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bioweb.sungrant.org » Technical » Policy » Biofuels Policy Mechanisms
| Biofuels Policy Mechanisms |
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The United States is currently attempting to develop energy policy instruments to deal with issues related to energy use. The reasons for developing energy policy are many and varied, and can include social, economic, environmental, and security considerations. For example, in the United States, a primary driver for current biofuels policy initiatives is national security due to reliance on imports, in many cases from unfriendly or unreliable sources, of over 60% of the petroleum used. Other drivers include climate change concerns resulting from the use of fossil fuels.
Policy instruments can be designed to shift a larger potion of the social costs (e.g., environmental impacts) to users and producers. Other tools are designed to reduce the risk of developing new technologies, particularly to private sector investors. Energy policy can be developed to affect the demand for, and/or supply of energy. Interventions can be specific to a particular technology, source, or use, or they can be generic–applying to all energy sources or uses.
Demand side policies are designed to affect the demand for fuel and include energy taxes to encourage consumers to use less fuels or buy more efficient vehicles. On the supply side, numerous approaches are being taken including subsidies, fuel standards, or guarantees (i.e., for loans, purchase quantities, purchase prices, etc.).
Subsidies to encourage the domestic production of fuels can be generic (i.e., a stipulated amount per Btu of energy) or be specified at rates not linked to energy value. Capital subsidies involve support for a portion of the capital cost of building production and/or distribution facilities and infrastructure. Renewable (or alternative) fuel standards (or mandates) are intended to increase domestic production and use of alternative fuels, and can be implemented with or without subsidies. Loan guarantees are used to cover the added risk of developing new technologies and products. Purchase guarantees are used to increase the use of domestically-produced alternative fuels when their cost of production is likely to exceed conventional fuels. A price guarantee can function in a manner similar to a purchase guarantee or it can function more like a variable subsidy.
The different policy instruments work in different ways and consequently affect consumers and producers differently. Following is a discussion of the mechanisms and differential impacts of selected policy instruments. |
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| Flat versus variable tax credits |
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Currently, ethanol production is federally subsidized via a flat tax credit of $0.51/gallon of ethanol blended with gasoline. The subsidy is paid per gallon of ethanol regardless of ethanol prices, input and production costs, energy value, or other market factors and is constant regardless of the price of ethanol or its profitability. Flat subsidies provide large profits to ethanol producers when oil prices are high, but may be insufficient to maintain production when oil prices are low. Additionally, a flat subsidy leads to increasing corn demand as long as oil prices remain high, which causes corn prices to increase substantially (Doering, 2005; Hurt, 2006).
The relationships between crude oil price and break-even corn price based on energy equivalence, energy equivalence plus additive value (assumed to be 35 cents per gallon for this illustration), and energy equivalence plus additive value plus the current federal blending subsidy of 51 cents per gallon (Tyner, 2007) are shown in figure 1. The energy equivalence relationship assumes that ethanol has 70% of the energy value of oil, which is slightly more than the direct energy equivalent. For any given crude oil price, the break-even corn price can be determined under each policy assumption. For example, at crude oil prices of $60/barrel (bbl), the break-even corn price is $4.72/bu when both the additive premium and the fixed federal subsidy are included. This price holds for a new plant (assuming a 12 percent return on equity and 8 percent interest on debt). For existing plants that have already recovered their capital investment, another $0.78/bushel can be added providing a break-even corn price of $5.50/bushel.
An alternative to a flat rate subsidy is a variable subsidy that varies as a function of the crude oil price. Legislation has been introduced to create a variable, rather than flat rate subsidy (Luger, 2006,a,b). A variable rate subsidy can reduce the cost to the federal government while still providing a safety net for ethanol producers.
The design of a variable subsidy depends on two key parameters--the price of crude oil at which the subsidy begins, and the rate of change of the subsidy as crude oil price falls. As an example, assume that the trigger price for the subsidy is a crude oil price of $60/barrel and that for oil prices higher than $60/barrel there is no subsidy, but that a subsidy occurs when oil prices are less than $60/barrel. Assume further that the subsidy increases by $0.025/gallon of ethanol for each dollar that crude oil prices fall below $60/bbl. At a crude oil price of $50/bbl, the ethanol subsidy is $0.25/gallon and at a crude oil price of $40/bbl, the ethanol subsidy is $0.50/gallon, a subsidy that is roughly the same as the current fixed subsidy of $0.51/gallon. Thus, for a crude oil price of less than $40/bbl, under these assumptions, the ethanol subsidy is higher than the current subsidy.
Breakeven corn and crude oil prices under a variable subsidy policy are illustrated in figure 2 (Tyner, 2007). In this example, at crude oil prices of $60/barrel, the break even price for corn is $3.12/bushel compared with $4.72/bushel under a flat rate subsidy. Corn break even prices are $2.90/bushel and $2.69/bushel for new plants at crude oil prices of $50/bbl and $40/bbl respectively. For existing plants that have recovered their capital investment, the corn break even price is $3.47/bushel at a crude oil price of $40/bbl. At a crude oil price of $70/bbl, the corn breakeven price is $3.65/ bushel and there is no ethanol subsidy. Thus a variable subsidy can provide a safety net for ethanol producers without putting inordinate pressure on corn prices.
Under the variable subsidy assumptions in this example, no ethanol subsidy is provided at a crude oil price over $60/barrel, and ethanol plant investment decisions are made based on market forces rather than driven by federal subsidies. At crude oil prices between $40 and $60/bbl, the variable subsidy is less than the fixed subsidy, and provides less incentive to invest in ethanol production and induces less pressure on corn prices, while still maintaining a safety net. With the fixed subsidy, ethanol plant investment decisions continue to be heavily influenced by the government subsidy even at crude oil prices that render ethanol production profitable in the absence of a subsidy.
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| Renewable fuels standard |
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The Energy Policy Act of 2005 includes a Renewable Fuel Standard (RFS) which mandates a minimum amount of renewable fuel that must be used in U.S. automobile fuel consumption. The RFS reaches 7.5 billion gallons by 2012, but given the current rate of expansion of alternative fuel production capacity in the U.S., the quantity is expected to be exceeded by 2007, resulting in a standard that is non-binding. President Bush, in his 2007 State of the Union address, proposed an alternative fuels standard of 35 billion gallons by 2017-a roughly seven-fold increase over current ethanol production. Fuel sources could be renewable fuels, clean coal liquids, or other domestic sources. For iron-clad standards, use is required regardless of market price.
Under fuel standards, changes in cost are typically passed on to the consumer through changes in fuel prices. This differs from subsidies which are paid through the government budget funded by taxes. The extent to which changes in fuel prices are passed on to consumers depends in part on the demand elasticity for fuel (percent change in fuel quantity demanded for a one percent change in the price of the fuel), with a higher percent of the price change passed on to consumers when demand elasticity is low. Current demand elasticity for gasoline is estimated to be very low (-0.03 to -0.08), and is lower than estimates from previous time periods (Hughes, 2006).
The functioning of a alternative (renewable) fuel standard is illustrated in figure 3. Each line represents a cost for alternative fuels. The bottom line is the U.S. Department of Energy target for cellulose ethanol ($47/bbl crude oil equivalent), and the top line represents the estimated DOE costs of producing cellulose ethanol today ($102/bbl crude oil equivalent). The horizontal axis is the price of crude oil and the vertical axis represents the percent change in consumer fuel prices relative to the prices that would occur in the absence of a fuel standard. Under conditions of low alternative fuel prices and/or high crude oil prices, consumers see little or no change in fuel price. With high alternative fuel prices (current state of technology), or low crude oil prices, changes in consumer fuel prices are significantly higher.
One option to limit the consumer exposure to large fuel price increases is to combine a variable subsidy with a fuel standard (figure 4) (Tyner, 2007). In this example, the horizontal axis is crude oil price and the curve is based on an alternative fuel cost of $60. A subsidy is provided only when crude oil prices fall below some predetermined level, say $45/bbl, which is illustrated by the line to the left side of the curve. The variable subsidy limits the price increase consumers see at the pump. This option is a form of risk sharing in that in the event of very low oil prices, the government budget and consumers share the increase in fuel prices.
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| References |
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Doering, Otto, and Hurt, Chris (2005). Competition for Feed Resources from Other Applications; Ethanol and Bio-Diesel. Retrieved December 8, 2006, from http://www.ncsl.org/programs/agri/EthanolBio-Diesel06.htm.
Hughes, Jonathan E.; Knittel, Christopher R., and Sperling, Daniel (2006). "Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand," CSEM Working Paper 159, University of California at Berkeley.
Hurt, Chris; Tyner, Wallace E., and Doering, Otto (2006). Economics of Ethanol. (ID-339). Purdue University Extension, Retreived December 18, 2006 from http://www.ces.purdue.edu/extmedia/ID/ID-339.pdf.
Lugar, Richard G. (2006a). “Lugar Announces Energy Plan,” Senator Lugar's address to the Richard G. Lugar-Purdue University Summit on Energy Security, August 29, 2006. Retrieved December 8, 2006, from http://lugar.senate.gov/energy/ and http://www.purdue.edu/energysummit.
Lugar, Senator Richard G. (2006b). “National Fuels Initiative,” S. 4000 introduced September 29, 2006. Retrieved December 8, 2006, from http://thomas.loc.gov/.
Tyner, Wallace E., (2007). “Biofuels, Energy Security, and Future Policy Alternatives,” paper presented at the USDA Global Conference on Agricultural Biofuels: Research and Economics, August 20-22, 2007.
Tyner, Wallace E., and Taheripour, Farzad (2007). “Future Biofuels Policy Alternatives,” paper presented at the Farm Foundation/USDA conference on Biofuels, Food, and Feed Tradeoffs, April 12-13, 2007, St. Louis, Missouri. http://www.farmfoundation.org/projects/documents/Tynerfuturebiofuelspolicyalternativeswithcover.pdf |
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