Investments into forest biorefineries under different price and policy structures

Hanna-Liisa Kangas ⁎, Jussi Lintunen, Johanna Pohjola, Lauri Hetemäki, Jussi UusivuoriFinnish Forest Research Institute, P.O. Box 18, FI-01301 Vantaa, Finland

a b s t r a c ta r t i c l e i n f o

Article history:Received 16 August 2010Received in revised form 13 April 2011Accepted 13 April 2011Available online xxxx

JEL classification:Q41Q42Q48Q58

Keywords:Renewable energyEnergy policyBiofuelBiorefineryPartial equilibrium model

Increasing scarcity of oil reserves and the high CO2 emissions from using oil have contributed to thedevelopment of renewable biofuels. Pulp and paper mill integrated forest biorefineries offer one importantmeans to increase biofuel production. This study analyzes the effects of policies to support biofuel productionin the pulp and paper sector. We study the relative effectiveness of three biofuel supporting policyinstruments, namely production subsidy, input subsidy and investment subsidy. We present a partialequilibrium pulp and paper market model with a biorefinery investment option. A numerical model is used toevaluate the impacts of policy instruments on wood prices, as well as input choices and investment strategiesof pulp and paper industries. The data represent the Finnish pulp and paper sector. We evaluate the values anddirect costs of the policy instruments in a situation of exogenous biofuel production targets. The direct costs ofinput and investment subsidies are higher than those of a production subsidy. With all the policy instruments,Finnish pulp and paper mills would invest in wood-gasifying technology, instead of black liquor based one.The number of biorefinery units is dependent on the subsidy type— investment and input subsidies are likelyto result in more numerous but smaller biofuel production units than a production subsidy. With all the policyinstruments the demand for wood increases in Finland leading to higher wood prices. This, in turn, couldreflect negatively on the profitability of the pulp and paper industries. To a significant degree, the model andthe results can be generalized to other countries and markets where integrated pulp and paper mills areoperating.

© 2011 Elsevier B.V. All rights reserved.

1. Introduction

The increasing scarcity of oil and the CO2 emissions related to itsuse have contributed to the development of alternative, renewabletransportation fuels. Additionally, the energy policies of differentcountries and regions are pushing forward this development. Forexample, the European Union (EU) hasmandated a 10% share for non-fossil energy of the overall petrol and diesel consumption by 2020 (EC,2008). Moreover, separate member states of the EU have explicitliquid biofuel production or consumption targets. For example,Finland has set a 7 TWh consumption target for 2020. In Finland,the objective is to meet the biofuel consumption targets to a largeextent by liquid biofuel production in pulp and paper integrated forestbiorefineries (Ministry of Employment and Economy, 2010). Indeed,forest biorefineries in the pulp and paper sector offer one importantsolution for increasing liquid biofuel production in all the countrieswith extensive forest resources and pulp and paper production

(Hämäläinen et al., in press). However, most of the EU member stateshave not yet decided on what policy instruments will be used tosupport biofuel production.

In this paper, we set fixed biofuel production targets andinvestigate what subsidy or biofuel price levels are required toreach the targets. The objective of this study is to find out what arethe impacts of the different policy instruments. The results arecalculated for three different subsidies. We compare the impacts ofthe subsidies on wood, energy, and pulp and paper markets.Additionally, we calculate the direct policy costs of the subsidies tothe government. We first formulate a model that allows for examina-tion of investments in different biofuel production technologies. Inparticular, we model technology and raw material options within amulti-output framework, in which the mill is producing biofuels aswell as heat and power, along with the conventional pulp and paperproducts. Second, the model is applied to numerical calculations, inwhich the impacts of different policy instruments are studied. Thenumerical calculations are based on plant level data from the Finnishpulp and paper industry and the Finnish energy markets. However,the model and the results can, to a significant degree, be generalizedto other countries andmarkets where integrated pulp and paper millsare operating. The study is a short-term analysis, with a focus on the2020 targets.

Energy Economics xxx (2011) xxx–xxx

⁎ Corresponding author. Tel.: +358 10211 2063; fax: +358 10211 2103.E-mail addresses: hanna-liisa.kangas@metla.fi (H.-L. Kangas),

jussi.lintunen@metla.fi (J. Lintunen), johannap.pohjola@helsinki.fi (J. Pohjola),lauri.hetemaki@metla.fi (L. Hetemäki), jussi.uusivuori@metla.fi (J. Uusivuori).

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The policies analyzed in this study are an input subsidy for forestresidue use in biofuel production, investment subsidy for biofuelproduction capacity investments and production subsidy for biofuelproduction.1 The support for using forest residues has been raised asa possible policy option in many industrialized countries withsubstantial forest resources to promote collection of energy woodfrom costly forest sites, and to reduce the input transportation costs ofcompanies using energy wood. The investment subsidy typicallyamounts to a share of the investment costs for biofuel productioncapacity paid by the government, or an investment loan issued by thegovernment at a rate lower than the market interest rate. Theproduction subsidy is a price premium on top of the fuel price for allthe biofuel units produced. That is, it increases the profitability ofbiofuel production. In many countries, input and investment subsidiesare the most common policies considered for promoting biofuelproduction. However, we also study the production subsidy, since thepolicy objective is targeted to biofuel production. Therefore, it isplausible that the production subsidy is cost-effective, in a sense thatit minimizes the direct policy costs for the government. Regarding theother policy instruments, we study the extent that direct policy costsdeviate from the production subsidy, if at all.

The research on biorefineries has so far been technology driven andspecialized (Larson et al., 2006; McKeough and Kurkela, 2008). This isnatural, since the advancements in technology are recent, and marketopportunities for the technologies are just opening up. Now that thetechnology is entering the market stage, there is a clear need for asynthesis of the current knowledge, and analytical assessment of futureeconomic and policy prospects and their impacts on biorefineries.However, the literature on and knowledge of these issues is very limited.Although there are a number of studies that have constructed pulp andpaper sector models (Buongiorno et al., 2003; Szabó et al., 2009), thereappears to be no numerical market or econometric model thatincorporates biorefineries into the pulp and paper sector. Mäkelä et al.(2011) have studied a quite similar problem of promoting pelletproduction in the sawmilling industry. At a conceptual and analyticallevel, Söderholm and Lundmark (2009) consider the economic implica-tionsof biorefineries integratedwithpulp andpapermills. However, theydo not construct a formal model. Unlike the earlier studies, the presentstudy links the pulp and papermarkets with the investment possibilitiesfor different biorefinery technologies in a modeling framework.

2. Forest biorefineries

A widely used definition for a biorefinery is a facility thatintegrates biomass conversion processes and equipment to producefuels, power, and chemicals from biomass (Cleveland and Morris,2006). From an economic and market perspective, it is essentially amultiple input–multiple output production unit that uses renewablebiomass in an efficient way.2 In a forest biorefinery, biomass can beused for pulp, paper and energy production (electricity, heat, biofuels)as well as for chemicals (turpentine, acids, etc.). The wood-basedbiomass can be black liquor, pulpwood, chips, bark, sawdust or forestresidues.3 A detailed description of the forest biorefinery concept canbe found for example from articles by Larson et al. (2006) andSöderholm and Lundmark (2009).

Under the general definition of biorefinery, there are a largenumber of different biorefinery systems, and their classification is not

a trivial task, as Cherubini et al. (2009) show. Following theirclassification, in this paper, we focus on pulp and paper industryintegrated biorefineries, which are based on a synthesis gas platform,producing synthetic Fischer–Tropsch-biofuels, and which use wood-based lignocellulosic raw material.4 In this paper, the pulp and papermill transforms into a forest biorefinery once it invests in biofuelproduction capacity. To be precise, the mill produces crude biofuels,which can then be refined to biofuels (e.g. diesel) in a separaterefinery. Currently, it appears, there is not a commercial-scaleindustrial production based on this concept of biorefinery. However,there are pilot-scale plants based on this concept (e.g. in Finland andUSA), and investment plans for launching commercial-scale industrialunits within the next few years.

Forest biorefineries can produce syngas in three different ways:black liquor gasification, wood biomass gasification or the gasificationof both. The gasification of black liquor and wood biomass requiresseparate production capacity. With the black liquor gasifier, the millloses the black liquor-based process energy which has to becompensated by using additional biomass or other fuels for producingenergy for the pulp and paper processes. There is thus a trade-offbetween the amount of biomass used for pulp and paper productionand energy production. The first option, the black liquor gasificationprocess, is mainly developed in Sweden (Landälv and Löwnertz,2010). The second option, and currently a more popular one, is toinvest in forest biomass gasification. The black liquor of the pulpprocess is used for CHP production in a recovery boiler, as is donecurrently. This concept is being developed intensively by Finnishcompanies. The third option is to invest both in black liquor and woodresidue gasifiers. This option is being considered for example in theUnited States (Larson et al., 2006). In the two latter options, theproduced amount of liquid biofuels is not strictly restricted by thepulp production decision, since the biofuel production is not solelybased on black liquor.

Besides forest biomass, a biorefinery can also use agriculturalbiomass or waste biomass for biofuel production. However, forestbiomass, the focus of this study, has several advantages. First, it doesnot compete with food or animal feed markets, to the extent thatagricultural land is not converted to forest land. Second, forestbiomass generally has better energy efficiency ratio than agriculturebiomass. The other advantages include the year round availability,easy storing, high density that reduces shipping costs, low ash andsulfur content and well-developed infrastructure that exists forgrowth, harvesting, transportation and processing. In the existinginvestment plans in pulp and paper biorefineries, forest biomass is thedominant raw material. Additionally, energy is clearly the mostimportant and dominant biorefinery output, at least in this decade.

In principle, almost any pulp and paper mill can become a forestbiorefinery. However, within the forest biorefinery platforms, there area number of differentpossibilities regarding the choice of raw-materials,outputs and technology. For example, the pulp and paper mills thatproducemechanical, but not chemical pulp, donot generate black liquoras a by-product in the pulp production process, and thus black liquorgasification is not possible in those mills. The number of investmentopportunities and risk factors related to forest biorefinery aremany. Theviability of each specific forest biorefinery's mix of input-producttechnology depends on end markets, substitute markets, biomassmarkets, and on the global, national and regional policies. Furthermore,the policies supporting biorefinery development depend on theintended goals for the biorefineries. For example, the optimalbiorefinery concept may differ depending on the extent that the policygoal emphasizes targets such as climate change mitigation, domestic

1 Forest residues are collected after final felling of a forest, or when improvements ofyoung forest stands are made. They constitute of chipped logging residues, small-sizedtrees, top refuse, stumps and roots.

2 The modern pulp and paper mills producing electricity and heat essentially fulfillthe biorefinery definition. However, the term biorefinery is usually used to distinguishthe mills producing also new products, e.g. biodiesel or chemicals from biomass.

3 Black liquor is a high-energy-content by-product of chemical pulp production,currently mainly combusted in recovery boilers to obtain recovery of the pulpingchemicals and produce combined heat and power (CHP).

4 We restrict the analysis to gasification processes, and therefore do not considerbiochemical processes, such as fermentation. Currently, the gasification technology hasadvanced more rapidly and extensively to actual investment stage, especially in theNordic Countries.

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Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

energy self-sufficiency, rural employment, energy efficiency, forestresidue use support or some combination of these. In short, there is nosingle best uniform solution for a forest biorefinery, rather the answermay well include a variety of different concepts, raw material options,productionprocesses, andoutputmixes, each tailored andoptimized forthe local conditions and objectives.

A number of factors are driving forest biorefinery development.First, the structural difficulties of the forest industry in the traditionallarge forest sector countries, such as Canada, Finland, Sweden and theUnited States, have caused the industry to re-think its strategies. Theforest industries in these countries have been suffering fromcontinuous profitability issues for some time, as well as the ongoing,and related problem, of new investments increasingly going outsidethese countries (South-America, Asia). In this context, biorefineriesare seen as one potentially important development which couldenhance the profitability and viability of the existing mills.

Second, climate and energy policies and the related trend inenergy prices are making investments in forest biorefineries increas-ingly attractive. Third, pulp and paper mills already have some of therequired biorefinery infrastructure, such as wood raw-materialprocurement and processing capacity. Fourth, forest biorefineriescan also utilize efficiently different wood raw-materials to producemultiple products, and hence take advantage of the synergy and scaleeffects of the production processes. Since multiple by-products areproduced within a pulp and paper integrated biorefinery, a majoradvantage is that the by-products can be used in the processes of themill. For example, heat can be used in the pulp and paper productionprocesses and black liquor and by-product gasses in energyproduction. In short, biorefineries help to maximize the value derivedfrom the biomass feedstock and existing infrastructure. As a result,products that may not be profitable to produce as a sole output couldbecome market competitive when their production is integrated intosimultaneous production of other products (Larson et al., 2006).

Because of the large number of different options available for forestbiorefineries, it is important to analyze how different raw-materialsand energy price levels, as well as policy instruments, influence thechoice of forest biorefinery investments. For example, at what energyprice and subsidy levels are forest biorefineries profitable? What typesof raw-material, technology and end-product mixes are most profit-able? How do different policy measures change the prices and choices?Given the very recent nature of the issue, the lack of any previousstudy or economic model analyzing these questions is no surprise. It isto this lack of knowledge that the present study seeks to contribute.

3. The model

The partial equilibrium market model describes plants producingpulp, paper, biofuel, heat and electricity. The paper, pulp, heat, biofuel

and wood markets are cleared in the model, i.e. the respective pricesare endogenous. Themarket equilibrium is competitive and agents actas price takers and do not possess market power. The model hasdifferent types of profit-maximizing producers (plants) that differ inthe initial capacities in production technologies. The plants can differwith respect to the raw-material inputs, pulp and paper gradesproduced, and the production technology used to produce biofuel,electricity and heat. The initial production capacities of the plants aredetermined by the plant-specific data (see Appendix).

3.1. Plant-level profit maximization

We use a multi-output, multi-input model to describe the optimalproduction of the pulp and paper mill. The separate productionfunctions are formulated for all the production processes, i.e. for pulp,paper, biofuel, and electricity and heat. The model allows for differentgrade groups for pulp and paper. An accurate description of thetechnology is given in Appendix.

We assume that in the production of paper grades, pulp and biofuelthe inputs are used in fixed proportions. The use of the Leontiefproduction function is justified by the short-term nature of theanalysis, as well as the rather disaggregated division of output goods.First, with current technologies the input–output relations seem to berather fixed. In a long-term analysis there could be more diverse waysfor the producers to adapt to changes in the market environment.However, as we focus on rather short-term analysis, these moreflexible production possibilities are not warranted. Second, if the inputproportions in, e.g., paper manufacturing are allowed to change, thenthe properties of the output would change. This could confuse theboundaries between different output types. In the current approach,we fix both input proportions and the attributes of the end product.

In our approach, the decision variable in paper production is theamount of output produced; whereas, in pulp and biofuel productionwe optimize the use of wood inputs. The special role of wood inputs inthe model specification follows from the complex flows of woodassortments in, out and within the forest biorefinery. We assume thatthe plant can both buy and sell wood assortments. At the same time,some of these assortments are accumulated as by-products ofproduction processes. Finally, the wood assortments can be used inthe production of goods and energy. Therefore, we focus on theoptimization of wood flows. The wood and energy flows of a forestbiorefinery are presented in Fig. 1.

Since the wood resources are scattered geographically, the use ofwood is linked to the transportation costs. The more wood a mill uses,the further the mill has to transport it from, and the higher the woodprocurement costs are. Thus, our model has non-linearity in the coststructure. Due to the importance of wood fiber input, this featureenables interior solutions for all production processes.

Fig. 1. The wood and energy flows in a forest biorefinery.

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Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

For energy generation, we assume that the power plants transformthe chemical energy of the fuel into heat and power by fixed efficiencycoefficients. However, we assume that the production costs may varydue to the mixture of fuels in combustion. This partial complemen-tarity of the fuels is an important feature in co-firing of biomass withfossil fuels (see e.g. Lintunen and Kangas, 2010). Although energytransformation is linear, the production function is non-linearenabling interior solutions in fuel use optimization.

The plants can invest in biofuel, electricity and heat productioncapacity. The way in which the biofuel production capacity invest-ment costs are specified, allows for economies of scale. The modeldoes not allow for investments in new pulp and paper capacity,because the problem is static, and the focus is on biofuel capacityinvestments. This assumption can be regarded as an approximation ofthe current situation in Canada, Finland, Sweden and the UnitedStates. These countries have been, and still are, suffering from theovercapacity of pulp and paper production. In the near future, there isno plan for new significant investments in increasing pulp and papercapacity in these countries, rather, there is likely to be further capacityreductions.

Since the model is new and has not been reported before, theplant-level profit maximization problem is described in detail inSubsections 3.1.1–3.1.5.

3.1.1. Paper productionIn paper production, the mill optimizes the production level for

each paper grade, given the different combinations of inputs. Eachpaper grade is produced by pulp, energy and other inputs.5 Productionfunction for paper grade m∈PA describes known productionprocesses using Leontief specification

ym = min Ym� �; ð1Þ

where the level of output is denoted by ym. The elements of the set Ym

are Yim=xi

m/aim for all the inputs i∈ I, where xim is the amount of input

used. The parameters, ai, are constant input requirements forproduction of a unit of output. The paper grade specific inputs includethe pulp grade inputs PU, the energy inputs J, and labor and otherinputs LO, i.e. I=PU∪ J∪LO. For the profit maximization, we separatethe pulp input costs from the other input costs. This is done to allowthe modeling of endogenously determined, plant specific internalpricing of pulp input. This separation is easy to perform due to theLeontief production function as we know that at production level y,the cost minimizing input use is xi=aiy for all the inputs i. The costsbased on input use, xi, given input prices, pi, are c=∑ i∈ I pixi.Therefore, we can write net revenues excluding pulp costs from paperproduction as

Rm = pmym−c ymð Þ = pm− ∑i∈Im

piami

!ym; ð2Þ

where the set Im contains all the non-pulp inputs and pm is the price ofpaper gradem. Given the production levels, ym, of paper grade,m∈PA,the consumption of pulp grade, g∈PU, in the manufacturing of paperis

xg = ∑m∈PA

amg ym: ð3Þ

This consumption condition is a production or procurement levelrequirement for the pulp production and is later included intofeasibility condition for all pulp grades.

3.1.2. Pulp productionIn pulp production, the mill optimizes the usage of wood fiber

inputs (pulpwood, chips, sawdust and recycled paper). The firms canuse pulp either for paper production or sell it to markets.6 Inaccordance, it is possible for the mill to buy market pulp, or use pulpproduced in the pulp and paper integrate. The production of chemicalpulp also yields considerable amounts of black liquor as a by-product.

Depending on the type of wood fiber input, w∈WT, distinctproportions of other inputs are needed in the process. We specifyseparate Leontief-type functions for all the wood fiber inputs andconsider the outputs identical within a pulp grade. Therefore, theproduction function for different pulp grades g∈PU is presented as anested perfect substitute function

yg = ∑w∈WT

ygw = ∑w∈WT

min αgw z g

w;Ygw

� �; ð4Þ

where the non-wood elements are Yiwg =xiw

g /aiwg for all non-wood

inputs i∈ Iwg , where xiw

g is the amount of input used. As in the case ofpaper production, the parameters, ai, are constant input requirementsfor production of a unit of output. The term αw

g zwg is the contribution

of the use of wood input zwg . In order to make the notation clearer inlater stages, we have treated wood inputs differently from the otherinputs. The constant coefficient αw

g denotes the amount of outputproduced per unit of wood input, i.e. it has inversemeaning comparedto the other coefficients a iw

g . In the profit maximization problem forwood fiber inputs, the other inputs are set to be used at their costminimizing level.

We follow the procedure presented in previous subsection butextend it slightly. Since the optimal amount of output is directlylinked with use of wood inputs by relation yw

g =αwg zw

g with the samelogic as above one ends up with non-wood input costs as a function ofwood use

cg zg� �

= ∑w∈WT

c zgw� �

= ∑w∈WT

αgw zgw ∑

i∈Ig

piagiw; ð5Þ

where i∈ Iwg is the set of non-wood inputs for pulp grade g∈PU. The

exclusion of wood input costs is based on the same reason as in thecase of pulp inputs in the paper production step. This approach allowsus to include endogenously determined plant specific internal pricingof wood inputs into the model.

3.1.3. Biofuel production and investmentsIn biofuel production, the firm optimizes the biomass input use

(wood fiber or black liquor). Since the technologies for the two inputtypes differ, the firm can invest in separate biofuel productioncapacities based on black liquor or wood fiber inputs. The biofuelproduction process generates by-product gasses that can be used as afuel in heat and power production. Also, heat is produced as a by-product in biofuel production and it can be utilized in the pulp andpaper production processes.

Given the above setting, biofuel production can be described ascombined production of crude biofuel from black liquor (bl) and fromwood fibers (w∈WT). Since we assume Leontief production function,the same procedure as in the case of pulp production is applicablehere. Therefore, the net profits excluding wood fiber costs frombiofuel production (superscript bf) are

Rbf = pbf ∑b∈GI

αbfb zbfb − ∑

b∈GIαbf

b zbfb ∑i∈Ibf

piabfi;b; ð6Þ

5 The other inputs include chemicals, which are a notable cost factor in paperproduction. Here, we have not separated chemicals due to difficulties obtaining goodquality data for these.

6 The only pulp grade traded in the markets in the model is chemical pulp. Thus,only chemical pulp can be bought from the markets or sold to the markets. The millhas to produce other pulp grades (i.e. mechanical and recycled pulp) according to itspaper production.

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Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

where the input set consists of black liquor and wood assortmentsb∈GI={bl}∪WT. The parameters have the same interpretations as inthe pulp production sub-model above. In addition, the production ofbiofuel yields by-products d∈{gas,heat} (McKeough and Kurkela,2008)

xd = γdybf; ð7Þ

where γd is the share of by-product that is generated by producingone unit of biofuel ybf.7 The by-product gas can be used as a fuel inelectricity and heat production.

Since biofuel production from black liquor or from wood fibersneeds different gasification technologies, these processes differ also interms of capital requirement. Thus, separate investment decisions forthe biofuel production capacity have to be formulated for both fueltypes. Initially, there is no biofuel production capacity in any of theplants. We assume that the unit costs of a biofuel production capacityinvestment decrease as the size of an investment increases. Thebiorefinery investment has important scale economies due to thenotable fixed costs as well as relatively costly technology in small-scale units.We approximate this non-differentiable cost structure by afollowing formulation

Cbfinv;b = cbfinv;b + hbfinv;b exp − Ibfb

χbfmin;b

0@

1A

24

35Ibfb : ð8Þ

Thus, we assume that constant asymptotic unit costs cinvbf of

invested capacity I bbf are adjusted by an additional convex unit cost

term. The scale of this extra cost term is set with a parameter hinv,bbf N0and the level of investments associated with the elevated unit costs isdetermined by parameter χmin,b

bf N0. The positive value of extra costterm assures that average costs are decreasing in the line withassumed scale economies. With given formulation, the investmentcosts are convex when IN2χmin. For investments smaller thanI=2χmin the marginal costs are decreasing, indicating concavity ofcosts. Thus, marginal investment costs are minimized at I=2χmin.This formulation is applied to both technologies b∈GT={BL,WOOD}.Formulation is illustrated in Figure A1 in Appendix.

3.1.4. Electricity and heat productionIn heat and electricity production, the mill optimizes the fuel use

(e.g. biomass, black liquor or natural gas). Since the biofuel productionalters the energy balance and the black liquor and wood input use in apulp and paper integrate, the investments in CHP and heat productioncapacity are made possible in the model.

The electricity and heat production differs from the otherproduction processes. Following Kangas et al. (2009) and Lintunenand Kangas (2010) we specify a linear function of energy transfor-mation in combustion. Thus, for electricity and heat generation, weemploy a linear energy conversion process, i.e. the power plant hasconstant output efficiency ηj given any fuel input mix. This impliesthat in energy transformation, the fuels are perfect substitutes. In thecase of co-firing, there are convex costs that cause the fuels to have avariable degree of substitutability. The net revenues of heat andpower co-generation are presented by

Rene = ∑s∈BT

Renes = ∑

s∈BT∑j∈J

pjηjs ∑f∈Fs

xfs−cfs xsð Þ− ∑f∈Fs

pecεf xfs

!; ð9Þ

where j∈ J={el,heat} are the outputs and s∈BT are the boiler types.Each boiler type has a set of allowed fuels, f∈Fs. The emission trading

costs are determined by the price of emission credit pec and theemission factor of the fuel εf. The cost functions c(xs) for differentboiler types and investments in new capacity follow (Lintunen andKangas, 2010).

3.1.5. Profit maximization problemBefore we can present the plant level profit maximization, it is

necessary to describe the modeling of wood input costs and marketpulp revenue function. In the formulation of the production functions,the wood fiber input costs were omitted. We model these coststhrough purchased wood fiber inputs zw

B for all the wood fibercategories w∈WT. The convex wood fiber input costs can beexpressed as

∑w∈WT

cw zBw� �

= ∑w∈WT

pwzBw +

23

∑w∈WT

twzBw

32

; ð10Þ

where B refers to buying, pw is the price of wood fiber typew, and tw isa unit transport cost that increases as a square root of wood use. It isassumed that transport costs grow linearly with the distance of woodfiber delivery and that the wood sources are evenly scattered.Therefore, the parameter value 3/2 is based on geometry (Kangas etal., 2009).

In the case of market pulp, themill sells pulp at givenmarket price,which generates the following revenue function

Rg = pg−cSg� �

xSg; ð11Þ

where S refers to selling, c gS are the extra costs linked to pulp selling(i.e. drying the pulp) and xg

S is the amount of sold pulp.Given the above specifications and assumptions, the pulp and

paper plant's profit maximization function can be expressed as

maxy;z;x;If g

π y; z; x; Ið Þ = ∑m∈PA

pm− ∑i∈Im

piami

!ym + ∑

g∈PUpg−cSg� �

xSg

− ∑g∈PU

∑w∈WTg

αgwz

gw ∑

i∈Ig

piagiw + pbf ∑

b∈GTαbf

b zbfb

− ∑b∈GT

αbfb zbfb ∑

i∈Ibfpia

bfib + ∑

s∈BTð∑j∈J

pjηjs ∑f∈Fs

xfs

−cfsð∑f∈Fs

xfsÞ− ∑f∈Fs

pecεf xfsÞ− ∑

w∈WTpwz

Bw +

23tw zBw� �3

2

� − ∑

g∈PUpgx

Bg

− ∑b∈GT

Cbfinv;b Ibfb

� �− ∑

s∈BTCeneinv;s Ienes

� �:

ð12Þ

There are several constraints in the pulp and paper plant's profitmaximization problem. First, there are feasibility constraints for woodfiber, pulp, black liquor, by-product gas and heat. Wood fiber used forpulp, biofuel and heat and power productions can not exceed theamount of wood fiber purchased, i.e.:

zBw + ∑w′∈WT

γw′w zBw′− ∑g∈PU

zgw−zbfw−zenew ≥ 0; ð13Þ

for all w∈WT. When buying wood fibers, other wood fibers may beachieved as side-products, namely bark as a side-product ofpulpwood, with a coefficient γw ′w. The amount of pulp used forpaper production and sold as market pulp, can not exceed the amountof pulp produced and purchased:

∑w∈WT

αgwz

gw + xB

g−amg ym−xSg ≥ 0: ð14Þ

7 The biorefineries can, to some extent, vary the ratio of produced biofuel and by-product gas, but we have not taken that into account, since there is no valid dataavailable.

5H.-L. Kangas et al. / Energy Economics xxx (2011) xxx–xxx

Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

Black liquor used for biofuel and heat and power productions cannot exceed the amount of black liquor generated as a by-product ofpulp production:

βgbl ∑

w∈WTPαg

wzgw−zbfbl−xenebl ≥ 0; ð15Þ

where β blg is the share of black liquor generated as a by-product from

producing one unit of pulp. The use of biorefinery by-product gas inheat and power production can not exceed the amount of gas that isgenerated from the biofuel production:

γgas ∑b∈GT

αbfb zbfb −xenegas ≥ 0: ð16Þ

All the heat that is used in the pulp and paper production processesand sold to the markets must be produced in the energy productionprocesses:

∑s∈BT

ηheat;s ∑f∈Fs

xf ;s + γheat ∑b∈GT

αbfb zbfb − ∑

m∈PAamheatym

− ∑p∈PG

∑w∈WT

αgwz

gwa

gheat;w−ysheat ≥ 0:

ð17Þ

Finally, there are capacity constraints for the production of paper,pulp, biofuel from wood fiber, biofuel from black liquor and CHPproduction, respectively:

ymmax−ym ≥ 0 ð18aÞ

ygmax− ∑

w∈WTαwz

gw ≥ 0 ð18bÞ

Ibbl−αbblz

bbl≥0 ð18cÞ

Ibwood− ∑w∈WT

αbwz

bw≥0 ð18dÞ

xenemax ;s + Ienes − ∑f∈Fs

xfs ≥ 0; ð18eÞ

where ymax and xmax refer to initial production and fuel inputcapacities, respectively. Denoting the constraints of the optimizationproblems by wf≥0 where f belongs to the set of constraints of theproblem (PC), the Lagrangian of the problem is given by

L = π + ∑f∈PC

wfλf ; ð19Þ

where λf is the Lagrangian multiplier, i.e. the shadow price of theconstraint.

3.2. Demand and market equilibrium

The demand for the end products is specifiedmainly as exogenous,and with a constant elasticity formulation. However, there are alsoendogenous parts in the demand. The demand functions for differentpaper (m) and pulp (g) grades and wood fiber types w are,respectively:

Dm = d0mp0mpm

!εm

ð20aÞ

Dg = d0gp0gpg

!εg

+ ∑kxSgk ð20bÞ

Dw = ∑kzBwk; ð20cÞ

where d0 and p0 are the reference demand and price, respectively, ε isthe elasticity and k refers to the producers.8 Heat demand is modeledsimilarly with the paper demand.

The supply of a paper grade m is the aggregated production ofpaper grade m by all the producers and the supply of pulp grade g, isthe aggregated amount sold by all the producers. Heat supply is thesum of sold heat by all the producers. The supply for wood fiber isspecified as

Sw = s0wpwp0w

� εw: ð21Þ

The pulp, paper, biofuel, heat and wood markets are cleared in themodel. The output prices are solved from the market clearancecondition for market K:

SK≥DK : ð22Þ

3.3. Policy instruments

We study three policy instruments for increasing biofuel produc-tion: production subsidy, input subsidy and investment subsidy. Theproduction subsidy is a price premium on top of the fuel price for allthe biofuel units produced. The input subsidy is received for each unitof a wood fiber type used in biofuel production. It may be wood fibertype specific, and in the numerical simulation we apply input subsidyfor forest residue use in biofuel production. The investment subsidy isa share [0,1] of the biorefinery investment costs that is paid by thegovernment. Production and input subsidies are modeled bymodifying the net profit function excluding wood fiber costs forbiofuel production (Eq. (6)), while investment subsidy is added in theinvestment cost function (Eq. (8)).

The net profits from biofuel production in the case of productionsubsidy (spr):

Rbf = pbf + spr� �

∑b∈GI

αbfb zbfb − ∑

b∈GIαbf

b zbfb ∑i∈Ibf

piabfi;b: ð23Þ

The corresponding net profits in the case of wood input subsidy(swip):

Rbf = pbf ∑b∈GI

αbfb zbfb − ∑

b∈GIαbf

b zbfb ∑i∈Ibf

piabfi;b + ∑

w∈WTsipwz

bfw : ð24Þ

Investment subsidy (sinv) decreases the investment costs of biofuelproduction:

Cbfinv;b = 1−sinv

� �cbfinv;b + hbfinv;b exp − Ibfb

χbfmin;b

0@

1A

24

35Ibfb ð25Þ

In the model, the biofuel demand is fixed, i.e. there is arequirement of how much biofuels should be produced by all theproducers k. Therefore, the value of the policy instrument is theshadow price of the constraint and it can be endogenouslydetermined in the model. The policy instruments can be comparedby calculating the direct subsidy costs Cs that the policies cause for thegovernment. The direct cost in the case of production subsidy is theamount of produced biofuel times the subsidy:

Cspr = spr ∑kybfk : ð26Þ

8 We have very disaggregated classification of the paper grades. Thus, since Finlandis a major paper producer, we assume that Finnish industry might impact theEuropean paper market prices and we want to allow for small adjustments in themarkets.

6 H.-L. Kangas et al. / Energy Economics xxx (2011) xxx–xxx

Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

The corresponding costs for input subsidy are the amounts ofspecific wood fiber types (in our numerical model, forest residue)used in biofuel production times the input subsidy:

Csis = ∑k

∑w∈WT

sipwzbfw;k: ð27Þ

In the case of investment subsidy the policy costs are given as theinput subsidy share [0,1] times the total investment costs:

Cbfinv = sinv ∑

k∑b∈GT

cbfinv;b + hbfinv;b exp −Ibfb;k

χbfmin;b

0@

1A

24

35Ibfb;k: ð28Þ

4. Policy impacts: numerical application

The model presented in Section 3 was applied for numericalsimulations. A competitive market partial equilibrium model wasformulated as a mixed complementarity problem, which was solvedusing the PATH solver in a GAMS modeling system. The setting isbased on real plant-level data from the pulp and paper industry andthe energy market in Finland in 2008. All the prices presented in thepaper are 2008 prices. The data for biofuel production technology andcosts were from Larson et al. (2006) and McKeough and Kurkela(2008). The Finnish Forest Research Institute (2009) provided datadescribing the wood supply. The pulp and paper market andproduction data were collected from various sources (e.g. Carlsonand Heikkinen, 1998; RISI, 2010). The energy production data followLintunen and Kangas (2010). For a detailed data description andsectoral specifications of the numerical model, see Appendix. Thereare currently no forest biorefineries in Finland, so the initial biofuelproduction level is set to zero.

4.1. Policies

The policy simulations are based on the following setting. First, it isassumed that the government sets a biofuel production target of 3, 6or 9 TWh per year, which would amount to about 5%, 10% or 15% ofthe total transport fuel consumption in Finland. Given these targets,we analyze the levels of biofuel price and policy instruments

(subsidies) that are needed to reach them. The policy instrumentsinvestigated in this paper include biofuel production subsidy, forestresidue input subsidy and investment subsidy for biofuel productioncapacity. The policy and target combinations are presented in Table 1.The required subsidy levels are calculated endogenously for biofuelprices ranging from €20/MWh to €50/MWh. In comparison, theexceptionally high 2008 average crude oil price was about €38/MWh(or 91$/barrel). As a reference, we also present the results for a casewith no biofuel policy targets or subsidies, i.e. no policy case.

4.2. Results

The production and input subsidy values required to reach theabove mentioned biofuel demands are presented in Fig. 2. The resultsare run for multiple biofuel prices and it seems obvious that the fuelprice has an impact on the results: the higher the biofuel price, thelower the subsidy values. Subsidies are not needed, if biofuel pricesare over €43/MWh, €44/MWh and €45/MWh for the 3, 6 and 9 TWhtargets, respectively. The investment subsidy works only in a quitenarrow range of biofuel prices. If the biofuel price is less than €30/MWh, the optimal production level of biofuel is zero due to the highvariable production costs. Thus, the investment subsidy cannot induceinvestments that yield biofuel production. At the more general 30–40% investment subsidy level, the biofuel price should be over €40/MWh for the investment subsidy to promote the investments.

Fig. 3 indicates the direct costs of the subsidies to government (seeEqs. (26)–(28)) at different biofuel production target levels. As couldbe expected, the production subsidy is the least expensive option atevery target level. The reasons behind this result are the following.With the production subsidy, the producer can freely choose its mix ofinputs since none of the inputs is in a privileged position. However, inthe case of the input subsidy, only forest residue is subsidized.Therefore, it is the only input which allows for profitable large-scaleproduction of biofuel, distorting the optimal mix of inputs. Extensiveuse of only one input leads to high transportation costs, inducing highmarginal production costs.

According to our results, the investment subsidy is usually themost costly subsidy, while the production subsidy is always less costlythan the investment subsidy. The high direct policy costs related tothe investment subsidy have a different origin than in the case of theinput subsidy. For the investment subsidy, the mix of inputs is notdistorted. However, the production of biofuel has low profitabilitywhen the biofuel prices are under €40/MWh. Thus, the level of theinvestment subsidy needs to be high. The high rate of subsidizingweakens the economies of scale observed by the firms and thereforethe firms invest in relatively small units with high unit costs ofinvestment. This results in inefficiently small biofuel production unitsand high subsidy costs.

Table 1The combinations of policy instruments and targets.

Target Instrument:productionsubsidy

Instrument:input subsidy

Instrument:investmentsubsidy

3 TWh (5%) ProdS, 3 TWh InpS, 3 TWh InvS, 3 TWh6 TWh (10%) ProdS, 6 TWh InpS, 6 TWh InvS, 6 TWh9 TWh (15%) ProdS, 9 TWh InpS, 9 TWh InvS, 9 TWh

20 30 40 500

5

10

15

20

25

30

(a) Production subsidy

euro

/MW

h

Biofuel price (euro/MWh)

3 TWh6 TWh9 TWh

20 30 40 500

10

20

30

40

50

(b) Input subsidy

euro

/m3

Biofuel price (euro/MWh)20 30 40 50

0

20

40

60

80

100

(c) Investment subsidy

%

Biofuel price (euro/MWh)

Fig. 2. The required production (€/MWh) and input (€/m3) subsidy values and investment subsidy shares for different biofuel prices.

7H.-L. Kangas et al. / Energy Economics xxx (2011) xxx–xxx

Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

The number of biofuel production units varies within the biofuelproduction targets, and within the policy instruments (Table 2).According to our results, the optimal size of investment is approxi-mately 170 MW for the production subsidy. The optimal size is quitesimilar for each mill due to the similarity of technologies betweenmills. For the input subsidy, the optimal size of investment isapproximately 140 MW for targets of 6 or 9 TWh. The smaller sizeof the investment follows from the fact that the input subsidy causesthe biorefineries to use almost only forest residues in biofuelproduction. The use of only one wood fiber type leads to high woodtransportation costs, since the specific transportation costs for eachwood fiber type increase as the amount of bought wood fiberincreases (see Eq. (10)). Therefore, for the input subsidy, smaller unitsconsume less forest residues and lead to lower transportation costs,and thus are more profitable. In contrast, for the production subsidy,all wood fiber types are used in biofuel production, and therefore thespecific transportation costs for a particular wood type are not thathigh for each biorefinery unit. With the investment subsidy, thenumber of biorefineries increases with the rise in the productiontarget level. However, the number of biorefineries varies also due tothe biofuel price. When the biofuel price is high (above €40/MWh),the number of plants making investments is about the same as in thecase of the production subsidy. However, as mentioned above, withlower biofuel prices (e.g. €38/MWh in Table 2), the number ofbiorefineries is significantly higher. The variation in the number ofbiorefineries causes the non-linearity in the investment subsidyshares observed in Fig. 2.

With all policies and biofuel production target levels, biofuelproduction investments are directed to the capacity that uses woodinstead of black liquor. Fig. 4 presents the wood use in the Finnishpulp and paper sector in the reference case of no policies, and for allthe combinations of policies and biofuel targets. The total wood use inthe pulp and paper sector increases around 1%, 3% and 6% compared tothe reference case with no biofuel production for the targets of 3, 6and 9 TWh. For the target levels of 3, 6 or 9 TWh, the wood use inbiofuel production would be about 2.5 million m3, 5 million m3 or

7.5 million m3, respectively. On the other hand, the biofuel productionsubsidies cause a decrease in the wood use in other energyproduction, i.e., CHP and heat production, because the competitionfor the wood resources increases, and alternative fuels for energyproduction exist. This leads to higher carbon dioxide emissions in theCHP and heat production, since emission neutral wood is partlyreplaced by fossil fuels. The increase in CO2 emissions is about 10% forall subsidies and targets. The CO2 emission increase is about the samefor all the targets, since with the higher targets, the overall CHP andheat production is less than the lowest target.

The use of wood fiber types differs between policy instrumentsand targets (Figs. 4 and 5).9 In the cases of the production andinvestment subsidies, all wood fiber types are used in biofuelproduction. In contrast, with the input subsidy, mostly forest residuesare used in biofuel production. For the production and investmentsubsidies, pulpwood and other pulp production inputs, namely, dustand chips, are used in biofuel production. Pulpwood use is dominatedby pulp production in all the policies. Forest residues are used inbiofuel, CHP, and heat production. Under most policies, the biofuelproduction uses more forest residues than the CHP and heatproduction. Forest residue use increases with all policies comparedto baseline calculations with no policies, since there is considerablepotential in Finland to use more forest residue. The forest residues arecollected after final felling, or they are harvested during the thinningof young stands. Since the price of forest residues has so far been low,the collection costs of forest residues have often been higher than theprice and thus forest residues have not been collected. However, withhigher demand and prices (see also Fig. 6), the collection becomesprofitable and the supply of forest residues increases.

The subsidies and the biofuel production targets result in greaterdemand for wood, and thus higher wood fiber prices (Fig. 6). With theproduction and investment subsidies, the price of pulpwood increasesmore than with the input subsidy. Conversely, with the input subsidy,the forest residue prices increase more than with the other subsidies.In fact, at the highest biofuel target level, the forest residue pricewould be even higher than the pulpwood price. This is a result fromdistortion of input mix observed with the input subsidy. The majorincrease in forest residue demand forces the prices to be high.

In addition to the wood prices, the marginal costs related to thewood fiber use include long-distance transportation costs. Especiallyfor forest residue, the transportation costs can be high. For plants that

20 30 40 500

50

100

150

(a) 3 TWh

Mill

ion

euro

/ ye

ar

Biofuel price (euro/MWh)

ProdSInpSInvS

20 30 40 500

50

100

150

200

250

(b) 6 TWh

Biofuel price (euro/MWh)20 30 40 50

0

50

100

150

200

250

300

350

(c) 9 TWh

Biofuel price (euro/MWh)

Fig. 3. Direct policy costs for the three biofuel production targets.

Table 2Number of biofuel production units (biofuel price 38 €/MWh).

Number ofbiorefineries

Production subsidy 3 TWh target 26 TWh target 49 TWh target 6

Input subsidy 3 TWh target 26 TWh target 59 TWh target 7

Investment subsidy 3 TWh target 36 TWh target 109 TWh target 18

9 According to the data, the supply of forest residues is set to be elastic and thustheir use can be increased in the pulp and paper markets. However, the increase offorest residue use is limited by the transportation costs that rise rapidly with their use.On the other hand, the supplies of the by-products of sawmilling processes (i.e. chipsand dust) are set to be inelastic and thus their supplies are mainly allocated betweendifferent uses. The supply of bark depends on the use of pulpwood, since most of thebark used in the industry results from the barking of the pulpwood. Therefore, onlysmall amounts of bark are traded on the markets.

8 H.-L. Kangas et al. / Energy Economics xxx (2011) xxx–xxx

Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

Tota

l wo

od

use

010203040506070

Million m3

Res

idue

Bar

k

Dus

t

Chi

ps

Pul

pwoo

d

CH

P a

nd

hea

t p

rod

uct

ion

0

Chi

ps

123456789

Million m3

Res

idue

Bar

k

Dus

t

Pul

pwoo

d

60 01020304050

Million m3

Res

idue

Bar

k

Dus

t

Chi

ps

Pul

pwoo

d

8B

iofu

el p

rod

uct

ion

1234567Million m3

0

Res

idue

Bar

k

Dus

t

Chi

ps

Pul

pwoo

d

No po

licy

ProdS

, 3TW

h

ProdS

, 6TW

h

ProdS

, 9TW

h InpS

, 3TW

h

InpS

, 6TW

h

InpS

, 9TW

h

InvS, 3

TWh

InvS, 6

TWh

InvS, 9

TWh

No po

licy

ProdS

, 3TW

h

ProdS

, 6TW

h

ProdS

, 9TW

h

InpS

, 3TW

h

InpS

, 6TW

h

InpS

, 9TW

h

InvS, 3

TWh

InvS, 6

TWh

InvS, 9

TWh

No po

licy

ProdS

, 3TW

h

ProdS

, 6TW

h

ProdS

, 9TW

h

InpS

, 3TW

h

InpS

, 6TW

h

InpS

, 9TW

h

InvS, 3

TWh

InvS, 6

TWh

InvS, 9

TWh

No po

licy

ProdS

, 3TW

h

ProdS

, 6TW

h

ProdS

, 9TW

h

InpS

, 3TW

h

InpS

, 6TW

h

InpS

, 9TW

h

InvS, 3

TWh

InvS, 6

TWh

InvS, 9

TWh

Pu

lp p

rod

uct

ion

Fig.

4.To

talw

oodus

ein

differen

tprod

uction

proc

esses(b

iofuel

price€38

/MW

h).

9H.-L. Kangas et al. / Energy Economics xxx (2011) xxx–xxx

Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

use large amounts of forest residue, the transportation costsconstitute over 25% of the marginal costs. In all policy scenarios, theplants that invest in biofuel production capacity are among the largestforest residue users. For example, for the production subsidy with a6 TWh target, the rise in transportation costs explains, on average, halfof the increase in forest residue marginal costs for plants that invest inbiofuel production.

Pulp and paper markets are not notably affected by biofuelproduction targets and policies. Pulp and paper production, as well asthe prices of different paper grades and chemical (i.e. market) pulp,are almost the same for the no-policy case and for all combinations ofpolicies and biofuel targets. The largest changes occur in thenewsprint production and price, and in the production of recycledpulp. However, these changes are also small.

10

0

20

30

40

50

60

/m3

Pulpwood

Residue

No po

licy

ProdS

, 3TW

h

ProdS

, 6TW

h

ProdS

, 9TW

h

InpS

, 3TW

h

InpS

, 6TW

h

InpS

, 9TW

h

InvS, 3

TWh

InvS, 6

TWh

InvS, 9

TWh

Fig. 6. Forest residue and pulpwood prices with biofuel price €38/MWh.

05

1015202530354045

Mill

ion

m3

Pulpwood use

012345678

Mill

ion

m3

Residue use

Biofuel production CHP production Pulp production

Biofuel production CHP production Pulp production

No po

licy

ProdS

, 3TW

h

ProdS

, 6TW

h

ProdS

, 9TW

h

InpS

, 3TW

h

InpS

, 6TW

h

InpS

, 9TW

h

InvS, 3

TWh

InvS, 6

TWh

InvS, 9

TWh

No po

licy

ProdS

, 3TW

h

ProdS

, 6TW

h

ProdS

, 9TW

h

InpS

, 3TW

h

InpS

, 6TW

h

InpS

, 9TW

h

InvS, 3

TWh

InvS, 6

TWh

InvS, 9

TWh

Fig. 5. Forest residue and pulpwood use in different production processes with biofuel price 38€/MWh.

10 H.-L. Kangas et al. / Energy Economics xxx (2011) xxx–xxx

Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

Sensitivity analyses are performed for all the parameters of themodel with several price levels of the biofuel.

Variation of the investment costs has only little effect on the inputuse decisions of the mill. However, the investment cost parametershave an important effect on profitability of the investment. Therefore,the changes in the related parameters cause notable shifts in value ofthe policy instruments. The values of the subsidies are also dependenton the scale of reference supply of forest residues and pulpwood, thetransportation costs and price elasticity of the supply of forestresidues as well as on the price of fossil fuels. The subsidy levels arefound to be insensitive to the parameter values of the specification ofdemand of pulp and paper.

5. Discussion and conclusions

Recently, a growing interest in biorefineries has emerged withinthe forest sector. We presented a short-term pulp and paper marketmodel that allowed investments in biofuel production capacity. Themodel was used in a numerical application to analyze the effects ofdifferent policies promoting biofuel production. The policies were aproduction subsidy for biofuels, an investment subsidy for biofuel-producing capacity and an input subsidy for forest residue use inbiofuel production. The numerical application was based on data fromthe Finnish pulp and paper sector.

The results showed that the choice of the policy instrument affectsthe direct policy costs, input choice in biofuel production, prices ofpulpwood and forest residues, and the number of established forestbiorefineries. On the other hand, the pulp and paper markets were notstrongly influenced by the biofuel production targets and policies.However, this study was a short-term analysis. In the long run,increasing biofuel production in the sector might impact theinvestment decisions in the pulp and paper technologies.

According to the results, the forest biomass-based biofuelproduction investments are close to being profitable in Finland witha fairly modest policy support. In order to reach the policy targets forbiofuel production, it was shown that among the policies studied, theproduction subsidy (a price premium) would result in the lowestdirect support costs. However, since the investment costs for biofuelproduction are notable and there is uncertainty about the biofuelprice, the producers might not be willing to invest in biorefinerieswith the production subsidy. This problem could be avoided if a fixedprice for biofuels were guaranteed for the producers. In this case,the production subsidy would change with the biofuel price. Theproduction subsidy would be equal to the difference betweenthe fixed price and the market price. Therefore, it would be similarto the feed-in premiums in renewable electricity production. Accord-ing to our results, the fixed price should be between €43 and 45/MWh,depending on the biofuel production target.

The number of pulp and paper mills investing in biofuelproduction was slightly higher (usually by one unit) with the inputsubsidy than with the production subsidy. This is because the inputsubsidy encourages the use of wood residue rather than a mix of rawmaterials. Using only one wood fiber type, in turn, favors smallerplants because of higher transportation costs. According to the results,the higher the government investment subsidy share is, the smallerthe biofuel production unit tends to be. Therefore, high investmentsubsidy shares (over 40%) distort the economies of scale resulting ininefficient small-scale biorefineries, and thus increase the direct costsof the policy to the government. Typical investment subsidy levels,which amount to a 30–40% share of the total investment costs, canonly induce investments if the biofuel price is already at a fairly highlevel (above €40/MWh). This is due to the high production costs ofbiofuel. In fact, the investment subsidy may lead to an undesirablesituation where companies do invest in biofuel production, but do notuse the capacity to produce biofuel if its price is low. Because of this,the investment subsidy may not be the optimal policy to promote

biofuel production from the policy makers' perspective. However, thepolicy-makers may appreciate the single payment nature of theinvestment subsidy. Additionally, from the company perspective,the investment subsidy may be a desirable policy, since it decreasesthe risk of the investment by lowering the investment costs.

The policies had only a small impact on the total wood consumptionof the pulp andpaper industry in the short run. Thiswas because the useof wood for biofuel production amounted to only a small part of totalwood consumption in the industry. The production and investmentsubsidies increase the price of pulpwood more than the input subsidy.This could reflect negatively on the profitability of the pulp and paperindustry and, therefore, itwould, ceteris paribus, be in the interest of theindustry to favor the input subsidy over the other subsidies. Only theinput subsidy increased notably the total use of forest residue. All thepolicies lead to wood use in electricity and heat production. Therefore,as fossil fuels are substitutes for wood, the carbon dioxide emissions inelectricity and heat production increase as a result of the policiessupporting biofuel production. Thus, the climate benefits from greaterliquid biofuel production are partly offset by higher emissions in otherenergy production. This result might also change, if the study would beextended to a long-term analysis. This is because in the long run, wooduse in CHP and heat production could be replaced by other renewableenergy.

The results showed that the input choice in biofuel production(wood fiber vs. black liquor) was dominated by the wood fiber. Thisresult may not be generalized to all countries, since it is specific to acountry with large forest resources, such as Finland. The large forestreserves enablewood to be used in several energyproductionprocesses,i.e. in biofuel, electricity and heat production. In contrast, scarcer forestreserves would require more restricted allocation of wood resources.Therefore, in countries with chemical pulp production capacity andscarcewood resources, the rawwood could be used in the pulp process,and black liquor (a by-product of chemical pulp production) in biofuelproduction. This is especially viable if the current recovery boilercapacity is at the end of its technical age and needs re-investments.That also stems from the fact that black liquor in its current use,CHP production, can be replaced by other fuels. However, our resultcorresponds with the current biorefinery investment plans, in thatforest biomass is considered as the dominant input in the plannedforest biorefineries, especially in Finland.

The optimal choice between different biofuel-supporting policiesdepends on the policy target. We find that the investment subsidy andinput subsidy for forest residue use aremore costly policy instrumentsfor the government than the production subsidy. However, if thepolicy goal is also to increase forest residue use or secure theprofitability of pulp production, the input subsidy could be theoptimal policy. On the other hand, if the goal is purely to minimizedirect policy costs, the production subsidy would be the optimalchoice. Therefore, the goals of the biofuel-related energy policiesshould be clear before decisions are made on the choice of the policyinstruments and their levels.

One of the shortcomings of this paper is that the impact of climatepolicies on biofuel production was not analyzed. This is because themodeling of the main users of liquid fuels (i.e. the transportationsector) was beyond the scope of the model. Therefore, the possibleincreases in carbon prices and their direct impacts on transportationfuel prices could not be analyzed. Tighter climate policy in thetransportation sector would most likely lower the subsidy prices thatare required to make forest biorefinery investments profitable. On theother hand, tighter climate policy would decrease the production ofpulp and paper products and thus the sector's biofuel productionopportunities would be weakened.

Indeed, including the transportation sector in ourmodelwould beaninteresting extension of the current study. Additionally, since we haveonly examined biofuel production in the pulp and paper industry, theincrease inwood use, for example, in pellet production is not addressed.

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Please cite this article as: Kangas, H.-L., et al., Investments into forest biorefineries under different price and policy structures, Energy Econ.(2011), doi:10.1016/j.eneco.2011.04.008

Hadwe also studied the other targets for increasing wood use in energyproduction simultaneouslywith biofuel production targets, therewouldmost probably bemore scarcity of the forest resources. This could implyhigher wood prices and thus higher biofuel production costs, andtherefore also higher subsidy levels would probably be required.Extending the current study to analyze simultaneously various wood-energy production targets would also be interesting.

Acknowledgements

This research has been funded by the Metsämiesten SäätiöFoundation. Earlier results have been presented at the UlvönConference on Environmental Economics in Ulvön, Sweden, 2010International EnergyWorkshop in Stockholm, Sweden and at the 33rdIEAA International Conference in Rio de Janeiro, Brazil. The authorswould like to thank Jani Laturi, Matti Mäkelä and two anonymousreviewers for their valuable comments. The usual disclaimer applies.

Appendix A. Supplementary data

Supplementary data to this article can be found online atdoi:10.1016/j.eneco.2011.04.008.

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