Renewable energy policy alternatives for the future.

In his 2007 State of the Union message, President Bush proposed a relatively large alternative fuel standard of 35 billion gallons by 2017. That is roughly six times current ethanol production. The Senate has passed a similar proposal. A fuel standard works very differently from a subsidy. It says the industry must acquire a certain percentage of its fuel from alternative domestic sources. In the President's proposal, the sources could be renewable fuels, clean coal liquids, or other domestic sources. With a fuel standard that is perceived to be iron-clad, the industry is required to procure these alternative fuels no matter what their cost in the market. Most of the change in cost of the fuels is passed on to consumers either through cheaper or more expensive fuel at the pump. (3) In other words, if crude oil is much cheaper than alternative fuels, consumers would pay more at the pump than they would in the absence of the standard. If it turns out in the future that alternative fuels are less expensive than crude oil, consumers would actually pay less at the pump. Thus, an alternative fuel standard may be viewed as a different form of variable subsidy--one in which consumers pay a different price at the pump than they would without the standard. For either a fixed or variable subsidy, the cost of the incentive is paid through the government budget. For a standard, consumers do not pay through taxes but pay directly at the pump.

[FIGURE 5 OMITTED]

Figure 5 illustrates the impact of an alternative fuel standard. The two lines represent $40 and $60 crude oil. The horizontal axis is the cost of the alternative fuel (unknown at this point), and the vertical axis is the percentage change in consumer fuel cost compared to the no standard case. Clearly in the left side of the graph with low alternative fuel costs, consumers see little or no change in fuel cost. But with high costs of alternative fuels (current state of technology), consumers could see significantly higher pump prices.

[FIGURE 6 OMITTED]

Based on the theoretical model presented above, it would be better to have a partitioned standard than a global standard. That is, given the reality that cellulosic biofuel sources have much more positive GHG impacts than either corn ethanol or biodiesel, any standard would need to be partitioned with a greater share of the biofuel coming from cellulose in order for the standard to achieve both national security and GHG emission reduction objectives. In fact, most of the legislation currently under consideration by Congress does partition the standard in this way.

Alternative Fuel Standard Plus Variable Subsidy

In the event that future crude oil prices fall dramatically, consumers could see significantly higher pump prices than without a standard. One option to limit consumer exposure would be to combine a variable subsidy with a fuel standard. Essentially, there would be no subsidy unless crude oil prices fell below some predetermined level, for example, $45/bbl. Then a variable subsidy would kick in, which would limit the price increase consumers would see at the pump. In a sense, this policy is a form of risk sharing so that in the event of very low oil prices, the government budget would bear part of the burden instead of pump prices absorbing the full impact. This option is illustrated in figure 6. In this case, the horizontal axis is crude oil price, and the curve assumes a $60 alternative fuel cost. The line on the left side that begins at $45 crude illustrates the impact of the variable subsidy combined with the fuel standard.

Conclusion

Clearly, there are many different policy paths we could follow in the development of renewable or alternative fuels. This article illustrates how several of the important alternatives could function. It also shows how a policy designed specifically to internalize the national security and global warming externalities could function. There are many other variants and combinations of these alternatives that could be considered. In addition, if the United States were to adopt a cap and trade climate change policy as has been proposed by the U.S. Climate Action Partnership (2007), the GHG emissions externality would be handled through cap and trade, and the subsidy/fuel standard policies would need to handle only the energy security externality. The priority for our profession is to advance more detailed research on the implications of these various alternatives.

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(1) We could also consider another variant of this model in which [beta] is a decreasing function of oil price. In that way, the model could encompass a variable energy security subsidy as well as the standard fixed subsidy.

(2) For this illustration, a relatively high carbon price of $27.50 was assumed to calculate the GHG credit. Soy diesel and gasoline were assumed to have the same energy level and ethanol two-thirds of that level.

(3) Recent studies of the demand elasticity for gasoline (Hughes et al. 2006) conclude that gasoline demand elasticity is very low (-0.03 to -0.08) and is lower than in previous time periods. With very low-demand elasticity, most of the price change due to supply shifts would be passed on to consumers.

Wallace E. Tyner is a professor and Farzad Taheripour is a postdoctoral fellow in the Department of Agricultural Economics, Purdue University.

This article was presented in a principal paper session at the AAEA annual meeting (Portland, OR, July 2007). The articles in these sessions are not subjected to the journal's standard refereeing process.