No, The Courts Didn't Just Overturn The RFS2 Mandate

by: Tristan R. Brown


Like many biofuels analysts, I had a bit of a shock when I saw the following headline in the New York Times late Friday night: "Court Overturns E.P.A.'s Biofuels Mandate." The American Petroleum Institute [API] has spent the last several months trying to have the cellulosic biofuels mandates for 2011 and 2012 (as well as the biomass-based diesel mandate for 2013) of the revised Renewable Fuel Standard (RFS2) thrown out by the U.S. Court of Appeals for the District of Columbia, so the headline alone is apt to cause some confusion among investors. Meanwhile, The Hill described the court's ruling as a "major victory" for the API. Having studied the court's decision [pdf], however, I'm now of the opinion that the ruling is ultimately quite narrow in scope and unlikely to substantially affect either the RFS2 or its corporate participants.

The "Phantom Fuels" Mandate

First, a bit of backstory. The Energy Independence and Security Act of 2007 (EISA) created the RFS2, which mandated the consumption of specific volumes of four different biofuel categories by refiners (for more on the RFS2, see my previous article here). The most contentious of those four categories has been the "cellulosic biofuels" category, which covers biofuels produced from lignocellulosic biomass. At the time that the EISA was being designed, crop-based biofuels such as corn ethanol and soybean biodiesel were being erroneously blamed for both rainforest destruction and starvation in the developing world, so Congress created the cellulosic biofuel category and capped crop-based biofuel production as a means of mitigating the two perceived problems (lignocellulose not being fit for human consumption).

In a nice touch of irony, crop-based biofuels have been largely rehabilitated by the empirical evidence in recent years (although the court of public opinion is still stuck in 2008), while cellulosic biofuel production has repeatedly failed to get off of the ground, despite EISA originally mandating the consumption of 500 million gallons (ethanol-equivalent) of cellulosic biofuels by 2012. The Environmental Protection Agency [EPA], which is charged by the legislation with overseeing the RFS2's implementation by calculating the annual mandated volume amounts on the basis of its projections for annual production, waived the requirement in the early years of the mandate due to lack of production. It did decide to enforce it (albeit at a greatly reduced volume) for 2012, believing that production would finally occur in that year. This decision to force refiners to purchase "phantom" (i.e., non-existent) cellulosic biofuels and ultimately penalize them for failing to do so by requiring their purchase instead of "cellulosic waiver credits" was the catalyst for Friday's Court of Appeals decision.

Massaging The Data

A major difficulty in analyzing a non-existent industry is that the data needed to complete a rigorous analysis frequently isn't available. Rather than just ignore the research question entirely, many analyses make use of something called "expert opinion" or "engineering judgment" to fill in the data gaps. This "lesser of two evils" approach is frequently employed and, at least within the legal and engineering professions that I have personal experience in, widely accepted when justified. The downside is that it turns an entirely objective methodology into more of a subjective one, exposing it to criticisms on the bases of differences in "expert opinion."

The EPA adopted a similar approach when developing the mandated volume of cellulosic biofuel for 2012 because the EISA effectively requires it to do so. Specifically, the legislation requires the Energy Information Administration [EIA] to supply an estimate of cellulosic biofuel production for the coming year, and then for the EPA to "determine" the mandate volume "based on" the EIA's estimate. This meant that the EPA was required to calculate a 2012 mandate volume based on production estimates for a non-existent industry (at least non-existent on a commercial-scale, that is), so some degree of "expert opinion" analysis was necessary. The API challenged this methodology but the court found it acceptable, stating that while the EPA is required to show "great respect" to the EIA's estimate when calculating the mandated volume, the legislation allows "deviation consistent with that respect." In other words, both the EIA's estimate and the EPA's mandate determination are based on expert opinion to a certain degree, and the EPA isn't required to slavishly adopt the EIA's expert opinion as its own.

The API also argued without success that the EPA determination methodology is irredeemably flawed because it makes use of EIA estimates that are in turn derived from statements from cellulosic biorefinery owners, the implication being that these are inherently and unreasonably optimistic. Since the API only challenged the EPA's methodology rather than that of the EIA, the court ruled that it couldn't fault the EPA for following the strict language of the EISA.

The court did take issue, however, with the EPA's decision to base its mandated cellulosic biofuel volume determination on a balancing of "uncertainty [in terms of actual attainment] with the projection of promoting growth in the industry," [pdf] the authority for the latter goal deriving from Executive Order 13563 [pdf]. The executive order does not directly relate to the RFS2, and merely states that one purpose of the U.S. regulatory systems is to "promote growth." The court held that the EPA's authority with regard to the RFS2 only derives from the EISA and, since the legislation does not require the EPA to skew its volume determination with an eye toward "promoting growth," the EPA's determination methodology represents an unlawful presumption of power by the agency.

Does It Even Matter?

What is interesting about the EPA's decision to include a growth promotion goal in its methodology is that this factor had virtually no impact on its result for 2012. The EPA's production projection for 2012 of 8.7 million gallons did exceed the EIA's projection of 6.7 million gallons. That said, the difference in projections is attributable to three factors: (1) differences in assumed cellulosic biorefinery capacity estimates; (2) differences in assumed cellulosic biorefinery start dates; and (3) the EPA's inclusion of a small amount of cellulosic biofuel produced at pilot-scale facilities. The court found no fault in these differences, attributing them to "little more than a technocratic exercise of agency discretion." So while the court found fault with the EPA's growth promotion goal, excluding it from the volume determination methodology has little, if any, impact on the 2012 mandated volume of cellulosic biofuel. Even if the court had ruled that the EPA must adopt the EIA's production estimate for 2012 (and it explicitly did not), the 2 million gallon difference in estimates, assuming a waiver credit price of $0.78/credit [pdf], would have translated to a $1.6 million benefit to refiners (i.e., 2 million gallons x $0.78/credit) in the form of reduced waiver credit purchases, split among them according to market share. The actual benefit of the court's decision to the refiners is closer to $7 million since the court ultimately vacated the 2012 volume mandate, but that's still a pittance when divided between them.

The court's decision is likely to result in the exclusion of the growth promotion goal from the EPA's volume determination methodology in future years. It is unclear that this will have a significant impact on the EPA's results, however, since it clearly had virtually no impact on its 2012 result (its difference with the EIA's estimate being attributable to a permissible "technocratic exercise of agency discretion"). So while at first glance the court's decision appears to be a loss for cellulosic biofuel producers such as Abengoa (OTCPK:ABGOY), DuPont (NYSE:DD), KiOR (NASDAQ:KIOR), and Rentech (NYSEMKT:RTK), and a win for obligated refiners such as Valero (NYSE:VLO), Phillips 66 (NYSE:PSX), Exxon Mobil (NYSE:XOM), BP (NYSE:BP), and Royal Dutch Shell (NYSE:RDS.A), the actual impacts of the ruling will be marginal.


Hyperbolic media headlines aside, the decision of the Court of Appeals for the District of Columbia on Friday to vacate the EPA's 2012 cellulosic biofuel mandated volume is unlikely to have more than a marginal affect on both obligated refiners and cellulosic biofuel producers. While the 2012 volume determination has been vacated, the relatively low value of the waiver credits that refiners were required to purchase in that year for failing to purchase non-existent cellulosic biofuels means that this will be of little benefit to refiners. Looking to the future, the court ultimately only found flaw with the EPA's decision to include a "growth promotion goal" in its methodology for calculating the mandated volume of cellulosic biofuel for 2012 and this goal had very little impact on the EPA's calculation result, so its absence from future mandated volume calculations shouldn't have much of an impact in those years, either. The EPA got sloppy in its methodology by including the growth promotion goal and the court gave it a slap on the wrist in response, telling it not to do so again. Any major changes in the prices of the aforementioned companies in response to the court's decision will be overreactions to the news.

Disclosure: I am long KIOR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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