How to Fix the Broken Cellulosic Ethanol Incentive System

Overview: Mandates, Zero Production, Penalties, and the Failure of the Current System

In the previous post, I discussed the annual ritual of rolling back the cellulosic ethanol mandates by 90% or more. For three years running, cellulosic ethanol production will come in far, far short of the mandated target volumes. In fact, of the 100 million gallons mandated last year and 250 million gallons mandated this year, there is still no qualifying production to date. For 2012, the EPA is considering reducing the 500 million gallon mandate to as little as 3.5 million gallons. This is a reduction of over 99%, and should be a crystal clear indicator that this system is not working as intended.

But even though product isn’t being delivered, taxpayers and consumers are still paying a price. We are on the hook for grants and loan guarantees that have been given to plants that have not — and in some cases never will — produce any cellulosic ethanol. Further, as the previous post highlighted, the system penalizes gasoline blenders for not purchasing cellulosic ethanol — despite there being no qualifying cellulosic ethanol on the market to buy. Due to the mandates, blenders must either purchase cellulosic ethanol — or buy waivers that are akin to indulgences for their sin of not purchasing cellulosic ethanol. So we have taxpayers subsidizing plants, blenders having to spend money to meet mandated obligations that can’t be met — and zero qualifying cellulosic ethanol production under this system. The current system is failing badly.

Congress is about to be under intense pressure to slash spending across the board. There is a very real risk of total loss of support for next generation biofuels given the history of the program to date. What is really needed is a different system that provides incentives only when product is delivered, and doesn’t penalize taxpayers, consumers, and gasoline blenders if no product is delivered. The current system is convoluted and hard to understand for most people, and it makes it easy to hide behind excuses if promised technology fails to deliver. So let’s strip it down and make it simple.

My Plan: Award Direct Per Gallon Subsidies for Oil Displacement

Instead of offering grants and loan guarantees for cellulosic ethanol producers — and forcing blenders to pay when they can’t purchase product — simply change the system to a direct per gallon subsidy for product that is sold. Here is how such a system could work.

1. Administer this program from the Department of Energy rather than the Environmental Protection Agency. This is more in line with their area of expertise and responsibility.

2. Eliminate the carve-out for cellulosic ethanol. We want to displace petroleum here, but it isn’t necessary to pick technology winners. Perhaps someone has a viable process for biomass-based di-methyl-ether that could displace lots of diesel and drastically reduce emissions. Under the current system, the playing field is tilted strongly in the direction of cellulosic ethanol. But let’s pretend for a second that cellulosic ethanol continues the pattern of failing to deliver. Then under the current system we have done a tremendous disservice to competing biofuels by choosing cellulosic ethanol as a winner, and we have wasted precious time.

3. Offer an initially generous, but declining direct per gallon subsidy for all qualifying biomass-based fuels. For example, offer a direct $2/gallon subsidy for the first 250 million gallons of qualifying fuel produced and sold as transportation fuel from a facility, and then $1/gallon for the next 250 million gallons of qualifying fuel produced.

4. Require all interested parties to register and pay a modest fee to the DOE to have their process evaluated (that sets the bar pretty low, but serves as a filter against the DOE being overwhelmed with half-baked ideas). If the DOE approves the process as qualifying (I would base “qualifying” in large part on the level of oil actually displaced) both parties sign an agreement committing the DOE to subsidize the qualifying product. This lowers the risk of having the funding cut on the basis of the next election.

5. Eliminate all grants and loan guarantees for these facilities. Why? Because they subject taxpayers to undue risk, and under the proposed system the prospective producer has an agreement with the DOE that should be financeable by a bank.

6. Let the technologies then battle it out for supremacy in the marketplace just like other products breaking into new markets. We will have simply tilted the playing field away from oil and toward biofuels. If a $2/gallon subsidy isn’t enough to generate some next generation biofuels, then we will need to seriously reevaluate the viability of some of the next generation candidates.

Private Business Should Take Over From the Government and Taxpayers

Such a system would have huge advantages over the current system. First, private business is now assuming the technology risk, and therefore will be responsible for conducting a high level of due diligence. This takes the technology risk assessment out of the hands of the government. Second, taxpayers won’t end up financing plants that never deliver, and gasoline blenders won’t pay penalties for product that never appears. Third, such a system makes it really clear just how “out of the money” certain technologies are. For instance, if you don’t see any algal biofuel producers stepping up under this system, then you know their costs are more than $2/gallon above those of the equivalent petroleum product.

Critics of this system might suggest that refiners would refuse to buy the product because they don’t want competition for oil. There is absolutely no merit in that argument. Oil companies have to buy most of the oil they refine anyway. They buy raw materials and sell them as fuel. A refiner is in the business of making money. If a cellulosic ethanol producer can produce ethanol for $1 or $2 a gallon — as many have claimed — they could sell to the refiner at far lower than the price of oil. For that matter, if they made it for $1/gallon they could give it away and make money with a $2/gallon subsidy. The refiner is going to buy whatever makes them the most money (which is why oil refiner Valero bought six ethanol plants). Maybe that’s cellulosic ethanol for $1.50 a gallon, or maybe it’s drop-in algal diesel at $2.50 a gallon. But what oil companies will not do — and I say this with absolute certainty — is spend $3 a gallon buying oil from Venezuela if they can get renewable diesel from Solazyme at $2.50 a gallon.

Other critics might say that we have no business subsidizing biofuels in any case. On that point, I disagree. I think our dependence on foreign oil is a threat to our economy and our national security, and as such warrants spending money on aggressively developing alternatives. But I leave that debate for another day. For the sake of this essay, let’s say that if we decide that biofuels should be subsidized then what I am proposing is a better way to go.

Would cellulosic ethanol be viable under such a system? It just depends on the size of the subsidy. I personally have many doubts that cellulosic ethanol will be scalable to the levels envisioned by Congress, for reasons that have to do with biomass logistics and the nature of the technology itself. I also doubt that it could compete on a level playing field with many of the other potential biofuels. (I explained in an article three years ago why I didn’t think cellulosic ethanol would be commercially viable, and five years ago I discussed the logistical challenges).

The system I am proposing would be a transparent way to filter out those who are essentially just hyping their technologies in order to receive tax dollars. Thus, you can imagine that those who are after tax dollars under the current system might strongly oppose such a change. But if a cellulosic ethanol producer can really produce ethanol for $2/gallon — and you don’t see them building plants when a $2/gallon subsidy is available — then you can be pretty sure that they can’t really do what they claim they can do. Producers will be paid for what they deliver as opposed to what they claim they can deliver, and it isn’t taxpayers who are on the hook for their hype.