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.
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.
The other means by which investment can be spurred is by offering a wealth of subsidies for the development of the industry. U.S. biofuel subsidies amount to around $4 billion per year as of 2008, which equates to $82 per barrel, and by 2022 these subsidies will have totaled $400 billion, meaning that the subsidy levels for biofuels in the United States are expected to increase significantly in the next decade. EU biofuel subsidies are at around $5.2 billion per year, although most of these are for first generation biofuels (Boin, 2010). The U.S. appears to spend a far greater amount of its subsidies on second generation biofuel development than does Europe.
The market for second generation biofuels has tremendous potential. Energy needs are continually increasing in the United States and increasingly these needs will need to be met without the use of fossil fuels. First generation biofuels have succeeded on account of tremendous financial support from the federal government, consisting of over 200 subsidies. Government support for second generation biofuels is equally strong in the U.S. Policymakers in the developed world are implementing these subsidies as a means to achieve aggressive policy goals with respect to biofuels replacing petroleum consumption.
There are compelling economic and national security reasons for these subsidies. In addition to reducing dependence on unstable or unfriendly regimes for our energy needs, second generation biofuels reduce some of the negative externalities associated with first generation biofuels. In addition, hundreds of thousands of blue- and white-collar jobs stand to be created from investment in second generation biofuels.
For an investor, all of the precursors of strong growth in the industry exist, save for one. The current price of crude oil is at a level where second generation biofuels are not cost competitive. However, there is some optimism in that subsidy and taxation policy can overcome this cost differential. There appears to be the political will, in the U.S. particularly, to implement the necessary policies to promote second generation biofuels. However, at current crude prices, this gap is only barely overcome by first generation biofuels, which are considerably cheaper to produce than second generation biofuels. Thus, without a significant increase in the price of crude oils, demand for second generation biofuels is expected to remain small. Without demand, the necessary capital knowledge and economies of scale will not be available to the industry to overcome the gap in production cost. An increase of 50% in crude prices (to around $120) would begin to close the gap, depending on the price of biofuels and the specific tax policies that the government implements to impact the price of second generation biofuels to the consumer. Beyond this point, second generation biofuels would have the potential to be profitable, in particular for the industry's largest, most efficient producers.
USDA. (2005). Biomass as feedstock for a bioenergy and bioproducts industry: The technical feasibility of a billion-ton annual supply. USDA. In possession of the author.
Bloomberg. (2010). Next generation ethanol and biochemicals: What's in it for Europe? Bloomberg New Energy Finance. In possession of the author.