NEW DIESEL RULE LITMUS TEST FOR CALIFORNIA REFINERS, REGULATORS

California refiner/marketers and regulators alike are testing their limits as preparations continue for stringent new state diesel fuel specifications that come into play Oct. 1.

The California diesel specs, which go far beyond federal requirements that take effect the same date, are a microcosm of pollution control challenges that loom ahead in California.

They also are seen as a litmus test for how U.S. refiner/marketers will deal with operating and supply concerns related to accommodating new fuel formulas dictated by government to improve air quality.

How regulators deal with refiners' serious compliance problems with this rule--and others on the not too distant horizon--has ramifications for the state and elsewhere, as California typically sets the environmental pace for the rest of the U.S.

The diesel specs, developed and administered by the California Air Resources Board (CARB), are one of the early proving grounds signaling how far refiners can stretch to cope with requirements for cleaner burning fuels. This has direct implications beyond California, because nine states and the District of Columbia have petitioned the U.S. Environmental Protection Agency for permission to adopt CARB's tougher than federal gasoline specifications, which begin to take effect for major refiners in 1995.

While the new California diesel specs may not set a precedent, they underscore how competing concern's over the environment and the economy are coming to a head. The fundamental decision at hand in California's regulatory arena is whether to keep pushing for cleaner air at almost any cost, or to accept less-clean air at lesser cost to regulated industries, and the state's economy on the whole (see related story, p. 23). And if California's traditional bellwether role extends to the economic arena as well, the state's economic devastation--which many attribute in large part to regulatory excess--the federal government may do well to take heed.

Significantly, CARB and other regulators are showing more inclination than usual to ease compliance requirements mid-course or take less stringent actions in the first place. Investment and compliance decisions in the refining sector are being affected accordingly.

Even the state's efforts to ease regulatory burdens are not without controversy, however.

On Sept. 9-10, California's South Coast Air Quality Management District (Scaqmd) is slated to vote on its Regional Clean Air Incentives Market (Reclaim), a sweeping revision of its strategy for controlling air pollution in southern California.

Reclaim is an attempt to move away from the traditional "command and control" style of regulation, where regulators mandate specific control technologies and methods that businesses must use to reduce emissions. Instead, Reclaim would use an "incentive" approach, similar to the alternative blend option provided in CARB's diesel fuel rule, but on a much larger scale.

Incentives notwithstanding, the program has elicited howls of protest from refiners in the region that say it will boost their operating costs by hundreds of millions of dollars.

DIESEL SPECS

California's diesel specifications, adopted in 1988, match federal requirements in calling for a reduction in sulfur content to 0.05 wt %. This compares with a current industry average of about 0.3 wt %.

The California diesel specs exceed federal requirements by simultaneously calling for steep cuts in the fuel's aromatic hydrocarbon content, which currently averages around 30-31 vol %. Under the new specs, aromatic content is capped at 10 vol % for large major and independent refiners and 20 vol % for small independents, as of Oct. 1, 1993. Small independents have 2 years to comply fully with the rule.

However, refiners don't necessarily have to meet the aromatic specs to be in compliance with the rule. CARB's rule gives refiners the option to certify alternative formulations that are equally effective in reducing emissions from diesel burning vehicles.

The reformulated diesel specs are one of three CARB programs designed to reduce diesel emissions. The agency also has adopted emission standards that require sootless diesel bus emissions, beginning with 1993 models. And it conducts a roadside testing program, similar to the state's Smog Check for passenger cars, that identifies high polluting trucks and requires repairs to bring emissions to within acceptable levels.

CARB notes that refiners have four ways to comply with new motor fuel specifications:

Producing fuel that meets CARB's specifications.
Producing an alternative formulation that meets air quality requirements.
Obtaining complying fuel from another refiner through purchase or exchange arrangements.
Producing some noncomplying fuel under variances.

So far, three major refiners--ARCO, Chevron Corp., and Texaco Inc.--have developed alternative formulations that CARB certified to be in compliance with the rule's overall emission standards. All but Texaco are offering their formulas for other refiners interested in this option.

A common thread in most alternative formulations is an increase in the fuel's cetane number, typically under 40, to more than 50, one analyst noted. This results in a poorer quality fuel but significantly reduces particulate (PM10) emissions, the analyst said.

Another approach being used by refiners is "deeper desulfurization" than required by regulation, another industry source noted. Chevron's formula, for example, has a sulfur level of 0.0053 wt %, a tiny fraction of the federal specs.

Even so, progress on developing board-certified alternative blends hasn't eased compliance hurdles.

Several months before the rule was slated to take effect, it became apparent the majority of California's refiners wouldn't be able to produce complying diesel in sufficient quantity to supply the market. This has left CARB with little choice but to shift the compliance timetable, because a diesel shortage would strap the state's huge agriculture industry. Diesel used in rail and ship transport is exempt from the rule.

COMPLIANCE QUESTIONS

Dogged by the potential for diesel shortages, CARB came under unusual pressure to grant variances to large refiners that can't meet the October deadline.

Chevron, the first to certify an alternative blend with CARB, is one of three large refiners that asked CARB to grant a variance exempting some supply from the Oct. 1 compliance deadline. Chevron, Unocal Corp., and Ultramar Inc. account for about a combined 88,800 b/d of diesel capacity, or about 53% of the state's current total diesel capacity of 167,000 b/d.

On Aug. 17, acknowledging that more time is needed to complete refinery upgrades, CARB granted the three refiners variances that effectively waive more than half the state's current output from having to comply with the new specs for the remainder of the year (OGJ, Aug. 23, Newsletter). By January 1994, the amount of noncomplying fuel authorized by the variances for the three refiners drops to 54,800 b/d. By October 1994, all three of the exempt refiners must bring all their supply into full compliance with the rule.

Among the other refiners, ARCO will use the alternative formulation for all of the diesel it will produce, or 20,000 b/d. This represents a slight cut from current output, ARCO said, but shouldn't "cause major upheavals."

CARB says it also has commitments from Texaco Inc., Exxon Corp., and various independents to supply a total of 58,000 b/d of diesel. Shell Oil Co. and Mobil Corp. had not indicated their plans by presstime.

CARB says it's probably too late for other refiners to obtain variances prior to the Oct. 1 deadline.

SUPPLY QUESTIONS

Because of tremendous political pressure to prevent shortages, most industry observers are confident this won't happen.

"There will be no shortages," CARB's Bill Sessa maintains. "We're taking every step possible to guarantee no shortages."

A refining analyst agreed, saying, "CARB would look pretty foolish if its rule touched off a shortage. They're taking real precautions not to let this happen."

Diesel demand in the state is now running about 155,000 b/d, CARB says. All told, the refiners who are certain to be in the market this fall, with either complying or noncomplying fuel, account for diesel capacity of about 167,000 b/d. CARB's low end estimates indicate that supply during the transition this fall could be about 5,000-6,000 b/d less than that level. This is still technically enough to meet expected demand, provided all refineries are able to produce at capacity.

Despite CARB's assurances, independent marketers are convinced supplies will be tight.

"There will be regional shortages," insists Jim Gigoux, executive director of the California Independent Oil Marketers Association (Ciomas). "As of Oct. 1, every one of our Exxon branded jobbers expects to be out of supply" and shopping on the spot market.

According to Gigoux, Shell also has notified one large marketer that it won't be able to produce enough complying fuel out of its Martinez refinery in the San Francisco Bay area to meet its current contract.

Gigoux contends CARB fails to grasp the complexity of the distribution network, which will mean market dislocations. For example, ARCO says it will no longer send diesel to three of its smaller northern California terminals at Stockton, Chino, and Fresno, but will continue supplying its major terminals at Richmond, San Jose, and Sacramento.

Ciomas' Gigoux noted, "It puts our guys at a competitive disadvantage if they have to drive 370 miles round trip farther than before to pick up diesel. They can only move one load per day, instead of three."

A CARB official said, "Some companies have been using this (rule) to cut off markets that are not as profitable. There will be a juggling of the traditional markets."

COMPETITIVE IMPLICATIONS

CARB has attempted to ease the competitive problems that could arise from broadened use of variances by making refiners pay to not comply.

Under CARB's plan, Chevron and Unocal will be levied 6cts/gal for all noncomplying fuel they sell in the state during the first year after the new specs take effect. Independent Ultramar will pay 5cts/gal for its noncomplying diesel sold in the state.

The surcharge equals what CARB estimates the new diesel fuel will cost to produce, and is a penny more than the top estimate for fuel meeting federal specs. CARB initially estimated a 12cts/gal differential, but says the availability of alternative blends has trimmed the estimate in half.

"The fees are designed to prevent variance holders from undercutting the prices of other oil companies that fully comply with the standards on time, ensuring an equal, competitive market for all oil companies," CARB said. The agency plans to use funds from the fees to mitigate increased emissions that will result from allowing noncomplying fuels to be sold.

VARIANCE CONTROVERSY

Granting variances for large refiners is not without controversy. ARCO, which invested more than $70 million to retrofit its hydrocracker complex to meet the new diesel specs, vehemently protested the variance applications by Chevron, Unocal, and Ultramar.

"(It) was the original intent of the CARB board to use the variance provisions to address only those isolated situations where companies were unable to comply with the law due to equipment failures or other events beyond their control," ARCO asserted after CARB's hearing on the matter in late July. "No elected official or board policy vote has endorsed this radical a chance in the use of variance provisions.

Some believe the variances foreshadow things to come when CARB's next round of gasoline rules take effect for large refiners in 1996. "I think CARB's going to have to grant the same kind of variances of that rule, too," said a refining official.

ARCO says that allowing other large refinery to pay the noncompliance fee would effectively create a $15 million surcharge that could be passed on at the pump for fuel that does nothing,to improve the environment, the company maintains. ARCO declined to disclose how much it will charge for its alternative diesel blend, saving only that it will be priced according to market conditions.

MARKET CONCERNS

Nobody knows what those market conditions will be, but several watching the market said price spikes could occur if even one major pulls out of the market because it can't obtain supply from another refiner.

One industry official predicts that truckers will increasingly buy cheaper fuel out of state, rather than paying extra for cleaner California diesel, much less the 6cts surcharge for diesel that doesn't even reduce emissions.

This potential will heighten to the extent potential regional shortages boost prices further. Exxon, the official noted, seems to be hedging its bets, with two large, new diesel islands along interstate Highway 40 just across the California border in Nevada.

The ultimate marketability of reformulated diesel is yet another problem looming on the horizon.

Steep reductions in sulfur and aromatic content adversely affect lubricity. This can cause failures of rotary injector pumps in small diesel engines used in agricultural equipment, according to a report on the experiences of Norway and Canada in a similar diesel cleanup effort. Although lubricity can be improved with additives, the additives used are fuel-specific, and vary depending on such factors as the composition of crude used as a feedstock.

Similar problems were cited in studies of lubricity problems resulting from severe hydrotreating of diesel to reduce auto emissions in Sweden, which was implicated in premature fuel injector pump failure (OGJ, Aug. 16, p. 71).

GOALS VS. REALITY

Regulators at CARB are trying to reconcile their original goals with the realities of today's market, as well as with scientific findings that have emerged since they first sought to implement the rule.

Originally, CARB had hoped to achieve a total 17% reduction in tailpipe PM10 emissions through the diesel rule. The agency believed that aromatic hydrocarbons contributed significantly to PM10 emissions but gave refiners a chance to prove otherwise by providing the option to alter other fuel components as long as they achieved the same results.

The industry found that steeper reductions in sulfur, alone with changing the cetane number, were just as effective in reducing particulates as the CARB specifications. As a result, the blends most likely to be sold on the market don't attack aromatics to the extent CARB wanted, which would have provided an extra benefit in reducing the ozone precursor nitrogen oxide (NOx).

Today, CARB faces the reality that a significant share of the market may be supplied by noncomplying fuel. this will postpone the Environmental benefits the agency hoped to achieve. The fact that "dirtier" diesel can be purchased less expensively by truckers from neighboring states will further erode the environmental benefits.

Three years from now, CARB could potentially face similar "reality tests" when its new gasoline specifications come into play.

Unless these problems are solved in tandem with supply and logistics concerns, the reputation of environmentally improved diesel fuels may eventually be damaged. Similar concerns sounded a death knell for federally subsidized efforts to promote extensive use of gasohol in every state in the early 1980s.

Meanwhile a different version of the same debate is playing out in another arena with concerns over Scaqmd's Reclaim program.

RECLAIM AND ECONOMIC PRESSURES

Under Reclaim, affected businesses will have to achieve extremely ambitious annual caps on the criteria pollutants NOx and sulfur dioxide.

However, businesses would have the option to decide how to meet the emissions reductions. Those who couldn't achieve the cuts directly could do so by obtaining emissions credits from firms that cut pollution more than required.

The proposal is of immediate concern to refiners in California, for it could dramatically affect how much needs to be invested. The rule's also worth watching elsewhere, as Reclaim is seen as prototype for similar changes in environmental programs being contemplated at the federal level.

While refiners and other businesses applaud the principles that motivated Reclaim, the proposal's been riddled with controversy from the start. A large coalition of businesses representing most of the state's major industries claim it just won't work in practice and could further erode the state's already battered economy. Among the concerns:

The emissions caps are unattainable for many companies using identified and proven technologies.
The baseline emission levels from which future performance is determined could have the effect of penalizing companies that have complied all along by starting them with a deficit.
Reporting and enforcement provisions are so severe that the companies could be penalized for a whole quarter if out of compliance for even 1 day.

Provisions dealing with the purchase and sale of emissions credits also have drawn considerable fire. Among other things, businesses assert that the emissions caps are so severe that most companies would likely horde any credits for surplus reductions for the years they may not be able to comply.

In addition, Scaqmd's ideal of establishing a "free market" for emissions credits simply hasn't been realized, noted an oil industry official. Scaqmd has proposed limiting the trading of credits to certain zones within its vast jurisdiction, which covers the Los Angeles basin east to the Arizona border, so less than half of the companies covered by the rule would be eligible to trade. Moreover, Scaqmd originally planned to monitor each emissions trading transaction, a move that could snarl the system in red tape and delays.

Scaqmd is expected to make significant changes in the plan at its September meeting, and there has been speculation for months that the rule may not pass. The agency was forced to postpone a final ruling by 2 months to hammer out fine points and deal with widespread concerns.

"Progress has been made to consider some cost factors, but we're still being very cautious. We're not supporting or opposing it," ARCO Products Co. said. In a departure from other oil companies, ARCO took a high profile early on in opposing the plan.

While there is potential for some of California's environmental rules to be tempered in years ahead, regulators are limited by the need to bring the state into compliance with the federal Clean Air Act.

As a result, refiners still face sizable investments to comply with requirements on the books.

CARB's upcoming gasoline reformulation specs carry an estimated price tag of as much as $5 billion for needed refinery upgrades in California alone.

According to ARCO, the proposed Reclaim rule could add hundreds of millions of dollars more to the company's compliance costs over the rule's multiyear span.

What if the combination of problems involving logistics, supply, price, and possible unforeseen damaging side effects involving diesel fuel reformulation can't be resolved in California, the world's environmental bellwether?

In that event, the CARB program and its fallout might well prove a window of opportunity for industry to cite as testimony to the folly of overzealous and misguided environmental regulation.