Can California's Low-Carbon Fuel Standard Boost This Renewable Energy Stock?

If California was a country, it would have the world's fifth-largest economy -- just ahead of the United Kingdom. That gives it tremendous market power for everything ranging from plastic bag bans to automobile fuel efficiency standards. At a time of increasingly volatile federal policies for renewable fuels, the state is also proving invaluable for companies such as Renewable Energy Group (NASDAQ: REGI).

Investors are prepared for the nation's largest biodiesel producer to face headwinds in feedstock pricing, weather, and federal subsidy prices in 2019. But California's Low-Carbon Fuel Standard (LCFS) provides reason for much-needed optimism. Is Renewable Energy Group doing everything it can to take advantage of the aggressive policy in the near and long terms?

What is the LCFS?

California adopted the original LCFS in 2009 but has updated it several times since then. The program is currently designed to reduce the carbon intensity (a measure of emissions per unit of energy) of transportation fuels each year until 2030, with a linear decline starting this year. The ultimate goal is to realize a total carbon intensity reduction of 20% from 2010 levels.

Primarily focused on gasoline and diesel use, the state uses a life cycle analysis framework to determine carbon intensity of various fuels. Therefore, ethanol generates emissions from combustion but also from agriculture and processing. Electric vehicles also generate carbon depending on power generation mix and transmission of electricity. That said, producers can qualify the carbon intensity of their specific fuels and take advantage of low-carbon production processes. Here are some examples set out by the California Air Resources Board.

The program works pretty simply from that table. When a fuel that's dirtier than the benchmark for that year is sold, it generates a deficit. When a fuel that's cleaner than the benchmark that year is sold, it generates a credit. The LCFS credits can be sold with fuel (allowing a refiner to immediately offset a deficit) or separated from the fuel and sold at a later date.

Strategically holding onto credits can pay off. Case in point: The value of California LCFS credits rose from $69 apiece in 2017 to $191 each at the end of Q1 2019.

The ambition and success of the California LCFS has had ripple effects across renewable fuel markets. It led to the formation of the Pacific Coast Collaborative, which aligns the low-carbon fuel policies of West Coast peers California, Oregon, Washington, and even British Columbia, creating an even larger and more contiguous market. Meanwhile, other Canadian provinces and Brazil have separately modeled renewable fuel programs on LCFS, creating more opportunities for Renewable Energy Group.

How does Renewable Energy Group benefit?

Renewable Energy Group generates LCFS credits when it sells biomass-based diesel in California, even if that fuel was manufactured in Iowa. The business estimates that sales of renewable fuel and LCFS credits in California combined to generate $353 million in revenue in 2018, or 15% of total revenue. The program was also one of the lone bright spots in Q1 2019 earnings, with a year-over-year revenue increase of $27 million.

Despite the growing financial importance of the LCFS to the business, Renewable Energy Group is in danger of falling behind competitors. It owns only one biodiesel manufacturing facility west of Texas, a 100 million gallon per year (mmgy) facility in Grays Harbor, Washington.

More important, renewable diesel, not biodiesel, is increasingly being used to fulfill California's LCFS. The fuel is chemically similar to petroleum-based diesel, and while it boasts a slightly higher carbon-intensity life cycle rating than biodiesel (resulting in fewer LCFS credits generated per gallon of fuel), renewable diesel generates more valuable federal credits. The result: Renewable diesel generated nearly three times as many California LCFS credits as biodiesel in 2018.

While Renewable Energy Group owns a 112 mmgy renewable diesel facility in Louisiana -- which provided half of the company's EBITDA in 2018 -- it remains a small player in the industry.

The competitive landscape makes renewable diesel the most important thing for investors to watch for Renewable Energy Group. The company is exploring a large-scale expansion of its existing facility in Louisiana, as well as a 250 mmgy facility in Washington as part of a joint venture with Phillips 66. The location would lower capital and operational costs, as the facility would be built next to the partner's Ferndale refineries and give the JV one of the only large-scale renewable diesel plants in LCFS territories.

A final investment decision is expected sometime this year, which means the facility could begin operations by 2021. Investors will be watching.

California's LCFS is a big deal, but renewable diesel ups the stakes

Renewable Energy Group is enjoying a significant financial boost from California's LCFS, which played a role in 15% of the company's total revenue in 2018. While the importance to the business is expected to increase as carbon-intensity benchmarks become stricter each year, the size of the economic bounty might hinge on the company's ability to remain a relevant player in renewable diesel.

Management has identified two sites for expansion, but identifying shareholder-friendly sources of capital might be more difficult. After all, it doesn't include renewable diesel expansion in its capital expenditure estimates. The easiest path forward would be to use the expected $237 million windfall from retroactively reinstated federal subsidies, but Congress hasn't indicated when -- or if -- that will happen. Wall Street appears to be pricing that uncertainty into shares, but if the tax credit does get reinstated, then Renewable Energy Group should have a clear path to long-term growth.

10 stocks we like better than Renewable Energy GroupWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.*

David and Tom just revealed what they believe are the ten best stocks for investors to buy right now... and Renewable Energy Group wasn't one of them! That's right -- they think these 10 stocks are even better buys.

See the 10 stocks

*Stock Advisor returns as of March 1, 2019

Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool recommends Darling Ingredients. The Motley Fool has a disclosure policy.