What should you do when your biggest customer doubles orders for your product, yet simultaneously passes regulations that may prevent you from selling your product to them in the future?

America’s ethanol industry may have a love-hate relationship today with California. After years as ethanol’s largest market, the state is now increasing the ethanol content in its gasoline from 5.7 percent to 10 percent per gallon. At the same time, wheels are being set in motion to implement California’s low carbon fuel standard (LCFS), which – as currently written – would prevent corn-based ethanol from qualifying as a low-carbon fuel for use in that state.

The switch to E10

While E10 is commonly used in the rest of the country, California chose a 5.7 percent blend of ethanol when it removed the oxygenate MTBE (methyl tertiary butyl ether) from its gasoline supply due to environmental concerns. In 1999 California became the first state to ban MTBE, and when it was phased out of its reformulated gasoline program in 2003, the state opted to use ethanol in the minimum amount – 5.7 percent – that would meet the 2 percent oxygen requirement under the Clean Air Act at that time.

Even using only the 5.7 percent blend, the huge California fuel market still earns top billing as the largest consumer of ethanol, and today the state is fully engaged in the switch to E10 – a move that will provide an important new market for America’s ethanol producers.

Rules have been passed allowing E10 to be used in California as of January 1, 2010, and according to the California Independent Oil Marketers Association (CIOMA), everything is proceeding smoothly with the change.

“The transition to E10 in California is well underway,” said Jay McKeeman, Vice President of Government Relations and Communications for CIOMA. “There don’t appear to be any problems.”

He notes that the introduction of the new blend is happening during the winter season, which helps ease the transition because of the characteristics of the base gasoline.

“California has winter and summer fuel blends,” McKeeman said. “Summer fuel blends are more finicky. This is occurring in winter by design.”

The increase in ethanol consumption in California supports a couple of key public policies. The federal Renewable Fuels Standard, for one, requires greater use of fuels like ethanol through 2022. Second, California’s new low carbon fuel standard (LCFS) mandates a reduction in the state’s overall greenhouse gas (GHG) emissions in the next ten years.

By 2020, the LCFS calls for the state’s GHG emissions to be back to 1990 levels and for GHG emissions from passenger vehicles to be reduced by 10 percent. According to the Energy Information Administration’s 2009 Annual Energy Outlook Analyses, “Although fuel providers can use a variety of strategies to produce lower carbon fuel, increasing the ethanol blends from 5.7 percent to 10 percent is thought to be a first step toward achieving the LCFS goals.”

In June 2009, the California Air Resources Board announced changes to its reformulated gasoline regulations and predictive model to ultimately allow for the greater use of ethanol. On August 29, CARB finalized the rule to allow higher ethanol blends, stating that all fuel sold in California must be compliant with the new CARB Phase 3 standards after December 31, 2009.

Independent refiner Tesoro brought a lawsuit against CARB over the 2008 rule that would allow higher ethanol blends, claiming that the Board failed to assess land use impacts resulting from greater production and use of ethanol. That suit was formally dismissed in April of last year. Tesoro has two refineries in California, one near San Francisco and one near Los Angeles.

While the new E10 resolution went into effect at the end of 2009, refiners can work with CARB to form an Alternative Emissions Reduction Plan (AERP) if they cannot meet the deadline. Refiners could, for example, purchase older and more polluting vehicles to remove them from California’s roads. After a two-year AERP, all refiners must be in compliance by December 31, 2012.

Kinder Morgan is the largest refinery and pipeline operator in California. According to McKeeman, Kinder Morgan has said it will not take anything except CARBOB (California Reformulated Blendstock for Oxygenate Blending) that meets the E10 requirements, which creates a marketplace dictate for E10 in the state. The refiner announced in February of last year that it would begin to make E10 available at its terminals effective Cycle 1 of 2010, according to a February 9, 2009 Oil Price Information Service report.

The transition to E10 is going “as smoothly as possible,” according to McKeeman. Although many may not realize it because the pumps are simply labeled ‘this fuel contains ethanol,’ California motorists now have more ethanol in their tanks.

California’s low carbon fuel standard

While ethanol use in California is increasing today, the future for corn-based ethanol consumption there is less certain due to the low carbon fuel standard (LCFS) passed last year.

California’s LCFS is the world’s first fuel standard specifically targeting a reduction in greenhouse gas emissions. The state has several policy goals relating to climate change, including:

· Achieving a 10% reduction in carbon intensity of transportation fuels by 2020

· Cutting GHG emissions back to 1990 levels by 2020, a 30% reduction

· Achieving an 80% reduction in GHG emissions by 2050

The BioEnergy Action Plan, as set in Governor Schwarzenegger’s Executive Order S-06-06, also calls for an increase in the production of biofuels in California. Goals are to increase in-state biofuels production to 20 percent by 2010, to 40 percent by 2020, and to 70 percent by 2050.

The California Air Resources Board released its proposed LCFS regulations in March 2009, a policy action called for under AB 32, California’s Global Warming Solutions Act, which was signed into law by the Governor in 2006. Members of the Air Resources Board held a hearing on April 23 last year to consider the adoption of the LCFS, with the measure passing on a 9 to 1 vote. The LCFS will require refiners, importers, and blenders of fuel within the state to ensure the fuels they provide for the California market meet an average, declining standard of carbon intensity.

“Indirect land use change”

California is setting a precedent for how biofuels are treated under climate change policies, and ethanol advocates are particularly troubled by CARB’s inclusion of a controversial theory called “indirect land use change” (ILUC).

The theory states that as crops as used to produce biofuels, crop prices are driven up, and farmers respond to increasing prices by clearing land to bring it into agricultural production. A paper published in Science Express in February 2008 by Princeton professor Timothy Searchinger (“Use of U.S. Croplands for Biofuels Increases Greenhouse Gases through Emissions from Land-Use Change”) brought the concept media attention.

The research states: “ Most prior studies have found that substituting biofuels for gasoline will reduce greenhouse gasses because biofuels sequester carbon through the growth of the feedstock. These analyses have failed to count the carbon emissions that occur as farmers worldwide respond to higher prices and convert forest and grassland to new cropland to replace the grain (or cropland) diverted to biofuels.”

Though the theory is based on computer modeling and is not corroborated by on-the-ground data, it became adopted into the biofuels portion of CARB’s framework for the low carbon fuel standard.

On March 2 of last year, 111 of the nation’s top scientists submitted a letter to Governor Schwarzenegger questioning CARB’s decision to include the theory of indirect land use change for biofuels. Their letter calls trying to enforce any indirect effects “highly premature,” stating that “the science is far too limited and uncertain for regulatory enforcement.”

“Indirect effects have never been enforced against any product in the world,” the scientists’ letter states. “California should not be setting a wide-reaching carbon regulation based on one set of assumptions with clear omissions relevant to the real world.”

The letter says this field of science is “in its nascent stage, is controversial in much of the scientific community, and is only being enforced against biofuels in the proposed LCFS.”

It’s this last point that has raised the most concern in the ethanol community. The California Air Resources Board has chosen to apply these indirect land use penalties only to biofuels – not to any other fuels in its low carbon fuel standard.

The American Coalition for Ethanol has spoken out for a fair playing field.

“We agree that the environmental impacts of the world’s energy supply need to be considered, but we insist on a fair playing field where biofuels and fossil fuels are judged by the same metrics when counting emissions,” said Brian Jennings, Executive Vice President of ACE. “If the indirect effects of biofuels are going to be quantified, then so should be the indirect effects – which are many – of protecting, exploring, and processing the world’s petroleum.”

The second main point of the scientists’ letter is this issue of selective enforcement.

“Leaving aside the issue of whether these effects can be predicted with precision or accuracy, or whether such a penalty is appropriate for the LCFS, it is clear that indirect effects should not be enforced against only one fuel pathway,” the letter states.

Petroleum can also have a price-induced effect on commodities and electric cars will increase pressure on the grid, yet so far CARB is proposing to enforce these indirect effects only against biofuels, the scientists note.

“This proposal creates an asymmetry or bias in a regulation designed to create a level playing field,” the letter states. “It violates the fundamental presumption that all fuels in a performance-based standard should be judged the same way (i.e. identical LCA boundaries). Enforcing different compliance metrics against different fuels is the equivalent of picking winners and losers, which is in direct conflict with the ambition of the LCFS.”

The future impact on U.S. ethanol producers

The addition of indirect land use change penalties puts corn-based ethanol above – and out of compliance with – the 2011, 2015, and 2020 targets for low-carbon fuels in California.

The proposed regulation assigns a direct emissions measurement to the corn-based ethanol, dependent upon the ethanol plant’s location, its fuel use, and distillers grain out. The direct emissions values range from 47.44 to 69.4 gCO2e/MJ, all measured in grams of carbon dioxide equivalent per megajoule of fuel. CARB is then assigning corn-based ethanol with indirect emissions as well, assigning a land use effect value of 30 on top of those direct emissions figures.

The total carbon intensity values of corn-based ethanol under this framework ranges from 99.4 gCO23/MJ, for a Midwest ethanol plant that produces dry distillers grain, to 77.4 for a California-based ethanol plant that produces wet distillers grain and is powered by 20 percent biomass.

Brazilian sugarcane ethanol is assigned a value of 73.4 gCO2e/MJ, with no indirect emissions charges.

Though today it’s nearly a 1 billion gallon market for ethanol, California’s LCFS may rewrite those figures. Nebraska, along with other ethanol states, is concerned about how the regulation will impact its product.

The Nebraska Corn Board estimates that 27 percent of Nebraska’s ethanol goes directly to the California fuel market, a value approaching $1 billion. Farmers and ethanol producers are concerned, the Board writes in a January 19 press statement, about the impact the California low carbon fuel standard will have on ethanol production in Nebraska.

“The result will be that Nebraska corn ethanol, and most all ethanol produced in the United States, will be shut out of an important domestic market. The economic impact will be negative for Nebraska’s ethanol industry, rural communities, and farmers,” said Jon Holzfaster, Nebraska Corn Board farmer director from Paxton, Nebraska and chair of the National Corn Growers Association’s Ethanol Committee.

“The model California uses somehow concludes that ethanol from South America is ‘better’ and that crude oil is OK,” said Kelly Brunkhorst, director of research for the Nebraska Corn Board. “Yet the major producer of ethanol in South America is facing a shortage and common sense tells us ethanol performs better than crude oil on many levels.”

California itself is home to seven ethanol plants. Five are “destination model” plants which ship in corn from the Midwest for manufacture into ethanol in California.

In a September 2009 report for the California Energy Commission, it was noted that the Parallel Products facility was the only one currently operation. At that time, 98 percent of California’s ethanol production capacity was sitting idle – 242.7 million gallons of the 247.5 million total.

According to news reports, the Calgren plant was operating on December 2009. On December 24, AE Biofuels announced that it will reopen the Cilion ethanol plant, targeting the first quarter of 2010. Pacific Ethanol has reopened its ethanol plant in Idaho, but no word on the two locations in California.

Setting a precedent

As if often the case in issues relating to the environment, California is setting a precedent with its low carbon fuel standard.

Eleven states in the Northeast and Mid-Atlantic are working together to form a similar regional standard. On December 30, 2009, these governors signed a memorandum of understanding to develop a LCFS, the target to have a framework in place by early 2011.

As Eric Washburn, ACE Legislative Counsel, wrote in his February column, it is clear by reading the memorandum and accompanying documents that the promotion of electric vehicles is a key goal of this new LCFS. And these states are clearly following California’s lead when it comes to applying indirect land use change to ethanol’s score.

“While the memorandum says that the states will ‘commit to determine the lifecycle carbon intensity of fuels based on the best available science and analyses,’ the only example of indirect emissions that is referenced is ‘land use changes attributable to fuel production,’” Washburn writes.

ACE leadership says the organization will be working in these states in the coming year – as well as in Wisconsin, which is considering its own LCFS – to ensure ethanol is treated fairly and to demonstrate ethanol’s proven benefits for air quality in the United States.

California’s LCFS is scheduled to be implemented on January 1, 2011, although pending lawsuits could indeed alter that – one by the ethanol industry and one by the National Petrochemical and Refiners Association. NPRA filed its legal challenge on February 2.

“The legal actions undertaken by this Association and other groups today reflect the concerns a wide variety of stakeholders have with California’s Low Carbon Fuel Standard,” NPRA President Charles T. Drevna said in a press statement. “The California LCFS is unlawful for a number of reasons, including the fact that it violates the Commerce Clause of the United States Constitution by imposing undue and unconstitutional burdens on interstate commerce.

“California’s LCFS also would have little or no impact on GHG emissions nationwide and would harm our nation’s energy security by discouraging the use of Canadian crude oil – our nation’s largest source of crude – and ethanol produced in the American Midwest ,” Drevna continued . “Discouraging the use of North American transportation fuel sources would only create additional, unneeded burdens for California’s consumers and economy, increase our reliance on energy from less stable parts of the world, and weaken our national security.

For now, ethanol demand in California is on an uptick. In 2008, the state consumed 951 million gallons of ethanol, this at the previous 5.7 percent blend level. As the blend rate increases to 10 percent in 2010, the market for ethanol there could grow to closer to 1.5 billion gallons – if the state stays at its approximate gasoline market size of 15 billion gallons.

It is important to note that the ethanol industry still operates under the federal Renewable Fuels Standard, which guarantees an increasing schedule of ethanol use through 2022. But it is clear that we live in a world that is seeking low-carbon fuels as a solution to climate change, and that the most environmentally friendly methods of production for these fuels will be favored. Ethanol market development and public policy efforts will be more important than ever as we go forward.