Biodiesel is one of the most promising members of the biofuels family. Two years ago, if you asked an Australasian debt banker about biodiesel you would have received a response along the lines of "biodiesel is the technology of tomorrow and always will be". At that time, facing commercially untested technology in a relatively virgin market and taking into account the low returns involved in a standard project financing, this attitude was in many respects understandable. In the meantime equity investors have established a foothold in an industry that is expected to surpass 14 billion litres of production around the world this year. Plans for new biodiesel projects are announced almost on a weekly basis.

What is biodiesel?

Biodiesel is an organic equivalent of mineral diesel produced by processing a range of oils, fats and other organically derived matter. Biodiesel can be partially blended with mineral diesel to run in conventional diesel engines, or for appropriate engines can be run neat (B100). Biodiesel manufacturers claim many practical advantages over mineral diesel, including lower emissions and improved engine longevity, owing to higher lubricicity as well as safer handling and the generally lower environmental impact of production and utilisation.

A recent report commissioned by the Australian Government quantifies the health benefit alone of using biodiesel over mineral diesel as worth A$0.05 per litre. The product has health and safety benefits for such traditional users of mineral diesel as the mining industry. Mining companies that want to improve operational efficiency and operational health and safety standards could use Biodiesel as a safer alternative to mineral diesel in confined combustible spaces. Companies such as CSM Energy of Australia generate electricity from recovered mine vented methane which replaces diesel fired one-site power units. Where remaining diesel is required in underground mining environments, an increasing trend towards biodiesel is being observed. For the environmentally conscious consumer there are, at least, three primary compelling arguments for the use of biodiesel:

1. They are produced from sustainable resources,
2. They have lower levels of pollutants emitted; and
3. They can be produced from existing feedstock such as recycled oils and fats, reducing fossil fuel imports.

When discussing consumer fuels it is widely recognised that the massive power and political influence of car manufacturers has significant bearing over future market trends. In response to these arguments automobile manufacturers, including Daimler Chrysler, are currently testing biodiesel for use in luxury car brands, including Mercedes.

Production process

Biodiesel is generally produced through transesterification, a process that combines vegetable oils, and/or animal fat (tallow) with alcohol in the presence of a catalyst, usually Methanol, to form fatty esters. Product recovery is separated into phases, which allow removal of glycerol, a valuable by-product. The remaining alcohol and ester mixture is then separated and any excess alcohol is recycled. The esters are then purified using a combination of water washing, vacuum drying, and finally filtration.

Economic environment

According to forecasts, in 2006 existing facilities will produce over 14 billion litres of biodiesel. The global market is dominated by three heavyweights, Brazil, the United States and Europe. The rest of the market is comprised of smaller players, each gathering momentum in their own region. In the United States there are currently 36 plants under construction, representing an additional 750 million litres of annual production, which is expected to be on-line within the next two years. The Australian government has a target of 350 million litres by 2011. The Australian Federal Government is supporting the industry by issuing a 100% rebate of excise tax (38.143 cents per litre) until 2011, which reduces by 10% each year reaching a floor of 50% by 2016. In addition, State Governments are legislating that a 5% blend of biodiesel is used to fuel all State diesel consumption.

In Germany recent statistics indicate that biodiesel satisfied 300,000 vehicles' fuel requirements. Currently Australia's biodiesel supports just 18,000 vehicles – even on a per capita basis, there is significant room for improvement.

In Australia only 23% of the Diesel market is accounted for at the filling station. The largest users, at 43%, are transport companies – both private hauliers and municipal transport. Mining and construction firms account for 33% with the balance being manufacturing and domestic use, Clearly all of the above sectors would benefit significantly from a safer and cleaner fuel.

Legislative changes effected on 1 July 2006 by the Federal government appear to have retarded the development of the Biodiesel market by forcing market participants to channel their sales through the major fossil fuel players to access the filling station market. Should Australian Biodiesel production reach 10-25% of the current mineral diesel market volume, then we may see an instance of the mineral fuel players effectively controlling the distribution of the greener alternative to their product. Although this does not sit well with many manufacturers it may become an important factor in distributing their product and overcoming one of the big issues that bankers have with the product.

Banking challenges

With many fundamentals its favour, and with many projects around the world in production and under development, what is holding back debt participants from accepting this industry? The reasons lie largely in the way that biodiesel is produced and sold, and the parties involved in construction of biodiesel plants.

Issue 1: Contractual structure
To date, this industry has not relied on the typical underpinning of a solid debt financing – fuel supply agreements and offtake contracts. These shortcomings could arguably be mitigated if lenders had access to a sufficient trading history for biodielsel, and projects had access to supplier and offtaker diversity.
To achieve this position, day-to-day consumers and transport firms need to be able to have easy access to a biodiesel option, as they do with the more than 2000 filling stations in Germany alone. A scenario potentially aided by the legislative changes.

Issue 2: Consistency of product
Although the production of biodiesel is straightforward, the quality and consistency of the output varies greatly depending upon the feedstock used; more specifically the Free Fatty Acid index. European and US producers have overcome this concern by consistently using rapeseed oil or Soya bean as a feedstock. But in Australia, for instance, a wide range of organic fatty ingredients is used, resulting in a product which has a wider ranging set of physical parameters. Because biodiesel production plants operate round the clock, fine-tuning the process to a particular feedstock several times a day is not a viable option. National BioFuels Group, for instance, has developed several projects around the world that use Soya bean as feedstock, which is widely available and produces consistent quality biodiesel with an even lower environmental impact. Overcoming this consistency issue makes projects such as this much more suitable for a project financing.

The cutting edge is using farmed algae as feedstock. Algae production can be undertaken in large farms, where conditions can be tightly controlled whilst blooming using solar energy before being processed, oil extracted and then used as feedstock.

Issue 3: Completion/Interface
The capital cost of an individual biodiesel project is relatively small in project finance terms. These smaller operations inherently attract smaller construction companies and process/ technology providers. Due to their position in the market these firms are not familiar with the comprehensive warranties and completion testing requirements required to satiate the requirements of a project finance bank.

The size issue also has another drawback, that is that the legal, consultancy and up-front banking costs involved in establishing a biodiesel project financing are often as much as 10%-15% of the overall project – not an attractive proposition.

Potential Solutions

We believe that from a debt financier's point of view there are at least two ways in which low-cost, long-term debt finance might be available to a biodiesel project:

Option A: Assuming that equity has funded the development of a portfolio of operating biodiesel production facilities with sufficient geographic and market diversity then that portfolio may form the basis of a borrowing base facility. So as long as the portfolio is satisfying the overall debt covenants then the facilities stay in place. As part of this structure there may be funds ring-fenced for the development of new biodiesel production facilities using well reputed and experienced contractors to construct two or three plants under one construction contract. This scale of contract makes dealing with an experienced construction major familiar with the terms and obligation of a project finance transaction all the more feasible.

Option B: a more traditional approach requires the industry to mature. Based on European experience, this could be 2 to 5 years away for the Australian market. Construct a biodiesel production facility whose scale is comparable to a mainstream refinery or petrochemical operation – alongside this the project enters into a traditional take-or-pay agreement with a national biodiesel supplier, which is then able to distribute to retailers.
Under both approaches there are additional factors to consider, such as the optimisation of transportation costs, geographic concentration, location of skilled labour, and the fact that large projects require large-scale infrastructure. However, these considerations are aligned with the day-to-day challenges project financiers have to assess on even the most vanilla of transactions.

Summary

Biodiesel as a fuel has more advantages than disadvantages. The disadvantages to date are synonymous with early-stage sunshine or cottage industries and this has created problems for developers wishing to access the lower cost funding possible using structured debt instruments.

These drawbacks can all be addressed if there is a consistent product, which is well marketed and encouraged by a committed government. To date, these drawbacks remain large enough to keep low-cost long-term finance on the sidelines.

In order to clear this hurdle biodiesel needs to gather consumer acceptance and trading history. This situation is currently being advanced by equity participants, whose excellent returns to date have been largely in line with the risk they assumed. These participants need to focus on addressing the key issues required by project lenders, whose contribution will be necessary if biodiesel is to capitalise on lower development costs.

However we suggest that the party that conquers the consistency issue and can either underpin sales with creditworthy contracts or demonstrate sufficient market diversity, will make a quantum advance in debt-market acceptance. This approach, when combined with a portfolio of projects, is likely to attract generous project finance proposals. n

Contact details
The author can be contacted at www.navigatorpf.com