BIOFUELS FOR AVIATION: INCENTIVES FOR A SUSTAINABLE SUPPLY CHAIN Christoph Jeßberger and Sebastian Wolf Bauhaus Luftfahrt e.V., Lyonel-Feininger-Str. 28, 80807 Munich, Germany

Keywords: alternative fuels, biofuels, sustainability, supply chain management, corporate responsibility, incentive systems Abstract Sustainable alternative fuels for aviation are seen as a necessity in the air transport industry to fulfil ambitious emission reduction goals, i.e. 50% decrease until 2050 [32]. In this context, the focus is often laid on the usage of biofuels. Since 2011, the usage of respective fuel is not only technically feasible and proved, but also formally allowed [3, 2, 45]. However, to be deployed on a large commercial scale they still lack a stable business environment. Additionally, many governments worldwide agree that the introduction of alternative fuels should only be supported if their production is guaranteed to be sustainable along all elements of their supply chain (for example EU, US and Brazil [18, 17, 60]). This aspect is the tipping point which needs to be solved initially. As such, a long-term political, legal and market framework is a prerequisite to establish a working supply chain for sustainable biofuels in aviation. This paper draws on supply chain management techniques as well as on stimulus-contribution and checks-and-balances theory to suggest different incentive systems to enable and encourage respective actors along a biofuel supply chain to comply with sustainability criteria. The aim is to faciliate a sustainable and efficient production of biofuels via market-based measures, government involvement or the combination of both.

1

INTRODUCTION

Sustainable alternative fuels, i.e. sustainable biofuels in case of biogenic raw materials, have the potential to show significant lower life-cycle CO2 emissions than conventional fossil fuels. On a life-cycle basis the opposite can also occur if environmental damages – like deforestation – are caused during the biomass production and/or biofuel conversion. In avoidance of that, sustainablity principles and sustainablity criteria have been developed to ensure sustainability along the entire supply chain from crop to tank [20, 18]. A major drawback of these sustainability systems is that the sustainability of biofuels is not testable like other physical characteristics. This means, non-sustainable production processes can remain undetected and could result in more severe pollution or environmental destruction than fossil fuels. Thus, the current system of sustainability priciples and standards

is neither prone to error nor totally fail-save. In other words, the biofuel market is in need of additional institutions which can handle those undetected non-sustainble production steps. Otherwise the biofuel industry may face financial as well as reputational losses. This paper aims at facilitating the production of sustainable biofuels via incentive and control measures, and is organized as follows. Section 2 describes the differences between supply chains of fossil fuels and biofuels highlighting a change in the decoupling point resulting in a shift from a “push” to a “pull” market. The sustainability challenges in the biofuel industry are outlined in Section 3. Section 4 provides an overview of the problems of transparency as well as trust in the compliance of sustainablity criteria and explains the applied theories of incentive and control mechanisms. Model-based solutions suggesting additional institutions of incentive systems and command-

and-control mechanisms are then depicted and described in Section 5. Finally, Section 6 concludes the paper.

2

CONVENTIONAL SUPPLY CHAINS

VS.

BIOFUEL Source: own compilation.

The oil and fuel industry is involved in a global supply chain that includes domestic and international transportation, ordering and inventory control, materials handling, import/export facilitation, and information technology. In this system, a company is linked to its upstream suppliers and downstream distributors via material, information, and capital flows up and down the supply chain. The fuel industry is thus a classic model for implementing supply chain management (SCM) techniques. SCM can be defined as the configuration, coordination and continuous improvement of a sequentially organized set of operations to maximize benefits and minimize costs along the supply chain [10]. Today’s conventional fuel supply chains are generally divided into different, yet closely related segments, an upstream and a downstream stage. The upstream supply chain involves the acquisition of crude oil, which is the specialty of the oil companies. Respective processes include the exploration, forecasting, production and logistics management of delivering crude oil from remotely located oil wells to refineries. Downstream starts at the refinery, where the crude oil is manufactured into the consumable products. This stage thus involves the process of delivering the crude oil derivatives to customers around the globe [30]. Based on forecasts, a certain volume is produced in a make-to-stock mode from available crude oil. As such, when a costumer places an order, this order is fulfilled by delivering from “stock” starting at the refinery or a storage facility. A conventional fuel supply chain therefore produces standardized products in a typical make-to-stock structure, making it a tradidionally supply led process

Figure 1: Decoupling points in conventional & biojet supply chains

dominated by the availability of crude-oil feedstock [40]. The biojet supply chain also comprises an upstream (encompassing cultivation, harvest and transport) as well as a downstream stage (starting with the conversion of plant oil or biomass into respective fuel over to the transport of the fuel to the end-user) [1], but it currently works differently. Although a longterm, make-to-stock process may be established, today’s biojet supply chains are not economically feasible. As such, they do not produce biojet to stock but on a make-to-order basis. Once an order is placed, the respective fuel is “pulled” through the supply process starting from the feedstock cultivation and procurement stages. Respective supply processes thus start only after an order has been placed downstream. In this context, two differing supply chain philosophies can be distinguished among conventional and biojet supply chains, namely “push” and “pull” production. As, ultimately, pre-products or bulk raw materials are used from stock in both supply chains, a suppply process generally comprises a push as well as a pull part. The link between these two production approaches is called a decoupling or order penetration point. As priorly discussed, conventional kerosene can mainly be considered a push product, while biojet is currently mainly “pulled” downstream. Conventional kerosene and current biojet production chains therefore

Note: Red: Competitive strengths and positions of conventional jet. Green: Competitive strengths and positions of biojet. Black: Valid for both. Source: own compilation based on [42].

Figure 2: Porter’s five forces diagram for conventional kerosene & sustainable biojet production have differing decoupling points along their chain, with the order penetration point of biojet much further upstream as shown in Fig. 1. This fact changes the power as well as responsibilities of respective suppliers and buyers. Using Porter’s five forces analysis [48] the shifts in respective powers of a conventional and a biofuel chain can be distinguished as shown in Fig. 2. Although usually employed to determine the competitive intensity and attractiveness of a market, changes in market power can also be discussed to derive implications for a facilitation of sustainable production practices. In conventional as well as in biojet supply chains, airlines are seen as the main buyers.

Suppliers of the raw material, in turn, differ. For kerosene they are large oil companies, while for biojet this position is generally taken on by small- and mid-sized feedstock cultivators. As such, the power of the suppliers and buyers is inverted in the respective chains. While conventional fuel supply is dominated by a few major, settled suppliers, the biofuel feedstock is mainly sourced from a range of small- and mid-sized providers. The power of the suppliers is therefore considered to be high for conventional jet and low for biojet. The power of the buyers is also inverted, shifting from low (conventional jet) to high (biojet). Although the number of buyers remains constant for both products, conventional kerosene is a

“make-to-stock” push-product with established production systems. The opposite applies to biojet chains. Currently being a “madeto-order” pull-product with no large-scale, economically feasible production capacities, the buyers have a relatively high level of power over suppliers. Additionally, the differing threats of substitutes, new entrants as well as shifts in competitive rivalry also facilitate a shifting of supplier to buyer powers (cf. Fig. 2). This is important when considering incentive systems for sustainable production practices. In line with a shift in power comes a change of the focal company. This is the visible entity of a supply chain, which is also held responsible and accountable for the procurement and production practices. While in conventional fuel chains oil companies are seen as main responsible actors, this perception changes for biojet. Here, airlines are seen responsible for the impacts incurred by the usage of biofuel [5, 36, 11]. Especially with biojet currently being “made-toorder”, the high buyer power thus turns into an increasing corporate responsibility, as feedstock procurement is seen to start once the product is “pulled” by an order. As such, in accordance with the “polluter pays” principle (i.e. the party responsible for producing a negative externality also pays for the damage done), biojet end-users are seen jointly responsible for a sustainable and pro-active SCM.

3

THE SUSTAINABILITY CHALLENGE OF BIOFUEL PRODUCTION

In 2009 the specification ASTM D7566-11 “Standard Specification for Aviation Turbine Fuel Containing Synthesized Hydrocarbons” [3] allowed the commercial use of synthetic fuel from coal, biomass and natural gas produced using Fischer-Tropsch synthesis (FT). Although the production of biofuel using FT has made significant technological progress in the last

years and offers a great long-term potential, there is currently no large-scale production of these fuels [21, 34, 54]. In a short- and mid-term perspective these fuels are therefore not available. However, a second annex was added to this specification in 2011, permitting the use of hydroprocessed esters and fatty acids (HEFA). Up to 50% of these bio-derived synthetic components can be added, resulting in a fuel which is essentially identical to conventional aviation fuel in terms of performance and operability, i.e. “drop-in” capable without limitations or the need for special handling or re-certification of aircraft [3, 2, 45, 23]. Additionally, in contrast to biomass-to-liquid technology, HEFA is a mature process already being used today on a commercial scale [15, 21, 19, 28, 29, 44]. It is thus currently the only commercially viable conversion pathway for alternative aviation fuel. However, a significant scaling up of respective feedstock production is needed to provide sufficient quantities to meet the demand of aviation. But direct and indirect negative externalities can occur especially in the process steps of land conversion and feedstock cultivation (cf. Fig. 3). Here, deforestation, loss of biodiversity, the intensive use of fertilizer and pesticides, the depletion of groundwater resources, soil erosion as well as the displacement of local residents are some of the impacts which could result from an expansion and/or intensification of current biofuel feedstock cultivation [13, 14, 16, 26, 28, 35, 49, 24, 59, 12]. Biofuels are thus both chance and challenge for the industry. A chance, as they provide aviation an alternative to fossil fuels; a challenge, as the necessary, massive production of appropriate feedstock could lead to significant detrimental side-effects. As shown in Fig. 3 the main social and environmental impacts occur far “upstream” in a biojet supply chain (left hand side of Fig. 3). In contrast, today’s supplier relationships are

Source: own compilation based on [56].

Figure 3: In-/Outputs of a biofuel supply chain mainly focussed on ensuring the price effectiveness, timely delivery and quality of fuel after refinement, i.e. “downstream” [9, 40]. Therefore, to ensure sustainable production practices, a longer part of the fuel supply chain must be taken into account and pro-actively managed [52, 53]. In this context, certification schemes are widely used to mitigate risks when employing biofuels. However, even certified endproducts cannot guarantee the high environmental and social quality needed for a mass usage of respective fuels. Despite the multitude of (voluntary) sustainability standards, the certification process is neither prone to error nor totally fail-save. Not only the wide range of different schemes, but also the current focus of certification processes make the control of compliance with sustainability criteria difficult. In Europe alone, for example, 14 different certification schemes are conform to the EU Renewable Energy Directive (EU RED) [18] and can be equivalently applied to certify the “sustainability” for one or more production steps within

a biofuel production process [20]. The different institutions mutually acknowledge the sustainability certificates of each other for individual steps along a supply chain. Although, this enables companies to freely choose a certification scheme, it significantly impedes the traceability and transparency of the process as discussed in the following.

4

BUILDING SUSTAINABLE BIOJET SUPPLY CHAINS

To initially build sustainable biojet supply chains, end-users rely on the propriety and validity of a certification process. In how far this is credible, however, is dependent upon a number of underyling socio-economic factors as pointed out in Jessberger and Wolf (2013) [37]. Especially as the initial phase of feedstock production contributes to an irreversible destruction of ecosystems as well as social impacts, there is a special need for optimising the entire chain in terms of transparency, control and traceability.

Source: own compilation.

Figure 4: Decision tree of biofuel market actors from crop to tank 4.1

The Problem of Transparency & Trust

Game theory helps to illustrate a typical decision process as well as strategic advantages and disadvantages of each actor along the biofuel supply chain. This way it is possible to point out the necessity for transparency and control mechanisms of downstream players. The schematic decision tree of Fig. 4 depicts a sequential decision process from a feedstock producer over a certifier, a biofuel producer and another certifier to the end-user. The biomass producer and biofuel producer can decide either to produce sustainably or non-sustainably according to defined criteria (e.g. of the RSB [50]). A certifier can then decide whether he grants a sustainability certificate or not. Ultimately, the end-user purchases the respective biofuel or not. An important aspect is, that neither the biofuel pro-

ducer nor the end-user can observe if the upstream production has been carried out according to sustainability standards (i.e. if a sustainability certificate is granted). Only the existence of a sustainability certificate allows to draw conclusions concerning the sourcing process. This means, for example, that a biofuel producer does not genuinely know whether he is in node C2 or C3 in Fig. 4. Via backward induction the nash equilibrium (i.e. truly sustainable production) can only be achieved by the strategy profile A1, B1, C2, D3, E6 (green path). Here, every producer adopts the strategy to “produce sustainably”, every certifier correctly grants a sustainability certificate and the end-user purchases sustainable biofuel. However, the certificate is the only available proof. As such, producers and/or certifiers may defect from the nash equilibrium (see Table 1) without being detected by

Table 1: Strategy profiles of deviating biomass producer and/or certifier

1 2 3 4

Biomass producer and/or certifier 1 nash deviate deviate nash

Biofuel producer and/or certifier 2 nash deviate nash deviate

Strategy profile A1, B1, C2, D3, E6 A1, B2, C3, D6, E11 A1, B2, C3, D5, E10 A1, B1, C2, D4, E7

the other players. This problem can also be described by moral hazard theory [41]. Here the root-cause lies in the defiance of sustainability criteria by upstream suppliers, but only downstream actors – the focal companies – are made responsible for non-sustainable biofuels. Moral hazard is also an issue for the end-user, as the sustainability certificate acts as a kind of insurance. The end-user “pays” for this “sustainablity insurance” via a certification for every tonne of biofuel ordered. This can influence an end-user’s decision to order large amounts of biofuel, although he is aware of the upstream social and ecological impacts that respective quantities may induce. Additionally, due to the current information asymmetry of the actual sustainability performance of biomass or biofuel adverse selection [41] may occur, i.e. an inefficient biofuel supply chain develops which produces non-sustainable, but possibly certified, biofuels. The example shows, that preceding processes are always out of scope of downstream actors. A company currently only has direct control and transparency of the 1st-tier suppliers. A view further upstream to 2nd- or 3rd-tiers is not explicitely required, albeit necessary to guarantee sustainability. However, these always bear (legal) responsibility for the sustainability performance of their products (principle of passing the buck) [6]. As a physically testing

of the sustainabiliy performance of biofuel is not possible, some actors may have an incentive to not comply with sustainability criteria and still pass on their alleged sustainable products. As such, a high level of trust is needed by the subsequent actors and especially the end-users. Conventional and (even more) sustainable supply chains thus heavily depend on the management of relationships and on the building of trust among associated actors. As such, the current view of the end-user needs to be (temporarily) expanded to an extended or better advanced view – which incorporates all actors up to the biomass producer – because the upstream compliance with sustainability standards can also not be observed in node C2. The major challenge in transforming conventional supply chains into sustainable ones thus does not only lie in the technical feasibility of introducing environmental and social standards, but rather in the management and co-ordination of involved actors [27]. In this context, three different forms of institutional arrangements, allowing the coordination of transactions between economic actors, can generally be distinguished [63, 64]. The choice of a suitable arrangement is based on the objective of minimising transaction costs that arise from the need to co-ordinate activities. In sustainable supply chains, this not only includes monetary expenses, but also non-monetary costs (non-conformaty costs) [37]. The choice of the co-ordinative technique among supply chain actors therefore includes [65]: • Uncertainty of transaction: Uncertainty is determined by the environment and behavioural uncertainty, i.e. uncertainty caused by the behaviour of the transaction partners. • Asset specifity: Assets include all investments that are carried out in the context of a transaction with a certain partner, i.e. investments in technology or human capital.

• Frequency of transaction: The frequency of transaction determines if economies to scale transpire with regard to production and co-ordination costs. High transaction-specific assets, high uncertainty and repeated transactions between partners generally lead to the choice of a hierarchy as an institutional arrangement. Low uncertainty of transaction, low asset specificity and single transactions, in turn, suggest the choice of market hierarchy. Hybrid forms lie between these extremes. The mechanisms of the underlying transactions thus vary according to the chosen institutional arrangement. In markets, price is the overriding co-ordinative factor, while hierarchies are dominated by command-and-control measures. Supply chains are considered a network of actors involved in a value-adding process. This network can be co-ordinated via price, negotiation and command-and-control techniques. The choice of a co-ordinative technique depends on the nature of the transactions and the related (product) characteristics as shown in Table 2. As the procurement of sustainably produced feedstock for biojet is currently not available on a large-scale while having to fulfill very specific criteria, a high transaction uncertainty as well as high asset specificity can be assumed. Additionally, a high transaction frequency is also needed to procure enough feedstock. As such, although the actors of a fuel supply chain currently rely on price as the coordination mechanism, a biojet chain to ensure the adherance to sustainability criteria should encorporate command-andcontrol mechanisms. This is especially the case for the first stages of initial process development and relationship management. Especially in the context of a rising buyer power, as pointed out in Section 2, the current price dominated co-ordinative technique should be expanded by a command-and-control based structure. The aim is to co-ordinate and con-

Table 2: Choice of institutional arrangements on the basis of characteristics Market Co-Operation Hierarchy Uncertainty of o + transaction Asset specifity o + Frequency of o + transaction Coordination Command Price Negotiation mechanism & control (“-” = low, “o” = medium, “+” = high)

trol transparency measures as well as build relationships and especially trust among the actors up- and downstream the supply chain. This is important as the end-user is in direct contact only to the 1st-tier supplier. Subsequently, once a high level of trust and co-operation is achieved, i.e. transaction uncertainty is reduced, command-and-control measures may be reverted back into negotiation or price based co-ordinative mechanisms. Thus, the increasing buyer power may be a unique driver for bringing about positive changes upstream the supply chain in terms of transparency and relationship management [55]. 4.2

Benefits of Incentive & Control Mechanisms

The increasing need of transparency and trust in the primary phases of supply chain development may be achieved by installing stimuluscontribution as well as checks-and-balances technqiues. According to the Stimulus-Contribution or Contribution-Inducement (C-I) theory, economic actors feel motivated by a range of inducements (e.g. money, products, recognition or fame) to contribute (e.g. labor, materials or money) to an organization [4, 43, 31]. An organization is most succesful if inducements and contributions compensate each other in terms of a cost-benefit analysis (the sum of contributions should correspond approximately to the sum of inducements). As such, respective actors contribute only if they value the inducements of-

fered at least equivalently to their contributions [31, 51, 38]. In the context of a sustainable biofuel supply chain, the willingness of each actor to pursuit a common goal (sustainable biofuel) is dependent upon the individual inducements provided. Thus, the decision of an end-user to purchase a biofuel depends on his trust in upstream compliance in sustainability standards. To build this high level of trust, initial command-andcontrol mechanisms are needed upstream. Furthermore, biomass producers need an equivalent inducement for such additional command-andcontrol mechanisms in order to continue to participate in a (sustainable) biofuel supply chain. Exerting its greatest influence on regulatory policy, the idea of Checks-and-Balances [8, 25, 62] is incorporated in various political frameworks and constitutions [46, 58, 57, 61]. For example, in German law on stock companies, in the system of independent central banks or more recently in some investment banks this idea is applicable, were watchdog functions are installed to monitor traders [7, 47, 39]. Checks-and-balances is an approach to compensate an imbalance of power by the use of mutual control mechanisms and, thus, a mutual restriction of power. In the context of sustainable biofuels an imbalance of power is present, for example, as biomass producers can decide to farm sustainably or not and downstream actors are dependent on this decision. Another example is the high power of buyers (cf. Porter’s five forces in Fig. 2 in Section 2) due to the “pull” effect caused by a biofuel order. On the one hand, market power of many small- and mid-sized farmers is very limited relative to a few suppliers and/or end-users “pulling” through the supply chain. On the other hand, existing small-scale farms may be driven out of the biomass market by powerful agro-industrial operators due to an end-user’s order of huge quantities of biofuel [37]. With the aid of command-and-control mechanisms as well as appropriate stimuli and inducements these issues can be solved as described in the

following section.

5

GOVERNMENT-CENTERED AND MARKET-BASED INCENTIVE SYSTEMS

Based on the previous findings, two incentive systems are discussed in the following which both aim at improving the compliance with sustainability criteria. Both theoretical models of incentive systems are based on a generalized biofuel supply chain (cf. Fig. 3 in Section 3). One system aims at a deeper governmental interaction of participating countries in the biofuel production process. The other incentive system describes a market-based approach with an increased cooperation of the downstream companies employing a fund to jointly encourage the development of a sustainable biomass production. The first case is described in Fig. 5. Here, the actors of the biofuel supply chain are surrounded by three key players setting the scene: Domestic government (e.g. Germany), foreign country’s government (e.g. Brazil) and an independent certifier. Green arrows highlight the important new instruments to stimulate additional continuous control mechanisms (blue arrows). If one actor of the biofuel supply chain deviates from this framework, i.e. not meets sustainability criteria, a mechanism of sanctions becomes effective (red arrows). Here, the central instrument is a bilateral import agreement between Brazil and Germany. Due to this agreement at governmental level, the Brazilian government is jointly liable for delivering sustainable intermediates to German facilities. Thus, Brazil has an incentive to additionally monitor its domestic biomass producers as well as the independent certifier. For that reason Brazil will choose and engage the services of an independent certifier rather than the biomass producer himself. By this means, the threat

Source: own compilation.

Figure 5: Incentive system based on an import agreement

Source: own compilation.

Figure 6: Fund-based incentive system

of a joint deviation by the biomass producer and the independent certifier as well as a wilful negligence of the certifier is reduced. A market based approach to enhance the realization of a sustainable biofuel production is illustrated in Fig. 6. Here, the framework for the actors of the biofuel supply chain is set by a fund, non-governmental organizations (NGOs) and governmental organizations (GOs), and again an indepentend certifier. This time, to fully enable a free market system, an independet certifier can be freely chosen at any stage of the value chain. Black arrows show the schematic system of controlling and issuing certificates. Indicated by blue and green arrows, a two stage approach of incentive systems for sustainable biofuels takes place as follows: Firstly (blue arrows), downstream actors – like end-users, suppliers and biofuel producers – jointly pay into a fund. This money is then invested in biomass production projects. From a German perspective, downstream actors are typically located in Germany or Europe and upstream players, like biomass producers, farm outside Germany or Europe, i.e. highly probable in developing countries. Thus, these projects may be developing projects and could also be financially supported by GOs. Another benefit of investing money via a fund are leverage and synergy effects in terms of being able to fund larger projects and saving money due to joint and, thus, lower administration costs. Similar to traditional development projects, NGOs are involved and can greatly enhance the successful production of sustainable biomass due to its local or regional know-how and network. For example, during the first two or three years of a biomass production project NGOs can support participating agrarian actors on-site by means of educational programs to train farmers in sustainable cultivation practices. Additional financial support can be provided through funding risky or expensive initial investments for a sustainable production. Moreover, with the aid of

such biomass production projects a trustful and fruitful cooperation between farmers, processing industry and end-users can be developed. Secondly (green arrow), if the initial two or three years of a developing project are over, the fund keeps alive the recurring production chain of sustainable biofuels with the same participants in every round. Downstream users of the sustainable biomass pay into the fund and biomass producers are reimbursed their extra costs for a sustainable production after the enduser has bought the biofuel. This way, the surcharge for the ensured sustainability of a biofuel is not part of the price of the biofuel but simply equals the funds passed from downstream users to upstream producers. 6

CONCLUSION

According to a 2011 EU Whitepaper CO2 emission reductions of 60% by 2050 (relative to 1990 levels) are to be achieved using 40% “low-carbon sustainable fuels” in the aviation sector [22].The ICAO SUSTAF Experts Group also recommmends a life-cylce net reduction of greenhouse gas emissions (relative to conventional jet fuel) for the deployment of sustainable alternative fuels in aviation. However they claim that “there is no globally recognized approach to determining sustainability for alternative fuels” [33]. Demonstrated in Section 5 of this paper two incentive models show how such a global approach could be implemented. In a nutshel, initial additional command-and-control mechanisms as well as inducements – regardless wether they are privately or publicly driven – help to build trust and facilitate transparency in the biofuel supply chain. That way, a working supply chain for sustainable biofuels as well as an efficient market output can be achieved.

ACKNOWLEDGEMENTS Special thanks to Jenny Walther-Thoss and Lydia Pforte, and thanks to all aireg members of the aireg working group “Sustainability” for the fruitful discussions about the mutual acknowledgements of sustainability certificates along the production chain. This paper benefited from the financial support of the Federal Ministry of Economics and Technology (BMWi) due to a decision of the German Bundestag.

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