Defusing the cellulosic bomb inside the Renewable Fuel Standard

Thought the 2014 volume debate over the Renewable Fuel Standard was tough enough?

What about the ticking bomb inside the RFS — that could completely flat-line the value of cellulosic RINs and make it near impossible to build cellulosic biofuels capacity for the US market, ever?

Good news, though. This UXB, though deadly, may be easy to defuse. The Digest does some Explosive Ordnance Recon and hazard survey.

In Washington this week, the final 2014 Renewable Volume Obligation proposal is expected to pass from the EPA to the Office of Management and Budget for review.

The RVO debate

Over the past months, there has been significant industry push back after EPA first proposed sweeping cutbacks to the RVO from the schedule originally established by the US Congress when it set up the Renewable Fuel Standard.

Fears of rising gas prices associated with “soaring RIN values” were blamed at the time — RIN price volatility, according to RFS critics, that flows from the problem of blending sufficient ethanol into the gasoline supply to meet RFS targets (the “blend wall”).

While the EPA has avoided specific commentary on revised target volumes, speculation is rampant that the final RVO will represent a less severe cutback from Congressional targets than originally proposed. The final RVO numbers are expected from OMB and EPA in June.

One item that has received far less attention in this RVO cycle than in previous years has been the cellulosic biofuels target — which sets the obligated volume for D3 RINs, and essentially creates through the RIN price the incentive to develop and deploy cellulosic biofuels.

In past years, there has been enormous attention paid to the cellulosic number — production has fallen well short of the volumes originally envisioned by Congress, and obligated parties successfully sued in the past to ensure that EPA did not “put their thumb on the scale” by setting the cellulosic RVO at a number higher than expected production.

Beyond volume, the RIN price

Cellulosic biofuel producers should be just as concerned about the future of D3 RIN prices as the actual volumes, producers and stakeholders are telling the Digest.

Here’s the problem, we’re told: in 2014 and for future RVOs, EPA could underestimate production volumes for cellulosic biofuels. An underestimate by EPA could cause market demand for cellulosic biofuel RINs to fall well short of actual production, and lead to a collapse of D3 RIN premiums. Leading to a reduced level of investment and interest in cellulosic biofuels.

How could this happen?

Consider this possibility: EPA has proposed to re-designate landfill biogas now used in CNG applications to “cellulosic biofuel.” This approval is imminent. 30 million gallons of fuel will enter the market, a volume that could tip the scales in the direction of an underestimate of cellulosic biofuel production — if any combination of cellulosic CNG, gasoline or ethanol capacity comes to market faster than expected.

The structural problem

“First of all,” Iogen CEO Brian Foody told the Digest, “we have to recognize EPA’s current predicament. The EPA guys are trying to approach the RVO in good faith, they’re trying to make it work. But there is going to be uncertainty in any number they bring forward. For example, here it is May, and no one can be exactly sure, down the gallon, how much production there is going to be in 2014. So, as an oil company, what value do you attribute to a D3 cellulosic RIN? You’d have to be guessing.”

What Foody is pointing towards is RIN surplus risk. If cellulosic biofuels production soars during the year relative to the proposed target, then the market could be swamped with D3 RINs, and the D3 RIN value would crash — accordingly, obligated parties might reasonably delay acquiring RINs early in the year so that they don’t pay high values for RINs that aren’t worth anything by year end.

The arrival of landfill-based CNG is one factor that could tip the scale. Or, early arrival or faster commissioning time than expected for several commercial-scale cellulosic ethanol plants expected to debut this year.

A remedy

“What we proposed at a recent Advanced Ethanol Council meeting,” said Foody, “is that EPA set up a rollover mechanism, a carry-forward provision.”

How would that work?

“Say there’s 20 million gallons in the RVO, but there’s 30 million gallons of production that year, for whatever reason. What EPA could do is add that 10 million shortfall into the next year’s RVO, so there’s no surplus causing D3 RIN prices to collapse and thereby scuttling the incentive to produce cellulosic biofuels that Congress intended.”

What about the opposite case, we asked? What if there’s 30 million gallons in the RVO, but there’s 20 million gallons of production that year, for whatever reason?

“It’s the same. EPA could subtract that 10 million from the next year’s RVO – again, so there’s no obligation for fuels that were not actually produced.”

Isn’t there a carry-forward provision already in the Renewable Fuel Standard?

“Yes,” said Foody. “But it doesn’t affect the RIN target. That carry-forward allows obligated parties to defer meeting certain obligations until next year — it doesn’t change the obligation itself to match it back to production.”

So, this is a proposed system that allows EPA to project a cellulosic biofuels RVO target, but go back and correct the target to reflect actual production?

“That’s right,” Foody confirmed.

Does EPA have the power to make this change through rule-making, rather than amending the RFS legislation? Foody tells us they do.

The Bottom Line

Well, that’s an interesting idea, isn’t it? Eliminate the problem of “phantom fuels” and the problem of killing the intended incentive for cellulosic biofuels — with one mechanical change from EPA.

Our understanding is that oilcos have not been brought into any discussion yet — so we’ve yet to hear from obligated parties. We’ll be interested to hear their reaction.