Measuring and Assessing Investment Risk in the Second Generation Biofuels Industry

Over the last decade, the second-generation biofuels industry has struggled to reach commercialization. The United States and the European Union have some of the world's most aggressive policies for alternative fuel promotion, including volumetric mandates, lifecycle fuel-carbon-intensity requirements, and fuel-taxation schemes. But these policies have not yet succeeded in bringing substantial volumes of new advanced biofuels to market. The Renewable Fuel Standard (RFS2) in the U.S. has proved to be a limited driver thus far, with the U.S. Environmental Protection Agency drastically lowering the amount of cellulosic biofuel that must be blended into gasoline and diesel each year. In addition, the industry faces barriers from the impending 'blend wall' of 10% ethanol in gasoline and uncertainty regarding policies and oil prices.

This paper presents a novel analysis of the financial risk of companies with a large stake in second-generation biofuel production (defined here as biofuel made from cellulose, algae, duckweed, or cyanobacteria). While previous studies have attempted to explain the slow commercialization of cellulosic and algal biofuels qualitatively, few have presented financial analysis across the sector. Using publicly available financial data, this paper applies investment analysis tools that are generally not applied to this space in order to develop a more rigorous understanding of the investment risk in this industry.

Using the capital assets pricing model (CAPM), we calculate beta coefcients, a metric of nondiversifiable market risk, from 2010 (post-financial crisis) to the present for nine companies that are producing or have a significant stake in cellulosic or algal biofuels. Seven of the nine companies have beta values greater than 1.0, indicating greater volatility than the stock market as a whole. Investors therefore see these companies as inherently riskier than other opportunities and, based on the CAPM analysis, would require a 15% average expected annual rate of return, compared with the S&P 500's 8% return.

The elevated risk seen in second-generation biofuel companies is one dimension that very likely contributes to unsteady and insufficient investment and the poor financial health of the industry. A direct implication of this analysis is that additional policy measures are needed to reduce risk and build confidence in second-generation biofuel companies in the early stages of commercialization. An examination of existing policies and tax incentives points to four specific changes to the U.S. tax code that could help accelerate the commercialization of second-generation biofuels. A federal tax credit for the production of second-generation biofuels exists, but its use has remained limited.

The proposed changes to this tax credit, and the issues they would help correct, are summarized in Table ES1. The first proposed change would allow eligible biofuel producers to claim an investment tax credit instead of a production tax credit, because the construction phase is when biofuel companies need financial certainty to attract investors. Second, allowing these parties to claim a grant in lieu of tax credit further enables them to use this support in the early stages, as they may not have tax liability against which to claim the credit for several years after construction begins.

The third proposed change is to provide policy certainty for investors by extending the tax credit until a threshold volume of biofuels has been produced, at which point support would no longer be necessary. Last, we propose harmonizing definitions of eligible pathways between this tax credit and the RFS2.