Aligning the public and private on transportation fuels

In his 2007 State of the Union speech, President George Bush called on the United States to reduce its gasoline consumption by 20 percent over the next decade by tightening fuel economy standards and producing 35 billion gallons of renewable fuel by 2017. The question many are asking is, “When will we get there?”

The western United States isn’t waiting. From a political standpoint, California, Oregon and Washington are creating the motivation through incentives for consumers and businesses to adopt or invest in solutions. In fact, California Gov. Arnold Schwarzenegger (R) has taken a leadership role on global warming efforts and the adoption of clean energy solutions.

Last year, venture capitalists took note of the governor’s progressive stance on climate policy and directed more than $1 billion to California’s clean technology sector, representing an almost 7 percent increase in California’s overall share of investments in the clean technology sector for 2006.

The U.S. government is also taking notice. The U.S. Department of Energy in June announced that it plans to spend $375 million in California, Tennessee and Wisconsin to develop more efficient ways to convert non-food crops into auto fuel.

Despite recent developments, the prevailing opinion in the investment community is that the President’s 20 percent renewable fuel target will be a sizable challenge to meet given the significant ethanol and/or biodiesel refining capacity increase required. Currently, only 12 million gallons of ethanol production capacity is online or in production against an annual U.S. fuel demand of 180 million gallons. The economics associated with competitive ethanol production are being challenged by the rising cost and fundamental inefficiency of corn as a food stock to generate ethanol, as well as the yet-unproven ability of cellulosic sources to be cost-attractive in the United States.

Meanwhile, biodiesel is gaining ground. The recently announced IPO filing for Seattle-based Imperium Renewables demonstrates the industry’s commitment to building capacity for biofuel production. Imperium says it expects to have an approximately 405 million gallon-per-year capacity by the end of 2008. These are important steps on the long highway to attaining President Bush’s goal.

Furthermore, the transportation costs and infrastructure capacity associated with ethanol and biodiesel distribution are constrained. Unlike Brazil’s, the U.S. fuel retail market (i.e., local service stations) is unequipped to sell multiple fuels from a single site with existing infrastructure. Retailers will need to invest in their storage and pump systems to sell multiple fuels. Of the nation’s 170,000 gas stations, only 2,000 have pumps for ethanol or biodiesel, according to recent statements from U.S. automakers.

Additionally, the transportation industry lacks the capacity necessary to move finished ethanol fuel from plants through refineries to the pumps, as ethanol cannot share the same pipelines with petroleum products. Unit, or dedicated, pipelines for ethanol cost as much as $2 million per mile and would, therefore, require substantial infrastructure investments. Rail is a delivery alternative, but lacks the capacity to handle potential increases in demand.

The magnitude of the overall challenge around meeting fuel demand in this country demands a strong cooperative partnership between public and private sectors. While the private sector “market” may be best at determining solutions, the public sector will have to create economic incentives that stimulate attention and investment. To be clear: Federal incentives will have to stick. Investors want to know that incentives created today will not be taken away within a couple of years. Ethanol’s $0.51 subsidy has been consistent and has motivated investors to build ethanol refining capacity. Many will argue that this subsidy unfairly favors ethanol at the expense of other, more efficient and economical energy solutions. However, the volatility of tax incentives and credits in the solar and wind space is directly correlated to the timing of inflows and outflows of capital to those industries. Unpredictability is manifested in higher costs of capital — higher interest rates, bigger discount rates and/or deferral of funding altogether.

The private sector, particularly investors, is motivated by economic incentive. Venture investors also look well-beyond government incentive opportunities and make decisions on technology investments that have economic potential in their own right. In fact, many investors execute their analysis of an investment opportunity knowing that a technology will have lower costs over time through ongoing research and development (R&D) and ingenuity.

What will motivate the progressive partnership between the public and private sectors to support the acceleration of transportation fuels? Not surprisingly, the price of oil will likely be the major determining factor. Sustained oil prices well above $60 per barrel will motivate whole industries and individual consumers alike to seek alternatives. Geopolitics (Russia’s oil games, for example) will also fuel increased volatility and unpredictability that will drive up prices.

The U.S. Senate is currently weighing the first major increase in federal fuel economy standards since the oil crisis in the 1970s. This measure would raise fuel economy standards to 35 miles per gallon by 2020, up from the current 25 miles per gallon average for cars and trucks. The legislation would also require U.S. drivers to use more than five times as much renewable biofuels as we do today. The bill would benefit Midwest corn farmers, but it does require that 60 percent of new biofuels be made from cellulosic materials such as agricultural waste.

In the United States, the moral imperative will not be enough of a motivator. Economics prevail and will, ultimately drive behavior. The sooner the private sector and the public sector align to achieve our needed transportation goals, the quicker we will reach our collective goals.

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Dan Pullman, a 25-year financial veteran, serves as vice president for international investment bank McNamee Lawrence & Co., where he specializes in providing investment banking services to high-growth companies within the energy sector. He can be reached at dan@mlcllc.com.