Defense-Funded Biofuels Program Can Spur Production and Lower Risk to U.S. Government

By Taite Mcdonald and Alex Beehler
In the wake of failed federal loan guarantees for green companies such as Solyndra and Range Fuels, the alternative-energy industry needs solutions that decrease government risk and elicit bipartisan support.

A Defense Department initiative, under the Defense Production Act, is one example of a useful role the government can play to expedite development and remove market barriers.

A March 2011 memorandum of understanding among the Navy, the Department of Energy and the Department of Agriculture establishes an interagency initiative to invest up to $510 million in the development of advanced fuels. The effort comes under the broad authority of the Defense Production Act, so investments that result from the MOU not only serve to meet the objectives of the military services, but also have the potential to play a significant role in encouraging market growth and boost energy independence from the Middle East.

The commercialization of first-generation biofuels relied heavily upon government programs such as Renewable Fuels Standard 2, biofuels tax credits, Agriculture research and rural development programs, and biomass initiatives. They bolstered ethanol and fatty acid methyl ether-based biodiesel. Many of these programs, however, are no longer available or have lost funding.    

Of concern to the Defense Department is that diminishing government support for green-energy sources could delay the commercialization of second generation or “drop-in” biofuels that the military services are seeking as alternatives to conventional jet fuel.

“The MOU should help facilitate partnerships to drive the advanced biofuels market forward,” said Renewable Energy Group President and CEO Daniel Oh, who is a West Point graduate and former Army infantry officer.

Even during times of political gridlock, both parties tend to agree that government funding is most beneficial when directed toward areas that can have the broadest impact on innovation and help emerging industries overcome market barriers.   

Extensive government support was provided to first-generation fuels — i.e. ethanol — that will not be required to commercialize second-generation products such as bio-based jet fuel and renewable biodiesel.

A number of technologies are ready for use, yet struggling to commercialize in the United States. The DPA initiative is the program with the potential to help advanced fuels come to market in a timely and cost-competitive manner.

There are also broader benefits of the program beyond facilitating the commercialization of advanced biofuels.  

Retired Navy Adm. Dennis McGinn, president of the American Council on Renewable Energy, said biofuels are “essential in both reducing our dependence on oil and improving our transportation

system. They are being actively pursued by all of our military services.”

NuElement is an alternative energy engineering services firm that submitted a response to the DPA “request for information,” in a teaming arrangement with Washington State University and subcontract support from Boeing researchers. “There are much broader benefits of the program as it can help to ensure national security from volatile energy supply and may offer commercial airlines some price stability,” said Karen Fleckner, CEO of NuElement.

“This becomes increasingly valuable against the threat of looming carbon taxes on aviation in the European Union that will increase cost of airplane travel and can impact the 20-year forecast of aircraft sales. The use of drop-in bio-aviation fuels will actually serve to help maintain U.S. competitiveness in this trillion-dollar market.”

President Obama officially announced the DPA effort Aug. 16. Shortly following the announcement, the three agencies released a request for information that set forth the anticipated requirements, broad objectives, and an expected timeline that was later amended.  

The goals are to reduce foreign oil dependency, help meet the statutory renewable requirements of the Defense Department and create jobs in the United States. The RFI also specified that each agency will contribute $170 million, that private industry must provide a 50 percent cost share or greater, and that byproducts such as bio-based chemicals can be produced to enhance further commercial viability. Specifically, USDA Credit Commodity Corp. funds will be designated for agriculture or fuels commodity risk. Defense funds will be designated to purchase equipment, and Energy Department funds will be tapped to capitalize the project.  

While these funds were not obtained in the fiscal year 2011 budget, some funding was appropriated to DPA Title III program in fiscal year 2012 and it is anticipated that these funds and USDA CCC dollars will be used toward the initiative.  

Inherent risks in deploying a new technology at a commercial scale remain, and present a significant challenge. While the market has begun to turn as more companies secure contracts with the military or commercial air carriers, the private markets have yet to regularly participate in the financing of biofuels projects. The solution to date has been to undertake costly scale-up processes and fund each of those steps with a combination of equity and public grants, in lieu of debt, or to seek government loan guarantees from the Agriculture or Energy departments. While the former is a viable, yet unsustainable option, the latter is no longer a solution upon which the industry can rely.   

In other energy sectors such as solar and wind, projects have successfully overcome similar obstacles with the help of the insurance industry that developed warranty products to secure financing. As a result, private debt providers have increased participation. Solar and wind companies have expanded at a greater rate than they would have otherwise.

“The 9003 USDA loan guarantee program has helped banks provide capital to these types of companies given their risk profile. If this program were to cease, it will be difficult for banks to provide capital for commercial-scale advanced bio-refineries unless technology and scale-up risk are adequately mitigated,” said Bret Turner, relationship manager in the CleanTech Practice at Silicon Valley Bank.

Risk insurance products would be a useful tool for separating out and wrapping the risk through a public-private partnership. John May, managing director at Stern Brothers, has been evaluating technology insurance products.

“Even if a company is to obtain a long-term contract from a creditworthy purchaser and obtain significant cash contributions from the government and private investors, it will still be difficult to attract private debt financing without addressing the technology risk associated with scaling up these facilities,” he said.

“The good news is that utilizing technology insurance products can mitigate technology risk in a manner that helps to attract private debt which can, in turn, drive down the percentage of government contribution needed to build commercial biofuels projects.”

But few insurance entities currently offer this product and those that do charge significant premiums. Under the wide-reaching authority of the Defense Production Act legislation, it is likely that government funding can be allocated to fund such insurance. Having the government support the development of insurance products for the biofuels industry in addition to funding a small portion of the underlying costs of the project would likely encourage private market debt participation while simultaneously defusing many negatives commonly associated with government funding.  

Technology insurance relies on third-party technology verification of projects so that the burden of choosing winning projects no longer resides with the government and, instead, with the
private sector and market.  

To be sure, DPA has yet to address the technology risk associated with first-of-a-kind commercial biofuels projects. Technology insurance products can serve to address this gap, but are not currently positioned to do so because they are not widely available. Support for the development of technology insurance could have a lasting positive impact on the advanced biofuels industry.

Taite McDonald is senior advisor at the Energy and Clean Technology Government Initiatives Practice of Wilson Sonsini Goodrich & Rosati, in Silicon Valley. Alex Beehler is an
independent consultant and senior advisor at the Energy, Climate and Environment Practice of Faegre BD Consulting, in Washington, D.C.

Topics: Energy, Alternative Energy

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