The Development of Forest-Based Biorefineries: Implications for Market Behavior and Policy

The Development of Forest-based Biorefineries: Implications for Market Behavior and Policy

Patrik Söderholm and Robert Lundmark Abstract and the use of biomass is expected to constitute a major In a forest-based biorefinery, the entire potential of share of the future total use of renewable energy sources forest raw materials and byproducts may be used to pro- in Europe (European Commission 1997, 2006). Essential duce a diverse set of products, including transport fuels, components of national energy policies in Europe, there- chemicals, and pulp and paper products. This paper ana- fore, include not only direct promotion of renewable ener- lyzes the general impact on forest raw material markets gy technologies (e.g., investment and R&D support), but following an increased diffusion of biorefineries and high- also carbon dioxide taxes and emissions trading in carbon lights a number of related public policy issues. The analy- dioxide allowances that discourage the use of fossil fuels. The transition from a fossil fuel-based to a carbon-free sis indicates that the character of forest raw material sup- energy system may have important consequences for the ply, in particular the distinction between main products use of raw materials in society, not the least in cases of and byproducts, will have a major influence on the func- agricultural and forest-based resources. Increases in the tioning and the organization of future forest products mar- relative prices of fossil fuels affect a large number of indus- kets. Moreover, the advent of new uses of forest-based bio- trial and end-use sectors of the economy. The reliance on mass will foster an increased competition for (and thus new energy carriers and materials could even induce fun- higher price of) this resource. An important policy lesson, damental structural and technological changes in the way however, is not to directly regulate the allocation of forest goods and services are produced and supplied. resources between different sectors or promote a certain This paper focuses on a potentially critical change in industrial structure. The rationale for policy intervention the way forest resources will be processed and used in the lies instead in identifying situations in which essential future, namely the development of biorefineries. A biorefin- societal costs and benefits do not enter the private deci- ery is a parallel to a petroleum refinery in which a feedstock sion-making process. The presence of external environ- (crude oil) is converted into fuels and selected market prod- mental costs (e.g., damages to the climate) and the public ucts (e.g., fertilizers and synthetic materials). In a biorefin- spillover effects from R&D and innovation activities pro- ery, however, biomass (plants and plant-derived material vide such rationales, but at the same time require careful based on photosynthesis) would be used as feedstock to analysis prior to the introduction of specific policy instru- produce a diverse set of products (e.g., animal feed, fuels, ments. Overall there exists a need to create a better under- energy, pulp and paper, fuels, or chemicals) depending on standing of the linkage between energy and forest products markets, with new co- and byproducts included. The authors are, respectively, Professor ([email protected]) and Associate Professor, ([email protected]), Economics Introduction Unit, Luleå University of Technology, SE 971 87 Luleå, Sweden. This An essential component of the European Union’s ener- paper was received for publication in March 2008 and has been gy policy is the promotion of renewable energy sources, through the Journal’s peer-review process. Article No. 10468.

I6 JANUARY/FEBRUARY 2009 the resource inputs and the processing techniques used. useful to highlight a number of general market develop- Biorefineries can be based on either agricultural (Audsley ments and policy issues that should constitute the basis and Annetts 2003) or forest-based raw materials (Van for future economic and social scientific work on forest- Heiningen 2006). A major benefit of integrated forest-based based biorefineries. Also some of the key issues present in biorefineries is that they can make use of the infrastructure the Swedish case are highlighted. at existing chemical pulp mills; and, at the same time, they The paper is organized in the following sections. The utilize a larger share of the wood components to produce a next section briefly presents the concept of an integrated diverse set of chemical products and energy carriers in addi- forest biorefinery with particular emphasis on the flow of tion to pulp. To a large extent, the existing pulp industry is forest raw materials and the end products that can be gen- already a multi-product industry producing electricity, heat, erated. Then, changes in forest products market behavior and other products in addition to pulp. With the develop- are analyzed with a focus on the supply of different types ment of new technologies, however, a large number of addi- of products as well as the potential for increased competi- tional products may be processed and generated in integrat- tion for the forest raw materials and processed products ed biorefineries; this raises questions about possible conse- based on these raw materials. Lastly, a number of poten- quences for forest raw materials markets as well as its impli- tial implications for energy and environmental policy fol- cations for public policy in the forest and energy sectors. lowing the development of biorefineries are highlighted. In a recent communication, the European Commission (2008) endorsed a separate minimum target for the share of sustainable biofuels in the European transport sector and The Basics of Biorefineries The primary goal of converting a given chemical pulp stressed the need for analyses of market impacts and inter- mill into an integrated biorefinery is to create more value actions following the advent of increased use of biofuels. from the bio-based raw material provided by the forestry sector.1 Mensink et al. (2007) noted that a biorefinery is charac- [The] Commission is committed to promoting in Tterized by an “efficient use of the entire potential of raw mate- all its policies the rapid development of second rials and by-streams of the forest-based sector towards a generation biofuels. It will closely monitor mar- broad range of high-added value products (by co-operation ket developments and their effects on food, feed, in and between chains)” (p. 3). Wood contains cellulose (40% energy and other industrial uses of biomass, and to 45%), lignin (20% to 30%), hemicellulose (25% to 30%), and take appropriate action if needed. (p. 8) extractives (3% to 4%). But, a considerable share of the har- vested wood, i.e., the forest residues, never enters the pulp Given this statement, the purposes of this paper are to analyze the impacts on forest raw material markets follow- digester, and in the chemical pulping process about 20 to 30 ing an increased diffusion of integrated biorefineries in the percent of the wood weight – primarily lignin and hemicellu- chemical pulp industry and to discuss a number of related lose – dissolve in the waste liquor (Van Heiningen 2006). energy and environmental policy issues. The analysis is Figure 1 illustrates the flow of forest resources and general in scope and does not include in-depth empirical byproducts in an integrated forest-based biorefinery, as work on specific biorefineries. A major share of the ongo- ing research in this field is dominated by engineers and 1 It should be noted that not every pulp mill may be converted to natural scientists (Van Heiningen 2006); it is, therefore, an integrated biorefinery, only selected ones (e.g., kraft pulp mills).

Figure 1. — Raw material flows and end use products in a forest-based biorefinery. Source: Based on Axegård (2005) and Backlund and Axegård (2006).

FOREST PRODUCTS JOURNAL Vol. 59, No. 1/2 7 well as the possible end products that ultimately could be remove the lignin from the black liquor by acid precipita- generated from the refinery. The new value streams can be tion. Lignin precipitation after pulping can be used to pro- divided into two main categories (Closset et al. 2005). First, duce carbon fibers when mixed with commercial polymers before wood is pulped, hemicelluloses (essentially a form of (such as polyesters) (Kadla et al. 2002). This is a light but sugar) can be extracted by leaching from, for strong material, which, among other things, example, forest residues and/or wood chips. is used in space technology and in produc- Important challenges for effectively using ing sport equipment (e.g., tennis rackets). these raw materials are to keep the lignin The automobile industry may also repre- content low in the extracted hemicellulose ...a transformation sent a major market for composite materials and to ensure that the wood chips entering of at least containing carbon fibers, in this case as a the pulping stage are of good quality. The parts of the pulp substitute for structural steel. Lignin can extracted hemicellulose can be converted to industry...into also be used to generate phenols, which mono-sugars through hydrolysis, which in represent intermediate products used in the turn can be used to produce ethanol through biorefineries is likely. production of, for example, compact discs a fermentation process. Through additional From the pulp industry’s and plywood. fermentation and subsequent processes, point of view, this Although a considerable amount of however, other – potentially higher value- provides an opportunity research is needed to commercialize the added – products may also be produced. For above technologies and processes, a trans- example, hemicellulose can be used to gen- to increase profitability, formation of at least parts of the pulp erate fiber additives in paper mills, barriers, while still making use industry (e.g., kraft pulp mills) into biore- and hydrogels. As a barrier in beverage of the existing capital fineries is likely. From the pulp industry’s packaging, it can serve as a substitute for point of view, this provides an opportunity aluminum (Backlund and Axegård 2006). and infrastructure. to increase profitability, while still making Hydrogels are gels with a high water con- use of the existing capital and infrastruc- tent, and the chemical structure of the hemicellulose ture. Moreover, renewable energy sources represent an makes it possible to derive hydrogels with different proper- important part of the solution in climate change policy ties. Hydrogels can be used in the health care and pharma- because of their carbon neutral character, and as the real ceuticals sector. The specific properties of hydrogels make prices of fossil fuels increase, bio-materials become poten- them suitable to distribute fertilizers. tially viable substitutes in a large number of economic sec- Today a great deal of research is focused on devel- tors. It is essential to understand the consequences of this oping processes that can make even greater use of hemi- development for the economic behavior of those who sup- cellulose. The number of chemicals and polymers that ply forest raw material at different stages in the value can be produced in an integrated forest-based biorefin- chains, and to highlight some important – and perhaps ery is potentially very large, but in the future most atten- partly neglected – implications for public policy. tion will likely be focused on the top 12 building blocks that may be produced from sugars (Werpy and Petersen Economic Implications 2004). One example is succinic acid, which is primarily of a Forest-based Biorefinery produced petrochemically from butane but can also be In this section, some important economic aspects of generated from the hemicellulose fraction of wood. a forest-based biorefinery are briefly discussed and Succinic acid can be used in industries producing phar- three issues are highlighted. First, a typical biorefinery maceuticals, detergents, solvents, and biodegradable Ewill supply a number of different products, and the char- plastic (Zeikus et al. 1999). In addition to hemicellulose, acter of the supply of these products may differ signifi- a number of additional substances can be extracted from cantly depending on the economic significance of the forest residues. Examples include suberin and betulinol, products. Second, many raw materials will supply a which can form the base for the generation of fatty acids diverse set of industries and intermediate consumers, and antioxidants. and a fundamental economic problem is how the forest Second, major opportunities also exist for manufactur- resource inputs will be allocated across different uses. ing bio-based products after the pulp digester. Currently, the Depending on the supply situation, a stronger reliance dissolved material in the spent liquor – so-called black on forest resources can give rise to increased competi- liquor – is generally burned to generate heat and electrici- tion for this resource in terms of higher raw materials ty and to recover pulping chemicals. Instead it is possible prices. Third and finally, the potential for structural to use thermochemical processes, gasification of the black changes in the organization and localization of the liquor, to produce synthesis gas, which in turn may be used affected industries are discussed. to produce a large variety of end products2 including hydro- gen, methanol, dimethyl ether, ethanol, and biodiesel. The Economic Character of Black liquor gasification is currently used at several Forest-based Product Supply demonstration plants, both in Sweden and in the United In the case in which two or more products are generat- States (Van Heiningen 2006). Another approach is to ed from the same facility (mill), it is useful to distinguish between three separate product categories: main products, 2 The conversion of forest residues into synthesis gas through coproducts, and byproducts. A main product is (by defini- gasification technologies is also possible. tion) so important that it alone determines the economic

8 JANUARY/FEBRUARY 2009 Figure 2. — Supply curves for main products and byproducts in a competitive market. Source: Based on Tilton (1992).

viability of a pulp mill or a biorefinery. If, however, two or There are two main differences between main product more products must be produced to make the mill econom- supply and byproduct supply. First, the supply of a byprod- ic, both will influence output decisions, and they are uct is constrained by the output of the main product. For defined as coproducts. Finally, a byproduct is produced in instance, the supply of black liquor from the pulping association with a main product or with coproducts. But, process will be constrained by the output of chemical pulp, the price of the byproducts will not influence output deci- and this will in turn put a cap on the overall output of prod- sions concerning the other (main or co-) products (Tilton ucts that can be generated from black liquor. Similarly, the 1992). These characteristics are important for understand- extraction of hemicellulose from wood chips prior to pulping the supply behavior in any multi-product biorefinery. ing and any related chemical products will ultimately be Figure 2 illustrates the difference in the supply curves constrained by the output of forest-based main products. for main products and byproducts. A supply curve shows This means that as the supply of the byproduct reaches this the quantity of the product supplied at various levels of constraint the supply curve becomes vertical (i.e., a higher the output price. It is important to note that a given sup- byproduct price does not increase the output of neither the ply curve assumes that producers have a certain amount byproduct nor the main product).3 Over time, technical of time to adjust to price changes. A distinction is made progress may lead to increases in the amount of byproducts between two time periods: the short-term and the long- that can be extracted from a given production level of the term. In the short-term the capital stock is fixed, while in main product. If so the main product constraint shifts to the the long-term this stock is permitted to vary. In the case of right, but it is still present. In the short-term the supply of a the supply of a main product, in the short-term the pro- byproduct will – just as is the case for a main product – be ducers have enough time to change production but not constrained by the existing capacity to process the byprod- capacity. At a very low price no supply is generated. But, uct. Second, in contrast to the case of main product supply, once the price reaches a certain threshold, supply can only costs specific to byproduct production will affect expand greatly in response to price increases as addition- byproduct supply. Any joint costs are borne entirely by the al production is found economical and thus offered for main product and do not influence byproduct supply. This sale. Eventually in the short-term, further output expan- also means that byproduct supply curves typically will be sions are constrained by the existing capacity of the facility. This implies that the short-term supply curve becomes located below the corresponding main product supply quite steep at high prices, and finally vertical at the capac- curves. But, byproducts are generally not free goods, since ity constraint. Over time new facilities can be developed, further processing of the products is necessary after they forest resources exploited, and processing facilities built. have been separated from the main products (Tilton 1992). Firms can also expand the capacity of existing operations. Coproducts represent essentially something in between This means that the relatively flat portion of the main main products and byproducts. The price of a coproduct will product supply curve encompasses far more output com- influence the output of a biorefinery, and this price must pared to the short-term situation. In the long-term, supply cover the product’s specific production costs plus some – is constrained mainly by the availability of known forest but not all – of the joint costs. Coproduct supply curves have resources. Figure 2 shows that the short-term supply the same general shape as those illustrated for main prod- curve lies below the long-term curve (until output reaches ucts in Figure 2. Since a coproduct need only bear a certain the capacity constraint). This is because in the short-term firms may continue production even if the price is below 3 It should be noted, though, that over the long-term the dynamic the average total cost (including thus fixed costs) as long nature of markets may give rise to a situation where byproducts as they are recovering their average variable costs. become main products.

FOREST PRODUCTS JOURNAL Vol. 59, No. 1/2 9 share of the joint production costs, supply may be available term may lead to a switch away from byproduct use, but at lower costs than is the case for main products. alternatively it may also induce organizational changes in These described product distinctions may significant- the relevant markets. ly affect the economics of a biorefinery. Byproducts are often comparatively inex- Competition for Forest- pensive to supply in the market (since no based Products joint costs are incurred). But, since the sup- As has been noted, a biorefinery builds ply is constrained by the output of the main on the concept of efficient use of the total product, the byproduct price may increase itSometiimes is argued that a strong potential of raw materials and byproducts significantly if the demand for the goods, from the forest-based sector toward a broad which use these byproducts in their produc- reliance on forest-based range of high added-value products. tion, increases. As is discussed below, this byproducts and Sometimes it is argued that a strong reliance may be particularly burdensome for previously unused on forest-based byproducts and previously involved consumers whenever there is wood materials means unused wood materials means that the com- intense competition for the underlying for- petition for the raw material among differ- est resource. As long as the output of the that the competition ent end uses is avoided. But, this may not at main product is fixed, no adjustments in for the raw material all be the case. Figure 3 illustrates a market byproduct supply can be expected, even in among different end situation in which the total derived demand the presence of high (current or anticipated) uses is avoided. for a given forest-based byproduct repre- byproduct prices. With the development of sents the (horizontal) aggregation of the new production methods in a biorefinery, But, this may not at sector-specific demand curves (A and B). the economic dependence on byproducts all be the case. For instance, hemicellulose can be used to such as black liquor may increase in the produce both barriers and hydrogels, and future. Mensink et al. (2007) note that: black liquor can be used to produce different kinds of energy carriers. In the case of an increase in New emerging technologies in biorefinery the demand for a given product (e.g., transport fuels) that like black liquor gasification, lignin produc- relies on a certain raw material (e.g., black liquor) as input, tion from black liquor, and so forth can cre- the price of the raw material will increase for all other users ate new and additional value added from the of this input. For those users whose demand for the raw fibre source. They can also secure the prof- material is rather insensitive to changes in the price of the itability of companies and contribute to input, this price increase will be particularly burdensome. meeting policy goals and targets. (emphasis The price insensitivity reflects the fact that these users find added) (p. 5) it difficult to substitute other materials for the material whose price has increased. If any of the existing or new byproducts become There are two key points of this procurement competi- increasingly important for the current competitiveness of a tion (Sedjo 1997). First, in order to be economically inter- biorefinery (Closset et al. 2005), they may have to be consid- esting for new end uses, the forest-based raw material must ered coproducts instead. It is important to understand the be priced low enough so that it can compete financially importance of this classification. A move toward a coprod- with, most notably, fossil fuels as a feed stock. For instance, uct implies that joint production costs must be shared with the producers of hydrogels must find it economical to sub- other coproducts. Consequently, the same product can now stitute biobased resources for fossil fuel-based ones if no longer be supplied as inexpensively as before. At the hemicellulose is to be used to serve the hydrogel market. same time, the supply of a coproduct does not face the main In many European countries, much of the demand for for- product constraint, and it is, therefore, more sensitive to est-based biomass is induced by public policy measures changes in its own price than is the case for byproducts. that increase the cost of fossil fuels, such as coal and oil. This implies that price developments of the coproduct may One example in which such policies have caused a rather be less volatile. Moreover, for a coproduct, interesting inter- significant competition for forest-based products is the use actions with the markets for the other coproduct(s) also of sawmill byproducts in the Swedish heat generation sec- take place. For instance, an increase in the price of an asso- tor (Lundmark and Söderholm 2004). In this sector relative- ciated coproduct (e.g., pulp) shifts the supply curve for the ly high carbon dioxide taxes have been imposed and exten- other coproduct (e.g., transport fuel) downwards, thus sive use of byproducts from sawmill industries is encour- implying greater supply at given prices. aged. This has led to a situation in which the wood board A common feature of by- and coproduct supplies is industry – the traditional user of byproducts from saw mills that the supply responses to changes in output prices are – suffers from the higher prices (see Cowie and Gardner limited since their production is only of limited economic [2007] for an analysis of similar competition for the bio- importance for the company that supplies these products. mass in Australia). A similar intense competition between It is worth emphasizing, however, that these same prod- the pulp and energy sectors over pulpwood may also be ucts may be of significant economic importance for those approaching (Sköldberg and Rydén 2006, Lundmark 2006). who buy them, especially if it is difficult for these buyers In the chemicals industry, the transition from petroleum to to switch between different types of products of roughly biomass as the primary feedstock has not yet taken place the same quality. This is a situation that over the longer on a grand scale, but with new technology and additional

10 JANUARY/FEBRUARY 2009 climate policy measures such a development Figure 3. — Dual-sector procurement competition for the same forest raw may be underway (Dale 2003). This could material. Source: Based on Sedjo (1997) and Lundmark and Söderholm (2004). create a further increase in the use of forest raw materials.4 Second, the financial returns to forest- based biomass production must be high enough to allow the suppliers of the processed biomass-based products to compete for the required wood resources and purchase it away from alternative uses. For instance, if the forest resource (in terms of hemicellulose) is to be allocated to the production of hydrogels, this sector’s willingness to pay for raw material must be higher than the corresponding willingness to pay for those that produce, for instance, barriers. Figure 3 shows that in the absence of a demand from sector B (e.g., hydrogels), the price of the forest-based byproduct (e.g., hemicellulose) would be . P0 At that price units of the byproduct would Q0 be consumed solely in sector A (e.g., barriers). As the new demand from sector B increases, however, the total demand curve will be repre- sented by the kinked, bold curve shown in Figure 3. The policy-makers. First, promoting additional use of biomass in price increases to and the total quantity supplied becomes one industrial sector may make such use more expensive in higher at . Total consumption of the byproduct in sector another, thus often creating a conflict between different pol- Q1 B ( – ) can be divided into two components: a component icy goals. For instance, Cowie and Gardner (2007) illustrate, Q1 Q2 ( – ) which is a result of the total increase in consump- Q1 Q0 using the competition for sawmill byproducts as an exam- tion and a component ( – ) which is a result of the fact Q0 Q2 ple, that the carbon credit earned by a bioenergy project that sector B has been able to partly compete the byproduct may be negatively affected by the presence of competition away from its previous use in sector A. for biomass resources. This is the case if the project crowds It is also easy to anticipate a future indirect competition out use of biomass (e.g., sawmill byproducts) in other sec- for the forest resource between different users. For exam- tors (e.g., the particleboard industry) and induces substitu- ple, as mentioned, the district heating sector in Sweden is tion toward more carbon intensive materials in these. occasionally able to outbid the pulp and paper industry for Moreover, the choice of specific policy instruments biomass in the form of pulpwood (Sköldberg and Rydén becomes a very important question, in particular the ques- 2006). Figure 3 shows that such a situation implies lower tion of whether to rely primarily on technology-neutral pol- pulpwood use in the pulp industry and hence reduced pro- icy instruments such as carbon taxes and/or emissions duction of pulp. But, this also means that the supply of the trading or on technology-specific instruments (e.g., invest- black liquor byproduct will be reduced, and thus further ment and R&D support). The former approach would leave limits the potential for producing transport fuels through it largely to the market forces to determine how the forest black liquor gasification. Brännlund et al. (2004) showed raw material should be allocated between different sectors, that in the Swedish case the pulp industry may be able to at while in the latter case the allocation problem would be least partly bid away sawlog quantities from the sawmill more directly in the hands of politicians and government industry. This situation will result in reduced volumes of authorities. These and other related policy issues are dis- saw logs in the sawmill industry, and hence lower produc- cussed in the last section of this paper. tion of both sawn wood and sawmill byproducts. From a for- Finally, it is worth mentioning that Figure 3 is based est sector perspective, this creates a larger potential for fuel on the assumption that the markets involved are charac- production through black liquor gasification, but at the cost terized by perfect competition (i.e., a large number of sell- of decreased sawmill production and thus reduced supply ers and buyers). In practice, however, a common market of sawmill byproducts for energy production. The future imperfection in forest raw materials markets is the pres- interdependencies between the energy and the forest sec- ence of oligopsony (i.e., a limited number of buyers). For tors use of biomass as well as the economic importance of example, large pulp producers in Sweden can often exer- the above reallocations are so far only poorly understood, cise some degree of market power resulting in a sub-opti- and thus merit further investigation and modeling efforts. mal allocation of forest resources (Bergman and Because a major part of the demand for biofuels is pol- Brännlund 1995). The resulting market price is lower than icy-driven, the above also implies some general lessons for that prevailing in a competitive situation, and the traded volumes become lower as well. Regardless, the diffusion of new end-use products based on forest raw materials may 4 Clearly, the economics of forest raw materials use will differ greatly across different geographical regions depending on, for alter this situation as a large number of potential new buy- example, the availability of fossil fuels. ers enter the market. Thus, over the longer term energy and

FOREST PRODUCTS JOURNAL Vol. 59, No. 1/2 11 climate policy may foster the development of more efficient als take place close to the source in order to ensure forest raw materials markets. favorable transport economics. These geographical issues are still very much uncertain and require addi- Organizational and Structural tional research. Changes As was previously noted, the develop- The Role of Public ment of new uses of forest-based biomass Policy in the may induce organizational changes in the industry, but it is difficult to anticipate the Even if cellulose Presence of extent and the nature of any such changes. products remain Biorefineries One possible scenario is when the buyers TA discussion of the role of public policy become shareholders in the company that the main output in the forest-based sector should address processes the raw materials as a way of in future forest-based two related issues. First the motives for state intervention in biomass-based markets need reducing risks as well as influencing supply biorefineries, the decisions and the use of raw materials.5 One to be clarified, and to the extent such may also envisage a situation in which forest sector will motives exist one must also address the increased private research efforts are likely have to find choice between different types of policy instruments and designs. In this section, two focused on the direct use of the forest new ways of resource (e.g., wood chips) rather than of types of economic motives for policy inter- the byproducts resulting from the produc- integration and vention in biomass markets, as well as the tion of pulp (e.g., black liquor). This could cooperation with other impact of related policy instruments are dis- partly reduce the dependency on pure cussed. Moreover, the analysis focuses on byproducts and in the end enhance security industrial sectors. domestic policies aimed at mitigating carbon of inexpensive raw material supply. Although dioxide emissions and promoting the diffu- much of what has been written on forest-based refineries sion of renewable energy sources while relatively little atten- so far tends to suggest that the existing pulp and paper tion is paid to international trade issues and regimes. industry will represent the heart of the biorefinery sector (Mensink et al. 2007, Closset et al. 2005), this remains an The Case For — and Against — open question, especially if the new products (e.g., chemi- Policy Intervention cals, transport fuels, etc.) become essential for the overall The economic (i.e., efficiency) motives for state inter- economics of the biorefinery. A likely outcome is that dif- vention in the prevailing market mechanisms are outlined ferent pulp mills tend to specialize in specific by- or in welfare economic theory (Johansson 1991). This theo- coproducts. Even if cellulose products remain the main ry states that in a market that operates without major output in future forest-based biorefineries, the forest sec- flaws, market forces will assure a balance between supply tor will likely have to find new ways of integration and and demand at a level where the marginal cost of output cooperation with other industrial sectors. These potential corresponds to the marginal utility of consumers (and restructurings clearly constitute issues for future research. where both equal the market price). If these conditions Moreover, so far much of the experience in produc- apply, society’s resources – including raw materials but ing new products in forest-based biorefineries stems also capital and labor – are allocated in ways that maxi- from small-scale pilot plants (Van Heiningen 2006). But, mize overall economic welfare. This is because the mar- if full commercialization is to be achieved large-scale ket guarantees that all mutually advantageous trades facilities are needed. The operation of integrated biore- between buyers and sellers will be realized, and this out- fineries will be characterized by economies of scale, and come is “efficient” in the sense that no one can be made this probably rules out small-scale facilities in remote better off without someone else being made worse off.6 locations which are far away from existing pulp mills. The goal of public policy is to try to rectify any market One may, however, envisage a situation in which some of failures, and an efficient policy must, therefore, build on the initial processing stages of virgin forest raw materi- an analysis of the causes for why the market fails in the above task. Below some of the most important types of market failures that could potentially constitute the basis 5 An interesting parallel can be made with the increased use of natural gas for electricity generation in Europe during the 1990s. for policy intervention in the biorefinery sector and in its The sharing of the risks between electricity producers and gas related markets are identified. suppliers can be partially or fully internalized through vertical It is important to point out, however, that the pres- integration. A number of cases exist in which electricity producers ence of intense competition for the forest raw material take an owner-share in gas production or gas producers purchase an owner-share in electricity generation or invest in gas-fired does not in itself represent a market failure, which calls power plants (Sorensen and Roland 1999). The experiences from for policy intervention. On the contrary, the raw materi- the gas-electricity case also show that this behavior is particular- al price increases that follow from new demand (Fig. 3) ly prevalent in fairly immature markets. are desirable from an economic efficiency point of view; they signal to all users that the specific resources now 6 In economics literature this situation is known as a Pareto efficient or socially efficient outcome. This stems back to Adam are scarcer and the higher prices induce firms and Smith’s ‘invisible hand theorem’ which states that self-interested households to use these resources more efficiently. This economic agents in a market economy will promote the general is exactly what market mechanisms are supposed to good of society.

12 JANUARY/FEBRUARY 2009 achieve. It is sometimes argued that the growing derived the full benefit from its efforts. The rationale for policy demand for forest raw materials in the energy sector will intervention in biomass markets is dependent on these crowd out valuable exports of pulp and paper products types of market failures in which essential societal costs and that net exports in small open economies will and benefits do not enter the private decision-making decline as a result (this since the value of process. Below two categories of market the energy imports that will be avoided is failures that are particularly relevant assumed to be low in comparison). For this given the potential growth of biorefineries reason, the argument states, the competi- and the role of biomass in energy and cli- tion for forest raw materials should be Public policy mate policy are highlighted. kept limited. This line of reasoning, howev- should, therefore, not er, gains very little support in economics attempt to replace the Negative Environmental literature. Most notably, over the long- most fundamental Externalities term the competition for forest raw materi- The first type of market failure is exter- als will not influence the overall current task of economic nal environmental costs (or negative envi- account balance (this since adjustments in markets – the promotion ronmental externalities), and they are pres- the foreign exchange level will take place). of an efficient allocation ent in situations in which resources – such Additionally, any public influence on the of productive as clean air – are provided free of charge by current account is usually best managed resources – but instead the environment. This increases the likeli- through different macroeconomic policy hood that environmental resources are measures (e.g., central bank policy) rather focus on those overused, unless incentives for firms and than through supporting specific sectors values that are not households to take account of these exter- or technologies and/or withholding forest priced in the market. nal costs in their decisions are implement- raw materials for use in other sectors ed. In this case the economic rationale for (Lundmark and Söderholm 2004). policy intervention is pretty clear-cut, Efforts to centrally allocate the use of raw materials especially if the environmental impacts affect a large num- have been common historically (not the least of course in ber of external agents.8 It should be emphasized that the the centrally planned economies in Eastern Europe), but sole motive behind these policy instruments is the reduc- typically they have failed to promote an efficient use of tion of environmental external costs and thus not the the resources. In Sweden the so-called Wood Fibre Act explicit promotion of certain technologies and/or produc- regulated the use of forest raw materials during the 1980s. tion methods. In other words, in climate policy, where the This Act built on the presumption that there was a short- primary goal is to reduce the external damage costs aris- age of forest raw material. The purpose of the Act was, ing from the combustion of fossil fuels, biomass-based therefore, to introduce a system of rationing when the energy constitutes one out of many means to achieve this demand from the traditional forest industry was priori- policy goal. Biomass must compete with other carbon mit- tized while only “excess supply” could normally be allo- igation options including carbon capture and storage tech- cated to other uses such as combustion in the energy sec- niques and other technologies that the traditional fossil tor. Hansing and Wibe (1992) showed that the Wood Fibre fuel producers and users may have strong incentives to Act primarily had negative economic impacts. Most develop (Söderholm and Strömberg 2003). notably perhaps, it tended to favor users who could effec- Since carbon in the atmosphere gets mixed more or tively lobby policy decision-makers rather than those less uniformly, emissions anywhere change concentra- users who had a high willingness to pay for (and thus high tions everywhere in the world (although with a long lead valuation of) the raw material. A major problem with time). A genuinely cost-effective climate policy, therefore, these types of policy interventions is that they typically requires that the marginal cost of emission reduction is underestimate the information requirements needed to the same in all sectors, activities, and countries. The envi- foster efficiency and they tend to view resource allocation ronmental economics literature suggests that market- as a static problem. In practice relative price changes and based policy instruments, i.e., those assigning a uniform technological progress may open up the possibility for new and more efficient uses of the raw material. The large number of products that in the future could 7 This also implies that the depletion of oil (and other non-renew- be produced from a forest-based biorefinery is a clear able energy resources) is not in itself a valid argument for policy interventions in the renewable energy sector. A world market for illustration of this; centrally planning the allocation of the oil exists, and this will signal any increased scarcity to consumers forest resource between these different end uses would in the form of higher prices. The promotion of renewable energy most likely lead to inefficient outcomes. Public policy can, however, be perceived as insurance against future high oil should, therefore, not attempt to replace the most funda- prices, but actions to raise the value of this insurance through different policy instruments are only efficient to the extent that the mental task of economic markets – the promotion of an private market’s assessment of these risks are lower than what is efficient allocation of productive resources – but instead optimal from society’s point of view. focus on those values that are not priced in the market.7 In general, the free market only gives firms and 8 In his seminal work, Coase (1960) demonstrates that bargaining households incentives to economize on those resources between the polluter and affected agents can, under certain conditions (such as low transaction costs), internalize external costs and for which they have to pay a price; only limited incen- achieve an efficient outcome. Yet, in most cases, due to the large tives exist for a firm to produce goods if it cannot reap number of parties involved, policy intervention is often needed.

FOREST PRODUCTS JOURNAL Vol. 59, No. 1/2 13 price on all carbon dioxide emissions, will ensure a cost- ly to be socially desirable under certain effective reduction of this particular greenhouse gas. The circumstances. First is the public good reason is that all actors will emit up to the point where nature of the environment itself, which marginal reduction costs equal this price, and since all makes environment, in effect, an area of activities face the same price, the marginal cost of emis- government procurement […], and hence a sion reduction will be the same (e.g., Kolstad and Toman suitable area for focused governmental 2000). But, due to concerns about the international com- technology efforts. Another is a second- petitiveness of energy-intensive industries as well as the best argument related to the practical lim- fear of carbon leakage, different tax levels and policy itations of environmental policy. Most instruments are often applied to different sectors of the economists […] would argue that the most economy. While such a policy differentiation may be eco- efficient single policy for addressing global nomically motivated for a small open economy in the climate change is an emissions policy that absence of international coordination of climate policy places a price on greenhouse gases […]. (Bergman 1996), it may also induce a situation that may However, [so far] there is little environ- prove inefficient over the longer term. The sectors that mental policy-induced incentive to devel- face strong international competition typically pay a op technologies that reduce greenhouse lower price for carbon emissions, and this also means gas emissions. In this second-best setting, that their relative willingness to pay for forest-based prod- policy to foster greenhouse gas-reducing ucts is reduced compared to those sectors that pay high- technology may be one of the main policy er carbon prices. This leads to a stronger incentive for levers available […]. (p. 169) substituting forest-based materials for fossil fuels in the latter sectors; although over time, the biomass potential- The technology development argument for policy ly could have been used more efficiently in the former intervention is, however, less straightforward than sectors. The above discussion indicates that internation- that relying on the presence of external environmental al coordination of climate policies could encourage a costs. The reason is that although the social benefits more efficient allocation of forest-based biomass across of R&D activities in new technology are higher than different sectors. private ones, it must be acknowledged that this is the case for many R&D activities throughout the entire Positive Externalities and economy (including many environmental projects). Technological Learning This implies that the opportunity cost of specific R&D While addressing negative environmental externali- projects may also be high. ties in public policy provides no direct An important policy lesson is that rationale for promoting specific technolo- even if policies to correct for environmen- gies, the second type of market failure is tal externalities are in place, the level of more closely related to technological devel- environmental R&D may be sub-optimal opment and diffusion. R&D activities are ...even if (and too low). Thus, technology policy ultimately concerned with the generation of policies to and environmental policy are comple- new knowledge and information. This infor- ments, and both are necessary. mation, however, is often (but not always) a correct for environmental Nevertheless, technology policy should collective good, implying that once generat- externalities are in initially focus on and address a broad set ed it can benefit many users at a low cost. place, the level of of knowledge spillovers through generic This means that a single firm cannot gener- policy instruments (such as patents and ally reap the entire benefit of its investment environmental R&D broad R&D subsidies) rather than focus in new knowledge, and it does not, there- may be suboptimal on R&D and innovation activities in one fore, have enough incentives to undertake (and too low). Thus, specific activity or sector (Otto et al. such activities. One example is that public 2006). In those cases in which specific knowledge may lead to additional innova- technology policy and activities are targeted, the technologies tions, representing knowledge spillovers environmental policy that generate the most significant knowl- that provide benefits to the public but not are complements, and edge spillovers must (as far as possible) to the original innovator. Also demonstra- be identified. Naturally, these activities tion projects may lead to important learn- both are necessary. must also generate significant environ- ing-by-doing impacts, which may be of great mental benefits and avoid locking out the public value. future use of even more efficient technologies. For Jaffe et al. (2005) concluded that existing public poli- instance, concern has been raised about the present pol- cy instruments to address these spillover effects from icy promotion of bioethanol production based on corn innovation and R&D activities – such as patents – often are and wheat (Charles et al. 2007). In this case, a large insufficient, and they conclude: amount of energy is used to cultivate, harvest, and process the biomass, even though only a relatively small There are, […], several interrelated rea- proportion is used to derive energy. This also implies sons why technology policy narrowly that the potential for net greenhouse gas emissions focused on energy and environment is like- reductions is limited.

14 JANUARY/FEBRUARY 2009 Applied to our case of forest-based biomass utiliza- pre-determined end use for these resources. Preferences, tion, the above implies that it is probably not efficient markets, and technology change over time, and so does to provide direct technology support for the diffusion of (and should) the flow of natural resources in the econo- biorefineries as such. Many of the benefits my. The development of forest-based that arise from the development of biore- biorefineries may imply a fundamental fineries are private in nature, not the least structural change in the traditional forest- of those related to optimal size, organiza- based industries, but so far our under- tion, process integration as well as any standing of these potential changes is lim- interaction and cooperation with other Natural recources ited. industry sectors. Thus, the generation of are essential for For this reason, this paper attempted knowledge spillovers would (although to identify and discuss a number of impor- present) be limited in these activities, and the functioning tant market behavior and policy issues the case for policy intervention is proba- of a modern that could provide a starting point for bly limited. From a public policy point of future economic and social scientific view, it is more efficient to support R&D economy, and research on the use of forest raw materi- activities in those areas which relate to, over time there is als. The strong independence between the for example, the chemistry and biology of different existing forest raw materials mar- forest raw materials use. Such R&D activi- no definite or kets and the importance of the character ties could spur further economy-wide pre-determined of the products involved (i.e., the distinc- innovation and research findings. The tion between byproducts and main prod- support of the diffusion of specific tech- end use for these ucts) were emphasized. The advent of new nologies (e.g., fermentation or gasification resources. uses of the forest-based biomass will fos- processes) could also be justified to the ter an increased competition for (and thus extent that they generate significant learn- higher relative price of) this resource. An ing-by-doing impacts, and thus show evidence of large important policy lesson, however, is not to directly regu- potential cost reductions as experience accumulates. late the allocation of forest resources between different One way to approach this latter issue is to identify sectors or promote a certain industrial structure. “clusters” (Rojas 2007) of technologies and processes The rationale for policy intervention lies instead related to the operations of a biorefinery, which may in identifying situations in which essential societal lead to spillovers from learning-by-doing in one technol- costs and benefits do not enter into the private deci- ogy to another. Thus, within a specific cluster the spill- sion-making process. The presence of external envi- over effects would be stronger than those taking place ronmental costs (e.g., damages to the climate) and the across clusters (Gritsevskyi and Nakicenovic 2000). public spillover effects from R&D and innovation Technology clusters with very promising potentials for activities provide such rationales, but at the same learning effects could provide a target for directed poli- time require careful analysis prior to the introduction cy support such as investment subsidies and R&D sup- of specific policy instruments. The advent of forest- port. In this endeavor, however, it should be recognized based biorefineries also implies that different policy that not only processes within a prospective biorefinery fields (e.g., forest policy, energy policy, R&D policy, could be targeted, but also technologies that facilitate chemicals policy, etc.) become more intertwined; a the use of the intermediate products that are generated need may exist for closer policy integration to avoid in the biorefinery. For instance, technology policies sub-optimal solutions. facilitating the reliance on forest-based biomass in the The above suggests that future research activities chemicals industry may be justified. in this field should focus on the development of new Finally, the processing of forest-based raw materials economic models of the forest sector, which address into valuable end products is a capital-intensive under- the strong interactions between the different – new taking with high up front investment (sunk) costs, and and old – forest products markets while still allowing new operations represent a high risk investment. Due to the simulation of different policy impacts on the use this fact and the strong influence of energy and climate and supply of these products. This requires the exten- policy in the involved sectors, it is of vital importance sion of existing forest products markets models that politicians aim at long-term stability in the use of (Lundmark 2007), which tend to focus on the prevailing specific policy instruments. The ability to foresee the end-use markets. future of economic value of capital and R&D investment is the source of an efficient allocation of natural Acknowledgments resources in a market economy. Policy plays an impor- The research undertaken in preparation of this paper tant role in affecting the relative size of these values has formed part of the Solander Science Park, a network across different investment alternatives, and policy sig- aiming at researching the biorefinery concept. Financial nals must not be perceived as ambiguous. support from the Swedish Energy Agency (AES program) Ais gratefully acknowledged, as are valuable help and com- Final Remarks ments from Ulrika Rova, Richard Gebart, Pontus Grahn, Natural resources are essential for the functioning of and two anonymous reviewers. Any remaining errors, Fa modern economy, and over time there is no definite or however, reside solely with the authors. FOREST PRODUCTS JOURNAL Vol. 59, No. 1/2 15 Literature Cited Kadla, J.F., S. Kubo, R.A. Venditti, R.D. Gilbert, A.L. Compere, and Audsley, E. and J.E. Annetts. 2003. Modelling the value of a rural W. Griffith. 2002. Lignin-based carbon fibers for composite biorefinery – Part 1: The model description. Agricultural fiber applications. Carbon 40:2913-2920. Systems 76:39-59. Kolstad, C.D. and M.A. Toman. 2000. The Economics of Climate Axegård, P. 2005. The Future Pulp Mill – A Biorefinery? Paper pre- Policy. 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Press, NY. succinic acid production and markets for derived industrial products. Applied Microbiological Biotechnology 51:545-552. Check Out Our Website For Information Regarding: Membership Sections & Chapters Conferences Executive Board & Committees Publications Links Interactive Library Technical Interest Groups Awards Student Corner www.forestprod.org

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