Renewable fuels: Policy effectiveness and project risk

This paper examines the impact of government policy on the risk profile of a small ethanol production facility. We derive four key results from a simulation model. First, we show that commodity price risk may discourage investment in a project, despite a positive expected rate of return. Second, we show that political uncertainty may have significant impacts on the risk profile of a project. Next, we show that using only production subsidies to attract investors is expensive, since the financial assistance is paid regardless of whether the plant is operating under positive or negative financial conditions. Finally, we show that a capital grant provides a valuable complement to a subsidy, because the grant reduces the amount of value investors must put at risk, and increases their leverage thereby enhancing returns, while the subsidy mitigates commodity price risk. Our results show that compared to a subsidy-only approach, a grant and subsidy combination provides an investment environment with similar downside protection and expected returns for less than 60% of the cost. Further, we show that the two policy tools combined yield a superior investment environment to that created by an equivalent or greater total investment deployed entirely in either of the policy tools without the other.