Difference Engine: End the ethanol tax
The Economist, 25 March 2013
THE uneasy relationship between America’s corn (maize) farmers and its oil refiners is fraying at the edges. The source of the conflict is the amount of corn-derived ethanol which has to be blended into petrol as an oxygenator, to boost the fuel’s octane rating (while also providing a generous off-budget subsidy for corn-growers). The farmers want the amount of ethanol used in petrol to be increased from 10% to 15% of each gallon sold at the pump. The distillers argue that diluting petrol with that amount of ethanol would damage engines and leave them liable to lawsuits from motorists and manufacturers alike.
Ethanol in such quantities can certainly damage engines that are not equipped to handle it—as few are. The problem is that, unlike the hydrocarbons of pure petrol, ethanol has a special affinity for water from the atmosphere. The entrapped moisture can corrode petrol tanks, pumps, fuel lines and injectors. Only 3.6% of vehicles on the road in America are certified to use fuel containing higher blends of ethanol like E15 and E85 (15% and 85% ethanol, respectively).
Moreover, ethanol burned in an engine produces more than twice as much ozone as the equivalent amount of petrol. Ground-level ozone is a big cause of smog. And, while good at boosting a fuel’s octane rating, ethanol packs only two-thirds the energy per gallon of petrol. As a result, motorists get fewer miles per gallon using fuel blended with ethanol than with undiluted petrol. So, even if blended fuel is cheaper per gallon than petrol (thanks to ethanol's subsidies), the overall cost of using it tends to be higher.
The tussle between Big Oil and Big Corn has burst into the open because of the sudden surge in petrol prices—up 12% since the beginning of March. This has happened at a time when oil prices in general have been flat, or even in decline.
The oil refiners claim high pump prices are caused by the cost of complying with the federal mandate to blend an increasing quantity each year of ethanol made from corn into the petrol they make. The American corn lobby says this is nonsense, given that wholesale ethanol trades at 70 cents a gallon (18.5 cents/litre) while petrol costs around $1.45 a gallon to produce. Diluting petrol with heavily subsidised bio-ethanol should therefore reduce, not increase, the cost of fuel at the pump. Sadly, things are not that simple.
Start with the Renewable Fuel Standard (RFS) established by Congress in 2005. This requires all fuel sold in America for transport purposes to contain a minimum volume of alcohol produced from renewable sources. The standard was amended by the Energy Independence and Security Act of 2007. This requires increasing quantities of four different categories of home-grown biofuels to be consumed annually over the following 15 years. Each renewable fuel category in the RFS schedule must emit lower levels of greenhouse gases than the petrol or diesel it replaces.
So far so good. From 2008, the RFS required nine billion gallons of renewable fuel (almost exclusively corn-based ethanol) to be blended into all transport fuel sold in the United States, rising to 36 billion gallons by 2022. The programme is managed by the Environmental Protection Agency (EPA).
This year, the oil and gas industries must purchase 13.8 billion gallons of ethanol produced from domestic corn, increasing to 15 billion gallons by 2015. The amount of corn-based ethanol will then remain fixed at that level for the remainder of the programme. The balance will be made up increasingly of cellulosic biofuels produced from wood, straw, corn stalks, switchgrass and other non-edible plants, along with lesser quantities of advanced renewable biofuels and biomass-based diesel. To monitor compliance, the EPA assigns a 38-digit Renewable Identification Number (RIN) to every gallon of ethanol produced from biological sources.
This is where it gets tricky. Because, back in 2007, the bureaucrats in Washington imagined motorists would go on guzzling gas at an ever-increasing rate, they did not bargain for changes in driving habits. Unbidden, the financial crisis of 2008 plunged the country into its deepest recession in living memory, sending unemployment rates soaring into double digits. In the process, commuting and leisure travel declined dramatically. As luck would have it, though, motorists seeking to downsize their vehicles for better fuel economy were greeted by a new generation of gas-sipping models that had been in the works from before the recession and hurried out for the more austere times.
Through belt-tightening, changes in work habits and smarter cars, American motorists are now using less fuel than they did five years ago. In 2007, they consumed 142 billion gallons of petroleum. By 2011, their annual consumption had fallen to 134 billion gallons.
Those fuel-sipping vehicles are unlikely to be swapped for gas-guzzlers when the economy recovers, as has happened in the past. This time the recovery is unlikely to coincide with a fall in oil prices. The billions of aspiring motorists in China, India and other emerging countries are already affecting the supply-and-demand equation for oil in a significant way—and are likely to keep upward pressure on its price for decades to come.
On top of that, technological change is sweeping the motor industry: the trend to turbo-charging; the abandonment of thirsty vee-eights for efficient four- and six-cylinder engines; the introduction of stop-start technology with electric assist; more hybrid and plug-in electric vehicles with better batteries. These, plus a doubling by 2025 of the CAFE (corporate average fuel-economy) figure, a legal requirement imposed on motor manufacturers, pretty well guarantee that America will be using a whole lot less petroleum in the years ahead.
The consequence is that oil refiners have now hit a “blend wall”. In short, they are required to purchase more corn-based ethanol than they can actually add to their petrol—hence the farmers' desire to see 15% blends made routine. With today's 10% blend, refiners in America need only 13.4 billion gallons of corn-based ethanol this year, but the RFS schedule requires them to take 13.8 billion gallons. Rather than purchase a physical excess of ethanol they do not need, the refiners meet their quotas by buying RIN credits from companies that have used more ethanol than mandated.
But with more and more refiners chasing fewer and fewer RIN credits, the price of credits has soared—up to $1.10 a gallon last week from a few cents six months ago. That, say the refiners, is why pump prices have risen so dramatically. As credits get in even shorter supply, the seasonally adjusted price of petrol in the United States is likely to climb still further.
Naturally, the corn lobby sees it differently. It argues that RIN credits are only a small part of the fuel-production process. “The run-up in credit value only lessens the overall profit that blending puts in the pockets of oil companies,” claimed corn supporters in a half-page advertisement in the Wall Street Journal last week. The corn lobby reckons some oil refiners make a profit of 75 cents on every gallon of petrol they produce.
And so they probably do. But that, too, is partly a result of an unforeseen circumstances—the commercial exploitation of America’s enormous deposits of shale-bound natural gas and oil. Thanks in large part to recent improvements in horizontal drilling and hydraulic fracturing (“fracking”), the country is on route to self-sufficiency. Less than a decade ago, America imported 60% of its crude. Today, the figure is down to 40% and falling fast—as ageing power stations across the country switch from dirty coal or oil to cheaper, cleaner natural gas.
Thanks to its abundance, the price of natural gas has become so low—having tumbled 70% since 2008—that it is now a competitive transport fuel (in compressed or liquefied form) for lorries, buses and delivery vans that previously relied on dirty old diesel. Unlike Europe and elsewhere, diesel is expensive in America because of the way the country's oil crackers are optimised for producing petrol.
From an environmental point of view, this shift is mixed news. Methane (the main constituent of natural gas) produces less carbon dioxide per joule of energy released than other fossil fuels. That is the good news. But the bad news is that methane is itself a greenhouse gas, trapping 20 times more solar radiation than carbon dioxide (though it does not remain in the atmosphere anywhere near as long). If it is handled carelessly and allowed to leak into the atmosphere, much of methane's advantage is lost.
Environmentalists worry that, given the abundance of cheap natural gas, renewable fuels are unlikely ever to become competitive—unless subsidised even more so than today. That could well sour political support for finding innovative ways of making cellulosic biofuels more economic. The 36 billion gallons of ethanol-equivalent biofuels the EPA requires to be produced by 2022 is now almost certainly a lost cause. Few expect cellulosic biofuels to be viable until oil prices (if ever) hit $200 a barrel.
That is a problem for the future. In the meantime, rather than rig things still further, as the farm lobby would like, there is one simple fix the EPA can do to ease matters for motorists. That is to relax (or, better still, abandon) the purchasing schedule for corn-based ethanol. The EPA has the authority to do so. If it refuses, then Congress should act to do so instead. The ethanol mandate is clearly wasteful, does environmental damage, contributes to higher food prices at home and abroad through the misallocation of agricultural resources, and is a needless tax on everyone who drives in America. Time for it to go.