Renewable energy policy alternatives for the future.

(1) a subsidy to correct for environmental benefits and (2) a subsidy for more energy security. We can combine these two subsidies to define the following subsidy rates: [S.sub.A] = [[alpha].sub.A] + [beta] and [S.sub.B] = [[alpha].sub.B] + [beta]. With these subsidies, the firms will choose to produce [q.sup.*.sub.A] and [q.sup.*.sub.B]. Now since we assume that [[alpha].sub.B] > [[alpha].sub.A] but both firms have the same marginal national security benefits, the government should consider a higher total subsidy per unit of output for firm B, [S.sub.B] > [S.sub.A]. This implies that a uniform subsidy is not an optimal policy when firms' marginal environmental benefits are not the same. Indeed, producing liquid biofuel from cellulosic materials should be supported at a higher level according to the difference in GHG emissions reductions.

Option 2. Standard

The government can announce [q.sup.*] = [q.sup.*.sub.A] + [q.sup.*.sub.B] as the goal for liquid biofuel production and force it through a penalty system. If the government announces [q.sup.*] for the standard, since firm A has cost advantages, it will produce more than [q.sup.*.sub.A] and firm B will produce less than [q.sup.*.sub.B]. In this case while the government can achieve the goal of [q.sup.*], firms will not produce at the levels which are socially optimal. To achieve [q.sup.*.sub.A] and [q.sup.*.sub.B], the government needs to announce two levels for standards--the total standard must be partitioned between the two sources.

Future Policy Alternatives

In essence, there is an unintended consequence of the fixed ethanol subsidy. When it was created, no one envisioned $60 crude oil, but today $60 oil and higher is a reality, and many believe oil prices are likely to remain high. Given this reality, what future federal policy options could be considered? There are several possible options:

* Make no changes in the current subsidy system, and let the other corn-using sectors (particularly livestock) adjust as needed.

* Keep the subsidy fixed, but reduce it to a level more in line with crude oil prices around $60.

* Convert the subsidy from a fixed subsidy to one that varies with the price of oil.

* Construct a subsidy policy with two components: (1) a national security component (either fixed or variable) tied to energy content of the fuel and (2) a component tied to GHG emissions reductions of the liquid fuel.

* Use an alternative fuel standard instead of subsidies to stimulate growth in production and use of alternative fuels.

* Use a combination of an alternative fuel standard and a variable subsidy.

No Changes

Certainly, one option is to do nothing--to let the other corn-using sectors adjust to higher corn prices. But as shown by the results presented above, that option could lead to substantially higher corn prices than we have seen historically. It certainly would lead to higher costs for the livestock industry (as currently evidenced) and ultimately for consumers of livestock products. It also would lead to reduced corn exports.

The breakeven corn prices shown in figure 2 are maximums that the ethanol industry could pay without sustaining economic losses at different crude oil prices. Whether these corn prices would be reached would depend on the rate of growth of the ethanol industry compared with the rate of growth of corn supply. We can certainly expect to see continued pressure on corn prices if no changes are made in federal policy.

Lower Fixed Subsidy

Since the current pressure on corn prices comes from the combination of $60 oil and the 51 cent per gallon subsidy, one option would be to maintain a fixed subsidy but lower it to a level more in line with the higher oil price. In this case, we will assume 25 cents per gallon. The corn breakeven price for $60 oil becomes $3.90 instead of $4.72 as it is under current policy. However, the fixed subsidy still has the disadvantage of not responding to possible future changes in oil prices. If oil fell to $40, the corn breakeven would be $2.84, and it would be $4.43 for $70 oil.

Variable Subsidy

Both the current fixed subsidy and a variable subsidy are intended to handle the energy security externality described above. In designing a variable subsidy, there are 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. We will illustrate the variable subsidy using $60 crude oil as the point at which the subsidy begins. That is, when crude is higher than $60, there is no subsidy, but some level of subsidy exists for any crude oil price lower than $60. In this illustration, we will use a subsidy change value of 2.5 cents per gallon of ethanol for each dollar crude oil falls below $60. Thus, if crude oil were $50, the subsidy per gallon of ethanol would be 25 cents. If crude oil were $40, the ethanol subsidy would be 50 cents per gallon. Therefore, for any crude oil price above $40, the ethanol subsidy would be lower than the current fixed subsidy. For any crude price less than $40, the subsidy would be greater than the current fixed subsidy.

[FIGURE 3 OMITTED]

Figure 3 illustrates the corn breakeven price for different crude oil prices if this variable subsidy were in effect. In this case, the corn breakeven price at $60 oil for a new ethanol plant would be $3.12 per bushel, compared to $4.72 with the fixed subsidy shown in figure 2. With oil at $50, the corn breakeven would be $2.90 for a new plant with the variable subsidy. An oil price of $40 would support a corn price of $2.69 for a new plant and $3.47 for an existing plant with capital recovered. An oil price of $70 would yield a breakeven corn price of $3.65 with no ethanol subsidy. Thus, the variable subsidy provides a safety net for ethanol producers without exerting inordinate pressure on corn prices.

For any crude oil price above $60, there would be no ethanol subsidy with the variable subsidy; so ethanol plant investment decisions would be made based on market forces alone instead of being driven by the federal subsidy. For any crude price between $40 and $60, the variable subsidy would be less than the current fixed subsidy, providing less incentive to invest and less pressure on corn prices, but maintaining a safety net.

Two-Part Subsidy

The two-part subsidy derives directly from the theoretical model provided above. For this illustration, we construct the national security part of the subsidy based on the energy content of the renewable fuel. Thus, ethanol from corn or cellulose would have the same energy security subsidy since they have the same energy content, but biodiesel would have an energy security subsidy 1.5 times larger since it has 150% of the energy content of ethanol. Similarly, biodiesel would have a larger GHG reduction component than corn ethanol but lower than cellulose ethanol because of the differences in emissions. The GHG component would be invariant with the price of crude oil, but the energy security part could be fixed or variable. In this illustration, we will assume that it is fixed.

Hill et al. (2006) indicate that corn-based ethanol provides a 12.4% reduction in GHG (compared to gasoline), and soy biodiesel provides a 40.5% reduction (compared to diesel). Tilman, Hill, and Lehman (2006) suggest that switchgrass can actually be carbon-negative; that is, more carbon is sequestered than is released in combustion. For cellulose ethanol, they calculate a 275% reduction in [CO.sub.2] emissions relative to gasoline from crude oil. Actual carbon balance depends on the production conditions. For purposes of this illustration, we will assume that cellulosic ethanol yields a 200% GHG reduction. One could envision a GHG component of the subsidy keyed to an index. For simplicity, we will use these three percentage figures for the index values for corn ethanol, soy biodiesel, and cellulose ethanol, respectively.

[FIGURE 4 OMITTED]

For the energy security component, we will key it to energy value--that is, to the energy content of oil displaced. The two-part subsidy is illustrated in figure 4. For this illustration, we keyed the base values for the national security component and GHG component to yield a corn ethanol subsidy roughly equivalent to the current federal ethanol subsidy of 51 cents. The base assumptions are 75 cents for the national security component per gallon of gasoline equivalent and 25 cents per gallon for 100% GHG emissions reduction. (2) The resulting total subsidy values are 53 cents for corn ethanol, 85 cents for soy diesel, and $1.00 for cellulose ethanol. Clearly, these values are merely illustrative to demonstrate that a two-part subsidy encompassing both the national security and GHG emissions externalities would be possible to accomplish.

Alternative Fuel Standard