y Steta Legal Solutions – Juan Carlos Machorro, Partner & Antonio Massieu Arrojo, Abogado – Mexico
One of the Managing Partners delivers a full analysis of the President Pena Nieto’s proposed secondary legislation for energy reform. Topics discussed in depth include the fiscal transition pact, proposed local content requirements and hydrocarbon model contract structures. He also reflects on why the inherent flexibility embedded within the legislation will be much welcomed by the industry.
What has been keeping the Energy practice busy over the few months since we last spoke?
Juan Carlos Machorro (JCM): In terms of actual project workload, we have been doing a lot lately in the domains of renewable energy and clean fuel. We have beenvery busy representing the developers and the investors of energy infrastructure projects. Clients have included local commercial banks and Mexican development banks such as the Banco Nacional de Obras y Servicios Públicos (Banobras) and Banco Nacional de Comercio Exterior (Bancomext) both of which have new mandates to focus on energy projects. We have also been collaborating with some of the multilateral development banks such as the International Finance Corporation (IFC) and KfW Entwicklungsbank. On hydrocarbons, we have been closely following the reform package and meeting with both existing and potential clients to discuss the groundbreaking developments underway.
Antonio Massieu Arrojo (AMA): The ongoing energy reform package concentrates on natural gas and reflects the future transitioning of Mexico energy portfolio away from fossil fuels to renewables via ever cleaner forms of energy. Natural gas represents the mid-way stage in this process and Santamarina y Steta’s project load seeks to mirror this trend.
What is your assessment of the proposed secondary legislation currently under congressional review and the extent to which that legislation remains consistent with the spirit of the original constitutional amendment?
JCM: The proposed secondary legislation has three main characteristics. Firstly, it is entirely consistent with the main features and spirit of the constitutional amendment that was approved at the beginning of the year. Secondly, the federal package that has been proposed to Congress refrains from going into unnecessary detail and is instead characterized by an in-built flexibility that will allow for the constitutional and legal tools to be harnessed to customize each particular project. And thirdly, in our opinion the reform reflects and follows international standards. Herein lies the real quality of the secondary legislationfrom an industry perspective. There will be enough leeway to make subtle adjustments to the rules of the game within certain parameters as Mexico’s hydrocarbons sector evolves.
Four types of agreement have been provided for – namely licenses, production sharing, profit sharing and the service agreements which we already have. The mastery of the federal legislation is that it allows for any type of combination that may be required. The law doesn’t stipulate a particular type of contract for a particular type of project and this is very positive because it means that the authorities’ hands will not be tied.
In short, we feel that both the constitutional amendment and federal package for secondary legislation have been well defined and drawn up. The third important step that will need to link into these first two phases will be the actual regulations and contract models that the government will be presenting to the market. We are confident that this will also be executed seamlessly because we have reason to believe that the government, through the CNH and SENER, has already been seeking first-tier advisory from a financial technical and legal point of view to analyze what models are being deployed across global markets before customizing them to the Mexican reality. The advantage of this is that the end products will be very familiar to the multinational companies that are shortly going to be entering the field of play.
Local content requirements have been set at 30 percent by 2025. To what extent will this be attractive enough for international investors while simultaneously appeasing local interest groups?
JCM: My comment about flexibility equally applies to local content requirements. These will be determined on a project-by-project basis rather than being written in stone upfront. The 30 percent target applies to the sum aggregate total of energy projects. Local content for individual projects will be determined in relation to local capacity to provide for a project’s needs. The fact that Pemex has held monopoly sway over the sector for the past 75 years has resulted in distortions to the market and prevented the creation of a comprehensive supply chain. A new market has to be allowed to emerge and evolve, and that includes the supply chains. If the government had opted for high mandatory percentages of local content in the style of Brazil, then this would have risked compounding the distortions that already exist. Nevertheless the ruling administration would have felt compelled to say something on local contact from a political perspective of needing to calm the indigenous construction and equipment maintenance interest groups. What they have done in effect is strike a smart balance that appeals to both sides. Foreign investors will not feel unduly concerned by the 25 percent target as most of them will have drawn up market entry strategies that involve partnering with local industry and deploying customized solutions that make the most of local capacities.
It is also important to point out that most of these rules are already provided for under existing free trade agreements that, legally speaking, take precedence over federal law. Mexico, along with Chile rank as trailblazers across Latin America in the volume of trade agreements they have established. Starting with NAFTA, these agreements contain ‘national treatment’ and ‘most favored nation’ clauses which mean that, in many instances, there may be legal grounds to challenge excessive local content requirements. The executive branch is very aware of this and the initiatives already spell this out.
AMA: Pemex isrenowned for being second to none in shallow water hydrocarbon production so it would be entirely reasonable to have high levels of local content, say 40 percent, for such projects. Mexican talent ranks as some of the very best for this sort of operation so it also makes complete economic sense for foreign firms to harness and leverage that residual talent to be found in the local market. The same cannot be said for deep-water projects and for those projects types there will need to be a heavy reliance on foreign expertise and equipment until Mexico can put in place its own foundations. This is the virtue of the flexible system that treats every project on its own terms and needs.
According to the government’s proposals, Pemex’s fiscal burden is going to be reduced to 65 percent of its profits within a decade. Former Chief of Staff to PEMEX’s General Counsel, Eduardo Núñez likens the transition from one fiscal regime where PEMEX pays to another where the burden falls on the private sector to the “Paso de la Muerte” – in short, a highly risky endeavor. What are the chances of such a fiscal transition being executed smoothly?
JCM: This is a move has been necessary for ages. One of the core reasons why Pemex wasn’t working was down to the fact that the Treasury Ministry has been taking too much of their profits and not allowing the NOC to reinvest the proceeds of their hydrocarbon wealth. I have faith that this will be implemented on a gradual basis, though much will depend on the investment behavior and response of the private sector and whether this adequately compensates for the shortfall in government income. To continue with Mr. Núñez’s analogy, I foresee the horses slowing down somewhat, before the rider makes his move.
A new tax revision will probably have to come though it is unlikely that it will be within this administration and certainly not before mid-term elections. Ultimately, however, there is an imbalance in government incomes that can only be remedied by broadening the tax base and weighting taxes more towards the consumption side. Only then will we see a partial de-linkage between the hydrocarbons sector and public finances.
This reform is not taking place in isolation. The bet of the administration has been to reform all at once so we have seen sweeping changes across sectors as diverse as telecoms, education and competition. The tax reform and the energy reform are intrinsically linked though it is the latter which represents the ‘mother of all reforms’ because it will be the catalyst to attracting outside investment and tangible projects. The longer it takes for Congress to approve it, the longer we will have to wait for actual projects to materialize.The last hurdle was local congresses approving the political reform. That has been happening and is almost a clean field now. The PAN is to collaborate in the reform despite the fact that the PRI, supported by its coalition partners, enjoyed enough muscle to have moved unilaterally. Instead they have opted for a cleaner process which is wise because of the sensitivities related to tinkering with the NOC, liberalization of the market and fiscal transition.
Labor liabilities are also being taken out of Pemex’s balance sheet and being absorbed by the Federal Government as public debt; this is also good news for two reasons (i) it will slim down Pemex’s financial condition making it fitter for competition, and (ii) it could operate as an effective tool to open the existing collective agreement with Pemex’s union, particularly on the company’s pension obligations moving forward.
AMA: it’s very positive that the energy reform is happening as part of a holistic process. The fiscal reform will allow Pemex to be successful in competing on an open market. Meanwhile new anti-trust laws that are being drawn up are also going to be essential. This is because we are going to have a real market for the first time in the energy sector and the anti-trust laws will be needed for fixing any market dysfunction that might occur. The whole table is being set for dinner and this will be immensely reassuring for potential investors and participants.
Is there anything that is missing from this reform? Are there any issues that are conspicuous by their absence?
JCM: Two items were not initially provided for anything like as clearly as many would have expected. Firstly there is a distinct lack of mention of renewables and green energy. Secondly, we were hoping for formal clear guidelines for dealing with the community aspects of projects. This is of high concern to developers not just of energy projects, but any kind of large scale infrastructure operation. Although there is already the need to go through public consultation, our view is that there needs to be standardized processes for hosting public consultations, engaging with local communities and stakeholder groups and for having social workers explain how a project will benefit a locality. If we look at international benchmarks, for example, both Peru and Colombia have regulations in place that enable local communities to share in the profits. It seems that something along these lines is likely to be incorporated in the latest discussions this reform for Mexico.
AMA: This reform is a halfway house that focuses on gas because it is clean, cheap and abundant. Green power is also abundant and clean, but not cheap which is why it is being currently overlooked. We must not forget that the primary selling point of the energy reform is cheaper electricity and gas bills.
No one can have any expertise in working on model contracts because they are entirely new to the local sector. Meanwhile you are going to have to deal with a whole new cast of regulatory actors.What are you doing to prepare for these new rules of the game?
JCM: The combination of international expertise and a well-established Mexican advisor is in our opinion required to result in products that are going to be very familiar to international firms, but also well adapted to the local context.
We are positioning ourselves well to compete in the new chapter of the Mexican oil and gas sector. We offer a full package of legal advisory solutions encompassing not just the technical component, but also the project finance, contractual, environmental, real estate, tax, labor and community aspects. This full service package is the blended with other unique attributes such as our professional proximity to the authorities and regulators, the end customer and our novel practice incorporating a human rights and community outreach dimension.
From a preparation perspective, we are participating in international roadshows dedicated to the reform in conjunction with representatives from SENER, the CRE and the CNH which allows us to present a common front that integrates the standpoints of both the authorities and the private sector.
Do you have a final message for the industry on the eve of reform?
You can import the best product, but if you do not know how to customize it to the culture you cannot hope to be successful. You will initially require proper advice from local counsel and presumably an decent indigenous partner that can be your eyes and ears throughout the entire initial stage of your market entry until you have grown your operations to the point that you can do all of this by yourself.
The current administration and legal advisors, which include Santamarina y Steta, are working hard to make the new framework as familiar as possible internationally – not just for contractual models but also for a comprehensive regulatory structure, the fiscal regime and the rule of law. What’s more, you will find the sophisticated partners that you are used to dealing with elsewhere round the world that comprise everything you would look for in a reliable, tailor-made partnership or joint venture. From a general point of view Mexico is more than enough ready to receive such partnerships.