A tale of two subsidies

It was the best of deals, it was the worst of deals. Why Genentech worked and Cascade Grain failed.

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It was the best of deals, it was the worst of deals. Why Genentech worked and Cascade Grain failed.

By BEN JACKLET

Both deals looked great on paper.

The first would lure a $13 billion biotech company to Hillsboro. The second would build the largest ethanol plant on the West Coast in Columbia County.

The benefits of building up Oregon’s bioscience sector and bringing alternative energy jobs to an area suffering from the downfall of Big Timber were self-evident. That’s why state and local officials went to extraordinary lengths to make them happen, offering more than $100 million in loans, grants and tax breaks. Some of their financing tactics required a certain suspension of disbelief — such as pretending that a remote industrial site outside of Clatskanie was an “urban” renewal area, and a shovel-ready property near Intel’s Oregon empire was in a “rural” enterprise zone. But when jobs are the goal, few will protest a bit of creative license.

To call the results mixed would be an understatement. While the biotech company — Genentech — has delivered the promised jobs and prosperity, the ethanol company — Cascade Grain — limped along for less than a year before filing for bankruptcy in January with millions of dollars of unpaid bills and millions more in jeopardized loans.

These two extreme examples provide insight into the wisdom and the folly of using multi-million-dollar incentive packages to prop up individual businesses at a time when the state’s involvement in private industry is escalating to heights not seen since the Great Depression. At the heart of these deals and hundreds of others like them is a sharp difference of opinion between those who believe that government interference in the competitive process creates more harm than good, and those who think that it is the duty of government not only to steer business, but to feed it as well, granting rewards in advance on the expectation and hope that the gains will justify the investment.

The fishing expedition that brought Genentech to Hillsboro was code-named “Project Marlin.” It was launched in September 2005, when the South San Francisco biotech giant with the stock ticker DNA began searching for a suitable home for a new filling and packaging operation. Making the short list of finalists were a half dozen sites in Dallas/Fort Worth, Phoenix, Ireland, Singapore and Oregon.

The competition quickly intensified. Genentech was growing by 1,500 jobs per year at the time and has made Fortune magazine’s 100 best companies to work for in the U.S. for 11 years in a row. Sarah Garrison of the Oregon Economic and Community Development Department, point person on the state’s recruiting campaign, recognized that the company was all business and expected absolute professionalism in return. “They wanted everything fast and in writing,” says Garrison, taking a break from the constantly vibrating smart phone by her side and the Bluetooth headset attached to her ear to offer insight into the Genentech recruitment.

Genentech wanted data-driven risk assessments examining everything from seismic fault lines underground to air traffic overhead. The company also was interested in learning what specific benefits might be negotiated with the states and nations under consideration. Less than two weeks after Genentech’s first site visit to Oregon, Garrison and other economic development officials from OECDD and the City of Hillsboro flew to California on an “incentives trip.” They met for two hours at a hotel near the airport with a half dozen Genentech executives to pitch the Oregon package. Genentech also invited teams representing the other sites under consideration to make offers on the same day, adding to the tension of the event.

“We were competing with Dallas/Fort Worth, where the governor of Texas had a $256 million slush fund to work with,” says Garrison. “They could throw a lot of money at Genentech, and we threw a lot at them, too. These were some of the biggest incentives we’d ever offered. We wanted to show this company a lot of love.”

Oregon’s incentive package eventually grew in value to $33.5 million, anchored by $26 million in property tax savings under the state’s Strategic Investment Program, the tool widely credited with luring Intel to Hillsboro. Another key factor was the state’s “single sales factor” corporate tax policy, which counts only sales within a state, improving profit margins for global companies such as Genentech.

On March 17, 2006, after more than 15 versions of a Memorandum of Understanding, Genentech chose Oregon. Construction of the fill/finish facility began in December 2006 and was expanded to include Genentech’s new West Coast distribution center in April 2007. The $400 million project has created hundreds of local construction jobs and 160 long-term, full-time positions at the new facility. A study by ECONorthwest estimates that by the time the Genentech facility is fully operational in Hillsboro it will generate $220 million in annual economic output and more than enough in personal income tax gains to cover the public investment.

According to Genentech spokeswoman Kelli Wilder, the company is expecting to grow to 200 to 250 local employees once the facility gains final approval from the Food and Drug Administration as early as 2010. Genentech also is keeping ownership of the 35 undeveloped acres at the site to meet “future business needs,” Wilder adds. The company’s stock price soared to $95 per share in March when Swiss pharmaceutical giant Roche closed the deal to buy Genentech for $47 billion.

One reason Genentech was courted so aggressively is because of the enticing possibility that the company may expand from distribution and packaging in Oregon into manufacturing and research and development, boosting the state’s 13,630-job bioscience cluster. That’s what happened with Intel and the semiconductor industry. Many of Intel’s finest scientists are based not far from Genentech’s new quarters. Also nearby is the glossy new Solar World manufacturing plant, another economic development success story where incentives played a starring role, especially a $20 million Business Energy Tax Credit. The same applies to the Danish wind power giant Vestas, which is negotiating a massive incentive package to build its new U.S. headquarters in Portland.

Vestas, Solarworld and Genentech are arguably the best things to happen to the Portland Metro economy in recent years, and economic development officials highlight their rising fortunes as evidence that incentives are smart investments in the future. But not everyone shares that enthusiasm. You don’t need to look hard to find examples of major public investments that result in limited private gains, or in some cases, embarrassing losses.

The idea of building a major ethanol plant at a soggy, remote former ammunition depot 53 miles upstream from the mouth of the Columbia River originally came from Enron, which considered investing $45 million into the project in 1999. The proposal disappeared along with Enron, only to be revived in 2004 by Charles Carlson, a former ConAgra executive with financial backing from the wealthy Berggruen family of New York City.

Without government support, the Cascade Grain plant would not have been built in time to profit from last summer’s soaring fuel prices. The state spent at least $24.84 million building roads and water systems and improving rail lines to make the Port Westward site feasible for industrial development.

Some of the investments came as grants, others as loans to the Port of St. Helens and Columbia County, both of which borrowed heavily on the assumption that the ethanol plant and other developments would generate jobs and rail tariffs and boost property values to pay off the loans through tax increment financing. Once the Port Westward investments had set the stage, the Oregon Department of Energy (ODOE) loaned Cascade Grain $20 million as part of its Small Scale Energy Loan Program, described in loan documents as an incentive unique to the Northwest and attractive to the loan syndicate because it allowed cash to be used to pre-pay senior debt to private lenders. It was the largest loan of its type ever made in Oregon. Add in two Business Energy Tax Credits worth a combined $16 million and you get a $70 million public investment in a company that had never produced a drop of fuel.

As if that weren’t enough, the state Legislature in the 2007 session created a mandatory market for the not-yet-operating plant by requiring unleaded gasoline in Oregon to contain 10% ethanol once statewide production reaches 40 million gallons per year.

Between the extravagant state and local support and the soaring price of oil, the outlook for Cascade’s 113-million-gallons-per-year ethanol plant looked excellent. The plant was well situated with barge and rail access and an available workforce hungry for steady paychecks. Cascade had lined up a buyer for its fuel in EcoEnergy, the largest marketer of ethanol on the West Coast. Demand was also high for leftover grains as cattle feed, with Land of Lakes/Purina signing up as a major buyer.

The project also benefited from a charismatic front man in Carlson, who won over local and state officials as a determined entrepreneur who knew how to get things done. “You won’t find anyone more focused than Chuck Carlson,” says Denny Houle, the regional director covering Northwest Oregon for OECDD. “He is top notch.”

Not long after breaking ground, however, Cascade Grain began to fight its contractor, JH Kelly of Longview, Wash. The contractor initiated an arbitration proceeding against Cascade Grain, missed its completion deadline by five months and slapped a $27.8 million lien on the plant on Aug. 29, 2008.

A vigorous dispute has emerged over who is to blame for the production problems that have plagued the operation. Charles Carlson estimates that the plant ran at full capacity only 20 days between launching in June 2008 and filing for bankruptcy the following January. In a declaration filed with the bankruptcy court, Carlson blames JH Kelly for “deficiencies in materials and workmanship (which) resulted in numerous shut-downs and plant failures.”

Attorneys for Kelly counter that Cascade has deliberately refused to pay its bills as ordered by an arbitration panel and “has a long history of … filing and losing motions in Oregon court” to buy time for reorganization rather than face up to its debts.

Whoever was at fault, the venture unraveled with frightening speed. EcoEnergy found a shipment of 128,000 barrels of Cascade ethanol to be contaminated because of elevated sulfate levels and declared a breach of contract. ConAgra stopped shipping corn due to insufficient funds. Cascade Grain missed its quarterly payments to lenders on Dec. 31, 2008 and shortly thereafter cut its staff from 58 to nine. By the time the mess spilled over into bankruptcy court on Jan. 29, creditors ranged from local companies such as Portland and Western Railroad of Salem and Northstar Chemical of Sherwood to global players such as Caterpillar Financial Services and the German bank WestLB. What was billed as a $200 million factory was freshly assessed at between $40 million and $56 million.

Among the institutions facing new risk from that steep drop in value are the Port of St. Helens and Columbia County, which are relying on increased property taxes from the plant and other Port Westward developments to pay off state loans. Port and county officials say Cascade may yet reorganize effectively, and they add that other energy companies are expressing interest in Port Westward. Pat Zimmerman, a retired Intel executive who tried unsuccessfully to block the Port Westward investments as a port commissioner, is less sanguine. She calls the financing plan for Port Westward “a tottering pyramid built on faulty assumptions.”

To be fair, Cascade Grain has not suffered alone. Few if any corn ethanol companies have fared well over the past year. Even when the price was strong, corn ethanol was blamed by researchers from the World Bank, the IMF and numerous universities for skyrocketing food prices. Then the ethanol price collapsed along with the economy, while the corn price stayed high. Today there is a glut of bankrupt corn ethanol plants selling for fractions of what investors thought they were worth. Most of the research money is shifting away from corn ethanol and toward fuel from non-edible plant sources, such as wood pulp, switch grass and algae.

It would seem that it took about a year for corn ethanol to go from fuel of the future to thing of the past. But Cascade Grain’s many supporters warn against premature autopsies.

David Williams, CEO of Ilwaco, Wash.-based Shorebank Pacific, which invested in the plant, says, “It’s in the right place, it’s got a market for its products, and ethanol is something we’ll have to deal with over the next five or 10 years. I tell you what, if gas were still $4 a gallon there would be a lot of hustling going on out there to make it happen.”

Lou Torres, spokesman for the ODOE, says, “We still think that once the markets correct themselves Cascade Grain will be a good investment for the state.”

OECDD’s Houle says he continues to hold out hope that Cascade Grain and other energy developments at Port Westward will eventually bring jobs to the region. “These things take time,” he says, “Not all of them work out. But over time many of them do.”

In a November 2008 report to the Legislature, the Oregon Economic and Community Development Commission described its various incentive programs to highlight the jobs created and investments secured. But the report did not provide an overarching numerical analysis of cost and benefits.

Anthony Rufolo, an economics professor at Portland State University, has a theory about why the state does not crunch the numbers objectively for its incentive programs. He was hired by OECDD in the 1990s to review the published literature on tax incentives. He found that the evidence overwhelmingly showed that incentives don’t work. “We presented our findings to OECDD, and they did their best to ignore them,” he says.

Rufolo says he has not seen anything in the academic literature to change his opinion. “If you look at the huge amount of money that is spent or given away through incentives and the lack of evidence that it does any good, the conclusion is that incentives are mostly a waste of money.”

Lake Oswego-based economist Bill Conerly, author of a report titled “The Hidden Costs of Ribbon-Cutting,” agrees. “Government’s job should be to create a good business environment for everyone,” he says. “Don’t bribe companies to come here. Don’t pick winners and losers. Let the competitive process run its course.”

But incentives are part of the competitive process. When it comes to recruiting major companies or encouraging ambitious start-ups, the state that doesn’t invest upfront risks losing out on businesses that can transform economies, such as Intel. “Incentives don’t pick winners or losers,” says Jill Miles, national recruiting officer for OECDD. “Incentives are there to break the tie.”

As an example Miles offers the new Procter & Gamble factory that is expected to employ up to 1,000 people in Utah. Boardman was a finalist to host the plant, and incentives broke the tie. Utah offered $84 million, the biggest package in the state’s history, edging out Oregon’s bid of $78 million. A third state that did not offer a similar package was “never in the running,” Miles says.

Critics warn that incentives arms races can lead to extravagant handouts based on unrealistically optimistic projections. But Bruce Laird, business development officer for OECDD, says strict performance contracts ensure that most projects supported by public dollars deliver the goods. Besides, he adds, states are inherently conservative investors. “We’re so risk-averse that there’s a lot of things we just leave alone,” Laird says. “We’re not venture capitalists. We’re public sector. But with a lot of these innovations you could make the case that it would be imprudent not to take a position in them.”

In the end, the question of whether or not governments should be taking positions in private companies is beside the point. The fact is, they are. The private sector is in no condition to be reviving the stalled economy. The public sector, which can raise money through tax-free bonds on the local level and spend money it doesn’t have on the federal level, will be in the economic driver’s seat for the foreseeable future. Just ask Rick Wagoner, the once- mighty former CEO of General Motors.

The practice of using public funds to break the tie between one location and another, one company and another, even one industry and another, rather than allowing free markets to determine value, will certainly accelerate in this recession, as will the corresponding temptations of favoritism, corruption and manipulation.

If history is repeated, the results will be mixed. Deals that looked great on paper will not always work out. Some will fail spectacularly. Others will succeed, and the resulting ribbon-cutting ceremony will perpetuate the perception that incentive packages create jobs and opportunity, whether they do or not.