Outlook drives interest in biofuels

22 February 2010 | By Trevor Castledine

Trevor Castledine is chief operating officer at Future Capital Partners

Investing in renewable transport fuel (RTF) production may be the best way to benefit from the growth of the renewable energy market over the next few years.

An investment in renewable energy is seen to fulfil a socially desirable purpose and attracts many investors, some of whom demand such investments to be included in their portfolio.

Renewable energy is set to outperform the market generally as an investment class for good reasons. Scepticism about the international community’s commitment to reducing emissions is melting away and financial incentives or penalties designed to encourage a shift towards sustainable energy are becoming more powerful.

This will mean huge increases in demand. Morgan Stanley, an American investment bank, has estimated that global sales from clean energy sources such as wind, solar and geothermal power and biofuels could grow to as much as $1 trillion (£640 billion) a year by 2030. In the meantime, the market may hit $505 billion in sales by 2020–almost nine times the level in 2005. (article continues below)

It is still important to pick the right green investment however, by avoiding technology risk, identifying situations where legislative incentives (or penalties) will create the biggest economic discontinuities and finding opportunities with other attributes that underpin the investment returns.

Investing in the next generation of renewable energy technology is exciting but will be a hit and miss business - with some amazing success stories but also much money disappearing into developing technology that never becomes commercially successful. Expert-led funds that diversify risk must be the way to access this type of investment, but diversification will also mean dilution of return expectation and the time-scales for bringing new technology successfully to market could be long.

In the medium term at least, profits from investment in the renewable sector will be driven by legislative incentives and penalties, so investors need to look at where those incentives are likely to create the biggest impact. The biggest benefits will accrue to available, proven technology, which is capable of making a major and reliable impact quickly.

”Most companies with renewable transport fuel in their portfolios have many other products and business interests, which could act as a drag to performance”

This brings us to RTFs. Globally, transport contributes a quarter of all greenhouse gas emissions, with 80% of that coming from road transport and half of that from cars. Liquid renewable transport fuels in the form of ethanol and biodiesel are the only low-carbon alternatives to fossil fuels and the liquid fuel infrastructure already exists, meaning that the transport and distribution logistics are already in place.

First-generation technology for producing RTFs is proven on a commercial scale–Brazil has been making bioethanol from sugar cane for nearly 40 years and a well established corn to ethanol industry sector exists in America.

So legislators are targeting this enormous source of potential carbon savings. The European Union (EU) Renewable Energy Directive (Red) has established a binding minimum target for renewable fuels to have a 10% energy-share (13% by volume) of the transport fuels market by 2020. This directive is embodied in British and other European States’ legislation and severe penalties will be applied to fuel retailers for failing to meet these blending benchmarks.

This will create a huge market for RTFs (6.5 billion litres in Britain, 49.5 billion litres in the EU) by 2020, equating to a new market in Europe the size of the global market for RTFs in 2006. Given blending at about 8-10 billion litres, this means a five-six-fold uplift in just 10 years (it took Brazil 30 years to develop a market for 20 billion litres).

Other global producers will not have sufficient capacity to meet EU needs and are also unlikely to comply with the stringent sustainability criteria introduced into the EU Red.

Also, the food for fuel argument is a non-starter, especially in relation to ethanol produced from European wheat, given the huge tracts of set-aside land and that it uses wheat that is not of high enough quality to produce bread. One by-product of bio ethanol production from wheat is a high protein animal feed that will displace imports of soya meal from areas where ecologically sensitive land may be used to produce it.

So investing in the development of the European RTF industry seems to offer a particular opportunity to capture the value of what are enormous legislative incentives, where the infrastructure is in place and proven, large-scale technology is available to meet the demand.

 

Getting access to such investments is not easy. Most publicly quoted companies with RTFs in their portfolios have many other products and business interests, which could act as a drag to performance. ’Green’ funds may give exposure to RTFs, but diversification may mean that successes from RTFs are dampened.

Seeking out opportunities that isolate the production of RTFs is the way forward. This might be through companies that exclusively own and operate RTF facilities or through an investment directly in the building and commissioning of an RFT facility.

Three other factors bring added interest to such an opportunity. First, market conditions mean that the availability of project finance is limited and financing spreads are relatively high, especially during the construction phase. That means that equity investors should benefit from windfall gains on refinancing post-construction or as and when liquidity returns to the financial markets.

Second, with oil majors having significantly underinvested in this technology over the past few years, vertical integration is likely with a trade sale offering a likely exit strategy at a healthy profit for prospective investors.

Third, structured appropriately, this investment proposition can also benefit from tax breaks associated with construction of major facilities, meaning that the risk/reward balance of the investment is improved even further.

RTFs offer a government-incentivised market where reliable technology can be put to use.