Editor’s Note: NGI’s Mexico Gas Price Index, a leader tracking Mexico natural gas market reform, is offering the following column as part of a regular series on understanding this process, written by Eduardo Prud’homme.

Prud’homme was central to the development of Cenagas, the nation’s natural gas pipeline operator, an entity formed in 2015 as part of the energy reform process. He began his career at national oil company Petróleos Mexicanos (Pemex), worked for 14 years at the Energy Regulatory Commission (CRE), rising to be chief economist, and from July 2015 through February served as the ISO chief officer for Cenagas, where he oversaw the technical, commercial and economic management of the nascent Natural Gas Integrated System (Sistrangas).

The opinions and positions expressed by Prud’homme do not necessarily reflect the views of NGI’s Mexico Gas Price Index.

With the September entry into operation of the Sur de Texas-Tuxpan pipeline, the volume of gas exports to Mexico has reached about 6 Bcf/d, and new projects set to come online in coming months promise to increase this flow. In theory, and if there are no bottlenecks in the Mexican gas network, the ceiling for export capacity is around 14 Bcf/d. Producers in the Permian Basin have a great commercial opportunity to export to Mexico. However, their ability to reach potential consumers in the Mexican market depends on the openness and robustness of each of the links in the supply chain.

Much has been written about the large trunklines and the integrated system that make up the Mexican gas transport network. In essence, the regulatory framework around this segment means open access to third parties, with rates that can be regulated or negotiated, and services subject to general conditions of service provision, which the U.S. market understands as tariffs.

The year is about to end, and the industrial organization that emerged from the structural reform implemented in the natural gas market between 2014 and 2018 remains in place. Today, shippers other than Pemex and CFE can transport gas and serve their customers, and even aspire to increase their market share. After the first open season, the concentration of the capacity market has decreased in subsequent renewal periods. This phenomenon suggests that established marketer Pemex has been losing customers when it reacts to the existence of supply alternatives resulting from vertical disintegration.

This is the type of result that we expected from open access and competition, an efficient development that ultimately maximizes the well-being of consumers, and of shippers.

But for the efficient development of the gas industry, the changes the transport network achieved in this decade are not enough to successfully gasify the country. The network coverage is limited to a range of variable amplitude that runs along the layout of the gas pipelines. In Mexico, there are few routes in which different transport systems run in parallel in a neighborhood.

Historically, the complicated geography and a lack of capital have significantly limited a higher density of gas pipelines and other types of communication. The National Gas Pipeline System (SNG) built by Pemex saw lateral lines and just over a dozen distribution networks come together organically. Power plants and some industrial users have had the opportunity to connect directly to these transport pipelines. Residential users, businesses and industries located in urban areas typically take gas from distribution networks.

In the first case, the infrastructure corresponding to the last miles that connect the productive units with the transport network has been developed and operated under different business models over time. Almost in all these schemes, commercial flexibility and user empowerment have not been taken into account. It has never been easy for a new user to obtain a delivery solution that is free of complications and almost always has to pay little transparent intermediation costs with expensive exit clauses.

In the past, when Pemex served as a promoter of economic development and oil rents flooded public coffers, it was feasible to build branch pipelines to attend to an industrial conglomerate and consider that branch as part of the SNG itself. These branches even formed distribution networks that covered industrial areas. At that time, this transport activity did not occur under a permit system, and there were no sector or environmental regulators. Pemex was the only supplier, so the administration of the projects was simply confined to the company. The dynamism of the extension of the SNG was based on public budgets managed within the same company. Execution decisions were within the discretionary scope, with considerations of development promotion, political favors or other discriminatory treatment.

The use of natural gas to generate electricity was of little relevance. However, being in charge of CFE, another public company, the physical interconnection between a plant and the SNG was financed with public resources in one way or another.

The economic crisis of 1994, known globally as the "tequila crisis" left the treasury unable to finance infrastructure that was not strategic. The establishment of criteria of economic merit in the elaboration of investment project budgets for Pemex and CFE limited the construction of new pipeline network branches. The gas reform of 1995 opened the transportation and distribution of gas by pipeline to private participation. The Comisión Reguladora de Energía (CRE) was formed and with it a regulatory framework in which each meter of pipe dedicated to transporting gas should be registered through permitting. This is how Pemex and the new private agents that built lines to supply generation plants to the CFE service were joined. Two permits were formed: Transporte de Usos Propios (TUPs), or transport service for own-use, and Sociedades de Autoabasto (AUBs), or societies of self-supply.

A pipeline for own-use use denotes exclusivity to serve an economic unit. A factory can build and operate a branch that interconnects it to the open access transport system as long as the capacity of such a connection pipeline is not used to move gas from another user. As there are no third parties involved, economic regulation is not necessary as there is no market power to limit. Consequently, transportation in these pipelines occurs without regulated terms and conditions. The obligations of a permit holder of a TUP are related to security aspects and the proper maintenance of infrastructure. The branch can extend a few meters or even kilometers. Therefore, the investment costs of a branch can be considerable.

An SAB aims to join efforts to facilitate the financing of such costs. The logic of society involves the idea of the absence of a relationship between a permit holder and a set of users: they are partners who voluntarily agree on a cost allocation scheme. Therefore they do not need the exercise of any economic regulation, since the way in which the service operates and costs are determined by the same partners.

The terms and conditions of an open access transport system consider clauses for the extension of the systems with the conditions of technical and economic feasibility. If the charge of the regulated rate is not sufficient to cover the branch costs, the parties may agree on the necessary charges.

In theory, access to services via a physical interconnection was possible with a carrier, in particular with the SNG. In practice, the budgetary rigidity of Pemex as the operator of the main transport system did not allow for efficient growth of the “last mile” to connect users. Thus, the TUP and SAB schemes were designed to open alternatives for users to take charge of the development of their connectivity. However, the way in which these figures were developed was not as expected and their effects have not been the most conducive to user empowerment.

The scale of most industrial projects does not justify the hiring of skilled professionals in the procurement of fuels. Consequently, the widespread notion that access to gas is achieved through Pemex had no way of being contrasted or nuanced. A frequent event has been that an industrial user concentrates on building their facilities, and a few weeks before the start of their operations, they realize that access to gas is not guaranteed; they don’t realize they need an interconnection. Given that obtaining capital to invest in Mexico is not a simple matter, doing so in an urgent situation with financial considerations already assumed is almost impossible.

In these circumstances, TUPs and SABs have been used in a very limited way. Their proliferation has occurred in a different way from their original motivations, and not without controversy.

The specialization absent in the tables of procurement of industrial users was supplied by companies responsible for developing the final sections of connection or offering comprehensive services in industrial parks. In practice, their services are transportation, including gas distribution. Such specialized companies organize different SABs and are part of that company. Its economic offer was to finance, build and operate its own use pipelines in exchange for gas purchase commitments. The recovery of facility costs was included in the price of gas, along with other marketing margins. The first-hand sale price was implicitly included in that integrated price, as Pemex delivered the gas at the beginning of the TUP.

Although this scheme solved the problems of financing the cost of the last miles of transport, the inherent marketing agreements limited the supply alternatives for a user. The monopoly power of the supplier is evident. In some areas adjacent to distribution networks, the alternative for an industrial user in that situation was to choose to connect to a distributor with a regulated rate and a transferred first-hand sale price. But since it is not subject to regulation, an SAB management company has commercial flexibility that allows price discrimination and thus offers more attractive consideration than a distribution fee. This practice gave rise to signs of market skimming by some distributors although there has never been a study of marginal costs that shows that this is the case. In addition, under any lens, this business model was legal and allowed better connectivity than would have been achieved with interconnections developed only by Pemex.

With the opening resulting from the 2013-2014 reform, own-uses were more limited by the legal and regulatory framework. By default, all pipelines became open access and any new system or the extension of a system requires open consultations and seasons that provide opportunities for potential users to join an interconnection project. The logic of imposing open seasons implies a new bureaucratic burden and raises transaction costs significantly. At a time when the emergence of new players and the sophistication of users opens opportunities for gas supply that may include in their implementation of pipelines of their own use, the process of conducting an open season reduces efficiency to connectivity. It is a fact that the implementation of an open season for the construction of branches has contributed little to a more inclusive network. In addition, the condition of captivity of users under the SAB scheme is not reversed. With this panorama, it is clear that the fact that there is effective open access in Sistrangas and other transport systems does not mean that all users who receive downstream gas today have better alternatives. When an intermediation is linked to the ownership of the corresponding traffic infrastructure without a regulatory mechanism, minor users will have limited options and the opening achieved with the new industrial organization will mean little. Consequently, the market size that new marketers may enter will also be limited and conditioned to deliver to wholesale agents without achieving a direct relationship with end-users.

Connectivity and the laying of last mile pipelines are not issues with simple solutions. Access to greater competition is not exempt from transaction costs. An infrastructure developer must be clear about the cost of providing its services and differentiate it from marketing activity. Exclusivity as a mechanism to obtain extraordinary margins damages the market as a whole, but the principle of open access cannot be imposed drastically. The discussion of how to achieve a better connection scheme is an obvious issue to be addressed by the CRE. Perhaps a favorable approach would be to develop a gas network code that takes broadly into account the perspective of the central actors of a market that aspires to be competitive: of the multiple gas suppliers and of the final consumers. Networks in their different modalities are simply means for these actors to maximize their benefits and well-being.