2017/18 Knowledge Sharing Program with Mexico (II): Local Content Policy and Industrial Development for the Energy Sector 2017/18 Knowledge Sharing Program with Mexico (II) 2017/18 Knowledge Sharing Program with Mexico (II)

Project Title Local Content Policy and Industrial Development for the Energy Sector

Prepared by Korea Development Institute (KDI)

Supported by Ministry of Economy and Finance (MOEF), Republic of Korea

Prepared for The Government of the United Mexican States

In Cooperation with Mexican Agency for International Development Cooperation (AMEXCID), Mexico Secretariat of Economy, Mexico

Program Directors Youngsun Koh, Executive Director, Center for International Development (CID), KDI Kwangeon Sul, Visiting Professor, KDI School of Public Policy and Management, Former Executive Director, CID, KDI

Project Manager Kyoungdoug Kwon, Director, Division of Policy Consultation, CID, KDI

3URMHFW2I¿FHUV Seung Ju Lee, Research Associate, Division of Policy Consultation, CID, KDI Jinha Yoo, Senior Research Associate, Division of Policy Consultation, CID, KDI Lorena Garcia, +ead of the Department for AsiaPaci¿c, AMEXCID

Principal Investigator Chong-sup Kim, Professor, Seoul National University

Authors Chapter 1. Chong-sup Kim, Professor, Seoul National University Chapter 2. Ji-Chul Ryu, Director, Future Energy Strategy Research Cooperative Chapter 3. Myung Kyoon Lee, Visiting Senior Fellow, Korea Development Institute

English Editor IVYFORCE

Government Publications Registration Number 11-1051000-000830-01 ISBN 979-11-5932-316-4 94320 ISBN 979-11-5932-302-7 (set) Copyright ؐ 2018 by Ministry of Economy and Finance, Republic of Korea *RYHUQPHQW3XEOLFDWLRQV 5HJLVWUDWLRQ1XPEHU 

2017/18 Knowledge Sharing Program with Mexico (II):

Local Content Policy and Industrial Development for the Energy Sector Preface

Knowledge is a vital ingredient that determines a nation’s economic growth and social development. Its true value was brought to light by the advent of the knowledge economy and a key question policymakers now face, especially in developing countries, is how an environment can be established that encourages and facilitates the creation and dissemination of knowledge across the nation. This need has led many countries to engage themselves in active policy dialogue to share their development experiences and benefit from mutuallea rning.

Korea’s development has also depended heavily on knowledge. Its remarkable transition from a predominantly agrarian economy to an industrialized country was made possible by its well- rounded and extensive understanding of technology, management, public policy, and other diverse issues acquired from domestic and foreign sources and through trial and error. Building on these rich experiences, the Korean Ministry of Economy and Finance (MOEF) launched the Knowledge Sharing Program (KSP) in 2004 to assist partner countries to improve their policymaking. KSP, as implemented by Korea Development Institute (KDI), focuses on providing solutions customized to each country’s economic, social and administrative settings, building capacity for effective policymaking and strengthening global networks for development cooperation. In 2017/18, KSP policy consultations were organized with 31 partner countries, with Mekong River Commission joining the partnership for the first time.

The 2017/18 KSP with the Mexico (II) was undertaken by the MOEF and the Mexican Agency for International Development Cooperation (AMEXCID) with the aim of “Local Content Policy and Industrial Development for the Energy Sector.” To that end, the KDI research team and the Mexican counterpart made a range of collaborative efforts by exchanging development experiences, conducting joint studies and designing a policy action plan in line with the country’s development targets.

With that, it is with great optimism for the future of Mexico that the results of the 2017/18 KSP are presented. I firmly believe that KSP will serve as a stepping stone to further elevate the mutual learning and economic cooperation between the two countries and hope it will contribute to Mexico’s sustainable development in the future. I wish to convey my sincere gratitude to Principal Investigator Prof. Chong-sup Kim as well as project consultants Dr. Ji-Chul Ryu and Dr. Myung Kyoon Lee for their extensive contributions to the successful completion of the 2017/18 KSP with Mexico (II). I am also grateful to Executive Director Dr. Youngsun Koh, Project Manager Dr. Kyoungdoug Kwon, Project Officer Ms. Seung Ju Lee and all members of the Center for International Development for their hard work and dedication. Lastly, I extend my warmest thanks to the AMEXCID, Ministry of Economy and related Mexican agencies for their active cooperation and great support.

Jeong Pyo Choi President Korea Development Institute (KDI) Contents

2017/18 KSP with Mexico (II) ...... 013 Executive Summary ...... 016

Chapter 1 Local Content Policy and the Development of the Oil and Gas Supplier Industry

Summary ...... 024 1. Introduction ...... 026 1.1. Background of the Research ...... 026 1.2. Purpose of the Research ...... 026 1.3. Structure of the Report ...... 027 2. Energy Reform in Mexico ...... 027 2.1. Energy Reform ...... 027 2.2. Oil and Gas Upstream ...... 028 2.3. Local Content ...... 031 3. Korean Experience 1: Domestic Production of Parts, Components, and Materials ...... 035 3.1. Import Substitution and Domestic Production of Parts, Components, and Materials ...... 035 3.2. Instruments for Domestic Production of Parts, Components, and Materials ...... 038 4. Korean Experience 2: The Development of the Shipbuilding Industry ...... 056 4.1. Evolution of the Shipbuilding Industry ...... 056 4.2. Korean Policies to Develop the Shipbuilding and Supplier Industry ...... 058 5. Competitiveness and Investment Attractiveness of the Shipbuilding and Supplier Industry in Mexico ...... 062 6. Policy Recommendations and Conclusion ...... 065 References ...... 069 Chapter 2 Policy to Revitalize the Oil and Gas Industries in Mexico

Summary ...... 072 1. Introduction ...... 074 1.1. Background ...... 074 1.2. Objective ...... 075 1.3. Research Scope ...... 075 1.4. Methodology ...... 075 2. Review and Perspective on the Oil and Gas Sector in Mexico ...... 076 2.1. Historical Review on Supply, Demand, and Trade ...... 076 2.2. Energy Reform in Mexico ...... 081 2.3. Perspectives and Challenges in the Oil and Gas Industry in Mexico ...... 083 2.4. Major Challenges in the Oil and Gas Sector in Mexico ...... 090 2.5. Policy Efforts to Enhance Local Contents in the Oil and Gas Industry ...... 093 3. Korean Experiences of the Oil and Gas Sector Development ...... 104 3.1. Overview ...... 104 3.2. Oil Industry Development ...... 105 3.3. Gas Industry Development ...... 113 3.4. Role of Oil and Gas in Korea ...... 115 3.5. R&D Infrastructures and Technology/Equipment Development for the Oil and Gas Industry in Korea ...... 116 3.6. Some Korean Experiences for the Upstream Activity ...... 122 4. Recommendation from Implications of Korean Experiences for Mexico ...... 126 4.1. Implications ...... 126 4.2. Recommendations ...... 128 5. Conclusion ...... 136 References ...... 138 Contents

Chapter 3 Policy Suggestions on the Development of Power Supply Technologies (PV, Wind, and Distribution)

Summary ...... 142 1. Introduction ...... 145 2. An Overview and Perspective of the World Renewable Energy Market ...... 147 2.1. Past Trends ...... 147 2.2. Future Perspective ...... 152 2.3. Selected Polices and Measures to Promote Renewable Energies ...... 155 3. Status Analysis on Mexico’s PV, Wind, and Distribution Technologies and Industries ...... 158 3.1. Mexico’s Power Sector Reform and Clean Energy Trend ...... 158 3.2. Mexico’s PV Technology and Industry ...... 162 3.3. Mexico’s Wind Technology and Industry ...... 163 3.4. Mexico’s Distribution Technology and Industry ...... 165 4. Korean Experiences ...... 167 4.1. Korea’s Renewable Energy Industry ...... 167 4.2. Policies and Measures to Promote NRE in Korea ...... 169 4.3. Energy Technology Development and Indigenization ...... 177 4.4. New and Renewable Energy Development and Deployment ...... 183 5. Policy Suggestions ...... 188 5.1. Regulatory Policies ...... 190 5.2. Financial Policies ...... 191 5.3. Additional Remarks ...... 191 References ...... 193 Appendix ...... 196 Contents | List of Tables

Chapter 1

Results of Round 1 ...... 030 Results of Farm-out Trion Block ...... 030 Results of Round 2 ...... 031 Number of Items Developed under Domestic Production Policy for Machinery Parts and Materials, as of 1991 ...... 036 Trade Improvement Effect of Promotion of Domestic Production by Sector, 1986-1991 ...... 037 Financial Supports ...... 041 Tax Incentives ...... 046 Technical Support Measures ...... 049 Other Support Measures ...... 052 Companies and Items Approved under Designation of Integrated Items ...... 054

Chapter 2

Major Oil Statistics in Mexico (1) ...... 076 Major Oil Statistics in Mexico (2) ...... 078 Natural Gas Statistics in Mexico ...... 079 Energy Mix in Mexico ...... 080 Recoverable Oil Resources by Category in Mexico, 2014 ...... 084 Oil Production by Type in Mexico in the New Policies Scenario ...... 086 National Refining System in Mexico ...... 087 Natural Gas Production, Proven Reserves, and Resources in Mexico ...... 089 Opportunities for Research and Development ...... 099 Local Content in Oil E&P in Mexico ...... 101 National Content in E&P in Deep Water ...... 101 Major Oil Statistics in Korea ...... 105 Refinery Capacity and Market Share by Company in Korea, 2016 ...... 107 Major Refinery Companies in the World ...... 107 Offshore Oil and Gas Exploration Status, as of June 2017 ...... 111 Major Natural Gas Statistics in Korea ...... 113 LNG Receiving Facility in Korea, 2017 ...... 115 Contents | List of Tables

Energy Mix in Korea ...... 116 Comparison of Energy Sectors between Korea and Mexico ...... 127

Chapter 3

Global Trends in Renewable Energy Investment by Technology, 2006-2016 ...... 154 Potential Power Generation from Renewable Sources ...... 160 Projection of Installed Capacity by Renewable Sources for 2019-2029 ...... 160 Wind and Solar Equipment Producers ...... 161 Installed Wind Power Capacity, 2015 ...... 163 Key Indicators of the Renewable Energy Industry ...... 167 Annual Turnover of Solar Products, 2014 ...... 168 Feed-In Tariff Excluding Solar PVs ...... 170 Feed-in Tariff for Solar PVs ...... 171 Subsidy Disbursed under FIT ...... 172 Percentage of Mandatory Power Supply from NRE Sources ...... 173 REC Weight on NRE Sources ...... 174 The Annual Government R&D Budget for Energy ...... 178 Solar PV Technology Development Roadmap ...... 182 Wind Technology Development Roadmap ...... 182 Evolution of New and Renewable Policies ...... 184 Comparison of Renewables Potential between Mexico and Korea ...... 189 Contents | List of Figures

Chapter 1

[Figure 1-1] Bidding Areas and Categories ...... 028 [Figure 1-2] Support System of Domestic Production Policy for Parts, Components, and Materials .. 039 [Figure 1-3] Institutional Framework ...... 040 [Figure 1-4] Selection Process of the Item Notification ...... 051 [Figure 1-5] Tonnage Completed and Delivered by Major Shipbuilding Regions from 1952 to 2002 .... 056 [Figure 1-6] Shipbuilding Clusters, as of 1990 ...... 060

Chapter 2 [Figure 2-1] Oil Production, Consumption, and Export in Mexico ...... 077 [Figure 2-2] Refinery Capacity, Output, and Oil Consumption in Mexico ...... 078 [Figure 2-3] Natural Gas Production and Consumption in Mexico, 1980-2016 ...... 079 [Figure 2-4] Energy Reform in Mexico: Timeline ...... 082 [Figure 2-5] Major Oil Fields in Mexico ...... 085 [Figure 2-6] Oil Production by Geographical Source in Mexico ...... 086 [Figure 2-7] Oil Refinery and Gas Processing Sites in Mexico ...... 088 [Figure 2-8] Refinery Capacity, Output, and Oil Consumption in Korea ...... 106 [Figure 2-9] Offshore Oil Exploration Block in Korea ...... 110 [Figure 2-10] KNOC’s Global Exploration Projects ...... 112 [Figure 2-11] Natural Gas Infrastructures in Korea ...... 114 [Figure 2-12] International Activity of KNOC’s Doo Sung ...... 123

Chapter 3 [Figure 3-1] Deaths from Air Pollution in 2013 ...... 147 [Figure 3-2] LCOE Ranges by Renewable Power Generation Technology for 2014 and 2015 ...... 149 [Figure 3-3] Renewable Power Generation and Capacity as a Share of Global Power, 2007-2015 .... 150 [Figure 3-4] Global New Investment in Renewable Energy by Asset Class, 2004-2015 ...... 151 [Figure 3-5] New Investment in Renewable Energy by Country and Asset Class for 2015 and Growth on 2014 ...... 151 [Figure 3-6] Historical and Forecast Global Weighted Average LCOEs ...... 152 [Figure 3-7] Electricity Technology Capital Cost Projection, 2010-2050 ...... 153 [Figure 3-8] Global Investment in Renewable Power and Fuels, 2006-2016 ...... 153 Contents | List of Figures

[Figure 3-9] World Net Additions to Renewable Power Capacity, Historical and Forecast ...... 155 [Figure 3-10] The Number of Renewable Energy Regulatory Incentives and Mandates by Type for 2014-2016 ...... 157 [Figure 3-11] Share of Renewable Energies in the Installed Capacity of Electricity Generation ...... 159 [Figure 3-12] Production Cost of the Secondary Batteries, 2016 ...... 161 [Figure 3-13] Expected Solar PV Capacity and Generation, 2016-2030 ...... 162 [Figure 3-14] Installed Capacity of and Electricity Generation from Wind, 2005-2015 ...... 163 [Figure 3-15] Expected Wind Power Capacity and Generation for 2016-2030 ...... 164 [Figure 3-16] Distribution Losses, 2002-2018 ...... 166 [Figure 3-17] Crude Oil Price Trend, 2010-2016 ...... 168 [Figure 3-18] RPS Process ...... 173 [Figure 3-19] Tax Revenue by Tax Types ...... 177 [Figure 3-20] Energy R&D of Selected Countries, 2011 ...... 179 [Figure 3-21] Schematic View of the 3rd Energy Technology Development Plan ...... 181 2017/18 KSP with Mexico (II)

Seung Ju Lee (Project Officer, Korea Development Institute)

Since 2004, the Korea Development Institute (KDI) has been implementing the Knowledge Sharing Program (KSP) with support from the Ministry of Economy and Finance (MOEF) of the Republic of Korea. As a knowledge-intensive economic cooperation program, KSP offers comprehensive policy consultations tailored to the needs of partner countries, encompassing in-depth analysis, policy consultation, and training opportunities. Based on a strategic bilateral relationship between Korea and Mexico, the KSP with Mexico was first initiated by the G20 Finance Minister Meeting of 2012. From 2012 to 2016, 18 policy consultation projects were completed as a means of strengthening bilateral economic cooperation between both countries with topics including labor, education, industrial policy, and economic development policy.

In particular, Mexico was designated as a Strategic Development Partner Country (SDPS) in 2014, which enabled intensive policy consultation and strengthening of the cooperation over the following two years. The KSP was conducted under the theme of “Enhancing Innovation Capacities for Sustainable Development of the Mexican Economy” in 2014 and “Implementing Innovation Ecosystem for Sustainable Growth of the Mexican Economy” in 2015. Throughout that time, KSP shared the Industry- Academia Cooperation (IAC) model of Korea Polytechnic University (KPU), which is a representative institution of industry-academia cooperative education in Korea. Based on this knowledge sharing, the first Industry & Academia Cooperation Center (CCAI: Centro de Cooperacion Academia-Industria) was established to improve corporate competitiveness in Mexico in June of 2016. In 2016, KSP continued the

2017/18 KSP with Mexico (II)ˍ013 policy consultation on the evaluation methods of CCAI’s IAC program and expansion plan under the main theme of “SMEs Development Strategies towards Revitalizing Sustainable Regional Economy in Mexico.”

To further promote competitiveness in Mexico, the 2017/18 KSP with Mexico (II) was implemented under the main theme of “Local Content Policy and Industrial Development for the Energy Sector” with the Ministry of Economy. Upon careful reviews and discussion with relevant ministries in Mexico, the Korean and Mexican governments agreed to pursue the three policy consultation topics, listed in the table below, under the theme for this year’s project. Respected Korean researchers were chosen to address the challenges in each sector, and Mexican consultants were also selected to enrich the research analysis on the current status in Mexico. With this joint effort, researchers were able to suggest practical and meaningful recommendations to partner organizations.

Project Title: Local Content Policy and Industrial Development for the Energy Sector Project Manager: Dr. Kyoungdoug Kwon (Director, Division of Policy Consultation, CID, KDI) Principal Investigator: Prof. Chong-sup Kim (Professor, Seoul National University) Sub-topics Researchers Local Consultants Local Content Policy and the Prof. Chong-sup KIM Development of the Oil and Gas - (Seoul National University) Supplier Industry Dr. Ji-Chul RYU Policy to Revitalize the Oil and Jaime Torres Ramirez (Future Energy Strategy Gas Industries in Mexico (Ministry of the Interior) Research Cooperative) Policy Suggestions on the Edith Montes Development of Power Supply Dr. Myung Kyoon LEE (National Autonomous Technologies (PV, Wind, and (KDI) University of Mexico) Distribution)

At the first stage of the 2017/18 KSP with Mexico (II), the Korean delegation, headed by Professor Chong-sup Kim, visited Mexico City, Mexico to conduct the KSP Launching Seminar and High-Level Meeting from August 20-27, 2017. During the visit, the KSP team identified policy priorities and discussed the government’s needs and policy direction on the chosen topics through meetings with the Mexican Agency for International Development Cooperation of the Ministry of Foreign Affairs (AMEXCID) and the Ministry of Economy (MoE). Furthermore, Martha Navarro Albo, Director General of Technical and Scientific Cooperation, AMEXCID, expressed appreciation for the KSP, as it will continue to enhance the capacity and knowledge of policy practitioners in Mexico through Korea’s development experience. Additionally, the KSP team had meetings with relevant institutions, including British

014ˍ2017/18 Knowledge Sharing Program with Mexico (II) Petroleum (BP), Ministry of Energy, ProMexico, and Comisión Federal de Electricidad (CFE) to collect necessary information.

For the Policy Seminar and In-Depth Study, the Korean delegation visited Mexico City from December 10-17, 2017. The KSP team gave presentations to promote understanding of the selected topics and held meetings with relevant ministries and organizations (e.g. Secretariat of Communications and Transportation (SCT), Cluster Naval Sinaloense, Mexican Association of Wind Energy (AMDEE), Secretariat of Finance and Public Credit (SHCP), National Solar Energy Association (ANES), Mexican Institute of Petroleum (IMP), and Mexican Association of Manufacturers of Photovoltaic Equipment (AMFEF)) to gather further data on the topics to help shape the details of each research project.

For the next stage, the Mexican delegations, led by Guillermo Martinez Jimenez, Director General for Local Content in the Energy Sector, Ministry of Economy, were invited to Korea from February 4-10, 2018 to participate in the Interim Reporting and Policy Practitioners’ Workshop. During the Interim Reporting Workshop, the Korean experts and Mexican delegations presented the interim research findings, and all participants had a rigorous discussion on enhancing the quality of policy recommendations. For the Policy Practitioners’ Workshop, the delegation visited the Embassy of Mexico, GS E&R corporation, Korea Energy Agency (KEA), LS Industrial System Co., Ltd., Korean National Oil Corporation (KNOC), Korea Energy Economics Institute (KEEI), and Korea Gas Corporation (KOGAS) to obtain first-hand knowledge of Korea’s development experience on each topic. Furthermore, the Mexican delegations participated in a Market Strategy Seminar where 64 Korean companies were invited on February 5 to further develop economic cooperation with Korea.

For the final stage of the 2017/18 KSP with Mexico, the Korean delegation visited Mexico for the Final Reporting Workshop and Senior Policy Dialogue. The Final Reporting Workshop was held on March 29 to share the final research results with relevant ministries, agencies, academia, and other stakeholders. During the Senior Policy Dialogue, the Korean delegation shared the final research findings and policy recommendations with Cristina Ruiz Ruiz, the Director General for Europe, Asia- Pacific and North America, AMEXCID, and Guillermo Martinez Jimenez from Local Content in the Energy Sector, Ministry of Economy. In addition, evaluations and interviews were conducted on the year-long project with Mexican counterparts to receive feedback.

2017/18 KSP with Mexico (II)ˍ015 Executive Summary

Chong-sup Kim (Seoul National University)

Mexico is one of the world’s leading oil producers. However, in the last 10 years, oil production has fallen and negatively affected the balance of trade. Proven oil reserves also decreased because of the small investment in oil exploration. To reverse this trend, the federal government developed a reform to the energy sector, which was approved in December of 2013, and which opened the sector to private and foreign investment.

The purpose of this research is to provide recommendations to the Mexican government on the policies, i) to satisfy the local content requirements and develop the oil and gas supplier industry, ii) to revitalize the oil and gas industries, and iii) to develop power supply technologies.

1. Local Content Policy and the Development of the Oil and Gas Supplier Industry

The reform established requirements for local content of some segments in this sector. The purpose of this research is to give policy guidelines to increase the rate of local content through the development of the oil and gas supplier industry in Mexico, based on the policies that Korea adopted for domestic production of parts and components and for the promotion of the shipbuilding industry.

The energy reform is likely to provide the Mexican oil and gas supplier industry with a great growth opportunity. Developing the shipbuilding and supplier industry

016ˍ2017/18 Knowledge Sharing Program with Mexico (II) seems to be the only way to significantly increase the local content in oil and gas supplier industry, especially in the deep water projects. The reform will bring a large increase in the demand for the products from the shipbuilding industry.

However, Mexican shipbuilding industry may not have the capacity to satisfy this new demand. Therefore, the supply side must also be addressed for the Mexican shipbuilding industry to fully take advantage of the new opportunity. To enhance the supply capacity of the Mexican shipbuilding industry, Korean experience in the promotion of domestic production of parts, components and materials could be very useful. Korea introduced a system of supports to increase the domestic production of parts, components and materials and the local content of the target industries. It is not necessary to implement all the measures at once, as the support measures were implemented gradually in Korea. In the short term, we can consider the measures that the Secretary of Economy can implement without the cooperation of other Secretaries or the need for sizable government resources. Most of the technical supports are in this category, such as Invitation of Domestic and International Experts for Technical Guidance, Technical Information Support, Open Utilization of High-Priced Test Analysis Equipment, and Quality Certification System of Domestic Machinery, Parts and Materials. Other support measures like Domestic Machinery Exhibition, Consulting Office for Domestic Production, and Prior Purchase System for Domestically Developed Products can also be implemented in the short term.

To introduce financial supports or tax incentives, cooperation with the Secretary of Finance is required, and therefore may take some time. However, we can take advantage of the existing funds, such as Fondemar or SMEs supporting funds, to promote the domestic production of intermediate goods in the oil and gas supplier industry. It is not necessary to use these funds for the exclusive purpose of producing parts and components of the oil and gas supplier industry. However, by including this purpose among the mission of the funds, it may be possible to mobilize some resources to promote this industry. Once some support measures are in place, the Notification System of Domestic Production Items could also be effectively implemented in Mexico. Under this system, items to be developed and produced domestically are selected every year and given a package of supports.

Another Korean experience that may be very useful for the development of the oil and gas supplier industry in Mexico is the promotion of the shipbuilding industry. The Korean government made a long-term plan to support the shipbuilding industry with policy loans, tax incentives, technical supports, and investments in related facilities. One important lesson from the development of the Korean shipbuilding industry is the role of clusters. Most of the shipyards were located in the southeastern region of Korea, together with all the supporting industries. This enormously increased the efficiency of the shipbuilding industry and helped with

Executive Summaryˍ017 the domestic production of parts, components and materials used in the industry. In Mexico, a Special Economic Zone can be established with the purpose of developing the shipbuilding industry, especially the segment related to the oil industry. A recommended strategy is to select the region that can contribute the most efficiently to the shipbuilding industry. Even multinational corporations (MNCs) would invest if the location was optimal for their business, not if their investment alleviates the underdevelopment of a region.

2. Policy to Revitalize the Oil and Gas Industries in Mexico

The oil and gas sectors of Korea and Mexico have very different traits. Mexico is an oil-producing country and a crude oil exporter, while Korea does not have any indigenous oil reserves and its oil supply depends entirely on imports. Despite the difference, some meaningful implications can be derived from Korea's experiences to develop policy that revitalizes the oil and gas industry. This is because the aim of energy reform in Mexico is largely consistent with the policy directions that Korea pursued in the past. The policy recommendations based on the implications from Korea's experiences are below.

Balance the development of the oil downstream and upstream sectors: The oil industry in Mexico, an oil-producing country, is required to shift its growth strategy from centering on the upstream sector to the downstream sector. It is desirable to expand the refinery capacity to meet demand increases for petroleum products as well as to boost the petrochemical industry domestically.

Create a more market-friendly investment environment by liberalizing the oil and gas market: In order to improve the oil and gas market environment and to reduce the negative effects of the existing state-owned monopoly, it is necessary to reduce market/non-market entry barriers for private and foreign enterprises in the oil and gas industry through up-mid-down streams as well as wholesale-retail market, based on market mechanism principles. Mexico should open not only upstream, but also downstream in the oil sector to private and foreign investments, and fully liberalize the oil industry in terms of lifting entry barriers, free trades of oil products and price liberalization.

Active Technology Development for Oil and Gas Upstream: Mexico should make an effort to pursue technology independence in the area where the country has the most potential to develop in the future. This will be an important policy challenge in lowering Mexico’s dependency on foreign technology. Mexico has to invest actively in the technology development focusing on deep-water oil and gas resource development as well as tight oil. In the case of the upstream sector, the development of offshore oil fields, especially deep-water oil and gas fields in the Gulf of Mexico,

018ˍ2017/18 Knowledge Sharing Program with Mexico (II) should benchmark other oil companies to enhance exploration and exploitation capacity for deep-water exploration. The government has to encourage Mexican companies to participate in the project in a foreign country, such as the United States, for the development of unconventional oil and gas, in order to accumulate new and advanced technology at the initial stage.

Establish research institutes specialized in policy and technology development and fostering skilled human resources: Professional and skilled human resources are the most important infrastructures for economic development. Mexico needs to expand this infrastructure to enhance the competitiveness of the oil and gas sector in the long term perspective. The most effective way is to establish a research institute for planning and technology development or strengthening. It is desirable to develop policy/strategy through research think-tanks with strong government support, and to encourage the private sector to strengthen their engineering services, particularly for the oil and gas sector projects.

Strengthen policy coordination/fiscal function: Harmonization of government policies between different sectors is required in order to prevent the failure of government policies and also to enrich the outcome of policy implementation. Transparency of the fiscal regime should be secured, and inter-sector policy coordination functions must be strengthened from the planning stage in order to minimize possible risk of policy failure by utilizing objective analysis and forecasting research outcomes. Mexico can draw from Korea's experience in Special Accounts for Energy and Resources (SAER) to establish a separate fiscal funding mechanism for the energy project.

Establishing a long-term basis to enhance local content in the oil and gas industry: In order to raise the local content in the oil and gas industry, it is necessary to foster skilled experts and to strengthen the long-term function of professional research organizations. In the short term, the oil and gas sector in Mexico can become more competitive by boldly promoting policy that eliminates entry barriers for private and foreign companies into Mexico's market, so that the companies will have an incentive to bring capital and technology through market mechanisms. Therefore, the recommendation for policy to enhance the local content of Mexico's oil and gas industry is a combination of the above-mentioned recommendations.

3. Policy Suggestions on the Development of Power Supply Technologies (PV, Wind, and Distribution)

Mexico’s power sector reform was enacted by the Electricity Industry Act in August of 2014. One of the main objectives of the power sector reform was to increase the share of clean energy. In 2008, a new law (LAERFTE) set the target of

Executive Summaryˍ019 35% clean energy generation by 2024, 40% by 2035 and 50% by 2050, which seems ambitious but is achievable. In spite of its great potential for generating renewable energy, Mexico has not been fully harnessing this potential for various reasons. This research aims to provide policy suggestions on the development of solar PV, wind, and distribution technology to contribute to achieving the long-term energy goals and to increase the share of clean energy in Mexico’s power generation.

As noted above, Mexico has great potential in renewable energy. Among various renewable energy sources, solar and wind have the highest proven potential. The solar potential is estimated to be practically unlimited in terms of national energy consumption. Wind is the fastest growing renewable source and the main driver of the increase in electricity generation from renewable sources. In achieving the 35% target of electricity generation from clean energy by 2024, wind will play a significant role.

The distribution loss of Mexico is 13.1% in 2015, with the target of 10.0% in 2018. This high distribution loss can be attributed to lack of investments due to slow economic growth and the long, aged lines. In order to reduce the distribution losses, the government has introduced some measures (MaRS, 2016): improve metering by verifying the compliance of existing meters, replace electromechanical meters with electronic meters, introduce new measurement technologies, enhance the quality and timeliness of billing and collection, and normalize irregular connections. Overall, the suggested measures to reduce the distribution losses focus on metering, billing, and collection. These measures are low-cost and take less time to implement but have limited effects. In order to reduce the losses to that of the OECD average, long- term investments to renew old lines, build new lines, and adopt new technologies would be necessary.

The growth of renewable energy in Korea can be heavily attributed to the government’s policies backed up by legislation and financial supports to make renewable energy competitive in the market. In order to effectively develop and deploy renewable energy and strengthen related industries, the Korean government has been designing various policies and programs. Among the policy options to increase the share of new and renewable energy, FIT and RPS have been the most effective and influential options. Besides them, there have been tax benefits, low- interest loans, direct support, and mandatory use.

In Korea, the development and indigenization of energy technology started in 1988. The primary objective of energy technology policy is to develop the most advanced technology in the world so that it increases the competitiveness of energy and related industries and ultimately contributes to economic growth and job creation. Policies and technology development should go hand in hand. Without

020ˍ2017/18 Knowledge Sharing Program with Mexico (II) technology development to ensure policies are properly implemented, Mexico’s renewable energy market would be open to foreign companies. In using electricity from renewable sources, the system stability of the grid is crucial to increase the share of electricity and maintain the quality. In that sense, the development and promotion of the secondary battery industry should be seriously considered along with the development of the renewable energy industry. All the policies should be supported by legislation, institutions, and the budget. Otherwise, they cannot achieve their objectives. Therefore, the decision makers should make concrete budget plans and set budget items to finance intended policies.

The renewable industry is not a marginal player any longer as technology advances and environmental concerns arise. With enormous renewable potential, Mexico is in a good position to become a leader in the global renewable energy market. Yet, it does not happen by itself. With well-planned and thoughtful policies and supports from the government, the private sector should play its own role. Active participation of the private sector is a key to the long-term success of policies that promote renewable energy and industry. The private sector is a real innovator and investor. The role of government is to provide proper rules, regulations, and initial support so that the private sector can play a fair game. The process of incentivizing the private sector to participate and invest in the market should also be carefully devised along with policy options.

For the development and deployment of renewable energy, various policy options are being implemented in many countries depending upon their socio- economic and industrial contexts. There are two broad categories of policy options: regulatory and financial, even though a policy sometimes has both regulatory and financial aspects. RPS is a widely used regulatory policy that requires electricity companies to supply a specific share of electricity from renewable sources. Together with RPS, FIT is another widely used financial policy. It is effective at the initial stage of promoting renewables, but it would cause an increasing financial burden for the government. Tax incentives, low-interest loans, and various types of subsidies are utilized to promote renewable energy. In particular, tax incentives and low- interest loans are used to attract private firms in commercialization and scaling-up of renewable technology. Mandatory use of renewable energy in public buildings is an easy way for the government to promote renewable energy. These policies should be coordinated with industrial policies and consider the competitiveness of the domestic renewable industry. In order to design and implement financial policies, the financing source should be determined in advance.

Executive Summaryˍ021

2017/18 Knowledge Sharing Program with Mexico (II): Local Content Policy and Industrial Development for the Energy Sector Chapter 1

Local Content Policy and the Development of the Oil and Gas Supplier Industry


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Local Content Policy and the Development of the Oil and Gas Supplier Industry

Chong-sup Kim (Seoul National University)

Summary

Mexico is one of the world’s leading oil producers. However, in the last 10 years, oil production has fallen, negatively affecting the balance of trade. Proven oil reserves also decreased due to low levels of investment in oil exploration. To reverse this trend, the federal government promoted a reform in the energy sector, approved in December 2013, which opened the energy sector to private and foreign investment. The reform established requirements of local content for some segments of this sector. For example, the local content in the exploration and extraction of oil and gas, which was estimated to be around 25% in 2015, must be increased to 35% by 2025.

The purpose of this research is to give policy guidelines to increase the rate of local content through the development of the oil and gas supplier industry in Mexico, based on the policies that Korea adopted for domestic production of parts and components and for the promotion of its shipbuilding industry.

The Energy Reform is likely to provide the Mexican oil and gas supplier industry with a great growth opportunity. Developing the shipbuilding and supplier industry seems to be the only way to significantly increase the local content in the oil and gas supplier industry, especially in the deep-water projects. The reform will bring a large

Keywords: Local Content, Oil and Gas Supplier Industry, Shipbuilding, Energy Reform, Part and Components

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2017/18 Knowledge Sharing Program with Mexico (II) increase in the demand for products from the shipbuilding industry.

However, the Mexican shipbuilding industry may not have the capacity to satisfy this new demand. Therefore, the supply side must also be addressed for the Mexican shipbuilding industry to take full advantage of the new opportunity. To enhance the supply capacity of the Mexican shipbuilding industry, Korean experience in the promotion of domestic production of parts, components, and materials could be very useful. Korea introduced a system of supports to increase domestic production of parts, components, and materials, and to increase the local content of the target industries. It is not necessary to implement all the measures at once, as even in Korea the support measures were implemented gradually. In the short run, we can consider the measures that the Secretary of Economy can implement without cooperation of other Secretaries, and which do not require large government resources. Most of the technical supports are in this category, such as invitation of domestic and international experts for technical guidance, technical information support, open utilization of high-priced test analysis equipment, and a quality certification system of domestic machinery, parts, and materials. Other support measures like domestic machinery exhibition, a consulting office for domestic production, and a prior purchase system for domestically developed products can also be implemented in the short run.

To introduce financial supports or tax incentives, cooperation with the Secretary of Finance is required, and therefore may take more time. However, we can take advantage of the existing funds such as Fondemar or funds supporting SMEs to promote the domestic production of intermediate goods in the oil and gas supplier industry. It is not necessary to use these funds for the exclusive purpose of producing parts and components for the oil and gas supplier industry. However, by including this purpose in the mission of the funds, it may be possible to mobilize some resources to promote the oil and gas supplier industry. Once some support measures are in place, a notification system of domestic production items could also be effectively implemented in Mexico. Under this system, items to be developed and produced domestically would be selected every year and given a package of supports.

Another experience of Korea that may be very useful for the promotion of the oil and gas supplier industry in Mexico is the promotion of shipbuilding industry. The Korean government made a long-term plan and supported the shipbuilding industry with policy loans, tax incentives, technical supports, and investment in related facilities. One important lesson from the development of the Korean shipbuilding industry is the role of clusters. Most of the shipyards were located in the southeastern region of Korea, together with all the supporting industries. This enormously increased the efficiency of the shipbuilding industry, and helped the domestic production of parts, components, and materials used in the shipbuilding

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025 industry. In Mexico, a special economic zone can be established with the purpose of developing the shipbuilding industry, especially the segment related with the oil industry. A recommended strategy is to select the region that can contribute most to the efficiency of the shipbuilding industry. Even multinational corporations (MNCs) would invest because the location is the optimum for their business, not because their investment contributes to alleviating the underdevelopment of some region.

1. Introduction 1.1. Background of the Research

Mexico is one of the world’s leading oil producers. However, in the last 10 years, oil production has fallen, which has negatively affected the balance of trade. Proven oil reserves also decreased because of the small investment in oil exploration. To reverse this trend, the federal government promoted a reform in the energy sector, which was approved in December 2013. The Energy Reform in Mexico established requirements of local content in the energy industry, along with the mandate to develop the supply chain in an open market framework. The local content in the exploration and extraction of oil and gas is estimated to have been around 25% in 2015, and the law requires it to be increased to 35% by 2025. Mexico has just started to develop deep-water and non-conventional field projects, resulting in a whole new development area that has few potential suppliers currently established in the country and to promote private investment in the hydrocarbon industry.

1.2. Purpose of the Research

The purpose of this research is to give policy guidelines to increase the rate of local content and development of the oil and gas supplier industry in Mexico by learning from the policies that Korea adopted for domestic production of parts and components and for the promotion of its shipbuilding industry. The research also aims at generating key reference materials to establish a comprehensive strategy for the industrial development and local content policy in Mexico’s energy sector in such a way that it can contribute to strategic decision-making, allowing it to fulfill the local content objectives established by the Hydrocarbons Law and the Electric Energy Industry Law, while at the same time consolidating the country’s insertion in the global value chains. The changes in the hydrocarbon sector and deep-water projects, with emphasis on existing and potential linkages between the two sectors stemming from local content policies, will bring great future effects, but it requires introduction of financial and public policy instruments that allow the energy sector to maximize benefits from the expected growth in the deep-water projects and hydrocarbon sector over the next few years.

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2017/18 Knowledge Sharing Program with Mexico (II) 1.3. Structure of the Report

The report is organized as follows: in section 2, the Energy Reform of Mexico is explained with a focus on the local content rule for the oil and gas supplier industry. In sections 3 and 4, relevant experiences of Korea are analyzed. The first one is the experience related to domestic production of machinery parts, components, and materials. The second experience is the policy to develop the shipbuilding industry. In section 5, the competitiveness and attractiveness of the Mexican shipbuilding industry is analyzed. In section 6, some policy recommendations are proposed.

2. Energy Reform in Mexico 2.1. Energy Reform

After the expropriation of oil in 1938, the Mexican government established a state-owned oil company, Petróleos Mexicanos (Pemex), which monopolized the Mexican oil industry for a long time. Thereafter, the Mexican government depended heavily on Pemex for its revenue. In the 1980s, Pemex was taxed at over 60% of its total income, and provided more than 30% of the government revenue. Due to this heavy tax burden, Pemex had limited capacity to invest in exploration and downstream industries. State monopoly also resulted in huge inefficiency with very small productivity growth. The strong labor union was also a source of this low efficiency and productivity. To improve this situation, the Mexican government has already introduced several reforms to the energy sector, but with only limited results. Most of the performance indicators of the oil sector, including proven oil reserves, barrels produced per day, and productivity per worker, are continuously declining.

Most recently, the Mexican government embarked on a series of institutional reforms in 2013. The government amended Mexico’s constitution to allow private investment in both the electricity and oil sectors. With this, Mexico aims at an ambitious transformation process that should end longstanding and entrenched state monopolies in its energy sector. The constitutional amendments of December 20, 2013, established new industrial structures in oil, natural gas, and electricity. As already mentioned, for more than 70 years, the hydrocarbon production in Mexico was an exclusive right of the state. This situation would change radically with the energy reform, which opened the door to private investment in the sector and its participation in various productive activities in the value chain. The main objective of the reform was to increase the competitiveness of the energy sector by creating a legal framework that guarantees international standards of efficiency, transparency, and accountability. Competition will begin in refined product and electricity markets, and private investment will be allowed in various segments of these industries,

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027 particularly in the upstream sector of the oil and gas industry. Private companies can now participate in the exploration and extraction of oil and gas under four types of contracts. One of them is the service contract, which was already possible before the reform and is still available. The other three are production-sharing agreements, profit-sharing agreements, and licenses, which are new options enabled by the reform.1)

2.2. Oil and Gas Upstream

One of the important objectives of the energy reform in Mexico is to introduce competition to the oil and gas industry, and receive foreign direct investment. Pemex can maintain its dominant position in this sector but will be forced to increase its productivity and international competitiveness. With the energy reform, private companies can participate in the development of onshore and offshore blocks, for which the licenses would be awarded through a bidding process.

The Mexican government has structured a five-year, three-round bidding program for a large, diverse, and rich portfolio of exploration and development blocks, both offshore and onshore. Prior to Round 1, the government granted Pemex an initial allocation of exploration and production rights to continue with its activities in Mexico,

[Figure 1-1] Bidding Areas and Categories

Source: ProMéxico (2017).

1) Vietor and Sheldahl-Thomason (2017).

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2017/18 Knowledge Sharing Program with Mexico (II) representing 85% of the country’s proved reserves and 20.6 billion barrels of oil equivalent (billion boe) of proved and probable reserves (2P) in what was called Round 0.

In the bid process, the Secretary of Energy (SENER) through the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos: CNH) publishes an open call to companies for the award of contractual areas of exploration and production of onshore, shallow water, and deep-water fields. Farm Out or Pemex Association is a process of strategic association between a company that has exploitation and production rights over a field (Pemex) with a third party (or several) to whom some of these rights are transferred (migrated). Pemex can partner with other companies through farm-outs to access the capital and technologies required to develop advanced projects. Pemex has requested to farm- out 14 assigned fields into eight new contracts. Partners will be selected through bidding processes.

The CNH has so far organized the bid rounds into four main groups: Round 1, Pemex Associations, Round 2, and Round 3. Round 1 covered 19 exploration and production blocks in shallow waters, 25 onshore production blocks, and 10 offshore deep-water exploration and production blocks. Round 2 covered 15 exploration blocks in shallow water, 24 onshore exploration and production blocks, and 29 exploration blocks in deep water. Trion, Ayin-Batsil, Cárdenas Mora, Ogarrio, and Nobilis-Maximino cover, respectively, the deep-water “Trion,” the shallow-water “Ayin-Batsil,” the onshore “Cárdenas Mora,” the onshore “Ogarrio,” and the deep- water Nobilis-Maximino blocks.

One major factor complicating Mexico’s reform effort has been the drop of oil prices that began in the middle of 2014. The drop in global oil prices since mid- 2014 has drastically affected the investment climate in the international oil industry. In Mexico, the decline in the oil price has complicated the energy reform plan, as energy companies are postponing upstream oil investments and exercising greater fiscal discipline. The first invitation to bid was a major setback for Mexico’s reform effort, as the fourteen shallow-water exploration blocks on offer attracted little interest, and contracts were awarded to only two blocks. In the second auction for shallow-water development blocks, the results were better, and in the third and fourth auctions, the results were even better, as shown in

.

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029 Table 1-1 Results of Round 1 Round 1 2.1 Exploration in 2.2 Extraction in 2.3 Extraction in 2.4 Exploration in Shallow Waters Shallow Waters Onshore Fields Deep Waters - Production Sharing - Production Sharing - License Contract - License Contract Contract Contract - 25/25 contracts - 8/10 contracts - 2/14 contracts - 3/5 contracts awarded on Dec. awarded awarded on July 15, awarded on Sept. 15, 2015 - Depth range: 500– 2015 30, 2015 - First oil: 2016–2017 3,600 km - First oil: 2019 - First oil: 2018 - Peak production: 77 - Resources: super - Peak production: - Peak production: Mboed light, light, and 79 Mboed (Mboed: 124 Mboed - Estimated heavy oil, gas, and thousand barrels of - Estimated investment: 1.1 wet gas oil equivalent per investment: 3.1 billion USD - Exploration phase: day) billion USD 4-10 years. - Estimated - Investment: 34.3 investment: 2.7 billion dollars billion USD - Awarded : Dec. 5th, 2016

Source: Presentation made by Mexico’s Secretary of Energy.

In total, 38 contracts were awarded out of 54 bids in Round 1, and award success rate was 70%. These contracts are expected to result in 49 billion dollars of investment from 48 new companies of 14 countries, and to increase the production by 1.1 million barrels per day. Among the 48 awarded companies, there were 26 Mexican companies. The companies that participated in the bids include Exxon Mobil, Chevron, British Petroleum, Fieldwood Energy, Hokchi Energy, Nuvoil, Renaissance Oil Corporation, Premier Oil, Murphy Oil Corporation, Petronas, Statoil, etc.

Table 1-2 Results of Farm-out Trion Block

Trion: Farm-out Trion Block

- Trion block in association with Pemex - License agreement - Investment: 7.4 billion dollars - Awarded: Dec. 5th, 2016 - 40% PEMEX, 60% BHP Billiton

Source: Presentation made by Mexico's Secretary of Energy.

In 2017, Mexico kicked off the process for its second multi-phase bid round, set to offer production-sharing contracts on 15 exploration and extraction blocks in the shallow waters of the Gulf of Mexico.

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2017/18 Knowledge Sharing Program with Mexico (II) Table 1-3 Results of Round 2 Round 2 2.1 Exploration and 2.2 Exploration and 2.3 Exploration and 2.4 Deep-water production in production in production in shallow waters onshore fields onshore fields - 10/15 contracts - 7/10 contracts - 14/14 contracts - 19/29 contracts awarded awarded awarded awarded - Exploration areas - Exploration areas - exploration areas - License contracts (8,900km2) located (5,066 km2) (2,595 km2) - Exploration area in Veracruz, Tabasco, - license contracts located in Veracruz, 70,844 km2 and Campeche - PEMEX’s Tamaulipas, Nuevo - Jan. 31, 2018 - June 19, 2017 infrastructure Leon and Tabasco - Estimated - 170,000 boed available for - License contracts investment: US$31 - First oil: 2020 production - First oil: 2018 billion 3P: 9,055 mmboe - First oil: 2018 - 3P: 251 mmboe (million barrels of oil - 3P: 643.2 mmboe equivalent)

Source: Presentation made by Mexico’s Secretary of Energy.

In Round 2.1, which was for the exploration and production in shallow waters, 10 contracts were awarded out of 15 bids. In Rounds 2.2 and 2.3, which were for the exploration and production of onshore fields, the results were much better, awarding 21 contracts out of 24 bids. Round 2.4, which was for the exploration and production in deep water, was dominated by Shell Exploracion y Extraccion de Mexico SA de CV, which picked up nine key blocks either alone or with partners.

The Mexican government announced the first bid of Round 3 on September 28, 2017. This will be the sixteenth upstream bid round in Mexico since the enactment of the energy reform in mid-2014. The new bid round (named Round 3.1), comprises 35 offshore blocks for exploration and production in the Burgos Region off the coast of northern Tamaulipas, the Tampico-Misantla-Veracruz Region off the coast of Veracruz, and the Southeastern Region off the coast of Tabasco and Campeche, all in shallow water in the Gulf of Mexico, collectively covering 26,265 km2, with prospective resources of approximately 1.988 billion barrels of crude equivalent.

2.3. Local Content

The companies that were awarded the contracts for the exploration and production of oil and gas will have to meet the regulation for local content. Articles 46 and 126 of the Law on Hydrocarbons enacted in 2014, states that companies holding contracts for the exploration and production of Hydrocarbons should use in their operations a minimum % of domestic content. The local content in the exploration and extraction of oil and gas is estimated to have been around 25% in

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031 2015, and the law requires it to be gradually increased to 35% by 2025. This measure excludes deep and ultra-deep-water projects, the minimum percentage for which will be determined on a case-by-case basis. The Official Gazette of Mexico published in March 29, 2016 stated that the national content in the activities of exploration and extraction of hydrocarbons in deep-water and ultra-deep-water was 3% in 2015 and should be 8% in 2025.

According to the Methodology for the Measurement of the National Content for the Exploration and Extraction of Hydrocarbon, and for the Permits in the Hydrocarbon Industry, the national content is determined using the following formula2):

where: PNC: percentage of national content CNB: value of the local content of all the final goods used CNMO: value of the local content of labor used CNS: value of the local content of the services purchased CNC: value of the local content of the services for training TT: sum of the value of the expenditures in the territory related with transfer of technology I: sum of the value of the spending for the investment for local or regional physical infrastructure B: sum of the accounting value of all the final goods, or value in Mexican pesos of the depreciation of final goods acquired. S: sum of the value of the services purchased MO: sum of the value of the labor used C: sum of the value of training service All the values are in Mexican pesos.

For the calculation for the national content of all the final goods, the following formula will be used:

௕

 ൌ ෍ ܲܥܰܤ௜ ൈܤ௜ ௜ୀଵ

where CNB: value of the national content of all the final goods used

2) Secretaria de Gobernacion (2014).

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2017/18 Knowledge Sharing Program with Mexico (II) PCNBi: proportion of national content of the final good i used directly, provided by each supplier

Bi: accounting value of the final good i acquired.

The supplier will consider that the proportion (PCNB or PCNM) is equal to 1 if any of the following criteria are met: a. fully obtained or produced within the territory b. produced in the territory and satisfy with the change in the tariff classification c. produced in the territory exclusively from materials qualified as national.

If none of the above criteria is satisfied, the supplier who produces an input will use the following formula to determine the proportion (PCNB or PCNM):

௠ σ௝ୀଵ ܲܥܰܯ௝ ൈܸܯ௝ ൅ܸܰܯܱ௜ ௜ ൌ ௠ σ௝ୀଵ ܸܯ௝ ൅ܸܯܱ௜

௟ σ௞ୀଵ ܲܥܰܯ௞ ൈܸܯ௞ ൅ܸܰܯܱ௝ ௜ ൌ ௟ σ௞ୀଵ ܸܯ௞ ൅ܸܯܱ௝

where

PCNBi: proportion of national content in final good i

PCNMj: proportion of national content of input j

VMj: accounting value of input j which was used in final good i

VNMOi: value of wages and honorariums paid to the national workers employed by a supplier for the production of final good i

VMOi: value of wages and honorariums paid to the workers employed by a supplier for the production of final good i

PCNMk: proportion of national content of input k

VMk: accounting value of input k that was used in input j

VNMOj: value of wages and honorariums paid to the national workers employed by a supplier for the production of final input j

VMOj: value of wages and honorariums paid to the workers employed by a supplier for the production of input j

However, satisfying these local content requirements is not easy, as the oil and gas supplier industry in Mexico is in a very low level of development. The role of the government, especially that of the Secretary of Economy, seems to be very important. According to article 125 of the Hydrocarbons Law published in the Official Gazette of Mexico (Diario Oficial de la Federacion), corresponds to the Secretary of Economy, with the opinion of the Secretary of Energy, to define strategies for the industrial development of local production chains and for the promotion of foreign direct

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033 investment in the oil industry, with special attention to small- and medium-sized enterprises (SMEs), in accordance with the following.3) The strategy for the industrial development of local production chains must:

a. identify industrial sectors and regions that will focus the strategy, aligned to the hydrocarbon industry demand, so it will be able to hire studies identifying products and services on the market, as well as to providers who offer them; b. integrate, manage, and update a register of domestic suppliers for the hydrocarbon industry, which register the national companies interested in participating in the industry and their development needs; c. implement programs for the development of national suppliers and contractors, starting from the detection of business opportunities; d. promote the closing of gaps of technical capacity and quality of enterprises, through support for technical and financial assistance programs, and e. integrate a Consultative Council, headed by the Secretary of Economy, with representatives of the Secretary of Energy, the National Commission for Hydrocarbons, the Energy Regulatory Commission, academics, and representatives from the private sector or industry, including at least three representatives of chambers or business organizations that have presence at the national level.

In addition, the strategy for the promotion of foreign direct investment should:

a. encourage the direct participation of Mexican companies to carry out, for themselves, the activities in the hydrocarbon industry; b. promote the association between Mexican and foreign companies to carry out activities in the hydrocarbon industry; c. promote the transfer of technology and knowledge.

Even if the Secretary of Economy has very important roles and responsibilities, it lacks adequate instruments to efficiently increase the local content and to promote foreign direct investment in the oil and gas supplier industry. Accordingly, the objective of this research is to search for these instruments.

3) Secretaria de Economica (2016).

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2017/18 Knowledge Sharing Program with Mexico (II) 3. Korean Experience 1: Domestic Production of Parts, Components, and Materials 3.1. Import Substitution and Domestic Production of Parts, Components, and Materials

There are many countries – especially developing countries – that implemented import substitution policy as their main development strategy. However, most of their policies aimed at domestically producing final goods, not intermediate goods or capital goods. Therefore, most of these countries faced the problem of increasing imports of intermediate goods and machinery as the domestic production of final goods increased. Korea confronted the same problem as the government-implemented import substitution policy in the early 1960s and export-promotion policy thereafter. However, Korea did not confine its import substitution policy to finished products, but expanded the policy to the domestic production of intermediate inputs and capital goods, with the purpose of strengthening of the local supply chain. Korea is one of the few countries that implemented domestic production policy of parts, components, and materials as well as machinery, and which had a significant success in that policy. The government played a significant role in promoting domestic production of parts and components by providing supports such as financial supports, tax incentives, and technical support.

The Korean experience related to the domestic production of intermediate inputs and machinery has strong relevance to the local content policy of Mexico in the exploration and extraction of oil and gas. In Mexico, the reliance of Pemex on imported equipment and services for the exploration and extraction of oil and gas, especially in the deep-water projects, prevented the development of the oil and gas supplier industry, and resulted in a very low level of local content. Since the establishment of Pemex in 1938, no significant efforts have been made to develop the oil and gas supplier industry. Therefore, even with abundant oil resources, Mexico lost the opportunity to increase the value added in the manufacturers related to the oil sector. Korea could increase the value added in its manufactured exports by domestically producing the intermediate inputs and strengthening the local supply chain, and one of the important factors that allowed this was the domestic production policy of parts, components, and materials.

In accordance with the enactment of the Machinery Industry Promotion Act, which was intended to promote the mechanical industry, ‘the Committee for Domestic Production of Machinery’ was established by the Ministry of Commerce and Industry in July 1968. The committee made and implemented policies to promote the domestic production of parts and components, and introduced policy instruments such as financial supports and tax incentives. In 1987, the First Five Year Plan for Domestic Production of Machinery, Material, and Components was launched and, during the period between 1987 and 1991, a total of 4,542 items were notified for domestic production through

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035 Notification System of Domestic Production Items, and 2,212 of them were completed. During this period, about KRW 520.5 billion (about US$ 464.9 million) was used to stimulate the domestic production of parts and materials, and 2,859 companies were supported by this program. Most of the companies participating in this program were SMEs, so technology transfer from large companies to SMEs was encouraged.

Table 1-4 Number of Items Developed under Domestic Production Policy for Machinery Parts and Materials, as of 1991 Notified items Completed items Success rate (%) General Machinery 1,677 677 40.4 Auto Parts 857 528 61.6

Ship-building Equipment 233 142 60.9

Electronic Parts 1,278 598 46.8

Materials 497 267 53.7

Total 4,542 2,212 48.7

Source: Park et al. (1992).

Until the mid-1970s, what the domestic production policy focused on was mainly automobiles, industrial machinery, heavy equipment, internal combustion engines, and electronic parts. However, from the mid-1970s, highly technology-intensive products such as plant and technology services, semiconductors, and computers were also included. Thanks to the program, these items could be developed in Korea in a short period and had significant import substitution effects. The program also targeted the shipbuilding and supplier industry, whose parts and components were mainly exported by Japan, Korea's strongest competitor.

In addition, pneumatic control valves, air compressors, bow thrusters, etc., have been developed locally by joint development of related industries such as shipbuilding industry and equipment manufacturers. In many cases, the shipbuilding equipment companies, which were mostly SMEs, could develop the notified items by cooperating with the government-funded research institutes and the large shipbuilding companies. In addition, when domestic technology capacity was lacking or import substitution had to be implemented urgently, it was possible to use advanced technology by technical cooperation with foreign companies.

Domestic Production Policy not only reduced the imports of intermediate inputs and machinery from industrialized countries, but also increased the exports of these items. As the domestic market for these items was not sufficiently large to allow the

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2017/18 Knowledge Sharing Program with Mexico (II) economies of scale and to guarantee the profitability, the companies that developed them were encouraged and supported to export their products. Between 1986 and 1991, the import substitution effect of the domestic production policy was 4.39 billion dollars. However, additionally, the expansion of exports of these products reached US$ 2.58 billion. Therefore, we can say that many of the products developed for domestic production not only substituted the imported products, but also gained international competitiveness in quite a short time (i.e., five years).

Table 1-5 Trade Improvement Effect of Promotion of Domestic Production by Sector, 1986-1991 (Unit: Million USD, %) Import Expansion of Total Substitution export Rate General Machinery 1,527 1,034 2,561 36.7 Auto Parts 782 208 990 14.2 Shipbuilding Equipment 162 58 200 3.2 Electronic Parts 962 879 1,841 26.4 Materials 960 401 1,361 19.5 Total 4,393 2,580 6,953 100.0

Source: Park et al. (1992).

However, these figures actually understate the export expansion effect of this policy. As mentioned before, Korea had been implementing an export promotion policy from the early 1960s. To increase the value added of exported products, the government also promoted the domestic production of the intermediate inputs. Therefore, the products that were not exported but used for the production of the final goods would also be finally exported as part of the final goods.

Domestic production of imported products is conducted with uncertainty regarding success, and it is difficult to predict the time required for the development of the product. During the long time of research and development, there is only cost without any profits for the company. In addition, the investment period is relatively long, so the financial burden is very high. Therefore, it requires special financial support, which is different from regular credits. In other words, in the absence of an institutional device to alleviate all the difficulties, it is advisable that companies rely on imports of intermediate products and technologies rather than trying to produce them domestically. We can derive from this the rationale for the intentional policy to support the development and production of parts and materials.

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037 3.2. Instruments for Domestic Production of Parts, Components, and Materials

The Support System of Domestic Production Policy for Parts, Components, and Materials consists of financial supports, tax incentives, technical supports, and other support measures. Financial supports can be divided into supports in the supply side and supports in the demand side. Tax incentives consist of tax-exemption and tax- reduction measures. Technical supports can be divided into technical development supports, technical guidance, providing information, and support for evaluation tests and quality certification. Other support measures include comprehensive support, support for market expansion, market protection support, and fair trade support.

These measures were not introduced at one time, but gradually throughout the 1970s and 1980s, and the overall support system was completed in the early 1990s. In 1988, the Council for Domestic Production Policy of Machinery, Parts, and Materials was created within the Ministry of Industry and Commerce to coordinate the efforts of domestic production by the different ministries involved. The role of this Council was to establish and prepare the strategy and the basic plan of domestic production, to evaluate the achievement related with domestic production, and to approve the support mechanisms, such as the financial support, demand support, and technical supports mechanisms. The Council is chaired by the Minister of industry and Commerce, and its members are Vice-Minister of Finance, Vice-Minister of Industry and Commerce, Vice-Minister of Science and Technology, Deputy Governor of the Korea Central Bank, Vice-President of the Korea Development Bank, Vice-President of the Industrial Bank of Korea, President of the Korea Institute for Industrial Economics and Trade, President of the Korea Institute of Industrial Technology, and President of the Korea Association of Machinery Industry, among others.

Under this Council, the Working Committee for Domestic Production of Machinery, Parts, and Materials has the responsibility of reviewing and assessing the achievements of domestic production, establishing the concrete working plan by industry, supporting the funds for the production of trial products, monitoring the products targeted for domestic production, selecting the items to be developed every year, developing the rules to be applied in the development of items, and deciding the roles of the Committee that could be delegated to the associations. The Working Committee was chaired by the Vice-Minister of Industry and Commerce, and the participants were from 21 related institutions, such as the Ministry of Finance, Korean Development Bank, Industrial Bank of Korea, Korea Institute of Industrial Technology, and others. Under the Working Committee, there were associations from industries, which executed the detailed issues related to the domestic production of parts and components. Among these industrial associations, there were the Association for the Promotion of Machinery Industry, Association for the Promotion of Electronic

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2017/18 Knowledge Sharing Program with Mexico (II) Industry, and Association for the Promotion of Textile Industry, and others.

[Figure 1-2] Support System of Domestic Production Policy for Parts, Components, and Materials

s Industrial Development Fund s Industrial Technology Improvement Fund s Fund for Supporting Establishment of New Business s Technological Development Fund (National Investment Fund, KDB and SMEs) Supply Side s Special Fund for SMEs s Venture Capital Fund Financial s Facility Fund of Export Industry and Domestic Production of Material, Supports Parts and Components Industry s Lease Fund

Demand s Domestic Machinery Purchase Fund (National Investment Fund, KDB) Side s Finance for Consumer of SMEs Products s Income Tax Exemption for Foreign Engineers s Local Tax Exemption for Income from Technology s Tax Exemption for Income from Technology s Special Consumption Tax Exemption on Specimen for Trial Research Tax s Income Tax Exemption for Technology-Intensive Business Founders Reduction/ s Tax Deduction and Special Depreciation for New Technology Enterprise Project Exemption s Tax Exemption and Special Depreciation Cost for Research Trial and Vocational Training Facilities Tax s Deduction of R&D Reserve Incentives s Tax Credit for R&D and Training Cost s Deduction of Technology Service Tariff s Tariff Reduction of 65-70% on R&D goods Reduction s Tariff Reduction of 30-55% on High-Tech Industrial Facilities Technical Domestic s Specific R&D Project Development Production s Industrial Base Technology Development Project Policy Support s Technical Guidance by Long-Termed Dispatched Researcher Technical s Training for Field Technical Personnel Guidance s Simple Automation Business Technical s Invitation of Domestic and International Experts for Technical Guidance Supports Providing Technical Information Support Information s

Evaluation s Open Utilization of High-Priced Test Analysis Equipment Test and s Inspection and Repair of Precision Machinery Quality s Quality Certification System of Domestic Machinery, Parts and Materials Certification s Support for Acquisition of Foreign Quality Certification Comprehensive s Search and Support for Prospective SMEs: Promoting Prospective SMEs Support s Notification System of Domestic Production Items s Domestic Machinery Exhibition Support for Market s Privatie Contract and Prior Purchase System for Domestically Developed Products Expansion s Designation of Integrated Items Market s Anti-Dumping Duties Other Protection s Protection System of Manufacturers of Domestic New Technology Products Support Support Measures s Assessment System of Industrial Impacts s Establishment of Fair Trade Fair Trade s Arrangement of Council Meetings of Parent Company and Sub-Contracting Support Companies s Arrangement of Subcontracts s Exemption of Military Service for Researchers Others s Exemption on Import Source Diversification System s Consulting Office for Domestic Production

Source: Lee et al. (1990).

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039 [Figure 1-3] Institutional Framework

Council for Domestic Production Policy of Machinery/Parts/Materials

Respective Working Committee for Domestic Production office of Machinery/Parts/Materials

Identification Association for the Promotion of Textile Industry of Prospective Items Association Association Association Association Association Association for the for the for the for the for the for the Promotion Promotion Promotion Promotion Promotion Promotion Recommend of Machinery of Electonic of Electric of Textile of Steel of Chemical Trial Industry Industry Industry Industry Industry Industry Production

Meeting for Meeting for Meeting for Import Import Import Substitution of Substitution of Substitution of Individual Item Individual Item Individual Item

Recommendation for Recommendation for Recommendation for Production Financial Support from KDB R&D Fund for SMEs Using New Technology

KDB SBC KITECH

Source: Song et al. (1995).

3.2.1. Financial Support Measures

As can be observed from

, the financial supports for the domestic production of parts, components, and materials can be divided into those related to the supply side and those related to the demand side. The measures to support domestic production were introduced gradually. Some of them, such as the Venture Capital Fund, Lease Fund, and Finance for Consumer of SMEs Products, were introduced in the early 1970s, but many others were introduced in the 1980s. Some of these measures were implemented with the main purpose of supporting the domestic production of parts, components, and materials. However, most of the measures were intended for a broader purpose, like promoting the SMEs or improving the productivity. The domestic production of parts, components, and materials was a part of the broader purpose.

For the domestic production of parts, components, and materials, several stages are required. In the first stage, the product must be developed through R&D. In the second, a company must be established, and the product must be commercialized. In this stage, the profit may be very small or even negative. In the third stage, the volume of production must be increased, and profit generated. The financial support measures each support the producer in one of these three stages. Industrial

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2017/18 Knowledge Sharing Program with Mexico (II) Technology Fund, for example, supports mainly the development of the product in the first stage. The Fund for Supporting Establishment of New Business supports the commercialization and market expansion of the products. The amount of financial supports in 1989 was 3,700 billion won (about US$ 5.4 billion).

Table 1-6 Financial Supports Amount Year of Sub- Support in 1989 Category Policy Instrument Introduc- Related Entities Category Stage (billion tion won) Korea Association of Manufacture Industry Machinery Industry, 1980 S1, S2 77 Development Fund Electronics Industries Association of Korea Industrial Technology Industrial Bank of Korea, 1986 S1 36 Improvement Fund Korea Development Bank Fund for Supporting Small and Medium Establishment of New 1984 S2, S3 5 Business Corporation Business Technological Development Fund Korea Development Bank, 1976 S1, S2 192 Supply (National Investment All Financial Institutions Side Fund, KDB, and SMEs) Special Fund for SMEs 1987 Industrial Bank of Korea S1, S2 880 Financial Support Korea Technology Finance Corporation, Korea S1, S2, Venture Capital Fund 1970 125 Industrial Technology S3 Association Facility Fund of Export Industry and Domestic 1986 All financial institutions S2, S3 1,000 Production of Material, Parts, and Components S1, S2, Lease Fund 1970 Lease companies 850 S3 Domestic Machinery Purchase Fund (National 1976 Korea Development Bank S2, S3 540 Demand Investment Fund, KDB) Side Finance for Consumer of 1970 All Financial Institutions S2, S3 SMEs Products

Note: 1) S1=R&D stage, S2=commercialization stage, S3=market expansion stage. 2) 1989 exchange rate: US$ 1 = KRW 680 Source: Lee et al. (1990).

Chapter 1 _ Local Content Policy and the Development of the Oil and Gas Supplier Industry
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041 The entities in charge of the support measures differ across the measures. The Manufacture Industry Development Fund is managed by the Korea Association of Machinery Industry and other industry associations, whereas Industrial Technology Improvement Fund is administrated by the Industrial Bank of Korea and Korea Development Bank. The Small and Medium Business Corporation is in charge of the Fund for Supporting Establishment of New Business.

The following is a short description of the purpose of the financial support measures.

s Manufacturing Industry Development Fund

The objective of the fund was to improve productivity and to strength competitiveness of the industry through balanced development and technological progress of manufacturers. The fund provided credits at low interest rates to stimulate technological activities, which were not usually eligible for regular credits. The credits provided by the fund were used mostly for the development of new products or technologies. In the early 1980’s, funds for specific industries, such as machinery, textile, and electronics industries, were introduced separately. However, in 1986, all these funds were merged into the Manufacture Industry Development Fund. Because of this historical background, the fund was managed by industrial associations such as the Korea Association of Machinery Industry, Electronics Industries Association of Korea, and others. Among the three stages of product development (R&D, commercialization, and market expansion), this fund supported the companies mostly in the R&D and commercialization stages. The interest rate was about 5% below the regular rates, and the loan period was from 8 to 10 years.

s Industrial Technology Improvement Fund

This fund was introduced in 1986 and was aimed at promoting the development technologies that could solve common difficulties of companies, and at developing new products, including parts and components. The fund was managed by state banks such as the Industrial Bank of Korea and Korea Development Bank. This fund supported companies mostly in the R&D stage.

s Fund for Supporting the Establishment of New Business

This fund was established in 1984 to support technology-intensive SME start-ups, and to commercialize products using newly developed technologies. The Small and Medium Business Corporation was responsible for the management of the fund. This fund supported the later stages of product development: commercialization and market expansion.

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2017/18 Knowledge Sharing Program with Mexico (II) s Technological Development Fund by National Investment Fund

The purpose of the fund was to promote the development of major basic technologies and products adopting new technologies. These new technologies or products must have been recognized by related institutes. The fund was established within the Korea Development Bank in 1976, and in 1984 it was expanded to all the financial institutions as the National Investment Fund. The amount executed in 1989 was 192 billion KRW, or 282 million USD.

s Venture Capital Fund

The purpose of this fund, established in 1970, is to develop the prospective basic businesses or industries that have high risk. The fund supports at all the three stages of product development (R&D, commercialization, and market expansion). This fund was managed by several institutions, such as the Korea Technology Finance Corporation, Korea Industrial Technology Association, and others. The year when the fund was established differs across institutions.

s Special Fund for SMEs

This fund was established in 1987 within the Industrial Bank of Korea to support the operation cost and investments of promising SMEs in 1987. The fund targeted companies producing patented products and those located in industrial parks, among others. In 1989, the total amount of the fund was 880 billion KRW, or 1.3 billion USD. There were other funds directed at SMEs, such as the SMEs Technology Development Fund, which was established in all financial institutions to improve technology development, to produce new technology products, to install new production process, or to import R&D equipment.

s Facility Fund of Export Industry and Domestic Production of Material, Parts, and Components

This fund was established in 1986 in all financial institutions to support the investment of exporting companies as well as the companies producing products that would substitute imports. The amount of the fund in total was about 1.5 billion USD in 1989.

s Lease Fund

This fund was managed by lease companies and supported companies when leasing industrial facilities.

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043 s Domestic Machinery Purchase Fund

This fund was established within the Korea Development Bank in 1976 to promote the purchase of domestically produced machinery. Whereas the previously mentioned support measures were directed to the supply side (i.e., the production of machinery parts and components), this fund was directed to the demand side. This is very important because the users of machinery parts and components would rarely use those that had been newly developed and produced domestically. This fund gave some incentive to use domestically produced products.

s Finance for Consumer of SMEs Products

This fund was established within all financial institutions in 1974 to promote the demand for products produced by SMEs.

3.2.2. Tax Incentives

Tax incentives for domestic manufacturers include tax exemption, tax reduction, tax deduction and special depreciation, tax credit, and tariff reduction. As in the case of financial supports, tax incentives were also introduced gradually. Not all of them were exclusively for the domestic production of parts, components, and materials, and they provided support in the different stages of development and commercialization. A short description of the purposes of the different tax incentives follows.

s Income Tax Exemption for Foreign Engineers

This measure was introduced in 1981 to support R&D activities in Korea. A 5-year exemption of income tax was provided for foreign engineers. Foreign engineers eligible for this benefit were those who had specific qualification and who were providing technological service in Korea based on a service contract. This measure was expected to support domestic production of new products at R&D, commercialization, and market expansion stages.

s Local Tax Exemption on Real Estate for R&D of Enterprises

This measure was introduced in 1981, and its objective was promoting R&D through the exemption of local tax on real estate owned by research institutes with proper research facilities and with 5 to 10 researchers.

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2017/18 Knowledge Sharing Program with Mexico (II) s Tax Exemption for Income from Technology

Introduced in 1979, this measure provided tax exemption to royalty income from patent rights or to the income from transfer of patent rights.

s Special Consumption Tax Exemption on Specimens for Trial Research

A special consumption tax exemption was provided to the purchase of specimen for laboratory use by research institutes of SMEs with more than five researchers, or by industrial technology research associations recognized by the Ministry of Technology.

s Income Tax Exemption for Technology-Intensive Business Founders

This measure provided tax exemption (for 3 years) followed by tax reduction (50% for 2 years) to technology-intensive business founders. This measure was applied to those who established technology-intensive SMEs after 1986. The businesses eligible for this benefit were those using basic manufacturing technologies recognized by the Ministry of Industry and Commerce.

s Tax Deduction and Special Depreciation for New Technology Enterprise Project

This benefit was provided to the projects that commercialized for the first time a patent right, or commercialized for the first time the technology developed by a specific research institute, which were recognized by the Ministry of Technology and the Ministry of Finance.

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045 Table 1-7 Tax Incentives Sub- Year of Support Category Policy Instrument category Introduction Stage Income Tax Exemption for Foreign Engineers 1981 S1, S2, S3 Local Tax Exemption on Real Estate for R&D 1981 S1 of Enterprises Tax Exemption for Income from Technology 1979 S2, S3 Special Consumption Tax Exemption on 1982 S1 Specimens for Trial Research Income Tax Exemption for Technology- Tax 1986 S2 Reduction/ Intensive Business Founders Exemption Tax Deduction and Special Depreciation for Tax 1974 S2 Incentives New Technology Enterprise Project Tax Exemption and Special Depreciation for 1976 S1 Research and Training Facilities Deduction of R&D Reserve 1973 S1 Tax Credit for R&D and Training Cost 1981 S1 Deduction of Technological Service 1977 S2, S3 65-70% of Reduction in R&D goods 1982 S1 Tariff 30-55% of Reduction in Materials for High- Reduction 1987 S2, S3 Tech Industrial Facilities

Note: S1=R&D stage, S2=commercialization stage, S3=market expansion stage. Source: Lee et al. (1990).

s Tax Reduction and Special Depreciation for Research and Training Facilities

Facilities defined in the Corporate Tax Law under “Table of Utilization Period of Fixed Asset by Activities” were eligible for the benefits of this measure.

s Deduction of R&D Reserve

R&D expenditure reserve was recognized as a cost for those who do business in construction, technology service, information management, R&D in defense industry, or insurance.

s Tax Credit for R&D and Training Cost

Tax credit for R&D and training cost were provided to those who did business in construction, technology service, information management, R&D in defense industry, or insurance.

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2017/18 Knowledge Sharing Program with Mexico (II) s Deduction of Technological Service

Income deduction was given to the technology service of service providers registered under the Law to Promote Technology Service.

s Tariff Reduction of 65-70% on R&D goods

Tariff reduction of 65-70% was given when products for research and development were imported.

s Tariff Reduction of 30-55% on Materials for High-Tech Industrial Facilities

Tariff reduction of 30-55% was provided when materials for high-tech industrial facilities were imported.

3.2.3. Technical Support Measures

Among the various support measures related to the domestic production policy, the technical support measures are aimed at promoting the development activities of domestic enterprises, and further embodying the technology within the enterprise in order to promote independent technology development. Technical support is generally divided into technical development support, technical guidance, providing related technical information, test evaluation of development items, and quality assurance/certification support. A short description of each follows.

s Specific R&D Project

This measure was introduced by the Ministry of Science and Technology in 1982 through the Law to Promote Technological Development with the purpose of promoting the research of basic science and core advanced industrial technologies. The target technologies were those that required large R&D investment and long periods of research. R&D projects were divided into five categories: public technology R&D projects, international joint research projects, specific-purpose basic R&D projects, promising SMEs technology support projects, and R&D evaluation projects. The sectors of research included information industry, material technology, industrial factor technology, energy resource technology, and large composite technology. The Ministry of Science and Technology received applications from government research institutes, public research institutes, private companies, and universities, and selected the projects that best fit with the purpose of this measure. Between 1982 and 1987, 2,384 projects were selected and a total R&D investment of 489 million USD was executed.

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047 s Industrial Base Technology Development Project

This measure was introduced in 1986 based on the Law of Manufacture Development, and was one of the two most important instruments for technology development, together with the Specific R&D Project. The projects were divided into technology development projects, promising SMEs technology support projects, and performance management of the technology projects. Projects were selected through technology demand research based on criteria of common difficulties of private companies, spill-over effects of the technology, and impacts on import substitution and exports.

s Technical Guidance by Long-Termed Dispatched Researcher

This program was aimed at dispatching researchers of government research institutes to SMEs for the purpose of solving technical problems of SMEs and developing their technical capacity. The period of dispatch was from 3 months to 3 years. The researcher received a 50% addition to salary from the hosting SME.

s Training for Field Technical Personnel

The SME Training Center, which was established under the Small and Medium Business Corporation, ran a technical training program for field technical personnel of SMEs in order to enhance the technical capacity of SMEs. The center offered short training programs of less than 1 week for precision processing, molding, and plating, to improve technical ability of field personnel and distribution of new technology, and longer programs of 2 years for compression molding, plastic molding, and others.

s Simple Automation Project

When SMEs wanted to introduce automation to the production process in order to reduce the defective rate, to improve the quality, and to increase productivity, the government supported up to 70% of the R&D cost through this program.

s Invitation of Domestic and International Experts for Technical Guidance

The purpose of this program was to enhance the competitiveness of SMEs through the improvement of production technology. Domestic and international experts may visit the SMEs, diagnose their problems, and provide technical guidance to solve those problems.

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2017/18 Knowledge Sharing Program with Mexico (II) s Technical Information Support

Korea Institute for Industrial Economics and Trade and other government research institutes collected a lot of information related to new technologies and provided the private companies with updated information in a useful format.

s Open Utilization of High-Priced Test Analysis Equipment

Based on this program, the research institutes under the Ministry of Science and Technology provided open access of high-cost research and measuring equipment to SMEs that lacked sufficient research infrastructure, in order to enable them to effectively carry out R&D activities.

Table 1-8 Technical Support Measures Year of Category Sub-category Policy Instrument Related Entities Introduction Government Research Specific R&D Project 1982 Technical Institutes Development Industrial Base Technology Government Research Support 1986 Development Project Institutes Technical Guidance by Long- Government Research 1986 Termed Dispatched Researcher Institutes Training for Field Technical Small and Medium 1979 Personnel Business Corporation Technical Korea Institute of Guidance Simple Automation Project 1985 Industrial Technology, Korea Productivity Center Invitation of Domestic and Small and Medium International Experts for 1983 Technical Business Corporation Technical Guidance Supports Korea Institute for Providing Industrial Economics Technical Information Support 1973 Information and Trade, Government Research Institutes Open Utilization of High-Priced Government Research 1984 Test Analysis Equipment Institutes Inspection and Repair of Korea Research Institute Support for 1975 Evaluation Precision Machinery of Standards and Science Test and Quality Certification System of Korea Institute of Quality Domestic Machinery, Parts, and 1985 Industrial Technology Certification Materials Support for Acquisition of Korea Institute of 1985 Foreign Quality Certification Industrial Technology

Source: Lee et al. (1990).

Chapter 1 _ Local Content Policy and the Development of the Oil and Gas Supplier Industry
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049 s Inspection and Repair of Precision Machinery

The Korea Research Institute of Standards and Science provided SMEs with inspection and repair service of imported research and measuring equipment, especially precision instruments and chemical research equipment.

s Quality Certification System of Domestic Machinery, Parts and Materials

Under this program, certifications based on international standards, foreign standards, and domestic standards were accorded to the parts, components, materials, and equipment newly developed by Korean companies. Through this, confidence between consumers and suppliers was strengthened, leading to the growth of the market.

s Support for Acquisition of Foreign Quality Certification

Korea Institute of Industrial Technology supported foreign certification process and tests for SMEs.

3.2.4. Other Instruments

Besides financial supports, tax incentives, and technical supports, there were other instruments for the domestic production policy of machinery parts, components, and materials. Other instruments can be divided into comprehensive support, support measures for market expansion, market protection support, fair trade supports, and others.

s Search and Support for Prospective SMEs: Promoting Prospective SMEs

Based on this program, 24 financial institutions and 14 government research institutes selected promising SMEs and provided integrated support of related institutions. For this purpose, the Integrated Support Group for Promising SMEs was established within the Ministry of Industry and Commerce, and was chaired by the Minister of Industry and Commerce. Under the Support Group, a Working Group was responsible for the execution of the specific support measures. Between 1983 and 1988, 5,763 SMEs were selected and 2.8 billion USD was provided to them as financial support.

s Notification System of Domestic Production Items

The Notification System of Domestic Production Items was introduced in 1985 as a policy instrument of domestic production of machinery parts, components, and

050
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2017/18 Knowledge Sharing Program with Mexico (II) materials. Items with large amounts of imports, especially from Japan, and with strong technological spill-over effects, are selected every year, and are provided with concentrated support. Selection criteria: 1) large import substitution effect (over US$100,000 for parts, over US$1 million for finished products and materials), 2) import share of Japan over 40%, 3) strong technological spill-over effects if developed domestically, 4) potential export item, 5) possible to start development in the same year. These items receive technical information and guidance from government research institutes, Korea Institute of Industrial Technology, etc., and loans from the Korea Association of Machinery Industry, Industrial Bank of Korea, etc., at a preferential rate. The selection process of the item notification is shown in [Figure 1-4].

[Figure 1-4] Selection Process of the Item Notification

Notification Bank

Determined in Working Committee for Domestic Production of Machinery/Parts/Materials

Reviewed in the Working Group of Collateral Relate Entities /Guarantee

Collected by Direction of Industrial Machinery, Ministry of Commerce and Industry Technological Feasibility First Screening by Officer of Items, Ministry of Commerce and Industry

Searched and Suggested by Manufacturer Associations or Application Research Institute

Application Application for Loan Companies Loan

Source: Lee et al. (1990).

s Domestic Machinery Exhibition

In the Domestic Machinery Exhibition, domestically developed and produced machinery and parts were exhibited, such as general industrial machinery, automobiles, electronic devices, shipbuilding equipment, farm machines, molds, steel materials, machine tools, and their parts. Together with the domestically produced

Chapter 1 _ Local Content Policy and the Development of the Oil and Gas Supplier Industry
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051 items, imported products that needed to be produced domestically were exhibited. The exhibition also played the role of marketplace, as the consumers of the products met with the suppliers, and transactions were made within the exhibition.

s Optional Contract and Prior Purchase System for Domestically Developed Products

The purpose of the Optional Contract and Prior Purchase System for Domestically Developed Products is to give priority to national producers in the government procurement. Higher priority is given to products with higher local content. Government procurement can be a very important policy instrument to stimulate the development and domestic production of some items. There are several positive effects when some demand is guaranteed by government procurement. The uncertainty related with demand decreases, so the investor can develop the product with smaller risk. Economies of scale can be attained, and the production will be more efficient.

Table 1-9 Other Support Measures Year of Category Sub-category Policy Instrument Related Entities Introduction Ministry of Commerce Search and Support for and Industry, Financial Prospective SMEs: Promoting 1983 Institutes, Research Comprehensive Prospective SMEs Support Institutes Notification System of Ministry of Commerce 1985 Domestic Production Items and Industry Domestic Machinery Korea Association of 1974 Exhibition Machinery Industry Optional Contract and Support Other Prior Purchase System for for Market 1974 Government Support Domestically Developed Expansion Measures Products Designation of Integrated Ministry of Commerce 1975 Items and Industry Anti-Dumping Duties 1974 Ministry of Finance Protection System of Market Ministry of Science and Manufacturers of Domestic 1977 Protection Technology New Technology Products Support Assessment System of Ministry of Commerce 1987 Industrial Impacts and Industry

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2017/18 Knowledge Sharing Program with Mexico (II) Table 1-9 Continued Year of Category Sub-category Policy Instrument Related Entities Introduction Establishment of Fair Trade 1980 Economy Planning Board Arrangement of Council Meetings of Parent Ministry of Commerce Fair Trade 1983 Company and Sub- and Industry Support Contracting Companies Arrangement of Korea Federation of 1986 Subcontracts SMEs Exemption of Military Service Ministry of National 1982 for Researchers Defense Exemption on Import Source Korea Industrial Others 1982 Diversification System Technology Association Consulting Office for Korea International Trade 1984 Domestic Production Association

Source: Lee et al. (1990).

s Designation of Integrated Items

The advantages of affiliation between firms, where the parent company buys most of the intermediate products produced by an affiliated company, are various. The parent company can purchase the inputs at a lower cost derived from lower wages of the affiliated companies without having to invest a large amount of money in production facilities and hiring many workers. The affiliated company, on the other hand, can secure a stable demand for its products from the parent company, and can increase its technological competitiveness by specializing in certain products.

The purpose of Designation of Integrated Items is to stimulate this relationship and increase the competitiveness of the affiliated SMEs. The parent company and the affiliated company must be submit a joint business plan for an item and get it approved by the Ministry of Industry and Commerce. The joint business plan includes the plan for the purchase of the item by the parent company, and the measures to improve the quality of the product, to modernize the facilities of the affiliated company, etc. Then the parent company must delegate the production of the item to the affiliated company, and transfer its production facility, if any, to the affiliated company. The supports given with this program include lots of financial supports and tax incentives. From 1982, the number of parent companies that had had their joint business plan approved was over 300, and that of the items developed under this scheme was over 1,000 each year, as shown in

.

Chapter 1 _ Local Content Policy and the Development of the Oil and Gas Supplier Industry
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053 Table 1-10 Companies and Items Approved under Designation of Integrated Items (Unit: Numbers) 1980 1981 1982 1983 1984 1985 1986 1987 1988 Sectors 6 24 34 43 44 40 40 41 43 Items 71 426 1,038 1,445 1,553 1,256 1,253 1,199 1,177 Parent 64 220 345 389 395 337 337 343 323 Companies Affiliated 263 1,141 1,190 2,435 2,487 2,180 2,188 2,166 2,060 Companies

Source: Lee et al. (1990).

s Anti-Dumping Duties

Anti-Dumping Duties were considered as a measure for domestic production policy as domestic products were very weak in the initial stage of development because of the low quality and relatively high price. When competing foreign companies try to impede the development of a new product by reducing the price, Anti-Dumping Duties can be a useful instrument to protect domestic industry against dumping sales of foreign products.

s Protection System of Manufacturers of Domestic New Technology Products

The objective of this measure was to ensure appropriate returns on the technology products developed domestically and to enhance the incentives of R&D activities by regulating the imports of similar products or technologies. However, the negative effects of the measure were also noticed, and the number of actual applications was very small.

s Assessment System of Industrial Impacts

Similar to Anti-Dumping Duties, the Assessment System of Industrial Impacts was introduced to protect domestic industries from the impacts of increased imports of foreign products.

s Establishment of Fair Trade

The development and production of parts, components, and materials would be successfully promoted if there were fair competition between parent companies and affiliated SMEs. The Law to Promote the Integration of SMEs established some obligations of the parent companies with respect to affiliated SMEs, including the

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2017/18 Knowledge Sharing Program with Mexico (II) maximum period of 60 days for the disbursement of the payments.

s Arrangement of Council Meetings of Parent Company and Sub-Contracting Companies

As the division of labor by sub-contracting increased, the conflict between parent companies and sub-contracting companies also increased. To solve the conflict between parent company and sub-contracting companies, the establishment of Council Meetings of Parent Company and Sub-Contracting Companies was recommended. As an incentive for the establishment, the government accorded tax reduction for the test and laboratory facilities the parent company provided to sub- contracting companies. The expenditure of the parent company to give technical guidance to sub-contracting companies was also deducted from taxable income. In the selection of projects for the Industrial Development Fund, preference was given to the projects proposed by the Council.

s Arrangement of Subcontracts

From 1986, the Korea Federation of SMEs mediated sub-contracts of domestically developed items with the companies in need of those items.

s Exemption of Military Service for Researchers

To supply excellent research manpower to the companies, this program exempted from military service the researchers employed by research institutes hiring more than 30 permanent researchers. Between 1982 and 1987, more than 4,000 researchers benefited from this program.

s Exemption on Import Source Diversification System

The Import Source Diversification System aimed at restricting the imports from countries with which Korea had a large trade deficit. However, product samples for the domestic development or products needed for the maintenance of the domestically produced items were exempt from this system.

s Consulting Office for Domestic Production

To provide information about domestic production policy and its measures, and to provide consulting service for the companies developing items for domestic production, the government established several Consulting Offices for Domestic Production.

Chapter 1 _ Local Content Policy and the Development of the Oil and Gas Supplier Industry
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055 4. Korean Experience 2: The Development of the Shipbuilding Industry 4.1. Evolution of the Shipbuilding Industry

From mid-19th century until 1945, Great Britain was the largest producer of ships in the world, whereas shortly after the World War II, some other European countries, including Germany, greatly increased their shipbuilding activities and shared the leadership with Great Britain. As shown in [Figure 1-5], European countries had more than 50% of the shipbuilding market share until the early 1960s. In the 1960s, Japan emerged as the world-leading shipbuilding nation. As for Korea, it has been establishing and expanding its shipbuilding industry since 1973, and in the 1990s, Korea shared world leadership in the shipbuilding industry with Japan.

[Figure 1-5] Tonnage Completed and Delivered by Major Shipbuilding Regions from 1952 to 2002

(Unit: million gt) 90 80 70 European Union 60 Japan 50 40 30 20 South Korea 10 China 0 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002

Source: Eich-Born and Hassink (2005).

Korea’s shipbuilding industry is a rare case that grew rapidly into an export industry by improving international competitiveness in a short period. In the 1960s, Korea, used to lag in the development of shipbuilding industry since it used to produce only costal, offshore fishing boats and vessels for domestic demand, and barges for export. However, in the 1970s and 1980s, it grew dramatically and became a leading country exporting large-scale vessels in the global market.

The shipbuilding industry of Korea was developed under close collaboration between the government and the private sector, especially large conglomerates. In

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2017/18 Knowledge Sharing Program with Mexico (II) particular, Ulsan Shipyard, built by Hyundai Engineering & Construction (E & C), was a monumental development. Hyundai E & C announced its plan to build the Ulsan Shipyard in September 1970 and held a historic and groundbreaking ceremony for the mega shipyard in March 1972. The plan was changed several times in the process. The shipyard was eventually completed in June 1974 and it was much larger and with better modern facilities than originally planned.

Hyundai made a contract for two VLCCs of 260 thousand DWT with a Greek company to be built in Ulsan Shipyard even before the shipyard was constructed. In March 1973, Hyundai began building the VLCCs and constructing Ulsan Shipyard at the same time. As the first ship “Atlantic Baron” was delivered to the Greek company in November 1974, it received remarkable attention, which led the Ulsan shipyard to be recognized as an international shipyard. The government supported Hyundai by (i) giving access to domestic and foreign funds with preferential interest rates; (ii) helping in obtaining and providing financial guarantees for the first order; (iii) making complementary investments in facilities and complementary industries, such as steel through the Pohang Iron and Steel Company (POSCO); and (iv) providing support for acquiring new technologies.

As could be seen from the case of Hyundai, the Korean government played an essential role in the development of the shipbuilding industry. Actually, the role of the government was essential in most of the other countries that had built a strong shipbuilding industry. In Korea, even in the early stage of economic development, there was a government plan to develop the shipbuilding industry, but since the industrial structure was weak and the economic development was centered on light industry, the heavy and chemical industries, such as the shipbuilding industry, could not be developed as wanted by the government. In the late 1960s, the Korean government enacted the “Shipbuilding Industry Promotion Act” and the “Machinery Industry Promotion Act” to establish a legal basis for fostering the shipbuilding industry in Korea, but it was not so effective, and the development of the industry was very slow.

The early 1970s was an important turning point for the Korean shipbuilding industry. A long-term Shipbuilding Industry Development Plan was established in March 1973, during the period of the Third Five Year Development Plan (1972-1976). In this plan, the government introduced a plan to transform the shipbuilding industry into one of the main export industries of Korea by 1980. The main goals of the plan were the following. First, Korea would be self-sufficient in vessels by 1980. Second, shipbuilding exports should reach 1 billion USD by 1980 (3.2 million gross registered tonnage - GRT) and 2 billion USD (6.2 million GRT) by 1985. Third, 9 shipyards should be constructed by 1980 and 5 more by 1985.

Chapter 1 _ Local Content Policy and the Development of the Oil and Gas Supplier Industry
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057 However, not all the goals were met. The goal of producing 1.3 million GRT was eventually not met, as production in 1976 was 1.17 million GRT, even though the overall shipbuilding capacity was 2.6 million GRT. In order to greatly expand the shipbuilding capacity to 2.6 million GRT by 1976, the government promoted 2 super mega-sized shipyards at the international level and 1 mid-sized shipyard of 150 thousand GRT. Small shipyards were merged into mid-sized shipyards and systematized to develop them into world-class medium-sized shipyards. As a result, in the 1980s Korea was able to rank in second place among the shipbuilding countries in the world.

The Fourth Five Year Development Plan (1977-81) included a number of objectives for the shipbuilding industry. One of these was the commencement of the production of parts and components domestically. Another was the development of the Planned Shipbuilding Program, which gave guidelines to the shipbuilding industry. Through the Planned Shipbuilding Program, the government selected the final users of ships, who would be provided with fiscal or financial support and would have the ships built in a domestic shipyard. The final purpose of the program was that ‘Korean cargo should be transported by Korean ships, and Korean ships should be built in Korea.’ From 1976 to 1993, 181 ships with a total of 4.5 million GRT were built under this program. Much of the finance of the shipbuilding industry would come from the National Investment Fund and foreign loans. In addition, government procurement would be used to overcome depressed international shipping markets. There was also an increased focus on replacing the imports of ships with Korean-built ships, as there were problems with reaching the objective of self-sufficiency by 1980. In fact, the goal could not be reached, as about 80% of the additions to Korea’s fleet in the early 1980s were imported.4) The Fourth Five Year Development Plan also made the first major revisions in the shipbuilding targets because of the global crisis of the shipbuilding industry, as the number of planned shipyards was reduced from 9 to 2.

The main policy measures to foster the shipbuilding industry are as follows: (a) government support, (b) low labor costs and the repression of labor, (c) favorable access to international and domestic funds, and (d) assistance in technology transfer.

4.2. Korean Policies to Develop the Shipbuilding and Supplier Industry

4.2.1. Industrial Policy

The HCI drive provided shipbuilding with (i) capital incentives, (ii) complementary investments, (iii) trade incentives, and (iv) tax holidays. The capital incentives included

4) Amsden (1989).

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2017/18 Knowledge Sharing Program with Mexico (II) preferential rates from state-owned banks with low nominal rates, with the high inflation making the real interest rate negative for most of the 1970s. A related method for securing access to capital was government guarantees for foreign loans. The Foreign Capital Inducement Law states that the Korean government would repay the loans to foreigners if the loans defaulted, with examples including foreign loans for shipbuilding. The second category of incentives was the government complementary investments, which included large infrastructure programs for new facilities. The government invested in industrial complexes for shipbuilding at Ulsan, Okpo, and Chukdo.5) Also of great importance was the promotion of the steel industry through the state-owned POSCO. The shipbuilding industry enabled POSCO to reach higher economies of scale, and POSCO provided the shipbuilding industry with steel at a comparatively low price, enhancing the competitiveness of that industry.

4.2.2. Technological Policy

The Korean shipbuilding in the 1970s lacked the technological know-how to be competitive in international markets; therefore, technological assistance from abroad was sought. Foreign assistance for the Hyundai plant at Ulsan was sought from Britain rather than Japan. Hyundai got 4 types of technological assistance: (i) dockyard designs from the English company, A&P Appledore; (ii) ship designs and operating instructions from Scott Lithgow; (iii) expatriates, European shipbuilders, working for Hyundai the first three years of operations; and (iv) production know- how from Kawasaki Shipbuilding.6)

At Hyundai, production know-how improved relatively fast, while design technology, the ability to design ships, took longer time. The production know- how increased through learning-by-doing in producing multiple types of ships. As mentioned before, the first contract was for 2 VLCCs. However, the market for VLCCs collapsed in 1974, and Hyundai started to take orders for medium- and small- sized vessels and managed to accumulate production know-how in the building of crude oil tankers, Roll-on-Roll-off ships, multi-purpose cargo vessels, bulk carriers, and container ships. Regarding design technology, Hyundai was dependent on foreign ship designs for most of the 1970s, even though the company started to acquire basic design abilities from as early as 1974. Gradually, Hyundai started to experiment with shipping designs and, in 1978, a Basic Design Department was set up within the company. Hyundai’s first self-designed ship was a 25,000 DWT bulk carrier ordered by Hyundai Merchant Marine in 1979. From 1978 to 1983, Hyundai was actively purchasing ship designs from other companies to increase their design technology. Hyundai made lot of efforts to develop specific expertise and technology

5) Kang (2001). 6) Amsden (1989).

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059 for the construction of gas carriers, and since 1978 has made license agreements with consultant companies to enhance its technological capability in cargo tank systems. Other Korean shipbuilders also choose to use licenses as a means for acquiring technology, as in the case of Samsung. The internal organization of Hyundai also evolved over time. The Department of Quality Control was established in 1973. An indicator that the quality of ships improved was that the success rate in vessel inspection increased.

4.2.3. Industrial Cluster

One important source of competitiveness and growth of the Korean shipbuilding and supplier industry was the formation of industry clusters. A cluster, industry cluster, or business cluster is a geographic concentration of interconnected firms, suppliers, and associated institutions in a particular field. Clusters are considered to increase productivity and competitiveness of the companies within the cluster through co-operation, collaboration, competition, networking, trade associations, and lobbying.7)

Shipbuilding clusters in Korea were developed in the Southeastern region of Korea, especially in Ulsan and Geoje. Ulsan is the base of Hyundai Heavy Industries,

[Figure 1-6] Shipbuilding Clusters, as of 1990

Source: Modified by author from various sources.

7) Benneworth et al. (2003).

060
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2017/18 Knowledge Sharing Program with Mexico (II) and Geoje is the base of Samsung Heavy Industries and Daewoo Shipbuilding & Marine Engineering. Most of the Korean shipbuilding companies have concentrated their manufacturing facilities in Gyeongnam, the southeastern province of Korea. Beside the top three shipyards, Hyundai, Samsung, and Daewoo, other small and large shipyards were established in the nearby region, as shown in [Figure 1-6].

With geographical concentration of shipyards, the producers of the intermediate inputs to shipbuilding industry have located nearby. Whereas Hyundai Heavy Industries, which is a shipbuilding company but that also produces the largest amount ship engines in the world, is located in Ulsan, 2 main manufacturers of ship engines, HSD (which changed its name to Doosan Engine in 2005) and STX, were both established in Changwon, close to Geoje. Steel is also supplied from within the region. One of the world largest steel producers, POSCO, is based in Pohang, north of Ulsan. Producers of other parts for the shipbuilding and subcontractors of the shipbuilding companies are also located in the cluster. Shipbuilding companies frequently sub-contract out parts of the production process, which, in many cases, are located very close to or even within the shipyard.8) For example, in 2003, Samsung Heavy Industries had 94 sub-contractors providing goods or services directly from the shipyard and another 16 located elsewhere. These sub-contractors together employed 12,268 workers, and produced approximately two-thirds of the value produced by Samsung Heavy Industries.

Shipbuilding companies in Korea actively supported both suppliers of parts and sub-contractors by providing technical assistance and physical spaces for their production. In this way, the suppliers could reduce costs and time required to transport their products to the shipyard, while at the same time they could improve the quality of supplied parts. Samsung, for example, has developed an industrial estate of 12 km2 near its shipyards, to help its sub-contractors.

The location of shipbuilding clusters in Ulsan, Geoje, and other locations in the southeastern part of Korea was because of favorable conditions for the construction of harbors, such as deep water and a lack of sandbanks. However, military strategic considerations also played a role, as Ulsan, for instance, was one of the few cities in South Korea that had not been taken by the North Koreans.9)

4.2.4. Domestic Production of Parts and Components

Until early 1980s, domestic production of shipbuilding equipment and parts was promoted by importing foreign technology. However, the level of domestic production was very low, and most of the important and high-value-added

8) Hassink and Shin (2005). 9) Hassink and Shin (2005).

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061 equipment was assembled with parts and materials imported from abroad. From the mid-1980s, owing to many government policies to promote the production of parts and components, such as the Notification System of Domestic Production Items, and coordinated efforts by the shipbuilding companies, there was a significant achievement in the domestic production of parts, materials, and machinery.

The number of items in the shipbuilding supplier industry listed by the Notification System of Domestic Production Items was 58 in 1986, 46 in 1987, and 34 in 1988. A comprehensive support system, including financial and technical support, was provided to these items. This number of shipbuilding supplier items was about 6% of all the items notified in these years.10)

Thanks to the development of the shipbuilding supplier industry, the average proportion of local content for the bulk carriers, tankers, and containers, which was 75-80% in 1988, increased to 84% for bulk carriers, 88% for tankers, and 89% for containers. For special ships, like LPG tankers, the local content increased from 60% in 1988 to 70% in 1989.

5. Competitiveness and Investment Attractiveness of the Shipbuilding and Supplier Industry in Mexico

In Mexico there are 65 shipyards, but within these, we must distinguish between two different types of shipyards. On the one hand, we have the shipyards for construction offshore, which manufacture platforms and other structures for the oil sector and are characterized by modern large-scale enterprises belonging to large national and international conglomerates. On the other hand, there are shipyards of construction and repair, which constitute the largest group of companies but of which only about fifteen have modern infrastructure and equipment. The rest are hand-crafted or semi-manual and dedicate mostly to the maintenance and repair of the local fishing fleets.

In 2013, the SEMAR (Secretary of the Navy) made a contract with Pemex for the renovation of the fleet. This contract was the most voluminous contract in the Mexican shipbuilding industry in recent years, as it includes the construction of tugboats, barges, and other support ships. The importance of this contract lies in the possibility that it may be a signal of re-establishing the relationship between Pemex and the Mexican shipbuilding industry. For a long time, Pemex has not built its ships in domestic shipyards. Even in the recent contract, there was a risk that the boats

10) Lee et al. (1990).

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2017/18 Knowledge Sharing Program with Mexico (II) would be requested from foreign shipyards due to the lack of capacity of national civil shipyards, as had happened shortly before with the renewal of the fleet of Pemex.11)

In Mexico, the shipbuilding and supplier industry is relatively weak, with very limited capacity and technology to produce platforms and ships used in the oil sector. After the shipyards of SEMAR, the most remarkable group of shipbuilders is the yards constructing metal structures for the petroleum industry, with a strong concentration in Altamira/Tampico and Tuxpan. As for the civil shipyards, the largest company in the sector is Talleres Navales del Golfo (TNG), successor to the Astilleros Unidos de Veracruz. Since 2006, it has belonged to the Hutchison Port Holdings Group and has been subcontracted by the SEMAR for the construction of 4 tugboats within the framework of the agreement between Pemex and the SEMAR. Another national shipyard that profited by this contract is Servicios Navales e Industriales (SENI), located in the port of Mazatlan. Other national shipyards with proven ability to build ships with relatively modern techniques (plasma cutting, forming panels, and assembly of block) are Astilleros Marecsa (which from 2012 has operated at the facilities of the old Astilleros Unidos del Pacifico), Astilleros Internacionales de Tampico, y Servicios Portuarios, located in Ensenada. Other shipyards have a medium technological capacity to carry out repair and maintenance activities. Within this group, shipyards on the Pacific side offer maintenance services to fleets of their respective ports, while the shipyards in the Gulf of Mexico extend their service to vessels participating in the exploration and production activities of Pemex.

The weight of the industry of construction and repair of ships has always been very small in Mexico. In addition, the Mexican shipbuilding industry has shown a great dependence on the petroleum industry and, to a lesser extent, on the fishing industry. In terms of the intermediate input industry, the small volume of the shipbuilding industry in Mexico has hindered its development in such a way that Mexico has had to import components such as electronic navigation equipment or high-horsepower engines. However, for propulsion systems, there are competitive suppliers such as Fundiciones Rice, a company in Mazatlan, which exports 80% of its production to the United States. Another encouraging sign is that in 2014 the verifying company Bureau Veritas certified the AHMSA Steckel mill for the production of shipbuilding steel.

The structure of the shipbuilding industry originates from the privatization in the 1990s. With the privatization, all of the assets of Astilleros Unidos, the state- owned shipbuilding company, were transferred to private companies. However, the private companies could not maintain the same level of activity, and some shipyards, especially those in the Pacific, faced a crisis resulting in closures. Therefore, until very

11) Montiel (2016).

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063 recently, the public sector, through the shipyards of the SEMAR, has been the only agent of shipbuilding, as well as carrying out more complex repair and maintenance works, in the country.

Recently there has been some inflow of foreign capital into the Mexican shipbuilding and supplier industry, with 2 different results. On the one hand, the construction of oil platforms has increased with the entry of 3 large multinationals in the sector: McDermott, Fluor, and Dragados, although in this segment there are also large national companies like the Monclova and Carso groups. On the other hand, there was an acquisition of Talleres Navales del Golfo (TNG) by Hutchison Port Holdings, the biggest port operator in the world. As for the internationalization of the Mexican shipbuilding companies, there were small exports and some construction of ships in Mexico licensed from foreign companies in the recent years.

As for sectoral policy for the shipbuilding industry, the sectoral program 2013- 2018 of the SEMAR established as one of its main objectives the promotion of shipbuilding industry through 3 actions: replacement of the minor fleet of Pemex Refining, renewal of the fishing fleet, and replacement of the Navy of Mexico surface units. In terms of specific instruments for support, the most important is the Mexican Shipbuilding Development Fund (Fondo de Desarrollo de la Marina Mercante Mexicana: Fondemar), which aims to facilitate the financing of the country’s shipbuilding sector companies by providing a partial guarantee of 50% of the credits requested. This fund supports the construction, rehabilitation, or purchase of vessels and naval artifacts that will be flagged as Mexican, as well as the creation and development of infrastructure in shipyards.

It is expected that the greatest spur to the shipbuilding and supplier industry has come from the increase in the activities of exploration and extraction of hydrocarbons that the energy reform in 2013 promoted, as it contained a requirement of national content in such activities. Deep-water projects, which can benefit the shipbuilding industry the most, have had to satisfy a minimum national content of 3% since 2015, which will increase to 8% by 2025.

To support the shipbuilding industry, the Mexican government is also planning to enact a new law, "Law for the Strengthening of the Commercial Ships and Shipbuilding Industry in Mexican," which stipulates that the shipyards, dry dock, and the shipbuilding support industry will have priority over foreigners for the construction, repair, maintenance, and scrapping of ships or craft owned by the Mexican government. It also establishes that Mexican companies that will receive the benefits of the law should also give preference to domestic shipyards for the construction, maintenance, repair, and dismantling of their ships.12)

12) Montiel (2016).

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2017/18 Knowledge Sharing Program with Mexico (II) Another relevant measure provided by this law is the establishment of a Committee of Support for the Commercial Ships and the Shipbuilding Industry by the Secretary of Communication and Transportation and representatives of other agencies related to maritime activities. The functions of this Committee will be to agree with state-owned enterprises on mechanisms to give preference to Mexican-flagged ships in the procurement of services, to support the construction and operation of shipyards by the Integral Port Administrations, and to establish comprehensive cooperation agreements with governments of other countries and international organizations in the field of training, technology transfer, and other aspects that favor the development of the shipbuilding and supplier industry. Measures of direct support expected to be derived from the action of this committee are the adoption of a system of taxation and tariff instruments that contribute to the international competitiveness of the Mexican shipbuilding industry.

6. Policy Recommendations and Conclusion

The Energy Reform is likely to provide the Mexican oil and gas supplier industry with a great growth opportunity. Developing the shipbuilding and supplier industry seems to be the only way to significantly increase the local content in the oil and gas supplier industry, especially in the deep-water projects. The reform will bring a large increase in the demand for the products from the shipbuilding industry. The sectoral program 2013-2018 of the SEMAR, which established as one of its main objectives the promotion of shipbuilding industry through replacement of the smaller fleet of Pemex Refining, will also contribute to the increase in the demand. It is very important that Pemex uses ships or offshore platforms produced in Mexico whenever possible. Of course, as the deep-water exploration and production requires a very sophisticated technology, there must be a long term plan to develop and produce this equipment.

However, the Mexican shipbuilding industry may not have the capacity to satisfy this new demand. Therefore, the supply side must also be addressed for the Mexican shipbuilding industry to fully take advantage of the new opportunity. Among the current instruments to support production, the most important is the Mexican Shipbuilding Development Fund (Fondo de Desarrollo de la Marina Mercante Mexicana: Fondemar), which aims to facilitate the financing of the country's shipbuilding sector companies by providing a partial guarantee of 50% of the credits requested. As mentioned before, this fund supports the construction, rehabilitation, or purchase of Mexican vessels and naval artifacts, as well as the development of infrastructure in shipyards.

To design the policies to enhance the supply capacity of the Mexican shipbuilding

Chapter 1 _ Local Content Policy and the Development of the Oil and Gas Supplier Industry
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065 industry, Korean experience in the promotion of domestic production of parts, components, and materials could be very useful. Korea introduced a system of supports to increase domestic production of parts, components, and materials, and to increase the local content of the target industries. However, the situation of Korea in the 1970s and 1980s differs from that of Mexico now. The most important difference is the change of the multilateral trading rules within the WTO. Many policies implemented by Korea in the 1970s to increase the local content would be a violation of the current WTO rules. Therefore, the measures taken by the Mexican government to increase the local content in exploration and extraction of oil and gas must be carefully designed not to violate the multilateral rules. However, rather than focusing solely on the legal issues, the economic impacts must be carefully analyzed, as mentioned in "Local Content Requirements: A Global Problem."13)

“In principle, many local content requirements are inconsistent with the rules of the World Trade Organization (WTO) and regional free trade agreements. In practice, the rulebooks have many gaps. Moreover, national respect for international trade and investment rules is more a matter of self-discipline than litigation. For both reasons, a ‘legalistic’ answer to the spreading use of local content requirements is not wholly satisfactory.”

After analyzing whether measures taken by Korea are consistent with WTO rules, some useful measures can be implemented in Mexico. It is not necessary to implement all the measures at once, as even in Korea the support measures were implemented gradually. In the short run, we can consider the measures that the Secretary of Economy can implement without cooperation of other secretaries, and which do not require large government resources. Most of the technical supports are in this category, such as invitation of domestic and international experts for technical guidance, technical information support, open utilization of high-priced test analysis equipment, and the quality certification system of domestic machinery, parts, and materials. Other support measures like the Domestic Machinery Exhibition, the Consulting Office for Domestic Production, and Prior Purchase System for Domestically Developed Products can also be implemented in the short run.

To introduce financial supports or tax incentives, cooperation with the Secretary of Finance is required, and therefore may take more time. However, we can take advantage of the existing funds, such as Fondemar or SMEs-supporting funds, to promote the domestic production of intermediate goods in the oil and gas supplier industry. It is not necessary to use these funds for the exclusive purpose of producing parts and components of the oil and gas supplier industry. However, by including this purpose among the mission of the funds, it may be possible to mobilize some resources to promote the oil and gas supplier industry. In the case of Korea, the

13) Hufbauer et al. (2013).

066
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2017/18 Knowledge Sharing Program with Mexico (II) financial support measures were not used exclusively for the domestic production of parts, components, and materials; nevertheless, some portion of the support was directed for this purpose.

Once some support measures are in place, the Notification System of Domestic Production Items could also be effectively implemented in Mexico. Under this system, items to be developed and produced domestically are selected every year and given a package of supports. This was the most systematic support for domestic production of parts, components, and materials in Korea, and had excellent results.

Another experience of Korea that may be very useful for the promotion of the oil and gas supplier industry in Mexico is the promotion of shipbuilding industry. Korea has a unique experience in developing shipbuilding and supplier industry in a very short period. The Korean shipbuilding industry was developed through a close collaboration between the government and the private sector. The government made a long-term plan and supported the shipbuilding industry with policy loans, tax incentives, technical support, and investment in related facilities.

Another important lesson from the development of the Korean shipbuilding industry is the role of clusters. Most of the shipyards were located in the southeastern region of Korea, together with all the supporting industries. This increased enormously the efficiency of the shipbuilding industry, and helped with the domestic production of parts, components, and materials used in the shipbuilding industry. In the case of Mexico, developing a cluster for the shipbuilding industry oriented to the oil industry could be a good strategy. For this purpose, the special economic zone (SEZ) can be a very useful tool. In Mexico, SEZs are areas with legislation separate to that of the rest of the country in regards to investment, taxation, trade, tariffs, and industrial relations. The objective of this scheme is to develop an administration that is more efficient and conducive to business and commercial transactions that encourage investment, the establishment of companies, and the creation of jobs, usually through the attraction of foreign direct investment.

With this scheme, a SEZ can be established with the purpose of developing the shipbuilding industry, especially the segment related with the oil industry. Mexican government seems to consider the states of Campeche and Tabasco, whose economies are heavily dependent on the oil industry, as good candidates for a of shipbuilding industry cluster. In this case, there would be 2 ports that can benefit the industry of shipbuilding: Dos Bocas and Isla del Carmen.

The problem of Mexican SEZ policy in relation to the development of shipbuilding industry is that it focuses more on the social and economic development of underdeveloped regions than on the efficiency. SEZ is intended to boost economic

Chapter 1 _ Local Content Policy and the Development of the Oil and Gas Supplier Industry
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067 growth and enhance public services in Mexico’s underdeveloped areas through the promotion of local and/or foreign direct investment, and by providing tax benefits, customs, and business facilitation measures. However, if a region for the cluster is selected because of its low level of economic development and not because of the efficiency for the shipbuilding industry, the development of a competitive shipbuilding industry will be more difficult to achieve. A better strategy is to select the region that can contribute the most to the efficiency of the shipbuilding industry. Even multinational corporations (MNCs) would invest if the location were the optimum for their business, not if their investment contributes to alleviating the underdevelopment of some region.

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2017/18 Knowledge Sharing Program with Mexico (II) References

Comision de Especialidad de Ingenieria Naval, (2017), “Estudio de Capacidades Tecnologicas y de Manufactura de la Industria Naval y Auxiliar,” in Desarrllo Integral Sostenible de Innovacion y Tecnologia de la Industria Naval y Auxiliar, “CORE” del Sector Maritimo Mexicano, Academia de Ingenieria Mexico. Amsden, Alice, (1989), Asia’s Next Giant: South Korea and Late Industrialization, New York: Oxford University Press. Benneworth, P., Danson, M., Raines, P., and Whittam, G. (2003), “Confusing Clusters? Making Sense of the Clusters Approach in Theory and Practice,” European Planning Studies, 11, p. 511. Bruno, Lars, and Stig Tenold, (2011), “The Basis for South Korea's Ascent in the Shipbuilding Industry, 1970-1990,” The Mariner's Mirror, 97:3, pp. 201-217 Cho, Dong Sung and Michael E. Porter, (1987), “Changing Global Industry Leadership: The Case of Shipbuilding,” in Competition in Global Industries, ed. by Michael E. Porter, Boston, Harvard Business School Press. Eich-Born, Marion, and Robert Hassink (2005), “On the Battle between Shipbuilding Regions in Germany and South Korea”, Environment and Planning A, Vol. 37 Hassink, Robert, and Dong-Ho Shin, (2005), “South Korea’s Shipbuilding Industry: From a Couple of Cathedrals in the Desert to an Innovative Cluster,” Asian Journal of Technology Innovation, 13:2, pp. 133-155 Hufbauer, Gary Clyde, Jeffrey J. Schott, Cathleen Cimino, Martin Vieiro, and Erika Wada, (2013), Local Content Requirements: A Global Problem, Peterson Institute for International Economics. Hyundai Heavy Industries, (2009), “Annual Report 2009,” Ulsan, Hyundai Heavy Industries. Kang, Hojin, “The Development Experience of South Korea – The Role of Public Policy,” Chapter 8 in Wong, Poh-Kam, and Ng Chee-Yuen, Industrial Policy, Innovation and Economic Growth: The Experience of Japan and the Asian NIEs, Singapore University Press, 2001 Lee, Gong-rae, Myung-ja Lim, Sung-in Hong, and Young-hoon Kim, (1990), Mid-term Evaluation of the Program for the Domestic Production of Machinery and Parts Industry and Measures to Improvement, Korea Institute for Industrial Economics and Trade. (In Korean). Montiel, Israel, (2016), Estudio de mercado para la integración productiva de cadenas de valor en las zonas económicas especiales como factor de atracción de inversiones para el sector de la industria de embarcaciones y auxiliares mexicana y diseño del Clúster Naval Mexicano, Confederación de Cámaras Industriales de los Estados Unidos Mexicanos (CONCAMIN).

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069 Park, Kwang-Soon, Mantae Cheong, and Hwiu-jong Choi, (1992), Evaluation of the Program for the Domestic Production of Machinery and Parts Industry, and Measures for Promotion, Korea Institute for Industrial Economics and Trade. (In Korean). PROMEXICO, (2017), Opportunities Energy Sector, a presentation made by PROMEXICO. Secretaria de Economia, (2016), Informe sobre los avances en la implementación de las estrategias para el fomento industrial de Cadenas Productivas locales y para el fomento de la inversión directa en la Industria de Hidrocarburos, Mexico. Secretaria de Gobernacion, (2014), Diario Official de la Federacion, “Acuerdo por el que se establece la Metodología para la Medición del Contenido Nacional en Asignaciones y Contratos para la Exploración y Extracción de Hidrocarburos, así como para los permisos en la Industria de Hidrocarburos”, DOF: 13/11/2014 Song, Byong-joon, Mantae Cheong, and Chul Cho, (1995), Measures to Enhance the Efficiency of the Program for the Domestic Production of Machinery and Parts Industry, Korea Institute for Industrial Economics and Trade. (In Korean). Vietor, Richard H.K., and Haviland Sheldahl-Thomason, (2017), Mexico’s Energy Reform, Harvard Business School.

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2017/18 Knowledge Sharing Program with Mexico (II) 2017/18 Knowledge Sharing Program with Mexico (II): Local Content Policy and Industrial Development for the Energy Sector Chapter 2

Policy to Revitalize the Oil and Gas Industries in Mexico


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Policy to Revitalize the Oil and Gas Industries in Mexico

Ji-Chul Ryu (Future Energy Strategy Research Cooperative)

Summary

Korea and Mexico have very different oil and gas sectors. Mexico is an oil- producing country and a crude oil exporter, while Korea does not have any indigenous oil reserves and its oil supply entirely depends on imports. Thus, given the difference between Korea and Mexico, it is difficult to derive implications mutually comparative between the two countries. However, despite the differences, some meaningful implications can be derived from Korea’s experiences for Mexico to develop policy to revitalize the oil and gas industry. This is because the aim of Energy Reform policy in Mexico is largely consistent with the policy directions that Korea pursued in the past.

Policy recommendations based on the implications from Korea's experiences are as follows:

1. Balanced development of the oil downstream sector with upstream: The oil industry in Mexico, as an oil-producing country, is required to shift its growth strategy from focusing on the upstream sector to focusing on the downstream sector. s Expanding the refinery capacity to meet demand increases for petroleum products as well as to boost the petrochemical industry domestically.

Keywords: Oil industry in Mexico, Economic Growth Base, Localization Strategy, Technology Development, Market Liberalization

072
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2017/18 Knowledge Sharing Program with Mexico (II) 2. Create a more market-friendly investment environment by liberalizing the oil and gas market: In order to improve the oil and gas market environment and to reduce the negative effects of the existing state-owned monopoly oil industry, it is necessary to reduce market/non-market entry barriers for private and foreign enterprises in the oil and gas industry through up-mid-down streams as well as the wholesale-retail market, based on market mechanism principles. s Open not only upstream, but also downstream of the oil sector to private and foreign investments s Fully liberalize the oil industry in terms of lifting entry barriers, free trade of oil products, and price liberalization.

3. Active Technology Development for the Oil and Gas Upstream: Mexico should pursue the technology independence in the area which the country has a large potential to develop in the future. This will be an important policy challenge in lowering Mexico's dependency on foreign technology. s Invest actively in the technology development focusing on the deep-water oil and gas resources development and tight oil development. s In the case of the upstream sector, the development of offshore oil fields, especially deep-water oil and gas fields in the Gulf of Mexico, should benchmark other oil companies to enhance exploration and exploitation capacity for deep-water exploration. s Encourage Mexican companies to participate in projects in foreign countries, say in the United States, for the development of unconventional oil and gas, in order to learn and accumulate new and advanced technology at the initial stage.

4. Establishing Research Institutes Specialized in Policy and Technology Development and Fostering Skilled Human Resources: Professional and skilled human resources are the most important infrastructures for economic development. Mexico needs to expand this infrastructure to enhance the competitiveness of the oil and gas sector in the long term. The most effective way is to establish research institutes for planning and technology development or to strength their function. s Establish research think-tanks for the development of policy/strategy as well as of technology with strong government support. s Encourage the private sector to strengthen their engineering services, particularly for the oil and gas sector projects.

5. Strengthening Policy Coordination/Fiscal Function: Harmonization of government policies between different sectors is required in order to prevent the failure of government policy and to enrich the outcome of policy

Chapter 2 _ Policy to Revitalize the Oil and Gas Industries in Mexico
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073 implementation. Transparency of fiscal regime should be secured. s Strengthen inter-sector policy coordination function from the planning stage in order to minimize possible risk of policy failure by utilizing objective analysis and forecasting research outcomes. s Benchmark Korea’s experience of the Special Accounts for Energy and Resources (SAER) for establishing a separate fiscal funding mechanism for the energy project.

6. Establishing a long-term basis to enhance local contents in the oil and gas industry: In order to raise the local content in the oil and gas industry, it is necessary to foster skilled experts and to strengthen the function of professional research organizations in the long term. In the short term, it will be necessary to make the oil and gas sector in Mexico more competitive by boldly promoting policy to eliminate entry barriers of private and foreign companies into Mexico’s market. This will mean that the companies will bring capital and technology to the market and will be incentivized by themselves through the market mechanism. Therefore, recommendation for policy to enhance the local contents in Mexico’s oil and gas industry can be composed of the combination of the above-mentioned recommendations. s Eliminate market inefficiency by liberalizing the oil and gas markets. s Actively implement technology development for the oil and gas upstream. s Encourage establishment of research think-tanks for the development of technology to enhance local content capability. s Foster skilled human resources.

1. Introduction 1.1. Background

Mexico’s oil production has contributed significantly to Mexico’s exports and financial revenues. However, the oil production in Mexico has continued to decline since 2004, and the production in 2015 dropped sharply to 32% of 2004 levels. The decline in Mexico’s oil production is due mainly to the depletion of onshore oil reserves, such as the Cantarell oil field, which accounts for more than 60% of Mexico’s crude oil production, and to the lack of investment resources of Pemex (Petróleos Mexicanos) as well as to the backwardness of Mexico’s domestic technology and the related equipment industry. In the case of natural gas, the increase in domestic consumption is met by an increase in imports from the United States.

074
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2017/18 Knowledge Sharing Program with Mexico (II) As part of efforts to improve this situation, the Ministry of Economy (MoE) of the Mexican government requested policy development of the energy sector and investment strategy to revitalize the oil and gas industry in Mexico as the 2017/18 KSP project.

1.2. Objective

The main objective of this study is to develop policy recommendations for the revitalization of the oil and gas industry in Mexico, drawing on the implication of Korea’s experiences in the oil and gas sector. To this end, a comprehensive analysis of the oil and gas industry and of the development potential in Mexico will be required. In addition, a study of Korea's experience in the oil and gas industry will be necessary to derive the implication for the strategy to revitalize Mexico’s oil, gas, and energy industry policies.

1.3. Research Scope

The scope of this study includes the following: s Diagnosis of the Mexican oil and gas industry and prospects - Current status of oil and gas industry in Mexico - Evaluation of future oil and gas production prospects and development potential - Diagnosis of major obstacles and conditions of development and production s Introduction of Korea’s oil and gas experiences including the industrial structures, legal and institutional framework, and private enterprise participation process s Policy recommendation for the revitalization and development of the Mexican oil and gas industry.

1.4. Methodology

Methodology adopted in the study includes the following: s Collaboration with professional organizations in Mexico - Data collection, survey, and analysis related to the Mexican oil and gas industry - Survey of oil and gas policy and current condition of the oil and gas industry in Mexico s Technical and information assistance from a local consultant, expert in Mexico - Review of Mexico’s policy for the oil and gas sector.

Chapter 2 _ Policy to Revitalize the Oil and Gas Industries in Mexico
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075 2. Review and Perspective on the Oil and Gas Sector in Mexico 2.1. Historical Review on Supply, Demand, and Trade

2.1.1. The Oil Supply/Demand

Mexico is one of the major oil producing countries, ranking the 11th oil producer in the world as of 2016. Mexico has 8.0 billion barrels of proved oil reserves as of the end of 2016, and the reserve–production ratio of crude oil equivalent in 2016 for the proved reserves is 8.9 years (BP, 2017). The proved oil reserves in Mexico significantly decreased over the last three decades, from 51 billion barrels in 1990 to 8 billion barrels in 2016.1)

Table 2-1 Major Oil Statistics in Mexico (1) Unit 1980 1990 2000 2005 2010 2016 Proved Reserve Billion barrels 47 51 20 14 12 8 Production MMTOE 107 145 170 186 146 121 Consumption MMTOE 49 71 88 91 89 83

Source: BP Statistical Review of World Energy (2017), compiled by author.

Oil production in Mexico has also significantly decreased for the last decade since the peak of 190.0 million tons of oil equivalent (MMTOE) in 2004 to 121.4 MMTOE in 2016. This was due mainly to the depleting oil reserves and lack of investment in E&P activities (Enerdata, 2017). Oil production was 36% lower in 2016 compared to the peak. Currently, a number of unfavorable factors are affecting the oil and natural gas industry in Mexico (SENER, 2016b and 2016c). These include the declined international oil prices, natural depletion of crude oil reserves in Mexico, and budget cuts to Pemex.

1) According to the International Energy Agency (2017), Mexico has 37.4 billion barrels of oil-equivalent (bboe) of proven, probable, and possible (3P) reserves, and the reserve–production ratio of crude oil equivalent in 2015 for 3P reserves is 29 years.

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2017/18 Knowledge Sharing Program with Mexico (II) [Figure 2-1] Oil Production, Consumption, and Export in Mexico

(Unit: Thousand b/d) 5,000

4,000

3,000

2,000

1,000

- 1980 1985 1990 1995 2000 2005 2010 2015 Consumption Production Exports

Source: BP Statistical Review of World Energy (2017), compiled by author.

Oil consumption rapidly increased until the mid-2000’s, then began to decrease since 2013, falling to 83.0 MMTOE in 2016 from 89.0 MMTOE in 2010. The transportation sector is the largest consuming sector of oil products, accounting for 79.2% of total oil demand. The power generation and the industrial sectors accounted for 10.1 % and 7.3 %, respectively. Oil demand for the electricity demand in Mexico has been significantly replaced by natural gas. In the last 10 years, the share of oil in total power generation fuel inputs has reduced from 38.7% to 12.3%, due to the substitution program of fuel oil to natural gas that the Comision Federal de Electricidad (CFE) has implemented. On the other hand, the petrochemical and cement industries are the largest oil-consuming sectors in the industry sector.

Mexico is a major exporter of crude oil. The country’s crude oil exports also declined from the mid 2000's as shown in [Figure 2-1], reflecting the decrease in oil production as well as increases in domestic demand. Mexico’s crude oil exports were 1.4 million barrels per day (b/d) in 2016, 32% less than in 2005. Exports accounted for 57.0% of total oil production in 2016. The ratio of export/production of oil rapidly declined over the last decade to 46.4% in 2014 from 54-57% level in the mid 2000's, but increased in the last 2 years. By country, 58.9 % of oil exports in Mexico were exported to the United States. In the last 10 years, crude oil exports to the United States have fallen at an annual average rate of 7.0%, due to rapid increases in unconventional crude oil production in the United States.

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077 [Figure 2-2] Refinery Capacity, Output, and Oil Consumption in Mexico

(Unit: Thousand b/d) 2,500

2,000

1,500

1,000

500

- 1980 1985 1990 1995 2000 2005 2010 2015 Refinery capacity Refinery output Oil consumption

Source: BP Statistical Review of World Energy (2017), compiled by author.

However, Mexico is a net importer of refined oil products because of insufficient oil refinery capacity. The lack of sufficient refining capacities and increasing domestic demand has led Pemex to export crude oil to be processed in the United States (EnerData, 2017). As shown in

, refinery capacity in Mexico slightly increased from 1.48 million b/d in 1990 to 1.52 million b/d in 2016. However, Mexico’s refineries have performed rather poorly in recent years, and their utilization rates fell to just 60% in early 2016. The low utilization rate reflects the inability of the refiners to run profitably at higher rates, as crucial upgrades of refining facility have been long-delayed (IEA, 2016). Refinery throughput significantly declined from 1.32 million b/d in 1990 to 0.93 million b/d in 2016. Thus, the gap between demand and refinery throughput was met by imports. According to BP (2017), Mexico imported 796.0 thousand b/d of oil products in 2016, which accounted for 42.6% of total oil demand in Mexico.

Table 2-2 Major Oil Statistics in Mexico (2) (Unit: Thousand barrels per day) 1980 1990 2000 2005 2010 2016 Oil Exports 875.0 1,387.0 1,814.0 2,064.7 1,539.3 1,400.3 Refinery Capacity 1,226.0 1,627.0 1,481.1 1,463.0 1,463.0 1,521.9 Oil Refinery Throughput 1,017.2 1,321.3 1,251.9 1,284.2 1,184.1 933.1 Oil Demand 1,047.7 1,580.4 1,965.2 2,029.6 2,014.4 1,868.7

Source: BP Statistical Review of World Energy (2017), compiled by author.

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2017/18 Knowledge Sharing Program with Mexico (II) 2.1.2. The Gas Supply/Demand

Mexico has 0.2 trillion cubic meters (tcm) of proved natural gas reserves, as of the end of 2016, and the reserve-production ratio of natural gas equivalent in 2016 for the proved reserves was 5.2 years (BP, 2017). The proved gas reserves in Mexico significantly decreased over the last three decades, from 2.0 tcm in 1990 to 0.2 tcm in 2016.

Gas production in Mexico significantly increased from 23.1 MMTOE in 1980 to 51.8 MMTOE in 2010, but it has been shown to decrease since 2014 due to reduction of non-associated gas production.

Table 2-3 Natural Gas Statistics in Mexico Unit 1980 1990 2000 2005 2010 2016 Reserves tcm 1.8 2.0 0.8 0.4 0.4 0.2

Production MMTOE 23.1 24.4 34.5 47.0 51.8 42.5

Consumption MMTOE 20.7 24.8 36.7 54.8 65.2 80.6

Source: BP Statistical Review of World Energy (2017), compiled by author.

Demand for natural gas increased much faster than the production, from 20.7 MMTOE in 1980 to 80.6 MMTOE, during the period. The rapid increase in gas demand is due mainly to the expansion of gas-fired power generation capacity in the country. Natural gas is the most important fuel for power generation in Mexico,

[Figure 2-3] Natural Gas Production and Consumption in Mexico, 1980-2016

(Unit: MMTOE) 100.0

80.0

60.0

40.0

20.0

- 1980 1985 1990 1995 2000 2005 2010 2015 Production Consumption

Source: BP Statistical Review of World Energy (2017), compiled by author.

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079 accounting for 69.6% of total power generation in 2015 and is also a major fuel consumed in the industrial sector. Major feedstock for the petrochemical industry in Mexico is also natural gas. However, the residential sector showed the lowest share in total gas consumption. The share of gas in Mexico’s total primary energy supply (TPES) increased from 23.3% in 1990 to 43.2% in 2016.

Thus, Mexico is a net importer of natural gas, as the gap between the production and consumption was met by imports. Mexico’s major import source of natural gas is the United States, mainly transported through cross-border pipeline networks between the two countries. Of the total volume of imported natural gas, 82.0% was by pipeline from the United States. LNG imports had an 18.0% share and came mainly from countries such as Peru, Nigeria, and Trinidad and Tobago.

2.1.3. Role of Oil and Gas in Mexico’s Energy Mix

Oil and gas play a significant role in the energy sector in Mexico. As shown in

, the share of oil in Mexico's TPES was 44.4% in 2016, although it appeared to decrease from 66.8 % in 1990. In addition, gas accounted for 43.2% in Mexico's TPES in 2016. The share of gas significantly increased from 23.3% in 1990, as its demand rapidly increased for electricity generation. Thus, oil and gas accounted for 87.6% in TPES in 2016. Together with coal, Mexico's dependency on the fossil fuels is very high, reaching about 92.9% in 2016, while that on clean energy, nuclear, hydro, and renewable energy were 1.3%, 3.6%, and 2.2% in 2016, respectively. This obviously implies that the energy mix in Mexico is not an environmentally friendly structure, given its high dependency on the fossil fuels.

Table 2-4 Energy Mix in Mexico 1980 1990 2000 2005 2010 2016 Oil (%) 64.6 66.8 62.0 54.2 49.7 44.4 Gas (%) 27.1 23.3 25.8 32.7 36.6 43.2 Coal (%) 3.0 3.2 4.6 6.8 7.1 5.3 Nuclear (%) 0.0 0.6 1.3 1.5 0.7 1.3 Hydro (%) 5.0 5.0 5.3 3.7 4.7 3.6 Renewable (%) 0.3 1.1 1.0 1.1 1.1 2.2 TPES (MMTOE) 76.5 106.3 142.2 167.7 178.3 186.5

Note: TPES stands for Total Primary Energy Supply. Source: BP Statistical Review of World Energy (2017), compiled by author.

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2017/18 Knowledge Sharing Program with Mexico (II) 2.2. Energy Reform in Mexico

2.2.1. Impacts of Oil Production Decline on the Economy

One of the main contributions made by the oil industry to the Mexican economy is to generate the necessary foreign currency to import a large part of the inputs required for the expansion and development of national industry. The favorable balance that the oil trade balance has been bringing for many years has not only allowed the country to lessen the impact of its trade deficit, but also contributed to the accumulation of foreign currency reserves, which, in turn, has contributed to the stability of the exchange rate and contained inflation. In the fiscal area, oil revenues have allowed the Mexican government to maintain public spending beyond the internal collection capacity, which has spurred economic growth to a certain extent (De la Vega, 2016).

However, due to the drop in international oil prices from 2014, as well as the decrease in the production of crude oil and oil products, and declines in crude oil exports, the oil trade balance began to present a negative trend. Given the current scenario of low international oil prices and the fall in oil and petroleum production, the balance of payment will tend to maintain a growing deficit, which will undoubtedly generate macroeconomic risks associated with the lack of foreign exchange, such as volatility of the type of oil revenues and higher inflation.

2.2.2. Energy Reform

Mexico nationalized the oil sector in 1938, and the Petroleós Mexicanos (Pemex), the state-owned oil company, dominated the oil industry in Mexico with fully integrated operations in E&P, refining, distribution, retail, and petrochemicals. After years of declining production, Mexico instituted significant energy reforms. In August 2014, in an effort to address the declines of its domestic oil production, the Mexican government enacted constitutional reforms that ended the 75-year monopoly of Pemex (US EIA homepage, 2017). Ending Pemex’s monopoly on the oil and natural gas sector in Mexico, the energy reform allows the oil industry to be strengthened with the participation of private and foreign companies, particularly to attract foreign investment in E&P.

Implementation of the Energy Reform consisted of 3 stages:

s First stage: Constitutional changes s Second Stage: Modification of the legal and institutional framework s Third Stage: Implementation of the Energy Reform

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081 [Figure 2-4] Energy Reform in Mexico: Timeline

Bid Rounds Upstream Five Year Plan 2013 New Participants

Implementation New Market

CENAGAS Open Markets Constitutional Secondary Midstream Reform Legislation Open Seasons New Participants New Infrastructure New Storage Policy

Import Permits Downstream Price Liberization

Source: ProMexico (2017).

To implement the Energy Reform, the Secretariat of Energy (SENER) developed the Energy Sector Program 2013-2018, which aims to guide the actions to solve the obstacles that limit the supply of energy, which promotes the construction and modernization of the infrastructure of the sector and the organizational modernization of the structure and regulation of energy activities, as well as of state institutions and companies. Regarding the oil and gas industry, it was established as a goal to ensure the supply of crude oil, natural gas, and petroleum products through the following strategies:

s Strengthen productive companies in the field of hydrocarbons. s Establish a regulatory framework that promotes best practices and encourages investment. s Expand the sustainable portfolio of oil reserves. s Raise productivity in the extraction of crude oil and associated products. s Increase production of dry and wet natural gas. s Optimize the production capacity in the processing of natural gas and refinery. s Develop the maximum potential of the petrochemical industry based on the greatest economic value chains.

It is noteworthy that E&P contracts require a minimum national content, which will gradually grow until reaching a national average of 35% within 10 years starting from 2015. The requirement considers that both personnel and physical infrastructure expenditure is set specifically for each field. For example, for deep-water developments, in the initial exploration period the national content requirement is 3%, 6% for the first additional exploration period, and 8% for the second additional exploration period. Over time, the minimum requirements are expected to increase (IEA, 2017, Ministry of Economy, Mexico 2016).

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2017/18 Knowledge Sharing Program with Mexico (II) Box 2-1 Types of Contracts for Foreign Company in the Upstream of the Oil and Gas Industry in Mexico

The constitutional reform establishes that the secondary laws will regulate the types of contracts that the State can use, with the objective of obtaining income that contributes to the long-term development of the Mexican economy, such contracts will be among others: s Service Contracts: the contractor delivers the entire production to the marketer, which may be the State or contracted by him. This will deliver all the income to the Mexican Petroleum Fund (FMP), once the payment for its services has been discounted. The FMP will pay the contractor according to the contract. s Shared Utility Contracts: The contractor delivers the entire production to the marketer. Revenue from marketing will be delivered to the FMP, and this will cover the payment to the contractor. s Production Sharing Contracts: The contractor delivers all the production to the State and the latter pays him in kind, that is, with a part of the production. s License Contracts: The State delivers the crude oil to the contractor through the “onerous transmission” of the hydrocarbons. At the moment of extracting them from the subsoil, the property of the nation over them is terminated. s Onerous Contract: This type implies a consideration, since it brings into existence equivalent benefits and encumbrances in both parties.

Source: SENER (2013).

2.3. Perspectives and Challenges in the Oil and Gas Industry in Mexico

2.3.1. Perspectives on the Oil Industry

2.3.1.1. Upstream Oil Development and Supply Potential

Mexico has a large potential to further develop hydrocarbon reserves in onshore as well as offshore areas including shallow water and deep water. According to the estimation by the International Energy Agency (IEA, 2016), Mexico's total size of technically recoverable oil resource was 118.0 billion barrels, and 48.6 billion barrels of oil have been produced to date. Thus, the remaining recoverable oil resources in Mexico are estimated to be 69.4 billion barrels, as of the end of 2014. Among them, 21.2 billion barrels will be from the conventional onshore oil fields, 20.1 billion barrels from shallow offshore, and 15.0 billion barrels from deep-water offshore. In addition, Mexico has the unconventional type oil reserves, tight oil, of which technically recoverable size is 13.1 billion barrels (see Table 2-5).

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083 Table 2-5 Recoverable Oil Resources by Category in Mexico, 2014 (Unit: billion barrels) Technically Remaining Cumulative Remaining Proven Recoverable Recoverable Production % of URR Reserves Resources Resources Conventional Onshore 41.6 20.3 21.2 51% 3.0 Shallow Water Offshore 48.4 28.3 20.1 42% 7.8 Deep Water Offshore 15.0 0.0 15.0 100% 0.0 Tight Oil 13.1 0.0 13.1 100% 0.0 Total 118.0 48.6 69.4 59% 10.8

Notes: 1) Data include crude, condensate and natural gas liquids. 2) URR = ultimately recoverable resources. Sources: IEA (2016), compiled by author.

To date, Mexico’s oil production has concentrated on the oil fields in onshore and shallow water offshore. Shallow water oil fields have been the mainstay of Mexico's oil production for decades, accounting for nearly 70% of current total output. However, oil production assets in the area ageing rapidly,2) which has led to the significant decline in oil production in Mexico in the last decade. Pemex has concentrated investment for decades in several large offshore fields using aggressive recovery techniques. However, after 2004 at the Cantarell complex, which was Mexico’s largest at the time, decline accelerated, leading to a drastic fall in national production. These factors added urgency to the implementation of the Energy Reform measures (IEA, 2016).

No oil production has been made yet from the deep-water oil field, nor from onshore tight oil. These oil fields are expected to still have significant oil resource potential to develop in future. The Secretariat of Energy (SENER) believes that approximately 50% of the country’s prospective conventional oil and gas resource lies in deep waters, which makes these resources an attractive proposition for international oil companies. Pemex, though, has limited operating experience of E&P in deep water. Its first discovery was announced at the Trion 1 well, in the Perdido area, during 2012. Further discoveries have been made in the surrounding blocks and, based on test results, SENER estimates that the Perdido area holds about one billion barrels equivalent of recoverable oil and gas. For the development of onshore tight oil, SENER has indicated that nominations or requests by potential investors that certain assets be added to future bidding rounds have exceeded expectations in basins containing tight oil resources (IEA, 2016).

2) Only 2% of cumulative historical production in Mexico comes from fields in which production started in the last 25 years, compared with 7% in the United States, 8% in Venezuela, and 35% in the United Kingdom (IEA, 2016).

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2017/18 Knowledge Sharing Program with Mexico (II) As the implementation process of the Energy Reform, a series of bidding rounds began in 2015 to open the oil and gas sectors to private/foreign investment and technology for the exploration and development of hydrocarbon resources in onshore, shallow, and deep water. The bids take place under the Five-year plan formulated by the SENER.

Box 2-2 Major Oil and Gas Fields in Mexico

s Onshore oil fields: Tampico-Misantla Basin, which includes Chicontepec, a super-giant field s Shallow-water oil fields: Cantarell and Ku-Maloob-Zaap complexes in the Sureste Basin in the Gulf of Mexico s Deep-water oil fields: Yucatan platform, Chihuahua, the Sierra Madre fold belt and the Vizcaino- La Purisma-Iray Basin in the Gulf of Mexico s Tight oil fields: Tampico-Misantla and Burgos basins

Source: Financial Times, recited from Choi Byung-koo (2017).

[Figure 2-5] Major Oil Fields in Mexico

Source: Financial Times, recited from Choi Byung-koo (2017).

According to the IEA’s energy outlook for Mexico (IEA, 2016)3), oil production in Mexico is expected to increase to 3.4 million barrels per day (b/d) in 2040 from 2.6 million b/d in 2015. Oil production from existing oil fields is projected to significantly decrease, from 2.2 million b/d in 2015 to 0.3 million b/d in 2040. Oil production from the unconventional oil, tight oil, is expected to contribute to the increase of the

3) IEA projection was made under the assumption that the Energy Reform process will be timely and successfully implemented (IEA, 2016).

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085 onshore oil production by reaching the production to 0.4 million b/d in 2040 (see Table 2-6).

Table 2-6 Oil Production by Type in Mexico in the New Policies Scenario (Unit: million b/d) 2015- 2005 2015 2020 2025 2030 2035 2040 2040 Delta Conventional 3.8 2.6 2.4 2.5 2.7 2.8 3.0 0.4 Crude Oil 3.2 2.2 2.0 2.1 2.3 2.4 2.4 0.3 Existing Fields 3.2 2.2 1.6 1.0 0.7 0.4 0.3 -1.9 New Fields - - 0.3 1.0 1.6 1.9 2.1 2.1 EOR - - - 0.0 0.0 0.0 0.0 0.0 Natural Gas Liquids 0.6 0.4 0.4 0.4 0.4 0.5 0.5 0.1 Unconventional 0.0 0.0 0.0 0.1 0.3 0.4 0.4 0.4 Tight Oil - - - 0.1 0.3 0.4 0.4 0.4 Total 3.8 2.6 2.4 2.6 3.0 3.2 3.4 0.8 Shallow Water 2.9 1.8 1.6 1.5 1.4 1.2 1.1 -0.6 Deep Water - - 0.0 0.2 0.5 0.7 0.9 0.9 Onshore 0.9 0.8 0.8 1.0 1.2 1.3 1.3 0.5

Note: EOR = Enhanced oil recovery. Mexico possesses significant quantities of heavy oil, but these do not fit the World Energy Outlook description of extra-heavy (unconventional) and are, thus, included in the conventional crude classification. Sources: IEA (2016), compiled by author.

[Figure 2-6] Oil Production by Geographical Source in Mexico

(Unit: million b/d) 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2005 2015 2020 2025 2030 2035 2040

Shallow water Deep water Onshore

Source: IEA (2016), compiled by author.

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2017/18 Knowledge Sharing Program with Mexico (II) By geological source, there has been a significant increase in oil production from deep-water oil fields during the projection period, reaching 0.9 million b/d, 26.5% in total production in 2040 (see Figure 2-6). Oil production from shallow water offshore is expected to rapidly decrease from 1.8 million b/d in 2015 to 1.1 million b/d in 2040 due mainly to the depletion of oil reserves in the area. Production from shallow waters will continue to play a major role in Mexico’s production, but the age of the resource base means that historic levels of shallow water output are unlikely to be seen again (IEA, 2016).

2.3.1.2. Downstream Development Re¿ning Project

The National Refining System (SNR) (SENER, 2016d) is composed of six refineries built and operated by Pemex, and Mexico’s total refinery capacity is 1,615 thousand b/d (see Table 2-7and Figure 2-7). However, the utilization rate of Mexico’s refinery is pretty low compared with those in other countries.

Table 2-7 National Refining System in Mexico Process Start of Geographical Refinery Location Capacity Operations Area (thousand b/d) Salina Cruz 1979 Salina Cruz, Oaxaca South-Southeast 330 Madero 1914 Madero, Tamaulipas North-east 190 Tula 1977 Tula, Hidalgo Center 315 Salamanca 1950 Salamanca, Guanajuato Center-West 220 Minatitlán 1956 Minatitlán, Veracruz South-Southeast 285 Cadereyta 1979 Cadereyta, Nuevo León North-east 275 Total 1,615

Note: Processing capacity refers to the capacity of atmospheric distillation in refineries. Source: SENER (2016b), compiled by author.

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087 [Figure 2-7] Oil Refinery and Gas Processing Sites in Mexico

Source: SENER (2016a).

The low utilization rate reflects the inability of the refiners to run profitably at higher rates, as crucial upgrades (necessary to process the increasingly heavier crude slate into oil products with tightening specifications) have been long-delayed (IEA, 2016). According to SENER, the utilization rate of the SNR was recorded as 77% in 2010 but dropped to 66% in 2015.

The SENER (2016) indicated that the crude-oil refining subsector is going through a process of reorganization, adaptation, and transformation combined with operational problems. Facing this situation, and considering the new legal frame derived from the Energy Reform, Pemex is working in the design of alliances scheme and new business cases which will enable it to relaunch its refining system in the medium term. Other considerations draw to a projection in three phases:

s 2ETURNTOOPERATIONLEVELSPRIORTO s  )MPROVEMENTSOFOPERATION YIELDS ANDPRODUCTSQUALITY s  #ONSTRUCTADDITIONALRElNINGCAPACITY

2.3.2. Perspectives on Gas Industry

Mexico has a large volume of remaining recoverable gas resources of 18.9 trillion cubic meters (tcm). According to the estimation by the International Energy Agency (IEA, 2016), the remaining recoverable conventional gas is estimated at about 2.8 tcm,

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2017/18 Knowledge Sharing Program with Mexico (II) mostly located offshore in deep water in the Gulf of Mexico, accounting for around one-third of the conventional resource base. Unconventional gas resources, shale gas, are expected to be more sizable and to be estimated by 16.0 tcm and to represent a considerable source gas for Mexico in future. The Burgos and Sabinas basins hold significantly larger resource promise than even Mexico’s conventional plays.

Table 2-8 Natural Gas Production, Proven Reserves, and Resources in Mexico (Unit: Trillion cubic meter, tcm) Ultimate Remaining Cumulative Remaining Proven Recoverable Recoverable Production % of URR Reserves Resource (URR) Resources Conventional 4.4 1.6 2.8 64% 0.4 of which Gulf of Mexico 1.6 0.0 1.6 100% 0.0 Basin Unconventional 16.0 0.0 16.0 100% 0.0 of which Sabinas and 15.2 0.0 15.2 100% 0.0 Burgos basins Total Mexico 20.4 1.6 18.9 92% 0.4

Sources: IEA (2016), compiled by author.

According to the IEA’s projection, gas production in Mexico is expected to increase by a little over one-third, to reach 60 billion cubic meters (bcm) by 2040. Around a quarter of total production is expected to come from shale resources. The timing of this increase is highly uncertain: the evolution of upstream costs and natural gas prices in the United States will have a large influence on the relative attractiveness of developments in Mexico. The majority of non-associated gas such fields are thought to be located in the Gulf of Mexico, underlining again the importance of deep-water technology to the hydrocarbon.

Domestic natural gas production, though rising strongly, does not keep up with rapidly increasing demand; therefore, Mexico continues to rely on pipeline imports in the foreseeable future. The Energy Reform includes a number of changes to the regulation of the gas market. To facilitate private-sector competition, the ownership of the transmission network (SISTRANGAS) has been transferred to CENAGAS, the newly created independent operator. The Energy Reform is the implementation of a new method to determine the first-hand sale price, which is to be referenced to prices in the southern United States. This aims to correct a number of market distortions, and the price of natural gas will be determined by the market, in the hope that accurate market signals will eventually encourage domestic gas production (SENER, 2016d).

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089 2.4. Major Challenges in the Oil and Gas Sector in Mexico4)

2.4.1. Technology Development and Application

The Oil Industry in Mexico requires a greater introduction of modern and more appropriate technologies for the exploration and exploitation of hydrocarbons (in the exploratory part, the use of the most modern technologies for surface exploration, such as seismic surveys with Wide Azimuth technology, and the use of new methods of electromagnetic prospecting) in order to reduce the risks associated with exploration and obtain better results. This should take into account that the exploratory conditions will be increasingly complex.

In unconventional hydrocarbon deposits, particularly shale gas, although they are a great opportunity to incorporate a greater amount of gas reserves to the country, their exploitation implies challenges at the regulatory level, social license and institutional structure that ensure Attractive tenders, design and monitoring of efficient contracts, as well as the expeditious obtaining of permits for the operation. However, the following problems occur:

s Lack of specialized human resources s No modern and innovative technological and financial capacities are available for the extraction of these resources, since deposits of this type require a greater technological deployment and greater efficiency to make them profitable. s There is not yet a national reference price.

Likewise, there is a lack of technology to develop the necessary infrastructure to sustainably exploit deep deposits. Most of this technology has been developed and is owned by foreign companies; Currently, to be able to conduct such drilling, Pemex rents platforms and technology, which considerably increases costs.

In the field of refining, one of the demands to be addressed is its technological backwardness and dependence, since the IDT stopped being promoted since the mid- 1980s. Neither Pemex nor the Mexican Petroleum Institute (IMP) allocated sufficient financial resources and in an adequate manner for its promotion, and even less in an environment where the creation of infrastructure was restricted, which in turn led to researchers demanding more current technologies. Refining in Mexico has not been a profitable business, because although SNR revenues have increased, it has accumulated consecutive losses since 1994, which has resulted in a negative equity

4) This section was prepared by contribution from a local Consultant in Mexico, Mr. Jaime Torres Ramírez.

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2017/18 Knowledge Sharing Program with Mexico (II) close to 20 million dollars at the end of 2016. The accumulation of difficulties has worsened because of Pemex's liquidity problems and low productivity.

2.4.2. Improvement of Policy Coordination

In the petrochemical sector, there is no coordinated promotion to generate the integration of the value chains of the Mexican chemical industry, in order to guarantee the long-term supply and competitive reference prices of basic raw materials and supplies produced by Pemex.

There is a slow rate of investments in infrastructure for the transportation, storage, and distribution of oil, which continues to affect the domestic market, even with increasing imports, due to lack of capacity to deliver fuels to consumption centers. The support and incentives for SMEs regarding the policy of national content suppliers and contractors are in a slow process of implementation by the government; at the beginning of 2017, the government supplier registered a low level of participation (396 companies in the hydrocarbon sector). This could delay their interest in participating in the sector and exclude them from the benefits of the Energy Reform.

2.4.3. Human Resource Development

There is a deficit of human capital in highly specialized areas linked to the production of hydrocarbons. Currently there is a deficit of oil, electrical, petrochemical, and technical engineers specialized in this branch because for many years the energy sector remained closed to economic competition. The country requires geoscientists who can read and interpret seismic data and engineers with deep technical knowledge, as well as experienced financial executives who can estimate assets, budget costs, and raise capital. During the bidding process, and especially in the concessions, it has been observed that engineers and specialists in shale fracture technologies are not available; and environmental systems are lacking, as are health, safety and risk analysis, and inspection and technical certifications. In the short term, this can cause a substitution effect in the labor demanded by the hydrocarbon sector (i.e., greater hiring of foreign personnel).

2.4.4. Restructuring Fiscal Regime

The tax collection from oil activity has been a determining factor in the budgetary income of the federal government. It has averaged more than 30% in recent decades, within a range of between 19% and 40% per year. As a proportion of GDP, oil revenues averaged 7%. The oil revenue figures exclude the collection of Value Added Tax (IVA) and Production and Services Special Tax (IEPS) associated with the oil

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091 activity and the coverage of risks due to the low price of crude oil.

The fiscal dependence on the extraction of hydrocarbons, especially crude oil, took root as one of the fundamental restrictions in the design of economic policy and the maintenance of the financial stability of the economy. In effect, maximizing the “oil platform” in physical units and establishing foreseeable figures for the international price of crude oil and the exchange rate became entrenched as imperatives in the preparation of the federation's expenditures and income budgets. However, these requirements do not necessarily correspond to the extraction and exploration capacity and the possibilities of generating Pemex resources as a productive entity in charge of efficiently attending to these activities. The tension – and often the conflict – between both purposes has been resolved by limiting the organization’s financial and production capacities, and even by incurring inefficiencies in the exploitation of oil reserves, with the foreseeable damages in one of the most important sources of revenue generation of the federal government.

The fiscal burden of Pemex, now as an EPE, and before a decentralized public body, remains extremely burdensome, not only in terms of operating results and the required economic and financial solvency, but also in comparison with the main companies, international organizations, and state entities in their field. Although the transformation of Pemex into EPE has been fulfilled in the legal and regulatory aspects, the operational transition will still take a period that can cover most of the next three years. Likewise, the current exemption regime for Pemex puts it at a disadvantage in terms of competition throughout the value chain with private participants, and poses demands that are not correlated with those established for private agents. At the same time, it exceeds the powers of autonomous management that it concentrates in its board of directors and its general management. More than a productive company of the state, Pemex is established at the service of the government in turn and managed by it with self-referenced systems of surveillance and accountability.

2.4.5. Strengthening Efforts to Enhance Policy Acceptability and Compatibility

The new legislation privileges the E&P of hydrocarbons as a matter of public interest, but also includes the obligation to carry out social impact studies and the principle of consent to carry out projects. Compensation to landowners is an advance in the protection of rights, but the type of property and its fragmentation can be an obstacle because communities and owners are almost never involved in impact assessments, nor are they clarified and guaranteed the rights of consultation and consent to approve projects. The reform hopes to detonate new investment projects for the E&P of hydrocarbons.

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2017/18 Knowledge Sharing Program with Mexico (II) The issue is relevant because almost 50% of the property in the states with oil activities is under some type of social regime. The declaration of social utility in favor of hydrocarbon activities, however, is too broad, and the limit for the rights of owners and communities remains unclear. The risks of a limited interpretation of the principles of social impact studies, prior consultation, and free and informed consent can be seen in conflicts, especially those related to unconventional reserves, which use techniques such as hydraulic fracturing and others similar to mining in reserves of extra heavy crude.

Finally, the regulatory regime that was approved is both complicated and dispersed, with two regulatory bodies and with very diverse provisions inserted in several other laws, in addition to that relating to regulatory bodies, and in charge of other authorities. This can lead to an authentic regulatory labyrinth, both from the point of view of the number of provisions and the variety of institutions involved in the exercise of regulatory action. It is clear that this dispersion, both functional and institutional, can affect the effectiveness of regulation.

2.5. Policy Efforts to Enhance Local Contents in the Oil and Gas Industry5)

2.5.1. Background

One of the main contributions made by the oil industry to the Mexican economy is to generate the necessary foreign currency to import a large part of the inputs required for the expansion and development of national industry. The favorable effect that the oil trade balance has been contributing for many years has not only allowed the country to lessen the impact of the deficit in the global trade balance, but also contribute to the accumulation of international reserves, which, in turn, has contributed to the stability of the exchange rate and containment of inflation. In the fiscal area, oil revenues have allowed the Mexican government to maintain public spending beyond its internal collection capacity, which has promoted economic growth to a certain extent (De la Vega, 2016).

However, due to the drop in international oil prices from 2014, as well as the decrease in the production of crude oil and petroleum, and the lower dynamism of exports, the oil trade balance began to present a negative trend. Given the current scenario of low international oil prices and the fall in oil and petroleum production, the BCP will tend to maintain a growing deficit, which will undoubtedly generate macroeconomic risks associated with the lack of foreign exchange, such as volatility of the type of oil change and higher inflation.

5) This section was prepared by contribution from a local consultant in Mexico, Mr. Jaime Torres Ramírez.

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093 In order to avoid the fall in the generation of net foreign currency by the oil sector in Mexico, it is necessary, among other things, to pursue policies aimed at reducing the level of imports of petroleum and petrochemical products and generating a higher level of public and private investment in order to stop the fall in oil and natural gas production and at the same time boost the local industry (De la Vega, 2016). An energy reform, as it has been seen in several countries and their experiences, has diverse contents, being the industrial and technological type that tends to influence in the search of favorable impacts on the existing industrial activities, creation of new industries, and impulse to new technologies. In industrial matters, when reviewing the content of the reform, two possibilities are presented: a) the promotion of national and local productive chains; b) the boost to the competitiveness of companies by reducing the costs of energy.

2.5.2. Identi¿cation of Policy Agenda

In the case of the first subsection, the MoE prepared a diagnosis of the participation of Mexican suppliers and contractors in works, acquisitions and leases of goods and services of the hydrocarbon sector, as well as specific objectives and annual quantitative targets of the national content level in goods, services, and works, respecting the provisions of international treaties (SE, 2014). In this diagnosis, it was detected that several companies supply thousands of inputs required by the industry of the oil sector, such as:

s Preparatory studies s Pipe and cementation s Flow system s Design engineering s Operation systems s Storage system s Feasibility tests s Starting system s Quality control and measurement systems s Operation platform s Valves s Electrical system s Drilling systems s Pumps s Machinery and equipment s Separation equipment

The main result of the above is that based on the purchases of goods, services, and leases, as well as public works and related services, it was concluded that the

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2017/18 Knowledge Sharing Program with Mexico (II) degree of national content is 35.1%; likewise, it is pointed out that the main factors that affect the efficient performance of the oil industry's production chain and, therefore, represent restrictions on the development of suppliers and contractors (particularly of Pemex) and with it the increase of national content:

s Ignorance of procurement procedures and their complexity, due to excessive requirements s Low compliance with technical standards s Insufficient local installed capacity to meet the company's requirements s There is a high geographical concentration of oil suppliers and contractors, since approximately 50% are located in the center of the country. In general, SMEs have low export capacity. s Technological lags in various sectors, which limit the oil company's access to quality products and competitive prices s Restrictions on financing, particularly for medium and small companies, which could be inserted into the supply chain s Limitations on access to and development of human capital s There is uncertainty in the demand of Pemex since its long-term needs are not known with certainty, which prevents companies from planning their investments; this is compounded by uncertainty in the materialization of the annual procurement programs, since they are subject to budgetary authorizations during the year.

Although in past administrations there have been programs that have tried to promote the productive chain that SMEs present in the oil industry, adequate results have not been achieved, due to the problems mentioned above as well as the different Pemex demand priorities in time, location, and specification. It is also noteworthy that the main companies that provide inputs, products, and services to the industry in the stages of E&P are of foreign origin and have technological capacity and equipment that are not available in Mexico. The services provided are capital-intensive, such as leases of platforms and vessels that involve large amounts of investment; therefore, the number of companies that offer them worldwide is limited. In the study, it is estimated that 80%of E&P activities are supplied 257 companies, while processes related to refining are supplied at a similar percentage to 1,733 suppliers. The concentration of acquisitions in a small number of families is high.

For its part, in technological matters, isolated actions have been taken to promote Research and Technological Development (RDT), but given the crisis and the allocation of limited resources to Pemex, and the inefficient policies in this area, the disarticulation between industrial policy and RTD, as well as the untying of education policy with the RTD itself, have resulted in little significant progress.

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095 Since 2006, concrete efforts have been made in the oil industry, through research funds created in the Mexican Petroleum Institute and in the federal government, in particular with the SENER-CONACYT-Hydrocarbons Fund. Different efforts have also been made to diagnose the technological needs of the oil sector, especially in the late nineties where it was decided to “be a technological follower”; the most recent was capitalized in the Strategic Technological Plan, which seeks to identify the main strategies and implement them in their business lines (Romo, 2016a).

In the training and development of human resources, there are also delays due to the disconnection of Pemex-Institutes of Higher Research, and even with the IMP, which originated the hiring of non-optimal human resources for the profile of the needs of the business, due to the conflict in hiring between the company and the union, and the lack of a strategic program of substitution of personnel. Nevertheless, they highlight the actions of Pemex E&P, which started the training program for new personnel in the area of geosciences and petroleum engineering in 2011.

In sum, the sectors of the national industry in the value chains based on productivity, innovation, and the development of human capital, mainly in the hydrocarbon sector, have so far not been able to develop based on industrial and technological policies of a more open and liberalized economy.

2.5.3. Local Contents in the Energy Equipment Industry

Compared to other international-level companies, Pemex as a single state company oriented to the production of oil and gas in Mexico, enjoyed for many years of comparative advantages, having a technological base that, although it did not mean an intensive use of emerging technologies, allowed an operation of certain profitability. However, this led to a lack of internal innovation in new equipment and technologies, resulting in the absence of a strategy for scientific and technological development, as well as a lack of qualified human resources. On the other hand, the strong productive integration of Pemex, which consisted in developing non- substantive functions by itself, limited the innovative capacity of the companies.

The foregoing fixed the Pemex profile as a “technological follower,” dependent on the advances available in the international market, without a program that implies an adequate acquisition, application, diffusion, and assimilation of knowledge and skills until 1996, when it defined a first strategy to close the lags. This gave limited results in its desire to modernize its technological capacity as well as the promotion of R&D activities. Perhaps the main success identified is that until now, the use of proven technologies has been preferred, due to the risks, costs, and uncertainty involved in the development of new technologies, in the E&P activities of the oil sector.

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2017/18 Knowledge Sharing Program with Mexico (II) With regard to companies supplying goods and services, some of them have maintained the strategy of acquiring technology abroad through representations and contracts, sometimes serving as a link between the transnational service companies and the state company Pemex. Recently they have opted to acquire the adapter technologies (i.e., those that only have to be bought and installed) since these can add a value of 50% to the operations, since with them the recovery factor and the production increase. Likewise, the investment is optimized and costs are reduced, while with the long-term costs are generally increased by 30%.

However, the depletion of reservoirs on land and shallow waters has meant that, in order to restore hydrocarbon reserves, E&P activities are extended to distances farther from the coast, at greater depths (deep and ultra-deep waters), in more extreme and complex geological environments (HP/HT), and in deposits with petro- physical characteristics and unconventional fluids (shale gas, oil shale, and extra heavy oils). Given the relevance that technology has for the development of the national oil industry since it is an essential strategic asset for its operations, to increase its competitiveness and productivity, by improving the key processes of the value chain, Pemex considered it essential to integrate a technological program (Pemex, 2013) that provides clarity on the needs of equipment and technologies of short-, medium-, and long-term of the company and of the possible mechanisms to address them. It should be noted that the objectives associated with E&P are those that mostly require technology:

s Increase inventory of reserves by new discoveries and classification. s Increase the production of hydrocarbons. s Obtain efficiency levels above international standards in gas exploitation and production costs.

In industrial transformation, the program indicates that the objectives with the greatest technological component are those associated with the improvement of operational performance. On the other hand, those projects for the growth of the current installed capacity have an important component of technology assimilation:

s Achieve an operative performance superior to the average of the industry in the transformation activities. s Increase and adapt the capacity of industrial transformation to ensure supply and maximize economic value. s Promote the development of the national petrochemical industry with its own and complementary investment.

Finally, in terms of logistics and marketing, the document states that the objectives to meet the specifications thereof are those that have the largest

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097 technological component:

s Optimize the capacity of logistics and conditioning of hydrocarbons s Strengthen customer orientation s Guarantee safe and reliable operation s Improve environmental performance, business sustainability, and relationship with communities

Therefore, Pemex has decided to integrate new technological solutions into its day-to-day operations. Of the technological needs that have been identified, 57% have to do with the deposits – that is, with their static and dynamic characterization (Martínez, 2017),6) while a 25% are related to the increase of production and only 18% with operational reliability. It is estimated that approximately 80% of these technological needs can be met quickly (in a period of one to three years).

On the other hand, in accordance with the “Report on progress in the implementation of strategies for the industrial development of local productive chains and for the promotion of direct investment in the Hydrocarbons industry” (SE, 2016a), regarding the cost structure for projects, the MoE detected opportunities for national suppliers in the cross-cutting areas such as drilling, intervention, and repair of wells; equipment for drilling floor and manifolds for drilling; and consulting and engineering associated with drilling. The areas with the most impact within the productive chain due to their value within the activities of the Hydrocarbon Industry are:

s In the exploration stage: geological and geophysical studies; services for drilling wells, flexible continuous pipe; drilling fluid services; and pressure tests s In the evaluation stage: production tests; well drilling; and reservoir engineering s In the development stage: construction of facilities; reservoir engineering; and intervention of wells s In the production stage: installation of pipelines and production tests; and reservoir engineering s At the abandonment stage: execution of the abandonment of surface facilities, restoration plans, and abandonment plans for substation facilities

Recently, to ensure the development and implementation of the technological strategy required by the substantive areas of E&P and to face the challenges of hydrocarbon exploitation in deep waters, the creation of the Research Center was initiated by SENER and the IMP for Deep Water and the Center for Innovation and

6) According to PEMEX estimates, 19% of the fields that exist in Mexican territory are fields in development; for this reason, the main technological focus of exploration and production is aimed at affecting a greater proportion of these latter blocks.

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2017/18 Knowledge Sharing Program with Mexico (II) Development for Extra Heavy Oils.7) These centers will develop technology and specialized services for SOEs such as Pemex and, in the first stage, consider focusing their research and development in the areas of:

s Flow assurance s Drilling fluids s Geotechnics s Methodical and hydrodynamic simulation s Technology qualification s Improvement of crude oils s Handling H2S

In addition, Mexico’s new energy model calls for the implementation of new advanced technologies to access frontier fields, and optimizing existing and new processing infrastructure through the identification of areas of opportunity to carry out R&D projects as shown in

:

Table 2-9 Opportunities for Research and Development Upstream Mid and Downstream s Advances materials s Refineries upgrading and optimization s Operations at high pressure and temperature s Processes integration: cogeneration, s Submarine corrosion prediction, monitoring, efficiency, linkage of refining, and and controlling petrochemical facilities s High-temperature differentials insulating s Low-energy-intensity bio-processes for crude materials processing and waste management s Ageing polymers analysis and non-metallic s Environmental impact reduction materials classification s Welding in extreme environments

Source: SENER (2016a).

At the same time, Mexico has established a Comprehensive Industrial Development Strategy to foster the development of new supply chains aiming to transform Mexico’s energy industry into a motor for economic growth. The strategy includes a Human Resources Development Program, a key element to capture, develop, and retain talent at the required speed. The program includes:

s Scholarships s Research centers s Training programs s Global partnerships (universities, research institutes, companies) s Academic and professional exchanges

7) https://mundo.sputniknews.com/economia/201507021038888893/, accessed on December 19, 2017.

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099 Through the modernization of the IMP, Mexico aims to take advantage of existing knowledge and expertise, and establish new partnerships to foster innovation and the deployment of state-of-the-art technologies and services throughout the value chain.

2.5.4. Action Plan to Enhance Local Contents in the Oil and Gas Upstream

The opening of the hydrocarbon sector to private investment should contribute to the development and consolidation of a national industry in a competitive environment, which is why it is necessary to adopt measures that encourage greater participation spaces for national supply. The participation of private investment should promote the inclusion and development of national and local suppliers in the value chain of the entire industry. This will allow greater benefits in other industries, greater employment, and greater economic development at the regional and national levels.

In the seventh transitory article of the reform, it was established that, in the procurement for the execution of allocations and contracts of the energy sector, the law would be in charge of establishing the bases and the minimum percentages of the national content, in order to promote the participation of national and local production chains, in accordance with the provisions of international treaties and trade agreements signed by Mexico (DOF, 2013). In the hydrocarbons sector, the average minimum percentage of national content in terms of exploration and extraction will gradually increase from 25% in 2015 to reach at least 35% in 2025. Individually, the minimum percentages of national content for assignors and contractors will be established by the SENER. In case of violating these provisions, the contractor must pay a percentage of the value of the concepts that have been acquired in breach of the minimum percentages (DOF, 2014). For exploration and extraction of deep and ultra-deep waters, minimum percentage values of national content of 3% were ordered in 2015 and 8% in 2025 (DOF, 2016).

The Hydrocarbons Law (Chapter VI) established that the MoE, with the opinion of the ES, would be responsible for defining strategies for the industrial development of local productive chains and for the promotion of direct investment in these industries. To comply with the above, the MoE will rely on the Public Trust to Promote the Development of Suppliers and National Contractors of the Energy Industry, a transformation of the Trust to Promote the Development of Suppliers and National Contractors for the State Oil Industry (Pemex). The new trust “aims to promote, through financial support and technical assistance, the development of local and national suppliers and contractors through financing schemes and support programs for training, research and certification, in order to close the gaps in technical capacity

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2017/18 Knowledge Sharing Program with Mexico (II) and quality, giving special attention to small and medium enterprises” (SHCP, 2014). With Nacional Financiera (Nafin) as fiduciary, the Energy Trust will be the main instrument to grant support from the Development Bank to the national suppliers of the energy sector. The purpose is to gradually increase the national content, with a realistic and applicable strategy, through concrete measures that allow the goals of this program to be achieved.

The Secretariat of Economy (SE) calculated the national content observed in the areas in Exploration and in the fields in Extraction in order to have the baseline to establish the requirements of national content in Assignments and Contracts for Exploration and Extraction, according to the type of area or field in which those activities will be carried out. In this regard, on November 6, 2015, published in the Official Gazette of the Federation (DOF) was the agreement by which the calculation of national content observed in the areas in exploration and in the fields in extraction in the first semester of 2014, which establishes the following

:

Table 2-10 Local Content in Oil E&P in Mexico Area / Field Extraction Exploration Shallow Waters 15% 17% Terrestrial 26% 27% Chicontepec 27% 24%

Source: DOF (2016), compiled by author.

On the other hand, on March 29, 2016, the agreement was published in the DOF establishing the values for 2015 and 2025 of national content in the exploration and extraction of hydrocarbons in deep and ultra-deep waters, which establishes the following values

:

Table 2-11 National Content in E&P in Deep Water

Area / Field 2015 2025 Deep and Ultra Deep Water 3% 8%

Source: DOF (2016), compiled by author.

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101 The minimum percentages of national content for the different types of projects have to be dimensioned in light of the particular complexity of each of them. It should be noted that the national content will tend to grow gradually considering that there are inherent limitations in the national supply, normative and contractual limitations established by the legislation in force, as well as limitations that indicate the international commitments that Mexico has signed with other countries. However, the national content can be increased with the implementation of a broad and deep strategy.

In relation to the strategies for the industrial promotion of Local Productive Chains and Direct Investment in the Hydrocarbons and Electric Industries published in 2016, the SE worked with the winning companies in hydrocarbon tenders, as well as with anchor companies, to generate a model agenda to help determine the real demand through their needs and, thus, be able to generate a catalog of the potential national demand (SE, 2017). A strategy was also generated to link the national supply with the new companies participating in the energy industry through the execution of focused business meetings. In this way, with the opening of the energy sector, it is trusted that technologically superior foreign companies, which have more efficient methods of production, will perform a technological spill and disseminate technological learning processes.

In order to promote national supply, the 2017 version of the Registry of National Suppliers of the Hydrocarbons Industry was launched, allowing companies to register goods and services through production chains, detailing development needs through their location by entity, and generate work plans with the corresponding states. As of July 2017, 915 suppliers had been registered (526 in hydrocarbons and 389 in electricity), highlighting the entities with the most records in Hidrocarburo to Mexico City, Campeche, Tabasco, Tamaulipas, and Veracruz, in goods such as pipes, pumps, valves, indicators of flow, pressure transmitters, switches, and services in well drilling, topographic studies, engineering, and construction management.

In December 2016, the Public Trust to Promote the Development of Suppliers and National Contractors of the Energy Industry issued three calls to access technical assistance support under the categories of Industry Standards, Regional Development, and Strengthening Value Chains in industrial sectors.

2.5.5. Prospect of Localization Potentials and Technology/Industry Development Strategy

Currently, the Federal Government through the MoE has proposed a strategy for the development of suppliers for the hydrocarbon sector based on the identification of the prospective demand for goods and services that the industry will need to carry

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2017/18 Knowledge Sharing Program with Mexico (II) out its activities. This will reveal the activities that, because of their pole of influence, are critical in the productive chain. On the other hand, the strategy takes into account the identification of the national companies that are providers of the sector and those that could potentially be in the short and medium term, according to their capacities and level of maturity. By obtaining the characteristics of the demand and supply, it is possible to generate the necessary links so that the business plans can be made between these two parties, in addition, which will allow identifying the development needs of the national supplier in order to design the tools and mechanisms that develop to the companies that need it. It also works closely with the operators that have won in the different rounds and tenders, the tractors and integrators that are those that demand the goods and services of the sector, and the federative entities to achieve the productive chain to supply the demand that the sector of hydrocarbons will generate in the coming years. In addition, cross- cutting programs are considered to promote the technical skills and international certifications needed by the sector, as well as the approach with other countries and international companies, both for the attraction of foreign investment for activities that may further detonate the strategy proposed by the SE as the search for technical assistance in matters related to the energy sector.

In summary, the strategy for the promotion of the hydrocarbons industry consists of the following:

s Identify the potential demand for goods and services for domestic suppliers in E&P activities that derive from contracts and assignments. s Identify, characterize, and locate the national companies that are part of the supply chain of the hydrocarbons industry and those that have the potential to belong to its value chain. s Detect business opportunities and development needs of national suppliers and contractors. s Promote the regional development of the hydrocarbon sector. s Reorient the technical and financial support granted by the Public Trust to Promote the Development of Suppliers and National Contractors of the Energy Industry to impact projects for the energy industry. s Promote of Foreign Investment.

However, unquestionable needs are detected to boost the industrial sector in relation to energy, such as:

s Identify with precision in the energy sector subsectors and/or branches (including products) that should be the focus of attention of industrial policy for its potential industrializing effect. s Promote the regional development of the hydrocarbon sector. Not only should

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103 regional development be focused on the states in which there is activity in the exploration and extraction of hydrocarbons, especially in those projects that are linked to the bidding rounds, including the Round Zero (Coahuila, Nuevo León, Tamaulipas, Veracruz, Tabasco, Campeche, San Luis Potosi, Hidalgo, and Puebla), but consider other areas and regions where there is productive potential, R&D, infrastructure, or manpower; s The redefinition of the technological requirements of the oil industry, in relation to the country's national innovation system; s The creation of appropriate institutions and markets to promote and finance R&D activities; s Recognize that, without disdaining the role of the national innovation system, it is necessary to connect with international central actors in energy and technology development; s Taking into account that in the structures of production and consumption of energy in Mexico, hydrocarbons predominate, defining criteria to guide this sector towards a cleaner development from a perspective of sustainability. s Directing greater financial resources and supporting the development of specialized human resources for technological innovation and the use of renewable energies. s Promoting an effective linkage of the national academic sectors, research centers, and industrial centers to identify the real needs of the energy sector in terms of research, for a better use of funds of public origin to finance science and technology activities and to better adapt to the training needs of professionals.

3. Korean Experiences of the Oil and Gas Sector Development8) 3.1. Overview

Korea is a resource-poor country. Korea’s indigenous energy resources include only small deposits of anthracite coal and hydropower. These indigenous energy resources could not satisfy the energy demand to fuel the continuous industrialization of the economy. Therefore, Korea has to import most of its energy resources, including oil, bituminous coal, nuclear fuel, and natural gas. Therefore, Korea's dependency of TPES on import has steadily increased from 73.5% in 1980 to 94.7% in 2016 (with nuclear energy included).

8) Discussions in this section are partly based on Park Ji-min and Ji-Chul Ryu (2012) and the Ministry of Industry, Trade and Energy and the Korea Resource Economics Association (2013).

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2017/18 Knowledge Sharing Program with Mexico (II) In order to strengthen energy security capability, Korea also successfully achieved the expansion of domestic energy supply infrastructure including oil refinery, power generation plants, and nation-wide network for oil, gas, and electricity systems. Korean government recognized the importance of the market (pricing) mechanism in pursing energy security. Thus, the government encouraged energy industries towards facilitation of the market element. In sum, the energy industry in Korea has been developed through three major approaches: 1) openness, 2) government's strong leadership, and 3) industrial structure based on the market mechanism (Ministry of Industry, Trade, and Energy, and the Korea Resource Economics Association, 2013).

3.2. Oil Industry Development

3.2.1. Supply/Demand

Korea does not have any oil reserves, so that supply of oil in Korea depends entirely on imports from overseas. The Middle East is a major crude oil supplier to Korea, accounting for 85.9% in Korea’s total crude oil imports in 2016. Oil consumption in Korea increased very rapidly over the last decades from 24.1 MMTOE in 1980 to 122.1 MMOTE in 2016. Oil is the largest energy source in Korea' energy mix, accounting for 42.7% in TPES in 2016. However, the share of oil in TPES declined from 62.6% in 1980 to 42.7% in 2016 due to the energy diversification effort from oil to natural gas, coal and nuclear.

Table 2-12 Major Oil Statistics in Korea Unit 1980 1990 2000 2005 2010 2016 TPES MMTOE 38.5 89.7 189.4 221.0 255.0 286.2 Oil Consumption MMTOE 24.1 49.5 103.8 104.7 105.0 122.1 Oil Share % 62.6 55.2 54.8 47.4 41.2 42.7 Ref. Capacity Thousand BPSD 608 798 2,316 2,598 2,774 3,234 Refinery Output Thousand b/d 492 842 2,433 2,335 2,390 2,928

Source: BP Statistical Review of World Energy (2017), compiled by author.

Korea is a net exporter of refined product, with exports averaging 77.5 million TOE in 2016. Exporting market of Korea’s petroleum products includes Japan, the United States, China, and the Southeast Asian countries.

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105 [Figure 2-8] Refinery Capacity, Output, and Oil Consumption in Korea

(Unit: Thousand b/d) 3,500 3,000

2,500 2,000 1,500 1,000

500 - 1980 1985 1990 1995 2000 2005 2010 2015 Refinery capacity Refinery output Oil consumption

Source: BP Statistical Review of World Energy (2017), compiled by author.

3.2.2. Downstream Sector: Industrial Structure and Policy Changes

For energy security reasons, Korea adopted the so-called “consuming-site-refining” principle for the development of the oil industry domestically. That is, Korea imports crude oil from oil-producing countries, and produces oil-refined products for the purpose of stabilizing domestic supply and flexibly responding to price fluctuations in the international oil market. Benefits of adopting this principle for Korea is that the country can maximize the inflow of value-added production into the economy gained from the oil refinery manufacturing process.

The oil refinery industry in Korea was launched in 1964 with an initial capacity of 35,000 barrels per stream day (BPSD). The capacity of oil refining increased significantly, along with the strong increase in petroleum demand, to 3,234 thousand BPSD in 2016, which was the world’s sixth largest refinery capacity as of 2016. Average operational utilization rate of the refinery facility in Korea was 95.0% in 2016.

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2017/18 Knowledge Sharing Program with Mexico (II) Table 2-13 Refinery Capacity and Market Share by Company in Korea, 2016 Refining Capacity Share Hold by Market Share (%) (thousand BPSD) Foreign Company SK Energy 1,215.0 27.5 GS-Caltex 785.0 20.0 Chevron 50% Hyundai Oilbank 390.0 16.3 S-Oil 443.0 16.4 Saudi Aramco, 63%

Source: Shin, Sang Yoon (2018), compiled by author.

Korea’s domestic downstream oil market is fully privatized and dominated by four private sector refining companies: SK Energy, GS Caltex, Hyundai Oilbank, and S-Oil (Saudi Aramco is the controlling shareholder of S-Oil). SK Energy is 100% Korean-owned. Chevron owns a 50% stake of GS-Caltex, and Saudi Aramco owns a 35% stake in S-Oil. The retail market in Korea is dominated by these four domestic refiners.

Korea’s refinery is very competitive in the global market of petroleum products with a rank of number six in capacity globally (in CDU; Crude Distillation Unit). They also have established export markets of petroleum products in Asia and North America. Three refineries in Korea are in the world top-five in terms of CDU capacity (see Table 2-14).

Table 2-14 Major Refinery Companies in the World Ranking Company Country CDU Capacity (1,000 b/d) 1 Reliance India 1,240 2 SK Energy Korea 1,215 3 PDVSA Venezuela 940 4 GS Caltex Korea 785 5 S-Oil Korea 669

Source: Shin, Sang Yoon (2018), compiled by author.

The oil sector in Korea was fully liberalized in 1997. Since then, there have been technically no non-market barriers to entry into the Korean refining and retail markets by new competitors. The oil industry is also subject to general business regulation by the Fair Trade Commission. The liberalization process of the oil industry in Korea is shown in the following .

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107 Box 2-3 Liberalization: The Case of Korean Oil Industry

The Role of Government s Policies for protection and support in the early growth stage - Refinery facility addition: the priority in 1960s - Regulations were required for nurturing the industry s Competition became gradually allowed. - One public refinery company was established in 1962 (monopoly). - Other private companies joined the industry in 1969, 1972, 1980, and 1988. - The public company was privatized in 1980 (SK). s The government significantly contributed to strengthening the industry’s competitiveness through the liberalization implemented in the late 1990s.

Liberalization in Trade s Eased regulations on storage obligation of traders from 60 days to 45 days (1992.10) s Abolished export/import report system for asphalt (1993.11) s Abolished export/import permit system for petrochemical raw materials and abolished export/import permit system for petroleum product (1995.1) s Abolished quality inspection for petroleum product which companies imported for their use (1995.4) s Replaced exporter/importer annual report system with registration system and abolished export/import permit system (1997.1)

Liberalization in Refining s Replaced the permit system with the report system regarding facility renovation (1991.11) s Replaced the permit system with the report system regarding refinery facility creation/ expansion (1997.1) s Replaced the permit system with the registration system regarding refinery business license (1998.10)

Liberalization in Distribution s Abolished distance limits between gas station in Seoul and metropolitan cities (1993.11) s Abolished the report system for lubricant sales business (1995.4) s Abolished distance limits between gas stations completely (1995.11) s Replaced the permit system with the registration system for petroleum sales business license and Eased regulations on storage facility of petroleum agent (700 kl from 1000/1500 kl) (1997.1) s Permitted direct trades between refiners and gas stations (1998.1)

Liberalization in Market-opening s Allowed FDI (Foreign Direct Investment) to petroleum products and LPG distribution businesses (1995.1) s Allowed FDI to LPG stations businesses (1996.1) s Allowed FDI to gas station business (1998.5) s Abolished foreign ownership limits on the refining industry (50% Ņ 100%) (1998.10)

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Liberalization in Pricing s Implemented the Price Linkage System with international oil prices (1994.2) s Eliminated price ceiling in petroleum product distribution (1997.1) s Eliminated price ceiling in LPG distribution (2001.1)

Results of Liberalization s The basis of pricing: Domestic import price Ņ International price s Expansion of foreign investment Ņ Higher transparency s Higher operating profit of refinery companies s Higher consumer surplus from secure supply even under high oil price trends s Domestic industry Ņ Export industry

Source: Shin, Sang Yoon (2018), recited from Lee (2002).

3.2.3. Upstream Sector

Korea has no domestic proven oil reserves, and very little gas reserves offshore. However, in the 1970's, when the country began to industrialize the economy, the Korean government stepped up its efforts to develop oil resources at home, recognizing the vulnerability oil supply that depends entirely on imports from overseas.

Korea is surrounded by the Yellow Sea, the East Sea, and the South Sea with extensive continental shelves of 300,000 square kilometers. For the offshore oil exploration, ten exploration blocks in three basins (Ulleung Basin, Yellow Basin, and Jeju Basin) were defined for oil exploration in 1970's (see Figure 2-9). With expectation that some potential of oil reserves would exist offshore in its territory, the Korean government invited major Western oil companies for the exploration of oil offshore. Western oil companies such as Gulf, Shell, and Koam Corporation explored oil and gas in shallow waters in Korea between 1972 and 1982, but they withdrew from the exploration project in Korea without any visible result (KNOC homepage).

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109 [Figure 2-9] Offshore Oil Exploration Block in Korea

Wells Sedimentary Basin Oil & Gas Show

Source: Korea National Oil Corporation, homepage http://www.knoc.co.kr/ENG/sub03/sub03_1_1_4.jsp, accessed on January 05, 2018.

In order to facilitate the exploration activity at the national level, Korean government founded the KNOC in 1979. The KNOC, as a state-owned oil company, became the largest entity in Korea for the upstream oil and natural gas project, and continued the offshore oil exploration activity in the offshore Blocks. To date, the KNOC has explored only 47 drills for offshore oil exploration in Korea, indicating that oil E&P activity in Korea is still very limited (see Table 2-15).

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2017/18 Knowledge Sharing Program with Mexico (II) Table 2-15 Offshore Oil and Gas Exploration Status, as of June 2017

Area size Physical Exploration Block 2 No. of Drills (km ) L-km km2 6-1 6,540 15,897 4,083 24 East Sea 6-1North & 8 12,560 5,107 504 2 1/1-2, 1-3 35,306 8,520 - 1/- Yellow Sea 2/2-2 39,869 19,114 298 4/1 3 41,620 8,193 - - 4 43,195 12,781 - 1 South Sea 5 44,529 11,995 - 4 6-2 11,939 12,786 - 3 JDZ Joint Development Zone 69,662 19,571 563 7 Total 305,220 116,549 5,448 47

Source: Korea National Oil Corporation, homepage, http://www.knoc.co.kr/ENG/sub03/sub03_1_1_4.jsp, access on January 05, 2018 and compiled by author.

Among them, only one project was successful in terms of being commercially viable as a producing field of natural gas. In 1998, KNOC discovered an oil and gas field in Block 6-1 in the East Sea, Donghae-1, having total proven reserves of 186 billion cubic feet of natural gas and 3.2 million barrels of condensate. Production was started in 2004 for 1,000 tons/day of gas. On average, KNOC has produced less than 1,000 b/d of ultra-light crude oil (condensates) from the Donghae-1 natural gas field, representing a negligible portion of its 2.4 million b/d total petroleum consumption. However, the success of this project was assessed as having greatly contributed to Korea's capability for commercial application of E&P technology as well as technology self-reliance and the related equipment industry in the E&P business.

As the domestic exploration projects are very limited, KNOC and private companies in Korea are actively advancing into overseas resources-development projects. KNOC has participated in 27 projects (20 producing blocks, 2 development blocks, and five fields under exploration overseas as of the end of 2017) in 17 countries, such as Indonesia and Vietnam in Asia, Central Asia (Kazakhstan, Uzbekistan), Latin America (Canada, USA, Peru, Venezuela), Africa (Libya, Nigeria) and Middle East (Iraq, UAE, Yemen). KNOC also participates in the unconventional natural gas development project in Eagle Ford, the United States, and has an opportunity to acquire the related technology, advanced expertise, and operational expertise in the unconventional energy development projects.

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111 [Figure 2-10] KNOC’s Global Exploration Projects

UK Kazakhstan Azerbaijan Canada

Russian Federation USA

Libya Venezuela Uzbekistan Korea Colombia Iraq Malaysia Yemen Nigeria Malaysia Peru

UAE

Source: Korea National Oil Corporation, homepage http://www.knoc.co.kr/ENG/sub03/sub03_1_1_4.jsp, accessed on January 05, 2018.

The Korean government has encouraged Korea’s E&P projects overseas as well as domestically through various policy instruments:

s Prepare and implement the Overseas Resource Development Plan by the Ministry of Trade, Industry and Energy (MOTIE) which is updated every three year with the time horizon of ten years since 2001 s Provide tax benefits and the extension of credit by the Korea Export-Import Bank s Provide financial support for the country’s upstream E&P projects through the Special Accounts for Energy and Resources (SAER), including the Success- Pay-Loan. This special loan scheme was established in 1984 to help public and private companies advance into areas of high strategic value but high risk. If the project fails, the entire amount of the loan is waived, but in the case of success, an extra premium is added in addition to the principal. It is an institution to encourage companies to invest by sharing the risk, such as in resource-development projects s Maintain good relations with oil-producing countries and to offer technology training to producing countries in the downstream sector

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2017/18 Knowledge Sharing Program with Mexico (II) 3.3. Gas Industry Development

3.3.1. Supply/Demand

Korea introduced natural gas into the country’s energy mix in 1986 in the form of liquefied natural gas (LNG). Korea has little more than 1.0 bcm of proven reserves of natural gas. Domestic gas production is negligible. Korea produced 118 thousand tons of natural gas, less than 0.5% of total consumption.9) Thus, most of the supply of natural gas in Korea is met by imports from overseas. Korea's imports sources of natural gas includes Qatar, Indonesia, Malaysia, and Russia.

Demand for natural gas increased steadily and significantly from 1.6 million tons in 1987 to 33.4 million tons in 2016. The share of natural gas in TPES increased from 3.0% in 1990 to 14.3% in 2016. Manufacturing city gas for consumption in the residential and industrial sector is the largest consumer of natural gas, representing about 50% of total gas use in Korea. Gas demand for power generation, mainly for the combined heat and power (CHP) producers, significantly increased from 1.7 million tons in 1990 to 15.3 million tons in 2016, accounting for approximately 44% of gas use in 2016. Compressed natural gas (CNG) is used in vehicles in Korea, as the government embarked on the program to introduce intra-municipal CNG buses from the end of 2002 in major Korean cities.

Table 2-16 Major Natural Gas Statistics in Korea (Unit: Thousand tons) 1988 1990 2000 2010 2016 Production - - - 415 118 Imports 1,898 2,237 15,239 32,604 33,453 Demand 2,094 2,329 14,557 33,083 34,858 Power Generation 1,905 1,741 4,354 14,268 15,344 City Gas 184 576 9,528 17,522 17,384 Other 5 12 675 864 1,804

Source: Korea Energy Economics Institute (2017), compiled by author.

9) All domestic gas was produced from the offshore Donghae-1 gas field, the only domestic gas field in production. The Korea National Oil Corporation (KNOC) started commercial production from this gas field in July 2004. Gas from the field is transported via a 75-km underwater pipeline to the Onsan gas treatment plant in Ulsan from where it is processed and distributed to the Ulsan and Kyungnam areas.

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113 3.3.2. Industry Structure and Infrastructures

Imports of LNG and wholesale part of natural gas market in Korea are dominated by the Korea Gas Corporation (KOGAS), the state-owned monopoly company, created in 1983. KOGAS is responsible for managing import, storage, transmission, and wholesale distribution of LNG in Korea. Regarding the retail market of gas, there are about 30 private city-gas companies supplying city gas to about 15 million consumers nation-wide.

[Figure 2-11] Natural Gas Infrastructures in Korea

Source: Korea Gas Corporation, homepage, http://www.kogas.or.kr/, accessed on January 21, 2018.

There are five LNG terminals in operation in Korea. 4 out of 5 are owned and operated by KOGAS. The privately owned Posco, a steel mill owner, operates an LNG terminal in Gwangyang to support its power. Korea had 72 tanks at four LNG receiving terminals, with a total storage capacity of 11.5 million kl; the nationwide transmission pipelines, totaling to 4,065 km in length, are all owned and operated by KOGAS.

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2017/18 Knowledge Sharing Program with Mexico (II) Table 2-17 LNG Receiving Facility in Korea, 2017 Storage Capacity Re-gas Capacity LNG Terminal Start (1,000 Π, #) (Ton/h) Pyeongtaek Nov. 1986 1,560 (14) 3,376 Tongyeong Sep. 2002 1,680 (12) 1,530 Incheon Oct. 1996 2,880 (20) 3,690 Gwangyang Jul. 2005 200 (2) 170 Samcheok July 2014 1,800 (9) 1,320 Total 11,470 (72) 8,766

Source: Korea Gas Corporation, homepage, http://www.kogas.or.kr/portal/contents.do?key=1963, accessed on January 21, 2018.

3.4. Role of Oil and Gas in Korea

Oil plays an important role in Korea’s energy mix. Oil accounted for 40.1% in TPES in 2016, although its share in TPES declined from 58.1% in 1980. Oil demand in Korea rapidly increased in the 1980’s–1990’s, when the petrochemical industry heavily expanded due to the industrialization of the economy. Subsequently, the oil demand growth appears to be slackened, and the fuel diversification from oil to natural gas and nuclear was actively implemented by the Korean government for the energy security reason. Oil-fired power generation has also been replaced by coal and natural gas since then. However, oil is still a major fuel in Korea’s energy mix. The industrial and transportation sectors are main consumer of oil. Petrochemical in Korea is an oil-based industry, not gas, and the transportation sector showed a high increase in oil demand as the number of motor vehicles rapidly increased along with the economy and income increases over the last two decades.

Natural gas is a major fuel for city gas, district heating systems by the combined heat power generation, and peak-loaded power generation in Korea. The role of natural gas in Korea most significantly increased, as it is a relatively environmentally friendly fuel compared with oil and coal. As mentioned above, the gas demand increase was also due to the rapid establishment of a nation-wide distribution pipeline network since the 1990's. Natural gas demand in Korea is expected to continuously increase in future, as the current Korean government announced its intention to pursue the energy policy towards a nuclear-free country by scrapping plans to build new reactors. Currently, natural gas accounts for 25.0% of total power generation in Korea, nuclear for 30%, and coal for 40%.

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115 Table 2-18 Energy Mix in Korea (Unit: Thousand TOE, %) 1981 1990 2000 2005 2010 2016 15,244.0 24,385.0 42,911.0 54,788.0 77,092.0 81,872.0 Coal 33.3 26.2 22.2 24.0 29.2 27.8 26,580.0 50,175.0 100,279.0 101,526.0 104,301.0 118,108.0 Oil 58.1 53.8 52.0 44.4 39.5 40.1 0.0 3,023.0 18,924.0 30,355.0 43,008.0 45,518.0 Natural gas 0.0 3.2 9.8 13.3 16.3 15.4 677.0 1,590.0 1,402.0 1,297.0 1,391.0 1,400.0 Hydro 1.5 1.7 0.7 0.6 0.5 0.5 724.0 13,222.0 27,241.0 36,695.0 31,948.0 34,181.0 Nuclear 1.6 14.2 14.1 16.1 12.1 11.6 2,492.0 797.0 2,130.0 3,961.0 6,064.0 13,575.0 Renewable 5.5 0.9 1.1 1.7 2.3 4.6 Total 45,718.0 93,192.0 192,887.0 228,622.0 263,805.0 294,654.0

Source: Korea Energy Economics Institute (2017), compiled by author.

3.5. R&D Infrastructures and Technology/Equipment Development for the Oil and Gas Industry in Korea

3.5.1. Research on Energy Policy and Technology Development

In the 1970’s–1980’s, the Korean government established many government research institutes specialized for each field in order to develop the national strategy for economic growth and to design industry and market structures. Most of these research institutes, being funded by the government, contributed to the development of national economy by developing government policies in various fields, to designing market systems and legal framework necessary for each field and to developing technology required for industrial development.

In the energy sector, the Korea Energy Economics Institute (KEEI) was founded for research on energy policy development, the Korea Institute of Energy Research (KIER) for energy technology development, and the Korea Institute of Geoscience and Mineral Resources (KIGAM) for geoscience research. In this sub-section, we will briefly review the function of these institutes.

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2017/18 Knowledge Sharing Program with Mexico (II) 3.5.1.1. Korea Energy Economics Institute (KEEI)10)

KEEI was founded in September 1986 by the Korean government under a legal framework of the Korea Energy Economics Institute Act (Law No. 3838) which was enacted in May 1986 with the following objectives: to develop policies on national energy and natural resources, and contribute to the national economy by collecting, investigating, analyzing, and disseminating information, and by educating policymakers on a variety of trends and information regarding energy and natural resources both at home and abroad.

KEEI undertakes research to develop energy policy, sector-specific policies for the oil, gas, and electricity industries, for the new and renewable energy sector, as well as for strategies for green growth and climate change. It also provides statistics, supply and demand outlooks by sector, and develops strategies for international energy co- operation. Thus, most of the energy policy related to Korea’s oil and gas industry have been developed and formulated by KEEI. Major functions of KEEI include:

s Collect, analyze, and disseminate trends and information on domestic and overseas energy-related issues s Conduct statistical survey on energy balance and national energy supply and demand s Research national energy and resource policy s Forecast supply and demand of energy and resources and research rationalization of energy utilization s Research energy database and development of energy economy analysis models s Research advancement of energy and resource industry s Research countermeasures to UN Framework Convention on Climate Change (UNFCCC) concerning energy utilization and industry activities s Develop policy and study support systems for new and renewable energy associated with regional energy planning s Research on infrastructure building for “low carbon, green growth” and related policy s Operate joint-research, joint-education programs on energy and resources with industry, universities, and other research institutes s Perform research projects commissioned by government, domestic/overseas public institutions, and private organizations.

10) KEEI homepage, http://www.keei.re.kr/, accessed on January 25, 2018.

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117 3.5.1.2. Korea Institute of Energy Research (KIER)11)

KIER was established in November 1991 as a government research institute to promote energy technology R&D. KIER's research areas include R&D for improving efficiency and securing environment-friendly technology in use of conventional energy resources such as oil, coal, and natural gas, and exploring new energy sources such as solar, wind, and water as well as its commercialization. The KIER also strives towards technology transfer, which can be reflected in successful commercialization of the R&D outcomes by means of industrialization of intellectual property rights, enlarging its R&D activity in bottleneck technology based on SMEs.

Major functions of KIER include:

s Energy technology development: Renewable energy technology development including PV, wind power, bioenergy, fuel cell, hydrogen energy - CO2 capture and GHGs treatment technology development - Clean use technology for fossil fuels including coal, non-conventional fuels - Energy efficiency related technology development in the area of industry, buildings, transportation, and electricity - Energy-materials-related technology development s Deployment of energy technology: Testing and certification, workforce training, technology support, and technology commercialization s Policy development of energy technology: Support for the establishment of national policies for energy technology.

3.5.1.3. Korea Institute of Geoscience and Mineral Resources (KIGAM)12)

KIGAM was established in 1976 as a government-funded independent R&D institute for geoscience research. It has four research divisions focusing (1) geological survey, (2) mineral resources research, (3) petroleum and marine research, and (4) geologic environment research.

Within the KIGAM, the Oil & Gas Research Center focuses on the interpretation of geophysical and geological data, assessment of petroleum resources in sedimentary basins and fields, and development of petroleum production techniques. These efforts have realized significant contributions to securing national petroleum resources. The center has been conducting assessment of gas hydrate resources in offshore Korea and developing safe and dependable technologies for gas hydrate reservoirs, thereby securing gas hydrates as future energy resources. Recent R&D projects focus on the evaluation of unconventional resources, which include shale gas, coal-bed methane, tight gas and oil sand, in cooperation with KNOC and

11) KIER homepage, http://www.kier.re.kr//, accessed on January 25, 2018. 12) KIGAM homepage, http://www.kigam.re.kr/, accessed on January 25, 2018.

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2017/18 Knowledge Sharing Program with Mexico (II) KOGAS. The main activities of the center include:

s Petroleum geology, geochemistry, and petroleum system analysis s Carbonate reservoir modeling and evaluation s Gas hydrate resource assessment, reservoir characterization, and production technologies s Characterization of unconventional reservoirs (e.g., shale gas, coal bed methane, and tight gas and oil sand) s Technical support for hydrocarbon

The Marine Geology and Geophysical Exploration Research Center within the KIGAM is conducting multidisciplinary marine geoscience research and developing world-class technologies for exploration of natural resources. The center has other missions including the acquisition of marine geological information around the Korean offshore, identification of potential areas of submarine mineral and energy resources, and so on. Main activities of the center include:

s Publication of marine geological thematic maps and coastal geo-hazard factor distribution maps of the Korean waters s Operation of the marine core center and development of technologies for high-resolution analysis of marine geological sediment samples s Development of 2D/3D oil and gas exploration technologies and their applications to domestic and overseas exploration research s Production of marine scientific data for the delimitation of the continental shelf boundaries.

3.5.2. Petroleum Import Surcharge

The first and second oil shocks in the 1970s had tremendous negative impacts on the Korean economy. Having experienced the oil shock impacts, the Korean government sought out a separate funding mechanism for the development of the energy industry. Most energy projects are capital intensive, requiring a huge amount of capital investments. At the time, Korea was a capital-poor country and had difficulty financing capital-intensive energy projects in both government and private sectors. In order to overcome the difficulties of financing problems in the energy sector, the government introduced a separate financing mechanism for the oil sector, the “Petroleum Business Fund,“ in 1979.

The fund raising mechanism for the Petroleum Business Fund was that the government imposed a certain surcharge on imported crude oil and oil products. The fund was collected from the oil importers. At the initial stage, the objectives of this fund were:

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119 s to stabilize of domestic oil price, s to invest for construction of oil stockpiling facility, s to support oil development projects, s to finance R&D on energy-related research and technology development.

The ultimate goal of this fund is to finance the national energy project to enhance the energy security capability in Korea by overcoming the capital shortage problem in the energy sector. One important aspect of this fund was that capital investment required in the energy sector was independently established, being separated from the general account system in the government fiscal budget mechanism. The Petroleum Business Fund was abolished in 1994 by being merged into the Special Account of Energy and Resources (see Section 3.5.3).

However, the Korean government continues to maintain the Petroleum Import Surcharge (PIS) system as a method to raise the fund for the Special Accounts for Energy and Resources. PIS can be defined as a quasi-taxation system that is imposed on oil refineries and petroleum importers who import crude oil and petroleum products. The legal framework for the PIS is based on the Petroleum and Alternative Fuel Business Act, and the MOTIE is responsible for the management of PIS and KNOC is the implementation agency.

As for the method of collection mechanism, PIS is collected from oil refiners, oil traders, and petroleum product sellers, who import crude oil and oil products and sell premium gasoline and butane. The surcharge differs by product. As of 2017, Korean Won (KRW) 16 per liter is imposed on imported crude oil and oil products, bio-diesel and coal liquefied fuel, and KRW 24,242 per ton on LNG. For the seller of premium gasoline and butane, KRW 36 per liter is imposed on premium gasoline and KRW 62,283 per ton on butane.

However, in case of exporting petroleum products, the surcharge can be refunded. The criterion for determining the export of petroleum products is based on the Foreign Trade Law. In addition, in the case of delivering to foreign military organizations in foreign currency, selling for fuel for vessels or aircraft flying in and out of Korea, and exporting to North Korea under the approval of the Minister of Unification, supplying oil products for industrial materials, the surcharge is subject to refund. Refund applicants can apply for a refund by attaching a refund application at the 1st day of the month after the reason for the refund occurs, and the government must pay the refund within 7 working days.

The net amount of collected PIS, excluding refunds, totaled KRW 1.60 trillion in 2014, KRW 1.64 trillion in 2015, and KRW 1.47 trillion (approximately equivalent to

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2017/18 Knowledge Sharing Program with Mexico (II) USD 1.4 billion) in 2016.13) PIS remains an important financial source for the energy projects implemented by the MOTIE.

3.5.3. Special Accounts for Energy and Resources

In order to enhance the efficiency and effectiveness of management of energy- related government funds, the Korean government merged six existing energy- resource related funds into the Special Accounts for Energy and Resources (SAER) in 1995. The six merged funds included the Petroleum Business Fund, the Coal Industry Development Fund, the Coal Industry Stabilization Fund, the Energy Rationalization Fund, and the Gas Safety Management Fund. The legal framework for SAER, the Act on the Special Accounts for Energy and Resources, was enacted in March 1994, and the SAER began to be implemented from January 1995.

The scope of energy-resource business covered by SAER was defined to include the following:

s Development, production, transportation, stockpiling, supply, and quality control of energy and underground resources, s Restructuring of energy and underground resources related industries, s Energy-saving and renewable energy, s Gas safety management and improvement of distribution structure.

SAER consist of three sub-accounts by expenditure type:

s Investment account, s Loan account, and s Oil price stabilization account (to absorb fluctuation of oil prices and to maintain domestic oil price stability).

Revenue for the investment accounts comes from the PIS, and the expenditure is for the fund necessary for the energy and resource related business. Revenue for the loan and oil price stabilization accounts comes from incomes from the loan, and the expenditure is the loan to support the related project. In order to secure the appropriate expenditure, it is possible to receive a transfer from the general account, and when the expenditure resources are insufficient, it can borrow for a long period within the amount obtained by the approval of the National Assembly. Unused budgets, being unspent in the fiscal year, can be carried forward to the next fiscal year, and are transferred to and accumulated in the oil price stabilization account as separate reserves. Any expenditure of the oil price stabilization accounts is subject to the approval of the Cabinet meeting.

13) Naver Knowledge Encyclopedia, http://terms.naver.com/, accessed on January 30, 2018.

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121 Like the case of PIS, the MOTIE is responsible for the management of SAER, and the KNOC is the implementation agency.

3.6. Some Korean Experiences for the Upstream Activity

As mentioned above, Korea lacks domestic oil and gas resources. Thus, E&P activities in the upstream cannot be active in Korea. However, Korea has developed the equipment manufacturing industry necessary to explore and produce oil and gas reserves offshore with advanced technology. In addition, Korea has invested heavily in research and development efforts to secure the necessary technologies for resource E&P.

This section review Korea’s experience in manufacturing the equipment for offshore E&P of oil and gas as well as in R&D activities related to the upstream development of oil and gas.

3.6.1. Manufacturing/Operation of the Offshore E&P Equipment

Korea’s shipbuilding industry is a world leader. In particular, ships and marine structures exploring and producing oil and natural gas at sea are mostly manufactured in Korean shipyards. The Samsung Heavy Industries, the Hyundai Heavy Industries, and the Daewoo Shipbuilding and Marine Engineering are the world-leading companies manufacturing drillships, semi-submersible rigs, jack-up rigs, FPSOs, and fixed marine platforms. However, given the lack of project of oil E&P activity in Korea, all products made in Korea’s shipyards are exported abroad.

Various factors have contributed to the development of the Korean shipbuilding industry. Korea started its shipbuilding industry for the first time in the mid-1970s. After that, the shipbuilding companies invested heavily in R&D for their own technology development in addition to technology imports from advanced foreign countries. In addition, the Korean industrial base has developed the material industry to secure the production of steel products needed by the shipbuilding industry, and a high level of investment in fostering human resources for the area has been made in Korea.

Beyond the manufacturing of drillships, Korea but also has an experience of operating a drillship for the exploration of oil and gas. KNOC owns and operates one drillship, which is called the Doo Sung. Doo Sung is Korea’s only semi-submersible drilling unit in operation, and was built in 1984 by Daewoo Shipbuilding and Marine Engineering (DSME). To date, Doo Sung has drilled boreholes not only in Korea, but also in international oil fields, including Alaska, China, Vietnam, Malaysia, Indonesia,

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2017/18 Knowledge Sharing Program with Mexico (II) and Russia. The number of successfully drilled boreholes reached 121 as of March 31, 2017. Doo Sung has successfully completed a drilling program for Donghae-2-1P (Production well) in Block 6-1C. Doo Sung achieved impressive performance through completing drilling operation prior to its original target date with zero downtime and no incidents occurred.14)

Box 2-4 Specification of the Doo Sung Drillship

s 4YPE3EMI SUBMERSIBLEDRILLSHIP s ,OADCAPACITY TONS s /PERATIONALDEPTH  FEET (45-450 meters) s -AXDRILLINGDEPTH FEET (7,500 meters) s -AXWINDSPEEDKNOTS (200 kilometers per hour) s -AXWAVEHEIGHTFEETMETERS s .OOFBEDS

Source: KNOC homepage, http://www.knoc.co.kr/ENG/sub03/sub03_5_1.jsp, accessed on January 07, 2018.

[Figure 2-12] International Activity of KNOC’s Doo Sung

Source: KNOC homepage, http://www.knoc.co.kr/ENG/sub03/sub03_5_1.jsp, accessed on January 07, 2018.

14) Source: KNOC homepage, http://www.knoc.co.kr/ENG/sub03/sub03_5_1.jsp, accessed on January 07, 2018.

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123 Korea has also an experience of constructing offshore gas production plant for the Donghae-1 gas field in the East Sea, which is a unique field producing gas in Korea. The history of this project is as follows:15)

s KNOC successfully performed an exploratory drilling in the Gorae 5 prospect located in the middle of Block 6-1 in July 1998. This was followed by a feasibility study for development and three appraisal drillings by 1999. s Based on the results of the study, development of the Donghae-1 gas field began in June 2001 with an exploitation permit from the Korea government. s Construction of production facilities took two years from March 15, 2002, and production began on July 11, 2004. Commercial production started in November 2004.

The production facilities of the Donghae-1 gas field consist of a subsea production control system, an offshore platform, topside facilities, an export pipeline, and onshore processing facilities.

s Subsea production control system: Main subsea equipment has four subsea Christmas trees that control gas production; four flow lines that convey gas to the offshore platform; and an umbilical line that supplies power and chemicals such as methanol and monoethylene glycol. s Offshore platform and topside facilities: Offshore platforms consist of 163-meter high jackets with four legs; three story topside decks with eight files of 72 inches in diameter; and a 152-meter undersea section. The platform was designed to withstand wind velocity of 50 meters per second and waves of up to 17.5 meters (record breakers in the last 100 years). The facilities are able to endure an earthquake of up to magnitude 6.5 on the Richter scale. s Pipeline: A gas pipeline runs 68 kilometers from the offshore platform to onshore facilities: 61 kilometers undersea and 7 kilometers above the ground. Gas is then transported to Korea Gas Corporation’s facilities through the 7-kilometer pipeline. s Onshore processing facilities: Onshore processing facilities consist of processing facility, electricity equipment, and office areas. The daily maximum processing capacity is 75 million cubic feet.

Through the Donghae-1 project, KNOC accumulated experience and knowhow in all areas, from exploration and development to production and distribution. This facility was known to be designed by Samsung Engineering and constructed by the Hyundai Heavy Industries, all Korean companies.

15) KNOC homepage, http://www.knoc.co.kr/ENG/sub03/sub03_1_1_4.jsp, accessed on January 07, 2018.

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2017/18 Knowledge Sharing Program with Mexico (II) 3.6.2. Technology Development for Upstream E&P

In addition to the KIGAM, the KNOC has the E&P Technology Institute (EPTI) for the development of technology. Major research areas of the EPTI include:16)

s Reservoir simulation, production oil reservoir geological modeling s Seismic, middle, and magnetic survey data acquisition, analysis, and data processing and visualization s Analysis on wide-area geological petroleum systems and exploration play s Evaluation of promising structure (resource amount, GCOS, etc.) s Evaluation and management of reserves s Complete oil well and ensure fluid flow stability in production pipe s Supporting drilling technology and evaluation after drilling s Feasibility evaluation for entering the development stage (technology part) s Evaluation of new mining technology (mining unit precise evaluation) s DB of Petroleum Development Technical Data

Reservoir simulation is one of the core technologies in the domain of petroleum engineering to form optimal development/production operation strategies, future production forecast, and reserve estimation as the computer-based modeling method for 3-D reservoir description. EPTI conducted reservoir simulation for Block 11-2 of Vietnam in 2008 to verify the development feasibility. The institute proposed the optimal field development strategy for Ada in Kazakhstan by executing a simulation study in 2009, 2010, and 2012. Both a discrete fracture network (DFN) model construction and simulation study with enhanced oil recovery (EOR) were also done for a fractured reservoir of San Pedro in Peru and a heavy oil reservoir of Hayter in Canada. In 2016, EPTI conducted an unconventional reservoir simulation study and technical support for horizontal drilling and hydraulic fracturing methods applied reservoirs, which are Montney in Canada and Eagle Ford in the USA.17)

EOR processes have emerged as useful methods for recovery of oil and gas from wells for which primary or secondary processes were used. Generally, the EOR methods are classified into miscible, immiscible, thermal, and bacterial techniques. CO2 or nitrogen flooding is miscible; polymer or alkaline surfactant polymer (ASP) flooding is immiscible; and steam injection and burning gas are thermal. The EOR methods are mostly related with reduction of residual oil saturation or oil viscosity and lowering of interfacial tension between oil and water. KNOC has strived to acquire diverse EOR technologies for years and collaborated with world-renowned research institutes for further study into CO2 injection. KNOC’s acquisition of oil companies with non-conventional or old oil and gas assets allowed the institute to

16) KNOC homepage, http://www.knoc.co.kr/ENG/sub03/sub03_8_1.jsp, accessed on January 08, 2018. 17) KNOC homepage, http://www.knoc.co.kr/ENG/sub03/sub03_8_2.jsp, accessed on January 08, 2018.

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125 benefit from their accumulated knowledge and knowhow. Now, KNOC is involved in a study of Development of IOR/EOR technologies and field verification for a carbonate reservoir in UAE.18)

As for the non-conventional oil development technology, the EPTI undertakes research on oil sand and tight/shale oil and gas E&P technology. Oil sands are natural mixtures of sand, clay, water, and bitumen. These mixtures are so dense and viscous that technologies such as steam and solvent injection are applied to lower viscosity for oil sands development and production. Oil sands are found all around the world, but they are heavily deposited in Athabasca, Canada, and the Orinoco Belt in Venezuela. KNOC bought the BlackGold oil sand assets in Canada in 2006 and exploration/development feasibility and enhanced oil recovery studies assigned by the Korea government have been performed for not only oil sands but also bitumen in unconventional carbonate reservoirs since 2007.19)

Tight/shale oil and gas are hydrocarbons trapped in sandstone, carbonate and shale formations which have very low permeability. In the past, development activities in tight and shale plays were not considered due to lack of drilling technology and uneconomical production; however, commercial development and production have been recently possible thanks to horizontal drilling technology and hydraulic fracturing method. KNOC has been conducting various R&D projects and expanded its business to tight/shale oil and gas right after the Eagle Ford joint venture with Anadarko Petroleum Corporation in 2010. A three-phased shale gas technology enhancement project for establishment of technical competency in reservoir characterization, well completion, and hydraulic fracturing and production operation optimization has been underway since 2013 and the 4-year R&D project owned by Korea government has been also conducted.20)

4. Recommendation from Implications of Korean Experiences for Mexico 4.1. Implications

As summarized in

, Korea and Mexico have very different aspects of their respective oil and gas sectors. Mexico is an oil-producing country and a crude oil exporter, while Korea has no indigenous oil reserve and its oil supply depends entirely on imports. In addition, Mexico's oil industry is a monopoly system dominated by the

18) KNOC homepage, http://www.knoc.co.kr/ENG/sub03/sub03_8_3.jsp, accessed on January 08, 2018. 19) KNOC homepage, http://www.knoc.co.kr/ENG/sub03/sub03_8_4.jsp, accessed on January 08, 2018. 20) KNOC homepage , http://www.knoc.co.kr/ENG/sub03/sub03_8_4_2.jsp, accessed on January 08, 2018.

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2017/18 Knowledge Sharing Program with Mexico (II) state-owned enterprises, Pemex, while Korea’s oil industry is fully liberalized and has a market competition system. In the downstream sector of the oil industry, Korea has sufficiently expanded its refinery capacity, and thus fulfills domestic supplies and exports petroleum products to overseas. However, even though Mexico is an oil- producing country, it lacks domestic refining facilities and, thus, imports petroleum products from abroad.

Table 2-19 Comparison of Energy Sectors between Korea and Mexico Korea Mexico Crude Oil Supply s Importer s Producer/Exporter Refinery s Surplus (Strong) s Shortage (Weak) Oil Products s Self-sufficiency/Exporter s Net importer s Government monopoly (Pemex) Oil Industry s Private/Open/Competition s Open to foreign investment s Domestic production Gas Supply s LNG imports s Imports of piped gas & LNG s State-own company for import/ s Government monopoly Gas Industry wholesale s Open to private companies s Private company for retail

As for the gas industry, both Korea and Mexico are importing natural gas. Mexico imports natural gas mainly through pipelines from the United States, but Korea imports natural gas in the form of LNG from abroad. In Korea, the Korea Gas Corporation (KOGAS), a state-owned company, is in charge of importing LNG and managing the nationwide pipeline network system and the wholesale market maintains a monopoly system. In Mexico, Pemex has been monopolizing the gas industry, but in the implementation process of the Energy Reform the gas sector was separated from Pemex by establishing the CENAGAS for the management of Mexico’s gas distribution system. Thus, Korea and Mexico show a similar industrial structure in terms of the gas industry.

Given the difference between Korea and Mexico, it will be difficult to derive some implications mutually comparative between the two countries. However, despite the differences, some meaningful implications can be derived from Korea’s experiences for Mexico to develop policy to revitalize its oil and gas industry. This is because the aim of Energy Reform in Mexico is largely consistent with the policy directions that Korea pursued in the past. For example, Korea has enhanced the market efficiency of the oil industry through the liberalization of the oil sector, and Mexico’s Energy Reform was has opened oil sector to private and foreign companies by overturning

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127 its past monopoly system by the state-owned enterprises, Pemex. In addition, some serious challenges Mexico faces now, such as the lack of advanced technology, less developed industrial facilities and infrastructures, and the shortage of skilled human resources were the problems that Korea sought to overcome in the past.

From this point of view, implications of Korea’s experiences for Mexico to revitalize the oil and gas industry can be derived as follows:

s Expansion of refining industry and fostering petrochemical industry; s Liberalization of the oil and gas market: Securing transparency through price liberalization, abolishing entry barriers, and creating competitive investment conditions; s Technology development: Deep-water oil and gas resources development and tight oil development; s Strengthening inter-sectoral policy coordination between the different sectors and improving the fiscal regime for the energy projects; s Establishment of a specialized research institute and fostering human resources; s Enhancement of local content through technology development, expansion of related-industrial basis, fostering skilled labor.

Policy recommendations based on the above-mentioned implications from Korea’s experiences will be discussed in more detail in the next section.

4.2. Recommendations

4.2.1. Balanced Development of Oil Downstream Sector with Upstream

A) Situation Analysis

Mexico produces a significant amount of crude oil, but the country contradictorily imports a large volume of refined petroleum products from overseas, particularly the United States. This is simply because of the lack of sufficient refinery capacity domestically in Mexico. Pemex is argued to suffer from the difficulty in financing for the expansion/upgrading of refinery capacity due to the high level of tax imposed on the company. It is obvious that the refined products are much-higher value-added than crude oil. Thus, Mexico may lose an opportunity to gain more high-value-added production into the economy by importing petroleum products refined from the exported crude oil.

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2017/18 Knowledge Sharing Program with Mexico (II) B) Korean Experiences

Korea lacks crude oil production, and the country depends entirely on imports for crude oil supply. However, Korea heavily expanded the refinery capacity in order to meet the increased demand for petroleum products during the industrialization period in the 1990’s-2000’s, which appeared, in turn, to contribute to boosting the petro-chemical industry in Korea. Korea’s refining industry has grown in size over the past 30 years, which has created conditions for the Korean oil industry to secure international competitiveness.

C) Recommendation

The oil industry in Mexico, as an oil-producing country, is required to shift its growth strategy from strategy centering on the upstream sector to one centering on the downstream sector. s Expanding the refinery capacity to meet demand increases for petroleum products as well as boosting the petrochemical industry in Mexico.

D) Expected Outcomes

The development of the petroleum downstream industry through the expansion of the refining industry will not only expand opportunities to create high added- value, but will also have a positive effect in the long run by solidifying the economic growth base through the complementary growth of the petrochemical industry .

4.2.2. Create More Market-Friendly Investment Environment by Liberalizing the Oil and Gas Market

A) Situation Analysis

Mexico’s oil and gas industry is solely dominated by Pemex, a government-own monopoly company. Monopoly may create inefficiency of the market and may easily end up with market failure. To avoid and eliminate the negative effect of the monopoly, a more competitive market environment needs to be created by allowing private and foreign companies into the sector.

B) Korean Experiences

The Korean government policy for the oil sector was to minimize the government intervention in the oil industry and to maximize the function of the market mechanism. The oil industry in Korea was fully liberalized in 1997 and opened to foreign investment, and petroleum product prices were fully liberalized without

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129 any government intervention. Foreign oil companies, such as an American company Chevron-Caltex and the Saudi Arabian oil company, ARAMCO, invested in the oil refinery industry in Korea and also operate the retail business of oil products in Korea.

In addition, Korea’s energy production/supply facilities are known to be the most efficient in the world, as fair competition market environment was established for the energy sector, and the most advanced technology was introduced for the installation of the energy facilities.

C) Recommendation

In order to improve the oil and gas market environment and to reduce the negative effects of the existing state-owned monopoly industry of petroleum, it is necessary to reduce market/non-market entry barrier for private and foreign enterprises in the oil and gas industry through up-mid-down streams as well as the wholesale-retail market. It would be desirable to expand opportunities to introduce a competitive market framework based on market mechanism principles. s Fully liberalize the oil industry in terms of lifting entry barriers, free trade of oil products, and price liberalization. s Remove market/non-market entry barriers not only for upstream but also downstream of the oil sector to encourage private and foreign investments.

In order to enrich the competitiveness of the oil and gas upstream production and to attract more investment from private and foreign companies, the following recommendation can be made: s In the case of non-exploration areas, it is possible to consider the incentive- granting method to induce the business participation, similar to the Success- Pay-Loan method implemented in Korea.

D) Expected Outcomes

Market efficiency in the oil and gas sector will be improved through the competitive market mechanism between market participants.

4.2.3. Active Technology Development for the Oil and Gas Upstream Industries

A) Situation Analysis

Mexico has a large potential of hydrocarbon resources to further develop, particularly in deep-water offshore and also unconventional oil, tight oil, and

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2017/18 Knowledge Sharing Program with Mexico (II) onshore. It is expected that approximately 50% of Mexico’s prospective conventional oil and gas resource reserves are in deep waters. As mentioned, IEA’s outlook (IEA, 2016) indicates that a significant increase in oil production will be made from deep- water oil fields in Mexico within the next two decades, while oil production from shallow water offshore is expected to significantly decline due to the depletion of oil reserves. Oil production from unconventional oil, tight oil, is expected to contribute to the increase of onshore oil production. However, oil companies in Mexico, (i.e., Pemex) have limited operating experience of E&P in deep water and also suffers from a lack of technology to explore the unconventional types of hydrocarbon, tight oil, and shale gas. Without having the technology, Mexico will pay a high level of rent to foreign company to import and apply the technology for the development of those oil resources.

Thus, domestic technology development for oil and gas E&P in deep-water and for the unconventional type of hydrocarbon is an urgent requirement for Mexico, in particular, in pursuit of policy effort to enhance the local contents in the oil and gas upstream sector.

B) Korean Experiences

In spite of the limited potential for E&P activity indigenously, Korea has invested in technology development for the E&P of oil and gas, in order to enhance its technology self-reliance in the overseas projects in which the Korean companies participate. This includes the E&P technology for unconventional shale gas as well as hydrocarbon reserves in deep water.

In addition to developing its own technology through R&D, Korean companies have acquired and accumulated technology, which is not available in Korea, by participating in overseas development projects jointly with foreign countries that have advanced technology.

C) Recommendation

Mexico should make an effort to pursue the technology independence in the area in which the country has a large potential to develop in the future. This will be an important policy challenge in lowering Mexico's dependency on foreign technology. s Invest actively in technology development focusing on the deep-water oil and gas resources development and tight oil development, s In the case of the upstream sector, the development of offshore oil fields, especially deep-water oil and gas fields in the Gulf of Mexico, should benchmark other oil companies to enhance exploration and exploitation capacity for deep-sea exploration.

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131 s Encourage Mexican companies to participate in the project in foreign country, say in the United States, for the development of unconventional oil and gas, in order to learn and accumulate new and advanced technology at the initial stage.

D) Expected Outcomes

Such technology development will contribute to enhancing the localization rate of the Mexican economy as well as to creating a higher value-added chain in the long term.

4.2.4. Establishing Research Institutes Specialized in Policy and Technology Development and Fostering Skilled Human Resources

A) Situation Analysis

One of the most serious challenges currently faced by Mexico is the lack of professional human resources, particularly in the oil and gas sector. There is a deficit of human capital in highly specialized areas related to the production of hydrocarbons, because the energy sector remained closed to competition for a long time. The country requires geoscientists who can read and interpret seismic data, and engineers with deep technical knowledge, as well as experienced financial executives who can estimate assets, budget costs, and raise capital. Thus, in many cases, skilled labor demands in the hydrocarbon sector are met by hiring foreign personnel or importing them from abroad (see Section 2.4.3).

B) Korean Experiences

In the 1970-80’s, the Korean government established many national policy research institutes as well as the science and technology research institutes for each field, and strongly promoted policy to attract professional experts and scientists, who were educated in developed countries, by providing a high level of compensation, including a relatively higher salary. As for the energy sector, the Korean government established the Korea Energy Economics Institute as a government think-tank for the development of energy policy and national energy strategy. Outcomes of the policy research institute was useful for energy companies in developing their business frontier for the future investment in the short-, mid- and long terms. In addition, the Korean government established national research institutes for energy technology development to enhance Korea’s competitiveness in the global energy technology market (see Section 3.5.1). In the 2000’s, the Korean government began to implement policy to introduce energy specialization programs to major universities to promote

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2017/18 Knowledge Sharing Program with Mexico (II) long-term efforts to foster specialized human resources.

In addition to the government effort, the private and industrial sectors established their own research institutes according to their needs. For example, KNOC has a strong research branch for the development of oil E&P technology. Most private companies also established their own research institutes or engineering service company. The function of an engineering services company is to provide the project feasibility study, design of the project scheme, a method to procure investment and technology related to the project, and so on.

C) Recommendation

Professional and skilled human resources are the most important infrastructure elements for economic development. Mexico needs to expand this infrastructure to enhance the competitiveness of the oil and gas sector in the long term. The most effective way is to establish research institutes for planning and technology development or to strength their function. s Establish research think-tanks for the development of policy/strategy as well as of technology with strong government support. s Encourage the private sector to strengthen their engineering services, particularly for the oil and gas sector projects.

D) Expected Outcomes

Mexico will be able to maintain a strong industrial development basis by utilizing results from the R&D outcomes, and this will eventually contribute to enhancing local contents in the long run.

4.2.5. Strengthening Policy Coordination/Fiscal Function

A) Situation Analysis

Following the Energy Reform, the Mexican government set various types of policy agenda and implementations of action plans to achieve the goal of the reform. However, it appeared that the government needs to strengthen the function of inter- sectoral policy coordination. For example, as mentioned earlier, in the petrochemical industry in Mexico, there is no coordinated promotion policy to integrate the value chains with the chemical industry, which is required for guaranteeing the long- term supply of raw materials produced by the refinery industry. Another example is that the support and incentives for SMEs regarding the policy of national content suppliers and contractors are in a slow process of implementation by the government, so that the level of registered participation was low, which implies

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133 that delaying their interest to participate in the sector would exclude them from the benefits of Energy Reform (See Section 2.4.2).

Fiscal dependency of the Mexican government on the oil industry is also relatively high. Thus, government revenue and budget are strongly affected by the performance of the oil industry in Mexico and international oil price changes. This, in turn, implies that the oil industry in Mexico has burdensome tax burden, which can result in financing problems of the oil industry as well as in delaying project for oil development.

B) Korean Experiences

In Korea, one ministry, the Ministry of Trade, Industry, and Energy (MOTIE), is responsible for planning and policy implementation for the energy and industrial sectors. Thus, the inter-sectoral coordination between the industrial and energy sector can be undertaken within MOTIE. In addition, in the process of policy formulation, MOTIE has strong logistical support from the research institutes, such as the Korea Institute for Industrial Economics and Trade (KIET), the Korea Energy Economics Institute (KEEI), and the Korea Development Institute (KDI), which means inter-sector coordination can be made at even the planning stage.

As for the fiscal mechanism for the energy sector, the Korean government established a separate funding system, the so-called the Special Accounts for Energy and Resources (SAER) (See Section 3.5.3). This special account is an important financial resource for oil and gas E&P projects, R&D on energy policy and technology development, energy conservation, investment for renewable energy, and so on. Through this account, the Korean government can ensure the availability of funding mechanism for the energy project independently of the general account system as well as the transparency of budgeting for the energy projects designed in the energy policy.

C) Recommendation

Harmonization of government policies between different sectors is required in order to prevent the failure of government policy as well as to enrich the outcome of policy implementation. Transparency of fiscal regime should be secured. s Strengthen inter-sector policy coordination function from the planning stage in order to minimize risk of policy failure by utilizing objective analysis and forecasting research s Benchmark Korea’s experience of the Special Accounts for Energy and Resources (SAER) for establishing a separate fiscal funding mechanism for the energy project.

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2017/18 Knowledge Sharing Program with Mexico (II) D) Expected Outcomes

The effectiveness of government policy and the transparency of fiscal regime will be secured.

4.2.6. Establishing Long-Term Basis to Enhance National Contents in the Oil and Gas Industry

A) Situation Analysis

Mexican government set a policy objective to enhance national contents in the oil industry, particularly for upstream E&P activity, which includes: to increase the goods and services produced in Mexico, to generate job, income, to enter the global value chains, to increase the Mexican human capital, and to promote technological transfer and development, both through national and foreign investment (Ministry of Economy, Mexico, 2016).

B) Korean Experiences

In the initial stage of industrialization in the 1970-80's, Korea suffered from serious lacks of capital and technology. At that time, Korea’s industrial structure was very primitive, mainly with labor-intensive industry, and most technology was imported from abroad. Major policy efforts implemented by the Korean government to overcome this problem during the industrialization progress included: s Technology development through expansion of R&D investment to increase technological self-sufficiency s Localization of material and parts industry s Development of a large-scale equipment manufacturing industry s Fostering professional and skilled human resources and establishment of professional research institutes.

These efforts can be evaluated as having contributed to enhancing the local contents and self-sufficiency of the Korean economy as the policy outcome.

C) Recommendation

In order to raise the local contents in the oil and gas industry, it is necessary to foster skilled experts and to strengthen the function of professional research organization in the long-term. In the short term, it will be necessary to make the oil and gas sector in Mexico more competitive by boldly promoting policy to eliminate entry barriers of private and foreign companies into Mexico’s market, so that the companies will bring capital and technology to the market and also will be able to

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135 self-incentivize through the market mechanism. Therefore, recommendations for policy to enhance the local contents in Mexico’s oil and gas industry can be composed of the combination of the above-mentioned recommendations. s Eliminate market inefficiency by liberalizing the oil and gas markets s Implement active technology development for the oil and gas upstream industries s Encourage establishment of research think-tanks for the development of technology to enhance local content capability s Foster skilled human resources s Strengthen inter-sectoral policy coordination and improve fiscal regime

D) Expected Outcomes

A robust industrial basis for technology development and market-friendly investment environment to promote the domestic manufacturing sector will be established. Private/foreign companies to participate in the upstream E&P activity gain the incentive to participate in technology transfer and eventually contribute to enhancing local contents.

5. Conclusion

Korea’s experiences in the energy sector may not be straightforwardly applicable to Mexico may not be appropriate, since the two countries have mutually different aspects, particularly in the oil sector. However, the Energy Reform in Mexico is shifting the energy sector towards more market-friendly mechanism from the government monopoly system by opening the oil and gas sector to private and foreign investors. Korea's oil industry was already privatized and opened to foreign investment. From this respect, some meaningful implications from Korea's experience could be derived for Mexico’s oil and gas industry.

In the implementation progress of the Energy Reform, Mexico faces some serious challenges, including the lacks of technology and specialized human resources, transparency problem in fiscal regime, and financing problem for the oil and gas E&P project. Korea also experienced such challenges in the process of industrialization of the economy, and the Korean government actively implemented policies to overcome the problems. Thus, Korea can share with Mexico its experiences for efforts to revitalize the Mexican oil and gas industry.

Policy recommendations based on implications from Korea’s experiences were prepared, reflecting these respects. Recommendations generally include the following:

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2017/18 Knowledge Sharing Program with Mexico (II) s Strengthening the market mechanism in the oil and gas sector in Mexico, s Enriching R&D capability for technology and policy development, s Enhancing policy coordination function and transparency of fiscal regime.

Policy efforts combining these recommendations will eventually contribute to enhancing the local contents in the oil and gas sector in Mexico.

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137 References

Aguilera Gómez Manuel et al., (2014), “Considerations on the Reform of the Oil Industry in Mexico”, ECONOMÍAunam, vol. 11 (33), p. 113. British Petroleum, (2017), BP Statistical Review of World Energy (2017). Checa-Artasu, Martín M., (2014) “Geography, Power and Petroleum in Mexico. Some Examples”, in Scripta Nova, Electronic Journal of Geography and Social Sciences, Vol. XVIII, vol. 493 (51), November 1. Choi, Byung-koo (2017), “Presentation material for the 2017/18 KSP for Mexico”, August 2017. De la Vega Navarro Ángel, Martínez Hernández Francisco, and Santillán Vera Mónica, (2016), “The Energy Reform of 2013/2014 and Industrial Development in Mexico: Contents, Implications and Proposals” in Economic Analysis, vol. XXXI (78), Third quarter of 2016, Universidad Autónoma Metropolitana (Azcapotzalco), Mexico. Enerdata, (2017), Country Energy Report, Mexico, https://www.enerdata.net/ International Energy Agency, (2012), Energy Policies of IEA Countries, Republic of Korea. International Energy Agency, (2017), Energy Policies beyond IEA Countries, Mexico. International Energy Agency (IEA), (2016), Mexico Energy Outlook, World Energy Outlook Special Report, Paris. Korea Energy Economics Institute, (2017), Yearbook of Energy Statistics 2016. Korea Energy Economics Institute, Homepage, http://www.keei.re.kr/ Korea Gas Corporation, Homepage, http://www.kogas.or.kr/ Korea Institute of Energy Research, Homepage, http://www.kier.re.kr/ Korea Institute of Geoscience and Mineral Resources, Homepage, http://www.kigam.re.kr/ Korea National Oil Corporation, Homepage, http://www.knoc.co.kr/ Larios, Vázquez Andrea (2015), “Development and prospects of renewable energy in Mexico,” Economy Report Magazine, iss. 390, January–February 2015, Faculty of Economics, UNAM, pp.132-135. Lee, Dal-suk (2002), Issues and Challenges after the Liberalization of the Petroleum Industry, Korea Energy Economics Institute, December 2002. Martínez, Elizabeth (2017), “Research and Innovation in the Oil Industry: Challenges, Opportunities and Prospects”, in PetroQuiMex Magazine, Technology Section, July 25, 2017. Ministry of Economy, Mexico, (2016), “Local Content Policy and Industrial Development for the Energy Sector (KSP Program)” Presentation material, December 2016.

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139 Promotion of Direct Investment in the Hydrocarbons Industry, Mexico. Secretary of Economy (SE), (2017), Fifth Report of Work 2016-2017, Mexico. Secretary of Energy (SENER), (2013), Sectoral Energy Program 2013-2018, Mexico. Secretary of Energy (SENER), (2016a), Mexico’s New Energy Industry: Investing in the Transformation, available on https://www.ief.org/_resources/files/events/mexico-energy- day---energy-reform-in-mexico/mexican-president-visit-ief-17-jan-2016.pdf Secretary of Energy (SENER), (2016b), Crude Oil and Petroleum Prospects 2016-2030. Mexico. Secretary of Energy (SENER), (2016c), Prospect of Natural Gas 2016-2030. Mexico. Secretary of Energy (SENER), (2016d), Diagnosis of the Petroleum Industry in Mexico. Mexico. Secretary of Energy (SENER), (2016e), Prospective of Renewable Energies 2016-2030. Mexico Secretary of Energy (SENER), (2017), Five-Year Plan for Tenders for the Exploration and Extraction of Hydrocarbons 2015-2019. Mexico. Secretary of Finance and Public Credit (SHCP), (2014), Reforms in Action: Energy Sector Funds, Press Release 073/2014. Shin, Sang Yoon (2018), The Energy Sector of Korea: Focusing on the Oil Industry, Korea Energy Economics Institute, Presentation material, February 2018. US Energy Information Administration (EIA), Homepage; https://www.eia.gov/

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2017/18 Knowledge Sharing Program with Mexico (II) 2017/18 Knowledge Sharing Program with Mexico (II): Local Content Policy and Industrial Development for the Energy Sector Chapter 3

Policy Suggestions on the Development of Power Supply Technologies (PV, Wind, and Distribution)


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Policy Suggestions on the Development of Power Supply Technologies (PV, Wind, and Distribution)

Myung Kyoon Lee (Korea Development Institute)

Summary

Energy Reform in Mexico started with amending Mexico’s constitution to allow private investment in the energy sector, which has resulted in the termination of 75-year-old monopolies. The power sector reform in parallel with the energy reform also has a deep implication for Mexico’s economy as the “economic competitiveness reform.”

In spite of its great potential in renewable energy, Mexico has not been fully harnessing this potential for various reasons. This chapter aims to provide policy suggestions on the development of solar PV, wind, and distribution technologies to contribute to achieving the long-term goals of energy policies and to increasing the share of clean energy in Mexico’s power generation.

The global expansion for renewable electricity would remain robust and renewable power capacity would rise by 40% over 2014-2020 (IEA, 2015). BNEF (2017) expects $10.2 trillion to be invested in adding new power generation capacity worldwide until 2040. Of this, 72% ($7.4 trillion) goes to renewables: $2.8 trillion on solar and $3.3 trillion on wind.

Keywords: Renewable Energy Policy, Feed-in-tariff, Renewable Portfolio Standard, Technology Development, Mexico’s Renewable Potential

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2017/18 Knowledge Sharing Program with Mexico (II) Mexico’s power sector reform was enacted by the Electricity Industry Act in August 2014. The power sector reform’s main objectives are: to reduce power generation costs and tariffs (competitiveness); to increase the share of clean energies (cleanliness); to promote investment; to enhance transparency. The tools to achieve those objectives are: the establishment of an independent system operator (CENACE) to make industry structure more competitive; launching a wholesale electricity market; implementing clean energy certificates (CELs); restructuring CFE into a state- owned productive company. In 2008, a new law (LAERFTE) set the target of 35% clean energy1) generation by 2024, 40% by 2035 and 50% by 2050, which seems ambitious but achievable.

Mexico has large potential for renewable energies. Among various renewable energy sources, solar and wind have the highest proven potential. The solar potential is estimated as practically unlimited in terms of national energy consumption. Wind is the fastest growing renewable source with a huge potential and a main driver of the increase in electricity generation from renewable sources. Wind will play a significant role in achieving the 35% target of electricity generation from clean energy by 2024. Apart from its environmental benefits such as reducing the emissions of GHGs and air pollutants, developing wind power technology and industry due to its decentralized characteristics will bring economic and social benefits to local communities and remote areas with limited access to electricity services.

The distribution loss in Mexico was 13.1% in 2015, with a target of 10.0% in 2018. This high distribution loss can be attributed to lack of investments due to slow economic growth and the long and aged lines. The monetized value of annual distribution losses is about 42.2 billion pesos ($2.29 billion USD) per year (MOFA Internet site). The government has introduced some measures to reduce distribution losses (MaRS, 2016): improving metering by verifying the compliance of existing meters, replacing electromechanical meters with electronic meters and introducing new measurement technologies, enhancing the quality and timeliness of billing and collection, and normalizing irregular connection. The suggested measures to reduce distribution losses mainly involve metering, billing, and collection; these measures are low-cost and can be implemented more quickly but have limited effects. Reducing the losses to that of the OECD average would require long-term investments to renew old lines, build new lines, and adopt new technologies.

The growth of renewable energies in Korea is heavily attributed to the government’s policies backed up by legislation and financial support to make renewable energies competitive in the market. The Korean government has been designing various policies and programs to effectively develop and deploy renewable energies and strengthen related industries. Among the various policy options to

1) This includes wind, solar, hydro, biomass, geothermal, combined heat and power, and new nuclear.

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143 increase the share of new and renewable energies, FIT and RPS have been the most effective and influential options. Besides these, there have been tax benefits, low- interest loans, direct support, and mandatory use.

The development and indigenization of energy technology in Korea started in 1988. The primary objective of energy technology policy is to develop energy technologies up to the most advanced level in the world to increase the competitiveness of energy and related industries and ultimately contribute to economic growth and job creation.

Policies and technology development should go hand-in-hand. Without technology development to properly implement policies, such policies would open Mexico’s renewable energy market to foreign companies. In the case of generating electricity from renewable sources, the grid’s system stability is crucial to increasing the share of electricity from renewable sources and maintaining the quality of the electricity. In that sense, the secondary battery industry’s development and promotion should be seriously considered along with the development of the renewable energy industry. All policies should be supported by legislation, institutions, and budgets; otherwise, policies cannot achieve their objectives. Therefore, decision makers should make concrete budget plans and set budget items to finance intended policies.

Renewable industry is no longer a marginal player as technology advances and environmental concerns arise. With its enormous renewable potential, Mexico is in a good position to become a leader in the global renewable energy market, but this cannot happen by itself. With well-planned and thoughtful policies and support from the government, the private sector should play a role. The private sector’s active participation is a key to the long-term success of policies to promote renewable energy and industry as the private sector is a real innovator and investor. The role of government is to provide proper rules, regulations, and initial support so that the private sector can play fairly. How the private sector can be incentivized to participate and invest in the market should also be carefully considered along with policy options.

For the development and deployment of renewable energies, various policy options are being implemented in many countries depending upon their socio- economic and industrial contexts. There are broadly two categories of policy options-regulatory and financial-even if some policies have both regulatory and financial aspects. RPS is a widely used regulatory policy that requiring electricity companies to supply a specific share of electricity from renewable sources. Other than RPS, FIT is a widely used financial policy; it is effective at the initial stage of promoting renewables but would give the government increased financial burden. Tax incentives, low-interest loans, and various types of subsidies are utilized to promote renewable energies. In particular, tax incentives and low-interest loans are

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2017/18 Knowledge Sharing Program with Mexico (II) used to attract private firms to commercialize and scale-up renewable technologies and industry. The mandatory use of renewables in public buildings is an easy way for the government to promote renewable energies; these policies should be coordinated with industrial policies and take the competitiveness of the domestic renewable industry into account. The financing source should be determined in advance to design and implement financial policies.

Multiple studies have stated that the renewable industry is more effective than the fossil energy industry at creating jobs. GGGI and UNIDO (2015) told a very encouraging story about investment and job creation; when the same amount of money was invested in both the clean energy industry (energy efficiency and renewable energy) and the fossil energy industry, the investment in clean energy industry created more jobs than that in the fossil energy industry.

Mexico and Korea can be compared in terms of the potential and prospect of renewable energies. First, Mexico has abundant solar radiation and wind reserves, while Korea has limited reserves. Second, Korea has a strong and advanced industrial base while Mexico has a fair industrial base to support the development of renewable industries. Third, Mexico has a sizable domestic market for renewable industries, whereas Korea has a small domestic market. Finally, the Mexican and Korean governments have strongly committed to the promotion of renewable energies and industry. Therefore, Mexico and Korea can be good partners and can complement each other’s weaknesses.

1. Introduction

The Mexican government initiated Energy Reform in 2013 to enhance the energy sector’s competitiveness, which is expected to eventually boost the Mexican economy’s industrial competitiveness. The Energy Reform started by amending Mexico’s constitution to allow private investment in the energy sector, which has resulted in the termination of 75-year-old monopolies held by state- owned corporations, Pemex in the hydrocarbon industry and Comisión Federal de Electricidad (CFE)2) in the power industry. Even if the focus of the Reform is normally on hydrocarbons, the power sector reform also has a deep implication in Mexico’s economy as Mexico’s Energy Minister referred to it as the “economic competitiveness reform” (Robles, 2016) and some observers believed the electricity reform would be implemented faster and with more opportunities than the hydrocarbon reform (Vietor and Sheldhal-Thomason, 2017).

2) A government-owned vertically integrated utility, which controls over 75% of the electricity generation (including the generation by independent power producers, IPPs) and all of transmission and distribution.

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145 Among the goals of the Energy Reform3), this chapter focuses on increasing the supply of clean energy, in particular photovoltaic (PV) and wind energy, together with reducing transmission and distribution (T/D) losses. In spite of its great potential in renewable energy, Mexico has not been fully harnessing its potential for various reasons: the energy policies had been favoring a large-scale centralized system, renewable energies had been regarded as costly and unreliable, and as the monopoly grew renewable energies were not paid serious attention. The share of renewables in installed capacity had reduced from 29% in 1999 to 25.2%4) in 2015.

The Programa de Desarrollo del Sistema Eléctrico Nacional (PRODESEN) expects that 21.1 GW out of 59.9 GW of additional power capacity between 2015 and 2029 will come from renewable energy sources. New Energy Outlook 2015 (Bloomberg New Energy Finance, 2015) proposed an even more ambitious renewable outlook, projecting that over 57 GW of additional capacity can come from wind (22 GW) and solar (35 GW) in 2015-2040.

Reported is T/D loss of 16%5), which is significantly higher than 6% of OECD average and 3% of South Korea, Iceland, and Singapore. This high T/D loss is attributed mainly to long and aged transmission lines and a low investment due to a slow economic growth. In order to reduce T/D losses, the Energy Reform allows private investments to build new T/D lines even if T/D remains under the control of CFE. With strategic investments in T/D, expected is a decrease in distribution losses from 16% in 2012 to 10% in 2018 (Robles, 2016).

This chapter aims to provide policy suggestions on the development of solar PV, wind, and distribution technologies to contribute to achieving the long-term goals of energy policies and to increasing the share of clean energy in Mexico’s power generation.

The rest of the chapter is structured as follows: an overview and perspective of the world renewable energy market; status analysis on Mexico’s PV, wind, and T/ D technologies and industries; case studies on the promotion and deployment of renewable energies and the development of T/D technologies in Korea; policy suggestions on the promotion and development of PV, wind, and T/D technologies in Mexico.

3) They are to lower prices by enhancing efficiency, to increase oil & gas production, to improve the balance of payments, to share the benefits with society, and to increase the supply of clean energy 4) It was 17,140.4 MW, up by 6.6% from 2014 (SENER, 2016). 5) It was reported by CFE in 2012 and recited from Robles (2016). The 16% of T/D loss causes more than $3 billion of lost revenue a year. CFE expects T/D loss to decrease to 10% in 2018.

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2017/18 Knowledge Sharing Program with Mexico (II) 2. An Overview and Perspective of the World Renewable Energy Market 2.1. Past Trends

The rapid growth of the global renewable energy capacity is mainly attributed to factors such as cost reduction due to technological advancement and growing concerns with climate change and local pollution. Concerns with the increase in fossil fuel prices has been decreasing since the oil price has shown a stabilized range at around $50 per barrel after the end of 2014 with the emergence of shale gas.

The production, transport, and use of fossil fuels have huge environmental impacts. Almost all emissions of SOx and NOx and 85% of PMs are attributed to fossil fuel production and consumption. In addition, fossil fuel combustion is the main source of carbon dioxide emissions causing climate change.

Air pollution from fossil fuel has significant health effects. Respiratory infections, heart disease, chronic obstructive pulmonary disease, stroke, lung cancer, etc. are major risks to health. In 2013, 85% of the world’s population was living in places that did not meet the World Health Organization (WHO) air quality guideline levels. Ambient air pollution was estimated to cause 2.9 million premature deaths worldwide and about 88% of these premature deaths took place in low- and middle-income countries. In addition to outdoor air pollution, indoor smoke is a serious health risk for about 3 billion people who use biomass and coal for cooking and heating.

[Figure 3-1] Deaths from Air Pollution in 2013

Source: http://www.healthdata.org/infographic/global-burden-air-pollution.

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147 Climate change is regarded as the biggest market failure in human history with high uncertainty and enormous potential impact. One and half a centuries ago (1861), Tyndale found that slight variations in the Earth’s atmospheric composition could lead to climate change; in 1896, the Swedish chemist Arrhenius predicted that the large-scale burning of fossil fuels could change the Earth’s atmospheric composition, which could cause climate change. The natural variability of the climate system led to the question of whether the current climate change trend was anthropogenic. IPCC AR4 (2007) confirmed that “Climate change is occurring now, mostly as a result of human activities.”

Unlike local pollution, climate change has several distinct characteristics that make finding solutions difficult: irreversibility, once it occurs returning to the previous state is impossible; universality, it affects everything on Earth; uncertainty, it is unprecedented and carries a high level of uncertainty; inequitable, polluters and victims are different both intra-generationally and inter-generationally; technological immaturity, replacing fossil fuels with no-carbon energy sources is technologically difficult and costly; no sovereign government, there is a low likelihood of concerted action.

Many scientists have analyzed the potential dangers. The Intergovernmental Panel on Climate Change (IPCC) 5th Assessment Report (2014) predicts a rise of 0.3- 4.8°C in temperature and a 26-82cm rise in the sea level by 2100 if no additional efforts are made. Nicholas Stern in his report, which is one of the most renowned analyses on the economic impact of climate change, estimated that “the costs of action to reduce greenhouse gas emissions to avoid the worst impacts can be limited to around 1% of global GDP each year. However, if the efforts are delayed, the estimates of damage could rise to 5-20% of GDP or more” (Stern, 2006). A regional economic impact study done by the Asian Development Bank (ADB) for Southeast Asia estimated that the potential mean losses in GDP due to climate change are likely 6.7% by 2100 under the scenario of relatively slow demographic transition, relatively slow energy efficiency improvements, and the delayed development of renewable energy (ADB, 2009). Most analyses conclude that the economic impacts of climate change will be highly significant if no efforts are made to avoid it.

One way to reduce GHG emissions is to replace carbon-based energies with no- or low-carbon energies such as renewable energies. Hence, concerns with climate change and local pollution have been driving the worldwide development and deployment of renewable energies. Another factor that contributes to the development and deployment of renewable energies is the cost reduction resulting from technological advancement.

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2017/18 Knowledge Sharing Program with Mexico (II) Renewable costs, particularly for solar PV and wind, have dramatically fallen in recent years. This decreasing trend will continue for a while in the coming years so that renewables have price competitiveness against conventional fossil energies in the near future even without considering externalities. The following figure by IRENA (2015) shows the levelized costs of renewable power generation in 2014 and 2025. Onshore wind can currently compete with fossil fuel electricity costs and grid- connected solar PV is expected to do so by 2025. Considering the accelerating trend of cost reduction in solar PV, it would be able to compete with fossil fuels earlier than expected. Along with this, global investment in renewables will rapidly increase as will renewable capacity.

[Figure 3-2] LCOE Ranges by Renewable Power Generation Technology for 2014 and 2015

(Unit: USD/kWh)

0.4

0.3

0.2

0.1

Range of today’s fossil fuel electricity costs

0.0 2014 2025 2014 2025 2014 2025 2014 2025 2014 2025 2014 2025 2014 2025 2014 2025 2014 2025 2014 2025 2014 2025 2014 2025 2014 2025 Geothermal Biomass-AD Hydropower Solar PV-Grid Wind onshore Wind offshore Biomass-Co-firing Biomass non-OECD Biomass-Gasification CSP PTC (no storage) CSP PTC (6h storage) CSP ST (6-15h storage) Biomass-Stoker/BFB/CFB

Note: LCOE stands for Levelized Cost of Energy. Source: IRENA (2015b).

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149 [Figure 3-3] Renewable Power Generation and Capacity as a Share of Global Power, 2007-2015

(Unit: %) 60.0 53.6 48.6 49.0 50.0 41.7 40.2 39.8 40.0 31.6 27.3 30.0 19.5 20.0 13.8 15.2 12.7 8.2 9.2 10.2 11.4 16.2 10.0 7.5 10.3 7.8 8.5 9.1 5.2 5.3 5.9 6.1 6.9 0.0 2007 2008 2009 2010 2011 2012 2013 2014 2015

Renewable capacity change as a % of global capacity change (net) Renewable power as a % of global power capacity Renewable power as a % of global power generation

Note: Renewable figure excludes large hydro. Source: UNEP and Bloomberg New Energy Finance (2016).

In 2015, global investments in renewable energy had increased 5% to $285.9 billion USD, which is more than six times that in 2004. The year 2015 was also the first in which more than half (53.6%) of installed power generation capacity was accounted for by renewables excluding large hydro; in addition, investment in renewables excluding large hydro in developing countries outweighed that in developed countries. Mexico was one of top 10 investing countries by investing $4 billion USD, a 105% increase on 2014.

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2017/18 Knowledge Sharing Program with Mexico (II) [Figure 3-4] Global New Investment in Renewable Energy by Asset Class, 2004-2015

(Unit: Billion USD)

Growth : 56% 54% 37% 18% -2% 34% 16% -8% -9% 17% 5%

278.5 285.9 257.3 273.0 239.2 234.0

182.2 178.7 154.0

112.0

72.8 46.6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Corporate R&D Government R&D VC/PE Public markets Small distributed capacity Asset finance

Source: UNEP and Bloomberg New Energy Finance (2016).

[Figure 3-5] New Investment in Renewable Energy by Country and Asset Class for 2015 and Growth on 2014

(Unit: Billion USD)

Growth: China 102.9 17%

United States 44.1 19%

Japan 36.2 0.1%

United Kingdom 22.2 25%

India 10.2 22%

Germany 8.5 -46%

Brazil 7.1 -10%

South Africa 4.5 329%

Mexico 4.0 105%

Chile 3.4 151%

Asset finance SDC Public markets VC/PE CorpR&D GovR&D

Source: UNEP and Bloomberg New Energy Finance (2016).

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151 2.2. Future Perspective

2.2.1. Technology Development

Renewable costs, particularly solar PV and wind, have enjoyed a dramatic recent cost decrease that is attributable to technological progress and better financing conditions; the estimated global weighted average of levelized cost of electricity (LCOE) by IEA (2015) showed a continuous decrease in both solar PV and onshore wind.

[Figure 3-6] Historical and Forecast Global Weighted Average LCOEs

LCOE Indexed change of LCOE 400 160 350 140 300 120 250 100 200 80 150 60 100 40 USD 2014/MWh 2010=100 50 20 0 0 2010 2015 2020 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Onshor wind Offshor wind Solar PV-utility scale

Source: IEA (2015).

According to a longer-term projection by the Rocky Mountain Institute, the capital cost of onshore wind is already lower than that of coal and the capital cost of utility-scale solar PV will be lower than that of coal before 2020. In particular, the cost reduction of solar PV is faster than other electricity technologies.

The assessment of technological progress conducted by IEA (2017b) shows advances in some clean energy technologies. Substantial progress has been made where clear policy signals have been provided on the value of technology deployment such as energy storage systems, electric vehicles, solar PV, and onshore wind. Solar PV and wind are two technologies for which the Mexican government wants to mobilize greater investment to develop and deploy. Over 2015–2020, electricity generation by solar PV and onshore wind are set to grow by 2.5 times and 1.7 times respectively.

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2017/18 Knowledge Sharing Program with Mexico (II) [Figure 3-7] Electricity Technology Capital Cost Projection, 2010-2050

7 coal integrated gasification combined concentrating solar cycle with carbon 6 power with 6-hr capture and sequestration (CCS) storage geothermal nuclear 5 distri- buted 4 PV biomass hydro

2009 S/W 3 utility-scale distributed wind PV coal 2 offshore wind onshore wind gas CC with CCS 1 gas combined cycle (CC) 0 2010 2015 2020 2025 2030 2035 2040 2045 2050

Note: Renewable costs exclude tax credits and similar subsidies; nonrenewable costs implicitly include many complex complex subsidies. Source: Rocky Mountain Institute, accessed on Jan. 18, 2018.

2.2.2. Investment Demand to Meet Renewable Targets

In 2016, global investment in renewable power and fuels6) was $241.6 billion USD (REN21, 2017). Investment in renewable power and fuels exceeded $200 billion USD per year for 2010-2016. In spite of the 2008 global financial crisis, global investment in renewable energy had significantly increased since 2009.

[Figure 3-8] Global Investment in Renewable Power and Fuels, 2006-20167)

World Total Billion USD 242 billion USD 350 312 300 281 278 244 255 242 250

181 234 200 178   159      150   Growth   2015-2016 113      100       50  

0  2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

World total Developed countries China Other developing countries

Note: 1) Figure does not include investment in hydropower projects larger than 50 MW. 2) Investment totals have been rounded to nearest billion. Source: REN21 (2017).

6) This does not include hydropower larger than 50MW. Including investments in hydropower larger than 50MW, total new investment in renewable power and fuels was at least USD 264.8 billion. Note that these estimates do not include investment in renewable heating and cooling technologies.

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153 Table 3-1 Global Trends in Renewable Energy Investment by Technology, 2006-2016 (Unit: Billion USD) 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Solar 21.9 38.9 61.3 64.0 103.6 154.9 140.6 119.1 143.9 171.7 113.7 Wind 39.7 61.1 74.8 79.7 101.6 84.2 84.4 89.0 108.5 124.2 112.5 Bio-power 12.8 23.0 17.5 15.0 16.6 19.9 14.9 12.4 10.8 6.7 6.8 Hydro 7.5 6.4 7.6 6.2 8.1 7.5 6.4 5.6 6.4 3.5 3.5 (< 50MW) Biofuels 28.6 27.4 18.4 10.2 10.5 10.6 7.2 5.2 5.3 3.5 2.2 Geothermal 1.4 1.7 1.7 2.8 2.9 3.9 1.6 2.9 2.9 2.3 2.7 Ocean 0.8 0.8 0.2 0.3 0.2 0.2 0.3 0.2 0.3 0.2 0.2 Total 112.7 159.3 181.4 178.3 243.5 281.2 255.5 234.4 278.2 312.2 241.6

Notes: 1) Bio-power includes biomass and waste-to-power technologies, but not waste-to-gas. 2) Solar and wind account for around 90% of total investment in the global renewable energy. Source: REN21 (2017).

If the global expansion for renewable electricity remains robust, renewable power capacity will rise by 40% over 2014-2020 (IEA, 2015); this outlook stems from decreasing costs for the deployment of renewable technologies (particularly solar PV and onshore wind) due to a combination of technology progress, expansion into newer markets, and improved financing conditions; this is often supported by price competition for long-term power purchase agreements, which have resulted in some very low contract prices over the past year in many areas such as Brazil, India, South Africa, the Middle East, and the United States.

The improvement of transparency in renewable policies for some countries such as India, both within and outside the OECD, also supports this outlook. Non-OECD countries account for 65% of global renewable additions through 2020 and 40% of global growth comes from China.

7)

7) BNEF (2017), recited from REN21 (2017).

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2017/18 Knowledge Sharing Program with Mexico (II) [Figure 3-9] World Net Additions to Renewable Power Capacity, Historical and Forecast

(Unit: GW)

180 Ocean 160 Geothermal 140 STE 120 Solar PV 100 Offshore wind 80 Onshore wind 60

Annual additions (GW) 40 Bioenergy 20 Hydropower 0 Accelerated case 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Source: IEA (2015).

BNEF (2017) expects $10.2 trillion USD will be invested in adding new power generation capacity worldwide until 2040. Of this, 72% ($7.4 trillion) will go to renewables: $3.3 trillion to wind and $2.8 trillion to solar. Investment in renewable energy will increase to around $400 billion USD per year by 2040, an annual increase of 2-3%. Investment in wind will grow faster than solar: wind will grow 3.4% and solar will grow 2.3% per year.

The European investment in renewables will grow by 2.6% per year on average up to 2040, averaging $40 billion USD per year and the total investment in renewables across Europe will reach almost $1 trillion over 2017-2040. Annual investment in renewables across the America will average $50 billion USD to 2040 and reach almost $1.5 trillion USD over the same period. Investment in solar grows faster than wind: solar grows 1.5% and wind grows 0.8% per year on average. The Asia-Pacific region will make almost as much investment in generation as the rest of the world combined. China and India alone will invest $4 trillion USD in their energy sectors. China will account for 28% and India 11% of the total regional investment over 2017-2040. Wind and solar will account for approximately a third of their total investment.

2.3. Selected Polices and Measures to Promote Renewable Energies

Many countries support the development and deployment of renewable energy technologies through various policies and their combinations. Support for renewable energy has focused on power generation rather than renewable technologies in heating, cooling, and transport. Many countries have also tried to integrate renewable generation into national energy systems. Among the various policies to

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155 promote renewable energies, each country has developed and adopted policies that are customized to its country context. The most widely used ones are as follows8):

Ȍ Electricity Polices

s Feed-in-tariff (FIT) is the most popular form of regulatory policy support for renewable power promotion. Although support for large-scale renewable projects is shifting to tendering in an increasing number of countries, the feed- in-tariff remains a primary policy in many such countries for the deployment of small-scale installations. FIT rates are continuously adjusted as technologies become more cost-competitive. s Renewable Portfolio Standards (RPS) is one of the most common regulatory policies that require electricity suppliers to generate a certain percentage of their electricity from renewable sources. s Tender is a rapidly expanding form of support for the deployment of renewable energies and is becoming a preferred policy tool for large-scale renewable projects. At least 34 countries issued new tenders in 2016; most tenders were issued for solar PV, and to a lesser extent for wind and geothermal power. Renewable technologies were competitive in some technology-neutral tenders. s Net metering/net billing is a policy that allows consumers who generate electricity to use that electricity anytime regardless of when it was generated. This means that the amount of electricity that consumers generate over a certain period is deducted from the electricity that consumers use, and this net electricity consumption amount is billed. This is particularly important for solar and wind, which naturally fluctuate due to their weather dependency. These are normally used to support the deployment of small-scale renewable energy systems alongside other policy mechanisms such as FITs or tenders that support larger-scale projects.

Ȍ Heating and Cooling Policies

Renewable-based heating and cooling technologies are generally promoted by a mix of targets, regulatory policies, and public financing rather than a single policy. Support for renewable heating and cooling in 2016 was mostly provided through financial incentives in the form of grants, low-interest loans, rebates, or tax incentives that aim to increase deployment and stimulate further technological development in some cases.

8) REN21 (2017).

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2017/18 Knowledge Sharing Program with Mexico (II) Ȍ Transport Polices

The use of renewable energy in transport is severely limited compared to electricity generation, heating, and cooling. Policy support to increase the use of renewable energy in the transport sector is how to expand the use of biofuels in road transport. Tax incentives and the mandatory mix of bio-fuels with conventional transport fuels are widely used. Argentina extended tax exemptions for biodiesel production through 2017 and Sweden introduced tax cuts on both ethanol and biodiesel. At the US state level, Hawaii introduced a tax credit for biofuel producers and Iowa extended biodiesel and ethanol tax credits through 2025.

[Figure 3-10] The Number of Renewable Energy Regulatory Incentives and Mandates by Type for 2014-2016

(Unit: Number of countries)

130 Power Policies 126 Countries 120 with Power Feed-in tariff/premium 117 118 Regulations payment 110 Tendering Net metering 100 Renewable portfolio standard (RPS) 90 Heating and 80 Countries Cooling Policies with Solar heat obligation 70 68 Transport 64 66 Technology-neutral Regulations heat obligation 60

50 Countries with Transport Heating and Policies Cooling (H&C) 40 Biodiesel obligation/ Regulations mandate 30 Ethanol obligation/ mandate 20 21 21 21 Non-blend mandate

10 29 countries 0 had other PowerH&CTransport Power H&CTransport Power H&C Transport heating & 2014 2015 2016 cooling policies

Source: REN21 (2017).

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157 3. Status Analysis on Mexico’s PV, Wind, and Distribution Technologies and Industries 3.1. Mexico’s Power Sector Reform and Clean Energy Trend

Mexico’s power sector reform was enacted by the Electricity Industry Act in August 2014; this officially broke up the state-owned monopoly CFE and established a new electricity market. The new electricity market structure allows independent power producers to own power plants and directly sell their electricity in a wholesale market operated by Centro Nacional de Control de Energia (CENACE), which is an authority that was newly formed in the reform.

The main objectives of the power sector reform are to reduce power generation costs and tariffs (competitiveness); increase the share of clean energies (cleanliness); promote investment; and enhance transparency. The tools to achieve those objectives include establishing an independent system operator (CENACE) to make the industry structure more competitive; launching a wholesale electricity market; implementing clean energy certificates (CELs); and restructuring CFE into a state-owned productive company.

In 2008, a new law (LAERFTE) set the target of 35% clean energy9) generation by 2024, 40% by 2035 and 50% by 2050, which seems ambitious but achievable. Bloomberg New Energy Finance (New Energy Outlook 2017) projects that renewables will account for 80% of Mexico’s electricity by 2040, which is a 30% point higher projection than the target by LAERFTE even without nuclear and combined heat and power. Furthermore, the development and deployment of renewable energies was promoted by the 2012 “Climate Change Law” legislation to reduce GHGs emissions.

In 2015, renewable energy accounted for 15.5 million tons of oil-equivalent (TOE) or 8.3% of Mexico’s total primary energy supply (TPES).10) Biofuels and waste accounted for highest (4.6%) among renewable energies in TPES. The electricity generation by renewables accounted for 15.3% (47,548.7 GWh) of the national total and hydro-power accounted for 80% of the installed capacity in clean energies. Wind accounted for 2.6% and solar 0.1% in electricity generation. The most rapid expansion of installed capacity in clean energy between 2005 and 2015 was claimed by wind, showing 104.7% annual growth, while the expansion of hydro capacity was 1.7% per year (SENER 2016).

9) This includes wind, solar, hydro, biomass, geothermal, combined heat and power, and new nuclear. 10) IEA (2017). Those are lower than the average of IEA member countries, which are 10% of TPES and 23.5% of electricity generation, respectively.

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2017/18 Knowledge Sharing Program with Mexico (II) In Mexico, “Clean Energies” are defined11) as sources of energy and electricity generation processes whose emissions or residues, when they exist, do not exceed the thresholds established in regulatory provisions that are issued for that purpose, whereas “Renewable Energies” are energies for which the resources are natural phenomena, processes, or materials that can be transformed into energy useful to humans, are generated naturally so that they are available continually or periodically, and do not release pollutant emissions when generated. Clean Energies include Renewable Energies but not vice versa. Clean Energies include wind, solar radiation, ocean energy, geothermal, bioenergy, methane and other gases from waste disposal, hydrogen, hydro, nuclear, wastes (agricultural and urban solid waste), efficient cogeneration, bagasse, thermal power with CCS, etc.

Mexico has a big potential for renewable energies. The national inventory of renewable energies shows 100,278 GWh of proven and probable electricity generation. The additional potential (excluding solar) is greater than 195,278 GWh per year. Among various renewable energy sources, solar and wind have the highest proven potential. The practical solar potential is estimated to be unlimited in terms of national energy consumption. In terms of installed capacity, clean energies account for 25.6%: hydro 18.6%, wind 4.1%, geothermal 1.3%, efficient cogeneration 0.7%, etc.12), as shown in the following figure.

[Figure 3-11] Share of Renewable Energies in the Installed Capacity of Electricity Generation

Biomass: 0.3% Efficient Cogeneration: 0.7% Photovoltaic 1: 0.2% Geothermal: 1.3% Biogas: 0.2% Wind: 4.1%

Hybrid systems 2: 0.0% Hydropower: 18.6% Not interconnected rural systems 3: 0.0%

Non renewables: 74.6%

Note: 1) “Photovoltaic1” includes interconnection contract in Baja California Sur. 2) “Hybrid systems2” refers to solar–wind combined systems. 3) “Not interconnected rural systems3” refers to electricity generation with biogas from animal disposal. Source: http://mim.promexico.gob.mx/swb/mim/Perfil_del_sector_erenovables

11) The Electricity Industry Act, Art.3, Section XXII. Translated by the Google Translation. 12) http://mim.promexico.gob.mx/swb/mim/Perfil_del_sector_erenovables

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159 Potential power generation from renewable energy and the projection of the installed capacity of renewables for 2019-2029 are given in the following tables.

Table 3-2 Potential Power Generation from Renewable Sources (Unit: GWh per year) Source Wind Solar Hydro Geothermal Biomass Wave Proven 19,805 16,351 4,796 2,355 2,396 0 Probable 0 0 23,028 45,207 391 1,057 Possible 87,600 6,500,000 44,180 52,013 11,485 0 Total 107,405 6,516,351 72,004 99,575 14,272 1,057

Source: SENER (2016).

An additional 20,950 MW of installed capacity will have been built by 2029. Wind and solar will account for 57.1% and 8.7% of the increased capacity, respectively.

Table 3-3 Projection of Installed Capacity by Renewable Sources for 2019-2029 (Unit: MW) Year 2019 2025 2029 Wind 6,670 11,749 11,952 Solar 1,341 1,792 1,822 Hydro 677 4,704 5,450 Geothermal 193 1,618 1,618 Bioenergy 78 78 108 Total 8,959 19,941 20,950

Source: SENER (2015), recited from http://mim.promexico.gob.mx/swb/mim/Perfil_del_sector_erenovables.

Between 2010 and 2015, 51 foreign direct investments were made in total in the renewable energy industry: 22 from Spain; eight from the USA; five from Germany; four each from Italy and the UK; two each from France and Portugal, and four from others.

Mexico has an industrial base of renewable energies with both project developers and equipment suppliers. Several domestic companies run businesses in their local market for small-scale projects that are involved in the development, manufacturing, and sale of renewable equipment and are expanding their business to the sustainable energy industry. The domestic companies that produce wind and solar equipment are in the following table.

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2017/18 Knowledge Sharing Program with Mexico (II) Table 3-4 Wind and Solar Equipment Producers Renewable Component Companies Sources Potencia Industrial (100% Mexican company), Dynamik Generator Kontroll (US company in Guadalajara) Vientek (a joint venture between Mitsubishi and TPI Blade Wind Composites) Tower Trinity, Tubac, CS Wind, Speco, Enertech Fabricaciones Bearing Kaydon, Liebherr, Frisa Baja Sun (Taiwan-Mex.), Risen Energy (China), SunPower (US), Solar Solar PV module Solartec (Mex.), Iusasol (Mex.), ERDM (Mex.)

Source: http://mim.promexico.gob.mx/swb/mim/Perfil_del_sector_erenovables and other sources.

In addition to its geographic advantage, proximity to the North American market, and abundant renewable resources, Mexico is well equipped with low production costs and a highly skilled workforce. Mexico’s successful development of automotive and electronic industries has provided experience and confidence to further develop the renewable energy industry. According to the national association of universities and high education institutions, 115,000 students graduate from engineering, manufacturing, and construction departments each year. One example of low production costs is Mexico’s production cost of secondary batteries, which is second lowest among selected countries.

[Figure 3-12] Production Cost of the Secondary Batteries, 2016

Canada 90.1 Mexico 90.6 Netherlands 92.2 France 93.4 Japan 94.1 Australia 94.2 United Kingdom 94.9 Italy 94.9 Germany 95.6 USA 100.0

Note: Cost index when USA=100.0 Source: http://mim.promexico.gob.mx/swb/mim/Perfil_del_sector_erenovables.

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161 3.2. Mexico’s PV Technology and Industry

In 2015, Mexico had 56.3 MW of installed capacity and generated 78.2 GWh from solar PV. With its abundant potential and decreasing cost, solar PV has won 54% of the second electricity auction. By the end of 2030, expectations are 6,890.9 MW installed capacity and 12,697.1 GWh electricity generation from solar PV. Capacity additions are particularly expected in 2016, 2017, 2018, 2025, 2026, and 2017.

[Figure 3-13] Expected Solar PV Capacity and Generation, 2016-2030

(Units: MW, GWh)

12,151.5 12,518.8 12,697.1 10,584.9 12,376.1

8,878.5

6,914.6 7,333.1 6,350.1 6,570.9 7,107.2 4,535.4 6,733.2 6,890.9 6,690.9 6,790.9

2,713.0 6,590.9 5,789.9 4,894.9 1,031.3 825.1 895.0 801.0 974.9 4,069.8 3,769.8 3,869.8 3,969.8 3,603.0 530.7 2,041.0 3,646.8 3,580.0 1,562.0 100.0 100.0 100.0 100.0 67.0 100.0 100.0 100.0

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 Capacity additions MW Total installed capacity MW Generation GWh

Source: SENER (2016).

The capacity addition plan in the above figure shows that the annual addition is concentrated in a few periods such as 2016-2018 and 2025-2027 and very little capacity is added in the remainder. With this uneven distribution of annual capacity addition, manufacturers will have difficulty making businesses and investment plans. In other words, manufacturers will be cautious not to create over-capacity when trying to meet the demand in high-demand periods because their manufacturing facility will be idling in low-demand periods unless they can export products in the global market. Then, the shortage of supply in high-demand periods will present opportunities for foreign companies. Therefore, the plan needs to be more evenly distributed so that domestic manufacturers can have more stable investment plans. The same concerns apply to the wind industry in the next section.

Currently, Mexico’s solar industry mainly involves assembling solar modules. Since the industrial base of solar modules are weak, developing a competitive solar industry requires that related industries such as semi-conductors and the material industry should be developed.

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2017/18 Knowledge Sharing Program with Mexico (II) 3.3. Mexico’s Wind Technology and Industry

In Mexico, wind is the fastest growing renewable source with a huge potential and is a main driver of the increase in electricity generation from renewable sources. In 2015, the installed capacity of wind power increased by 37.75% compared to that in 2014; power generation also increased by 36.08% in the same year. By the end of 2015, there were 32 wind farms, most of which (23) were located in the eastern area, particularly in Oaxaca. The installed capacity of Oaxaca is 2,308.6 MW. Following the eastern area, the next is the western area with 445.6 GWh of electricity generation and the third is Baja California, with an installed capacity of 166 MW and 272.6 GWh electricity generation in 2015.

[Figure 3-14] Installed Capacity of and Electricity Generation from Wind, 2005-2015

(Unit: MW, GWh) 3,000 10,000 8,745 9,000 2,500 8,000 6,426 7,000 2,000 6,000 1,500 4,185 5,000 4,000 1,000 3,000 1,744 2,000 500 357 545249 255 249 166 1,000 0 - 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Installed Capacity MW Generation GWh

Source: SENER (2016).

Table 3-5 Installed Wind Power Capacity, 2015 Region Installed Capacity (MW) Electricity Generation (GWh) Baja California 166 272.6 Noroeste 2 3.6 Noreste 166 196.8 Mulege 0.6 - Occidental 250.4 445.6 Oriental 2,308.6 7,824.4 Peninsular 1.5 2.1 Total 2,895.1 8,745.1

Source: SENER (2016).

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163 Wind will play a significant role in achieving the 35% target of electricity generation from clean energy by 2024. In addition to its environmental benefits from reducing GHG emissions and air pollutants, developing wind power technology and industry due to its decentralized characteristics will bring economic and social benefits to local communities and remote areas with limited access to electricity services. From the results of the first and second electricity auctions, wind power capacity is anticipated to triple by the end of 2019; there will be an additional 2,455 MW in 2018 and 3,857 MW in 2019. Almost 12,000 MW of new capacity will be added in 2016-2030, among which 53% are in a construction phase or about to start construction.

[Figure 3-15] Expected Wind Power Capacity and Generation for 2016-2030

(Units: MW, GWh) 47,495.5 47,365.6 43,715.6 17,365.6 39,673.4 47,365.6 34,659.5 30,758.8 27,753.4 30,758.8 30,758.8 21,480.3 15,762.7 15,101.1 15,101.1 15,101.1 15,101.1

13,109.5 13,911.6 10,520.9 12,593.2 10,964.5 9,734.2 9,734.2 9,734.2 9,734.2 8,376.2 2,818.8 1,358.0 1,230.4 1,628.7 5,557.4 1,318.4 1,085.7 759.6 611.0 1,189.5 4,471.7 3,860.7

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030

Capacity additions MW Total installed capacity MW Generation GWh

Source: SENER (2016).

The figures of expected solar PV and wind capacity until 2030 show that installation is concentrated in certain years: 2016-2018 and 2025-2027 for solar PV; 2016-2029 and 2024-2027 for wind. This uneven capacity expansion plan presents difficulties to domestic solar PV and wind turbine manufacturers who want to make business plans and expand and maintain their manufacturing capacity. In case domestic manufacturers lack the capacity to provide equipment and parts aligned to the high-demand years, the excessive demand would be met by foreign companies, which would adversely affect the promotion and development of domestic renewable industries. Therefore, some actions should be taken to make the capacity installation plan more even or to help domestic manufacturers be better prepared so that the increase in clean energy supply can contribute to industry development, job creation, and income growth.

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2017/18 Knowledge Sharing Program with Mexico (II) 3.4. Mexico’s Distribution Technology and Industry

Just like power generation, T/D has been monopolized by CFE for a long time. With the energy reform, even if the state maintains control over T/D, private companies are allowed to enter the T/D business through joint ventures or bilateral agreements with CFE.

Mexico currently has 104,393 km of distribution lines and another 28,070 km will be added in the next 15 years. The distribution loss was 13.1% in 2015 and the target for 2018 is 10.0%, as shown in the following figure. This high distribution loss can be attributed to the lack of investment due to slow economic growth and the long and elderly lines, half of which are older than 20 years. In some areas, the transmission system is not ready to be connected with renewable generation due to high congestion levels.

The 13.1% distribution loss is higher than OECD members’ average distribution loss of 6% and its monetized value is approximately 42.2 billion pesos ($2.29 billion USD) per year (MOFA Internet site). The distribution losses vary between areas; it is as high as 25% in the Valley of Mexico (Tulancingo, Pachuca, and Cuernavaca). Technical losses from old and poor distribution lines account for 6% of the total electricity generation while non-technical losses such as theft, non-payment, or inadequate billing arrangements account for 8% (MaRS, 2016).13)

The government has introduced the following measures to reduce the distribution losses (MaRS, 2016):

a. Improving metering by verifying the compliance of existing meters, replacing electromechanical meters by electronic meters, and introducing new measurement technologies; b. Enhancing the quality and timeliness of billing and collection; c. Normalizing irregular connections.

13) The distribution loss shows a bit of discrepancy depending upon data source. For instance, it is 13.1% in Bloomberg (2016) whereas 14% (6% of technical losses and 8% of non-technical losses) in MaRS (2016).

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165 [Figure 3-16] Distribution Losses, 2002-2018

(Unit: %)

16 15.9 15 15.3 14.6 13.9 13.1 12.5 12.0 11.6 11.7 11.8 11.0 11.2 11.6 11.0 10.6 10 10.0

5

0 2002 2004 2006 2008 2010 2012 2014 2016 2018

Historical Target

Source: KEEI (2016).

The measures suggested to reduce distribution losses mainly involve metering, billing, and collection. These measures are low-cost and take less time to implement but have limited effects. Long-term investments in renewing old lines, building new lines, and adopting new technologies are necessary to reduce the losses to the level of the OECD average.

Considering that renewable sources such as solar PV and onshore wind are competitive under off-grid and decentralized systems in remote areas, they will be able to contribute to reducing distribution losses as the distance for transmission and distribution of electricity decreases.

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2017/18 Knowledge Sharing Program with Mexico (II) 4. Korean Experiences

Box 3-1 Reforming Electricity Markets

There is a large body of evidence from elsewhere in the OECD and beyond to support the case for electricity market reform. A well thought-out reform programme can deliver better quality of service for consumers, support economic growth and welfare, strengthen government’s fiscal position, and deliver more affordable and secure access to electricity for all. Reform of energy markets is a process, not an event, and the government needs to articulate a clear programme that takes into account the main drivers for reform alongside milestones and dates. The main elements of an electricity market reform programme should include; greater restructuring of the Korea Electric Power Corporation (KEPCO) and revisiting the design of the wholesale market; and strengthening the independence of the sector regulator to enable fair competition, including the removal of barriers to new entrants and third-party access to network infrastructure, and creating clear roles for publicly owned and private entities. The reform programme should draw upon best practice elsewhere, be free from interference from market participants and short-term political interests, and be fully inclusive, taking into account the needs of potential new entrants and end users throughout Korea. The government should also develop targeted welfare mechanisms to ensure the interests of vulnerable customers are protected.

Source: IEA (2012), Energy policies of IEA countries, Republic of Korea.

4.1. Korea’s Renewable Energy Industry

The growth of renewable energies in Korea is heavily attributed to the government’s policies backed up by legislation and financial support to make renewable energies competitive in the market. With the commencement of Lee Myungbak’s administration in 2008, the renewable energy industry had made remarkable progress under the government’s new national vision of “Low Carbon, Green Growth.” Since 2008, all indicators except investment have shown notable increases.

Table 3-6 Key Indicators of the Renewable Energy Industry 2008 2010 2012 2014 2016 No. of Enterprises 134 209 200 438 405 No. of Employees 6,496 13,149 11,836 15,545 14,412 Investment (KRW billion) 1,901 3,537 1,358 870 688 Annual Turnover (KRW billion) 3,268 7,663 6,467 9,905 10,089 Export (USD billion) 1.71 3.93 2.52 3.06 3.05

Source: MOTIE (2014) and MOTIE & KECO (2017).

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167 The renewable industry growth stagnated or reduced in 2016 as the era of high oil prices over $100 ended and oil prices plummeted to below $60 at the end of 2014.

[Figure 3-17] Crude Oil Price Trend, 2010-2016

(Unit: USD per barrel) 140

120

100

80

60

40

20

0 2010 20112012 2013 2014 2015 2016

Brent West Texas Intermediate

Source: https://www.eia.gov/todayinenergy/detail.php?id=29412.

However, as technology advances and global concerns over sustainable development and climate change have risen, the demand for renewables will continue increasing and the renewable industry will keep growing in coming decades.

4.1.1. Solar and Wind Industry

Solar PV has been rapidly growing since 2012 when RPS started. RPS has been attributed to more than 90% of solar installation in 2012-2015. In the sales of solar products, the domestic market accounts for less than a third of the total annual turnover; this means that the solar industry depends more on export markets than the domestic market.

Table 3-7 Annual Turnover of Solar Products, 2014 (Unit: 100 million KRW) Poly- Parts/ Ingot Wafer Cell Module Equipment Concentrator Total silicon Material Annual turnover 10,976 1,429 3,157 957 36,442 1,921 8,432 45 63,358 Domestic 1,440 72 373 235 9,677 1,536 6,463 45 19,840 Export 9,536 1,356 2,784 722 8,710 385 1,969 0.3 25,462 Plant abroad - - - - 18,056 - - - 18,056 Share (%) 17.3 2.3 5.0 1.5 57.5 3.0 13.3 0.1 100.0

Source: KEMCO (2016).

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2017/18 Knowledge Sharing Program with Mexico (II) Korea has strong competitiveness in the solar PV industry due to its technological advancement even if Chinese manufacturers have the highest share in the global market with their price competitiveness. The industrial paradigm of solar PV is shifting from simple product manufacture to project development including financing. Three keywords for success suggested by the Korea Energy Agency are price competitiveness, diverse business models, and project financing ability. Korean companies are striving to gain a competitive edge in the global market through process improvement for cost reduction, the development of next-generation technology, lowering entry barriers to the financial market, and developing new financial products and standardizing new business models for developing countries.

Unlike solar, Korea’s wind technology lags far behind the world’s best. The international comparison of wind technology done by Korea Institute of Science & Technology Evaluation and Planning (KISTEP) in 2017 claims that Korea’s wind technology is at 72.7% of the world’s best technology, which means that Korea is lagging 5.3 years behind.

With a 37.6% annual growth rate for wind installation since 2003, the installed capacity of wind reached 834 MW in 2015 (Korea Electric Association, 2016). According to “the 7th Electricity Demand & Supply Basic Plan” (MOTIE, 2015), the target capacity for wind in 2029 is 7.5 GW and wind accounts for 28.1% of renewable electricity generation. Meeting this target requires that wind capacity increases by 15.7% each year until 2029, which means that 450 MW of wind turbines should be installed each year.

4.2. Policies and Measures to Promote NRE in Korea

The Korean government started promoting NRE in 1987 when “the Promotional Act of Alternative Energy Development” was legislated. Since then, the Act has been amended eight times and the National Basic Plan for NRE Technology Development and Deployment has been formulated four times.

Among the various policy options to increase the share of new and renewable energies (NRE), feed-in tariff (hereafter, FIT) and the renewable energy portfolio standard (hereafter, RPS) have been most effective and influential options in promoting NRE. Besides them, there have been tax benefits, low-interest loans, direct support, and mandatory use. FIT was introduced in 2002 and then replaced by RPS in 2012. A renewable energy portfolio agreement (RPA) bridged the transition period between FIT and RPS.

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169 4.2.1. Feed-in Tariff (FIT)

FIT is subsidy to fill the gap between the market price and generation costs of NRE sources so that NRE sources with high generation costs can compete against fossil fuels with low generation costs. This was introduced in March 2002 and ended in December 2011 due to the increasing burden on government budgets and the lack of price competition mechanisms among NRE sources and project developers. Even if it had ended in 2011, it would have lasted until 2031 for projects that came into effect in 2011.

Table 3-8 Feed-In Tariff Excluding Solar PVs

(Unit: KRW/kWh) FIT (KRW/kWh) Power Source Facility Size Category Fixed Variable Wind 10 kW or larger - - 107.29 - 1 MW or larger 86.04 SMP+15 Commercial 1 MW or smaller 94.64 SMP+20 Hydro 5 MW or smaller 1 MW or larger 66.18 SMP+5 Others 1 MW or smaller 72.80 SMP+10 Solid Incineration 20 MW or smaller - - SMP+5 Waste RDF 50 MW or smaller - - SMP+15 20 MW or larger 68.07 SMP+5 LFG 50 MW or smaller 20 MW or smaller 74.99 SMP+10 Bio- 150 kW or larger 72.73 SMP+20 Biogas 50 MW or smaller energy 150 kW or smaller 85.71 SMP+25 Ligneous Biomass 50 MW or smaller 68.99 SMP+15 biomass Tidal range: With dike 62.81 - Marine 8.5 m or higher Without dike 76.63 - Tidal Power 50 MW or larger Energy Tidal range: With dike 75.59 - 8.5 m or lower 90.50 - Biogas based 227.49 - Fuel Cells 200 kW or larger Other fuel based 274.06 -

Notes: 1) Fossil fuel content is the share of calories by fossil fuel out of the total calories used for electricity generation. Note 2) In hydro, “commercial” means that hydro power generation is the business’ main purpose and “others” means that the hydro power generation is the business’ secondary purpose. Not 3) Facility size is the sum of the size of facilities run by the same project developers and located within 250 m between project boundaries. Note 4) SMP stands for “System Marginal Price.” Source: MOTIE and KEMCO (2016).

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2017/18 Knowledge Sharing Program with Mexico (II) FIT had been implemented as a main option to expand the share of NRE in the total primary energy supply. It was backed up by laws and administrative guidelines. The Electricity Business Law mandates the purchase of electricity generated by NRE sources at fixed prices. Any electricity generated by NRE sources and connected to the national gird is eligible for purchase by the Korea Electric Power Corporation (KEPCO) at pre-determined fixed prices for 15-20 years.14) The FIT varied by technology and the fixed prices for solar PV were adjusted as the generation cost decreased due to technology development.

Table 3-9 Feed-in Tariff for Solar PVs

(Unit: KRW/kWh) 30 kW or 30-200 Period Duration 0.2-1 MW 1-3 MW >3 MW smaller kW -2008.9.30 15 years 711.25 677.38 15 years 646.96 620.41 590.87 561.33 472.70 2008.10.1-2009.12.31 20 years 589.64 562.84 536.04 509.24 428.83 15 years 566.95 541.42 510.77 485.23 408.62 Open Area 2010.1.1- 20 years 514.34 491.17 463.37 440.20 370.70 12.31 Using 15 years 606.64 579.32 546.52 - - Structure 20 years 550.34 525.55 495.81 - - 15 years 484.52 462.69 436.50 414.68 349.20 Open Area 2011.1.1- 20 years 439.56 419.76 396.00 376.20 316.80 12.31 Using 15 years 532.97 508.96 480.15 - - Structure 20 years 483.52 461.74 435.60 - -

Notes: 1) “Structure” means rooftops and the outer walls of buildings and “Open Area” means all other places except those classified as “Structure.” 2) Solar PVs over 1 MW are taken as Open Area. Source: KDI (2013).

As of Dec. 2015, 2,067 facilities are supported by FIT and the installed capacity is 980 MW. In addition, the cumulative generated electricity under FIT is 18,708 GWh and the total amount of subsidy provided is 2.48921 trillion KRW.15) Even though FIT was terminated at the end of 2011, the expected amount of subsidy for the remaining facilities for the next 15-20 years is over 300 billion KRW per year. The following table shows the electricity generated and the amount of subsidy disbursed each year.

14) Solar PV projects could choose either 15 or 20 years. 15) Approximately $2.27 billion USD.

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171 Table 3-10 Subsidy Disbursed under FIT

(Units: electricity generated, MWh; subsidy, KRW million; installed capacity, kW) Share Share Category 2002-2015 Category 2002-2015 (%) (%) electricity electricity 3,227,242 17.3 53,946 0.3 generated generated subsidy subsidy 38,790 1.6 522 0.0 Hydro disbursed Biogas disbursed no. of facilities 59 2.9 no. of facilities 2 0.1 Installed Installed 81,726 8.3 2,657 0.3 capacity capacity electricity electricity 3,550,706 19.0 99,215 0.5 generated generated subsidy subsidy 20,987 0.8 486 0.0 LFG disbursed Biomass disbursed no. of facilities 10 0.5 no. of facilities 1 0.0 Installed Installed 65,250 6.7 5,500 0.6 capacity capacity electricity electricity 6,070,512 32.4 15,502 0.1 generated generated subsidy subsidy 35,081 1.4 Solid 70 0.0 Wind disbursed disbursed Waste no. of facilities 15 0.7 no. of facilities - - Installed Installed 320,250 32.7 -- capacity capacity electricity electricity 4,594,112 24.6 18,707,923 100.0 generated generated subsidy subsidy Solar 2,238,843 90.2 2,482,064 100.0 disbursed Total disbursed PVs no. of facilities 1,977 95.6 no. of facilities 2,067 100.0 Installed Installed 497,227 50.7 980,110 100.0 capacity capacity electricity 1,096,778 5.9 generated subsidy 147,286 5.9 Fuel disbursed Cells no. of facilities 3 0.1 Installed 7,500 0.8 capacity

Source: KEMCO (2016).

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2017/18 Knowledge Sharing Program with Mexico (II) 4.2.2. Renewable Portfolio Standard (RPS)

In Korea, RPS requires that power companies with > 500MW installed capacity to supply a certain percentage of their electricity from NRE sources. Eighteen power companies were regulated by RPS in 2016; the power companies under the RPS scheme are assigned individual mandatory amounts of power supply from NRE sources and are supposed to submit Renewable Energy Certificates (REC) to the regulatory body. RECs are calculated by multiplying MWh and the weight given to NRE sources.16) The following table shows the predetermined percentage of power supply from NRE sources for each year.

Table 3-11 Percentage of Mandatory Power Supply from NRE Sources

(Unit: %) Year 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023- % 2.0 2.5 3.0 3.0 3.5 4.0 5.0 6.0 7.0 8.0 9.0 10.0

Source: http://www.knrec.or.kr/business/rps_guide.aspx.

Until 2015, solar had a separate target to meet, but solar and non-solar targets were integrated from 2016 onwards. Power companies under the RPS scheme are subsidized as a part of their expenses to meet the RPS targets, and the unmet amount of RPS requirements can differ for up to three years within 20% of the assigned amount.

[Figure 3-18] RPS Process

Power Targets Reporting to Implementation Evaluation Companies Selected Assigned Authority

Installed Capacity Assigned REC Submission Certification In-house or of 500MW or Targets (expenses or Penalty outsourcing Larger Announced refunded) Imposed

NRE Project REC Certification REC Market Developers Body

Source: MOTIE, Korea and KEMCO (2016).

16) REC = MWh x weight on each source of NRE.

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173 The following table shows the weight on different sources of NRE to calculated REC. The weight on different categories has been adjusted to promote small- scale installations and technologies that require higher upfront costs. Among solar installation, it gives favor to small-scale and installations on existing structures and water surfaces. New energy such as fuel cells and ESS and costly installations such as off-shore wind are given higher favor to encourage the use of less land-which is a scarce resource in Korea-and technological development.

Table 3-12 REC Weight on NRE Sources

Energy Sources and Criteria Category REC Weight Installation Type Installed Capacity 1.2 Less than 100 kW 1.0Installed in open area 100 kW or larger 0.7 Over 3,000 kW

Solar PV 1.5 Installed using existing 3,000 kW or smaller 1.0structures Over 3,000 kW 1.5 Installed on water surface 1.0 Power trading through self-generation facility 0.25 IGCC, off-gas 0.5 Solid wastes, land-fill gas Hydro, on-shore wind, bio-energy, RDF, waste-to-gas, 1.0 tidal (with dike), and Power trading through self-generation facility Ligneous biomass, off-shore (connection distance < 5 km), 1.5 water heat Other NREs 2.0 Fuel cells, algae 2.0 Off-share wind (connection Fixed distance over 5 km), 1.0~2.5geothermal, tidal (no dike) Variable 5.5 2015 5.0ESS (connected with wind) 2016 4.5 2017

Source: http://www.knrec.or.kr/business/rps_guide.aspx.

REC can be obtained through the power companies’ own electricity generation from NRE sources or purchased from other NRE power suppliers. Hence, the government does not need to guarantee a fixed price for a fixed period like FIT.

174
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2017/18 Knowledge Sharing Program with Mexico (II) Since the initiation of the RPS in 2012, the supply of RECs has continued increasing: 4,154,000 RECs (64.7%) in 2012; 7,325,000 RECs (67.2%) in 2013; 10,078,000 RECs (78.1%) in 2014; 12,486,000 RECs (90.2%) in 2015. The installed capacity built under the RPS (6,041 MW) for four years (2012-2015) is 6.2 times greater than that built under FIT for 10 years. In addition, the solar power supplier policy17) has encouraged small-scale solar power suppliers to invest in solar PV facilities under the RPS.

4.2.3. Low-interest Loans and Tax Incentive Programs

Long-term, low-interest loans with a five-year grace period and 10-year repayment period are provided for NRE power producers and NRE equipment manufacturers up to 90% of the total costs to promote private investments and the deployment of NRE facilities (both electricity and heat).18) Ancillary objectives include the decrease in fossil fuel dependence and reducing carbon dioxide emissions. This program is supported by the “Promotional Act of NRE Development, Utilization and Deployment” and executive orders. The total amount of loans provided until 2015 is 1.69 trillion KRW, which is approximately $1.5 billion USD. In addition, 6% of the total investment is deducted from income tax or corporate income tax for small companies; this is 3% for intermediate-sized companies and 1% for large companies.

Financial supports for renewable energy, which started in 1983, have been financed by energy special accounts19) and electricity industry funds.20)

4.2.4. Household Subsidy Program

This program was initiated in 2009 under the name “One Million Green Home Project,” which extended the “Hundred Thousand Solar Home Project” that started in 2004. This aimed to promote NRE industry as a new growth engine for economic growth and to properly respond to climate change. “Green Home” refers to a low- energy, eco-friendly house that adopts NRE sources (such as PV, solar heat, and geothermal) and high-efficiency lighting, boiler, and insulation such that it minimizes fossil fuel consumption and GHGs and air pollutant emissions.

The target is to deploy NRE to a million households by 2035, and the program is linked with regional characteristics of solar radiation and wind speed, industrial spill-

17) The power companies under the RPS should purchase the power from solar power suppliers at a fixed price for at least 12 years. 18) 90% of total costs for SMEs, 70% for intermediate-sized companies, and 40% for large companies. 19) Energy special account is financed by charges and fees imposed on crude oil import, petroleum products sales, etc. This amounted KRW 5.76 trillion (approximately $5.3 billion) in 2017. 20) Electricity industry fund is financed by charges added to the electricity bill. It is charged within 6.5% of the electricity bill and currently 3.7%. This amounted KRW 4.2 trillion (approximately $4 billion) in 2016.

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175 over effects, and job creation. The policy target of each phase is as follows: phase 1 (2009-2012), building the foundation of NRE growth; phase 2 (2013-2016), inducing voluntary participation from the private sector; phase 3 (2017-2020), industrializing a new growth engine.

In total, 729.9 billion KRW (approximately $660 million USD) was provided in 2004-2015 for 223,459 households: 186,580 households for solar PV, 24,296 households for solar heat, and 9,634 households for geothermal. This replaced 102,816 TOE of fossil fuels.

4.2.5. NRE Mandatory Use for Public Buildings

Newly constructed public buildings, renovated public buildings, and newly added parts of existing public buildings whose floor size exceeds 1,000m2 should supply more than 18% (as of 2016) of their expected energy consumption from NRE sources. This will demonstrate the active role of the public sector in promoting NRE sources and expanding the NRE market; this program is backed up by law and administrative guidelines. Between 2011 and 2015, 2,765 installation plans were submitted, which account for 13.04% of the expected energy consumption and 210,757 TOE of potential NRE supply.

4.2.6. Regional Deployment Subsidy Program

Another program to promote NRE sources was providing subsidies with local governments that carried out regionally customized NRE projects. This program, which started in 1996, supported both NRE installations and energy savings until 2005. However, the NRE and energy savings were separated in 2005. Depending upon the support ratio by the subsidy and the nature of the projects, subsidies were grouped into two categories: for building the infrastructure and for installing NRE facilities. The subsidy for building the infrastructure is provided up to 100% for the feasibility study, human resources development, and public relations for projects. The subsidy provided for installing NRE facilities is up to 60%.

In 1996-2015, 771.6 billion KRW was provided for regional deployment subsidy program. With this program, 131,228 TOE of energy in total was saved and 383,533

tCO2 total emissions reduction was achieved.

The following table provides a snapshot of various policies and programs for NRE development and deployment.

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2017/18 Knowledge Sharing Program with Mexico (II) [Figure 3-19] Tax Revenue by Tax Types

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 100,000 Solar PVs Million Green Homes Program Green Smart Energy System, Zero Energy House, Wind 2000 (small turbine) Villages

Subsidy to NRE Facilities Gradual Reduction in Subsidy

Loan for NRE Facilities Installation & Investment

Local Autonomy’s Subsidy Program Obligation of Public Building (Construction cost) Obligation of Public Building (Energy Load) Feed-In-Tariff Sunsetting of FIT

RPS RPA

Biofuel Deployment RFS: BD20, BD85 FFVs Deployment Wind 2000 (Deployment of 2,000MW by 2020)

Strengthening of NRE Standardizaion/Certification

Source: KDI (2013).

4.3. Energy Technology Development and Indigenization

4.3.1. Background and Policy Objectives

The development and indigenization of energy technology began in 1988. Nonetheless, it was in the mid-2000s that energy technology became one of the top policy agendas of the government. There were a number of critical events that enhanced the awareness of energy technology development among policy makers. One is the rapid rise in oil price since 2005. As a non-oil producing country, Korea has a bitter memory from previous oil shocks and their adverse impacts on the national economy. The other is the entry into force of the Kyoto Protocol in 2005 and the subsequent evolution of regulation on the emissions of greenhouse gases (GHGs) worldwide.

The rapidly rising oil price and global regulation on GHG emissions concerned the policy makers and caused them react in more active ways than ever before, which created interest in the development of energy technologies to increase

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177 energy efficiency and to reduce the high dependency on imported fossil energies (oil, gas, and coal). Full-fledged efforts began in 2006 when “The 1st National Energy Technology Development Plan (2006-2015)” was adopted by the National Science and Technology Committee. The “Energy Law” mandates that the “Energy Technology Development Plan” is to be formulated every 5 years and should cover a time span greater than 10 years in length. The latest plan is the 3rd plan, which was published in 2014 for the period of 2014-2023.

The primary objective of energy technology policy is to develop energy technologies up to the most advanced level in the world, increasing the competitiveness of energy and related industries and ultimately contributing to economic growth and job creation. Specific objectives and action plans are constantly updated as new plans are formulated.

4.3.2. Investment in Energy R&D

Investment in energy R&D has continuously increased since the 1st and 2nd energy technology development plans and has grown by 10.6% per year since 2006.

Table 3-13 The Annual Government R&D Budget for Energy

(Unit: billion KRW) Year 2006 2007 2008 2009 2010 2011 2012 2013 Annual growth Budget 408.1 464.3 567.3 638.7 702.0 785.9 752.4 825.4 10.6%

Source: Korean government, 2014.

In 2011, Korea’s energy R&D was ranked 8th in the world in terms of the absolute amount and 9th in terms of its GDP share. About 76% of R&D was carried out by firms, including public corporations, and 21% was conducted by research institutes and schools. With this increasing R&D investment, Korea’s technological competitiveness has increased as well, but there is still a gap21) between the world’s best technology and Korea’s technology.

The export of renewable energy grew from $1.7 billion in 2008 to $2.5 billion in 2012. While the global renewable market has been rapidly growing, Korea’s market share is limited. Korea accounted for 2.2% of the global renewable market in 2012 (MOTIE, 2014) while China accounted for 24.5%, the US accounted for 17.8%, and Germany accounted for 12.8%. Future R&D should also consider how to increase the global market share.

21) Korea’s renewable technology reached 86% of the world’s best technology in 2013 (MOTIE, 2014).

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2017/18 Knowledge Sharing Program with Mexico (II) [Figure 3-20] Energy R&D of Selected Countries, 2011

(Unit: % of GDP)

1.4 1.304 1.2

1.0 0.927 0.8 0.715 0.700 0.597 0.589 0.576 0.557 0.6 0.486 0.422 0.4

0.2

0.0 Finland Hungary Japan Denmark Canada Norway Portugal France Korea United States

Source: Korean government (2014).

4.3.3. The 3rd Energy Technology Development Plan

When formulating the 3rd plan, more than 300 experts participated; different views and opinions were collected from industry, academia, government, and civil society. This plan is composed of 17 programs for energy technology development in the energy supply, energy demand management, and energy convergence/ innovation categories, which reflect the policy objectives of the 2nd National Energy Basic Plan and recent changes in the technology paradigm.

Energy supply technologies include: s Development of next generation strategic resources s Highly efficient, clean thermal power generation s Safe nuclear power generation s New and renewable hybrid system s Next generation clean fuels s Next generation transmission/distribution

Energy demand management technologies include: s Smart homes/buildings s Smart factory energy management systems (FEMS) s Smart micro-grid s Energy negawatt system s Demand-responsive ESS (energy storage system) s CCUS (carbon capture, utilization, and storage)

Energy convergence/innovation technologies include: s Future power generation s Wireless power transmission

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179 s Future high-efficiency energy conversion/storage s Cutting-edge manufacturing process technologies based on 3D printing s Energy internet of things (IoT) + big data platform

The policy objectives of the 2nd National Energy Basic Plan with which the 3rd Energy Technology Development Plan is aligned are as follows: s Shifting to demand-side management (13% reduction in energy demand by 2035) s Decentralized power generation system (15% of total power generation) s Harmonization with the environment and safety s Strengthening energy security and the stable supply of energy s Creating a new energy market

The following schematic view shows the main framework of the 3rd energy technology development plan, including visions and goals of becoming the world’s leading country in energy technology. Korea has constantly aimed to become a leading technology country in many areas and energy is not an exception. Energy technologies that are decentralized, clean, efficient, safe, and smart capture Korea’s strategy of combining cleanness and safety of new and renewable energy with smart information and communication technology (ICT).

Ultimately, this energy technology development plan intends to contribute to economic growth and environmental sustainability simultaneously.

The following two tables show Korea’s technology development roadmaps for solar PV and wind. The government selects strategic technologies for solar PV and wind and sets clear numerical targets along the timeline to the furthest extent possible. This is in line with Korea’s long-time economic development strategy, which is “selection and concentration” for the efficient use of limited resources.

180
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2017/18 Knowledge Sharing Program with Mexico (II) [Figure 3-21] Schematic View of the 3rd Energy Technology Development Plan

Vision & Goals

Direction of Technology Development

4 Strategies and 11 Tasks

Building innovation infrastructure for capacity development

Source: Korean government (2014).

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181 Table 3-14 Solar PV Technology Development Roadmap

Strategic Item ~2014 ~2015 ~2016 ~2017 ~2025 ~2035 Efficiency enhancement technology in Crystalline silicon solar cell Crystalline silicon hybrid solar Silicon efficiency of cells in mass production 23%, cell technology solar cell module production cost per unit: $0.6/Wp · efficiency 30%, life expectancy Thin silicon solar cell production technology (panel thickness 100Σ) 30 years Large size CIGS module mass production technology (glass panel) Large-size mass production technology (glass panel) CIGS module efficiency 16%, 5G, production cost per unit: $0.6/Wp · efficiency 20%, production cost per unit: $0.5/Wp thin film Non-vacuum CIGS tech. Flexible CIGS module production technology solar cell · module efficiency 20%, · module efficiency 14%, width 0.6m, production cost per unit: $0.5/Wp production cost per unit: $0.3/Wp BIVP system technology for building exteriors · high insulation 1.0W/m2, high transmissivity 20%, Skin adherence flexible BIPV technology Solar BIPV efficiency (thin film 10%, dye 8%) · durability 20 years PV High insulation & high transmissivity in BIPV window system High performance/high penetration BIPV window tech.

Technology for the core materials/technology in highly efficient, Mass production technology for high efficiency and Dye- improved longevity and large-size modules/Module production improved longevity senstized technology/Quality assessment technology · efficiency 18%, life expectation 30 years, solar cell · Module efficiengy 8.5%, life expectancy 11years, production cost per unit: $0.5/Wp production cost per unit: $0.7/WP Technology for the core materials and elements/High-efficiency and Organic & Next-generation QD solar cell technology, tandem large size modules production technology/Module production Next- solar cell technology equipment/reliability enhancement technology generation · efficiency 15%, life expectancy 5years, · standard single-layer cell efficiency: 105%, prodution cost per unit: $0.3/Wp solar cell efficiency of sub-modules in the solution process: 6.5%

Source: KEMCO (2016).

Table 3-15 Wind Technology Development Roadmap

Strategic Item ~2014 ~2015 ~2016 ~2017 ~2025 ~2035

Small-size Compared with a market leader: capital, O&M cost 95%, and AEP 100% (under 100kW) system High RPM with noise mitigation, urban small-size wind power development system development and demonstration

Medium and large System competitiveness size (100kW~5MW) High efficiency, low wind speed (2MW level) wind enhancement and system system development power system development/demonstration dissemination

Extra-large size Construction of the (5~8MW) 5~8MW system development/demonstraion demonstration and system development dissemination complex Wind Power Development Super-conduct wind Design and manufacturing technology development of 5MW and Improvement power generator super-conduct power generators demonstration (over 8MW) of system

Developing control technology for the floating wind power generators

Floating offshore Floating water tank model Demonstration and wind power · 25% of total project budget commercialization

Bases of floating methods, mooring device design, manufacturing and construction technology

Source: KEMCO (2016).

4.3.4. Institutional Arrangements

For long-term consistency and budget support, the promotion of new and renewable energies is supported by various laws and plans, such as the Energy Law, Energy Use Rationalization Law, Electricity Business Law, Atomic Energy Law, New and Renewable Energy Basic Plan, Energy Basic Plan, and the Korea Institute of Energy and Resources Research Law. In particular, the Energy Law mandates that the government formulate a long-term energy technology development plan every 5 year and implement it.

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2017/18 Knowledge Sharing Program with Mexico (II) Multiple government agencies and organizations participate in policy formulation and implementation. Energy technology development responsibilities are shared between the Ministry of Trade, Industry, and Energy (MOTIE) and the Ministry of Science and ICT (MOSI). While MOTIE focuses on technologies close to commercialization and industrialization, MOSI does basic R&D and explores future technologies. Many public research institutes, private companies, and academics participate in policy formulation and technology R&D according to their own roles and responsibilities. Notably, Korea Energy Technology Evaluation and Planning Institute (KETEP) was established in 2007. Its mission is to develop a long-term energy technology development roadmap and to manage the government-funded energy R&D projects through fund allocation, project evaluation, and coordination under the oversight of MOTIE.

4.4. New and Renewable Energy Development and Deployment

4.4.1. Background

Since the oil shocks in the 1970s, energy security has long been a primary energy issue in the Republic of Korea due to its very limited hydrocarbon reserves and rapidly increasing demand for energy alongside economic growth. The share of the manufacturing sector, which consumes more energy than the service sector and the agro-fishery industry is far greater in the Korean economy than in other developed countries with a strong manufacturing sector, such as Germany and Japan.22)

An additional issue that has intruded into the national agenda in recent years is climate change, which requires a drastic decrease in the consumption of hydrocarbon- based energies to reduce carbon dioxide emissions. New and Renewable Energy (NRE) is considered a key tool for solving the abovementioned issues at the same time, not only in Korea, but also for most countries regardless of whether they are developing or already developed.

In order to effectively develop and deploy renewable energies and strengthen related industries, the Korean government has been designing various policies and programs. The production of NRE increased from 6,856,000 ToE to 11,537,000 ToE between 2010 and 2014 and electricity generation via NRE increased from 5,890 GWh to 26,882 GWh over the same period (KECO, 2016).

22) It is 28.8% for Korea, 22.6% for Germany, and 19.0% for Japan in 2014. That of US, Canada, UK, and France is below 15%. The share of manufacturing sector in the global GDP had decreased from 25.7% to 16.5% while that in Korea had increased from 17.5% to 28.8 (KDI, 2017 and Hyundai Research Institute, 2016). Furthermore, the share of energy-intensive industries (such as petro-chemical, automobile, shipbuilding, and iron & steel) in manufacturing sector is significant in Korea compared with other OECD peers.

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183 Table 3-16 Evolution of New and Renewable Policies

Year Legislation Notes Promulgation of the Promotional Act of 1987 Legal basis of NRE R&D activities Alternative Energy Development Promotional Act of Alternative Energy Amendment for legal basis for 1997 Development, Utilization and Deployment (1st NRE dissemination Amendment) National Basic plan to Develop and 2001 Target: 2%(2003) Deployment of Alternative Energy Promotional Act of NRE Development, Obligation on public bldgs. 2002/3 Utilization and Deployment (2nd/3rd (const. cost), Certification, FIT Amendment) The 2nd National Basic Plan for Alternative 10 year plan, target: 3% (2006), 2003 Energy Technology Development and 5% (2011) Deployment Promotional Act of NRE Development, Including standardization, 2004 Utilization and Deployment (4th Amendment) RESCOs, etc. The 3rd National Basic Plan for NRE Target: 2020 (mid), 2030 (long), 2008 Technology Development and Deployment NRE industry promotion Promotional Act of NRE Development, RPS: 2012 (2%) Ņ 2022 (10%) 2009/10 Utilization and Deployment (5th Amendment) Obligation on public bldgs. (load) Promotional Act of NRE Development, 2013 RFS (implementation in 2015) Utilization and Deployment (6th Amendment) Establishment of Nat’l Basic Plan Promotional Act of NRE Development, 2014. 1. for NRE every five years (planning Utilization and Deployment (7th Amendment) cycle) The 4th National Basic Plan for NRE 2014-2035 plan, target: 11% 2014. 9. Technology Development and Deployment (2035) Promotional Act of NRE Development, 2015 KS certificate system Utilization and Deployment (8th Amendment)

Source: KDI (2013), updated by the author.

4.4.2. The NRE Basic Plan

The Korean government updates the “NRE Basic Plan” every five years based on the “Act for Promoting NRE Development, Utilization, and Deployment.” The 4th basic plan was published in 2014 for the 2014-2035 period.

The achievements of the NRE sector between 2008-201223) were remarkable. The annual growth rate of NRE was 10.9% while the annual growth rate of the primary

23) This 5 year period was the president Myung-bak Lee’s administration, which set “Low Carbon, Green Growth” as the long-term national vision of Korea and aggressively supported the NRE industry.

184
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2017/18 Knowledge Sharing Program with Mexico (II) energy supply was 3.7%. The NRE accounted for 3.18% of the primary energy supply in 2012. In terms of electricity generation, the annual growth rate of electricity generation by NRE was 46.6% while that of total electricity generation was 6.0%. The NRE accounted for 3.66% of total electricity generation in 2012.

The rapid increase in the share of NRE in the primary energy supply and electricity generation benefited from NRE promotion policies such as Feed-in-Tariff (FIT) and Renewable Portfolio Standard (RPS). In particular, RPS resulted in the expansion of the built-in capacity by 1,743 MW in two years (2012-2013), which is 1.7 times higher than FIT’s expanded capacity over eleven years (2001-2011) of 1,031 MW.

Between 2007 and 2012, the NRE industry showed a remarkable growth in volume. The number of enterprises was doubled, and the number of employees and exports each increased by 3.4 times. The growth of the NRE industry was led by solar and wind power, which had a big spill-over effect. The combined share of solar and wind power in investments, turnovers, and exports accounted for 91%, 85%, and 97%, respectively. The table shows key indicators of the NRE industry.

In 2012, the NRE industry shrank due to its global restructuring as a result of oversupply and the economic recession.

According to the Delphi survey24) conducted by the Korea Energy Economics Institute in 2013, Korea’s NRE technologies have reached 86% of the world best technologies (MOTIE, 2014) and are now 5% ahead of China’s.

Box 3-2 The Visions and Goals of the 4th Basic Plan

Ȍ 11.0% of the primary energy supply by the NRE in 20351) (2020) 5.0% → (2025) 7.7% → (2030) 9.7% → (2035) 11% s Make solar and wind the core RE sources; decrease the share of wastes and increase that of solar and wind.

Ȍ Striving to nurture the ecosystem of the NRE industry to shift it from being “Government- led” to a “Private–Public Partnership” s Designing a market-friendly system, proposing lucrative business models, deregulation, and promoting private investments through developing new models suitable for NRE deployment. Ȍ Building capacity for sustained growth through exports s Going beyond the domestic market and developing international markets

Note: 1) The 11% in 2035 is revised as 20% in 2030 by the new government in 2017. Subsequent revisions are in progress. Source: MOTIE (2014).

24) About 500 experts participated in the survey.

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185 The following are the detailed action plans listed in the 4th basic plan.

A. Consumer-oriented deployment and expansion policies s Promoting consumer participation: developing consumer participation business models through benefit-sharing with local residents - (Benefit-sharing) Benefit-sharing business models for projects with a high risk of protest from residents : Giving extra credits to RE power plants in which the local community participates : Favorable terms for the loans for RE projects - (Eco-friendly energy town) Applying the best available technologies to environmental facilities such as incinerators and landfill sites and providing benefits to the local residents : Making RE projects resident-led (subsidy/loans + investments by the residents) and cooperatives - (Rental business) Private entities run the business, from construction to maintenance, and the consumers pay rental fees. - (Consumer protection) Strengthening the maintenance of RE projects and providing consumers with useful information : Building business-led A/S systems : Providing consumers with information on participating firms : Providing consumers with localized and sector-wise statistics - (Supporting strategic areas) Providing intensive support for areas with big spill-over effects : Constructing a mini-grid in off-grid remote islands with a high dependency on fossil fuels

B. Market-friendly system s Adjusting RE targets and integrating markets - Diversifying options for RE suppliers by integrating solar and non-solar markets : Until 2015, at least 1.5 GW should be supplied by solar s Expanding the deferral period for RE supply from one year to three years s Enhancing rationality for REC weight to increase investments in NRE - Solar: more favor given to small scale and installations in buildings and surface water because of their lower environmental impacts - Non-solar: more favor given to off-shore wind, tidal, and geothermal to ease their upfront high cost burden - Promoting the Renewable Energy Certificate (REC) trade in the market s Support the sales of small enterprises - Long-term power purchase agreements - Quota for small enterprises of below 100 kW installed capacity

186
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2017/18 Knowledge Sharing Program with Mexico (II) s Change programs from individual household/building-based to community- based and subsidy-based to after-production rebate-based s Flexible loan programs that take market situations into account s Increase the NRE share of public buildings from 20% to 30% by 2020

C. Promoting exports of NRE s Increase financial support to small and medium sized enterprises (SMEs) aiming at developing international markets through guarantees and insurance s Providing NRE enterprises with information on NRE products, international buyers, tenders, country-wise NRE status, etc. s Providing experts consultation for entry of NRE enterprises into international markets s Government-level bilateral cooperation and cooperation with international organizations. s Setting strategies tailored to regions and countries s Reviewing potential projects with North Korea

D. Creating new NRE markets s Developing new energy sources - Geothermal, ocean currents, solar heat, etc. - Promoting installation of Energy Storage System (ESS) with RE facilities - Recovery of wasted heat from thermal power plants: supplying heat to greenhouse, cattle farms, etc. to reduce the energy costs of farmers s Renewable Fuel Standard (RFS): bio-energy for transport - RHS in place - Start with bio-diesel and add bio-ethanol and biogas afterwards - Issuing RECs for bio-diesel above the required level s Renewable Heat Obligation (RHO) - Certain proportion of heat energy for buildings should come from NRE sources - Apply to large-scale newly constructed buildings (excluding residential and public buildings) s Integrating RPS, RFS, and RHO in the long-term to increase flexibility and meet commitments

E. Building capacity for NRE R&D s Investing in R&D for practical technologies with a short lead time - Reduction in generation costs: solar, wind, and fuel cells - Support commercialization: establishing a life cycle support system from R&D to commercialization - Support entry into international markets right before commercialization

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187 - Linking R&D and deployment to create a virtuous cycle: deployment Ņ cost reduction Ņ wider deployment Ņ further cost reduction s Selecting and developing future technologies and hybrid system - Future technologies: core cutting-edge technologies such as solar, fuel cells, bio, floating off-shore wind - Hybrid system: integration of NRE power generation technologies with ESS s Education and training - Government certified diploma - Linking the field and academia - Training academy

F. Building infrastructure for systematic support s Pre-emption of global standard - Introducing international standards (IEC/ISO) into Korean Standard (KS) to internationalize KS - KS certificates for individual NRE facilities s Integrating certification of the NRE equipment with KS - KS covers the NRE certification - Nominate KS certification entities for NRE - Bilateral certification between countries to ease exports s Building test beds for SMEs - Phase I: regional test beds for PV, wind, and fuel cells - Phase II: integrated cluster for industry, academia, and research institutes s Deregulation: rationalize facility-related regulation and streamline executive guidelines - Scrapping RE specialized enterprise system - Scrapping building RE certificate system - Scrapping part-sharing system - Streamlining six guidelines under the NRE laws s Active public relations for the public to feel environmental benefits and the increase in energy self-sufficiency rate

5. Policy Suggestions

Mexico and Korea can be compared to each other in regards to their potential and the prospects of their renewable energies. Firstly, Mexico has abundant solar radiation and wind reserves, while Korea has limited reserves. Mexico’s big advantage is that it covers a large territory with vast areas of unused land. Solar and wind requires a lot more land than fossil energies to supply the same amount of electricity. However, land itself is a scarce resource in Korea. Secondly, Korea has a strong and advanced industrial base. In 2015, Korea was the world’s 6th biggest export country,

188
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2017/18 Knowledge Sharing Program with Mexico (II) selling $526.9 billion in the global market, primarily industrial products. Mexico also has a fair-sized industrial base to support the development of its renewable industries. Thirdly, Mexico has a sizable domestic market for renewable industries, with a population greater than 120 million and 1.9 million km2 of land, whereas Korea has a small domestic market with a population of 50 million and 0.1 million km2 of land. As such, Mexico’s renewable energy target is much more ambitious than Korea’s. Finally, the governments of Mexico and Korea have strongly committed to the promotion of renewable energies and industry. Therefore, Mexico and Korea could become good partners that complement each other’s weaknesses.

Table 3-17 Comparison of Renewables Potential between Mexico and Korea

Mexico Korea Resource reserves Excellent Poor to fair Industrial base Fair Good to excellent Domestic market Sizable Small Access to neighboring markets Relatively easy Difficult Government’s will Strong Strong

Multiple studies say that renewable industry is more effective than fossil energy industry in creating jobs.25) Among them, one study (GGGI and UNIDO, 2015) relates a very encouraging story about investment and job creation. When the same amount of money is invested in both clean energy industry (energy efficiency and renewable energy) and the fossil energy industry, the investment in clean energy industry creates more jobs than it does in the fossil energy industry. The input-output model was used to determine the job creation effect by investment in five different countries: Brazil, Germany, Indonesia, Korea, and South Africa. Per USD 1 million of investment, 16.2 more jobs are created in the clean energy industry than in the fossil energy industry in Brazil, 1.9 in Germany, 81.3 in Indonesia, 1.5 in Korea, and 33.1 in South Africa. Even if we cannot say so with 100% certainty, the same job creation effect would likely take place in Mexico like these five countries. This means that the development and deployment of renewable industry would contribute not only to sustainable development and energy security, but also to job creation, which is a primary policy agenda of every country in the world.

For the development and deployment of renewable energies,26) various policy

25) There are other studies that show an opposite result, depending upon assumptions, data, and models. 26) To promote the deployment of renewable energies and development of renewable industries, a considerate, step-wise approach would be effective: agenda setting → status analysis → policy design → implementation → monitoring → feedback → improvement.

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189 options are being implemented in many countries depending upon their socio- economic and industrial contexts. With its abundant renewable resources, Mexico is in a very good position to develop and deploy renewable energies. What is needed is a careful design and adoption of renewable policies. In the policy formulation and implementation process, inter-ministerial coordination and cooperation is also necessary because policy options frequently involve multiple government agencies and ministries. For instance, in order to design and implement tax incentives, cooperation with the Ministry of Finance is indispensable. Considering the overall energy balance and mix, the Ministry of Energy should be involved.

There are two broad categories of policy options, regulatory and financial, though a policy sometimes has both aspects. Traditionally, governments prefer regulatory policies because they do not require a high financial burden, are relatively easy to design and implement, and give more discretion and control to the government. However, financial policies that give participants economic incentives are widely and increasingly being adopted.

5.1. Regulatory Policies

Among others, the two main regulatory policies that Korea has been using are RPS and the mandatory use of renewables in public buildings. RPS is a widely used regulatory policy that requires electricity companies to supply a specific share of electricity from renewable sources. Mexico is already implementing this in the name of the clean energy certificate (CEL: Certificado de Energia Limpia). Mexico’s CEL, which is crucial to its renewable energy strategy, requires electricity suppliers and large consumers to increase their share of clean energy in total electricity supply/ consumption from 7.4% in 2020 to 10.9% in 2021 and 13.9% in 2022. The sale of the first CELs took place in March 2016, but the trade of CELs will begin in 2018.

Mexico’s CEL is more inclusive than Korea’s RPS in the sense that CEL allows electricity from nuclear and efficient cogeneration while Korea’s RPS does not.27) The long-term success of CEL depends on whether its initial operation is smooth and the participants can meet their own needs. When the CEL market begins operating in 2018, what needs to be improved and added will become clearer.

The mandatory use of renewables in public buildings is an easy way for the government to promote renewable energies. Between this policy’s inception in 2004 and 2011, KRW 83 billion (5.92% of construction costs) was spent on meeting this requirement. Between 2011 and 2015, 13.04% of newly expected energy consumption in new public buildings and newly built parts of existing

27) On the other hand, Korea’s new and renewable energy includes hydrogen and fuel cells, which are still in the development stage.

190
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2017/18 Knowledge Sharing Program with Mexico (II) public buildings was supplied by renewables, which amounted to 210,757 toe. The mandatory use of renewable energy in public buildings is one policy option that the Mexican government should consider. Though the additional cost may pose a problem, Mexico would be able to implement it with less cost than Korea because Mexico contains ample renewable resources and renewable costs keep decreasing.

5.2. Financial Policies

Together with RPS, FIT is a widely used renewable policy. Though it was effective at the initial stage of promoting renewables, its increasing financial burden was the main reason for Korea to replace it with RPS after 10 years of implementation. The implementation of FIT without competitive renewable industries will help foreign companies increase their shares in the renewable market. Therefore, depending upon the policy priority, FIT should be carefully considered and designed, as should its terminal date.

Tax incentives, low-interest loans, and various types of subsidies are utilized to promote renewable energies. In particular, tax incentives and low-interest loans are used to attract private firms in the commercialization and scaling-up of renewable technologies and industry. These policies should be coordinated with industrial policies to take into account the competitiveness of the domestic renewable industry. In that sense, renewable technology development plans and policies should be formulated and implemented along with renewable promotion policies, and the domestic renewable industry should grow with it. Otherwise, the incentives and opportunities given by renewable energy promotion policies would be harnessed by foreign companies and the Mexican economy will not benefit accordingly.

In order to design and implement these financial policies, a financing source should be determined in advance. In the case of Korea, the energy special account and electricity industry fund have been financing financial support and promotion of new and renewable energy. The energy special account has been financed by charging crude oil imports, petroleum product sales, and other related enterprise, and the electricity industry fund is financed by additional charges to the electricity bills of consumers.

5.3. Additional Remarks

Apart from the two aforementioned policy groups, a few suggestions are hereby added. Policies and technology development should go together hand-in- hand. Without technology development to make sure that policies are properly implemented, these policies will open Mexico’s renewable energy market to foreign companies. Domestic companies will not receive much benefit.

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191 In the case of electricity from renewable sources, the system stability of the grid is crucial to increasing the share of electricity from renewable sources and maintaining the quality of electricity. Since renewable electricity, particularly solar and wind, is highly weather-dependent, reducing the volatility of the renewable power supply should be taken into account from the initial planning stage. The development and promotion of the secondary battery industry should be seriously considered along with the development of the renewable energy industry, especially since the secondary battery industry has a rapidly growing global market.

All policies should be supported by legislation, institutions, and the budget. Otherwise, these policies cannot achieve their objectives. Therefore, decision makers should create concrete budget plans and set budget items to finance the intended policies.

The renewable industry is not a marginal player anymore since technology has advanced and environmental concerns have arisen. Given its enormous renewable potential, Mexico is in a good position to become a leader in the global renewable energy market. However, this will not happen by itself. With well-planned and thoughtful policies and support from the government, the private sector should play its own role. Active participation of the private sector is key to the long-term success of policies to promote renewable energy and industry. The private sector is a real innovator and investor. The role of the government is to provide proper rules, regulations, and initial support so that the private sector has a level playing field. How the private sector should be incentivized to participate and invest in the market should also be carefully devised along with policy options.

International organizations such as IEA (2017a) and IRENA (2015a) provide policy suggestions that the Mexican government must consider. Those policy suggestions are attached in the Appendix at the end of this chapter.

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Bloomberg New Energy Finance. (2016), “Mexico’s 2016 Official Power Sector Forecast.” Boo, Kyung-Jin; Ryu, Ji-Chul; Kim, Ho-Chul; Park, Jimin. (2013), “Energy Policies”. Knowledge Sharing Program: KSP Modularization, The Korea Development Institute. Henbest, Seb. (2015), “New Energy Outlook 2015.” Bloomberg New Energy Finance. Henbest, Seb. (2017), “New Energy Outlook 2017.” Bloomberg New Energy Finance. Hyundai Research Institute. (2016), “The changes in the industrial structure of G7 countries and Korea and its implications.” IEA. (2012), “Energy policies of IEA countries, Republic of Korea 2012.” International Energy Agency Publication. IEA. (2015), “Medium-Term Renewable Energy Market Report 2015.” International Energy Agency Publication. IEA. (2017a), “Energy policies beyond IEA countries, Mexico 2017.” International Energy Agency Publication. IEA. (2017b), “Energy Technology Perspectives 2017.” International Energy Agency Publication. IPCC. (2007), “Climate Change 2007: Synthesis Report. Contribution of Working Groups I, II and III to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change.” IPCC, Geneva, Switzerland, 104 pp. IPCC. (2014), “Climate Change 2014: Synthesis Report. Contribution of Working Groups I, II and III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change.” IPCC, Geneva, Switzerland, 151 pp. IRENA. (2015a), “Renewable Energy Prospects: Mexico.” Remap 2030: A Renewable Energy Roadmap. International Renewable Energy Agency. IRENA. (2015b), “Renewable Power Generation Costs in 2014.” International Renewable Energy Agency. KDI. (2017), “Major Indicators of the Korean Economy.” Korea Development Institute. KEMCO. (2016), “2016 New & Renewable Energy White Paper.” Korea Energy Management Corporation. KEEI. (2016), “World Energy Market Insight”, No. 16-38. Korea Energy Economics Institute. KISTEP. (2017), “Evaluation of Technologies 2016.” Korea Institute of S&T Evaluation and Planning. KEA. (2016), “Electricity Almanac 2016.” Korea Electric Association. Korean government. (2014), “The 3rd energy technology development plan.”

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193 KPMG. (2016), “Global Trends in Renewable Energy.” MaRS Advanced Energy Center. (2016), “Market Information Report: Mexico.” MaRS Market Insights: Going Global Series. MOTIE. (2014), “The Fourth NRE Basic Plan.” Ministry of Trade, Industry, and Energy, Korea. MOTIE. (2015), “The 7th Electricity Demand & Supply Basic Plan.” Ministry of Trade, Industry, and Energy, Korea. MOTIE and KEMCO. (2016), “2016 New and Renewable Energy White Book.” Ministry of Trade, Industry, and Energy and Korea Energy Management Corporation. MOTIE and KECO. (2017), “New & Renewable Energy Industry Statistics 2016.” Ministry of Trade, Industry, and Energy and Korea Energy Agency. Stern, Nicholas. (2006), “The Economics of Climate Change”, Cambridge University Press. REN21. (2017),” Renewable 2017 Global Status Report.” Paris: REN21 Secretariat. Robles, Alejandro Chanona. (2016), “Tracking the Progress of Mexico’s Power Sector Reform”, Wilson Center. Retrieved from https://www.wilsoncenter.org/sites/default/ files/tracking_progress_of_mexicos_power_sector_reform.pdf SENER. (2015), “Renewable Energies Outlook 2015-2029.” SENER. (2016), “Renewable Energies Outlook 2016-2030.” UNEP and Bloomberg New Energy Finance. (2016), “Global Trends in Renewable Energy Investment 2016.” UNIDO and GGGI. (2015), “Global Green Growth: Clean Energy Industrial Investments and Expanding Job Opportunities.” United Nations Industrial Development Organization and Global Green Growth Institute. Vietor, Richard H. K., and Sheldhal-Thomason, Haviland (2017), “Mexico’s Energy Reform,” Harvard Business School Case 717-027. Weiss, John. (2009), “The Economics of Climate Change in Southeast Asia: A Regional Review.” Asian Development Bank. Retrieved from http://hdl.handle.net/11540/179. License: CC BY 3.0 IGO.

Internet sites IHME, http://www.healthdata.org/infographic/global-burden-air-pollution, accessed on Feb. 27 2018 KECO, http://www.knrec.or.kr/business/rps_guide.aspx, New and Renewable Energy Center, Korea Energy Agency, accessed on Jan. 3 2018.

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2017/18 Knowledge Sharing Program with Mexico (II) MOFA, Latin America Resource·Infra Cooperation Center, Korean Ministry of Foreign Affairs, http://energia.mofa.go.kr/?4bm73o3w2eHaviUk7d6NyvLvf1uGiiBLTWmip9rIAN%2F%2Bp5 ngyv81YsZvo9j4jCG2QwsDPk6M8LO%2BEPy9a4W7JfVbli%2FP3gHONIjRYjKDVv8%3D, accessed on Jan. 8 2018. PRO MEXICO, http://mim.promexico.gob.mx/swb/mim/Perfil_del_sector_erenovables, accessed on Jan. 10 2018. Rocky Mountain Institute, http://www.10xe.orwww.10xe.org/RFGraph-technology_capital_cost_projections, accessed on Jan. 18 2018. U.S. Energy Information Administration, https://www.eia.gov/todayinenergy/detail. php?id=29412, accessed on Feb. 27 2018

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195 Appendix

Recommendations by IEA (2017a) and IRENA (2015a) for Mexico to Develop and Disseminate Renewable Energies 1. IEA (2017): Energy Policies Beyond IEA Countries, Mexico 2017

s Ensure the liquidity of clean energy certificates markets and minimize the risk that the target for clean energy generation is missed because of potentially large increases in the volume of the certificates required. s Consider defining more stringent minimum requirements, including those related to permits, for pre-qualification for future long-term auctions, making use of lessons learnt from the first long-term auctions. s Explore the cost-effective potential for increasing the use of renewable energy in the heating and cooling sector, in order to reduce the use of fossil fuels and thus help limit emissions and increase energy security. s Develop a long-term strategy and a roadmap for alternative fuels in the transport sector, including increased use of renewable energy and electrification, and assessing the role the transport sector should play in achieving Mexico’s overall energy and climate objectives.

2. IRENA(2015a): REmap 2030, Renewable Energy Prospects: Mexico

Ȍ Establishing transition pathways for renewable energy

s Develop an adequate, ambitious, and timely electricity transmission plan that guarantees potential renewable power deployment. s Reinforce the recently enacted Geothermal Energy Law with appropriate requirements for sustainable long-term geothermal resource exploitation, incorporating the vast experience developed in geothermal exploitation by the CFE. s Incentivize industry development to improve local expertise and increase the national supply of renewable energy technology components and equipment. s Expand the current short-term modern cook stove programme to a long-term strategy to accelerate the full replacement of traditional biomass, with an emphasis on financing schemes for low-income users. s Set more ambitious liquid biofuels targets and create programs to create a business case for EVs. s Set up a supportive policy, planning, and regulatory framework to foster significant

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2017/18 Knowledge Sharing Program with Mexico (II) and affordable biomass supply for industrial combined heat and power (CHP) and solar water-heating. s Foster and extend policies that ensure the sustainable development and use of biomass resources. s Integrate green energy policies in regulations for new buildings construction to facilitate the extended adoption of PV and solar water-heating in this sector.

Ȍ Creating an enabling business environment

s Through effective economic, financial, and/or fiscal incentives, establish a market where renewables are cost-competitive to realize the medium- and long-term renewable energy objectives (i.e. clean energy targets to 2018, 2024 etc.) s Ensure that the recently created the clean energy certificate (CEC) scheme is fully operational and effective to achieve the targets set. s Design power exchange rules that support the efficient participation of renewable energy generators and ensure grid access for all technologies. s Draw up adequate rules for grid connection, access, and cost-sharing to guarantee renewable power development. s Ensure that clear and publicly available information on administrative procedures for renewable energy development is effectively communicated across the whole stakeholder spectrum.

Ȍ Ensuring smooth integration of renewables into the system

s Build grid infrastructure that can accommodate variable renewable energy shares up to 26%, and secure the necessary financing for this task. s Set clear rules for power system operation, including grid codes, rules for dispatch and curtailment, ancillary services, etc., that foster better renewables deployment and dispatch. s Adjust power system operational practices to give greater flexibility, implementing accurate renewable generation forecast systems, shorter gate closure timeframes, larger balancing areas, and sub-hourly updates of dispatch schedules. s Ensure the isolated Baja California and Baja California Sur power systems are connected to the national grid to make their solar and wind potential fully available. s Strengthen decentralized power generation through appropriate legislative frameworks. These need to allow diverse ownership structures and self-supplier involvement, simplified administrative procedures, net-metering/billing schemes, and advanced metering infrastructure. s Draw up legislation and power market rules that allow new players to participate in the energy service market, permitting aggregation of generation, demand-side, and

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197 storage. s Develop a working biomass feedstock market to ensure sustainable and affordable supply by considering the nexus between sectors that (jointly) produce, transport, and use these feedstocks. Develop the infrastructure to utilize the major biogas potential to its full extent locally.

Ȍ Creating and managing knowledge

s Improve awareness of potential renewable energy use and energy efficiency in buildings among manufacturers, users, and project developers/installers. s Develop a network that integrates capacity-building skills and human resources, linking and expanding the science/technology/business axis. s Develop power system models incorporating higher shares of variable renewable energy in power generation, transmission, and system operation. This yields an understanding of the optimal solutions for ensuring security of power generation supply in the long and short term. s Critically assess the socio-economic and environmental impacts of renewable energy projects, and communicate this clearly to all stakeholders. s Embed technology standards, certification, and control for component and equipment supply and installation. s Improve the assessment of renewable energy potential presented in INERE28) to ensure the best data available by accounting for technical, economic, and sustainability constraints.

Ȍ Unleashing innovation

s Improve government support for innovation, research, and development to cut renewable energy costs and improve technical efficiencies. s Provide incentives for research and development in renewables and extend the Energy Sustainability Fund (Fondo Sectorial en Sustentabilidad Energética, FSE) to exploit capacity-building and innovation in renewable energy s Continue consolidating partnerships for innovation in wind, solar, and geothermal. s Promote the activities of the various Mexican Energy Innovation Centers. These investigate scientific and technological solutions for administrative, logistical, and economic problems affecting sustainable energy expansion in Mexico. s Develop technologies to increase sustainable energy crops and forest wood supply. s Improve energy efficiency and the electrification of end-use sectors to reduce dependency on biomass.

28) National Renewable Energy Inventory (Inventario Nacional de Energías Renovables).

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2017/18 Knowledge Sharing Program with Mexico (II) .go.kr ksp www.

Ministry of Economy and Finance Government Complex-Sejong, 477, Galmae-ro, Sejong Special Self-Governing City 30109, Korea Tel. 82-44-215-7741 www.moef.go.kr Korea Development Institute 263 Namsejong-ro, Sejong Special Self-Governing City 30149, Korea Tel. 82-44-550-4114 www.kdi.re.kr

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Center for International Development, KDI ISBN 979-11-5932-316-4 ISBN 979-11-5932-302-7(set) cid.kdi.re.kr