Shouldering the risk: strategy for risk management essential to moving cellulosic technology forward.
To date, there are still no commercial-scale cellulose-to-ethanol facilities in operation. The risks and uncertainties of these still unproven technologies are significant. Breakthroughs in new technologies continue to develop along multiple fronts to reach commercialization. A partnership of technical expertise and the financial wherewithal from both private and public sectors is required to bridge the developmental gaps and to distribute the startup risks.
Financing represents the greatest hurdle for an unproven technology. This article describes the difficulties involved with the financing of unproven technologies and describes the significant partnerships now arising to direct the evolution of the cellulose-to-ethanol industry.
Financing unproven technologies
Twenty-five years of industry experience has helped ethanol industry lenders and financial backers to become well acquainted with the risks associated with ethanol projects. The risks of these projects typically involve a traditional power plant, burning either natural gas or coal, and a well-proven process technology. However, cellulosic ethanol plants that will soon compete for financing will use equipment and/or process technologies that have little or no commercial operating history.
Unproven technology risks embrace all phases of a new project: construction and startup as well as operations. Of particular concern after a plant begins to operate at capacity is 'conversion risk,' the relative efficiency at which the plant is operating. Lenders are rightfully concerned that cutting-edge technologies operate at state-of-the-art efficiency, and particularly so if their exposure is substantially greater than it would be with a proven technology. But, if it can be independently certified that the plant can operate at a level sufficient to repay the debt plus some risk margin, lenders may be persuaded to assume a portion of the conversion risk.
Biofuels lenders who understand the history of the industry may have fewer concerns about conversion risk. Typically, once an ethanol project operates successfully for a couple of years, it's very likely that it will continue to do so. Consequently, lenders now tend to focus more on the technology risks involved with construction and startup phases of a project, and less so on operations.
Because cellulosic ethanol has no commercial operating history, there is an element of technology risk that cannot be assessed. Further, in the absence of a track record, lenders will want to see if the project has demonstrated success on a smaller scale. In other words: How successful is the pilot plant or the demonstration plant?
Unlike a pilot plant, a demonstration plant uses a continuous process on an industrial scale. A demonstration plant is usually a necessary stepping stone from a pilot plant to a commercial-scale facility. It's very difficult to leapfrog from a 500-gallon tank to building a 20- or 50-million-gallon biorefinery. Moving from a successful demonstration plant to the next level involves finding a construction contractor willing to assume the risk that the demonstration plant can be replicated on a commercial scale.
A related challenge confronting cellulosic ethanol is the absence of a traditional engineering, procurement and construction (EPC) contractor. The EPC is a contractual arrangement signed by the builder and technology provider to guarantee the plant's timely delivery and performance to specifications. The contract is necessary to plant developers as they attempt to obtain financing.
The "full wrap"
Building a traditional ethanol plant involves working with one of the small handful of process providers that offer turnkey design and construction services under a design-build contract. The contract covers the process provider's core technology and the "balance of plant," which often includes every plant system, from grain receiving to fuel storage and all points in between. The process provider is then responsible for ensuring that the fully integrated plant is constructed on time to contract specifications and is fully operational at the specified (nameplate) production capacity. This engineering, procurement and contracting agreement is known commonly as a "full wrap."
But as industry expansion strains the ability of most process providers to supply full-wrap services, many technology firms are shifting away from active involvement in design and construction. Firms now focus instead on licensing their core technologies and leave the design and construction of the facility to third-party engineers and contractors. The responsibility and risk of ensuring that all of the disparate systems, buildings and equipment fit together into an integrated operating facility now lie with the owner.
An EPC for a cellulosic plant must embrace elements of conversion risk that protect against inadequate throughput efficiency. Also, liquidated damages (see below) will need to be assessed to repay the debt should the project fail to operate as contractually specified.
Lenders and private equity funds prefer to back an "early development" project--a single unproven technology or process that is part of a system of proven technologies--rather than a "revolutionary" system. However, with the appropriate guarantees (and sufficient reserves), the uncertain elements of the unproven technology can be "wrapped" in with the final performance of the project and proven technologies.
Revolutionary systems are ideally small-scale venture capital investments that range from $5 million to $7 million, rather than large project transactions that involve a 20-year payout. Generally, the limit for venture capital is about $50 million and requires a 25- to 30-percent return on investment. There is another rub for cellulosic ethanol. For even a relatively modest, commercial-scale cellulosic ethanol biorefinery of 25 to 40 million gallons per year, capacity is expected to cost upwards of $300 million.
Expecting quick returns
However, perhaps an even greater problem with venture capital financing of a cellulosic project is the expectation of a quicker return. A venture capitalist expects a technology investment to be a means to build a company and gain significant value from the relatively quick selling of either many units of the business, or the entire business itself. This expectation lies in sharp contrast with a private equity investor in energy or infrastructure who looks for a return from business operations over an extended period of time.
So, unless a cellulosic plant is financed entirely from equity, at levels far exceeding those that traditional venture capital sources will support, an equity investor will expect a lender to finance construction. Otherwise, it will be difficult to persuade the equity fund to provide developmental capital.
A financing impasse can result. Lenders refuse to assume risk on unproven technologies and equity funds won't provide funding unless a lender will finance construction.
An alternative approach might be to separate the unproven elements from the rest of the project. The proven portion of the project might then be financed using traditional sources and the unproven portion using equity. Overall, the project is a blend of equity and traditional project financing.
A problem with this approach, however, is that equity stands in line behind any debt should the project fail and go to foreclosure or liquidation. The challenge with this structure is to provide a return with a reasonable risk premium, given the enormous scale of the project. Apart from the federal government or a deeply-pocketed construction contractor to guarantee performance, such a project is very unlikely to secure private equity funding.
Liquidated damages, related issues
One way to get past the technology risk issue might be to negotiate with the contractor or the equipment vendor to assume the risk and pay the risk bearer in the form of liquidated damages. Damages are said to be liquidated when the amount of damages recoverable in the event of a specified contract breach (for example, late performance at construction, or inefficient performance at conversion) is agreed at a specified date.
Two conditions must be met to uphold liquidated damages. First, the amount of the damages identified must roughly approximate the damages likely to be incurred by the party seeking relief in the event of failure. Second, damages must be sufficiently uncertain at the time the contract is made that both parties recognize the significant benefit of being spared any future difficulty of estimating those damages.
Liquidated damages for construction risk are generally written to account sufficiently for each phase of construction risk: mechanical completion, substantial completion and final completion. Liquidated damages for mechanical completion, when the plant is fully ready to start operations, should be no less than the complete cost of construction. Otherwise, the exposure to investors is too great.
Liquidated damages for substantial completion, where the plant is demonstrated to fully work at a specified target capacity--50 percent, for example--ranges from 10 to 20 percent of construction costs. Final completion involves the plant fully operating at the nameplate capacity specified in the contract, and generally requires liquidated damages of not less than 10 percent.
Other ways to allocate risk
Suppose, however, that a project is sufficiently interesting for a venture capitalist and a lender to consider financing, but the lender is unwilling to assume the technology risk. A project finance expert can parcel out, or deconstruct, and distribute the risks of a project among many takers: insurance providers, ethanol or specialty product marketers, sponsors, construction contractors and technology licensors.
Generally, however, it's the construction contractor, equity provider and--on rare occasions--the technology providers that are the principle risk takers in a project. While insurance providers have also attempted to wrap the risk of new technologies into projects, insurance is generally considered ineffective protection because of the gaps in coverage. Moreover, a performance bond on a construction contract is significantly easier to collect than an insurance contract which may have many outs.
Federal government role
Many are looking to the federal government to assume a significant part of the risk in developing renewable energy technology. This expectation is being fulfilled in the proposed Farm Bill, which includes billions of dollars for renewable energy (see sidebar), and by a $2.1 billion guaranteed loan program under the U.S. Department of Energy. To qualify for loan guarantees under this program, a project must meet two basic requirements:
* It must avoid, reduce or sequester pollutants and gases, and
* It must use new, or significantly improved, technologies when compared to those in general use in the marketplace.
However, lenders have been loath to participate in the program because the guarantees are structured to put the lender in the "first-loss" position in the event of foreclosure. The government guarantee is for up to 80 percent.
Because the U.S. government takes the first lien on the project, a lender would be left with a second lien for the non-guaranteed 20 percent of the loan value. For a $400 million loan, 20 percent is not an insignificant sum. So a lender has a major exposure if there is a liquidation.
The guidelines also require that both guaranteed and non-guaranteed portions of a loan be traded together in secondary markets. So where lenders often desire to sell the guaranteed portion of a note on a facility, selling just the guaranteed portion appears not to be an option. While the guidelines left unexplained what would happen if this condition were breached, it could lead to inability to enforce the loan guarantee. Opportunities to restructure the risk into a package of wraps and/or strips thus appear unavailable. The intent of the program may have been to encourage lenders to finance projects with unproven technologies, but its impact had the opposite effect.
The U.S. Department of Energy (DOE) recently announced that is investing up to $385 million for six biorefinery projects over the next four years (see sidebar, page 17). Each award is equivalent to a 20-percent equity stake. With these awards and the pending guaranteed loans that follow, the federal government will not only guarantee the loans on the projects, it will also assume the first loss in the event of foreclosure.
Given the scale of investment and the role of intellectual property in cellulosic ethanol, the farmer-owned business model may struggle to find its place in this emerging segment of the industry. However, as cellulosic technologies become proven, producer-owned businesses may to be launched--or existing ones expanded--to produce cellulosic ethanol under some forms of licensing arrangements.
In four of these six plants, farmers will produce the main source of cellulosic feedstock necessary to produce ethanol. It may be possible, therefore, for farmers to negotiate a place in the ownership structure for themselves. Broin Companies' system of partnering with farmers and rural investors seems very adaptable to tie together capital, intellectual property and feedstock sourcing.
The DOE solicitation, announced about one year ago, was initially for $160 million for three biorefineries. However, in an effort to expedite the goals of President Bush's "Advanced Energy Initiative" and "Twenty-in-Ten-Initiative" (which aim to increase the use of renewable and alternative fuels in the transportation sector to the equivalent of 35 billion gallons of ethanol a year by 2017) Energy Secretary Bodman raised the funding ceiling.
"We had a number of very good proposals, but these six were considered 'meritorious' by a review panel of bioenergy experts," Bodman said.
Anthony Crooks, Agricultural Economist
USDA Rural Development
Biorefinery projects awarded $385 million
The U.S. Department of Energy recently awarded $385 million in funds for six biorefineries developing technology for creation of cellulosic ethanol. Combined with the industry cost share, more than $1.2 billion is expected to be invested in these six biorefineries.
* Abengoa Bioenergy Biomass of Kansas LLC, Chesterfield, Mo., will receive up to $76 million. The proposed plant will be located in Kansas and produce 11.4 million gallons of ethanol annually and enough energy to power the facility. Any excess energy will be used to power the adjacent corn dry grind mill. The plant will use 700 tons per day of corn stover, wheat straw, milo stubble, switchgrass and other feedstocks. Investors/participants include: Abengoa Bioenergy R&D Inc.; Abengoa Engineering and Construction LLC; Antares Corp.; and Taylor Engineering.
* ALICO Inc., La Belle, Fla., will receive up to $33 million. The proposed plant will be in LaBelle (Hendry County), Fla., and will produce 13.9 million gallons of ethanol a year and 6,255 kilowatts of electric power, as well as 8.8 tons of hydrogen and 50 tons of ammonia per day. For feedstock, the plant will use 770 tons per day of yard, wood and vegetative wastes and, eventually, energy cane (sugar). Investors and participants include: Bioengineering Resources Inc. of Fayetteville, Ark.; Washington Group International of Boise, Idaho; GeoSyntec Consultants of Boca Raton, Fla.; BG Katz Companies/ JAKS LLC of Parkland, Fla.; and Emmaus Foundation Inc.
* BlueFire Ethanol Inc., Irvine, Calif., will receive up to $40 million. The proposed plant will be in Southern California, sited on an existing landfill and will produce about 19 million gallons of ethanol annually. For feedstock, the plant would use 700 tons per day of sorted green waste and wood waste from landfills. Investors/participants include: Waste Management Inc.; JGC Corporation; MECS Inc.; NAES; and PetroDiamond.
* Broin Companies of Sioux Falls, S. D., up to $80 million. The plant is in Emmetsburg (Palo Alto County), Iowa, and after expansion, it will produce 125 million gallons of ethanol per year, of which roughly 25 percent will be cellulosic ethanol. For feedstock in the production of cellulosic ethanol, the plant expects to use 842 tons per day of corn fiber, cobs and stalks. Participants include: E. I. du Pont de Nemours and Company; Novozymes North America Inc.; and DOE National Renewable Energy Laboratory.
* Iogen Biorefinery Partners LLC, of Arlington, Va., will receive up to $80 million. The proposed plant will be built in Shelley, Idaho, near Idaho Falls, and will produce 18 million gallons of ethanol annually. The plant will use 700 tons per day of agricultural residues, including wheat straw, barley straw, corn stover, switchgrass, and rice straw as feedstocks. Investors/partners include: Iogen Energy Corp.; Iogen Corp.; Goldman Sachs; and The Royal Dutch/Shell Group.
* Range Fuels (formerly Kergy Inc.) of Broomfield, Colo., will receive up to $76 million. The proposed plant will be constructed in Soperton (Treutlen County), Ga., and will produce about 40 million gallons of ethanol and 9 million gallons of methanol annually. As feedstock, the plant will use 1,200 tons per day of wood residues and wood based energy crops. Investors/participants include: Merrick and Co.; PRAJ Industries Ltd.; Western Research Institute; Georgia Forestry Commission; Yeomans Wood and Timber; Treutlen County Development Authority; BioConversion Technology; Khosla Ventures; CH2MHill; Gillis Ag and Timber.
Farm Bill supports cellulosic ethanol development
Agriculture Secretary Mike Johanns says the Administration's new Farm Bill proposal would dramatically expand the federal commitment to renewable fuels. He notes that a series of Farm Bill forums showed "real excitement about renewable energy" and the new funding it provides for renewable energy research, development and production--much of it targeted to cellulosic ethanol.
The Farm Bill would establish a program to invest $25 million a year for four years for incentives to encourage the development and expansion of cellulosic ethanol production. In addition, the BioPreferred Program would be reauthorized and would provide $18 million over 10 years to expand the use of biobased products by the federal government and to speed the development and adoption of these products in the private sector.
Among other energy provisions of the Farm Bill are measures to:
* Include a biomass reserve within the Conservation Reserve Program (CRP), under the proposed Conservation legislation.
* Reauthorize the Renewable Energy Systems and Energy Efficiency Improvements grants, loan and loan guarantee programs to provide an estimated $2.17 billion of cellulosic ethanol loan guarantees and $500 million for grants, under the proposed Rural Development legislation.
* Revise the Biomass Research and Development Act of 2000, providing $150 million for grants focusing on cellulosic ethanol production, under the proposed Rural Development legislation.
* Include a Bioproducts Research Initiative, providing $500 million in grants to increase the cost-effectiveness of bioenergy, in the proposed Research legislation.
* Provide $150 million for Forest Service research into better ways to use woody biomass for the production of bioenergy, in the proposed Forestry legislation.
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|Date:||May 1, 2007|
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