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Biofuels or Bio-fools?

From the May/June 2007 Issue

Vinod Khosla, a Silicon Valley legend, is leading the venture capital rush into replacements for gasoline: biofuels made from corn and rougher stuff like switchgrass. But if prices fall and political subsidies vanish, the bubble may burst.

KhoslaOn September 21, 1901, in the small town of Jennings, a group of men working for W. Scott Heywood became the first to find oil within the bor­ders of Louisiana. Heywood’s luck didn’t last. The well soon clogged with sand and dirt and was aban­doned. But today, Louisiana produces more than 50 million barrels of crude oil and condensate per year, so a sign outside Jennings (pop. 10,986) commem­orates that lucky strike.

Then, on February 16, 2007, Jennings reached another milestone. Louisiana Governor Kathleen Blanco visited the town to cut the ribbon for a dif­ferent sort of energy project: a 50,000-gallon pilot plant to produce cellulosic ethanol.

Like gasoline refined from crude oil, ethanol—that is, ethyl alcohol—is a fuel that can be engineered to power cars and trucks. While normally made from fermented kernels of corn, ethanol can be concocted from the cellulose (a sugar-based polymer) found in almost any vegetable matter, including fast-grow­ing prairie grass and the husks and stalks of corn itself. To expand ethanol production to a truly use­ful level in the United States, these other, rougher sources of fermentation—which produce what’s called cellulosic ethanol—are essential. “If ethanol is to be a significant solution to our transportation needs,” said Alan Greenspan, former chairman of the Federal Reserve, “it will have to be cellulosic.”

Up until now, however, low yields and high costs have made cellulosic ethanol a commer­cial dud. Then, a few years ago, a small company called Celunol Corporation, based in Cambridge, Massachusetts, licensed a handful of patented genetically modified bacteria developed by scien­tists at the University of Florida.

These flexible E. coli strains can convert the cel­lulose in a wide range of substances into ethanol quickly and cheaply, allowing the company to build plants next to any available source: waste lots around cities, orange peels in Florida, and sugarcane in Jennings, where Celunol built the pilot plant that Governor Blanco inaugurated in February. Celunol is planning a full-scale cellulosic plant with a capacity 500 times that of the pilot, not far from Heywood’s well. “I love the irony of it,” says Carlos Riva, the chief executive of Celunol. “This is worthy of two signposts.”

Riva, who is 53, built his career in the conven­tional energy business. With degrees from MIT, Stanford, and the Harvard Business School, he once worked for construction company Amec, directing global strategy for building oil and gas infrastruc­ture. He later served as CEO of InterGen, a power generation firm that’s a joint venture between Shell and Bechtel. But when Riva wound up as a private energy investor in Britain a few years ago, it didn’t take him long to decide that cellulosic ethanol was the Next Big Thing.

It was a simple question of math. In 2005, Congress passed the Energy Policy Act, which required 7.5 billion gallons of renewable fuels—mostly ethanol—to be blended into gasoline per year by 2012. Then, in his State of the Union Address this year, President Bush called for increasing that mandate to 35 bil­lion gallons by 2017, both to help the environment and to reduce America’s reliance on foreign imports of fossil fuels. The ethanol mandate advocated by the president represents one-fourth of the gasoline consumed last year in the United States.

The VCs and entrepreneurs have become increasingly political of late, lobbying for ethanol subsidies and penalties on oil and gas.

Politically powerful farmers and agricultural pro­cessors cheered both the new law and the speech. With industry capacity for ethanol now around 5 billion gallons annually, traditional corn eth­anol makers have embarked on a building binge. But many experts think that relying on corn alone to feed a 35-billion-gallon market would be fool­ish and probably impossible. First, while ethanol is perceived as a clean fuel, the old corn conversion processes have often been too dirty and inefficient for anyone to take the claim of “green” status seri­ously. Second, meeting the target would consume the nation’s entire corn crop. In the cellulosic indus­try, says Riva, “there’s a general sense that grain can only achieve between 12 to 15 billion gallons in this country because of the impact on corn prices. As a nation, as a society, we are going to be able to take as much cellulosic ethanol as the nation can pro­duce economically.”

Celunol isn’t the only business chasing the cel­lulosic dream. John Howe, the company’s vice president for public affairs, jokes that when he looks out his window in Cambridge, he can see six other firms working on the same problem. Most are fueled by a gusher of venture capital flowing as mightily as Heywood hoped his well would. In 2005, accord­ing to the National Venture Capital Association, venture capitalists (VCs) poured $195 million into alternative energy companies. In 2006, that figure reached $727 million. Cleantech Venture Network, an arm of the Cleantech Group (a consortium of companies that invest in green technologies) cal­culates that biofuel investments rose sevenfold from 2005 to 2006 (see chart on page 93).

Riva reports that Celunol has had little trouble raising money. Its funders include big venture capi­tal players like Braemer Energy Ventures, Rho Capital Partners, Charles River Ventures, and Khosla Ventures. The last is run by Vinod Khosla, one of the four co-founders of Sun Microsystems in 1982, who, four years after that, joined Kleiner, Perkins, Caufield, & Byers, the legendary Menlo Park, California, venture capital firm that backed Google, Genentech, and many other successful tech and bio­tech companies. Khosla, who has degrees in electrical and biomedical engineering (plus, of course, an MBA), is perhaps the number-one proselytizer of cellulosic ethanol, touting it as America’s great new fuel to anyone who will listen. The last time there was this much venture capital pumped into one industry, the dot-com bubble inflated and burst.

While thousands of companies and trillions of dollars in market capitalization were destroyed when that bubble popped, the investments of VCs, small investors, and big financial institutions laid the groundwork for today’s robust high-technology industry. Even if the biofuels excitement is excessive, it could end up doing a great deal of good for energy, the environment, and the economy. But there is a big difference between the dot-com boom and the bio­fuels boom, and the presence of Governor Blanco at the Jennings plant hints at it.

In the early days of the Internet revolution, governments stayed mostly out of the way of com­merce. No bureaucrat required that Americans do 25 percent of their shopping online. By contrast, energy policy is more tied to questions of national security, environmental benefits, and agricultural politics. Few governments are willing to live and let live when it comes to biofuels. Ethanol currently benefits not just from the multibillion-gallon man­date, but also from a 51-cent-per-gallon-of-ethanol tax credit to blenders that mix the stuff with gaso­line. At the same time, a tariff on imported ethanol reduces foreign competition.

Without political intervention, if the price of oil drops back to $30 or $40 a barrel, biofuels will be unattractive economically. So Khosla, the other VCs, and entre­preneurs like Riva have become increasingly political of late, lobby­ing for ethanol subsidies and penalties on oil and gas. So far, the Big Corn lobby that has built the ethanol industry has been happy for the help. But precisely because of the new technology the VCs are funding, the two ethanol factions—the old and the new—are on a crash course.

The cast of characters connected with the Renewable Fuels Association (RFA) hints at the tensions bubbling in the ethanol camp.

Patzek said that if drivers properly inflated their tires, it would have a greater impact on U.S. energy security than switching to ethanol would.

RFA’s treasurer, Nathan Kimpel, runs the New Energy Corporation of South Bend, Indiana. Launched back in 1984, this 100-million-gallon-per-year ethanol plant has a spotty environmental past. Through much of the 1980s and 1990s, New Energy’s neighbors woke up on overcast mornings to what Jack Dillon, South Bend’s director of envi­ronmental services, calls “a persistent odor” from the fermenting corn. He characterizes it as “very much like a brewery”; other residents describe it as baking bread gone horribly wrong. Aside from the smell, corn ethanol production can release vol­atile organic compounds such as acetaldehyde and formaldehyde, possible carcinogens. Byproducts can also include carbon monoxide.

While the plant has been improved, this smelly history hints at a tricky issue. For all the moral clarity massed behind ethanol as a green, renewable fuel, the data on its current efficiency and environmental impact are awfully murky. Growing corn isn’t clean. Manure trucked in and spread on cornfields releases greenhouse gases. Bacteria in the manure flood into nearby waterways, and chemical pesticides slathered on the fields leach into the ground. Transporting corn to the Midwest’s giant ethanol plants involves fossil-fuel-hungry trucks and trains.

Tad Patzek, a geo-engineering professor at the University of California at Berkeley, and David Pimentel, a professor of agriculture and ecology at Cornell, released two studies a few years ago that tried to quantify ethanol’s efficiency. They cast a broad net for inputs, and found that etha­nol has a negative energy balance. In other words, it takes more energy to produce a gallon of etha­nol than a gallon of ethanol can supply. Patzek said in a 2005 speech that if drivers properly inflated their tires, that would have a greater impact on U.S. energy security than switching to ethanol would. Other researchers question Pimentel’s and Patzek’s data. They say it’s old. Emotions flare over this subject. An Agriculture Department official once got so worked up that he told Patzek to “go back to Poland.”

Alexander Farrell, an energy expert who also teaches at Berkeley, tried to calm the debate with a January 2006 article in Science magazine that aggregated six different studies, including Pimentel’s and Patzek’s. Farrell’s team found that, on the whole, corn ethanol had a positive energy balance, though “the average hides a lot,” he said in an interview. “Some ethanol has a bigger benefit, and some a negative benefit—worse than gasoline.” As for greenhouse gases, “the average is not terri­bly positive. There are technologies and plants today that perform well, but no one has an incentive for good performance.”

At the pump, ethanol faces another big problem: it is less powerful than gasoline in today’s engines. New flex-fuel vehicles that can run on 85 percent ethanol blends (E85) show decent fuel efficiency, and if an engine is built to take complete advan­tage of ethanol, the biofuel’s high octane levels could give it some advantages over gasoline. But ethanol-optimized vehicles are as rare as ethanol service stations. That means that in the near future, ethanol, since it gets fewer miles per gallon in con­ventional cars, needs to be cheaper per gallon than gasoline to compete. Achieving that low price is tough because of America’s limited corn supply. In 2005, ethanol plants consumed 14 percent of the nation’s corn crop. Without efficiency gains or mas­sive imports, producing seven times as much fuel, under Bush’s proposed mandate, would put the pro­portion of the crop close to 100 percent.

But ethanol policy isn’t necessarily about prac­ticality. It’s about politics, personified in another presence on the RFA’s board: Martin Lyons, senior vice president for ethanol sales and marketing at Archer Daniels Midland Company.

ADM is an agricultural conglomerate based in Decatur, Illinois, with a $24 billion market cap and an outsized influence in Washington. Senators from the Midwest, where ADM has constructed seven plants that produce over 1 billion gallons of etha­nol annually (one-fifth of U.S. production), fight hard to guarantee markets for this giant employer and investor. Local residents don’t exactly mind the money, either. They also vote.

In 2000, Arizona Senator John McCain learned about Big Corn’s power the hard way. He said the ethanol industry wouldn’t exist without Congress’s meddling. He said that ethanol subsidies were a giveaway to companies like ADM. That won him no friends in Iowa, the nation’s largest corn pro­ducer, which happens to host the first key caucus of each presidential election cycle. McCain decided to duck the Iowa caucuses in 2000.

By August 2006, with an eye on the White House once more, McCain had changed his tune. While still skeptical about subsidies, he told an audience in Grinnell, Iowa, “I support ethanol, and I think it is a vital alternative energy source.”

Ethanol PlantThanks to its political heft, Big Corn is even more powerful than other parts of the farm lobby. Not all farmers benefit from ethanol subsidies; farm­ers who buy feed corn for cattle, for example, suffer from higher costs when corn prices rise. So do peo­ple who eat corn. In Mexico, the price of tortillas has doubled over the past year as the ethanol boom has bid up the cost of this commodity. The country’s poorest citizens have taken to the streets to protest the increases. Here’s an ethical question: in a world where people starve, does it make sense to run cars on food?

Ethanol fans don’t worry about this question too much, however, because they don’t see ethanol’s competitors—oil and gas—as having a claim to the moral high ground. Nor do they see the oil and gas industries as champions of the free market. Dennis Langley, former CEO of Kansas Pipeline Co., a transporter of natural gas, began his career doing construction projects as a teenager, eventually acquiring $2 billion in energy assets. He recently helped start E3 Biofuels. “I came out of that indus­try,” he says of oil and gas. “It is clearly the most subsidized industry in the U.S.” Perhaps. But there’s little doubt that, for its small size, ethanol gets an enormous amount of government help, too.

What is clear is that, despite its environmental and efficiency woes, corn ethanol has been the lucky beneficiary of an American political quirk, first pointed out by economist Bruce Yandle in a famous 1983 article in the journal Regulation. In the article, Yandle, now dean emeritus of the Clemson College of Business and Behavioral Sciences, recounted that, while he worked at the Federal Trade Commission, he noticed a funny thing about regulations that captured the public’s imagination and managed to endure. These regulations evolved not because of rational cost-benefit analysis, Yandle wrote, but because of odd alliances between what he called “Bootleggers and Baptists.”

The theory goes like this: during America’s long debate over alcohol in the first part of the 20th century, religious folks—in shorthand, the Baptists—provided a moral narrative for limit­ing sales. They sincerely believed government should support sobriety. They lobbied their rep­resentatives to enact Prohibition. That belief, however, sealed them into a marriage with the bootleggers, who were, in effect, rent-seekers profiting from rules that prevented law-abiding competition.

In 2005, ethanol plants consumed 14 percent of the nation's corn crop. Producing seven times as much fuel, under Bush's proposed mandate, would put the proportion close to 100 percent.

Yandle suggested that most regulations could be viewed in this light. Groups with moral motives provide cover for those who benefit eco­nomically (groups that, unlike bootleggers, typically operate within the law), even if the two sides don’t have much else in common. So far, this dynamic has propelled etha­nol from obscurity to the center of American energy policy. Environmentalists play the Baptist role, urg­ing governments to force us to be moral in our fuel choices. The Natural Resources Defense Council, for instance, has called ethanol “energy well spent.” Corn farmers and ethanol industrialists become the boot­leggers, quietly enjoying the monetary green their questionable green status confers on them. (And, of course, you have the delightful irony of ethanol being alcohol, source of the real bootleggers’ lucre.)

From teachers’ union bosses pushing smaller class sizes “for the children” to banks cheering consumer-protection laws that crowd out small players, Yandle’s theory holds pretty well. In the politics of ethanol, though, the VCs and the bio­fuel entrepreneurs they are funding are creating a new twist to these odd alliances: they’re com­bining the bootlegger and Baptist roles.

Like traditional “Baptist” environmental groups, many of the mon­eyed do-gooders who show up at Cleantech Venture Network forums have impeccable environmental credentials. They are honestly evangelical about the need for new fuels. Unlike traditional environmentalists, how­ever, they’re pouring millions of dollars of their own money into ethanol start-ups. Because of this financial interest, they aren’t opposed to regulations that guarantee them returns as rent-seekers.

So the VCs and the young biofuel companies have been angling to get a piece of government largesse—some of it quite direct. Last year, for example, New York state awarded a $14.8 million contract to the Mascoma Corporation, a firm backed by Khosla Ventures, to build and operate a cellulosic ethanol demonstration facility in Rochester. The plant will show which New York products can be churned into ethanol and lure more investment.

Vinod Khosla has become the most visible face in this Baptist-bootlegger hybrid movement. Born in India, Khosla always wanted to change the world through entrepreneurship. His first attempt failed: a soy milk product for Indians who lacked refrigeration. Later attempts, like Sun Microsystems, did better.

Khosla and his colleagues have plenty of money to throw around in politics, but despite the exu­berance, there’s a learning curve to climb. Khosla’s first big battle, over a California ballot initiative last year that would have taxed oil companies in order to fund research and development in alternative fuels, ended in defeat. Khosla contributed about $1 mil­lion to support the measure, called Proposition 87. Others chipped in even more. In the end, it was the most expensive referendum in American history. But the rent-seeking was too obvious; even the Los Angeles Times cautioned voters against this “new form of corporate welfare.”

Then President Bush handed the biofuels indus­try a New Year’s present with his State of the Union address. Cleantech Venture Network members cheered alongside ADM. Given how small the indus­try is now, and how much it must grow to reach 35 billion gallons, there’s room for everyone, bootleg­gers and Baptist-bootleggers alike.

But make no mistake. The VCs and biofuel entre­preneurs plan to compete not only with oil and gas, but also with the old corn ethanol plants. Then they plan to replace them. “Everyone is trying to figure out right now what the winning horse is going to be, which is the winning technology, which is going to be the best investment,” says Craig Cuddeback, the Cleantech Group’s chief operating officer. While many of these VCs got burned by dot-coms in the 1990s, they don’t believe their biofuel investments are inflating a similar bubble. While the price of oil has declined since its peak, few bet that it will dip below $30 a barrel again. That’s the push factor. Then there’s the pull: even in the absence of gov­ernment mandates, a growing, wealthy segment of consumers cares about the environmental impact of its decisions.

It is unlikely, however, that any of the 2008 presidential candidates will want to test the idea that there is a replacement for corn as fodder for ethanol.

These days, those qualities lie on the verge of commercial feasibility. Dennis Langley, the former Kansas Pipeline CEO, had been looking for an etha­nol opportunity for the past decade. He finally took the plunge after finding a patent for a closed-loop process that uses manure from an adjacent feedlot to produce biogases that power a corn-fed ethanol plant. Cattle then dine on what’s left of the corn after making ethanol, completing the loop. Langley’s first plant came online in Mead, Nebraska, in late 2006, with a capacity of 25 million gallons of ethanol a year. His company, E3 Biofuels, will break ground this year on three new plants, each producing 50 million to 150 million gallons.

Companies like E3 promise to make corn eth­anol greener, but as Khosla writes on the Khosla Ventures website, most new players view corn as just “a valuable stepping stone to other sources of biomass-derived liquid fuels.” Since the sugars in many biomasses can be turned into alcohol, the challenge is finding materials and processes that make that alchemy clean and cheap.

So now the hunt is on. Purdue University scientists recently won a Department of Energy contract to investigate the ethanol potential of hybrid poplars, which can grow 15 feet a year with little mainte­nance. The researchers are genetically altering the poplars’ lignin—the substance in the cell walls that makes cells rigid and protects interior cellu­lose—to make the tree’s cellulose more accessible. Switchgrass, a fast-growing perennial that thrives on prairies and along roadsides, also promises accessible cellulose; miscanthus (another grass) can produce ten dry tons of biomass per acre per year. As President Bush put it, “All of a sudden, you may be in the energy business, you know, by being able to grow grass on the ranch and have it harvested and converted into energy.” Khosla estimates that if South Dakota harvests grasses and turns them into ethanol, it can produce the energy equivalent of 3.4 million barrels of oil per day.

Cellulosic start-ups are also investigating munici­pal waste, byproducts of paper manufacturing, and potato peels. Even established companies looking for additional revenues are dabbling in this trash-conversion business. Merrick/Coors of Golden, Colorado, produces about 3 million gallons of eth­anol a year out of brewery waste. Land O’Lakes of Melrose, Minnesota, likewise makes about 3 million gallons of ethanol a year out of cheese whey. Turning trash into energy promises more environmental benefits (and fewer moral issues) than doing the same with edible corn. Cellulosic ethanol is cleaner than corn, and, if it’s also cheaper (as many investors and scientists believe it will be), then there will be no reason to burn food for fuel. Farmers won’t be happy.

Already, the showdown is brewing. “I interact with a lot of corn growers,” says Seth Snyder, an Argonne National Laboratory biochemical engi­neer who studies ethanol. “They feel that with an increase in corn production, they’ll be able to meet all those needs.” But Khosla writes that “no one in their right mind is proposing we use corn ethanol” in the long term.

Cary Bullock, a 20-year veteran of the energy industry who now runs a Cambridge start-up called GreenFuel Technologies, agrees with Khosla. “The corn lobby has done very well,” says Bullock, whose firm uses carbon dioxide emissions and algae to pro­duce fuel. “If the objective of our energy policy is to be a farm subsidy, that’s fine. If it’s to get renewable fuels, clearly it leaves a lot of things out.” Tax cred­its and regulations have been written with one crop in mind: King Corn.

It is unlikely, however, that any of the 2008 presidential candidates will want to test the idea that there is a replacement for corn as fodder for ethanol—at least not in Iowa, the nation’s top corn-producing state. Even if politicians are happy to be seen cutting ribbons in Jennings, Louisiana, and investing in cellulosic ethanol plants in New York, the corn farmers and their allies at ADM still dominate national politics and, thus, national alternative-energy policy. But science and econom­ics trump politics. If switchgrass and orange peels can be efficiently turned into fuel for the gas tank, then Iowa’s farmers will have to go back to grow­ing corn for hogs, not for ethanol for SUVs—and another bubble will deflate. Or perhaps oil prices will fall back to 1990s levels and politicians will lose enthusiasm for subsidizing alternatives. What hap­pens then? Double bubble.

Laura Vanderkam is a New York writer.

Illustration of Vinod Khosla by Ryan Graber; Artist's rendering of a Celunol Corporation plant in Jennings, Louisiana courtesy of AMEC and Celunol Corp.

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