Introduction to Renewable Fuels
Nationally and globally, there is growing focus on renewable fuels as a potentially profitable part of the strategy to reduce carbon emissions and mitigate climate change. While a number of renewable fuels regulations and governmental incentives have been in force in the U.S. for nearly a decade, the intense investor, corporate and governmental focus on environmental, social and governance issues (“ESG”), together with advances in technologies and industry maturation, may be leading to an inflection point. In the U.S., governmental policies directed towards incentivizing renewable fuels, both in the form of regulatory requirements to produce a certain volume of renewable fuels annually and also the generation of tax and environmental credits resulting from the production of renewable fuels, may represent an area for compromise between the incoming Biden administration and a possible divided Congress with respect to climate change and energy policy.1 These incentives contribute significantly to making renewable fuels attractive to producers, importers, and blenders of transportation fuels, as well as investors.
This will be the first in a series of pieces discussing legal and related topics that could be relevant to projects and transactions involving renewable fuels. In this introduction, we provide a general overview of renewable fuels, certain incentive programs that are available for renewable fuels, and the market for renewable fuels.
Bioenergy is energy, typically in gaseous or liquid form, produced from biomass. In gaseous form, bioenergy is referred to as biogas, and in liquid form, bioenergy is referred to as biofuel. Biomass is organic matter that is converted to energy through combustion, or through thermochemical, biochemical or chemical processes. Truly “renewable” biofuels are derived from organic sources that theoretically can be replaced in the environment naturally at a rate sufficient to keep up with consumption. Some biofuels are chemically very similar (if not identical) to petroleum gasoline, diesel, or aviation fuel, and can be used in existing engines and infrastructure without the need for blending with traditional fuels or modification to the engine or infrastructure (although they may be blended).2 Fuels such as these are sometimes referred to as “green” or “drop-in” biofuels. Other biofuels are chemically different and must be blended with traditional petroleum based fuels and may only be blended up to a limit of the overall fuel mixture. The difference between renewable diesel and biodiesel a good example. Both can be used in compression ignition diesel engines, are produced from generally the same feedstocks, and are treated very similar for purposes of key tax incentives. They also both potentially result in meaningful carbon emission reductions relative to hydrocarbon fuels. They are, however, chemically different, produced by distinctly different processes, and where renewable diesel can be fully substituted for petroleum diesel, biodiesel must generally be mixed with petroleum diesel in ratios less than 20% (otherwise, significant modifications to standard diesel engines are likely required).
Renewable Fuel Standard
The Renewable Fuel Standard (“RFS”) requires U.S. transportation fuel to contain a minimum volume of designated renewable fuels. The volume amounts are statutory targets through 2022, after which the Environmental Protection Agency (“EPA”) has statutory authority to determine the target volume amounts. In its final rulemaking for the RFS 2020 standards, the EPA calls for 20.09 billion gallons of total renewable fuel. The EPA administers the RFS and is responsible for (i) evaluating “fuel pathways” and which renewable fuels are eligible for the RFS program, (ii) establishing the volumes of renewable fuel that will be required for a compliance year based on the statutory targets, fuel supply and other conditions and (iii) monitoring compliance with the RFS using the system of tradable credits referred to as renewable identification numbers (“RINs”). In order to generate RINs, a renewable fuel producer must be registered under the RFS program. Registration requires providing the EPA with technical information regarding the production of the renewable fuel.
RINs are generated when a producer makes a gallon of renewable fuel. A RIN can be traded between parties once it is “separated” from the batch of renewable fuel that generated the RIN in accordance with applicable EPA regulations. “Obligated parties” under RFS are refiners or importers of gasoline or diesel fuel in the United States. Each obligated party is assigned an EPA-specified renewable volume obligation (“RVO”) that is based on a percentage of the determined RFS volume requirements for the applicable compliance year and projections of gasoline and diesel production for that year. An obligated party complies by either producing renewable fuels, or by purchasing sufficient RINs for each applicable category of renewable fuels for the applicable compliance year. Under limited circumstances, obligated parties can petition the EPA for a waiver from the RFS’s renewable fuel mandates.3
Federal Income Tax Credits
Federal law currently provides tax incentives relating to the production and blending of renewable diesel and biodiesel. These incentives include three income tax credits for fuels containing renewable diesel or biodiesel: (i) a blender credit of $1.00 per gallon of biodiesel used in the production of a “qualified biodiesel mixture” (which includes renewable diesel and biodiesel) that is sold or used as fuel by the producer (the “Blender Credit”); (ii) a credit of $1.00 per gallon of R100 renewable diesel or B100 biodiesel produced and either sold at retail or used as fuel by the producer (the “Producer Credit”); and (iii) a small agri-biodiesel producer credit of $0.10 per gallon of qualified agri-biodiesel (biodiesel derived from virgin oils) that is produced by a qualified producer4 (the “Small-Agri Credit”). The Blender Credit and Producer Credit are mutually exclusive. The Small-Agri Credit can be combined with both the Blender Credit and the Producer Credit with respect to agri-biodiesel only. In lieu of a credit against income taxes, a blender may claim a refundable credit against its fuel excise tax liability in the same amount as the Blender Credit. No tax credits are allowed under any of the programs unless the fuel is either produced within or used within the United States. These tax credits currently apply to any sale or use of the applicable fuel through December 31, 2022.
California Low Carbon Fuel Standard
California’s Low Carbon Fuel Standard (“LCFS”), administered by the California Air Resources Board, is designed to encourage the use of cleaner, low-carbon transportation fuels in California, encourage the production of those fuels, and thereby reduce greenhouse gas (“GHG”) emissions and decrease petroleum dependence in the transportation sector. Fuel producers, importers, and certain other parties in the State of California, are subject to the LCFS. Parties that sell or offer for sale transportation fuels in California are required to meet annual carbon intensity reduction targets or buy LCFS credits to meet the standards. LCFS standards are based on the “carbon intensity” (“CI”) of gasoline and diesel fuel and their respective substitutes. CI is measured in terms of grams of carbon dioxide (“CO2”) equivalent per megajoule of energy (gCO2e per MJ). Low carbon fuels below the CI benchmark generate credits, while fuels above the CI benchmark generate deficits. Credits and deficits are denominated in metric tons of GHG emissions (avoided or emitted based on the baseline and the corresponding reductions) and credits can be sold, banked, or used to satisfy a compliance obligation. Other U.S. states are exploring the implementation of programs substantially similar or modeled after the LCFS program and Canada is exploring the implementation of a nationwide program.
The renewable diesel and biodiesel sector is still a relatively young and small (but growing), especially when compared to the existing corn ethanol sector. Profitability for all of these sectors still mainly depends on government policy incentives such as the tax credits mentioned above. Renewable fuel is among the most rapidly growing renewable energy technologies. In particular, renewable diesel production, while still only accounting for a small fraction of the diesel fuel market in the U.S., has grown due to the federal incentives and the LCFS. This, in turn, has made renewable diesel attractive to oil refiners during the COVID-19 pandemic due to the reduced demand for transportation fuel, and several petroleum refiners have announced plans to convert existing facilities to produce renewable fuels. Production of renewable diesel is up roughly 7% in 2020.5 Some analysts have predicted that refineries could produce as much as 3.8 billion gallons of renewable diesel by 2025, which would account for approximately 5% of total diesel fuel production in the U.S. during 2019. However, availability of feedstock in the form of used cooking oils, grease and rendered animal fat could be a limiting factor on this growth, especially given the decline in restaurant demand during the COVID-19 pandemic.6 Distiller’s corn oil (a by-product of ethanol production), soybean oil and other virgin oils can also be used to produce renewable diesel; however, soybean oil costs more to produce and yields lower LCFS credits, and as a result, is less favored than other feedstocks. Additionally, the use of virgin oils presents land use issues, and advanced renewable fuels produced from cellulose are still developing in terms of technology and scalability.
The renewable fuels sector is poised to be a part of the growing renewable energy sector in the U.S. Due to governmental incentives, renewable fuels are a profitable alternative to traditional refined petroleum products during a time of low demand, as is evidenced by the growth in renewable diesel production despite the recent economic downturn. This demand-resilient profitability, coupled with increased efforts to reduce GHG emissions from the transportation sector, could cause renewable fuels to remain attractive as the U.S. economy rebounds.
3 There are several different waiver provisions available under the RFS. One such provision, the small refiner waiver provision, is currently the subject of ongoing litigation in the D.C. Circuit following a decision in the 10th Circuit earlier this year severely restricting the ability of refiners to seek small refiner waivers unless they had done so consistently since 2011. Regulatory requirements related to the RFS (including the ability of obligated parties to seek waivers from the RFS’s mandates) will be the subject of future articles.
4 A qualified producer is generally a producer who has a productive capacity for agri-biodiesel of 60 million gallons or less.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.