about possible negative effects on their projects and are now looking more closely to the dispute resolution mechanisms and other options and means of recourse that may be available to them to protect their investments in Mexico. On the local side, judicial claims have been filed by various permit holders resulting in temporary and definitive injunctions suspending the effects of the LIE Amendment nationwide.[15] However, AMLO has stated that his administration will pursue any means available to uphold the LIE Amendment, including sending a new bill to the Mexican congress to amend the Mexican Constitution and Amparo Law to render the LIE Amendment constitutional.[16] Although AMLO’s Morena party does not hold enough seats in the Mexican Federal congress—nor in the local State congresses—to pass such a Constitutional amendment, AMLO’s statements make it clear that, hell or high water, unwinding the Energy Reform is a top priority for the AMLO Administration.

As can be surmised, the LIE Amendment is likely to create commercial and operational issues for power generators operating in Mexico, particularly as they confer specific advantages upon CFE. Similarly, the LH Amendments’ preferential treatment of Pemex and increases in the government’s discretionary powers could create significant adverse economic impacts on private investors in the oil and gas sector. Such issues may give rise to a number of complex commercial and investor-state disputes. The nature of any commercial dispute will depend on the specific terms of an investor’s commercial contracts, but could include claims against their counterparties (whether state-owned or otherwise) relating to breach of contract, force majeure, “material adverse change” and changes to local laws and regulations.

The nature of any investor-state dispute will turn on a combination of the specific actions taken by the government and the terms of the applicable investment treaties or laws. Mexico is a party to over 40 bilateral and multilateral investment treaties, which give foreign investors a direct right of action against the Mexican government for breaches of international law. Such treaties include bilateral agreements between Mexico and countries like Spain, France, Netherlands, China, Germany, the UAE, Korea and the United Kingdom, as well as multilateral treaties such as NAFTA, the USMCA and the CPTPP.

While the specific terms of each treaty will vary, they each will cover qualifying “investments” made by qualifying “investors,” as those terms are defined in the relevant treaties. These treaties will include investments such as physical assets owned in Mexico, equity shares held in a company, debt instruments, property interests, certain contractual rights and other tangible and intangible interests arising out of capital investments made in Mexico. Subject to the nationality of the ultimate investor (or any intermediate company through which the investment is channeled), virtually all of the treaties should apply to investments in the Mexican power sector and oil and gas sector affected by the LIE Amendment and LH Amendments, respectively.

These treaties are intended to protect foreign investors from adverse government actions falling into three general categories:

First, investors are protected against the uncompensated expropriation (or taking) of their property. An expropriation can occur directly, where a government formally seizes title and possession to an investor’s property, or indirectly, where the investor retains title and possession of its property, but the value of that property is materially diminished through a government’s action (including the passage of laws and regulations). For example, the LH Amendments provide the Mexican government with a discretionary right to “intervene” in the operations of oil and gas permit holders if the government finds there is an imminent danger to national security, energy security or the national economy. These provisions, if acted upon, could be ripe for expropriation claims.

Second, the treaties protect foreign investors against discriminatory treatment. In particular, under the concept of National Treatment, a foreign investor may not be treated worse than a similarly situated domestic investor. Thus, for example, Mexico would have difficulty enacting measures that prefer domestic power generators over foreign power generators operating in the same sectors. Similarly, under the concept of Most Favored Nation, Mexico could not enact measures or take actions that treated foreign investors from one country better than foreign investors from other countries. Overall, the anti-discrimination provisions in investment treaties are intended to ensure that similarly situated parties are treated equally, regardless of nationality. The LIE Amendment appears to give CFE preferential treatment on commercially significant matters such as the electric grid dispatch order rules and access to clean energy certificates in a manner that will disadvantage and discriminate against foreign investors. This may give rise to claims of discriminatory treatment by foreign investors.

Third, foreign investors are protected against unfair and inequitable treatment and are entitled to the full protection and security of the law. These provisions require a host state to ensure a certain level of transparency and stability within the law and may hold a state responsible where its actions undermine a foreign investor’s reasonable expectations regarding the investment climate in which it is operating. The LIE Amendment likely will materially affect foreign investors’ expectations regarding the operating environment for power generation facilities, including, for example, the criteria in Mexico for access to clean energy certificates, expectations with respect to equal access to dispatch priority on Mexico’s power grid and the validity of existing power purchase agreements for legacy projects. Similarly, the LH Amendments will likely create substantial uncertainty in the oil and gas sector, such as through the new “deemed rejection” standard for permit holder requests for consent to assign oil and gas marketing permits if the government has not responded to such requests within the statutory period. That said, the availability of such a claim will depend upon the specific wording of a given treaty. For example, the scope of the “fair and equitable treatment” right in the USMCA is significantly more limited compared to several of Mexico’s bilateral treaties.[17]

Investors wishing to bring investment treaty claims against the Mexican government in connection with the LIE Amendment or LH Amendments would need to do so in accordance with the procedures set out in the various treaties. Perhaps most importantly, investors will need to consider how a particular investment treaty affects their right to bring claims in the Mexican courts and, similarly, how challenging Mexico’s actions in the local courts could affect their ability to bring claims in arbitration. In this regard, treaties to which Mexico is a party typically fall within one of the following categories:

  • Treaties in which investors are required to decide between pursuing their claims in the Mexican Courts or in arbitration (i.e. treaties with “fork in the road” provisions). This rule can be found in Mexico’s bilateral investment treaties with, for example, Spain, France, Germany and Portugal.
  • Treaties that give foreign investors the right to pursue claims in local courts first, while preserving the right to subsequently file for arbitration at any time. Under these treaties, a party that wishes to pursue a claim in arbitration must first discontinue any domestic proceedings it had initiated and waive its right to bring any subsequent claims in the courts of the host country. This rule can be found in, for example, the Mexico-U.K. and Mexico-UAE bilateral investment treaties.
  • Treaties which require investors to exhaust their remedies in the Mexican courts or administrative tribunals before commencing arbitration. An example of such a treaty is Annex 1 of the USMCA under which U.S. investors in Mexico would be required to exhaust local remedies before commencing arbitration against the Mexican government in connection with an alleged breach of the USMCA.

Most treaties to which Mexico is a party also require significant notice to the Mexican government before a claim can be submitted to arbitration, and include prescription periods which bar claims from being brought after a specific period of time (typically three or four years).[18] For example, under several of Mexico’s bilateral treaties, an investor is required to provide at least six months’ notice to the Mexican government from the date of the event(s) giving rise to the claims before those claims can be submitted to arbitration.[19] Investors are also typically obliged to engage in negotiations with the government before bringing claims in arbitration.

Accordingly, in addition to analyzing their substantive rights under the applicable treaties, investors seeking to bring claims in connection with the LIE Amendment or LH Amendments by way of arbitration under an investment treaty will need to carefully navigate these and other procedural requirements before bringing any such claims.

Special thanks to visiting attorney Pedro Lladó for his valuable assistance with this note.

Footnotes

[1] SeeAmendments to Mexican Oil & Gas Midstream and Downstream Regulations,” SHEARMAN & STERLING, May 18, 2021.
[2] In the original Spanish, the “DECRETO por el que se reforman y adicionan diversas disposiciones de la Ley de la Industria Eléctrica,” Official Gazette website, March 9, 2021.

[3] supra note 1.

[4] Cristobal Riego, “Mexico’s electric power reform bill: Who will be most affected,” BNAMERICAS, Feb 26. 2021.

[5] Kirk Semple et al, “Mexico Set to Reshape Power Sector to Favor the State,”THE NEW YORK TIMES, March 7, 2021.

[6] Article 121 et. Seq. of the LIE and Article 7 et. seq. of the Ley de Translación Energética.

[7] Cristobal Riego, “Mexico power sector law will dampen investor appetite – experts,” BNAMERICAS, March 11, 2021.

[8] Ignacio Fariza, “México generará la electricidad más barata del mundo,” EL PAIS, Dec 8, 2017.

[9] In the original Spanish, the “Iniciativa con Proyecto de Decreto por el que se reforman y adicionan diversas disposiciones de la Ley de la Industria Eléctrica,” CAMARA DE DIPUTADOS, Feb 1, 2021.

[10] Id.

[11] Article 12, 17 and 129 of the LIE.

[12] Article 33 et. Seq. of the LIE.

[13] Article 36 et Seq. of the Ley del Servicio Público de Energía Eléctrica (now derogated by the LIE).

[14] Andrew Baker, “Mexico’s CFE To Seek Renegotiation Of Natural Gas Supply Contracts,” Feb 11, 2019.

[15] David Saul, “Juez otorga suspensión definitiva a reforma eléctrica de AMLO,” March 19, 2021.

[16] Karol Garcia, “AMLO propondrá reforma constitucional si la justicia frena la reforma eléctrica,” March 17, 2021.

[17] See Article 14.6 of the USMCA which provides that “the mere fact that a Party takes or fails to take an action that may be inconsistent with an investor’s expectations does not constitute a breach of [the right to fair and equitable treatment] even if there is loss or damage to the covered investment as a result.” By comparison, Article 2(3) of the Mexico-Germany bilateral investment treaty provides that “[e]ach Contracting State shall in any case accord investments of the other Contracting State fair and equitable treatment” and that “[n]either Contracting State shall in any way impair by arbitrary or discriminatory measures the operation, management, maintenance, use, enjoyment or disposal of such investments.”

[18] See e.g. Article 9(3) of the Mexico-France bilateral investment treaty; Article 14.D.5 of the USMCA; Article 2(3) of the Schedule to the Mexico-Netherlands bilateral investment treaty.

[19] See e.g. Article 12 of the Mexico-China bilateral investment treaty; Article 10 of the Mexico-UAE bilateral investment treaty; Annex 1, Section 2 of the Mexico-Italy bilateral investment treaty.

Authors and Contributors

Christopher M. Ryan

Partner

International Arbitration

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+1 202 508 8098

+1 212 848 4000

+1 212 848 4000

Washington DC

Gabriel Salinas

Counsel

Private Equity

+1 713 354 4846

+1 713 354 4846

Houston

Robert O’Leary

Associate

Project Development & Finance

+1 212 848 7050

+1 212 848 7050

New York

Jesse D.H. Sherrett

Partner

International Arbitration

+1 202 508 8084

+1 202 508 8084

Washington DC