Mexico - Fourth Power Sector Program Project

CIRCULATNG COPE RETURN TO TOBRTUNR REPORTS DESK RESTRICTED Report No. P-1095 WITHIN ONE WEEK && 0 This report is for official use only by the Bank Group and specifically authorized organizations or persons. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or complcteness of the report. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PR ESID ENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO COMISION FEDERAL DE ELECTRICIDAD (CFE) AND NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR THE FOURTH POWER SECTOR PROGRAM June 7, 1972  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPENT REPORT AND RECOQMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DRECTORS ON A PFOPOSED LOAN TO COMISION FEDERAL DE ELECTRICIDAD (CFE) AND NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR TH4E FOtlRTH POWER SECTOR PROGRAM 1. I submit the following report and recommendation on a proposed loan to Comision Federal de Electricidad (CFE) and Nacional Financiera, S.A. with the guarantee of the United Mexican States for the equivalent of $125 million, to help finance the continuing expansion program of the power sector of Mexico. The loan would have a term of 20 years including five years of grace, with interest at 7-1/h percent per-annum. PART I - BANK LENDING TO MEXICO 2. My report and recommendation (P-1036) dated April 19, 1972, which was distributed in connection with a proposed B;;nk loan for a ports project, gave recent information on the Mexican economy and its prospects (for the relevant sections of that report, see Annex II). As of April 30, 1972 the Bank had made 26 loans to Mexico totalling $1,074 million net of cancellations, of which the Bank held $839 million including $157 mil- lion not yet disbursed. In the meantime the ports, railway and industrial fund loans have been approved aggregating $130 million. A suwmary of Bank loans and IFC investments and a report on project execution is attached as Annex I. Country data are at Annex II. PART II - THE PROJECT Background 3. From 1965 to date the Bank has made three loans totalling $325 million to help finance the programs of the entire power sector, having previously made seven loans from 1949 to 1962 totalling $255 mil- lion, net of cancellations, to finance projects of the two main power companies. The sector programs have included the installation of new generating, transmission and distribution facilities under a long range expansion plan, which is reviewed-periodically by the Bank and SOFRELEC, one of CFE's consultants.  -2- The 1972-74 Program 4. The fourth power sector project follows the general pattern of the three previous sector projects in that it consists of the investment program expected to be carried out over a specific period, in this case the three years 1972-7T. The total cost of the 1972-74 investment program is estimated at the equivalent of $1,368 million with a foreign exchange cost of $650 million. Of the total some 60 percent is for generation, transmission and substations, 23 percent for distribution, 6 percent for village electrification, 8 percent for overhead and 3 percent for frequency unification, consultants and miscellaneous. Major generation equipment includes 3,015 MW of hydroplant, 3,900 MW of steam-turbine plant, 670 MW of nuclear plant and 500 MW of gas-turbine plant. The transmission program envisages the construction of 3,000 km of h00 IcV lines, 2,900 km of 220 kV lines and 5,600 km of 69-161 kV lines; furthermore, 17,000 MVA of main stations and 300 MVA of small substations will be constructed. The distribution networks, including village electrification, will be expanded at an annual cost of $120 million. Further details are shown in Annex III. 5. Investment in the power sector has been increasing rapidly in recent years and is expected to continue to increase substantially to assure the generation and distribution capacity necessary to meet Mexico's rapidly growing power demand. Actual investment in 1970/71 was 35 percent higher than had been projected by CFE in 1969 because of increasing prices in world markets and the need for major additions to the program, particularly gas turbines, as a result of more rapid growth of demand than had been expected, as well as delay in the implementation of frequency unification, which is discussed in paragraph 18 below. The annual investment now projected for 1972-74 is h0 percent higher at current prices than the average for the past two years as a result of the growing demand, the general increase in prices and the inclusion in the program of Mexico's first nuclear plant, which has a relatively long installation period. Financing Plan 6. The 3harp increase which has occurred in physical investment and prices has led to much larger borrowing than had been expected; as a result, debt service in 1971 absorbed the bulk of internal cash genera- tion of the power sector plus contributions by the Government and power users. In 1970-71 these resources financed only 12 percent of the investment program instead of the 35.percent projected at the time of appraisal; even though the sector has been earning the 8 percent return on its assets required under the last loan. With tariffs remaining at their present level practically all of the 1972-74 investment program would have had to be financed from borrowing and the heavy debt burden of the power sector would have been further increased.  -3- 7. The Mexican Government has recognized that a substantial in- crease in tariffs is essential for the sound financing of the fourth power sector program and its Energy Policy Committee has recommended an average tariff increase of 17-1/2 percent. A revision in the rate structure providing for an average increase in excess of this percentage has now been worked out by the Federal Electricity Commission and the procedural steps required in Mexico to initiate power tariff changes are now being taken. The revision provides for substantial increases in rates charged industrial, commercial and larger residential users, with reductions in those charged smaller consumers in line with the Government's general aim. of reducing income inequalities in Mexico. Several months will be required to take all of the steps needed to implement the rate changes, which the Government plans to bring into effect before the end of the current calendar year. This timing is part of a phased program for increasing public enterprise tariffs, including those for petroleum products and urban water supply without interfering with the recovery of the economy from the industrial recession in 1971. 8. To avoid delay the Government has requested that the Bank proceed with the loan without waiting for the increase in power tariffs on the understanding that the documentation necessary for loan effective- ness will not be submitted until the tariffs have been raised. My recommendation is that we proceed on this basis; a letter from the borrow- ers and the guarantor incorporating the understanding would be signed simultaneously with the loan documents. To help to assure on a continuing basis the sound financing of the power sector the Guarantee Agreement (in Section 3.03) specifies that net internal resources shall cover at least 18 percent of investment expenditure in 1973 and 25 percent in 197h and subsequent years. 9. These understandings are reflected in the financing plan for the 1972-74 con5truction program which is set out below. The borrowing necessary to complete the plan is summarized in the following paragraphs. Amount Percent of (in . millions) Total (a) Resources of Power Sector (1) Internal cash generation 1133 Less debt service and *other deduction 923 Net internal resources 210 15.3 (2) Federal and users contri- butions 113 8.3 Subtotal 323 23.6  Amount Percent of (in $ millions) Total (b) Export Financing (1) Joint loans (in 68 connection with 5t4ME and 659ME) (2) Parallel loans 50 (3) Other export credits 69 Subtotal 187 13.7 (c) IHRD TTBalance of loans 47 544ME and 659ME *(2) Proposed loan 125 Subtotal 172 12.6 (d) Other Borrowink (1) Internal 282 20.6 (2) External 404 29.5 Subtotal 686 50.1 Total Financing 1,368 100 Export Financing 10. The financial plan for the fourth power sector program reflects a transition from joint financing, used for the first three Mexico power sector projects, to parallel financing. A total of $1L8 million of orders qualified for joint financing under the third power sector program by December 31, 1971, which was established as the cutoff date for such orders. These orders are being covered on a 50-50 basis by the Bqnk and joint loans from equipment-supplying countries; disbursements under the latter are expected to total $68 million during 1972-74. 11. The joint financing system has been based on the participation of all developed countries supplying substantial amounts of electrical equipment to Mexico and the shift now contemplated to parallel financing was an outgrowth of a decision by the United States not to continue its participation. CFE has selected a list of major equipment in the 1972-7h program totalling about $120 million (Note: figure subject to revision) to be reserved for competitive bidding among countries which are prepared to provide parallel financing for orders won by their suppliers. In view  -5- of the time needed to place orders and for delivery of equipment, disburse- ments under the parallel loans are projected at about $50 million during 1972-74. 12. The list of equipment for parallel financing excludes the steam supply system for Mexico's first nuclear power plant. This sytem will be financed through supplier credits under separate arrangements, since the manufacturers of nuclear equipment are ready to offer financing with terms of at least 15 years and at reasonable interest rates. In case CFE decides to procure the turbogenerator separately, it would request its inclusion in the part of the program to be financed by parallel loans. The Proposed Bank Loan 13. The proposed Bank loan would cover payments on the following items: $ Millions Equipment eligible for Joint financing 35 Other equipment 73 Civil works (foreign exchange component 15 only) Consultants 2 14. Equipment to be financed under the Bank loan is being procured through international competitive bidding with a maximum preferential margin of 15 percent for Mexican firms. If orders are won by Mexican firms the loan would finance the full ex-factory price. There are no preferential tariffs affecting the goods tc be financed under the loan. There would be a substantial amount of equipment in the program reserved for procurement in Mexico, but this would not be financed by the Bank. Civil works contracts with an estimated value greater than Mex$20 million ($1.6 million) would, as under the four previous power loans to Mexico, be awarded on the basis of international competitive bidding. 15. The term of the Bank loan would be 20 years following the pattern of past power sector loans. However, the grace period lould be five rather than four years in view of the heavy burden of debt service on the power sector during the next five years. Other Borrowing 16. To complete'the financing required to carry out the 1972-7h program, substantial amounts, in addition to the Bank loan and the export credit financing described above, will have to be borrowed from commercial banks and by bond issues and other means, both from within Mexico and abroad. The scale of the borrowing required will decrease as internal cash generation by the power sector increases after 1972. The proportion of the construction program financed by borrowing of all kinds is expected to decline from 94 percent in 1972 to 60 percent in 1976. Total debt service  -6- coverage by internal cash generation is projected to increase from 0.9 times in 1972 to 1.L times in 1973. Since the interest coverage covenant is not expected to be met through 1973, however, the Bank's consent would be needed for borrowing to finance the construction program. Sector Performance 17. Performance of the power sector in recent years has been generally satisfactory. Longer range planning of the sector's generation and trans- mission facilities is called for, however, and the methods for putting this into practice will be worked out during 1972-7l by CFE's planning department, assisted by SOFRELEC, under terms of reference to be discussed with the Bank. CFE has also undertaken to make further improvements in its load fore- casting. A computerized control system for the sector's investment program and budget will also be introduced, 18. The major failure in performance during 1970/71 was in carrying out the first phase of frequency unification to match the existing 50- cycle Centro system with the 60-cycle system of the rest of Mexico, as had been agreed in connection with Loan 659-ME and the two previous loans. While various master plans have been prepared, no action has been taken, mainly because of opposition'by the management of Centro and its labor union. After a thorough review of the merits of frequency unification in August 1971, President Echeverria signed the decree directing that a program of frequency unification be formulated and completed by 1977. The issue of a second decree creating the entity to 'carry out the conversion was, however, delayed because it became bound up with highly controversial Jurisdictional disputes involving the three labor unions in the power sector. This jurisdictional problem has now been resolved and the second decree was issued in May, which will enable work on frequency unification to proceed without further delay. Economic Evaluation 19. The power sector project is well justified. It is designed to meet the power needs of Mexico's rapidly growing economy, as well as to expand electrification in rural areas. In the annual reviews of its program CFE studies all practical alternative methods of meeting its peak load and energy requirements, subject to a minimum standard of dependability. The economic return on the 1972-7h time-slice of investment is about 1 percent. The assumed benefits include bnly directly attributable revenues. The full value of the economic return, which would reflect the extent to which Mexican consumers would be prepared to purchase more expensive privately generated power, would undoubtedly be higher.  -7- PART III - LEGAL INSTRUMENTS AND AUTHORITY 20. The draft Loan Agreement between the Bank and Comision Federal de Electricidad and Nacional Financiera, S.A., the draft Ouarantee Agreement between United Mexican States and the Bank, the Report of the Committee provided for in Article III, Section h(iii) of the Articles of Agreement and the text of a Resolution approving the proposed Loan are being distributed to the Executive Directors separately. 21. I am satisfied that the proposed Loan would comply with the Articles of Agreement of the Bank. PART IV - RECOMMENDATION 22. I recommend that the Executive Directors approve the proposed Loan. Robert S. McNamara Attachments President June 7, 1972  Annex I Page 1 of 3 THE STATUS OF BANK GROUP OPERATIONS IN MEXICO A. STATMENT OF BANK LOANS AND IDA CREDITS (as at April 30, 1972) Anount (Bank) & Refund- ings Loan or less Cre dit Cancella- Un- Nimaber Year Borrower Purpose tions disbursed 19 loans fully disbursed 759.0 - 450 1966 Nacional Financiera, S.A. -Irrigation 19.0 1.9 527 1968 Nacional Firanciera, S.A. Irrigation 25.0 17.2 528 1966 NacionalJ Financiera, S.A. Roads 27.5 3.9 659 1970 Cornision Federal de Electricidad and Naclonal Fi.nanciera Paowe- 125.0 27.5 695 197C NacionzaJ Firanciera, S.A. Roads 21.8 20.9 747 1971 Nacional hinanciera, S.A. Agriculture 75.0 62.6 793 1972 Nacional Finarciera, S.A. Tourior 22.0 22.0 I/ Totel 1,07b.3 156.C Of which has been repaid 230.2. TotJl now outstanding 8U*.. Amount sold: 50.7 Of which has been rerJid c 6.0 L.7 Total now held by Bank 83_ __ TotL2 undisbursed 156.C L56.0 1/ Not yet ef:ectfve Note: Three lo:rTs for norta ($20 r.illion) railw;.ys ($?5 m.illion) and - industri.3- finance ($35 ..i2ion) were approved subsenuent to the above date; they are not yet effective.  Arnnex I Page 2 of 3 B. STATEMENT OF IFC DIVESTMENTS (as at April 30, 1972) Aiour.t in $ million, Year Obligor Type of business Loan Equity Total 1958/59 Industrias Perfect Circle, Industrial equip- 0.8 - o08 S.A. * ment 1958 Bristcl de Mexico, S.A. * A/C Enaine over- 0.5 - 0o5 haul 1961 Acero Solar, S.A. * Twist Drills 0.3 - 0.3 1962/ Canpania Fundidora Fierro Steel 2.3 21lt