Is RNG Right for Your Farm?

Janine Sekulic: 

Well, good morning, and thank you for joining us.  I'm Janine Sekulic.  I'm based in Chicago and I lead BMO's US Agriculture Team.  The economics of renewable natural gas and the evolution of carbon markets have generated serious interest in animal- in the by-products of animal agriculture.  It's providing what looks to be an exciting opportunity for livestock producers to expand operations, diversify their revenue and improve their own carbon footprint.  These are complex discussions that sometimes raise more questions than answers and we've certainly had a number of those discussions with our customers, and so we have lined up a panel of internal and external experts to help address some of those.  We've got a lot to cover in a pretty short time, so let's get right into it. 

I'll start off by introducing our panelists.  Joining us from New York is Aiden Seder[?], vice President of BMO's Energy Transition Group.  Aiden provides advisory services and leads transaction execution for energy related opportunities supporting clients as they navigate to a low carbon economy.  Aiden is specifically focused on RNG, renewable fuels, environmental products, carbon capture and hydrogen.  He has over 11 years of experience in oil and gas, including energy investment banking here at BMO and previous technical experience in subsurface [inaudible] at Canadian Natural Resources.  Thanks for joining us, Aiden.

From Calgary, Alberta, we have Steve Kehoe, director in BMO's Energy Transition Group.  Steve is a broad specialist focusing on new energy transition technologies, including among others, low carbon fuels, renewable natural gas, hydrogen and carbon capture and sequestration.  Steve came into this role with a Bachelor of Engineering Science with Distinction and a Master of Engineering Science in mechanical engineering from Western University and he's an ambassador with the Energy Futures Lab.  Prior to joining BMO, Steve worked in the oil and gas industry in production and exploitation engineering and then spent 12 years working in acquisitions and divestitures advisory with BMO's Energy Group evaluating energy assets and executing transactions.  His work on the hydrogen economy has become an important touchpoint for many BMO clients, government and agencies.  Thanks for joining us, Steve. 

From Madison, Wisconsin, we are pleased to have Jordan Hemaidan, partner and energy group chair at Michael Best.  Jordan helps energy companies and other sophisticated businesses structure and contract for large scale capital expansion procurement, including representation in citing and certification cases for large power generation facilities, electric transmission lines, private energy facilities and large agricultural projects.  He also represents clients in the transactional and regulatory aspects of purchasing and developing renewable energy projects, including wind, solar and biomass.  Jordan is known for his ability to achieve consensus among various stakeholders as well as his creative solutions in resolving disputes and completing transactions.  His practice also includes a wide range of energy related procurement and construction matters, including contract negotiation, contract administration, bid protests and dispute resolution.  He guides public utilities through rate making and other regulatory matters by establishing close relationships with regulators, yet never compromising his ability to fight for his clients.  Thanks for joining us, Jordan.

Jordan Hemaidan:  

Thank you, Janine.

Janine Sekulic: 

Joining us from New London, Wisconsin is Dan Wenzel.  Dan is a founding partner of the Dairy Business Consulting Group.  He has been working in the dairy industry since 1986 and has been a consultant working with large modern dairy since 1990.  Dan provides financial and business management services to dairy farms, including budgeting and monitoring analysis, benchmarking, expansion planning, workout scenarios and expert witness consulting.  He also helps his clients with on-farm communication, farm transfer preparation and advisory team meetings.  Raised on a dairy farm in Manitowoc, Wisconsin County – the Canadian comes out every once in a while when I try to say those Wisconsin names.  I got it.  Dan graduated with honors from the University of Wisconsin Madison with a Bachelor of Science degree in Dairy Science and Agricultural Economics. 

And last but certainly not least, from Marshfield, Wisconsin, we have Brad Gucey[?], Senior Vice President in Agriculture Relationship Manager here at BMO.  Brad manages a portfolio of production agriculture customers with a focus on dairy accounts.  He has 10 years of experience in dairy nutrition and over 25 years of agricultural banking, 21 of which have been here at BMO.  Brad is also very involved in the industry and in his community and is passionate about farm safety and mental health.  He served 21 years in the Wisconsin Army National Guard, retiring in 2004 after a successful deployment to Afghanistan.  Thank you for your service, Brad.

Brad:

Thanks for being worth it, Janine.

Janine Sekulic: 

Thank you.  He holds a bachelor’s degree from the University of Wisconsin River Falls and would note that he saw his first bio digester in 1981 and has been involved in financing the earlier round of digester projects.  Well, I am excited about the breadth of knowledge and the perspective that we have here today.  I've got some questions to get us started.  I would encourage you, if you have questions, please type them in the chat box.  We'll get to as many as we can today and we'll follow up later on the rest.  At the end of the webcast, you'll also see a survey pop up once you log out and we'd really appreciate your feedback on what you see today and what things you might look to us from in the future.  Okay, so let's get started.  Let's start with what's driving all of this activity and the carbon market in general.  So Aiden, maybe we'll start with you.  What is the carbon market? What's trading? Who's buying? How do they connect with sellers?

Aiden:  

Good question, Janine.  I'm sure everyone's heard a variety of different concepts and names and voluntary and compliance in fuels.  And I think to simplify it all, it's just important to simplify compliance.  And the right way to think of that is people that need to do it or participate in that market and voluntary people who choose to participate.  And so when we think about RNG, there's two types of credits that are really important.  There's the RINs or what's referred to as Renewable Fuel Standard, which is a federal program administered to the EPA and then the California Low Carbon Fuel System, which is a state program that's administered to the California Air Resource Board, often referenced as CARB.  These programs apply to fuel importers and refiners.  So think of people that are making your diesel, your gasoline or importing from other countries and they're obligated to participate in this program.  So many of the largest refiners in the world like Shell, like Valero are purchasing credits and there's a variety of parties that are generating them.  And so these folks connect through third party intermediaries directly in order to facilitate the buying and selling of the credits.  And that's how the market works in a very short, kind of, in a nutshell, if you will.

Janine Sekulic: 

Okay.  So what has that value of those credits done over time and how did the value of the different types of credits compare?

Aiden:  

That's a good question too.  So the two markets we talked about and it's important, we're only talking about a subset of these.  You know, we could go on for hours and hours if we were going to talk about this one topic alone.  So the LCFS market, so that's the California market we just talked about, has gone through some pricing pressures.  So over a couple of years ago, you would've seen the price being about $190 a time that's come down to, you know, about a less than a $100 a time.  And this has been driven by the large volume of renewable products that have come online.  So the reason for the program is to incentivize renewable products like renewable natural gas to enter the market, but there's been a lot of these products that have entered today.  And so carb, if you remember the California Air Resource Board who administers the program is contemplating some broad scale changes in order to support that pricing backup.  There's no magic, you know, 8 ball that identify exactly where they go, but they're working towards providing some pricing support to that program.  RINs, which is the federal level program we talked about, have gone through some pricing volatility, but have actually been quite stable over the last while.  So there's a bunch of different RINs, and I won't go into it, but the one that you want to keep an eye on if you ever go to the EPA website is the D3 RIN.  So Delta 3, that's the one that's most applicable to RNG producers.

Janine Sekulic: 

Okay. That kind of leads into a question I was just about to ask, which was how transparent is that market for credits, but it sounds, like where do we find these values? It is the EPA website generally.

Aiden:  

That's a good question.  Yeah, the EPA website provides you some real-time pricing where people who are trading will report in the pricing on a weekly basis.  So you can see some weekly averages on their website.  And then the California Air Resource Board, again, they provide some weekly pricing as well, which you can find on their websites.

Janine Sekulic: 

Okay.  And are those really the only two- I know you've already sort of mentioned there are a number of others, but can you give us a couple of examples maybe of other?

Aiden:  

Yeah, so look, there's more markets coming online.  Two of the major ones that are coming online in 2023 are going to be Washington State and the federal system in Canada for folks that are near or proximal to the border.  But there's also programs in Oregon and British Columbia, if you're on the West coast or in the Western interconnect.  And further, there's programs that are voluntary.  So what's happening is parties out there, just corporations who consume natural gas, will enter into off-take contracts similar to the renewable power market, where they will go to someone who's generating renewable natural gas and say, I will buy it for this set price for an extended period of time, which just completely bypasses the credit market altogether.

Janine Sekulic: 

Got it.  Okay.  So maybe Steve, that leads to a question for you.  I guess obviously, there's a supply and demand sort of built into the value of these credits for the gas in general.  I guess what's the size of the market for RNG? How many digesters can we build and do you think there's a risk of saturation?

Stephen Kehoe:

In terms of saturation, I don't think it's a risk.  One of the stats I heard was that if we were to capture all of the renewable natural gas we could in North America from all the sources, so cattle, dairy, municipal solid waste, it would amount to about 2 BCF per day.  And when you think that North America consumes about 115, 120 BCF per day, it's a drop in the bucket.  So I think from the perspective of people who own these assets, so think dairy farmers, you've got an asset that's very limited that's going into a market that's very broad.  So I would say there's not a risk of it being saturated.  It's almost the opposite.

Janine Sekulic: 

That's very promising for the kind of longevity of these projects for sure.  How does the work that you are doing today compared to the work you did in the heyday of conventional oil and gas?

Stephen Kehoe:

I think it's very similar and we see it as a very similar market.  So when we would work with oil and gas companies, we typically worked - the area I worked in and Aiden was in that for a bit as well, they're relatively small companies, so junior mid-size and they essentially worked as like the R&D arm of bigger oil companies.  So they would go out and develop properties.  They would get into a point where they were sustainable and commercial and then they would want to be sold.  So we would act as essentially like a real estate agent.  So we would represent them, we would help them build a marketing plan and then take it to market.  And we also have the relationships with most of these companies that would be buyers.  So larger oil companies, private equity firms, midstream companies sometimes.  So we would have those relationships and then we would help these oil companies get the best value for their asset that they had built up.  And then typically what they would do is after they sold that, they would go start up another one.  So it was sort of a running treadmill that way and it worked really well.  So we see this as a really good analogy with what's going on with farming right now and with the whole renewable natural gas space.  So dairy farmers, cattle farmers, they've got the asset and I'm sure many of them are being approached right now by different developers.  And as many of them are clients of the banks, we want to make sure they get the best possible deal they can.  So that's sort of the situation we see is where they've got the asset and you've got to maximize that value.

Janine Sekulic: 

That's great context.  I think that kind of ties or leads over nicely to talk to Jordan, our attorney on the panel.  Jordan, you've been working in this space since very early on.  And from your standpoint, how have the structures of these contracts or projects evolved?

Jordan Hemaidan:  

I think it's a very interesting history, Janine.  What we saw at first, I'll call it the tale of two developers.  We saw first very sophisticated subsidiaries of established energy companies coming in, targeting farms that already had digesters.  That's what I'll call a low hanging fruit.  And these sophisticated companies who made this their target were very successful at sort of rolling up these larger farms that already had digesters and structuring the deals so that the main compensation to the farm was in the form of a fixed rent amount under the lease.  And then there would be a separate manure supply agreement that wouldn't be separate compensation under that so the rent amount, which remained unchanged except for maybe an inflation escalator throughout the long term of the contract, the competition was fixed.  At the same time, there was sort of an explosion of developers who mean very well, but who were very thinly capitalized.  Now, one would think that farms would take a look at these folks and just say, thanks, but no thanks.  But what they were good at is sort of promising the moon, saying, hey, we're going to build either the biogas upgrade facility if you already have a digester or the entire capital expansion with the digester and upgrade facility and we're going to have, I'll say loosely, a partnership and we're going to give you 50% of the net profit of the project, which is extraordinarily generous for the person who's taking the technology and capital risk to offer.  But the problem was they didn't have the money behind them.

So I think a lot of farms got caught up in, you know, negotiating contracts, which promised the moon, but where there wasn't enough capital to back it up and then these developers were left scrambling not only for capital, but if they could get it sort of in the back of the queue for procurement of the long lead steel items, which was especially challenging during the supply chain crisis, which we're still feeling the effects of.  So the evolution from there, I'll say, has been sort of a movement to the middle where most developers, including sophisticated ones, are now offering a percentage of EBITDA from the project, certainly not 50.  You're seeing more around the range of 10% to 20% to the farm.  Oftentimes now, even with the price pressures that Aiden talked about, you're seeing the developers willing now to spend pretty significant amounts of money to change the manure handling aspects of the farm, if they're betting on sand, for example, to move to solids and to make the investment for the farmer and manure separation equipment and drying equipment to make that possible and maybe deducting some of that from the percentage that the farm will get over time until it's paid back.

I've also seen an increasing willingness on developers to leave the digester and the manure separation equipment behind at the end of the term.  You won't see them leaving the biogas upgrade or compression equipment that that's on a skid, that's very portable, it's going to go away at the end if they don't continue the relationship.  But I think farms are now seeing the potential to have very nice capital upgrades including in some cases switching from flush systems to vacuum systems for manure collection and that that's a big plus for the farms.  So that's where I'm seeing these deals sort of converged to.  Farms are sophisticated too.  These are sophisticated businesspeople.  They do want to focus on milk and cows because that's what they're in this for, but I think most are starting to see that a taking a fixed amount of rent for the project isn't enough skin in the game for them and they're willing to take a little bit of a chance on price volatility and arrange their compensation in terms of how much the project is earning.

Janine Sekulic: 

Right, right.  So that's a great point.  So is there a process by which a producer could evaluate the offer? Is that something that you, as their representation or as someone who's helping put that deal together, is there a way for them to say, this is a good deal or I'm leaving something on the table? I guess in some way, you always run that risk, but I guess is there enough- are there enough comparables out there to get a sense of that, do you think?

Jordan Hemaidan:  

Well, I think this is a challenge.  First of all, I'm pretty straightforward upfront with my clients that I've got too much to do to be able to keep up on the economics of where the offset price, where the credit prices are, where they're moving, whether or not- because developers are going to be very close to the best about what their proforma look like and what sort of profit proposition there is.  And I don't know what the cost proposition is, so I really don't feel qualified to tell my clients from an economic standpoint if this is a good deal.  That said, you know, I work with partners in consulting and engineering firms who are good at keeping up on these things and who can give at least a gut check back at the envelope formulation to the farm about how good of a deal they could hope to get.  And for something less than $10,000, they can have an engineering firm do a preliminary carbon intensity score evaluation because you know, the value of the renewable natural gas is first and foremost determined by your carbon intensity score and sort of counterintuitively, the lower that score is, the better off you are.  It's all about how much methane emissions you're avoiding.  And so again, the lower the score, the better.

So having an idea of what that score is and what the value is of how much gas you're going to produce of that score can be very powerful for a farm in terms of getting some estimates about what they hope to get paid and what they ought to get paid.  I think the other thing too that I would just- that pops to mind here that I think farms need to be very careful of is making sure that the developer has good relationships with finance sources.  And most of these deals we're seeing now and this is another way they're evolving- most of these deals up until last year were very equity heavy, private equity heavy.  So we're looking at 80%, 90% equity and now that is coming down as banks get more comfortable and more interested in this space.  And of course the cost of that debt is going to be a lot lower than the cost of equity.  So that's freeing up some money.  Another thing that farms ought to be aware of is that in the administration's Inflation Reduction Act, which was just signed into law, there is an investment tax credit now that can pay up to a third of the capital costs of these projects.  And you can imagine that dramatically changes the proforma for a project.  And I think farms need to be aware of that when they're negotiating for how much of that [inaudible] they're going to be able to get as well.

Janine Sekulic: 

Steve, I don't know if you maybe want to chime in on this.  So you've looked at a number of contracts and talked to a number of producers.  Do you have some thoughts just to maybe to add to what Jordan's outlined?

Stephen Kehoe:

Yeah, exactly.  And that's the kind of advice that Jordan was talking about.  It's very similar to what we have done in the energy space previously.  And we're definitely getting a lot more comfortable being able to do that now.  We've seen a number of these contracts and we can see what the difference is between some.  I mean, you've primarily got- you know, you could have- at one end, you could have hundred percent owned and operated by the farmer, where you put up all the capital and you'd operate it and take care of your own off-take agreements.  I don't think anyone wants to do that.  I think they all want to stick with their primary business, which is producing milk.  The other one would be sort of a JV where you sort of partner with the developer.  I haven't really seen any of those, but by far the most common contracts are the developer will come and put up all the capital.  And as Jordan mentioned, there's that- it's about a 30% tax credit now.  So with the Inflation Reduction Act, RNG biodigesters are now equal to solar and wind developments.  So it's the same investment tax credit that's available there. 

There's another new markets tax credit that can be available as well that can cover up to another 20%.  So it's possible that these developers are getting up to half of the capital covered through tax credits, which- it's important for the farm to know because it does change the economics and then it also makes it very important for the farmer to understand that they- yeah, you can get a fixed fee.  So basically a dumping fee for your manure plus some kind of a rent.  But I think it's more important to try and negotiate in some sort of a revenue sharing agreement, whether it's revenue sharing directly or a royalty payment.  So those are a lot of the factors we like to consider, I guess, when we'd be reviewing these contracts.

Janine Sekulic: 

Okay.  Great.  Thank you.  Maybe turning, like, just kind of switching a little bit to the operational aspect, Dan, of what this means- what these projects mean for the farm and for day-to-day operations.  What are you hearing from your clients? What are some of the biggest frustrations maybe that you've heard from your clients when it comes to the construction phase of these projects?

Speaker:  

In my experience with the construction phase, I've had a couple that have gone okay and I've had some that have had some frustrations.  Basically, the timelines and deadlines, the construction site, the management of the construction site is different than what the farm is used to.  The farm likes to get it done and I think there's just a lot more corporate and breadth of bureaucracy in some of the construction design and planning.  Another thing I've run into is the gas company, forgetting what they agreed to, in some cases it's been quite a time has elapsed since this thing was signed versus the construction.  Sometimes people have changed.  An example is there's supposed to be a pipe buried to the farm for gas and the gas construction crew said, well, that's your responsibility and the farmer said, well, that's your responsibility.  They dug out the fine print and the farmer was right.  So it's really important to know what you're agreeing to.  And I've run into that a couple times.  Another thing I've seen is the gas company may be putting in installing some pipes and pumps and a lot of times I'll see the farm is responsible to the digester and then after the digester, the management is at the gas company.  But the gas company may install pumps that are too small, pipes that are too small.  Farmers saying that's not going to work.  And lo and behold it doesn't work.  I think part of it is cost cutting.  Part of it is just now annoying.  You're partnering with someone that doesn't know the dairy operations.  I've had a farm where they've had to unplug the pump several times already and since that time the gas companies came back and changed the pump and changed the diameter of the pipe.  Also I think it really just comes down to you're partnering with someone that doesn't understand your business and it just takes a little bit of time to step back and communicate and make sure that that's a smooth process.

Janine Sekulic: 

Great.  Yeah, good considerations for sure.  I guess, you know, what are some of the kinds of things that a dairy- like you mentioned that your customers are needing to make some investments, maybe is it, changing barn dynamics or animal movement, or is there considerations around any of those kinds of things? Or is it pretty much just you bolt this on and it's business as usual?

Speaker:  

Well, you know, depending upon the better- the more cows you have, the better deal you can get.  And so if you're big enough, that's fine.  Otherwise, I have people that have expanded to either get a digester or to get a better deal with the digester.  So first of all, they have to be in a financial position to do that.  Secondly, they have to make sure they have secured milk market to add more milk, but obviously barns and cows, but it may fall into manure storage, feed storage and then the whole bedding situation.  Going to sand, going away from sand for some is a concern.  So am I going to go to a screw press and dryer and do I need a dryer? Other people I've decided to stay with sand and are going to have a sand separation.  So I think all those things that occur with the normal expansion would occur with this, just the addition of the bedding system.

Janine Sekulic: 

Thank you.  Turning, now just sort of thinking about those investments in the capital that's required on the dairy farm side to make this happen, turning to our banker, what are some of the key metrics that a banker specifically BMO is going to be looking at when it comes to financing, maybe financing and expansion to accommodate one of these projects, like Dan mentioned.  Does it change anything from a financial perspective?

Speaker: 

As I look at things, the key metrics really don't change different from a RNG project or not.  At the end of the day, you still have to ask the same two questions.  Number one, what does it do to my cost of production? Number two, what does it do to my balance sheet? And when I'm talking about cost of production, I'm looking at profit and losses.  I mean, it doesn't make sense to make an investment to lose money, right? So we want to make sure that we've got a profitable plan and place and that it has adequate cash flow to cover debt service.  The second thing with the balance sheet, when I'm talking about that, I'm looking at, you know, what does it do to the balance sheet? I want to make sure I pay close attention to working capital and then also to my longer-term shock observer, which is equity.  Working capital, I want to see somewhere around that two and a half months or more of working capital available after construction.  And I want to see somewhere over 40% equity in the balance sheet after construction.  So understanding that I think it was a couple of the folks mentioned, the gas companies maybe or the developers maybe putting some money into these projects, that could have a significant impact on the balance sheet and make a project more viable because that money is coming in, both on limiting the amount of debt being used and/or providing a better or stronger cushion on the balance sheet.  So that's one of those considerations that you want to think about as you look at that expansion, if there is cash coming in or not for that project from the gas company.

Janine Sekulic: 

I think this was a really great discussion and like I mentioned, we're certainly- we'll make sure that contact information is available after this or that the replay is available, if folks are interested.  I'd like to thank our panelists for your insights this morning and thank the rest of you for taking the time to join us and listening.  We want to remind you that we're all here to help you through that process, obviously and we'd love to hear any feedback or follow-up questions that you might have.  So there certainly is a lot of uncertainty out there today, but we certainly believe there's a ton of opportunity for primary agriculture here in this decarbonizing world and we're really excited to help navigate through that.  So with that, we're right at the time.  So thank you again, everyone.  Have a great day.