The Ministry of Energy (Secretaría de Energía, or SENER) and the Federal Electricity Commission (Comisión Federal de Electricidad, or CFE) have published calls to participate in two bidding procedures for projects related to electricity transmission in Mexico.

The first call corresponds to the Award of the Management and Operation Agreement for the Electric Transmission Infrastructure for the interconnection between the Baja California Electric System and the National Interconnected System (Adjudicación del Contrato de Gestión y Operación de la Infraestructura de Transmisión Eléctrica para la interconexión entre el Sistema Eléctrico Baja California y el Sistema Interconectado Nacional), which was published by SENER on February 2, 2018: the SENER-BC Project.

The second call corresponds to Project: 303 TL in Direct Current Ixtepec Capacity-Yautepec Capacity (Proyecto: 303 LT en Corriente Directa Ixtepec Potencia-Yautepec Potencia), which was published by CFE on February 13, 2018: the CFE-Yautepec Project.

The SENER-BC Project and the CFE-Yautepec Project are the first to be tendered in Mexico under its new energy constitutional and legal framework, which allows the participation of private entities in the financing, installation, maintenance, management, operation and expansion of infrastructure for the transmission of electricity via a public utility.

The purpose of this memorandum is to address the background and regulatory and contractual aspects of the SENER-BC and CFE-Yautepec Projects.

I. Background: Electric energy transmission as a public utility

Prior to the constitutional energy reform of 2013, all activities within the electricity industry value chain (including transmission), to the extent that they were deemed a public service, were exclusive activities of the Mexican State, and were carried out by CFE. Because CFE was responsible for the provision of the public utility—as well as for the planning and operation of the National Electric System (Sistema Eléctrico Nacional) 1 through the National Center for Energy Control (Centro Nacional de Control de Energía, or CENACE) 2—the construction and modernization of electric energy transmission infrastructure relied entirely on the investment capacity of CFE, thereby constraining the development of such infrastructure.

In December 2013, Articles 25, 27 and 28 of the Mexican Constitution were reformed and added with the purpose of promoting investment and competition within the Mexican electric industry. The implementation of this new legal framework3 constitutes a total paradigm shift in the sector. But despite full liberalization and full openness to the participation of private capital in certain areas of the value chain, the law preserves transmission and distribution via public utility as strategic areas to be provided by the Mexican State exclusively, either through SENER or CFE.

Notwithstanding this limitation, the new legal and regulatory framework expressly establishes the possibility that any governmental entity may enter into contracts with private parties4 in order for such private parties to carry out, on behalf of the Mexican State, the financing, installation, maintenance, management, operation and expansion of the infrastructure necessary for such public utility.5

This shift in constitutional principle, together with the availability of the revised legal and regulatory framework, enable the development of the SENER-BC Project and the CFE-Yautepec Project.

II. Regulated Transmission Rates

The source of payment for both projects will be an increase in the regulated rates paid by Wholesale Electricity Market (WEM) participants for the use of the National Transmission Network, through CENACE.

In accordance with the provisions of the Electricity Industry Law (Ley de la Industria Eléctrica, or the LIE), the Energy Regulatory Commission (Comisión Reguladora de Energía, or the CRE) is authorized to issue and update the regulated transmission rates (Tarifas Reguladas de Transmisión). The purpose of such regulated transmission rates is to foster the efficient development of the industry and competitive markets, reflect best industry practices and to protect the interests of users.6

The CRE calculates and adjusts these rates by applying a methodology7 requiring that transmission owners (e.g., CFE) and contractors obtain the estimated income necessary to recover their efficient costs of operation, maintenance, financing, depreciation, technical and non-technical losses, applicable taxes and a reasonable profit.8

The CRE can modify regulated transmission fees when they do not adhere to the principles established in the LIE as described above.9 The procedure to modify regulated transmission rates is set forth in the LIE regulations and has a term of 90 days, during which the CRE decides whether to authorize the rate adjustment.

Regulated transmission rates may also be adjusted to incorporate investments made by SENER and CFE through the tender of contracts,10 such as the SENER-BC Project and the CFE-Yautepec Project.

Once these projects are awarded, the CRE will issue an agreement through which these investments are recognized and acknowledged as part of the total required income of the National Transmission Network, which requires WEM participants to pay the charge.

CENACE is responsible for charging the regulated transmission rates to WEM participants, taking into account the amount of energy extracted and injected into the National Transmission Network. Likewise, CENACE is responsible for paying transmission owners (e.g., CFE) and contractors the amounts charged for regulated transmission rates through its invoicing and payment process.

The invoicing and payment process foresees the existence of a Working Capital Fund, which ensures the availability of resources in the event that any WEM participant fails to comply with its payment obligations.11

Should a WEM participant default, CENACE ensures payment by accessing the Working Capital Fund and replenishes such fund by executing the liquid performance guarantees of the relevant WEM participants, among others.

III. Scope of the projects

The SENER-BC Project and the CFE-Yautepec Project are part of the Expansion and Modernization of the National Transmission Network Program (Programa de Ampliación y Modernización de la Red Nacional de Transmisión), which aims to reduce congestion costs, encourage efficient expansion of generation and maintain the criteria of quality, reliability, continuity and security of the National Transmission Network.12

III.1 SENER-BC Project13

The SENER-BC Project comprises the development of the following:

a. A point-to-point, direct current transmission line operating in a bipolar form with a capacity of 1,500 MW, at a voltage level of ± 500 kV and with a length of 700 km.

b. Two converter stations with HVDC VSC technology of 1,500 MW, with a direct current transmission voltage of 500 kV, primary AC voltage level of 400 kV and secondary voltage according to the manufacturer’s design.

The project will be located in the northern Mexico, and will run from the Cucapah Electric Substation in Mexicali, Baja California to the Seri Electric Substation in Hermosillo, Sonora.

The main objective of this project is to link the National Interconnected System (Sistema Interconectado Nacional, or the SIN) with the Baja California Interconnected System (Sistema Interconectado Baja California, or the SIBC).

The SIN is the main electrical system in Mexico, and covers a large part of Mexican territory. The SIBC is located in the north of the peninsula of Baja California, which is electrically isolated from the rest of the country. However, the SIBC is interconnected with the electrical system of the western US, so linking it to the SIN expands opportunities for interaction with other electrical systems.

The SENER-BC Project is expected to reduce the price of electricity in Baja California, improve the operation and reliability of the SIBC, and encourage wind and solar generation in the region.14 The project will require an investment of an estimated US$1.1 billion.15

III.2 CFE-Yautepec Project16

The CFE-Yautepec Project comprises the development of the following:

a. A two-pole direct current transmission line with a voltage of ± 500 kV and a length of 610.5 km.

b. Five transmission lines in alternating current, with voltage of 400 kV and lengths of 25.3 km, 0.3 km, 131.3 km, 0.0 km and 138.7 km.

c. Seven electrical substations of various technical specifications.

d. Two converter stations of 3,600 MW and ± 500 kV

This project will be located in the States of Mexico, Morelos, Oaxaca and Veracruz, and in Mexico City. Its main objective is to encourage the integration of renewable energy generation (mainly wind and hydroelectric) that has great potential in the southern region of the country, and to facilitate the transfer of this energy to the Valley of Mexico where there is a high demand.17 The project will require an investment of an estimated US$1.2 billion. 18

IV. Contractual aspects of the SENER-BC Project

The SENER-BC Project is structured as a DFBOT (design, finance, build, operate and transfer) project.

The basis of this structure is the execution of an electric energy transmission management agreement (the SENER Agreement) between SENER and the winner of the tender, which may be incorporated as a special purpose vehicle (SPV) and act as the contractor under the SENER Agreement.19

Due to the characteristics of this structure and in accordance with the provisions of the SENER Agreement, the SPV is jointly and severally liable with SENER to carry out the provision of the public electric energy transmission utility before the CRE and CENACE.20

This project design is similar to that of the Independent Power Producers implemented by CFE under the former Electricity Utility Law, in which private entities produce electric energy for exclusive sale to CFE in exchange for consideration.

The winner of the tender is required to establish an irrevocable investment, management and source of payment trust with SENER and the SPV as trustors and trustees. The trust will receive and manage the assets of the SENER-BC Project, as well as the economic resources derived from the SENER Agreement, to serve as a means of repayment of the financing.

a. Contractor’s Obligations under the SENER Agreement

The SENER Agreement requires that the SPV do the following:

a) Obtain financing for the SENER-BC Project no later than 30 days before the scheduled construction start date, through bank financing, issuance of securities, private equity funds or a combination thereof.

b) Design the infrastructure of the SENER-BC Project based on the minimum specifications established by SENER in the tender, including the definition of the transmission line’s trajectory.

c) Obtain the rights of way necessary for the development of the SENER-BC Project. This procurement must be carried out in accordance with the new surface occupation provisions set forth in the LIE, which require a special mechanism for the negotiation, execution of agreements and validation of the surface occupation provisions before the jurisdictional authority.21

Bankability Note: Failures and delays in obtaining necessary rights of way are some of the most common causes of delay in a transmission line project. Owners and lenders will want to ensure that (i) a detailed land acquisition plan is developed at the outset of the project, (ii) the owner and/or any EPC contractor has the appropriate experience and resources to secure the necessary rights of way and (iii) any relief granted to an EPC contractor for failure to obtain the necessary rights of way is appropriately limited to the corresponding relief granted to the owner under the SENER Agreement.

d) Obtain all the government authorizations necessary for the development of the SENER-BC Project, including, among others:

a. Social impact authorizations issued by SENER including, if applicable, performing a prior, free and informed consultation with affected indigenous communities.22

b. Environmental impact authorization issued by the National Agency for Industrial Safety and Environmental Protection of the Hydrocarbons Sector (Agencia Nacional de Seguridad Industrial y de Protección al Medio Ambiente del Sector Hidrocarburos).

c. The interconnection procedures to the electric networks with which the interconnections will be made.

d. Authorizations arising from crossing rivers, other rights of way and changes in land use, among others.

Bankability Note: Failures and delays in obtaining necessary permits are also common causes of delay. Owners and lenders will want to ensure that owner is proactively working to obtain the same, and that the cost of any social or environmental impact mitigation measures are, to the extent possible, known up-front and included in the project budget and financial model.

e) Build the SENER-BC Project either directly or through an EPC subcontractor

f) Carry out (directly or through a subcontractor) the operation and maintenance of the SENER-BC Project in accordance with the provisions of the SENER Agreement and applicable regulations.

g) Transfer its trust beneficiary rights in the SENER-BC Project to the trustee at the end of the term of the SENER Agreement, free of all encumbrances.

b. Consideration under the SENER Agreement

In the SENER-BC Project, the SPV obtains a “Constant Annual Contractual Payment,” which consists of a fixed annual amount corresponding to the amount offered by the consortium integrating the SPV in the tender and covering all expenses incurred by the SPV in connection with the project.

The Constant Annual Contractual Payment will be denominated in pesos and paid monthly after the commercial operation date (COD) and throughout the commercial operation phase of the project (25 years). The payment is expected to be updated yearly based on the variation of the National Consumers Price Index (Índice Nacional de Precios al Consumidor). This monthly amount may be affected by possible reductions, sanctions or penalties applied in accordance with the SENER Agreement.23

Bankability Note: To the extent the debt or any operating costs are denominated in a currency other than pesos, an appropriate hedging strategy may need to be implemented to ensure coverage of such amounts.

The Constant Annual Contractual Payment is paid by CENACE to the contractor through the trust. The contractor and CENACE enter into an agreement called the Agreement for the Technical and Commercial Operation of the Transmission (Convenio para la Operación Técnica y Comercial de la Transmisión), which grants the contractor the right to receive from CENACE the amounts corresponding to the consideration, as explained below.

There is a mechanism to guarantee the availability of liquid resources to make these payments, a trust account called “Liquidity Reserve Account” (Cuenta de Reserva de Liquidez) from which resources will be transferred when the “Regulated Income Account” (Cuenta de Ingreso Regulado) from which CENACE funds transfers does not have sufficient resources.24

c. Lenders’ Rights under the SENER Agreement

In general, under the SENER Agreement, lenders have the right to:

a) Register and appoint a common representative who receives all notifications under the SENER Agreement. Only registered lenders will be recognized and acknowledged as such.

b) Receive monthly notifications with respect to the contractor’s compliance with its obligations under the SENER Agreement.25

c) Receive a pledge of the contractor’s rights, payments, income, assets, trustee rights and representative actions.

d) Assume control of the SPV if it does not comply with its financial obligations provided in the financing documents or cure (within 60 days) any serious breach by the contractor provided in the SENER Agreement, in order to prevent early termination.

Bankability Note: Any replacement of the contractor or change of control resulting from an exercise of the share pledge would be subject to the consent of SENER and its confirmation that the new contractor/shareholders comply with the relevant bid criteria and have the requisite capacity to comply with their respective obligations in respect of the project.

e) Participate in the technical committee of the trust, through two members with voting rights. A representative can also be added for each one of the lenders, also with voting rights.

d. Termination of the SENER Agreement

The SENER Agreement will be in effect for 30 years as of its date of execution; however, it may be terminated early in the following cases:

a) Mutual agreement of the parties.

b) Unilateral decision of SENER due to general interest or justified causes.

c) Non-compliance by SENER to cover the Constant Annual Contractual Payment, or when a law that prevents the continuation of the SENER Agreement is approved.

d) For serious breach of the contractor.

e) Excluded liability event (an extended act of God or force majeure; e.g., 270 days).

The early termination of the SENER Agreement does not imply the payment of any contractual penalty. However, the termination of the SENER Agreement leads to the calculation of a settlement prepared by an expert appointed by the parties, which will contain the amounts to be collected and paid between the parties derived from the early termination.26

Bankability Note: It is not clear that the settlement amount will be sufficient to repay the full amount of the debt in all circumstances; this should be clarified. Also note that in order for SENER to pay any settlement amount, the relevant funds would need to be allotted to SENER at such time in the applicable federal budget.