2021 Mexican Constitutional Reform Bill: Proposed Changes for Foreign Investors in the Electricity Sector – JD Supra

Credit: Original article can be found here

The Situation: On September 30, 2021, President Andrés Manuel López Obrador sent a draft bill to the House of Representatives (Cámara de Diputados) that amends articles 25, 27, and 28 of the Mexican Constitution relating to energy issues (the “Reform Initiative”). If passed, the Reform Initiative would transform the electricity sector in Mexico by leaving control of the sector to the state and imposing several restrictions to private investment that are even more onerous than those that existed before the 2013 Energy Reform.

The Result: Pursuant to the Reform Initiative, (i) the Federal Electricity Commission (“CFE”) would be the only entity allowed to commercialize electric energy in Mexico; (ii) the Wholesale Electric Market would no longer exist; (iii) all existing and pending permits for electric energy generation, as well as all agreements for electricity purchase executed by the public sector, would be cancelled; (iv) Clean Energy Certificates (“CELs”) would be cancelled; and (v) the private sector would be limited to generating 46% or less of Mexico’s energy requirements and would be required to sell to CFE exclusively under an unclear and contradictory sale scheme.

Looking Ahead: For the draft bill to pass and become binding law, two-thirds of Congressional members (i.e., chamber of deputies and senators) must vote in favor of the Reform Initiative, and then a majority of the state legislatures—including Mexico City—must also vote in its favor.

On September 30, 2021, Mexican President Andrés Manuel López Obrador sent the Reform Initiative to the House of Representatives and the United Commission of Constitutional and Energy Matters for review and plenary voting.

As currently written, the Reform Initiative contains numerous onerous provisions similar to those existing prior to Mexico’s 2013 Energy Reform. The most problematic provisions provide:

(i) That the generation, conduction, transformation, distribution, and supply of electric power, including the exploitation of natural resources and assets, would become a strategic area of the state, without the status of a state monopoly;

(ii) That the state would preserve the nation’s energy security and self-sufficiency, and the continuous supply of electric energy to the entire population, as an indispensable condition to guarantee national security and the human right to a dignified life;

(iii) That the state would be in charge of the energy transition through the use of the nation’s available energy sources by establishing the scientific, technological, and industrial policies necessary for this transition and eliminating CELs;

(iv) That the CFE would be in charge of the above-mentioned functions as well as the current functions of the National Center of Energy Control, or CENACE, including dispatch procedures, as well as the planning and control of the National Electric System, and the elimination of State Productive Companies, the Energy Regulatory Commission, or CRE, and the National Hydrocarbons Commission, or CNH;

(v) That the private sector would be allowed to participate in up to 46% of the energy generation required by the country (with the CFE generating the remaining 54%), but without establishing a procedure by which the private sector may continue operations once the generation of electricity turns into a state strategic activity and private sector permits are cancelled;

(vi) That existing and pending generation permits would be cancelled, giving these plants the possibility of participating in 46% of the energy generation required by the country while competing to offer to CFE the lowest production costs for energy sold to CFE. This excludes plants that operated under self-supply companies’ permits that were “granted in contravention to the provisions of the Electric Energy Public Service Law,” and it does so without establishing any criteria for determining said contravention, as well as plants that operated under independent energy producers permits with regard to the surplus power “arising from permits superimposed on the original permit of the plant;”

(vii) That the dispatch procedures in electric plants would be carried out based on economic merit and in compliance with certain reliability, continuity, and stability criteria. While in principle this provision could lead to energy generation at a lower cost, in practice the government has used it as a basis for limiting the use of clean energies, arguing that the intermittency of clean energy generation can cause damage to the grid or require more power plants to come online to meet energy demand, thereby putting the grid’s reliability, continuity, and stability at risk;

(viii) That CELs would be cancelled, which will eliminate their market and the obligation of generators of atmospheric emissions to acquire said certificates; and

(ix) That lithium would be included among the minerals considered strategic for the energy transition, meaning that no concessions will be granted for its exploitation.

What Is the Importance of the Reform Initiative?

The Reform Initiative is a counter reform to the 2013 Energy Reform. The Reform Initiative increases substantially the state’s control of the Mexican electricity sector through the CFE and restricts participation of the private sector. As a consequence of the Reform Initiative, Mexico’s Wholesale Electric Market will disappear as well as private party participation in the different links of the electric industry’s production chain, except for electric energy generation for sale exclusively to the CFE. In making these changes, the Reform Initiative will violate the principle of progressivity under the human rights system because the changes will eliminate free competition in the electricity sector, will endanger the environment, and will result in an inefficient use of natural resources used to reach the energy transition.

What Should Foreign Investors Know to Protect Their Rights if the Reform Initiative Is Approved and Implemented?

While the Reform Initiative contains several proposals that may be considered incompatible with the principles provided for in the Mexican Constitution, such as the principle of progressivity and nonretroactivity, as well as the guarantee of a healthy environment and sustainable development, should the Reform Initiative be approved, domestic legal avenues for investors will be limited. This is so because the Reform Initiative is an amendment to the Constitution.

Foreign investors, however, may have recourse under international law. Several provisions of the Reform Initiative may violate the rights granted by Mexico to foreign investors in more than 40 investment treaties and free trade agreements, which, under Mexican law, are on par with rights granted under Mexico’s Constitution. Therefore, while considering the legal options to challenge the Reform Initiative, foreign investors in the electricity industry should be sure to consider an international approach.

In particular, and depending on the corporate structure of the investment, foreign investors may be able to initiate international legal proceedings through the investment protection clauses in international treaties. These treaties include the various bilateral Reciprocal Investment Promotion and Protection Treaties signed by Mexico and other nations (i.e., those with Spain, the Netherlands, Germany, and France), as well as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, or CPTPP, which is in force for Mexico, Australia, Canada, Japan, New Zealand, Peru, Singapore, and Vietnam. In addition, for some U.S. investors, Annexes 14-D and 14-E of the Agreement between Mexico, the United States, and Canada (“USMCA”) are also a potential source of investment protection, as is Chapter Eleven of the North American Free Trade Agreement (“NAFTA”) which, although superseded by USMCA, continues to apply to some investments until July 1, 2023. Notably, NAFTA’s applicability may be limited as it contains broad exceptions for the energy sector.

The availability of international law protections and the strength of these protections depends on the specific treaty, with some treaties providing more robust protections to international investors. It is therefore important for foreign companies to consider how their Mexican investments are structured, before a dispute arises, to ensure the strongest treaty protections possible. The most common treaty protections that potentially may be implicated by the Reform Initiative are the protection against expropriation without fair compensation and the guarantee of fair and equitable treatment.

As a matter of international law, an expropriation takes place when an investor is substantially deprived of the use, benefit, or control of its investment. Importantly, investments generally include not only subsidiary companies or shares therein, but also contracts, permits, and other legal entitlements. An expropriation may be found even without a formal seizure of assets, where the investor retains paper title over the property. If the state’s acts deprive an investor of the ability (but not necessarily the right) to exploit and enjoy its investment, a claim for expropriation may be possible. Most of Mexico’s international treaties protect qualified investments from expropriation unless the governmental actions were taken for reasons of public interest, on a nondiscriminatory basis, in accordance with the rule of law or due process, and upon payment of compensation.

Fair and Equitable Treatment (“FET”) is, at its core, a guarantee of good faith and due process, and is the most frequently invoked standard in investment disputes. Where available, it is likely to be the strongest claim in a dispute related to the Reform Initiative. Under the general FET standard, Mexico must not impair, by arbitrary, unjustifiable, or discriminatory measures, the operation, management, maintenance, use, enjoyment, or disposal of protected investments. Some of Mexico’s treaties narrow the FET standard to treatment in accordance with international law or with customary international law. The FET standard is fact-specific and may be breached by a state’s actions or omissions that (i) are not transparent or consistent and create an unstable or unpredictable legal framework or business environment for the investment; (ii) violate the investor’s legitimate expectations, which were relied upon by the investor to make the investment; (iii) are discriminatory; or (iv) violate due process or result in a denial of justice, among others. The investor’s legitimate expectations can be based on Mexico’s legal framework, contractual undertakings, and any undertakings and representations made by Mexico. Changes in Mexico’s legal framework may potentially breach the FET obligation if they represent a reversal of assurances made by Mexico to the foreign investor.

When considering legal action against Mexico, investors should carefully examine their treaty coverage. Each treaty contains unique procedural requirements, such as temporal limitations on bringing an international claim. Further, the applicable treaty may contain a “fork-in-the-road” provision, which can require an investor to choose between bringing a domestic proceeding or an international arbitration. If an investor believes its treaty rights potentially have been violated by the Reform Initiative, international counsel should be consulted in order to preserve and maximize potential claims and remedies.

Three Key Takeaways

  1. The Reform Initiative proposes to return control of the generation, conduction, transformation, distribution, and supply of electric energy to the state as a strategic area. This Reform Initiative suggests to take advantage of the electric energy assets and natural resources required for such purposes, without this constituting a monopoly on the part of the state, foreseeing the elimination of existing electric energy generation permits. It also limits participation of the private sector to 46% of the energy required by the country.
  2. When considering legal options against the Reform Initiative, foreign investors in the electricity industry may consider a two-pronged approach: domestic and international. How a particular investor is affected, and what protections the Reform Initiative may violate, requires a case-by-case analysis. When considering legal action against Mexico, investors should carefully examine their protections under applicable treaties, especially because the enactment of the Reform Initiative by amendment of the Mexican Constitution will likely limit available domestic challenges.
  3. It will be a challenge to address these issues and successfully navigate the complex options to protect investments in the energy generation sector in Mexico. Our presence in Mexico, the United States, and all relevant European jurisdictions, including Spain, our strong Latin American practice, and our unparalleled experience in the energy markets and in the litigation and arbitration space in Mexico, the United States, and Spain allow us to help in dealing with the multifaceted challenges that the Reform Initiative involves. Our cross-border, fully bilingual, multidisciplinary team is ready to deliver comprehensive legal advice on the options in defense of the rule of law.