The Forgotten Flaw in Biofuels Policy

While there are legitimate rationales for public policy interventions to promote environmental and energy security objectives, all too often policies implemented in practice are a far cry from the ideal type of intervention. And often policymakers use multiple and overlapping instruments to promote the same objective, which makes it difficult to disentangle and understand the effect of each individual instrument. Biofuel policy is a good example of this, where refiners are subject to minimum requirements on the use of ethanol for producing blended gasoline, while at the same time they receive tax relief for ethanol use. As discussed in this week’s commentary by Harry de Gorter and David Just, these tax breaks, when used in conjunction with a binding mandate, may undermine the very objectives they are designed to promote.

Next week’s commentary by Virginia McConnell and Margaret Walls discusses market-based approaches to controlling urban development.

Gasoline prices are at record highs, and there is widespread public confusion over the reasons why and who is really to blame. But the devil is all in the details. Here we will look at one aspect of the ongoing policy arguments over the effect of biofuel mandates on food prices and the environment. Far more corn grown in this country is now going toward fuel production, not food consumption, causing food prices to escalate around the world. And many recent studies argue that indirect land-use changes - resulting from farmers shifting from other crops to corn and taking land out of conservation to plant even more - may enhance greenhouse gas emissions. What is left out of the debate is a significant contradiction in current biofuel policy: tax credits subsidize petroleum-based gasoline consumption when used in conjunction with mandates. This has very important implications because the primary goal of biofuel policy is to reduce dependence on oil.

Reducing greenhouse gas emissions and local air pollution as well as improving farm incomes and stimulating rural development are oft-stated complementary policy goals. However, any beneficial effects on energy security and the environment stemming from the new Renewable Fuel Standard (RFS) could be completely offset by current tax credits. (The RFS is part of the recently passed Energy Independence and Security Act that mandates the use of 36 billion gallons of renewable fuel in the United States by 2022.) And this issue is not just a domestic issue: many countries employ both biofuel mandates and tax credits simultaneously.  Here's an explanation for how, under the mandate, the tax credit effectively subsidizes gasoline consumption. Consider first how the tax credit would work by itself. To take advantage of the government subsidy, blenders of corn-based ethanol and petroleum-based gasoline bid up the price of ethanol until it is above the market price of gasoline by the amount of the tax credit (57 cents per gallon if we include state tax credits). If the price premium over gasoline is less than 57 cents per gallon, then blenders will make excess profits from the government subsidy by pocketing the difference. Competition among blenders will ensure that there is no "free money left on the table" such that the price of ethanol exceeds that of gasoline by the full 57 cent per-gallon tax credit.		Harry de Gorter Associate Professor Department of Applied Economics and Management Cornell University
Now consider the case where the ethanol price is determined by the renewable fuel mandate and there is no tax credit. The pump price for blended gasoline is a weighted average of the higher ethanol price and the gasoline price. Consumers must now pay a higher price for blended gasoline (for a given amount of ethanol use) than when only the tax credit was in place. (It's important to set this policy exercise in context: the actual market price of gasoline is determined separately by world supply conditions and only indirectly affected by ethanol policy in the United States.) Now re-introduce a tax credit, this time along side the mandate. If the mandate is binding, the related ethanol price premium exceeds the tax credit and there is no incentive this time for blenders to bid up the price of ethanol (unlike before when the tax credit was the only policy). Instead, to take advantage of the ethanol subsidy offered to them by the government, blenders will offer a lower fuel price to consumers. This is because ethanol market prices cannot decline because they are determined by the binding mandate. Blenders will therefore compete for the government subsidy by reducing in their fuel price the implicit price paid by consumers for gasoline until there is no free money left on the table. The price paid by consumers for gasoline declines until the per-unit subsidy on ethanol is exactly exhausted on an adjusted per-unit basis of gasoline consumption. This increases gasoline consumption and thereby the market prices of both gasoline and oil.		David R. Just Associate Professor Department of Applied Economics and Management Cornell University

The intended effects of the tax credit are reversed: there are increases in gasoline consumption (and thus in greenhouse gas emissions), oil prices, and wealth transfers to the Middle East. Meanwhile farmers are worse off than if there was no tax credit. Farmers are, indeed, making record profits because the price of corn is so high, but ethanol prices have not changed. Higher oil prices (due to the gasoline consumption effect of the tax credit), however, adversely affect farm input costs.

What if the tax credit is binding and the mandate is dormant? In other words, what if the ethanol price premium (with a mandate only) would be lower than the current tax credit? In this case, the hypothetical ethanol price premium with a mandate only would represent the implicit subsidy on gasoline consumption due to the tax credit because the tax credit is not allowing the mandate to bind. Furthermore, the mandate could easily be increased to generate the same desired level of ethanol consumption as the tax credit is currently generating. In this way, one obtains the same level of ethanol consumption but with no taxpayer costs.

Using a mandate alone has an additional advantage: for the same level of ethanol consumption, a mandate generates a higher consumer price paid for gasoline and so further enhances energy and environmental policy goals. The policy implication is clear: eliminate the tax credits and save billions of dollars in taxpayer costs. Otherwise, the tax credit is working against all the policy goals relating to energy security, environmental protection, and rural prosperity.

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Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.

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