An Analysis of UK Biomass Power Policy, US South Pellet Production and Impacts on Wood Fiber Markets Prepared for the American Forest & Paper

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1 0915 An Analysis of UK Biomass Power Policy, US South Pellet Production and Impacts on Wood Fiber Markets Prepared for the American Forest & Paper Association

2 The An Analysis of UK Biomass Power Policy, US South Pellet Production and Impacts on Wood Fiber Markets was produced by: Seth Walker Chris Lyddan William Perritt Lori Pilla Economist, Bioenergy Director, Timber Senior Editor, Timber and Biomass Senior Print Production Specialist Disclaimer of Warranty Although RISI, Inc. shall use its best efforts to provide accurate and reliable information, RISI, Inc. does not warrant the accuracy or adequacy thereof. RISI, Inc. MAKES NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO THE RESULTS TO BE OBTAINED FROM THE USE OF ITS SERVICES AND MAKES NO WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. RISI, Inc. SUPPLIES ALL SERVICES ON AN AS IS BASIS. If notified of an error in its Services, RISI, Inc. shall take reasonable steps to correct such error. 2015, RISI, Inc. All Rights Reserved.

3 Table of Contents Introduction... 1 Definitions...1 Key Findings...2 Policy Overview and Analysis of Wood Pellet Electricity Generation in the United Kingdom.2 US South Wood Pellet Production Economics...2 Wood Pellet Market Development and Fiber Consumption...3 Policy Overview and Analysis of Wood Pellet Electricity Generation in the United Kingdom... 3 Renewable Energy Policy in the United Kingdom...4 Policy Outlook for Wood Pellet Generation...8 Wood Pellet Generation Economics...8 US South Wood Pellet Production Economics Pellet Costs, Prices and Profitability...11 Wood Pellet Fiber Paying Capability...13 Wood Pellet Market Development and Fiber Consumption US South Wood Pellet Fiber Consumption...17 Overall US South Woodfiber Supply and Demand...18 US South Industrial Pellet Mill Fiber Furnish...19 Findings...20 Appendix Table UK Biomass Power Generation Economics and Ability to Pay for Fiber at Breakeven iii

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5 Introduction The United States wood pellet market has developed rapidly as demand from Europe, particularly the United Kingdom (UK), has grown. RISI projects US wood pellet exports will increase from 3.9 million metric tons in 2014 to 10.6 million metric tons in 2019, up from 500,000 metric tons in 2010 and 2.0 million metric tons in The purpose of this study is to help the American Forest & Paper Association (AF&PA) better understand the magnitude of current and future UK biomass subsidies. The report is comprised of three distinct sections: 1. Policy overview and analysis of wood pellet electricity generation in the UK 2. US South wood pellet production economics 3. Wood pellet market development and fiber consumption The general approach of the study is to start with the policy and economics of biomass electricity generation in the UK, then move upstream on the supply chain to wood pellet production, then finally analyze markets for biomass feedstocks. From a quantitative standpoint, first we calculate the ability of UK biomass power plants to pay for wood pellets based on the two main subsidy schemes, then use those findings to analyze the ability of US South wood pellet producers to pay for raw material. We also estimate the volume and types of woodfiber to be used to produce wood pellets. Definitions Units of Measure Metric tons (mt) = 1,000 kg Short tons (st) = 2,000 lbs 1 mt = st Green short ton (gst) is a short ton of wood that has been recently cut and has an assumed moisture content of ~50% Gigajoule (GJ) a common unit of energy equal to one billion joules (one joule = one wattsecond) Megawatt (MW) a common unit of electrical capacity or power equal to one million watts Megawatt-hour (MWh) a common measure of electricity production equal to 1 MW of capacity * 1 hour of operation 1 MWh = 3.6 GJ Exchange rate: 1 British Pound ( ) = 1.52 US Dollars ($) Biomass Feedstocks Pulpwood roundwood stems with bark on, up to 55 feet in length to a top size of roughly 2-3 inches Wood chips clean wood ~ 4mm - 8mm thick and up to 45mm length Mill residuals sawdust, shavings and oversize wood chips

6 Forest biomass slash and logging residues or other material unsuitable for sawlog or pulplog harvest, material typically left in the woods except in the case of energy harvest, whether or not at a pulp mill Bark purchased bark from debarking operations at mills Key Findings Policy Overview and Analysis of Wood Pellet Electricity Generation in the United Kingdom Fueled by coal-to-biomass conversions, the UK wood pellet market has grown from 200,000 metric tons (mt) in 2010 to 4.2 million mt in 2014, 60% of this volume is coming from the United States. RISI projects UK pellet imports to increase to 6.0 million metric tons in Renewable energy policy in the UK is in a period of transition, with the main subsidy scheme changing from the Renewables Obligation (RO), a system of tradable certificates, to Contracts for Difference (CfD), a scheme that gives renewable energy producers a guaranteed price of electricity that is generally significantly higher than the market price of electricity. The CfD scheme is more attractive to investors than the RO, but thus far only two unit conversions have been awarded CfDs. Gross margins for pellet-fired generation under the RO are estimated at 12%, down from 18% prior to the removal of a recent subsidy on August 1. The gross margin for pellet-fired generation with a CfD for 105/MWh is 25%. Coal production under our assumptions carries a gross margin of 10%. RISI estimates the maximum ability to pay for wood pellets at $215/mt under the RO and $275/mt with a biomass conversion CfD. US South Wood Pellet Production Economics US South pellet export prices averaged $190/mt delivered to Europe (CIF) in the first half of Pellet mills are typically developed only after an off-take agreement is secured. These agreements have escalators for key inputs including wood costs. In 2015 wood costs account for 50% of pellet mill costs. Average profit margins for US South pellet producers are estimated at 7% in Based on our analysis, the ability of pellet mills to pay for fiber at breakeven under various scenarios are listed below: pellet mill ability to pay for fiber (delivered,mill): Current pellet market prices at $190/mt (CIF Europe): $36.61/green short ton (gst) Modeled contract structure with wood cost indexation: $40.43/gst Maximum under Renewables Obligation scenario: $47.77/gst Maximum under Contracts for Difference scenario: $74.55/gst Accounting for an estimated $22 cut and haul cost, these estimates translate to the following ability to pay for fiber estimates at the stumpage level (note: current stumpage prices of approximately $11/gst): Current pellet market prices: $15/green short ton (gst)

7 Modeled contract structure with wood cost indexation: $18/gst Maximum under Renewables Obligation scenario: $26/gst as compared to the current market price of $11/gst Maximum under Contracts for Difference scenario: $53/gst as compared to the current market price of $11/gst Without a subsidy, UK utilities would lose money (i.e., not break even) if they used pellets as a fuel source to generate electricity. The loss would come to about $26 per short ton of stumpage even before the cost of the wood is factored in. Wood Pellet Market Development and Fiber Consumption RISI's forecast is for fiber consumption from US South pellet producers to increase from an estimated 12.5 million gst in 2015 to 21.3 million gst in 2019, up from 2.2 million gst in 2010 and 5.5 million gst in Hardwood and softwood pulpwood prices have increased moderately from 2011 to the present. US South pellet producers' fiber furnish currently is estimated at 64% softwood pulpwood, 12% hardwood pulpwood, 12% mill residuals and 12% forest biomass. Policy Overview and Analysis of Wood Pellet Electricity Generation in the United Kingdom The industrial wood pellet market in the UK has grown from just 200,000 metric tons (mt) in 2010 to 4.2 million mt in The rapid growth comes as power companies have displaced coal capacity with wood pellets in order to qualify for renewable energy subsidies and reduce their emissions output. The UK market has shown that displacing coal with wood pellets is one of the most cost-efficient means of meeting the country's renewable energy and emissions targets. Initially, utilities displaced small amounts of coal with wood pellets in a process known as co-firing. Pellet co-firing requires relatively little capital expenditure, and renewable electricity production and emissions reductions are credited for the portion of energy coming from pellets instead of coal. In the early part of the decade, a series of policy changes and required permanent closures of coal plants shifted incentives away from co-firing and toward whole unit conversions. Coal-to-biomass conversions are technologically relatively simple; however, they become capital-intensive projects due to the intricacies of dry storage and handling of wood pellets. While coal can be carried uncovered in ships and rail cars, and stored in piles outside, wood pellets require covered transport and storage throughout the supply chain. The most notable coal-to-biomass conversion, at the Drax Power Station, is estimated to cost 700 million (over $1 billion), much of which has been spent on things like storage domes at multiple port facilities, storage at the power plant itself and a brand new fleet of specially designed wood-pellet rail cars. This section of the report analyzes the policy drivers and economics of wood pellet electricity generation in the UK. We show the revenue and cost streams of converted coal units under various subsidy schemes, how those compare to traditional coal fired stations, and quantify converted power stations' ability to pay for pellet fuel under the two main subsidy schemes

8 Renewable Energy Policy in the United Kingdom Transition from the RO to CfDs Renewable energy policy in the UK is in a period of transition. The Renewables Obligation (RO), which was introduced in 2002, is being phased out, however biomass generators that have been accredited under the RO will be eligible for the program until At the same time, the RO is being replaced by a new scheme, Contracts for Difference (CfD). The RO is an example of a Renewable Portfolio Standard (RPS) while the CfD gives renewable energy generators a guaranteed price for electricity that is generally significantly higher than the market price of electricity. The UK government's stated purpose for the switch from the RO to the CfD program is to give "greater certainty and stability of revenues to electricity generators by reducing their exposure to volatile wholesale prices, whilst protecting consumers from paying for higher support costs when electricity prices are high." 1 Enabling Guidance While the RO and its predecessor, the Non-Fossil Fuel Obligation (NFFO), predate the European Union's 2009 Climate and Energy Package s Renewable Energy Directive, 2 since its passage the directive has been the main renewable energy policy driver for EU member states. The aims of the EU's so-called "20/20/20 goals" calls for a 20% reduction in GHG emissions, 20% of energy to come from renewable sources, and 20% gains in energy efficiency across Europe all by In 2014, the EU agreed to an EU-wide target of at least 27% renewable energy consumption by Figure 1 EU National Renewable Energy Targets, 2020 Share of Renewables in Final Energy Demand Austria Belgium Bulgaria Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Romania Slovakia Slovenia Spain Sweden United Kingdom Level in 2005 Target in % 10% 20% 30% 40% 50% 60% 1 https://www.gov.uk/government/collections/electricity-market-reform-contracts-for-difference

9 In order to meet the renewable energy targets, each member state was given its own individual goals based on the country's current energy mix and socioeconomic factors. Some countries such as Sweden already had a significant portion of their energy from renewable sources. Sweden was tasked with increasing its share of energy from renewables from 39.8% in 2005 to 49% in The UK lies on the other end of the spectrum with renewable energy only accounting for 1.3% of its total mix in The UK's target for 2020 is 15%. 3 Each member state had to develop its own National Renewable Energy Action Plan (NREAP) to show how it would incentivize and facilitate these changes. Figure 1 shows renewable energy targets for the EU-27 from the NREAPs. The Renewables Obligation The Renewables Obligation Order of 2002 introduced the RO scheme as an amendment to the UK's Electricity Act. Under the RO, renewable energy producers are issued tradable Renewable Obligation Certificates (ROCs), each of which represents 1 MWh of renewable energy production. Electricity suppliers in the UK are required to source an increasing percentage of their electricity from renewable sources. ROCs are used by suppliers to demonstrate compliance with the RO. If suppliers do not acquire enough ROCs to meet their obligation, they must pay a buy-out price per MWh which is adjusted for inflation each year. Funds from buy-out payments are used for the administration costs of the RO and the remaining amount is redistributed back to electricity suppliers in proportion to the number of ROCs they submitted for compliance. 4 ROC Banding The Renewables Obligation Order of 2009, which came into effect on April 1 of that year, introduced a number of changes to the operation of the Renewables Obligation (RO). The most significant of these was "banding," which established different levels of support for different technologies according to a number of factors, including their level of development. When banding levels are changed, existing generating stations already accredited under the scheme keep the old banding level. The current level of support for a biomass conversion is 1 ROC/MWh. Biomass co-firing qualifies for ROC/MWh depending on the percentage of biomass, while "enhanced co-firing," which is 85% or more biomass, qualifies for 0.9 ROC/Mwh. Greenfield dedicated biomass qualifies for 1.5 ROC/MWh without combined heat and power (CHP) and 2 ROC/MWh with CHP. ROC Prices The RO is unique among RPS systems because of the buy-out option and buy-out fund. Electricity suppliers can either pay the buy-out price or buy ROCs and receive a share of the buy-out fund. Theoretically, the difference between the price of a ROC and the buy-out price should equal the expected share of the buy-out fund. 5 When ROCs are in short supply, as was the case during the first several years of the RO, ROCs are traded at a premium over the buy-out price since generators could expect a share of the buy-out fund. However, when more ROCs are produced than are required to meet the RO, ROCs are sold at a discount to the buy-out price, this was the case in 2014 and so far in 2015 (Figure 2). In the first 3 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/47871/25-nat-ren-energy-action-plan.pdf 4 https://www.ofgem.gov.uk/environmental-programmes/renewables-obligation-ro 5 https://www.stir.ac.uk/media/schools/management/documents/workingpapers/sedp bryan-lange-macdonald.pdf

10 Figure 2 UK Renewables Obligation Certificate and Buy-Out Prices British Pounds per ROC ROC Price Buy-Out Price half of 2015, ROCs averaged on "E-ROC auctions," an online clearinghouse of UK ROC transactions, 6 while the buy-out price was in the first quarter and in the second quarter. Contracts for Difference The Contracts for Difference (CfD) program was introduced as part of the UK's Electricity Market Reform (EMR). The CfD will be offered alongside the RO until it expires on March 31, During this transition period renewable energy generators may choose which subsidy scheme they wish to pursue, though they are not guaranteed to be awarded either. The CfD reduces risk generated by volatility in electricity price markets by providing low-carbon generators a guaranteed price of electricity for the length of the contract (currently 15 years). The CfD provides renewable electricity generators the difference between a measure of the market price for electricity and the strike price, the price guaranteed by the contract, which varies by technology. In 2014 CfD prices ranged from 55/MWh for landfill gas to 305/MWh for tidal and wave energy. The CfD price for biomass conversions is 105/MWh and 125/MWh for dedicated biomass plants with CHP. State-Aid Investigation So far CfDs have only been awarded for three biomass units in the UK: two biomass conversions, Drax Unit 1 and RWE Lynemouth, and a dedicated greenfield plant, MGT Power Teeside. The European Commission (EC) is currently investigating the two conversion CfD contracts to see if they violate state aid rules. The commission is investigating whether the public funds used to support the project are limited to what is necessary and do not result in overcompensation and whether subsidizing such a large volume of wood pellets could significantly distort competition in

11 the biomass market. 7 The MGT Teeside facility has already cleared the EC's state-aid investigation process. Since MGT has not finished construction and Drax and Lynemouth are under EC investigation, at this point no wood pellets have been used to generate electricity that qualifies under the CfD. Levy Control Framework The Levy Control Framework (LCF) is a cap on the amount of public spending on renewable energy projects. The LCF was established in 2011 and is imposed by the Treasury and regulates spending by the Department of Energy & Climate Change (DECC) on the RO, CfD and other renewable programs. The LCF cap is set to rise from 1.8 billion in FY 2011/12 to 7.6 billion in FY 2020/21 (inflation adjusted in FY 2011/12 pounds). However, current forecasts show projected costs at 9.1 billion in 2020/21, 1.5 billion over the LCF cap. As a result, DECC has recently introduced measures to reduce spending on the RO and CfD programs. The RO (already set to end in 2017) was closed to large-scale solar photovoltaic in 2015 and will be closed to onshore wind in DECC recently decided to change its policy on grandfathering for biomass conversions and co-firing under the RO. The move was announced in a position paper on July 21, 2015, 8 and is retroactive to the consultation date, December 12, Under the new policy, support for mid- and high-range (enhanced) biomass co-firing and biomass conversions is removed for facilities that were not already receiving these subsidies prior to the consultation date. The two main exceptions are: 1. Generating stations awarded CfDs and awaiting EC state-aid clearance, or those who are awarded CfDs in the future and will be subject to state-aid clearance. 2. Facilities that were already conducting mid- or high-range co-firing at the time of the consultation have until December 12, 2015, to move to full conversion. In addition to controlling costs of the soon-to-expire RO, DECC must also control the cost of the CfD program. The principal control for the department will be the number of contracts awarded and their strike prices. 9 Climate Change Levy The Climate Change Levy (CCL) was introduced in 2001 as a way to improve energy efficiency and reduce greenhouse gas emissions. The tax is applied to electricity, gas, liquid petroleum gas (LPG) and solid fuels. In FY 2014/15, the CCL for electricity production was 5.41/MWh. Until recently renewable energy producers were awarded Levy Exemption Credits (LECs) for every MWh of electricity produced. These credits offset the CCL paid by electricity suppliers to whomever they sold their renewable power. On July 8, 2015, the Office of Gas and Electricity Markets (Ofgem) announced that as of August 1, 2015, the CCL exemption for renewable sources would be withdrawn. The exemption was removed not only due to budget issues, but also because "since the exemption was introduced, more effective policies have been put in place to support renewable electricity generation" 10 (i.e., ROCs and CfDs) https://www.gov.uk/government/consultations/changes-to-grandfathering-policy-with-respect-to-future-biomass-co-firingand-conversion-projects-in-the-renewables-obligation https://www.gov.uk/government/publications/climate-change-levy-removal-of-exemption-for-electricity-from-renewablesources/climate-change-levy-removal-of-exemption-for-electricity-from-renewable-sources

12 By stopping the issuance of LECs, Ofgem essentially raised the cost of renewable electricity by 5.41/MWh. When the change was announced, Drax lost more than a quarter of its stock value and said the move would cost 30 million throughout the rest of 2015 and 60 million in Policy Outlook for Wood Pellet Generation There are currently five major UK generation units already using, or likely to use, large amounts of wood pellets in the near future. These include Drax Units 1, 2, and 3, RWE Lynemouth and MGT Teeside. Based on the recent ruling regarding RO grandfathering clauses, any additional conversions will be ineligible for the RO and will have to be awarded CfDs by DECC. There is currently a great deal of tension in the UK government s renewable energy policy (the first non-coalition Conservative government since 1992). Since the election earlier this year, the government has taken a number of steps to curb spending on renewable energy subsidies in an effort to reduce the government s budgetary outlays and to control the cost of renewable energy programs to consumers and businesses. These include the elimination of the renewable energy exemption, including biomass energy, from the CCL and ending subsidies for on-shore wind and solar projects. At the same time, the UK is legally obligated to achieve the 15 percent renewable energy target by 2020 set in the EU s Renewable Energy Directive. With press reports that the government plans to shut down all of UK s coal-fired power stations by 2023, the government could consider conversion to biomass power as a relatively low-cost, high-availability source of renewable energy. Under such a scenario, the U.S. South could become a significantly greater source of wood pellets. Wood Pellet Generation Economics In order to quantify the financial attractiveness of wood-pellet-fueled electric generation under various subsidy schemes, we will borrow a term from natural gas markets, the "spark spread," which is a common metric for estimating the profitability of natural gas-fired electric generators. The spark spread is the difference between the price received by a generator for electricity produced and the cost of the natural gas needed to produce it. 12 For this analysis, to compare wood pellet conversions under the RO and CfD with conventional coal we will use the following formula: Revenue Electricity prices for all scenarios were taken from the average daily spot price on the APX Group Power Spot Exchange. 13 The average wholesale price of electricity from January-July 2015 was 40.45/MWh. A biomass conversion under the RO would have generated 1 ROC/MWh and the average price of a ROC over that same period was For a plant burning coal, revenue is equal to the electricity price: 40.45/MWh. For a biomass conversion under the RO, revenue is equal to the electricity price plus the value of a ROC: = 82.99/MWh. Meanwhile, a biomass conversion under the CfD program would generate revenue equal to the "strike price." The strike price is a fixed price for renewable energy generators offered under the CfD program. Under the CfD the subsidy that renewable generators receive is a payment equal to the difference between the strike price and a measure of the market price of electricity. The current strike price for biomass conversions is 105/MWh

13 Table 1 Converted Wood Pellet and Coal Electricity Generation Revenue British Pounds per ROC Wood Pellets RO CfD Coal Electricity Price ( /MWh) Subsidy Value ( /MWh) ROCs ( /MWh) CfD ( /MWh) LEC ( /MWh) Total Revenue ( /MWh) Of note, prior to August 1, 2015, generators under the RO would have also received LECs worth approximately 5.41/MWh. Costs Fuel is the primary cost for any thermal power plant. For this analysis, RISI used average import prices for wood pellets and coal from key selected trade partners. In the first half of 2015, the average price of wood pellets was 123/mt (US$187.50/mt), while coal cost 53/mt (US$80.80/mt). For all scenarios the assumed efficiency is 38%. Wood pellets are assumed to have an energy density of 17 GJ/mt and coal 25.1 GJ/mt. Based on these assumptions, the efficiency adjusted fuel cost for wood pellet burning plants is 68.54/MWh compared with 20/MWh for coal burning plants. Emissions are the next most significant cost for thermal power plants in the UK. The current price of emissions in the UK is 18.08/mt CO2e. This includes the price of emissions on the European Union Emissions Trading Scheme plus the UK carbon price support. Coal emissions Table 2 Converted Wood Pellet and Coal Electricity Generation Costs Average Prices in First Half 2015 Wood Pellets RO CfD Coal Fuel Fuel Price ( /MT) Fuel Cost ( /MWh) Fuel Net Calorific Value (GJ/MT) Plant Efficiency Fuel Consumption (MT/MWh) Efficiency Adjusted Fuel Cost ( /MWh) Emissions Emissions Price ( /MT CO2e) Emissions Intensity (kg CO2e/MWh) Total Emissions cost ( /MWh) Marginal Cost ( /MWh)

14 are approximately 987 kg/mwh CO2e. 14 Wood pellet emissions vary based on the specific supply chains, which have to be audited. The value used in this analysis comes from the upper limit of 240 kg/mwh CO2e established by DECC. 15 Based on these assumptions, the emission cost for wood pellet burning plants is 4.34/MWh compared with 16.22/MWh for coal burning plants. The total variable costs covered in this analysis are 72.88/MWh for wood pellet burning plants and 36.22/ MWh for coal burning plants. Profitability In this study we measure profitability in terms of a Spark Spread. The Spark Spread is calculated as total revenue (power sales + subsidy value) marginal costs (fuel + emissions). This measure is similar to EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). Based on our current analysis, the spark spread for wood pellet burning facilities is 10.11/MWh under the RO and 32.12/MWh under the CfD. Meanwhile, the spread for coal stations is 4.23/MWh. Gross margins for pellet-fired generation under the RO are 12%, down from 18% prior to the removal of the CCL exemption. The gross margin for pellet-fired generation with a CfD for 105/MWh is 25%. Coal production under our assumptions carries a gross margin of 10%. Ability to Pay for Wood Pellets The gross ability to pay for fuel can be calculated by adding together the fuel cost and spark spreads. The gross ability to pay for fuel is 79/MWh (US$215/mt) of pellets under the RO and 101/MWh (US$275/mt) with a 105/MWh CfD. Table 3 Converted Wood Pellet Profitability and Ability to Pay for Pellets Average Prices in First Half 2015 Wood Pellets RO CfD Coal Profitability Spark Spread = Total Revenue - Marginal Cost ( /MWh) EBITDA Margin 12% 31% 10% Gross Ability to Pay for Pellets = Fuel Cost + Spark Spread /MWh /MT $/MT The ability to pay for pellets under both the RO and CfD is higher than the market price of wood pellets from North America, which is about US$187.50/mt. Considering that the CfD offers a higher level of subsidy and more certainty than the RO, it is the preferred scheme for pellet-fueled generators, however the availability of CfDs is limited. 14 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/69554/pb13773-ghg-conversion-factors pdf 15 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/66519/6339-consultation-on-biomasselectricity--combined-hea.pdf

15 US South Wood Pellet Production Economics Pellet Costs, Prices and Profitability The goal of this section is to identify the costs, prices and profitability of the growing US South wood pellet industry and then assess the ability of wood pellet producers to pay for fiber. All costs and prices in this forecast are reported in nominal dollars, now and over the five-year forecast period. Cost and price estimates are based on aggregated data from the RISI and PFI Pellet Manufacturing Survey, interviews with pellet and shipping industry representatives and a North American bioenergy cost survey conducted for RISI. Wood costs were obtained from RISI's North American Woodfiber & Biomass Market Report and forecasted based on RISI's ongoing demand and supply modeling as published in the North American Timber 15-Year Forecast. North American Industrial Export Pellet Market Prices Nearly all industrial wood pellet mills that have been built in North America have been developed with long-term off-take agreements for their production already in hand. RISI does not believe it is possible for an independent developer to secure financing for the construction of a large-scale industrial wood pellet facility without contracts for the sale of the vast majority of production prior to breaking ground. Typical wood pellet contracts are for periods of 5-10 years with indexation for common costs and inflation. Some of the earliest contracts were so-called "cost-plus" contracts where essentially all costs were passed through to the counterparty with a set margin for pellet producers. More recent contracts are constructed to split the risk between pellet producers and European counterparties. Some common indexes for these contracts are: consumer or producers prices (CPI or PPI), diesel prices, and stumpage or delivered wood cost. Many large producers have contracts that are CIF (cost, insurance and freight) delivered to Europe, while smaller producers often sell delivered to a US Port FOB or FAS (free on board or free alongside). Since the majority of wood pellets shipped to Europe from the United States are under long-term contract in US or Canadian dollars, declared value customs data are a better representation of the average prices of wood pellets from North America than any of the euro-based spot price indices for wood pellets. The average price of wood pellets from North America to Europe in the first half of 2015 was $190/mt. RISI forecasts future pellet prices by indexing 85% of the price to PPI and 15% to delivered wood prices, about half of the total share of wood costs on a CIF Europe basis

16 Table 4 US South Wood Pellet Export Market Costs, Prices and Profitability US Dollars per Metric Ton of Pellets Unless Otherwise Specified Prices UK Import Price Total Cost (CIF UK) Transportation Costs Ocean Freight Loading Haul to Port Revenue Mill Realization Price Mill Total Cost Fixed Costs Overhead Depreciation + Interest Variable Costs Energy Labor Wood Other Average Profit Average Profit Margin 16% 13% 13% 16% 14% 6% 7% MWh/tonne for British Columbia; MWh/tonne for US South gst pulpwood/tonne for US South 3 Includes repairs and maintenance, dies and rolls, safety equipment, wood yard costs, liability and fire insurance, taxes and all other supplies Pellet Costs In order to understand the profitability of wood pellet mills, we need to understand their cost structure. This section will analyze the cost structure of the average industrial wood pellet mill in the US South. Transportation Costs Transportation costs from a US South pellet mill to the European market are quite significant. Since pellets are such a low grade/density commodity, transportation costs represent about 22% of the total value of pellets delivered to Western Europe. In addition to ocean freight, hauling pellets to an export port and handling and loading are also significant costs. RISI's estimates for transportation costs were obtained from interviews with North American producers, shipping companies and port facilities. Transportation costs are forecasted using a model that adjusts for inflation and oil prices

17 Mill Costs Wood costs represent the highest percentage of total costs of pellet manufacturing. In 2015, wood costs are 50% of mill costs for producers in the US South. Most US South wood pellet exporters utilize roundwood pulpwood. We assume a yield of 2.24 green short tons (gst) of pulpwood per metric ton of pellets produced. This yield includes wood (mostly bark) burned in the drying process. The pulpwood price forecast comes from RISI's North American Timber Forecast. Economies of scale help industrial pellet producers keep labor, overhead and "other" costs down. There does not seem to be any change in electricity requirements to produce pellets based on scale, but producers in the US South require more energy to process the roundwood. The capital intensive industrial export plants have high depreciation and interest costs. Based on publically available cost estimates for recently constructed mills, our capital expenditure estimate for wood pellet export facilities is $195/mt of installed capacity in Mills in the US South reportedly use five- to seven-year depreciation timelines, matching the length of their contracts. For this forecast, we have assumed seven years for deprecation for these mills. For interest rates, we assume that these well-organized companies with strong financial backing receive seven-year loans at just 100 basis points over treasury yields. A 1:1 debt-to-equity ratio was assumed as well. Profitability The contractual structure of the North American export pellet market based on long-term off-take agreements allows for fairly predictable industry profitability. In 2015, the average profit margin for US South producers is estimated at 7%. These profit estimates are likely below developer and investors expectations, but currency markets are expected to keep industry-wide profitability near these levels in the medium term. We feel these estimates are also reasonable considering the relative safety of long-term, cost-indexed contracts. Wood Pellet Fiber Paying Capability AF&PA has asked RISI to analyze the pellet fiber paying capability of US South wood pellet producers based on the following scenarios: Current market prices for wood pellets RISI's assumptions about typical contract structures with pass-through clauses for wood costs Maximum breakeven pellet prices under the RO Maximum breakeven pellet prices with a CfD Without any subsidies For this analysis we examine a typical firm's ability to pay for wood fiber or what we deem "fiber paying capability", which is the amount that a firm can pay for raw material at a breakeven point. This analysis essentially measures the ability of a firm to absorb wood biomass costs and is an indicator of how competing industries will fare in the competitive wood biomass market. This method can be used as an indicator for industry development and investment. Fiber paying capability (FPC) quantifies an industry sector's ability to compete for fiber. It is essentially the margin left to pay for fiber (measured here in US dollars per green short ton) after all other fixed and variable costs and expected returns on investment have been deducted from the mill-realized

18 product price (Figure 3). It is important to note that FPC is merely a comparative measure and mills may operate when fiber costs are more than their FPC so long as they are recuperating variable costs. Required inputs for this analysis include cost and capital structure for each competing end-user as well as the current mill gate or FOB selling price for the products manufactured. Figure 3 Fiber Paying Capability (FPC) Methodology Sales Price (Mill Realized) - Selling Costs Delivery, Commissions, etc. - Financial Costs Interest, Depreciation, etc. Salary - Fixed Costs Mill OH Maintenance Labor Materials - Variable Costs Energy Chemicals = FPC Ability to Pay For Fiber RISI typically measures FPC on a delivered basis to account for the substitutability of various types of woodfiber (i.e., roundwood, chips, fine mill residuals), particularly for wood pellet production. However, AF&PA has asked RISI also to analyze fiber paying capability at the stumpage level. In order to do so we will subtract a $22/gst South-wide average estimate for harvest and haul cost from our delivered FPC. US South Pellet Export Mill FPC Wood pellet mills generally have a secure revenue stream primarily based on long-term contacts with utilities. These contracts are typically indexed off of key input costs like diesel and stumpage prices. Since some contracts that pellet producers have with their European counterparts have passthrough clauses for wood costs, they can increase their ability to pay for fiber when the market price of that material comes up. Additionally, pellet producers may face substantial penalties if they do not meet the volume requirements in their contracts and will therefore likely operate at breakeven or at a loss in order to meet their contractual obligations during times of market tightness. The primary variable adjusted for each of the scenarios is the revenue per metric ton of wood pellets. Transportation costs of $42/mt are subtracted from the CIF delivered cost of wood pellets to the UK. Mill costs are static with the exception of wood costs for our "typical contract" scenario

19 (where they vary as fiber costs rise). Total costs for US South industrial pellet mills are estimated at $137/mt in 2015, with wood costs accounting for $69/mt ($31/gst). Scenario Analysis Table 5 US South Pellet Mill Fiber Paying Capability - Scenario Analysis Current Pellet Market Prices Modeled Contract Structure RO CfD No Subsidies Pellet Price CIF UK Transportation Costs (42.00) (42.00) (42.00) (42.00) (42.00) FOB Mill Realization Price Total Costs (Excluding Wood) (66.00) (68.00) (66.00) (66.00) (66.00) Ability to Pay Per MT Pellets (9.22) Per ST Delivered Woodfiber (4.12) Less Harvest and Haul (22.00) (22.00) (22.00) (22.00) (22.00) Per ST Stumpage (26.12) 1. Current Market Prices RISI estimates the price of wood pellets imported into Europe from North America at $190/mt, leaving mill realization price at $148/mt at current freight rates. Ability to pay for fiber is currently $82/mt pellets, which translates to $37/gst of delivered woodfiber including $15/gst for pulpwood stumpage. The South-wide average price of pulpwood stumpage in 2015 is $11/gst. 2. Typical Contract Structures Typical long-term contracts for wood pellet mills often include escalators for changing wood costs. These escalators are structured to account for some, but not all, wood cost changes. Whereas wood costs typically account for about 30% of the total delivered cost to the UK, RISI's modeling of pellet costs, prices and profitability indexes 15% (about half) of the CIF UK price of pellets to wood costs. The remaining 85% of the delivered-to-europe price is indexed off the producer price index (PPI). Since the final contract price has wood cost escalators, when the cost of fiber goes up, so does revenue and therefore FPC. However, since the 15% indexation does not account for all of the potential changes in wood costs, the maximum FPC occurs when wood costs and FPC are equal (Figure 4). In our model this is at a market price of $40/gst for wood delivered to the pellet mill, or a total wood cost of $91/mt of pellets. Extending this analysis to the stumpage level, the maximum FPC of pellet mills with typical contracts is $18/gst in

20 Figure 4 Calculating Maximum FPC Based on Modeled Contract Structure Pellet Price, US Dollars per Metric Ton Wood Costs FPC Maximum FPC Delivered Wood Price, US Dollars per Green Short Ton 3. FPC Based on Breakeven Pellet Prices under the RO In the "Policy Overview and Analysis of Wood Pellet Electricity Generation in the United Kingdom" chapter of this study, we established the breakeven ability of UK utilities to pay for wood pellets under the RO at $215/mt in Based on this pellet price, US South pellet producers would be able to pay approximately $48/gst of delivered fiber or $26/gst of stumpage at breakeven. This compares with current average pulpwood stumpage prices in the South of about $11/gst FPC Based on Breakeven Pellet Prices with a Biomass Conversion CfD In the "Policy Overview and Analysis of Wood Pellet Electricity Generation in the United Kingdom" chapter of this study, we established the breakeven ability of UK utilities to pay for wood pellets with a 105/MWh CfD at $275/mt in Based on this pellet price, US South pellet producers would be able to pay approximately $75/gst of delivered fiber or $53/gst of stumpage at breakeven. This compares with current average pulpwood prices in the South of about $11/gst FPC without Any Subsidies Without any subsidies, the ability of a UK utility to pay for pellet fuel is the price of electricity minus the cost of emissions ( 40.45/MWh /MWh = 36.11/MWh). Converted to US dollars per metric ton based on 17 GJ/MWh and 36.11/MWh results in $98.78/mt of wood pellets. Less transportation costs, this leaves an FOB mill realization price for US wood pellet producers of $56.78/mt, which is less than the production cost of wood pellets without even accounting for wood costs. Hence, UK utilities/pellet producers would lose $26 per gst without even factoring in the cost of the stumpage. 16 Although we have accounted for both fixed and marginal costs at the pellet mill, the maximum ability to pay for pellets under various subsidy schemes was calculated using spark spreads that do not include fixed costs or smaller variable costs like labor, and maintenance at the UK utility

21 Wood Pellet Market Development and Fiber Consumption The United States wood pellet market has developed rapidly as demand from Europe, particularly the UK, has grown. Industry growth is concentrated in the US South. US wood pellet exports are expected to increase from 3.9 million metric tons in 2014 to 10.6 million metric tons in Wood pellet production by industrial mills in the US South is projected to increase by a compound annual growth rate of 15% per annum throughout the same period. While some exports will come from smaller conventional mills that rely on fine mill residuals throughout the US, the vast majority of increased exports will be produced by southern industrial pellet mills. Our forecast is for production from industrial export mills to increase from 3.4 million metric tons in 2014 to 8.7 million metric tons in Figure 5 US Wood Pellet Production Million Short Tons Northeast North Central West South - Conventional South - Industrial Export US South Wood Pellet Fiber Consumption In the US South, wood fiber consumption by pellet producers is projected to increase 14% annually from 2015 to In this chapter we discuss the impact of increased wood fiber consumption by bioenergy on regional supply and demand balances in the US South. Supply and forest product industry demand estimates were obtained from RISI's North American Timber 15-Year Forecast. We estimated the total low-grade wood fiber supply available. This excludes roundwood harvested for lumber, plywood or poles. For supply concepts, the "operable supply" of pulpwood measures the volumes of wood biomass that are both accessible and recoverable at reasonable costs (i.e., commercially available) in a given year. Forest biomass estimates are aggregate volumes produced during harvest and silviculture activities with no adjustment made for accessibility and economic recoverability. Residual chip and mill residual operable supply is assumed to be equal to production. Our estimation of the supply potential for urban wood waste assumes only a fraction of total wood waste generation will be available in sufficient scale to be a cost-effective and quality source of supply

22 Overall US South Woodfiber Supply and Demand RISI estimates demand for wood fiber from bioenergy industries will grow at 11% annually from 2015 to Concurrently, there will be a resurgence in the oriented strand board (OSB) markets, spurring 6% annual growth in roundwood consumption by that industry from Pulp output in the US South is expected to remain flat throughout the forecast period. In aggregate, the US South's demand for all pulpwood and lower-grade feedstock will increase 2.2% annually from According to RISI's North American Timber Forecast in real 2014 dollars, US South pulpwood stumpage prices increased from a low of $8.84/gst for softwood and $7.34/gst for hardwood in 2011 to $11.27/gst for softwood and $11.48/gst for hardwood in 2015 (Figure 6). Table 6 Woodfiber Demand US South Million Dry Short Ton Woodfiber Consumed by Forest Products Industry Pulp, OSB, Other Panels Figure 6 US South Pulpwood Stumpage Prices US Dollars per Cord - Inflation Adjsuted Softwood Hardwood

23 US South Industrial Pellet Mill Fiber Furnish Introduction and Definitions Fiber furnish in the US South pellet sector currently involves a variety of sources, forms, origins and (sometimes confusing) definitions. Factors influencing an individual mill's furnish include procurement strategies and logistics, competitive local forces and costs, converting mill systems, end-product requirements, sustainability concerns and more. Pulpwood is the predominant source of fiber used to make pellets in the US South. Secondary sources are fine mill residuals and forest residues. Regarding mill residuals, of the pellet facilities already in operation, several are aligned with sawmills and therefore consume high proportions of mill residuals (and little, if any pulpwood). However, the much larger, stand-alone facilities (in development and already operating) do, in fact, consume predominantly pulpwood. Going forward, the overall share of pulpwood furnish will grow, relative to mill residuals, as production shifts to larger industrial facilities that rely more predominantly on pulpwood. It is important to note, there is some level of mislabeled product flowing into pellet mills currently. In particular, some operators define certain volumes of purchased pulpwood in the form of in woods grindings that are mixed with biomass as entirely forest biomass when in reality a significant portion of that supply is pulpwood. This mislabeling adds confusion and complexity to the objective measure of overall pellet furnish. Pulpwood Traditional pulpwood (roundwood stems with bark on, up to 55 feet in length to a roughly 2-3 inch top size) account for the largest share, by far and for some pellet mills nearly 100% of furnish. For this report, that volume type is defined as pulpwood. Forest Residues Forest Residues (slash or harvest residues) is material too small or poor quality for pulp. Forest biomass is traditionally used as boiler fuel at pulp mills and stand-alone biomass power plants. Forest residues are recovered in two ways. Currently, the majority of what we consider forest residue pellet furnish is material mixed together with pulpwood and delivered directly from the woods from active, one-pass logging operations. Virtually none is derived from inactive, post-harvest sites, i.e., recovery of biomass or residues left behind from prior harvests. A portion of this furnish includes mixing-in residue stems with loads which are otherwise mostly pulpwood stems. This residue harvest is derived in concert with active pulpwood harvest. However, it is not a viable supply source on a stand-alone basis, meaning in general without the concurrent pulpwood harvest, biomass is too limited in volume and too costly to be economically viable. A portion of this material is considered forest biomass while much of it is traditional pulpwood. The other, smaller source of forest residues results from in-woods drum chippers producing truck loads of custom pellet chips or "micro" chips (typically half the size of traditional pulp chips). Here, biomass stems are mixed with pulpwood in in-woods chippers

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