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The Nexus of Science, Technology, and Foreign Policy Series: Ethanol and Energy Security [Rush Transcript; Federal News Service]

Speaker: Vinod Khosla, Partner, Khosla Ventures
Moderator: Sebastian Mallaby, Editorial Writer and Columnist, the Washington Post
November 30, 2006
Council on Foreign Relations Washington, DC

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SEBASTIAN MALLABY: Well, welcome to this evening’s meeting of the Council on Foreign Relations. I’m Sebastian Mallaby of The Washington Post.

A couple of housekeeping points: One is that you’re supposed to turn off your cell phones, BlackBerrys and other potential sources of disturbance. And the other is that this meeting, unlike many at the council, is on the record. The subject, of course, is energy security, which is central not only to the national debate but to things that have been going on at the council.

At the national level we’ve had President Bush talking about the nation’s addiction to oil. I think it’s a safe bet that it’ll come up in the next Congress again—energy security.

At the council there’s been a task force headed by John Deutch and Jim Schlesinger which reported recently. Actually, that report came up with the conclusion that energy independence is basically unattainable and that one has to manage the dependence, as opposed to trying to shoot for independence.

Our guest here this evening, Vinod Khosla, is an articulate challenger to that point of view. He’s a challenger that we all have to take seriously, because he’s one of the nation’s foremost venture capitalists and has, therefore, a fairly good track record of predicting which technologies are going to really change our lives, and early bets on Amazon and Google attest to that.

And I think it’s right to say that Vinod’s view is basically that we can shift away from dependence on importing oil from the Middle East in favor of growing alternatives in the Midwest. I remember a slide he once showed of a short of bamboo-like grass shooting 11 feet up into the air. And the point is that if we plastered South Dakota with this stuff, we’d be importing a lot less from Saudi Arabia and also emitting less carbon.

So we’re here to understand your views and to exhort them, maybe to challenge them a little bit. And I want to start with, I guess, the most obvious question, which is the United States, after all, consumes one-quarter of the world’s oil. It imports, I think, three-fifths of that. Is it really feasible to have an alternative to oil? Is that an attainable objective?

VINOD KHOSLA: Absolutely. And the reason it’s achievable, and the reason other people don’t think it’s achievable—and the different view comes from what assumptions you make about technology. Having gone through many technology risks, and to imagine what the world can be like, imagine the world 20 years ago before the Internet, before long-distance phone calls, before cell phones—when cell phones weighed five pounds. That’s how much change that has happened in the last 20 years and people forget the context.

Now if you fast-forward 20 years, you should see as much change in the next 20 years—and it doesn’t matter whether we are talking about telecommunications or pharmaceuticals or energy—as we saw in the last 40 or 50 years, because technology keeps accelerating and the rate of change keeps increasing.

This assumption is almost never factored into the forecasting that economists do, in what the political scientists do. And I’ve had this debate with John Deutch. In fact, he did—John did write an op-ed, I think, in The Washington Post or The Wall Street Journal—I forget which one of the two—and a critique of his op-ed is on my website in a paper there. And we have a friendly relationship. We generally agree on most things. It’s not like we disagree a lot. We agree where the solutions lie. We disagree on the magnitude of the solutions.

For those of you who are interested, this is on my website, there are three papers. One’s called “Imagining the Future,” which is about what the world can be, as opposed to what the world is. The second paper is actually addressing all the myths around ethanol. And we can come back—it’d be great to talk about why there are so many myths. It’s courtesy of the American Petroleum Institute. And the third is about policy that we need to do.

But the short answer to your question is if you make even modest technology assumptions, and relatively low-risk assumptions about where the world could go in terms of land—yields of crops of lands and what technology can produce—it is relatively easy to imagine how the world becomes independent of oil, not just to replace gasoline and diesel, but beyond that into things like replacing all plastics and other materials that need to be renewable if you’re really going to have a sustainable world. And we can come back to the international aspect of not only does it make it sustainable, but it also makes it much more balanced and helps alleviate poverty and other causes of international friction.

MALLABY: I’m glad you brought up the issue of land use, because if you hadn’t done that I would have done it for you. I mean, some people do say that if you imagine growing enough cellulosic ethanol to power the U.S. transport fleet, you would be covering so much land that the space left to grow food would diminish and you know—that that’s the binding constraint.

Can you talk to us why A, people make that assertion; and B, why you think it’s wrong?

KHOSLA: Okay. So the basic assumption—and it depends on the agenda of the person and there’s many different agendas. The biggest agenda out there is the American Petroleum Institute, very much powering a large and broad public relations campaign to prove to people that this can’t be done, and so you shouldn’t even attempt it. That’s a very fundamental thing—there’s other side agendas.

The Earth Policy Institute, for example, takes somewhat of a view against biofuels. As I spent enough time with them, it became clear their issue is completely different, not—because of all the focus on biofuels, not enough energy research; DOE funding is going into wind energy research. And so they want to bring the debate back to wind energy. So they push the idea of wind energy to generate hydrogen, to run hydrogen cars.

One researcher—not of the Earth Policy Institute, but another place—since this is on the record, I won’t blame the Earth Policy Institute—actually specifically mentioned this issue of research funding and what our priorities are and how the shift to biofuels has reduced funding in others areas. And hence, they have to make a bigger issue out of it and raise questions.

Having said that, the last 50 years or so have seen our corn yields—yields per acre of corn—go up by a factor of seven—seven times. We used to feed one-third the number of people on 50 percent more land 75 years ago in this country. And we now do about 150—between 140 and 150 bushels per acre. And there’s almost no incentive to increase yields, because we have too much corn, or have had too much corn. Even with that, almost automatically, corn yields will go up 50 percent over the next 10 or 12 years.

Now all the forecasts I’ve seen around biomass yield assume that yields won’t change 25 years out. Now that is completely untenable because we are taking a crop that has never been optimized. It’s a crop that just grows. In fact, it’s generally a pest when we try and get rid of it. It has never been optimized. And if you make an assumption that we can do a two to three X increase in yield, instead of the seven X we got with corn, we get the numbers that says all of our gasoline needs in this country can be met with 50 million acres. Fifty million acres is a small number—I think everybody in the community would agree that’s a small number, if in fact my yield assumptions are true.

Yearly yield assumptions that I have are in the same papers I mentioned—the first of the three papers, in the appendix—and I’ve run them by theoretical plant biophysiologists and said, “What’s the maximum theoretical yields?”—practical researchers and said, “What percentage of maximum can be assumed?” Run it by a bottoms up forecast with companies working in biotechnology to say, “Are these yearly yield improvements reasonable? Can you achieve them doing the best tools in genetic engineering and some other plant breeding techniques?”

The answer always comes back yes. And I probably checked these with a half a dozen specialists in their fields using very different approaches from theoretical to practical.

MALLABY: But the bottom line here is that you think one could generate enough ethanol using what percentage of the nation’s land which is currently devoted to agriculture?

KHOSLA: So I believe we can replace all of our gasoline with 50 million acres or so.

Just for comparison, George Shultz and Jim Woolsey did a piece based on completely independent research done at the Rocky Mountain Institute, where they estimated that we could replace half of our gasoline with 30 million acres. So their number was 60 million acres. Completely independent number from relatively independent sources – the NRDC did a separate estimate, and that was 114 million acres.

MALLABY: Can you put that in context of the amount of land now devoted to—

KHOSLA: Now, to give you a sense, we have probably 350 (million) to 400 million acres under cultivation. We have 40 million acres in our CRP program—it’s called the Conservation Reserve Program, which is where we pay farmers about $48 an acre not to grow crops on that. This is land that was taken out of cultivation. So essentially, the CRP land itself, even with Jim Woolsey’s and George Shultz’s assumptions, would replace all our imports. That’s the scale.

MALLABY: Now another objection I’ve heard, and perhaps you could talk about this too, is that, you know, one has to factor in changing weather patterns. This debate is happening because climate is changing. And climate change itself may change agricultural yields and put a spanner in the works. So do you think there’s some truth to that?

KHOSLA: There could be truth to that. It’s hard to predict the direction of climate change and how it might impact agriculture.

The one thing we can say for sure is when we are talking about cellulosic crops, they use far less water, which is the principal source of change if weather patterns were to shift. Also, it’s very, very likely if the weather patterns shift that the rain patterns will shift, not change dramatically. The total amount of rain may actually go up, because evaporation from the oceans will go up. So we may need to grow food in different areas. The most important piece is almost all the energy crops use far less water than today’s row crops.

I want to bring up one other very important demographic fact for the U.S., and it’s also going to be true worldwide. Today—and this is important for those people who bring up this argument of food versus fuel—one pound of beef takes 25 pounds of corn to produce and almost 1,000 gallons of water. That’s a pound of beef.

The natural demographic shift in beef—red meat consumption in this country would free up more than 50 million acres in the next 25 years. If the trend that has happened over the last 10 or 15 years on red meat to white meat continues, just that fact, because we use 250 million—the bulk of our agriculture, 250 million acres, the bulk of our agriculture land to grow food for animals, not for humans.

MALLABY: So we can defeat heart disease and—

KHOSLA: Absolutely! (Laughter.) We can do it together. We might even help poverty along the way.

MALLABY: Let’s switch a bit, the focus, to the question of the policy interventions that might be needed to make all of this happen. And is this something that you can sit back and allow venture capitalists to put their money into this technology make it happen, or does government have to do something?

KHOSLA: There’s two fundamental things that are happening. First, for the first time, the best minds in the country are working on this problem. And that is a far more fundamental change than we realize.

I asked the dean of engineering at the University of California-Berkeley, one of the top five engineering schools in the country, what percentage of his professors were doing research related to energy three years ago. The answer was something south of 5 percent. I asked him this summer—he did an informal survey—and more than 50 percent of his professors and researchers, the best minds in the country, were now interested in working on the energy problem. If the solution to energy is through innovation, then this is the best news I’ve heard—independent of any one technology or fact, the fact that so many bright people have focused on one of the bigger problems.

The same is absolutely true of MIT. In fact, Susan Hockfield, the president of MIT, has changed the focus of MIT and made it—made energy their single largest initiative. When we have those minds working on it, we will get the innovation. And innovation is what we need to solve this problem. Energy R&D in this country has been declining for 30 years. And what little effect that has there in energy R&D is focused on how to find more oil, how to use oil differently, how to produce oil from shells and tar sands and others, coal—not on alternatives to oil or alternatives to coal, for that matter, and we can come back and talk about that.

So the best minds working on it is the principal change. Now I can go through 20 different technical breakthroughs that will help solve the problem, but I don’t think that’s a productive use. Almost certainly this change will happen and it’s feasible. Now where’s—where’s the bad news? People ask me, “What can throw this off track and what’s the policy things we need?”

We had a ballot initiative in California. Chevron spent almost as much trying to defeat us as the last—in one state on one issue—as the last presidential election cost John Kerry across 50 states. You know, it’s sort of off that scale. It was three times more expensive than the single most expensive Senate race in the country this election season. And that’s how much money they have.

Another way to look at it: A $4 change in the price of oil—and that happens every two or three weeks—is worth a trillion dollars in asset value to Saudi Arabia. A country a fraction of the size of California has its assets changed by $1 trillion every time oil changes by $4. Now, how much money will be put into throwing us off track? That’s the real danger. That’s what policy must guard against, because I have no question—if you have a true free market in this and a level playing field—the alternatives are much more viable than oil in almost every way.

MALLABY: But do you really think that you just need a free market and a level playing field? Or do you also need some interventions to kick-start the process to make ethanol catch on?

KHOSLA: Okay. So I would say if you truly had a free market, absolutely. But we don’t. We pretend we have a free market. OPEC, to begin with, is a cartel, so oil isn’t a free market.

We talk about the subsidies to ethanol—50 cents a gallon. There was a CNN article in last week that estimated the subsidy to oil was $4 a gallon. All kinds of hidden things in legislation. There’s a clause in some piece of legislation—I don’t even know which one—called, esoterically, “excess of percentage over cost is an accounting trick.” That one clause is worth $82 billion in subsidies to the oil companies and nobody knows it. Okay? That’s one clause.

How did I know this? Senator Harkin told me this. He asked the GAO about every direct subsidy to oil—and these are direct subsidies; these are not indirect subsidies—that they knew about. This was part of GAO report, and hence, it should be public data. I have a copy for anybody who’s interested. There are six such clauses mentioned in that report. Now the ones that are not quantifiable, I suspect there’s 20 of those that I don’t know about.

So this is not a level playing field between cartels and what Venezuela’s trying to do, and clauses like that that are hidden in legislation. Have you ever heard anybody talk about the $82 billion subsidy on this one clause? How many times have you heard about the ethanol subsidy, which is 3 billion (dollars) a year?

MALLABY: So it’s not a level playing field, and therefore, what should the government do?

KHOSLA: What should the government do? Three simple things. I’m a free market Republican, so you’ll see most of that from me. I believe we can reduce the level of subsidies for biofuels today and increase the level of investment, because with the right policy, Wall Street will make the investments that today the government is having to make—somewhat ineffectively.

So what are those? If we indicate stable, long-term policy, Wall Street can make predictable investments. The risk assessment on Wall Street goes down dramatically if you just tell Wall Street, “This is something we’re serious about for the long term, with one caveat.” That one caveat is, if you want consumers to buy your fuel, produce it cheaper without subsidies.” Okay, what does that mean?

What that means is the following: Today we don’t have enough flex-fuel cars that can take these alternative fuels. Say we have a funded mandate—and here I depart from the free market a little bit, but I’ll come back to why—to produce these cars and make sure that 50 or 70 percent of these cars by 2012 or 2014—something the auto CEOs have already committed to doing, voluntarily—are on the market. If that happens over 15 years, our fleet will be capable of taking either fuel.

Now why should we pay the $35 a car it takes to do this? Because as a nation we get an energy option. The next best thing to energy independence is energy options. Diversity of sources is a significant reduction in our risk around energy.

For $35 a car we can save ourselves a lot of defense costs. We spend $50 billion a year just on the defense of the sea lanes through which oil passes. That’s one of the indirect subsidies that was part of this $4 a gallon estimate. We could dramatically reduce that cost if we had the option of taking multiple fuels.

All we are saying is, if you can produce a cheaper fuel, consumers will buy it. And we’ll make sure that we make the investment towards developing those fuel sources by mandating that the cars are there.

MALLABY: So sort of in the spirit of competition policy, you would say, “Make the fleet able to take either”—

KHOSLA: Right.

MALLABY:—“and then let them compete.”

KHOSLA: Yeah.

It’s an anti-monopolistic policy and reduces, I think effectively, our total spending on defense and energy security. That’s the reason to have a mandate here. And it’s a mandate that the automakers are already doing, but it lends confidence to Wall Street. So that’s absolutely critical.

The other related mandate is to say that 10 percent of our gas stations, which is a relatively modest amount—and I’ll come back to how we fund this, while reducing the amount of spending on subsidies in just a minute—10 percent of our gas stations should offer E85 or an alternative fuel.

Sweden, by the way, has effectively—is effectively mandating about 60 percent of their gas stations do this by saying gas stations that provide more than a certain volume of fuel a year have to offer E85 as an option. I’m only suggesting 10 percent, because I believe at that level, consumers will have the confidence to start buying flex-fuel cars and buying E85 fuel, because it will be close enough, and the rest the market will take care of. So I’m picking the minimum level that I believe achieves critical mass.

Now how do we fund this with the third variable? The other thing Wall Street is afraid of is the power of the oil companies and the national oil companies like Saudi Aramco. And the national oil companies exercise a tremendous amount of power in the international markets, because they own 80 percent of the oil resources.

In fact, contrary to popular belief, the private oil companies like BP and Shell only own 20 percent of the oil. It is in their interest, because the magnitude of the hit on this if oil prices change—$1 trillion for every $4 for Saudi Arabia alone—it’s in their interest to manipulate oil prices, to drive producers of alternatives out of business. This is good business strategy. Not only that, it happened in 1983, ‘84, ‘85. 1973 was the oil shock. And economists will tell you, the econometric coupling between economic growth and the price of oil went down, which means the two became unrelated.

Saudi Arabia—and this is documented in the Cambridge Energy Research Associates’ reports—decided to couple the economy and economic growth to the price of oil by reducing the price of oil to $8. Well, that coupling is what we call an addiction to oil. They achieved that by manipulating the price of oil, and we delivered. That’s what Wall Street is worried about again.

So I’m suggesting that the current subsidy that we have—about 51 cents a gallon on ethanol—be made countercyclical with the price of oil—that it be 50 cents at $50 oil; it be 25 cents if oil went up to $75, because these alternatives are in fact much more competitive if oil is expensive; and it go up to 75 cents if oil dropped to $25 a barrel, which Saudi Arabia can do.

This is nothing more than signaling to potential price manipulators that this manipulation is futile. It has the side effect of dramatically reducing the effective subsidy. In fact, it reduces the effective subsidy by about half based on current Energy Information Administration forecasts of oil prices.

So you can pay for these mandates that I talked about before and still have a 50 percent reduction in costs and have a much safer countercyclical insured environment for biofuels producers while they’re trying to get up and get on their feet.

MALLABY: Okay. So government needs to do three things: It’s got to be one-sixth Swedish on the—

KHOSLA: One-sixth—

MALLABY:—the mandates for gas stations to have alternative fuels. It needs to mandate that the flex-fuel cars be produced by Detroit. And it needs to have this variable subsidy to prevent price manipulation.

KHOSLA: Yes.

MALLABY: Okay.

Well, let’s open the floor now to council members. I want to remind you, please, to wait for the microphone, speak directly into it, stand, state your name and affiliation. Please keep the questions concise.

I see a question in back there in the center.

QUESTIONER: Hi, I’m Libbie Prescott with the State Department.

Oftentimes in the U.S., the discussion about ethanol assumes that we’re using corn as an input. And I don’t know a tremendous amount about the technology that we’re talking about here, and it hasn’t—it’s not really the proper forum for that, but there’s obvious political reasons for that assumption, and that is the domestic weight of the agricultural industries in the U.S. And I guess I’m wondering if, with the knowledge that you have of the technology, whether you think that that assumption of this input of corn—which obviously gives a lower output of ethanol than a lot of other possible inputs such as sugarcane and various other products that don’t have quite as large of an agricultural lobby in the U.S.—whether that might actually ultimately impact the success of the technology. So rather than looking at is as ethanol as the end point, how do we maximize getting ethanol—we’ll be evaluating it based on a politically driven circumstance? And I would like to hear your opinion on that.

KHOSLA: Very good question. And I understand—I was looking at the roster—there’s a few people from Chevron and Exxon here. (Laughter.)

It’s important to note that there’s two entirely different markets for ethanol. One is the market to take ethanol and blend it to gasoline as an additive. The oil companies have essentially accepted that that’s okay. The other market is to use ethanol as a primary fuel as a replacement for gasoline. These are two completely different markets. Most of the ethanol in this country goes into this additive or blending market, not in the E85 primary fuel alternative to gasoline market.

In Brazil, most of the ethanol is used in this primary competitive to gasoline market—the E85 market. They call it—it’s E100 in Brazil. The oil companies are very, very interested in making sure that if the E85 market develops, it develops extremely slowly. Contrary to all the great PR, press campaigns, advertising campaigns you see, the American Petroleum Institute is highly focused on this one thing.

So what are the implications? Unwittingly, they’re using the corn ethanol lobby to reduce the level of imports, and reduce our migration—or slow down our migration to E85 as a primary fuel. I have proposed a compromise that increases the renewable fuel standard—what’s called the RFS—to 15 billion gallons by 2015 for the blending market alone. So the corn lobby is happy. And in fact, I believe the corn lobby has really done us a great service in this country, so I’m very supportive of that, and I think corn ethanol has created an environment that makes it possible to invest in other types of ethanol.

In return, I’ve asked that we reduce the tariff or remove the tariff. And there’s reasonably good support for that idea from many people in the farm community. Now I know it sounds crazy to say that there’s actually corn farmers who agree with removing tariffs, but I can tell you there’s far more support because they realize they’re now running into the end of this blending market which is limited to about 15 billion gallons, and they’re starting to se that we need to develop this new market—the E85 market.

I suspect some sort of compromise there is possible as part of a grand policy compromise in Washington. There seems to be, even from traditional opponents, enough openness—I shouldn’t say acceptance yet, but openness—to the idea that helps their community yet allows consumers to get cheap E85, so this market takes off. That is absolutely essential not only for the U.S., but it’s essential that these—the producers in countries like Brazil develop and service other markets like Europe.

Almost certainly, in my view, that macro geopolitical balance will look like this: 15, 20 years from now, if we are on biofuels, Latin America and Africa will both supply Europe; we have sufficient land in this country to be completely independent, possibly including Canada; that India will probably be supplied out of Africa; China will probably be supplied out of either Africa or Australia; Mongolia has 300 million acres of land and almost no people. (Laughter.) So you might imagine—I wish I had a chart on this—a geopolitical map of the biomass-based flows.

There’s one other really important piece of this equation that I personally enjoy very much and look forward to, which is the biomass belt on this planet almost exactly coincides with the poverty belt. If in fact this vision happens then we will do more to alleviate poverty and all the international tensions that come from poverty than any other single thing I can think of or all the foreign aid we could possibly give, even if we got extremely more—a lot generous than we are today. So that’s a side benefit that I find very exciting.

MALLABY: The council will produce a very good report on Saudi Mongolia. (Laughter.)

We have a question—I think Dave McCurdy over there.

QUESTIONER: If you can hear me—

MALLABY: It’s just coming.

QUESTIONER: Okay. All right. Thank you. I’m Dave McCurdy.

You said you’re a free market Republican; I’m a free market Democrat. And I had a question—actually two parts. If you are advocating E85 market, in effect are you urging government to actually pick a technology at the expense of other potential technologies, other alternative fuels or other—hydrogen or other types of, you know, potentially beneficial technology?

And then secondly, you accused the oil industry of having certain motives. What do you actually see—the motives of the auto industry in this country, vis-a-vis genuinely supporting the development of alternative fuels, alternative technologies?

KHOSLA: So let me answer the second question first. The auto industry is embracing flex-fuels, it being very self-interested, as they should be. They’ve lost the hybrid race to Toyota. Toyota is behind our Ford and GM in Brazil on flex-fuel cars, and in the U.S., and so it’s in their interest to promote flex-fuel cars. It serves our purpose reasonably well.

As to this notion of picking technologies, it’s a very tough question, because if we said, “Let’s pick one alternative, and we don’t care which one, and encourage that,” we’d achieve the same thing. So there was a piece of legislation not often discussed in California called AB 1012 which was on Governor Schwarzenegger’s desk. On September 30 th he had to either sign it or not sign it, and after a lot of consultation, he decided not to sign it. It required 50 percent of the cars be an alternative fuel car, but “alternative fuel” was defined as any biofuel—it could be compressed natural gas; it could be hydrogen; it could be plug-in electrics. And I was very, very supportive of it because it didn’t pick a technology, and I thought it would achieve exactly the same thing. So though we’ve talked about biofuels, if we had enough time we could get into the details.

Now that would achieve the same purpose. The same mandate would achieve the goal of the government not picking a technology. Now talk to people in the know, and say, “At the macro level, we need to serve this planet’s energy needs. What are the possible sources”—and I had this discussion with Ernie Moniz who heads the alternative technologies effort at MIT and was undersecretary of Energy—we had this conversation yesterday.

I said, “What are all the possible sources—large-scale sources of energy that at a macro level make sense?”

And he said, “The only other choice—other than oil—is biomass and some day possibly electricity if we get enough renewable electricity. Those are the only two choices because that’s what physics and theory dictates.”

That was his answer. I’m not giving you my answer. I happen to agree with his answer, and that’s why I’m reciting it here.

The electric choice depends on battery technology, and we don’t see the breakthroughs today.

One of the reasons I like the biofuels choice is—we have no board to draw a little graph; I would have loved to draw one—is because electric and biofuels are completely compatible. If we have a hybrid flex-fuel car—and Saturn and GM and Ford have talked about that—then what we’ve done is essentially said what fuels go into a car if battery technology moves faster than biofuels technology, then more of the power of that car will come from the electric side because the battery capacities will increase. If biofuels move faster, then they’ll get a larger share of the total power of an automobile.

That’s a great place to be because we’ve said we can use gasoline or we can use biofuels if they’re cheaper or we can use electricity if it’s cheaper, including the cost of batteries. And that’s as close to choice as I can come without saying, “Let’s allow every choice and not do anything.” That’s the hard choice.

You know, from a national security point of view, we have to make some choices and make sure that we have at least one more option beyond oil in the next 25 years.

MALLABY: Let’s get another question. I see one over here on this side.

QUESTIONER: Thanks. I’m Shannon Herzfeld from Archer Daniels Midland. Nice to see you again.

KHOSLA: Mm-hmm. (Laughter.)

QUESTIONER: Always a pleasure to see you.

I applaud many, many, many of your statements. I just wanted to perhaps probe a little bit your final policy recommendation, which is the countercyclical characteristic of the support payments that you are talking about. Ag processing, as most people know, is a rather cyclical business reflecting what the product price is and what your feed stocks are costing, and the two of them make a rather cyclical profitability profile. And if you have a countercyclical support system, what I understand you’re doing is lopping off the highs, lopping off the lows, and then you have government, by setting the pivot point support level, dictating what the overall rate of return in the sector is. And as I think about this a bit more, it begins to look, at least to me, a bit like a public utility model, which seems to be at odds with trying to attract the type of technology that you’re so familiar with. So I wondered if you’d comment on that a bit.

KHOSLA: Sure. I’ll be happy to comment.

It is not the public utility model. You know, I’m sort of what I call a “pragmentalist.” We have a system today with a 51-cent-a-gallon subsidy. And the only question I ask is not whether that’s right or wrong, because to me that’s political reality. So the question is, is there an alternative I can present that will be acceptable to enough people to pass politically, yet make the subsidies smaller and the insurance greater. And my proposal does both. It encourages Wall Street to invest more because they’re guaranteed—not guaranteed, but they’re more protected against price manipulation.

You know, if oil is at $75 a barrel, nobody in the ethanol business needs the subsidy to make lots of profit, and we are wasting government dollars by giving a subsidy. However, if you have price manipulation, oil goes to $25 a barrel, which is—it is not expected to—unmanipulated it is not expected to, even in the wildest forecasts I’ve seen. But it could happen because of price manipulation, because we’ve seen an example of that 20 years ago. Then we have insurance against that and countercyclical support.

Now to Wall Street it doesn’t matter whether oil can go to $25 or not. There is a pervasive belief that oil prices can be manipulated. So it’s more about signaling to them that we will prevent manipulation than about really providing them more support. The very fact of signaling that we will provide for wide countercyclical insurance will ensure that oil prices are not manipulated down.

So I am—I’m sure I can devise a better system that may not be politically realistic. So I’m saying we have a system today and a set of subsidies—how can I change it for the better in a politically acceptable way, and the last is a qualifier that is extremely important to me, because otherwise I can design lots of theoretical schemes.

MALLABY: The way you describe it, it’s partly insurance and partly deterrent. Deterrent to the—

KHOSLA: Yeah.

MALLABY: David Sandalow here had a question.

I’m going to get it back after you.

QUESTIONER: Hi. David Sandalow from Brookings.

Ethanol from cellulose is still pretty expensive, Vinod. How quickly do you see cellulose ethanol becoming competitive with other liquid fuels on a cost basis? And will this vary from feedstock to feedstock or be uniform across all cellulosic forms?

KHOSLA: A very good question. The American Petroleum Institute again would have you believe that cellulosic ethanol is very far away. I love the American Petroleum Institute, as you can tell. (Laughter.) They have a massive PR campaign and I just came across a—did a ballot initiative against them and they spent over $100 million against us. So I—forgive my love for them. (Laughter.)

The answer is, cellulosic ethanol is much closer than we think, but there’s a different kind of chicken-and-egg problem. If the principal market in this country is the blend market at 15 billion gallons, which is mostly—will be taken up by corn ethanol, then an investor has no interest in taking the risk of investing in cellulosic technologies if the oil company is going to keep us in the blend market.

If investors believe that this is a 150 billion (dollar) gallon or $200 billion market or $300 billion market—depending upon the price you assume—then there’s lots of interest in taking the risk of investing in cellulosic technologies because if you succeed, then the price is large. So if we convince people that we really are serious about getting a reasonably high percentage of our fuel supply from ethanol or ethanol-like fuels, then we will see increased investment from Wall Street in cellulosic ethanol.

The technology, I believe, is ready today. Now what makes me believe that? DOE recently did an RFP—a request for proposals—for cost-sharing of new ethanol plants. They got eight fully qualified proposals where investors with very different technologies were willing to put up $60 (million) to $70 million of their own money to get a cost-sharing arrangement. Now if these investors did not believe that these technologies were ready for commercialization in 2007, they would not have put up that money and we would not have seen these proposals. Two of our companies were among the eight—or there were actually more proposals; some were weaned out early. So that many people with very different technologies believe the technology is ready to build a commercial plant today and were willing to put serious amount of investment dollars behind it. That tells me it’s true.

Now I will tell you, I’m involved with two cellulosic companies that will build these plants whether DOE gives them a grant or not. The only question in cellulosic ethanol today is not if the technology works, but at what price can you produce it? And like any new technology, the more you produce, the lower your price of production gets. And this is the problem of kick-starting it. We’ve chosen to say we’ll do it anyway, and as we learn and gain experience, the cost will come down.

So what are the numbers? I believe today with relatively small plants—a good scale plant for corn ethanol is 100 (million) to 200 million gallons a year; a good scale refinery for oil or for gasoline is a billion gallons a year—that even at 5 million gallons a year—very small plant for cellulosic ethanol—our costs are below $2 a gallon, including capital costs, which tend to be high for cellulosic ethanol.

MALLABY: And that’s the cost to consumers at the pumps, is it? Or—

KHOSLA: That is the cost of production. Okay?

MALLABY: Yeah.

KHOSLA: For comparison, corn ethanol is probably at a buck to a buck-thirty a gallon, depending upon what price you assume for corn, and corn prices have been overall fairly volatile recently. In Brazil, it costs between 70 (cents) to 80 cents a gallon to produce a gallon of ethanol.

Any of those prices are lower than what it costs to produce gasoline at $60-a-barrel oil, except the cellulosic ethanol at $2, and that’s why you haven’t seen plants. But we’ve taken the bet and I’m almost certain any of these technologies would produce ethanol at below a buck-fifty a gallon if somebody built a hundred million-a-year plant.

So we’ve got this chicken-and-egg problem. It’s a kick-start problem. If you solve the kick-start, we’ll be well on our way to continual improvement in costs.

The question you should ask—and this is great because it’s the Council on Foreign Relations—we buy the cheapest oil in the world from Saudi Arabia, but we insist on having it compete against the most expensive ethanol in the world. We don’t buy the 70-cent-a-gallon ethanol we can buy in Brazil to compete against the Saudi oil we buy, which is the cheapest oil. That sound like a level free-market playing field to you? (Laughter.) You know?

MALLABY: There’s been a questioner waiting patiently in the back, on the left there.

KHOSLA: Could I have somebody grab me just a glass of water please? Thank you.

QUESTIONER: Amy Christensen with Google.org.

I wanted to actually loop this back in to the Council on Foreign Relations and talk about what you think increasing reliance on ethanol here in the U.S. could do for our foreign policy relationships as these markets you talked about—Asia and Africa supplying to Europe and the U.S.—what that could do to our relationships. I’m thinking, for instance, from Tom Friedman’s fake letter—hopefully future letter from Nancy Pelosi to the Chinese leadership to cooperate on our common challenges around energy and climates. I’d love your thoughts on that. Thanks.

KHOSLA: Well, the person who has written most eloquently on the topic is Senator Lugar, and his speech this summer at Purdue is on my website also. I think it’s the most eloquent statement of the problem. In fact Condi Rice said recently that we can’t have essentially a foreign policy while we have an oil dependence—at least not an independent foreign policy.

Look, there’s no question. I’ve talked to the government in India. They will always support Iran because Iran supplies 10 percent of their oil and 11 percent of China’s oil supply. They can’t cross Iran. India and China are doing joint ventures in Sudan, despite Darfur. Why? Because for their populace, energy is more important than human rights in Sudan.

I could go on. I think the audience here probably has many more examples than I do, but I highly recommend Senator Lugar’s speech on this topic.

MALLABY: Right here in the front.

QUESTIONER: I’m Mitzi Wertheim with the Center for Naval Analysis, but I’m running an energy seminar series called “Energy: A Conversation about our National Addiction,” sponsored by the Defense Department.

I want to ask you about the infrastructure requirements for shifting to blended oil, because I think figuring out how that gets funded is a tremendous challenge.

KHOSLA: It is not a tremendous challenge. (Laughter.)

Let me give you the numbers, okay? If we fully funded a mandate to provide 70 percent of our cars be flex-fuel, that’s some number like 600 (million dollars) or $700 million a year, a fraction of the subsidies to oil. If we fully paid for 10 percent of our gas stations to offer E85, I believe that number would be less than a billion dollars. These are small in the context of even the ethanol subsidy. So the variable subsidy will pay for all this and still cause a dramatic reduction in costs.

Now what about the rest of the infrastructure? The infrastructure—the best way to study that is to study it in Brazil. Okay? If I were to put a parallel infrastructure to gasoline distribution in the U.S. for the first 10 billion gallons of ethanol for E85 as a fuel—not for blend—it’s about $50 million. In fact, I know private investors were looking at making that investment because it is a profitable investment. You could go do a deal with somebody like Kinder Morgan, which already does distribution in this world—there’s six companies like Kinder Morgan that will serve that.

Now we don’t need to put in the infrastructure for a hundred billion gallons day one. In Brazil, these investments came in small increments. They were completely transparent. There was—it sort of happened. Only now, when it’s become such a big part of their economy, are people like Petrobras putting in pipelines.

Now, contrary to what the petroleum guys tell you, ethanol can be pipelined—is being pipelined in Brazil, and they’re building in more pipelines today. It’s not in the same pipes as gasoline, and that’s the key. That’s the one piece of fact they take and distort into a general belief that ethanol can’t be pipelined.

So they are doing it in Brazil, but it’s being done on a private basis, and I have no question it will be done here on a private basis.

These will be small incremental things that happen. It is already being served fairly well. People talk about transportation. We are building 30 new ethanol plants in California. Does it involve more infrastructure? No, it doesn’t. Why? Because some entrepreneur figured out that corn is already being shipped to California for cattle feed. They extract the starch to produce the ethanol from the corn that is already being shipped and then feed the remaining protein to the animals.

There is a—Fagan, I believe, is considering a large terminal in Stockton, California. Fagan is a South Dakota traditional Midwest contractor building a lot of ethanol plants. Look, this will happen. It’ll happen in 50 (million dollar), 100 (million dollar), $200 million increments on an economic basis because there’s a rate of return associated with all these functions. They’re done for oil; they’re done for gas.

If we can get rid of coal, by the way—and we can come back and talk about that—that is 70 percent of all rail traffic in this country. We’d have way more rail capacity than we need for ethanol.

Now how do we get rid of coal? I don’t know if you want to go talk about it, but there are economic solutions for coal too.

MALLABY: That could be another topic.

I think—I want to take one more question. There was somebody over here. And that would be it, I think. The gentleman here with an orange tie.

QUESTIONER: I’m Jerry Johnson with the American Capital. One question with regard to India and China: Given their extreme economic growth—even if we implemented all the policies that you recommended today—their demand for gasoline will probably outstrip any reduction of demand in the U.S. What, in your view, should be our policies toward India and China to get them also to embrace ethanol usage?

KHOSLA: The best thing we can do for India and China is to demonstrate that we can get energy independence using biomass. Imagine the social impact in India or China if biomass was the source of fuel. It’s the single largest source of imports, not only in this country but in India and China, and if we could demonstrate this alternative stock, they would absolutely adopt it. Now, maybe India will go to Tanzania where there’s millions and millions of acres of land. India and China are experimenting with a different crop called sweet sorghum, which grows on marginal lands where food cannot grow. And almost certainly, domestic production in India and China will come from sweet sorghum as the feedstock, not corn, not sugarcane.

So, role models is what counts best. If we can prove to the world we can do it, the rest will take care of itself. Look, Reliance in India is old, which is the largest private oil company other than the national oil company—is already investing in ethanol. Why? Because they see the interest here. India just instituted a 10 percent land requirement in the last two months. This will happen.

Thank you all very much.

 

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