RenovaBio Becomes Law—but Implementation Looks to be Two Years Away
Brazil’s president Michel Temer signed RenovaBio into law on 26 December 2017. RenovaBio is a government programme designed to stimulate biofuel production and use in Brazil in order to help meet the country’s commitment to reduce greenhouse gas emissions under the Paris Agreement.
How will RenovaBio work?
Key elements of RenovaBio include the certification of emissions associated with biofuel production on a mill-by-mill basis, and the issuance of emission reduction certificates associated with the physical production of biofuels (principally ethanol and biodiesel) and other forms of clean energy (e.g. electricity production via biomass cogeneration and biogas production). Imported fuel will also be certified.
Fuel distributors will be given annual goals (linked to the Paris Agreement commitments) to accumulate a certain volume of emission reduction certificates and will be liable to penalties if they fail to achieve these goals. Distributors will be able to accumulate these certificates either directly via the purchase of ethanol or biodiesel, or indirectly, via a secondary market, from other distributors who may be willing to sell surplus certificates that they have acquired, or from any other parties who may be permitted to buy and sell the certificates.
If it sounds complicated, well, it is. At least, that’s our conclusion looking at the flow diagram of the RenovaBio processes that the government has published (see below – in Portuguese, but the number of moving parts is evident). Furthermore, the legislation signed by the president indicates that RenovaBio’s full implementation will take place on a date two years after it is signed into law, effectively meaning the beginning of 2020, although the wording is somewhat confusing. The timing makes sense because, as the graphic suggests, there is much work to be done to set up the structure and administration of RenovaBio.
What is it going to cost, and who is going to pay?
At present there is no clear answer to the question what RenovaBio is going to cost and who will be paying. There will certainly be additional fixed costs incurred by various parties along the supply chain owing to the requirement that every fuel producer needs to be technically audited (in order to arrive at an estimate of the emissions associated with their ethanol or biodiesel production). There will also be costs associated with the issuance and any trading of the emission reduction certificates, as well as with the monitoring and auditing of distributors’ fuel sales needed to check their compliance with annual targets.
These costs will occur at various points along the supply chain. It would seem natural that they are offset by the gain in revenue associated with the purchase and sale of emission reduction certificates along the supply chain. Thus, biofuel producers would be compensated for extra costs because they would receive extra revenue from the sale of emission reduction certificates to distributors or other parties. By the same logic, fuel distributors would have to pass on to their own customers—motorists—any cost of acquiring emission reduction certificates in order to not risk a reduction in unit revenues and margins once the programme comes into effect.
This brings us to pricing—how are the certificates to be priced? The simple (and wholly unsatisfying) answer is ‘according to supply and demand’. Demand for certificates we already know to be dependent on the national annual emission reduction target. It also ultimately depends on how much of a punishment can be expected by a company for not complying with its annual target. The published legislation states that the fine applicable to a distributor under such circumstances could range from BRL 100,000 (approximately USD 30,000) to BRL 50 million (around USD 15 million). How much of a blow to the wallet would this be to one of the country’s fuel distributors?
Assuming a basic commitment to comply on the part of distributors, the details of demand will be subject to various influences. The first is another element of policy, namely the obligatory mixes of anhydrous ethanol in gasoline, and of biodiesel in diesel. These are important because the demand associated with such measures is not price-sensitive (in econo-speak, it’s inelastic), and is therefore not influenced by movements in the price of anhydrous ethanol or biodiesel. That makes such demand somewhat more predictable over a one-year planning horizon.
The demand for hydrous ethanol, which is a substitute for gasoline in flex-fuel cars, is by contrast highly price sensitive—so any event that significantly affects the price relationship at the pump between hydrous ethanol and gasoline will have a significant effect on hydrous ethanol demand. Thus the local price of gasoline (which, owing to Petrobras’s pricing policy of import parity, is dependent on world oil prices and the BRL/USD exchange rate) is likely to be an additional determinant of ethanol demand, with higher gasoline prices spurring more owners of flex-fuel cars to opt for hydrous ethanol.
Of course, in such a situation, it is probable that supply would also be influenced—all other things being equal, higher gasoline prices would be expected to boost ethanol production. It is also clear that sugar prices will have an influence on ethanol supply, via their influence on the sector’s allocation of cane to sugar and ethanol production respectively. And, beyond this, the weather will also have a role to play given its impact on the size of the cane crop.
Where does all this get us as far as pricing goes? Not far—it appears that among the factors most likely to boost the price of emission reduction certificates are high sugar prices and high gasoline prices. Thus, for the moment, it looks like millers probably won’t need to pray for anything extra.
Pricing and investment
However, there is another element to RenovaBio’s scope that is relevant to pricing, and that is the expansion of biofuel production required to meet the ambitious greenhouse gas emission reduction targets committed to by Brazil under the Paris Agreement. In order to achieve this, the pricing of emission certificates is going to have to generate enough additional margin on ethanol production, plus enough perceived steadiness in that additional margin going forward, to encourage industry participants or new players to invest in new production capacity.
We believe that a large number of players in the sector have painful memories of a euphoric wave of investment in new capacity that turned into a drawn-out nightmare following crises in financial, commodity, and credit markets and some unhelpful government intervention. Few of those players who either maintained robust finances throughout the last decade or who have recently achieved robustness through hard work and perseverance are likely to be keen on leveraging themselves up to the hilt again in a hurry.
For this reason, we believe that rapid expansion of sector capacity is highly unlikely, and that those companies able to consider expansion will do so either by acquisition (thus with no net increase in sector output) or incrementally through growth in productivity in the field and in the factory. Whether such a vision of future growth is compatible with the ambitions for increased ethanol production that are incorporated in the country’s Paris Agreement commitments and in RenovaBio’s future annual emission reduction targets is a topic for further investigation.
Our conclusions are necessarily preliminary, given the prevailing lack of detail:
• RenovaBio appears to have little short-term impact (i.e. on the upcoming 2018/19 crop year). The targets for greenhouse gas reductions for a period of no less than ten years will have to be established six months following the president’s signing of the legislation, but, in our reading of the text, monitoring and enforcement of the targets are only scheduled to be implemented two years after the signing of the legislation.
• RenovaBio is a positive signal to the Brazilian cane sector that the state views it as a key piece of its strategy to achieve an ambitious increase in the use of renewable fuel and an equally ambitious decrease in the reduction of greenhouse gas emissions. The fact that the state has now devised a long-term programme to encourage biofuel use goes some way to address the sector’s perennial complaint about lack of visibility on policy.
• On the other hand, as discussed above, it seems to us that at least some of RenovaBio’s workings will depend on, or be influenced by, global markets—for sugar, oil, and exchange rates, to name a few. This suggests that full long-term visibility regarding the pricing of commodities and emission reduction certificates will continue to be elusive, creating risks that will have to be managed to the extent that is possible.
• The investment wave and subsequent crisis that dominated the last decade of the cane sector’s history will not be quickly forgotten, and this may temper the response of the sector, in terms of investment in new capacity, to the opportunities that RenovaBio is expected to create. Furthermore, a key catalyst for the 2005 – 2009 expansion boom, as well as an encouraging outlook for ethanol market growth, was an abundance of cheap funding, at both global and local levels. Few would expect this to be repeated this time around. To our mind, all of this argues for a slow and steady expansion of capacity, rather than another boom, if all goes well with RenovaBio and the markets.