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Updated with comment from the EPA: What’s bad for Cello Energy, the Khosla Ventures-backed startup that an Alabama jury last week decided made fraudulent claims about its biofuels technology, could in a way be good for cellulosic ethanol — or at least open up new incentives […]

cellulosicethanolharvestgenericUpdated with comment from the EPA: What’s bad for Cello Energy, the Khosla Ventures-backed startup that an Alabama jury last week decided made fraudulent claims about its biofuels technology, could in a way be good for cellulosic ethanol — or at least open up new incentives for the fuel. As the research firm ThinkEquity notes in a new report, if cellulosic ethanol production falls short of the EPA’s estimate of more than 100 million gallons next year, new incentives are supposed to kick in to support production of the fuel as part of the proposed Renewable Fuel Standard update, or RFS2, which is slated to increase the amount of renewable fuels that must be blended into gasoline.

The EPA has yet to finalize RFS2 (just last week it extended the comment period for RFS2 changes to Sept. 25), and at this point the agency’s initial estimates for 2010 production appear out of reach. According to ThinkEquity, that’s largely because the EPA included a contribution of 70 million gallons of cellulosic ethanol from Cello Energy as part of the estimate in its Draft Regulatory Impact Analysis, and for Cello, 70 million gallons looks like it will be a stretch. The startup has one factory capable of producing, in a best-case scenario, only up to 20 million gallons per year, if the technology works. On top of that, it’s just been slapped with an order to pay more than $10.4 million in the fraud case brought by onetime investor Parsons & Whittemore Enterprises.

In the event of a shortfall (not enough renewable fuels to meet minimum blend requirements), ThinkEquity wrote in its report late last month that the EPA can sell credits that would increase the value of cellulosic ethanol to a minimum price of about $3 per gallon (up from ethanol futures’ current $1.77 per gallon). Alternatively, it can hold off on implementing the rule until after January 2010, giving the industry more time to ramp up production. Delays may be the more likely route, but we are waiting to hear back from the EPA about how Cello Energy’s legal and financial struggles might affect the standard or revised estimates.

The way ThinkEquity tells it, the EPA had no obvious reason to have so much confidence in Cello’s output when the agency put out its Draft Regulatory Impact Analysis with the 70 million-gallon estimate. According to the firm’s report, released late last month, on the Renewable Fuel Standard, it was surprising (to both analyst David Woodburn and people in the biofuels industry) that Cello even made it onto the EPA’s radar, given its limited production capacity and financial resources:

“The major difference between our list and the EPA’s list is the EPA’s inclusion of 50 million gallons coming from Cello Energy plants not yet under construction — a firm that many industry players had not heard of until the EPA’s May announcement”.

Woodburn goes on to say ThinkEquity “probably wouldn’t pay much attention to Cello until we could see evidence of the process output,” but it has been intrigued by a couple factors — first, Khosla Ventures’ $12.5 million investment (part of an agreement revealed in court to also include a pledge to invest another $25 million for additional facilities), and second, the firm that Cello hired to do its patent work. According to Woodburn:

“Cello’s patent work was done by a firm that we worked with when we were in the pharmaceutical industry (think big budgets) over a decade ago — not a typical resource for a solo inventor.”

But those “intriguing” factors hardly indicate an ability to more than triple production capacity within a year. Based on the findings from the fraud case last week, we saw two main lessons for investors getting giddy over a buzzy technology: Do your homework, and prepare to wait. Looking at the EPA’s high expectations for a startup like Cello, with serious financial and technological hurdles ahead if it’s going to scale up its production as planned (not to mention the added challenge of repairing its reputation to win over customers), it seems those lessons can also be applied with more diligence at the federal level.

Update: The EPA press office tells us, “We are continuing to assess the viability of not only Cello, but also the various other technologies and companies in supplying cellulosic biofuel as we finalize the RFS2 standards this fall, and in particular, the cellulosic biofuel standard for 2010.”

Generic picture of cellulosic ethanol via Alextiller and creative commons.

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