Energy Incumbents & Cleantech Stars: Collaborating for a new Class of Low-Carbon Assets

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By Tom Rand

Some difficult math has come to light, and the numbers are starting to make investors nervous. To limit warming to safe levels (2C) we’ll need to leave nearly three-quarters of known fossil fuels reserves in the ground. Period. Those reserves currently sit on the balance sheets of energy incumbents. Under pressure from institutional investors, energy incumbents – including, recently, ExxonMobile – are starting to reveal their carbon risk: the risk that traditional reserves will become stranded assets due to carbon constraints.

One way to release that pressure is to find low-carbon energy assets to replace traditional reserves. Cleantech collaborations – partnerships between traditional energy companies and emerging cleantech stars – offer new ‘cleanfield’ developments with significant upside to both parties. It’s no longer ‘us’ and ‘them’ – it’s just ‘us’.
Think of clean energy projects – cleanfields – as equivalent to new oil or gas fields, and equity investments as exploration costs. Just like a test well and geophysical survey provide visibility into project risk and economics, so do equity investments.
But there’s a big difference.

Exploration costs that uncover incremental traditional reserves increase carbon risk. That’s a bad deal for investors: if we can’t burn even a portion of existing reserves, surely incremental reserves are 100% unburnable. One is exploring for an asset than can never be sold.

Cleanfield exploration costs reduce carbon risk – and have more upside potential, since equity comes with ownership of the intellectual property that unlocks those new clean energy projects.  Scale is not yet a problem. Most cleanfield assets won’t reach choke points in supply, or demand, for years to come.

It would seem fiduciary duty requires board members of incumbents to at least consider seriously this new class of low carbon assets. It’s a hedge on long-term carbon risk. But here’s the kicker – next-generation clean energy assets have higher IRRs than traditional fields.

Early movers like Enbridge – who invested ‘exploratory’ money in like companies Morgan Solar and Hydrogenics – are already reaping the rewards of profitable partnerships. Hydrogenics’ stock has increased almost seven-fold stock since Enbridge invested, as they developed electricity-to-gas projects across Germany. Morgan Solar’s projects will generate IRRs in excess of 35% (more than 60% ROE). Enbridge has earned a front-row seat for both of these opportunities.

Let’s take a closer look at another collaboration waiting to happen: Woodland Biofuels. Their commercial plants produce ethanol from cellulosic fiber – agricultural, forestry and municipal waste. And at an OPEX of $1.15/gallon, they’re positioned to be the lowest cost fuel producer in North America – including the incumbents. Project IRR is comparable to, or better than, oil & gas development, with a lower risk profile and higher long-term upside.

Here’s an apples-to-apples comparison of a 25,000 bpde oil or gas field development versus a financing of Woodland’s equivalently sized ‘field’ of ten commercial plants (fig 1):

Woodland compares favorably on a project finance basis, but it’s when we look at a full analysis of ongoing risks and future upside that it really comes out ahead.

Exploratory costs: A typical oil or gas field requires geophysical survey and a couple of test wells to define the risk and resource. Woodland’s equivalent of an initial well – their $14 million demonstration plant in Sarnia – is in production today, demonstrating commercial plant economics. A further $10 million refines operational data that’s fed into the final stage of detailed commercial plant design. In this model it’s assumed to be an equity investment in the technology itself, not a single project. This allows, in addition to risk and economic assessment, significant future upside in the form of licensing, royalties and further project development.

CAPEX: Commercial engineering partner AMEC has confirmed CAPEX of approx. $5-6/gallon. That equates to $75,000 per barrel/day of oil equivalent (bpde). This compares favorably to a traditional oil & gas field.

IRR: The IRR on a Woodland plant is expected to exceed 25%, unlevered. Assuming 50% debt, the return on equity rises to nearly 60%. That can clearly compete with traditional oil & gas fields. When compared to the incremental reserves associated with oil sands, however, it’s much higher (see below).

Technical Risk: Woodland’s risk profile is low, due mainly to the maturity of the technology. Aside from an operating, well-scaled demonstration plant, much of their core technology – a three-step catalytic process from syngas to ethanol – has already been commercially proven by partners like Air Products and Eastman Chemical. Turns out it’s not much different from a traditional energy or chemicals play.

Regulatory Risk: While Woodland appears to face regulatory risk in the form of reduced ethanol mandates, it’s mitigated by the highly competitive nature of their ethanol compared to dominant corn-based ethanol, which is much more expensive. Cellulosic ethanol can displace corn ethanol, and so faces a very large market even without increased regulatory support. Fossil fuels face increasing regulatory scrutiny, particularly in the North American context.

Reserves Risk: All geophysical fields have risk associated with remaining reserves. In Woodland’s case, geophysical risk is replaced by contractual counter-party risk on the part of fiber suppliers. Multiple suppliers and long-term contracts are readily available, reducing reserve risk to near-zero.

Price Sensitivity: Woodland produces a final, retail drop-in fuel replacement and thus faces risk at the retail price level. This is lower risk than upstream product pricing risk.
Carbon Risk: All fossil fuel producers face the risk of carbon pricing, either in the form of a domestic price that increases the cost of production, or in the form of external tariffs or low-carbon fuel standards as contemplated by jurisdictions like Europe and California. Woodland’s carbon risk is negative – as markets price carbon, Woodland’s product becomes more competitive. This risk can be quantified, as shown by economist Andrew Leach (see below). When a price on carbon begins to bite, many oil sands plays will become uneconomic.

Future Upside: There is negligible future upside to a depleting oil or gas field. On the other hand, the initial equity investment (here ‘development cost’) provides significant upside on sales and licensing agreements (directly and with third parties globally) – including not just cellulosic ethanol, but ethanol from reformed natural gas.
Woodland is one of many cleanfield asset classes. Cleantech has matured. Many emerging stars – like Woodland and Morgan Solar – can compete head-to-head with fossil fuels, without subsidies and at scale. Incumbents who partner with them stand to benefit from the transition to a low-carbon economy by creating a new class of low risk, high value ‘cleanfield’ projects. The cost of entry is a small equity investment. The potential upside is huge.

Tom Rand focuses on carbon mitigation and is active in Cleantech venture capital, technology incubation & commercialization, and public advocacy. He is Managing Partner of the $30 million MaRS Cleantech Fund, a Senior Advisor at the MaRS Discovery District. Tom holds a BSc in electrical engineering (U of Waterloo), an MSc in philosophy of science (University of London and LSE) and an MA and PhD in philosophy (U of Toronto) and is an Action Canada Fellow.

This article is part of a series written by Tom Rand exclusively for The Canadian Business Journal

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