Among a handful of notable developments as 2020 ends is an uptick in interest in renewable fuel projects.

Renewable fuel is not an oxymoron. There are federal, regional and state programs to reward the use of fuels that have environmental benefits. The value and risks of renewable fuel projects depend heavily on government regulations.

This article is a primer for investors on the federal renewable fuel standard or "RFS" to assist with investment decisions.

Renewable fuels

Renewable fuel is fuel produced from renewable inputs such as sugar cane, vegetable oil or municipal waste. 

The renewable fuel standard was enacted in 2005 as a tool to reduce greenhouse gas emissions, expand the domestic renewable fuel sector and reduce reliance on foreign oil. The standard is administered by the US Environmental Protection Agency.

The RFS requires a specified volume of petroleum-based transportation fuel, heating oil and jet fuel to be displaced each year by renewable fuels. Basically, it requires renewable fuel, like ethanol, to be blended into petroleum-fuels so that gasoline mixtures sold for use in motor vehicles, for example, are 10% ethanol or other forms of biofuel. 

There are four biofuel categories under the RFS: cellulosic biofuel, biomass-based diesel, advanced biofuel and conventional biofuel. The volume requirements are currently set by statute through 2022.

An example of cellulosic biofuel is ethanol produced from grass, wood or other plants. An example of biomass-based diesel fuel is fuel used in diesel engines or as heating fuel derived from plant and animal products. Advanced biofuels can be made from any type of renewable biomass (except biomass that could be used as food). An example is compressed natural gas from municipal wastewater treatment facility digesters. Ethanol made from corn starch or biodiesel made from soybean oil are examples of conventional biofuels. 

The EPA has significant discretion to adjust the national renewable volume obligations for each of the four biofuel categories through an annual rulemaking process. It also has authority to waive the volume requirements if it determines the RFS is causing severe economic or environmental harm, or if there is inadequate domestic supply of biofuels to satisfy the mixture requirements.

The required mixture levels have been a touchy political issue the last four years, especially in the run up to the Iowa presidential caucuses in early 2020. Both farm and oil interests have been key Republican constituencies, but the Trump administration found it very difficult to strike a balance that satisfied both camps. The incoming Biden administration will face pressure from oil refiners for relief and competing pressure from farm interests to maintain a high biofuel blending ratio.

Some of the political pressure can be relieved by granting waivers. However, to date, the EPA has limited waivers to narrow classes of entities or individual companies.

There is obvious risk in a program that may change on an annual basis or be totally waived. However, EPA to date has maintained relative consistency with respect to the volume obligations and the limited waivers it has granted have not been enough to effect a material change in biofuel use. The bigger issue has been COVID-19. Fuel use is down across the board and both oil and farm interests are hurting.

Once an investor can get past the change-in-law risk, the focus turns to whether the biofuel project will produce eligible product on a reliable basis that can feed the RFS blending market.

Potential market

The RFS program affects nearly every participant in the market for ground transportation fuels.

There are six different types of market participants in the supply chain.

They are refiners who manufacture gasoline and diesel fuel, renewable fuel producers who produce fuels like ethanol and biodiesel, importers who import both petroleum-based and renewable fuels, blenders who combine renewable fuels with petroleum-based fuel to create transportation fuel for use in US vehicles, retailers who purchase the blended transportation fuel and sell it to consumers at gas stations, and consumers who purchase transportation fuel for their vehicles at gas stations.

Refiners and importers of gasoline and diesel fuels are "obligated parties" that must comply with RFS. Each obligated party has an individual volume obligation to mix biofuels into the fuel it supplies by applying its percentage of gasoline and diesel fuel that it will introduce in the United States during the coming year, as compared to other obligated parties, to the volume of biofuels that the US government wants used during the coming year. Obligated parties must demonstrate compliance with their individual renewable volume obligations, or "RVOs" annually.

The obligated party in the context of a project financing of a biofuel project will typically be the customer who signed a contract for the ethanol or other biofuel to be produced by the project being financed, or it may be one or more owners of the biofuel project (in the case where a refiner, for example, owns an ethanol plant).

Eligibility

The RFS creates a market for the output from biofuel projects. Biofuels qualify for inclusion in the renewable fuel program only if EPA has determined that the particular type of biofuel will help to reduce greenhouse gas emissions as compared to a 2005 petroleum baseline.

Biomass-based diesel must meet a 50% lifecycle greenhouse gas reduction.

Cellulosic biofuel must be produced from cellulose, hemi-cellulose, or lignin and must meet a 60% lifecycle greenhouse gas reduction.

Advanced biofuel can be produced from qualifying renewable biomass (except corn starch) and must meet a 50% greenhouse gas reduction.

Conventional biofuels like ethanol derived from corn must meet only a 20% lifecycle greenhouse reduction.

Common renewable fuel projects include municipal wastewater treatment facilities, public or private landfills generating biogas, and dairy farms, breweries and other entities that treat high-solids wastewater with anaerobic digestion and generate a biogas byproduct.

RINs

An obligated party can satisfy its compliance obligations by blending renewable fuels into transportation fuel or by obtaining renewable identification numbers, or "RINs," to meet its renewable volume obligations.

RINs are the credits that obligated parties use to demonstrate compliance with the RFS. One RIN is created for each gallon of RFS-eligible biofuel produced. RINs are defined using a unique 38-character number that is issued (in accordance with EPA guidelines) by the biofuel producer or importer at the point of biofuel production or the port of importation.

The RIN can be used by an obligated party for compliance in the year it is generated and the immediately following year. If the obligated party has excess RINs, it may sell them to others who may be short or save them for use in the following year.

A biofuel producer should plan ahead to ensure it is registered to generate RINs before producing fuel. The registration requirements for biofuel producers can be found at 40 C.F.R. § 80.1450.

Biofuel producers that generate RINs must register with the EPA at least 60 days before generating RINs.

The EPA may deactivate a biofuel producer's registration for several reasons. They includes inactivity lasting 24 consecutive months, failure to comply with registration requirements, failure to submit any required notification within the specified timeframes, and failure to pay any penalties imposed.

Trading RINs

Generally, RINs are to fuel as renewable energy certificates, or "RECs," are to electricity.

All RINs are tracked through the same system: the EPA Moderated Transaction System, or "EMTS." The EMTS is a "buyer-beware system," meaning all due diligence is the duty of the obligated parties to certify validity. There have been some well publicized cases of fraud.

Most RINs are bought and sold through private contracts registered with the EMTS, but there are also RIN spot markets. RINs can be traded in two ways. They can be assigned with the batch of fuel to which they relate and that travel with that batch of fuel from party to party, meaning any party buying the fuel also gets the RINs associated with it. Alternatively, RINs can be sold separately.

When a manufacturer produces a batch of biofuel, it must report certain information to the EPA through EMTS, including the type and quantity. The same holds true for a party buying, selling or retiring RINs by turning them into the government to satisfy its annual compliance renewable volume obligation. The party must report the transaction through EMTS, including the year generated, type of biofuel, quantity of RINs and per-unit price.

To reiterate: any party that owns RINs at any point during the year must be registered with the EPA and follow the RIN recordkeeping and reporting guidelines.

A typical RIN lifecycle transaction might look like the following.

When a qualifying fuel is produced, a RIN is generated and belongs to the biofuel producer. The RIN may then be sold by the producer directly to an obligated party or a RIN trader on an assigned or separated basis. A RIN may be resold by a trader (or an obligated party with more RINs than it needs) on an assigned or separated basis.

A RIN that is originally sold as part of an assigned purchase may be separated from the fuel to which it was originally assigned and resold on a separate basis. 

When the RIN is used to demonstrate compliance, it is retired by turning it into the government.

The EPA collects historical data on RIN prices to which the public can refer to get a sense of typical market RIN prices. Current published RIN price ranges per category of biofuel generally range from a minimum of 5¢ per RIN, except for more plentiful conventional biofuels where the minimum price is 1¢ per RIN, to a maximum price of $2 per RIN, except for cellulosic biofuel where the maximum price is $3.50 per RIN.

Each RIN represents a gallon of biofuel.

Certain types of biofuel RINs are worth more than others because a fuel with a higher greenhouse gas reduction threshold can be used to meet the standards for a lower greenhouse gas reduction threshold and is therefore more versatile.

Cellulosic biofuel can substitute for all the other types of biofuel and, therefore, is the most valuable.

Noncompliance penalties

RIN noncompliance can be costly for obligated parties. Penalty levels for noncompliance set an upper limit on the amount an obligated party will be prepared to pay for RINs.

A non-compliant obligated party could be subject to civil penalties of up to $47,357 a day (subject to annual inflation adjustments).  Non-compliance may also require that the obligated party disgorge (or return) any economic benefits that resulted from its non-compliance.

Consequently, contracts for the purchase of RINs often include indemnity or significant liquidated damages provisions for failure to deliver contract quantities of RINs. There may also be an option to cover by purchasing RINs in the spot market in the event that a seller does not produce as many RINs as anticipated.

Biofuel sales

In addition to RIN sales, the sale of the underlying renewable fuel may also provide an important revenue stream, even when the RIN has been separated. In practice, a biofuel producer will produce biofuel that generates RINs. The biofuel producer will often immediately separate the RINs from the fuel, sell the RINs to obligated parties, and then sell the fuel to a gas marketer. Income from separated RINs allows the biofuel project to offset the cost of producing the biofuel.

An obligated party may satisfy its renewable volume obligation by acquiring RINs or by blending biofuels into conventional transportation fuels. There is a controversial restriction called a "blend wall" that caps the amount of biofuels that can be incorporated into gasoline (currently, it is 10%). Some obligated parties have expressed concern that this blend wall inflates the value of RINs. 

There are important downstream factors to consider in any biofuel sale, whether the sale is for use by an obligated party to satisfy its RVO or is a sale of the biofuel to an end user.

If the biofuel will be shipped via pipeline, the project will need to have an interconnection agreement to connect with the pipeline. This agreement will specify the quantity of biofuel permitted to flow into the pipeline as well as the gas quality standards necessary to permit entry into the pipeline.

In many instances the biofuel project will also require a gas transportation contract to move the biofuel from the biofuel project to the pipeline or on the pipeline to the customer. Use of third-party pipelines typically requires gas upgrading technology and gas compression to meet pipeline specifications. The interconnection and gas transportation agreements should be analyzed in connection with any biofuel offtake contract to ensure the project has the right to deliver biofuel to the customer in sufficient quantities and correct specifications.

In conclusion, there are several unique regulatory diligence topics to consider when analyzing the viability of a biofuel project that will depend on RFS-driven revenues.

They include proper feedstocks and conversion technology to qualify the project under the RFS, RIN registration and compliance, offtake contracts or spot-market sales plans for RINs and biofuel with special attention to the term, change-in-law risk allocation and consequences or indemnities tied to underproduction in such contracts, contractual rights to interconnect and move the biofuel, and controls to ensure the biofuel meets applicable quality specifications.