Renewable energy policy alternatives for the future.

The United States has been subsidizing ethanol since 1978. In the last decade, a subsidy has been added for biodiesel. The ethanol subsidy has ranged from 40 to 60 cents per gallon over the entire time period (Tyner and Taheripour 2007). The ethanol subsidy is currently 51 cents per gallon, and the biodiesel subsidy is 50 cents for biodiesel made from recycled materials, such as cooking grease or tallow and $1 per gallon for biodiesel made from oilseed crops, such as soybeans. Over the years, the objectives for biofuel subsidies have included increased farm income, achieving environmental gains (clean burning), increasing national security, and more recently reducing greenhouse gas (GHG) emissions related to global warming. At present, the national security objective seems to be the top priority (Copulos 2003 and 2007).

Crude oil price as measured by the U.S. refinery acquisition cost in nominal terms has ranged between $10 and $30/bbl between 1983 and 2004, except for a couple of short-term spikes (see figure 1). Thus, for most of the period we have had a fixed ethanol subsidy, while the crude oil price has been around $20/bbl. In 2004, the crude oil price began its steep climb to around $70/bbl, and it has been hovering between $60 and $80/bbl in recent months. This rapid increase in the crude price while the ethanol subsidy remained fixed led to a tremendous boom in construction of ethanol plants. Ethanol production in 2005 was about 4 billion gallons, and it will be 8 billion in 2007, and surpass 11 billion in 2008. It has been, then, the combination of high oil prices and a subsidy that was keyed to $20 oil that has led to this boom. The ethanol boom has, in turn, led to a rapid run-up in corn and other commodity prices (soybeans and wheat, in particular) in 2006-7. The run-up in commodity prices has fueled debate over the food-fuel issue and raised questions on the extent to which renewable fuels can be supplied from corn alone.

These debates have also led to discussions of alternative mechanisms for stimulating renewable fuels production. In this article, we examine some other alternatives and their likely consequences. Before progressing to other alternatives, it may be useful to illustrate the impacts of the current policy and its impact on commodity prices. There are three components to the market value of ethanol: energy, additive, and subsidy. It is interesting to portray these values in terms of the relationship between crude oil price and the maximum price a dry mill could afford to pay for corn at each crude oil price. Many assumptions are required to establish these relationships, which are detailed in Tyner and Taheripour (2007). Figure 2 displays the relationships between crude oil and breakeven corn prices on the basis of energy equivalence, energy equivalence plus additive value (the value as an oxygenate is 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. The energy equivalence line is based on the assumption that ethanol has 70% of the energy of gasoline, slightly more than the direct energy equivalence. Using figure 2, we can trace out the breakeven corn price for any given crude oil price. For example, with crude oil at $60/bbl, the breakeven corn price is $4.72/bu including both the additive premium and the fixed federal subsidy. Without the subsidy, the breakeven corn price would be $3.12. These figures are for a new plant and include 12% return on equity and 8% debt interest. If we consider an existing plant with capital already recovered, we add 78 cents per bushel to yield a breakeven corn price of $5.50. It is important to note that additive value has been 20 cents higher than the value assumed here, but this high level is not likely to persist.

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Theoretical Background

Before moving to an analysis of policy alternatives for the future, we provide a theoretical framework for renewable energy subsidies. The economic theory mainly elucidates that in the presence of externalities, the government can restore economic efficiency using tax and subsidy policies (Baumol and Oates 1988). Although tax and subsidy policies are known policy instruments for dealing with externalities, there are other alternatives, such as alternative fuel standards and cap and trade as well (Baumol and Oates 1988; Goulder et al. 1999; Parry 2002). In this analysis, we consider only subsidies and renewable fuels standards. In the United States today, the major externalities often mentioned in the context of renewable fuels are national security and the global warming associated with GHG emissions. The national security externality derives from the notion that the United States is much less secure as a nation being dependent on imported oil for almost two-thirds of our supply, with about half of that coming from sources that are considered to be politically unstable or unreliable. Converting to domestically supplied renewable sources is considered to be an important means of lowering this security cost. The GHG externality related to global warming is linked to renewable fuels because their contribution to GHG emissions is much lower than fossil fuels, especially renewable fuels from cellulosic materials. In developing the theoretical model, we consider these two dimensions.

For the theoretical model, we assume there are two firms that can produce a homogeneous liquid biofuel. The first firm (A) produces liquid biofuel from food crops, such as corn. The second firm (B) produces liquid biofuel from cellulosic materials. We define the following long-run cost functions for these firms:

(1) [C.sub.A] = [C.sub.A]([X.sub.A], [q.sub.A])

(2) [C.sub.B] = [C.sub.B] ([x.sub.B], [q.sub.B]).

Here [C.sub.A] and [C.sub.B] represent costs for firms A and B; [x.sub.A] and [x.sub.B] are vectors of input prices; and [q.sub.A] and [q.sub.B] represent firms' outputs. Both firms use primary and intermediate inputs such as capital, labor, energy, water, and chemicals. In addition, firm A uses corn, and firm B uses cellulosic materials. We assume that the cost structures of these firms are different, and they have different marginal costs (MC), such that: [MC.sub.B] ([q.sub.B]) > [MC.sub.A]([q.sub.A]) for all values of [q.sub.B] = [q.sub.A]. This means that producing liquid fuel from cellulosic materials is more expensive than producing liquid fuel from food crops. Assume that the price of the liquid biofuel P is an increasing function of the price of crude oil [P.sub.o] and that firms are price takers.

Now suppose production of liquid fuel generates two types of social benefits: environmental benefits (E) and national security (N). The environmental benefits can be a reduction in GHG emissions, and the national security benefits can be less dependency on volatile crude oil imports. In addition, assume that firms are homogeneous in their impacts on national security, but they are heterogeneous in terms of environmental benefits. We assume that firm B generates higher marginal environmental benefits than firm A, but both firms have the same marginal national security benefits. To avoid complexity, suppose E and N are linear homogenous functions in variable q. These assumptions imply that:

[E.sub.i] =- [[alpha].sub.i] [q.sub.i] for i = A, B and [[alpha].sub.[beta]] > [[alpha].sub.A] (3)

[N.sub.i] = [beta][q.sub.i] for i = A, B. (4)

Here [[alpha].sub.i] and [beta] denote the environmental and security marginal benefits, respectively. Now assume that the government wants to correct the market failure due to the existence of these external benefits. What are the optimal levels of production for these firms? To answer this question we define the following social optimization model for given input prices of [X.sub.A] and [x.sub.B]:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (5)

-- [C.sub.i]([x.sub.i], [q.sub.i])]

where [w] denotes social welfare.

The following first-order conditions would determine the optimal production levels in the presence of external benefits: (1)

P([P.sub.o]]) + [[alpha].sub.i] + [beta] (6)

= [MC.sub.i]([x.sub.i], [q.sub.i]), for I = A and B.

We denote the potential optimal production levels with [q.sup.*.sub.A] and [q.sup.*.sub.B]. We consider two options to achieve these production levels: a subsidy or a renewable fuel standard.

Option 1. Subsidy

To achieve [q.sup.*.sub.A] and [q.sup.*.sub.B], the following subsidies should be paid to firms A and B:

[SE.sub.i] = [[alpha].sub.i], for i = A and B (7)

[SN.sub.i] = [beta], for i = A and B. (8)

Here [SE.sub.i] and [SN.sub.i] are subsidies per unit of output to correct for environmental and security benefits, respectively. Indeed, in the presence of environmental and security benefits, the government should pay two types of subsidies: