But who’s buying? The Navy, biofuels, and subsidies

On December 5, the US Navy announced the largest ever purchase of biofuels by the US government—at 450,000 gallons, worth roughly $12 million, it eclipses any other one-off purchase in government history. The purchase is also unique for its makeup, as all 450,000 gallons are advanced “drop-in” biofuels, which can be burned in any gas-burning engine. None are corn ethanol. The purchase is likely to be the first of many, and the end goal is a US Navy with significantly reduced use of conventional fuels, replacing at least half of the 1.26 billion barrels used per year with advanced nonconventionals by 2020.

This may represent a new model for encouraging the development of domestic clean energy. By committing to a potential purchase of up to 1.26 billion barrels of advanced biofuels, the Navy has effectively guaranteed a portion of the market, giving producers incentive to invest, innovate and produce in order to win a piece of the action. This can be used as a template for future industry encouragement: by guaranteeing a market rather than subsidizing production, the government can encourage growth while minimizing the potential for moral hazard.

To this point, the government has focused on subsidizing bio-fuel production while fending off competition. Specifically, the US government offers a $1 per gallon tax credit for producers of both corn-based and cellulosic (advanced) ethanol, a 45 cent per gallon credit for those blending ethanol with conventional diesel fuel and a 54 cent per gallon tariff on imported biofuels. These measures are intended to make biofuels, primarily corn-based ethanol, cost-competitive with conventional fossil fuels, and they have been augmented with Renewable Fuel Standards, which mandate that the US produce 15 billion gallons of corn-based ethanol, 1 billion gallons of biodiesel and 16 billion gallons of cellulosic fuels annually by 2022.

Spurred by the combination of a generous series of subsidies, an overall production mandate and a public increasingly aware of the perils of relying on foreign production of fossil fuels, the US biofuels market grew from a niche market in 2000 to a 134-refinery, 7.4 billion gallon industry in 2010. Another 6.2 billion gallons are slated to come online in the next several years.

However, the current structure of government support for biofuels has a number of problems. First, it is not cheap or cost effective relative to other kinds of fuel. Even with subsidies, ethanol is pricey and energy-inefficient. Biofuels currently require 35% more energy per BTU than oil and 61% more per BTU than natural gas, with a comparable difference in economics. In other words, only through government subsidies can current ethanol production compete with traditional fuels. More importantly, with the subsidies in place, the industry has no incentive to find ways to operate more efficiently.

Second, the subsidy approach has resulted in the displacement of food crops. In the US, the primary feedstock for biofuels production has been corn. Politically, this has provided a double bonus: elected officials can say that they are both fighting climate change while supporting the powerful farm lobby. However, by shifting agricultural feedstock from the end-user to the ethanol market, the food supply becomes constricted, resulting in higher prices. As became obvious in 2008, many, particularly in developing nations, have been unable to keep up with these rising prices. Social unrest has been the result.

Last, the system has not been particularly effective at stimulating a real, functional biofuels market. This is due to two factors. One, current subsidies reward production volume, regardless of the presence of an end-user or the methods used to produce, allowing the industry to operate inefficiently indefinitely. Two, Renewable Fuel Standards have been ineffective in guaranteeing a market. While the latest round of Renewable Fuel Standards mandates 16 billion gallons of cellulosic ethanol by 2022, all indications are that the industry won’t even come close to that. In fact, the EPA recently lowered the 2011 target from 243.4 million gallons to 6.6 million, with the 2012 target likely to be lowered as well. This is a result of refiners consciously deciding to under-produce versus their targets, largely because the overall size of the market remains uncertain.

This brings us back to the US Navy’s biofuels goal. As has already been noted, the Navy is a sizeable user of conventional fuels—even with a number of nuclear-powered vessels, the Fleet still burns in excess of 1.26 billion barrels of fuel a year across its fleet of ships, aircraft and amphibious vehicles. By committing to an eventual transition to advanced biofuels, the Navy has effectively said, “in the coming decades, there will be a minimum market of 1.26 billion barrels of advanced biofuels”—a sizable proportion of the current projections for the industry.

On top of this, the US Navy, the Department of Energy (DOE) and the US Department of Agriculture (USDA) have come together to offer a joint investment of $510 million in advanced biofuels production capacity. The general idea is that, between the seed funding and the guarantee of a potential market, a domestic advanced biofuels market might find the conditions it needs to get on its own feet (check out the RFI here). This may prove to be the more effective approach. By providing seed funding, the government can financially support the initial R&D required to get advanced biofuels into larger-scale production; by guaranteeing a buyer, they can create the market certainty lacking with the RFS approach. By providing a buyer but not production support, they have created the conditions necessary for production while encouraging innovation; even with a guaranteed market, the Navy still has options, and the cheapest, most effective biofuels producer will win the largest piece of the pie.

It is worth noting that the Navy’s recent purchase was not cheap. 450,000 gallons at $12 million is roughly $27 per gallon—about four times the current cost of conventional fuel. At this price, the purchase has not been without its detractors. However, as with any nascent industry, demonstration-scale production is not cheap. The industry promises (and the Navy hopes) that as the advanced biofuels industry develops, economies of scale will kick in and prices will fall. This is already happening; the December 5 purchase was roughly half the cost, per gallon, as the Navy’s initial advanced biofuels purchases in 2009.

If prices continue to fall at this rate, and oil prices rise, then advanced biofuels could theoretically be cost-competitive with conventional fossil fuels far sooner than anticipated. While this remains to be seen, if things work out as planned, the US could find itself with not only a new and dynamic industry but also a new model of government encouragement of industry.