- Industry: Environment
- Product(s): @RISK
- Application: Cost-benefit analysis of biofuel production under two government policies
Dr. Wallace Tyner and his colleagues at Purdue University in Indiana used @RISK to conduct a cost-benefit analysis of building an aviation biofuel plant, and to determine the potential impacts of two different government policies to jump-start this technology: reverse auction and capital subsidy.
I use it to teach all my students to introduce uncertainty into project evaluation. It’s been a tool in my portfolio for a long, long time. You can do something with much less expense and much easier with @RISK today compared to what I painstakingly did years ago.Dr. Wallace Tyner, Purdue University
Developing biofuels for aircraft is a risky endeavor, as transforming plant material into liquid fuel is still very expensive compared to the price of fossil fuels. Dr. Wallace Tyner and his colleagues at Purdue University in Indiana used @RISK to conduct a cost-benefit analysis of building an aviation biofuel plant, and to determine the potential impacts of two different government policies to jump-start this technology: reverse auction and capital subsidy. They found that both policies reduced risk in investment of aviation biofuels, however a reverse-auction policy reduced the risk of this investment more. Their research is detailed in their article “Field to flight: A techno-economic analysis of the corn stover to aviation biofuels supply chain,” published in the March/April 2015 issue of Biofuels Bioproducts & Biorefining.
Jet fuel makes up roughly 11% of the transportation sector’s energy consumption in the United States, and it is predicted to increase to 13% by 2040. Currently aviation is responsible for 2% of the world’s manmade CO2 emissions. The U.S. Energy Independence and Security Act (EISA) of 2007 set a target level of 16 billion gallons ethanol equivalent (or 9.8 billion gallons of jet fuel equivalent) cellulosic biofuel by 2022. The US consumes over 20 billion gallons of aviation fuel each year—thus, there is a large potential market for aviation biofuels. Nevertheless, converting cellulosic material (which consists of the non-edible portions of crops like corn stover, and do not compete with food markets) into biofuels is costly, presenting higher risk for private investors. Incentives are likely necessary to entice private investors to invest.
The biofuel industry faces five major areas of uncertainty that impede investment: crude oil price, feedstock availability and cost, conversion technology yields and costs, environmental impacts, and government policy. Previously, researchers have provided point estimates or ranges of estimated costs, but little research has been done to quantify the uncertainty in these input variables and translate that uncertainty into uncertainty distribution for breakeven price, internal rate of return (IRR), net present value (NPV), etc.
Researchers Amanda Bittner, Dr. Wallace Tyner, and Xin Zhao at the Agricultural Economics Department at Purdue University investigated these variables in the development of cellulosic aviation biofuel plants under the influence of two different government incentive policies: reverse auction and capital subsidy. In a reverse auction, the government would put out a request to supply aviation biofuels, and different private investors place bids on the price per gallon of fuel, with the lowest bidder winning the contract. The government must pay the contracted price per gallon of the biofuel, regardless of the current price of oil. The other incentive policy, a capital subsidy, involves the government paying for a portion of the capital costs in developing the biofuel.
Using @RISK to Forecast Fuel Prices
The Purdue researchers used a discounted cash flow (DCF) model to find the net present value (NPV) of a theoretical aviation biofuel plant. They incorporated four variables that have a large impact on the non-risk adjusted breakeven fuel price: capital cost, feedstock cost, final fuel yield, and hydrogen cost (the price of hydrogen input used in producing biofuels). They created empirical distributions for each variable from literature and/or experts, and then used @RISK to incorporate uncertainty into the variables using a PERT distribution. The researchers created projections to forecast what the fuel prices would be in the future, and what the breakeven biofuel price would have to be in two different situations:one in which the fuel price has no overall trend, and one case in which the fuel price has an increasing trend.
In the case where the fuel price has no trend, the researchers found a breakeven price at $0.88/liter. With a stochastically increasing market fuel price (which started at $0.80/liter and rose to $1.01/liter at the last year of the biofuel plant’s life), the researchers found an initial breakeven price of $0.79/liter. Looking at these numbers, Dr. Tyner notes, “this is not a profitable activity,” and government policy is likely necessary to jumpstart private investment.
Thus, the researchers next wanted to investigate what kind of government policy would be most effective in reducing the risks around investing in aviation biofuels, and at what point in the probability distribution would investment firms be willing to place a bid. While breakeven price results are normally calculated to find the point where there is a 50% chance of making money and a 50% chance of losing money, “it is highly unlikely that firms would be willing to bid at the 50% level due to the high risk,” the authors write in their paper. “We decided to illustrate a 75% chance of getting an economic return at least equal to the company hurdle rate, and a 25% of losing,” says Dr. Tyner.
Which Lowers Risk More? Reverse Auction or Capital Subsidy
The researchers next examined the impact of reverse auction and capital subsidy under three different contract lengths: 5-year, 10-year, and 15-year, to see how contracts of increasing duration would impact the probability of financial loss for investors.
For the reverse auction scenario with a fuel price with no trend, and producers bidding at a 25% probability of loss, the reverse auction fuel price is $1.02/liter. As the contract length increases, the mean NPV increases and becomes positive when the contract length is at 10 years. Additionally, the probability of loss decreases as the contract length increases. For a reverse auction scenario in which the fuel price increases, the results are similar, with an increasing NPV and a decreasing probability of financial loss as the contract length increases.
The Purdue team then compared the reverse auction to a capital subsidy that has the same expected cost to government as the reverse auction, for contracts that last 5, 10, and 15 years. “It is clear that the reverse auction is much more effective in reducing risk for private sector investors than is the capital subsidy,” the authors write in their paper. “The probability of loss is also lower in all cases for a reverse auction, decreasing by almost 40% to about 23% when there is a 15-year contract.”
They also compared the bid price at which producers could achieve 25% probability of loss with each policy, and found that the equivalent bid prices with a capital subsidy are much higher than the prices under reverse auction, indicating that reverse auction is more efficient in reducing risk for private investors. “At those different contract lengths, the numbers are pretty startling,” says Dr. Tyner.
@RISK: A Long-Time Trusted Tool
Dr. Tyner uses @RISK for research, as well as for teaching his course in benefit cost analysis. “I use it to teach all my students to introduce uncertainty into project evaluation,” he says. “It’s been a tool in my portfolio for a long, long time.” He also notes how it has made his work drastically more efficient. “You can do something with much less expense and much easier with @RISK today compared to what I painstakingly did years ago,” he says.