If Lee Lynd has his way, we’ll soon be filling our tanks with fuel made from wood chips, switchgrass, and cornstalks. Mr. Lynd is the head of DartmouthCollege’s biofuel research group, the largest U.S. academic group devoted to biomass conversion. Last year, with the help of some $4 million in venture capital from famed venture capitalist and alternative energy enthusiast Vinod Khosla and expertise from biotech whiz Colin South, Mr. Lynd founded Mascoma, a company that hopes to get cellulosic ethanol (made from plant and tree waste) into our cars—and into the mainstream (see profile, p. 35).

The rise of venture-backed companies like Mascoma, as well as competitors Iogen and Abengoa, proves that cellulosic ethanol is no longer the realm of environmentalists and academics. Prominent business leaders like Virgin Atlantic Airways CEO Richard Branson and Microsoft founder Bill Gates are investing in the technology, and its champions include everyone from Christian evangelicals concerned about global warming to political conservatives such as U.S. President George W. Bush and R. James Woolsey, a Booz Allen Hamilton vice president and former CIA director who uses solar power to run his small farm.

“We’ve got the tree-huggers, the do-gooders, the sod-busters, the cheap hawks, the evangelicals, and Willie Nelson [in favor of biofuels],” Mr. Woolsey says. “Now I probably ought to add the Silicon Valley entrepreneurs and the venture capitalists.”

Long limited to small volumes, ethanol could finally come into its own thanks to cellulosic technology, which generates ethanol from agricultural waste like switchgrass, corn stover (cornstalks), and sugarcane bagasse. Cellulosic technology could make the fuel cheaper, more available, and more sustainable—and could finally help ethanol take a bite out of the world’s 84-million-barrel-per-day oil habit.

But that dream is still a long way from reality. So far, only a handful of pilot plants and one demonstration plant have been built. And then there are the difficulties of growing and collecting cellulose crops, transporting the fuel (ethanol can’t be transported through existing oil pipelines), persuading gas stations to dedicate pumps to ethanol, and expanding the number of cars that can use ethanol fuels.

Despite these challenges, cellulosic ethanol startups are determined to turn the concept into a profitable business (see startup profiles, p. 34). “There is a small ecosystem of startups that’s emerging around cellulosic ethanol,” says Joel Makower, a principal at research firm Clean Edge.

Ethanol Primer

Ethanol is a high-octane biofuel that is blended with gasoline and used in vehicles; it’s the same alcohol used in many alcoholic beverages and fragrances. In Brazil, ethanol makes up more than 40 percent of transportation fuel—by far the highest percentage worldwide. Brazil’s ethanol program launched in 1975 after the cost of its oil imports tripled in 1973, and world sugar prices fell sharply in 1974. Ethanol production increased there more than 500 percent between 1975 and 1979, and reached 4.23 billion gallons in 2005, according to a report by David Sandalow, a director at the Brookings Institution, a research and policy organization in Washington, D.C.

Aside from Brazil, demand for ethanol as a fuel remained low throughout the last decade, limited mostly by its price. It simply made no sense to make ethanol for fuel when oil cost less than $20 a barrel. Producers had little incentive to make ethanol, either. Take India, for example. A ton of sugarcane there costs about $31 to produce, and can be turned into 70 liters of ethanol, fetching $39, or 105 kilograms of sugar, fetching $47, according to Business Brains, an ethanol and biodiesel consultancy in Kolhapur, India.

Today, the situation has changed. With oil prices at $70 a barrel, ethanol is attracting a second look. According to New Energy Finance, 36 new commercial ethanol plants were financed worldwide in 2006, compared with 25 in 2005 and seven in 2004. And although the U.S. uses far less ethanol than Brazil, it actually was the No. 1 producer in 2005, with production growing more than 20 percent to 4.26 billion gallons, according to Mr. Sandalow. China is the No. 3 producer, making just shy of 1 million metric tons in 2005, a number expected to at least double by 2010.

Supply Constraints

Despite these advances, traditional starch-based ethanol’s growth is limited by the supply of farm crops, and the technology has met resistance from nations that would rather eat their crops than power their cars with them. In China, for instance, news that the country became a net food importer for the first time in 2004 set off a mini-crisis in Beijing, where food self-sufficiency has traditionally been a sacred cow.

“To make it out of food crops doesn’t make sense in the long run,” says Rona Fried, editor of the green investing newsletter Progressive Investor. “Not only is there limited land, but people need to eat more than they need to use fuel.”

The U.S. Energy Information Administration estimates that 20 percent of the land in Europe and the United States would be needed to grow crops to produce enough biofuel to replace 5 percent of gasoline and diesel. The U.S. Department of Energy estimates that starch-based ethanol production will top out at 12 billion gallons a year unless the industry taps into food crops—far less than the 60 billion gallons per year needed to meet the country’s goal of replacing 30 percent of its transportation fuels with biofuels by 2030.

No wonder cellulosic technologies that enable the industry to make ethanol from agricultural waste instead of food crops are getting so much attention.

In 2004, Ottawa, Ontario-based Iogen completed the first cellulosic demonstration plant using an enzyme-based process. The company plans to be first out with a commercial plant with a production capacity of 20 million gallons per year in September 2007. Meanwhile, Abengoa and Celunol are currently building demonstration plants in Spain and the U.S., respectively, both using a steam-explosion processing technology from SunOpta, an organic and natural food company developing cellulosic technology.

Newcomer ClearFuels, with a steam reformation process, hopes to build its commercial-scale demonstration plant by the end of this year, and BioEnergy—which wants to make lactic acid and other co-products simultaneously with ethanol—expects its first two biorefineries to be completed in 2008. Pune, India-based ethanol plant equipment manufacturer Praj Industries has a multi-feed technology for starch-based ethanol and is also working on cellulosic ethanol, although it refuses to specify a timeline to commercial availability. And though its business model has been maligned in the blogosphere, Xethanol is also a contender, with plans to build a 50-million-gallon plant in Augusta, Georgia, that should be in operation by “mid-2007.”

While Europe is more focused on biodiesel than ethanol, Volkswagen, Shell, and Iogen recently completed a feasibility study for the production and sale of cellulosic ethanol made from wheat husks in Germany, finding that the fuel had fewer emissions and was “cost competitive in the transport sector.”

Commercialization is the next step, though cellulosic ethanol likely won’t be on the market until 2008 at the earliest—and 2020 at the latest—say observers. “The only reason cellulosic ethanol has not yet become commercialized is because of a lack of financing for the first project,” says Stephen Gatto, CEO of biotechnology startup BioEnergy (see profile, p. 34). “Everyone wants to be first to be second.”

Most investors not only want to see a proven concept before sinking money in cellulosic ethanol plants, they are also concerned that ethanol could suffer if feedstock prices rise or fuel prices fall. Despite these risks, venture capital, private equity, and government funding has stepped up in the last two years. Asset financing for ethanol grew to $4.13 billion in 2006, compared with $2.08 billion in 2005 and a mere $278 million in 2004, according to London-based research firm New Energy Finance.

Not Yet Coming to a Pump Near You

Before cellulosic ethanol winds up in our gas tanks, producers will have to figure out how to bring costs down to what drivers are likely to pay. Nobody knows for sure what cellulosic ethanol will cost to produce at higher volumes. With current technology and scale, estimates run between $3 to $4 per gallon, says Blake Simmons, a chemical engineer and principal member of the technical staff at Sandia National Labs. Since ethanol gets only 60 percent the mileage of gasoline, it remains much too expensive to be viable as a consumer fuel.

Government policies—including incentives—may help bridge the price gap until production costs can be reduced. Most ethanol entrepreneurs are focused on lowering the costs by simplifying production, increasing the amount of ethanol made from the same amount of feedstock, cutting the cost of enzymes, or finding ways to use cheaper feedstocks (see “Digesting the Technology,” p. 34).

And, of course, cellulosic ethanol will remain a pipe dream until it is embraced by carmakers and gas stations. The chicken-and-egg problem is that the majority of gas stations won’t distribute ethanol until there are enough cars to make a market for them. Still, stations selling ethanol in the U.S. grew from 238 in January 2005 to 797 today.

Ethanol also faces potential competition from biobutanol, biodiesel, and other emerging fuels. Diesel already gets better mileage than gasoline, and biodiesel could be used in any diesel car with no changes, says Nicholas Parker, chair of the Cleantech Venture Network. In June, BP and DuPont announced a partnership to develop biobutanol, which could get better gas mileage than ethanol and be transported in oil pipelines.

These fuels aren’t necessarily competitors, says Murray Burke, vice president and general manager of SunOpta, which is working on both biobutanol and cellulosic ethanol. Biobutanol can also be used in conjunction with ethanol, increasing the performance of ethanol-gasoline blends, he says.

With all those potential detours, the road to cellulosic ethanol could be long and bumpy. But with so much innovation happening, and with avid backing from leaders as varied as the U.S. president, business leaders, environmentalists, and investors, its chances of leading us to a future where cars run on biowaste appear better than ever.

“Clearly, there’s a lot of sorting out to do here,” Clean Edge’s Mr. Makower says. “But I think ethanol is better positioned than a lot of other fuels to gain widespread consumer acceptance. People get it and they accept it.”

---

Finding the $weet $pot…

Biofuel vexes VCs

There’s little doubt that alternative fuels, ethanol in particular, are attracting a great deal of venture capital interest. But few VCs have yet to figure out how to create profitable alternative fuel companies.

In fact, venture capitalists have long deemed biofuel companies as incompatible with venture-style returns. Now, with IPOs of all kinds a rare event, VCs’ time horizons have been lengthened to the point where long-term ethanol plays look appealing. Biofuel companies are still expensive businesses to start and grow, but a newfound interest in gasoline alternatives has spurred venture investors to reconsider the sector.

First, though, they have to figure out which alternative fuel to get behind. Corn-based ethanol? Cellulosic ethanol? Biodiesel? Each has its merits.

If there is a poster-child for ethanol investment, it’s probably Altra, a biofuel company that managed to attract $170 million in funding from top-flight venture firms like Kleiner Perkins Caufield and Byers and Sage Capital Partners. KPCB chose Los Angeles-based Altra because it’s a national leader in ethanol production, according to partner John Doerr. “Its unique, proprietary technology and strong, passionate team make it a sustainable, high-impact business,” Mr. Doerr says.

Then there’s Vinod Khosla, former general partner at KPCB, who founded Khosla Ventures in 2004. He has emerged on the ethanol scene as an influential personality in the clean fuels sector, and he isn’t above playing politics by bankrolling alternative energy ballot initiatives.

That said, he is also bankrolling companies. Besides Altra, where he co-invested with KPCB, he has also backed three other ethanol companies: Mascoma, which is developing technologies for coaxing ethanol from cellulose (see profile, p. 35); Cilion, an operator of modular ethanol plants; and Praj Industries, an Indian company offering fermentation and distillation technologies.

Not all venture capitalists are sinking money into biofuels, however. Over the past year, Chuck McDermott, general partner at RockPort Capital Partners, has seen a lot of biofuel companies, but hasn’t found one in which to invest.

“We’ve looked at a dozen biofuel deals, but we haven’t been able to find a classic VC deal,” says Mr. McDermott. “There’s not a lot of technology in ethanol. Catalysts are slightly different, but it’s the same with biodiesel. It’s really a cooking class. We’ve not found venture returns there.”

Another red flag for VCs is valuation. When sectors get crowded—which many observers believe the ethanol field to be—valuations tend to get overheated. This particularly concerns Mark Donohue, general partner at Expansion Capital Partners. His firm recently closed its second Clean Technology Fund, with $55 million in the coffers.

Ethanol may be the clean fuel du jour, but VCs like Mr. Donohue worry it is already overexposed as an investment opportunity. “I think ethanol has a great growth story ahead of it, but we feel the valuations of ethanol companies are too high, and that biobutanol is going to be the ultimate winner in the space,” says Mr. Donohue.

He believes biobutanol—which is closer to gasoline in composition and can be produced by fermenting biomass such as sugar beets, corn, straw, and corn stalks—is a better long-term bet than ethanol. One reason biobutanol may come out ahead is that it’s ultimately easier to use. Ethanol needs to be blended, whereas biobutanol can be dumped directly into the gas tank.

Ethanol may still turn out to be a widely used fuel, but that doesn’t mean it will necessarily be a profitable investment for venture capitalists. After all, the sweet spot for VCs has always been technology, and many ethanol producers are more like manufacturers than technology firms.

“If we can find a technology in fermentation that whole groups of ethanol producers would want to adopt, that’s an attractive opportunity for us, rather than investing in one ethanol producer,” says Mr. Donohue.

Contact the writer:JKho@RedHerring.com

del.icio.us

Digg this

Slash it