Renewable Energy Biofuels Are Becoming

Renewable Energy

Biofuels are becoming an important component of renewable energy initiatives. While first generation ethanol production, mainly from corn in the U.S., has created negative externalities by repurposing agricultural output for energy usage, second generation biofuels have the potential to achieve similar energy output levels without altering agricultural land use patterns. As with any new technology, there are a number of precursors for its success. This paper will analyze those precursors as part of making the case for developing second-generation biofuels. It is hypothesized that second generation biofuels represent a strong investment opportunity, but the timing of that opportunity is dependent on both fossil fuel prices and on the ability to develop these biofuels without creating negative externalities in food production.

Second Generation Biofuels

First generation biofuels were often corn-derived ethanol, and have generally failed to find traction in the marketplace. First generation biofuels remain today a niche product and are generally uncommon in most parts of the United States and Europe. Tax incentives for the development of the industry also resulted in the repurposing of agricultural land for the production of biofuels, away from food production. This has resulted in food price increases and a decrease in the stock of arable land used for food production worldwide, at a time when many parts of the world face food shortages. The lack of market enthusiasm and the lack of negative externalities are two of the main problems that it is hoped will be solved by the development of second generation biofuels.

First generation biofuels are those that derive from starches, sugars and oils. Starch is converted into sugar, which is then fermented and distilled to produce ethanol. Oils are modified to be burned, and natural sugars such as corn can be directly fermented and distilled. First generation biofuels typically displaced food production because the crops utilized to make these biofuels are typically food crops. First generation biomass has moved past hydroelectric energy to become the number two source of energy, ahead of hydroelectric with approximately 3% market share (USDA, 2005). Biofuel has earned this market share largely because it is the only economically viable renewable alternative to liquid transportation fuel (Ibid).

Second generation biofuels are biofuels that are derived from all plant and plant-derived materials. This includes, for example, animal manure, residues from wood processing mills, construction and demolition debris, residues from logging operations and wood from forests (Ibid). Many of these biofuels have been used in traditional, subsistence cultures for millennia, but have yet to be harvested and converted to energy on an industrial scale. The USDA conducted a survey that determined there is a sufficient stock of biofuel resources both from forest land and from agricultural demand to displace 30% of fossil fuel consumption on a sustainable annual level (Ibid). In Europe, a similar survey determined that upwards of 62% of its gasoline consumption could be displaced with internal biofuel resources without making any changes to current agricultural patterns (Bloomberg, 2010).

These figures indicate that there is enough supply of raw material in both North America and Europe to sustain a large industrial second generation biofuel industry. This stock of biomass implies that should an industry develop, it can grow to be large enough to enjoy economies of scale in both production and in research and development as well. With sufficient size, a market can be developed in the form of engines and other products that specifically utilize power derived from biomass. The production of products that make use of these fuels is essential to market development, which is one of the key precursors to the successful development of a second generation biofuels market.

Precursors

Growth in the current biofuels market has been subject to a number of constraints, and for the most part those constraints will also limit growth in the second generation biofuels industry as well. Two of the main precursors have already been given short discussion -- ample supply of raw material and specific benefit above what is offered by first generation biofuels. The latter of course is that second generation biofuels do not displace agricultural production; and it has been determined that the former condition exists in both Europe and North America.

Some of the other precursors to the development of a viable second generation biofuels industry are economic benefit, national security benefit, sufficient capital, economic utility, technological capacity and a favorable political environment. There is considerable total economic benefit to the development of this industry. Fossil fuel resources purchased overseas represents significant cash outflows, which results in trade deficit, job loss and weakened currency. When fuel resources are developed domestically, they allow consumption spending to remain in the domestic market. Among other things, this spending creates domestic jobs. The European survey estimated that one million man-years of new employment would be created by the development of a viable second generation biofuels industry (Bloomberg, 2010).

The USDA study confirmed that the technological capacity exists for the development of a second generation biofuels industry. One of the technological concerns is with respect to blending biofuels with petroleum. In the United States, vehicles are to be mandated in the future to accommodate a 15% blend. Fuel flex vehicles represent an alternative that has been used successfully in Brazil and Sweden, and these vehicles have received sufficient political and economic support to account for 25% of the new vehicle market (Bloomberg, 2010).

Economic utility refers to the purchase decision the consumer makes. If the consumer is behaving rationally, then he or she will purchase the product that delivers the best combination of cost and reward. Typically with energy purchases, there is little premium that consumers are willing to pay for sustainability. As such, for proper development of a second generation biofuel energy, the prices for such fuels must be competitive. Bloomberg (2010) estimated that "if agricultural residues can be delivered to the biorefinery gate for €77 per tonne, then next generation ethanol is close to being cost competitive with wheat ethanol production." This finding is taken as evidence that the feedstock cost is not prohibitive for the development of the industry. The main prohibitive costs are with respect to the conversion of feedstock into fuel. These costs can be expected to decrease as production facilities achieve greater economies of scale, which will occur as demand rises.

Competitiveness with current ethanol production may be achievable, but the greater issue is competitiveness with fossil fuels. If the ultimate objective with respect to the development of a second generation biofuel industry is to displace fossil fuel consumption, then the economic argument must be made in comparison to fossil fuel prices. At present, second generation biofuels are not cost competitive with fossil fuels. A liter of next generation ethanol costs €0.71 to produce; a liter of wheat ethanol costs €0.51 to produce; a liter of gasoline costs approximately €0.26 for crude and refining costs. This implies that the market for second generation biofuels will be difficult to develop if the economic utility of the product does not improve.

Political support therefore becomes a critical precursor to the development of this industry. At present, there are no economies of scale in the conversion of second generation biofuels because demand is low. Thus, the product is not economically competitive. In order to spur demand, the cost must be made competitive. This typically will require subsidies to the industry, which is generally understood as the infant industry argument. In order to facilitate the growth of an industry into an economically viable entity, governments will provide subsidies, tax incentives and trade protections in order to render the industry cost competitive until the market is large enough for the industry to be cost competitive without such protections. Usually, this type of political support is given industries of particular strategic importance.

One factor affecting the strategic importance of the second generation biofuels industry is the economic benefit, particularly to nations dependent on imported fossil fuels for their current energy needs. In addition, that current energy supplies are often sourced from unstable regions or those governed by enemy regimes (i.e. Saudi Arabia, Venezuela), there is significant geopolitical incentive to develop alternatives to these fossil fuels, in addition to the economic incentive. Thus, there is political will to develop this industry, and the support given to first generation biofuels by the federal government is indicative of the potential support that can be given to a second generation biofuels industry.

For the most part, the precursors for the development of the second generation biofuels industry exist, which is an encouraging sign for potential investors in the sector. There is political will to develop the industry, and a strong economic case for supporting this industry. The raw materials exist and so does the technological capacity to move this industry forward. The constraints associated with the current high cost of conversion will be overcome with additional capacity and the development of economies of scale. Capital will be acquired if the industry can be made profitable. There is simply no reason to believe that rational investors would ignore a profitable, high-profile energy business if growth and profitability prospects are strong. Thus, the sole remaining major precursor to success is economic utility, which is a function of the cost of second generation biofuel production compared with the production costs of alternatives.

Gasoline is the main competitor of concern, given the stated objectives of both American and European governments of using second generation biofuels to displace gasoline consumption in the coming years and decades. At current crude oil prices, there is a significant gap in the cost of producing a liter of gas vs. The cost of producing a liter of second generation ethanol. For this gap to close, crude oil prices would need to nearly double from their current rate of $82 per barrel. These prices would eclipse substantially the historic highs set in 2008.

Prescriptions

The technological capacity for industrial scale production exists today, but relative to the production of competing products, the costs are high. One of the reasons for the relatively low cost of competing products is the economies of scale that have been achieved in their production, and the distance along the technology curve for production efficiency techniques. Oil refining is efficient because of the amount of capital involved, the scale of the industry and the decades of experience that has gone into improving the efficiency of refining technology. Only an increase in demand will bring to second generation biofuels the capital, knowledge and economies of scale to develop these types of efficiencies. The cost of crude oil may increase to the level needed to spur this investment, however this is not a good case for investment in second generation biofuels. If one wishes to speculate on crude oil prices, there are more efficient means of performing that task on the futures markets.

It is incumbent on government, then to provide the conditions for the development of second generation biofuels. Previous efforts to spur demand in alternative energy have been successful. Germany developed the world's largest solar panel market by subsidizing consumer and business investment in solar panels. The current biofuel market in the United States owes much of its success to nearly 200 different subsidies afforded the industry to encourage investment and consumption of these products.

There are two main ways to spur this investment. One is to spur the development on the demand side. This is the easiest solution to implement -- tax differentials between gasoline and second generation biofuels can spur consumer demand for the biofuels by making them cheaper. This can be done without raising the gas tax, simply by avoiding taxation on biofuels. With a much lower tax rate, the different in production costs can be offset such that biofuels are price competitive at the retail level.