Stratifying Project Risk to Ensure Cash Flow

The foundations have been laid for Mexico’s energy transition with a new injection of renewables into the country’s energy mix that will be provided by the projects awarded in the long-term electricity auctions. The immediate challenge will be to apply project finance principles to power-producing technologies that lack a sufficiently long track record in the country to put investors’ minds at ease. The ability of the projects to achieve financial closing will be the measuring stick of the success of the energy transition. But financing requires stability, and according to Rubén Cruz, Energy and Natural Resources Lead Partner at KPMG, the success of the projects could be jeopardized by political uncertainty. “We are living the implementation of a reform that is subject to political terms,” he says.

The maturing market will welcome a larger number of players, both on the supply and demand side. Cruz sees CENACE’s Clearing House, introduced during the third long-term auction, as a positive step forward. “The previous system of having a single off-taker imposing a maximum price and expecting savings from there is equivalent to forcing private suppliers to reduce their profit margins,” he says. Cruz believes the first midterm electricity auction is a valuable complement to the Clearing House initiative since it addresses the issue of signing long-term bilateral contracts. “At KPMG we think that no one knows how the market will evolve in such an extensive period of time, especially when technology costs like solar are drastically decreasing,” he says. “A project’s viability is greatly assisted by shortening terms to three years.”

Engineering a business model that is efficient and attractive enough to win a long-term electricity auction can be tricky, but Cruz says KPMG supports it clients in various ways throughout the process. “KPMG structures a sponsor’s investment under a competitive-cost framework, taking into account the local tax structure and capital repatriation provisions,” he says. “To do this adequately and in line with regulation, companies need a firm with KPMG’s capabilities and people who have the required expertise.” In any project finance deal, effective risk allocation between parties is key. “One way of dividing risk fairly is to provide those partners that are comfortable handling construction risk, such as EPC companies, the benefits of the project’s sale once the project reaches ramp-up phase,” says Cruz. A strategic combination of flat rates under longterm bilateral contracts and variable rates obtained in the spot market will play a major role in diversifying risk levels. Cruz expects a secondary market of derivatives to develop as the market matures. Mexico’s energy transition eliminates government subsidies, enhancing renewable energy’s power-generation footprint. Instead, the country’s regulatory authorities have implemented CELs, a compulsory requirement that starts in 2018 with the intention of providing liquidity to renewable energy projects and transferring part of the cost of creating a green generation matrix to the industry. “This is a step in the right direction as it avoids market distortions and incentivizes companies to balance their energy costs with their energy savings to avoid transferring this differential to the final consumer,” says Cruz. “The great question surrounding CELs remains their market exchange value in monetary currency, for which the noncompliance penalty is an initial approximation.”

KPMG has set out to incentivize participation and increase the number of private players in Mexico’s energy market by providing optimal conditions for financial funding within commercial development and transnational banking, either through club deals or syndicate loans. Cruz says the firm’s added value lies in its ability to anticipate the direction in which the market will evolve, with the advantage of its international network of 152 offices worldwide and more than 189,000 partners and staff. “We cannot predict the future, but we can look back at history,” he says. “A comparison with other countries that have undergone the same process can give us an idea of the most likely future developments in the country’s energy market.”