Executive Summary
What the report is about
This report discusses some economic and policy issues associated with the production of liquid biofuels in Australia and overseas. Ethanol and biodiesel are the principal alternative fuels discussed here, and the topics covered include:

• Competition for crops with alternative markets: Food, fibre, livestock and biofuel producers are competing for the same commodity crops in the international arena.
• Policies affecting biofuels security: There are net subsidies to petroleum-based transport fuels and vehicle use in Australia, and recent changes to the fuel taxation system have had a negative impact on the biodiesel industry.
• Options for expanding demand: Misunderstandings and misinformation among consumers, and a lack of availability of E10 and B5 in southern and western states, are currently constraining demand growth.
• Options for encouraging future capital investment: In addition to an emissions trading scheme, targeted incentives could be introduced to promote the judicious use of biofuels.

As the production of biofuels is an emerging industry in Australia, the information contained in this report is important in determining what benefits may accrue from any proposed diversion of human and animal feed stocks – sugars, cereals and oilseeds – into biofuel production.

Who is the report targeted at?
The report was prepared to provide information and advice to all levels of government and industry in Australia. It is of particular relevance to the energy and transport sectors, as well as those agricultural sectors engaged in the production of sugars, cereals, oilseeds and livestock. Since it includes a review of the research literature on economic and policy aspects of ethanol and biodiesel, it may be of interest to other scientists in the energy, transport and agricultural fields.

Background
Australia’s land and water resources will be increasingly contested for animal, food, fibre, and energy production, as well as environmental services like carbon sequestration and biodiversity. The choices we make about biofuels will have far reaching implications for the nation’s economy, environment and society. It is critical that any move to a large-scale biofuel industry in Australia is sustainable. The sustainability credentials for biofuels across the areas of greenhouse gas emissions, land and water impacts, financial viability and social acceptability must be clear.

Internationally, biofuels have been promoted as a response to greenhouse gas emissions, supply constraints in the oil industry and energy security. In the USA, the accelerating use of corn for the production of ethanol has led to significant increases in the feed corn price and protests from various quarters (in and outside the USA). With the biofuel industry in its infancy in Australia, questions have emerged on the effect the development of a local biofuel industry could have on other industries and whether targets or mandates are suitable policy instruments to promote their use in the marketplace.

The recent report Biofuels in Australia – issues and prospects (O’Connell et al. 2007) synthesises our knowledge of the implications of a biofuels industry in Australia. The additional detail described in this report on the economic and policy aspects of biofuels is supplementary to the above report.

Aims/Objectives
The aim of the research was to provide an independent, refereed report on some key economic and policy issues associated with the production of biofuels in Australia, for example:

• Competition for crops with alternative markets: To what extent can Australian food, fibre, livestock feed and biofuel producers afford to compete for the same commodity crops?
• Policies affecting biofuels security: How does the level of net subsidies provided to fossil fuels and vehicle use compare with subsidies and policies impacting on biofuel producers in Australia?
• Options for expanding demand: How can certain misunderstandings and misinformation among consumers and a lack of availability of biofuel bends in southern and western states be addressed?
• Options for encouraging future capital investment: Are targeted incentives the best strategies to adopt in order to promote the judicious use of biofuels?

Methods used
Most of the material in this report was derived by reviewing existing stocks of knowledge – research papers from refereed journals, unpublished reports, news articles and personal contacts with industry leaders and other scientists. Although there is a large amount of material on biofuels available on various websites, much of this sponsored by the ethanol and biodiesel industries, it was discounted as secondary to the other sources. Effort was made to locate papers on ethanol production from grains and sugars, and biodiesel production from oils and tallow, as these are the most likely feedstocks to be used in the production of first generation biofuels in Australia.

Results/Key findings
Competition for crops with alternative markets

• In some commodity markets, food, livestock and biofuels producers compete for the same crops
• while in others it is less clear that this is the case. About 61% of the world’s ethanol production comes from sugar crops – sugar cane, sugar beet or molasses. Brazil is able to shift from sugar to ethanol production in response to oil-sugar price shifts. When the sugar price is high relative to ethanol, producers stay with sugar. But when the ethanol price rises relative to sugar, they produce more ethanol. Thus food and fuel uses are competing for the same crop in this case.
• Most of the remaining ethanol is made from grains, with corn-based ethanol production growing by about 30% per year in the USA. Recent price increases include doubling of USA corn prices in 2006-7; rising prices of food staples such as milk, eggs and chicken in highly-populated nations like China, India and the USA, as well as tortillas in Mexico; doubling of rapeseed (canola) oil prices in Europe over the last five years; and European prices of cereals, starches and glucose increasing by about 20% in the last year.
• However, the case of competition for feedstocks is less clear for other crops than it is for sugar.

The degree of substitution between grains for food, feed and biofuels is not clear, and the impact of other factors such as an increase in energy price, the steady increase in demand for food and feed, or the impact of drought and climate change has not been thoroughly investigated.

• Although competition with food producers for crops has not been a serious issue for Australia’s few ethanol producers (who use waste starch and C-molasses), increases in global grain commodity prices have increased world agricultural commodity prices, especially grains, thus increasing returns to Australian producers.
• Currently ethanol from waste starch and C-molasses, and biodiesel from waste oil can be produced for less than 45 c/L (roughly competing with oil at US$40 per barrel). Ethanol from sugar, and biodiesel from tallow and canola, can be produced for less than 80 c/L (roughly competing with oil at US$80 per barrel). Production costs vary mostly because of different feedstock costs.
• Higher levels of ethanol production from C-molasses could place upward pressure on molasses prices, and eventually have an impact on the price and availability of molasses for other uses – such as in the food additive and stock feed markets.
• Use of wheat or sorghum as feedstocks to fuel the expansion of the Australian ethanol industry will increase competition with grains for food and with feedgrain for livestock. Similarly, expansion of Australia’s biodiesel industry will trigger competition with soap and detergent manufacturers for input feedstock.
• A whole new set of markets for second generation (lignocellulosic or algal) feedstocks is expected to develop, which have not been explored in Australia. Although some biomass-based sources have no competing markets, they do have competing uses – e.g. retaining carbon in ecosystems.
• In the case of a large-scale biofuel industry, there is likely to be competing markets not just for the feedstocks, but also for the factors of production – including land, water and labour – which would then impact on many other industry sectors, especially in regional Australia.

Subsidies to the fossil fuel industry

• Estimates of subsidies to all fossil fuel use in Australia range from 2 to 10 billion Australian dollars per year. These estimates include:
• perverse subsidies i.e. those which increase greenhouse gas emissions and reduce economic efficiency
• subsidies to motorists – which would still apply if the motorists were running their vehicles on alternative fuels instead of fossil fuels.
• Further research is needed to improve the estimates of subsidies directly associated with fossil fuel use in Australia.

Australian biofuels policies and impacts

• The major biofuels policy at the national level is a 350 ML target by 2010. Based on current production levels, current installation of new facilities, plus recent uptake by some oil majors, it seems likely that this target will be met. Different states are developing their own approaches, which are in various stages of development.
• Assistance currently provided to producers includes:
• a production grant of 38.1 c/L, which fully offsets the excise paid on biofuels
• a capital grant that effectively provides around 1c/L in additional assistance over the lifetime of the plant.
• Assistance to biofuels is scheduled to fall to 12.5 c/L for ethanol and 19.1 c/L for biodiesel by 1 July 2015. A banded excise system will impose rates on different fuels, classified into high, medium and low energy groups. This strategy broadly keeps constant the excise payable per kilometre travelled by vehicles using the fuel.
• Domestic producers are eligible for the excise rebate from the Australian government. Ethanol imports are subject to both a general tariff of 5% (zero if imports are from the USA) and the full excise of mid-energy fuels of 25 c/L. This differential treatment of domestic and imported sources amounts to a tariff on imports reducing the competitive pressures on domestic producers, and may lead to higher biofuel prices for Australian businesses and households.
• Recent changes to the fuel taxation system have had a major impact on the biodiesel industry.

Changes to the Fuel Tax Act 2006 mean that the payment of a producer grant (under the Energy Grants (Cleaner Fuels Scheme) Act 2004) extinguishes the fuel tax liability – i.e. if the producer of the biodiesel has received a grant, the purchaser of biodiesel cannot claim a fuel tax credit. This penalises any biodiesel purchaser who could ordinarily claim a rebate on diesel, and thus impacts on the demand for biodiesel.

Comparison to overseas subsidies and policies
Drivers for the use of biofuels differ greatly between countries and between fuels.

• Ethanol was initially regarded as a fuel extender. Then it was used as a replacement for methyl tertiary butyl ether (MTBE). MTBE is an oxygenate which reduces air pollution from petrol in cities. When MTBE contaminated groundwater in the USA, it was banned by the end of 2002 – with ethanol being chosen as the replacement oxygenate. Oil companies then realised that ethanol was a good octane enhancer. It is now considered as an alternative fuel, and major policy support in Brazil and USA is largely a response to the issue of national energy security, and a general culture of government support for domestic agriculture.
• Many countries moved to using Ultra Low Sulfur (ULS) diesel because of air pollution problems caused by sulfur in the fuel. When the sulfur was removed, however, many lubricant properties of the diesel were lost. Biodiesel has excellent lubricant properties, and was introduced to a diesel blend as a lubricant enhancer. The further benefits of biodiesel were then demonstrated – especially in terms of lower particulate emissions and thus reduced air pollution and better health outcomes. It is now considered as an alternative fuel rather than an extender. Major policy support in the European Union (EU) is based on reducing greenhouse gas emissions and improving urban air quality, rather than as a response to energy security.

Current barriers to demand
Total demand for transport fuel has two components:

• Intermediate demand – purchasing patterns of intermediate producers such as oil companies, services stations, farming co-operatives who process, blend and distribute fuels for eventual sale to customers.
• Final demand – purchases by individual consumers and households.

Barriers to intermediate demand include:

• Industry projections quoted in the Prime Minister’s Biofuels Action Plan show that oil majors expect to exceed the government's biofuels target of 350 ML by 2010. BP’s recent decision to purchase 40 ML of ethanol from Manildra over the next year will make it Australia’s largest marketer of biofuels, and result in nearly half of BP’s fuel sales in NSW containing ethanol.
• Prior to this, only about 5% of the 8,000 or so service stations across Australia have been selling ethanol or biodiesel blends.
• Until BP’s increased outlets come on stream, ethanol and biodiesel blends are being provided mostly by independent and small scale fuel providers.
• A lack of availability of E10 and B5 in southern and western states remains one of the largest barriers to demand growth.

Barriers to final demand include:

• Consumer confidence is the major barrier. Regional motorists are more comfortable with E10, and Queenslanders favour ethanol more than drivers from other states. This is probably due to Queensland government initiatives to promote ethanol.
• Motorists are concerned that ethanol will damage their engines. This concern is unfounded for modern cars running on E10.
• The motor industry does not warrant vehicles for blends containing greater than 10% ethanol.
• E10 typically slightly reduces fuel economy (by 2-3%) because of its lower energy density, and motorists therefore expect it to be slightly cheaper.

Trade barriers include:

• An additional consequence of recent changes in sulfur content rules has been to restrict the import of fuel from many Asian sources, due to their high sulphur content. This shelters the oil majors in Australia from further external competition in their refining capacity.
• Both the USA and the EU impose tariffs on ethanol imports.

Strategies to stimulate demand
Those recognised by the Biofuels Taskforce (2005) include:

• industry-based information dissemination
• more marketing and promotional activity
• simplification of the FCAI vehicle list on E10 suitability
• further E10 vehicle operability testing
• simplification and modification of the current fuel ethanol information standard.

The following additional options could be considered for addition to this list:

• removal of demand barriers
• rollout incentives – investment incentives could be made available to companies to expand distribution networks by constructing retail outlets whose sales included, for example, 10% ethanol and 5% biodiesel blends
• price discounting:
• if a biofuel is produced for less than the price of the standard fuel, pass on the savings to the consumers
• introduce controls on weekly fuel price movements
• discount the price of ethanol to compensate for differences in fuel efficiency
• mandating fuel blends: there are many complex issues involved in mandating biofuels, but several states will introduce mandates shortly - Queensland intends to mandate a minimum 5% ethanol in regular unleaded petrol produced and wholesaled in Queensland from 31 December 2010. Also, NSW is, in principle, supporting a 10% ethanol mandate in unleaded petrol produced and wholesaled in NSW, on a phased-in basis with full implementation by 2011
• producing and/or mandating flexi-fuel vehicles would address consumer confidence issues, and place Australia in a position to increase our ethanol use in the future
• tax, excise and import incentives:
• between July 2011 and July 2015, production grants for ethanol and biodiesel will incrementally reduce to about half the current excise rate
• currently, the production grant for biodiesel also applies to imports of biodiesel to Australia. Imported ethanol does not receive a production grant, although in 2011 imported ethanol will be treated equivalently to domestically produced ethanol
• the effect of this on the local production of ethanol is unclear. It is possible that Brazilian ethanol could be purchased at a lower price than Australian produced ethanol, so that the industry may experience increased competition from overseas producers when the import market is opened up in 2011.

Effectiveness of present policy in encouraging sustainable capital  investment and growth in supply

• Australia’s policy platforms for biofuels differ significantly from Europe, America and other nations which actively promote the production and use of biofuels. Some of the intended and unintended consequences of these proactive policies are currently unfolding – particularly in the USA, where there has been a massive increase in the production of ethanol, with consequent increases in the grain price and impacts for the human and livestock food supplies.
• In contrast, Australia’s policies have been cautious. Recent marketing announcements by BP, along with additional new production capacity coming on stream shortly, suggest that biofuel production is likely to reach or exceed the 350 ML target by 2010. Reductions in levels of excise relief from 2011 onwards, and the uncertainty in the domestic industry about future directions, may slow down further capital investment.
• There are limits and security of supply risks to a biofuels industry based on domestic feedstocks and first generation technologies. These first generation technologies can serve as a stepping stone towards a biofuels future based on second generation technologies.
  Given the potential for lignocellulosic ethanol and algal biodiesel to change the economics of the biofuels industry in the coming decade, policy interventions based on current technologies and feedstocks require careful consideration.
• There is a need for a closer assessment of the potential for second generation technologies, such as lignocellulose and algae (Biofuels Taskforce 2005), and an industry roadmap for the implementation of these technologies.

Targeted incentives and assistance programs

• There are opportunities to use targeted incentives in the area of biofuels. For example, if a set of criteria was based on a set of preferred outcomes (e.g. lower greenhouse gas emissions, higher energy input-to-output ratios, better health or regional outcomes), then incentives could be targeted and scaled on this basis.
• These incentives would require a technically defensible and transparent basis. For example biofuels from second generation lignocellulosic sources could target positive hydrological, biodiversity or regional benefits.
• An emissions trading scheme could promote the use of biofuels, if sale of renewable fuels did not require purchase of emissions allowances, whereas fossil fuel suppliers would be obliged to purchase emissions allowances in order to sell fossil fuels.

Can a domestic industry supply sufficient biofuel to satisfy consumer demand?

• Because consumer demand is currently a barrier to biofuel expansion, there is likely to be sufficient capacity to meet any growth in consumer demand for biofuels for the rest of this decade. The challenge facing Australia’s biofuels industry today is to produce basic blends like B5 and E10 cheaply enough to attract interest from lukewarm oil majors and misinformed and therefore sceptical consumers in the southern and western states.

Implications for relevant stakeholders Government policy makers:

• Focus on renewable energy supplies which maximize the chances of positive environmental, social and economic outcomes and do not directly compete with food supply.
• Consider the introduction of targeted incentives in the area of biofuels.
• Ensure consistent policy development for biofuels with any policy framework for alternative fuels or sustainable energy in Australia, and consistency across the agriculture, forestry, energy, transport and carbon market domains.
• Seek to understand potential interactions between policy and other factors which require analysis in order to gain the intended benefits and avoid unintended costs. The transitional pathways to a sustainable energy future need to be clearly mapped – including the sequence of steps and policy changes required to reach the intended destination.
• Seek to identify and minimise potential distortions that may arise through interactions with other policies.

Biofuel industry:

• Consider economies of co-location, e.g. co-locate and integrate grain ethanol production with beef feedlots or dairies utilizing co-products like wet or dry distiller’s grains (e.g. Braid 2007).
• Prioritise use of low-cost and low-emissions feedstocks like waste oils and starches, thereby complementing existing activities through the use of wasted by-products and low-value inputs wherever possible, rather than competing for inputs.
• Seek to understand and implement sustainability into business development plans.
• Seek to pass on savings on rebates to consumers to provide price incentives.

Consumers:

• Strive for co-location and integration of processes – as described above – which can expand the local industry and thereby benefit the local community.
• Better understanding of consumer attitudes and behaviours is required.

Conclusions and recommendations
Competition for crops with alternative markets

• There is currently negligible competition between biofuel and food production in Australia because the biofuel industry is in its infancy and does not heavily rely on food as feedstocks.

As the industry grows, however, this may be an issue and competition for food, animal feed and water must be carefully understood and managed. Internationally, it is mooted that the increase in commodity price is due to competing demand between food and biofuel, but the extent to which biofuel production is driving price (compared to other factors such as drought) deserves closer examination.

• Maintaining a strong, up-to-date understanding of the international and domestic commodity markets which affect feedstock prices, and the competition between competing markets under various policy, technological, economic and other drivers is essential to keep abreast of this fast moving area of development. Maintaining a strong understanding of supply and transportation logistics and their costs is needed. A significant cost of delivering feedstocks to the factory gate can be in the transportation cost.
•  A consistent set of policies with well researched intended outcomes, clear transition pathways, clear benefits and minimimal risks to the public, future generations and industry will place Australia in an excellent position to secure a sustainable energy future with a stable environment for investor confidence.
•  Second generation processing technologies which rely on non-food feedstocks (e.g. lignocellulose) appear promising in terms of lower energy input systems, and lower costs.
  Further analysis is required to obtain a robust assessment of the impact of second generation biofuels applicable to Australian feedstock production systems, market conditions and infrastructure requirements.
• Any new energy industry – especially one based on domestic biomass – will change the material and energy flows through the whole economy once it reaches a critical size. The biophysical and economic impacts of these need to be understood, particularly in the dynamic market conditions for commodities, fuel and carbon.

Policies affecting biofuels security

• If estimates of specific taxes and subsidies that are directly associated with fossil fuel use in Australia are to be improved, further research is required. It would be worthwhile to update and consolidate earlier analyses and to examine the impact of recent changes in taxation, including changes to fuel excise and the freight fuel excise rebate.
• Given the potential for lignocellulosic ethanol and algal biodiesel to change the economics of the biofuels industry in the coming decade, policy interventions based on current technologies and feedstocks require further consideration, which should ideally be based on a well reasoned technology roadmap (O’Connell et al. 2007).
• Australia would benefit from remaining abreast of international developments in subsidies and other forms of support to biofuel production, including their impacts on other domestic and international industries, communities and economies.
• Australia would benefit from close linkages with international developments in sustainability certification and trade.

Options for expanding demand

• Intermediate and final demand are barriers to uptake of biofuels. Understanding how consumer attitudes and behaviours are formed is needed, including how and what information is given to consumers and what incentives may work to encourage uptake. For example, the federal government has invested significantly into understanding some of these issues with respect to consumer attitudes to biotechnology, focussing on GM crops and stem cells.
• A more detailed assessment than is provided here of domestic and international trade barriers with respect to emerging production and markets for biomass and biofuels would be useful to Australian industry and government.
• Effective use of different approaches and policy instruments including removal of demand barriers, rollout incentives, price discounting, mandating fuel blends, producing and/or mandating flexi-fuel vehicles, and tax, excise and import incentives is critical. Any policies to stimulate demand would ideally be underpinned by a clear understanding of the interactions and consequences of these different approaches so that the intended consequences were achieved while minimizing unintended ones – including potential interactions with other policies across the domains of agriculture, forestry, water, energy and carbon markets.

Options for encouraging future capital investment

• There are opportunities to use targeted incentives in a similar way in the area of biofuels. To be a viable and sustainable alternative to fossil fuels, a biofuel should provide a net energy gain, possess environmental benefits, be economically competitive, and able to be produced in large quantities with minimal adverse impact on food or livestock feed supplies. Trees, other woody plants (including woody weeds), and various grasses and forbs (broadleaved herbs) can be produced on less productive agricultural land with little or no fertiliser, pesticides and energy inputs and may have hydrological, biodiversity or regional benefits as well as greenhouse gas reductions. These options are good candidates for research and carefully targeted incentive and assistance programs in the near future.
• A set of internationally consistent sustainability criteria (e.g. greenhouse gas emission profile, energy return on energy invested) could be developed around which incentives could be targeted and scaled. The incentives would require a technically defensible and transparent basis, linking production feedstocks and technologies to environmental (or other) target outcomes.
• A full and detailed discussion of the critical area of emerging carbon trading schemes and potential interaction with biofuels was beyond the remit of this report. Interactions between biofuels policies and domestic and international carbon market schemes warrant some serious further investigation.