T. Melgin, McKinsey & Company, Helsinki, Finland; A. MUCHA-GEPPERT, McKinsey & Company, Warsaw, Poland; X. VEILLARD, McKinsey & Company, Paris, France; and A. WARRELL, McKinsey & Company, Washington, DC
As countries around the world seek to limit their carbon emissions, sustainable fuels will play an important role. This category consists of a broad range of low-carbon fuels, including biofuels, eFuels and chemical byproducts. Because sustainable fuels can fill gaps in decarbonization and complement electrification, demand is expected to triple over the next 20 yr, reaching approximately 600 MM metric t by 2050 (FIG. 1).1 Today, completed advanced-biofuels projects and the announced investment pipeline in sustainable-fuel capacity have reached $100 B.2
The sustainable-fuel market is still mostly nascent, characterized by complex regulations and interdependencies across sectors. Physical and regulatory constraints on feedstocks have resulted in price volatility, supply chain and infrastructure bottlenecks, while varying pricing across regions and import and export rulings have added to this volatility. The mix of fuel types will evolve through 2050. Road fuels have represented most of the demand and growth to date, but in the 2020s categories such as sustainable aviation fuel (SAF), renewable natural gas, synthetic natural gas and bio- and eMethanol will make up a larger share. During the 2030s, technological advancements could spur growth in new advanced biofuel pathways and eFuels, complicating the global market while injecting much-needed capacity and liquidity.
With such complex market fundamentals, sustainable fuel traders should seek to understand which markets will increase in liquidity, which arbitrage plays to explore across products, which storage hubs to invest in, and which offtakes to secure to gain access to supply. Winning traders will build and enhance selected capabilities to keep pace with the market’s evolution.
Current market and development factors. A fascinating but challenging aspect of the sustainable fuel market is the broad range of categories it encompasses (FIG. 2). Biofuels account for the vast majority of the market, but drop-in sustainable fuels and hydrogen (H2)-based eFuels could reshape the landscape in the coming decades. The development of these fuels will be nonlinear—they will mature at different paces, and their specific uses could replace fossil fuels at different rates.
The rise of eFuels. In the coming years, constraints on sustainable biomass feedstocks are expected to create a gap between supply and demand for fuels with existing technologies. Although biomass feedstocks (notably lignocellulosics) have significant potential for energy production, practical constraints on their collection mean the global community will likely be unable to achieve net-zero targets without a shift to eFuels and dedicated biomass production on marginal lands or surplus agricultural land (FIG. 3).3
The eHydrocarbon market could still emerge in the late 2020s, but volumes will likely not become significant compared with bio-based production until the following decade. In addition, the cost competitiveness of different production pathways continues to be uncertain given the limited adoption and potential to reduce production costs of some of the pathways over time (FIG. 4). European Union (EU) regulators have taken the strongest long-term view on the role of eFuels, introducing proposals to mandate the use of renewable fuels of non-biological origins (RFNBOs).4,5
The business case and location choices for eFuel production are affected by access to affordable renewables, the availability of sustainable carbon (eAmmonia, which does not contain carbon, is an exception) and integrated production costs of H2 derivatives (which are affected by rules such as temporal correlation, requiring electricity storage or H2 to produce compliant fuels). Classifications vary by the H2 type (e.g., the carbon intensity or whether the electricity source includes nuclear in addition to renewables) and carbon (e.g., carbon derived from fossil, biogenic or direct air capture sources) and can affect a product’s market value. Future producers are concentrating primarily on non-fossil carbon sources such as ethanol, pulp and paper, and waste-to-energy plants.
Production can provide opportunities in regions with a high potential for renewables and biogenic-carbon availability, such as Latin America, North America and parts of Asia and Europe. Africa, Australia and the Middle East could be major producers of eAmmonia and potentially eHydrocarbons for markets that allow the use of fossil carbon in eFuels. The high cost of direct air capture must fall dramatically to be competitive with carbon capture from industrial sources.
Competing policy approaches to support market development. Multiple countries and regions are active in the global sustainable fuel market. The EU and North America are at the forefront in drop-in sustainable fuels. Meanwhile, an established significant market for conventional biofuel has experienced growth over the past 30 yr, with bioethanol in Brazil, China and India and biodiesel [fatty acid methyl ester (FAME)] from palm and soybean oil in Latin American and Southeast Asian countries.6 Asia–Pacific, Australia, China, Japan, India, Singapore and South Korea are emerging as potential demand hubs for drop-in fuels such as SAF, eMethanol and eAmmonia to serve as energy carriers or fuels for the marine sector.
An examination of the EU and U.S. markets highlights the complex and varied landscape across regions as well as different approaches to spurring sustainable fuel’s adoption.
EU. The EU has set ambitious targets for reducing carbon emissions and is using legislation to support demand. For example, the “Fit for 55” package of legislation aims to decrease the EU’s greenhouse gas (GHG) emissions by at least 55% by 2030, establishing targets for renewable energy use in the Renewable Energy Directive amendment (29% for the transport sector by 2030) and specific feedstocks (5.5% for advanced biomass and RFNBO by 2030, of which a minimum of 1% must be RFNBO).7 Proposed legislation would lay the foundation for SAF demand, mandating a 2% share of SAF supply in 2025, 6% in 2030 and 70% in 2050 (of which 35% would be RFNBO).8 By providing long-term demand signals, including compliance mechanisms, EU leaders have sought to create prerequisites for investment decisions.
On the supply side, the EU and its member states have imposed bans and restrictions on feedstocks that can be used for biofuels. The region is shifting from food crops (such as palm, soy and corn) to waste and residue streams for advanced biofuels.9 In addition, it is defining sustainability criteria for eFuels, favoring biogenic or direct air capture carbon and green or low-carbon H2 that meets stringent criteria (as laid out in the RFNBO delegated act).10 A recent proposal to allocate some EU emissions trading system (ETS) funds from aviation to support SAF adoption could also introduce incentives similar to those found in the U.S. Inflation Reduction Act (IRA).11
North America. The passage of the IRA in 2022 signaled a dramatic shift for the U.S. The act features $370 B in tax credits for the renewable energy industry, including a credit of $1.75/gallon (g) for SAF through 2026 and a production tax credit of $3.00/kilogram (kg) of H2 that contains GHG emissions below 0.45 kg CO2 per kg of H2 (such as onshore wind or nuclear). By attracting investment, the IRA seeks to scale up SAF production to at least 3 Bgpy by 2030, with the goal of 100% blending by 2050.12
These tax credits could significantly boost manufacturing capacity. However, a high share of projects have yet to clear the final investment decision (FID) stage. Twelve major North American passenger and cargo airlines have made SAF commitments through 2030, but their offtakes are still far from meeting future demand, and few of those offtakes can be considered fully binding.
The North American market also has several policies to support the use of sustainable fuels. For example, the U.S. Renewable Fuel Standard (RFS) and the state-level Low-Carbon Fuel Standard (LCFS) programs affect pricing and create markets for credits.
Aligning market supply and demand. The different policies and approaches could lead to supply-and-demand imbalances across regions in the medium term. The market could snap back into balance in multiple ways, including:
Outlook on global trade flows through 2050. The development of sustainable fuels will proceed at different paces depending on category and region. However, based on trends to date, a few observations can be made about how global trade flows could play out through 2050. A significant share of production and consumption takes place within regions, shaped by various mandates, incentives and trade rules. Some inter-regional trade also occurs, notably of feedstocks and fuels—for example, from Asia-Pacific hubs to Europe and North America. Producers outside the U.S. are increasingly looking to the EU as a potential export market. Therefore, many feedstocks and fuels can be considered as partially global commodities.
Although the recent IRA package in the U.S. is intended to meet local demand, it is starting to attract more investment to the region. This activity may be contributing to the widening gap in pricing among regions. Some demand patterns are also shifting: for example, airlines refueling with SAF have access to cheaper prices in California than in the EU. Furthermore, proposed book-and-claim schemes could lead to global or regional optimization of demand volumes based on local incentives.13
Looking toward the future, long-term scenarios will likely be shaped by high demand growth beyond the EU and U.S., the increased interest in securing supply, regional and local feedstock constraints, greater market complexity and the partial commoditization of markets such as renewable diesel and SAF. On one hand, feedstock shortages could lead to the adoption of more expensive or capital-intensive production pathways, such as the conversion of lignocellulosic feedstocks. Differences in sustainability criteria across regions may result in the growth of regional markets and product differentiation based on that sustainability criteria.
Conversely, the rise of eFuels combined with a scarcity of the biomass needed to support 2050 net-zero scenarios may lead production to concentrate in the global south, depending on the cost of direct air capture and requirements for non-fossil carbon sources. As an alternative, production could be more regional, with sustainability criteria differing by region. The resulting long-term outcome will likely be a mix of global commoditization and local fragmentation, creating opportunities for a range of feedstock, technology and fuel combinations.
How traders can win in sustainable fuels. The sustainable-fuel market is poised to ramp up significantly in scale and complexity. Five interdependent areas will shape the market in the coming years (FIG. 5). To better identify value creation opportunities and risk, market participants must understand how these areas influence one another and how to keep pace with advances. For example, traders that have a good grasp of the shifting market balances but lack an understanding of the pace of investment in new technology platforms could be at a disadvantage.
Build a regulatory intelligence team. The regulatory landscape varies dramatically among countries and regions and is evolving rapidly. Traders that develop a deep understanding of local market regulations, credit qualifications, future trends and potential changes will be better able to shape their trading strategies and secure offtakes or supply arrangements.
The economics of sustainable fuels such as renewable diesel, which has relatively high production costs, are highly dependent on regulatory incentives and vulnerable to regulatory uncertainty. For example, the cost of SAF from HEFA-used cooking oil (UCO) in Europe without incentives was recently about $2,200 per metric t, 100%–150% more than the cost of producing fossil-based kerosene today.14 That means users either rely on substantial credits [such as the LCFS, Renewable Identification Numbers (RINs), Blenders Tax Credit, or the new IRA credit stack in the U.S.] to break even or customers pay the required price for mandated volumes and pass those costs on to customers (the primary mechanism in the EU).
The outlook for many of these programs could be affected by regulatory changes, which will influence the price of subsidized fuels in the years ahead. For example, multiple IRA credits will expire after several years. The RFS program has also historically been volatile, with the price of RINs often driven by legislative outcomes and market perception of new targets set by the U.S. Environmental Protection Agency (EPA).
Develop global trade flow models. Gaining an understanding of global trade flows will be far more difficult in the coming years given the level of uncertainty, lack of transparency (including the dearth of trade categories for some products) and complexity in the sustainable fuel market. Optionality is especially critical in this environment. Winning traders will model how fast each commodity will grow and in which market it will likely clear (including within-year demand dynamics), as well as anticipate shifts and monitor key changes in logistics capability and access within regions.
Enhance origination capabilities. Traders will need robust origination functions to secure offtakes or supply agreements for specific feedstocks and products that offer competitive flow advantages. Successful traders will structure these agreements to balance price, volumetric flexibility and logistics to enhance optionality and derisk volume flows if market dynamics change. Traders also have opportunities to rent or buy blending facilities, acquire sustainable fuels (including certificates) and fossil fuels, perform blending, and detach sales of molecules and credits—essentially creating a secondary market in a given country for the certificates.
Commodity trading organizations attracted to sustainable fuels by their dynamic nature and growth could try to anticipate how the market will evolve and identify inconsistencies in pricing across products or over time, offering opportunities for market arbitrages. Successful traders look for areas of greatest transactional volume and seek to build scale around these opportunities. Often, they will use scale to continue to capture value when margins collapse as the gaps start to close.
Strengthen the trading team. The interdependencies of feedstock, fuel and credit prices within sustainable fuels and across other sectors are complex. Successful traders must model correlations among products and explore arbitrage opportunities across specifications, locations and timing. For example, as demand grows for second-generation feedstocks for drop-in fuels, the prices of advanced waste and oils could become more volatile. Through 2021 and part of 2022, soybean oil prices exhibited high volatility in response to intensifying competition from renewable diesel and FAME producers in the U.S. amid limited supply from export markets. Feedstocks with limited or scattered availability and competing demand for alternative uses are at the greatest risk of such volatility.
The trading team must have a broad level of expertise across various commodities and understand the interplay of those commodities in different markets and products. Specialist trading across high-volume commodities will still exist, but because each market will be influenced by a growing array of factors, traders will need far broader commodity knowledge to be effective.
In the coming decades, the sustainable fuel market will be transformed by increased demand, substantial investment, disparate policies across regions and technological advancements. Despite the many factors that will shape the market, rapid growth and volatility could offer enticing opportunities to capture value. Winning traders will develop new capabilities to track regulatory changes, monitor global trade flows, improve origination and build out their trading teams to navigate this complex trading landscape. HP
LITERATURE CITED
TAPIO MELGIN is a partner in McKinsey’s Helsinki office.
AGATA MUCHA-GEPPERT is a solution manager in McKinsey’s Warsaw office.
XAVIER VEILLARD is a partner in McKinsey’s Paris office.
ANDREW WARRELL is a partner in McKinsey’s Washington, DC office.