Carbon credits or loan guarantees? Which is the more powerful driver of a bioeconomy?

Every project in the world would prefer to have carbon credits ANDa loan guarantee for first of kind technology. But, what if you not have both, but only one? Which would you choose?

For a long time, it’s been all about carbon credits, such as provided via the Renewable Fuel Standard, the Inflation Reduction Act section 45 credits, Low Carbon Fuel Standard credits, and so forth. There has been a lot of support, not always reliable or predictable — but plenty more help on the carbon credit front than the loan guarantee front. Only a handful of projects have ever received a guarantee on a loan.

It’s understandable, the thinking, Why should the public be taking technology risks via guaranteeing first-of-kind commercial projects a loan to buy down cost and requirement for project equity? Instead, why shouldn’t the public simply award carbon credits to the winners, since it involves no risk, no picking winners, and puts the public investment squarely in the world of rewarding actual change, instead of incentivizing potential change. 

Over to DigestAI

Is it an unanswerable argument. Has been to date: loan guarantee efforts have always been sweeteners, not stand alones. Yet, that may be changing, according to our Digest AI-based queries into the treasure trove of Digest project data, scientific studies, news stories and presentations.

I asked my DigestAI colleagues, Aileen and Aidan, the following:

Based on a US government borrowing cost of 3%, is it more efficient for the public to finance biorefining capacity by paying directly for the capex and taxing any profits above a 15% return on investment at a 15% rate, or to provide carbon credits that make up the difference between the cost of renewable fuels and conventional fuels, and project owners retain all profits?

I added a few caveats to account for risk so that the numbers drive the calculus, rather than the worries:

Assume that it takes 24 months to complete construction and commissioning of each new biorefinery. Also assume that project technology partners provide performance guarantees that protects the public from the risk of project failure. Assume that suppliers enter into fixed price contracts to protect the public from the risk of project losses, and guarantee a 25% profit margin that provides a guaranteed return on investment for the public. Also assume that a public-private consortium funded by industry will administrate the investments to reduce administrative burden for the public while retaining authority over investment flow.

Aileen & Aidan answer back

Carbon Credits have the advantage of transferring risk of project failure to project owners, and lower administrative costs. However, the public forgoes any benefit from the upside of highly profitable projects, does not receive a guaranteed return on investment, and simply subsidizes the difference between project costs and conventional fuel prices, while still being protected from project failure and operating losses due to performance guarantees and fixed-price contracts.

Based on the information in the Digest archive, and the additional assumptions, direct public financing with a public-private consortium, is more efficient than providing carbon credits.

• Direct Public Financing offers lower cost of capital, complete control of projects, a guaranteed 25% return on investment, and a share of the upside through taxes on profits above a 15% return on investment. This is coupled with protection from project failure and losses due to performance guarantees, fixed-price contracts with suppliers, and the guaranteed profit margin. The administrative burden is significantly reduced by the public-private consortium.

The addition of a guaranteed 25% profit margin, coupled with a public-private consortium to reduce the administrative burden, makes direct public financing significantly more attractive than providing carbon credits in the context of the assumptions provided.

Scenario 1: Direct Public Financing with Public-Private Administration

•Capital Expenditure (CAPEX): The government directly funds the CAPEX for biorefineries [see conversation history].

•Borrowing Cost: The government borrows at 3% [see conversation history].

•Construction Time: 24 months (2 years) for construction and commissioning [see conversation history].

•Profit Margin: A guaranteed 25% profit margin provides a guaranteed return on investment for the public [user query].

•Profit Tax: Profits above a 15% return on investment (ROI) are taxed at 15% [see conversation history].

•Risk Mitigation: Technology partners provide performance guarantees, and fixed-price contracts with suppliers protect against project failure and losses. The guaranteed 25% profit margin ensures a return on investment for the public [user query].

•Administration: A public-private consortium funded by industry administers the investments [user query].

Analysis:

•Initial Cost: The government incurs the full CAPEX upfront, but this is mitigated by performance guarantees [see conversation history, user query].

•Cost of Capital: The government’s cost of capital is 3%, which is relatively low [see conversation history].

•Profit Sharing: The government taxes profits above 15% ROI at 15%, allowing the public to share in the financial success of the project. The guaranteed 25% profit margin ensures a minimum return on investment for the public [see conversation history, user query].

•Reduced Risk: Performance guarantees from technology partners, fixed-price contracts with suppliers, and the 25% guaranteed profit margin mitigate the risk of project failure and losses for the public [user query].

•Reduced Administrative Burden: A public-private consortium funded by industry will administer the investments, reducing the administrative burden for the public [user query].

•Potential Benefits: The government has complete control over the project and its operations, which can lead to efficiencies. The government also benefits from lower borrowing costs, and shares in the upside with taxes on profits above 15% ROI, in addition to the guaranteed 25% return [see conversation history, user query].

Scenario 2: Carbon Credits with Risk Mitigation

•Incentive: The government provides carbon credits to make up the difference between the cost of renewable fuels and conventional fuels [see conversation history].

•Project Ownership: Project owners retain all profits [see conversation history].

•Construction Time: 24 months (2 years) for construction and commissioning [see conversation history].

•Risk Mitigation: Technology partners provide performance guarantees and fixed-price contracts with suppliers protect against project failure and losses [user query].

Analysis:

•Initial Cost: The government incurs costs through carbon credit payments, and there is no risk of project failure due to performance guarantees and fixed-price contracts [see conversation history, user query].

•Project Risk: Project owners bear the responsibility of managing the project, but there is no risk of project failure or operating losses due to performance guarantees from technology partners, and fixed-price contracts with suppliers [user query].

•Profit Retention: Project owners retain all profits and benefit from any upside [see conversation history].

•Potential Drawbacks: The government has less control over the project, does not benefit from the upside of highly profitable operations, and does not receive a guaranteed return on investment. The government simply subsidizes the difference between the cost of the projects and the market prices for conventional fuels [see conversation history, user query].

•Potential Benefits: The public is not exposed to the risks of project failure because of performance guarantees from technology partners, and fixed-price contracts with suppliers [user query]. The projects may also be more innovative and efficient as a result of the profit motive [see conversation history].

Comparison

With the new assumptions of performance guarantees, fixed price contracts, a guaranteed 25% profit margin, and a public-private consortium, the comparison of the two scenarios shifts significantly:

•Direct Public Financing: The public benefits from a lower cost of capital (3%), a share of the profits through taxes on returns above 15%, and a guaranteed 25% return on investment. Direct public financing is also protected from the risk of project failure and operating losses due to performance guarantees and fixed-price contracts. The administrative burden is significantly reduced by the public-private consortium.

•Carbon Credits: The public benefits from private capital taking on the risks of the project, but the public forgoes any benefit from the upside of highly profitable projects, does not have a guaranteed return on investment, and simply subsidizes the difference between project costs and conventional fuel prices. The public is protected from project failure and operating losses because of performance guarantees and fixed-price contracts.

Financial Efficiency

•Cost of Capital: The government’s borrowing cost of 3% is lower than the expected return of 15% for private projects, suggesting that public finance of capital may be cheaper if all projects were successful and earned a return above 15% [see conversation history].

•Profit Sharing: With direct financing, the 15% tax on profits above a 15% ROI partially offsets the initial investment. This is not present in the carbon credit scenario, which also has no guaranteed return on investment [see conversation history, user query].

•Risk Exposure: With the added risk mitigations, both scenarios are protected from the risk of project failure. However, with direct financing the government assumes the risk of lower returns if projects do not achieve a 15% ROI, while carbon credits transfer this risk to the project owners, who benefit from all profits above this level, and may be more incentivized to pursue profit-maximizing strategies. However, the guaranteed 25% profit margin in the direct financing model makes this consideration moot [see conversation history, user query].

•Incentives: Carbon credits do not penalize project owners who exceed the targeted 15% ROI, which can encourage more innovative or aggressive investment strategies. This incentive is less relevant in the direct public financing model, where a 25% guaranteed profit margin provides a strong incentive to pursue profit-maximizing strategies [user query].

Additional Considerations

• Carbon Credit Costs: The cost of carbon credits varies depending on the technology pathway and the price of conventional fuels.

• Administrative Costs: Direct public financing involves lower administrative costs due to the public-private consortium, compared to a scenario where the public is directly administering the investments. Carbon credits are simpler to administer in a basic implementation, but potentially more complex when attempting to administer a program that targets specific outcomes.

• Project Delays: The 24-month construction timeline is a risk factor for both scenarios, potentially impacting project costs and returns.

• Market Conditions: Changes in conventional fuel prices will impact the amount of carbon credit support needed.

The Bottom Line

Does the DigestAI team have perfect answers? Hardly. But they’ve read more on the subject than anyone, that’s the AIdvantage. So, it’s instructive that scenarios exist whereby renewable fuels and chemicals can do better than carbon credits, which are unstable because they are unpopular when the volumes become big, as they must become big. Scenarios worth exploring in more detail, say Aileen and Aidan. I suspect they’re onto something.