MEXICO CITY, Aug 6 (Reuters) - Oil politics will dominate Mexico’s energy reform debate, set to kick off in earnest this week, but the government is also poised to propose an electricity overhaul that could dramatically reduce costs for businesses.

If Mexico’s existing state-run electricity monopoly is dismantled and market forces spark more competition and private power generation, experts say electricity rates could drop by as much as half.

A senior lawmaker close to the reform negotiations from the ruling Institutional Revolutionary Party, or PRI, says the government’s proposal will overhaul the electricity sector. It will likely include constitutional changes to allow an expansion of private sector investment in generation.

However, transmission and distribution will remain under government control and will not be open to private competition.

“It will build a secondary electricity market where, without losing state control over transmission and distribution, there are clear rules so it is more efficient,” the lawmaker said, insisting on anonymity to avoid undermining President Enrique Pena Nieto’s formal presentation of the bill, due on Wednesday.

“The idea here is you can generate (electricity) regulated by the state ... and sell it more efficiently.”

The lawmaker added that additional laws will be changed so that electricity subsidies will be “migrated from general subsidies to targeted subsidies” to help the truly needy.

Last week, the opposition conservative National Action Party, or PAN, unveiled its proposal, which includes constitutional changes to allow a total opening of the electricity sector.

Mexico has the eighth-most-expensive electricity costs in the 34-nation Organization for Economic Co-operation and Development, which groups the world’s most developed countries.

Not only do government electricity subsidies favor agricultural and residential users over industry and crowd out needed infrastructure investments, but Mexico’s largest businesses have seen their power costs more than double over the past decade. They have risen from 6 cents per kilowatt hour in 2003 to about 13 cents per kilowatt hour this year.

Mexico’s state-run electricity utility, CFE, currently controls all aspects of the sector, while other government officials led by the finance ministry set rates and subsidies.

Since 1960, Mexico’s constitution has established public sector “exclusivity” over electricity. In 1992, a limited reform allowed private companies to generate electricity, but required the power generated to be either used for the company’s own consumption or sold to CFE, effectively stifling competition.

In spite of the limitations, private-sector generation accounts for about 30 percent of the county’s power, as many companies have sought self-supply arrangements to lower their energy bills.

“The main problem is that we just don’t have the capacity to meet our future electricity demand,” said Rafael Ch, an energy researcher with Mexico’s CIDAC think tank, noting that growing demand of about 4 percent per year will require an additional 40 gigawatts of capacity by 2026.

According to CFE data, total installed generation capacity in Mexico stands at 52 GW.

The PAN’s energy reform would do away with the constitutional requirement of a state-run power sector, put the country’s regulatory energy commission, the CRE, in charge of setting rates and amend secondary laws to overhaul the current subsidy regime in favor of one that helps the poorest consumers.

Mexico’s electricity subsidies, among the largest in the world, currently cover about 30 percent of overall power costs and as a result distort prices and inflate demand.

The PAN’s proposal also calls for an independent grid operator that Foss says could better manage the country’s higher-voltage networks that serve industrial users by ensuring adequate investments and system reliability.

About half of Mexico’s current electricity is generated from natural gas, up dramatically since 2000, when costlier, dirtier fuel oil was the major electricity fuel.

But the country’s domestic gas production has slid over the last few years, while insufficient pipeline infrastructure caps the amount of natural gas it can import from its northern neighbor, home to the world’s cheapest supplies.

“Mexico has a short-term problem with not enough natural gas,” says Hector Moreira, a board member of state oil and gas monopoly Pemex.

Moreira notes that in the next two years, major gas pipeline projects will come online, allowing for more U.S. gas imports. Once new cross-border pipelines are completed, he says, “the price of electricity could drop by half,” since fuel oil is about twice as expensive as natural gas.