Want to trade renewable fuel markets? What You Need To Know In Five Questions & Answers
Renewable fuel markets are going through a historic and perhaps pivotal period in the United States and beyond. The EPA’s RIN markets posted record prices this spring and continue to see volatility related to policy and legal developments. Meanwhile, established markets in California and Oregon continue to move steadily onward. And Washington state is now building the third state-based clean fuels program, after recent passage of its comprehensive carbon and fuels legislation. Our interview with Nathan Clark, Managing Director of North America at IncubEx, explores what is driving these markets and what to look for next in this exciting and growing marketplace.
Q: Let’s start with an overview of the state and national renewable fuels markets and drill down from there. What are some of the key themes or trends you see in state and EPA markets?
The key trend is the overall expansion of renewable fuels programs in the US, Canada and globally right now and that is at the state, regional and federal level.
And in many ways, the policy risk around RINs has been mitigated for some of the project developers by this proliferation of LCFS programs at the state and regional levels. So, if you are an ag-methane project developer you were probably looking for carbon offsets and D3 RINs historically, and you may have received those RINs with some degree of policy uncertainty. But now, you have a larger suite of potential environmental markets and environmental attribute monetization at the state level given the development of the LCFS/ OR CFP programs and the possibility of additional low carbon fuels markets in Canada and other states. That should make those projects much more economical and I think you are seeing that with the increase in capital flows.
On the other hand, the policy uncertainty around the EPA’s Renewable Fuel Standard (RFS) Program doesn’t seem to be quite as extensive as under the prior administration but it’s still there. The recent announcement from the Biden administration that they are putting off releasing the new RVO numbers has an impact on RIN market volatility. A fully-integrated refiner may be able to weather that storm more easily. But for those who aren’t, those RIN price fluctuations are likely having a big impact on how they are making business decisions. When you have the market moving that much in such a short time horizon, that volatility is going to have an impact on planning.
That is an ideal scenario for futures, where your need to hedge is greater than it ever has been. So the timing for these products is good. It’s just a matter of getting the proper adoption and attention of folks who have been doing it one way for a long time. It’s an education process but the timing is right.
Q: The RIN markets posted record prices earlier this year. What drove that?
At IncubEx, we are price agnostic and do not forecast price but generally speaking there are some policy, legal and fundamental drivers here. This is also where RINs and LCFS markets begin to diverge as the policy environments and regulatory structures differ greatly. All environmental markets have policy and regulatory structure as a price drivers but the difference between LCFS and RINs is that LCFS has longer-term certainty with respect to the program framework and environmental targets. There are political forces on both sides of the RFS program constantly trying to strengthen or weaken the RVO targets in one way or another. Significant developments like adjustments to the RVO or other aspects such as the status of small refinery exemptions usually impact price materially. Regarding SREs, the US Supreme Court ruled in June that small refinery exemptions can be granted by the EPA, even if those exemptions lapsed in prior years. Minus that, you see other fundamental drivers like ag market fundamentals on feedstocks, natural gas pricing and crude and refined product prices, fuel demand, etc.
Q: Are you seeing continued correlations to other markets?
There are a number of price relationships worth noting in the RIN markets. Market participants keep a close eye on prices in crude, RBOB and heating oil as well as key crack spread ratios for crude, gasoline and heating oil such as 3–2–1 and 5–3–2 ratios. RIN costs are factored into those.
Grain prices are also key markets for RINs as well. Corn is the biggest feedstock for D6 RINs and derived distiller’s grains (basically corn crush) is also important. Other commodities such as distiller corn oil, soybean oil for biodiesel and glycerin are also key markets to watch.
So these market fundamentals continue to play a role in renewable fuels markets despite the policy uncertainty.
Q: It has been a volatile year because of those issues in the RIN space. What are we seeing in terms of volatility in the RIN and LCFS markets?
If policy is one of the biggest drivers, then you have two good case studies. You have policy certainty in the LCFS and volatility has been pretty low. Contrast that with RINs where policy framework is seemingly having a bigger impact.
Hedging price risk out the curve in the LCFS markets may be attractive for developers, especially from a project finance perspective and price caps are another major factor there. That is also true for developers in the D3 and D4 RIN market where we saw new all-time highs in price.
Past experience developing standardized contracts for environmental commodities such as in the EU carbon market and a broad range of environmental commodities in North America would suggest that these contracts will prove extremely effective tools for navigating the RINs and LCFS markets to manage risk and create capital efficiencies.
Q: RINs have garnered most of the recent headlines but there is much happening at the state level. Give us your view on what we’ve seen there and what other fuel markets on your radar.
You have a pretty sound case for clean fuels markets that could cover almost half the country’s population. The Transportation Climate Initiative (TCI) includes states that are heavily populated on the East Coast. They all released a statement of their desire to work on TCI. Couple that with the development of the Canadian market, plus active markets in California, Oregon with Washington coming in 2023 and potentially into New Mexico — that’s about half the cars on the road. The Canadian Clean Fuels Program is similar to those in California, Oregon and British Columbia and is a national program that is scheduled to start in December 2022.
LCFS markets are great to incentivize project development and offer optionality on where to sell the fuel. Those programs are agnostic to technology and projects have their own carbon intensity (CI) score. There is an incentive to find the lowest CI fuel. If you have a dairy farm or a landfill, you can take that waste stream and create compressed natural gas or offset diesel emissions or even go beyond that. All of that is taken into account when calculating and confirming that CI score, which incentivizes developers to keep investing and innovating.
These markets have largely matured in the OTC market. The next phase is the futures market, bringing OTC transactions to exchanges as you see more commercial hedgers realizing the benefits which will in turn broaden the scope of participants in the market. There are a lot of counterparty credit considerations and material balance sheet implications so that provides a strong motivation to move to an exchange cleared contract. So we’re seeing more interest, particularly as more firms from the broader investment community move into this space. Many of those folks have fairly sophisticated trading backgrounds so the market dynamics are starting to evolve.
It’s similar to the early days of the emissions markets with SO2 and NOx, which were traded OTC for many years. Over time, futures contracts picked up a lot of momentum and we saw a lot more cleared deals on the exchange. We believe these markets will follow many before them and evolve with blocked trades and clearing playing a larger role. That’s beneficial to the market because you are decreasing counterparty risk and freeing up bilateral credit lines so companies can trade more with each other. Every other environmental commodity where we have developed exchange traded products in has followed a similar playbook.
Nathan Clark serves as Managing Director of IncubEx and was previously a Managing Director at Environmental Financial Products, a firm that specializes in inventing and developing new financial instruments for the environment.