Bio-energy and the European Pulp and Paper Industry An Impact Assessment

Bio-energy and the European Pulp and Paper Industry An Impact Assessment MCKINSEY & COMPANY, INC. AND PÖYRY FOREST INDUSTRY CONSULTING FOR CEPI Project Summary July 16, 2007 This document is a summary of a study conducted by McKinsey & Company and Pöyry for CEPI. It is intended for limited distribution only such as group and individual discussions by CEPI, its national associations, or member companies, as agreed to by McKinsey and CEPI. No other circulation, quotation, or reproduction is permitted without prior written approval from

BACKGROUND AND OBJECTIVE OF STUDY Challenging RES targets As one of the key measures to address the climate change challenge and the security of energy supply, the European Commission and the European Member States have agreed on a binding target to reach a 20% share of renewable energy sources 1 (RES) in the total energy output of the European Union by the year 2020. Reaching this target will require significant efforts over the next few years. In 2005, the share of RES in the EU energy output was 6%. In its policy package, the RES Roadmap, the Commission states that renewable energy is expected to reach a share of between 10.5 and 12.5% in 2020 under business-as-usual scenarios. To reach 20%, a strong effort is therefore needed by governments, industries, and civil society. From the RES Roadmap it is clear that solid biomass will need to play an important role in achieving this target. The European pulp and paper industry already an RES contributor The European forest based industries 2 are among the biggest users of biomass and the single largest user of wood biomass. The European pulp and paper industry is also a major participant in the bio-energy field as the biggest user and producer of bio-energy of all EU manufacturing industries. As producing and consuming bioenergy is one of the operating characteristics of the industry, it has a long tradition of investments in bio-energy and energy efficiency. The industry s total energy use is roughly 360 TWh, of which approximately 49% is based on biomass (in the form of by-products from processes and wood not suitable for paper production). This also means that roughly 25% of all bio-energy in the EU is produced in connection with the pulp and paper industry. In some countries the contribution is as high as 60-70%. 1 Renewable energy sources in the definition used by the European Commission include for example wind, biomass, solar, biogas, hydro, and geothermal energy. Nuclear power or peat is not included. 2 The industries producing pulp, paper, and paper packaging plus the woodworking industries such as sawmills and wood based panel mills. The industry in total constitutes a relevant economic activity. According to CEPI, the European pulp and paper industry has a turnover of 78.6 billion euros. It invests on average 5 billion euros per year in Europe, provides direct employment for some 259,000 people, and indirect employment to some 1.8 million people, two thirds of which in rural areas. 2

The RES targets are thus a key issue to this industry, both as the industry already is a major producer of bio-energy, and as a focus on biomass directly impacts the industry s raw material markets. Objective of the study This study was initiated by the European pulp and paper industry to assess the potential implications for the European wood and recovered paper markets of achieving the RES target, and to estimate its impact on the pulp and paper industry. An important aspect of the study has been to determine what role the pulp and paper industry could play to enable the EU member states to achieve the renewable energy target in 2020. The assessment is based on the evolution of the industry demand and fiber supply in 16 European countries 3. The study was commissioned by the 20 member companies and 12 national associations of the Confederation of European Paper Industries (CEPI) and conducted by McKinsey & Company, Inc. in collaboration with Pöyry Forest Industry Consulting, during the period January to May 2007. A reference group of representatives from the commissioning companies and a reference group from the European Commission have supported the project team with expertise and guidance. EU COMMISSION S RES SCENARIO ON ENERGY DEMAND FOR BIOMASS To reach the 20% RES target, the RES Roadmap includes a number of assumptions and expectations on future development. These assumptions and expectations set the basis for how much wood biomass would be required to meet the RES target. Most importantly: 1. The EU energy-efficiency target. The member states have agreed that by 2020, European consumption of energy should be 20% lower than a business-asusual forecast would predict for 2020. The target of 20% RES set for Europe is to be reached after the effects of the energy-efficiency target. 3 Austria; Belgium; Czech Republic; Finland; France; Germany; Ireland; Italy; Netherlands; Norway; Poland; Portugal; Spain; Sweden; Switzerland; UK. 3

2. The role of other RES technologies. The majority of the RES target will be met by other renewable technologies than biomass, such as wind; hydro; waste; solar power; and geothermal energy. Within biomass, not only forest-based biomass but also agricultural biomass is expected to rapidly grow to a significant contribution towards the RES target. 3. Land use for biomass production. The models used by the European Commission assume that a significant part of currently set-aside land will be used for energy crop production. 4. The availability of CHP. The EU models imply that large-scale combined heat and power (CHP) installations for biomass will be available by 2020 to produce energy from biomass in the most efficient way. In the European Commission s roadmap a significant emphasis is put on solid biomass with the expectations that it could contribute roughly 40% of the total RES energy output by 2020. Such biomass can for example come in the form of agricultural residues, bio-energy crops, municipal solid waste, as well as forest biomass. Based on the expectations and assumptions above, and with other data from sources available to us, the project team estimates the RES Roadmap s expected contribution from wood biomass (including forest residues, fuel wood, wood, and used wood) for energy generation to be around 680-840 TWh of renewable energy, corresponding to approximately 340-420 million m 3 of wood, in 2020 in the 16 countries we have studied. This includes generation of heat, power, and second generation (ligno-cellulosic) biofuels (small amount). There are of course large uncertainties in this. Whether other RES technologies, like wind, manage to fulfill (or even exceed) the expectations set on them; whether we can actually convert set-aside land to the degree needed; and whether we actually reach the energy-efficiency target is all yet unclear. But based on existing research and current trends, we believe our estimate is a reasonable starting approximation. For sure, the assumptions under the EU renewables plans are of great importance and need to be assessed and secured. POTENTIAL FUTURE SCENARIOS We have taken the extra demand for wood biomass for energy production as a starting point for assessing a number of potential future scenarios. To do this, we have a) analyzed the balance between demand and supply of forest biomass; and 4

b) modeled the potential implications for the pulp and paper industry and the ability of forest biomass to contribute its expected share to reach the RES target. Current assumptions in the Commission s roadmap and expectations lead to a potential mismatch between demand for and supply of wood One finding of the study is that, with current EU plans, expectations, and assumptions on the contribution from various technologies, there will likely not be sufficient forest biomass available to meet 2020 demand in the 16 countries we have studied. The demand for forest biomass for energy purposes would come on top of the demand from the pulp, paper, and wood products industries. In the study, we have estimated the expected demand from the existing solid wood product industry and pulp and paper industry in 2020, totaling 380 million m 3. For this estimate we have used growth rates of 0.8% and 1.3% per year, respectively. Together with the demand for energy purposes, this would make the total demand for wood biomass reach 720-800 million m 3. This estimated total potential demand would have to be met by supply primarily from three areas: EU harvesting. Harvesting of forest biomass (saw logs, pulp wood, and fuel wood/residues) in line with current levels, estimated at 355-370 million m 3. Added to current harvesting levels we estimate that an additional 70-80 million m 3 can be mobilized from forests in a first round of efforts. This approximately corresponds to 35% of the total sustainably available, but currently unutilized, forest biomass, both roundwood and residues. Imports. The availability of wood for export to Europe is not estimated to change drastically in most regions. It is likely that the need for biomass in other geographies will grow roughly in line with their own supply. We have therefore assumed that only Russia will have significant amounts of surplus biomass available for export and that the total available import volumes will be ~40 million m 3. Recovered wood. In the absence of policy changes, the volumes of recovered wood are not expected to change much and will be around ~50 million m 3 in 2020. 5

Planting of new forests or intensified production from forests besides the mobilization of wood, although important for the long term, has not been included in the 2020 supply/demand assessment as it will most likely bring large scale solutions only after 2020. With these estimates taken together, we conclude that there is a mismatch in expectations between the future demand for forest biomass and the future supply. If the RES Roadmap assumptions were to be followed, by 2020, we estimate a possible mismatch (or gap ) of roughly 200-260 million m 3 of wood, corresponding to 400-520 TWh of renewable energy production, in the 16 countries studied. The availability of biomass for the production of bio-energy is a crucial part of the feasibility of the RES Roadmap. The RES Roadmap impact assessment has been based on the PRIMES and Green-X models. In the Green-X model an assessment of biomass availability has been made and checked with the European Environmental Agency s estimates 4. In the Green-X model it is assumed that most, if not all, of the forest biomass currently not used can be made available (mobilized). The modeled wood demand for energy production in the EU impact assessment is derived from this starting point. A key difference with the assumptions underlying the RES Roadmap is the fact that we do not expect all technically available wood not harvested today to be mobilized for use, either by the traditional industries or the energy industry. Based on current local examples, current research, and discussions with experts, we indeed believe that a 35% average mobilization across Europe, and across different types of forest holdings is more realistic but will still require significant efforts and widespread application of best practices. It seems to us that the degree of mobilization has not been sufficiently factored into previously published work. Actions to improve the supply/demand balance are therefore needed urgently. This can partly be achieved by enabling other RES technologies to contribute more than currently expected. But also: urgent actions have to be taken to increase the amounts of solid biomass (forest as well as agricultural) as much as possible to meet the EU RES target. Maximizing the forest potential could offer a large contribution and the EU pulp and paper industry should be a key enabler in doing so. 4 See the EEA s study How much bioenergy can Europe produce without harming the environment? (EEA 07/2006), which is an important building block for the RES Roadmap. 6

We are using this estimate of the demand-supply gap as one key element in our scenario analyses. Supply/demand mismatch can also appear in recovered paper Not only wood but also the other major raw material of the pulp and paper industry, recovered paper, may see an increasing mismatch between demand and supply. Today, 50% of the paper industry s fiber raw material comes from recovered paper and board. Modern technologies for combined heat and power generation allow for using recovered paper directly for incineration, thus making it a potential energy feedstock. There is also a possibility that municipal solid waste would increasingly be used for energy generation, without prior sorting out of the paper from the waste stream, thereby reducing the supply of recovered paper to the market. Analyses of the buying power of energy companies and early indications from individual large modern combined heat and power plants show that a potential threat indeed exists. From a resource-efficiency perspective it would in most cases be more efficient to recycle the fiber first before using it for energy production. Impact on the industry Reducing the potential mismatch between demand and supply of wood due to RES targets could be accomplished either by increasing the supply of biomass (and preferably the assortments where there is limited competition between industries) or decreasing the demand from energy producers by for example ensuring other RES technologies than biomass-based ones can take a larger share of the RES target. But if the current EU assumptions on the wood needed for bio-energy would remain and policies to enforce these assumptions would be put in place, this mismatch between supply and demand would bring a serious challenge to the European pulp and paper industry. Therefore, the second important element of this study has been to make an assessment of the impact on the concerned industry sectors: Energy, Wood products, and, in particular, the Pulp and paper industry. We have approached this assessment by means of a model that allows these three industry sectors to compete for wood and recovered paper. Through this model we have evaluated a 7

set of scenarios to illustrate the potential future outcomes and impact on the sectors. Our starting point is twofold: The baseline is the current situation, where, in 2005, the share of RES in the EU energy output was roughly 6% In a business-as-usual development, this share may increase to, at best, 12% in 2020. If efforts were made to go from business-as-usual to a 20% RES target, with current policies and technology expectations, we see the following future scenario potentially unfolding: 1. Mismatch between demand and supply exists, with current subsidy levels What if the mismatch between demand and supply expectations plays out as we have estimated it; if all other RES technologies, including agricultural biomass, develop as the Green-X model expects; and if current economic incentives to support the buying power of the bioenergy industry (i.e., feed-in tariffs or certificate schemes for power generation) are in place? In this situation we find prices of biomass to increase significantly (for all sectors) but that, in the end, some energy producers do not have the buying power to purchase the biomass they need. In our modeling, some 240 TWh of bio-energy is not produced. This corresponds to 8% of the total RES target in absolute terms, or 1.6 percentage points of the 20% target. In addition, the pulp and paper industry is in this scenario unable to fulfill 17 million m 3 of its demand for wood raw material. From the perspective of fulfilling RES targets therefore, the current direction may not be sufficient, while at the same time the pulp and paper industry would be negatively impacted. Given this, it seems logical to strive towards ensuring that a demand-supply mismatch does not develop in the first place, which we describe in scenario 2: 2. No mismatch exists between demand and supply What if the mismatch between demand and supply of wood biomass is essentially made to disappear? This could be done through significant efforts to increase the supply of biomass for the energy industry that is not in competition with the pulp and paper industry s needs. But it could 8

also include increasing the contribution from other renewable energy sources, potentially off-shore wind, waste, and small scale hydro power. In this situation we find that bio-energy contributions to the RES target largely follows expectations and that the impact on the pulp and paper industry is limited. However, regional mismatches and transportation costs still increase prices of biomass somewhat, impacting the competitiveness of parts of the pulp and paper industry. The two main alternatives to close the demand-supply gap would have different implications, for example in terms of cost: Funds could be directed towards increasing the supply of biomass. From our analysis we conclude that freeing up land for effective use of biomass and encouraging farmers to grow bio-energy crops on this land, and increasing mobilization of forest biomass are two of the most important actions to be taken. We estimate that, under the right conditions, these two actions can close the supply deficit in scenario 1. Regarding energy crop biomass, the European Energy Agency has estimated that some 16 million ha of land could be freed up for this purpose. The project team estimates that the financial support needed to overcome most economic hurdles for growing such energy crops would be on the order of 1.5 2 billion euros annually, on top of the financial incentives existing today. Alternatively, policy measures and incentives could be directed towards other, non-biomass, renewable energy sources to close the gap of 240 TWh in scenario 1. The energy sources that are then not already fully accounted for in the RES roadmap (e.g., geothermal heat and solar thermal power) would need substantial support to become financially attractive alternatives. We estimate that generating an additional 240 TWh from these sources would come at a support cost that is at least 4-6 times higher than the support needed to overcome the economic hurdles to growing energy crops. In a third, more extreme scenario, policy makers focus on enforcing the RES target without closing the demand-supply gap of biomass. This scenario 3 however turns out to become very costly for all players: 3. Enforcing the RES target without having closed the mismatch between demand and supply of forest biomass What if we assume that policy measures are taken to ensure that the RES 9

targets are met? This could be done by giving bio-energy producers additional financial incentives (of the same kind that exists today) so that they essentially have sufficient buying powers to satisfy their needs, or by requiring them, through regulation, to purchase sufficient amounts of biomass. At the same time we assume that not enough can be accomplished to alleviate the strain on forest biomass the demandsupply mismatch we estimated is still there. This situation would make a significant part of the European pulp and paper industry (and of the wood products industry) globally uncompetitive. Our modeling indicates that the pulp and paper industry would be unable to purchase some 75 million m 3 of wood for its production. Through our modeling, we estimate that the cost of the additional financial incentives to ensure the bio-energy industry has enough buying power to purchase the biomass it needs would be on the order of 16 billion euros annually. Naturally, these numbers are only indicative. They depend on a number of assumptions, both regarding exogenous factors such as price of CO 2 emission rights and electricity prices, and simplifying assumptions in the modeling. However, they are robust versus reasonable changes in assumptions and thus appear to indicate the right direction. Conclusions The future is not likely to completely follow any of the specific scenarios above. But the modeling allows us to draw some key conclusions: If current RES Roadmap assumptions remain and no actions are taken, the estimated future fiber demand-supply mismatch is worrisome. Unless supply can be increased or other routes to reach the RES targets can be devised, we are likely to see significantly increased costs for wood and recovered paper. In addition, cost increases could compromise the viability of plans to reach the RES targets or threaten the competitiveness of the European paper industry (or both). The threat to industry competitiveness is much driven by the fact that cost increases for the wood raw material will largely be a European phenomenon, whereas 10

the paper industry s end product markets are often global and thus the ability in many product segments to pass through costs is limited. The way for the energy sector to reach RES targets (and, specifically, to fulfill its needs of biomass) should be a key issue in future impact assessments of politically set support systems. The economic incentive schemes used today impact the raw-material risk for the pulp and paper industry; designing and targeting incentive schemes in ways that enable further supply of biomass without jeopardizing the competitiveness of the pulp, paper, and wood products industries would be preferred. If, on the other hand, support systems are developed that enable energy producers to completely fulfill their biomass demand in competition with other industries, the effects on the current main users of the raw materials could be severe. This needs to be addressed in impact assessments of RES promotional measures and upcoming policy making, for example the 2008 proposal on financial support schemes for renewables. THE PULP AND PAPER INDUSTRY IS A KEY ENABLER TO MEET THE TARGET Neither compromised viability of RES plans nor threatened pulp and paper industry competitiveness is desirable; particularly as this study concludes that the pulp and paper industry in effect is in a strong position to support and enable the European Union to reach the RES targets and add value in the process. In essence, the pulp and paper industry can build on three areas of strength: It has the infrastructure and logistics to handle massive amounts of biomass. In addition it has significant sourcing knowledge and market contacts to purchase fiber-based feedstock. Parts of the industry also have direct access to own forest sources. It has the assets and locations on which to build future production of bio-energy, either in the form of power, heat, or transportation fuels. It has a generation efficiency of heat and power that often ranks among the best available technology (often 85-90% through combined heat and power generation as compared with 35-40% in conventional 11

condensing electricity production) as well as synergies with its current industrial processes. In addition to being a supporter and enabler of the RES targets, a thriving European forest products industry is a warrant for sustainable 5 and professional forest management practices that help advance the broader goals of reducing CO 2 emissions. This study therefore concludes that there is a strong need to increase the supply of biomass to all the sector users in Europe in ways that do not inadvertently affect the pulp and paper industry in a negative way. Increasing supply sufficiently will require strong and concerted efforts at both European and national levels by both policy makers and industry in unison. WHAT NEEDS TO BE DONE? In order to limit the negative impact on the concerned industries, while reaching the RES targets, we see three main areas that need to be addressed: 1. Ensure that the non-biomass elements of the RES roadmap develop as expected, by for example: Ensuring the energy-efficiency target is met. Accelerating policies to increase energy efficiency in generation (combined heat and power!) and consumption of energy. Including an efficiency criterion in incentive systems for power and heat generation should be considered. Accelerating the development of other renewable energy sources, for example wind, biogas, and geothermal energy in order for them to meet their expected share of the target. 2. Take massive further action to close the expected fiber demandsupply gap in 2020 In our study, we conclude that this cannot be done by the pulp and paper industry alone. To a large degree it would require policy support and joint efforts between industry and policy makers. We believe the most important efforts to work with include: 5 In 2004, 45% of the wood raw material used by pulp and paper mills was certified (FSC or PEFC). 12

Maximizing the sourcing and sustainable mobilization of wood and recovered paper in the EU. This action area is very much related to the forest industry and where the forestry industry has the greatest ability to contribute. Significant efforts from the European pulp and paper industry, wood-based sectors, and forest owners are crucial. The difference in challenges between small forest holdings (better segmented and proactive approach to owners) and large (revised perspectives on growth, yield, and conservation needs, as well as revised forest management policies and practices) must be recognized. Nevertheless, these actions will also require support from policy makers nationally and possibly on European level. Such policy support would for example include: Developing more resource-efficient forest management practices Ensuring better recovery of wood (for example through banning landfill of recovered wood) Modifying current subsidy schemes for biomass-based power generation to mobilizing forest biomass and encouraging using forest residues rather than pulp wood or saw logs Reworking forest taxation schemes to support timely harvesting Ensuring sufficient land for growth of energy crops and optimizing the efficiency of that land. Most of these actions related to agriculture need to be addressed by policy makers on the Member State level. This would include: Ensuring actions to free up land for energy crops in the amounts indicated by, for example, the European Environment Agency (~16 million ha) Using land in the most (energy) efficient way, for example reassessing the use of land for 1 st generation biofuels Working to ensure the attractiveness of energy crops within the Common Agricultural Policy. Adopting a principle of resource efficiency, analogous to the existing Waste Hierarchy. One outcome of such a principle could for example 13

be the abovementioned modification to bio-power subsidy schemes. When following the life-cycle of wood from production of forest industry products, to recycling for raw material use, and with bioenergy produced at the end of the lifespan, the same amount of bioenergy can be produced but more total value can be derived for society. The European Commission and the Member States must most likely, address this jointly. Actively working on increasing and facilitating sustainable overseas supplies of raw materials and biomass. This could include supporting planting of forests outside the EU, remove import barriers for sustainably produced 1 st generation biofuels, but also more pragmatic work to remove or reduce export tariffs on wood. The European Commission and the Member States must, most likely, address this jointly. Supporting the development of more efficient 2 nd generation biofuel technologies. 3. Invest in the future (beyond the 2020 time horizon of this study), by for example: Accelerating policies with a long term commitment to encourage forestation within the EU and outside the EU. This is a crucial measure in climate change mitigation as well. Sustainably increasing long-term growth of European forest resources. Simplify the CDM (Clean Development Mechanism) procedures to make it easier to get support for afforestation outside the EU. Focusing R&D efforts and the development of market concepts on the efficient use of raw materials and energy sources. Supporting the development of new technologies in biomass-based power generation, 2 nd generation biofuels, and gasification. Supporting the development of other renewable-energy technologies. With measures such as those outlined here, we believe there is a way for European policy makers to reach the still very challenging overall 20% RES target with limited negative impact on other industries dependent on wood as raw material, 14

and that the pulp and industry can indeed play a crucial role as an enabler for reaching the RES target. 15