The Economics of Biofuels

YICGGYICGG

Rome, 20 August 2008Rome, 20 August 2008

Paolo PaesaniPaolo PaesaniUniversity of Rome “Tor Vergata”University of Rome “Tor Vergata”

Economics DepartmentEconomics Department

Motivation and outline

Motivation

Biofuel economics is about technological progress, government subsidies, agricultural, energy, transport and environmental policies, comparative advantages and protectionism, global governance, green finance, fuel vs. food … energy security and climate change

Outline of the presentation

The global growth-transport cycle Introductory overview The economics of biofuelsThe economics of biofuels “Biofuels: is the cure worse than the disease?”

The global growth-transport cycleThe global growth-transport cycle

Introductory overview

Biofuels, fuels derived from sugar, animal fats and vegetable oils used mainly as a liquid energy source for vehicles, are regarded as having the potential to address many of the economic and environmental problems posed by the global growth-transport cycle.

Although used as motor fuels since the 1920s, Biofuels have started to emerge as rivals to fossil fuels within the last couple of decades, particularly so since 2003, when the price for a barrel of crude oil started rising above USD 30.

Global production of biofuels amounted to 0.8 Ej in 2005, approx 1% of total road transport fuel consumption. Technically, up to 20 Ej from conventional ethanol and biodiesel has been judged possible by 2050 (source OECD).

Introductory overview

The economics of Biofuels

Industry structure

Production of feedstock cropsProduction of feedstock crops The production of crops is carried out by hundreds of The production of crops is carried out by hundreds of

thousands of farmers across the world. thousands of farmers across the world.

Biofuel manufacturingBiofuel manufacturing Major global players include ADM, Bunge, Cargill and Major global players include ADM, Bunge, Cargill and

Louis Dreyfus (agri-business multinationals)Louis Dreyfus (agri-business multinationals) Ethanol manufacturing is carried out by companies Ethanol manufacturing is carried out by companies

already part of the agricultural industry.already part of the agricultural industry. The structure of the bio-diesel industry is bi-polar, with a The structure of the bio-diesel industry is bi-polar, with a

few large companies involved in producing bio-diesel on few large companies involved in producing bio-diesel on an industrial scale, and at the other end a large number an industrial scale, and at the other end a large number of very small, often locally or farmer owned industry. of very small, often locally or farmer owned industry.

Industry structure

Distribution and retail salesDistribution and retail sales The wholesale distribution (including blending) is carried The wholesale distribution (including blending) is carried

out by small and medium-sized companies in some out by small and medium-sized companies in some countries and by large, sometimes state-owned oil countries and by large, sometimes state-owned oil companies in others. companies in others.

Usually retail distribution is guaranteed by the existing Usually retail distribution is guaranteed by the existing network of petrol and diesel fuel distributors.network of petrol and diesel fuel distributors.

End-usersEnd-users The majority of end users of Biofuels are individual owners The majority of end users of Biofuels are individual owners

of private vehicles. of private vehicles. In some countries, government agencies, military forces In some countries, government agencies, military forces

(notably the US army), municipal governments and cities (notably the US army), municipal governments and cities purchase bio-diesel for their fleet of vehicles/buses.purchase bio-diesel for their fleet of vehicles/buses.

Current and future production costs

The costs of producing biofuels vary significantly from one country to another, depending on feedstock, process, costs of energy and labor and location.

Location determines access to particular feed-stocks and energy supplies, the prices of which are, to a large degree, driven by market developments at the global scale.

The basic processes currently used for producing ethanol and bio-diesel do not vary greatly, though the scale of actual plants actually does.

According to Doornbosch R. & R. Steenblik (2007) “The expansion of biofuels derived from starch, sugars or plant oils alone will hit a limit within the next decade. Any increase in supplies beyond that limit will have to come from second-generation technologies and feedstocks”.

Production costs: ethanol

Most of the ethanol produced in Most of the ethanol produced in the tropics is derived from the tropics is derived from sugar-cane. The costs depend sugar-cane. The costs depend on feed-stock costs, scale of on feed-stock costs, scale of operation, ability to switch operation, ability to switch between the sugar and ethanol between the sugar and ethanol markets. Modern plants burn markets. Modern plants burn cane residue for process heat. cane residue for process heat.

Costs of ethanol produced from Costs of ethanol produced from starch depend on heat source starch depend on heat source and milling procedure.and milling procedure.

““Further incremental cost Further incremental cost reductions can be expected, reductions can be expected, particularly through large-scale particularly through large-scale processing plants, but no processing plants, but no breakthroughs in technology breakthroughs in technology that would bring costs down that would bring costs down dramatically” (source IEA)dramatically” (source IEA)

Production costs: bio-diesel Currently, the main oil seed Currently, the main oil seed

used for bio-diesel production used for bio-diesel production are derived from soybeans, oil-are derived from soybeans, oil-palm fruit, coconut, rapeseed, palm fruit, coconut, rapeseed, sunflower seed. sunflower seed.

Value of oil feed-stocks depends Value of oil feed-stocks depends on yields (varying from 400-600 on yields (varying from 400-600 liters per hectare for soybeans liters per hectare for soybeans to 4000-7000 litres per hectare to 4000-7000 litres per hectare for oil palm), compatibility with for oil palm), compatibility with crop rotation/soil enrichment, crop rotation/soil enrichment, value of residue after pressing.value of residue after pressing.

““There remains some scope for There remains some scope for reducing unit costs of reducing unit costs of conventional bio-diesel conventional bio-diesel production by building bigger production by building bigger plants. Technologies plants. Technologies breakthroughs are unlikely”. breakthroughs are unlikely”. (source IEA)(source IEA)

Government support for Biofuels

Government support for biofuels Policies that directly bear on the level of production are Policies that directly bear on the level of production are

quantitatively the most relevant ones and are found to have quantitatively the most relevant ones and are found to have the most distorting effects. the most distorting effects.

Domestic production of biofuels is directly supported by Domestic production of biofuels is directly supported by governments through: border protection (on average +20% governments through: border protection (on average +20% on the cost of imported ethanol) and production subsidies on the cost of imported ethanol) and production subsidies (US, leading country in the use of these subsidies grant €0.1 (US, leading country in the use of these subsidies grant €0.1 per litre). Many countries support biofuel use through per litre). Many countries support biofuel use through Regulations mandating usage or blending percentages and Regulations mandating usage or blending percentages and tax preferences tied to fuel excise taxes or sales taxes.tax preferences tied to fuel excise taxes or sales taxes.

According to According to Doornbosch R. & R. Steenblik (2007) ““Government policies supporting and protecting domestic Government policies supporting and protecting domestic production of biofuels are inefficient, cost-ineffective and production of biofuels are inefficient, cost-ineffective and contribute to creating a structural imbalance between contribute to creating a structural imbalance between demand and supply … Government subsidies should be re-demand and supply … Government subsidies should be re-directed towards R&D on SGBF technologies (less directed towards R&D on SGBF technologies (less environment damaging)environment damaging)”. ”.

International markets

Ethanol and vegetable oils have been internationally traded Ethanol and vegetable oils have been internationally traded for many decades: prior to the late 1970s only for industrial for many decades: prior to the late 1970s only for industrial uses (e.g. beverages industry), from the late 1970s onwards uses (e.g. beverages industry), from the late 1970s onwards also for Biofuel production purposes.also for Biofuel production purposes.

A reasonable estimate is that in 2005 trade covered about A reasonable estimate is that in 2005 trade covered about 10% of the world’s fuel ethanol consumption. The 10% of the world’s fuel ethanol consumption. The percentage of vegetable oils used fro Biofuels feed-stocks percentage of vegetable oils used fro Biofuels feed-stocks and bio-diesel is unlikely to have exceeded the 10% and bio-diesel is unlikely to have exceeded the 10% threshold.threshold.

Trade is likely to grow in the future, mostly due to limits to Trade is likely to grow in the future, mostly due to limits to growth in production, particularly in Europe. growth in production, particularly in Europe.

A number of barriers to trade, both tariff and non-tariff, A number of barriers to trade, both tariff and non-tariff, remain and domestic production is supported even there remain and domestic production is supported even there where it should not be so. where it should not be so.

Policy implications

Impacts on agricultural marketsImpacts on agricultural markets The fundamental motivation for supporting Biofuels has The fundamental motivation for supporting Biofuels has

always been everywhere the desire to stimulate new always been everywhere the desire to stimulate new demand for crops in order to raise agricultural prices and demand for crops in order to raise agricultural prices and incomes and the value of farm assets, particularly land.incomes and the value of farm assets, particularly land.

Until recently, support policies in OECD countries Until recently, support policies in OECD countries provided an additional outlet for crops, without affecting provided an additional outlet for crops, without affecting end-user prices.end-user prices.

Energy policiesEnergy policies The idea that domestic Biofuels production will reduce a The idea that domestic Biofuels production will reduce a

country’s dependence on foreign sources of energy and country’s dependence on foreign sources of energy and the “renewable energy appeal” have helped increase the the “renewable energy appeal” have helped increase the political popularity of Biofuelspolitical popularity of Biofuels

Questions remain: non-renewable inputs to Biofuel Questions remain: non-renewable inputs to Biofuel production, uncertainty about displacement factors (oil is production, uncertainty about displacement factors (oil is used to produce Biofuels), energy efficiency as an used to produce Biofuels), energy efficiency as an obvious alternative. obvious alternative.

Policy implications Environmental policiesEnvironmental policies

Another motivation for supporting liquid Biofuels has come Another motivation for supporting liquid Biofuels has come from their superior emission profiles when used as motor from their superior emission profiles when used as motor fuels compared with (low-grade) petrol and diesel. fuels compared with (low-grade) petrol and diesel.

Whether the COWhether the CO22 emitted in the various stages of Biofuel emitted in the various stages of Biofuel production exceeds the COproduction exceeds the CO22 absorbed by the crops and absorbed by the crops and saved when using Biofuels is a topic of fierce debate.saved when using Biofuels is a topic of fierce debate.

In respect of soils and water, the expansion of crops for In respect of soils and water, the expansion of crops for Biofuels can actually have negative effects. Biofuels can actually have negative effects.

Transport and related tax policies Transport and related tax policies The largest intersection with transport policies has been the The largest intersection with transport policies has been the

numerous exemptions from fuel tax excise.numerous exemptions from fuel tax excise. Many policies at the local level favour flex-fuel vehicles.Many policies at the local level favour flex-fuel vehicles.

Conclusions

Biofuels could theoretically achieve a market share of Biofuels could theoretically achieve a market share of 20% of the liquid fuels market in 2050. Recent OECD 20% of the liquid fuels market in 2050. Recent OECD calculation suggest that 13% is a more realistic figure.calculation suggest that 13% is a more realistic figure. As the current percentage is 1%, huge resources are pouring into the biofuels industry.

High fuel prices and generous regulatory support have given the industry healthy margins and relatively short investment payback times (Caesar W., J. Riese, T. Seitz (2007)).

Biofuels potential in terms of enhanced energy security, Biofuels potential in terms of enhanced energy security,

net energy provision, GHG reduction, biosphere net energy provision, GHG reduction, biosphere preservation, however, remains VERY UNCERTAIN.preservation, however, remains VERY UNCERTAIN.

Critics claim that biofuels will increase energy-price volatility, food prices and even GHG emissions and warn against potential damages to bio-diversity and the environment.

Conclusions

As long as oil prices stay at the present level, biofuels will As long as oil prices stay at the present level, biofuels will continue to be regarded as a viable alternative to fossil continue to be regarded as a viable alternative to fossil fuels in spite of resurgent doubts and high uncertainty.fuels in spite of resurgent doubts and high uncertainty.

Renewable energy appeal, energy security and climate Renewable energy appeal, energy security and climate change concerns, possibility that commodity prices fall change concerns, possibility that commodity prices fall again, lobbying power of producers act in the same again, lobbying power of producers act in the same direction.direction.

Rising commodity prices, lack of technological Rising commodity prices, lack of technological breakthroughs, contrary lobbying power, swinging breakthroughs, contrary lobbying power, swinging government and public opinion pose downside risks to government and public opinion pose downside risks to biofuel production. biofuel production.

Biofuels should (and are likely) to remain a useful Biofuels should (and are likely) to remain a useful

niche energy source, ideally to be produced were it niche energy source, ideally to be produced were it is less costly and environmentally damaging to do is less costly and environmentally damaging to do so and internationally traded on a reasonably free so and internationally traded on a reasonably free basis. Certification, control by national authorities basis. Certification, control by national authorities and SGBF R&D should be strongly encouraged. and SGBF R&D should be strongly encouraged.

Bibliography Brannlund R., B. Kristrom, T. Lundgren, P.O. Marklund (2007)

“The economics of Biofuels” USBE Research Institute, Umea University, Sweden

Caesar W., J. Riese, T. Seitz (2007) “Betting on Biofuels”, The McKinsey Quarterly 2007 Number 2

McMillen, S. (2007) “The Economics of Biofuels: A New Industrial Revolutuion? “, Connecticut Department of Economic and Community Development

Doornbosch R. & R. Steenblik (2007) “Biofuels: is the cure worse than the disease?”, Round Table on Sustainable development, available at http://www.foeeurope.org/publications/2007/OECD_Biofuels_Cure_Worse_Than_Disease_Sept07.pdf

Steenblik R. (2007), “The distorted economics of Biofuels”, Joint Transport Reserach Centre, Discussion paper 2007-3, December 2007