Uncertainty, Irreversibility, and Investment in Second-Generation Biofuels
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Uncertainty, Irreversibility, and Investment in Second-Generation Biofuels Tanner McCarty & Juan Sesmero
# Springer Science+Business Media New York 2014
Abstract The present study quantifies the importance of price risk and irreversibility for investment in a corn stoverbased cellulosic biofuel plant. Using a real-option model, we recover prices of gasoline that would trigger entry into the market and compare it to breakeven price. Our analysis shows that the price premium (above breakeven) required by investors to enter the market due to risk is substantial. Managerial flexibility (embedded in the option of mothballing and reactivating the plant) does not sensibly reduce the entry premium. Results also show that price volatility may greatly reduce plants’ responsiveness to gasoline prices and decrease supply elasticity. In combination, results suggest that (1) policies supporting second-generation biofuels may have fell short of their targets because of their failure to alleviate price uncertainty and (2) the use of price-based instruments such as reverse auctions, either in isolation or in combination with mandates, may be warranted. Keywords Cellulosic biofuels . Price volatility . Managerial flexibility . Real options . Renewable fuel standard . Price-based policy
Introduction Over the past decade, the USA has increasingly pushed for the development of economical forms of renewable fuels. This is due to increased concerns over climate change, energy security, and the desire for domestic job creation. Biofuels in particular, and lately cellulosic biofuels, have received a large amount of attention due to their potential benefits in T. McCarty : J. Sesmero (*) Department of Agricultural Economics, Purdue University, KRAN 591A, West Lafayette, IN 47907-2056, USA e-mail: [email protected]
addressing these problems. The first renewable fuel standard was established in 2005 and expanded to the form used today with the passage of the second renewable fuel standard in 2007 (RFS2). The RFS2 requires, by the year 2022, 136 billion liters of biofuel (ethanol equivalent) to be used annually within the USA, 61 billion of which must come from cellulosic sources. It also sets a cap on the maximum amount of biofuel from corn ethanol at 57 billion liters. Despite policy support and high gasoline prices, cellulosic biofuel production has continually fallen well short of mandates set forth by RFS2. In 2013, cellulosic biofuel production totaled 23 million liters, 3.76 billion liters below the target goal of 3.78 billion liters for the year, set by the RFS2 [1]. Numerous studies, in both business and academic realms, have routinely found that a cellulosic biofuel plant built today could have a positive mean return on the investment [2–7]. However, they have also found that there is significant uncertainty around that mean. For instance, Petter and Tyner [6] found that the probability of economic loss is almost 50 %. Unfortunately, the approach used by these studies (net present value of investment) does not allow calculation
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