**Designing Natural Gas Distribution Concessions in a Megacity: Tradeoffs between Scale Economies and Information Disclosure in Mexico City***

# **Introduction**

In 1995 the Mexican government initiated structural reform of the natural gas sector— reform that permitted private investment in transportation, storage, distribution, trade and marketing while maintaining a State monopoly in production. It prepared a detailed regulatory framework to implement the sector liberalization, including an element to develop distribution systems through concessions in specific geographic areas (Rosellón and Halpern 2000). The concessions are bid and the winner is permitted physical exclusivity for 12 years in gas distribution but not in gas marketing.<sup>1</sup> In each concession award process a distribution geographical area is defined and minimum consumer coverage targets are established. Bidders present technical and financial proposals, including a market demand study. The winning proposal must be technically sound and offer the lowest average revenue for the first five-year period.<sup>2</sup> Densely populated geographic areas pose a problem for exclusivity in distribution. If the concession is granted to a single firm, scale economies might be very attractive, but regulating a “mega-monopoly” would be difficult. If the distribution area is subdivided, economies of scale decrease while information for comparative regulation increases. These and such elements as technical characteristics of the geographic area and potential for competition in related services were considered when designing natural gas distribution franchises for the Mexico City Metropolitan Area (ZMCM).

Unit cost is the main variable related to scale of operation. Since natural gas distribution has natural monopoly characteristics, unit costs should fall as distribution franchise zones get bigger. An assessment was made as to how the partition of the ZMCM would affect the amount of information available to the regulator, the nature and magnitude of financial risk borne by the distributor, the scope for promoting competition in activities related to natural gas distribution, and the pace of build-out of the network. As the number of distribution franchise zones increases, so will competition and the speed of developing distribution systems—along with risk and uncertainty. Another element considered in the partition decision was the configuration of existing distribution infrastructure in the ZMCM and the areas with technical risk.

> *    Several sections of this paper draw on and update the analysis contained in Juan Rosellon, editor, _División Óptima de la Zona Metropolitana de la Ciudad de México para Fines de Dristribución de Gas Natural,_ Documento de Trabajo 121, CIDE, México.

> 1 The Energy Regulatory Commission regulates distribution tariffs through average revenue yield price caps. In general, gas marketing inside the distribution area is not regulated because this activity is contestable. The distributor’s marketing subsidiary competes with other marketeers. When there is not enough competition either from marketeers or substitute fuels, the final price to the distributor’s captive gas buyers is regulated through an acquisition price methodology. See Rosellón (1998 a).

> 2 Distributors that had a distribution concession prior to April 1995 are also incorporated to the permit regime.

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