The Hidden Hook in the Renewable Fuel Standard

August 5, 2010 |

Did the Bush Administration and the 110th US Congress put hidden cellulosic ethanol hooks into the Rewnewable Fuel Standard?

For some time, cellulosic ethanol producers have been aghast that the cellulosic ethanol mandates within the Renewable Fuel Standard are being annually waived down to insignificance by the EPA. “What’s the point of a cellulosic ethanol mandate if obligated parties can escape their obligation by simply doing nothing to organize capacity?” goes the thinking.

“Especially given that obligated parties, through organizations like NPRA, are seeking to limit markets for ethanol and thereby stymie investment in the sector,” is another typical view.

Why does the EPA waive down the cellulosic ethanol mandate every year?

Well, it’s a good question. The short answer is that the EPA is required by Congress to make an annual production estimate for cellulosic ethanol and to waive down the CE portion of the RFS mandate if capacity is not available. Digest sources explain that the requirement to do so was the result of a deal between the Congress and blenders, in return for not opposing the enabling 2007 EISA Act.

It tuned out like Indirect Land Use Change – no one among the EISA Act’s many supporters foresaw what a complete ball and chain the clause on cellulosic ethanol capacity would become.

“Investors constantly ask us the simple question,” says AE Biofuels CEO Eric McAfee, ” If the EPA is not enforcing the cellulosic ethanol mandate and only providing a few months of forward visibility each year, how are investors expected to fund cellulosic ethanol capacity that will require five years or more to repay the funding?”

EPA’s response: our hands are tied, new legislation is needed. The text of the EISA Act tends to agree. And with elections looming and the energy and climate bills seemingly stalled for another year, it’s anyone’s guess when RFS might be “fine-tuned” to address some of its shortcomings and unintended consequences.

But here’s where it may get interesting. (Note, you may wish to download the Digest’s CE incentive spreadsheet, which contains the numbers discussed from here forward.)

Why didn’t the EPA waive down the advanced biofuels mandate for 2011 – what’s that about?

The EPA, while waiving down the cellulosic ethanol mandate for 2011 from 250 million gallons to a range of 6.5-25 million gallons, did not waive down the advanced biofuels mandate as a whole, which remains at 1.35 billion gallons of ethanol equivalent renewable fuel for 2011. You see, while EPA is required to waive down cellulosic ethanol mandates, they “may” waive down advanced biofuels mandates – or they may not. So far, EPA is taking the view that Congress’ intent was to get renewable fuels into the market, and have chosen not to waive down advanced biofuels.

What’s that “ethanol equivalent” thing?

Keep a close on on that term “ethanol equivalent”. Biomass-based diesel, whether it is renewable diesel or biodiesel, gets a 50 percent premium because it has far higher BTUs per gallon than ethanol. Renewable diesel gets a 70 percent premium. So, while the biomass-based diesel mandate for 2011 is set at 800 million gallons, that counts as 1.20 billion gallons for the purposes of satisfying the mandate. And as mentioned above, 6-25 million must come from cellulosic ethanol.

Back to the mandate

But that leaves 125-144 million gallons to be met through the advanced biofuels requirements. Biomass-based diesel, Brazilian sugarcane ethanol and cellulosic ethanol would all qualify.

Now, blenders generally opt for the cheapest alternative. Biodiesel is priced 3.47-3.68 per gallon, as projected for next year by CARD. Sugarcane ethanol from Brazil right now costs around $2.81 per gallon, wholesale, according to recent analysis from RFA.

It defines a cellulosic ethanol opportunity – an arbitrage between the price of cellulosic ethanol and its competing fuels. A Digest table of cost scenarios is here.

Bottom line, it may well be cheaper, far cheaper, to buy and blend cellulosic ethanol than competing fuels, even if EPA is waiving the CE mandate down to nothing – just to satisfy the overall advanced fuels mandate.

A cellulosic ethanol opportunitycapital incentives hidden in the RFS?

That arbitrage between the cellulosic ethanol price and the price of other advanced biofuels – made even sharper by tariffs and tax credits, creates an incentive.

It’s modest in the beginning – looks like around $8 million in cellulosic ethanol incentive baked into the 2011 mandate. That’s about $0.06 cents per gallon in our back-of-the-envelope analysis, for the first 75 million gallons while Dynamic Fuels capacity is utilized. After that, the next most cost effective fuel for mandate purposes is biodiesel, where there is a $1.38 differential per gallon for those last 17 million gallons. That’s another $20 million+ in capital incentive. Still not much, but interesting.

In 2011, nice. By 2022, a monster?

By 2022, it’s potentially a monster. As much as $11.0 billion per year. Those kinds of figures would inspire any obligated party to: (a) pray for a waiver, (b) hope that competing fuel prices plummet; or (c)  invest in capacity.

A free Digest spreadsheet – play your own RFS games

In our Digest chart (download it here), we’ve taken current costs, and applied the current tariff and the cellulosic ethanol tax credit. We’ve also used 2011-12 cost targets from CARD, Dynamic Fuels, POET, and RFA for the competing fuels, and assumed that the relative prices between them will not change (which they will, but in directions impossible to predict and which may may CE even more compelling).

The Bottom Line

Even without changes in the RFS, if the EPA chooses to enforce the advanced biofuels mandate, there may be good news for cellulosic ethanol investors – and opportunities in CE for obligated parties – even if the cellulosic ethanol mandates are waived down. SInce it takes years to get capacity built, the operable figures are not the impact in 2011 or 2012, but the arbitrage in 2016 or 2017. There, the numbers start to get pretty darn compelling.

Disclosures

The author does not own any cellulosic ethanol stock, or renewable energy investments of any kind. Purity of portfolio, however, is no guarantee of sanctity of numbers, and readers should approach forward-looking scenarios with caution.

For example, there is no guarantee that the costs of producing fuels will remain static. There’s just as much uncertainty, if not more, on the stability of tax credits and tariffs referred to in this analysis. Changes in either could materially alter the landscape.

Notes and kudos

An earlier version of this story had an incorrect ethanol equivalency value for renewable diesel. Thanks to diligent Digest reader Juan Casto for pointing it out. The Digest’s spreadsheet has also been adjusted.

Kudos: A big Digest thank you to Eric McAfee, CEO of AE Biofuels, whose thoughts on a related subject started this analysis rolling. One of those guys who sharpens the thinking of others. Good trait.

Going back even further, John McCarthy, CEO of Qteros, has been thinking earlier and smarter than the Digest has on this topic. Here’s some of that thinking, well worth a read.

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