Christmas for Renewables

Last night the US House of Representatives passed the compromise tax bill without any amendments and by a healthy margin, though narrower than the 81-19 vote in the Senate on Wednesday. The bill now goes to the President for his signature. The provisions added after the initial negotiations between the White House and Republican leadership delivered a substantial Christmas present to the nation's renewable energy industry, including several key items on the industry's wish list: extension of the ethanol blenders' tax credit at its current rate of $0.45 per gallon; extension of the Treasury Renewable Energy Grants, which provide cash in lieu of investment tax credits; and a retroactive extension of the $1.00 per gallon biodiesel tax credit, which had lapsed at the end of 2009. However, as with many Christmas presents, the bill that will come due next year is also substantial. And the one-year extensions granted to these incentives leaves their long-term fate in the hands of the new Congress, which is widely expected to be more focused on deficit reduction than on stimulus.

This result constitutes a remarkable trifecta. As recently as a week ago it seemed likely that the Treasury Grant program would expire on schedule, and that the ethanol credit, if not actually allowed to expire, would at least be reduced to reflect its redundancy with the Renewable Fuel Standard (RFS), which requires refiners and fuel blenders to add biofuel to gasoline. As for the biodiesel tax credit, it looked like a lost cause all year, having failed on multiple previous attempts to reinstate it. The US ethanol industry even prevailed in having the $0.54 per gallon duty on imported ethanol extended for another year, in order to shield taxpayers from paying incentives to foreign producers and the industry from cheaper competition--though I'm not sure how competitive Brazilian cane ethanol really is these days, with sugar trading at around $0.30/lb ex duty. (As I understand the tradeoff, a gallon of cane ethanol consumes roughly the same raw materials as 10 lb. of cane sugar.)

It's a tribute to the greatly expanded scale of renewable energy that the price tag for the one-year extension of these three incentives is as high as it will be. This year, even with US wind turbine installations running well behind their record pace in 2009, the Treasury has spent $3.9 billion on the grant program for projects installing geothermal, solar, wind and other renewable electricity equipment. With continued strong growth in both solar thermal and photovoltaic projects and even a modest uptick in wind installations, the tab for 2011 could easily break $4 B. (A separate manufacturers tax credit, which had a better claim on creating green jobs here in the US, was not extended.) Meanwhile, with conventional ethanol and biodiesel blended at the mandated rates for next year, they should account for around $5.9B and $0.8 B, respectively. That comes to $10.7 billion for all three programs.

Although the tax compromise has extended the energy policy status quo for another year, change is in the air. With continued, though narrower bi-partisan support, the ethanol industry's argument that its tax credit is still necessary after 32 years--even with a steadily increasing RFS mandate--is losing credibility. Part of the industry would prefer this money to be spent encouraging infrastructure for E85 and other higher-percentage blends that represent ethanol's future growth opportunity, if any. As for the Treasury Grants, a temporary stimulus measure intended to make up for the disappearance of the tax equity market during the financial crisis, the defensibility of treating the investment tax credit on which it is based differently from any other credit in the tax code is waning. This mechanism looks increasingly exposed as the broader category of "tax expenditures" becomes an obvious target for deficit cutters, and the justification for extending it beyond next year would probably vanish if the Congress enacted legislation along the lines of Senator Graham's Clean Energy Standard. The industry should make the most of the current Christmas package, because the odds are against a repetition of it turning up under next year's tree.

Ethanol and the Gulf Spill

The implications for the oil industry from the ongoing Gulf of Mexico oil spill are already taking shape, with the administration calling for a Challenger-style investigation and rewriting the playbook for oil & gas leasing and the issuance of safety and environmental permits for offshore drilling. It's less clear how the spill might affect other aspects of energy, beyond boosting the public's interest in pursuing clean energy options. However, it would be ironic if a problem perceived to have arisen because of a "cozy relationship" between oil companies and regulators resulted in an even cozier relationship between the government and the ethanol industry that depends on it for both financial support and the rules that mandate the use of its product. Yet that's exactly what could happen as the administration decides whether to increase the allowable percentage of ethanol in gasoline.

Perhaps you've seen the new ads from Growth Energy, an ethanol trade association: "No beaches have been closed due to _____ spills", with the word "ethanol" fading slowly into view. Then there's "We won't have to wait millions of years to replenish our _____ reserves," and other statements emphasizing ethanol's employment and energy security benefits. It's a clever campaign, and well-timed. On one level, using more ethanol in gasoline seems an obvious response to concerns about our dependence on oil. For all its many shortcomings, ethanol remains the most successful oil substitute in the US market, thanks to the combination of a $0.45 per gallon blenders' tax credit and the steady ratcheting-up of the annual federal renewable fuels standard. Ethanol currently displaces the equivalent of approximately 500,000 barrels per day of gasoline that would otherwise be imported or refined here from imported crude oil. The problem is that the market penetration of ethanol is rapidly approaching the 10% blending limit that has been approved as safe for use in engines that haven't been modified to run on higher-percentage ethanol blends, such as E85. And because E85 has so far failed dismally to take off--accounting for just 0.01% of US gasoline sales in 2008, based on EPA's analysis--any additional ethanol would have to be squeezed into ordinary gasoline, at least in the near term.

Our proximity to this threshold, referred to as the "blend wall", is determined by two factors, in addition to the federally-mandated ethanol blending volume: total US gasoline sales and US ethanol output. Last year Americans bought just under 138 billion gallons of gasoline (including the ethanol blended into it), a reduction of about 3% from the 2007 peak. Without further growth in demand, 10% of that would be 13.8 billion gallons per year (gpy). According to the Renewable Fuels Association, another ethanol trade association, the capacity of existing US ethanol facilities plus those under construction already totals 14.7 billion gpy. In other words, once all the ethanol plants now being built are finished, the industry could supply more than 10% of US gasoline demand without breaking a sweat. But without either a higher blending limit in gasoline or a sudden, unexpected surge in E85 sales, any additional ethanol beyond that level would have no home in the US fuels market. Nor is it obvious that corn ethanol exports represent a viable long-term outlet. Left unresolved, this is a guaranteed train-wreck.

Under the circumstances, it's natural for the ethanol industry to ask its patron for help, in the form of a request for a waiver to blend more than 10% ethanol into each gallon of gas. Last winter, the Environmental Protection Agency told Growth Energy that it was studying their request and would respond by mid-2010. That deadline is nearly upon us, and with more oil spilling into the Gulf of Mexico every day, the pressure on EPA to agree must be mounting. This can't be an easy call to make, especially with the auto makers citing test results indicating that ethanol blends above 10% could harm some car engines. Saying no would call into question the nation's entire long-term renewable fuels strategy, at a time when green jobs and green energy are being widely promoted as the key to a new, more competitive economy. Yet granting that request, either as a favor to the ethanol industry or as a hasty response to the Gulf Coast oil spill would be a mistake that could have serious repercussions, both for consumers and for the administration making such a call. Stay tuned.

Update as of 6/18/10: EPA delays its decision on E15 until the fall.

Recharging the Electric Car

An article in yesterday's Wall St. Journal prompted some thoughts about the relative merits of entirely-electric cars (EVs,) compared with hybrids employing varying degrees of electric boost. It's interesting that Honda and GM, both of which have marketed all-electric cars in the past, should arrive at such different conclusions on the subject. Honda now apparently finds pure EVs superior to hybrids and plug-in hybrids (PHEVs,) while GM, which invested close to a billion in today's dollars in its EV-1 in the 1990s, is not convinced. Although some of the factors that led to the failure of the EV-1 might no longer apply, others look daunting, except perhaps to environmental regulators, who would naturally find zero-local-pollution EVs preferable to hybrids.

When you consider the experience of GM's EV-1, a few things stand out--after setting aside the unfounded allegations that it was killed by a conspiracy. As the testimonials from its former lessees attest, the EV-1 was a terrific car, as long as your driving needs didn't exceed about 75 miles, or you didn't need to transport more than one additional passenger. The latter was a design issue, constrained by the size of the original lead-acid battery pack and the body shape GM selected. But while the range was largely a function of the available battery technology, it also reflected the challenge of quickly recharging a partially-drained battery, even with a small number of high-voltage recharging facilities that GM and its partners installed around Southern California. How many of us would have really wanted a car that couldn't go more than 100 miles without stopping for a charge that might take an hour?

Batteries have improved a lot since the first EV-1 left the factory. If the lithium batteries around which GM is planning its Chevrolet Volt PHEV are able to deliver 40 miles of gasoline-free driving, surely a larger array of the same batteries could take an all-electric version of the same car 200 miles or more. That's the basis of the Tesla, which claims a range of 245 miles for its sleek electric roadster, running on thousands of laptop batteries.

Paradoxically, that range is both good news and bad news. Because it easily exceeds what most of us require for our daily commutes or errands, it effectively severs the chicken-and-egg infrastructure dependency that I believe really killed the EV-1: you can't sell EVs without recharging facilities but can't justify the recharging facilities without lots of EVs already on the road. A 200+ mile range eliminates the need for most recharging away from home, workplace or other predictable sources of electrical outlets and reduces the inconvenience associated with the lengthy intervals required for low-voltage recharging. In the process, though, it also eliminates most of the incentive to build a fast-recharging infrastructure to meet the needs of longer-distance travel.

It's arguable that this isn't a real impediment. When I first started looking at these issues in the mid-1990s, I saw compelling data that suggested that American motoring habits were evolving towards each household owning a mini-fleet of specialized vehicles: the commute or train car, the kid-hauler, the weekend sports car, etc. That meant that a car like the EV-1, which couldn't fill all of these roles but excelled at one, had great potential. Unfortunately, that view turned out to be wrong, or at least premature. This is still a key question today. Would millions of consumers be happy to own a car that they couldn't sensibly drive from Boston to Washington, DC, let alone from Washington to Minneapolis?

If the answer is yes, then a pure electric car looks pretty good, and the added complication and expense associated with a plug-in hybrid might not be justified, provided the cost per Watt-hour of batteries keeps falling. Personally, though, I think the flexibility of a PHEV able to run on gasoline, E-85 or electricity will appeal to more folks than a simpler battery car. I also doubt that the target market for the six-figure Tesla will tell us much about that trade-off. But isn't it nice that technology is finally providing multiple choices for our future transportation needs? EVs and the various hybrids may compete for market share, but they could also coexist nicely, all furthering the gradual electrification of automobiles.

Sharing the Forecourt

A comment in an article on Brazilian ethanol in today's Financial Times got me thinking about how ethanol will move into the US retail marketplace, as it outgrows its current role as a gasoline blending component. The FT cited Ricardo Leiman of Noble Group, who remarked, "There is a conflict of interest between [fossil fuel] distributors and the newcomers." That's certainly the conventional wisdom, with E-85 pumps at major oil company stations as rare as hen's teeth. But I wonder if that gives sufficient credit to the marketing segments of these large enterprises, which have pursued profits in many other areas not directly related to the output of their own refineries. It also ignores the structure of the retail gasoline market, which could be quite hospitable to ethanol, once it reaches critical mass.

First, consider the composition of the retail motor fuels business in the US. Of the 169,000 retail fuel facilities across the nation, fewer than 10% are actually owned and operated by integrated oil companies such as ExxonMobil, Shell, ConocoPhillips or Chevron. The rest are run by retailers with varying degrees of independence. Some own their own facility, while others lease it from the company. Many receive their supplies through a distributor, rather than directly from the company. As a result, even if all of the major oil companies decided that E-85, biodiesel or some other alternative fuel represented an unacceptable threat to the petroleum products they produce, the number of stations at which they could enforce a ban on E-85 is only a small fraction of the total. For the vast majority of service stations, the question of whether to add a pump to sell E-85 or biodiesel isn't determined by corporate policy, but by the economics for the station owner.

Gasoline retailing is not a high-margin business. That's why there are so many convenience stores and co-branded food outlets, both of which offer much higher unit margins than for fuel. Total potential E-85 sales in a given area would be a function of the local flexible fuel vehicle (FFV) population and the number of other E-85 outlets in the same market. FFVs currently make up only 2% of the US car population, and until their numbers grow substantially, E-85 will be a low-volume business for most retailers. That combination of low margins on low volumes limits the return on the investment required to convert a station to sell E-85, offset by any available government incentives. And unless the owner is willing to add an additional tank, he must sacrifice the revenue on another grade of fuel to make this switch. The primary obstacles for introducing E-85 at most retail sites are strictly financial, and only time and the growth of the FFV fleet will overcome them.

Viewed from this perspective, the major oil companies are in a much better position than individual retailers to introduce E-85 selectively into a new market. Not only do they have the financial resources to absorb the costs of conversion, but they also possess sophisticated software that would allow them to determine the best sites to convert, and how to phase alternative fuel into the market, in synch with the expanding FFV fleet. Nor do I think the marketing groups of these companies will resist this, if it provides an opportunity to enhance both profitability and brand image.

Many people forget that the integrated oil companies are no longer the monolithic, command-and-control organizations they once were. Their marketing divisions are independent profit centers charged with earning an attractive return on their employed capital. Many of the executives responsible for these units have more in common with the people running other retail businesses than with their colleagues who run the refining or exploration and production segments. When I tried to get Texaco's marketing department interested in installing electric vehicle recharging facilities at service stations in Southern California in the late 1990s, their main worry was how they could make money on them, not their effect on gasoline sales. What counts is traffic, and if E-85 will bring them traffic, they will buy in. The best way to make sure that E-85 spreads quickly is to ensure that the major oil companies can take advantage of the same incentives for E-85 as independent retailers. Alternative fuel advocates should view major oil company marketing groups as natural partners, rather than potential opponents.

Energy Outlook will observe the US Independence Day holiday tomorrow and resume new postings on July 5.

A Superfluous Subsidy

While listening to the podcast of a recent conference call with the President of the American Petroleum Institute, a question from one of the participating bloggers provoked one of those slap-your-forehead moments for me. Robert Rapier, who writes the R-Squared Energy Blog, asked why ethanol still needed a subsidy, since its use is now mandatory under the new Renewable Fuels Standard (RFS) regulation in the US. It bothers me that when I was dissecting the RFS the other day, this never occurred to me. Mr. Rapier's question seems highly appropriate, since ethanol is now required under not one, but two federal fuel regulations, along with various state and local rules. It's hard to avoid the conclusion that, with ethanol production booming, it doesn't require three support mechanisms, and so the subsidy should go.

As I described last week, the new national RFS sets an annual quantity of alternative fuel--which today means principally ethanol--that must be blended into gasoline, starting with 4 billion gallons in 2006 and rising each year. Anyone caught short must buy credits from another blender who used more ethanol than required. At the same time, however, most of the present ethanol supply is used to satisfy the oxygenate specification under EPA and state reformulated gasoline (RFG) regulations. So ethanol producers have a guaranteed market on two levels: the amount required for RFG and an overlapping and steadily increasing quantity set by the RFS. And that is now in addition to the 51 cent per gallon Volumetric Ethanol Excise Tax Credit, which effectively subsidizes production of fuel ethanol by enabling refiners and blenders to pay more for it than it is worth as a gasoline extender. How many other businesses would like to have the government pay them to make something, and then force their customers to buy it?

The US ethanol market would eventually look very different without the subsidy. Let's start with some numbers. Eyeballing the chart for the May ethanol contract on the Chicago Board of Trade exchange, ethanol was going for about $2.20/gallon (delivered in storage in Chicago) when the comparable wholesale gasoline futures contract for May was trading for an average of $1.92/gallon in New York. Considering that rail freight can add another 10-15 cents/gal. to the price of ethanol delivered to the blending location, incorporating 10% into gasoline raises its cost by about 4 cents/gallon, offset slightly by ethanol's higher octane rating. In today's market, the difference is covered by a 5 cent contribution from the excise tax credit.

Absent the subsidy, several things would have to happen. First, since the demand for ethanol required to meet oxygenated fuel specifications would not change, ethanol sellers into that segment should be able to hold their prices, while refiners would see their net cost of producing marketable gasoline rise. Eventually, the ethanol price for this segment would settle out at a level equivalent to the gasoline price plus the market value of the new, traded Renewable Identification Number attribute created by the RFS. Most of the resulting increase in gasoline cost would eventually be passed on to consumers.

Once the ethanol supply exceeds the quantity necessary to back out any remaining MTBE from the oxygenate requirement--somewhere around 6 billions gallons of ethanol per year--the price of any production in excess of the national RFS quota would fall toward parity with gasoline, plus a small premium for its octane value. Some of the surplus might end up in E-85, which at least for now commands a premium price, but the resulting price pressure would eventually trigger a shakeout among ethanol suppliers. Large, efficient (newer) ethanol producers would win, and some small producers with higher costs would go out of business, or have to idle their facilities until the expanding RFS quota broadened the mandated market enough to include them.

To complicate the picture further, if the subsidy were lifted, it would be hard to justify maintaining the 54 cent tariff on imported ethanol. If that were repealed, marginal US suppliers would find themselves under even more pressure, and they would lose share to imports that might come in at a low enough price to compete into gasoline on blending value alone.

But if small ethanol operators could ultimately lose from the end of the subsidy, who would win? Not the oil companies, which stand to see their blending costs increase, perhaps by more than they can recover in the marketplace. Although some foreign ethanol producers might benefit, the biggest winners would be the US economy and taxpayers. We'd get all the ethanol necessary for environmental and energy security purposes at the most efficient price, and at an immediate federal budget savings of $2.5 billion/year, and growing. At that point, the only remaining argument for continuing the subsidy would be to protect the least efficient domestic producers from competition, at a very high effective cost per gallon.

New Ethanol Risks

A new study from a Stanford University scientist suggests that burning large quantities of ethanol might actually promote more smog, even as it reduces greenhouse gas emissions. I have a healthy respect for unintended consequences, and the only surprising aspect of this result is that it should pop up now, after so many decades of blending ethanol into gasoline. Coming as this does in the midst of a growing debate about the tradeoffs between ethanol and food supplies--a topic that has apparently caught the attention of Venezuelan President Hugo Chavez--it complicates the picture for our de-facto primary alternative energy strategy.

Engineers have known for a long time that ethanol increases evaporative emissions from gasoline, thus boosting the local concentration of ozone precursors in the air we breathe. That was one of the factors that led refiners to favor MTBE over ethanol, until the unintended consequences of the former, in terms of groundwater contamination and odor, became clear. The Stanford study sheds new light on what happens to ethanol molecules in the atmosphere. If this finding is confirmed by other researchers, it is likely to create additional obstacles for E-85, besides infrastructure. It might also generate more interest in a process for turning corn and other biomass into clean-burning propane, which until ethanol's recent popularity was our most successful "alternative fuel."

E-85 proponents might be skeptical of the study's results, because of their coincidental timing--just when ethanol is taking off--or the connection between Stanford and ExxonMobil. However, the statement from Senator Feinstein's office suggests that officials are taking it seriously. Whatever the final outcome, this is a useful reminder that every large-scale energy alternative has consequences that must be weighed carefully against those of the status quo, to ensure that we get the most benefit from our investment of time and treasure, and to avoid costly dead ends.

By the way, Energy Outlook got a nice plug from the Wall Street Journal's blogroll on Tuesday. I'd like to welcome any new readers that found this site as a result.

Fill 'Er Up

The Washington Post reports that when the auto industry CEOs met with President Bush yesterday, they pleaded for alternative fuel infrastructure to fill up the alternative fuel cars they are building. Despite decades of car makers and oil companies pointing fingers at each other over energy and environmental challenges, there's a lot to be said for the former worrying that the latter won't provide enough refueling opportunities to make owning a car requiring hydrogen, for example, convenient for consumers. The key question is who should pay for the installation of this infrastructure. It's not who you might think.

GM's CEO, in particular, has good reason to worry about the availability of alternative fuel. His company invested a fortune in the all-electric EV-1 in the 1990s, only to see it founder in the market, at least partly due to lack of recharging infrastructure, as I've described in detail in a previous posting. This is a big deal for hydrogen cars, as well, though they're years from the point at which refueling becomes the critical-path item. When the subject turns to ethanol and E-85, however, the argument gets considerably murkier.

By definition, cars that have been engineered to run on E-85, a mix of 85% ethanol and 15% gasoline, are "flexible fuel vehicles" (FFVs). That means they can run on gasoline with any fraction of ethanol from 0% to at least 85%. A shortage of E-85 pumps apparently didn't pose much of an impediment to selling "over 2 million" of these vehicles, as GM claims in its "Live Green, Go Yellow" campaign. The issue here is not selling more FFVs, but the risk that the government will stop counting them as alternative fuel vehicles that count towards carmakers' Corporate Average Fuel Economy quotas, because most of these vehicles have never used a gallon of E-85. That's worth serious money to Detroit.

So who should pay to make E-85 more widely available? Most people would probably say oil companies, but most of the service stations in the country aren't owned by the big oil companies; they're owned by small businesses, either individuals or local distributors. Selling retail gasoline isn't a terribly lucrative business, especially if you face competition from supermarkets and Walmart, who view fuel sales as a lure to customers, not a profit opportunity.

The problem at service stations is simple. A retail facility typically has only three underground tanks. One of them is in unleaded regular (ULR) service, one in premium (ULP) service, and the third most likely in diesel service. A dealer can't give up his ULR tank, because that's at least half of his throughput. And he won't give up his ULP tank, because he needs it to blend 89 octane mid-grade, which, along with ULP, provides his highest margin. That leaves the diesel tank. Switching that to E-85 is certainly possible, but how attractive is it? He must weigh lost diesel sales--plus any convenience store revenue that goes with them--against the chance that an FFV driver will pass his station to find one selling E-85. Absent a much bigger public outcry for E-85, I know that I wouldn't make that bet, myself.

Given these constraints, the choice comes down to an investment decision. Does a station owner rip up concrete to add another tank, putting his whole facility out of business for at least a month, in order to add a product for which the initial demand is probably only a few hundred gallons per month, versus the typical 100,000 gallons/month he sells on his other products? I don't see how you make a return on that investment, even after the $30,000 federal tax credit that's available.

What about providing more government assistance? Surely as taxpayers all of us have a vested interest in enabling sales of locally-grown ethanol that backs out imported oil. Well, even if the benefits of ethanol were large and unambiguous, the country saves exactly the same amount of foreign oil when a gallon of ethanol is sold as part of a 10% blend with gasoline (E-10), which requires no modifications to either service stations or cars, as when it's sold in E-85. Based on last year's ethanol production and current gasoline demand, ethanol output could nearly triple before it used up all its E-10 blending opportunities. The case for public support for converting stations to E-85 thus rests on political, rather than economic foundations.

The market isn't the answer to every problem, but in this case the market offers an important insight: if you want to make E-85 widely available, you should look to the parties that stand to gain the most from doing it. That brings us inevitably back to the carmakers, who have a major stake in ensuring that enough E-85 is available to preserve their CAFE ratings, along with citizens' groups that are passionate about energy security. A savvy auto firm might see some nice partnership opportunities in such alignments, which could eventually rope in an oil company interested in improving its image. In the meantime, the rest of us are no worse off if E-85 isn't available on every corner.