Mexico's energy sector is undergoing a profound transformation. Renewable energy operators have entered the market, mostly as power suppliers to the state-owned utility company CFE. It is expected that more and more companies and municipalities will become interested in the benefits afforded by self-generation, and in the positive effects that result from the use of environmental technologies. New financial opportunities have arisen in connection with clean energy projects, which merit the attention of investors.

At the same time, hydrocarbons continue to be the main driving force of energy-related projects in Mexico, and the state-owned company Petróleos Mexicanos (Pemex) is the most important source of income for the federal government. Hydrocarbons will remain in the leading role for years to come, despite the challenges being faced by the industry, which include its role as a contributor to climate change, increased costs and diminished reserves. Upstream operations – especially those related to deep-water – are among the most dynamic areas of the Mexican economy. With thousands of wells to be developed in the next few years and state of the art technology to be applied, the investment prospects in this sector are truly exceptional.

Financing energy projects

The success of an energy project depends to a great extent on a company's ability to obtain sufficient financing. It is therefore essential to find sources of funding, provide satisfactory collateral and understand the local laws governing not only the project itself but also the rights and obligations of borrowers and lenders.

The most common sources of funding include bank loans and lines of credit, as well as capital markets. Additionally, multilateral development banks have created special programmes to encourage different types of projects, including the use and development of environmental technologies.

Renewable and energy-efficient operations may also benefit from innovative instruments such CERs (certified emissions reductions), which are issued to Clean Development Mechanism projects. These are projects that capture or reduce greenhouse gas (GHG) emissions in developing countries. CERs are highly negotiable commodities, whose main purchasers are companies that need to comply with emission reduction thresholds in developed countries. Our firm encourages investors to explore this option when their project entails carbon reductions. Each project is different, of course, and there is no general financing formula that will work for all of them.

Project operators can tap into the capital markets through the issuance of shares, bonds, securitisations and other types of securities that are common in the domestic market. Companies participating in the capital markets should be prepared to comply with local market regulation and to provide periodic financial information to regulators and investors.

Finding lenders in the Mexican market can be challenging, due to the risks inherent in project finance. From the borrower's point of view, the terms and conditions under which local banks are willing to grant credit may be more restrictive than those offered by banks in other markets.

Lenders will require some form of collateral to secure the credit. Regardless of the type of project being financed (upstream oil, power or renewable energy), the collateral requested by the lender could include the company's fixed assets, receivables or pledges of shares. In the case of upstream oil projects built for Pemex, the contractor does not have any rights of ownership or equity participation in the project. Similarly, contractors will not take title to power projects built for Comisión Federal de Electricidad (CFE), the state-owned utility company. The role of these contractors is to build the project, which will be entirely operated and owned by Pemex or CFE. In order to overcome the limitations posed by the current laws governing hydrocarbon exploration, extraction and power generation, it has been necessary to develop special financing mechanisms such as the Proyectos de Inversión Diferida En El Registro del Gasto (PIDIREGAS) and the transfer of project-related rights into Mexican trusts or fideicomisos.

The situation is different for those companies who own power-generating plants: independent power producers and self-supply generators. Independent power producers are those who own generation plants and sell power exclusively to CFE. Self-supply generators are those who develop projects to cover their own power requirements. Wind power companies, for example, may build plants under contract from a client that wishes to cover its own energy needs. They may also develop projects on their own initiative and offer to provide energy to local companies or individuals, who become partners in the project. Ownership of the project, and of valuable equipment such as wind power turbines, represents an attractive collateral for lenders once a project reaches the construction stage. Self-supply generators, however, can encounter substantial problems when funding the planning stages, and can also find it difficult to evidence the long-term viability of their project. Until now, the self-supply generating projects that have come to fruition have been developed by large Mexican companies to meet their own needs.

Contracts for upstream oil and power projects are awarded through public bids. The law specifically allows the assignment of collection rights under these contracts (although all other assignments are forbidden). The assignment must be made in compliance with the applicable Mexican law, and with any requirements set forth in the project contract. The contracting governmental entity must consent to the assignment; this consent is normally granted, provided that the contractor is in compliance with all of its obligations under the project contract. Under most contracts, the governmental entity will not undertake any responsibility towards the assignee, other than to make payments to the indicated account when due, and any such payments are subject to the condition that the contractor must be in compliance with all of its obligations, including technical specifications and timely delivery of the works. The lender's ability to collect from the governmental entity will therefore depend on the contractor's performance of the contract.

All security interests created in favour of lenders must be properly documented and enforceable in Mexico. A lien created under foreign law, and any judgment regarding said lien issued by a foreign court, will be unenforceable in Mexico. Consequently, when the collateral is located in this country, all security interests should be formalised in accordance with Mexican law and subject to the jurisdiction of Mexican courts. It should be borne in mind that the process of the creation of enforceable liens can be more formalistic, and slightly more time consuming, than in some other countries.

Hydrocarbon upstream operations

Stopping and reversing the decline in hydrocarbons production is one of the most serious challenges for President Calderón. At the current rate, the reserves of crude oil would be exhausted in approximately 9.3 years, and those of natural gas in 9.7 years. The Cantarell field, which presently provides more than 50% of national production, is rapidly declining. Although the Burgos Basin will substantially increase the availability of natural gas, the current massive imports are not expected to change in the next few years.

Investment opportunities

By entering into long-term public procurement agreements with corporations worldwide, the goals of the federal government towards 2012 are the following: (i) achieving an oil production of at least 2.5 million barrels per day; (ii) maintaining production of natural gas at around 5 billion cubic feet per day; and (iii) raising the rate of restitution of oil reserves to at least 50%.

As a programme to achieve these goals, Calderón's administration has established the following strategic tasks:

• to strengthen the government's authority regarding the reserves in order to achieve the best possible management of these resources, balancing the extraction of hydrocarbons and the incorporation of reserves;
• to guarantee the sustainable exploration and exploitation of hydrocarbons in order to ensure that the next generations will be able to benefit from the resources of the Mexican subsoil;
• to promote mechanisms for the implementation of high-technology in infrastructure energy projects, as well as research projects;
• to evaluate the applicable legal framework, acknowledging that this is the most effective tool for the development of hydrocarbons production;
• to promote the competitiveness of PEMEX at the international level; and
• to involve the necessary private investment in order to achieve these objectives.

The financial importance of hydrocarbons production is such that 47% of the total federal budget is dedicated to this sector. $73 billion will be dedicated to exploration and production for the 2007 to 2012 period.

Framework and changes under discussion

Oil production is a relevant area in public procurement law, in which a somewhat complicated system of public bids is still the general rule. Investment restrictions and further regulatory obstacles are also heavy burdens to the modern development of the oil and gas sector in Mexico.

In this context, President Calderón and two of the three national political parties have been very active in sponsoring the debate towards a potential reform of the oil industry this year.

Whereas the ruling Partido Acción Nacional (PAN) backs the draft bill presented by the president, the former governing Partido Revolucionario Institucional (PRI) has not only submitted its own – relatively similar – bill but has also positioned itself as the key actor in a rather complex legislative process. The PRI's leverage is based on the fact that, given the composition of the current legislature, the votes of representatives of two national parties are needed in order to pass any of the proposed amendments. In this context, the Partido de la Revolución Democrática (PRD) is clearly opposed to the Executive's proposal.

Draft bills

President Calderón presented a draft bill to congress amending three main pieces of legislation for the Mexican oil industry and proposing a new law creating the Oil Commission. The main goals of the draft bill are the following:

• the use by PEMEX of international corporate government practices;
• to regulate PEMEX's scheme of operation to increase its corporate performance; and
• to strengthen PEMEX's control mechanisms.

The proposed amendments can be summarised as follows.

Nueva Ley Orgánica de PEMEX (new governing law for PEMEX )

This proposal reflects Calderon's intention to provide PEMEX with international corporate government practices, giving it an extensive operational autonomy. If this new law is passed, PEMEX's administrative council would be modified so as to include a commissioner. The consideration contemplated in contracts entered into by PEMEX would have to be paid before the conclusion of the relevant works or services. General public participation would be allowed to finance PEMEX through letters of credit called bonos ciudadanos. PEMEX's management would be allowed to determine the operational structures of the company and decide on the creation of new subsidiary entities.

Ley Reglamentaria del artículo 27 Constitucional en el Ramo Petrolero (Regulatory Law of Constitutional Article 27)

Under this new law, private investment in the industry would be allowed through government-issued licences, including a mechanism for cooperation in the storage, transportation and management of oil products. The new private investment contracts would not grant investors ownership rights over hydrocarbons. Deep-water projects would not allow participating foreign companies to gain in return any of the oil found in them. Even though the draft proposes economic incentives for discoveries, profits or production would not be shared by PEMEX.

Ley de la Comisión Reguladora de Energía (Law of the Energy Regulation Commission)

This Commission would be in charge of fixing first-hand sale prices of oil, gasoline transportation rates and rates for pipeline distribution.

Ley de la Comisión del Petróleo (Oil Commission Law)

The main purpose of this Commission would be to provide technical assistance to the Ministry of Energy. It would also be in charge of finding the most efficient technology for hydrocarbons exploration and exploitation.

The debate over Mexico's oil reform has focused on the extent to which the bill proposed by the president allows for private investment and the possible privatisation of the industry. The federal government has made it clear that although the proposal allows private investment in strategic areas such as the management, storage and transportation of hydrocarbons, PEMEX would maintain its ownership rights over oil. Additionally, the proposed plan would allow PEMEX to enter into service contracts with foreign oil companies without privatising the industry and without amending the Constitution. It must be noted that the Mexican Constitution prohibits the state's oil monopoly from entering into risk-sharing joint ventures with other oil companies.

One of the most important arguments for those who oppose the draft bill is that PEMEX would be left outside of the oil-production chain and would be solely in charge of oil sales, imports and exports.

Although the PRI's proposal is based on the president's draft bill, it is comparatively more restrictive. Some illustrations of this are the following: (i) it substantially limits the application of the so-called incentive contracts, which – in the Executive's bill – would align PEMEX with international upstream industry practice; (ii) instead of limiting federal bureaucracy in the oil and gas sector, it enlarges it by authorising the creation of new agencies that would operate similarly to PEMEX; and (iii) it is essentially opposed to liberalisation in the downstream sector, which is a significant innovation in Calderón's proposal.

The outcome of the lively debate on these reforms is likely to materialise before the end of this year. It is expected that, though the PRD has simply refused to discuss the merits of the drafts submitted by the president/PAN and by the PRI, it will soon take an active role by tabling a third proposal. The result of this democratic exercise is certain to shape the future of the Mexican oil industry and the involvement of foreign participants in its modernisation process.

Renewable energy

Energy generation based solely on fossil fuel combustion entails long-term problems, such as the reduction of reserves and the contribution of these fuels to climate change. Fortunately, Mexico has a vast national potential for energy generation from renewable sources (solar, wind, mini-hydro, geothermic, biomass and biogas), which offers a solution to these problems, and which also makes it possible to supply power in those areas not covered by traditional power generation (as is the case for small rural communities). Renewable energy (RE) provides the means to produce energy in a sustainable manner: human needs are met while preserving the environment, ensuring that these needs will be met not only in the present but also in the indefinite future.

The development of RE in Mexico has been delayed due to a national energy policy based on short-term economic costs criteria, without giving full consideration to long-term supply and price stability, which are ensured by RE. In order to achieve the full development of RE in Mexico, three issues need to be tackled: (a) the creation of a regulatory framework that eliminates barriers and opens the possibility for new projects; (b) the availability of adequate financial mechanisms; and (c) the dedication of resources for technological development.

On the subject of regulatory framework, and regarding power generation in particular, the applicable law (Ley del Servicio Público de Energía Eléctrica) provides that private generation is only allowed in specific cases: (a) for self-supply; (b) to complement productive processes through co-generation; (c) to produce power for CFE; and (d) for export. In this context, the two existing government-owned utility companies have a mandate to purchase power at the lowest possible short-term economic cost. This poses a challenge for the development of RE, which can entail higher costs than conventional energy sources.

In January 2006, the Interconnection Contract for RE Sources model, issued by the Energy Regulation Commission, came into effect. The contract sets forth the terms for calculating and crediting the capacity provided to the power grid by RE projects. A new model contract for the interconnection of small solar sources was issued in July 2007. A favourable framework for the full development of RE is expected to arrive with the passing of the proposed Ley Para el Aprovechamiento de Fuentes Renovables de Energía (Law for the Use of Renewable Energy Sources). Among other things, this new bill contemplates the following:

• the creation of a trust fund that will provide incentives for projects that generate electricity through RE;
• the requirement that payments to private generators of power incorporated into the National Electric System will reflect the operation cost incurred in the operation of the generation projects; and
• the obligation of the National Electric System to accept power from RE sources whenever such power is produced.

The project is under discussion in the legislature, and there is hope that it will be passed soon. In the meantime, investors can obtain financial aid for RE projects from different sources, including:

• the Infrastructure Investment Fund of Banobras;
• incentives for generation, such as those provided by the Global Environmental Facility, the UNDP and the World Bank;
• CERs issued in accordance with the regulations of the Clean Development Mechanism of the Kyoto Protocol;
• VERs (Voluntary Emissions Reductions) issued under voluntary schemes for the reduction of GHGs; and
• fiscal incentives: the Income Tax Law has an accelerated depreciation rate of 100% in a single tax year for investments in machinery and equipment for RE generation.

The Mexican government is planning to increase power generation through renewable resources. According to the National Infrastructure Programme, 25% of the country's electricity should be generated by RE, including hydroelectrics, by 2012. A substantial number of projects will need to be developed in order to achieve these goals, meaning an unprecedented opportunity for investors.

Author biographies

David Enriquez Goodrich Riquelme y Asociados David Enríquez is a partner in the maritime, offshore oil and gas law practice group of Goodrich Riquelme y Asociados. He is the author of various books and articles on maritime commercial law, oil and gas law and international economic law published by Foreign Affairs, Editorial Porrúa, Oxford University Press and UNAM. David has been the Mexican representative before seven international organisations on maritime affairs, including the International Maritime Organisation (2004 to 2005). David graduated from Universidad Panamericana in Guadalajara. He holds an LLM with specialisation in maritime law from the European Institute of Maritime Studies in Gijon, Spain, an LLM with specialisation in maritime law from Southampton University, a PhD/SJD in maritime law from Universidad Panamericana and a diploma in international economic policy from the London School of Economics. David is a national research fellow of the National Researcher System (CONACYT). Email: denriquez@goodrichriquelme.com Eugenia Gonzalez-Rivas Goodrich Riquelme y Asociados Eugenia González is a partner in the transactional and finance practice group of Goodrich Riquelme y Asociados. Eugenia's practice focuses on financings, mergers and acquisitions and general commercial and corporate matters. She has experience representing equipment lenders, suppliers and borrowers in complex secured transactions, financed purchases of equipment and equity investments. At the beginning of her career, Eugenia was part of the team of lawyers at Goodrich Riquelme that represented Gaz de France in the privatisation process of natural gas distribution operations in Mexico. Last year she advised two of the investors in the leveraged acquisition that represented the largest M&A transaction in the Mexican housing industry. Eugenia graduated from Escuela Libre de Derecho in Mexico City (1996) and received an LLM from Harvard Law School (2000). She is admitted to practice in Mexico and New York. Eugenia is the author of Strategies for Drafting International Contracts, published by Editorial Porrúa (2003). In 2006, she was included in Latin Lawyer Magazine's listing of the 40 leading female lawyers in Latin America. Email: egonzalez@goodrichriquelme.com Gabriela González-Merla Laguna Goodrich Riquelme y Asociados Gabriela González-Merla heads the European office of Goodrich Riquelme y Asociados, located in Paris. She is in charge of the climate change and trading emissions area of the firm. Gabriela has over 10 years experience in the area of environment and energy, advising clients, among other things, on the implementation of the Clean Development Mechanism (CDM) of the Kyoto Protocol in Mexico and Latin America. She acted as counsel for the approval by the Mexican authorities of the first programmatic CDM in Mexico and has advised the Mexican government on CDM implementation since 2003. As an environmental energy legal specialist, Gabriela has been invited to give presentations on CDMs at seminars conducted in Madrid, Paris, Washington DC, Houston and Mexico, and has participated as a specialist in a CDM summit organised by the World Bank in Berlin. She has published various articles regarding climate change and the CDM in international reviews. Gabriela graduated from the Escuela Libre de Derecho (1998) and holds an LLM in environmental law from the London School of Economic and Political Science (2001). She was the recipient of a scholarship granted by the German Federal Ministry of Education and Research for a course on climate change at the Research Centre Jülich, Germany (2004). Gabriela also holds a diploma in environmental law and policy in Mexico from Universidad Iberoamericana and one in Mexican energy law from ITAM. Email: gmerla@goodrichriquelme.com