Japan Considering Sustainability Credentials for Palm Kernel Shells

With Japan considering palm kernel shell sustainability requirements, Japanese imports will likely face a steep decline as regulations go into effect. Once requirements can be met by palm oil producers, they will inevitably trend upward again.
By William Strauss and Yoshinobu Kusano | April 30, 2019

FutureMetrics has learned that the Japanese Ministry of Economy, Trade and Industry is considering palm kernel shell (PKS) sustainability requirements. According to information informally circulating, it appears the requirement of sustainability, legality and traceability for PKS is under serious discussion and likely to be imposed on current and new PKS procurement. The exact regulation wording and whether these rules will be applied to already-signed contracts for PKS are unknown, but it appears very probable that Japan is moving toward a more rigorous set of requirements on biomass fuel procurement.

Japan is already a major importer of PKS. In 2018, the country imported 1.265 million metric tons of PKS, 68 percent of total PKS exports, all of which came from Indonesia and Malaysia.

PKS is a primary fuel for many of the Japanese independent power producers (IPPs) that are generating or soon plan to generate power with the benefit of the feed-in-tariff (FiT). The FiT is part of the Japan’s policy for increasing the proportion of low- to zero-carbon-emitting power generation. Many IPP projects are also committed to use industrial wood pellets in their fuel mix.

In most jurisdictions that have policies to support the use of renewable biomass fuels, in order to receive policy benefits, the biomass fuels must be certified as being produced from sustainable sources. This is the basic necessary condition that assures all the carbon emitted by the combustion of the fuel is absorbed by the growth of the biomass replacing what has been harvested and used as fuel.  As the basis for carbon emission mitigation in the power sector, industrial wood pellets used as a substitute for coal in power stations in western Europe and England must meet strict and rigorously applied rules, proving that the forest inventories are not being depleted in order to qualify for the policy support.

Japan is a major importer of wood pellets, and it’s expected that its pellet imports will exceed its PKS imports in 2019. Because of the history of sustainability requirements for EU and U.K. industrial wood pellets, major producing nations are almost 100 percent certified under one of several recognized and accredited certifying bodies. Thus, when Japan finalizes its sustainably requirements for biomass fuels, pellets produced in Canada, the U.S., Europe, Australia, Russia and South America will already have the credentials to be legally considered as qualifying fuel in FiT-supported IPPs and in utility power plants that cofire.

This is not the case with PKS. The PKS supply chain is highly fragmented with many independent smallholder farmers. Some estimates have smallholders in Indonesia comprising 60 percent of total palm oil production by 2030. An estimate by the World Resources Institute suggests that less than 1 percent of independent smallholders are certified as sustainable by the Roundtable on Sustainable Palm Oil and Indonesia Sustainable Palm Oil. Whatever the actual totals, a significant portion of PKS is derived from uncertified sources. Indonesia and Malaysia, due to a legacy of rapid and massive deforestation to clear land for small and large palm oil plantations, have challenges in building credibility. Managing the growth of the industry and controlling deforestation has been a difficult balance for the palm oil-producing nations. Expanding smallholder certification will be a positive change, but will take time.

There are also structural differences in the supply chains for PKS and pellets that present challenges. Pellet producers have invested many hundreds of millions of dollars to build pellet factories, and need to have a reliable and consistent output over many years to satisfy the return on investment criteria of the investors and lenders. In contrast, PKS aggregators have relatively little capital invested, as there is no conversion of raw material to an upgraded product. Unlike industrial wood pellets, PKS markets do not have producers that can engage in long-term offtake agreements with quantity and quality guarantees, and with delivered price certainty.

FutureMetrics expects that some portion of the current imports from Malaysia and Indonesia will be curtailed. Reduction in the quantity of PKS imported into Japan will depend on the final METI rules and the ability of PKS suppliers to meet those rules.

We also expect that industrial wood pellet demand in Japan will increase as IPPs seek alternative fuel to keep the rate of power generation from their stations at the required level. At least in the near- and medium-term, the FiT is sufficient to compensate for the higher cost of pellet fuel. Margins will shrink because the cost of pellet fuel is about 15 percent higher per MWh than PKS. The way the FitT is crafted, however, with a fixed rate over 20 years, it is generous in the early years in order to provide a buffer between a fixed top line revenue and the inevitable increasing costs of fuel and plant operations that will occur over 20 years. In later years, margins are expected to shrink due to cost increases (inflation), while the top line FiT revenue remains fixed.

In the early years of the FiT, there is enough buffer built into the rate to allow higher-cost pellet fuel to substitute for PKS. Presumably, as palm oil producers respond to certification requirements over time, PKS imports will trend upward after what is likely to be a rapid and relatively sudden drop when sustainability requirements are implemented.

Authors: William Strauss
President, FutureMetrics Inc.

Yoshinobu Kusano
Policy Advisor, FutureMetrics Inc.