Renewables Commodity Market: Aspects of EU Biofuels Trading

Commodities lawyers have in recent years seen a marked growth in work relating to renewable energy. This was to be expected, even inevitable, as renewable energy products, notably biofuels, come to be traded as commodities.

Some of the challenges are familiar. Transporting and storing bio-ethanol and biodiesel gives rise to many of the same issues that affect petroleum products such as aviation fuel and heating oil. Other challenges, such as the lack of standard contracts for biofuels or effective mechanisms for hedging physical sales and purchases, reflect the relative immaturity of the sector and should be met in due course.

A further set of issues results from the role played by government regulation and incentives in creating and driving the biofuels market. The rapid growth in the biofuels sector in Europe is largely the result of controversial EU targets for a minimum biofuel content in road fuel. The EU also seems determined to regulate the market. The European Commission has announced that it is considering trade remedy action against biodiesel imports from the USA on the grounds that they are subsidized or dumped. It should therefore be borne in mind that there is a strong political element to biofuels trading which is likely to remain so long as governments wish to encourage the use of biofuels as renewable energy.

Physical risks – transportation and quality

In some ways it makes sense to view bio-ethanol and biodiesel as little different from petroleum products. Physical problems of one form or other affect all commodities during transportation, and they can usually be overcome if it is worth paying to transport the commodity in the right conditions.

Every product has characteristics that need to be taken into account. A principal characteristic of ethanol is that it can absorb water easily and become corrosive, whilst biodiesel has problems with viscosity which require its temperature to be maintained during carriage. The result is that both products tend to be carried in relatively small quantities and relatively expensively, in tankers with stainless steel cargo tanks, which were typically built to carry acids and other chemicals. But then, similar care is taken with the transportation of aviation fuel, which must comply with strict quality specifications, such as Defence Standard 91-91. Very serious problems can arise from contamination during carriage or storage of fuels, as illustrated by the damage caused to cars in south east England in 2007 due to the presence of silicone in gasoline (petroleum) sold by supermarkets.

What sets biofuels apart from other fuel commodities is that the equipment and procedures for testing biofuel products are still being perfected. There have been persistent difficulties obtaining reliable measurements of the Cold Filter Plugging Point (CFPP) of biodiesel – the critical temperature at which a fuel will cause a fuel filter to plug due to components crystallizing or gelling. On a number of occasions biodiesel cargoes have been certified by inspection companies as meeting required contractual CFPP levels on shipment in the USA, but when tested again on arrival in Europe have been found not to satisfy those standards.

Biodiesel traders have grown used to quality testing problems, and have had to become adept at dealing with them when they occur; both by fixing the product and negotiating compromises with their trading counter-parties. However, such ad hoc measures will not always solve problems. In falling markets, failures in quality testing can lead to substantial disputes which cannot be settled outside the court or arbitration.

Reliable ascertainment and maintenance of product quality is fundamental to all international commodities trading, and the expectation must be that systems and procedures for testing biofuels will improve quickly to cater for the growing volume of trade. In the meantime, however, traders will inevitably be more uncertain about the quality of what they are buying and selling than ought to be the case.

To date, the large profits that have been earned from biofuels trading have meant this uncertainty has not driven participants out of the market. But, with a sustained downturn, the particular physical risks and uncertainties associated with transporting biofuels could become a more significant discouragement to trading.

Commercial risk: contracts

Another clear difference between international trade in biofuels and trading in other commodities, such as petroleum or agricultural products, is that there are few standard contracts for the physical sale and purchase of biofuels. Contracts tend to be recorded quickly, often by brokers, and key provisions, which would appear as a matter of course in contracts for the sale of other more established commodities are regularly omitted.

This reflects that significant international trade in biofuels is a relatively recent development, and that trading tends to be undertaken by smaller companies, which often do not have in-house legal departments and are often reluctant to engage external lawyers to prepare contractual templates with standard terms and conditions. The circumstances are similar to those in which the sales and purchases of crude oil and petroleum products were recorded a quarter of a century ago. Back then, contracts involving large volumes and many millions of dollars were being sketched out on two or three pages, and large-scale litigation was a frequent result.

Unsurprisingly, steps are being taken to develop contract forms for biofuels trading. Some of the larger market participants have been working with lawyers to develop their own standard terms and conditions for biofuels sales, and trade bodies are beginning to develop what they hope will become standard industry contracts. In 2007, for example, the Grain & Feed Trade Association (GAFTA) introduced amendments to its biomass contracts (No. 201, 202 and 203) to allow them to be used for trading ethanol and other biofuels on CIF, FOB and Ex Store/Silo terms, and the Federation of Oils, Seeds and Fats Associations (FOSFA) introduced standard contracts (No. 60 and 61) for FOB and CIF sales of biodiesel.

It is worth noting that these early attempts to produce standard contracts come from bodies which regulate the trade of agricultural commodities. Biofuels bridge the traditional divide between wet commodities and agriculturals. Traders in agricultural commodities, such as Dutch company Nidera, now supply bio-energy products, including biofuels for road transport. And companies known primarily for trading oil products, such as Vitol, actively blend, sell and transport biofuels, particularly ethanol. It remains to be seen whether biofuels will remain a crossover commodity of this kind, or if, in time, they will come to occupy just one side of the fence.

Market risks

One of the principal causes of commodities disputes is market fluctuations. The simplest disputes involve buyers trying to avoid performance obligations in a falling market, and sellers doing likewise when the market has strengthened since the contract was agreed and more attractive deals are available.

Straightforward disputes of this kind have become less frequent in recent years under contracts for the sale of crude oil and petroleum products. Prices are typically calculated by reference to average prices published during agreed periods by market indices, such as Platts. Furthermore, both parties can be expected to have hedged their positions with one of the derivative contracts offered by ICE Futures, NYMEX or other futures exchanges.

These arrangements largely insulate traders from market movements, reduce incentives to withdraw from contractual performance, and so minimize the potential for expensive legal disputes. There are rare occasions when a party may become exposed to market fluctuations, for example where a buyer rejects a cargo and stops payment to the seller, thus preventing the completion of the physical transaction and preventing closure of the corresponding paper position. However, even then, the availability of a range of derivative contracts, including swaps and options, will usually enable both parties to maintain effective hedges, albeit at a cost. It is hardly surprising that banks providing trade finance to companies trading in oil products make their provision of finance conditional upon physical contracts being comprehensively matched by a book of paper positions.

These mechanisms and safeguards are often absent from biofuels trading. Physical trading in bio-ethanol is sometimes imperfectly hedged using crude oil derivatives on the basis that there is some linkage (through road fuel) between the markets for the two products. By contrast, the physical trade of biodiesel is often completely unhedged, and consequently has enormous market risks for buyers and sellers, strong incentives to dishonour contractual obligations, and correspondingly frequent disputes.

When prices for biodiesel deliveries into the EU fell sharply during the summer of 2008 there was a proliferation of unperformed and dishonoured physical contracts, and some very serious losses. Legal disputes have inevitably followed. This pattern is likely to be repeated as long as there are no established means of hedging physical biodiesel contracts. It contributes to the view, held by many inside and outside the market, that biodiesel trading is a ‘Wild West’, where huge profits can be made, but where the naïve and unsuspecting can fall victim to less scrupulous participants.

There is a widely held assumption that biofuel trading will eventually go the way of other commodities, with larger trading companies and investment banks entering the markets and the smaller trading companies being subsumed or sidelined. That may well be the case. It happened with trading in oil products, and there is no obvious reason why it should not happen with biofuels. However, larger institutional traders are likely to remain outside or on the periphery of the biofuel markets whilst there remains a lack of effective mechanisms for hedging physical sale and purchase. The prospect of unhedged market risks and frequent litigation is a potent deterrent for such companies. In the meantime, the biodiesel market in particular is likely to be left for smaller participants less averse to risk, and will remain a place where very large profits and losses can be made and where sharp elbows are a prerequisite.

The expansion of international biofuels trading has been driven by national and international initiatives and regulations. The most important stimulus within the EU is Directive 2003/30 EC, which requires Members States to set targets for minimum biofuel content in road fuel with a view to achieving a minimum EU-wide biofuel content of 10% by 2020. Despite misgivings about the effect of biofuels production on the environment, the European Commission reaffirmed its 10% target in March 2008. An important external stimulus has been US federal legislation introduced in 2004 under which US exporters can receive subsidies of up to $264/m3 simply by adding a drop of mineral diesel to biodiesel, the so-called ‘B99.9’ blend. A combination of this US legislation and the EU targets for minimum biofuel content in road fuel has led to a dramatic increase in the importation of biodiesel from the US to Europe.

In April 2008 the European Biodiesel Board (EBB) asked the European Commission to initiate trade remedy action against US biodiesel imports on the grounds that they are subsidized and dumped. The complaint was specifically directed at the B99.9 blend. The EBB claimed that US imports have ‘progressively disrupted the margins of European biodiesel producers, putting most of them out of business’ and resulted in decreasing utilization of European production capacity and lower production figures. Under EU anti-dumping and anti-subsidy rules, such indicators are important elements of the material injury that must be found to allow for counter measures to be taken against such imports.

In June 2008, the European Commission announced it had considered the EBB’s complaints and had found sufficient evidence to initiate investigations into the allegation of subsidisation and dumping.

Since then, the Commission has issued questionnaires to North American exporters and EU importers of biodiesel to elicit information about how the market operates. The Commission is also seeking the views of EU consumers and users of US biodiesel on whether restrictions would be in the ‘community interest.’ Under EU rules, the Commission must balance the benefit to European producers in protection from imports, against the benefit to European importers and consumers of maintaining their unfettered access to low-priced imports.

If the EBB’s complaints are upheld, the Commission may impose anti-dumping and anti-subsidy duties which could have a significant impact on market conditions. Provisional duties may be imposed two to nine months following initiation, and definitive duties may be imposed after 15 months of investigations.

Tensions between the EU and the US seem inevitable. The anti-subsidy investigation, though directed against US companies, would unavoidably target the US executive and legislature themselves, as the source of the allegedly unlawful subsidies. This could pit the EU and US in a direct conflict which would have a negative effect on EU/US trade relations. The consequences of the European Commission’s investigations therefore reach well beyond biofuels trading. With the Commission’s investigation and the continuing controversy of the EU’s targets for minimum biofuel content in road fuel, the sector is likely to remain subject to governmental intervention for the foreseeable future.

Alistair Feeney is a partner at law firm Holman Fenwick Willan
e-mail: alistair.feeney@hfw.com

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