C. Baird Brown
Ballard Spahr Andrews & Ingersoll LLP
Philadelphia
On July 29, Congress passed the Energy Policy Act of 2005, which was signed into law by President George W. Bush on Aug. 8. Title XV of the act establishes requirements and incentives for increased production of renewable motor fuels. The act requires most refiners, blenders, and importers of motor fuel to meet minimum renewable fuels targets.
Ethanol derived from cellulosic biomass or waste, is given special credit. In addition, the act provides for loan guarantees and grants for the construction of certain new ethanol facilities. The act also eliminates the oxygenation requirement for reformulated gasoline, imposes a phased prohibition of MTBE, and provides assistance to MTBE producers in converting their facilities to renewable fuel production.
These provisions can be expected to drive a continued expansion of the nation’s ethanol production capability. This article discusses the provisions of Title XV and some of the financing strategies available for new ethanol facilities.
Renewable fuel program
The Energy Policy Act grants the administrator of the Environmental Protection Agency the power to promulgate regulations implementing a renewable fuel program. The program requires that renewable fuel constitute an increasing proportion of motor fuel sold in the United States.
Renewable fuel includes motor fuel that is produced from grain, starch, oilseeds, or other biomass, including biodiesel and ethanol derived from cellulosic biomass or waste and natural gas produced from a biogas source. Cellulosic biomass includes wood and woody plants and wood and plant wastes. The renewable fuel must be used to reduce the volume of fossil fuel present in gasoline.
The act provides that four billion gallons of renewable fuel must be included in the nation’s fuel mix in 2006 and prescribes increasing volumes for succeeding years rising to 7.5 billion gallons in 2012. According to the Energy Information Administration, the gross volume of gasoline sold in the US in 2003 was 139 billion gallons. Therefore, the applicable volume for 2012 is 3.5 percent of the total volume of gasoline sold in 2003.
Currently, ethanol-based fuel is only a small percentage of the market. In 2003, the EIA estimated that the US consumed 2.88 billion gallons of ethanol or approximately 2.07 percent of motor fuel sold.
Fuel industry participants can meet the requirements of the program either by producing, blending, or importing renewable fuel themselves, or by purchasing credits from those who do. Industry members that exceed their own quota generate credits that can be used in the current or two succeeding years. Small refiners, blenders, and importers, who are exempted from the requirement for the first five years, can opt in and generate credits for sale to others.
The act provides extra incentives for production of ethanol from cellulosic biomass or waste by counting each gallon of such ethanol as 2.5 gallons for purposes of satisfying the requirement through 2012. Thereafter, at least 250 million gallons of cellulosic biomass ethanol must be included in the nation’s annual fuel mix.
Credits are freely transferable and may be used within one year of the date of generation. A producer who fails to meet its yearly renewable fuel obligation may carry forward a deficit. To come into compliance, a fuel industry participant must produce sufficient renewable fuel to meet the subsequent year’s obligation and repay the previous year’s deficit with credits. To offset the deficit, the producer may purchase additional credits or expend previously generated ones.
Loan guarantees
The act establishes a loan guarantee program for the construction of facilities used to process and convert municipal solid waste and cellulosic biomass into fuel ethanol. The secretary of energy may provide loan guarantees during the 10 years after the enactment of the act.
To qualify for a loan guarantee, an applicant must establish that:
• absent a loan guarantee, credit is not available to the applicant under reasonable terms,
• the applicant’s earning power and the value of collateral establish a reasonable assurance of repayment; and
• the interest rate on the loan is reasonable.
Applicants receive preferential status if they:
• meet all federal and state permitting requirements,
• are most likely to be successful, and
• are located in local markets that have additional needs due to either:
• a limited availability of land for waste disposal;
• the availability of sufficient quantities of cellulosic biomass; or
• a high level of demand for fuel ethanol or other commercial byproducts of the facility.
The applicant must also provide collateral such as insurance or a performance bond.
Grants
The new legislation establishes a grant program. Ethanol producers using cellulosic biomass or waste as feedstocks are eligible to receive grants from the secretary of energy. These grants support construction of eligible ethanol production facilities.
Eligible production facilities must be located in the US and use either cellulosic biomass or waste from “agricultural residues, municipal solid waste, or agricultural byproducts” as feedstock.
$100 million is authorized for appropriation during 2006, $250 million during 2007, and $400 million during 2008.
Ethanol production
Over 95 percent of current production of renewable fuels in the US is accounted for by ethanol, and over 99 percent of the ethanol production capacity uses corn as a feedstock. By contrast with other ethanol production technologies, production from corn is a mature, proven technology. However, production of ethanol from corn benefits from both corn price supports and federal tax subsidies (which are due to expire in 2010) and would not otherwise be self sustaining.
Studies have reached conflicting results as to whether production of ethanol from corn results in a net gain in fuel production given the use of fossil hydrocarbons in growing, fertilizing, and transporting corn and transporting the resulting ethanol.
Production of ethanol from wastes should provide additional efficiencies, but involves breaking down more complex carbohydrates (cellulose and hemicellulose) through acid pyrolysis or enzymatic action. Gasification of wastes and production of ethanol from the synthesis gas has also been tested at small scale. While these less tested technologies carry more risk, the financial incentives in the act are all aimed at these technologies.
The act would give greater credit in the fuel program to ethanol produced from cellulosic biomass, including agricultural residues, and other wastes. Moreover, as discussed below, existing tax-exempt financing options would favor solid waste disposal processes.
Strategies for fuel industry participants
Every large refiner, blender, and importer of fuels will be required to meet the renewable targets set by the administrator, either by directly producing or importing renewable fuel or by buying certificates. The market for certificates may well prove to be volatile. In 1995-1996, for example, high corn prices greatly reduced ethanol production.
Moreover, if targets exceed aggregate production, the price of certificates may escalate uncontrollably. This has been the experience in deregulated wholesale electricity markets, which have a regulatory requirement for reserves (in other words a fixed requirement that is insensitive to price). On hot days where the power grid is near its limit, the price of reserves can rise uncontrollably. Since a new renewable fuel production facility will typically take more than a year to bring on line, shortages could well develop.
To protect themselves from price volatility fuel industry participants subject to the new renewable standard may wish to hedge by obtaining long-term rights to production capacity. That can be done in three ways: 1) long term purchase contracts; 2) direct ownership of production facilities; and 3) ownership of interests in production facilities.
Each of these could serve to support the financing of new production facilities. The balance of this article discusses some of those financing strategies.
Financing options
One or more long-term purchase contracts from credit-worthy buyers would support a project financing by an independent developer of a renewable fuel production facility. In these circumstances the obligations of the fuel industry participant are limited to a requirement to buy fuel if tendered. In contrast, direct ownership of a facility by a credit-worthy fuel industry participant would allow financing based directly on the credit of the owner. The fuel industry participant would be directly liable for the debt incurred to finance the facility.
Between these two extremes lies a range of intermediate alternatives involving partial sponsorship by a fuel industry participant. These alternatives include joint ventures, either with other fuel industry participants or other interested parties, and other forms of limited or contingent support. Increased support typically entails increased risk but also typically results in greater control and may also carry entitlement to preferable tax and accounting treatment.
Project financings
There are a number of independent developers of renewable fuel production facilities. These include a few major players, such as Archer Daniels Midland and Cargill, and a number of agricultural co-ops, whose principal interest is in increasing sales of corn.
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Some of these players would also have an interest in fuel produced from agricultural waste. Some municipal waste disposal companies and public authorities have an interest in waste-to-ethanol projects. Finally, some development companies bring new technology to a project but no source of feedstock.
The credit structure for a project financing is built around a single asset. The developer seeks to manage all the risks relating to the operation of the asset so that the project produces a steady, predictable rate of return that is fairly independent of fluctuations in the markets for inputs and outputs. In the case of a renewable fuel production facility, the principal risks to be managed are feedstock supply, offtake arrangements for the ethanol and additional products of the process, construction risk, operating risk and, relating to both of the last two, technology risk.
Construction risk is usually managed by having a credit-worthy construction company build under a fixed-price, fixed-schedule contract with performance guarantees demonstrated in rigorous acceptance tests. For small- to medium-sized facilities with proven technology this may be less necessary, but it can be a challenge for larger or more experimental facilities. The federal loan guarantee program adopted in the act seems particularly suited to well-structured projects with technology risk.
With respect to operating risk, the market is often accepting of smaller operators so long as they have a demonstrated track record. A long-term operating contract that controls the escalation of operating costs, however, is important.
For feedstock, demonstrated supply matters most. If the feedstock is a commodity, such as corn, fluctuation of the supply price raises concerns. Where the feedstock is a waste stream, however, it is often enough to show that there is ample supply and that no less-expensive disposal option is available. The economics of a waste disposal facility can be substantially improved by payments to the facility for disposing of its waste feedstock.
The economics of waste disposal facilities are often also enhanced by the use of tax-exempt debt for financing. The internal revenue code defines solid waste disposal facilities as one of the qualified uses of the proceeds of tax-exempt bonds, even where the activity is conducted by private companies.
While such financings are subject to moderately complex rules, the bond markets are often more receptive to such financings than traditional lenders. Covenants may be less onerous and, because of the tax-exempt status of interest on the debt, the interest rates may be as much as several percentage points lower than comparable commercial debt.
Finally, the output should be sold pursuant to a long-term contract with stable prices. Because the buyer is obligated to pay money (not just deliver feedstock) the credit quality of the buyer or buyers is critical.
The long-term contracts generally need not cover the entire output of the facility, but must cover enough so that the assured payments can be expected to cover operating costs plus debt service. Indeed, lenders or underwriters typically analyze projects in terms of their debt service coverage ratio. They look at the overall costs (including cost of acquiring feedstock if it is a commodity) compared to revenues. The coverage ratio is the ratio of the net revenues to the debt payments.
The more risks involved in a project, the higher the debt service coverage ratio must be to satisfy lenders. A well-hedged project with high credit quality participants and offtake arrangements may need only a small margin of coverage protection to obtain financing, but a risky project may be expected to have coverage ratios greater than two to one.
Because of the structural complexity and extensive negotiations involved in long-term contracts, project financings can have high closing costs. They are not necessarily suitable for small facilities. From the point of view of the fuel industry participant, however, they may provide an assured long-term supply of ethanol at the lowest risk end of the spectrum.
Direct financing
At the opposite end of the spectrum, a fuel industry participant may develop and own a renewable fuel production facility itself and finance it as a corporate credit. This entails managing the risks associated with development.
As a matter of due diligence such a participant will investigate all the risk factors that concern a project finance lender and may choose to manage some of those risks in similar ways. However, the participant may be content to accept more commodity risk or view such risks as being hedged by other aspects of its business. From a finance point of view, however, the transaction is much simpler and can be financed as a small portion of ordinary corporate borrowings.
Even when a major fuel industry participant chooses to use its corporate credit, tax-exempt financing will make sense for waste disposal facilities. Petroleum refiners frequently finance the waste disposal aspects of a refinery with tax-exempt debt (which may be as much as 20 to 25 percent of the all-in cost of a refinery).
Refiners treat this as an opportunity to carry a portion of their corporate debt at tax-exempt rates. Government tax-exempt bonds are simply issued with a corporate guarantee, the proceeds are loaned to the refiner and the refiner agrees to pay back the loan by paying off the bonds.
Intermediate strategies
A substantial range of possibilities lies between a pure project financing and a financing on the owner’s credit. One of the most common is a joint venture in which several owners share the risks of a facility. Such a venture could bring together parties with varied interests, such as the feedstock supplier, the construction contractor, the operator, and the fuel output purchaser, or could be an alliance of several fuel industry participants who want to limit their level of risk while taking advantage of efficiencies of scale in the facility.
Joint venture parties can finance a facility as a single enterprise, either by using a project finance structure or by severally guaranteeing project debt. Either of these approaches can be pursued with tax-exempt debt. They can also each bring their own financing for their own portion of the project, which could be secured away from the project.
Conclusion
The Energy Policy Act will require substantial expansion of US ethanol production facilities. Fuel industry participants can participate in that expansion and secure long-term supplies through a variety of strategies suited to their circumstances. While the technology is still developing, substantial incentives, both in the act and arising from other market factors, favor development of ethanol production from agricultural and other wastes. OGFJ
The author
C. Baird Brown [[email protected]] is a partner in the Philadelphia office of Ballard Spahr Andrews & Ingersoll LLP and co-head of the firm’s Energy and Project Finance Group. His legal practice includes the development and financing of oil drilling and refining assets, power plants, waste disposal and recycling activities, and satellites. He has counseled clients in connection with mergers and acquisitions, taxable and tax-exempt, rated and unrated, and registered and unregistered financings, credit enhancements, and leveraged leases.
Ethanol provisions called ‘corporate welfare’
Don Stowers, Editor, OGFJ
While the nation’s farmers, environmentalists, and the US Congress and even President Bush embraced elements in the Energy Policy Act of 2005 that favor greater ethanol production, not everyone was as enthusiastic.
Two conservative think tanks - the Cato Institute and The Heritage Foundation - have condemned provisions of the act related to ethanol as “corporate welfare” for the agricultural industry. They also criticized the “additional pork” that was handed to energy producers in the form of tax breaks.
Ben Lieberman, a senior policy analyst at The Heritage Foundation, called the act “little more than a collection of old ideas that have never worked, new ideas unlikely to work, and a lot of pork for the energy industry.”
The Energy Policy Act provides that 7.5 billion gallons of ethanol be added to the nation’s fuel supply annually. The law effectively doubles the amount of ethanol (alcohol) used in fuel.
“This ethanol mandate is good news for Midwestern corn farmers and big ethanol producers but will raise the price of gasoline at the pump,” said Lieberman.
James Bovard, an associate policy analyst with the Cato Institute, said that Archer Daniels Midland, the giant Illinois-based agricultural producer, is a “case study in corporate welfare.” He added that ADM has been the most prominent recipient of agricultural subsidies and tax breaks for many years thanks to federal protection of the sugar industry, subsidized grain exports, ethanol subsidies, and other programs.
“At least 43 percent of ADM’s annual profits are from products heavily subsidized or protected by the American government,” added Bovard.
“An ethanol mandate could end up adding several cents to the price of a gallon of gasoline - a burden that American motorists hardly need,” said the Heritage Foundation’s Lieberman.
He was equally critical of the petroleum industry, saying the act provides $11 billion in “giveaways” to oil and gas companies. “The [act] even includes new incentives for oil drilling, as if $59 per barrel (now closer to $70/bbl) isn’t incentive enough.”
The Biotechnology Industry Organization expressed a contrary view. Jim Greenwood, president and CEO of BIO, said the act will improve domestic security by setting goals for production of renewable fuels made from US agricultural resources that will reduce US reliance on foreign energy sources.
“This legislation will provide incentives to hurry the future of biofuels,” said Greenwood. “Soon, we will be producing 25 percent of our transportation fuel needs by using industrial biotechnology to produce bioethanol, while adding $5 billion to the farm economy.”
The act provides up to $200 million yearly until 2015 for ethanol made from non-traditional feedstocks like wheat straw and corn stover. Ethanol, traditionally, is created by refining corn, sugar cane, and other types of plant materials.
Baylor University in Waco, Tex., is one of the early beneficiaries of the Energy Policy Act. Baylor was awarded a $373,000 federal research grant to make fuel-grade ethanol out of fiber using sources such as cornstalks, wood chips, and straw.
Ethanol critics claim that growing and processing corn for ethanol uses more fuel than it saves. Using fiber instead of grain could be more energy efficient, said environmental studies professor Peter Van Walsom, who is spearheading the Baylor project.
Van Walsom said he envisions growing native Central Texas prairie grasses for fuel, which could also help restore wildlife habitat. Such a crop would not require the large expenditures of fuel and fertilizer it takes to grow corn, he added.
Lieberman was not impressed with the ethanol proponents’ arguments. “There has never been any reason to believe that the tax code can do a better job than markets in making the right energy choices for America,” he said. “Yet, Washington keeps trying. In this respect, the energy bill is the same old failed policy on an unprecedented scale.” OGFJ
