Mexico - Power Sector Project

RETURN To RESTRICTED REPORTS DESK Report No. TO-497b I WM/Tl11N K ONE WEEK This report was prepared for use within the Bank and its affiliated organizations.. They do not accept responsibility for its accuracy or completeness. The report may not be published n-or may it be quoted as representing their views. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION APPRAISAL OF THE INVESTMENT PROGRAM OF THE ELECTRIC POWER SECTOR MEXICO November 26, 1965 Projects Department  CURRENCY EQUIVALENTS 1 US $ = 12. 50 Pesos (Mex. $) 1 Mex. $ . 100 centavos (g) = 0. 08 US $ 1 million Mex. $ = 80, 000 US $  APPRAISAL OF THE INVESTMENT PROGRAM OF THE ELECTRIC POWER SECTOR MEXICO TABLE OF CONTENTS Page No. SUMMARY i-i I. INTRODUCTION 1 A. History of the Power Sector 1 B. Previous Bank Lending to the Mexican Power Industry 3 II. THE BORROWERS 4 III. OPERATIONS, ORGANIZATION AND MANAGEMENT 6 A. Operations 6 B. Organization and Management 7 IV. POWER MARKET 9 V. THE PROJECT 10 A. Planning, Design and Supervision 13 B. Capital Requirements 13 C. Procurement 15 VI. THE LOAN 16 VII. FINANCIAL ASPECTS 18 A. Tariffs 18 B. Capital Structure and Present Financial Position 19 C. Past Earnings Record 23 D. Proposed Financing Plan 25 E. Future Financial Position 29 F. Protective Covenants 30 VIII. CONCLUSIONS 31  LIST OF ANNEXES 1. INSTALLED CAPACITY AND GENERATION 2. SALES OF MAJOR ENTITIES 1960-1964 3. SALES OF MAJOR ENTITIES 1964-1971 4. THE 1965-73 EXPANSION PROGRAM Table and Chart No. System 1 Central 2 Puebla-Veracruz (Malpaso) 3 Michoacan-Chapala-Guanajuato 4 Sonora-Sinaloa 5 Falcon-14nterrey 6 Tijuana-Mexicali 7 Torreon-Chihuahua 8 Yucatan 9 Colotlipa-Acapulco 10 Ciudad Juarez 5. THE FREQUENCY CHANGE 6. LIST OF PROJECTS (a) Under construction on January 1, 1965 (b) To be constructed after January 1, 1965 7. ESTIMATED COST OF CONSTRUCTION AND FORECAST OF EXPENDITURES 8. FINANCIAL STATEiqENTS: COMISION FEDERAL DE ELECTRICIDAD (CFE) Table 1 Income Statements 1961-1964 2 Sources and Applications of Funds 1961-1964 3 Balance Sheets 1961-1964 9. FINANCIAL STATEMENTS: COMPANIA DE LUZ Y FUERZA DEL CENTRO, S.A. (CLFC) Table 1 Income Statements 1961-1964 2 Sources and Applications of Funds 1961-1964 3 Balance Sheets 1961-1964 10. FINANCIAL STATEMENTS: INDUSTRIAL ELECTRICA MEXICANA, S.A. de C.V. (IENSA) Table 1 Income Statements 1961-1964 2 Sources and Applications of Funds 1961-1964 3 Balance Sheets 1961-1964  11. FINANCIAL STATEMENTS: POwER SECTOR Table 1 Forecast of Earnings 1965-1971 2 Sources and Applications,of Funds 1961-1971 3 Balance Sheets 1964-1971 12. 1964 SALES BY CFE, CLFC, AND IEMSA DIRECT TO ULTII!ATE CONSUMERS 13. EQUITY AS OF DCEM3BER 31, 1964 Table 1 CFE 2 CLFC 3 IEMSA 14. LONG AND 14EDIUM-TERNv DEBT AS OF DECEMBER 31, 1964 Table 1 CFE 2 CLFC 3 IEiSA MAPS  APPRAISAL OF THE INVESTMENT PROGRAM OF THE ELECTRIC POWER SECTOR MEXICO SUMMARY i. Mexico has requested assistance from the Bank in financing a part of the investment program of the Power Sector now being carried out by Comision Federal de Electricidad (CFE), Compania de Luz y Fuerza del Centro (CLFC) and Industrial Electrica Mexicana, S.A. de C.V. (IEMSA). The loan would be available for expenditures covering a two-year slice of the program, 1965-1966. The proceeds would be applied to foreign equipment, local equipment purchased after international bidding with up to 15% protection, and a percentage of civil works equivalent to the foreign currency component. Mexico requires about US-$145 million for this purpose of which it expects to be able to obtain about US$35 million from other foreign lenders. ii. The Power Sector is now completely owned by the Government. The intention is ultimately to merge the separate entities, but so far progress has been slow. The proposed Bank loan would improve the coordination between the entities and thus lead toward consolidation. iii. The program includes: the completion of many generating plants, transmission lines, substations, and extensions to distribution networks already started and partially financed; a large number of facilities which will be started and completed during the next two years; and several projects to be commenced which will not be finished before the proposed loan is fully drawn down. The change of frequency of the Central System from 50 to 60 cycles per second will be initiated. The program will be subject to Bank review and approval in 1966. Should part of the program slip into 1967, disbursements would be continued provided the Sector reaches and maintains an adequate earnings level. iv. The staffs of the Sector entities are capable, with the assistance of consultants, of carrying out the program. The management of CFE, the largest and most important entity of the Sector, needs strengthening. v. The financial position of the Sector has been weak. The major expansion program which almost doubled the Sector's fixed assets within the last three years was not supported by an adequate level of earnings. A rate increase in 1962 brought temporary relief but it was not sufficient to offset later operating cost increases. The capital structure has been heavily burdened by medium term suppliers credits which were the only available source of finance except for a major Bank loan (US$130 million) to CFE in 1962. The resulting heavy debt service obligations and inadequate earnings led to the incurrence of short-term debt which could not be liquidated and continued to grow. By the end of 196%4, when the rate covenant of Loan 316-NE became operative, CFE did not meet its requirements; no steps were taken at that point to improve the earnings situation.  - ii - vi. During the negotiations for the proposed loan, agreement was reached on two important aspects of the Sector's financial situation: the earnings level of the consolidated Power Sector and the solution of the short-term debt problem. In the new rate covenant the Guarantor has agreed to obtain an 8% rate of return on the Sector's adjusted net fixed assets in operation (rate base); in 1966 this would be achieved by increasing the Power Consumption Tax, and thereafter the necessary rate or Power Consumption Tax increases would be determined in the course of annual reviews by the regulatory agency. The present short-term debt problem will practically be resolved by refinancing operations now being completed. It is expected that by the end of 1966 current assets of the Sector will cover current liabilities. Commitments were obtained in this connection which should help to avoid a recurrence of the unsatisfactory past experience. vii. Fbrecasts have been prepared which show an acceptable financial picture assuming that the Sector would maintain the minimum required rate of return. Internal cash generation after meeting debt service would contribute an average of about 35% towards construction costs in 1965 and 1966. Annual interest would be covered more than two times and annual debt service coverages would remain well above 1.5 times. On this basis, a Bank loan of US$110 million with a term of 20 years, including a four-year grace period, is appropriate.  APPRAISAL OF THE INVESTMENT PROGRAM OF THE ELECTRIC POWER SECTOR MEXICO I. INTRODUCTION 1. The purpose of this report is to appraise a request from the Government of Mexico for a loan to the Power Sector which would help to finance the 1965-66 construction expenditures. The loan would be made to the Comision Federal de Electricidad (CFE) with portions to be made available to Compania de Luz y Fuerza del Centro (CLFC) and Industrial Electrica Mexicana, S.A. de C.V. (IEMSA). 2. An appraisal of the programs and financial positions of the three major entities, CFE, CLFC and IEMSA was made in Mexico by Messrs. H.C. Hittmair and R.H. Sheehan in April and May 1965 and was later supplemented by additional information submitted to the Bank. 3. Based upon estimates of the cost of the 1965-66 slice of the Sector's expansion program, a figure for the required external financing of about US$145 million was determined. As a result of many discussions between the Bank and representatives of lending institutions in Europe, Japan, Canada and the U.S. prospects now appear favorable that appreciable amounts of foreign lending can be made available for the Mexican power program on terms reasonably close to those of the Bank. During negotiations it was agreed that Mexico would make its best efforts to obtain no less than the equiva- lent of US$35 million to be used for the 1965-66 program. The size of the proposed Bank bDan was accordingly reduced to US$110 million. For a further discussion of the loan amount, see Chapter VI. A. History of the Power Sector 4. The early development of the M4exican power industry foll1ws a pattern similar tg) that of many other Latin American countries: from scattered, small undertakings in the late nineteenth century; through a continuous growth period financed mainly by private foreign capital; to the founding of a Government owned public utility, the Comision Federal de Electricidad (CFE); and ultimately to the full nationalization of the industry. 5. In the spring of 1960 the Mexican Government through Nacional Financiera S.A. (NAFINSA) purchased the assets of American and Foreign Power Company's subsidiary Impulsora de Empresas Electrica, S.A. (Impulsora) for US$65 million. The rights and obligations under this contract were later transferred to a small existing power company, Industrial Electrica Mexicana, S.A. de C.V. (IEMSA), an affiliated company of CFE operating in Mexicali (see also paragraph 18). Later in 1960 the Government acquired a majority of the outstanding shares of the Mexican Light and Power Co. Ltd. (Mexlight), a Canadian corporation. In 1963 the physical assets of Mexlight in Mexico were transferred to its largest operating subsidiary, Compania de Luz y Fuerza del Centro (CLFC) (see also paragraph 19).  - 2 - 6. With these purchases the Government obtained control of the public supply sector, and in December 1960 it added the keystone to the nationalization process by amplifying Article 27 of the Mexican constitution in the following terms: "It pertains exclusively to the (Mexican) Nation to generate, transmit, transform, distribute and supply electric energy for the purpose of providing public service. In this field no concessions will be granted to private parties and the Nation will usefully employ the goods and natural resources required for these purposes." 7. Up to the end of 1960 CFE had purchased more than 50 small electric companies. After the purchase of Impulsora and Mexlight by the Mexican Government the pace of acquisition was accelerated and by early 1965 CFE had added some 50 more companies to its operating systems. In two specific acquisition cases, those of Electricidad y Gas de Monterrey, a subsidiary of the International Power Co. Ltd. and the Compania Electrica de Sinaloa, S.A., where the valuation of the properties was disputed, CFE and the private foreign interests jointly appointed the U.S. firm of Stone & Webster to work out an independent valuation. At the end of 1964 the Government owned or controlled 3,672 MW or some 80% of the total installed capacity in the country, with CFE being by far the largest producer of power. The remainder of the generating capability was made up of captive industrial plant and a considerable number of small enterprises, the majority of them with an installed capacity of less than 500 kw. Of the capacity available for public supply the Government now controls all but about 2%. Thus for all practical purposes the nationalization of the Mexican power industry can be considered complete. 8. It was the intention of the previous Government to consolidate all of the electric power holdings into some form of integrated national orga'nization. In 1962 Electricite de France (EDF) in conjunction with SOFRELEC submitted a report to the Government recommending that a single autonomous organization be set up, but with a structure and control different from that of CFE. The principal recommendations of the report were that regional divisions be created with full control over planning, construction, and operation of distribution networks and that the Board of Directors of the new organization be given more specific responsibilities than CFE's Board and have a continuity of office. However, up to the start of the new National Administration in December 1964 no concrete steps had been taken to create a new organization and progress towards consolidation of the Sector had been disappointingly slow. 9. In March of 1964L, the outgoing Administration appointed an ad hoc committee to study all the facets of the reorganization of the Power Sector. The committee's report which was submitted on October 31, 1964, is a comprehensive document which presents a review of the present structure of each entity, the financial outlook for the Sector, the tariff structure, the labor union situation, and the pIanning and execution of the construction program. The report agreed in general with the EDF study and recommended inter alia: that a new organization "Electricidad de Mexico" be created with complete responsibility for  - 3 - the planning, organization, development and coordination of the public Power Sector; that the frequency of the Central System be changed from 50 to 60 cycles per second; and that a new, uniform system of accounts be established fortthe Power Sector. Short of a formal consolidation, the new Administration has started to take action on all important problems pertaining to coordination of the Power Sector and during negotiations satisfactory understandings were reached on planning, financing, and operations. B. Previous Bank Lending to the Mexican Power Industry 10. The Bank has made seven loans to the Mexican Power Sector for a total amount of US$254.8 million; 85% of this amount or US$217.8 million went to CFE and 15% or US$37 million to Mexlight. The amounts of the loans and the years when they were made are given in the following tabulation: Loan Repaid as of Year Loan No. Borrower Amount June 30, 1965 (in thousands of US$) 1949 12-ME CFE 24,100 12,203 1949 13-ME CFE 1/ (10,000) _ 1950 24-ME I4exlight 26,000 11,042 1952 56-ME CFE 29,700 9,760 1958 186-ME Mexlight 11,000 2,534 1958 194-ME CFE 34,000 2,755 1962 316-ME CFE 130,000 3,315 254,800 hjl,609 I/ See paragraph 11 below For the loans to CFE, NAFINSA as the Government's fiscal agent and development bank was a co-borrower in accordance with its role as the Mexican agency charged with the negotiation and administration of foreign loans. The loans to Mexlight were secured by a first mortgage on its properties; the loans to CFE were unsecured. 11. Loan 13-NE was made to CFE and NAFINSA and then relent to Mexlight pending a reorganization of its capital structure which made it possible to provide equal security to the Bank and the existing bondholders; the reorganization was also designed to facilitate Mexlight's access to the capital market in the future. The reorgani- zation was concluded in 1950 and Loan 13-ME was repaid from part of the proceeds of Loan 24-ME. 12. All of the above loans are fully disbursed and the projects which were financed with the help of the loans up to and including 194-ME are in operation. These first six loans financed the installation  - h - of 1,296 MW of new capacity in every important region of the country. 13. While the earlier loans basically financed individual plants, Loan 316-ME in 1962 was unique in that it encompassed CFE's total investment program for 1962-1965. The proceeds of this loan were applied to equipment for all projects and parts of projects within the program which had not yet been financed from other sources. The loan also provided for disbursements for the foreign exchange component of civil works expenditures. The scope of the financing required a flexibility in the application of the funds which is not usually associated with a project loan. In order to take into account changes in load growth, construction costs, operating costs, etc. CFE has made annual reviews of its construction program since 1962. These revisions were examined in 1963 and 1964 by the consulting firm of SOFRELEC and the changes were then approved by the Bank. In one instance, the substitution in December 1963 of the 720 MW Malpaso hydroelectric station for another hydro and a thermal plant, the Bank's Board of Directors was informed before the approval was given. Loan 316-ME was completely disbursed in February 1965 and during the drawdown of the loan 1,334 MW of new generating capacity were put into operation and 3,395 km of high voltage transmission lines were completed. II. THE BORROWERS 14. The proposed loan would benefit the three major entities of the Mexican Power Sector: CFE, CLFC and IEMSA. The appraisal was limited to these three companies. The various smaller operating companies which are Government owned but still maintain their corporate identity were excluded from the lending operation; their inclusion would have resulted in administrative complications not warranted by their relatively small expansion plans. 15. In the various discussions which followed the request for a loan to the Power Sector, the Mexican authorities indicated that they ex- pected CFE to be the Borrower on behalf of the Sector. As in previous loans to CFE, NAFINSA would sign as co-Borrower. Funds required for the capital expenditures of CLFC and IEMSA would then be made available through CFE. The main argument put forward for this procedure is that it will be a positive step towards future consolidation of the Sector. CFE, through its General Manager, has formal control over the Sector (see paragraph 26). By controlling the loan funds and thus the expansion plans of CLFC and IEMSA, CFE would further strengthen its control over these companies which is a prerequisite for coordinated planning and operation. This procedure would hopefully lead to a future corporate or legal consolidation. 16. The 1962 Bank loan to CFE was made after the Government had purchased the major private companies. The basic condition for this loan was a tariff increase which the Tariff Commission worked out on a nationwide basis considering the requirements of practically the entire electric utility industry. The tariff commitments entered into at the time of the loan however applied only to CFE and were not accompanied  by similar requirements for CLFC and IEMSA. A part of the financial difficulties that have developed in the subsequent years was due to this absence of commitments from the other entities (see paragraph 71). In order for the proposed loan to achieve the maximum of coordination in the Sector, the ideal arrangement would be to have a single organization be the borrower, responsible for the planning, operation and financing, and subject to the Bank's loan covenants and requirements. Such an entity does not yet exist; and since its formation at this time would require the prior solution of such serious problems as different wage scales of the three labor unions and the dissolution of Mexlight, (see paragraphs 20 and 24), it is proposed: (a) to accept as a transitory measure CFE as the Borrower, (b) to have CFE make available part of the loan funds to CLFC and IEMSA on terms and conditions satisfactory to the Bank, and (c) to base the rate and debt limitation covenants, on the consolidated figures of the three entities (see paragraphs 84-89). 17. The lending to CFE will raise no particular problems. CFE is an autonomous Government agency created in 1937 for the main purpose of constructing and operating power facilities and of participating in the ownership of separate power undertakings. Its properties are unencumbered by any liens or mortgages and previous Bank loans were made without any specific collateral. 18. IEMSA was founded in 194h as a subsidiary of the foreign- owned California Electric Power Company located in Mbxicali. In 1960 the Mexican Government, through NAFINSA, acquired all outstanding shares from the parent company. In May 1962 NAFINSA assigned to IEMSA the rights and obligations it had acquired through the 1960 contract for the purchase of the Impulsora assets from American and Foreign Power. Subsequently the domicile of the company was transferred to Mexico City. In November 1964 IEMSA purchased from CFE the properties of the former Mbnterrey company by issuing its shares. As a result CFE now owns 77% of IEISA's share capital; 23% of the shares are still held by NAFINSA; and there is a participation by three banks with one share each for legal reasons. Except for a relatively small tax lien of Mex.$3 million no mortgages or liens of any kind have been placed on its properties. 19. Mexlight was founded in 1902 as a Canadian corporation authorized to do business in Mexico. The Mexican Government today owns 95% of its common stock and 74% of its preferred stock. Up to 1963 Mexlight was a combination holding and operating company with very substantial assets in Mexico and with several wholly owned Mexican operating subsidiaries. In November 1963 it sold its Mexican assets to one of its operating subsidiaries taking additional shares and bonds of that subsidiary. The subsidiary was subsequently renamed Compania de Luz y Fuerza del Centro, S.A. (CLFC). Mexlight thus ceased to be an operating company and has assumed the role of a holding company. CLFC outweighs the other three Mexlight subsidiaries by far in importance and size because it serves the high density Mexico City market, whereas the other subsidiaries supply the outlying areas. For purposes of simplification, whenever in this report the  - 6 - term CLFC is used it should be understood to comprise the other operating subsidiaries as well. The group can actually be considered as a single organization because the top officials of CLFC also have the corresponding positions in the other Mexlight subsidiaries. 20. Mexlight, as a Canadian holding company owned by the Mexican Government, does not appear to serve any useful purpose. However, the immediate dissolution of Mexlight does not seem to be practicable. The Mexican authorities contend that the amount of funds required to liquidate Mexlight by paying off minority interests and long-term debt (some US$15 to US$20 million) would be better employed in the development of the Sector. The terms of Mexlight's outstanding long- term debt in the hands of the public are favorable and could not be matched by refinancing operations, at least under present market conditions. The acceptance of less favorable refinancing terms would run contrary to present efforts to improve the Power Sector's debt structure. In accepting this view the Bank insisted that Mexlight's future borrowings be contained and an agreement was reached during negotiations that the Guarantor would not, without the .Bank's consent, permit Mexlight to issue additional bonds under its Indenture of Mortgage or to sell or pledge the bonds (Series C) which are now held in the treasury of M4exlight. III. OPERATIONS, ORGANIZATION AND IANAGENT A. Operations 21. CFE and IEMSA through their operating divisions generate and distribute power in practically every part of Mexico except the central part, l/ in and around Mexico City, where CLFC and its subsidiaries fulfill this task. CLFC sells at retail only, and in addition to its own generating, purchases a large block of power from CFE. IEMSA is also primarily a retail distributor and, in the same manner as CLFC, it generates some of its own requirements and purchases power from CFE as well. In some systems where IEMSA has cheaper energy it reverses the procedure by selling to CFE. Besides selling to its own consumers, to CLFC, and to IEMSA, CFE also sells in block to its subsidiaries and affiliates. The head office of CLFC and the divisional offices of CFE and IEMSA have the administrative respon- sibility for the scheduling of plant operations and for the normal expansion of distribution facilities. 22. From an operational point of view the Power Sector comprises ten major systems (see maps) in which the generating facilities of the three entities are interconnected, plus many small isolated systems. The coordination of planning for new generating plants and transmission lines of these major systems has been the responsibility of CFE since 1960. 1/ The Central System is the only system in M"exico which operates at 50 cycles per second; the remainder of the country operates at 60 cycles  - 7 - 23. In the matter of coordination of operations there is much room for improvement. Fbremost is the need for a single control over plant operations in each system. In four of the systems a central dispatch control has already been set up. Originally the purpose was to minimize spillage of water from the hydro developments in order to avoid wasting energy but this was later extended to provide for the most economical means of system operation by scheduling the use of all plants. During negotiations CFE agreed to establish a central dispatch control for the remaining systems as soon as practicable. 24. There is also the need to reduce operating costs by eliminating the duplication of jobs, particularly between IEMSA and CFE, in the divisions and systems where they overlap. The principal deterrent to this type of economy is the fact that each entity has its own labor union, and each union jealously guards the gains it has made in the past. There is a wide divergence of pay scales among the entities, thereby making it almost impossible to shift men from one organization to another. The long range solution to this problem, as well as to the problem of reducing unit operating costs, would be to restrict future increases for the higher paid unions to an absolute minimum, to reduce the labor force by normal attrition, and to retrain men whose positions would be eliminated. At the time of negotiations CFE submitted to the Bank a memorandum on administrative policy which includes as basic principles to achieve cost reduction in the Sector: the elimination or retraining of surplus staff at all levels, the merging of smaller companies into CFE, restricted hiring of new staff, the introduction of automation in the generating plants, improvement of preventive maintenance, and a reorganization of the warehousing and accounting operations. B. Organization and Management 25. The organizations of OLFC and IEMSA reflect their former existence as private companies; in view of their present size and probable limited expansion they can be considered functionally satis- factory. However, CFE as the leader of the industry operates with an organizational structure which is not only inadequate for present day needs but which requires modification in order to form a nucleus into which the other enterprises could be merged. One of its basic flaws is that it places too much direct responsibility for the day to day operations on the Director General who is at present in formal charge of sections (finance, tariffs, operations, etc.) which would normally be headed by directors with a corresponding delegation of authority. The field of activity of the Sub-Director General is limited to the supervision of the technical departments and does not involve the general executive assistance which would normally be expected. Considering the size of CFE (2,500 MW installed capacity), its scattered operations (10 regional divisions), and its growth over the last three years (total fixed assets increased by 117% to Mex.$13.8 billion), its form of organization needs strengthening, particularly by delegation of authority at the upper levels. It is apparent that the concerted effort of CFE to cope with the rapid growth of the last years  - 8 - did not leave enough time to modify rhe organization in order to obtain greater operating efficiency. The lower rate of expansion projected for the physical growth of CFE over the next few years should allow an opportunity to make the necessary organizational adjustments, while at the same time taking all other steps that would lead to the ultimate consolidation of the industry. 26. The present organization of the entities implies that the Power Sector is unified at the top. The M4inister of Commerce and Industry is the Chairman of the Board of both CFE and CLFC, and many of the same government officials are members of both Boards. Management control over the Sector is now being exercised by the Director General of CFE who is at the same time Managing Director (Consejero Delegado) and member of the CLFC Board, and Chairman of the Board of IEMSA. This recent concentration of authority in the hands of the Director General of CFE should make it impossible in the future for the individual companies of the Sector to adopt conflicting policies. 27. One weakness of the present management arrangement is that the Director General of CFE is likely to be so occupied with CFE's organiza- tional problems that he will not have sufficient time to devote to policy-making for the Sector. It is almost an impossibility for one individual to perform both tasks without the strong support of a group of managers for the various fields of activity to whom the Director General could delegate the executive authority. Another management complication arises from the fact that in Mexico with the change in the Presidential Office (every six years), the top officials in the decentralized Government agencies customarily are replaced by new appointees. The present Director General of CFE and his management group took office in January 1965 following the 1964 elections. In addition to his training as an economist he has had experience in the public utilities field as Administrative Head (Oficial Mayor) of CFE during the 1952-58 administration. To preserve a greater continuity of operations than in the past, the new Director General held over the Sub-Director General of the previous administration; this is an encouraging sign particularly in view of the proven engineering and executive abilities of the individual concerned. Furthermore, the managements of CLFC and IEMSA were reappointed thus indicating an awareness by the Government of the need for unbroken control. 28. To obtain a better grasp of the Power Sector problems the Director General has set up coordinating committees on which high ranking officials of CFE, CLFO and IEMSA are represented. Individual committees have been established to consider technical aspects, finances, accounting, legal aspects, tariffs and purchasing. These committees serve a very useful purpose as advisors to the Director General in his capacity as the chief administrator of the Sector. The Bank plans to be kept informed of the recommendations of the committees so as to satisfy itself that progress is made towards coordination of the Sector as rapidly as possible. 29. A start on the reorganization of CFE has recently been made by setting up new director positions for the head of the construction  - 9 - department, for the controller who would be responsible for accounting and auditing, and for the head of a new supply department to coordinate all purchasing and warehousing. During negotiations the Director General indicated that he would consider redefining the responsibilities of the Sub-Director General to include direct executive functions over the other departments in addition to the technical departments, and that he was further studying the possibility of a new department of finance which would combine the functions of financial planning and budgeting. The timing for the carrying out of these organizational changes will depend in a large part upon the availability of qualified personnel to fill the new positions. Project supervision missions will review in particular the progress made towards improving the organization. IV. POWER I'RKET 30. Statistics of installed capacity and generation for the entire country are shown in Annex 1. Between 1940 and 1950 both installed capacity and production almost doubled, whereas between 1950 and 1960 the increases were somewhat greater than double. Since 1960, the annual rate of increase in new capacity has averaged 11.5% and the corresponding annual rate of increase in energy production averaged 9.5%. The total installed electric power capacity in Mexico at the end of 1964 was 4,594 MW and the total generation for the year 1964 amounted to 17,154 GWH. 31. By the end of 1964 the three major entities, CFE, CLF3, and IEMSA were operating 3,467 MW of capacity or some 75% of the total installed in the country. Generation by these organizations for the year 1964 totalled 12,849 GWH and sales to consumers and other distributors, but net of sales to each other, amounted to 10,802 GWH. Total transmission and distribution losses and station service needs amounted to 16% of their combined gross generation which is reasonable. 32. Sales for the three companies for the period 1960 through 1964 are shown in Annex 2 and projections until 1971 are shown in Annex 3. The percentage increase in sales over each previous year has grown from 9.8% in 1961 to 18.5% in 1964. For the years 1961, 1962 and 1963 the rate of growth of CFE's sales, taken separately, was much higher than the other entities due to the Comision buying up or taking over smaller companies throughout the country and because of increased bulk supplies to its affiliates from its newer, more efficient plants. The exceptional increase in CFE's sales for last year was due principally to the supply of over 300 GWH to its Dbxicali affiliate to replace energy which heretofore had been purchased from utilities in the United States, and to the supply of over 200 GWH to Petroleos Mexicanos (PEMEX) and the new aluminum industry in the Veracruz area. 33. Forecasts of demand and generation for the three agencies have been made, system by system, under the coordination of CFE. The detailed forecasts for the ten major systems are shown in tables 1  - 10 - through 10 of Annex 4. For each system historic loads and sales for the past five years were used as a basis for extrapolating "normal growth." To this, the expected large new industrial loads were added to obtain totals. For the current year the increase in combined sales is projected at 8.4% but in 1966 and 1967 the forecast is for higher increases of 14.5% and 11.7% respectively. The bulk of these projected increases is due primarily to industrial expansion. These new loads include the doubling of aluminium capacity and fertilizer plants in the Puebla Veracruz area, a new match industry in the Isthmus, pumped irrigation in Sonora-Sinaloa, and a polyethylene plant at Reynosa. In 1968 the forecast annual increase drops to 8.0% and thereafter is assumed to average about 7%. These values are based on a rate of growth which has come to be considered as normal and therefore they are reasonable. 34. The forecasted maximum loads and installed capacity until 1973 are shown for each system in the charts of Annex 4. In each case new generating capacity is scheduled so that sufficient firm capacity will be available to meet the load. Mbreover, in the Central and Puebla-Veracruz systems sufficient excess capacity will be available to provide the needed flexibility for the frequency change (see paragraph 36). V. THE PROJECT 35. The Project proposed to be financed by the Bank loan con- sists of a two-year time slice of the Power Sector's continuous expansion program; the arbitrarily selected period covers planned expenditures during the calendar years 1965 and 1966. The program includes the completion of a large number of projects in varying stages of construction as wiell as the start of new projects which will not be completed during the loan period. Some 865 MW of generating capacity already under construction is expected to be placed in operation during 1965 and 1966, but the new work in the program consists mainly of transmission and distribution. The Bank loan would be available to meet estimated eligible expenditures on the program. 36. The significant feature of the power program is the start of the frequency changeover of the Central System from 50 cycles to 60 cycles. The previous Administration had approved the initiation of the change, had so informed the Bank, and had appropriated funds for this purpose in 1964, but except for continued studies by consultants, no work has been done on the actual changeover. 37. The frequency unification involves the modification of the 50 cycle hydro and thermal generating units to operate at 60 cycles and the conversion or replacement of consumer-owned frequency sensitive equipment. A report prepared in 1963 by the Bechtel International Corporation had proposed that the entire program be carried out over a four-year period by a new Government-authorized agency at a cost which is now estimated to be about US$100 million. The changeover organi- zation would have complete responsibility for the engineering and  - ll - administration of the project; the utilities would perform the physical conversion work on their respective systems; and the work of modifying the consumer-owned equipment would be done by contractors. The present Mexican proposal, which was confirmed by the Government during the negotiations, contemplates a conversion period extending over a period of eight years at a cost of about US$112 million. The unification would be carried out in two phases, the first of which would cover all the 50 cycle zone except Mexico City and its immediate suburbs and would be completed in three years. Although the plans for the conversion organization are not yet final, the Government has stated that CFE would have full responsibility for the program. During negotiations, CFE agreed with the Bank that it would proceed promptly with the appointment of key personnel for the changeover organization and would engage competent consultants, acceptable to the Bank, to provide assistance with the planning, engineering, and procurement of goods. A brief history of the frequency unification and a summary of the presently proposed plan is contained in Annex 5. 38. The Government has taken an extremely cautious approach to the frequency unification in spite of the fact that its economic justification has been clearly established. This hesitancy appears to have been based on fears of complaints by consumers. In an effort to shorten the conversion period and hasten the ultimate consolidation of the Sector, the Bank will closely follow the progress of the first phase and will urge the Government to complete the changeover as rapidly as possible. The actual progress made will be carefully reviewed when considering future Bank lending for the Power Sector. 39. The facilities which comprise the Sector program, either already started or to be started, are tabulated in Annex 6. Presented below is a summary of the major facilities in the program: Generating Plants under Construction, Scheduled for Completion before December 31. 1966 No. and Size of Date of System Plant Type Units (MW) Completion Central Infiernillo Hydro 4 0 156 December 1965 "1 San Bartolo Hydro 1 ' 20 March 1965 Puebla-Veracruz Chilapan Hydro 2 @ 9 May 1965 "1 Pajaritos Gas Turbine 2 @ 14 July 1965 Torreon-Chihuahua Francisco Villa Steam 3 @ 30 May 1965 Monterrey Nava Steam 1 0 37.5 June 1965 Acapulco La Venta Hydro 5 0 6 March 1965 Yucatan Nachicocom Diesel 2 0 9 September 1966  - 12 - Generating Plants under Construction, Scheduled for Completion after December 31, 1966 No. and Size of Date of System Plant Type Units (MW) Completion Puebla-Veracruz Malpaso Hydro 4 3 180 1968 Sonora-Sinaloa Topolobampo Steam 1 'I 40 1967 Tijuana Tijuana Steam 1 i 82 1967 Torreon-Chihuahua La Laguna Steam 1 @ 38 1967 Also under construction are 88.5 MW of small units in the isolated systems but the program does not include any other large generating plants on which construction would commence before 1967. The equipment for all these plants (except Malpaso) has already been largely financed by supplier credits and Loan 316-SME. During 1965-66 some 2,900 kms of 69 kv and larger transmission lines and about 2,700 MVA of new substation capacity are planned to be completed and about Mex.$1,500 million will be allocated to the expansion of distribution and rural electrification. 40. Almost all the major facilities in the program are being carried out by CFE. CLFC will complete the 220 kv ring around Mexico City and IEMSA will complete its Durango generating plant and some transmission lines, but the bulk of the investment by these two companies will be limited to distribution expansion and rehabilitation. In accordance with present Government policy, all large future generating plants and transmission lines will be built by CFE. 41. The programs of CFE and IEMSA for 1965-66 are now reasonably well defined, but the program of CLFC is still indefinite for 1966. CLFC had originally planned to expand its distribution system at a much faster pace than in previous years and had planned to proceed with putting a large part of its network underground as soon as possible. Last year the Bank suggested that CLFC should engage consultants to review its program and to provide design assistance with such underground distribution as justified. In point of fact, CFE arranged to have Bechtel review CLFC's program. The Bechtel report, which was completed in April of this year, agreed with a large part of CLFC's plans including the need for underground distribution, but concluded that some 40% of the originally proposed investment could be postponed for a reasonable period without reducing reliability of the system or the standard of service. It was unfortunate that CLFC did not itself retain consultants; apparently because the consultants were hired by CFE, their recommendations were strongly criticized by CLFC and an agreement has still to be reached on the extent of the program for 1966. The 1965 part of CLFC's program represents a compromise solution with CFE which is in line with previous years expenditure and appears reasonable. However, before the Bank could agree to the balance of the program, CLFC will be required to employ a consulting engineering firm acceptable to the Bank to review all of its plans. Preliminary discussions held with CLFC indicated that the company would  - 13 - accept this condition. During negotiations the Bank was assured that satisfactory arrangements for consultants would be made. These would be confirmed in the subsidiary agreement with CLFC (paragraph 52). A. Planning, Design and Supervision 42. Each year since 1961, the Sector program has been reviewed by CFE to determine the new generating capacity required and to determine the advisability of further extensions or interconnections of transmission systems. In performing these studies CFE has made comparisons of the capital and operating costs of alternative schemes, using the present worth method. In 1963 and 1964 SOFRELEC reviewed the proposed program changes and the Bank approved them. The procedure of annual revisions by CFE, with Bank approval required for changes, has proven to be satisfactory. CFE has agreed to continue these annual revisions in 1966 and 1967 and will retain SOFRELEC to review the changes and prepare reports for submission to the Bank. 43. The design of the projects in the program has been carried out, as for the past several years, by the staffs of each entity. CFE will continue to retain a Board of International Consultants to review the design and construction of major hydro projects and will continue its contract with Ebasco to provide assistance as required with the design of steam plants. CFE is using the services of the Societe Generale c'Entreprises (SGE) for construction supervision of the 380 kv transmission line between Infiernillo and Mexico City, and intends to engage SOFRELEC to review the layout, design and construction of the 380 kv transmission line between Malpaso and Mexico City. These arrangements are satisfactory. 44. Prior to Loan 316-ME acceptance testing of new generating units was not done. It is incompatible with good utility management not to check on the manufacturer's guarantees and to perform tests which would provide efficiency data needed for the proper scheduling of units. Four of the completed thermal plants in the last program have so far been tested under the supervision of Ebasco and tests on three more units will be carried out this year. However, arrangements for testing of the completed hydro units have not yet been made even though the previous loan provided that all major items of equipment entering operation through 1965 would have an acceptance test. During the negotiations CFE agreed that as a matter of policy it would carry out formal acceptance tests for all new plant within the periods provided for in the purchase contracts. B. Capital Requirements 45. In accordance with the policy of the previous National Administration the various entities submitted to the Secretaria de la Presidencia in November 1964 their programs of new investment for 1965. When the new Administration took office last December it informed all Government departments and agencies that capital expenditures were to be held to a minium. In February 1965 the new Director General of CFE, acting for the Power Sector. submitted a revised estimate which  - 14 - reduced the overall cost of the 1965 program by 25%. The Secretaria approved CFE's 1965 program on May 6, 1965 and the programs of IEISA and CLFC on June 18, 1965. The delay in Government approval was due to the change in Administration and is not expected to recur. 46. The Sector's estimated construction expenditures for the next nine years are shown in Annex 7. A summary for the years 1965 and 1966 is given below: Estimated Expenditures (in Millions) 1965 1966 Total Totals (Mex. $) (US $) CLFC Transmission Lines and Substations 18 35 53 Distribution Expansion 302 418 720 Frequency Change 0 13 13 320 466 786 62.9 IEISA Generation, Transmission and Substations 60 110 170 Distribution Expansion 118 137 255 178 247 425 34.0 CFE Generation, Transmission and Substations 513 1153 1666 Special Equipment & Plant Betterment 25 6 31 Rural Electrification 105 125 230 Distribution Expansion 97 150 247 Overhead Chargeable to Construction 100 106 206 Frequency Change 0 9 9 840 1549 2389 191.1 Changeover of Consumers' Equipment 5 45 50 4.0 TOTAL 1343 2307 3650 292.0 47. The estimates of cost of the equipment for CFE's program are based on current international and Mexican prices and are reasonable. The equipment costs for CLFC's and IEMSA's programs are based on Mexican prices without international competition. During negotiations it was agreed that the procedure of international bidding with a 15% "Buy Mexican" differential would be adopted for these two companies, hence the equipment costs for IEMSA and CLFC are likely to be as much as 20% to 30% lower than estimated. The civil works components of the construction costs are probably not as reliable as the equipment  - 15 - components. Although the estimates have been carefully prepared, and contain a 10% margin for contingencies, past experience has indicated that in the Power Sector these costs invariably over-run the estimates. 48. The above estimates of annual expenditures are sufficiently reliable for the preparation of a financing plan since the estimates and the financing plan must be reviewed at least every year. In view of the Government's delay in approving the investment program and the fact that many administrative changes have been made in the Sector this year, construction is behind schedule. The delay will result in corresponding shifts in expenditures from 1965 to 1966 and from 1966 to 1967. There has been a gradual trend toward more meaningful estimates and toward control of construction costs but there is still room for progress. Frequent Bank project supervision missions will have to be scheduled to keep in close touch with the situation. C. Procurement 49. Under Loan 316-ME, CFE was required to obtain most of its equipment after international competitive bidding, with local manu- facturers granted the previously mentioned 15% differential. The Director General of CFE has informed the Bank that the same procurement basis would be adopted for the other two entities. As a consequence the Government has agreed it will promptly issue the required import permits for all three organizations. 50. CFE's present policy with regard to civil works, as agreed during negotiations for the last loan, is to award contracts above Mex.$20 million on the basis of broad international competitive bidding. In the new Sector program there are only two projects for which construction contracts have not yet been awarded which would fall in this category: the 380 kv double circuit transmission line from Malpaso to Temascal and the single circuit line from Temascal to Mexico City, both of which would be carried out by CFE. The remaining civil works contracts in the Sector program would be awarded to Mexican contractors either on the basis of competitive bidding or for small contracts by negotiation. Since this is a continuation of a previous procedure, and the reimbursable foreign exchange component of the civil works contracts is estimated at only 15% of total expenditures, this method would provide an acceptable basis for loan disbursements. The only sizeable foreign currency item in the civil works contracts is construction equipment. 51. Until the beginning of this year CFE's procurement of equipment was being done by five different departments. At times requests for bids for almost identical types of equipment or materials were being made simultaneously by two and three departments. The new Director has taken steps to improve this situation by setting up a new supply department to standardize bidding procedures and to consolidate orders into reasonable sizes. During negotiations it was agreed that for orders over US$100,000 equivalent CFE would submit specifications, bid comparisons, and recommendations for awards to the  - 16 - Bank before the contracts are placed. For orders of less than US$100,000 equivalent, this information would be made available for review in Mexico by Bank project supervision missions. VI. THE LOAN 52. The proposed loan would meet most of the external financing needs of the power program for 1965 and 1966, following the methods of procurement used for Loan 316-ME. The loan would cover: foreign equipment; domestic equipment if competitive with foreign equipment provided there is no more than 15% protection; indirect foreign exchange expenditures for civil works; and interest during construction. On the basis of the Government approved program for 1965, estimates of expenditures for 1965 and 1966, and the above procurement criteria, the Sector would require foreign funds totalling US$145 million equivalent. As stated in paragraph 3, Mexico would try to obtain at least US$35 million equivalent from other lenders; the proposed Bank loan would amount to US$110 million to be used for the following purposes: Recipient Purpose CFE CLFC IEMSA Total Total (Mill. (in Millions of Mex.$) US$) I. Contracts for the purchase of goods and materials (including consultants and other services) not financed from other sources. 668.8 262.5 200.0 1131.3 y0.5 II. 15% of civil works ex- penditures (estimated average foreign exchange component) not financed from other sources. 125.0 28.7 27.5 181.2 14.5 III. Interest during construction 43.7 10.0 8.8 62.5 5.0 TOTAL LOAN AMOUNT 837.5 301.2 236.3 1375.0 110.0 Equivalent in US$ million 67.0 24.1 18.9 110.0 The above allocation of funds from the proposed Bank loan is based upon the following assumptions: (a) The US$35 million of other foreign loans would be made available for CFE's equipment purchases; (b) 90% of CFE's remaining equipment purchases and 80% of CLFC's and IEMSA's total equipment purchases are included in Category I. The balance would be for small locally produced items for which international competitive bidding would not be justified;  - 17 - (c) Only 10% of CLFC's and 60% of IEKSA's equipment expenditures for 1965 are assumed to be reimbursable because a considerable number of orders have already been placed under procurement directives from the Pexican Government which excluded international competition for locally manufactured equipment; (d) 15% of civil works expenditures was estimated as the average foreign exchange component, as compared to 35% under Loan 316-ME; this estimate was based on sample studies which showed that with the emphasis on transmission and distribution in the present program the indirect foreign exchange cost, primarily for construction equipment, would be much lower. The portions of the proposed loan to be made available to CLFC and IEMSA and the conditions under which the funds will be utilized will be stipulated in subsidiary agreements, the effectiveness of which is a condition of the loan. 53. It is questionable whether the Sector will be able to spend all the Bank funds envisaged during the one year which will probably be left when the loan becomes effective. On the basis of the present construction program the assumed reimbursement for 1965 and disbursements for 1966 would be as follows: 1965 1966 Total Total (in Millions of 1Hx.$) (in Millions of Us$) CFE 358.0 435.8 793.8 63.5 CLFC 38.0 253.2 291.2 23.3 IEMSA 104.0 123.5 227.5 18.2 500.0 812.5 1312.5 105.0 Interest during construction - 62.5 62.5 5.0 Total Disbursement 500.0 875.0 1375.0 110.0 Equivalent in US$ 40.0 70.0 110.0 Delays have already occurred due to the lack of long-term funds and to the cautious approach shown by the new Administration; part of the program has slipped from 1965 to 1966 and it is doubtful whether these delays can be made up in 1966. The Bank would continue to make disbursements in 1967 for the Project from the Loan Account provided that the Sector meets all its obligations. In order to make such disbursements the closing date has been set for June 30, 1967.  - 18 - VII. FINANCIAL ASPECTS 54. The financial aspects of the program illustrate the transition from the individual entities to the new concept of a coordinated Power Sector. Separate financial statements are shown covering the period 1961-64 for CFE (Annex 8), CLFC (Annex 9) and IEMSA (Annex 10) and the consolidated picture of the Sector for the period 1965-1971 with compara- tive consolidated figures for past years (Annex 11). A decision was re- cently made by the Minister of Finance that starting in 1966 CFE would be responsible for submitting annually consolidated operating and construc- tion budgets for the Government owned Power Sector and that CFE would furthermore be responsible for budgetary control and performance except for tariff measures which are still regulated by a tariff commission (para- graph 56). On this basis close financial coordination between the indi- vidual companies would be achieved, even before a formal consolidation. The presentation of the financial forecasts concentrates on the consolidated picture and references to individual companies are made only where necessary to highlight specific situations. 55. The accounts of the companies are audited by independent outside auditors employed by the Secretaria del Patrimonio Nacional, the supervisory agency for Government enterprises. The accounting firms which are at pre- sent under contract to conduct these audits are well qualified and would meet the Bank's requirements for independent outside audits. A. Tariffs 56. Electricity tariffs in Mexico are regulated by the Tariff Com- mission for Electricity and Gas, originally an advisory body within the Ministry of Industry and Commerce and transformed in 1948 into an autono- mous Government agency. Request for rate action by the Tariff Commission can be initiated by the Ministry of Industry and Commerce or by the franchise holders. The Commission's rulings have been governed by the Law of the Electricity Industry of 1938 (Electricity Law) and the detailed regulations (Reglamento) set forth in 1940 and extensive later amendments. Basically the Law allows tariffs that would cover all operating costs, provisions for retirement and replacement, and a return on a rate base consisting of gross fixed assets in operation plus working capital. This return is supposed to be not less than the highest rate for Government bonds unless the franchise holder himself is satisfied with a lower return. The Law provides for ad- justment factors for increases in the cost of labor, fuel and purchased power. 57. With the nationalization of the power sector in 1960, the regula- tory approach to tariffs lost its former justification of controlling the profits of a private monopoly. In 1961, on the instructions of the Ministry of Industry and Commerce, a study was made by a technical committee to determine the rate level necessary to assure adequate contributions from earnings towards the 1961 to 1964 expansion program of CFE, its affiliates, of Nexlight, and IEMSA. As a result of this study (which differed in con- cept from the electricity legislation) the Tariff Commission in January 1962 increased rates so as to achieve a 20% increase in revenues and at the same  - 19 - time provided for the gradual introduction of uniform nationwide tariff schedules to be in effect by 1964. The increase in tariffs was, at the same time, supposed to produce a return of 5% on the rate base as summarized in paragraph 56 above. The Tariff Commission had con- sidered some future operating cost increases in setting the new rates; however when actual increases, particularly in labor costs, exceeded these estimates no action was taken. 58. Annex 12 shows Power Sector consumption and revenues by classes of consumers in 1964 and the resulting average revenues per kwh. Thirty-two percent of the total sales which went to domestic and commercial customers produced 55% of the revenues at an average rate of more than 40h (equiva- lent to 3.2 US