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Opportunity for profitable investments in cellulosic biofuels
Energy Policy 39 (2011) 714–719
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Energy Policy journal homepage: www.elsevier.com/locate/enpol
Opportunity for profitable investments in cellulosic biofuels Bruce A. Babcock a, Ste´phan Marette b, David Tre´guer b,n a b
Center for Agricultural and Rural Development, Iowa State University, 578F Heady Hall, Ames, IA 50011-1070, USA INRA, UMR Economie Publique INRA-AgroParisTech, 16 rue Claude Bernard, 75231 Paris Cedex 05, France
a r t i c l e i n f o
a b s t r a c t
Article history: Received 2 September 2010 Accepted 27 October 2010 Available online 19 November 2010
Research efforts to allow large-scale conversion of cellulose into biofuels are being undertaken in the US and EU. These efforts are designed to increase logistic and conversion efficiencies, enhancing the economic competitiveness of cellulosic biofuels. However, not enough attention has been paid to the future market conditions for cellulosic biofuels, which will determine whether the necessary private investment will be available to allow a cellulosic biofuels industry to emerge. We examine the future market for cellulosic biofuels, differentiating between cellulosic ethanol and ‘drop-in’ cellulosic biofuels that can be transported with petroleum fuels and have equivalent energy values. We show that emergence of a cellulosic ethanol industry is unlikely without costly government subsidies, in part because of strong competition from conventional ethanol and limits on ethanol blending. If production costs of drop-in cellulosic biofuels fall enough to become competitive, then their expansion will not necessarily cause feedstock prices to rise. As long as local supplies of feedstocks that have no or lowvalued alternative uses exist, then expansion will not cause prices to rise significantly. If cellulosic feedstocks come from dedicated biomass crops, then the supply curves will have a steeper slope because of competition for land. & 2010 Elsevier Ltd. All rights reserved.
Keywords: Cellulosic biofuels Market conditions Investments
1. Introduction Large public and private research efforts are currently being undertaken to remove technical and logistical barriers to converting cellulosic feedstocks into liquid transportation fuels. For example, the US Department of Energy (DOE) in 2008 established five research centers at a total cost of more than $300 million. In addition, in 2009 DOE committed $480 million to improve the energy efficiency of biofuels and biomass conversion plants. BP provided $500 million to the University of California-Berkeley and the University of Illinois to fund the Bioenergy Institute. Conoco Phillips established a $22.5 million joint research program with Iowa State University. In the European Union (EU), the total contribution for biofuel projects (mostly second generation) under the Seventh Framework Program adds up to h45 million. Additional programs funded by member states aim at fostering the development of second-generation biofuels, like a h27 million special fund in Denmark and a h137 million, 5-year program in Finland (Jung et al., 2010). The rationale for research efforts in the United States (US) is not difficult to find because the 16-billion-gallon US mandate for cellulosic biofuels by 2022 will not be achieved without major research breakthroughs in the areas of conversion technologies,
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feedstock logistics, and agronomic knowledge. The rationale for EU research efforts is less clear because its 10% mandate1 for biofuels likely can be met at reasonable cost through a combination of domestically produced and imported conventional feedstocks (primarily rapeseed oil). Concern about the availability and cost of food commodities is a motivating factor for support of cellulosic biofuels in both the EU and the US because replacing biofuels made from commodities that can also be used to produce food with cellulosic biofuels would likely lead to lower food prices. And given the wide availability of potential cellulosic feedstocks, it is possible to envision a future in which gasoline and diesel are largely replaced by cellulosic biofuels.
1 The 10% target contained in the Renewable Energy Directive (Directive 2009/ 28/EC) also includes green electricity and hydrogen, rather than a strict biofuel target. Moreover, the Directive introduces sustainability criteria, namely, that minimal greenhouse gas savings have to be achieved. Biofuels must provide at least 35% carbon emission savings compared to fossil fuel in 2010.This level will rise to 45% by 2013 and 50% by 2017, with 60% for new installations. Some types of land are deemed unfit to grow biofuels crops (primary forests, protected areas, grassland with a rich biodiversity, wetlands, and peatlands) and social standards have to be met (domestic and foreign production should comply with eight conventions of the International Labor Organization). However, no legally binding reference to ‘indirect land use’ aspects was kept in the final text, but the European Commission has been asked to come forward with proposals by the end of 2010 to limit indirect land-use change. The Parliament and the Council will then have to make a decision based on these proposals before 2012.
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Future production of cellulosic biofuels will come about only if public and private research efforts successfully lower the cost of production enough to induce private capital to flow into the sector or if subsidies are large enough. Public investment in such plants does not seem likely. US interest groups have not had the power to push Congress and the Administration to offer investment loan guarantees for cellulosic biofuels plants. Future prospects for such guarantees look dim because of budget concerns. In the EU, the recent market reactions to the fiscal positions of most member states have created an environment that does not favor either government ownership of plants or loan guarantees. Private investment will only occur if future market conditions are favorable for profit-making. Thus it makes sense to expand beyond the engineering and agronomic research effort on cellulosic biofuels to include research on the future market conditions that cellulosic biofuels will face. Much of the existing literature on the future of cellulosic biofuels has focused on whether feedstock supplies will be sufficient to meet a given production target (Perlak et al., 2005), or the relative attractiveness of alternative feedstock supplies (Khanna et al., 2008). Bruce McCarl and co-authors (McCarl and Schneider, 2001; Schneider and McCarl, 2003, for example) have estimated supply curves of CO2 reductions from alternative sources using a programming model. These supply curves are used to project the quantity of cellulosic biofuels (from various feedstocks) that will enter the market for any given CO2 price. But these studies do not examine the actual market for cellulosic biofuels other than as it is influenced by climate change policy. In other words, the necessary market conditions suitable for the emergence or the absence of second-generation biofuels were overlooked by the previous studies. Projections of biofuel supply and demand in the US were recently released by the Food and Agricultural Policy Research Institute (FAPRI) using a model that includes cellulosic ethanol as one of the commodities. Cellulosic ethanol competes with corn ethanol in the market. In both the programming model and the FAPRI model it is difficult to understand how the market for cellulosic ethanol works because the details are hidden in the models. Thus, it is difficult to understand the conditions that are required to make future private investments in cellulosic biofuels profitable. The contribution of this article is an examination of the future market for cellulosic biofuels as it is influenced by both market forces and government policy. In carrying out this examination, we differentiate between cellulosic ethanol, which must compete with existing corn and sugarcane ethanol production, and drop-in cellulosic biofuels, which can be transported in pipelines and substitute directly for gasoline, jet fuel, and diesel. Our examination is necessarily speculative to a degree because cellulosic biofuels production has yet to occur. The future time period that we examine is 5 years in the future. This length of time is far enough into the future to allow supply adjustments to occur in both input and output markets, and to allow the US mandate for cellulosic biofuels to become quite substantial. For example, in 2015, the US mandate for cellulosic biofuels production (in ethanol-equivalent gallons) is 3.0 billion gallons. By 2015, the supply of conventional biofuels (corn and sugarcane ethanol) will have grown substantially from their current levels. The US mandate for corn ethanol will be 15 billion gallons, and Brazilian domestic demand for ethanol will likely have surpassed 13 billion gallons. The article begins with a discussion of the important market forces that will influence the US and EU future demand for cellulosic ethanol. The role of competition with conventional biofuels and petroleum-derived fuels is highlighted. We demonstrate that because of a high degree of competition and uncertainty caused by uncertain technologies and commodity prices, it will be difficult for market forces alone to induce a large degree of private
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investment in cellulosic biofuels. We then turn to an examination of how government policy can influence profit potential through mandates and trade measures. Government policy can generate profit potential but it also adds more uncertainty because what the government gives, it can also take away.
2. The market conditions for cellulosic ethanol We first consider how market forces will impact the future demand for cellulosic ethanol. Cellulosic ethanol will need to compete with other transportation fuels. The existing important transportation fuels are petroleum-based fuels and conventional ethanol. From the perspective of the US market, conventional ethanol can be differentiated into domestically produced corn ethanol and imported sugarcane ethanol. If cellulosic biofuels expand, they will not displace these conventional biofuels because owners of existing conventional biofuels plants will continue to operate their plants if it is profitable to do so. Thus cellulosic biofuels will be competing against all transportation fuels. Advocates of cellulosic biofuels point to the amount of CO2 reduction that can be accomplished by replacing corn ethanol, gasoline, or diesel with cellulosic biofuels. In terms of a percentage reduction, it is true that cellulosic biofuels may have much lower emissions, but McCarl and Schneider (2001) have shown that the CO2 savings do not make cellulosic biofuels competitive until the price of CO2 rises to more than $40 per ton. This means that it will be difficult for cellulosic biofuels to compete with other lower-cost sources of CO2 reductions. Thus, the primary source of profitability for cellulosic biofuels must be found in the market for transportation fuels, not in the market for CO2 reductions. We now turn to a simple example for characterizing the market conditions linked to the introduction of the cellulosic ethanol. In Fig. 1, quantities of ethanol are located along the horizontal axis, and costs and prices are located along the vertical axis. Consider the total medium-run (5 years ahead) supply ST and demand D of ethanol in the US, as depicted in Fig. 1. The mediumrun assumption means that investment costs in the 5-year horizon are treated as variable costs and that current investments are treated as fixed costs. Overall supply ST of biofuels is represented by a line made up of three different components, namely, the domestic corn and cellulosic ethanol supplies – respectively, SI and SII – and import supply, which for exposition we assume equals the Brazilian ethanol excess supply curve SB. The quantity ST is obtained by horizontally adding up the different quantities supplied at each
Fig. 1. Ethanol supply and demand with no government programs.
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price P: ST(P) ¼SI(P) +SII(P)+ SB(P). With no government programs in place, the market equilibrium is at point E; the quantity on the US ethanol market is QE sold at price PE. Proper interpretation of this market equilibrium requires knowledge of some details of the supply and demand curves in Fig. 1. The ethanol demand curve in Fig. 1 is drawn as being fairly inelastic, which simply means that the price of ethanol is sensitive to ethanol quantity. This price sensitivity is consistent with a US ethanol market that does not export large quantities of ethanol and one that is quite saturated. Current fuel standards limit blend rates to 10% ethanol for automobiles made before 2007 and 15% for later model vehicles.2 An inelastic demand for ethanol is consistent with a US market that is at or approaching the maximum allowable blend rate, also called the ‘blend wall’, which is a physical limit on the amount of ethanol that can be used in the market. Ethanol demand is much more elastic with a robust export market or when the market is not approaching the blend wall because ethanol would then substitute more freely for gasoline. The implications of an elastic demand for cellulosic biofuels are discussed below. There is a range of quantities for which US corn ethanol can be produced at lower cost than what it costs to import ethanol from Brazil. At low quantities of US domestic production, corn prices would be quite low, and excess US ethanol production capacity would exist. In addition, export supply from Brazil is the quantity of ethanol in excess of Brazilian domestic demand, which is expected to grow rapidly (Babcock et al., 2010). Thus the US price must be high enough to pull ethanol out of the Brazilian market. It is likely that the Brazilian excess supply curve is more elastic than the US domestic supply curve over a 5-year time horizon because Brazil has more land available for sugarcane production than the US has available for corn production. Therefore there is a point at which the US corn ethanol supply curve intersects the Brazilian export supply curve from below, as is shown in Fig. 1. Because there are no commercial cellulosic ethanol plants in existence, the marginal cost of cellulosic ethanol includes capital costs. After combining capital costs with feedstock acquisition costs and current estimates of conversion costs, it is likely that, given current production technologies, current ethanol prices cannot cover even the lowest-cost source of cellulosic ethanol. Thus the intercept of the cellulosic ethanol supply curve (SII) is higher than the equilibrium price PE. With such a market configuration, cellulosic ethanol is not competitive, and no industry emerges. If the intercept of the cellulosic ethanol supply curve turns out to be lower than that shown in Fig. 1, then an industry could emerge. However, given a saturated ethanol market, the primary impact of cellulosic ethanol production would be to lower the price of ethanol. Corn and sugarcane ethanol would remain strong competitors with cellulosic ethanol. In a 5-year time horizon, the prospect of having to compete with entrenched ethanol producers in a saturated market is not likely to prove attractive to investors. Consequently, our first conclusion is that a cellulosic ethanol industry is not likely to attract investors because of a saturated market and strong competition from existing producers.
interventions that treat cellulosic ethanol differently than conventional ethanol. We then examine how production of ‘drop-in’ cellulosic biofuels that can substitute directly for gasoline or diesel rather than for ethanol creates a clear economic benchmark for investment success. And third, we show how the choice of cellulosic feedstocks can influence the longevity and magnitude of investor gains once the economic benchmark has been achieved. 3.1. Discrimination among biofuels One way to make cellulosic ethanol more attractive to investors is for government to differentially regulate, tax, or subsidize cellulosic ethanol relative to conventional ethanol. For example, the US government currently gives a $1.01 tax credit for cellulosic ethanol and a $0.45 per gallon tax credit for conventional ethanol. This higher tax credit means that the ability to pay for cellulosic ethanol is $0.56 per gallon higher than for a gallon of corn ethanol. In addition, the US government has adopted mandates for cellulosic biofuels that are distinct from mandates for conventional biofuels. Fig. 2 shows the impact of distinct mandates. With a cellulosic ethanol mandate of QI and a conventional ethanol mandate of QII, total ethanol consumption is QT. The market-clearing price is PE. The vertical distance between PE and point A on the supply curve of cellulosic biofuels and between PE and point B on the supply curve for conventional biofuels is the difference between the minimum price needed to produce the respective mandated quantities and the maximum price that blenders are willing to pay for these quantities. These vertical distances measure the amount of subsidy that must be given to biofuels producers to induce them to produce mandated volumes or the amount by which blenders are taxed because of the mandates. Tax credits could make up for some or all of these mandate costs. Fig. 2 shows that government mandates can create a market for cellulosic biofuels, albeit at a cost to either taxpayers or blenders, who, in turn, would pass some portion of their costs onto fuel consumers. Current US policy is reasonably well-represented by Fig. 2 with the exception that existing import tariffs that increase the cost of meeting the conventional biofuels mandate are not accounted for. In addition, it is highly unlikely that actual mandated volumes of cellulosic biofuels would be produced. Instead, mandates would be waived to a level that could be met by whatever production capacity comes on line in the next few years. The policy question that needs to be addressed is whether it actually makes sense to carve out a special mandate for cellulosic ethanol. The cost of
3. How to enhance the investment outlook for cellulosic biofuels There exist market conditions, technology choices, and policy interventions that can enhance the investment outlook for cellulosic biofuels. We examine three below. First we examine policy 2 The US corn and ethanol industries are lobbying for blend rates of 15% or 20% for all vehicles.
Fig. 2. Ethanol supply and demand with mandates.
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meeting a total mandate of biofuels would be much lower if there were no cellulosic ethanol carve-out. This can be seen by comparing the vertical distance between the total supply curve ST at quantity QT to the cost of meeting the cellulosic carve-out. One argument that could be made for the carve-out is that greenhouse gas reductions from cellulosic ethanol are much larger than for conventional ethanol. This is certainly true, but if reductions in greenhouse gas emissions are the objective of a policy, then economic costs would be lowered if they were targeted directly with a tax or a cap-and-trade system that extends to sectors other than biofuels. At a minimum, the magnitude of the cellulosic ethanol mandate should reflect the value and quantity of emission reductions. A second possible justification for a mandate for cellulosic biofuels is that the current costs of producing cellulosic biofuels do not reflect possible large-scale cost reductions that can come about from technological breakthroughs and learning by doing. Such cost reductions will never occur unless the cellulosic biofuels industry gets off the ground. If this reasoning holds, cost reductions will be enough for cellulosic biofuels to compete on their own merits. If this is the justification for producing cellulosic biofuels, then the mandates should be large enough to foster enough investment so that the industry can learn from its own mistakes. Clearly, the 16 billion gallon mandate by 2022 that is current US law goes well beyond the level needed to foster experimentation and learning by doing.
3.2. Drop-in fuels Figs. 1 and 2 make clear that the coexistence of first- and secondgeneration facilities combined with an upper limit on blending ratios will give few possibilities for a large cellulosic ethanol industry without large subsidies. Competition with ethanol from corn and from Brazil makes the emergence of cellulosic ethanol in the US difficult. But this difficulty could be partially overcome if cellulosic biofuels plants produced a fuel other than ethanol that could be directly ‘dropped’ into the fuel supply without concern about energy content or maximum blending limits. Green or nonester biodiesel that meets all the fuel specifications that diesel meets is one example. Biobutanol is another. There are two advantages to these fuels. First, they would be priced at par with either gasoline or diesel. No discounting would be needed. Second, their introduction would not cause a large price drop because demand for them would be quite elastic. The demand for transportation fuels is quite inelastic in a 1–5year time frame. This means that the price of transportation fuels would have to fall by much more than 10% to accommodate a 10% increase in the use of transportation fuels. This does not mean, however, that the demand for a drop-in biofuel is inelastic. If the market share of a drop-in biofuel is 10%, for example, a 10% increase in the quantity of the biofuel represents only a 1% increase in the quantity of transportation fuels if all other quantities of transportation fuels are held constant. This means that a 10% increase in the quantity of a drop-in biofuel would have approximately one-tenth the impact on the market price of transportation fuels as would a 10% increase in all transportation fuels. This implies that the demand elasticity of biofuels with a 10% market share is approximately 10 times larger (more negative) than the total demand elasticity for transportation fuels. With a market share of less than 1% or 2% (1–3 billion gallons), the demand elasticity is between 50 and 100 times more elastic than transportation fuels. Thus at low volumes the demand curve for drop-in cellulosic biofuels is almost perfectly elastic at the price of the fuel that it is substituting for either gasoline or diesel.
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The benefit of selling into a perfectly elastic demand curve at a value lower than or equal to either gasoline or diesel is that it creates a more certain investment climate for cellulosic biofuels because the benchmark for a successful investment is clear. All that has to be done is to produce the cellulosic biofuel at a cost that is less than the price of either gasoline or diesel. This contrasts with the situation cellulosic ethanol faces in which market saturation and competition from conventional ethanol makes it difficult to determine a benchmark for success. Of course, being able to sell cellulosic fuel at the price of gasoline or diesel does not guarantee market success. The cost of producing the fuel must be lower than the selling price if the industry is to exist without a subsidy. If this necessary condition has been met, the ultimate size of the cellulosic ethanol industry depends on the steepness of the cellulosic supply curve. This in turn depends primarily on the availability of cellulosic feedstock, a topic to which we now turn.
3.3. Role of feedstock prices Whether it makes economic sense to convert a feedstock into biofuels is mainly determined by three factors: conversion efficiency, the price of biofuels, and the price of feedstocks. If conversion margins (defined as the price of biofuels minus the cost of feedstock minus conversion costs plus by-product value) are large enough, then the capital required to build and operate a plant will likely be available. For drop-in biofuels, the price of biofuels should be equal to the wholesale price of gasoline or diesel. Thus, given the price of crude oil and conversion technology, margins are primarily determined by feedstock costs. Elobeid et al. (2007) showed that the eventual size of the corn ethanol industry is determined primarily by how quickly the price of corn increases to break-even levels. They showed that with an elastic ethanol demand, there is a one-to-one correspondence between crude oil prices and corn prices. Increases in crude oil prices increase ethanol margins, which induces expansion of ethanol. This expansion increases the price of corn until margins return to long-run break-even levels. In the long-run, the size of the corn ethanol industry depends on the elasticity of the supply curve of corn. Because corn is a highly tradable commodity, when the price of corn in Illinois increases, so too does the price of corn in Japan. If the price in Japan did not increase, then corn would not be shipped to Japan. Because transportation costs of corn are low relative to its price, spatial differences in the price of corn are quite limited. In contrast, cellulosic material has a much lower value than corn relative to transportation costs because it is much less dense. This means that it takes a much larger price increase in a region that is short of material to cover transportation costs of importing feedstock. This also means that there is no meaningful national or international price of cellulosic material, which is why hay prices can differ so dramatically across regions. Because shipping costs are so high and because there is no existing market for cellulosic biofuels feedstocks, the price of cellulosic feedstocks will largely be determined locally.3 What the local price of feedstock will be depends on whether there is an alternative use for the material. If the feedstock has no alternative use—it really is ‘‘waste’’—then its price will be determined by how much it takes to induce farmers to collect enough feedstock to fuel a plant. If the feedstock has an alternative use, then the price must be high enough to bid the feedstock away from the alternative use. As long as the local supply of the cellulosic feedstock exceeds local demand, then expansion of cellulosic biofuels production, whether 3 Pre-treatment of cellulosic feedstocks that increase their value and density could increase value and lower transportation costs enough to enable a spatially integrated market for treated feedstocks to emerge.
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it occurs locally or far away, will not significantly increase feedstock prices.4 Feedstock prices will increase only if available local supply must be rationed because of competition from biofuels plants. High transportation costs of cellulosic feedstocks therefore create a different market situation than that experienced by the corn ethanol or biodiesel industry because corn and vegetable oil are widely traded commodities, so expansion in any region will result in increased feedstock prices. One caveat to this market situation is that cellulosic feedstocks are potentially low-cost sources of greenhouse gas reductions when they are co-fired with coal to produce electricity. Thus if the price of CO2 increases sufficiently, then cellulosic biofuels plants will need to compete with power plants for feedstock, a competition that the biofuels plants are not likely to win. Assuming that conversion technology advances to the point at which the cost of producing biofuels is less than the cost of diesel or gasoline, then the eventual size of the industry will be determined primarily by the price and availability of feedstock. Given the wide variety of sources of cellulosic material, if cellulosic biofuels become economically viable, and if power plants do not buy all available feedstocks, then it is likely that a wide variety of feedstocks will be used based on their opportunity cost and availability. Corn stover is the most abundant source of crop residue in the US. The amount of corn stover that could be collected and converted to biofuels depends on soil erosion constraints, the amount of corn produced, and the cost of collection efforts. Graham et al. (2007) estimates that at least 70 million tons of stover could be collected with harvesting costs of less than $30 per ton. Petrolia (2008) estimates that corn stover harvesting and transportation costs would be higher, beginning at $50 per ton. At 70 gallons per ton, 70 million tons of corn stover translates into a cellulosic biofuels volume of almost 5 billion gallons. At low volumes of cellulosic biofuels made from corn stover, it is likely that the biofuels plants will be located close to corn production regions that have high concentrations of stover. As volumes increase, plants will be located in areas of decreasing density, which will result in higher feedstock acquisition costs. As long as biofuels plants are sited with care, then expansion should occur without significantly increasing feedstock prices other than what is needed to cover local transportation costs. In Europe and parts of the US, the availability of woody biomass is high enough to make it a potential feedstock. Forest residues include logging residues, and thinning, rough, rotten, or salvageable logs. It has been estimated that up to 45 million tons of such residues could be used economically in the US. Residue from lumber and pulp mills could also be used for biofuels production, but this would require that biofuels outcompete current uses of these residues. The potential supply of biomass produced from dedicated energy crops is quite high, but only at increasing costs because as more cropland is taken out of crop production, crop prices will increase, thereby increasing the cost of using land for biomass production. There is some amount of cropland that is currently not in production and some amount of potential cropland that could be brought into biomass production for biofuels. Expansion of biofuels based on cellulosic feedstocks produced on these lands would not necessarily increase the price of feedstocks, in contrast to expansion based on conversion of cropland. 3.4. Other factors We now provide additional details about other factors influencing the emergence of second-generation biofuels. 4 Invariance of local price to demand growth elsewhere depends on transportation costs for cellulosic material being too high for spatial arbitrage to occur.
3.4.1. Technological progress for second-generation biofuels and no biofuel policies implemented A downward shift in the supply curve for cellulosic biofuels from major technological progress is necessary for generating enough profits to attract investors and a competitive second-generation biofuels industry if government subsidies and mandates are not available. If the cellulosic biofuel produced is ethanol, then displacement of first-generation facilities would lead to a very low corn price, which would reinforce the low-price pressure for ethanol. Thus, research efforts designed to achieve this technological progress should target production of drop-in fuels. 3.4.2. More elastic corn or sugarcane ethanol supplies Lower costs and more elastic supplies of conventional biofuels feedstocks because of higher yields or technological progress in the transformation of feedstock to biofuels would lead to even lower ethanol price levels than shown in Fig. 1. Either of these changes lowers the possible competitiveness of cellulosic ethanol, thus reinforcing the need to focus on drop-in fuels. 3.4.3. Corn ethanol supply is capped (or land is constrained in the case of EU rapeseed biodiesel) Setting a cap on corn ethanol production combined with an expansion of allowable ethanol blend rates would decrease the total supply of ethanol, increase the ethanol price, and thus favor the emergence of second-generation biofuels facilities that produce ethanol rather than drop-in fuels.
4. Conclusions The likelihood that a significant cellulosic biofuels industry will emerge in the US is low, particularly if ethanol is the targeted biofuel. The reasons are that cellulosic ethanol will have to compete with conventional ethanol, and there are limitations on the amount of ethanol that can be blended with gasoline. The necessary condition for cellulosic ethanol to be successful is a targeted subsidy or mandate that carves out a portion of the ethanol market for cellulosic ethanol. But even with such a carve-out, the ultimate size of the US ethanol market is much smaller than future US biofuels mandates, so it simply is not feasible for these mandates to be met through a combination of conventional and cellulosic ethanol. A more promising future is possible for drop-in biofuels made from cellulosic feedstocks because they would avoid the blending limits and transportation difficulties of ethanol. But the future for drop-in biofuels will be bright only if ongoing research efforts focus on producing drop-in fuels and lead to sharply lower production costs so that these new fuels will be reasonably competitive with petroleum-based fuels. One advantage that cellulosic biofuels have over conventional biofuels is a lack of an integrated feedstock market. The spatial dimension of markets for cellulosic feedstocks will be limited because of high transportation costs. As long as the potential supply of a cellulosic feedstock in a region is not exhausted, then expansion of cellulosic biofuels will not drive up feedstock costs. Higher feedstock costs caused by expansion of corn and sugarcane ethanol production limit the potential profitability of these industries. Advocates of expanded corn ethanol production argue that the relationship between corn ethanol and cellulosic biofuels is mutually beneficial: by developing an infrastructure for transporting large volumes of ethanol and by forcing fuel refiners to blend increasing quantities of ethanol in petroleum gasoline, producers of corn ethanol naturally pave the way for the emergence of a new
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generation of biofuels. However, if producers of cellulosic biofuels produce ethanol rather than drop-in biofuels, corn ethanol will not be an enabler of the nascent industry but rather a tough competitor that ultimately limits the profitability and investment opportunities in cellulosic biofuels.
Acknowledgements This work was partially funded by the US Department of Energy Great Lakes Bioenergy Research Center (DOE Office of Science BER DE-FC02-07ER64494). Financial support received by the ‘‘New Issues in Agricultural, Food and Bioenergy Trade (AGFOODTRADE)’’ (Grant Agreement no. 212036) research project, funded by the European Commission, is also gratefully acknowledged. The views expressed in this paper are the sole responsibility of the authors and do not reflect those of the Commission which has not reviewed, let alone approved the content of the paper. The paper does not reflect the views of the institutions of affiliation of the authors either.
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Energy Policy journal homepage: www.elsevier.com/locate/enpol
Opportunity for profitable investments in cellulosic biofuels Bruce A. Babcock a, Ste´phan Marette b, David Tre´guer b,n a b
Center for Agricultural and Rural Development, Iowa State University, 578F Heady Hall, Ames, IA 50011-1070, USA INRA, UMR Economie Publique INRA-AgroParisTech, 16 rue Claude Bernard, 75231 Paris Cedex 05, France
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a b s t r a c t
Article history: Received 2 September 2010 Accepted 27 October 2010 Available online 19 November 2010
Research efforts to allow large-scale conversion of cellulose into biofuels are being undertaken in the US and EU. These efforts are designed to increase logistic and conversion efficiencies, enhancing the economic competitiveness of cellulosic biofuels. However, not enough attention has been paid to the future market conditions for cellulosic biofuels, which will determine whether the necessary private investment will be available to allow a cellulosic biofuels industry to emerge. We examine the future market for cellulosic biofuels, differentiating between cellulosic ethanol and ‘drop-in’ cellulosic biofuels that can be transported with petroleum fuels and have equivalent energy values. We show that emergence of a cellulosic ethanol industry is unlikely without costly government subsidies, in part because of strong competition from conventional ethanol and limits on ethanol blending. If production costs of drop-in cellulosic biofuels fall enough to become competitive, then their expansion will not necessarily cause feedstock prices to rise. As long as local supplies of feedstocks that have no or lowvalued alternative uses exist, then expansion will not cause prices to rise significantly. If cellulosic feedstocks come from dedicated biomass crops, then the supply curves will have a steeper slope because of competition for land. & 2010 Elsevier Ltd. All rights reserved.
Keywords: Cellulosic biofuels Market conditions Investments
1. Introduction Large public and private research efforts are currently being undertaken to remove technical and logistical barriers to converting cellulosic feedstocks into liquid transportation fuels. For example, the US Department of Energy (DOE) in 2008 established five research centers at a total cost of more than $300 million. In addition, in 2009 DOE committed $480 million to improve the energy efficiency of biofuels and biomass conversion plants. BP provided $500 million to the University of California-Berkeley and the University of Illinois to fund the Bioenergy Institute. Conoco Phillips established a $22.5 million joint research program with Iowa State University. In the European Union (EU), the total contribution for biofuel projects (mostly second generation) under the Seventh Framework Program adds up to h45 million. Additional programs funded by member states aim at fostering the development of second-generation biofuels, like a h27 million special fund in Denmark and a h137 million, 5-year program in Finland (Jung et al., 2010). The rationale for research efforts in the United States (US) is not difficult to find because the 16-billion-gallon US mandate for cellulosic biofuels by 2022 will not be achieved without major research breakthroughs in the areas of conversion technologies,
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feedstock logistics, and agronomic knowledge. The rationale for EU research efforts is less clear because its 10% mandate1 for biofuels likely can be met at reasonable cost through a combination of domestically produced and imported conventional feedstocks (primarily rapeseed oil). Concern about the availability and cost of food commodities is a motivating factor for support of cellulosic biofuels in both the EU and the US because replacing biofuels made from commodities that can also be used to produce food with cellulosic biofuels would likely lead to lower food prices. And given the wide availability of potential cellulosic feedstocks, it is possible to envision a future in which gasoline and diesel are largely replaced by cellulosic biofuels.
1 The 10% target contained in the Renewable Energy Directive (Directive 2009/ 28/EC) also includes green electricity and hydrogen, rather than a strict biofuel target. Moreover, the Directive introduces sustainability criteria, namely, that minimal greenhouse gas savings have to be achieved. Biofuels must provide at least 35% carbon emission savings compared to fossil fuel in 2010.This level will rise to 45% by 2013 and 50% by 2017, with 60% for new installations. Some types of land are deemed unfit to grow biofuels crops (primary forests, protected areas, grassland with a rich biodiversity, wetlands, and peatlands) and social standards have to be met (domestic and foreign production should comply with eight conventions of the International Labor Organization). However, no legally binding reference to ‘indirect land use’ aspects was kept in the final text, but the European Commission has been asked to come forward with proposals by the end of 2010 to limit indirect land-use change. The Parliament and the Council will then have to make a decision based on these proposals before 2012.
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Future production of cellulosic biofuels will come about only if public and private research efforts successfully lower the cost of production enough to induce private capital to flow into the sector or if subsidies are large enough. Public investment in such plants does not seem likely. US interest groups have not had the power to push Congress and the Administration to offer investment loan guarantees for cellulosic biofuels plants. Future prospects for such guarantees look dim because of budget concerns. In the EU, the recent market reactions to the fiscal positions of most member states have created an environment that does not favor either government ownership of plants or loan guarantees. Private investment will only occur if future market conditions are favorable for profit-making. Thus it makes sense to expand beyond the engineering and agronomic research effort on cellulosic biofuels to include research on the future market conditions that cellulosic biofuels will face. Much of the existing literature on the future of cellulosic biofuels has focused on whether feedstock supplies will be sufficient to meet a given production target (Perlak et al., 2005), or the relative attractiveness of alternative feedstock supplies (Khanna et al., 2008). Bruce McCarl and co-authors (McCarl and Schneider, 2001; Schneider and McCarl, 2003, for example) have estimated supply curves of CO2 reductions from alternative sources using a programming model. These supply curves are used to project the quantity of cellulosic biofuels (from various feedstocks) that will enter the market for any given CO2 price. But these studies do not examine the actual market for cellulosic biofuels other than as it is influenced by climate change policy. In other words, the necessary market conditions suitable for the emergence or the absence of second-generation biofuels were overlooked by the previous studies. Projections of biofuel supply and demand in the US were recently released by the Food and Agricultural Policy Research Institute (FAPRI) using a model that includes cellulosic ethanol as one of the commodities. Cellulosic ethanol competes with corn ethanol in the market. In both the programming model and the FAPRI model it is difficult to understand how the market for cellulosic ethanol works because the details are hidden in the models. Thus, it is difficult to understand the conditions that are required to make future private investments in cellulosic biofuels profitable. The contribution of this article is an examination of the future market for cellulosic biofuels as it is influenced by both market forces and government policy. In carrying out this examination, we differentiate between cellulosic ethanol, which must compete with existing corn and sugarcane ethanol production, and drop-in cellulosic biofuels, which can be transported in pipelines and substitute directly for gasoline, jet fuel, and diesel. Our examination is necessarily speculative to a degree because cellulosic biofuels production has yet to occur. The future time period that we examine is 5 years in the future. This length of time is far enough into the future to allow supply adjustments to occur in both input and output markets, and to allow the US mandate for cellulosic biofuels to become quite substantial. For example, in 2015, the US mandate for cellulosic biofuels production (in ethanol-equivalent gallons) is 3.0 billion gallons. By 2015, the supply of conventional biofuels (corn and sugarcane ethanol) will have grown substantially from their current levels. The US mandate for corn ethanol will be 15 billion gallons, and Brazilian domestic demand for ethanol will likely have surpassed 13 billion gallons. The article begins with a discussion of the important market forces that will influence the US and EU future demand for cellulosic ethanol. The role of competition with conventional biofuels and petroleum-derived fuels is highlighted. We demonstrate that because of a high degree of competition and uncertainty caused by uncertain technologies and commodity prices, it will be difficult for market forces alone to induce a large degree of private
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investment in cellulosic biofuels. We then turn to an examination of how government policy can influence profit potential through mandates and trade measures. Government policy can generate profit potential but it also adds more uncertainty because what the government gives, it can also take away.
2. The market conditions for cellulosic ethanol We first consider how market forces will impact the future demand for cellulosic ethanol. Cellulosic ethanol will need to compete with other transportation fuels. The existing important transportation fuels are petroleum-based fuels and conventional ethanol. From the perspective of the US market, conventional ethanol can be differentiated into domestically produced corn ethanol and imported sugarcane ethanol. If cellulosic biofuels expand, they will not displace these conventional biofuels because owners of existing conventional biofuels plants will continue to operate their plants if it is profitable to do so. Thus cellulosic biofuels will be competing against all transportation fuels. Advocates of cellulosic biofuels point to the amount of CO2 reduction that can be accomplished by replacing corn ethanol, gasoline, or diesel with cellulosic biofuels. In terms of a percentage reduction, it is true that cellulosic biofuels may have much lower emissions, but McCarl and Schneider (2001) have shown that the CO2 savings do not make cellulosic biofuels competitive until the price of CO2 rises to more than $40 per ton. This means that it will be difficult for cellulosic biofuels to compete with other lower-cost sources of CO2 reductions. Thus, the primary source of profitability for cellulosic biofuels must be found in the market for transportation fuels, not in the market for CO2 reductions. We now turn to a simple example for characterizing the market conditions linked to the introduction of the cellulosic ethanol. In Fig. 1, quantities of ethanol are located along the horizontal axis, and costs and prices are located along the vertical axis. Consider the total medium-run (5 years ahead) supply ST and demand D of ethanol in the US, as depicted in Fig. 1. The mediumrun assumption means that investment costs in the 5-year horizon are treated as variable costs and that current investments are treated as fixed costs. Overall supply ST of biofuels is represented by a line made up of three different components, namely, the domestic corn and cellulosic ethanol supplies – respectively, SI and SII – and import supply, which for exposition we assume equals the Brazilian ethanol excess supply curve SB. The quantity ST is obtained by horizontally adding up the different quantities supplied at each
Fig. 1. Ethanol supply and demand with no government programs.
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price P: ST(P) ¼SI(P) +SII(P)+ SB(P). With no government programs in place, the market equilibrium is at point E; the quantity on the US ethanol market is QE sold at price PE. Proper interpretation of this market equilibrium requires knowledge of some details of the supply and demand curves in Fig. 1. The ethanol demand curve in Fig. 1 is drawn as being fairly inelastic, which simply means that the price of ethanol is sensitive to ethanol quantity. This price sensitivity is consistent with a US ethanol market that does not export large quantities of ethanol and one that is quite saturated. Current fuel standards limit blend rates to 10% ethanol for automobiles made before 2007 and 15% for later model vehicles.2 An inelastic demand for ethanol is consistent with a US market that is at or approaching the maximum allowable blend rate, also called the ‘blend wall’, which is a physical limit on the amount of ethanol that can be used in the market. Ethanol demand is much more elastic with a robust export market or when the market is not approaching the blend wall because ethanol would then substitute more freely for gasoline. The implications of an elastic demand for cellulosic biofuels are discussed below. There is a range of quantities for which US corn ethanol can be produced at lower cost than what it costs to import ethanol from Brazil. At low quantities of US domestic production, corn prices would be quite low, and excess US ethanol production capacity would exist. In addition, export supply from Brazil is the quantity of ethanol in excess of Brazilian domestic demand, which is expected to grow rapidly (Babcock et al., 2010). Thus the US price must be high enough to pull ethanol out of the Brazilian market. It is likely that the Brazilian excess supply curve is more elastic than the US domestic supply curve over a 5-year time horizon because Brazil has more land available for sugarcane production than the US has available for corn production. Therefore there is a point at which the US corn ethanol supply curve intersects the Brazilian export supply curve from below, as is shown in Fig. 1. Because there are no commercial cellulosic ethanol plants in existence, the marginal cost of cellulosic ethanol includes capital costs. After combining capital costs with feedstock acquisition costs and current estimates of conversion costs, it is likely that, given current production technologies, current ethanol prices cannot cover even the lowest-cost source of cellulosic ethanol. Thus the intercept of the cellulosic ethanol supply curve (SII) is higher than the equilibrium price PE. With such a market configuration, cellulosic ethanol is not competitive, and no industry emerges. If the intercept of the cellulosic ethanol supply curve turns out to be lower than that shown in Fig. 1, then an industry could emerge. However, given a saturated ethanol market, the primary impact of cellulosic ethanol production would be to lower the price of ethanol. Corn and sugarcane ethanol would remain strong competitors with cellulosic ethanol. In a 5-year time horizon, the prospect of having to compete with entrenched ethanol producers in a saturated market is not likely to prove attractive to investors. Consequently, our first conclusion is that a cellulosic ethanol industry is not likely to attract investors because of a saturated market and strong competition from existing producers.
interventions that treat cellulosic ethanol differently than conventional ethanol. We then examine how production of ‘drop-in’ cellulosic biofuels that can substitute directly for gasoline or diesel rather than for ethanol creates a clear economic benchmark for investment success. And third, we show how the choice of cellulosic feedstocks can influence the longevity and magnitude of investor gains once the economic benchmark has been achieved. 3.1. Discrimination among biofuels One way to make cellulosic ethanol more attractive to investors is for government to differentially regulate, tax, or subsidize cellulosic ethanol relative to conventional ethanol. For example, the US government currently gives a $1.01 tax credit for cellulosic ethanol and a $0.45 per gallon tax credit for conventional ethanol. This higher tax credit means that the ability to pay for cellulosic ethanol is $0.56 per gallon higher than for a gallon of corn ethanol. In addition, the US government has adopted mandates for cellulosic biofuels that are distinct from mandates for conventional biofuels. Fig. 2 shows the impact of distinct mandates. With a cellulosic ethanol mandate of QI and a conventional ethanol mandate of QII, total ethanol consumption is QT. The market-clearing price is PE. The vertical distance between PE and point A on the supply curve of cellulosic biofuels and between PE and point B on the supply curve for conventional biofuels is the difference between the minimum price needed to produce the respective mandated quantities and the maximum price that blenders are willing to pay for these quantities. These vertical distances measure the amount of subsidy that must be given to biofuels producers to induce them to produce mandated volumes or the amount by which blenders are taxed because of the mandates. Tax credits could make up for some or all of these mandate costs. Fig. 2 shows that government mandates can create a market for cellulosic biofuels, albeit at a cost to either taxpayers or blenders, who, in turn, would pass some portion of their costs onto fuel consumers. Current US policy is reasonably well-represented by Fig. 2 with the exception that existing import tariffs that increase the cost of meeting the conventional biofuels mandate are not accounted for. In addition, it is highly unlikely that actual mandated volumes of cellulosic biofuels would be produced. Instead, mandates would be waived to a level that could be met by whatever production capacity comes on line in the next few years. The policy question that needs to be addressed is whether it actually makes sense to carve out a special mandate for cellulosic ethanol. The cost of
3. How to enhance the investment outlook for cellulosic biofuels There exist market conditions, technology choices, and policy interventions that can enhance the investment outlook for cellulosic biofuels. We examine three below. First we examine policy 2 The US corn and ethanol industries are lobbying for blend rates of 15% or 20% for all vehicles.
Fig. 2. Ethanol supply and demand with mandates.
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meeting a total mandate of biofuels would be much lower if there were no cellulosic ethanol carve-out. This can be seen by comparing the vertical distance between the total supply curve ST at quantity QT to the cost of meeting the cellulosic carve-out. One argument that could be made for the carve-out is that greenhouse gas reductions from cellulosic ethanol are much larger than for conventional ethanol. This is certainly true, but if reductions in greenhouse gas emissions are the objective of a policy, then economic costs would be lowered if they were targeted directly with a tax or a cap-and-trade system that extends to sectors other than biofuels. At a minimum, the magnitude of the cellulosic ethanol mandate should reflect the value and quantity of emission reductions. A second possible justification for a mandate for cellulosic biofuels is that the current costs of producing cellulosic biofuels do not reflect possible large-scale cost reductions that can come about from technological breakthroughs and learning by doing. Such cost reductions will never occur unless the cellulosic biofuels industry gets off the ground. If this reasoning holds, cost reductions will be enough for cellulosic biofuels to compete on their own merits. If this is the justification for producing cellulosic biofuels, then the mandates should be large enough to foster enough investment so that the industry can learn from its own mistakes. Clearly, the 16 billion gallon mandate by 2022 that is current US law goes well beyond the level needed to foster experimentation and learning by doing.
3.2. Drop-in fuels Figs. 1 and 2 make clear that the coexistence of first- and secondgeneration facilities combined with an upper limit on blending ratios will give few possibilities for a large cellulosic ethanol industry without large subsidies. Competition with ethanol from corn and from Brazil makes the emergence of cellulosic ethanol in the US difficult. But this difficulty could be partially overcome if cellulosic biofuels plants produced a fuel other than ethanol that could be directly ‘dropped’ into the fuel supply without concern about energy content or maximum blending limits. Green or nonester biodiesel that meets all the fuel specifications that diesel meets is one example. Biobutanol is another. There are two advantages to these fuels. First, they would be priced at par with either gasoline or diesel. No discounting would be needed. Second, their introduction would not cause a large price drop because demand for them would be quite elastic. The demand for transportation fuels is quite inelastic in a 1–5year time frame. This means that the price of transportation fuels would have to fall by much more than 10% to accommodate a 10% increase in the use of transportation fuels. This does not mean, however, that the demand for a drop-in biofuel is inelastic. If the market share of a drop-in biofuel is 10%, for example, a 10% increase in the quantity of the biofuel represents only a 1% increase in the quantity of transportation fuels if all other quantities of transportation fuels are held constant. This means that a 10% increase in the quantity of a drop-in biofuel would have approximately one-tenth the impact on the market price of transportation fuels as would a 10% increase in all transportation fuels. This implies that the demand elasticity of biofuels with a 10% market share is approximately 10 times larger (more negative) than the total demand elasticity for transportation fuels. With a market share of less than 1% or 2% (1–3 billion gallons), the demand elasticity is between 50 and 100 times more elastic than transportation fuels. Thus at low volumes the demand curve for drop-in cellulosic biofuels is almost perfectly elastic at the price of the fuel that it is substituting for either gasoline or diesel.
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The benefit of selling into a perfectly elastic demand curve at a value lower than or equal to either gasoline or diesel is that it creates a more certain investment climate for cellulosic biofuels because the benchmark for a successful investment is clear. All that has to be done is to produce the cellulosic biofuel at a cost that is less than the price of either gasoline or diesel. This contrasts with the situation cellulosic ethanol faces in which market saturation and competition from conventional ethanol makes it difficult to determine a benchmark for success. Of course, being able to sell cellulosic fuel at the price of gasoline or diesel does not guarantee market success. The cost of producing the fuel must be lower than the selling price if the industry is to exist without a subsidy. If this necessary condition has been met, the ultimate size of the cellulosic ethanol industry depends on the steepness of the cellulosic supply curve. This in turn depends primarily on the availability of cellulosic feedstock, a topic to which we now turn.
3.3. Role of feedstock prices Whether it makes economic sense to convert a feedstock into biofuels is mainly determined by three factors: conversion efficiency, the price of biofuels, and the price of feedstocks. If conversion margins (defined as the price of biofuels minus the cost of feedstock minus conversion costs plus by-product value) are large enough, then the capital required to build and operate a plant will likely be available. For drop-in biofuels, the price of biofuels should be equal to the wholesale price of gasoline or diesel. Thus, given the price of crude oil and conversion technology, margins are primarily determined by feedstock costs. Elobeid et al. (2007) showed that the eventual size of the corn ethanol industry is determined primarily by how quickly the price of corn increases to break-even levels. They showed that with an elastic ethanol demand, there is a one-to-one correspondence between crude oil prices and corn prices. Increases in crude oil prices increase ethanol margins, which induces expansion of ethanol. This expansion increases the price of corn until margins return to long-run break-even levels. In the long-run, the size of the corn ethanol industry depends on the elasticity of the supply curve of corn. Because corn is a highly tradable commodity, when the price of corn in Illinois increases, so too does the price of corn in Japan. If the price in Japan did not increase, then corn would not be shipped to Japan. Because transportation costs of corn are low relative to its price, spatial differences in the price of corn are quite limited. In contrast, cellulosic material has a much lower value than corn relative to transportation costs because it is much less dense. This means that it takes a much larger price increase in a region that is short of material to cover transportation costs of importing feedstock. This also means that there is no meaningful national or international price of cellulosic material, which is why hay prices can differ so dramatically across regions. Because shipping costs are so high and because there is no existing market for cellulosic biofuels feedstocks, the price of cellulosic feedstocks will largely be determined locally.3 What the local price of feedstock will be depends on whether there is an alternative use for the material. If the feedstock has no alternative use—it really is ‘‘waste’’—then its price will be determined by how much it takes to induce farmers to collect enough feedstock to fuel a plant. If the feedstock has an alternative use, then the price must be high enough to bid the feedstock away from the alternative use. As long as the local supply of the cellulosic feedstock exceeds local demand, then expansion of cellulosic biofuels production, whether 3 Pre-treatment of cellulosic feedstocks that increase their value and density could increase value and lower transportation costs enough to enable a spatially integrated market for treated feedstocks to emerge.
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it occurs locally or far away, will not significantly increase feedstock prices.4 Feedstock prices will increase only if available local supply must be rationed because of competition from biofuels plants. High transportation costs of cellulosic feedstocks therefore create a different market situation than that experienced by the corn ethanol or biodiesel industry because corn and vegetable oil are widely traded commodities, so expansion in any region will result in increased feedstock prices. One caveat to this market situation is that cellulosic feedstocks are potentially low-cost sources of greenhouse gas reductions when they are co-fired with coal to produce electricity. Thus if the price of CO2 increases sufficiently, then cellulosic biofuels plants will need to compete with power plants for feedstock, a competition that the biofuels plants are not likely to win. Assuming that conversion technology advances to the point at which the cost of producing biofuels is less than the cost of diesel or gasoline, then the eventual size of the industry will be determined primarily by the price and availability of feedstock. Given the wide variety of sources of cellulosic material, if cellulosic biofuels become economically viable, and if power plants do not buy all available feedstocks, then it is likely that a wide variety of feedstocks will be used based on their opportunity cost and availability. Corn stover is the most abundant source of crop residue in the US. The amount of corn stover that could be collected and converted to biofuels depends on soil erosion constraints, the amount of corn produced, and the cost of collection efforts. Graham et al. (2007) estimates that at least 70 million tons of stover could be collected with harvesting costs of less than $30 per ton. Petrolia (2008) estimates that corn stover harvesting and transportation costs would be higher, beginning at $50 per ton. At 70 gallons per ton, 70 million tons of corn stover translates into a cellulosic biofuels volume of almost 5 billion gallons. At low volumes of cellulosic biofuels made from corn stover, it is likely that the biofuels plants will be located close to corn production regions that have high concentrations of stover. As volumes increase, plants will be located in areas of decreasing density, which will result in higher feedstock acquisition costs. As long as biofuels plants are sited with care, then expansion should occur without significantly increasing feedstock prices other than what is needed to cover local transportation costs. In Europe and parts of the US, the availability of woody biomass is high enough to make it a potential feedstock. Forest residues include logging residues, and thinning, rough, rotten, or salvageable logs. It has been estimated that up to 45 million tons of such residues could be used economically in the US. Residue from lumber and pulp mills could also be used for biofuels production, but this would require that biofuels outcompete current uses of these residues. The potential supply of biomass produced from dedicated energy crops is quite high, but only at increasing costs because as more cropland is taken out of crop production, crop prices will increase, thereby increasing the cost of using land for biomass production. There is some amount of cropland that is currently not in production and some amount of potential cropland that could be brought into biomass production for biofuels. Expansion of biofuels based on cellulosic feedstocks produced on these lands would not necessarily increase the price of feedstocks, in contrast to expansion based on conversion of cropland. 3.4. Other factors We now provide additional details about other factors influencing the emergence of second-generation biofuels. 4 Invariance of local price to demand growth elsewhere depends on transportation costs for cellulosic material being too high for spatial arbitrage to occur.
3.4.1. Technological progress for second-generation biofuels and no biofuel policies implemented A downward shift in the supply curve for cellulosic biofuels from major technological progress is necessary for generating enough profits to attract investors and a competitive second-generation biofuels industry if government subsidies and mandates are not available. If the cellulosic biofuel produced is ethanol, then displacement of first-generation facilities would lead to a very low corn price, which would reinforce the low-price pressure for ethanol. Thus, research efforts designed to achieve this technological progress should target production of drop-in fuels. 3.4.2. More elastic corn or sugarcane ethanol supplies Lower costs and more elastic supplies of conventional biofuels feedstocks because of higher yields or technological progress in the transformation of feedstock to biofuels would lead to even lower ethanol price levels than shown in Fig. 1. Either of these changes lowers the possible competitiveness of cellulosic ethanol, thus reinforcing the need to focus on drop-in fuels. 3.4.3. Corn ethanol supply is capped (or land is constrained in the case of EU rapeseed biodiesel) Setting a cap on corn ethanol production combined with an expansion of allowable ethanol blend rates would decrease the total supply of ethanol, increase the ethanol price, and thus favor the emergence of second-generation biofuels facilities that produce ethanol rather than drop-in fuels.
4. Conclusions The likelihood that a significant cellulosic biofuels industry will emerge in the US is low, particularly if ethanol is the targeted biofuel. The reasons are that cellulosic ethanol will have to compete with conventional ethanol, and there are limitations on the amount of ethanol that can be blended with gasoline. The necessary condition for cellulosic ethanol to be successful is a targeted subsidy or mandate that carves out a portion of the ethanol market for cellulosic ethanol. But even with such a carve-out, the ultimate size of the US ethanol market is much smaller than future US biofuels mandates, so it simply is not feasible for these mandates to be met through a combination of conventional and cellulosic ethanol. A more promising future is possible for drop-in biofuels made from cellulosic feedstocks because they would avoid the blending limits and transportation difficulties of ethanol. But the future for drop-in biofuels will be bright only if ongoing research efforts focus on producing drop-in fuels and lead to sharply lower production costs so that these new fuels will be reasonably competitive with petroleum-based fuels. One advantage that cellulosic biofuels have over conventional biofuels is a lack of an integrated feedstock market. The spatial dimension of markets for cellulosic feedstocks will be limited because of high transportation costs. As long as the potential supply of a cellulosic feedstock in a region is not exhausted, then expansion of cellulosic biofuels will not drive up feedstock costs. Higher feedstock costs caused by expansion of corn and sugarcane ethanol production limit the potential profitability of these industries. Advocates of expanded corn ethanol production argue that the relationship between corn ethanol and cellulosic biofuels is mutually beneficial: by developing an infrastructure for transporting large volumes of ethanol and by forcing fuel refiners to blend increasing quantities of ethanol in petroleum gasoline, producers of corn ethanol naturally pave the way for the emergence of a new
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generation of biofuels. However, if producers of cellulosic biofuels produce ethanol rather than drop-in biofuels, corn ethanol will not be an enabler of the nascent industry but rather a tough competitor that ultimately limits the profitability and investment opportunities in cellulosic biofuels.
Acknowledgements This work was partially funded by the US Department of Energy Great Lakes Bioenergy Research Center (DOE Office of Science BER DE-FC02-07ER64494). Financial support received by the ‘‘New Issues in Agricultural, Food and Bioenergy Trade (AGFOODTRADE)’’ (Grant Agreement no. 212036) research project, funded by the European Commission, is also gratefully acknowledged. The views expressed in this paper are the sole responsibility of the authors and do not reflect those of the Commission which has not reviewed, let alone approved the content of the paper. The paper does not reflect the views of the institutions of affiliation of the authors either.
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