For a country with some pressing power needs, and a power finance framework praised by most bankers, dealflow in Mexico has been almost funereal. Three power deals have closed in the last twelve months, of which one was mandated in 2002, and the other two were pidiregas. Indeed, the relative performance of the sole IPP syndication - Rio bravo 3+4 - and the two pidiregas - El Cajon and Elina Occidente - suggests that structured CFE deals may be the mainstay of the Mexican market going forward.

The state-owned power monopolies - the Comision Federal de Electricidad (CFE) and Luz y Fuerza Del Centro - will need to add 25,000MW of capacity 2003-2012. And as Eugenio Laris Alanis, the director of financed investment projects at the CFE noted, transmission projects will, at $196 billion, be almost equal to the $223 billion to be spent on generation. That timetable is flexible, says Laris, since "the plan exists to satisfy demand, and we can adapt. Last year, for instance, we had to deal with low water levels, and had to install some gas turbines at short notice."

Four generation projects will cross his desk this year, of which two will be obra publica financiada (OPF) deals. OPF deals are those for which the government will pay the full cost of the project back to the contractor upon completion. These projects avoid operating risk, and are particularly suited to renewables. As such, the first two of the following deals will be OPF, while the second two will be independent power projects, where the CFE commits to buy power.

Mexico's bid pipeline

Cost ($ Financing

Name MW million) Bid out Start date route

CE La Venta II 101 112 July 1 July 2006 OPF

CH La Parota 900 1,019 July 1 Jan 2011 OPF

CCC Agua Prieta II 411 336 October 1 Apr 2008 IPP

CCC Tamazunchale II 972 780 November 1 Apr 2009 IPP

Total 2,384 2,246

Source: CFE

The La Venta II deal promises to be one of the first wind financings in the sector, although it will be the rare example of an OPF that is not included in the CFE's budget, which has to be passed by congress. Nevertheless, Laris says that the CFE is working on a model power purchase agreement for renewables. He notes, however, that the CFE is currently obligated to buy the cheapest power possible - and that wind is being pursued when it is not quite competitive.

Nevertheless, the framework for renewables investment is there - one participant called it: "the most innovative there is." This includes an interconnection agreement that allows a producer to bank power, as well as claim carbon credits. Conduit Capital Partners, the successor to the Scudder power business in Latin America, plans to close financing with Scotia Capital on a portfolio of hydro plants that benefit from the sale of carbon credits to the World Bank carbon fund.

More disappointing was news that the CFE is unlikely to bid out the Petacalco project in 2004. This plant, which would be fired using the petcoke byproduct of Pemex' refining operations, was eagerly anticipated. Ultimately, this OPF financing, which would follow earlier deals for Termoelectrica del Golfo (search 'TEG' on projectfinancemagazine.com for details), will likely go out in 2005.

The next most keenly anticipated bid is that for Tamazunchale, located at the same site as the abovementioned second unit, for which four bidders have been shortlisted. These are believed to be Calpine/Mitsui, InterGen, Mitsubishi and Petrobras. At least two of these groups are understood to be bidding using spare turbines, a factor that makes the contest all the more unpredictable.

According to Guillermo Espiga, InterGen's vice-president, finance, "We have been successful in raising debt and equity in Mexico in the current environment, and feel that the CFE is creditworthy. However, we've been able to sell power to the US and industrials [the Bajio and La Rosita projects]. We would like to see some clarification of the constitutionality of IPPs, as well as the ability to sell power direct to the customer rather than through the self-supply framework."

Espiga echoes a common concern at the independent power producers - that the present use of compromises and loopholes is still too fragile to withstand a political shock. Bellicose statements from opposition senators exacerbate these fears, even if such outbursts are neither representative nor to be taken seriously. The political and legal element of reform may be the least important part of the package.

According to John Schuster, director, structured finance, at US Ex-Im, "The idea that there would be a crisis, and that we need immediate reform might be misplaced. The issue usually is that a crisis happens when you least expect it. We may be better off looking at Mexico's tax and fixed policy on Pemex, or whether CFE's prices reflect its cost of service and capital."

Schuster, as well as Espiga, and several other participants at the roundtable, all note that the CFE's creditworthiness is a central, and ongoing, concern. Signs are that the CFE is aware of this, since Francisco Santoyo, CFE's chief financial officer, notes that with assets of MXP603 billion, and liabilities of MXP237 billion, CFE is if anything underleveraged. Santoyo can point to impressive gains in outputs and productivity, but his claims of a healthy financial standing have been met with some scepticism.

In particular, the scale of CFE's liabilities is a cause for concern, as one banker based in Mexico City pointed out. Santoyo noted, however, that CFE completed a inaugural asset-back bond issue in 2003, a local debt issue backed by accounts receivable from industrial users. The CFE is likely to benefit from strong demand in the local markets, although it can benefit from at most $1 billion of the $40 billion in pension fund assets, since portfolio managers cannot exceed a 5% exposure to a given issuer.

International bond markets are much more receptive, as the bond issue for the El Cajon project demonstrated. Bookrunners Citigroup and WestLB raised $250 million in a 144A placement, part of a total $682.4 million debt package. The bond element featured a negative cash carry, an unavoidable feature, but the debt was tightly structured so as to gain an investment grade rating, and mirror CFE risk as closely as possible.

Gabriel de la Concha, director of project finance at lead sponsor ICA, explains that the debt for the construction of a 750MW hydroelectric plant was structured so that lenders would disburse funds to the project to the same level as approved and completed work. This sum, equal to the value of the completed work as collateral, would be augmented by a $26 million corporate-backed letter of credit, which functions something like equity. It also creates a virtual retention fund that increases as the recognised value (which exceeds costs) increases.

El Cajon has a long construction period - five years - meaning that it is a rare example of a pidiregas deal that would be suitable for a bond financing. But the deal's investment grade rating, and a universe of investors that is still looking for emerging market yield make it a significant one. And OPF deals have a strong following among bankers.

Pemex should take note of this point - it has been far more wedded to the use of traditional public works contracts than the OPF template. As Nicolai Dillow, assistant vice-president at Norld/LB notes, the OPF has a more defined termination annexe and disbursements are directly linked to approved works (VOs). Traditional contracts are likely to feature costs that the awarder has not recognised, and must therefore be financed through a revolving credit. But it also includes more exposure to the contractor than banks may be comfortable with because, as Bulent Osma, vice-president at Nord/LB says: "Since pricing is a factor of the weighted exposure to the contractor and awarder, cheaper debt means distributing as much exposure as possible to the most creditworthy party." In this case, the CFE or Pemex is ideal.

For those banks remaining in the project finance space, mitigation is the key, even with the right structure. Bruno Mejean, senior vice-president at Nord/LB, says: "we do not have an immediate problem with exposure limits, and believe that the next 18 months should be easier than the last 18. Rio Bravo and El Cajon solved a lot of issues. The insurance market now goes out to 15 years - six months ago it was 10 years - and Opic is now looking seriously at the sector. We are now able to insure B loans as well, if we so choose."

The key will be the ability of sponsors to refinance projects, where the record - Nord/LB's refinancing of the Mexican Water Trust aside - is mixed. One banker notes that "refinancing Union Fenosa and Iberdrola's projects would make the market a lot more confident." InterGen's Espiga says: "we have been approached by investment banks a number of times to refinance our projects in the bond markets, but for one reason or another the timing has never been right. I think that the CFE has done too good a job of tapping the available capacity" Another banker notes that complete recycling in the capital markets, rather than agency enhancement, is the best way to free bank capacity.

Pemex will have a much greater share of future financing requirements, despite its diminished role in the power sector. Pemex and CFE will now contract directly for the gas requirements of IPPs. The independents endured a brief phase where they had to negotiate offtake and supply agreements back-to-back, The experience was apparently so traumatic that the CFE is again supplying projects with fuel, and is also likely to be the main importer of liquefied natural gas (LNG).

Felipe Luna, vice-president, natural gas at Pemex Gas y Petroquimica Basica says: "When addressing concerns about gas supplies - or availability - we should differentiate between short term and long term balances: Last year the gas system was strained for a short period because we had low water levels for hydro generation at the same time that the San Fernando pipeline was still in its final stage of construction; this was a very short term concern at that point; in the long term Pemex E&P will definitely be part of the solution and LNG should be looked at as a supplement to domestic production."

Luna does not need to be apologetic - in addition to the refinery upgrade projects and the abovementioned Water Trust (for details, see Project Finance, March 2004, p.34), Pemex, together with El Paso, closed financing on the San Fernando pipeline in 2002. He referred to this and other pipeline projects as different versions of the 'Mexican model' that has proven to work over the past 8 years.

While acknowledging that the model is not perfect, Luna said that these success stories are the result of a joint effort with sponsors and lenders working together to find solutions that work within the existing regulatory framework. He also said that the recovery of investment in exploration and production and research and development would benefit from a long-expected reform of the fiscal regime under which Pemex operates. The next, large-scale, round of platform deals - eight in all - as well as smaller compression projects, will give an indication of Pemex' resolve.

One of the key elements of the Mexican legal framework that participants wanted to see reformed is the part of the acquisition law that deals with financing infrastructure. Lisa Henneberry, partner at Squire Sanders highlights the article 54 general interest termination provision, as well as the difficulty in assigning contracts.

Henneberry has recently worked on the Altamira LNG receiving terminal , sponsored by Shell, which has a gas sales agreement with the CFE to support it, but is not a pidiregas. Important risk mitigants, according to Henneberry, are to "consider different means of offsetting either party's non-performance through comprehensive resale provisions, and structure around the inability to assign contracts. You can, for instance, assign proceeds to secure payment streams."

Most frequently, however, discussion turned to the possibility of deeper reform of the energy sector. Here, opinion divided between those who sided with the government institutions and felt that however imperfect the current framework had potential, and those who felt that complacency could be fatal. "Do not discount a problem because it may appear at one point to be theoretical or unlikely to become a real problem," warned Pierre Bouvery, principal investment officer at the International Finance Corporation, "Argentina proved that situations can change dramatically. It is insufficient to say that because the market accepted a certain risk yesterday, it has to accept the same risk today."

As one of the bankers working on the Rio Bravo 3+4 transaction, Bouvery experienced first hand the problems of syndicating a deal in an uncertain environment, and noted that until late 2003 there was a smaller pool of institutions ready to lend to the sector. Bouvery notes the professionalism of the Energy administration and the CFE, but is firmly in the camp of those that want to see more reform.

Eduardo Andrade, president of the Mexican Electrical Energy Association, sees the current situation as largely positive: "The CFE regaining responsibility for gas was seen as a blow to deregulation, and a delay, but it is easier for the CFE to manage this risk. That said, reliability is increasingly an issue. I would like to see a bill, along the lines of the Clinton-Richardson legislation in the US, that would mandate electrical reliability standards." Andrade also has high hopes for the oil and gas sector. Techint, of which he is also the Mexican head, has won one of the new multiple service contracts, one of the first four to be awarded. The pipeline for the next 18 months looks healthy.