Mexico - Transmission and Distribution Project

Document of The World Bank I FOR OFFICIAL USE ONLY Report No. 8191-ME STAFF APPRAISAL REPORT MEXICO TRANSMISSION AND DISTRIBUTION PROJECT MARCH 20, 1990 Country Department II Infrastructure and Energy Operations Division Latin America and the Caribbean Regional Office lbis document has a resticted disribution and may be used by redpients only In the pedornalaoe of thdr officaii duties Its contents may not othewise be disclosed witbout World Bank suthzton.  CURRENCY ELUIVALENTS Currency unit M Mexicon Peso (MVxl) US1.60 Mox 2,716.00 (Controlled exchange rat. as of March 9, 1990. The exchange rate Is currently being devalued by I Mexican Peso daily) UNITS AND MEASURES ton (T) - metric ton u 1000 kg Tcal a teracalorl.s a 98.04 TOE * 1012 calories TOE 2 ton of oil equivalent a 0.0102 Tcal kW = kilowatt = 103 watts VW a megawatt lips kW oW a gigawatt = 103 UW kWh = kilowatt hour = 103 watt hour MWh a megaatt hour 10 kWh GWh = gigawatt hour = 100 kWh TWh terawatt hour 109 kWh kV = kilovolt = 103 voitc MVA = megvolt ampere a i00 volt-ampere bbd = barrels per day ACRONYMS CFE a Comini6n Feweral do Electricided (Government owned national electrie utility) CLFC 2 Compailtn de Luz y fuerts del Centro (Electricity distribution company, subsidiary of CFE, serving the metropolitan are of Mexico City) FRA a Financial RohabIlitatton Agreemnt (Between Goverr'.nt and CFE) 1DB = Inter-American Dev6lopment Ban.. INAH a Instituto Naclonal de Antropologta e Historia (National Institute of Anthropology and History) NAFIN w Nacional Financiera, S.N.C. (Covernment owned national development agency) PEMEX a Petr6leos Mexicanos (Government owned national oil company) POISE = Programa de Obras * Inversiones del Sector El6ctrico (Ten-year Investment Program) SARH a Secretarta de Agriculturs y Rocursos HidrSulicoe (Ministry of Agriculture and Hydro Resources) SECOFI = Secretarta do Comercio y Fomento Industrial (Ministry of Commorce nd Industrial Development) SEDUE = Secretar1a de Desarrollo Urbano y Ecologla (Ministry of Urban Development and Ecology) SEMIP = Secr-tarfa de Energra, Mines o Industria Paraestatoal (Ministry of Energy, Mines and State Enterprises) SHCP a Secretarta de Hacienda y Cr6dito PNblico (Ministry of Finance and Public Credit) SRA a Secretarta do Reforms Agraria (Ministry of Agrarian Reform) SPP = Socreterfa de Programacidn y Presupuesto (Ministry of Planning and Budget) FISCAL YEAR January 1 - December 31  FOR OFFICIL USE ONLY MEXICO TRANSMISSION AND DISTRIBUTION PROJECT STAFF APPRAISAL REPORT TABLE OF CONTENTS Page No. 1. LOAN AND PROJECT SUMMARY ..............................., 1 2. THE ENERGY AND POWER SECTORS .. 4 A. INTRODUCTION. 4 B. THE ENERGY SECTOR. 4 Energy Resources. 4 Energy Demand and Supply. 5 National Energy Policy and Sector Objectives 6 Energy Conservation .................................... 6 Petroleum Products Production, tyses and Prices 7 Energy Sector Orgar.ization. 7 Problems of the Energy Sector. 8 C. THE ELECTRIC POWER SECTOR. 8 Power Sector Organization and Regulation. 8 Electricity Power Demand and Supply. 9 Operational Performance ... ........................... 11 Power Sector Planning .12 The Investment Program .13 The Special Transmission Program .14 The Special Distribution Program .14 The Special Thermal Power Plant Renovation Program 15 Hexico's Nuclear Power Program .15 Electricity Pricing .16 Financial Performance .18 Government Subsidies and Cash Tranfers .18 Financial Rehabilitation Agreement (FRA) .18 Financial Forecast ................... 19 Government Power Sector Strategy .20 CFE's Procurement Practices .20 Bank Participation in the Sector .21 Bank Objectives and Long-Term Strategy .21 3. THE PROJECT .22 Introduction .22 Project Description .22 Estimated cost .23 This report is based on the findings of an appraisal mission composed of Messrs. Luis H. Luzuriaga (Principal Power Engineer, Task Manager), Ricardo Klockner (Financial Analyst), Robert Goodland (Environ- nmental Specialist), Luis Gutierrez (Energy Economist), Abderrahmane Megateli (Energy Specialist), and Alfred Banks, Consultant (Thermal Power Plant Specialist), that took place starting in June 29, 1989. Ms. Norah Arancibia assisted in the production of this report. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorizatiou.  - ii - Page No. Financing Plan . ....................................... 24 Legal Arrangements ..................................... 25 Project Implementation and Status of Preparation ...... 25 Procurement ..... ............... 25 Environment ..... ............................. 27 Disbursements ..... .................................... 28 Auditing ......8........................................ Z Performance Indicators ...... .......................... 28 Risks ................................................. 29 Economic Justification ................... ............. 29 Project File .. 30 4. AGREEMENTS REACHED AND RECONMENDATIONS .... ....... 30 ANNEXES; 2.1.0 - Present Situation of the Energy Sector .. 32 2.1.1 - Historical Energy Balance .. 39 2.1.2 - Fuel Prices in Mexico . . 40 2.1.3 - Energy Sector Organization Chart . . 41 2.1.4 - Facts About the Petroleum Sector and PEMEX ..... 42 2.2.0 - CFEs Institutional Aspects ..................... 43 2.2.1 - CFE's Organization Chart . . 49 2.2.2 - Staffing ...................................... 50 2.3.0 - CFE's Power System and Market . . 51 2.3.1 - Historical Data for the Poaer Sector . . 55 2.3.2 - Existing Power Plants as of December 31, 1988.. 56 2.3.3 - New Power Plants Planned for 1989-1998 .. 57 2.3.4 - Performance Data on CFE's Thermal Power Plants 58 2.3.5 - Global Demand Forecast by Type of Service ..... 59 2.3.6 - Global Energy Balance Forecast . . 60 2.3.7 - Global Capacity Balance Forecast .............. 61 2.4.0 - Power Sector Investment Program . ........... 42 2.4.1 - Investment Program Period 1989-1998 ............ 64 2.4.2 - Power Sector Investment ................... .... 65 2.5.0 - Electricity Pricing ................ ........... 66 2.5.1 - Tariff Schedule . . .................... 69 2.5.2 - Consumers Classification by Type of Service .... 71 2.5.3 - Evolution of Electricity Rates Period 1962- 1988 ....... .... . 72 2.6.0 - Sector Finances ................................ 73 2.6.1 - Actual and Forecast Income Statements .......... 76 2.6.2 - Actual and Forecast Sources and Application of Funds ....... 77 2.6.3 - Actual and Forecast Balance Sheets ............. 78 2.6.4 - CFE's Funding Mix, Period 1980-1996 ............ 79  - iii - Paae No. 2.7.0 - Financial Rehabilitation Agreement (FRA) ....... 80 3.1.0 - CFE's Special High Voltage Transmission Line Program ...........83 3.1.1 - CFE's Special Transmission Program - Program Cost Su umm ary .................................. 85 3.2.0 - CFE's Special Distribution Program . . 86 3.2.1 - CFE's Special Distribution Program - Program Cost Sulrmmary.. ...... .. .... 89 3.3.0 - Thermo-electric Power Plant Special Renovation Program ... .. ....... 90 3.3.1 - Thermo-electric Power Plant Renovation Program Program Cost Suimmary . ......... 92 3.4.0 - Project Description and Cost ................. 93 3.4.1 - Project Cost Estimate .. . 95 3.4.2 - Special Programs Financed by the Bank Loan. ... 96 3.4.3 - Implementation Schedule and Procurement Method 97 3.4.4 - Estimated Loan Disbursement Schedule ........... 98 3.4.5 - Proposed Loan Allocation by Categories ........ 99 3.5.0 - Economic Analysis ............. 100 3.6.0 - Performance and Financial Indicators ........ . 106 3.7.0 - Project File ................................... 107 MAP: IBRD No. 21868  pi MEXICO TRANSMISSION AND DISTRIBUTION PROJECT 1. LOAN AND PROJECT SUMMARY Borrower: Nacional Financiera, S.N.C. (NAFIN) Guarantor: The Government of Mexico Beneficiary and Executing Aenc: Comisi6n Federal de Electricidad (CFE) Amount: US$450.0 million equivalent Terms: Repayment in 17 years, including five years grace, at the Bank's standard variable interest rate. On-lending Terms: The loan proceeds would be on-lent by NAFIN to CFE under terms and conditions which would include, inter alia, (i) the sub-loan would be denominated in US dollars, (ii) the on-lending terms and conditions would be the same as the Bank loan, and (iii) NAFIN would charge a fee amounting to 10 of the interest charged by the Bank and an intermediary fee. US dollar to Mexican peso exchange and interest rate risks would be borne by CFE, and NAFIN would bear the US dollar to basket of currencies exchange risk. Proiect Obiectives: (a) Promote improvements and renovation of thermoelectric power plants to reduce the investment requirements of the sector; (b) correct distortions in the tariff structure, reducing cross subsidies among consumers to improve end-user efficiency; (c) strengthen CFE's internal capabilities to address environmental issues related to the operation of thermoelectric power plants and to the construction of transmission lines; (d) further pursue the improvement goals agreed under the Hydroelectric Development Project (Loan 3083-ME) on management, technical, financial and energy conservation aspects; and (e) fund CFE's transmission and distribution program for 1991-92 with the purpose of meeting industrial and commercial demand and slightly expanding residential coverage, while improving the technical efficiency and reliability of electric service. Proiect Description: A sector investment project that includes a time slice (1991-92) of CFE's investment program in transmission, distribution and thermal plant renovation. The Bank loan would help fund four basic components: (a) a transmission and substation prograu aimed at expanding and improving installations rated 400 kV to 115 kV (402 of the total loan); (b) a distribution program that would expand and improve the distribution grid (34.5Z); (c) a program to renovate thermoelectric power plants to improve thermal efficiency and availability of CFE's main plants (25.0X); and (d) environmental and pollution control studies related with these components (0.52).  Prolect Risks: The main risk would arise from failure to cosntinue increasing electricity rates, which vould affect sector finances and result in a shortage of local counterpart funds and in project execution delays. However, the Government appears to be firm in its price policy reforms and has shown strong evidence of its commitment; in this context, the recent extension to the economic pact signals the end to a long period of price freeze, shifting instead to a more predictable and continuous process of regular public sector price adjustments. Another concern is the lack of access to external financing in the amounts required, for which the Bank would play an active role in putting together a cofinancing package. The project does not pose special technical or environmental problems. Estimated Cost Local a/ Foreign Total 1991-1992 Time Slice: ---------Million US$------------ Generation Program 1,811.8 1,120.9 2,932.7 Transmission Program b/ 624.3 366.2 990.5 Distribution Program 563.8 459.9 1,023.7 Equipment Upgrading bi 213.0 214.0 427.0 General Plant 82.9 36.1 119.0 total Base Cost (June 1989 prices) 3,295.8 2,197.1 5,492.9 Physical Contingency 366.6 243.5 610.1 Price Contingency 365.0 243.4 608.4 Total Project Cost 4,027.4 2,684.0 6,711.4 Interest During Construction - 416.0 416.0 TOTAL FINANCING REQUIREMENTS 4,027.4 3,100.0 7,127.4 a/ Includes approximately US$576 million of identifiable taxes and duties b/ Includes studies under the project (US$1.5 million) Financina Plan Local Foreign Total ---------------Million US$----------- CFE's Own Resources 3,675.0 294.3 3,964.3 Consumer Contributions 154.4 0 154.4 Government Contributions 198.0 0 198.0 IBRD Proposed Loan 0 450.0 450.0 IDB Proposed Loan 0 300.0 300.0 Bilateral Sources (Eximbank Japan) 0 150.0 150.0 Loans Already Negotiated a/ 0 133.0 133.0 Turn-key Contracts 0 560.0 560.0 Suppliers' Credits 0 1.212.7 1.212.7 Total Funds 4,027.4 3,100.0 7,127.4 a/ US$133.0 to be disbursed in this period from the Bank's Hydroelectric Development Project.  -3- Estimated Disbursements ---------------Million US$----------- Bank FY 1990 al 1991 1992 1993 Annual 50.0 125.0 175.0 100.0 Cumulative 50.0 175.0 350.0 450.0 a/ Deposit of US$50.0 million in the Special Account including retroactive financing of US$20.0 million for qualified expenditures incurred after July 15, 1989. Economic Rate of Return: 14Z on CFE's Ten-year Investment Program Map: IBRD No. 21868  - 4 - 2. THE ENERGY AND POWER SECTORS A. INTRODUCTION 2.01 Two issues have dominated the performancl' of the Mexican economy in the eighties: the overhang of a massive debt, which has required attaining significant trade surpluses to service it and to reduce its relative weight over time, and the problem of containing inflation, fueled to a large degree by fiscal deficits. The Government's present ecor.omic strategy addresses these two issues through a program of structural reforms aimed at opening up the economy to external competition, limiting the role of the State in the productive sectors and fostering the development of non-traditional exports and through foreign debt re-negotiation. In addition, the stabilization program that was put in place in December 1987 has been successful in reducing inflation by addressing tha fiscal issue by, amongst other measures, raising the prices for goods and services provided by public enterprises, and by following a restrictive monetary and fiscal policy and implementing short-term price and wage controls. 2.02 In this context, energy sector policies play a very important role. In addition to the significance of petroleum exports as a source of foreign exchange, there are major issues regarding the size of the subsidies that the power sector has been receiving from the Federal Government, the distortions to resource allocation caused by subsidized fuel prices and electricity rates, and the costs to the economy of investment and procuremera policies in the power sector, which were not based on economic conside.ations. The Mexican Government has begun to address these issues: fuel prices have been raised in real terms, procurement by public sector enterprises is being opened to external competition, and under the recently approved Hydroelectric Development Project, electricity rates are being increased and investment programs are being based on economic criteria. B. THE ENERGY SECTOR Energy Resources 2.03 Mexico is endowed with substantial and diversified energy resources, both renewable and non-renewable. Its main resources are hydrocarbons, with total proven reserves of 67.6 billion barrels of crude oil equivalent. These reserves include 46.2 billion barrels of crude oil (about 51 years of reserves to production ratio at 1988 average production of 2.5 million bbd), 6.8 billion barrels of crude oil equivalent of condensate and 14.6 billion barrels of crude oil equivalent of Iry natural gas (53 trillion cubic feet). Although gas reserves are important, their exploitation is associated to the production of oil (Annex 2.1.0). Proven coal reserves discovered so far amount to 600 million tons (equivalent to 3 billion barrels of crude oil) with an additional 140 million tons of probable reserves; most of the coal is classified as steam coal and is used for power generation; it is not suitable for coking purposes. The known proven uranium reserves are 10,600 T, but total reserves potential arc probably much larger.  - 5 - 2.04 Of the renewable energy resources, the most important is hydro- power. There are 554 identified sites with a theoretical output of 150 TWh/year, of which approximately 80 TWh/year (equal to Mexico's electric energy sales in 1987) are technically feasible, equivalent to 22,000 MW, of which 35Z have been installed. However the development of these projects faces the following serious restrictions: (a) most of the sites are located in the 3outhern region, and would require the development of long transmission lines to the large power markets in the central and northern regions; and (b) the development of the large sites ct the Usumacinta River, which borders Mexico and Guatemala, would cause serious environmental and resettlement problems and would flood ancient Mayan archaeological ruins. 2.05 About 400 known geothermal zones have a potential for the installation of up to 3,900 MW in thermal plants; at present only 700 MW have been installed. This is one area where there is still room for expansion for power generation. Non-conventional potential resources, like solar and biomass energy, do exist but they would not contribute significantly to energy production in the country in the medium-term. Energy Demand and Supply 2.06 In 1988, Mexico's gross energy production was 2,038 thousand Tcal (equivalent to 200 million TOE), of which nearly 902 was hydrocarbon production. Gross internal energy consumption was 1,245 thousand Tcal or 1.4 TOE per capita.1 The 1988 energy balance is shown in the next table, and the evolution of the energy supply and consumption in Annex 2.1.0. Mexico0a 1988 Eneroy Balance Gross Energy SuppIy Thousand Tcal Pere nteas Hydrocarbons 1,831.6 89.2 Blaoms (Wtood and Sagess.) 99.4 4.8 Hydro energy 63.6 2.6 Coal 32.8 1.6 Geothermal Energy 12.8 0.6 Imports and Stock Varlations 24.0 1.2 Tote; Supply 2,058.6 109.0 Eneroy Uses Internal Consumption: Industrial Sector 269.5 18.1 Transport 269.6 18.1 Residential and Comumrclal 181.6 8.8 Power Sector 176.6 8.6 Other Use 140.4 6.8 Energy Sector Consumption and Loses 221.0 10.8 Subtotal, Internal Consumption 1,257.6 61.2 Exports and barter 796.0 89.8 Total Use 2,053.6 100.0 Source: SEVIP 1/ As compared to Brazil with 1.3 TOE per capita, Chile 0.80 and Colombia 0.70.  - 6 - 2.07 The gross energy supply increased from 1975 to 1982 at about 172 p.a. (average) and then remained stable with slight yearly fluctuations. The gross energy consumption by source of energy shows that the contribution of hydrocarbons increased from about 762 in 1975 to about 852 in 1980 and fluctuated around 852 thereafter. Final energy consumption for the industrial sector and the transport sector accounted for 36Z in each while the residential and commercial consumed 24Z, and the agricultural sector 3.42. Because of energy savings as well as economic stagnation, energy consumption in the period 1982-88 increased only slightly (Annex 2.1.1). National Energy Policy and Sector Obiectives 2.08 The National Energy Program prepared by the Ministry of Mines and State Enterprises (SEMIP)and approved by the Government in August 1984 as part of the National Development Plan, presented an analysis of the role of energy in the country's development, the main problems faced by the sector, and set general sectoral objectives and medium term (1984-88) and longer term (to the year 2000) targets and strategies. The broader sectoral objectives are: (i) meeting overall energy demand including export of hydrocarbons; (ii) energy conservation, par icularly in the state-owned industries with emphasis on simple, inexpensive measures to cut down inefficient energy use; (iii) energy diversification away from the current excessive reliance on hydrocarbons, towards greater use of alternative primary energies such as hydroelectricity; and (iv) improving the financial situation of sector's enterprises, so as to achieve full cost recovery. A new National Energy Program, prepared as part of the new National Development Plan of June 1989, places special attention to three main issues: energy conservation, environment and pricing (Annex 2.1.0). 2.09 While the goal of meeting overall energy demand has been achieved, the other goals have been only partially fulfilled. In particular, the energy diversification and conservation objectives are still major issues of the energy sector that need to be addressed. Because of the depressed international markets, petroleum production declined by an annual average of 32 during 1982-1986 from 2.75 million bbd to 2.43 million bbd; production in 1988 was 2.51 million bbd. Between 1978 and 1988, gross electricity generation increased at an average rate of 6.7X from 53,252 GWh to 101,958 G'Wh. Energy Conservation 2.10 Energy conservation in Mexico started to be a major consideration in energy planning and a policy factor at the beginning of this decade, but results obtained so far have been modest because the programs implemented have not been comprehensive and were limited in scope; achievements were concentrated mainly in the industrial sector, which accounted for more than 75Z of the energy saved. 2.11 Energy conservation in Mexico is linked to the modernization of the industrial and transport sectors, the two miajor energy users. During 1982-87, a promotional drive was undertaken to promote the use of advanced equipment, machinery and new technologies that would promote industrial production efficiently. The European Economic Community is assisting SEMIP  to develop a model that would help predict the energy demand for the transport sector and evaluate measures to save energy both in the transport as well as in the industrial sectors. Furthermore, in order to consolidate its efforts nation wide, the Government established in September 1989 a National Energy Commission, supported by state and local commissions. Under loan 3083-ME (the Hydroelectric Development Project), the Bank is financing the execution by SEMIP of a national energy conservation program that would promote the efficient use of energy in Mexico by the industrial, transport, commercial and residential usere. Petroleum Products Production, Uses and Prices 2.12 Petroleum products production increased at an average annual rate of 2.5Z from 1.24 million bbd in 1982 to 1.41 million bbd in 1988. The volumes of the petroleum products marketed within the country increased at an average annual rate of 1.22 during 1982-87. During the same period fuel oil increased at an annual rate of 8.1? due to the large requirements of CFE for this product. The use of gasoline remained at the same level of 1982 while LPG use increased by an average rate of 6.1?. Diesel oil's use decreased by a rate of 3.2Z. 2.13 In the period 1983-88 fuel prices were increased, in real terms, 1272 for natural gas, 128? for residual oil, 83Z for LPG and 612 for diesel. At the end of 1989, the domestic prices for most petroleum products were close to, and for some products considerably above, the relevant international (border) prices, the exception being residual oil ("combustoleo") and LPG, whose domestic prices were about 75Z and 542 of their border prices (Annex 2.1.2). Significantly, residual oil is an important cost element in the price of electricity, and CFE is an important user of this type of fuel as it consumes 70? of the residual oil produced in the country. On January 26, 1990, the Government enacted the Rules to the Federal Law for Public Enterprises ("Reglamento de la Ley Federal de las Entidades Paraestatales"). Under these rules, prices and tariffs for goods and services shall be established considering principles of economy, efficiency and financial viability; when such goods and services are tradeable internationally, prices shall be fixed considering the prices prevailing in the international market. During negotiations, the Government gave assurances to the Bank that these principles shall be applied to the pricing of oil and oil derivatives and the Government agreed to increase by June 30, 1992, the price of the residual oil consumed by CFE for thermoelectric generation to international level (para. 4.01(a)). *International level' is defined as the average f.o.b. export price for the same type of fuel obtained by r 4EX during 1989. 2.14 The mechanisms by which fuel prices are fixed and the type of taxes applied are explained in Annex 2.1.0. The public enterprise Petroleos Mexicanos (PEMEX) plays a subordinate role in setting these prices, which are mostly decided by SEHIP and SHCP. Two taxes are applied to petroleum products: Value Added Tax (VAT) and "Impuesto Especial Sobre Produccion y Servicios' (IEPS). Energy Sector Organization 2.15 The energy sector is under the jurisdiction of SEMIP and it is composed of two subsectors: hydrocarbon and power. Hydrocarbons are  - 8 - controlled by PEMEX which is backed by a sophisticated research institute, the 'Instituto Mexicano del Petroleo" (IMP). The power subsector is also controlled by a public enterprise, Comision Federal de Electricidad (CFE) which has a wholly-owned subsidiary "Compaflia de Luz y Fuerza del Centro, (CFLC) in charge of distributing electricity in the Federal District and the vicinity. CFE gets technical support from the Instituto de Investigaciones Electricas (IIE). Annex 2.1.3 presents an organization chart of the sector and Annex 2.1.4 gives additional facts about PEMEX. With the new 675 MW Laguna Verde Nuclear Plant being constructed by CFE, which is expected to start commercial operation in 1990, the nuclear subsector is making its first steps in Mexico. Annex 2.1.0 gives more details on the organization and regulations of the energy sector. Problems of the Energy Sector 2.16 A major problem of the sector is the high consumption of energy per unit of outpus-, which has caused a high growth of energy consumption. Gross energy consumption in the country grew at an average annual rate of 9Z during 1975-82; although this high rate was partly due to high rates of economic growth Pnd urbanization and to the transformation of the industrial structure in Mexico toward more energy intensive industries, it also reflected the inefficient use of energy, fostered by very low prices and lack of a comprehensive conservation program. 2.17 A second problem is the high dependency on non-renewable resources, due partly to a biased pricing policy towards hydrocarbons; their share in internal consumption of primary energy in 1988 amounted to 822 (Annex 2.1.1). An important potential for diversification is in electricity generation through tne development of hydro, coal, geothermal and nuclear generation. However, the goal of the Government of reducing the share of hydrocarbons to 70Z by the year 2000 might be too optimistic. 2.18 A third problem of the sector is the poor financial situation of sector enterprises, which the Government is addressing through a pricing policy based on economic criteria. The pace of price adjustments, however, has had to steer a careful compromise between these objectives and short run stabilization policy goals. C. THE ELECTRIC POWER SECTOR Power Sect.or Orparitzation and Regulation 2.19 Electricity service in Mexico is under the responsibility of one public utility: Comision Federal de Electricidad (CFE), in operation since 1937. It generates, transmits and distributes electricity on a country- wide basis, except for distribution in the area of Mexico City and environs which are served by Compaflia de Luz y Fuerza del Centro (CLFC), a former private utility, now wholly-owned by CFE. CFE is under the jurisdiction of the Ministry of Energy, Mines and State Enterprises (SEMIP) which supervises energy-related activities. The Ministry of Finance and Public Credit (SHCP) regulates electricity prices and the financial operations of state enterprises, while the Ministry of Planning and Budget (SPP) supervises the budget and regulates the contracting and procurement activities of the sector. Finally, the Ministry of Agriculture and Hydro Resources (SARH) is concerned with the regulation of water resources.  2.20 As established by the General Law of the Electricity Service, amended in December 1983, CFE has an Administrative Council (Junta de Gobierno) as the governing unit in its organizational structure, with overall corporate responsibility for company affairs. Its Chairman is the Minister of Energy, Mines and State Enterprises (SEHIP) and its other members are the Ministers of Finance and Public Credit (SHCP); Agriculture and Hydro Resources (SARH); Commerce and Industrial Development and Planning and Budget (SPP); the General Director of the National Government Oil Company (PEMEX); and three labor delegates. A Supervisory Council has three members representing the Federal Comptroller, SEMIP and the Administrative Council. The General Director is the Chief Executive Officer of the company. The directors of Construction, Operations and Administration report directly to him, as well as the heads of the Accounting, Finance and Legal departments. An organization chart is shown in Annex 2.2.1. 2.21 CFE's distribution activities are carried out by 14 geographical regional offices with a limited degree of autonomy. A total of about 120,900 persons work for the power sector, of which 89,200 belong to CFE and 31,700 to CLFC; out of the total sector employees, about 68,500 operate the power system, 33,700 are temporary workers in the construction force and 18,700 are contingent workers for major maintenance of power plants and transmission and distribution installations. Under the ongoing Hydroelectric Development Project, CFE is executing a management study to adequately evaluate the areas that need strengthening and develop a program to achieve this. The study will be completed by June 30, 1991, and by December 31, 1991, CFE will exchange views with the Bank on the conclusions and recommendations of the study and provide to the Bank a plan of action satisfactory to the Government and the Bank, to implement such recommendations including a timetable for implementation. Annex 2.2.0 gives a more detailed description of CFE. Electricity Power Demand and SUP ly 2.22 The Mexican power sector has registered important achievements: electric coverage, which amounted to 54? of the population in 1970, increased to 86Z by 1988; access to electricity in urban areas is 94Z, and 67Z in the rural areas. A rural electrification program, started in Mexico more than 30 years ago, aims to increase coverage to 75Z by 1995. Electricity consumption (total sales) increased at an annual rate of 7.82 from 1970 to 1988 of which a large share was due to new connections: during this period, the number of users increased by 5.8 Z annually. Industrial consumption amounted to 56Z of total sales during 1988, followed by residential with a share of 20.?, 92 by the commercial sector, 8? by agricultural activities, 5 public services and 2? exports. In 1988, total electricity consumption amounted to 1021 kWh per capita 2 , as compared to 447 kWh in 1970. 2/ Consumption in other countries in 1988: Brazil: 1,250 kWh per capita; Colombia: 950; and Chile: 1200.  - 10 - 2.23 In 1988, the total installed capacity for public service was 23,921 MW, of which 322 were hydroplants (see Annexes 2.3.1 and 2.3.2). In addition, there were 3,500 MV of captive capacity, mainly thermal. Energy losses were 13.62 with respect to net generation, of which about 70? are estimated to be technical losse8s and 30? unaccounted energy (billing errors, theft, etc.). As part of the ongoing Hydroelectric Development Project, CFE is carrying out a study to improve the efficiancy of CFE's electric power system, including analysis of design criteria and operating practices; the study, which would recommend means of reducing energy losses (technical and non-technical), will be completed by June 30, 1991. The following table presents an overall view of Mexico's historical (1981 and 1988) and projected (1992) power sector. Main Data on Mexico's Power Sector 1981 1988 1992 al Installed Capacity (GW) 17.4 23.9 27.9 Hydro 6.6 7.7 8.1 Thermal 10.6 15.5 18.1 Geothermal 0.2 0.7 1.0 Nuclear 0.0 0.0 0.7 Net Maximum Demand (GW, 11.8 16.1 20.8 Gross Generation (TWh) 68.2 102.0 130.7 Hydro 24.4 b_ 20.8 25.8 Thermal 42.8 76.9 95.1 Geothermal 1.0 4.4 6.4 Nuclear 0.0 0.0 3.4 Energy Sales (TWh) 57.0 83.9 108.0 Residential 11.2 16.8 22.3 Industrial 31.7 46.9 61.7 Commercial 6.3 7.3 7.7 Rural 3.8 6.4 8.7 Other 4.0 6.5 7.6 Net energy losses Cl (z) 13.2 13.7 13.0 Number of customers (million) 10.1 14.4 15.8 Population served (2) 80.0 86.0 88.0 al Bank estimates based on CFE's projections. b_ 1981 was an exceptionally rainy year, which explains the high amount of hydro generation. cl With respect to net generation. 2.24 The power sector is an important user of hydrocarbons: in 1988 an equivalent of 179 thousand Tcal were used for generation, more than 8? of total gross interr.al energy consumption. According to the current expansion plan and CFE demand forecast, 190 thousand Tcal will be used in 1992 for thermal power generation (almost 9Z of total domestic energy consumption), and 264 thousand Tcal (10Z) in 1997. In 1988, residual oil  - 11 - provided 77Z of the total CFE's thermal generation, gas 152 and coal 8I. CFE's program of diversification of energy resources will be carried out observing least-cost principles through the installation of 2,860 MW (of which 1,240 MW are being partially financed by the Bank, Loan 3083-ME) in hydroplants in the period 1989-1997; 418 MW in geothermal plants, 1,350 MW in a nuclear plant (Laguna Verde, whose first 675 MW unit is expected to be on line in 1990); 2,100 MW in domestic coal plants and 4,150 MW in dual fuel (oil and coal) thermal plants. In order to further increase diversification, the Government has entrusted to CFE the prospection for coal, as this type of fuel will be used mainly for power generation. Coal exploitation is made by a semi-public enterprise (Minera Carbonifera Rio Escondido SA - MICARE), of which CFE is a shareholder. 2.25 The demand forecast presented by CFE during appraisal of the project, estimates a rate of growth of 6.62 p.a. for energy sales for the period 1988-1998, as compared to 6.42 in the period 1978-88. The forecast takes into account an increase in consumption by existing consumers (approximately 4.0Z) and the connection of new services including important industrial loads already requested to CFE. This projection, which is the result of aggregation of local demand forecasts prepared by each distribution region. was verified by CFE using an econometric model that correlates electricity consumption with macroeconomic indicators (GDP, gross public investment and population). Although CFE's methodology yielded adequate forecasts in the past when the economy grew steadily, the macroeconomic and financial uncertainties of the future as well as the planned rate adjustments might lead to a lower demand than forecast by CFE. The Bank prepared sensitivity analysis considering electricity price increases to reach marginal cost levels by 1997, concluding that demand could grow at rates as low as 52 p.a. in the period 1988-98. However, other sensitivity cases considering optimistic outlooks for Mexico's economy resulted in higher demand growths; thus, for corporate planning purposes, power system expansion has been based on CFE's forecast. Adjustments to the generation expansion program to account for other demand growths, could be easily introduced by CFE by advancing or delaying the construction of thermo-electric power plants, which require short lead times. The Bank agreed with this approach as CFE is committed, under the Hydroelectric Development Project (Loan 3083-ME), and as it has been done in the past, to review annual;:y the demand forecast, considering prevailing market and economic conditions; any resulting modifications to the expansion program will be presented to the Bank by October 31 of each year. In addition, the Bank is collaborating with CFE in the development of a more robust forecasting methodology, that would improve CFE's planning capability. Annex 2.3.0 gives details of CFE's electric power market, including demand forecast. Operational Performance 2.26 During its 50 years of existence, CFE has extended electricity service across the entire country, reaching high rates of population coverage. CFE has the staff to perform efficiently the planning, design, construction and operation of the electric power system. Plant maintenance planning, scheduling and stocking of spare parts are satisfactory. The number of customers per employee in operation is 166, about average for the larger Latin American countries. During the last seven years, because of  - 12 - financial constraints, CFE was forced to limit investments and to reduce expenses in the maintenance of power plants; as a result, the existing installations were overworked, decreasing the availability of the thermal power plants to 65Z in 1981. Lately, however, a rehabilitation program improved their performance (in 1988, availability was 76Z) and the goal is to reach 77Z by 1994 (see Annex 2.3.4). The proposed project includes an upgrading component that would help CFE to achieve this objective (para. 2.38). Power Sector Planning 2.27 The Nationel Development Plan, approved by the Government in August 1984 and updated in June 1989, establishes global objectives, policies, strategies and goals. Since 1962 CFE prepares and updates annually a detailed Ten-year Investment Program for the Power Sector (Programa de Obras de Inversiones del Sector Electrico-POISE), which is approved by CFE's Administrative Council, getting in this way implicit approval from the central Government. Considering macro-economic conditions, SPP and SEMIP define investment ceilings for CFE, which in the past resulted in investment programs that favored thermal generation (the least capital intensive option) at the expense of hydroelectricity. 2.28 CFE has developed or adopted mathematical models for the optimization of decisions on the power system investment program. A set of models are used for power generation planning, to select and time the installation of new power plants from a list of candidate projects that include hydro, nuclear, geothermal and thermoelectric (oil and coal fired and dual fuel) power plants. The associated transmission lines and substations are analyzed using mathematical models to check technical characteristics such as load flow, voltage levels and system stability and reliability. Distribution planning has been done in a deterministic and relatively traditional fashion (see Annex 3.2.0), but with the assistance of the Mexican Institute of Electrical Research (Instituto de Investigaciones Electricas) CFE is now introducing advanced techniques for distribution planning. The investment program is developed in two phases: first, a least-cost program is determined considering, among other, conditions such as hydrology, availability and efficiency of equipment, fuel cost at border prices, operation and maintenance cost, and cost of capital. In a second stage, the least-cost program is subject to a financial analysis considering availability of funds and budget constraints. The least-cost generation expansion program established by CFE for 1989 and 1990 was modified to consider an investment ceiling imposed by SPP. After 1991 no financial restrictions have been included. Considering both CFE's own financial position and the macroeconomic situation, which in the near future calls for a continued fiscal effort to achieve the Government stabilization targets, the investment program and the corresponding financial requirements are reasonable. 2.29 The Government and CFE agreed under the ongoing Hydroelectric Development Project (Loan 3083-ME) that CFE shall: (a) each year during implementation of the Project, carry out a technical and economic analysis in order to update the investments proposed to be made in the power sector under the Ten-year Investment Program and shall, when making such analysis: (i) utilize least-cost principles; (ii) utilize export prices for oil  - 13 - derivate products; (iii) consider all environmental and resettlement costs associated with making such investments; and (iv) take into account financial restrictions on CFE due to macroeconomic conditions. Each updated Ten-year Investment Program shall include an updated financial projection to carry out the Plan, and an economic justification of, and a viable financing plan for, major generation installations not previously included in the Ten-year Investment Program. CFE shall review with the Bank each updated Plan, promptly after it has been completed; (b) execute only the installations included in the Ten-year Investment Program; and (c) by October 31 of each year during implementation of the Project, and at the request of either the Bank or the Government, review with the Bank and the Government, the progress in carrying out the Ten-year Investment Program. The Investment Program 2.30 The proposed power sector Ten-year Investment Program which is discussed in detail in Annex 2.4.0, is based on a generation expansion program which considers updated demand forecasts. A total investment equivalent to US$35.1 billion (constant 1989 prices) is proposed for the period 1989-1998, during which a total of 17,626 MW would be added to the system, at an average unit cost of US$1,993 per kW installed for the entire system; the program includes 55Z to be invested in generation, 22? in transmission and 232 in distribution (see Annex 2.4.1). Unit costs used by CFE to prepare the investment program are in line with international costs. It should be mentioned that during this period the Laguna Verde Nuclear Power Plant (1,350 MW), construction of which began in 1976, will be completed at an expected unit cost of close to US$2,520 (1989 base) per KU, excluding financial charges; no further nuclear developments are scheduled to start in the next decade. 2.31 The proposed investment program is sound, as it adequately addresses sectoral objectives and takes into account both economic and financial concerns. The allocation of 23? of the investment program to distribution is higher than the average 171 invested in the past five years, and adequate for the purpose of improving reliability to consumer level. The proposed project would focus on options to reduce investments (i.e. peak load pricing, demand management, seasonal rates, etc.), improve conservation and start plant renovation; during the execution of the project the criteria for distribution expansion will be reviewed critically. The project would also assist CFE in carrying out programs to improve further the efficiency and reliability of the distribution network, to extend metering to all customers now connected directly, and to shorten the billing period through decentralization measures. 2.32 Under the ongoing Hydroelectric Development Project, SEMIP is carrying out, with the assistance of CFE, a co-gener&tion study and will consider the possibilities of utilizing for public service part of the 3,500 MW privately owned in Mexico and possible incentives for new private investments in co-generation as means to reduce CPE's investments in generation facilities. 2.33 As part of the Ten-year Investment Program, CFE has designed three "special programs to address some urgent investment needs in the area of  - 14 - transmission, distribution and thermal power plants. These programs, to be partially financed by the proposed operation, are described in the following paragraphs. The Special Transmission Program 2.34 In the last six years CFE had to reduce drastically investments in new installations because of its difficult financial situation and had to prioritize investments, usually giving preference to the construction of new generating plants or completion of the ones under construction, in order to meet the growing demand of electricity; investments in transmission, distribution and power plant renovation and upgrading were low, barely enough to maintain the quality of service and energy losses at levels normally achieved by CFE. As the situation cannot be suetained, CFE has decided to start a special four-year transmission program, justified in detail in a study submitted to the Bank (see Annex 3.1.0). The program will have an estimated current cost of US$860.0 of which US$637 million would be spent in the 1991-92 period; the proposed Bank loan would finance about 212 of the total cost (US$180 million). 2.35 Details of the program are given in Annex 3.1.0; the physical goals of the special four-year program are summarized as follows: Construction of transmission lines: - Rated 400 kV 1,485 km - Rated 230 kV 2,505 km - Rated 138 kV and lower 3.494 km Total 7,484 km Installation of new transformers: - Rated 400 kV 3,005 MVA - Rated 230 kV 4,918 MVA - Rated 138 kV and lower 2.475 MVA Total 10,398 MVA The Special Distribution Program 2.36 The situation of the distribution system in the entire country is critical, as feeders and distribution transformers are loaded above economical and in many instances, above acceptable thermal levels, about 1,000,000 customers are connected to the grid without meters, power factor needs to be improved, and older installations must be replaced. CFE, knowing that the situation could deteriorate rapidly, has decided to start, wita the financial assistance of the proposed project, a special five-year program justified in a study presented to the Bank (see Annex 3.2.0); the program will have an estimated current cost of US$770 million, of which US$451 million would be spent in the 1991-92 period, mainly to purchase part of the materials and equipment required for the program, and to install part of that equipment; the proposed Bank loan would finance about 202 of total cost (US$154 million). 2.37 The scope of CFE's special distribution program is discussed in detail in Annex 3.2.0, and its physical goals for the 1990-94 period are summArized below:  - 15 - Construction of 115 and 60 kV lines 500 km Construction of primary feeders 1400 km Construction of secondary feeders 18,800 km Capacity additions to 109 substations 2,080 MVA Installation of distribution transformers 1,250 MVA Addition of capacitor banks 4,100 MVAC Purchase of maintenance vehicles 830 units Purchase of computerized billing equipment 665 units Purchase of electric meters 5.6 million The SRecial Thermal Power Plant Renovation Program 2.38 CFE has a total of 150 thermoelectric generating units, with a total name-plate capacity of 17,055 MW (Annex 2.3.2). The lack of adequate levels of maintenance in existing thermal power plants has been the cause why several of CFE's plants are operating at less than optimal performance. To take care of the problem in a systematic way, CFE has prepared a special upgrading program for 38 of its units with a total rated capacity of 6720 MW; most of these units have 11 to 31 years of service, and therefore require an upgrading, replacement or repair of materials and systems such as boiler superheaters, reheaters, economizers, air preheaters, boiler casings, turbine and feedwater heaters, instruments and controls, etc. The program, to be carried out in the 1990-94 period, will have a total current cost of US$289 million (US$165 million to be spent in the 1991-92 period), of which the proposed Bank loan would finance 391 (US$113 million), for the purchase of parts and materials. 2.39 The above special upgrading program is discussed in Annex 3.3.0; the goals to be achieved with the program ares - Increase availability of the units, adding available capacity to the power system by .............................. 678 MW - Recuperate name-plate generating capacity adding available capacity to the power system by .... .... ..... *....... * ..... 418 MW - Improve thermal efficiency from the present range (in kCal/kWh) of ............ 3000-2615 to a new range of .. ....................... 2606-2263 Mexico's Nuclear Power Proaram 2.40 The Laguna Verde nuclear power plant, with two units rated 675 MW each, is located 70 km NNW of Veracruz, in the coast of the Gulf of Mexico. No other nuclear plant is being considered for the expansion of the power generating system in the near future. Although the construction was decided by the Government and the site was selected in 1970 with assistance of the International Atomic Energy Agency (IAEA), its construction only started in 1976. The first unit is now completed, nuclear fuel was loaded in October 1988, it reached operational tests at 752 power, and is scheduled for commercial operation at 1002 power in 1990. Construction of the second unit is progressing well and is scheduled for commercial operation at the end of 1993. The plant has a Boiling Water Reactor with a  - 16 - Mark II type containment building, engineered and constructed to meet the American Nuclear Regulatory Commission's safety and environmental protection standards and codes and licensing regulations - including the backfittings recommended as a result of the analysis made of the Three Mile Island Nuclear Plant accident - as well as the recommended radiation exposure limits set by the International Commission of Radiation Protection. CFE has submitted to the National Commission of Safety and Safeguards (NCSS, empowered by law to exert the nuclear regulatory functions in Mexico) the Final Safety Analysis Report, and the NCSS is in the process of issuing the operating licence for the first unit. In the past 20 years CFE and NCSS (or its equivalent in the past) have been able to develop the manpower required to regulate and implement a nuclear power project to meet international standards of quality and safety, at present with only essential support from consultants and manufacturers. 2.41 Thr*Te Operating Safety Analysis Review Teams-OSART, fielded by the IAEA upon request of the Mexican Government (the latest one was held in September 1987), have advised CFE and CNSS on additional measures to be taken to get Laguna Verde operating without undue risks to the population and the environment; CFE has followed the OSART recommendations. Also, twice a year the IAEA safeguard inspectors make the material balance of the nuclear fuel as established in the tri-lateral safeguard agreements entered among IAEA, Mexico and nuclear suppliers, in compliance with the full scope of nuclear safeguards required by the Nuclear Weapons Non-Proliferation Treaty and the Tlatelolco Treaty (Treaty for the Prohibition of Nuclear Weapons in Latin America), of which Mexico is a party. Nuclear fuel and radioactive wastes will be stored at site during at least 10 years. Through an environmental program ccmprising sixteen stations, a laboratory and suitable equipment, CFE is doing the radiological monitoring of the air, water, animal, vegetable and marine life since 1982 and will continue to do so through the nuclear power plant lifetime and beyond. Two important emergency plans are already in place at Laguna Verde: the Internal Emergency Plan, intended to mitigate the effects of accidents and to protect the nealth and safety of the nuclear plant staff, and the External Radiological Emergency Plan, intended to face, at regional level, emergencies derived from accidents or incidents in the plant that may affect the population and ecosystems, including the evacuation of about 17,000 persons in a 16 km radius around the Laguna Verde nuclear plant. 2.42 CFE gave assurances to the Bank tUat the abovc practices, which are acceptable to the Bank, will continue in the future to ensure a safe operation of Laguna Verde, and CFE will continue having environmental and safety reviews every two years, with the assistance of experts from a well- known international nuclear energy agency. Electricity Pricing 2.43 There are two major issues confronting electricity tariffs in Mexico: first, electricity rates have been subsidized by the Government since the 1970's, and second, tariff structures do not reflect the costs of supplying electricity to each customer class. During 1986, revenues covered operating costs and left a positive margin of 6.2Z because fuel costs (set at level of about 65Z of international prices) were subsidized by the Government. It was then estimated that fuel subsidies plus  - 17 - government direct contributions to CFE amounted to about 1.1 of GDP and, consequently contributed significantly to the fiscal deficit, which was they, 15.6Z of GDP. Significant progress has been achieved in reducing these subsidies, and in 1989, fuel subsidies and Government transfers amounted to about 0.32 of the GDP. 2.44 Electricity rates fell, in real terms, about 372 between 1980 and 1983; between 1984 and 1986, rates were sharply increased in nominal terms (136Z, 462 and 120Z respectively in 1984, 1985 and 1986) but due to higher than expected inflation, they still failed to reach the 1980 level. In 1987 and 1988 average rates were increased on 1132 and 1252, respectively, in nominal terms but rates did not achieve the 1980 level due to offsetting inflation. The Government and CFE are now committed to a sounder policy under targets included in the sector's Financial Rehabilitation Agreement (PRA), which requires that the 1991 average electricity rate should be increased 18.8S in real terms with respect to those rates of the first semester of 1989; in line with the agreement, average rates were already increased on average 26.62 in 1989 (or 5.52 in real terms). This increase is particularly noteworthy as it was implemented at a time when there was a price and wage freeze in effect. It is also important to note that the increase sought to address some of the most glaring tariff structure distortions. thus residential rates for consumers above 200 kWh per month were increased by 2002, public lighting service by 1002, and water supply and sewerage service by 102. 2.45 Most Government subsidies would be eliminated by 1991, the only ones remaining would be for low-income residential and rural users (about 22 of total revenues). The rates to industrial customers who use 56Z of CFE's energy sales are close to LRMC; the agricultural consumers, using 82 of energy, have the largest gap with respect to LRMC. On the average, CPE's average electricity rate for 1988 was 762 of the LEMC, and it is planned to reach LRMC (about UScents 6.5 per kWh) by 1997. Annex 2.5.0 presents additional information on CPR's electricity rates. 2.46 CFE, with IDB financing, engaged the services of ENDESA, the National Electric Utility of Chile, to assist in the preparation of a tariff study based on marginal cost principles, which the Bank reviewed and found satisfactory as a guideline for policy actions. On the basis of this study, CFE has already started to apply tariffs based on marginal costs to industrial consumers; by April 1990, 270 industrial customers consuming 272 of CFE's sales are expected to be billed under this program. Under the Hydroelectric Development Project, CFE agreed to carry out a Second Phase of the Tariff Study to set up a tariff system based on marginal costs for medium voltage consumers, to be completed by June 30, 1991, and to exchange views with the Bank on the conclusions and recommendations of such study and provide to the Bank a plan of action, satisfactory to the Government and the Bank. to implement such recommendations, including a timetable for implementation not later than December 31, 1991. 2.47 During negotiations, the Government and CFE agreed to modify, not later than January 1, 1992, the present electricity tariff structure with the purpose of promoting efficiency in the use of electricity and reducing cross-subsidies among CFE's customers; CFE agreed to link this action plan with the results of the Tariff Study being executed under Loan 3083-ME (para. 4.01 b)).  - 18 _ Financial Performance 2.48 Power sector finances showed a deteriorating trend during the 1976-1985 period. Operating income which was positive until 1982, became substantially negative in 1983. Positive results were obtained during 1984-1986 but again became slightly negative in 1987 basically because rate increases did not keep up with inflation. During this period, heavy interest charges on debt resulted in negative net income for every year. This required subsidies and cash transfers from the Government as well as large levels of borrowings, some years in excess of the investment program, resulting in a great and increasing dependency on external funding. In 1988, CFE's finances started to improve as a result of the FRA (para. 2.52); a positive rate of return was achieved (1.42) and, for the first time, the self financing ratio was positive (1.82). Annex 2.6.0 contains supplementary information on CFE's finances together with actual and forecast financial statements. Key financial indicators are detailed in Annex 3.6.0. Government Subsidies and Cash Tranfers 2.49 As compared to the GDP, total Government subsidies and cash transfers increased from 0.72 in 1979 to 2.3Z in 1983, and then declined to 0.32 in 1989, as shown in the following table: 1979 1983 1985 1986 1988 1989 a) In US$ million 1651 3488 3179 1370 664 939 - Fuel oil subsidies 712 1332 1036 275 181 225 - Cash transfers 938 2156 2142 1095 483 714 b) As percentage of GDP 1.2 2.3 1.7 1.0 0.4 0.3 - Fuel oil subsidies 0.5 0.9 0.6 0.2 0.1 0.1 - Cash transfers 0.7 1.4 1.1 0.8 0.3 0.2 2.50 Fuel subsidies increased from 0.52 of GDP in 1979 to 0.92 in 1983, and then declined to 0.12 in 1989, as a result of the Government policy of reducing the difference between domestic and export prices. Currently, the domestic residual oil price is estimated at 752 of the export price. The financial forecasts assume that in 1992 both prices would be the same (para. 2.13). 2.51 Cash transfers increased from 0.72 in 1979 to 1.42 in 1983, to help meet the heavy debt service burden (para. 2.48). Since then, cash transfers have declined to 0.22 as a result of the application of the FRA. Financial Rehabilitation Agreement (FRA) 2.52 In view of the serious deterioration of sector finances, and within its general policy of adjustment with growth, in August 1986 a three-year agreement for the financial rehabilitation of the power sector was signed between the Government and CFE, which included as a first step the conversion of about US$8.6 billion of CFE's debt into equity, leaving CFE with a balance of about US$1.7 billion debt. The agreement included  - 19 - provisions for substantial rate increases in real terms and improvement of productivity (efficiency targets and operating costs). It also included actions to strengthen institutionally CFE, including improvements in organization and accounting, and established a reporting scheme to monitor its implementation. The Government and CFE signed a new FRA on August 31, 1989, which defined more precisely certain terms and sets out realistic productivity improvement targets. Annex 2.7.0 presents a summary description of the FRA and proposed targats. The new FRA, to be in effect until December 31, 1994, includes, inter alia, the following agreements and targets: a) to convert CFE's short-term debt (US$500 million) into Government equity; b) to limit CFE's short-term borrowing (less than one year) from internal and external markets to no more than 10 percent of annual cash operating expenses; c) to increase electricity rates in real terms not less than 92 average in 1990 and 92 average in 1991 over those rates existing in the first semester of 1989; d) to achieve by 1990 and thereafter, a funding mix for new investment with the following compositions 402 minimum interual funding, 102 maximum Government contribution and 502 maximum borrowings; e) to improve CFE's operational productivity according to certain specific performance targets; f) to continue the implementation of hourly tariffs and other measures to reduce peak load. Financial Forecast 2.53 CFE's financial situation is expected to improve substantially during project implementation, provided that CFE's efficiency targets under the FRA are achieved and that electricity rates are adjusted, by 9Z p.a. in 1990 and 1991, according to the agreements reached with the Bank under the Hydroelectric Development Project, allowing CFE to reach a rate of return of about 32 in 1990 and close to 42 in 1991. These commitments would be repeated under the project. 2.54 Under the above assumptions, CFE would be able: (i) to generate over 402 of its total financing requirements for investments; (ii) to achieve a debt service coverage ratio higher than 1.5 starting in 1990; and (iii) to eliminate all need for Government equity contributions starting in 1991, except for small subsidies for electric service to low-income residential and agricultural consumers. To assure the successful rehabilitation of CFE's finances started under the ongoing Hydroelectric Development Project, during negotiations, CFE and the Government agreed (i) to reach, as a minimum, the following rates of return on net fixed assets in operation revalued annually under methods acceptable to the Bankt 42 in 1992, 52 in 1993; 62 in 1994, 6.52 in 1995: and 72 in 1996 and thereafter, and (ii) finance at least 402 of its annual investment budget with internally generated funds. If in any year CFE would be unable to finance  - 20 - at least 402 of its investments, the above rates of return shall be increased as required (para. 4.01c )). 2.55 Under Loan 3083-ME, the Government and CFE are committed to review annually, by October 31 of each year, the Ten-year Investment Program for the power sector (para. 2.29). In order to assure that CFE's short-term goals are consistent with the long-term strategy, the Government and CFE agreed, under the proposed operation, to present to the Bank by October 31 of each year the proposed CFE's annual operating and investment budgets and financing plan for the upcoming fiscal year (para. 4.01 (d)). 2.56 It is expected that to achieve those targets, in addition to the tariff increases required in 1990 and 1991 (para. 2.53) CFE will have to continue increasing electricity rates in real terms on average about 62 in 1992, 42 in 1993, 62 in 1994 and lower amounts thereafter. The rate hikes of September and December 1989 represent an average increment of about 5.5Z (in real terms) over those rates existing during the first semester of 1989. Government Power Sector Strate&v 2.57 Within the framework of its general energy policy, the Government has established the following objectives for the electric power sector: a) to promote an efficient use of electricity through realistic pricing policies, energy conservation, and improvement in sector operations; b) to diversify the sources of power generation by supporting the development of cost-effective alternatives to conventional oil- fired steam plants, such as hydroelectric, coal fired, and geothermal power plants; c) to strengthen the financial condition of the sector by implementing the FRA, through significant conversion of debt into equity, electricity rate increases and reduction of operating costs; and d) to make electricity available to an increasing number of consumers with emphasis on low-income consumers and on productive rural consumers. CFE's Procurement Practices 2.58 In accordance with Government legislation and policies, in the past CFE restricted its sources to national suppliers, and permitted international competition only when no Mexican manufacturer or contractor existed or had the capacity to do a job. However, after Mexico joined GATT in 1986, public enterprises, including CFE, are gradually opening their market to international competition. Under the proposed operation, all of the contracts financed by the Bank will be procured in accordance with Bank guidelines for procurement of goods and services and hiring of consultants.  - 21 - Analogous commitments are being obtained under the proposed IDB loan, co- financer of the project. One of the objectives of the Bank's strategy towards the Mexican power sector is to support the Government policy of a gradual opening of procurement to international competition. Bank Participation in the Sector 2.59 The Bank participated actively in financing development plans in the power sector in Mexico until 1974, when the Eleventh Power Project was completed. Until then, the Bank had made eleven loans to the power sector for a total of about US$705 million. During the period of Bank participation, the sector grew at a steady pace and its finances and institutional aspects were substantially strengthened. Thereafter, Bank missions visited Mexico in several occasions to consider resuming lending, but no further loans were possible as important financial and procurement issues remained unsolved. During the absence of the Bank, sector finances deteriorated substantially as the Government let electricity rates erode, in real terms, following a policy of subsidies financed by petroleum revenues. Only two project performance audit reports have been prepared for Bank power loans to Mexico: No. 859 dated September 9, 1975 and 1775 dated October 26, 1977 for the Third and Fourth Power Sector Programs (loans 659-ME and 834-ME), respectively. Both PPARs show the positive contribution of Bank resources to the sector's physical development and to the achievement of an important technical objective: frequency unification. They also show the Bank's inability to solve CFE's institutional problems and to reverse the deteriorating trend in sector finances which resulted in its long absence (15 years) from sector operations. 2.60 in August 1986. the Government and CFE signed a power sector Financial Rehabilitation Agreement and in August 1989 the Agreement was renewed for another five years (para. 2.52). The FRA focuses on the most critical issues that the Bank had been raising and defined measures to address them. During the recent past the dialogue with the power sector has been constructive and led the Government to request financial assistance from the Bank for the Hydroelectric Development Project (Loan 3083-ME, approved in June, 1989) and for the proposed Transmission and Distribution Project. Bank Obiectives and Long-Term Strategy 2.61 The Bank's role in the sector is to support the general energy policy of the country and the objectives established by the Government for the power sector bys a) assisting the country to obtain added foreign currency for financing, on adequate terms, the power sector investment program, through the Bank's own lending instruments or acting as a catalyst for other sources of financing; b) ensuring the adequate consideration of least-cost principles in the power sector investment program; c) promoting financial policies that will eliminate the need for Government subsidies, and ensuring that pricing policies lead to an efficient allocation of resources; I  - 22 - d) prompting the Government to gradually open up the procurement in the power sector to international competition; e) helping CFE in its institution building efforts, through implementation of streamlined norms and procedures and clear delimitations of accountability; f) strengthening the sector's norms and procedures on environment and social matters as related to construction and operation of power projects; and g) promoting co-generation and efficient use of energy through adequate policies. 3. THE PROJECT Introduction 3.01 At the request of the Government, the Bank sent three preparatory missions to Mexico, the first one on April 1988, with the purpose of assisting CFE to define a project that would qualify for a Bank loan of quick disbursement; a time-slice (1991-1992) of the power sector's Ten-year Investment Program was selected as the project. Appraisal took place starting June 26, 1989; negotiations took place in Washington on January 29, 1990 and were concluded in Mexico City on March 9, 1990. Project Description 3.02 The proposed loan would be a sector investment loan that would help fund a time slice (1991-92) of CFE's Ten-year Investment Program; within this time-slice, the funds of the Bank would help finance four basic components: (a) a special transmission and distribution program aimed at expanding and improving installations rated 400 kV to 115 kV (40.0? of the Bank's proposed loan; para. 2.34); (b) a special distribution program that would expand and improve the distribution grid (34.5X; para. 2.36); tc) a special program to renovate thermoeleutric power plants to improve thermal efficiency and availability of CFE's main plants (25.0?; para. 2.38); and (d) environmental and pollution control studies related with those components (0.5?; paras. 3.13 and 3.14). CFE's total 1991-92 investment program is described in Annex 3.4.0 and summarized belows Generation Programs (53Z of the total cost). Complete construction and place into operation 1227 MW in new power plants and start construction of new power plants rated 4900 MW. Transmission Program: (18X). Complete construction started in previous years and start new construction of high voltage transmission lines, substations and related facilities. Included here is the special transmission program (para. 2.34) (10? of total cost) and a Study of the Environmental Aspects of Transmission Lines and Substations (para. 3.13) that the Bank loan would finance.  - 23 - Distribution Programs (192). During the two-year period one million new customers would be connected to the system; the special distribution program is included (para. 2.36) (72 of total cost). Equipment Upgrading (8X). The purpose of this program is to renew and upgrade existing installations, including generation, transmission and distribution facilities, to attain the performance and efficiency expected from each component of the power system. Included is CFE's thermal power plant renovation program (32 of total cost) described in para. 2.38, and a Thermal Power Plant Pollution Control Study (para. 3.14). General Plant (22). Under this component are included the facilities required for the operation of the company, such as office buildings, vehicles, office equipment, etc. Estimated cost 3.03 The total 1991-92 investment program, including physical and price contingencies is estimated at USe6,711.4 million (current costs), of which approximately 402 is foreign cost. Interest during construction and other financial charges on loans (including the proposed Bank loan) amount to be about US$416.0 million. Local cost estimates include approximately US$576.0 million of identifiable taxes and duties. Detailed cost estimates are given in Annex 3.4.0 and are summarized below: Prolect Cost Estimate (1991-92 CFE's Investment Program) __