An Econometric Analysis of Regional Convergence and Market Integration in the Mexican Power Industry. Un Análisis Econométrico de Convergencia Regional e Integración en el Sector Eléctrico Mexicano.

1. An Econometric Analysis of Regional Convergence and Market Integration in the Mexican Power Industry Un Análisis Econométrico de Convergencia Regional e Integración en el Sector Eléctrico Mexicano Dr. Alejandro Díaz-Bautista Economics Seminar, June 2005 Professor of Economics and Researcher at the Department of Economic Studies, and Coordinator of the Master’s Program in Applied Economics at COLEF. Mexico Address: Blvd. Abelardo L. Rodríguez 2925, Zona del Río, BC, 22320, México. U.S. Address : P.O. Box “L”, Chula Vista, CA, 91912-1257, USA. Email: adiazbau@gmail.com [email_address] Dr. Díaz-Bautista received his Ph.D. in Economics from the University of California Irvine (UCI). He also earned his master's degree in economics at UCI. He was also educated at UCSD and ITAM in Mexico City where he earned his Bachelor’s degree in Economics. His career has involved academics, government service and consulting for private firms.

4. In 1960, the Mexican electricity industry was nationalized. In that year, only 44 percent of the population in Mexico had access to electricity. Since then, investments were made in order to provide electricity to more than 95 percent of the population. During this period, the organization of the industry under public ownership and administration was appropriate for the integration of the industry and the expansion of the grid, due to the scale of the investments and the available technology. However, in recent years, the economic performance of the industry has been deteriorated. According to government estimations, in the next six years, the demand for energy will grow at a rate no less than 6 percent per year. The dependency of the funds to a limited public budget makes total public financing almost implausible, taking into account the urgent needs in other areas of the economy.

5. The Energy Ministry under the Salinas administration developed a visionary ten year plan for supplying Mexico's growing electric power needs. The idea was to invite private capital, national and foreign, to invest in electric power facilities. Mexico changed its basic law on electricity during 1993 to permit the participation of the private sector in power generation. New regulations were issued in 1993 and modified in 1994. Private investors could construct, own, and operate generation facilities for the purposes of self supply, cogeneration , independent power generation, and small production, up to 30 MW of capacity.

6. The reform of the Public Service of Electric Energy, expanded and defined the participation of private entities in the activities of electric energy generation, importing and exporting. In article 3, the law defines five activities that are not considered public service such as the generation of electric energy for self-supply purposes. The activities include cogeneration or small production; generation of electric energy performed by the IPP's for sale to CFE; generation of electric energy to be exported, if such energy is the result of cogeneration, independent and small production, importing of electric energy for own uses, and generation of electric energy to be used in emergencies due to interruptions in public service.

7. In February 1999, the Mexican government announced the "Structural Change of the Electricity Industry in Mexico" (Secretaría de Energía, 1999). With this reform, the government shifts its view of the industry from public ownership to one in which private investment is fundamental and the authorities serve only as regulators of the industry. It opens to competition the generation and supply of electricity, and maintains both the transmission and distribution sectors as regulated monopolies. During the Fox administration a second structural reform was announced in the power sector. It established an open market for electricity in which the market price is determined by selecting, from the available generators, at the lowest cost until expected demand is met.

10. Regional Competition and the Law of one Price in the Power Sector The law of one price states that a good must sell for the same price in all regions. This law applies in the regional and international markets and is a common sense notion. If the law were not true, unexploited profit opportunities would exist, allowing someone to earn riskless profits by purchasing low in one region and selling high in another. In the study, a comparison is made for the equilibrium price tendencies in regional markets. In an arbitrage free economy with no transactions costs, any given time state claim will sell for the same price, no matter how obtained. This will also be true for any package of time-state claims in power. This property is known as the law of one price.

11. The law of one price implies that every commodity should have the same price worldwide when measured in the same currency. Rogoff's (1996) survey is the best single review and summary of research on law of one price. In a path breaking paper in the energy literature, De Vany and Walls (1993) argued that the recently developed cointegration techniques were the natural way to evaluate competition between the natural gas spot markets at dispersed points in the national transmission network. They found that more than 65% of the natural gas markets had become cointegrated in the U.S. The increased cointegration of prices showed evidence that open access had made gas markets more competitive. De Vany and Walls (1999) developed a cointegration analysis of spot electricity prices and gave some insights on transmission efficiency in the western United States grid. I follow the work by De Vany and Walls (1999), and apply cointegration analysis for electricity prices in Mexican nodal regions.

16. Stationarity

23. Cointegration

32. Empirical Methodology and the Economic Model of the Power Sector This paper employs a time series cointegration method to study the validity of the law of one price. Linear cointegration techniques, such as unit root tests, examine the properties of power data by assuming the variables behave the same regardless of their proximity to the hypothesized equilibrium condition. I test the law of one price by examining the power prices between different regions of Mexico, between sectors of the economy in Mexico and finally between the US and Mexico. I anticipate the differential to be small, after the passage of the law of 1993 and behaving in a random, non deterministic way. When the deviations are large, arbitrage and substitution could restore the approximate equilibrium price.

33. Price and Marginal Cost in the Power Sector 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW 100 MW Cantidad (MW) Costos de plantas públicas Precio actual (PA) Demanda Precio ($/MW) Generadores despachados P Costos marginales auditados de centrales de generación

34. Curva de demanda 20 kW 40 kW 30 kW 120 kW 100 kW CARGA INSTALADA DEMANDA MÁXIMA

35. First I test hourly and daily nodal marginal costs by months for 25 regions in Mexico between 1992 and 1993 and between 1997 and 1998. The first sample is taken from Mexico's CFE statistics. I also test annual price data for the U.S. and Mexico from 1973 to 1999. The sample is residential, commercial, industrial and agricultural power prices from 1973 to 1999 in Mexico and the U.S. .The Ministry of Energy, INEGI, Bank of Mexico, Comision Federal de Electricidad and Ministry of Finance supplied the Mexican data, and the U.S. data comes from the Energy Information Administration and the U.S. Department of Energy. The econometric methodology to test for cointegration across nodal power regions is the likelihood ratio cointegration test used by Johansen (1991).

36. Empirical Results in the Regional Power Model Given a group of non-stationary power price series, I am interested in determining whether the series are cointegrated, and if they are, in identifying the cointegrating (long-run equilibrium) relationships. To test the results of pairwise series cointegration, I used the Johansen Test. The accurate question is not the effect of deregulation, but was the deregulation of the power sector real? Tests were also performed for a unit root in the level, first difference, or second difference of the series. If the test failed to reject the test in levels but rejected the test in first differences, then the series contains one unit root integrated of order one I(1). Unit root tests like the Dickey Fuller (DF), Augmented Dickey-Fuller (ADF) test and the Phillips-Perron (PP) test were also performed.

37. The next tables show the likelihood ratio cointegration test results across nodal power regions in Mexico for 1993 and 1998. The null hypothesis of a unit root is rejected against the one-sided alternative if the t statistic is less than (lies to the left of) the critical value. For example, the test fails to reject the null hypothesis of a unit root in the Central series at any of the reported significance levels. The unit root hypothesis is not rejected even at the 10 percent level for the central Power price series.

42. The empirical results are very interesting. In 1993, 73% of the nodal power regions were not cointegrated. Before deregulation and the removal of legal restrictions and integration of markets by law, and not by interconnection, we have a large percentage of nodal regions showing lack of cointegration. After the passage of several laws permitting more competitive markets, Mexico has a more integrated power network. In 1998, 75% of the regional nodal power markets had cointegrated prices. The result suggests that almost all power regions were interconnected via transmission lines. This means that the Mexican power network between regions is competitive and has the capability for complete open access.

43. Consider the Baja California Region, since it remains isolated from the rest of the Mexican National Interconnected system in terms of interconnection via transmission lines. In 1998, the Baja California Region showed lack of cointegration with other regions. We can rule out this region since it has no possibility of integration after deregulation.

44. Cointegration in the power series by Sectors between the United States and Mexico The law of one price does not to hold between the United States and Mexico for several reasons. Tariffs, product differentiation and quality, and institutional entry barriers are a few of the impediments in the history of the Mexican power markets. Other impediments include restrictive agreements between manufacturers and retailers, exchange rate volatility, tariffs and transportation costs. The next table shows that the hypothesis of non-cointegration is not rejected for the residential prices between the US and Mexico at 1% and 5% critical levels. This is not surprising since only large users can choose foreign distributors in Mexico.

46. Conclusions The results show the apparent failure of the law of one price in 73% of the Mexican Regional Power Markets in 1993 due to the presence of substantial barriers to producer arbitrage. High barriers mean that only large price differentials can induce convergence in prices. The results also suggests that the law of one price doesn’t hold in the residential sector between the U.S. and Mexico between 1973 and 1998, since the price differentials behave randomly and linear tests are unable to find evidence of the price convergence condition.

47. Conclusions The empirical examination of nodal power prices between regions in Mexico in 1998 leads me to conclude that regional power markets became more integrated after the economic reform in the power sector. By 1998, 75% of the nodal price market pairs between regions were cointegrated, showing a higher degree of integration in the Mexican National Power Transmission Network. Partial Open access in the Mexican transmision system has provided the basis for integrating separate and distant markets into one market. Cointegration in the heavy industry power series between Mexico and the US, and increasing power exchanges between Mexico and the U.S. shows also a more integrated North American than the one thought by energy analysts.

48. Thank You! Muchas Gracias! An Econometric Analysis of Regional Convergence and Market Integration in the Mexican Power Industry

49. An Econometric Analysis of Regional Convergence and Market Integration in the Mexican Power Industry Un Análisis Econométrico de Convergencia Regional e Integración en el Sector Eléctrico Mexicano Dr. Alejandro Díaz-Bautista Economics Seminar, June 2005 Professor of Economics and Researcher at the Department of Economic Studies, and Coordinator of the Master’s Program in Applied Economics at COLEF. Mexico Address: Blvd. Abelardo L. Rodríguez 2925, Zona del Río, BC, 22320, México. U.S. Address : P.O. Box “L”, Chula Vista, CA, 91912-1257, USA. Email: adiazbau@gmail.com [email_address] Dr. Díaz-Bautista received his Ph.D. in Economics from the University of California Irvine (UCI). He also earned his master's degree in economics at UCI. He was also educated at UCSD and ITAM in Mexico City where he earned his Bachelor’s degree in Economics. His career has involved academics, government service and consulting for private firms.

51. Tarifas específicas No aplica 5: DF, Monterrey, Guadalajara. 5A: Resto del país 6: No aplica Por temperatura Por temperatura Regionalización 9, 9M: No hay requisito de demanda/ Baja o media tensión 9CU, 9N: No hay requisito de demanda/ No hay requisito de tensión No hay requisito / baja y media tensión Demanda superior a 250kW /mes* / baja tensión No hay requisito / baja tensión Demanda / tensión 9, 9M: Cargo por energía en bloques de consumo 9CU, 9N: Cargo por energía plano Agrícola 9, 9M, 9CU, 9N 5, 5A: Cargo por energía plano 6: Cargo fijo por servicio, cargo por energía plano Servicios públicos (alumbrado público, bomebo aguas negras) 5, 5A, 6 Cargo fijo + cargo por energía en bloques de consumo Doméstica para alto consumo DAC Cargo por energía en bloques de consumo Doméstico 1, 1A, 1B, 1C, 1D, 1E, 1F Estructura Uso final Tarifa

52. Tarifas generales Cargo por demanda + cargo por energía en bloques horarios Baja California, Baja California Sur, Central, Noreste, Noroeste, Norte, Peninsular, Sur No hay requisitos / alta tensión Alta tensión (niveles de subtrasmisión y transmisión) H-S, H-SL, H-T, H-TL O-M: Cargo por demanda + cargo por energía plano H-M: Cargo por demanda + cargo por energía en bloques horarios Baja California, Baja California Sur, Central, Noreste, Noroeste, Norte, Peninsular, Sur O-M: Menor a 100kW / media tensión H-M: Mayor a 100kW / media tensión Media tensión O-M, H-M No aplica Regionalización 2: Menor a 25kW / baja tensión 3: Mayor a 25kW / baja tensión Demanda / tensión 2: Cargo por fijo mensual + Cargo por energía por bloques de consumo 3: Cargo por demanda + cargo por energía plano Baja tensión 2, 3 Estructura Clasificación Tarifa