Time for Teddy Talk

There are times for TED Talks about wondrous advances in technology and the future that awaits us.

Then, there are times for Teddy Talks: of practical progress, problem solving, and turning wondrous advances into actual, scaled-up, sustainable, job-creating engines of the economy.

While the United States political establishment rocks and roils on the topic of immigration, there’s a topic that should occupy their time as well, and that is the problem of out-migration — specifically, technologies born or to an extent developed in the United States, being siphoned off overseas to serve the building of advanced, renewable, sustainable bioeconomies elsewhere.

The Big Bang in the Bargain Basement

This past year we have seen significant technology from Mascoma get snapped up by Lallemand, Allylix acquired by Evolva, Verenium acquired by BASF. Meanwhile, Solazyme and Amyris are commercializing with their first full-scale plants in Brazil, Verdezyne and Heliae have raised the bulk of their most recent announced financings from South-East Asia, Genomatica has been heavily supported of late from Europe. LanzaTech will build its first scaled plant in China, and probably its second.

Seen at a company level all of these are good match-ups and kudos to all for getting the deals they need— in some cases at bargain prices for the buyer. Seen at the national level, it’s a brain drain.

The Hunter-Gatherers

Meanwhile the US sticks to the hunter-gatherer model of oil & gas exploration, based on the premise that cheaper-to-extract fossil reserves won’t ever be discovered elsewhere, wherein US will be once again saddled with the job of buying cheap fuel from overseas, dependent on imported fossil energy all over again.

This year, hunter-gatherers are doing well — with the price of oil & gas at five-year lows as Europe’s economy sputters and China’s flirts with a soft landing, and a new generation of extraction technology being deployed more widely in the US than elsewhere, for now. But we can guess where hunter-gatherer economic models end up, based on how well they haven’t done well in the past.

The Rise of Elsewhere and Elsewhat

The underlying problem we hear from executives in the advanced bioeconomy again and again is a variation of “we’d like to build here, but the financing dictates and we’ll probably go offshore.”

We’ve also heard another consistent theme. Companies that started based on the target of fuels, who have dovetailed either temporarily or permanently into chemicals, protein, or nutraceuticals.

Heliae started as a technology based around jet fuel from algae, and these days there’s hardly a word about fuels in their development program. Solazyme and Sapphire Energy see fuels these days as a part of the mix, not the driver, and in Solazyme’s case it’s a small part indeed, for now. News from Amyris, too, has revolved around chemicals. Algenol’s and LanzaTech’s focus has broadened. Cobalt Biofuels has long since changed to Cobalt Technologies and is generally focused on chemicals. Aurora Biofuels became Aurora Algae. Maverick Biofuels became Maverick Synfuels. Coskata and Primus Green Energy changed their underlying “first commercial” feedstock from bio-baed to fossil-based.

In some cases, it was a matter of new discoveries in the lab opening opportunities. In other cases, the technologies were stymied in the lab in terms of reaching fuel-grade economics, and peeled off into smaller-volume, higher-margin markets. But in many cases, the problem is financing.

Investor Exhaustion

In financing a “first commercial” we often hear about the political instability associated with the US Renewable Fuel Standard causing investor distress. Why then are investors from the EU and Asia stepping in so aggressively? The EU’s fuel directives appear even more fuzzy than the RFS, and Southeast Asia has relatively small unevenly enforced mandates where they have them at all. Most of the companies headed for Brazil, where there is a vibrant fuels market, are making chemicals and other high-margin products, not biofuels — for example, the afore-mentioned Amyris, Solazyme and Cobalt.

As we see it — based on the extensive conversations we have with companies and investors alike — is a virtually universal case of investor exhaustion. The timeline and the risks to reach fuel-grade economics become too daunting for the investor group, who order a pivot, sometimes with it ordering a change in CEO.

The 15-year journey from lab to affordable renewable fuels at scale can get tough for venture firms who are structured around 10-year funds raised from limited partners. Not to mention the 58-year journey that took place from the discovery of Kier’s process for refining petroleum in 1849 to the invention of the first gasoline station in 1907 and the birth of the modern transportation fuel industry.

Seen from the company point of view, it’s understandable and laudable that companies facing investor exhaustion find other markets to go into. Becoming part of a viable business is the first prerequisite for a technology that aims to change the world.

Seen from the national level, it’s a missed opportunity for fuel diversification — the kind that exists in the power sector and which leads to more stable prices for end users, and can result in more international energy security as countries tap bioresources to supplement fossil reserves.

If investor exhaustion is a culprit, then investor exhaustion must be studied and remedied — unless we are simply to bless the cycle of immigrate, learn, invent, outmigrate, deploy.

Not the USA’s first rodeo in perplexing finance challenges

The problems of financing new technologies deployed in rural areas has beset the United States before . As Wikipedia relates the tale:

“In 1908, the Administration of Theodore Roosevelt commissioned a study on the problems facing rural families…The commission concluded that access to credit was one of the most serious problems facing rural farmers and recommended the introduction of a cooperative credit system. Four years later, Presidents William Howard Taft and Woodrow Wilson sent a commission of Americans to study cooperative credit systems for farmers in Europe….This commission concluded that the best form of cooperative credit system would include both long-term credit to cover land mortgages and short-term credit to cover regular business needs.”

From this bipartisan, multi-administration effort came the Federal Farm Loan Board and the 12 Federal Land Banks, owned by a combination of national farm loan associations, outside investors and the Federal Farm Loan Board. Republicans expanded the system in 1929, creating the Federal Farm Board just before the Great Depression broke out in 1929, which was renamed today’s Farm Credit Administration in 1933 as a part of New Deal legislation.

It is highly unlikely that the same structures that worked in 1908, 1929, or 1933 will work today — times change. But some of the elements are worth understanding, and the bipartisan spirit with which agricultural stability was pursued should inspire us to seek new answers in stabilizing the transportation fuel supply. Especially now, when fuel prices are relatively low and there’s less pain at the pump for legislators to contend with.

Rewind to ’05

In the 2005 re-set of energy policy, the US aimed to broaden the transportation fuels to broaden the mix to include biofuels. The federal government focused on development (through the Bioenergy Technologies Office, or BETO) and deployment (primarily in association with the USDA and through a loan guarantee program), aiming at providing access to debt for risky first-of-kind technologies.

We have seen quite a bit of development, to the point where first-generation and biodiesel are established technologies, second-generation cellulosic fuels are deploying at scale now, and new technologies for drop-in hydrocarbon fuels are on the way. It’s an admirable record, though not every investment paid off — just as not every oil well pays off, either.

Deployment has been more uncertain. Only one transportation fuel technology ended up with a DOE loan guarantee — and that one secured nearly 7 years after the loan program debuted, and it was the lowest-rated technology on a credit score basis the DOE ever did. The Loan Office got loads more criticism for the one loan guarantee it issued, than for the problem of only granting one.

It was never contemplated by the Congress that Wall Street’s money would suddenly develop a kind of strategic courage that it historically has never possessed. No one believed back then that private capital would completely, all by its onesey, bring forward a risky but rewarding generation of new technologies when there were plenty of safer investment choices out there in the world of project finance. Yet, that is the expectation in 2014.

The problem is not how to allocate the proceeds from a winning bet on new technology with big capex. The problem is how to allocate the losses from a losing bet, and losers there will be in any big technology shift. Not every rocket ever dreamed up landed on the moon.

If we are sufficiently intrepid in taking risks, someone is going to have to lose along the way — the question is how to spread the risk, while solving the problem of investor exhaustion — specifically, the tendency of investors to divert towards high-margin markets instead of transportation fuels, for technologies that might have made a difference in the energy equation had the investor patience been sustainable.

The Navy Model

The Navy has proven to provide, over the years, a pretty good model for how to get things done. They replaced sail with steam — instead of dovetailing into textile manufacturing as a number of steam technology investor groups chose to do. They replaced steam with diesel oil, even though a number of oil technologies made a lot of money in the gasoline or chemicals business, the Navy stayed with ships. They replaced diesel (where feasible) with nuclear, choosing to stay focused on propulsion rather than getting distracted by the opportunities to make money producing electrons.

Illustrating by example

Here’s a simplified scenario to illustrate how a revised capital structure might work.

In this case, $10 billion is committed to such a zero-interest, public-private fund under private sector management, on condition that the projects will have to be able to produce biofuels at a targeted cost (based on reasonable projections of feedstock cost), after a thorough assessment by a panel of experts.  The private fund managers pick the commercial-scale projects based on risk assessment.

The fund could be larger or smaller based on the public’s appetite for mitigating risk through a broad portfolio approach that deploys multiple technologies and across multiple geographies.

The project finance is returned by the project to the fund in the form of regular payments. The fund managers keep the profits from the fund, and guarantee repayment of the zero-interest loan by the public sector.

If the cost of capital is capped at 10 percent — and the default rate is 8 percent — the fund earns 2 percent returns, or $200 million for the fund managers. Should the fund managers manage to keep defaults down the the DOE loan program levels of around 3 percent, the earnout could go as high as $700 million after defaults are paid out.

(Note on defaults: The fund managers would continue the repayment schedule to the fund from the profits accruing to the fund in the form of interest payments — reducing their “profit” but shielding the public from funding defaults).

The fund could likely manage its technology failure rate by managing down the size of first commercials, second commercials and third commercial projects. For example, if a first commercial were limited to 20 million gallons but a second commercial could be 40 million gallons — the technology failure rate could be 15 percent and yet the fund might only record a 5 percent overall “dollar default rate”, because second deployments of proven technologies would more than offset first commercial failures.

It’s a simple example, designed to stimulate thinking. But in this case, the private sector has an excellent opportunity to earn income, while the public sector sees its strategic goal realized and avoids taking the risk with the public dime.

The blue-ribbon panel

Solution? Certainly, better to have a study, as in the days of Roosevelt, and soon. Then, the hallmark of a leader was to convene a bipartisan commission to study a national problem and develop a solution for the public that rises above politics. Let’s see if Teddy provides inspiration to a new generation of leaders. He certainly could, and should.

We sure could use an alternative model, and soon.

We suspect it might well be a shake-up of the model pursued to date — where the limited partners provide the capital, managers chasing returns run the portfolio, and the public provides the loan guarantee.

We might find that a set of public-private partnerships will provide the capital, a set of fund governors chasing strategic goals run the portfolio, and the private sector provides guarantees through the vehicle of technology insurance (sold on a portfolio basis to manage the cost).

The key is to have patient capital that is less tempted by the prospect of financial returns to stray from strategic returns — and to move the public out of the role of providing loan guarantees, which results either in a collapse of risk-tolerance or just enough failures to make the funding mechanism into a political football. Which repeats the RFS stability problem all over again.

Making it real means a bi-partisan group that speaks softly and carries a big stick. That’s how Teddy talked, and it works.