H.R. 12112, loan guarantees for the production of synthetic fuels


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H.R. 12112, loan guarantees for the production of synthetic fuels
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United States -- Congress. -- House. -- Committee on Interstate and Foreign Commerce. -- Subcommittee on Energy and Power
U.S. Govt. Print. Off. ( Washington )
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Table of Contents
    Front Cover
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    Table of Contents
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    Opening statement of Hon. John D. Dingell, chairman, Subcommittee on Energy and Power
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Full Text

94th Congress COMMITTEE PRINT 2d Session J

H.R. 12112

MAY-J-UN-E 1976




HARLEY 0. STAGGERS, West Virginia, Chairman
TORBERT H. MACDONALD, Massachusetts SAMUEL L. DEVINE, Ohio JOHN E. MOSS, California JAMES T. BROYHILL, North Carolina
FRED B. ROONEY, Pennsylvania JAMES M. COLLINS, Texas
BROCK ADAMS, Washington NORMAN F. LENT, New York
W. S. (BILL) STUCKEY, JR., Georgia H. JOHN HEINZ 111, Pennsylvania


JOHN D. DINGELL, 'Michigan, Chiairmian TIMOTHY E. WIRTH, Colorado CLARENCE J. BROWN, Ohio
ROBERT (BOB) KRUEGER, Texas (ex officio)
(et officio)


Opening Statement of ion. John D. Dingell, chairman, Subcommittee on Page
Energy and Power ------------------------------------------------ 1
May 25, 1976:
Robert W. Fri, Deputy Administrator, Energy Research and Development Administration, Washington, D.C. (accompanied by Dr.
William McCormick, Director, Office of Commercialization) --------- 3
John A. 1ill, Deputy Admiinistrator, Federal Energy Administration,
Charles A. Berg, Bucklield, Maine (no statement)
Monte Canfield, Jr., U.S. General Accounting Office, Director, Energy
and Minerals Division, Washington, 1).C -------------------------21
Dr. Edward G. Cazalet, manager, decision analysis--energy, Stanford
Research Institute, Menlo Park, Calif ---------------------------- 30
May 26, 1976:
Dr. Barry Bosworth, research associate, Brookings Institute, Washington, D.C ----------------------------------------------Laird Willott, senior vice president, Dillon, Read & Co.., Inc., New
York, N.Y ---------------------------------------------------- 49
Charles J. (ichetti, director, office of emergency energy assistance.
State of Wisconsin, Madison, Wis --------------------------------87
Arthur S. Seder, Jr., president, American Natural Resources Co.,
Detroit, Mich ------------------------------- -----------------88
J. E. Bixby, vice president and chief financial officer, Texas Eastern
Transmission Corp., Houston, Tex ------------------------------- 99
Robert McClements, Jr., president, Sunoco Energy Development Co.,
Dallas, Tex -------------------------------------------------109
Hollis Dole, Washington representative, Atlantic Richfield Co.,
Washington, D.C ---------------------------------------------117
Edmund M. Wheeler, president, The Fertilizer Institute -------------127
May 27, 1976:
Hon. Olin Teague, chairman, Committee on Science and Technology__ 140
Don S. Smith, Commissioner, Federal Power Commission. (accompanied by: Leon Wahrhaftig, manager, System.i Operation Division, Bureau of Natural Gas: Dr. William Llndsey, Assistant Chief, Office of Economics; Jane Drennan, attorney, Office of Special Assistance;
and Dan Goldstein, attorney, Federal Power Commission) ---------147
George Percival, director, British Gas Corp.. International Gas Consultancy, Ltd., Stamford, Conn. (no statement)
Fletcher L. Byrom, chairman of the board, Koppers Co., Inc., Pittsburgh, Pa ---------------------------------------------------235
Kathy C. Shreve, acting project director, solid waste ammonia 1,roject.
office of management and budget, city of Seattle, Wash. (no
Marilyn Romans, director of corporate planning, Fusion Energy
Corp., Princeton, N.J----------------------------------------- 20
Thomas B. Neville, director, Stanford Western Energy Policy Study,
Stanford. Calif 9--25
Milton Beychok, consulting engineer. 17709 Oak Tree Lane, Irvine,


May 27, 1976 :-Continued
John L. McCormick, Washington representative, Environmental Policy Page
Center, Washington, D.C --------------------------------------- 268
Carolyn Ruth Johnson, chairman, mining workshop, Colorado Open
Space Council, Denver, Colob------------------------------------ 275
Garry IDeLoss, staff attorney, Public Interest Research Group,
W ashington, D.CCC--C------------------- ---------------- CCCCCCC287
June 8, 1976:
Robert WV. Fri, Deputy Administrator, Energy Research and Development Administration, Washington, D.C. (Accompanied by Dr. Philip C. White, Assistant Administrator for Fossil Fuel, ERDA; Dr. William McCormick, Director of Office of Conmnercialization; Dr. Raymond Zahradnik, Director of Office of Coal Conservation, Division of Coal Conservation; Dr. Harry Johnson, Director of Planning Staff:, George Rial, Director of the Division of Demonstration Projects; Len Topper; and Lynn Rawicz, Deputy General Counsel) (no
additional statement) - - - - - - - - - -


Gov-. Thomas P. Salmon, Governor of Vermiont, and chairman of the Natural Resources and Environmental Management Committee of the National Governors' Conference------------------------------------- 29
Gov. Richard D. Lamm. Governor of Colorado, and chairman of the synthetic fuels task force of the Natural Resources and Environmental Resources and Environmental Management Committee of the National Governors' Conference-------------------------------------------- 305
Diane Yale Sauter. research director, emergency task force on energy options, Scientists' Institute for Public Information, New York, N.Y -------314 James L. Livermnan, Assistant Administrator for Environment and Safety, Energy Research, and D~evelopment Administration, Washington, D.C- 338

JOHN 0. C1#iMELL. MICH.. CHIRMAN PHONE 402~) 223-1030
PH;LI ft. gt.V.p IND, CR_,~LO J. MN.^D. CALJP.
ROMER? (80b) KkEC R .X





This afternoon, the Subcommittee on Energy and Power is

beginning three days of hearings on H.R. 12112, dealing with loan

guarantees for the demonstration and commercialization of new energy


This bill, after being reported out of the Science and Technology

Committee, was then sequentially referred to both this Committee and to

the Committee on Banking, Currency and Housing. Under the terms of this referral, we must report back to the House on this legislation not later

than June 10, 1976. I believe we have our work cut out for us.

As Chairman of the Energy and Power Subcommittee, I have spent a

good part of these last two years examining this Nation's energy situation

and, while I share in the general enthusiasm for broadening our energy

resource base, I must admit that I have some questions concerning how we go about it. Utilizing the mechanism of Federal subsidy to engage these

problems is of great interest to me particularly when, as indicated in

testimony by Dr. Robert Seamans, the ERDA Administrator, this is only the beginning of a much larger program. I think it is of vital importance to

make sure that we get off on the right foot and thus avoid perpetuating any

first errors.

Secondary and tertiary recovery of oil and gas, solar and geothermal

energy technologies and intensified conservation efforts have much to offer

to this Nation's energy resource pool. Do we know how sound our present

system of priorities for each of these activities is? How then should we


evaluate the effectiveness of the huge sums we are talking about in H.R. 12112?

1 should like to note at this time, some of the questions brought

up in the "Dissenting Views" of the Science and Technology Committee Report on this bill. My Colleagues, Messrs. Ottinger, Hechler, Blouin and Hayes have expressed some concern as to the shape this loan guarantee program has taken. In their dissenting views they have called this program uneconomic and declared that it would distort energy priorities in favor of high capital, high risk options to the detriment of conservation and renewable resources. They also expressed concern that this is merely another camel's nose under the tent with rQgard to the Rockefeller $100 billion Energy Independence Authority, particularly since the House voted down a similar program offered as Section 103 of H.R. 3474 last year. These are all important questions which, I trust, will receive consideration during our present set of hearings.

I should like to offer one thought before we begin hearing testimony. This country and its economy were in a large part founded on the idea of risk and reward. In the special case of the synfuels loan guarantee program, we ought to keep in mind that the public is one of the parties at risk and that a successful venture ought to attempt to benefit the taxpayer as well a~s the large corpanies which have recently registered record profits and whose loans would, in this case, be guaranteed by the taxpayer.

With that thought, let us begin the task at hand. This afternoon we

hae oth public arid Administration witnesses. Gentlemen, let me welcome you all.



May 25, 1976

Mr. Chairman and Members of the Committee:

I -am pleased to appear before you today as this

Committee begins its consideration of H.R. 12112 which would provide to ERDA loan guarantee authority and authorizatior for synthetic fuel and other full-scale energy demonstration projects.

Mr. Chairman, the President strongly supports the

early enactment of this legislation and believes it esse,.ial that the Congress move promptly and decisively on this proposal. In this regard, we at ERDA stand ready to assist you in whichever ways you desire in order that the Committee may rapidly become familiar with the important proposals contained in this legislation.

I would like to note at the outset, that there have been few energy legislative proposals which have been studied so thoroughly and received such detailed scrutiny. Last year, following the President's proposal for a synthetic


fuels program, a 50-man, 13-Agency Federal Task Force under the aegis of the Energy Resources Council completed a 2,200 page comprehensive study which resulted in a'iecommendation to the President for a 350,000 bbl/d commercial demonstration program.' Last year., and again this year the House Science and Technology Committee completed 16 days of hearings on the loan guarantee and other aspects of this proposal and received testimony from more than 70 leaders representing Federal and state government, the financial community, industry, universities, environmental groups, Indians, labor, and consumers. The Science and Technoloqy Committee and its staff have worked over the past two months to fashion, what I believe, is one of the most innovative, thoughtful and potentially effective pieces of new en--ray legislation. I would like to emphasize that this new loan guaranty legislation is different in several important respects from last year's bill and contains a number of significant improvements which are summarized in Attachment 1. As this Committee begins its consideration of H.R. 12112, I am hopeful that you also will become convinced of the soundness of this legislation and the important contribution it can-make to addressing our Nation's serious energy problems.

Mr. Chairman, we believe sufficient studies have

clearly shown the need for this program and it is now time for positive and decisive action on this proposal so that

we can begin laying the foundation for reducing our Nationts reliance on conventional supplies of oil and gas. Today, we are importing 40 percent of our petroleum supplies compared with 36 percent two years ago shortly before the Arab oil embargo. Our domestic gas production has been steadily declining for the past three years. I submit that it does not require a sophisticated understanding of energy matters to see the clear trend of increased reliance on imports, and I forone believe this Country must reverse it.

As you know,, the President has proposed a comprehensive set of neor-term energy supply and conservation measures that include Alaska and OCS development, use of our Naval Petroleum-Reserves, auto fuel economy-standards, appliance efficiency labeling, strategic oil storage, natural gas deregulation and others. But even if all of these measures were adopted immediately, U.S. domestic production of cil and gas is projected to resume again its decline in the late 1980s. This means that just to maintain oil imports at the current level of about 6 million barrels per day, synthetic fuels will have to be produced in substantial quantiti-es early in the 1990s. in fact, ERDA projects that the demand for synthetic fuels will rise to 5 million barrels per day in 1995 and 10 million barrels per day in the year 2000 even assuming increased supplies resulting from gas deregulation and other supply measures and decreased demand from conservation. In order to achieve this production capacity, our


synthetic fuel industry would have to grow from 1 million barrels per day in 1985 at a compounded annual rate of about 17 percent per year -- a very optimistic target fok such a capital intensive industry. Because of the long lead-times in constructing these plants and the regulatory uncertainties involved, we must begin now to establish the information and the experience necessary for growth of this industry in the, late 1980s and early 1990s.

We cannot, however, expect the private sector to meet this need in a timely fashion without positive Government assistance. There are a number of serious obstacles now inhibiting private investment in this new and complex field. Uncertainties in both the future OPEC determined price of world oil, and in the price of synthetic fuels produced from the first few plants, are important factors discouraging private investment. If world oil prices were to fall, substantially, large plant investments could not be paid off from the revenues generated from synthetically-produced fuels. Adding to this- risk are other uncertainties including those related to environmental impacts, socioeconomic impacts, financing of synthetic fuels facilities, availability of skilled labor and critical materials and public acceptance. These uncertainties must be identified and resolved in the near future if this Nation is going to achieve levels of private investment needed to finance the


production of several million barrels per day of synthetic fuels early in the 1990s.

Mr. Chairman, this is the reason the proposed legislation is needed now -- to enable the Federal Government

-to offer needed incentives to'build and operate over the next five years a limited number of large scale plants to produce clean synthetic fuels from coal, oil shale and other domestic resources. Such a program (a possible project mix 1 illustrated in Attachment 2) will provide vital information concerning the commercial viability and environmental acceptability of each of the major synthetic fuels types in contributing to our Nation's future energy supplies.

Without such a program of Federal assistance we, as

a Nation, run the risk of either seriously delaying the time when synthetic fuels can be available in the U.S. and thus substantially increasing our level of imports, or of inviting a crash synthetic fuels program five to ten years from now. The latter would entail a precipitous effort that undoubtedly would result in inadequate consideration of environmental, socio-economic and other local impacts that should-b, -_ carefully provided for early ir. the commercialization process. Mr. Chairman, I do not think we want to run the risk of repeating the experience we have recently been through in the nuclear power area, where many of the environmental, regulatory and other governmental policy uncertainties, not


having been fully resolved prior to wide commercialization, are now slowing the growth of this important energy source. We should learn from this experience and, in the synthetic fuels area, address and resolve any potential problems at the outset.

I would now like to make several general comments on the proposed legislation, H.R. 12112. It should be clearly understood that, in, the case of the loan guaranties, the actual cost of this program to the government is expected t..o be only a fraction of the required loan guaranty authorization. We estimate, at a maximum, the budget authority needed to cover the $4 billion in loan guaranties for the projects authorized-by H.R. 12112 would be about $1.0 billion or $500 million each for FY 1977 and 1978. Because we do not expect any major plant defaults, we do not even expect that this amount will be needed, but it is required in order to make the guaranties credible to potential lenders. Attachment 3 provides estimates of credit authority, budget authority and budget outlays for the proposed program.

H.R. 12112, along with ERDA's existing authorities and other applicable laws, also includes the necessary safeguards to ensure that this program is carried out with minimum environmental and socio-economic impacts and with maximum overall benefit to the Nation. Examples of such key provisions are:


* A comprehensive $300 million program for

assisting local communities to finance essential

public facilities needed as a result of the

siting of a synthetic fuels plant.

* Environmental monitoring of each plant along

with full compliance with the National Environmental Policy Act including site-specific

Environmental Impact Statements.

* Review ana approval, by the Governor of the

potentially affected State, of each proposed

demonstration project.

* Compliance with all applicable Federal and

9tate environmental laws and-regulations.

* Preparation of an assessment of water availability and the impact on water supplies of

each proposed project.

* Review by the Attorney General and the Chairman

of the Federal Trade Commission of all proposed .guarantees to ensure no adverse impacts on competition or concentration in the energy


9 Encouragement of maximum participation in the

program by small business.



9 A statutory advisory panel to provide input into the program by affected states, Indian tribes, industry, environmental organizations and the general public.

e Acquisition of title by the government to

inventions conceived in the course of demonstration projects with provisions for waiver in the cases it is desirable.

Dissemination of information generated from

the program to all interested parties, except for proprietary information and trade secrets. In summary, Mr. Chairman, the proposed legislation is

essential, it is responsible and I urgently request the

Congress to act quickly and favorably on it.

Finally, I would like to note for the Committee that

about two months ago, for t-he first time in our Nation's history, we actually imported more oil than we produced

during a given day. Inasmuch as it would take us at least

five to six years to build the first plants to replace these

natural fuels from coal or shale, it would seem the height of national imprudence not to provide legislative means to proceed with such construction as quickly as possible. Our

energy fuel clock is ticking away steadily. It is running down on an irreversible course and it is not going to wait

for political considerations or resolution of all market


Thank you, Mr. Chairman. I will be pleased to

answer any question you or any other member of the Commit tee may have at this time. We have provided the members of the Committee a detailed program fact book which is included as Attachment 4 to my testimony..


Attachment 1


*Reduced original $6 billion guaranty limit to $4 billion for synthetic fuels, renewable resource and energy
conservation projects.

" Provides that up to 50% (but no less than 20%) be used
to demonstrate renewable energy resources and energy
conservation technologies.

" !.imits oil shale projects to "commercial modules" rather
than full-scale commercial plants and authorizes "costsharing" agreements.

*Encourages maximum participation in program by small business.

*Stipulates that all demonstration projects be located within the United States.

*Establishes stringent cor'~lict of interest requirements for ERDA officials administering program including public

*Mandates ERDA Annual Re-ports to Congress on all major aspects of the program including any significant potenti.U
adverse impacts which may result and all funds received
and disbursed under program.

*Requires that all proposed projects costing over $200 million be subject to Congressional review and possible

*Establishes a statutory adviso ry panel to ensure adequate consideration of views of affected States, Indian tribes,
industry, environmental organization!-., and the general
public on the impact of the program.

*Require's competitive bidding proceduro:; for ERDA awards.



Fuel Plant No. of Guaranty Amt.
Category Type Plants Needed Catecorv

!oah Btu Gas 1,600 million L
High Btu Gas 2 1,600 million

Cther Fossil 1,200 million
Shale Conversion 2 400 million
(single module)

Utility and Industrial 4 800 million
Fuels (low, medium Btu gas, methanol,

_iomass, Ponew- 800 million 20%
"Ies, Conser.: tion, etc.
Biomass (municipal, 6 300 -_million
wood, agricultural, industrial waste)

Renewables (direct 5-10 3n' million
waste utilization, solar, etc.

Industrial Conser- 5-10 200 million

-pact Assistance 300 million 71
Continaencv 100 mil.

TOTAL 4,000 mil .

72-880 0 76 2


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of the



Mr. Chairman and Members of the Committee, I am pleased to testify

today in favor of H.R. 12112 which would amend the Federal Nonnuclear Energy Research and Development Act of 1974.

H.R. 12112 would provide Federal assistance for a demonstration program to produce synthetic fuels from coal, oil shale, and to convert renewable energy resources to desirable energy forms. I cannot emphasize too strongly, Mr. Chairman, that there is an urgent national need to increase the production of energy

supplies from our abundant domestic resources. H.R. 12112, as reported out by your colleagues in the House Science and Technology Committee, represents an important milestone toward

meeting that need.


Our Nation has been blessed with an aI)undince of energy rcF:ources. Our emergence as a wCrld pcwcr reflects that fact. We still have an abundance of energy resources, but the don.:stic resources we rely on most--oil and gas--are dwindling rapidly. Meanwhile, the use of our more plentiful resources is limited by the lack of adequately proven technology, unfavorable economics, a ;d concern over environmental consequences, The result has been a growing dependence on imported energy, the availability and price of which is controlled by a few countries.

Let us explore the energy picture a little further:

-- Oil production in this country is more thar a

million barrels a day less than at the start of

the embargo.

-- The natural gas problem continues to worsen.

Proved reserves in the lower 48 states have declined steadily. Production is also declining at the rate

of 6 to 7 percent a year.

Of our fossil fuels, only coal production increased last year. And it was only six percent higher than

the year before.

Finally, more than one-half of all new coal and

nuclear power plants scheduled for operation between

now and 1985 have been deferred or delayed in the

last 18 months.


As you can see Mr. Chairman, the short-torm energy situation is not bright. Mreovcr, our long-term energy situation will be worse unless we taKe positive actions to increase supply and reduce demand. If we do nothing, oil imports will reach dangerously high levels between now and 1985. H.R. 12112 is an important piece of legislation. Its enactment will be a key step to accelerating the development of alternative domestic energy supplies. These supplies will be vitally needed as our traditional energy supplies--notably oil and gas-continue to decline. Thus, H.R. 12112 may be viewed as a long-term energy insurance policy--a policy we cannot afford to be without.

The long-term nature of alternative fuels technology must be emphasized to underscore the need to get started now. Consider, for example, that the first nuclear powerplant was built in the mid-fifties. Yet it wasn't until 1970 that we obtained as much energy from nuclear power as we obtain from firewood. The lead-time problem will also apply to synthetic fuels, solar energy and geothermal energy. To overcome this problem, we will have to provide Federal assistance during the next decade to bring these new technologies to commercial use. H.R. 12112 authorizes a demonstration program; thus, the quantity of synthetic and other fuels produced will not be large. However,


cnactmc~nt of this lc';islati-on will help remove the b::rriers

and lay the cround-w-ork for thei accelerated development, of, one or more major energy industries in this country before the turn of the century.

Synthetic fuels will not be inexpensive. Between now and 1985, we estimate they will be more costly than both domesticallyproduced and imported petroleum. But if we don't invest the financial resources now, in the years beyond 1985 when our oil and natural gas reserves are further depleted, we won't have a chance to replace them in a timely manner. Thus, Federal participation in a synthetic fuels program should be viewed as a deposit .-n an energy savings account that will be returned to the Nation with substantial interest. The same thing may be said for efforts that are underway to develop other new energy technologies. I would like to comment on a few provisions of H.R. 12112 which are exceptionally noteworthy. First, it is widely recognized that commercial size synthetic

fuel plants and related facilities have the potential to create significant environmental damage if not designed and operated properly. One of the stated objectives of this legislation is to gather information about the environmental consequences of such facilities. This objective will ensure that reliable environmental data is obtained~with the plants using advanced control techniques, to provide a sound basis


upon whicn to reCguiaTciL

But more importantly, H.R. 12112 would establish a pnol to advise the ERDA Administrator on the impacts of the program on communities, states, and Indian tribes, and on environmental and health and safety effects of synfuel plants. One of the panel members shall be designated by the National Governors Conference. Other members will come from Indian tribes, environmental organizations and the general public. This panel will help ensure that the Federal Government is responsive to the needs and concerns of state and local governments. Fi::11y, Mr. Chairman, I would like to point out that this Nation still faces an energy crisis. The most serious causes


of this crisis are the uncertainty as to future supplies and prices, uncertainty as to Pederal regulatory policies, and uncertainty as to future markets. I'm firmly convinced that passage of H.R. 12112 in essentially its present form would remove a substantial part of this uncertainty and help resolve our future energy supply-demand imbalance. The benefits would be two-fold: first, between now and 1985, we would gain valuable data and experience in producing synthetic and other fuels on a commercial scale. Second, passage of this legislation would demonstrate that we, as a Nation, have the resolve to undertake a difficult task. This alone would help remove some of the uncertainty associated with our energy policy.

I urgently request that your Committee and the Congress act expeditiously and favorably on this important piece of legislation.

Thank you. I will be glad to answer questions you may have.


United States General Accounting Office Washington, D.C. 20548 FOR RELEASE ON DELIVERY EXPECTED TUESDAY AFTERNOON
May 25, 1976
Statement of
Monte Canfield,, Jr.
Director,, Division of Energy and Minerals before the
Subcommittee on Energy and Power
Committee on Interstate and Foreign Commerce
United States House of Representatives
Developing and Commercializing Energy Technology

Mr. Chairman and Members of the Committee, we welcome the opportunity to be here today to consider with you the difficult problems of developing and commercializing energy technology. I would like to lay out a perspective and then focus my comments on two things.--an overview of the scope of various legislative proposals now

before the Congress that would provide various combinations of

Federal financial support for developing and commercializing

energy technologies;

--a brief description of recent and ongoing GAO work bearing on

the question of Federal financial assistance for developing and

commercializing energy technologies. PERSPECTIVE ON ENERGY DEVELOPMENT

A large number of issues and choices face Congress in dealing with energy development. Energy development is a slow process. Legislative action will occur years in advance of actual impacts. While we recognize



that legislative decisions will be required without full information,

it is important that the Congress and the Nation focus on sane critical issues and trade-offs that can enhance the quality of the decisions to

be made.

First, there are no simple choices. Each technology has to be weighed

against the benefits and costs of competing options. Those options are

not only on the domestic production side. For example, while often

overlooked, conservation is truly one of our least costly supply options. Consideration of financing conservation improvements as

alternatives to, and complements to, large capital-intensive supply

technologies is essential to rational decisionmaking.
Second, although no consensus exists among financial experts,
sufficient capital will probably not be forthcoming to support the entire range of developing energy technologies. We can't do everything--we must

choose. Further, since it is unlikely that private industry will be able to capture the benefits of many of the more expensive and risky

research and development options, some form of Government financing will probably be necessary to stimulate new energy technologies. Developing

the criteria to choose among competing technologies and choosing the

funding levels for each will be difficult, but equally essential.
For each option we should pursue the question: When could the

technology be commercialized? Also the energetics, or thermodynamic

efficiencies, should be carefully weighed. Such a weighing of the

. .... . . .....


net energy output for each technology, will enable us to make energy

efficiency comparisons among competing technologies. Adverse environmental effects and social costs of development must be considered as

part of the total cost of any energy development project. Also, external influences, such as dependence on foreign oil, must be

considered in choosing among future options and short term security.

Even once a decision is made to pursue a given option, we are not

home free. Deciding among the most desirable methods for encouraging

development, including various forms of Government ownership, tax

policy, import controls, loan guarantees, price supports, etc., all

depend upon the technology and the energy strategy and goals.

With this perspective in mind, it is useful to recognize that there

are three main types of legislative proposals to financially assist the
development of new energy technologies. Only by looking at all three areas comprehensively can a true picture of the total costs of energy

development emerge.

First, what is termed "front-end" assistance is proposed. This

amounts to subsidies to states and local governments in regions which are

largely rural and unindustrialized to help them plan for development and

to provide the public facilities necessary as a result of the development.

Assistance could be in the form of loans, loan guarantees, and planning



Second, since private investors are reluctant to build and operate new risky commercial or near-commercial facilities, incentives in the form of loan guarantees, interest subsidies and tax write-offs are proposed.
Finally, even after commercial-sized plants are subsidized and
operating, there is a potential that synthetic fuels will be too high priced to compete with alternatives such as domestic oil and coal or oil imports. Therefore, subsidies to producers in the fom of price supports or to users in the form of tax incentives or low interest loans have been proposed to enable higher cost technologies to compete in the market place.
For example, legislative proposals have been submitted which would guarantee purchase of products. One would set up a board to purchase synthetic fuels and solar energy, and auction them off to the highest bidder. Some of these proposals cover more than one of the three financing categories discussed; but none is truly comprehensive. The point is that no one piece of proposed legislation covers in any
comprehensive way the entire range of financial support being considered. ENERGY INDEPENDENCE AUTHORITY
The Administration's most comprehensive energy development proposal
would establish an Energy Independence Authority (EIA). The bill, S. 2532, would encourage the development and commercial operation of domestic energy sources and to a lesser extent, encourage energy conservation. A total of $100 billion would be available to the EIA. The proposal would


authorize direct investment in energytechnologies, loans, loan guarantees, and price guarantees.

Our central concern lies in the proposal's lack of balance. The
bill exhibits a clear preference for initiatives of the supply-increasing variety. According to one provision of the bill the conservation projects eligible for funding appear to be those not in widespread use. This would appear to preclude, for example, assistance to a utility-administered residential insulation project, since home insulation is already in "widespread domestic commercial use". No equivalent condition is attached to supply increasing projects.'
The bill would hamper conservation efforts rather than simply fail to promote them. This is true because the bill would result primarily in the allocation, not creation of capital. The EIA's loan funds would, in large part, be raised in the private capital market. Its guarantees would make projects it assists financially more attractive to private capital than conservation projects not backed by Federal guarantees. Thus, both its loans and its guarantees will siphon private capital away from conservation projects which might have been able to obtain private financing in the absence of EIA operations.
The choice of projects to receive financial assistance, and the
form of assistance, ought to be based upon reasonable forecasts of the degree to which each project will advance the goal of independence per


dollar of assistance accorded it. We believe that many initiatives in the direction of conservation hold the promise of moving the country farther down the road toward energy independence per dollar spent than do most supply increasing options.
In addition the bill is underlaid by some assumptions regarding
national policy which are by no means settled. Its predilection toward nuclear power generation is the most obvious example. Another is seen in its willingness to give the Government a large quasi-commercial interest in energy supplies which would be in competition with Imported crude oil. Since the bill does nothing to limit imports directly, the underlying assumption appears to be that world crude prices will stay, high enough to insure the profitability of the EIA's investments in alternative domestic supplies. Thus, the Government would have a financial interest in keeping world crude prices artificially high. We believe that legislation regarding financial support for synthetic fuels and other energy development should be coordinated in a systematic framework which includes all the likely costs associated with development and detail on the mix, number, and size of plants, and types of financial support needed for each. Specifically, adequate financing for synthetic fuels commercialization requires further information, analysis, and evaluation of many factors, particularly the arrangements for subsidies or price supports which may be necessary to make synthetic fuels competitive. Subsidies or price supports in turn raise the question of Government energy pricing policy. For


example, oil and gas prices are being held down by regulations while it appears that it would be necessary to subsidize higher cost synthetic fuels. While legislation on energy development need not be comprehensive, it should seem obvious that a balanced and consistent energy strategy can provide a useful framework within which individual proposals can be evaluated.


Our March 1976 report discussed an Administration proposal to authorize ERDA to provide up to $6 billion in loan guarantees for, among other things, commercial demonstration facilities for the production of synthetic fuels. To encourage industry to participate in synthetic fuels commercial demonstration programs the Administration recommended Government incentives consisting of loan guarantees, price supports, and construction grants.

Because of time constraints we did not evaluate the pros and cons of the various forms of Federal assistance considered by the Admiistration in arriving at its recomendation in that report. We did note, however, that important policy and judgmental questions were involved in arriving at the recommendations. A different emphasis on certain considerations such as impact on the budget, degree to which an alternative preserves and enhances competition, ability to achieve program goals, and extent of Federal involvement in management of operations--could conceivably lead to a different choice of alternative forms of assistance.
We stated our view that the Congress should consider awaiting further studies which ERDA expects to complete in July 1976 before approving any legislation. The studies should provide better information on the scope


and magnitude of Federal assistance needed to carry out the programs, including better information on the type and number of plants needed. ON-GOING GAO WORK
GAO has undertaken a review which focuses on technologies that have demonstrated technical feasibility but which do seem to have impediments to full commercialization. These impediments are caused by a variety of non-technical reasons such as financial, environmental, and regulatory. The technologies considered are synthetic fuels, solar and geothermal energy, enhanced oil and natural gas recovery and certain conservation measures. Within this framework we will first address future supply/demand balances to the year 2000 and consider the probable roles of each of these technologies. We will attempt to determine the current status of each of the technologies and the current impediments to commercialization as well as the pros and cons of various Government options to stimulate financing activity. The options will cover such mechanisms as direct loans, loan guarantees, price guarantees, tax incentives and Government ownership.
We will then attempt to evaluate what priorities the Government should attach to the various technological options for the purpose of allocating funds or guarantees. In this section we will consider various social and economic goals such as obtaining the most energy at least cost, the maintenance of a competitive environment, economies of scale, tradeoffs between first -and second generation technologies' and the implications of onbudget and off-budget financing. As a conclusion, we will attempt to specify


legislative or polity approaches would, in our judgment, allow the aost consistent and systematic consideration of Government'. role in financing energy commercialization efforts. We will also identify key tradeoffs, in this area between the supply and conservation options

cons i de red 4 n ou r report.

As you can see, Mr. Chairman, there are matters requiring closer examination regarding the scope and magnitude of Federal financial support for synthetic fuel and other forms of energy development. We hope that our further study will provide some useful insights on these matters. We plan to complete our study in mid-summer which is around the same general timeframe that ERDA plans to complete its follow-up studies on synthetic fuels.
I want to emphasize that our study not only addresses the fundamental question of whether early commercialization of synthetic fuel technology should be pursued as aggressively as the Administration proposed but also the broader question of how this country can best provide for its future energy needs.
In summary, we are suggesting that information which should be

available frgnERDA and GAO this summer should be helpful to the Congress as it proceeds toward final legislative action on H.R. 12112 or any of the other bills currently in Congress dealing with the Federal financial support for construction costs, price supports, and-initial costs to

State and local governments.

Mr. Chairman, this concludes my prepared statement. We will be glad to respond to questions.

72-880 0 76 3


May 25, 1976


Mr. Chairman and members of the committee: I am pleased to be here today to discuss the synthetic fuels bill (HR 12112). My statement is based on my consulting work for the Synthetic Fuels Interagency Task Force and for other government agencies and private energy companies. In my work for the Synthetic Fuels Task Force I directed a team of SRI analysts who worked closely with government experts and analysts to conduct an overall cost/benefit analysis of synthetic fuels commercialization policy. In making this statement I do not represent the Synthetic Fuels Task Force, SRI, or any of the other organizations for which I have consulted. All of the information I will quote today is publically available and much of it is documented in Volume II of the report by the Synthetic Fuels Task Force Report.

I think most of us'agree that decisions concerning government
incentives for synthetic fuels commercialization are very complicated. Necessarily, many of the factors affecting the desirability of government support for synthetic fuels are uncertain or involve difficult value judgments. For example, the future costs of imported oil and synthetic fuels are highly uncertain and have a major impact on the ultimate market for synthetic fuels. Also, value judgments on the indirect international relations effects of depending on fuels are

"Recommendations for a Synthetic Fuels Commercialization Program: Volume II-Cost/Benefit Analysis" report submitted by the Synthetic Fuels Interagency Task Force to the President's Energy Resources Councel, November 1975, for sale by the U.S. Government Printing Office, Washington, D.C., 20402, price $4.20, stock number 041-001-00111-3.


clearly central to fle(; decision on the synthetic fuels bill. In MY statement I will focus on these and other important fators affecting this decision.
The most important economic factor affecting dec. .:nis on-commercializing synthetic fuels is the size of the future ma-. Let for synthetic fuels. Figures 1 and 2 show the total quantity of synthetic fuels that would be produced under different assumptions concerning synthetic fuels costs and imported oil prices.' The vertical scale on the figures is expressed in quadrillions of Btu's per year on the left and millions of barrels per day of oil equivalent on the right. (For comparison, the total U.S. oil and gas consumption in 1975 was about 26 million barrels per day.) The horizontal scale spans the next fifty years.
The nominal or middle case shown in both figures projects synthetic fuels production at about 10 million barrels per day in the year 2000. Many assumptions underly the nominal case. For example, the nominal case assums the imported oil price will increase continuously to about $18 per barrel in 1975 dollars by the year 2000. The low import price case in Figure 1 assumes import prices drop to about $8 per barrel and then rise to current levels by the year 2000. The assumption of low import prices reduces the projected synthetic fuel production considerably. The assumption of high import prices, $3 per barrel higher than for the nominal case, increases synthetic fuels production only slightly. Clearly, the market potential for synthetic fuels is highly dependent on imported oil prices.
The cost of synthetic fuels is also an important determinate of the size of the synthetic fuels. The average cost of synthetic fuels in the nominal case is about $15 per barrel at the plant. If the cost of synthetic fuels is high, $22 per barrel, the production of synthetic fuels is reduced considerably. If the cost of synthetic fuels is only $12 per barrel there is a slight increase in production over the nominal case.


Figures I and 2 illustrate the great uncertainty in the size
of the future synthetic fuels market. Joint variations in synthetic and imported fuel costs would produce even wider variations in synthetic fuels production.
Other variables affect synthetic fuels production but not to the
same degree as imported oil prices and synthetic fuels cost. Figures 3 and 4 show the effect of changes in assumptions regarding domestic-oil
and gas availability and end-use total energy demand. Uncertainty about these variables is less important than uncertainty about synthetic and imported fuel prices.
Some variables while important for other reasons, have no effect
on synthetic fuels production. For example, a national nuclear moratorium would not significantly affect synthetic fuels production because the best alternative to nuclear for electric power production is coal.
The uncertainty in the market potential as illustrated by these
figures is a major reason why commercial synthetic fuels projects have not proceeded. Presently this uncertainty is reflected iu terms of, the inability of private companies to raise capital for synthetic fuels projects. Thus many companies have concluded that the only way a synthetic fuels industry can develop.at this time is with government loan guarantees and other incentives.
A decision on government guarantees and incentives for synthetic fuels must take account of a broad range of international, environmental and economic issues in addition to the market economics.faced by private industry. Synthetic fuels are a substitute for impor ed fuels. Dependence on imported fuels involves such concerns as international relations, balance of payments and exposure to future embargoes. -On the other hand, dependence on synthetic fuels involves environmental consequences and large capital investments. Also, early development of a synthetic fuels industry would reduce uncertainty about synthetic fuels technology. and contribute-to lower costs for later synthetic fuels plants through' development of infrastructure and technological learning. Many of these important issues are not fully accounted for in corporate decision making and therefore must be accounted for in the government's decision.


The Synthetic Fuels Task Force with the assistance of SRI, performed
a comprehensive analysis of four levels of synthetic fuels commercialization programs: no program-, an information program of 350,000 barrels per day by 1985; a medium program of 1,000,000 barrels per day; and a maximum program of 1,700,000 barrels per day. The analysis considered several thousand possible outcomes under varying conditions of imported oil prices, synthetic fuel costs, domestic energy supply and demand and future corporate synthetic fuels investment. Judgments by the task force on crucial factors were made explicit in the analysis. The overall measures of net benefit produced by the analysis reflect all significant categories of cost and benefit with the exception of specific international relations categories that I will describe shortly.
As shown in Figure 5. the expected costs of all commercialization
program levels exceed the benefits. Relative to no government program, the expected discounted net benefits (in 1975 dollars) are:

-1.6 billion for the information program
-5.4 billion for the medium program
-11.0 billion for the maximum program

It is important'to note that there is considerable uncertainty in the ultimate net benefit. This uncertainty is explicitly accounted for in the analysis by weighting the net benefit of each possible outcome by the probability that it will occur. The analysis showed, for the information program, that there was a 10 per cent chance that the net benefit of this information program would exceed 7 billion dollars and correspondingly, a 10 per cent chance that the net loss would exceed 9 billion dollars. When the benefit levels are properly weighted by their corresponding probability the resulting expected net benefit is negative.
The key factor affecting the net benefit of a synthetic fuels
commercialization program is the strength of the oil producers' cartel. A strong oil producers' cartel in 1985 was judged to increase prices of imported oil by 4 to 9 dollars per barrel over that of a weak cartel. The probability of a'strong cartel existing in 1985 was assessed at 50



per cent by the task force. Figure 6 shows how the net benefit of the synthetic fuels program levels are affected by the probability
assigned to a strong cartel in 1985. The vertical scale measures net benefit; tl-ehorizontal scale is the probability assigned to a strong
cartel in 1985. If a weak cartel occurs all program I'vels 'have hl
negative net benefits; if a strong cartel occurs all program levels have
positive net benefits. Assuming all other factors are held constant,
the breakeven probability required to justify a synthetic fuels program
is 80 per cent.
Wide differences of opinion on the probability of a continuing strong cartel exist. Some argued that the free market always
prevails and therefore they advocate assigning a very low probability of
a strong cartel existing. Others assign a high probability of a strong
cartel on the basis that unless we believe the cartel will remain stone
we will not take the necessary actions to help*weakeA.the cartel.
Neither extreme is'correct. Clearly the assessment of the strength of
the cartel is a difficult judgment but it is one that must be made
on the basis of the best available Information in order to formulate
a wise policy on synthetic fuels.
Three categories of overall benefit were defined by the analysis: economic benefit, dependence costs and environmental and socioeconomic
costs. Economic benefit is the difference between what the country
would pay for fuels without a synthetic fuels progravand what it would
pay with a synthetic fuels program For example, the net economic benefit
of the information level program is negative, a 1.7 billion dollar
net loss because the expected synthetic fuels costs are higher than the
expected imported fuels costs.
Dependence costs include future embargo losses, balance of payments costs and international relations costs. The analysis credited a
synthetic fuels program with any reductions in dependence costs that would
result from substituting synthetic fuels for imported fuels. Assuming
the probability of another embargo to be 10 per cent per year, the
information level synthetic fuels program is credited with 400 million dollars reduction in expected embargo loss. This reduction may appear small but the amount of synthetic fuels produced by the program is also


small relative to total imports, and large reductions in i,,i-orts as a result of synthetic fuels only occur under conditions where synthetic
fuels are much cheaper than imports.

With respect to concern with embargoes, it is worth noting that n strategic storage program is a much more effective alternative for reduc-ing eip. rgo losses. On the same basis as the synthetic fuels analysis, a storage program of 600 million barrels has an expected positive net benefit of 9 billion dollars.
The effect of a synthetic fuels program on U.S. balance of payments was judged insignificant. Possible reductions in imports over the long life of a synthetic fuels plant would be balanced by reductions in U.S. exports of other goods.* Thus, there would be no significant net impact on U.S. employment, tax revenues, or gross national product. In other words, the balance of payment effects on this synthetic fuels decision can be safely ignored.
International relations costs or benefits could include demonstration to other nations of U.S. resolve to be a world leader in energy or perhaps the economic benefits to other nations of a U.S. program. But the crucial international relations issue is whether U.S. foreign policy interests would be improved or degraded by reduced imports of fuel from other nations. The task force analysis was unable to draw any firm conclusions on this benefit category and the 1.6 billion dollar net negative benefit for the information level program does not assign any costs or benefits to the international relations effect. The implication is that those who assign a higtipositive benefit to the international relations effect (greater than the 1.6 billion dollar loss) should support a synthetic fuels commercialization program.

Another way to illustrate the importance of the international

relations issue is to consider the effect of an import quota on the value of a synthetic fuels program. If the government should adopt a quota at about the current level of six million barrels per day of imports, the information level program would have strongly positive net benefits of about 5 billion dollars. On the same basis, however, the cost to the nation of the import restritions would be 44 billion dollars.


The final category of benefits includes environmental and socioeconomic costs. The costs of complying withpresent and future environmental standards and providing for a portion of the community infrastructure are included in the costs of synthetic fuels. The high level of uncertainty about environmental and socioeconomic costs is one reason for the uncertainty in the cost of synthetic fuels.
The economic costs of synthetic fuels do not include the social costs of synthetic fuels associated with residual air emissions, water quality and depletion, land disturbance, health and safetyand social disruption impacts. The cost/benefit analysis utilized rough judgments on the equivalent dollar costs of these impacts. The total.. discounted external environmental cost of the information level program was about 400 million dollars. Coincidently, this cost approximately balances the embargo costs associated with imported fuels.
Finally, I must emphasize that all projections of future energy supply and demand tell us that synthetic fuels will ultimately take their place in the market; only the timing of this event is uncertain. Moreover, the task force analysis says nothing about the benefits of, continued research and development on synthetic fuels; presumably
continued research and development including the construction of modules of potentially commercial plants is beneficial.
Government decisions on the commercialization of synthetic fuels
involve the commitment of large amounts of national resources. Regardless of whether the government incentives take the form of loan guarantees, price supports, capital grants, tax relief, or regulatory changes, it is the consumer who pays the bill. Since government decisions are not subject to the normal economic checks and balances of the market place it is essential that decisions on synthetic fuels commercialization be based on the best available analysis and expert judgment and not on the emotions of the moment.


Figure 1


100 A I II 1. I 5
cc 100 50

80 High Import, 40 U.
CC ,Prices C)

C L ., 3 0 r
Co*-, 60 --," Nominal Case ":
C C= ,, _20 C__ -40 -2 Low Import.
cc ---= rie 10 "'
20" Prices------ - S "" *

LU c
0 0
1975 1980 1986 1992 1998 2004 2010 2016 2022

Figure 2

1 0I i I I I i i 5 .
cc 100 ,
80 Low Synthetics .,/ 40 C)
,'" 30
Z &0 Nominal Case 3 U

40 20 w
20 ,- High Synthetics >
M-20 ----C _- 10 cc
1075 1 198 1 9
0 0
1975" 1980 1986 1992 1998 2004 2010 2016 2022


Figure 3

1 100 50

80 Low Oil and 7 40 co
cc Gas Availability U- ..

60- 30 uM~ M (D "" -j <:
c 40 ---" 20
_j---- Nominal cc
"20e Case cc
cc .0~
c" -"2"0 10 'J "
0 -0- -High Oil and
.- Gas Availability
0 I0
1975 1980 1986 1992 1998 2004 2010 2016 2022 w

Figure 4


*cc 100 Nominal -' 50 U.
,, Case
._c 80 High Demand ,40

4 60"*-- 30 .1
Z "40 ,'"-" 20W
.'- ,, Low Demand W
cc 1
20 1 -:0;cc

90 1 1 1 10 1975 1980 1886 1992 1998 2004 2010 2016 2022


Figure 5


oResults of Analysis
Information Level7(350,00t. Barre'slday)
M inLevel

(1,000,0'D Barrels/day)

Maximu m Level

(1,703,030 .Barrels/ly.J

-10 -5.0 01 +5.0
EXPECTED DISCOUNTED NET BENEFIT RELATIVE TO NO PROGRAMt (billions of 1975 dollars) 'Excodas potential international relations effect

Figure 6

oSensitivity to Probability of a Strong Cartel 10

OF THE *0 14 __7

a-. o .PROGRAi 0~

x FROM )0LST0106i



Stateient by Barry Bosworth Research Associate, Broakings Institution* before the
Congress of the United States
Subcmynittee on Energy and Power
Qburnittee n Interstate and Foreign Conierce May 26, 1976

I wish to thank the Subccrmrittee for the invitation to cmrnent an the use of loan guarantee programs to promote growth in energy supplies. While I am aware of most of the issues, I wish to make clear that I am not particularly knowledgeable in the energy area and I wish to limit my remarks to the econcic effects of loan guarantee programs. Thus, I will only consider the issue of loan guarantees versus other incentive programs without addressing the first issue of whether or not the proposed plants should be built. In this regard our previous experience ith loan guarantees may be of value to the Subcwamttee. This specific issue is closely related to my oun research interest in financial market structure.

First, the decision to provide special incentives in

the energy area must be seen as reflecting a tradeoff with other claims on the Nation's resources. If more

resources are moved into the energy area, less will be

available in other areas of private investment, consurrption, and government expenditures.

If this is done through preferred access in the

capital markets, the offsetting reductions would

*The views expressed are my own and are not necessarily those of
the officers, trustees, or other staff mrbers of the Brookinas Institution.


cam from other investn-nt primarily housing

and higher risk loans to small business.

- In contrast, direct budgetary financing would

cnc.trate the offsets in other government

expenditures and current ccnsurptlcn.

- 7he fact that these programs might create jobs

is irrelevant to this particular decision, since

such a statement is true of any economic expenditure and is not a basis for favoring one over


- At the same time, it is unrealistic to believe

that such a program will hawe a serious disruptive influence cn capital markets.

Second, the simple existence of a loan guarantee program does not necessarily increase the total annnt of investment in the subsidized area.

- It is very hard to exclude projects that imuld

have been undertaken in the absence of a guarantee,

and the guarantee may be exhausted by these projects.

- Such substitutin effects have caused serious prcblems for student loan guarantees and sare parts of

the hcme mortgage market.

- Because the administrator of such a program fears

recriminations in the event of default the actual

risk criteria may be no easier than that of the

private market.


- Thus, a loan guarantee program will automatically

take over the whole market, and its maximn size mst exceed the amount of investment that would have occurred in its absence if any incremental

increase in effort is to result.

Third, a loan guarantee encourages the termination of a project at an earlier date than without a guarantee.

- For example, assume operating costs are $10/

barrel of oil equivalent and that fixed capital

costs at $10ibarrel require a price of $20/ barrel. Without a guarantee, the plant will

make a profit at $20/barrel; but, nb:re important,

it will continue to operate at any price above

$10/barrel (operating costs) until the fixed

capital plant is exhausted as a means of minimizing the loss.

- However, with a guarantee the firm will default

at any price below $20/barrel and leave the gowrnment with the problem of operating the


- Alternatively, either price guarantees or government financial participation avoid this problem

of premature shutdaqn.

Fourth, Ln combination with current tax laws, a loan guarantee program can seriously distort incentives and become a tax haven rather than a viable eccnoaic operation.


- For example, a 90 percent loan guarantee together

with a 10 percent investment tax credit results

in zero acner equity after the plant is 'constructed.

- If at any tine the Gners' equity becomes negative,

the rational investor will default.

- In future years rapid tax depreciation and depletimn loers the critical level of the loan guarantee

even further.

- Since many of the knaledge benefits are likely to

accrue in the construction phase and first few years

of operation, there is a strcng likelihood of default

before the loan is repaid.

- Such a problem of loan defaults was serious for scue

parts of the federal housing program, and there is no

reascn to think that businessmen are less rational

than homeowners.

- Thus, it will be very important to insure that any

combination of loan guarantees, tax measures, and construction loans maintains a substantial amount

of mwner equity in all years of the project.

Such projects are likely to be most attractive to public utilities.

- Rate of return regulation allas the cost to be

folded into the rate base.


- The opportunity to have a guaranteed source

of supply is likely to be of more concern than

costs, since the risks of being cut off frsm

natural gas supplies in the future are reduced.

- Haever, a program to reduce the risk position

of the public utilities is not consistent with

efforts to explore uncertain costs of new energy


Therefore, regulated public utilities should

probably be excluded from such a program.

I believe that the most realistic viaq of these projects is not that they are sirrply of high risk, but rather there is every expectation that the first few will be unprofitable.

- For a few ndustries they are attractive as a

guaranteed source of supply particularly

regulated utilities where cost is not of pimary concern.

- But, for others, the problem is most similar

to that of infant industries where those who

follow will benefit from the learning aspects

of the first. In such a case, an effective

stimulus of these new technologies, if desired,

will require a direct government contribution

to costs rather than just a loan guarantee.


A clearer insight into the risk problem can be obtained by consideration of three alternative cases.

-Case I: The project is profitable at irean

expected future prices but there are risks

of price declines.

In this case a loan guarantee sin-ply
encourages a premature shutdoan at any price belowd total unit costs instead of ccntinuinar
t>opqerate at prices above variable costs.
The investors are protected against loss but
the project is not continued.
Cn the other hand, price guarantees elirninate this type of risk.

-Case II: The project is unprofitable at the

expected price.

Normally, the project would not be undertaken but might be with a loan guarantee with an
intention to default because the returns are
positive in the first few years because of tax
or knowledge benefits.

-Case III: The risks result from uncertainty about

costs rather th-an prices.

Again, a loan guarantee results in default
and premature shutdown; but, in addition, a price
guarantee is inappropriate. In this case, only
direct government participation in the costs will
reduce risks. Any use of adjustable price guarantees
begins to look like cost plus contracting.

-In practice, any project is likely to be a mixture

of these cases, but in no case is a loan program

72-880 0 76 4


an appropriate response to risky projects. It encourages their beginning but it also encourages their early tennination.

Thw guarantees are usually designed for situations,

such as home mortgages -- where the costs of gathering information about many small lenders is very high

and where a pooling of many loans reduces risks and

allows for the use of average default experience as a means of charging an insurance fee. This is not the case for a few large projects where the private

market knows as much or more than the govermnt.

The fact that these are large projects does not itself create

a need for a guarantee since U.S. capital markets have frequently been able to neet such needs in cther areas with

participatory financing.

In sunmary, I am most concerned that loan guarantees will significantly reduce incentives to develop viable production processes because of premature decisions to quite, limited owner ecuity, and their potential use as tax havens. In addition, I think it undesirable to place further burdens upon the capital markets as the reans of directing resources to the energy field.

Direct governTient loans financed out of tax

revenue would reduce caTpetition with other

capital projects. But they would also involve


the prcblem of perverse incentives when investors

can avoid the risks.

-Price guarantees seem to be the most direct response

to the issue of future price uncertainty, but they should include a buy-out feature based on the value

of the remaining capital. Otherwise, the government

might be ccmitted to subsidizing high cost energy

if alternative sources result in much la.4er than

expected future prices. Such a price guarantee

iust be equal to or less costly than a loan guarantee

over the life of the project.

The problem of cost uncertainty can only be met by

a sharing of capital and operating cost through a

joint venture as was done for the nuclear programs.

Loan guarantees, construction grants, and other subsidies to capital costs can also seriously distort the evaluation of the most econanic technique when choosing between those which are capital-intensive

(subsidized) versus operating cost-intensive


Finally, I wish to errphasize that nry reirarks are direted only at the alternative meaans of subsidy and not the desirability of the overall venture. I am primarily conicerned that loan guarantees result in significant distortion of incentives since they are of value only


in case of failure. A loan guarantee is of minimal value to the =mst viable projects and of great value to the most doubtful. I am not convinced, after consideraticn of tax advantages and the accrual of knowledge in the early years of the project, that sufficient wxner equity will remain to insure repayment of the loans. I believe that price guarantees and financial participation by the government nrore directly address the issue of risk without distorting incentives. At present, however, the proposed form of the price guarantee proposal is too vague to jud~ge its effect.

I would oppose the construction grant to public utilities since it encourages -vertical integration of a natural irnopoly and is an inap propriate special response to a general industry prcblem of debt capacity. Unless financed by a tax on users such grants artificially lower energy prices and discourage conservation.


Prepared Statement of D. Laird Willott Before The
Subcommittee on Energy and Power of the
Interstate and Foreign Commerce Committee U.S. House of Representatives
May 20, 197o

Mr. Chairman and Members of the Committee:

My remarks today are offered in the context of the stated

general national policy of the Fe'deral Nonnuclear Energy Research and Development Act of developing, on an urgent basis the technological capabilities to support the broadest range of energy policy options through conservation and use of domestic resources. We believe that government, business and consumers should join to foster the development, with all deliberate speed and resolution, of additional energy supplies from all possible sources.

In discussing the need for the proposed Federal support and loan guarantees in H.R. 12112, I will limit my comments primarily to a particular area of my firm's experience which is the financing requirements for commercial size demonstrations of high Btu coal gasification technology. The development of this technology has certain characteristics in common with certain proposed demonstrations of oil shale technology with which we are also familiar.

My personal predisposition would be to avoid Federal financial support and loan guarantees for the development of synthetic fuels, including commercial size high Btu coal gasification and oil shale projects. However, based upon the characteristics which affect the financial viability of these projects, the financial characteristics of the regulated natural gas companies sponsoring coal gasification projects and current regulatory attitudes, we have concluded that the


fa vnanc -a! supcort an d lo--an gu arant'-ees envisioe in H .R.

>1~7 wtl~ eesry to acomlshte innin these project.

~ss~jL2 : cm an oil sale facilities possess several

tr? tts hl afet! ter 'Iac iblty These

:~esed ec~lcg;--. for or~csot' the size contemplated;

relativelv lcog constructUion neriods. Testing several! vears;

a very hicgh-. level. of carital intensity;

-~:rydcsos and

eene on c- n --or conv person feedst,"ock, which- is su'b~ect

,rhe rec-U. lited natual as industry. is the primary s onsor of'hig cc CC~s::ca~nDro, ects. The unicue c Iharacteristics of thi7S

:nduS rV Wh ICh. in cobn at[i on w-Ith t he projec t 's financ ial ch aract'-e rlimit heablty of ;:7as ctaisto und-erta--:e these rro.-ects ad ec tne f:o-lowiLng1

4nanes q 1,thi1-n the, regulated natural zas industry have not

bieen able to acuu~esufficient capital, especially equity

capital, nor hav.e they been allowed to earn a return on

ter exz-sting assets which would enable them to take the

txype or dezree of financial risks inherent in coal ;:asification

prof aects; and

eclfninz reserves and curtailments of natural gas have

adversel- fecte 7he abilf-1iy of the natural gas industry

to attract long. term capital.

in order for comrilsize synthetic fuel projects to

conetesuccessfully for capital funds, we believe t,-hat prior to


the commencement of construction, financially acceptable assurances must be given to potential lenders that the rrofects will be completed and placed into service or, if not, that their loans will nevertheless be repaid under all circumstances. The macniude of the capital requirements for these projects, the major risks associates with them, and the existing financial structure of toe regulated natural gas industry all combine to make it impossible to satisfy the lenders' assurance requirements. it is rarticularl': attarent that the proposed Federal loan guarantees are required in t:is area for high 3tu coal gasification projects.

In our judgment, the government should be given reasonable

assurances that its loan guarantees will not be called upon if the projects are completed and placed into operation; similarly, we believe that equity investors must be provided with financial incentives commensurate with project risks to induce their tar: cation For these assurances and incentives to be met, especial': -or ocal gasification projects, it is our opinion that all e aents, full costof-service tariffs must be approved and implemented by the appropriate regulatory authorities on both the national and local levels. These tariffs will be designed to assure potential lenders and equity investors that gas consumers will provide sufficient cash flow to operate the protect and service capital. These tariffs will also help to assure the government that its support during a project's operating period is principally a contingent backstop to consumer commitments.

Federal loan guarantees as a contingent btackstopc to toe on~e


tariff arrangements are needed during a project's operating period because of the historical attitude of the Federal Power Commission towards all events, full cost-of-service tariffs, the current opposition of many state regulatory commissions to provisions which would enable the tracking of such tariffs, and the risks that regulatory authorities, courts or legislatures could take, or be 'required to take, many subsequent actions that would compromise or eliminate initial regulatory approvals of such tariff support.

We believe that the proposed government -uarantee of debt, in

combination with gas user tariff support and project sponsor support in the form of equity investments, is an appropriate method by which to accomplish the financing of commercial size coal gasification facilities. In our opinion, this combination will satisfy the repayment assurances of institutional lenders during both the construction and operating periods. It should be recognized that institutional lenders are expected to provide a substantial portion of the recuisite capital and that they act in a fiduciary capacity. 7n such capacity, they are charged with the protection of the funds of their beneficiaries, the saving and investing public. To the extent that they perceive a greater degree of risk in one project relative to the many other investment alternatives available, they cannot be expected to advance funds to that project. Furthermore, n many instances state laws impose requirements and limitations on the type and degree of investment risk they can take.

We would now like to comment upon specific provisions in the proposed legislation.


The mandate given by H.R. 12112 mounts a very broad attack on the energy problem. It represents a very comprehensive undertaking with almost unlimited Dossibilities for research and development and, if well done, should result in extensive benefits to the country as a whole. The most important aspect of H.R. 12 12 is that it gets the job started--the job of developing energy technologies, including synthetic fuel technologies.

The current version of H.R. 12112 authorizes loan guarantees of

up to $2 billion in 1977 and $2 billion in 1978 with a limit on guarantees to be made available to high Btu gas development of 50% of these amounts. These authorized amounts aDppear to be adequate to get high Btu gas programs under way. However, I must point out that the effort mounted by HR 12112 will of necessity eXtend over many years and will in all probability require ongoing support for some years for several reasons:

(A) H.R. 12112 covers a very wide range of energy technologies which could be fostered and developed.

(B) A commercial size demonstration facility for the envisioned

energy technologies will be very costly. One high Btu coal gasification project of commercial development size could cost, even on a minimum basis, approximately $1 billion over a several year construction period. Construction cannot commence until all financing is arranged, and such arrangements cannot be obtained without sufficient guarantees.

(C) The financing of the essential community planning and

development costs resulting directly from the demonstration facilities


could utilize a significant amount of the guarantees available. Additionally, to the extent that an applicant for assistance for a commercial demonstration facility would have to advance sums to states, political subdivisions or Indian tribes for this purpose, these payments would have to be added to the cost of the applicant's facility and funded as part of the overall financing plan for the facility. In our opinion, it will be necessary for these payments to be guaranteed because they are subject to the same risks as the

her caDital inves ed in these projects. Tax abatement

necessarily represent a source of capital to finance these payments because they are not realized without sufficient earnings to utilize them.

(D) The extensive number of approvals and consultations necessary for each project will involve substantial amounts of time which,, during periods of inflation, will add to the cost of the demonstrations and thereby could adversely.aff"ect their economic viability.

As a general comment, there is one additional financial incentive outside -'%-,he guarantee area which I believe would be helpful to financing synthetic fuel and other energy projects. This lies in the area of additional tax incentives. Many projects will generate large investment tax credits which, to the extent the credits car, be utilized to reduce Federal income taxes payable., could provide ,additional capital funds to finance project construction. However., because of the potential size of the credits and because of the general tax limitation that such credits can only be utilized to a maximum of 50% of taxes payable, many of these credits may not be

used as they become available. To assure that such credits can be utilized to provide additional capital funds, I would recommend that in the case of activities of the nature to which H.R. 12112 is addressed, the tax laws be amended to allow the full use of project tax credits up to 100% of sponsor taxes payable.

As to the potential impact of the government assistance proposals on our capital markets and economy., we previously testified before the House Committee on Science And Technology that,, in our opinion, a $6 billion program spread over the construction periods contemplated for synthetic fuel projects would not be expected to disrupt the capital markets when considered against the historical amounts of capital raised by the private and public sectors. We are still of that opinion for the proposed program. We also believe that the economy would benefit significantly from such a program principally because of the overriding importance of energy to our country's economic health.

Wben trying to measure the impact of any guarantee program,

it is important to realize that there are many factors which cannot be accurately predicted and which will materially affect future capital markets. These factors include: the capital requirements of the public sector (Federal, state and local governments), especially those requirements arising from deficit spending; the capital requirements of the private sector; government monetary policy; taxation policy; rates of inflation; savings rates; international balance of payments; and industrial efficiency and productivity. Because



these factors are unknown., it is impossible at this time to predict

with any real accuracy -what the size of the capital markets or the total

demand for capital funds will be over the next decade.

Estimates of the capital expenditures for the energy related industries in the next several years are extremely large by historical standards. Unless necessary tax and other incentives are implemented, current trends would indicate that internally generated

funds for these industries will fall short of funding their historical share of capital expenditures. The balance of these requirements for

funds must be met by external financing.

The government guaranteed securities issued in connection with any energy program would compete principally with the highest grade

corporate debt securities. The net amount of all corporate debt

securities issued during the five-year period from 1971 through 1975 was approximately $113 billion. Based upon the size of this market, we believe that the proposed $4 billion loan guarantee program would

not have an adverse effect on the corporate debt market in general or on the ability of either the energy or non-energy industries to

raise capital in the next decade.

Any government guarantee program., however, should not be taken too lightly, especially if it is assumed that additional guarantee authorizations will be approved under H.R. 12112 and other energy

programs. The ability of companies with lower credit ratings to

compete for available capital could be lessened at times. In addition, higher grade corporate debt securities could face slightly

. .. ..........
higher interest rates in order to compete with an increased supply

of government guaranteed debt.

The provision in H.R. 12112 which specifies that the concurrence

of the Secretary of the Treasury must be obtained with respect to timing, interest rate and substantial terms and conditions of any
guarantees should prove most helpful in minimizing any impact of the proposed program on the capital markets.

In summary, the availability .,)f proposed loan guarantees should further the general objectives of the Federal Nonnuclear Energy Research and Development Act and hence should.facilitate the development of additional energy sou rces to meet the country's needs.

I appreciate the opportunity to appear before your Committee and will be pleased to respond to your quest-ions.


Appendix A
Dillon Read Statement before
the Subcommittee on Energ
and Power of the Interstate
and Foreian Commerce Committee,
May 26, 176

Biographical Sketches

D. laird Willott began work with Dillon Read as a corporate finance associate in 1966. In 1969, he was elected a Vice President, and in 1975, he was elected a Senior Vice President. Mr. Willott specializes in the energy and natural resource industries and is responsible for several of the firm's clients in those areas. in connection with these industries he has concentrated on project financial planning. With Mr. Willott at the hearing is Michael R. McClurg whose biographical sketch follows.

Michael R. McClurg joined Dillon Read in 1971 as an associate in the corporate finance department. In the following year, he was elected a Vice President. Most of his time with the firm has been devoted to the development of financing plans for energy related projects and activities. These projects include the high Btu coal gasification facilities sponsored by American Natural Resources Company and Panhandle Eastern Pipe Line Company, an oil shale project for a major oil company, a naphtha based synthetic gas project for a major gas distribution company, and a nuclear fuel enrichment joint venture between a major oil company and a technologically based industrial company.


Business of Dillon, Read & Co. inc.
As a firm, Dillon Read has worked for many years with the regulated natural gas and the petroleum industries, providing general investment banking services including financial advice as to specific energy projects such as those involving synthetic fuel production. For example, Dillon Read is financial advisor to the American Natural Resources Company on its proposed high Btu coal gasification project. We also have been retained by Panhandle Eastern Pipe Line Company to advise them w respect to a proposed high Btu coal gasification project. Through our investment banking relationship with Texas Eastern Transmission Corporation, we have been indirectly involved with the Western Gasification Company high Btu coal gasification project. In addition, we have performed certain financial advisory services in connection with a major oil shale project.

Dillon Read has had a long and continuing association with the natural gas industry. Since 1946, when the industry began its development as a major supplier of energy, Dillon Read has raised in excess of $4.7 billion of capital for the industry. During the past five years, Dillon Read managed the sale, either publicly or privately, of $1.4 billion of natural gas company securities. Dillon Read also has completed negotiated financings and/or has acted in a financial advisory capacity to several companies in the oil industry. Over the past five years the firm has managed or co-managed a total of $2.8 billion in negotiated security offerings for its natural gas and oil company clients.


The principal activities of the firm include the development of financing programs; advice on appropriate capital structures; review and appraisal of capital markets; advice on design, amounts and timing of underwritings and private placements; organizing and managing syndicates of leading investment banking firms to underwrite issues; the private placement of securities and a wide variety of financial advisory services including corporate reorganizations and mergers and acquisitions. Dillon Read's record of negotiated financings for corporations, municipalities, and governments is summarized below for the five-year period 1971-1975: Total
Corporate Securities

Public Offerings $ 6,133,000,000

Private Offerings 1,312,0005000

Total Corporate Securities 7,445,000,000

Municipal and Governmental Securities .2,846,000,000

Total Negotiated Securities, 1971-75 $10,291,000,2000


Appendix B
Dillon Read Statement before the Subcommittee on 'Energy and Power of the Interstate and-Foreign
Commerce Committee, May 26, 1976.

Financial Characteristics of High Btu Coal Gasification Projects

The financial characteristics of high BTU coal gasification projects is important to understand because it provides a basis for determining the need for government assistance on projects that are to be undertaken by the regulated natural gas industry.

The most important elements of high Btu projects for financing purposes are:

(1) The capital requirements inv'o'lved.

(2) The major risks and problems associated with such


(3) Federal Power Commission decisions and principles.

Capital Requirements Involved

Perhaps enough has been written and spoken about the vast

technological and developmental costs of the large-scale synthetic energy projects of the next few years., but, the very magnitude of the price tag is a critical element in the ability to finance the job. The costs of these super projects relative to the historical costs of the sponsoring companies' in-place plant, as well as the depreciated book value of their existing plant facilities is significant. For example, a $1 billion coal gasification project represents approximately 40% and 33% of the original cost of the plant, property and equipment of American Natural Resources Company and Texas Eastern Transmission Corporation, respectively, as of

72-880 0 76 5


December 31, 1975. It also represents approximately 56% and 51% respectively of the depreciated book value of all of their property, plant and equipment.

It should also be carefully noted that despite the tremendous size of these gasification plants, the incremental gas supplied by one of these projects will be relatively small in comparison to the current deliveries of either Pmerican Natural or Texas Eastern. It is this inverted relationship, the requirement of huge capital commitments to provide relatively small amounts of incremental gas to existing systems., which poses critical financing problems.

Major Risks and Problems

The major risks and problems associated with commercial

sized high Btu coal gasification projects., which could adversely affect the economic and financial feasibility of such projects, and which would be of concern to potential investors and thus must be recognized in the financing arrangements, can be separately considered as those arising during the construction period and those arising during the operating period. Construction Period Risks and Problems

Completion poses perhaps the most difficult of all problems attendant to the financing of these projects. The potential


purchasers of debt securities are no"" in a position to make accurate judgments as to technological, construction, regulatory, environmental, or inflationary risks. These investors will require protection against such risks through a financially acceptable assurance that the projects will be completed and placed in service within a prescribed amount of time, or if not, that their investments will be recovered.

The major risks associated with the completion of these projects that-are of concern to potential -investors are:

(1) Gasification Process

The gasification process selected for use in the first of 'these proposed commercial size project s is known as the "Lurgi Process." Investors will recognize that the Lurgi Process has been commercially proven for the manufacture of medium Btu gas., and the methanation process to increase the Btu content to the

-desired level has been successfully demonstrated. However, there are no commercial sized gasification plants in operation in the United States, and there are no plants in operation anywhere in the world which are as large as those contemplated by certain companies in the regulated natural gas industry. Until the Lurgi Process is commercially proven in the United States,, the opinion of qualified engineers will provide the sole assurance of its physical capability. Although reliance on the opinion of qualified engineers is not unprecedented for financing certain projects or activities of relatively proven capability or moderate cost., we believe that potential investors will not rely solely on such opinions as a basis for committing


funds primarily because of the status of the gasification technology and the relative and absolute dollar size of the projects.

(2) Potential Time Delays and Cost Overruns

These projects entail a potential for time delays as a

result of the confDlexity of the gasification plant, the regulatory and environmental proceedings,, and the long lead time required for planning, engineering and construction. Any time delays could lead to cost overruns, as would an increase in the rate of inflation beyond that incorporated into the financing plans. The risk of cost overruns is magnified by the relative and absolute size of the capital requirements.

(3) Capital Intensity

As stated above, these projects are highly capital intensive. The combination of the high capital intensity and the long lead time compounds the risk of delays and cost overruns.

(4) Nature of Construction

The nature of constructing these projects., particularly the gasification plant component.,is such that it is not feasible to minimize the risks by a step-by-step construction process which would prove the gasification process before the full project investments are made. Once a substantial commitment is made and the long construction period is begun, there is no alternative to completion of the entire project except abandonment.

Operating Period Risks

The major risks associated with the operating period of

these projects that are of concern to potential investors are:

(1) Government Action

Federal, state or local government action might be taken

in a number of ways which would preclude the economic oDeration of the projects. For example, adverse strip-mining legislation might result in the termination of the coal supply for the gasification plant, thus preventing operations. Environmental

legislation might be adopted making continued operation of the projects infeasible or the cost of production so high as to make the gas unsaleable.

(2) Regulatory Action

Despite acceptable initial approvals, which to date have not been granted nor is there any indication that they can be obtained, federal, state or local regulatory authorities, courts or legislatures could take, or be required to take, many subsequent actions that would not permit the projects to earn their full cost of service and would therefore impair or eliminate the ability to assure the amortiJzation of project investment.

(3) Force Majeure

The projects could experience damage or interruption of operations due to non-insurable risks such as wars, strikes, explosions and acts of God. If such events impair the operations of these projects for any significant time, there would be insufficient cash flow to service financing.


(4) Competitive Pricing

Investors would be concerned about such factors as the development of new, cheaper domestic sources of energy or reductions in costs of foreign supplies, as well as the possibility of changes in the Federal governments position regarding reliance on foreign imports. If any of these possibilities occur, the cost of gas produced by these projects could become non-competitive which in turn could mean that the gas could not be sold at prices sufficient to service financing. This risk would be significantly reduced if regulatory approvals could be obtained on a basis that provided for full cost of service pricing.

Federal Power Commission Decisions and Principles

The economics of coal gasification and the ability to arrange

the financing will be very much dictated by Federal Power Commission ("FPCt*) decisions on substitute natural gas, including coal gasification. To date, the FPC decisions have established certain basic principles on jurisdiction, pricing, and sale of "substitute" and "ne source" gas in int 1erstate commerce. The applicable FPC decisions are contained in Opinions Numbers 622 (issued June 28, 1972), 622A (issued October 5, 1972), 637 (issued December 7, 1972), 637A (issued February 6, 1973), 663 (issued September 4, 1973), 728 (issued April 21, 1975), and 728A (issued November 21, 1975).

Based on a review of the aforementioned opinions, the FPC

established principles for coal gasification can be summarized as:


1) Coal gasification plants produce "artificial gas" within the

meaning of the Natural Gas Act (the "Act").

(2) The Act does not vest the FPC with jurisdictional powers

over artificial gas (SNG); therefore, the coal feedstock,

the gasification plant, the facilities for the transportation

of the SNG when unmixed with natural gas and the sale of

SNG when unmixed with natural gas are not within the jurisdiction of the FPC.

(3) The Act does vest the FPC with certificate authority over

the facilities necessary to permit the mixing of SNG with

natural gas, over the transportation facilities and any

applicable transportation rate after mixing, and over the

rate at which the SNG is sold for resale in interstate

commerce after mixing with natural gas.

(i) In Opinion Number 728A, the FPC has conditioned its selling

price authorization for SNG projects to a maximum fixed price which will apply to all SNG produced after project completion

and during the testing operations. Thereafter, subsequent prices would be established in Section 4 pricing procedures

before the FPC; such pricing procedures include a minimum

bill provision which provides a method for recovering capital

invested and return on equity except for sliding-scale penalty

provisions that operate if SNG quantity and BTU content fall

below certain levels.

(5) Although deferred for future consideration in Opinion No. 728,

the FPC has applied "incremental" rather than "rolled-in"


Pricing to SNG in prior decisions.
(6) Although not directly enacted for coal gasification projects,

the FPC has established curtailment policies based on enduse priorities, which rank large commercial and industrial

requirements behind residential and small commercial requirements.

Discussion of Federal Decisions

T.I.e FPC curtailment policies are at odds with the prescribed policies for pricing SNG when mixed with natural gas. This makes it difficult to imagine that large commercial and/or industrial users would be willing to sign long-term SNG purchase contracts., at incremental prices designed to support the gasification project financially, when such supplies could be curtailed for higher priority uses.

When totally considered, the FPC decisions and policies summarized above would not permit the arrangement of debt capital for project financing prior to the commencement of construction. The debt capital could not be arranged even if a project sponsor were willingto make substantial equity commitments and debt guarantees because the FPC decisions and policies subject a project sponsor to so many large risks,, particularly given the large capital costs involved, that he may not be able or willing to commit the full amount of equity or guarantee required to satisfy lenders that a project could be completed, or if not,, that the debt- could be repaid.


Even with the minimum bill provision included in FPC Opinion No. 728A, it will not be possible to arrange project debt without additional financial guarantees and assurances. The minimum bill provision would not commence until a project produced gas. While such a pricing mechanism may provide a method of recovering funds invested in a project after operations have commenced and gas production has begun, we do not believe that it provides a basis for raising (as distinguished from recovering) capital to construct and complete a project. The minimum bill provision does not-, provide a basis for assuring lenders that a project can be completed (so that operations and gas production can commence or if not, that their investments will be recovered. Further., there is no method of assuring lenders that the minimum bill provision for recovering investments would be maintained by future Federal Power Commissions over the operating life of a project. Need for Governmental Assistance

Attempts to cope with the financing problems of high Btu coal gas projects have included consideration of all events,, full cost of service tariffs to assure debt service and surcharges on present customers to provide-a portion of construction costs. Regulatory bodies have thus far been unwilling, in part because of the risks involved.,to permit these tariff arrangements. In addition, further assurances will be required as to completion, production of gas, and its transportation and sale.

Initial regulatory approvals will not be sufficient as subsequent actions of regulatory bodies cannot be predicted. Institutional lenders., primarily insurance companies and pension


funds who would be expected to provide a substantial portion of the debt capital, act in a fiduciary capacity and are charged with the protection of their beneficiaries' funds. State laws impose requirements and limitations on the degree of investment risk that can be committed by institutional lenders. These lenders' requirements cannot be satisfied by relying solely on the cost of service tariffs or the credit of the sponsoring companies.

The huge capital requirements of these projects, the major

risks and problems associated with their construction and operating periods, and the FPC decisions issued to date on such projects., in combination with the financial structure and characteristics of the regulated natural gas industry discussed in Appendix C., make it impossible for these projects to be financed in the absence of government loan guarantees as proposed in H.R. 12112.


Appendix C
Dillon Read Statement before
the Subcommittee on Energy
and Power of the Tnterstate
and Foreign Commerce Cnite
May 26, 1976.

Financial Characteristics of
Regljated Natural Gas 7jUt iity Comanies

To understand the financial characteristics of regulated

natural gas companies and to appreciate their current inability to undertake the costly construction of commercial sized high Btu coal gasification projects, it is necessary to examine the Natural Gas Act and the overall evolution of the industry.

In essence, the Natural Gas Act was an attempt to regulate the natural gas industry on a basis comparable to the electric utility industry under the Federal Power Act; that is, the Natural Gas Act was intended to ultimately place the pricing of gas under a utility-type framework. At first regulation only was applied to the natural gas pipeline companies. With the passage of time,

however, it became apparent that as the unregulated wellhead price of gas began to increase, regulation of natural gas pipeline companies did not fully accomplish the intended purpose of a utility type pricing structure for gas. For this reason, the courts decided in the Phillips Case that regulation of the wellhead price of gas was necessary. Consequently, in 1954, regulation was substituted for supply and demand in determining the price at which the interstate pipeline companies could purchase natural gas.


Under regulation, gas prices have been set at levels which make it extremely cheap relative to other forms of energy. This has caused both the demand for and the consumption of gas to increase rapidly. As supollesof low priced gas have been depleted, additional reserves have not been developed in amounts sufficient to offset higher consumption; as a result, shortages and resulting pipeline curtailments have arisen. Furthermore, available gas in unregulated intrastate markets is priced far above the maximum level which interstate pipeline companies are permitted to offer thereby contributing to additional shortages in interstate markets.

Despite these problems, however, the transmission industry historically was regarded by investors and lenders as possessing financial characteristics which were 'favorable for investment for several reasons.

First, the industry was built and financed on huge gas reserves which represented a cheaD source of energy.

Second, the industry expanded at aC substantial rate primarily because the regulated low price of natural gas created enormous demands. This rapid expansion in customers and consumption during the period from the end of World War !I until the early 1970's formed a solid foundation for debt and equity financing.


Third, the pipeline industry traditionally has been a

regulated industry both on the national level through the Federal Power Commission ("FPC") and on the local level through state regulatory authorities. While regulation has created many problems for the industry, it has provided an implied obligation for reasonable returns of and on invested capital which has given assurances to lenders and equity investors alike with respect to debt repayment and rates of return on equity.

Fourth, during the 50's and 60's the industry operated

in a period of what would be regarded today as relatively healthy and stable capital markets. Capital funds were available, interest rates were low, and public and institutional demand for gas company securities was high. These factors, in combination with T-FPC and state rate making procedures which seek to minimize capital costs and overall gas costs, led gas companies to utilize relatively large amounts of long-term debt in their capital structures because the after-tax cost of debt generally is much lower than the after-tax cost of equity.

Finally, the- principal business of natural gas companies

was the construction and operation of pipeline systems employing relatively low level technology for the transmission and distribution of natural gas. Activities outside the sh-J--ment of gas,


such as exploration or development, were not a major element or area of capital commitment in the industry as it traditionally evolved, and thus it became identified as an industry of generally low risk.

In contrast, the industry currently is facing rapidly

changing circumstances which are affecting its operating struc-ture and financial viability. For example,, in a matter of' a few years, the gas supply of the industry has changed from' a sur-olus situation to a reserve deficient status. Reserve life indexes continue to decline, to something less than ten years supply if Alaskan gas is excluded. The declining reserve picture, more than any other single factor, has caused lenders and investors to reexamine the traditional financing patterns of the industry and has prompted them to modify their investment policy. As a consequence, the industry has virtually stopped expanding. It is currently regarded as a mature industry, forced to curtail customers in the face of shortages and significant unused oioeline capacity. Caught between sharply higher Capital and operating costs and the reluctance of regulatory authorities to increase service rates and gas costs precipitously, the industry is faced with a skeptical investment community. Lenders and equity investors alike are questioning the industry1 s


ability to meet its high level of debt commitments plus provide a reasonable return on equity. This is especially true in connection with the highly capital intensive synthetic fuel proJects that currently are being proposed.

Coupled with these changes has been the deterioration in the capital markets which has resulted not only in tighter money and higher interest rates in general, but also in the overall shortening of maturities and increased sinking fund requirements for gas company debt securities in particular. Also, as a :onsequence of adverse conditions in the capital markets, recent corporate ban-ruptcies and local government financial crises, the question of credit has become all i-ortant. The ability to finance and raise capital at all is now a matter of credit standing, and there are companies, entire industries as well as selected governmental entities, which at certain times are not able to secure financing at any cost. Under these conditions the higher leveraged and lower credit companies and industries, such as the regulated natural gas industry, are forced to compete on disadvantageous terms with other borrowers, and at times they are foreclosed from substantial portions of the capital market.

Finally, on top of these deteriorating financing characteristics, the regulated natural gas industry has been force by


circumstances to assume an entirely new role, that is, seeking and developing its own supplies of gas. Exploration and'developrnent has traditionally been an adjunct of and financed by other companies outside the regulated natural gas industry. At this point in time, however, the regulated natural gas industry, with enormous commitments in facilities and increasing reauIrements to maintain existing gas deliveries, is faced with obtaining adequate supplies by its own efforts and financial commitments. In this regard, the industry has made ad-vance payments to producers in excess of $2 billion. In effect, advance payments are interest free loans which are used to explore for and develop new gas reserves. The gas companies are able to collect the carrying cost of these payments through their rates, but they also use a large portion of their capital raising capacity in securing funds for such payments. As of December 31, 1975 the Federal Power Commission terminated the ad'zance payment program so that any future gas company financial arrangements with producers will not be provided any assured basis for collecting the carrying costs of such arrangements through gas prices. This fact will force the gas companies to undertake higher risk financial commitments in an attempt to obtain additional gas supplies. Given the financial structure of the gas companies, the increase in financial risks may be so large as to preclude the undertaking of alternative


financial arrangements to the now defunct advance payment program; this is particularly true given the prospect that nationwide allocations of gas supply could be mandated.

In addition, regulated gas companies have sought to augment their gas supplies through such other means as direct ex-ploration activity and liquefied natural gas projects, and currently they are contemplating synthetic gas production from coal. Because of the high leverage and regulated nature of the industry, however., natural gas companies have never developed a capital structure capable of taking large scale exploratory or experimental risks for new sources of gas. A regulated return structure has not been conducive to building an excess equity base or large cash reserves which could absorb the risk of complete loss associated with the new sources of gas supply. Moreover, this risk is not offset by a potential for greater rewards in the event of economic success or excellent management because the rate of return on equity is limited by regulatory inflexibility.

Although all of these elements have contributed to the

generally reduced capital capacity of the regulated natural gas industry, it is the overall increase in the cost of doins; business that imposes the most significant aues4 ':ions. in this regard., no element has contributed more to the uncertainty of financing capability than inflation. This is especially true in connection with the highly capital intensive commercial sized coal gasi.:ication projects that certain companies are sponsoring at this time. In short, the ability of any industry, and in particular the

72-880 0 76 6


regulated natural gas industry, to finance huge synthetic fuel projects in vastly inflated dollars, based on a plant and financial structure of highly depreciated dollars, is exceedingly problematic. For the regulated natural gas industry, which has been traditionally highly leveraged and regulated as to equity return, the task is especially onerous. Other lower leveraged and non-regulated industries may be able to handle inflation by both increasing their leverage as well as achieving higher rates of return on risk capital. The regulated natural gas industry has no flexibility with respect to increasing its debt leverage and is effectively precluded by regulatory restrictions from obtaining higher returns on risk capital. To this extent the industry is penalized in the capital market arena.


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Appendix D
Dillon d Statement Before the Subcommittee on Energy and Power of the Interstate and Foreign Commerce Committee. May 26, 1976.

Comments on H.R. 12112

Section 18 (a) The definition of a "demonstration" facility with

respect to a high Btu coal gasification project should envisage a commercial sized facility or process brought

to the point where costs, reliability.and qual ity of

product are known and where conventional financing becomes possible on a comparable facility. In the case of high Btu coal gasification, a "pilot plant"

will riot meet these criteria.

18 (b) (1) The authorized loan guarantees should clearly apply to

all construction and start-up costs, including all taxes

and capital and financing costs.

It is assumed thqt the $4 billion of authorized loan

guarantees relates to the principal amount of such guarantees. It is also assumed that the guarantees on the debt outstanding on September 30, 1986, will

extend to the maturity of such debt.

18 (b) (3) Concurrence of the Secretary of the Treasury with

regard to certain terms of the guarantees should be

most helpful in minimizing any possible impact on the

capital markets.


IS (b) (6) The issuance of loan guarantees on the basis of

competitive bidding to the extent possible must be carefully approached because of the lack of

comparable criterion upon which to Judge the merits

L." o alternative projects.

18 (c) (7) In the case of a facility planned to be located on

Indian lands, the written consent to such location

by the appropriate Indian tribe could lead to inordinate

delays unless some statutory overriding provision is

authorized. (See comment re: 18 (e) (1))

18 (e) (1) The ability of the Administrator to proceed with a

project by reason of overriding national interest,,

even though the Governor of a State objects, should

be extended to other political entities if the present

language does not convey this authority. Financing cannot

proceed until all such matters have been satisfactorily


Perhaps the right of eminent domain should be included.

18 (e) (2) The Administrator should have exclusive authority with

respect to a determination of project costs and who

should pay such costs. The Administrator's determination should be binding upon the States., political subdivisions

and Indian tribes; otherwise, a disparity could result


from those costs recognized by the Administrator and

those costs recognized by other entities. This disparity

could jeopardize the willingness and/or ability of the sponsor(s)to undertake the project to the extent it must

finance this disparity on its own credit.

18 (g) (2), It should be made clear that in the event the loan

(3) and (4) guarantees are invoked, the Administrator's recourse

extends only to the project and is subrogated to

the ri ,hts of the lenders to which the loan guarantees


18 It is assumed that the fees will apply to the average

principal amount of outstanding obligations covered by

the guarantees.

18 (k) (1) (c) The costs incurred in connection with essential

community planning and development will necessarily

constitute a part of the total cost of a project.

In our opinion, guarantees will be necessary to finance

these costs because the capital required thereto will

be exposed to the same risks as the other capital

invested in a project. Tax -abatements are not an

acceptable basis for financing these payments because

the abatements are not realized without sufficient earnings to utilize them; therefore, they do not


provide a sound basis upon which to depend for recovery

of investment.

18 (k) (5) (b) If the Administrator requires that community development

and planning costs be included in the cost of a facility such costs should be approved by regulatory authorities

for rate purposes in the case of facilities sponsored

by regulated public utilities.

18 (w) it is assumed that the language of this subsection does

not affect the provisions of 18 (b) and 18 (n) in any way that would compromise honoring the payment of the

guarantees or operation of the separate "Fund".

General Comment

It is recognized that a certain number of approvals and consultaiic would be necessary in order to execute properly the purposes of H.R. 12112. The following are referred to:

Secretary of Treasury a) consultant as to rules and

regulations for guarantees

b) concurrence required as to terms of guarantees with capital marke impact in mind

Attorney General a) comments on competitive aspects

Federal Trade Commission and may make recommendation agal

____ ____ ____85

Governor of State a) must evaluate project

b) may recommend against

Local Political Subdivisions -a) may review and comment b) receive grants for impact studies, etc.

Indian Tribes -a) may review and comment b) receive grants for impact studies, etc.

c) must give written permission

Secretary of Interior -a) approve u-e of Indian lands Committee on Science and a) approval of' guarantees
Technology, House of' Representatives b) receive reports prior to

Committee on Interior and commitment of guarantee
Insular AffaT-,s SeateHouse of Representatives -a) together, may reject guarantee Senate -9

Environmental Protection AgencyFederal Energy AdministrationDepartment of Housing and Urban a) consultant as to comprehensive
plans to implement program Department of the InteriorDepartment of AgricultureDepartment of Treasury Advisory Panel -



The number of persons or entities involved will, in all probability, require substantial amounts of time which., as a result of inflation, will add to the cost of the demonstrations and could adversely affect their economic viability.


Energy and Power of the U3.S. House Interstate and Foreign Commerce Committee

May 26, 1976

1. A. The Natural Gas Shortage in the Midwest

B. Federal Loan Guarantees: A necessary step or
unnecessary federal intervention

II. Other Federal and State Regulatory Matters: The
American Natural Resources Approach

III. Financing

Environmental (FPC)
Cost of Service (All Events) Rate
Wholesale rolled-in vs. Incremental Pricing
Ratchet rate of return adjustment for Equity
Allowance for funds used during construction (AFUDC)
Retail rolled-in pricing
Distribution company affiliates
Investment Tax Credit as a Source of Affiliated Equity Finance
Limited Liability for Distribution Compan~y Partnership

IV. Pricing Non-Historic Gas

Inverted Rates
White Markets
Jobs and Economic Prosperity
Tanstaaf 1
Project Risk
Investment Rules

V. Related Issues

Regulatory changes
Low BTU gas Arctic gas
De-regu lation



May 26, 1976


Before the Subcommittee on Energy
and Power of the U.S. House
Interstate and Foreign Commerce Committee May 26, 1976


My name is Arthur R. Seder., Jr. I reside in Detroit, Michigan, and am President of American Natural Resources Company.

I have filed a written statement with the Subcommittee,

which I ask be included in the record. my oral statement will be confined to a very brief review of our coal gasification project and the reasons why we think the proposed Federal loan guarantee program is in the public interest, after which I will try to address some of the questions that have been raised concerning the necessity and desirability of the legislation.

American Natural Resources Company is an integrated natural gas pipeline and distribution system. Our distribution affiliate, Michigan Consolidated Gas Company, supplies gas at retail to over 1,000,000 consumers in Michigan, including metropolitan Detroit and other cities and towns. Our interstate pipeline affiliate, Michigan Wisconsin Pipe Line Company,, transports gas from the Louisiana Gulf Coast, from the Panhandle-Hugoton area of Texas and Oklahoma, and from Canada for sale at wholesale to Michigan Consolidated and 53 other gas distribution companies located in Michigan, Wisconsin and five other midwestern states. Altogether we are the supplier of gas to an area having a population of over 8r0001000.


We propose to build in western North Dakota a coal gas plant using lignite as feedstock and producing about 91 billion cubic feet of high-Btu gas each year. This is enough gas to heat about 450,000 homes in our service area and would constitute about 10 percent of our present system supply. We propose to build the plant in two phases, the first to be completed in 1981 and the second several years thereafter.

If H.R. 12112 is enacted and if we are awarded a loan guarantee, we would be able, we think, to begin construction

sometime next year.

We are confident of our technology.

We have secured the necessary state permits to draw water from the Garrison Reservoir on the Missouri River.

We have made our filing with the Federal Power Commission and have completed hearings on all but the environmental aspects

of our case by the end of next week.

We have filed an extensive Environmental Impact Report, and a draft EIS is now being prepared by the Department of the Interior.

The fact of the matter is, however, that while we think,

we can finance our project with the loan guarantees contemplated by H.R. 12112,, we know that we cannot finance without them.

The central problem in financing without Government support is simply one of size. My company's net plant investment is about $1.8 billion, which makes us one of the larger gas utility systems in the country but a relatively small company as compared with the major oil and manufacturing companies.. The difficulty is that a


single 250 million cubic foot per day coal gasification plant is estimated to cost about $1.5 billion by the time it is completed in the early 19801s, or roughly the equivalent of the entire investment my company has accumulated in the 75 years since it was formed.

Even if American Natural guaranteed the debt to be issued by our coal gasification project, therefore, our System's assets and income simply do not provide the credit base sufficient to convince lenders that American Natural could pay off the loan if the project went under. And we could not prudently agree to such a guarantee in any event because to do so would seriously affect our ability to raise capital for cther gas supply projects and to maintain the safety and reliability of our natural gas system.

The question is frequently asked why, if the project is

economically and technologically viable, investors are not willing to put up the necessary capital without Government guarantees. The answer is that our System and other sponsors of coal gasification projects are willing to risk the equity capital required by the project, a hunting to 25 percent of its total cost. The problem is that the other 75 percent must be provided by lenders who are unwilling to take the sa kinds of risks anddemand assurances of a return of their capital. With an investment this size and a new technology involved, these institutional lenders,, who are fiduciaries, simply cannot take the risks that are involved.

The nation's supplies of natural gas are dwindling rapidly, and our System urgently needs the deliveries from the first coal gasification-plant to meet essential customer requirements in the


early 19801s. Beyond that,, we must establish as quickly as possible the technological and financial viability of these coal conversion processes so that many more plants can be constructed in the remaining years of this century.

It is for these reasons, essentially, that our company hopes that Congress will, as swiftly as possible, enact a loan guarantee program that will enable firms of moderate size to continue participating in the development of high-Btu coal' gasification projects.

I would like to turn now to some of the questions that have been raised about the loan guarantee program insofar as high-atu coal gasification projects are concerned.

First, the question is raised whether the deregulation of natural gas, or a substantial increase in wellhead prices# would not obviate the need for gas produced from coal. The answer to that is clearly "No."

While there are undoubtedly significant quantities of potential reserves of natural gas yet to be discovered, and while deregulation would clearly increase the incentives to drill for natural gas, we see no possibility that the rate of new reserve additions would rise sufficiently to offset the decline in existing gas reserves. Accordingly we foresee a continually widening gap between natural gas supply and demand even assuming considerably higher natural gas prices and the reduction of market demand to high priority-usds.

In this connection let me briefly make three points:

(1) From peak discoveries of new reserves totaling about 21 trillion cubic feet per year in the years 1964-67, new reserve


Additions in the lower 48 states have fallen to an average of only about 9 trillion cubic feet in each of the last five years. Production of gas is at a level of about 20 trillion cubicfeet annually, leaving a supply gap of about 11 or 12 trillion cubic feet per year. While deregulation would certainly help to narrow this gap, the need for supplemental supplies is clear and unmistakable.

(2) Whatever the estimated potential ot undiscovered reserves, it will take a long time to discover and produce them. The largest pools and those easiest to find and produce have long since been discovered. What is left are the smaller reserves, the deeper reserves, the reserves located under the ocean beds and those located in remote and inhospitable Arctic regions. So, while the potential reserves of natural gas may be there, it will be increasingly difficult, costly and time-consuming to find, produce and

transport them to market.

(3) While the initial price of gas produced from coal will be higher than domestic natural gas, coal gas has several distinct advantages over the long term. First, its cost will remain virtually constant over the 25-year life of the gasification plant and may even decline, whereas the cost of natural gas and every other alternate fuel will continue to increase at at least the rate of general inflation. Thus the cost of coal gas will undoubtedly be a bargain before the plant is half depreciated. Second, a new natural gas reserve delivers full volumes for only 5 to 10 years, after which deliveries from that reserve decline and are exhausted in 15 to 20 years. A coal gasification plant will operate at full capacity

-2 '76 7


for the entire life of the plant of 25 or 30 years or longer, and we have ample coal reserves for that period.

I should add that our System does not contemplate that we will be serving any low priority boiler fuel loads with gas produced from coal and that this supplemental supply will be required to meet residential and small commercial market requirements.

Assuming that the cost of synthetic gas made from coal is rolled-in, or averaged, with the larger deliveries of natural gas on our System, the overall cost of gas to the consumer will not be increased inordinately and will remain below the cost of fuel oil and far under the cost of electricity for an equivalent number of Btu's.

The question is sometimes asked whether the need for loan

guarantees does not necessarily imply that the projects are uneconomic and whether the loan guarantee program is not in essence a subsidization of the private utility business. The answer to

both questions is "No."

The coal gasification project we have proposed is economically feasible and will provide a return on capital to both debt and equity investors. As I have stated, the market for the product will clearly be there, and the rolled-in price of synthetic and natural gas can be sold competitively with other fuels. The equity investor--our company--is willing to risk its investment. The difficulty is that the lender--the institutional investors who must supply the debt capital--cannot afford to risk the large sums of money involved on a brand new enterprise never before tried in this county. That does not mean that the lender does not believe that the project is technologically and economically viable. It


simply means that until enough plants have actually been built to demonstrate their viability, the lenders, as fiduciaries, cannot Afford to provide the very large sums required.

The loan guarantee program in no sense provides a subsidy

to the sponsoring utility system. In the first place, the guarantee only protects the lender, not the equity investor, whose investment is completely at risk if the plant is not successful. Second, no front end money is involved; the loan guarantee comes into play only in the unlikely event the plant is not completed or is otherwise unable to produce enough gas even to pay the debt service. Third, any reduction in debt costs resulting from the Government loan guarantee would simply lower the cost of gas to the consumer,, i not increase the owner's profit. The utility's earnings from the plant will be set by the Federal Power Commission at a fixed percentage return on the equity actually invested in the plant.

Another question sometimes asked is whether it would not be advisable to construct low-Btu coal gasification plants at lower cost.

It should be understood that low-Btu gas cannot be mixed with natural gas and therefore could not be transported or distributed in existing gas pipeline and distribution systems or consumed in homes and commercial establishments. Its only use is as an industrial fuel. For that reason, a low-Btu gasification plant would not meet the need for large supplemental supplies of gas to meet residential and commercial needs.

While low-Btu gas may be used to meet industrial energy

needs, that is possible only where a large industrial complex can


be supplied by a separate distribution system. Even then, problems of utilization, standby systems, etc. must be overcome.

It should be recognized, moreover, that unlike a high-Btu coal gasification plant built at or adjacent to a mine, a low-Btu plant must be built very close to the user industrial complex both because of the high cost of transporting the gas long distances and the high carbon monoxide content of low-Btu gas. This means that the coal must be transported from the mine to the plant by rail or water at a much higher cost per Btu than the transportation of high-Btu gas through a pipeline. Thus, a lower cost of producing low-Btu gas could be offset by a higher cost of transporting coal to the plant.

We believe that there may be a role for low-Btu coal gasification plants in certain specific market areas, but it in no way lessens the more immediate need for coal gasification plants that can provide gas which can be mixed with natural gas for distribution to homes, stores and apartments through existing distribution. facilities.

Finally, the question has been raised as to whether, if the need for loan guarantees AXiseg becekuse theinvestment required is so large in relation to the size of gas utility systems some other segment of industry might be better equipped to undertake these projects.

I think it is significant that all of the high-Btu coal

gasification projects now proposed are sponsored by gas pipeline and distribution systems. We are trying to implement these projects., not because of the financial rewards,, but because of our responsibility to provide gas to the market areas we serve. In short,