KiOR Inc. and Re-Crude

Barrett (2009) writes that a dramatic shift in technological innovation will serve as the key to propelling the mitigation of climate change. In the long run, undoubtedly, he is right. Technological innovation, however, is costly, high-risk, takes time and absorbs extensive amounts of financial and physical resources. At the same time, the estimated costs of climate change are high enough to warrant innovation and technological investment. But what is the real value of the new technology? How realistic are the results often promised by these entrepreneurs? The following is an exercise in determining the business and economic value of a new technology recently brought forward for IPO in April 2011. The company is KiOR Inc. and their product is a synthetic crude oil, “Re-Crude,” that is made from woodchips (though potentially expandable to other forms of cellulosic materials) and utilizes catalytic cracking to extract energy, a technology that has been used in the liquid transportation fuel industry for over 30 years and that is well understood. The final product can be refined in the current liquid-fuel infrastructure and can be refined into both gasoline and diesel fuels, much like it fossil-based counterpart.

According to the S-1 released by the company, the facts are:

• Estimated cost of $190mm for a 500 Bone Dry Ton (BDT)/day plant

• Production of 1500 BDT/day will put price of Re-Crude at $1.80/gal or $76/barrel

• 1 BDT yields 67 gal of Re-Crude

• 1 high-grade BDT costs $72.30 (Southern Yellow Pine)

• KiOR backed by $1bb long-term matching loan guarantee from DOE

• Estimated to release 80% less greenhouse gases throughout the lifecycle of the product

• Energy equivalent of crude

• Completely incorporates into current liquid fuel infrastructure

From a business perspective, the calculations suggest:

• Yearly production: 1500 BDT/day x 67gal/1 ton BDT x 1 barrel/42gal x 365 day/yr

873,400 barrels/yr

• Yearly Revenue: 873,400 barrels/yr x $76/barrel

$66.4mm

• Costs of biomass: $72.30/BDT x 1500 BDT/day x 365 day/yr

$39.6mm

• Annual Overhead costs: estimated at ~$10mm

So, from a business perspective, this is a viable business. What about from an environmental perspective?

• 1 gallon of gas releases: 20-22lbs CO2/gal

• ~$20/ton of CO2

• Re-Crude production: 873,400 barrels or 36.7mm gallons

• Re-Crude reduces emissions by: 16 lbs CO2/gal

• Re-Crude saves:

16 lbs CO2/gal x 36.7mm gal/yr

587mm lbs of CO2

587mm lbs CO2 x 1 ton/2000lbs x $20/ton

$5.9mm saved in costs incurred otherwise due to CO2

The purported savings of Re-Crude could amount to nearly $6mm in adverted externalities as well as a great business potential. Sound too good to be true? Well, it is, sort of.

Sensitivity analysis suggests that if the price of the input rises to above $121/BDT, the fuel becomes more expensive than the current (April 23^rd, 2011) price of oil ($113/barrel). Prices in the lumber market have been rising steadily in the past years due to increasing demand worldwide for construction materials (and this new technology would only exacerbate this trend). Similarly, the $1.80/gal production cost estimate is an at best figure only achieved after sufficient scaling of the (expensive) production facilities. More than likely, the price of $1.80/gal won’t be achievable in the near-term (within 2-3 years) and will most likely remain above $2-3/gal. The breakeven point with current oil prices is around $2.85/gal Re-Crude.

Similarly, this production method promises potential, yet the absolute amount of current consumption of fossil-based fuels in the US alone far surpasses the annual supply by this company. We consume over 20mm barrels of oil a day. That’s almost 7.5bb barrels a year! Re-Crude, to even make a 1% annual dent in the liquid fuel industry would have to incorporate over 400 plants (399.5 more than exist currently at a cost of ~$200mm per plant) and also would require forest resources that would deplete current stocks within 25-40 years (100 years if we stop harvesting for lumber to build anything). Similarly, current stocks of the most sought after woods are in the southeastern United States, where it may be difficult to develop 400 plants.

In short, the technology has potential, but will not serve as the change agent for the liquid fuel industry. The physical and environmental resources (currently) do not exist. On a small scale, this may provide a potential gap fuel, but will ultimately not be a long-term solution to climate change or emissions reduction. The variable costs will surely become volatile or at least higher as demand grows, and though the producers ensure that other forms of input material will soon be incorporated, it simply doesn’t stand that this particular process will make the revolutionary impact on the liquid transportation sector that Barrett suggests is needed. At the same time, the value of this production method is that it provides another option in circumventing future energy concerns. Barrett pointed out that as cliché as it is, there is simply no silver bullet to mitigate all issues associated with climate change. Ultimately, KiOR and Re-Crude will serve as one potential step in the multi-system approach necessary to challenge climate change.

An Alternative Approach to Carbon Markets: Impact Reduction Options

Several weeks ago at the International Impact Investing Challenge, Benoit Passot and his teammates from the Stanford Graduate Business School presented a fascinating approach for carbon reduction wherein companies issue “impact shares” alongside regular equity shares. Benoit and I later discussed variations on the concept that his team presented, including an approach where companies write options with environmental performance improvement targets as triggers (instead of traditional strike prices) that facilitate real cash payouts to the company if they achieve the improvements. In this post, I’d like to elaborate on this concept and argue that it has the potential to materially affect the overall market for carbon reductions.

The overall goal of the option, from the purchaser’s perspective, is to achieve a reduction in a negative impact such as the release of carbon into the atmosphere. The purchaser is willing to put up collateral to cover the option in the case that that environmental target is reached (and option triggered), and the purchaser loses nothing monetarily if the targets are not met – the option simply expires. For the sake of this illustration, assume that the “purchaser” is some sort of environmental advocacy group that is taking a market-based approach to facilitating carbon reduction.

From the firm’s perspective, they will routinely be presented with the ability to write these options. As in any good “option”, there is significant upside for the firm in that they can generate revenue by achieving targets and exercising the options and collecting the payout from the advocacy group. These options change the financing structure of carbon reduction activities and will lead to a more favorable outlook for these activities across the firm’s capital budgeting. From the perspective of the advocacy group, the cost associated with the options (the payouts to firms that achieve reductions and meet targets) takes the place of other costly activities such as lobbying firms and governments. It is not meant to fully transplant these activities, rather the option can be thought of as a powerful tool for advancing a specific advocacy agenda such as “cleaning up” a certain industry or region.

As with the Stanford team’s impact shares concept, the impact reduction options that I am advocating have almost endless variations. Benoit argues persuasively that there are in fact many permutations of the idea, and generally that the concept of these environmental target-based financial tools is best thought of as a suite of financial derivatives. In the case of the impact reduction options, one could imagine a firm buying them for “zero” dollars from the advocacy groups, buying them for a small price to ensure alignment of incentives, or even selling them off at some point in time to entities that seek to provide performance guarantees for carbon-reducing products.

The fundamental question is as follows: will firms adopt the use of environmental improvement objectives and incentives as a means to manage their internal cost of capital? That remains to be seen and is most likely the main objection to my argument that these options can be viable tools for carbon reduction. My counter to such skepticism takes me full circle, back to the setting for my initial conversations with the Stanford team: the Impact Investing community. The Monitor Institute estimates that in the near term, Impact Investing can grow to 1% of overall global assets under management. That’s about $500 billion, of which even a fraction dedicated to these financial instruments (impact shares, impact reduction options, etc.) can make a sizable market. At this point, the real potential for demonstration that reductions to a firm’s cost of capital for carbon reduction measures will substantially alter their decision making process.

We’ve all seen the cost curves for eco-efficiency upgrades and have scratched our heads and debated why firms time and time again make “no-go” decisions. Impact shares and impact reduction options might unlock this easily captured value.

Mitigation Banking and the Risk of Irreversible Damage

A common objection to mitigation banking is that it will somehow put environmentally valuable land at greater risk. People (myself included, at one point in time) seem to believe that that the mere exposure of the decision-making process for which lands will and will not be developed to market forces (mitigation banking, in this case) will systematically place treasured lands at greater risk.

I will argue that mitigation banking is an excellent policy choice and that the economic effects of a mitigation banking market do not materially increase this risk. Accordingly, these markets provide a net benefit – both economically and environmentally.

Here’s my quick and dirty illustration of the economics of mitigation banking, focusing specifically on measured environmental effects:

Quickly summarizing the chart: Since ($) cost is distributed uniformly over some range, over time as inexpensive land acquisitions are made, the cost of mitigation banking increases. Concurrently, the environmental value of lands (assumed to be randomly and normally distributed) and the associated offset level required is captured by project developers seeking mitigation banking trades.

Also concurrently, there is a “downward pressure” presented by interest groups, communities and other conservation entities that in essence removes the most environmentally valuable lands from the opportunity set. Over time, the cost of mitigation banking trades for relatively less valuable lands (randomly distributed across a smaller range thanks to the downward pressure) rises, removing any “environmental arbitrage” (spread between dollar value and environmental value, translated into dollar value through quantity required in offsetting).

Land acquisition costs, then, represent a larger portion of a project’s development. Remember – projects that seek to offset lands with high environmental value will need to purchase a larger quantity of offsets from mitigation banking markets. The incentives (through competitive pricing) created over time increasingly favors less environmentally valuable lands. The economics of mitigation banking make it unlikely that developers will target highly-valued (environmentally) lands, which makes it less likely that irreversible damage will occur in those lands.

Under a situation without mitigation banking, the fate of those lands are left to solely to bureaucratic processes, which are themselves capable of producing errors (or allowing corruption) resulting in the irreversible damage.

Many people (again, including myself at one point in time) have invoked the precautionary principle when proposals for policies like mitigation banking are advanced. This is probably the main counterpoint to the argument that I have made. To an extent, it is valid in that it serves as a risk-measure to correct for the mispricing of mitigation offset levels (e.g. land being undervalued environmentally in terms of offsets required). But ultimately it may lead to wasted resources and political bad will. Mitigation banking, on the other hand, attaches relative environmental value to land in a way that frames the discussion in a less polarized way. At a minimum, it carves a new place in the development decision-making process for “environmental value.” Something that even BANANAs may appreciate.

The Real Option Value of Urban Farming

Many people in the class (including Professor Ho!) laughed at the notion of vertical farming in urban areas. The argument underlying this scorn presumably involves the inefficient use of valuable urban real estate for (less valuable?) agricultural purposes. It would follow that agriculture would be better purposed on less expensive land in places with less people/economic activity.

I will argue that most instances of urban farming, including vertical farming in urban areas, are economically prudent activities that deserve more attention and will grow in the future for reasons that make economic sense.

Consider two probabilities:

P_all = probability that a specific large area (the northeastern US, for example) can import all of its food at all times

P_switch = Probability that the same region can quickly reorganize its economy in the midst of a food shortage to produce food to support itself

Let’s dig a bit deeper into the probabilities. P_all is almost always true. But is it always true? Are we 100% confident that we can import milk from other states forever? Always? From China? The answer must be “no.” So at any given time there is some value P’_all that represents the probability that the region needs (to some extent) to support itself with food production.

P_switch increases along a learning curve. If no one across the entire region practices agriculture in that specific region, then P_switch is very small, if not zero. As some people begin to practice agriculture in that region, P_switch increases. Let us also assume that one cannot simply import farmers in to a region and have them immediately begin growing, since knowledge of local growing conditions, seasons, etc. is cumulative and learned over time.

Here is why we shouldn’t laugh at vertical farming in urban regions: without such activities, the probability of surviving a major food shortage in a region (or less gravely, not destroying economic value) is very low. P’_all * P_switch represents the scenario wherein a region for some region cannot import all of its food and is forced to switch. Without any value for P_switch, maximum value is destroyed. With some value, there is a chance that the system can absorb shocks.

This probability exercise is simple to the point of being silly, but it illustrates the real option value of widespread regional, small farm agriculture – particularly in or near urban areas. And it hints at the potential benefits of such a decentralized system in absorbing less probable system shocks. I’ll add that there are positive externalities (urban agriculture has aesthetic and educational value) that developers are interested in incorporating into their developments.

Opponents to my argument will invariably counter that in this age of specialization and global portability of resources, the odds of P_all must be 100%. And it seems they are willing to take that bet.

I prefer the taste of cherry tomatoes right off the vine and a cheap hedge against highly improbable events.

Which country benefits the most from climate change?

Richard Tol discusses the various economic impacts that will result from climate change in his paper “The Economic Effects of Climate Change”.  Some of the economic consequences of climate change fall into the following areas:

Positive Effects	Negative Effects
Less sea ice -> lower cost of oil production, lower cost of sea transport	Desertification in some areas -> death and agricultural loss, cost to redesign water management systems
More rain in some areas -> higher agricultural productivity	More floods in some areas -> death and agricultural loss, cost to redesign water management systems
Ocean current collapse -> some regions get colder	Ocean current collapse -> some regions get colder (eg. Western Europe)
Higher wind speeds in some areas -> decreased cost of wind and wave energy	More severe and frequent tropical storms -> death and property damage, higher building standards/higher cost of construction
Tourists will move towards higher latitudes and elevations	Tourists will move towards higher latitudes and elevations
Warmer weather -> lower heating costs, fewer traffic disruptions from snow and ice, fewer expenditures on clothing and food	Warmer weather -> Higher cost for cooling (from homes to power plants), more wildfires
	Biodiversity Loss -> willingness to pay for nature conservation <1% of income
	Ocean acidification -> loss of fisheries
	Sea Level Rise -> property damage, agricultural loss, saltwater intrusion into groundwater

Feedback loops could create abrupt climate change with the collapse of the West Antarctic Ice Sheet or a massive release of methane from melting permafrost.  Because change may not be gradual, the benefit to well-positioned countries could be either subtle or stark.  The countries that will benefit the most from climate change will be those at higher latitudes due to the low risk of increased tropical storms, low risk of increased flooding and low risk of increased desertification.  Countries that aren’t reliant on ocean currents for favorable weather will be at low risk for an ocean current collapse.  The UK, Ireland, Norway, and Iceland would be worst hit by a shutdown of the gulf stream thermohaline circulation.  South Africa is at risk for a collapse of the Benguela Current.  Countries with high elevations with populations away from the coasts will benefit from increased tourism money and will be at low risk to sea level rise.  Countries with access to the Arctic Ocean will benefit from increased oil production and lower sea transport costs.  These include Canada, Greenland, Iceland, Norway, Russia and the United States, but all of these countries except Russia face risks from ocean current collapse and sea level rise.  In Canada, for instance, nearly 40% of the population lives near the ocean.

The remaining countries at latitudes above 45° with high elevation and low amounts of population in coastal areas are: Austria, Belarus, Czech Republic, Hungary, Liechtenstein, Luxembourg, Russia, Slovakia and Switzerland.  Countries with abundant natural resources like fresh water and agricultural land, on a per-capita basis, will be better off.  Belarus, Hungary and Russia are the only countries from this list with a physiological density (pop per km² of arable land) better than the world average.  Hungary and Russia are better than the world average on a renewable water resources per person basis.  Due to the enormous benefit from increased Arctic Ocean sea travel, increased access to arctic oil and increases in agricultural productivity across the vast stretches of Siberia, Russia comes out a clear winner.

Russia will receive increased tourism revenue as the country becomes warmer.  The warmer weather will increase agricultural production, decrease cold-related deaths, reduce the cost of heating, lower expenditures for clothing and reduce the amount of snow-related traffic disruptions.  Russia isn’t at risk to increased tropical storms or an ocean current collapse, and the country will benefit greatly from reduced sea ice in the Arctic Ocean allowing more oil exploration and allowing new shipping lanes to open up.