Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Francisco J. Barnés de Castro Francisco Salazar Diez de Sollano

Foreword

We are pleased to present “Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE) „ a timely report and analysis by Francisco Xavier Salazar and Francisco Barnes, Mexican electricity market and regulatory experts. Francisco Salazar, a Non-Resident Fellow at the Institute of the Americas is former Chairman of Mexico’s Energy Regulatory Commission (CRE). Francisco Barnes is a former CRE Commissioner, Deputy Secretary of Energy in Mexico and former President of the National Autonomous University of Mexico (UNAM). Since the Lopez Obrador administration took office in December 2018, there have been a series of decrees and interventions in Mexico’s energy sector. Perhaps most pronounced have been efforts aimed at the country’s liberalized power market and clean energy deployment. The administration has set forth specific criticisms of the prevailing market structure, particularly with regards to Mexico’s Federal Electricity Commission (Comisión Federal de Electricidad or CFE). Specifically, the Lopez Obrador administration and the director general of CFE argue that the 2013 energy reform and electric sector industry law and its power market elements have obligated CFE to acquire clean energy and the corresponding renewable energy credits (CELs in the parlance of the Mexican market). This structure and the market- based mechanism of long-term auctions, in their view, have caused CFE to incur additional losses. Amendments to Mexico’s Electric Power Industry Act, signed into law on March 9, 2021, resulted in judicial proceedings surrounding the constitutionality of the legislation. Legal challenges have been set forth by both industry and legislators of the opposition. The debate of the law’s constitutionality has in turn led to a new proposal from the government. In September, the administration sent an initiative to Congress aimed at amending the constitution and completely restructuring the electric sector and market. Beyond the constitutional and legal debate, we believe it is important to fully comprehend the underlying economic premise for restructuring the electric sector and redefining the role and obligations of CFE. Moreover, as the world meets in Glasgow for the COP26 United Nations Climate Summit, it is also crucial to understand emission and climate impacts. We commend our authors for their rigorous analysis in the following pages. The report contains a fact-based economic study of current policies and regulations and provides an assessment of the impacts both in terms of CFE’s financial outlook and emissions profile. The report also offers a series of clear-cut conclusions and recommendations. As the report details, the purchase of clean energy through the auctions in order to obtain the corresponding CEL certificates has allowed CFE to avoid incurring variable generation costs at its thermoelectric plants, which would have been far higher than the cost of purchasing the clean energy. Indeed, the amount saved can be estimated based on fossil fuel use avoided and cost of the emissions that would have been generated, as we review in detail. This is a particularly contentious moment for the world in terms of energy security, managing climate action, but also defining the most appropriate and sustainable course as a country for its citizens. Those are clearly sovereign debates and decisions. But we also strongly believe that the debate deserves to be an informed one and thus demands fact- based analysis of these critical topics. We believe this paper meets that objective and will serve to enhance the discourse in Mexico, but also more broadly, in North America.

Richard Kiy President & CEO

Jeremy M. Martin Vice President, Energy & Sustainability

Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Introduction

Ever since Mexico’s Electric Power Industry Act (Ley de la Industria Eléctrica, or LIE) went into effect in 2014, the “green wheeling charge” ( porteo verde ) mechanism that had been used by the government to incentivize the development of clean energy by emulating the internalization of power generation externalities is allowed only for plants that had existing legacy interconnection agreements, and then only until these agreements expire. Under the amended LIE, all new clean-energy power plants and expansions of existing plants will be awarded Clean Energy Certificates (Certificados de Energías Limpias or CEL) for each megawatt hour (MWh) of clean energy produced and delivered into the grid. The Federal Electricity Commission (Comisión Federal de Electricidad or CFE) has argued that the LIE, by requiring CFE to obtain clean energy and the corresponding CEL certificates through the long-term power auction mechanism, has forced it to incur additional losses. However, the analysis that follows shows that the purchase of clean energy through auctions, which CFE used to obtain the corresponding CEL certificates, has allowed the commission to avoid variable generation costs at its thermoelectric plants. These generation costs would have been far higher than the cost of purchasing the clean energy. As explained in the following sections, the amount saved can be estimated based on fossil fuel use avoided and cost of the emissions that would have been generated. To calculate these estimates, this paper uses the European market (the deepest and most liquid) for carbon dioxide (CO 2 ), and the historical cost in the United States in the case of sulfur dioxide (SO 2 ).

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Net Thermal Efficiency and Net Heat Rate The development of new wind and solar power plants reduces the use of fossil fuels for generating electricity. The extent of the reduction depends on the type of fossil fuel power plant supply that would be avoided by having clean energy available. Table 1 shows the thermal efficiency of power plants that could be potentially replaced. Although CFE’s most modern plants have higher efficiencies, the efficiencies selected for this analysis are representative of those with a higher likelihood of being replaced based in the economic dispatch process.

Table 1. Net Thermal Efficiency (High Heating Value)

Technology

Efficiency

Combined Cycle (new) Combined Cycle (average)

58% 51% 35% 34% 40%

Steam Thermal

Coal

Internal Combustion

Gas Turbine 33% Note 1. Net thermal efficiency is defined based on the fuel’s high heating value. Note 2. Turbogas’s most modern plants have higher efficiencies.

Note 3. Although Petacalco power plant has a seventh, supercritical unit with 42% thermal efficiency, this analysis considers only the average efficiencies of the six older units and the other two coal plants, (Río Escondido and Carbon II). This thermal efficiency can in turn be used to calculate the net heat rate per MWh generated, as shown in Table 2. Table 2. Net Heat Rate (Low Heating Value) Technology Natural Gas (GJ/MWh) Diesel (GJ/MWh) Fuel Oil (GJ/MWh) Coal (GJ/MWh) Combined Cycle (58%) 7.084 Combined Cycle (51%) 8.056 7.779 Steam Thermal 11.738 11.357 Coal 11.472 Internal Combustion 9.937 Gas Turbine 12.450 12.022 GJ = gigajoules Note 1. Net heat rate is expressed based on the fuel’s low heating value Note 2. Net heat rate is determined from the net thermal efficiency, the relationship between the low heating value and the high heating value for each fuel, and assuming that 3% of the energy is self-consumed.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Competitiveness of Thermal Power Plants The economic competitiveness of each thermal power plant in the economic dispatch is based on their variable cost per MWh generated and supplied to the grid. This factor can be obtained by adding the cost of fuel per MWh supplied to the grid and the variable operation and maintenance (O&M) costs. The cost of fuel per MWh supplied to the grid is in turn obtained by multiplying the net heat rate by the fuel cost per GJ. Table 3 presents the current fuel prices for the national electricity grid at the time of the analysis.

Table 3. Fuel Costs

Cost (USD/GJ)

Fuel

Natural Gas

3.74

Diesel

33.32 10.87

Fuel Oil

Coal (Domestic) Coal (Imported)

2.54 4.01

USD = U.S. dollars; MXP = Mexican pesos Sources: Prices of natural gas, diesel, and fuel oil: Secretaría de Energia (SENER), Prontuario Estadístico [Mexican Ministry of Energy. Statistical Compendium] June 2021. Price of domestic coal: Arturo Solís, “CFE gastará 2,000 millones de pesos en carbón para generar electricidad,” Forbes Mexico, July 14, 2020, https://www.forbes.com.mx/negocios-cfe-carbon- electricidad/. Price of imported coal: Diana Nava, “Glencore gana contrato por 520 mdd para venderle carbón a la CFE,” El Financiero, April 9, 2019, https://www.elfinanciero.com.mx/economia/glencore-gana-contrato-por-520- mdd-para-venderle-carbon-a-la-cfe/. Table 4 and Figure 1 show variable costs of CFE thermal power plants whose dispatch could be avoided through clean energy generation. Table 4. Variable Generation Cost Technology Fuel Fuel Cost (USD/MWh) O&M (USD/MWh) Variable Cost (USD/MWh)

(58%) (51%) (51%)

Natural Gas Natural Gas

26.49 30.13 259.20 43.90 123.45 29.12 46.03 108.02 46.56 400.59

3.40 3.40 3.40 3.50 3.50 3.60 3.60 8.30 4.80 4.80

29.89 33.53 262.60 47.40 126.95 32.72 49.63 116.32

Combined Cycle

Diesel

Natural Gas

Fuel Oil

Conventional Thermal (steam open cycle)

Coal (Domestic) Coal (Imported)

Internal Combustion

Fuel Oil

Natural Gas

51.36

Gas Turbine

Diesel 405.39 O&M variable cost: Centro Nacional de Control de Energía (CENACE), Informe de la Tecnología de Generación de Referencia [National Energy Control Center; Generation Technology Benchmark Report]; 2020, and Comisión Reguladora de Energía de Colombia, Costos de Tecnologías de Generación [Colombia Energy Regulatory Commission; Generation Technology Costs]; 2020.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Figure 1. Variable Generation Cost

Once the variable costs of thermal power plants have been estimated, it is key to correlate them with the electricity rates currently in effect for medium- and high-voltage transmission. These rates, known as Medium Voltage Hourly High-Demand rate (Gran demanda de media tensión horaria; GDMTH) and Industrial Demand Subtransmission rate (Demanda industrial en subtransmisión; DIST), are the tariff rates paid by the vast majority of CFE customers. Table 5 shows these CFE rates for the month of June in Mexico’s Bajio region in U.S. dollars per MWh, while Figure 2 compares current tariff rates to variable costs that could be avoided through the use of available clean energy. Table 5. CFE Rates CFE Rates GDMTH DIST $/kWh USD/MWh $/kWh USD/MWh Base 0.9580 45.62 0.9940 47.33 Intermediate 1.6907 80.51 1.6162 76.96 Peak 1.9243 91.63 1.9145 91.17 Note 1. CFE: June 2021 rates for the Bajio region (Salamanca, Gto.) Note 2. Rates converted to U.S. dollars using an exchange rate of MXP$21/US$1.

As shown in Figure 2, the variable cost for fuel oil–fired power plants is unrecoverable, even under peak rates.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Figure 2. Variable Generation Cost vs GDMTH Rates (Bajío)

Variable costs for diesel-fired plants clearly are much higher and cause huge losses to CFE every time they have to be brought into operation. Such is the case of the Yucatán Peninsula, where natural gas supply is severely limited and thus fuel oil and diesel- fired plants set the marginal price. A similar situation affects costs in Baja California Sur, which is not connected to the national grid and only recently has begun to receive natural gas. In these two regions, CFE could enjoy significant savings by injecting clean electricity to the grid—whether from self- supply partnerships with permits granted before LIE went into effect, or from the new plants installed to supply clean energy for CFE, purchased through long-term

auctions. Figures 3 and 4 show the relative savings in Yucatán and Baja California Sur.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Figure 3. Variable Generation Cost vs GDMTH Rates (Yucatán)

Figure 4. Variable Generation Cost vs GDMTH Rates (Baja California Sur)

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Savings to CFE from Clean Energy Purchased at Long- Term Auctions In order to protect basic service customers and ensure that services are provided at the lowest price possible, LIE requires basic service providers to purchase their electricity and obtain their CEL certificates through public auctions hosted by Mexico’s National Energy Control Center (Centro Nacional de Control de Energía; CENACE) and open to both public and private generators on equal basis. During the previous administration, CENACE held three long-term auctions for purchasing clean energy (mostly wind and solar) and obtaining the corresponding CEL certificates, with extremely favorable results for CFE. Table 6 presents the average prices for the three auctions. Table 6. Clean Energy Cost from Long-Term Auctions

Energy cost + CEL (USD/MWh)

Long-Term Auction (LTA)

1st LTA 2nd LTA 3rd LTA

47.78 33.47 20.57

Source: CENACE communications The savings from contracted clean energies that CFE gained from these auctions- are evident when the price CFE has to pay for the clean energy is compared to the variable costs of thermal plants that would otherwise enter into service, as the data in Figure 5 indicate. In Figure 5, the four columns furthest to the right are the technologies and fuels being used at the Baja California Sur plants and some of the Yucatán plants, which were the focus of many clean energy offerings, particularly during the first auction. Figure 5. Variable Generation Cost of Thermal Plants vs. Clean Energy Cost

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

The figure quantifies the savings per MWh that CFE has when avoiding bringing thermal plants into service, thanks to the availability of clean energy contracted through long-term auctions. From the above comparison, it can be concluded that, in areas of Mexico that are fully interconnected, depending on the type of power plant replaced: • The renewable energy contracted during the first auction represents a savings to CFE of: o 62% vs. the variable cost of fuel oil–fired steam power plants; o 4% vs. the variable cost of Petacalco coal-fired plant, that operate with imported coal. • The renewable energy contracted during the second auction represents a savings of: o 74% vs. the variable cost of fuel oil–fired steam plants; o 33% vs. the variable cost of Petacalco coal-fired power plant; and o 29% vs. the variable cost of natural gas–fired steam plants. • The renewable energy contracted during the third auction represents a savings of: o 84% vs. the variable cost of fuel oil–fired steam power plants; o 59% vs. the variable cost of Petacalco coal-fired plant; o 57% vs. the variable cost of natural gas–fired steam plants; and o 37% vs. the variable cost of the two coal-fired power plants that use domestic coal.

Figure 6. Net Savings from Clean Energy Long-Term Auctions

Note that these savings do not include the market value of the CEL certificates that come with the

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

contracted clean electricity. This is relevant because, even in the few cases where there are no net savings, the incremental cost is still lower than the cost of purchasing the corresponding CEL certificate in the market. Avoided Emissions In addition to the averted fuel and O&M costs, a full comparison requires an estimate of the CO 2 and SO 2 emissions offset by the use of renewable sources for power generation. They can be calculated based on the net thermal efficiency of the power plant no longer operated, the fuel used by said plant, and the corresponding emission factors for each fuel, shown in Table 7.

Table 7. Emission Factors

Coal (Domestic)

Coal (Imported)

Emission Factor

Natural Gas

Diesel

Fuel Oil

kg CO 2 /GJ (1) kg CH 4 /GJ (1) kg N 2 O/GJ (1) kg CO 2 e/GJ (2) kg SO 2 /GJ (3)

56.10

74.10

77.40

94.60

94.60

0.0010 0.0001

0.0030 0.0006

0.0030 0.0006

0.0010 0.0015

0.0010 0.0015

56.15

74.35

77.65

95.07

95.07

0.0232

0.0231

1.95

1.03

0.76

CH 4 = methane; N 2 O = nitrous oxide; CO 2 e = carbon dioxide equivalent Note 1. See Federal Register 03/09/2015 for the technical details and formula for methodologies used to calculate greenhouse gas/compound emissions. Note 2. Using an equivalency factor of 25 for CH4 and of 298 for N2O (Intergovernmental Panel on Climate Change). Note 3. Determined based on heating value and % of sulfur (S) content Figures 7 and 8 below show the CO 2 e (CO 2 equivalent of CO 2 , CH 4 and N 2 O emissions) and SO 2 emission values for the different types of power plants, expressed in tons per MWh. Figure 7. CO2e Emissions

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Figure 8. SO2 Emissions

Figure 9 and Figure 10 show the average nitrogen oxides (NO X ) and particulate matter emissions from 1990 to 2002, as reported by CFE to the Ministry of Energy (SENER).

Figure 9. NOx Emissions

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Figure 10. Particulate Matter Emissions

These graphs further illustrate the benefits of using cleaner fuels, such as natural gas, for power generation whenever the use of fossil fuels cannot be avoided. It is clear that fuel oil– and coal-fired power plants have the largest SO 2 , NO x , and particulate matter emissions, which are the most harmful to human health. Value of Avoided CO 2 Emissions The market value of the avoided emissions can be estimated with the information available from the emissions trading markets in place in several countries for different gases. On January 1, 2005, the European Union launched the most ambitious CO 2 emissions trading market to date under Directive 2003/87/CE. It covers all 27 member states for CO 2 emissions generated by the following activities: • Thermal power plants; • Cogeneration; and • Combustion installations with a rated thermal input exceeding 20 MW Emissions allowance trading, also known as a cap-and-trade system, is a market instrument that creates a financial incentive or disincentive to encourage industrial plants to collectively reduce their production of pollution-causing emissions.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Typically, a cap-and-trade system involves the following basic elements: 1. Emissions Permit: A permit granted to each covered facility, allowing it to emit a particular gas into the air. Permits cannot be bought or sold. 2. Emissions Allowance: Allowance allocated to a covered facility to emit a specific volume of gases into the air. The emission allowance is transferrable; that is, it can be traded. 3. Emissions Cap: The sum of the total emissions allowances placed “in circulation.” The cap is set below the current emission trends. It establishes the desired environmental goal and gives financial value to the allowances, since they will be in short supply. 4. Allowance Allocation: The specific mechanism used for distributing emission allowances among covered facilities (free distribution, auctioning, etc.). 5. Compliance: Surrendered allowances equal to a covered facility’s actual air emissions. Each individual facility has the obligation to cover all their emissions with allowances. 6. Emissions Tracking: The method used to track emissions from covered facilities in order to know the number of allowances a facility will be required to surrender. 7. Allowance Registry: An electronic log that keeps an account of emissions allowances in circulation: total granted, who received them initially, who traded them and who holds them at the time of compliance . The European Union Emissions Trading System covers more than 10,000 facilities. It has saved more than 2 billion tons of CO 2 , and covers about 45% of the European Union’s greenhouse gas emissions. CO 2 emission allowances are publicly traded and may be freely purchased in the market. Figure 11 shows the pricing trends for the past two years.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Figure 11. Price of CO2 Emission Allowances

Considering that the average price paid in the European market in July 2021 was €54 per avoided ton of CO 2 emissions, equivalent to US$64/ton of CO 2 at the average euro/dollar exchange rate for that month, the value of the avoided CO 2 emissions per MWh generated by clean energy sources can be estimated based on which thermal plant would not service the grid and the corresponding level of emissions per MWH for that plant. The results are shown in Figure 12.

Figure 12. Estimated Value of Avoided CO2e Emissions

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Value of Avoided SO 2 Emissions The value of avoided SO 2 emissions can be estimated through an exercise similar to that presented in the previous section. It has been three decades since the Clean Air Act Amendments (CAAA) of 1990 were signed into law in the United States, setting in motion a grand market-based environmental policy experiment. In the late 1980s, countries around the world became concerned by acid rain, a phenomenon caused by SO 2 and, to a lesser extent, NO x reacting in the atmosphere to form sulfuric and nitric acid. Acid rain damages forests and aquatic ecosystems and contributes to the formation of fine particulate matter that is extremely harmful to health. In the United States, the combustion gases generated by coal-fired power plants were at the time the largest source of SO 2 emissions and a significant source of NO x emissions. 1 In response to these and other concerns, the U.S. Congress passed, and then-President George H. W. Bush signed, the CAAA into law. Title IV of said law created a trailblazing SO 2 Allowance Trading System. Though the concept of mandating a cap on emissions and providing an emissions allowance trading market seems commonplace today, back in 1990 this market-based approach to regulating environmental emissions was untested. By the end of the 20th century, the SO 2 Allowance Trading System was considered so innovative and successful that it led to a series of new policies, both in the United States and abroad, for addressing a range of environmental challenges, included the threat of global climate change. The most notable of these innovations was the previously mentioned European Union Emissions Trading System, adopted in 2003. Figure 13 shows the evolution of emission allowance prices for the duration of the program (1994–2010).

Figure 13. SO2 Emission Allowance Pricing (2015 USD per ton)

For the purposes of this study, the assumed value of avoided SO 2 emissions per MWh was the average price of US$150/ton of SO 2 (in 1995 dollars) that prevailed in the US market for the 1994–2004 period, equivalent to $260/ton in current dollars. The results are shown in Figure 14.

1 Robert N. Stavins and Richard Schmalensee, “The SO 2 Allowance Trading System: The Ironic History of a Grand Policy Experiment,” Harvard Kennedy School, 2012. https://www.hks.harvard.edu/publications/so2-allowance-trading-system-ironic-history-grand- policy-experiment

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Figure 14. Estimated Value of Avoided SO2 Emissions

Equivalent Generation Costs To plan and define public policies, and to perform a cost-benefit analysis of potential measures to reduce harmful emissions, equivalent generation costs need to be calculated. This paper looks specifically at the variable equivalent generation costs, defined here as the variable generation cost for fossil-fuel power plants plus the cost of purchasing emissions allowances in an efficient market in order to offset the generated emissions. Based on the above definition, Figure 15 presents the equivalent variable generation costs for the types of fossil fuel-fired power plants presented in the previous sections, along with a comparison to the prices paid by CFE for the clean energy contracted through long-term auctions.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Figure 15. Equivalent Variable Generation Cost

When the equivalent variable generation cost for thermal power plants is compared to the cost of clean energy contracted through auction, the net benefit of clean energy sources becomes even clearer. Clean Energy Commitments Mexico’s Energy Transition Law sets the following mandatory goals for clean energy sources in the power generation portfolio: • 2018 25% • 2021 30% • 2024 35% These same goals are part of the voluntary commitments made by Mexico under the Paris Accord. However, Mexico is far from achieving these goals.

Figure 16 shows the evolution of power generation in recent years.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Figure 16. Recent Evolution of Power Generation

Clean energy as a percentage of total power generation increased in 2021. However, this shift was not the result of an increase in generation from clean energy sources, but rather due to the pandemic. Indeed, the system experienced a reduction in total demand and, as a result, total power generated with conventional fossil fuels also fell.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

Petacalco Case Study

Petacalco coal power plant operating with fuel oil

The Petacalco coal-fueled power plant has six twin units with a capacity of 350 MW each and a thermal efficiency of 35%. An additional 650-MW supercritical generator, with a 41% efficiency, went online in 2010. All the units are designed to be fueled by high-quality imported coal with a low ash and sulfur content. Although the first six units have been adapted to operate on fuel oil in an emergency, the heat recovery systems were not designed to operate long-term with high-sulfur-content fuel oil, such as that produced in Mexico. Mexico has a surplus production of domestic high-sulfur fuel oil. Because of international agreements, this surplus can no longer be exported for the production of bunker oil for maritime vessels. To provide an outlet for this fuel oil surplus, it was decided to fuel the Tula and Hermosillo power plants with fuel oil instead of natural gas and also to fuel the six subcritical units at Petacalco with fuel oil instead of coal. CFE stopped importing coal and, therefore, the 680-MW supercritical steam unit, that cannot operate with fuel oil, was left offline for lack of fuel. This recent picture shows the first six units operating full bore with fuel oil.

The consequences of this decision can be summarized as follows:

1) The cost incurred for using domestic fuel oil instead of imported coal at the first six units is US$2.8 million/day or US$800 million/year—the equivalent of investing in a modern, 1,200-MW combined cycle power plant.

6 x 350 MW x 24 h/d x 0.85 x (116.3 − 36.3) USD/MWh = 2,857,000 USD/d

2) As previously stated, the supercritical 680 MW unit cannot be fired up due to the lack of coal. The

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

daily cost of having to substitute this unit with a conventional, less efficient fuel oil–fired thermal plant, such as Tula or Manzanillo, is US$1 million/day.

680 MW x 24h/d x 0.85 x (116.3 − 36.3*0.35/0.41) USD/MWh = 1,011,000 USD/d

3) The six subcritical units fueled with high-sulfur fuel oil emit 950 tons/day of SO 2 into the air. Given the area’s humidity, these emissions turn into more than 1,200 tons/day of sulfuric acid— approximately the production of a medium-sized sulfuric acid manufacturing plant. This sulfuric acid will eventually become acid rain, which is liable to damage crops, forests and buildings and has a deleterious impact on human health. 4) Mexican fuel oil also contains high concentrations of vanadium, which transforms into vanadium pentoxide in the boiler burners and condenses on the walls of the heat recovery systems. The deposited vanadium pentoxide acts as a catalyzer and converts a small percentage of SO 2 into SO 3 (sulfur trioxide), which in turn reacts with the humidity contained in the combustion gases. As a result, 10 to 20 tons per day of sulfuric acid are produced within the units, corroding the metal surfaces of the heat recovery systems. La Paz, Baja California Sur Case Study

The two largest power plants (out of the five that CFE operates in the state of Baja California Sur) are located in the city of La Paz. Up to 2019, they comprised five internal combustion units (210 MW) and three vapor units (112.5 MW) that operate with fuel oil, plus three diesel-fired gas turbines (69 MW). During 2020 and 2021, CFE added six more gas turbines (187 MW), fueled by diesel, due to the lack of natural gas supply. In addition to these plants, La Paz has two privately owned solar power plants, Aura Solar I and

Aura Solar II (55 MW). Two more privately owned plants are currently under construction: a gas turbine plant (145 MW), expected to come online in 2021, at the same time as natural gas supplies are set to arrive, and a wind farm (50 MW). Because of the elevated temperatures and high humidity during the summer months, peak power demand within the grid can be triple the off-peak demand. To meet the highly variable demand registered at different times of the day and through the year, several combinations of units from the different power plants need to be brought on line at different times. As a result, whereas the average local marginal price in the real-time market (LMP) during 2020 was MXN$2.23/kWh (US$112/MWh) 2 . For nearly half the year, prices oscillated between MXN$1.00 and MXN$2.00/kWh (US$50–US$100 /MWh) 3 , and more than 30% of the year prices were above MXN$3.00/kWh (US$150/MWh); LMPs even surpassed MXN$5.00/kWh (US$250/MWh) during certain periods. The highest LMPs were registered during the summer months, when the diesel-fired gas turbines

2 For comparison, in 2020, the real-time market LMP for the National Interconnected Grid (Sistema Interconectado Nacional; SIN) was MXN$567/MWh, and MXN$419/MWh for the Baja California grid. 3 This calculation assumes an exchange rate of MXN$20/US$1, which was the rate at the end of 2020.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

determine the marginal price 4 . In contrast, approximately 52% of the electricity sales in the city of La Paz — a total of 800 gigawatt-hours (GWh) — were delivered to more than 111,000 residential customers at a median tariff price of MXN$1.05/kWh (US$50/MWh). The average LMP was therefore more than double the median residential tariff price paid for more than half of the electricity sales 5 . The overall median tariff price for the total demand was MXN$2.00/kWh (US$100/MWh), not even enough to cover the variable costs of generation.

In 2020, 75% of the electricity produced by CFE power plants in the Baja California Sur grid was generated in La Paz. Nearly all of that generation was from units fueled by fuel oil. Based on the processes used to produce this electricity, an estimated 19,600 tons of sulfur dioxide were released into the air in La Paz in 2020. Furthermore, an

estimated 1.334 billion tons of CO 2 e were also emitted. Using the same US$260/ton value for the avoided SO 2 emissions and US$64/ton for CO 2 e emissions, the 2020 totals in emissions allowances would represent US$5 million and US$85 million, respectively. In addition to the renewable energy plants mentioned earlier, the Energy Regulatory Commission reported a distributed generation installed capacity of 23.1 MW in Baja California Sur at the close of 2020. It should be noted that, according to CENACE’S response to a freedom of information request, since the first semester of 2020 there has been zero available capacity for installing new renewable energy systems in Baja California Sur. 6 It is difficult to fathom why renewable energy alternatives have not been considered, in view of this situation where: • Power generation in La Paz is fully dependent on imported fossil fuels (diesel and fuel oil) from the US and/or Mexico’s mainland; • Generation costs are very high; • In spite of having the highest electricity rates in the country, they are insufficient to even recover 4 In the Baja California Sur grid, the efficiency of the Punta Prieta thermal power plant is close to 30% and the Baja California Sur internal combustion power plant is over 40%, while the diesel-fired gas turbines have an efficiency of approximately 20%. 5 Taking into account both demand and real-time-market LMP, the weighted average for the Baja California Sur grid is more than MXN$2,422/MWh. 6 After the December 2016 publication of the Interconnection Manual for Power Plants with Less than 0.5 MW Capacity , the interconnection capacity for plants of this type into the Baja California Sur grid was limited to 10 MW. In March 2017, CENACE mandated CFE to not allow any new interconnections because the limit set forth in the manual had been surpassed. This limit was increased to 18 MW in December 2017 through Agreement A/066/2017, with 3 MW assigned to the La Paz region and the remaining 15 MW to the Los Cabos and Constitución regions. Beginning in 2020, all new interconnection applications will require a new study in order to determine distributed generation capacity in Baja California Sur. Without such studies, no decisions can be made on interconnecting new distributed generation plants to the grid.

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

the marginal costs; • Large volumes of pollutants are being emitted; and • Renewable sources of energy are abundant.

For example, if every residential consumer had a small, 1-kilowatt solar unit, the amount of electricity billed to that segment of the market would be reduced by around one-fourth. In Baja California Sur, every kWh that CFE can avoid generating and billing would be a subsidy saved. This is particularly true for more than 50% of the generated electricity that is sold at highly subsidized residential rates. Conclusions From this analysis, it can be concluded that: • Variable generation costs for fuel oil and diesel-fired thermal plants cannot be recovered under the current rate structure. • The clean energy contracted by CFE through the first three long-term auctions represent substantial savings compared with the variable generation costs required to bring thermal plants online, regardless of the fuel used to operate them. The avoided costs are even more significant when the replaced energy would have come from a fuel oil– or diesel-fired thermal plant. • The 2021 and 2024 clean energy portfolio goals mandated by law and committed to by Mexico in international agreements appear impossible to achieve. • Power plants fueled by coal or fuel oil instead of natural gas generate not only more greenhouse gas emissions but also much larger amounts of other harmful pollutants, such as SO 2 , NO x , and particulate matter. Imposing the use of fuel oil instead of natural gas or imported coal in dual fuel power plants, as has been done in the last couple of years, cause important economic losses as well as significant damage to human health and the environment. • It is a significant contradiction for a fuel that is no longer allowed to be used in the middle of the ocean, because of its high environmental impact, is being used instead to fuel power plants located near densely populated locations. Recommendations • CFE must accelerate the modernization of its generation system by installing new combined-cycle power plants, repowering its hydroelectric plants, and taking advantage of its natural gas fired steam power plants to bolster grid resiliency to support increased wind and solar generation and so that obsolete coal and fuel oil–fired plants can be retired as soon as possible. • The auction mechanism set forth in the Electric Power Industry Act, which has allowed CFE to contract clean energy under increasingly competitive conditions, must be preserved. • The economic dispatch process based on marginal costs must also be preserved, with some minor adjustments to avoid impacting CFE’s subsidiary in charge of basic supply (e.g., power plants that have a supply contract with CFE should be brought on line based on the contract-designated electricity price, rather than their marginal cost). • Investments must be made to strengthen transmission and distribution networks in order to eliminate current restrictions that force the use of more expensive, less efficient power plants instead of taking full advantage of the system’s most efficient plants. • Intermittent power plants that require capacity backup must have clearly set payments for ancillary services, provided mostly by CFE’s plants. • The various regulatory and non-regulatory barriers recently imposed by the current administration to new permits for wind and solar power plants should must be eliminated. • The remaining barriers for installing distributed generation systems (those with less than 0.5 MW

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

capacity) must be eliminated, and basic service providers should offer preferential loans to low- income residential consumers with subsidized rates, given that it is cheaper for the government to subsidize the investment in efficient distributed generation than to subsidize electricity with reduced rates. About the Authors Francisco José Barnés de Castro Francisco Barnés completed undergraduate studies in Chemical Engineering at the National Autonomous University of Mexico (UNAM) and obtained a Master of Science and a PhD in Chemical Engineering at the University of California, Berkeley. He carried out his academic career at UNAM where he held the following positions: Full-time career teacher between 1973 and 2015, when he retired; Dean of the School of Chemistry (1986-1993); Secretary General (1993-1995); Chancelor (1997-1999). He also counts years of professional experience in the public sector including: Technical Secretary of the Mexican Petrochemical Commission (1982-1986); General Director of the Mexican Petroleum Institute (1995-1996); Undersecretary of Energy Policy and Technological Development (2001-2004); Undersecretary of Hydrocarbons (2004); Commissioner at the Energy Regulatory Commission for two consecutive periods (2004-2014). Dr. Barnes has been a member of the International Advisory Council of the Pacific Northwest National Laboratory (USA) and of the Joint Public Advisory Committee of the Commission for Environmental Cooperation (USA), as well as of the advisory councils of the University of Guanajuato and the Research, Innovation and Technological Development System at the State of Yucatán. He has been a member of the board of directors of: National Laboratories for Industrial Development (LANFI); Applied Chemistry Research Center (CIQA), Center for Research and Advanced Studies (CINVESTAV), at the Mexican Petroleum Institute (IMP), Electrical Research Institute (IIE), National Association of Universities and Higher Education Institutions (ANUIES), National Council of Science and Technology (CONACyT), Nacional Financiera (NAFIN), National Institute of Electricity and Clean Energy (INEEL),at the United States and US-Mexico Foundation for Science (FUMEC), where he was president during 2010-2012. He was also president of the board of 17 chemical companies in the public sector. Dr. Barnes is currently a member of the board of directors of INCO Foundation, ICA Foundation and the National Laboratory for Advanced Informatics (LANIA)s, which he currently chairs. He is also independent counselor for Estrategia Energía Eléctrica Comercializadora and Pellet México. He has been president of the Mexican Institute of Chemical Engineers, of the National College of Chemical Engineers and Chemists and of the Mexican Association for Energy Economics, vice president of the Union of Universities of Latin America and the Caribbean (UDUAL) and vice president for North America of the World Energy Council. Dr. Barnes is the author or co-author of more than 20 papers in scientific journals and more than 50 papers on educational and technical issues; of two books: "Process Engineering” and “Technological Advances in the Refining Industry"; as well as of two international patents. Dr. Barnes is currently Managing Partner of CIFRA2 Consulting. Francisco Xavier Salazar Diez de Sollano A Non-Resident Fellow at the Institute of the Americas, Salazar 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).

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Clean Energy Cost-Savings: A Study of Mexico’s Federal Electricity Commission (CFE)

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. 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. 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 and the Caribbean, the United States and Canada. Located on the University of California, San Diego campus in La Jolla, 30 miles from the border with Mexico, the Institute provides a unique hemispheric perspective on the opportunities opened by economic and social reforms in Latin America and the region’s relationship with 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. The Institute continues to serve as an honest bróker between the public and private sectors across the hemisphere to help forge a constructive dialogue on the issue of clean energy transitions and emerging economic opportunities derived from renewable energy deployment. For more information, visit iamericas.org

@IOA_Energy

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