Unintended Consequences in the California Biodiesel Market


Originally published in The Jacobsen on February 22, 2016
California Biodiesel Industry Commentary

For those of us who believe in science, and the realities of the climate change that is upon us, California’s Low Carbon Fuel Standard (LCFS) is a groundbreaking, but somewhat controversial piece of legislation. It’s driving policy changes and conversations not only in California and the Pacific coast region of North America, but all over the world. Perhaps more importantly, along with all of California’s climate regulations, the Golden State’s policies are changing behavior and changing markets. The question is, are all the market changes what the state policy makers and regulators had in mind, or are we experiencing something more akin to the law of unintended consequences?

I’ve had many conversations with colleagues and customers in the fuels industry about the LCFS and the questions it raises. Will the regulation work past 2018? How often might the California Air Resources Board (CARB) modify it and what impacts will that have on business? Would the regulated entities in the petroleum industry voluntarily address climate issues even though many continue to deny or question the science? I’m guessing that many others have been having these same conversations and many of the questions remain unresolved.

But no matter your opinion of the regulations, things are changing. The fact that the US solar industry employs more people than the entire oil and gas industries and the solar installation sector alone employs 77% more people than the domestic coal mining industry, seems to indicate that it’s time for us to recognize that we are in an energy paradigm shift – at least the beginning of one – and the LCFS, along with other climate policies, is helping to drive it. I’m certainly not suggesting that the oil and gas industry is disappearing or that the 99% of us who still power our vehicles with fossil fuel every day will magically be driving EVs or hydrogen fuel cell vehicles any time soon. But I think it’s important for us to remember what the former Saudi oil minister said in 1973 during the first oil shock: “The Stone Age didn’t end because we ran out of stones, and the oil age will not end because we’ve run out of oil.”

What I’m suggesting is that there is a movement taking place and it includes multiple low-carbon solutions for transportation. Currently, biofuels are responsible for close to 90% of the LCFS credits being generated and it appears this will be the case for several years to come. The biofuel with the greatest opportunity for immediate and near term growth in California is biodiesel. Given the volume of this low-carbon biofuel produced in California and the US, it makes a tremendous amount of sense to deploy it in as intelligent, thoughtful and pragmatic a way as possible to help meet the compliance obligations created by the LCFS.

Therein lies the rub, however. What seems to have happened in California is a perfect storm of regulation without proper preparation or coordination between state and federal regulators, which is resulting in a dramatic oversupply of the biodiesel market. And by “preparation” I mean “infrastructure”, at least in this very important instance.

In the US, biodiesel currently enjoys a variety of credits under several state and federal programs. First of all, the federal blenders tax credit (BTC) generates $1 per gallon for biodiesel produced or consumed in the US. Additionally, as of this writing, the average value for 2016 D4 biodiesel RINs is 78 cents, and since there are 1.5 RINs/gallon that translates to $1.17/gallon. This means that every gallon consumed in the US generates an immediate $2.17/gallon, not including the value of the physical product. This significant bump incentivizes blending, bolstering the market for domestically produced biodiesel, and drives gallons to US markets from all over the world.

Meanwhile, in California, LCFS credits are trading at an average of about $124.00/MT. With a low carbon CI of 15 gCO2e/MJ, for example, that translates to another $1.33/gallon, which works out to about $3.50/gallon of combined credit value. If I’m a biodiesel producer almost anywhere in the world other than California it costs me roughly 30-40 cents/gallon to send my product to California, whether by truck, rail or vessel. That means that if I send my gallons to the Golden State I should theoretically be able to put ANOTHER dollar in my pocket after freight costs, over and above what I get from the federal programs. Why in the world would I send it anywhere BUT California? Great question!

Currently, only about 15% of fuel terminals and racks around the state are capable of blending biodiesel, which means that the only way to blend is either at retail sites, through marketers with infrastructure to handle blending, or at about 10 wholesale fuel terminals. As a result of this infrastructure bottleneck, only a small portion of what is being sent to California can be consumed through normal distribution channels. The rest languishes until it can find a buyer, driving prices down in a spiral I call “circling the drain.” It’s gotten so bad that in recent weeks we’re hearing that, after the credit values, physical product is not only being given away for free, but there are instances where suppliers actually have paid to have their product taken away. They are still making money from the aggregate BTC, RINs, and LCFS credit values, but the physical product they produce effectively has a value of zero, or less than zero. One could argue that the entire value being created by the LCFS is being given away and not going to the producers. This is clearly an unintended consequence of federal and state regulations.

You might assume that some of this fuel could make its way to regional markets in Las Vegas, Phoenix or Portland, but LCFS requires that credits be retired if exported out of the state, and no LCFS value can be realized – even though we know that climate change does not stop at the California border. So if I produce biodiesel in San Diego, I can send it 850 miles to Crescent City without an issue, but sending it 350 miles to Phoenix or Vegas is a no-no. I think this might be another unintended consequence of the LCFS regulation.

So how does the state begin to resolve these issues? By being thoughtful and pragmatic. Almost every drop of biodiesel is blended with petroleum diesel, so it would seem that the state should be working as closely as possible with the petroleum industry to ensure the blending infrastructure is built out as quickly as possible. But relations between the state of California regulators and the petroleum industry have historically been, shall we say, less than supportive.

In 2015, California producers were responsible for 32 million gallons of the total biodiesel consumed through blending in the state. More precise overall numbers from the California Energy Commission have not yet been released, but my guess would be that in-state production will end up being about 1/3 of the total gallons consumed last year. Many of those overall gallons were consumed at higher blend rates between 5-20% by a few fleets or at major and independent retailers taking advantage of deep discounts resulting from the unintended consequences discussed earlier: “free” is a great price.

There were about 3.5 billion gallons of diesel consumed in California, which means in aggregate the state is blending at about 2.5% and producing about .9% locally. But the blend rate through the existing wholesale distribution infrastructure is much lower when we consider the volumes going to B20 fleets and retail blenders.

We know that there is currently about 2.5 times the production capacity in the state as what’s being produced, which is a pretty dramatic underutilization rate given the value of LCFS credits. But it seems to be a mystery to many as to why this is happening. But is the mystery that difficult to figure out?

California has done some admirable things. LCFS is driving demand for low carbon fuels and technologies. In anticipation of a robust market for these fuels, the state invested millions of dollars in developing production of biodiesel and other biofuels, which has created hundreds of high-paying green jobs in some of the most disadvantaged communities around the state. The in-state biodiesel production capacity alone, if fully utilized, would reduce over 750,000 metric tons (MT) of carbon emissions from our atmosphere, which would be equivalent to removing almost 175,000 cars from the road.

But state regulators forgot about the distribution infrastructure, assuming perhaps that the market would take care of that. Oops! Guess what? The market forgot to take care of that – or for some reason wasn’t motivated to do so. If the state wants to figure out how to fully realize its investment in production it needs to address the distribution side of the equation, and had better do that soon.

I’ve not discussed production costs in California. Anyone who operates a production business in the Golden State is familiar with the challenges associated with that activity. I’ve also not discussed low-carbon feedstock availability – another topic that impacts market viability – and is quickly becoming a priority in the biofuel value chain. But I’ll save those topics for future articles.