Some of the most creative minds in project finance have been working towards a solution to the fuel problems raised in financing an independent power project in Mexico. Some of them have thrown up their hands, thrown some contingent equity at a project, and thrown some force majeure risk back on the sponsors. Others claim to have arrived at a cheaper and less risky solution, but remain cagey about how this can be achieved. Either way, the issue is now dead, because Mexico's electricity monopoly, the Comision Federal de Electricidad (CFE), is now back in the gas business.

The resolution says a lot about the paradoxes of the Mexican energy market, but also what makes it so attractive to developers. The country has benefited from strong economic growth, a business-friendly government, and a constitution that makes attracting private investment a complex and fudge-heavy affair. Most of the fudges, it should be added, are fairly friendly to developers.

Nevertheless, with mid-term elections looming in Mexico, and a palpable atmosphere of lethargy at the Comision Reguladora de Energia (CRE), Mexico's regulator, bankers looking for some clarity are likely to be disappointed. The major obstacle to making a power plant financeable has been that the CFE and Petroleos de Mexico (Pemex) now negotiate offtake and fuel supply agreements separately. The potential mismatch between when electricity is required and when fuel is supplied has made lenders nervous.

Four plants have been financed under this regime ? Campeche (a TransAlta project financed by Bank of America and EDC), Altamira II (an EdF/Mitsubishi plant financed through JBIC, Citibank and Mizuho), Naco Nogales (a Union Fenosa deal supported by US Ex-Im) and Tuxpan III+IV (a Union Fenosa plant financed through JBIC, Deutsche and BTM).

Campeche, which has just commenced operations, was able to obtain a gas balancing agreement from the CFE, whereby the CFE would resell gas that it did not call on the project to deliver. The experience was evidently satisfactory for TransAlta since, according to its vice president and treasurer Marvin Waiand, the Candian generator is looking, through bids and acquisitions, to increase its installed capacity from 511MW to 1000MW.

Altamira was the first project to come face to face with entirely separate gas and offtake contracts, and ultimately used contingent equity support from the sponsors to improve the project's economics. Tuxpan's sponsors and JBIC are staying silent on their means of mitigation, although sources close to the deal deny it used sponsor support. Naco Nogales did not have to deal with Pemex supply issues, since it used an El Paso supply contract. According to John Schuster, power sector director for the structured finance division at US Ex-Im, the El Paso contract was originally a strength of the deal, but new risks arose during the deal, since the pending implementation of Ferc capacity allocation decisions, and El Paso's decision to exit the merchant energy business, posed potential risks to gas delivery.

The $210 million deal was also very conservatively leveraged, with a total debt capacity of $92.5 million, although it did have to struggle against insurance worries, solved with contingent support. The one advantage of the time taken to complete the financing was that the Siemens 501G turbines went from unproven technology suffering from teething problems to established generating equipment.

Future deals, however, will not have to struggle with the fuel issue, since the Secretary of Energy has decided that future tenders for plants will again buy their fuel via the CFE. The move has been met with delight on the part bankers, who realise that the credit profile of forthcoming facilities will again be that of a tolling agreement with the CFE.

But the move essentially is a step backwards, and goes little of the way towards opening up the Mexican gas market to competition. The more committed players, such as El Paso, have all been forced to pare back their operations. Nevertheless, El Paso still closed a landmark financing in the form of the San Fernando pipeline project, which featured a solid take or pay contract with Pemex Gas y Petroquimica Basica (PGPB, the co-sponsor), and construction plus ten-year debt, some of which came from Ex-Im, and some of which was uncovered.

Paula Swain Priestley, project finance director at El Paso, says that the $230 million financing was achieved within a seven-month time-frame (and, she proudly notes, without any conditions precedent waivers) by anticipating lender wishes in advance. The other key feature, however, was the use of surplus equity to cover lender concerns that the sponsors might not obtain rights of way in time (for additional details see Project Finance, March 2003, p.38).

Likewise Pemex Refinacion has proved a strong partner for the Poseidon water project, for which Nord/LB has a financing out in the market. This deal is understood to have a rating inside the investment grade bracket but, according to Bruno Mejean, head of structured finance for Nord/LB in New York, banks will be attracted to the credit more than institutions because of the debt's short average life. Nevertheless, the deal, whose sponsors are Earth Tech Mexico and Trident Global water Partners, has a rock-solid contractual structure and operating history. Nevertheless, the picture of the finances of the individual pieces of Pemex is difficult to ascertain.

Pemex has acquired a great deal of expertise and marketing muscle, so much so that it has an opportunity to be a major player in continental gas markets. In this respect, the move towards the CFE contracting for its own gas in bulk is bold. The CFE has issued a request for proposals (RFP) for LNG capacity to serve the Altamira cluster of plants ? indeed this is one reason why the Altamira V bid will now allow a CFE supply contract.

The RFP has attracted a fair amount of criticism from project sponsors, who note that since the bid does not specify the facility to be built, and is not an OPF, the eventual contract will not be financeable. Unless the ultimate document specifies that the CFE will buy back the plant should it not be used, and if the LNG is not competitive, the prospect of a stranded asset will scare lenders away. Fernando Alonso, chief promotion officer at the Ministry of Energy, says the bidding process has just started, and discussions and clarifications will be possible while a final contract is being negotiated.

The ramifications of the CFE's entry could also mean the end of outside involvement in gas marketing in the country. As Lisa Henneberry, partner at Squire Sanders points out, ?the CFE could take the private suppliers out of the market, since these are unlikely to be able to compete. Those IPPs doing business with the CFE will not be exposed to dispatch risk, unlike those dealing with private suppliers. The CFE was meant to be the anchor tenant, but not the only one.?

Eduardo Andrade, in his capacity as head of the Mexican Electric Energy Association (AMEE, he also heads up business development at Techint) believes that the development is simply ?useful in the short-term. The CFE and Pemex can discuss contracts and set rules, and hopefully the CRE can find some teeth. A natural gas market needs a strong structure, because competition in the present environment is not there.?

Antonio Souza, head of the energy area at Protego Financial Advisors, says that ?the measure is a comfortable bridge, possibly a confusing bridge, but the only bridge at present. Pemex is the 800-pound gorilla that is very difficult to match on price. The situation is similar to that in the Brazilian electricity sector, where the government privatised distribution before reforming production. This crushed the distributors. My hope would be for a outside player like Tractebel to take on Lazaro Cardenas [a proposed LNG terminal on the west coast] without using the CFE or Pemex, but this will take nerve.?

It may also find willing bankers difficult to come by. Bankers seem by and large comfortable with the role of the CFE as intermediary. Mejean, for instance, suggests that the CFE would be a useful backstop for generators selling onto the open market, and would look at the Altamira plant so long as the underlying contract is financeable. Rajesh Sharma, director of energy in the project finance department at EDC, says that ?keeping in view the projected demand in Mexico and the US demand supply imbalance, continued gas imports from US are no longer a viable option and Mexico needs to develop its domestic supply sources. A number of announced LNG plants continue to be US focused which may not resolve Mexico's domestic supply issues.

The mechanics of the bidding process, however, still consumes the bulk of the attention from sponsors and lenders, and the razor-thin margins and tight construction schedule required by the CFE is still causing problems for offtakers. Guillermo Espiga, responsible for Latin American project finance at InterGen, wants there to be a more relaxed attitude on the part of the CFE towards the start of construction ? if this has to start quickly following an award, it will most likely have to happen using equity.

The likely winners are still assumed to be the French, Spanish and Japanese sponsors. They have been the only developers to have closed deals in the last 16 months. Even without the need to inject contingent equity, the dominant players will continue to be those with the lowest cost of capital and ROE expectations.

One observer noted that these sponsors expected to see more of an upside from their investment, and have become disillusioned. Sharma notes that the competitive bid tariff has put pressure on developers and, faced with rising bid costs, these are losing interest. Nevertheless, Andrade from AMEE stresses that for several embattled US developers their US interests are amongst their strongest performers. AES, for instance, has had to deny reports that it is looking to sell the Merida III plant.

Developers want to see a CFE that is transparent in its pricing structures. Indeed the theme that most consistently unites those at the roundtable is the fact that the CFE would need to start offering realistic tariffs, although given the political repercussions so close to the election such a move is unlikely. Souza notes, however, that ?while everyone is waiting for a new congress, our assumption is that its composition will be similar to that of today.? Nevertheless, Priestley's concern that CFE's credit will not be able to support its increasing obligations was one widely shared by roundtable participants.

Mejean wants to see a greater involvement of the domestic capital markets in power finance, particularly in transmission, and is waiting for an increase in activity from the monolines. Thomas Mueller, partner at Ritch, Heather y Mueller echoes this view, pointing to the recent securitization of bill receivables by the CFE. Souza is less convinced, saying ?the CFE has taken a traditional idea, but is using it for the wrong reasons. It is using receivables to cover working capital rather than bring the tariff up to realistic levels.?

The other area where there is considerable disquiet at the regulatory framework is in the renewables sector. Mexico has among the finest wind resources in the world (understandable, since the north shares a number of topographical features with Texas), and the potential for wind projects is immense. However, the Mexican government offers neither US-style tax breaks nor European-style subsidies. Instead, as Sam Sherman from Credit Agricole Indosuez points out, ?while there is no tariff subsidy and the fiscal environment does not support renewables, the regulatory scheme allows energy banking. This allows wind projects to offer a steady supply to offtake parties. So long as lenders accept the wind forecast, the project's revenues are predictable, and therefore bankable. However, the high break-even tariff required means that only certain high-tariff uses, such as municipal public lighting, can be served by these projects in the absence of a tariff subsidy or direct tax incentive.?

If the CFE were permitted to contract for wind capacity this would be a positive step forward, and would mean that bankers could pile in with gusto. But the CFE is obliged to go for both the lowest fuel cost but also the lowest per kW installed cost. Wind rarely makes it past this last hurdle. The CFE is likely to build the capacity itself, as Alonso concedes, probably as an Obra Pública Financiada (OPF), similar to tranmission financings.

The tax regime is probably not going to change to any significant degree, although a generous depreciation allowance may be possible, subject to the constraints of the Mexican Hacienda. Nevertheless, this is an area where Mexico could easily become a powerhouse in wind finance, and the resource may be good enough to do without a subsidy package, although Frederick schmuck of GE points out that the penalty regime laid out under the guidelines for wind farms could certainly deter bankers.

The final, most promising area is the imminent awarding of multiple services contracts (MSCs) by Pemex Exploracion y Produccion (PEP). These have been specifically designed to get round the explicit constitutional bar on outside ownership of the country's oil and gas industry. As Alonso stresses, the MSCs are ?not a concession, and they do not provide private companies with property rights over the natural gas or exclusivity in exploration and production.? They work by rationalising the myriad subcontracts typically signed by Pemex into eight geographically-based super-contracts covering a host of types of work.

The scheme is designed to kickstart Mexican self-sufficiency in natural gas, and would provide payments to operators according to works performed and services rendered. The MSCs require a minimum global investment experience of between $750 million, easily enough to interest a major or consortium, down to $10 million, a tempting target for an independent operator. According to Santiago Garcia-Verdu, analysis submanager for the scheme, the main economic criterion in awarding bids is the discount offered to Pemex' reference price catalogue.

The contracts are authorised as Pideregas, which means that it generates enough cashflow to pay for itself, and carries a government guarantee, and would have a roughly 10- to 20-year duration. As such, they mimic the transmission deals that the CFE has put together with the likes of Siemens, Techint and Earth Tech. While any debt would not be covered by a guarantee, the deals would essentially be a blend of Pemex and construction risk.

The two major worries about the programme are that it is open to constitutional challenge, and that the timetable to execute the contracts is extremely aggressive. On the first point one participant stressed that interested parties will have 30 days to challenge the contract from the date of the award. ?That hurdle has been passed,? Garcia-Verdu says, ?this is perceived by corporates as a light risk, and one that they can handle.? In terms of the timetable, Garcia-Verdu says that PEP has found that some bidders have found the technical data provided on the internet difficult to access, and that a short extension may be possible.

Pemex' willingness to accept these modifications will he governed in large part by the response of bidders to the RFP. In this respect it will follow the progress of the IPP programme. When a developer like Espiga asks for the CFE to accept performance bonds at a lower level than their current $40 million tag, or that it do a better job in convincing banks that surplus power production can be wheeled, there is a chance that these comments can be taken on board.

Perhaps the most fully rounded vision is that of Andrade. He wants to see a stricter division of transmission and generation, with the transmission operator, while remaining in public hands, incentivised to keep costs to a minimum and maintain an efficient grid. This would go some way towards addressing Espiga's second concern. As for the supply side, Henneberry is eager to see a balanced mix of fuel sources, although third party suppliers will find their product unattractive if the CFE goes into the gas business.

Such complaints are familiar to developers in Mexico, however. Schuster believes that the extra obligations that the CFE has taken on could become burdensome. ?There is a limit to the extent that CFE can be a panacea to various problems,? as he puts it. These complaints might be taken as an understandable desire on the part of corporates and their lenders looking for a better deal in Mexico. However, as Project Finance went to press, reports emerged that Iberdrola and Union Fenosa were looking at suspending their investments in Mexico until a clearer regulatory picture emerges. If two of the most steadfast friends of the Mexican IPP programme start to balk, then the CRE may have to take notice.