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By the numbers, fraud in biodiesel credit trading is still pretty small beans

Oil companies want to get a free pass for failings in a voluntary, unregulated marketplace they created for themselves.

Under the renewable fuels standards adopted by Congress, companies producing diesel fuel are required to add fuel derived from soybeans, used restaurant grease and other nonpetroleum sources to their blends.
REUTERS/Bazuki Muhammad

Watch for credit-trading scams to become the next rap against biodiesel.What the Strib called “an obscure type of business fraud” in a recent piece on Cargill Inc.’s difficulties is becoming less obscure by the day.

Under the renewable fuels standards adopted by Congress, and applied by the Environmental Protection Agency, companies producing diesel fuel are required to add fuel derived from soybeans, used restaurant grease and other nonpetroleum sources to their blends.

Or, they can just buy a pass in a voluntary, unregulated marketplace of their own creation. As the Strib’s David Shaffer explained, with notable clarity and concision:

Each gallon of biofuel produced gets a renewable identification number or RIN. Companies can use RINs as proof of compliance with the federal biofuel blending mandate.  The credits also can be legally traded on the commodities market separate from the fuel itself. That way a company with more than enough credits can sell extra ones to a company that hasn’t blended enough biodiesel to satisfy the mandate, which is based on each firm’s market share.

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However, some unscrupulous players have produced RINs without actually producing the corresponding fuel, then sold these credits to companies like Cargill and Koch Industries. As the New York Times’ Matthew Wald observed last Thursday, in a broad look at the situation nationwide, “the credits are easier to counterfeit than hundred-dollar bills,” because the 38-digit RINs “have no physical form and are traded electronically.”

Indeed, Cargill’s lawsuit over phony RINs isn’t even against the “producer” who originated them, but against a broker who was buying and selling credits that turned out to be bogus.

So, is this a really big problem? And does it point to something inherently unsound with renewable fuels, or the fledgling industry producing them? I think the answers are no and no.

But Americans have an abiding skepticism, steadily reinforced by the oil industry, about renewable fuels. So problems in this sector always seem to get special media attention.

And some of the numbers are indeed attention-getters, at least until you look at them in context.

Putting the numbers in perspective

Cargill hasn’t disclosed the dollar amount of its loss on 1.2 million bogus RINs; Shaffer came up with an estimate of $1.2 million based on a market price of 99 cents the day he wrote his story, while noting that RINs had traded as high as $1.59 apiece in the past year. (And a week ago they were trading for around 50 cents, according to The Progressive Farmer.)

Wald mentions a scammer in Maryland who took in $9.3 million and another in Texas who raked in nearly five times as much, and writes:

No one is certain how many of the credits are real. So far, more than $100 million in fraudulent credits have been identified, the refining industry estimates. That amounts to roughly 5 percent of the credits issued since 2009, but the percentage could rise as current investigations of other producers progress.

Well, $100 million is certainly a big number, assuming a possibly self-interested industry estimate is trustworthy.

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But 5 percent?

And how about three? That’s the number of producers who’ve been caught generating fake RINs so far.

Even Oil & Gas Journal, in a recent editorial ripping pretty much every aspect of the renewable fuels program and EPA’s administration of it, mentions the RIN frauds only in passing. It laments that “convictions this summer for fraudulent sales of biofuel credits threaten to undermine a crucial regulatory mechanism” for achieving objectives it detests to begin with.

And though some coverage of this issue has suggested that genuine production shortages might drive creation of some fake RINs,  Oil & Gas Journal’s editorial acknowledges there’s enough production capacity to meet the requirements set by Congress and the EPA – even though it naturally thinks those requirements ask too much, too soon.

Why trading doesn’t always work

Why should a cap-and-trade kind of system that has worked reasonably well for similar initiatives – like reducing sulfur dioxide emissions from coal-burning power plants, and getting the lead out of gasoline – run into trouble when applied to biodiesel production?

Wald takes an interesting look at that question in a later blog post with the mis-aimed but perhaps irresistible headline, “How a Green Fuel Turned Slimy.” The fraud opportunity lies not in the fuel but, he says, in the structure of the industry producing it:

The number of power plants and oil refineries is relatively small because big plants have economic advantages over small ones. And they are mostly owned by large, well-established companies. So it is relatively easy to keep track of the players. What is more, power plants and refineries are already required to keep a variety of other kinds of records that an auditor can use to determine if the reduction claims are plausible, like how many tons of coal a plant burned or how many gallons of gasoline it produced.

By contrast, the biodiesel producers tend to be smaller because their raw materials — animal fats collected from restaurants or slaughterhouses, oil from soybeans  are usually collected from many small sources and it is not economically feasible to haul them very far. So the multiplicity of small producers in scattered places created an opening for fraud. The big cases so far have been involved start-ups, or, more accurately, pretend start-ups.

It makes sense, I guess, that a company the size of Cargill or Koch – or of Exxon Mobil, Marathon and Sunoco, all of whom bought phony RINs  – would find it difficult to vet each producer offering to sell credits. Enter the middlemen, like the one Cargill is now suing for failing to validate all the RINs it brokered.

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But this risk was evident at the outset. EPA didn’t create the trading mechanisms – and it didn’t have to. Its obligation is to make sure the players are meeting their obligations under the law. Even allowing credit-trading as a form of compliance could be seen as lenience of a kind.

A strategic lack of diligence?

It’s hard to believe, given all that experience with production auditing, that the oil companies didn’t see these problems coming. It’s easier to imagine that in some cases the RIN purchasers made a strategic gamble to buy blithely and hope for the best —counting on a fallback position, should some of the credits prove phony, of insisting that EPA let them off the hook as innocent victims of others’ misdeeds.

Which is exactly what’s happening now, Wald writes, even as EPA prepares a new rule laying out their due-diligence obligations:

Oil companies, which are long accustomed to arm-wrestling regulatory agencies in Washington, want the EPA to guarantee that the refiners will not be penalized if RIN credits they buy turn out to be false. The EPA has signaled that it is prepared to do that, provided that refiners have done due diligence on the credits under whatever rule the agency adopts. But it is unclear whether the agency will bow to another demand from the refiners: to drop an EPA requirement that companies shop for valid replacement credits if they are found to be holding bogus ones.

Burden on the small producer

Setting aside the oil companies’ problems, perhaps the frauds’ worst consequence for national progress on renewable fuels, and for rural communities with a stake in this new energy sector, is that fallout from the RIN frauds may make it too hard for small producers to compete with big ones in the biodiesel markets.

A buyer’s due-diligence costs will be as high with a small supplier as with a big one, but spread over fewer RINs. If you were an oil company, what would you do?

On the other hand, some small producers think the scandal may turn out to be a blessing, by encouraging buyers that previously ignored them to take a second look. One of them told Meghan Gordon at Platt’s Oilgram News earlier this week that

[S]ales of the fuel and associated RINs have picked up, now that buyers have visited his plant to see for themselves that he runs a legitimate operation — something few brokers or oil companies bothered to do before the fraud.

“It’s made it tough on all small producers, but it’s also opened some doors for me to larger companies that got burned on some of those RINs. … They flat send people out here and they say, ‘You’re the real deal.’ And I say, ‘If you [SOBs] would have called me, I’d a told you a long time ago.”