There is no sign of a let-up in Mexico's ambitious independent power programme. The Mexican government has four plants out to bid, representing 1300MW of capacity, with plans for a further six by year end. The current economic environment has not harmed electricity demand, Standard & Poor's has brought the country's rating up to BBB-, and Moody's has added another notch, taking the sovereign to Baa2.

The outlook for the sector, and power finance, is therefore very promising ? the figure commonly quoted is an additional 16GW by 2010, of which 4.8GW will be self-supply. But the Mexican authorities have placed a few new obstacles in the way of obtaining watertight structures. Both illustrate the continuing ambivalence within the Mexican polity about the lengths to which private sector involvement in the energy sector should go.

The first shock was a Supreme Court ruling that President Vincente Fox' presidential decree, authorising sales of excess output from inside-the-fence plants, was illegal. Elements in the senate opposed to Fox' plans, especially the former governing PRI are believed to be the inspiration behind this issue's appearance before the court. The ruling has the potential to alter the economics of plants like the Vitro Monterey facility, which can sell surplus output to state electricity company the Comision Federal de Electricidad (CFE) at predetermined rates.

The second is the new mechanism by which independent power producers (IPPs) obtain their fuel supply. Previously the CFE had been the formal supplier of gas to power plants rather than state-owned oil and gas producer Petroleos de Mexico (Pemex). This meant that it was a great deal easier to index power prices to shifts in the price of natural gas, so that the power purchase agreements (PPAs) struck between the independents and the government vaguely resembled a fuel conversion agreement. Even with margins for sponsors at very competitive levels, cost pass-through made projects bankable. Now sponsors must deal with Pemex.

It is this second factor that has the most potential to disrupt the IPP programme. The first, while frustrating to inside-the-fence-producers, is an issue that will have little resonance for new producers. As Antonio Souza, head of the project finance advisory group at Protego Energia, points out, ?there are very few large industrial offtakers left, maybe Grupo Mexico, ISPAT and AHMSA. For the Alfa-PEGI project we had to begin to do a large aggregation of loads ? something like 37 different PPAs in place with various Alfa-Pegi affiliates?.

Dealing with Pemex is probably not as bad as past experiences might dictate: certainly few roundtable participants went on record with negative sentiments about this mainstay of government tax revenues. The lack of co-ordination between the two state-owned bodies, however, is troubling, and this mismatch between fuel supply and dispatch rates has already started to hit the pace of plant financings. As one participant put it, ?this is the single biggest issue facing financings at the moment. We need to sit down and find a solution as fast as possible.?

After the scorching pace of financing in 2000, 2001's financing calendar was a little more sedate. Coming in at the start of the year was TransAlta's $133.6 million, 250MW Campeche transaction. Campeche marked something of a first, since it managed to avoid using the multilaterals (especially departing stalwart the Inter-American development Bank (IDB)) entirely. Strictly speaking, Sithe and Alstom's Termoelectrico del Golfo II was earlier, but this was an expansion of an IDB-backed project.

Campeche used EDC-provided political risk insurance, whilst the Canadian export credit agency (ECA) and Bank of America co-led the financing on the plant. This cover took the deal out to an unprecedented 16-year tenor. EDC is set for a very good run, so long as sponsors still use Siemens Westinghouse turbines since, US Ex-Im aside, few other agencies can yet match its flexibility. For TransAlta's next project, the 259MW Chihuahua plant, it will wait before funding long term debt. ?TransAlta is comfortable financing the Chihuahua project on its balance sheet for now but will eventually place non-recourse financing on the project?, according to Assistant Treasurer Frank Hawkins.

Fuji Bank and Dai-Ichi Kangyo Bank (both now Mizuho) and BNP Paribas followed this feat with a $325.5 million financing for Tuxpan. Sponsors of this 495MW combined-cycle gas-fired power plant are Mitsubishi Corp and Kyushu Electric. Of this, only $86.8 million came from commercial banks, with $130.2 million direct from JBIC and the remainder as equity. This, like Campeche, has no offtaker aside from the CFE.

By far the most intriguing financing, however, came from the reliably innovative InterGen ? La Rosita. Disputes about its closing date aside, the deal marked a cross-border first, given that a portion of its output is sold across the US border to energy marketer Coral Energy. La Rosita is one of the largest examples yet seen of the overaggregation approach, whereby sponsors install additional turbines at a site and use the economies thereby gained to bid down the cost of power sold to the CFE under an anchor PPA, selling additional capacity on a merchant basis or, indeed into the US.

The main elements of the debt are a $420 million loan covered by political risk insurance, again from EDC, and a $120 million uncovered portion, which essentially matches the 250MW out of a total 810MW sold to A-rated Coral. 250MW is sold to the CFE, whilst the remaining 310MW is entirely merchant, and has used InterGen's borrowing base approach to increase lender comfort by creating a capital structure appropriate to the degree of offtake risk assumed by lenders (for further details, see Deals of the Year, Project Finance, March 2002).

La Rosita is in a fortunate position since it is far more closely tied to the US and Baja California grid and gas supply network than other IPPs. Nevertheless, it is well placed to capture any market share that is available whenever a more open market emerges. The signs of this happening are better than may be expected.

Fernando Alonso, chief investment promotion officer at the Mexican Department of Energy, is sure of one aspect of the reforms to the country's energy sector saying that ?the privatization of the CFE is not on the cards. Proposals for energy reform are now in discussion with Congress and we shall probably have an extraordinary session in July. Congress, however, is responsible for modification of the law?. Moreover, as Hawkins at TransAlta notes, ?According to a clause in PPA agreements, if in the event of privatization of CFE the new entity is of a lesser credit quality the obligations under the PPA's are supported by the government of Mexico.?

The largest obstacle to privatization is probably the sheer size of the investment programme underway. Franklin Minerva, managing director of MBIA's global infrastructure group, says ?we take the view that in the near term the CFE won't be privatized in part because of the high level of contingent obligations for the Mexican State that would be triggered by a change in CFE's ownership status. Given the volatility associated with deregulation in some other contexts (most notably California), there would likely be a temporary shortage of private debt capital available to the sector if the Mexican market were suddenly deregulated and CFE privatized. But the financial markets would ultimately sort through the new framework.? But changing the law to allow direct sales to industrials will take time, and would also take time to implement, as Alonso concedes.

Relations with Congress will be the key to shaping the country's market. But Souza does not believe that the court judgement is too serious, and may even be positive. ?It says to Congress that the reality of the electricity market does not match the constitution. There is an interpretation that IPPs are illegal but that is a very dangerous game,? he says, adding that opinion polls show around 60% support for private investment. The main issue, as most participants agree, will be how to draft LNG legislation to work within the constitutional framework.

More important will be finding a constant source of new players to replace those that fill up on Mexican exposure. In theory the investment-grade sovereign rating makes a capital markets financing possible. But institutional investors are still a little wary after past crises. John Anderson, from John Hancock says ?we ask ourselves every time whether a deal is different to an Argentinean or Indonesian one. We like to have either dollar streams or an asset of strategic importance. The CFE fits the latter and we think that its debt burden is about where it should be for its rating.?

Until a vibrant project bond emerges out of Mexico, the burden will be on new banks to continue the work done by those leaving. The omens are good. As Bruno Mejean, head of structured and project finance for Nord/LB in new York points out, ?conditions in the US power market are driving many sponsors and lenders into Mexico, but while the current economic conditions are good, lenders are always cautious in the long-term?.

Mejean, like many lenders at his tier, believes that there is still an important role for covered debt to play in the market. He believes that in order for the price of power to reach affordable levels there is still a role for multilaterals to play in the market to extend maturities to the maximum term possible, i.e., the 25-year term of CFE PPAs ?Ideally we look for comprehensive cover on long-term Mexican debt,? he adds, ?and since some private policies contain important exclusions, US Ex-Im's cover impresses us.?

An equally cautious perspective comes from another banker with arranging experience in Mexico. ?The real test will come when projects come online and whether the government can live up to its obligations,? he says. ?We've seen this scenario before, and the UMS has not got into the paying phase yet.?

Tony Muoser, managing director in Citigroup's project and structured trade finance group, believes that there are several markets still open. ?There are several investor classes out there that haven't been utilised, including monoline-wrapped debt, private placements and even local debt. He also points out that existing lenders may be able to sell on some country risk through collateralised loan obligations, as Citi has done. Minerva at MBIA reinforces that saying, ?there's a lot of capacity in capital markets that hasn't been adequately tapped yet. But the deals that could go to the capital markets first may be refinancings, since people can get comfortable that these issues have been satisfactorily addressed.?

Local currency is at present not an option despite the obvious benefits of a match between peso-denominated debt and PPAs. But the local banking system is very wary of project debt, and pension funds are not comfortable with debt rated below A, or even higher. Maturities can go out to ten years, but liquidity is an issue, so large financings will have to be executed in the cross-border market, points out Barry Gold at Citigroup.

Guillermo Espiga, vice-president for Latin American project finance at InterGen, notes that there are a few obstacles to a capital markets refinancing for CFE projects. ?These projects are financed on the basis of bids to the CFE at the lowest level on an NPV basis. We can work with banks to create a highly customized amortization schedule but after the first 12-15 years of operations there is not much cash flow to refinance. There is a better chance on getting one done with excess generating capacity on offer. La Rosita is a good example of a project with potential for refinancing in the capital markets thanks to the combination of cash flows generated by CFE and the power produced in excess of the CFE contract.?

But financing more La Rositas, and refinancing them with bonds, depends on the creation of a more substantial cross border power market with the US. Espiga's assertion is that ?it is a reality and we have proved that with La Rosita. Also let's not forget that CFE trades with California on an everyday basis.?

The difficulty will be working with the Electrical Reliability Council of Texas (ERCOT), whose grid accounts for half of Mexico's cross-border potential. But whilst ERCOT is one of the last, and certainly the most prominent, vestige of Texan separatism, synchronisation of the two power grids is not an option. Gas sales probably offer more potential.

By far the most pressing issue however, is the supply/ dispatch mismatch, which consumed much of the discussion. Rajesh Sharma, director, project finance (energy) at EDC, raised a number of possible solutions to the fuel supply-dispatch mismatch, having examined at close hand the issues while working on Campeche. ?I'm not sure how many future deals will be able to use a fuel transport arrangement like Campeche. Instead, one could try to negotiate gas supply which is interruptible at the option of the project, bid a minimum fuel cost as part of the tariff structure, or a minimum daily dispatch could be tied to contracted minimum fuel supply obligations. At the moment, however, recovery of fuel supply costs is an important issue to the extent that lenders are asked to take fuel-dispatch mismatch risks.? Lenders are also unsure as to whether a default in Pemex' obligation constutes a force majeure event.

It may not be possible to change the rules on projects already bid out. Returning to purchasing fuel from the CFE runs against the guiding principles of Mexico's regulators. But true pass-through of fuel costs will not be possible until CFE has a transparent process by which it prices electricity sold to consumers. This is currently subsidised. But given the lack of information, as Sharma at EDC points out, it is difficult to get the dispatch profile of a plant right.

Alonso from the department of energy notes that bidder interest is still strong, despite the fuel supply issue. He notes that reform of CFE's consumer pricing structure is under way and subsidies are being decreased. In the mean time, however, some conclusions did come from the meeting concerning the issue. The first is the creation of an independent system operator and more transparent dispatch procedures. The second is some form of minimum dispatch requirement in PPAs. The third, inevitably, is more lobbying of the CFE, more noise from sponsors and more creative bids ? the normal give-and-take in the creation of a workable power market. n

Project Finance would like to thank:

The roundtable participants: Franklin Minerva, MBIA; Guillermo Espiga, InterGen; Frank Hawkins, TransAlta; Rajesh Sharma, EDC; Fernando Alonso, Mexican Department of Energy; Tony Muoser, Citigroup; John Anderson, John Hancock; Bruno Mejean, Nord/LB; Antonio Souza, Protego Energia.

The discussion's moderator:

Dino Barajas, Milbank Tweed Hadley & McCloy

The day's chairman:

Barry Machlin, Mayer Brown Rowe & Maw

And the event's sponsors:

Mayer Brown Rowe & Maw, EDC and Nord/LB