7.1.1 From Bioenergy to Bioeconomy

The past decade has seen a notable growth of bioenergy consumption in the Organisation for Economic Cooperation and Development region in the transportation, heat, and power sectors. This is a result of two dominating drivers: high and volatile fossil fuel prices and policy measures aimed at reducing greenhouse gas emissions to curb the growing threat of anthropogenic climate change. Bioenergy is expected to continue to increase its share in the global and European energy system (Chum et al., 2011). In addition, there is growing interest from both researchers and policymakers in the growing potential of biomass to replace fossil raw materials in other sectors, including but not limited to plastics, pharmaceuticals, and textiles (European Commission, 2012; McCormick and Kautto, 2013).

Biorefineries will play a key role in the large-scale implementation of the bioeconomy, and it is envisioned that biorefineries will replace the current role of petroleum-based refineries in the fossil-based economy (Kamm and Kamm, 2004). Developing efficient systems for the supply of biomass—the raw material input to the processes making up the backbone of the future bioeconomy—will be a key challenge if this vision is to become reality.

The prospect of commoditization of biomass is closely related to these discussions. Searcy et al. (2014) suggest that for biomass to be competitive with fossil materials and fuels, the former have to adopt the physical and institutional market infrastructure of the latter. The eventual emergence of the biobased economy will be highly dependent on the availability of standardized input goods, playing similar roles to those in the current fossil-based economy.

7.1.2 Commoditization of Biomass Markets

The term “commoditization” is increasingly used in relation to biomass markets to describe the transition of biomass-based fuel markets from local and informal to international and commercial (Wynn, 2011; Johnson, 2014). In this chapter, we will discuss the process of commoditization and what is required for an international biomass commodity market to emerge. Comparisons covering both physical/material properties and institutional/market-related issues are drawn with established commodity markets, thereby facilitating a discussion of the prospects of successful biomass commoditization.

7.2.1 Properties of the Good Itself

Commodities tend to be intermediate goods in the sense that they are not used primarily by final consumers, but instead as input in different forms of industrial processes. It is worth noting that these processes can take a wide range of different forms, ranging from combustion for generation of heat and power (energy commodities) to more intricate treatments in, for example, a petrochemical complex. Different end-users have different requirements in terms of input material quality but, in general, heterogeneity in inputs entails a higher risk of disturbance to the process itself or to end-product quality. This is especially true in industrial processes other than pure combustion-based energy generation. For this reason, standardization of input raw material quality is arguably the most crucial characteristic of commodities. Commodities are fungible, that is, “any one sample of ‘it’ would be interchangeable with any other sample of ‘it.’” (Kub, 2014, p. 21). Many naturally occurring materials tend to be quite heterogeneous at the point of origin, be it an oil well or a copper mine. There are also goods, especially of biological origin, that are vulnerable to quality changes or deterioration during transport or storage. For these reasons, some sort of preprocessing is often necessary to achieve fungibility. A typical example is that oranges became a globally traded commodity not by trading the raw fruits but instead trading frozen concentrated orange juice (Newman, 2014).

If there are significant differences in a commodity related to physical qualities, this should be easily controlled and each commodity category should accordingly be divided into different standard qualities. For example, the coal market is divided into two main segments: steam coal and coking/metallurgical coal. Steam coal is used for energy purposes, primarily generation of electricity in condensing power stations. Coking/metallurgical coal, on the other hand, is used as a reducing agent in blast furnaces to remove oxygen from ore and produce pure iron.¹ Similarly, distinct grades of wheat are delineated by density and minimum percentages of specific wheat qualities (Clark et al., 2007; USDA, 2013). In the coal market, the separation of the steam coal market segment and the coking coal market segment is floating and market-determined. Sometimes, high-quality steam coal can be used as coking coal and conversely, if the coking coal market is weak but there is strong demand for steam coal, some coking coal shipments might be sold as steam coal (Cameron, 1997; Schernikau, 2010).

It is important to note that quality in this context is restricted to physical product-oriented quality, that is, ash content, moisture content, etc. Process-oriented quality criteria (ie, how the commodity has been extracted, cultivated or processed) have rarely—if everbeen an issue in established commodity markets (cf, Lima and Silveira, 2014). This is something that we will come back to later when discussing if and how traceability and sustainability certification can be combined with commoditization.

7.2.2 Market-Related Properties

Whereas the first part of the definition above (“intermediate good with a standard quality”) concerns the nature of the good itself, the second part (“…which can be traded on competitive and liquid global international markets”) is related to how the good itself is traded between market actors. First of all, it is worth noting that a crucial consequence of the fungibility of commodities is that if all shipments are identical in terms of quality, price will be the sole criterion that determines whether a purchase will be made or not. In turn, this means that in order for a producing firm to be successful, focus on low costs will be a key component of business strategies in commodity markets (Porter, 2008).

As for the first of the criteria in our definition, commodity markets are competitive if there are many buyers and sellers and no single market actor or group of actors can exert enough influence to affect overall market prices. Market prices should thus be set according to the standard (theoretical) economical process of continuous fluctuations in overall market supply and demand balances and ensuing adjustments towards market equilibria (Clark et al., 2007).

Having said this, it is highly doubtful that truly competitive markets will ever exist in the real world. In markets for fossil energy commodities, there are certainly plenty of signs of imperfect market competition.

Market liquidity is an indication of how easy it is to convert an asset into cash without major adjustments to the price of the asset in question.² In order to facilitate market liquidity, it must be simple to acquire a reasonably correct value of the asset, that is, markets need to be transparent. Market transparency in turn is dependent on search costs, that is, the costs of acquiring adequate information necessary to take part in a transaction. A consequence of the fungibility of commodities is that search costs tend to be low, as comparisons between different offers are easy to make. In other words, standardization and fungibility are important in facilitating market transparency and in turn market liquidity (Carruthers and Stinchcombe, 1999).

However, another more important precondition for market liquidity is that there is adequate short-term demand for and adequate supply of the good in question. If there is no demand for a good that you are producing, it can obviously not be converted into cash at all. Since 85% of global energy demand is supplied by fossil fuels, the absence of a market is not a short-term issue for coal, oil, and natural gas. However, demand and supply differ between countries and regions depending on infrastructure (eg, a natural gas network) and energy policies.

The final part of the definition above relates to the geographical extent of markets, that is, the degree of international market integration. In fossil fuel markets, the level of market integration varies between fuels. In the crude oil market, more than 60% of global production is traded internationally, and for all practical purposes it can be seen as fully globalized even in a formal way (Kim et al., 2007). The same is mainly true for coal markets, at least the portions of the coal market actually traded between countries (Zaklan et al., 2012). Natural gas markets, which hitherto have been very dependent on fixed infrastructure in the form of pipelines, have been rather regionalized with only about 29% international trade, although the increased role of liquefied natural gas will likely lead to an increasingly global natural gas market (Siliverstovs et al., 2005).

7.2.3 Futures Contracts: A Sign of Advanced Commoditization

Another key feature of considered commodities is the availability of futures contracts based on the physical commodity in question. Futures contracts can be used for physical supply, but are primarily used for price risk management and hedging. Establishing successful trade in a futures contract is by no means a simple affair. In fact, most futures contracts do in fact not draw sufficient market attention to be useful in the long-term and are thus withdrawn. In order for a futures contract to be successful, the fulfillment of the above-listed commodity criteria is generally deemed a necessity (Brorsen and Fofana, 2001). Thus, it is reasonable to see the successful establishment of a futures contract as a litmus test for the progress of a commoditization process.

7.3.1 The Commoditization of the Crude Oil Market From 1973 to 1987

Although the current situation with crude oil as an established commodity with an active futures market may be perceived as the normal order of things, the oil industry was dominated by vertically integrated companies for most of its history up until the 1970s. This was reflected in rigid price schemes and only small volumes actually being traded in the open market. Most oil flowed from wellhead to consumer within one single company, primarily one of the so-called Seven Sisters³ that dominated the industry up until the 1970s (Parra, 2009; Yergin, 2009).

The historical prevalence of vertical integration as a means of organizing the crude oil industry is in fact not surprising, at least not if one looks at what is suggested by transaction cost theory (Williamson, 1979). Crude oil has a high degree of product heterogeneity and requires very capital-intensive infrastructure for processing. These are factors that are likely to result in industry organization relying on tightly coupled supply chains with vertical integration as a logical strategy.

The dominance of the Seven Sisters in the oil industry began to be challenged in the 1960s as new petroleum-rich countries started to develop their resources. In several cases, these new countries actively chose to encourage so-called independent (ie, non-Seven Sisters) oil companies to participate in development of new fields (Parra, 2009). This meant that growing—albeit still relatively quite small—volumes of crude oil were being handled outside the vertically integrated majors.

However, real change in the oil industry came in the 1970s with the oil crises in 1973–74 and 1979–80. The first crisis came in the middle of an ongoing wave of nationalization of oil resources, and consisted of two main components: (1) an OPEC embargo against the US and the Netherlands for their support of Israel in the Yom-Kippur war of October 1973 and (2) a significant reduction in Saudi Arabian oil production. Together, these two events had a massive effect on world energy markets as well as on the global economy, and were instrumental in highlighting the strengthening grip of OPEC countries over resources and prices. The Seven Sisters were losing nominal control over upstream resources, thereby involuntarily divesting the first stage of the vertically integrated supply chain (Van Vactor, 2004). Nevertheless, basic industry structures still remained by and large the same, as the producing countries were still reliant on the multinational oil companies for bringing the oil to market, with only marginal amounts sold and distributed through other channels (Fattouh, 2011).

This all changed when the second oil crisis came in 1979 as the Iranian revolution broke out and production in Iran dropped by 90% in a matter of weeks. British Petroleum (BP) in particular was very heavily dependent on oil from Iran, and when production more or less stopped, BP had to work frantically to make up for this shortfall to be able to live up to its own downstream obligations. The only way to do this was to try to outbid the other multinationals over crude from other countries, thereby further opening up the oil market into a vastly more dynamic structure (Van Vactor, 2004).

At the same time, OPEC tried to maintain a homogeneous price structure within the cartel, an ambition that was obviously challenged when individual OPEC countries took advantage of BP’s scramble for volumes to make up the Iranian shortfall. Long-term contracts were broken which meant that the companies on the receiving end of these contracts in turn had to find these volumes elsewhere at higher prices. All this meant opportunities for a host of traders and brokers to move in to facilitate the large number of spot deals that followed (Fattouh, 2011; Van Vactor, 2004).

The consequence of this was a very chaotic market situation, with vast price dispersion as actual OPEC prices could vary in the 15–45$ range in December 1979. This was at the same time as the cartel tried to uphold a jointly administrated pricing system where the official benchmark OPEC price was only supposed to change after negotiations at official all-OPEC meetings (Van Vactor, 2004).

During the early years of the 1980s, oil demand dropped significantly at the same time as new production was coming online from the North Sea and elsewhere. These new suppliers gained market access by offering their crude in the spot market at lower prices than OPEC and hence OPEC’s market share dropped from 51% to 28% in the time period (1973–85) (Fattouh, 2011). Spot market deals were also vastly growing as a share of the total market and prices in long-term contracts were to an increasing extent indexed to spot market prices. The consequence was an even closer link between oil prices and actual market fluctuations in terms of supply and demand balances. Moreover, in the early 1980s, price reporting agencies such as Platt’s and Petroleum Intelligence Weekly started collecting and reporting crude oil spot prices on a weekly basis (Van Vactor, 2004). Information technology had also developed to the point where very rapid dissemination of information to market actors was possible, which further increased market transparency (Rost, 2015).

A crucial step in the commoditization process was taken when the New York Mercantile Exchange (NYMEX) successfully launched a crude oil futures contract in 1983. This had been attempted several times previously by different exchanges, but all previous launches had failed. However, NYMEX had a few years earlier been successful in launching a heating oil contract in a time when the energy market was obviously quite tumultuous already and when a cold winter in the US northeast further increased the need for price risk management tools. This paved the way for the later launch of the NYMEX crude oil futures contract, thereby putting the final major piece in the puzzle that makes up today’s crude oil market (Van Vactor, 2004).

7.3.2 Analysis

If we go through our list of commodity criteria from Section 7.2 and analyze the oil example from this perspective, the main issue preventing the process of commoditization before the 1970s was arguably the lack of market competitiveness. As for the other criteria, oil markets were already very much international in the 1960s, standards had been developed since the 1920s and oil was obviously an intermediate good used to produce everything from asphalt to plastics. In addition, as most transactions were within a single firm, market liquidity was by and large a nonissue. However, the oligopolistic market structure and the fact that most oil flowed within the organizational walls of one of the Seven Sisters presented an insurmountable obstacle to further market development. Thus, it was not until the vertically integrated structures were ruptured that the commoditization process truly picked up speed. When (1) the OPEC countries started to assert control over oil resources and then—in the wake of the Iranian revolution—(2) spot market activity increased drastically, the barriers to commoditization were by and large removed.

7.4.1 “Intermediate Goods”: What Is the Commodity Used For?

The first and perhaps least controversial commodity criterion is the definition that commodities are intermediate goods. This is true for both wood chips and wood pellets, although the classification of the latter merits some qualification as it is used in both industrial and consumer markets.⁴

Worth noting about wood chips is that they are used both for energy purposes and as raw material in the production of pulp and paper products. This is worth discussing a bit further, especially in light of a development towards a biobased economy, where more possible end-users for biomass are expected to emerge and grow in significance. Here, there are interesting similarities with the market for coal and its division into steam coal and coking coal. In biomass markets, wood chips and precursors like pulpwood-quality roundwood might occasionally be used for energy purposes in weak pulp markets or bullish energy markets (Olsson, 2012). In other words, current market conditions decide whether the commodity in question is used for energy purposes or as an industrial input.

With the role of policy measures as a key determinant of biomass market developments, the issue of whether a certain shipment is used for energy or for industrial purposes has however become a rather contentious issue (Brännlund et al., 2010). In particular, in discussions about the actual implementation of a biobased economy, the issue of cascading is often brought up as a founding principle, emphasizing the importance that biomass resources are used in a way that maximizes resource efficiency (eg, European Commission, 2012). In this framework, which is based on a hierarchy of different uses, energy should be the last and final stage of the biomass use chain, that is, wood should first be used to produce lumber for, for example, construction, which at the end of its lifespan can be used to produce, for example, particle board and then, when the piece of particle board is finally to be discarded it should be combusted with energy recovery. As a principle, there is much to be said for this idea. However, there are discussions on an EU level of implementing the cascading principle in legislation and as a part of long-term strategies towards the biobased economy (European Commission, 2014). Actual implementation of such a framework is bound to be problematic, at least if past experiences in similar ventures are taken into account.⁵

The introduction of policy measures that aim to steer streams of fuels and raw materials in one direction or the other are difficult to implement with success. Category leakages and lack of policy cohesiveness between countries are likely to create loopholes in legislation that would require continuous patchwork and consequently more of the political uncertainties that have hindered stability in bioenergy markets.

The complexities arising from policy ambitions prioritizing some uses of biomass over others should thus not be underestimated, especially when it comes to these policy ambitions interfering with market functions. The political component is arguably the most significant risk in biomass markets when it comes to presenting obstacles to market development and commoditization. However, it is also worth contemplating the prospect of further segmentation of biomass markets between the use of biomass for energy and the use of biomass as (industrial) production process input. This would have important consequences not least for our next topic: standardization and product homogeneity.

7.4.2 Fungibility, Homogeneity, and Standardization

7.4.3 Market Structure

A general characteristic of biomass markets is that the bulky nature of biomass and the ensuing low economic value per volume unit make transportation costs a large share of overall costs. This has a tendency to reduce the geographical extent of biomass markets.

The international trade in biomass for energy has thus far primarily been an issue of international trade in wood pellets for use in large-scale generation of heat and electricity, where pellets are often replacing coal. Industrial wood pellet markets seem to inherit much of the basic structure of the international coal trade, but with an even higher degree of market concentration. Although no recent assessment of the market concentration is publicly available, a handful of European utilities (Drax, EON, RWE, Dong, Vattenfall, GDF-Suez) make up the vast majority of globally consumed pellet volumes.

From a global perspective, the vast majority of wood pellet producers operate rather small production facilities. However, a gradually larger share of global pellet production is being concentrated in a smaller number of key production facilities with the emergence of a rapidly expanding wood pellet production sector in the southeastern United States. US pellet production plants are several times larger than the largest European facilities (excluding the Vyborgskaya plant in the Russian Federation).

Another key characteristic of the transatlantic trade in wood pellets is that several of the large pellet plants constructed in the US are actually owned by the very same European utilities that are end-consumers of the pellets to be produced. As was noted in the discussion on the oil industry in Section 7.3.1, vertical integration can often be a natural strategy for managing both price risks and supply risks, especially in immature markets with heterogeneous products.

In addition, the industrial wood pellet market can also be classified as oligopolistic, at least on the buyers’ side. The high level of market concentration in wood pellet markets is evident from the effects of the 2012 fire in RWEs wood pellet-fired power station in Tilbury. The damage from the fire meant that Tilbury was out of operation for several months. The power station would have consumed pellet volumes amounting to what was at the time a significant share of the total global market, volumes that then were sold into the open market, leading to a significant drop in prices (Kinney, 2012). The fact that events at a single facility had clear effects on overall market prices is a clear indication of the level of market concentration.

7.4.4 Market Liquidity

The concept of market liquidity and its status in biomass markets is closely related to fungibility but also to market concentration. An increased level of market transparency would be expected as a result of increased levels of standardization in biomass markets, especially wood pellets. Market liquidity is to a large extent a function of adequate supply of and adequate demand for the product in question. This was not an issue in the vertically integrated oil industry of the 1960s⁶ as reviewed in chapter “Biorefineries: Industry Status and Economics,” but the special characteristics of biomass markets (the policy dependence in particular) mean that both sides of the market are uncertain. Wood pellet demand has certainly been growing for several decades and the heating market segment continues to do so at a solid pace. However, demand growth from the power market is quite erratic and dependent on policy decisions relating to policy measures supporting renewable electricity.

This means that, depending on the current policy environment, demand may be very strong or very weak, leading to general uncertainty that has clear implications for market liquidity. It is difficult to know, for example, if an investment in the pellet supply chain will make economic sense. It might not be possible to sell the produced pellets at a price necessary to make the investment profitable. Of course, these are the kinds of decisions that all businesses face, but the reliance of biomass markets on policy measures and the lack of long-term signals in, for example, EU policy regarding biomass for energy means that uncertainties are unusually high. A similar dilemma faces a power station considering converting its boilers from coal to pellets. The conversion will likely require large volumes of pellets, but whether or not these will be available in the open market is very difficult to know given the large overall level of market uncertainty. In this context, prevailing strategies of off-take contracts and vertical integration make sense, reducing risks at both ends of the supply chain. However, the process of facilitating bilateral contracts can be very arduous and time-consuming with each new transaction requiring specific negotiations and agreements on a large variety of conditions (Maroo, 2012; cf, Rodriguez et al., 2011; cf, Joskow, 1987).

7.4.5 International Market Integration

As for the level of international market integration in biomass markets, this is a topic that has thus far only been analyzed to a rather limited extent in comparison to the plethora of analyses of fossil fuel markets. There is no doubt that there is plenty of international trade in both wood chips and wood pellets, and in the latter case there are also very large intercontinental trade flows, especially from North America to Europe. It has been estimated that almost half of total global wood pellet production was traded between countries in 2010 (Lamers et al., 2012), which means that in this regard wood pellet markets are more internationalized than both coal and natural gas markets.

However, market integration is not only a matter of traded volumes, but rather—and actually even more so—of actual spillover of market fluctuations from one region to another. Whether this is the case is commonly investigated by analyzing price series over time to determine the extent to which prices comove. This methodology has been widely implemented in markets for coal (Zaklan et al., 2012), oil (Kim et al., 2007), and natural gas (Siliverstovs et al., 2005). As for wood fuel markets, the level of international market integration seems to be quite low. Only wood pellet markets in neighboring countries (Sweden–Denmark and Austria–Germany–Italy) show signs of market integration according to recent studies (Olsson et al., 2011, 2012; Olsson and Hillring, 2014; Bürger, 2015).

7.4.6 Conclusions

In this chapter, commoditization of biomass markets has been analyzed by focusing on the development of wood pellet markets and with the commoditization of crude oil as a point of comparison. It is important to note that this comparison only holds partial value as a result of the current fragmentation of the wood pellet market into (1) an industrial market focused on large-scale production, transport, and consumption (mainly for electricity generation) and (2) a more geographically constrained market with small-scale heating as the main source of demand. The two are not perfectly delineated or defined and there is a certain extent of flows between them, but in terms of market organization there are clear differences that must be acknowledged.

As with crude oil, it can be argued that vertical integration is the natural form of organization of at least the industrial portion of the wood pellet market.⁷ Both oil and wood pellets can vary substantially in quality—although wood pellets arguably less so than crude oil—and both fuels are reliant on capital-intensive infrastructure and economies of scale to make economic sense. To our knowledge there is no up-to-date comprehensive information on the extent of vertical integration in the industrial wood pellet market. However, it certainly seems to be an increasingly common strategy for European utilities to invest in overseas wood pellet production facilities to thereby have control over almost the entire supply chain,⁸ with RWE and Drax as key examples (Voegele, 2014). There are also examples of vertical integration being utilized as a strategy from the supply side. In August 2015, pellet producer German Pellets announced the acquisition of a Belgian power station planned to undergo conversion from coal to pellets (Argus Media, 2015).

The question is: what might shift market developments to a higher share of spot trading in wood pellet markets? In the oil market, a host of factors combined to change (what seemed to be) the “natural” organization of the industry to something completely different. The decoupling of the resource ownership from the vertically integrated supply chain was obviously a key factor, but the tumultuous market swings and violent price fluctuations from 1973 to 1987 are arguably as important. The latter certainly stimulated the interest in short-term spot deals that could be done to draw use of a temporary favorable market opportunity that might only last a short while until things turned around. The information technology development of the 1970s and 1980s also made it possible to quickly access relevant market information. Brokers and traders were drawn into the market to facilitate these deals and profit from arbitrage opportunities. Similarly, the demand from market actors for stability and reduction of price risk paved the way for the establishment of the NYMEX crude oil futures contract. In the final section of this chapter we will outline the major obstacles that need to be removed for biomass to complete the commoditization process.

7.5.1 Futures Contract Failure: A Sign of Market Immaturity

In addition to the five criteria that we used for the basis of analysis herein, a key characteristic of most commodity markets is the existence of a futures market based on the physical market of the commodity in question (cf, Siqueira et al., 2008).

In November 2011, APX-Endex in cooperation with the Port of Rotterdam introduced the possibility of trading a wood pellets futures contract based on their price index. This was generally seen as a ground-breaking move in terms of it being the first example of financial trading in a solid biomass fuel (Port of Rotterdam, 2011). However, the contract did not receive a large amount of interest from market actors and little or no actual trading in the contract carried out (Walet, 2012). In fact, as of the fall 2012 not a single trade in the contract had been conducted (Maroo, 2012) and less than 2 years after its introduction, ICE Endex discontinued the contract (ICE Endex, 2013).

It should be mentioned that a somewhat unusual feature of the APX-Endex contract was that physical delivery was mandatory, whereas in other futures markets this is an option that is available but rarely used. This is likely to have contributed to the failure of the contract (Rost, 2015). At the same time, CME offers a wood pellet swap contract which in contrast is a strictly financial product with exchange only of financial flows and not of any physical pellets (Murray, 2012). Allegedly, trade in this contract has also been very sparse. Although it is important to note that most new futures contracts are terminated within 10 years of their introduction (Brorsen and Fofana, 2001), the reasons for the failed attempts at financial trade in wood pellets are likely to be found in current pellet market structures. The key question is: which are remaining obstacles and what steps need to be taken for these to be overcome?

7.5.2 The Road to Commoditization

Porter (2008) argues that “…products have a tendency to become more like commodities over time as buyers become more sophisticated and purchasing trends tend to be based on better information” (Porter, 2008, p. 3107). Does this mean that commoditization of biomass is only a matter of time? Or are there specific characteristics to biomass markets that will continue to present obstacles to commoditization over the foreseeable future?