Changes in the Generation Dispatch Criterion in Mexico

INSTITUTE OF THE AMERICAS P O L I C Y B R I E F Changes in t he Generation Dispatch C riterion in Mexico: A SUMMARY OF DIRECT IMPACTS

Francisco X. Salazar Non-Resident Fellow Institute of the Americas

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

Amendments to Mexico’s Electric Industry Law, signed into law on March 9, 2021, have generated a series of debates and, perhaps most importantly, resulted in proceedings in Mexico’s Judiciary surrounding the constitutionality of the legislation. Legal challenges have been set forth by both industry and legislators of the opposition. Beyond the key question and debate of the law’s constitutionality, the legislation will have significant effects on the economy and the environment that bear noting. For starters, the amendments change the generation dispatch criteria which stands out for its short run impacts on the cost of supply for regulated users and the increase in Green House Gas (GHG) emissions. This Policy Brief will detail the impacts of the power sector legislation based upon the results of an analysis carried out for Mexico’s Business Coordinating Council (CCE by its acronym in Spanish). The change in the generation dispatch is the result of the introduction of contracts with physical delivery commitments, instead of financial contracts, as the mechanism to provide energy to CFE Basic Supply. Previously established market rules and regulations clearly afford CFE Basic Supply the role as the only regulated load serving entity (LSE) operating in the market. The clear impact is a departure from the criteria of using minimum variable cost to construct the supply curve in the market. Indeed, such a substitution, along with a provision that states that electricity, power and related services should be offered to the wholesale market based on unit production costs, but guaranteeing physical contracts in the first instance only need be viewed for the discriminatory elements at their core. Considering that physical contracts can only be signed with plants owned by CFE Gencos this implies that these will displace and discriminate against what are more efficient privately operated power plants in the generation dispatch. Under the minimum cost dispatch, available generation plants are sorted from lowest to highest variable costs for each hour of the day at each node. The last generator to meet the total demand at the corresponding hour and node sets the locational marginal price (LMP). Figure 1 illustrates the change and its results.

INSTITUE OF THE AMERICAS | POLICY BRIEFING

1

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

Figure 1. Illustration of the change in dispatch

 Under a minimum cost dispatch, the merit order to generate implies an efficient allocation to supply all demand, both for basic service users and the rest of the consumers.

 The new dispatch order implies that CFE plants with higher variable costs displace more efficient private plants.

 Change is limited by basic service demand and CFE existing contracts.

Figure 2. Illustration of the change in dispatch Under the new dispatch order, the generation of plants with physical contracts is guaranteed, independently of their variable costs, displacing more efficient plants. See Figure 2.

INSTITUE OF THE AMERICAS | POLICY BRIEFING

2

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

To be fair, at this stage the degree to which more efficient plants will be replaced by less efficient ones is not perfectly clear. But what is clear is the desired dispatch order set forth by President Lopez Obrador’s effort: 1. CFE hydro plants; 2. other CFE plants; 3. Wind and solar private plants and 4. Natural Gas Combined Cycle (NGCC) privately operated plants. Nevertheless, this specific criterion was not part of the legislative package and thus legal reform itself. On the other hand, applying this construct literally would imply paying double for energy that is already contracted with private generators under a take or pay scheme (such as from renewable auctions, for instance). Given the slight variation of the exact legislation and overarching rhetoric from the Lopez Obrador administration, our analysis simulated two scenarios to estimate the implications of changing the dispatch order. A “high” scenario assumed a greater reliance on CFE plants based on fuel oil, although maintaining the dispatch of energy from auctions. The “low” scenario assumed a greater participation of NGCC from Independent Power Producers (IPPs) but with fuel oil consumption remaining still higher than in the absence of the reform. An extreme scenario in which absolutely all CFE plants are dispatched before the renewable plants from IPPs or renewable auctions was discarded due to its very high costs and unlikely eventuality. Figure 3 illustrates what happens because of the change in the dispatch order in any of the two scenarios. CFE inefficient plants with physical contracts to supply the basic service demand are “forced” to generate displacing more efficient plants that would have been dispatched otherwise (under the minimum cost criterion). As a result, the last plant to satisfy the total demand –which includes non-basic service users–is one with a lower variable cost that the one that would have been dispatched under normal conditions. This change has several implications. In the first place, there is a cost overrun due to “forced” generation by inefficient CFE plants. Physical contracts imply that these users will have to pay a higher price than the LMP in the market. At the same time, however, the new LMP is lower than it would have been under the normal dispatch. This in turn means a lower marginal rent for all efficient generators being dispatched but a benefit for qualified service users.

INSTITUE OF THE AMERICAS | POLICY BRIEFING

3

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

Figure 3. General implications of changing the dispatch order

 In order to satisfy the same demand CFE’s more inefficient plants are forced to generate.

 Private efficient generators are displaced despite they have lower variable costs.

 As a result, CFE Basic Service will face a cost overrun while the wholesale market faces a reduction in LMPs, which will incentivize a migration towards the qualified service.

INSTITUE OF THE AMERICAS | POLICY BRIEFING

4

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

By comparing the simulation of the two scenarios with the no-reform scenario, the analysis produced the following specific results 1 : 1. A loss in the efficiency of the thermal fleet used to supply the basic service demand in a range between approximately 9 and 14% (see charts 1 & 2). This is the result of substituting efficient NGCC plants from IPPs with old conventional thermal plants using fuel oil to satisfy the basic service demand. 2. A significant cost overrun in energy sold to CFE Basic Supply, ranging from US$2,000/year to US$3,000/year; these substantial cost overruns are shown in the blue bars in charts 3 & 4 below for both the “high” and “low” scenarios. 3. An increase in energy costs per MWh for basic supply in an average range of 10.8 - 16.4% compared to the values registered in 2020; these increased energy costs are reflected by the orange lines in charts 1 & 2 for both the “high” and “low” scenarios. 4. An increase in CO 2 emissions that goes from 5.15% to 13.34% between 2022 and 2026 (in addition to a higher relative increase in other emissions like SO 2 , NO x and particles due to the increase in consumption of fuel oil). This is the result of both using a less efficient thermal plants fleet and fuel oil instead of natural gas.

1 Simulations were run by GME ( Mercados Energéticos ) using a SDDP tool.

INSTITUE OF THE AMERICAS | POLICY BRIEFING

5

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

Charts 1 & 2. Efficiency loss in the thermal plant fleet to serve Basic Service demand

INSTITUE OF THE AMERICAS | POLICY BRIEFING

6

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

Charts 3 & 4. Cost overruns in million dollars and in USD/MWh for both scenarios

INSTITUE OF THE AMERICAS | POLICY BRIEFING

7

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

Chart 3. CO 2 emissions

Low scenario

High scenario

No reform Historic trend

180.0

170.0

160.0

150.0

Million tons

140.0

130.0

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

In regard to the cost overrun for CFE Basic Service, this will have to be borne by the users or by the taxpayers, to the extent that the fiscal resources have already been granted to subsidized rates increases. Another entity that could absorb part of the costs would be PEMEX if it sells fuel oil with generous discounts to CFE. Most likely, however, the increase will have to be absorbed by industrial or

INSTITUE OF THE AMERICAS | POLICY BRIEFING

8

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

commercial users that cannot migrate to the non-regulated alternative (qualified service), particularly the small and medium-sized businesses, many of whom have operated in good faith under the market rules and regulations. Indeed, it appears evident that a strong incentive to migrate to qualified service is an unintended consequence of the proposed power market reform. Higher regulated rates for basic service will promote that large consumers will seek to be supplied by non- regulated LSEs (qualified suppliers or generators) at lower prices. As a result, in an unfortunate vicious circle, electricity rates will increase even more due to the fixed costs of basic service, which will have to be covered by a lower volume of energy sales. Beyond the cost and supply issues detailed, the reform’s eventual impact on the environment is noteworthy. At a time of global attention on climate action and reducing GHG emissions, Mexico’s power reforms point the country in a different direction. Chart 3 shows the increase in CO 2 emissions. Clearly, the change in dispatch order implies a major step backward for Mexico’s CO2 emission levels that were being greatly reduced by an increase in generation by both renewables and NGCCs. Chart 3 does not the other pollutants and emissions such as SO 2 , NO x or particles which will increase due to the fact burning fuel oil for power generation emits more of all of these pollutants. Naturally, the other implication of the change in the dispatch is the fact that Mexico will not be able to meet its clean energy goals, which even before the reform was introduced was going to be difficult to achieve. Conclusion The change in the electricity dispatch derived from the amendments to Mexico’s Electric Industry Law will have widespread economic consequences. Indeed, the impacts could affect users of the Basic Supply, the private sector, CFE itself and public finances, to the extent that the increase in the cost of Basic Supply, estimated between 2000-3000 MUSD/year, is offset by subsidies. If the government does not bear costs through subsidies, consumers will be affected by increases in electricity tariffs resulting from an increase between 11% and 16% in the cost of energy. This increase will likely be borne by small and medium-sized businesses that cannot migrate to the “qualified service” and that will not be covered by any subsidy. At the same time, CFE will also be affected, as

INSTITUE OF THE AMERICAS | POLICY BRIEFING

9

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

higher tariffs will promote consumer migration, mainly from large users. As a result, in a vicious circle, the electricity tariffs will be further increased by the fixed costs of the basic service which must be covered by a lower volume of energy sales. However, and regardless of who assumes the cost, many other people will also suffer the consequences from increased environmental pollution and higher GHG emissions, not to mention that the country will not meet its clean energy goals. About the Institute of the Americas Established in 1981, the Institute of the Americas is an independent, inter-American institution devoted to encouraging economic and social reform in the Americas, enhancing private sector collaboration and communication and strengthening political and economic relations between Latin America, the Caribbean, the United States and Canada. Since 1992, the Institute’s Energy & Sustainability program has played a crucial thought-leadership role in shaping policy discourse and informing policymakers and investors on the most important trends in the energy sector. About the Author Francisco Xavier Salazar Diez de Sollano is a partner at Gadex, Enix and Trust Mexico. Gadex is a consulting firm specialized in the natural gas market in Mexico, Enix is devoted to energy regulation while Trust Mexico analyses socio political risks for infrastructure projects in the country.

Francisco is also the Coordinator of the International Confederation of Regulators (ICER).

In 2016, he was appointed as the first “Institute of the Americas Regional Energy Integration Non-Resident Fellow” and as executive fellow at the School of Public Policy of the University of Calgary.

INSTITUE OF THE AMERICAS | POLICY BRIEFING

10

CHANGES IN THE GENERATION DISPATCH CRITERION IN MEXICO: A SUMMARY OF DIRECT IMPACTS

During 2015-2017, he was Chair of the Mexican Chapter of the World Energy Council (WEC). In 2017 he became a member of COMEXI, the Mexican Council on Foreign Relations From 2005 to 2015, he served as Chairman of the Energy Regulatory Commission (CRE) time during which he was an active promoter of energy reform in Mexico. During 2011-2015 he chaired the Ibero-American Energy Regulators Association (ARIAE). Prior to being a regulator, he was a congressman for two terms. In Congress he served as a Chairman of the Energy Committee at the Chamber of Deputies.

At the beginning of his professional career, he also was involved in the Chemical Sector.

Mr. Salazar holds an MSc in Public Financial Policy from the London School of Economics and Political Science, a BSc in Chemical Engineering from the Autonomous University of San Luis Potosi, and Diploma studies in Law and Economics from other universities. He has taught courses on Public Finance and Monetary Economics at local universities in San Luis Potosi and written on the use of economic instruments in environmental public policy, as well as on energy policy and regulation. Mr. Salazar has also participated as member of editorial boards from major newspapers and business magazines in Mexico.

INSTITUE OF THE AMERICAS | POLICY BRIEFING

11