The New New Thing

Are subsidies wrecking the development of a clean energy source?

Every year, there is a new green technology that triggers eager predictions that the days of gasoline-powered engines are numbered. Last year, it was lithium-ion batteries. The year before that, it was hydrogen fuel cells.

This year's buzz generator—a new biofuel developed by a small Illinois company called Coskata—holds genuine promise to become a cleaner and cheaper alternative to gasoline. But the fuel's efforts to achieve commercial viability will be hurt, not helped, if its well connected investors succeed in convincing the federal government to mandate a distribution infrastructure for it.

Coskata's backers include General Motors CEO Rick Wagoner and Sun Microsystem co-founder and venture capitalist extraordinaire Vinod Khosla. They want every gas station in the country to replace half of their gas pumps with special units known as E-85 pumps. E-85 is a blend that contains 85 percent ethanol and 15 percent gasoline. Like diesel, it must be pumped through a different system than conventional gasoline.

Most ethanol in the United States is produced from corn, but Coskata says that it has found a way to generate ethanol from woodchips and other biomass at potentially half the cost of gas and a third the cost of corn-based ethanol. What's more, it has done so without any research subsidies that many other alternative fuel ventures get. This is especially impressive since such "cellulosic ethanol" has to date been more expensive than corn-derived ethanol. That's because the sugar in corn is relatively easy to extract, while that in wood chips and other raw materials for cellulosic ethanol is hard to reach because it is protected by a rigid cell wall. Breaking down this cell wall has been prohibitively expensive. Until now, that is.

Coskata's breakthrough involves a new thermal process that gasifies biomass (and, in the future, potentially even rubber tires and petroleum coke) to produce something called syngas, a mixture of carbon monoxide and hydrogen. This gas is then fed to Coskata's patented cocktail of five bacteria that turn it into ethanol. Using this method, Coskata says, it can generate more ethanol from less feed and water than corn-based techniques.

Coskata's fuel has a number of other advantages over corn-based ethanol. Since corn doesn't grow everywhere, corn-generated ethanol generated has to be transported. Given ethanol's corrosive and volatile nature, this can't be done through existing oil pipelines. So it has to be hauled in trucks, which adds to its costs (not to mention related greenhouse gas emissions). This is one of the main reasons why the energy-adjusted average price of E-85, whose main ingredient is corn-based ethanol, is currently around $3.53 per gallon-despite a 50-cent per gallon federal tax subsidy for producers. This is still 20-30 cents higher than the price of gas right now when it is at a record high.

What's more, diverting corn for fuel has the undesirable effect of raising food prices. Higher corn prices lure farmers to grow corn over other produce, bumping up prices of fruits and vegetables. Meat-eaters are effected, too, since corn is a major component of livestock feed. Because Coskata's fuel can be produced anywhere, from any sort of plant, it avoids these drawbacks.

Impressive though Coskata's technology is, its market success will ultimately depend on offering pump prices that are about 25 percent lower than gas, since ethanol contains 25 percent less energy than gas. Coskata is confident the pump price of its fuel will be somewhere between 50 cents to $1.00 lower.

But that range spans the difference between market success and failure. Assuming average annual gas prices of $3.00 per gallon, a 50-cent saving won't be enough to compensate consumers for the lower energy content of ethanol-much less offset the $20,000 to $200,000 that gas station owners would have to spend to install ethanol tanks and pumps. Savings of $1.00 might do the trick, but that will require Coskata, which plans to produce 40,000 gallons of fuel by the end of the year, to develop a highly efficient production process.

But its incentive to do so will be vastly diminished if the federal government delivers it a ready market by forcing ethanol on gas stations. This might allow Coskata to capture some market share now, but over the long run its fuel will have a harder time becoming a sustainable alternative to gas, especially if gas prices drop. It will also be less able to compete with foreign ethanol if the federal government slashes tariffs on the stuff. That's a real possiblity, despite the powerful farm lobby, given the interest in promoting greener alternatives to traditional gasoline.

Khosla—an IT revolutionary turned ethanol evangelist—is fully capable of understanding such market realities. He told CNN Money some years ago that he believes in making only small investments in startup companies because too much cash breeds over-confidence and thwarts experimentation. "The right way to build a company is to experiment in lots of small ways, so that you have plenty of room to make mistakes and change strategies," he noted. That's precisely what a guaranteed market for Coskata will prevent it from doing.

It's widely recognized that the government is inept in directing subsidies to market winners. Consider three quick examples: In the 1970s, the federal government pumped hundreds of millions of dollars to develop thermal solar technologies as an alternative to the photovoltic cell. Three decades later, there is nothing even close to being commercially viable. The government also pumped billions of dollars into developing liquid fuel from coal to cut down on our consumption of Middle Eastern oil—another total bust commercially. More recently, in 2003, George W. Bush pumped $1.3 billion into a "Freedom Car" that would run on hydrogen-powered fuel cells. Four years later, the Freedom Car is not even close to being commercially viable and the enthusiasm for those fuel cells has considerably waned.

Ethanol's backers maintain that a government mandate to convert half of all pumps to ethanol is necessary because the major oil companies won't let gas stations install E-85 pumps. But this is a bogus claim. Federal laws, including the most recent energy legislation, prohibit gas station owners and oil companies from discriminating against ethanol. The real reason why stations don't carry ethanol is that it simply does not currently offer the returns to offset the thousands of dollars needed to make them ethanol-ready—much less make up the losses from oil sales.

There's no question that government intervention through taxes, regulations, and subsidies has distorted energy markets and provided oil companies with an unfair advantage. So it is not surprising that even a self-made billionaire such as Khosla with a promising new fuel on his hands should think it's right to demand government help. (Actually, he does this quite often, including last year when he attempted unsuccessfully to convince California voters to impose new taxes on oil to fund research into alternative fuels.) However, mandating a distribution infrastructure for ethanol would take government intervention in energy markets to a whole new level. Worst of all, it will make even promising new companies such as Coskata less able to innovate in a real, ultimately self-sustaining way.

If Coskata's fuel can make it without market-distorting subsidies, it will. The best thing that Washington can do for the company—and, more important, for consumers—is to ignore GM and Khosla's demands.

Shikha Dalmia is a senior analyst at Reason Foundation, a Los Angeles-based, free market think tank.