I just received this e-mail from an MBA student out east. I thought it would make a good blog posting.

Hello Mr. Pray

I read your Jan 09 article in Ethanol Producer magazine recently and it raised a question related to a project of mine at Babson College in Wellesley, MA.
In your opinion, how can the enzyme suppliers or other R&D companies in the (mainly) cellulosic ethanol space take advantage of offsets/reductions? For example, if a company’s technology is directly linked to more efficient production of ethanol, can they indeed qualify for any offsets, i.e. as a supplier of offsets?
My understanding has been that US companies must engage in offset programs via the Clean Development Mechanism.

Any insight you can share will be greatly appreciated.

Sincerely yours,

_____________

Dear _________:

I can’t recall exactly how much detail I went into in that article. I was forced to cut it down in length by 2/3rds to meet editorial requirements. But the issue is really a broader question of who gets the credit for the underlying product. Unfortunately, I cannot weigh in on the Clean Development Mechanism that you mention as I know of no domestic implementation of that idea. Assuming that existing market forces and that the United States implements a cap and trade program of the the general sort already passed by the House, I can try to answer your question. We have to start with answering the question of who will get the credit for a given product. It is not assured that the producer of carbon neutral or negative products will get that credit or offset. There are several entities that can try to claim that same offset. Let me give you an example using ethanol as the stand-in.

1. The party that generates the product;
2. The party that markets the product to the actual buyer; or
3. The buyer who decides to buy that product instead of a carbon intensive product.

I have heard it explained to me by the top carbon credit broker when I tried to create a consortium of biofuel companies to market their potential carbon offsets about two years ago that they should not get any offset whatsoever. His argument was that they just make the product. Making the product does not “offset” a corresponding carbon intensive product. What if nobody wanted it? What if it had some negatives attached to its use? What if it was so expensive that the cost/benefit just was not there? And even assuming it was competitive, was it competitive because of tax credits and other incentives? Does the government need to get the offset?

The argument that this broker made is that the buyer or consumer is the one who decides to “go green” and buy a carbon friendly product. The value is actually created at the other end of the transaction. So, isn’t the buyer the one who gets the credit? In other words, assuming that ethanol was a carbon neutral product (a different debate, I know), it is the person at the gas station who decides to spend maybe some extra money to buy E-85 for its positive effect. It is at that precise moment when a carbon neutral product replaces a carbon-based product. From an economic standpoint that is when the ultimate cost-benefit decision is made. Therefore, the argument goes, that person ought to be given the offset. But how can you administer a carbon offset program at the gas pump? Do you print off little certificates redeemable on the exchange? No. it most likely would not work in a system where the product is sold in tiny amounts. So, we need to move upstream from the actual consumer to the distributor. Instead of 200 million buyers, making a total of 10 billion annual transactions for car fuel, you move to the distributor. If I remember correctly, I believe that there are 2,000 automotive fuel distribution “choke points” where every gallon must pass through at one point. This provides an easy way to monitor the sale of different products. The argument is that you should create the offset at this level because that is the only way to manage it. The distributors would, in theory, pass on the economic benefit inherent in the offset to the consumers who are making the decisions.

The irony is that the distributors are in fact the same entities (the oil industry) that is most opposed to any biofuel products and has lobbied long and hard to stop any progress on carbon offsets, taxes, or other “green” initiatives. So, that is a solution that does not go over well with my ethanol clients.

There are several counters to this argument. First, it is that the incentive to create the product in the first place that should be rewarded. The eventual buyer will never have the opportunity to make the cost/benefit decision if the product will never arrive there because there is no economic incentive to make a more expensive product. Second, every gallon of ethanol can be identified through the EPA’s renewable identification number (RIN) assigned by the producer of every batch of fuel that is produced. This has been the law since 2007. So, it is economically possible to track the ethanol gallons through the distribution system so that everyone can be assured that the product did in fact find a market.

You ask about other entities such as enzyme suppliers or R&D companies and whether they can get an offset or reduction. First, it should be obvious that given my discussion above that those companies are only likely to have an opportunity to get an offset or reduction if the producer making the product gets the offset. Their potential ability to secure that offset is definitely tied to who gets the offset for the product. For the sake of argument let us assume that the ethanol company gets the offset. It is certainly possible that the enzyme or R&D company may try to get a share of that offset. However, due to licensing, patent, and other complications, there is no easy way to know who really deserves it. I can foresee endless debates among engineers, entrepreneurs, lenders, management, and others as to what entity is actually responsible for the carbon-negative implications of that device or product. Therefore, the only practical way I see those companies getting any offset is to contract for it. My concern is that the cost of negotiating and monitoring the contract is likely to exceed the practical benefit for any but the largest of transactions. An economist might argue, therefore, that the real benefit is actually obtained through the purchase price for the product. If I, as an ethanol company, know that a certain enzyme is likely to increase either production, reduce costs, or create value through a carbon offset, then I will be more willing to pay more money for that product. There has to be some “discount” or the transaction ends up as an economic wash and nothing gets bought. But that is the only way that I would see such an entity getting the carbon credit or offset in your question.

Jim Pray