How traders can capture value in sustainable fuels

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As countries around the world seek to limit their carbon emissions, sustainable fuels will play an important role. This category consists of a broad range of low-carbon fuels, including biofuels, e-fuels, and chemical by-products (see sidebar, “Know your sustainable fuels”). Because sustainable fuels can fill gaps in decarbonization and complement electrification, demand is expected to triple over the next 20 years, reaching approximately 600 million metric tons (Mt) by 2050 (Exhibit 1).1Charting the global energy landscape to 2050: Sustainable fuels,” McKinsey, July 7, 2022. To date, completed advanced-biofuels projects and announced investment pipeline in sustainable-fuel capacity have reached $100 billion.2

The contribution of sustainable fuels to liquid-fuel demand could double by 2030.

The sustainable-fuel market is still mostly nascent, characterized by complex regulations and interdependencies across sectors. Physical and regulatory constraints on feedstocks have resulted in price volatility; supply chain and infrastructure bottlenecks, variations in pricing across regions, and import and export rulings have added to this volatility. The mix of fuel types will evolve through 2050: road fuels have represented most of the demand and growth to date, but in the 2020s categories such as sustainable aviation fuel (SAF), renewable natural gas and synthetic natural gas, and bio- and e-methanol will make up a larger share. During the 2030s, technological advancements could spur growth in new advanced-biofuel pathways and e-fuels, complicating the global market while injecting much-needed capacity and liquidity.

With such complex market fundamentals, sustainable-fuel traders should seek to understand which markets will increase in liquidity, which arbitrage plays to explore across products, which storage hubs to invest in, and which offtakes to secure to gain access to supply. Winning traders will build and enhance selected capabilities to keep pace with the market’s evolution.

Current market and development factors

A fascinating but challenging aspect of the sustainable-fuel market is the broad range of categories it encompasses (Exhibit 2). Biofuels account for the vast majority of the current market, but drop-in sustainable fuels and hydrogen-based e-fuels could reshape the landscape in the coming decades. The development of these fuels will be nonlinear: they will mature at different paces, and their specific uses could replace fossil fuels at different rates.

The market for sustainable fuels includes a broad range of categories.

Several factors will shape the market’s development over the next few decades.

The rise of e-fuels

In the coming years, constraints on sustainable biomass feedstocks are expected to create a gap between demand for and supply of fuels with existing technologies. Although biomass feedstocks, notably lignocellulosics, have significant potential for energy production,3 practical constraints on their collection mean the global community likely won’t be able to achieve net-zero targets without a shift to e-fuels and dedicated biomass production on marginal lands or surplus agricultural land (Exhibit 3).

Over the next 30 years, achieving net zero will require a fundamental shift in the way sustainable fuels are produced.

E-hydrocarbon markets could still emerge in the late 2020s, but volumes will likely not become significant compared with bio-based production until the following decade. In addition, the cost competitiveness of different production pathways continues to be uncertain given the limited adoption and the potential to reduce production costs of some of the pathways over time (Exhibit 4). EU regulators have taken the strongest long-term view on the role of e-fuels, introducing proposals to mandate the use of RFNBOs4 in the transport sector with specific quotas for the aviation and marine sectors.5 These mandates seek to create a market for those products.

Many emerging advanced aviation fuels could become cost competitive with HEFA in the 2030–40 period.

The business case and location choices for e-fuel production are affected by access to affordable renewables, availability of sustainable carbon (e-ammonia, which doesn’t contain carbon, is an exception), and integrated production costs of hydrogen derivatives (which are affected by rules such as temporal correlation, requiring storage of electricity or hydrogen to produce compliant fuels). Classifications vary by type of hydrogen (for example, carbon intensity or whether electricity source includes nuclear in addition to renewables) and carbon (such as carbon derived from fossil, biogenic, or direct-air-capture sources) and can affect a product’s value in the market. Currently, future producers are concentrating primarily on nonfossil carbon sources such as ethanol, pulp and paper, and waste-to-energy plants.

Production can provide opportunities in regions with a high potential for renewables and biogenic-carbon availability, such as Latin America, North America, and parts of Asia and Europe. Africa, Australia, and the Middle East could be major producers of e-ammonia and potentially e-hydrocarbons for markets that allow the use of fossil carbon in e-fuels. The high cost of direct air capture needs to fall dramatically to be competitive with carbon capture from industrial sources.

Competing policy approaches to support market development

Multiple countries and regions are active in the global sustainable-fuel market. The European Union and North America are at the forefront in drop-in sustainable fuels. Meanwhile, an established significant market for conventional biofuel has experienced growth over the past 30 years, with bioethanol in Brazil, China, and India and biodiesel (fatty acid methyl ester [FAME]) from palm and soybean oil in Latin American and Southeast Asian countries.6 Asia–Pacific, Australia, China, Japan, India, Singapore, and South Korea are emerging as potential demand hubs for drop-in fuels such as SAF as well as e-methanol and e-ammonia to serve as energy carriers or fuels for the marine sector.

An examination of the EU and US markets highlights the complex and varied landscape across regions as well as different approaches to spurring adoption of sustainable fuels.

European Union. The European Union has set ambitious targets for reducing carbon emissions and is using legislation to support demand. For example, the “Fit for 55” package of legislation, which aims to decrease the European Union’s greenhouse-gas emissions by at least 55.0 percent by 2030, establishes targets for the use of renewable energy in the Renewable Energy Directive amendment (29.0 percent for the transport sector by 2030) and specific feedstocks (5.5 percent for advanced biomass and RFNBO by 2030, of which minimum 1.0 percent RFNBO).7 Proposed legislation would lay the foundation for SAF demand, mandating a 2 percent share of SAF supply in 2025, 6 percent in 2030, and 70 percent in 2050 (of which 35 percent would be RFNBO).8 By providing long-term demand signals, including compliance mechanisms, EU leaders have sought to create prerequisites for investment decisions.

On the supply side, the European Union and its member states have imposed bans and restrictions on feedstocks that can be used for biofuels. The region is shifting from food crops (such as palm, soy, and corn) to waste and residue streams for advanced biofuels.9 In addition, it is defining sustainability criteria for e-fuels, favoring biogenic or direct-air-capture carbon and green or low-carbon hydrogen that meets stringent criteria (as laid out in the RFNBO delegated act).10 A recent proposal to allocate some EU Emission Trading System (ETS) funds from aviation to support SAF adoption could also introduce incentives similar to those found in the US Inflation Reduction Act (IRA).11

North America. The passage of the IRA in 2022 signaled a dramatic shift for the United States. The act features $370 billion in tax credits for the renewable-energy industry, including a credit of $1.75 a gallon for SAF through 2026 and a production tax credit of $3.00 per kilogram (kg) of hydrogen that has GHG emissions below 0.45 kg CO2 per kg H2 (such as onshore wind or nuclear). By attracting investment, the IRA seeks to scale up SAF production to at least three billion gallons a year by 2030, with the goal of 100 percent blending by 2050.12

These tax credits could significantly boost manufacturing capacity. However, a high share of projects have yet to clear the financial-investment-decision (FID) stage. Twelve major North American passenger and cargo airlines have made SAF commitments through 2030, but their offtakes are still far from meeting future demand, and few of those offtakes can be considered fully binding.

The North American market also has several policies to support the use of sustainable fuels. For example, the US Renewable Fuel Standard (RFS) and the state-level Low Carbon Fuel Standard (LCFS) programs affect pricing and create markets for credits.

Aligning market supply and demand

The different policies and approaches could lead to supply-and-demand imbalances across regions in the medium term. The market could snap back into balance in multiple ways, including the following:

  • If capacity ramps up faster than projected demand, additional voluntary use could result—especially in markets with subsidized supply, such as the United States.
  • Fuel producers might choose to recalibrate their product slate—for instance, by producing more renewable diesel instead of SAF or more bio-naphtha for the chemicals sector.
  • Many projects that have yet to clear the FID stage, particularly those with limited access to feedstock or financing, might not launch or could be delayed for several years. Further, few offtakes and credit schemes are contractually binding for the next seven to 15 years, which is often the payback time required to achieve positive returns in the highly capital-intensive advanced-biofuels and e-fuels pathways.
  • Insufficient demand could cause a significant decline in average use of production capacity, leading to compressed margins and slower capacity growth until the market rebalances through growth in demand.
  • In the long term, e-fuels or e-crude could become the “new oil,” assuming renewable energy production is not constrained, sustainable-carbon trading develops, or the cost of direct air capture approaches that of carbon capture.

Outlook on global trade flows through 2050

The development of sustainable fuels will proceed at different paces depending on category and region. However, based on trends to date, we can make a few observations about how global trade flows could play out through 2050. Currently, a significant share of production and consumption takes place within regions, shaped by various mandates, incentives, and trade rules. Some interregional trade also takes place, notably of feedstocks and fuels—for example, from Asia–Pacific hubs to Europe and North America. Producers outside the United States are increasingly looking to the European Union as a potential export market. Therefore, many of the feedstocks and fuels can be considered as partially global commodities.

Although the recent IRA package in the United States is intended to meet local demand, it is starting to attract more investment to the region. This activity may be contributing to the widening gap in pricing among regions. Some demand patterns are also shifting; for example, airlines refueling with SAF have access to cheaper prices in California than in the European Union. Further, proposed book-and-claim schemes could lead to global or regional optimization of demand volumes based on local incentives.13

Looking toward the future, long-term scenarios will likely be shaped by high demand growth beyond the European Union and United States, the increased interest in securing supply, regional and local feedstock constraints, greater market complexity, and the partial commoditization of markets such as renewable diesel and SAF. On one hand, feedstock shortages could lead to the adoption of more expensive or capital-intensive production pathways, such as the conversion of lignocellulosic feedstocks. Differences in sustainability criteria across regions may result in the growth of regional markets and product differentiaion based on sustainability criteria.

On the other hand, the rise of e-fuels combined with a scarcity of the biomass needed to support 2050 net-zero scenarios may lead production to concentrate in the global south, depending on the cost of direct air capture and requirements for nonfossil carbon sources. As an alternative, production could be more regional, with sustainability criteria differing by region. The resulting long-term outcome will likely be a mix of global commoditization and local fragmentation, creating opportunities for a range of feedstock, technology, and fuel combinations.

How traders can win in sustainable fuels

The sustainable-fuel market is poised to ramp up significantly in both scale and complexity. Five interdependent areas will shape the market in the coming years (Exhibit 5). To better identify value creation opportunities and risk, market participants will need to understand how these areas influence one another and how to keep pace with advances. For example, traders that have a good grasp of the shifting market balances but lack an understanding of the pace of investment in new technology platforms could be at a disadvantage.

Companies in the dynamic sustainable-fuel market can derive value by understanding the interdependencies in five key areas.

Given the number of imbalances expected to arise across product categories, traders must develop or enhance several core capabilities to be competitive.

Build a regulatory intelligence team

The regulatory landscape varies dramatically among countries and regions and is evolving rapidly. Traders that develop a deep understanding of local market regulations, credit qualifications, future trends, and potential changes will be better able to shape their trading strategies and secure offtakes or supply arrangements.

The economics of sustainable fuels such as renewable diesel, which has relatively high production costs, are highly dependent on regulatory incentives and vulnerable to regulatory uncertainty. For example, the cost of SAF from HEFA-UCO14 in Europe without incentives was recently about $2,200 per metric ton, 100 to 150 percent more than the cost of producing fossil-based kerosene today.15 That means users either rely on substantial credits (such as LCFS, Renewable Identification Numbers,16 Blenders Tax Credit, or the new IRA credit stack in the United States) to break even or customers pay the required price for mandated volumes and pass those costs on to customers (the primary mechanism in the European Union).

The outlook for many of these programs could be affected by regulatory changes, which will influence the price of subsidized fuels in the years ahead. For example, multiple IRA credits will expire after several years. The RFS program has also historically been volatile, with the price of RINs often driven by legislative outcomes and market perception of new targets set by the US Environmental Protection Agency.

Develop global trade flow models

Gaining an understanding of global trade flows, while feasible in the current context, will be far more difficult in the coming years given the level of uncertainty, lack of transparency (including the dearth of trade categories for some products), and complexity in the sustainable-fuel market. Optionality is especially critical in this environment. Winning traders will model how fast each commodity will grow and in which market it will likely clear (including within-year demand dynamics) as well as anticipate shifts and monitor key changes in logistics capability and access within regions.

Enhance origination capabilities

Traders will need robust origination functions to secure offtakes or supply agreements for specific feedstocks and products that offer competitive flow advantages. Successful traders will structure these agreements to balance price, volumetric flexibility, and logistics to enhance optionality and derisk volume flows if market dynamics change. Traders also have opportunities to rent or buy blending facilities, acquire sustainable fuels (including certificates) and fossil fuels, perform blending, and detach sales of molecules and credits—essentially creating a secondary market in a given country for the certificates or “tickets.”

Commodity trading organizations attracted to sustainable fuels by their dynamic nature and growth could try to anticipate how the market will evolve and identify inconsistencies in pricing across products or over time, offering opportunities for market arbitrages. Successful traders look for areas of greatest transactional volume and seek to build scale around these opportunities. Often, they will use scale to continue to capture value when margins collapse as the gaps start to close.

Strengthen the trading team

The interdependencies of feedstock, fuel, and credit prices within sustainable fuels and across other sectors are complex. Successful traders will need to model correlations among products and explore arbitrage opportunities across specifications, locations, and timing. For example, as demand grows for second-generation feedstocks for drop-in fuels, the prices of advanced waste and oils could become more volatile. Through 2021 and part of 2022, for example, soybean oil prices exhibited high volatility in response to intensifying competition from both renewable diesel and FAME producers in the United States amid limited supply from export markets. Feedstocks with limited or scattered availability and competing demand for alternative uses are at greatest risk of such volatility.

The trading team will need to have a broad level of expertise across many different commodities and understand the interplay of those commodities in different markets and products. Specialist trading across high-volume commodities will still exist, but because each market will be influenced by a growing array of factors, traders will need far broader commodity knowledge to be effective.

In the coming decades, the sustainable-fuel market will be transformed by increased demand, substantial investment, disparate policies across regions, and technological advancements. Despite the many factors that will shape the market, rapid growth and volatility could offer enticing opportunities to capture value. Winning traders will develop new capabilities to track regulatory changes, monitor global trade flows, improve origination, and build out their trading teams to navigate this complex trading landscape.

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