The figures for the growth in Brazils ethanol industry are impressive. It is the worlds second largest producer, after the United States, the worlds biggest exporter and the cheapest producer globally of ethanol. It has plenty of room for expansion thanks to the ready availability of land, with about 150 million hectares (370 million acres) available for agriculture, according to government data. Much of the countrys climate is perfect for sugarcane, a far more efficient ethanol feedstock than corn, which is the primary source of ethanol in the United States.
Domestic demand is increasing fast too, with consumption of ethanol hitting 16.7 billion liters in 2007, a figure set to grow by close to 3 billion liters in 2008. That is because Brazil is seeing explosive growth in car sales and a pronounced shift to buying flex-fuel cars, which can run on gasoline or ethanol. Today, close to 90% of car sales are flex-fuel and sales overall are increasing at close to 30% per year, with predictions that Brazil will sell 2.8 million cars this year, according to industry association Anfavea. Ethanol has been around intermittently since the 1970s, promoted at that time by a government keen to reduce expensive oil imports. With oil prices crossing the US$100 per barrel threshold this February, price-sensitive Brazilians are filling up with ethanol.
The unique combination of ethanols long association with Brazil and its recent renaissance thanks to high oil prices positions the country well. It was clear that Brazil had first mover advantage when we started to analyze where to invest, notes Sylvia Larrea, Investment Officer and team leader of the first Greenfield biofuel project financing supported by the Inter-American Development Bank (IDB) through its Structured and Corporate Finance Department. Despite the competitive advantages of Brazil (see box for IDB investments), the Bank is also looking closely at potential financings for ethanol in other countries and with other feedstocks, including sugar beets.
One of the main reasons for optimism has not been so much the increase in domestic consumption as the likelihood that foreign markets will open to Brazilian ethanol. That has seen everyone from Bill Gates to George Soros come to São Paulo to pump money into an industry that has been extremely isolated and remains highly fragmented. Market leader Cosan has just an 8% market share.
The conviction that foreign markets will open up to foreign imports seems logical enough. The argument runs that rich governments need to embrace an alternative, renewable fuel that will not exacerbate global warming and at the same time, they want to reduce reliance on oil with its high prices and insecurity of supply.
That gut feeling is correct and many elements are already in place. Some developed countries are already obliged to open up in order to meet more demanding mandatory quotas of ethanol. The United States is seeking to reduce gasoline usage by 20% in the next 10 years and the European Union is planning to set targets that should mandate that 20% of energy is derived from agro-fuels by 2020.
There has been one problem though in assessing the export potential of Brazilian biofuel. Investors greatly underestimated other countries resistance to Brazilian imports. Dismantling agricultural protectionism is highly politically charged and that has seen the U.S. develop its own corn ethanol while the E.U. has preferred biodiesel.
Previous optimism as to the market opening up helped asset prices to spiral just as the price of sugar was plunging from 16 cents to 9 cents a pound. That hit ethanol companies hard. The experience was particularly painful for foreign portfolio investors. Shares of market leader Cosan lost almost exactly 50% of their value in 2007. The good news is that this has discouraged more speculative investments.
The share price increases didnt reflect reality, comments Cosan CFO Paulo Diniz. Investors didnt know the sector, they were not familiar with the business. It was the flavor of the month with [President George] Bush advertising biofuels in the U.S. Investors bought these shares without any deep analysis.
The IDBs Larrea is aware of the troubled recent history. The market is demand driven so prices skyrocketed and asset prices were very high. Now, the industry is going through an important phase of consolidation that will continue through next year, says Larrea.
Ethanol growth is not just here today gone tomorrow, agrees Marcelo Junqueira, non-executive director of Clean Energy Brazil, listed on the small board of the London Stock Exchange. The U.S. will need to import ethanol while intense demand growth in Brazil will help the industry domestically. The biggest challenge for the industry in attracting quality, long-term investors and prising open foreign markets is establishing a stronger record on labor and the environment. Both are often cited by the European Union in its decision to maintain trade barriers.
Elio Neves, President of the Federation of Rural Employees of São Paulo in Araraquara, the heart of cane-growing territory, says salaries for laborers have stagnated in recent years. Working conditions are tough: workers cut the cane in shadeless fields with a machete-like tool, a podão, the design of which has not
changed much since its invention. São Paulo, which still accounts for close to 80% of national production, is legislating to improve conditions and eliminate manual cutting over the next four years.
Of the larger ethanol businesses, some 80% have already mechanized, points out Antonio Augusto Duva, manager, Soft Commodities desk in the São Paulo office of BNP Paribas. Mechanization of harvesting would avoid poor labor conditions faced by canefield workers, but it would also eliminate jobs, so it is not welcomed by most of the 300,000 canefield workers.
The Inter-American Development Bank is very aware of these issues, says Larrea. In the due diligence process for all projects financed by the IDB, the Bank makes sure that working conditions are taken into account and that the borrowers and other entities participating are in compliance with local laws and regulations. Clear requirements for high standards are included in loan agreements, and these are maintained through regular monitoring by independent parties. New workers needs are complex, according to Larrea. Issues include registration of workers, entitlement to health and education, negotiated salaries and more basic needs such as access to potable water and shade, transportation and appropriate clothing when working in fields. The IDBs presence brings best practices to the industry and its role as honest broker is well regarded by communities and investors.
Minimizing environmental damage is mired in controversy and is not easy to solve through technological advances. Global concerns center on encroachment on the Amazon and other sensitive areas with other products being driven into those regions (the Amazon climate is not suitable for cane, but deforested areas support cattle and soy). The Amazon alone accounts for some 50% of Brazils territory while the biodiverse swampland of the Pantanal in the western part of the country and over the border in Bolivia and Paraguay is about 10 times the size of Floridas Everglades. A government decree last year prohibited planting in most of the Amazon and the swamplands of the Pantanal but in spite of this and other measures, the argument rumbles on.
Marcelo Furtado, campaign director for Greenpeace Brazil, argues that Brazil has a history of weak monitoring and enforcement of standards. Cane doesnt pose much of a threat, says Fernando Reinach, executive director of Votorantim New Business, an investor in technology in the industry. He points out that sugarcane yields have risen significantly and that as cane takes up just 6 to 7 million hectares, there is great scope for expansion of the industry without engendering widespread deforestation.
For the IDB, ethanol is part of a wider alternative fuels policy in everything from wind farms to geothermal initiatives. We keep far away from conservation areas, says Larrea. And if you look at the numbers you can see that of the amount of arable land, less than 2% is used for sugarcane production. She believes
that the governments willingness to tackle the issue with areas designated for sugarcane planting will ensure a sustainable outlook for the industry.
The buzz around Brazilian ethanol is palpable and indeed the fuel is positioned to capture a growing part of the alternative fuels scene, particularly if it can gain access to rich countries. Many, like Reinach, are starting to sketch a vision where a range of technologies play complimentary roles in different regions of the world depending on a range of factors, including climate, availability of land and wealth. They will include water, wind, nuclear, new technologies and, of course, biofuels.
THE IDBS BIOFUEL PORTFOLIO
The IDBs expanded mandate for financing private sector projects, approved in August 2006, enabled the Bank to broaden financing activities beyond its traditional infrastructure focus, to areas ranging from manufacturing to tourism to biofuels, says Larrea. Once the biofuels team received the green light, they quickly set to work researching different ethanol markets, focusing on size, costs of production and competitiveness.
In 2007, the Bank carried out a US$120 million debt refinancing operation for sugar and biofuels producer Moema. In 2008, it is working on more ambitious greenfield projects which involve investments inland. Low-cost vertically integrated projects are the shape that bioenergy is taking, explains Larrea.
The three greenfield projectsItumbiara Bioenergy, Ituiutaba Bioenergy and Campina Verderepresent a combined investment of over US$1 billion and are all located away from the traditional growing center in central São Paulo state, where asset prices have moved steeply higher. Itumbiara is in Goiás and the other two in neighboring Minas Gerais, all in the center-west of Brazil.
Each project will involve the building of an ethanol and sugar mill, with the capacity to produce 2.7 million tons of crushed cane per year; the development of land for planting; and the construction of a 56 megawatt biomass co-generation energy plant to supply electricity to the plant. Excess electricity from the plants will be sold to the Brazilian grid, says Larrea. Cane is already being planted and the mills will be ready later this year. The Bank is keen to be an active part of the development of the biofuels industry in Latin America and the Caribbean to help spread advanced technology and international best practice.
Consolidation of the industry coupled with IDBs participation and sophisticated international investors will start to improve established practices in areas such as labor and the environment, says Larrea.
Although Brazil has been the primary market for investing in the biofuels sector, the IDB is actively seeking opportunities in other markets through providing support to financial intermediaries experienced in this field and through a regional deal approach. An example is the LACFIN Regional Sugar and Biofuel Program, which is a program to support a company with extensive experience in sugar/commodity lending, to provide loans to sugar and biofuel projects mainly in Brazil, Colombia, Dominican Republic, Mexico, Panama and Peru. The total project size is up to US $500 million, for which the IDB will provide senior debt in the form of a US$125 million IDB A/B Loan for the initial tranche and additional B Loan tranches over time as the operation grows. We are strengthening companies with vast experience in this sector, says Yumiko Kusakabe, Investment Officer in the IDBs Structured and Corporate Finance unit and team leader of the project. With this structure we are able to not only support multiple countries in one transaction, but by taking a diversification approach we are also able to reduce the risk profile and attract additional lenders to the facility.
Complementing these efforts, in smaller countries the IDB is financing technical studies that will help to improve the regulatory framework and evaluate the potential to produce biofuels in places such as Nicaragua, Honduras and El Salvador. In addition it is supporting initiatives to expand the potential of biofuels and energy efficiency in Guyana.