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Mexico’s energy sector reform creates uncertainty for investors

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Mexico’s energy sector reform creates uncertainty for investors

Mexican President Lopez Obrador recently submitted a constitutional reform bill to increase government control over the energy sector. The proposed reform would allocate to state-owned companies over half of the electricity market and would eliminate requirements for clean energy production. In this Macro Flash Note, Joaquin Thul describes the key aspects of the reform proposal and explains why this increases uncertainty for investors.

Joaquin Thul
Joaquin Thul

The 2013 reform of Mexico’s energy sector opened the market to private investment. This pivotal change increased investment in infrastructure for electricity generation and the development of renewable energy sources. The proportion of total foreign direct investment (FDI) directed to the energy sector increased from 5.4% in 2013 to 20.3% in 2018 (Figure 1). This change favoured the implementation of new technologies and by the end of 2020 over 90% of the country’s 109 electricity generation firms were private.1

This model required energy distribution firms, both private and public, to participate in energy auctions designed to reduce wholesale prices via competition.2 However, private firms have been criticised by President Lopez Obrador since taking office in December 2018 for their alleged rent seeking behaviour.3

Figure 1. FDI in Mexican Energy sector (% of total FDI)

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Source: Mexico’s Ministry of Economics

Last week, President Lopez Obrador submitted a constitutional reform proposal to Congress which would increase government control over the sector, significantly changing how energy is generated and distributed in Mexico. The key aspects of the reform are summarized below.

First, Mexico’s Federal Electricity Commission (CFE) would cease to operate as a state-owned electricity company to become a government division, in line with other Ministries. Since the 2013 energy reform, companies such as CFE or Pemex (the state-owned oil company) competed in their respective markets with other private firms, without any preferential treatment. Under the proposed reform the CFE will become part of the government’s operations and the key energy producer in the country. It is still unclear if these changes will also apply to Pemex.

Second, CFE would generate 54% of the country’s energy, with private companies supplying the remaining 46%. Following the 2013 reform which opened the electricity generation market to private firms, CFE’s market share had fallen to 38%. Analysts anticipate CFE would need to acquire some of the power plants constructed by private firms in the last eight years to meet the new production target. The US Chamber of Commerce has argued this change would represent a violation of the USMCA trade deal agreement, under which governments cannot favour state-owned companies.

Third, the proposed reform would eliminate independent upstream oil and gas regulator Comision Nacional de Hidrocarburos (CNH) and midstream, downstream and electricity regulator Comision Reguladora de Energia (CRE). The regulation of services would fall under the scope of the Secretariat of Energy, a government agency, which would oversee production and regulation of electricity and oil markets.

Fourth, the government would stop issuing new permits for the exploration and mining of lithium. This proposal would give the Mexican government a monopoly on the development of lithium mines, a key mineral in the production of batteries for mobile devices and electric vehicles (EV). Mexico has one of the biggest lithium deposits in the world located in Sonora, a state in the North-West of the country, with a mine estimated to hold proven and probable reserves of 244 million tonnes, (Figure 2). The importance of lithium for batteries and the existing rules for production of vehicles under the USMCA trade agreement, makes the exploitation of lithium resources in Mexico a potentially attractive business for the government.4

Figure 2. Top 10 biggest lithium mines in the world (million tonnes)

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Source: Mining Technology. Data as of September 2021

Finally, the reform aims to eliminate Clean Energy Certificates issued to incentivise the construction of infrastructure for renewable energy. Currently, energy distribution firms are required to have a Clean Energy Certificate per 1 MWh of energy, which are acquired from their suppliers, certifying the use of clean energy sources.5 This incentivises the use of renewable energy, helping to achieve Mexico’s environmental goal of generating 35% of its energy from clean sources by 2024.

Figure 3. Performance of Mexican assets YTD

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Source: Refinitiv and EFGAM

Mexican assets reacted negatively to the proposed reforms, with the yield on the government 10-year bond rising by 900 basis points over the last few days of last month to 7.6%, the highest level since March 2020. Similarly, the 5-year CDS contract on Mexico has sold-off by 2000 basis points since mid-September. Furthermore, the Mexican peso has depreciated against the US dollar by almost 4% over the last week, while domestic equity markets have fallen by over 3.5% over the last month, (Figure 3). Despite this, Mexican stocks are up by almost 16% so far in 2021, one of the strongest markets in Latin America. The close commercial ties with the US have benefited the Mexican economy, which is still expected to growth by over 6% in 2021.

Overall, President Lopez Obrador’s attempt at reforming the constitution to nationalise the country’s energy sector is a risky political move which increases uncertainty. The government needs the support of two thirds of the Upper and Lower houses to pass this reform. However, following the legislative elections in June 2021, Lopez Obrador’s party Morena lost its two-thirds majority in the Lower house.

In all likelihood the reform will be passed with some modifications by Congress as opposition parties will try to reduce the government’s intervention in the sector. More concerning is perhaps the fact that by limiting private sector energy production, the government will continue to crowd out foreign direct investment in the sector. Additionally, the elimination of clean energy certificates would lower incentives to use renewable energy sources, with negative environmental consequences. In the short term, Mexican assets are likely to remain volatile until a solution is reached for the energy sector that gives more certainty to investors.

1 Mexican Energy Agency
2 Energy markets in the United States, Canada and Europe operate in a similar way
3 Rent seeking is defined as the behaviour of an individual or entity seeking to increase their own wealth without creating any benefits or wealth to the society.
4 According to USMCA, 75% of automobile content must be produced within North America.
5 One megawatt hour (MWh) equals 1,000 kilowatts of electricity generated per hour.