Although current efforts to produce cellulosic ethanol are frequently referred to as being near fruition, considerable uncertainty remains about the speed with which cellulosic ethanol will become commercially viable. So far, no company has been able to produce cellulosic ethanol in mass quantities at a cost that can compete with starch- or sugar-based ethanol. Moreover, the US Energy Information Administration recently released a report projecting that renewable fuels will not be able to meet the 36 billion gallon federal mandate by 2022. Yet, because cellulosic ethanol has the potential to improve the environmental benefits of using biofuels significantly, efforts to achieve its commercialization continue.

In recent years, these efforts have increasingly been bolstered by incentives provided by the federal government. Given the recent nomination of Tom Vilsack as US Secretary of Agriculture and Steven Chu as US Secretary of Energy, both of whom have been public advocates for the development of cellulosic ethanol, federal support for the industry is expected to continue. Such support must overcome not only the technical hurdles to commercializing cellulosic ethanol, but also the financial and legal hurdles that contribute to the uncertainty surrounding its future.

What is Cellulosic Ethanol?

Cellulosic ethanol is distinguishable from starch- and sugar-based ethanol primarily by the fact that it is produced from feedstocks that are not typically used as foods. Whereas starch- and sugar-based ethanol are produced from feedstocks such as corn and sugarcane, feedstocks that can be used to produce cellulosic ethanol include residual non-food parts of agricultural crops such as corn cobs and sugarcane bagasse, residual parts of forestry and waste products such as wood chips and organic garbage, and non-food crops such as poplar and switchgrass. Such a variety of feedstocks can be utilized because lignocellulose, the material that is processed into cellulosic ethanol, is found in all plants.

The components of lignocellulose — cellulose, hemicellulose and lignin — contain sugars and carbon that can be converted into ethanol once the lignocellulose has been broken down so that the sugars or carbon can then be separated. This need to break down lignocellulose and separate the sugars or carbon is the primary technical impediment to the commercialization of cellulosic ethanol. Although several processes exist for producing cellulosic ethanol, none of these processes has been proven cost efficient on a commercial scale. Among the most promising current efforts are those focused on processes that break down cellulose and hemicellulose into sugars through the use of enzymes or chemicals (biochemical processes) and those focused on processes that break down the carbon in lignin by gasification (thermochemical processes).

One big advantage of cellulosic ethanol is political: it does not drive up food prices. The feedstocks that can be used to produce cellulosic ethanol are more abundant than those used to produce starch- and sugar-based ethanol. A joint study by the US Department of Agriculture and US Department of Energy found that 1.3 billion tons of biomass feedstock could be used annually in the United States for biofuel production — the vast majority of feedstocks needed for cellulosic ethanol production — with only minor changes in land use and agriculture. In addition, since cellulosic ethanol can be produced from feedstocks that are often residual or waste products, criticisms related to increases in greenhouse gases from indirect land displacement have not been directed at cellulosic ethanol. Also, since several waste-feedstocks used for cellulosic ethanol do not require chemicals and fertilizers to be produced, cellulosic ethanol often has lower lifecycle greenhouse gas emissions than petroleum fuels or starch- and sugar-based ethanol.

Role of the Federal Government

Cellulosic ethanol receives federal support through a combination of incentives, including regulatory mandates, tax credits and depreciation allowances, grants, loan and guarantee arrangements, and biomass crop programs. These federal incentives are contained in several pieces of legislation, such as the Energy Policy Act of 2005, the Energy Independence and Security Act of 2007 and the 2008 Farm Bill.

Among the incentives is the renewable fuel standard or “RFS,” a federal mandate that requires increasing volumes of renewable fuels be blended into transportation fuel in the United States each year. The US Environmental Protection Agency, which administers the program, requires each fuel supplier (a fuel refiner or importer) to show each year that it has met the requirements of the RFS through a combination of purchases of renewable fuels and purchases of credits from other suppliers that have made renewable fuel purchases.

The RFS requires fuels produced from non-corn feedstocks that have 50% lower lifecycle greenhouse gas emission than petroleum fuels — called “advanced biofuels” — beginning in 2009 and fuels produced from cellulose, hemicellulose or lignin that have 60% lower lifecycle greenhouse gas emissions than petroleum fuels — called “cellulosic biofuels” — beginning in 2010 form an increasing percentage of the RFS.

As the RFS increases from 11.1 billion gallons in 2008 to 36 billion gallons in 2022, the mandate for advanced biofuels increases from six million gallons in 2009 to 21 billion gallons in 2022 and the mandate for cellulosic biofuels increases from one million gallons in 2010 to 16 billion gallons in 2022. As a result of these increases, by 2022, advanced biofuels are scheduled to represent 58.3% of the RFS, and cellulosic biofuels are scheduled to represent 76.2% of the advanced biofuels, the balance of the RFS being met by earlier generation ethanol and biodiesel fuels.

Tax subsidies are also important. In addition to the general tax credits for renewable fuels, such as the volumetric ethanol excise tax credit and the small ethanol producer tax credit, cellulosic ethanol production is provided with additional tax benefits. Producers of cellulosic biofuels are entitled to a tax credit or $1.01 per gallon on production after 2008, but the amount is reduced by the volumetric ethanol excise tax credit and the small ethanol producer tax credit. Also, a special depreciation allowance for cellulosic ethanol facility property allows for a depreciation deduction for 50% of the cost of a new enzymatic process cellulosic ethanol facility in the year that it is placed in service. The cellulosic biofuel credit and the depreciation allowance both expire on December 31, 2012.

Grants, loan guarantees and loans may be available through the US Department of Agriculture. The biorefinery assistance program provides loan guarantees of up to $250 million per project to fund the development, construction, and retrofitting of commercial-scale biofuel facilities producing advanced biofuels. The guarantees can cover up to 90% of principal and interest on a loan. They cannot exceed 80% of project costs. The program also provides grants for up to 30% of project costs to assist the development and construction of demonstration-scale biofuel facilities producing advanced biofuels. A separate bioenergy program for advanced biofuels provides up to $300 million in payments to biofuel producers to support the expanded production of advanced biofuels. Also, a repowering assistance program provides up to $35 million in grants to owners of existing biofuel facilities to promote the use of renewable biomass to produce heat or power as a substitute for fossil fuels.

Grants, loan guarantees and loans may also be available through the US Department of Energy. A biomass research and development initiative provides up to $200 million in grants for the development of biomass crops and the development and construction of demonstration-scale biofuel facilities producing advanced biofuels. A separate biorefinery project grants program provides up to $186 million in grants for biomass research and development and demonstration-scale biofuel facilities. Loan guarantees up to $10 billion for renewable energy and energy efficiency are provided under several programs to support loans from private lenders for the construction of advanced biofuel facilities that produce ethanol from cellulosic feedstocks and various other clean energy projects. The cellulosic biofuels production incentive program permits the US Department of Energy to provide incentives through per-gallon payments up to $25 million for cellulosic biofuels facilities until annual production of cellulosic biofuel in the United States reaches one billion gallons or the incentive program expires in December 31, 2014.

Impediments to Commercialization

Even though several facilities for commercial cellulosic ethanol production are under construction, the total cost of developing a cellulosic ethanol facility is not well known at present. Without an understanding of the total cost of engineering, constructing and testing a cellulosic ethanol facility, it has been difficult for developers to obtain standard construction schedules, cost commitments and performance guarantees from contractors. Without price, schedule and performance guarantees, it is difficult to raise equity for these projects, and it is nearly impossible to raise debt from private financial institutions. Lenders will be sensitive to any increases in the cost of developing the cellulosic ethanol facility, and although the Department of Agriculture and Department of Energy administer a variety of programs offering loans and guarantees, developers will likely have to assume the risk for some of these increased development costs.

Another cost issue relates to the operating costs of a cellulosic ethanol facility. Until a cellulosic ethanol technology is deployed on a commercial scale, it is impossible to know the full cost of producing ethanol from certain feedstocks. Currently, the high costs of processes for breaking down lignocellulose and separating the sugars and carbon are an impediment to the commercialization. Where operating costs either cannot be reasonably determined, or cannot be shown to decrease from the high costs associated with current processes, it may be difficult for a developer to obtain additional funding to move forward with commercial development. Also, high operating costs put pressure on working capital, which may result in the cellulosic ethanol facility being unable to meet its debt service.

Developers of cellulosic ethanol facilities have found it difficult to commercialize their new technologies due to what has been termed the “valley of death.” The valley of death is a period in the development of a new technology when it is susceptible to failure due to the developer’s difficulty in raising additional cash to fund its commercialization. During this period, a developer faces an increasing demand on existing cash, as cash is spent on development, and a decreasing ability to raise additional cash, due to the project’s lack of demonstrable positive future cash flow. Venture capital investors tend to provide financing to developers once the technology has been shown to be commercially viable, just before the upturn in cash flow is experienced. Private equity investors are typically interested in investing in companies that are already operating and established in the market, rather than developers that have an as-yet unproven technology.

One way of moving a technology through the valley of death is for a developer to enter into a strategic joint venture with an established company. By doing this, the developer can use the cash flow of the established company in order to raise additional cash for commercialization of the new technology. However, using a strategic joint venture requires identifying companies that are willing to accept the risk associated with the new technology and have access to sufficient cash to support additional development costs or can guarantee debt financing for the developer. Several oil companies have invested recently in cellulosic ethanol, including BP in a strategic alliance with Verenium, Suncor in a partnership with Lignol and Royal Dutch Shell with Iogen.

Developers have increasing access to loans and guarantees from the US government. This is another possible route through the valley of death. For example, the Department of Energy has provided funding for nine small-scale projects and four commercial-scale projects, including an additional $76.3 million in POET to develop a cellulosic facility (after an initial $3.7 million investment). Also, the Department of Agriculture recently announced that it will begin providing loan guarantees of up to $250 million under the biorefinery assistance program to support commercial-scale advanced biofuel facilities.

Another possible hurdle to the commercialization is the uncertainty surrounding access to feedstocks. Although the Department of Agriculture administers programs to promote the production of biomass crops, it is unclear whether these programs will convince farmers that a market for biomass crops will develop. Many of these crops may take several years to establish before a marketable crop is available for production, and until such time, it may be difficult to predict whether these crops will be commercially viable. Without knowing whether crops can be produced at commercial yields and prices, and in the absence of a market for biomass crops, it may be difficult for developers of cellulosic ethanol facilities to procure binding feedstock agreements.

In addition, the production and transportation costs for cellulosic ethanol feedstocks (residual non-food parts of agricultural crops, residual parts of forestry and waste products and non-food crops) on a commercial scale are largely unknown. Feedstocks that contain significant amounts of lignocellulose tend to be bulky, which may present difficulties and additional costs in terms of harvesting, collecting, transporting and storing these feedstocks. Much of the marginal land that has been identified as being a major source of feedstocks for cellulosic ethanol production lacks access to populated areas where ethanol would be used, which may further increase transportation costs. Projections of the amount of available feedstocks are based on the assumption that feedstocks can be harvested at increased per-acre yields, which in certain instances would require additional spending on new harvesting machinery. Also, the projections do not necessarily take into account the impact that such harvesting may have on continued increases in per-acre yields for agricultural crops, due to the removal of harvest residue that would otherwise fertilize the next year’s crops. All of these additional costs will remain difficult to quantify until cellulosic ethanol facilities enter commercial production.

Another risk to large-scale commercial production is what has been termed the “blend wall.” Currently, most ethanol-gasoline fuel blends contain no more than 10% ethanol (a fuel known as E10). Blenders stop at 10% because the automakers take the position that using higher percentages of ethanol will void most vehicle warranties. Given that current US consumption of gasoline is estimated at 142 billion gallons a year, absent an increase in the percentage of ethanol that can be blended with gasoline, the total annual market for ethanol in the US is expected to reach the blend wall at a maximum of 14 billion gallons of ethanol. The RFS is scheduled to increase beyond the current blend wall in 2012 and provides an incentive to increase ethanol production even though there may be no one to buy the additional ethanol in practice.

Unless the percentage of ethanol that can be blended with gasoline is increased, through a change in the types of vehicles sold in the US, additional production of commercial cellulosic ethanol will be difficult to absorb into the motor vehicle fuels pool. This concern is heightened by the fact that most, if not all, cost projections for producing cellulosic ethanol using current technology show that the fuel is not cost competitive with starch- and sugar-based ethanol.