Wednesday, June 27, 2007

Mandate To Nowhere?

Of all the provisions of the Senate energy bill that were debated over the last several weeks, the greatly expanded mandate for renewable fuels was probably the least controversial. It increases the amount of renewable fuel--chiefly ethanol--that fuel marketers must sell annually from the previous target of 7.5 billion gallons by 2012 to 36 billion gallons by 2022, or the equivalent of about 1.6 million barrels of oil per day. It's easy to understand the appeal of this from an energy security perspective, with ethanol providing modest climate change benefits, as well. And with 21 billion of the 36 billion gallons slated to come from cellulosic ethanol, rather than from corn ethanol that competes with food, it sounds like a blueprint for a better energy future for the country. But are we placing too large a bet on the relatively unproven technology of producing ethanol from converted crop waste and non-food energy crops? An article in Slate raises some worrying questions about this strategy. After reading it, I came up with a few concerns of my own.

The author's critique of cellulosic ethanol focuses on the resources and the rapid pace of development that would be necessary to produce the volumes mandated by the Senate. He also questions the net energy benefits of cellulosic ethanol, based on a forthcoming study from the University of Colorado. Finally, he expresses doubts about whether the total impact of ethanol will be worth its cost. The article is worth reading, and all of these issues ought to be addressed rigorously before the House of Representatives takes up this proposal in a few weeks.

Like many people, I've generally accepted most of the claims about the potential of cellulosic ethanol to provide a useful petroleum substitute that will be bigger, better, and ultimately cheaper than that the corn-based variety, about which I have had serious concerns for 25 years. Chalk it up to the natural American enthusiasm for new technology. But after reading the Slate piece, I started thinking about the implications of a biofuels mandate this large. If gasoline demand continues growing at 1%/year, 36 billion gallons would cover about 21% of the total gasoline consumed in that year, after adjusting for ethanol's lower energy content. That compares to about 3% last year. And if conservation and the new CAFE standards actually manage to slow the growth in demand, the proportion would be even higher. That makes this a high-stakes gamble, indeed.

How reasonable is it to expect the current ethanol industry, the oil industry, or a new set of players--including a number of high-tech types--to grow a 21 billion gallon per year cellulosic ethanol business from zero in the next 15 years? I'm less skeptical on this point than Slate. Even if cellulosic ethanol plants cost twice as much to build as the traditional kind, the total cumulative investment involved would be on the order of $40 billion. If there's one thing American business can do, it's raise money. Of course, I don't hear many people talking about just what would attract that money: profits. The only way you're going to build this many ethanol plants is if someone thinks there are big profits to be made, either on the wholesale price of ethanol or from government subsidies. If one of my clients asked me, I'd tell them to focus on price, because investing that kind of money on the prospect of indefinite federal largess looks pretty risky. Bottom line, don't expect cellulosic ethanol to be much cheaper than gasoline, or it won't happen.

So if the economics work, and if the plants get built, what else could go wrong? Ignoring the basic technology risk, there are a couple of potentially serious constraints that could bite. First, consider logistics. The supply chain for cellulosic ethanol looks much more logistics-intensive than for gasoline. Producers will have to haul large quantities of low-grade plant matter to their facilities and then ship large quantities of ethanol out by rail and truck, because it can't share pipeline space with oil products. The feedstock alone would comprise about 200 million tons per year of additional haulage. Developers will also face the old dilemma of locating near their raw materials or their markets. Whether that will be dictated by transportation limitations or the economies of manufacturing scale remains to be seen.

Then we have the problem of consumption, which hardly sounds like a problem at all, until you realize that 98% of the cars on the road today can't handle ethanol in concentrations over 10% of gasoline without modifications. The new 15 billion gallon corn ethanol mandate is sufficient to bring every gallon of gasoline sold today up to that fraction. Effectively, cellulosic ethanol producers would either have to displace corn ethanol from standard gasoline or create a large enough market for E-85 to absorb it. That means growing the current fleet of 5 million flexible fuel vehicles (FFVs) to around 44 million within 15 years. Doing that will require that 20% of all cars sold from here on out be FFVs, to the tune of 3 million per year.

And if that weren't enough to get the Congress just a little bit worried about the risks of forcing that much ethanol into the system, we come to the key vulnerability of the whole plan. An FFV is just that: flexible. No one can ensure that every FFV will fill up with E-85 every time, even if the fuel were readily available across the country, as the Senate bill requires. Sooner or later, drivers will figure out that unless E-85 is consistently 25% cheaper than gasoline, they will get more miles per dollar on the latter. But that discount can only exist if wholesale ethanol is cheaper than wholesale gasoline everywhere, or if the subsidy is large enough. And if wholesale ethanol is always cheaper than gasoline, the economics of rapid ethanol capacity expansion start to look shaky. The net result of this feedback loop is that the lower the FFV E-85 usage rate is, the more FFVs we will need, in order to burn 21 billion gallons/year.

Cellulosic ethanol could still turn out to be a wonderful boon, overcoming all of these obstacles and going beyond to truly begin to wean the US off imported oil. But what we're asking of this untested technology is analogous to the growth of the automobile and its fuel infrastructure in the first third of the 20th century, telescoped down to 15 years. After a little reflection, I find that I'm less comfortable with the idea of this transformation happening by fiat, without a demonstration of competitive superiority in the marketplace.

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