There is a lot of buzz around renewable natural gas (RNG) as a means for dairy farmers to diversify revenue while improving their carbon footprints. For many operators, it can be a particularly attractive option, especially given the current market and economic conditions.
However, embarking on an RNG project is a complex endeavor, and it isn’t right for every operation. Let’s take a look at the pros and cons, financing options and how to get ready to take advantage of RNG.
Pros and cons
As with any expansion, you will need to consider how RNG could impact your cost of production and your balance sheet. You will want to make sure you have a profitable plan in place and that it has adequate cash flow to cover debt service. You will also want to pay close attention to working capital and to your long-term shock absorber – also known as equity.
One key driver of the recent RNG activity is the ability to earn environmental credits. Credits can be generated by converting livestock manure into RNG via an anaerobic digester. Operators can then monetize those credits by selling them to a buyer, typically through one of the following:
- Renewable identification numbers (RINs). These are used as currency under the Environmental Protection Agency’s Renewable Fuel Standards Program.
- California’s Low Carbon Fuel Standard (LCFS). This program is designed to decrease the carbon intensity of the state’s pool of transportation fuel. Fuels with carbon intensity scores lower than diesel generate LCFS credits.
Also, any expansion project – especially one of this scope – dries up your equity as a result of the increased leverage, so you will need to be careful not to end up with a balance sheet that cannot support both short-term and long-term periods of low margins.
Financing options and their implications
Of course, you can use traditional bank financing to fund an RNG expansion. The concern here is that your leverage may get too high, which means you will want to stress test both your budget and your balance sheet.
You can also earn advances on future income from the RNG project. We have seen a willingness of RNG project developers to inject capital into the expansion project. While the advantage is that this keeps leverage on the farm lower, it also typically results in lower RNG revenues in the future. Make sure you weigh the options, particularly paying attention to the time value of money and interest costs.
Also, note that it takes time to plan and build an RNG project. Once it is in operation, it usually takes about a year to earn a carbon intensity score that will let you realize revenues from RINs or LCFS credits. This means you will be deploying capital to construct a project, and you will need liquidity to operate and finance the expansion for about two years before you realize the bulk of the revenues.
Make sure you can follow through
Scenario planning and stress testing of both cash flow and earnings budgets will be crucial to determining whether your operation can benefit from an RNG project. Ask yourself, "If I stub my toe in the middle of the project, do I have a contingency plan in place? Is my working capital strong enough to carry me? Will I need to borrow additional funds, and do I have the capacity to do so?"
Keep Murphy’s Law in mind: what can go wrong will go wrong and usually at the worst possible time. Think about what you can do to manage that scenario. The rule of thumb for doing this is the "10-10-5" rule. Run the numbers to see if your plan can survive a 10% drop in revenue, a 10% increase in costs or a 5% increase in interest rates. If the plan cannot sustain that, you may want to revisit your options and have a stronger risk management plan. After construction, a good rule of thumb to follow is to have two-and-a-half months of working capital available and more than 40% equity in the balance sheet.
Financial considerations aside, operators will have to determine the impact an RNG project can have on their day-to-day operations. Because construction firms install the digester, there are often layers of corporate bureaucracy that stretch out the timelines and deadlines for construction, design and planning. You will also have to work with the gas company to install the pumps and pipes that get manure to the digester consistently. Because the gas company may not understand the ins and outs of your business, you will need constant communication to make sure you have a say. The operation of the RNG plant will also require time, maintenance and management.
Also, because the credits you earn are tied to your carbon intensity score, hiring an engineering consultant to provide a rough estimate of your expected score is valuable for determining what you can expect to earn. Finally, if you do take the plunge into RNG, make sure you manage your environmental credits properly. Only give developers what they are entitled to, which is the credits and monetization of those credits that arise from their production. Beyond that, make sure the agreement reserves the rest of the credits for your activities on the farm.
Given market volatility and economic realities, it is easy to understand why expanding into RNG production would be an attractive source of revenue for dairy farmers. Just make sure you have done your homework to determine if it is the right choice for you.
This article is provided for information purposes only. Readers should consult their own professional advisers for specific advice tailored to their needs. Information contained in this article may be subject to change without notice.
