Shouldering the risk

Strategy for risk management essential to moving
cellulosic technology forward

By Anthony Crooks, Agricultural Economist
USDA Rural Development


n his 2007 State of the Union Address, President George W. Bush emphasized the need to increase alternative fuel production to 35 billion gallons by 2017, or nearly five times the original target of 7.5 billion gallons (see sidebar). To meet this goal, the commercial-scale conversion of biomass feedstocks into ethanol, and primarily cellulose to ethanol, will play a prominent role. This effort will create more opportunities for producer-owned co-ops and LLCs to become biofuel producers.

To date, there are still no commercial-scale cellulose-toethanol facilities in operation. The risks and uncertainties of these still unproven technologies are significant. Breakthroughs in new technologies continue to develop along multiple fronts to reach commercialization. A partnership of technical expertise and the financial wherewithal from both private and public sectors is required to bridge the developmental gaps and to distribute the startup risks.

Financing represents the greatest hurdle for an unproven technology. This article describes the difficulties involved with the financing of unproven technologies and describes the significant partnerships now arising to direct the evolution of the cellulose-to-ethanol industry.

Financing unproven technologies
Twenty-five years of industry experience has helped ethanol industry lenders and financial backers to become well acquainted with the risks associated with ethanol projects. The risks of these projects typically involve a traditional power plant, burning either natural gas or coal, and a wellproven process technology. However, cellulosic ethanol plants that will soon compete for financing will use equipment and/or process technologies that have little or no commercial operating history.

Unproven technology risks embrace all phases of a new project: construction and startup as well as operations. Of particular concern after a plant begins to operate at capacity is ‘conversion risk,’ the relative efficiency at which the plant is operating. Lenders are rightfully concerned that cuttingedge technologies operate at state-of-the-art efficiency, and particularly so if their exposure is substantially greater than it would be with a proven technology. But, if it can be independently certified that the plant can operate at a level sufficient to repay the debt plus some risk margin, lenders may be persuaded to assume a portion of the conversion risk.

Biofuels lenders who understand the history of the industry may have fewer concerns about conversion risk. Typically, once an ethanol project operates successfully for a couple of years, it’s very likely that it will continue to do so. Consequently, lenders now tend to focus more on the technology risks involved with construction and startup phases of a project, and less so on operations.

Because cellulosic ethanol has no commercial operating history, there is an element of technology risk that cannot be assessed. Further, in the absence of a track record, lenders will want to see if the project has demonstrated success on a smaller scale. In other words: How successful is the pilot plant or the demonstration plant?

Unlike a pilot plant, a demonstration plant uses a continuous process on an industrial scale. A demonstration plant is usually a necessary stepping stone from a pilot plant to a commercial-scale facility. It’s very difficult to leapfrog from a 500-gallon tank to building a 20- or 50-million-gallon biorefinery. Moving from a successful demonstration plant to the next level involves finding a construction contractor willing to assume the risk that the demonstration plant can be replicated on a commercial scale.

A related challenge confronting cellulosic ethanol is the absence of a traditional engineering, procurement and construction (EPC) contractor. The EPC is a contractual arrangement signed by the builder and technology provider to guarantee the plant’s timely delivery and performance to specifications. The contract is necessary to plant developers as they attempt to obtain financing.

The “full wrap”
Building a traditional ethanol plant involves working with one of the small handful of process providers that offer turnkey design and construction services under a design-build contract. The contract covers the process provider's core technology and the "balance of plant," which often includes every plant system, from grain receiving to fuel storage and all points in between. The process provider is then responsible for ensuring that the fully integrated plant is constructed on time to contract specifications and is fully operational at the specified (nameplate) production capacity. This engineering, procurement and contracting agreement is known commonly as a "full wrap."

But as industry expansion strains the ability of most process providers to supply full-wrap services, many technology firms are shifting away from active involvement in design and construction. Firms now focus instead on licensing their core technologies and leave the design and construction of the facility to third-party engineers and contractors. The responsibility and risk of ensuring that all of the disparate systems, buildings and equipment fit together into an integrated operating facility now lie with the owner.

An EPC for a cellulosic plant must embrace elements of conversion risk that protect against inadequate throughput efficiency. Also, liquidated damages (see below) will need to be assessed to repay the debt should the project fail to operate as contractually specified.

Lenders and private equity funds prefer to back an “early development” project — a single unproven technology or process that is part of a system of proven technologies — rather than a “revolutionary” system. However, with the appropriate guarantees (and sufficient reserves), the uncertain elements of the unproven technology can be “wrapped” in with the final performance of the project and proven technologies.

Revolutionary systems are ideally small-scale venture capital investments that range from $5 million to $7 million, rather than large project transactions that involve a 20-year payout. Generally, the limit for venture capital is about $50 million and requires a 25- to 30-percent return on investment. There is another rub for cellulosic ethanol. For even a relatively modest, commercial-scale cellulosic ethanol biorefinery of 25 to 40 million gallons per year, capacity is expected to cost upwards of $300 million.

Expecting quick returns
However, perhaps an even greater problem with venture capital financing of a cellulosic project is the expectation of a quicker return. A venture capitalist expects a technology investment to be a means to build a company and gain significant value from the relatively quick selling of either many units of the business, or the entire business itself. This expectation lies in sharp contrast with a private equity investor in energy or infrastructure who looks for a return from business operations over an extended period of time.

So, unless a cellulosic plant is financed entirely from equity, at levels far exceeding those that traditional venture capital sources will support, an equity investor will expect a lender to finance construction. Otherwise, it will be difficult to persuade the equity fund to provide developmental capital. A financing impasse can result. Lenders refuse to assume risk on unproven technologies and equity funds won’t provide funding unless a lender will finance construction.

An alternative approach might be to separate the unproven elements from the rest of the project. The proven portion of the project might then be financed using traditional sources and the unproven portion using equity. Overall, the project is a blend of equity and traditional project financing.

A problem with this approach, however, is that equity stands in line behind any debt should the project fail and go to foreclosure or liquidation. The challenge with this structure is to provide a return with a reasonable risk premium, given the enormous scale of the project. Apart from the federal government or a deeply-pocketed construction contractor to guarantee performance, such a project is very unlikely to secure private equity funding.

Liquidated damages, related issues
One way to get past the technology risk issue might be to negotiate with the contractor or the equipment vendor to assume the risk and pay the risk bearer in the form of liquidated damages. Damages are said to be liquidated when the amount of damages recoverable in the event of a specified contract breach (for example, late performance at construction, or inefficient performance at conversion) is agreed at a specified date.

Two conditions must be met to uphold liquidated damages. First, the amount of the damages identified must roughly approximate the damages likely to be incurred by the party seeking relief in the event of failure. Second, damages must be sufficiently uncertain at the time the contract is made that both parties recognize the significant benefit of being spared any future difficulty of estimating those damages.

Liquidated damages for construction risk are generally written to account sufficiently for each phase of construction risk: mechanical completion, substantial completion and final completion. Liquidated damages for mechanical completion, when the plant is fully ready to start operations, should be no less than the complete cost of construction. Otherwise, the exposure to investors is too great.

Liquidated damages for substantial completion, where the plant is demonstrated to fully work at a specified target capacity — 50 percent, for example — ranges from 10 to 20 percent of construction costs. Final completion involves the plant fully operating at the nameplate capacity specified in the contract, and generally requires liquidated damages of not less than 10 percent.

Other ways to allocate risk
Suppose, however, that a project is sufficiently interesting for a venture capitalist and a lender to consider financing, but the lender is unwilling to assume the technology risk. A project finance expert can parcel out, or deconstruct, and distribute the risks of a project among many takers: insurance providers, ethanol or specialty product marketers, sponsors, construction contractors and technology licensors.

Generally, however, it’s the construction contractor, equity provider and — on rare occasions — the technology providers that are the principle risk takers in a project. While insurance providers have also attempted to wrap the risk of new technologies into projects, insurance is generally considered ineffective protection because of the gaps in coverage. Moreover, a performance bond on a construction contract is significantly easier to collect than an insurance contract which may have many outs.

Federal government role
Many are looking to the federal government to assume a significant part of the risk in developing renewable energy technology. This expectation is being fulfilled in the proposed Farm Bill, which includes billions of dollars for renewable energy (see sidebar), and by a $2.1 billion guaranteed loan program under the U.S. Department of Energy. To qualify for loan guarantees under this program, a project must meet two basic requirements: