Taxes

Black Liquor Binge

Bringing an end to the costly and unnecessary Alternative Fuel Mixture Credit

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Thanks to a federal tax credit that was originally introduced in 2005 to encourage motor vehicle users to add a little biomass fuel to their diesel, the stench of rotting eggs that permeates the air in mill towns like Coosa Pines, Alabama and Baileyville, Maine smelled as sweet as perfume this year. That's because the stench results from the incineration of black liquor, and in 2009, burning this sticky, chemical-laced byproduct of the wood-pulping process proved far more profitable to the pulp and paper industry than actually selling newsprint, cardstock, or any of the other myriad products it manufactures. On December 31st, however, the good times come to an end.

In a year where the government famously entered the automobile business and spent months trying to increase its presence in the healthcare industry as well, state support of the pulp and paper industry went largely unnoticed by the general public. On the level of sheer weirdness, and as a case study in unintended consequences, however, it was at least the equal of the more notorious bailouts. In one year, approximately three dozen companies received upwards of $8 billion from the U.S. Treasury for increasing their consumption of diesel fuel when they were supposed to be decreasing it, depressing worldwide paper prices at a time when demand for paper isn't particularly strong, and discouraging the production of recycled paper in the name of environmental sustainability. Oh, and as if that weren't enough, they almost started a war—okay, a trade war—with Canada!

The elixir at the heart of all this drama is a sticky, chemical-ridden substance known as black liquor. To turn trees into the glossy pages of your favorite magazines and catalogs, pulp mills first "cook" wood chips in a broth of sodium hydroxide and sodium sulfide. This extracts the cellulose fibers from the chips that eventually get made into paper; the dark mixture that remains, which consists mostly of lignon and chemicals, is known as black liquor.

In bygone days, and even in more recent times, pulp mills used to dump ?this black liquor into those natural but not terribly efficient recycling bins otherwise known as lakes and rivers. As early as the 1930s, however, the industry had also started incinerating black liquor in recovery boilers. This allowed pulp mill operators to reclaim still-useable chemicals and also to create something that could in turn power turbogenerators. In this manner, they were able to create electricity they could use to run their machinery.

Today, the pulp and paper industry generates approximately two-thirds of the energy it uses through such processes. Some mills produce so much energy via black liquor and other renewable byproducts that they sell it to local ?utilities.

When Senator Chuck Grassley (R–Iowa) proposed a 50 cents per gallon ?tax credit for alternative fuel users as part of 2005's Safe, Accountable, Flexible, Efficient, Transportation Equity Act, he reportedly wasn't thinking about black liquor or the pulp and paper industry. Instead, he wanted to encourage motor vehicle operators to use domestic alternatives rather than imported fossil fuels.

However, while the "Alternative Fuel Credit" section of the statute explicitly states that the credit applies only when the alternative fuel is used in a "motor vehicle or motorboat," the "Alternative Fuel Mixture Credit" section of the statute is not so explicit. It states that the credit applies to any alternative fuel mixture that is "for sale or use in a trade or business of the taxpayer." According to a recent press release issued by Rep. Ann Kirkpatrick (D-Ariz.), Congress "expanded the tax credit to allow non-transportation entities to qualify" in 2007.

While most pulp mills were burning pure black liquor in their recovery boilers, some canny alchemist realized that by adding a small amount of diesel to the process, the black liquor would be transformed into an alternative fuel mixture—and thus quality for the 50 cents a gallon tax credit. In late 2008, at least two companies, Verso Paper and International Paper, applied to the IRS for certification as "alternative fuel mixers" and passed muster. Shortly thereafter, the checks started arriving. In February 2009, Verso Paper received a $29.7 million payment from the IRS for its black liquor usage in the last three months of 2008. In March, International Paper received a $71. 6 million payment for the black liquor it used in a month-long period at the end of 2008.

In a March Securities and Exchange Commission filing, Verso revealed that it had received the payment and that more could be on the way. Two weeks later, JPMorgan analyst Claudia Shank Hueston published a briefing on how the industry at large might benefit from this development. After that, every pulp mill in the country started adding adding diesel to its black liquor and the Treasury Department found itself on the hook for what would eventually amount to billions of dollars.

For pulp and paper companies, these are tough times. Thanks to declines in the construction industry and the subsequent sawmill closings, the price of wood chips has gone up even as demand for paper has fallen. Newspapers are shrinking or disappearing altogether, magazines aren't any healthier, and even junk mailers are showing genuine restraint these days. In good times and bad, digital revolution be damned, we'll always need toilet paper and cocktail napkins—but that's not enough to keep the industry afloat. Over the last two years, it lost 25 mills and 250,000 jobs.

In the early months of 2009, worldwide demand for paper was declining and inventory levels were high. For the companies that qualified for the tax ?credit, however, business had fundamentally changed. Instead of producing pulp and paper for their traditional consumers, they were consuming alternative fuel mixtures for the federal government. In the second quarter of the year, Rayonier earned $79 million for burning black liquor and $28 million for selling its products. In the first three quarters of the year, Clearwater Paper earned $87 million for burning black liquor and $48 million for selling its products. During that time, its stock price rose from $15.50 to $59.31.

"The tax credits give U.S. companies a huge incentive to keep their kraft-pulp mills running full bore and then to turn that pulp into paper, even if it has to be sold at rock-bottom prices," observed the anonymous editor of Dead Tree Edition, a blog that focuses on the production and distribution of print publications. He also noted that mill operators were choosing kraft-pulping over more environmentally friendly methods of pulp production, and surmised that they were likely using such tricks as "cooking" wood fibers longer to maximize their output of black liquor.

In May, Canada, Brazil, Chile, and the European Union sent a letter to Congress threatening trade sanctions against the U.S. in retaliation for the negative ?impact the tax credit was having on global markets. In July, the European Commission accused U.S. paper manufactures of using the no-strings-attached "cash injection" they were getting from the government to "undercut market prices for other wood products" like newsprint.

In response to such criticisms, and as a relatively modest attempt at fiscal restraint, Sen. Grassley and Sen. Max Baucus (D-Mont.) floated the idea of terminating the credit at a Senate Finance Committee meeting in April. Other senators leapt to the paper's industry's defense, however. "Given the gravity of our economic circumstances, do we really want to punish an industry that employs 1.3 million Americans?" asked Sen. Olympia Snowe (R-Maine). "Here's an industry that generates a majority of its own power," exclaimed Sen. Debbie Stabenow (D-Mich.). "We don't want to penalize them."

In less entitled times, words like "punish" and "penalize" were generally associated with phenomena such as jail time, fines, or public floggings. Now, apparently, it's a penalty when the government stops giving companies piles of cash simply for engaging in practices that are inherently beneficial to them. It's a brave new world but a costly one. By the time Alternative Fuel Mixture Credit expires on Thursday, the government will have paid out more than $8 billion to a few dozen companies—and to what end? Smurfit-Stone Container, the second-largest recipient of 2009's black liquor binge, with an estimated take of more than $500 million, is ringing in the new year with permanent mill closures in Frenchtown, Montana and Ontogan, Michigan. Apparently even carbon-neutral fuel can't propel a company into the future if demand for its products is waning.

Contributing Editor Greg Beato is a writer living in San Francisco. Read his Reason archive here.