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Weekly UpdatesWorldwide, many governments now require that a minimum percentage of transportation fuels sold consist of biofuels. A recent FAO study concludes that "virtually all existing laws to promote ... biofuels set blending requirements, meaning the percentages of biofuels that should be mixed with conventional fuels" (Jull et al. 2007, p. 21). (1) But along with mandates, biofuel tax credits are also common worldwide. We define a biofuel tax credit as a reduction (or elimination) of the fuel tax charged on sales based on the biofuel content. A recent World Bank study finds that "among various support measures [for biofuels], fuel tax credits are most widely used" (Kojima, Mitchell, and Ward 2007, p. 54). (2) The stated political objectives of biofuel mandates and tax credits are many Among the most prominent are to reduce oil use, local air pollution, traffic congestion, and C[O.sub.2] emissions. As well, biofuel policies are often cited as means to improve farm incomes, reduce the tax costs of farm subsidies, and enhance rural development (Rajagopal and Zilberman 2007).
In the United States, the Energy Independence and Security Act (EISA 2007) established a new renewable fuel standard (RFS) that mandates the use of 36 billion gallons of biofuels annually by 2022. Of this mandate, 15 billion gallons must be corn-based ethanol. The previous RFS implemented in 2005 was never binding due to the combination of high oil prices and biofuel tax credits. State and local governments in the United States also impose mandates. These take several forms including biofuel consumption requirements for government fleet vehicles. (3)
In addition to mandated use of biofuels, the EISA also calls for the continuation of existing biofuel subsidies in the form of federal tax credits. States also provide tax credits for ethanol use at an average rate of 6 cents per gallon (Koplow 2007). The estimated taxpayer cost of these tax credits for 2022 is $28.7 billion. The EISA mandates the use of 15 billion gallons of "conventional biofuels" (corn-based ethanol) and provides a tax credit of 45 cents per gallon of these fuels after January 2009, in addition to the existing state tax credits. The EISA mandate for "cellulosic advanced, noncellulosic advanced," and "biomass-based diesel" totals 21 billion gallons and is to receive a tax credit of $1.00 per gallon.
The purpose of this article is to present a conceptual framework to analyze the economics of a blend mandate and derive the economic implications of combining a tax credit with the blend mandate. Although U.S. legislation calls for a minimum level of annual biofuel consumption (a "consumption mandate"), the mandate is implemented through the use of an annual minimum blending requirement called the renewable fuel standard (RFS), which is the ratio of ethanol to total fuel consumption that each fuel-producing firm must meet. The RFS is enforced by a trading credit scheme administered by the U.S. Environmental Protection Agency (EPA), tying together biofuel producers with refiners, exporters, and blenders of oil-based gasoline. Biofuel producers and importers generate renewable identification numbers (RINs) with each gallon of biofuel they produce. This RIN credit is transferred whenever the biofuel is sold to blenders or refiners. The RIN credit can be used by fuel blenders as evidence of compliance with the RFS. If the blend exceeds the RFS, then they can sell (i.e., trade) their excess RINs to other obligated parties who can now blend biofuels at a rate below the RFS (EPA 2008). (4) The EPA therefore verifies the correct number of RINs for the total quantity of fuel blended.
The government sets the RFS blending requirement every year based on their expectation of total U.S. fuel consumption. If at the end of the year total fuel consumption differs from expectations, the RFS is adjusted for the following year to compensate for the over- or underprediction of total fuel consumption. The RFS, therefore, varies from year to year and is an endogenous function of the government's expected gasoline consumption. Each firm must meet or exceed the blend requirement on each sale unless RINs are purchased from firms willing to exceed the requirement.
Because no taxpayers' monies are involved with mandates, it is commonly assumed that consumers face higher gasoline prices to pay for the higher biofuel prices. We show that this is not always the case with endogenous oil prices. The mandate is shown to have an ambiguous effect on the consumer fuel price, which is calculated as a weighted average of the biofuel and oil-based gasoline or diesel prices. The market price for the biofuel increases with either a tax credit or a mandate by itself. Consumer fuel prices always decline with a tax credit by itself, but can either increase or decrease with a mandate by itself. The direction of the change in consumer prices when implementing a mandate depends on the relative supply elasticities of gasoline/diesel and the biofuel.
We also evaluate the effects of adding a tax credit to a binding blend mandate. While the tax credit in the absence of a mandate acts as a consumption subsidy for biofuels, the tax credit with a mandate becomes a consumption subsidy for fuel--both biofuel and oilbased fuel (gasoline or diesel). Adding a tax credit to a binding mandate, therefore, can offset benefits from reductions in gasoline/diesel consumption due to the mandate alone. As a result, oil prices rise as do C[O.sub.2] emissions, local pollution, and traffic congestion. At the same time little benefit is provided to producers of either the biofuel or the feedstock as biofuels are typically a small share of fuel consumption, resulting in the fuel consumption subsidy having a small impact on the biofuel market compared to a direct ethanol subsidy. In short, adding a tax credit to a binding mandate contradicts the stated goals of biofuel policies. For the same level of biofuel production (i.e., holding farm income constant), the government can achieve energy goals at a substantially lower cost by not using both policy instruments at the same time but relying on a mandate alone.
This article is organized as follows. The next section develops a conceptual model of a biofuel blend mandate. The third section derives the result that an increase in the blend mandate can have an ambiguous impact on the consumer price of fuel. The penultimate section derives the result that a tax credit, when implemented along side a blend mandate, switches from being a consumption subsidy for the biofuel to a consumption subsidy for fuel. The last section provides some concluding remarks.
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A Conceptual Framework to Analyze a Biofuel Mandate (5)
We present a simplified model of biofuel mandates here. Within this simplified model, we assume an exogenous oil-based gasoline price, (6) a single supply of gasoline curve (no distinction between domestic and imported gasoline supply), and no imports of biofuels. A complete exposition of the full theory--allowing for an endogenous oil (gasoline) price--is given in the appendix. To further simplify the analysis, we assume that fuel consists of only two products: ethanol and gasoline. The analysis in this article holds equally well for policies governing biodiesel and oil-based diesel.
Consider a competitive market with a domestic supply curve for ethanol [S.sub.E] and a supply curve for gasoline Sc as in figure 1. The domestic demand for fuel (the ethanol-gasoline mixture) is denoted by [D.sub.F]. Ethanol and gasoline are assumed to be perfect substitutes in consumption, as is arguably the case for blends containing less than 10% of ethanol in conventional engines and for blends containing up to 85% ethanol when used by flex cars. For ease of exposition, the intercept of the ethanol supply curve [S.sub.E] is arbitrarily set to coincide with the price of gasoline within this simplified example.
Consider a mandate where a minimum share of ethanol, [alpha], is required in all fuel sold, with [alpha] [member of] (0, 1). The mandate drives up the price of ethanol relative to equilibrium under no mandate, causing the market prices for ethanol and gasoline to diverge. In equilibrium, consumers must pay the marginal cost to the blender of producing a unit of fuel mixture. This marginal cost is given by the weighted average price of ethanol and gasoline where the weights are formed by the required share of ethanol under the mandate:
(1) [P.sub.F] : [alpha][P.sub.E] + (1 - [alpha])[P.sub.G]
where [P.sub.F] is the weighted average consumer price, [P.sub.E] is the corresponding market supply price of ethanol, and [P.sub.G] is the price of gasoline. This constitutes the marginal cost of the mandated mixture because [P.sub.E] is the marginal cost of ethanol and Pc is the marginal cost of gasoline to the blender. To find the market equilibrium prices [P.sub.E] and [P.sub.F], we must determine the market prices that cause total fuel supply to equal total fuel demand. This requires the derivation of a total fuel supply curve, [S.sub.F]([P.sub.F]), determined by the component supply curves [S.sub.E] and [S.sub.G]. The mandate requires that
(2) [alpha][S.sub.F]([P.sub.F]) = [S.sub.E]([P.sub.E])
and
(3) (1 - [alpha])[S.sub.F]([P.sub.F]) = [S.sub.G].
Because equation (1) implies a one-to-one relationship between [P.sub.E] and [P.sub.F], we can represent the ethanol supply curve [S.sub.E] as a function of [P.sub.F]. Solving for [P.sub.E] from equation (1) and substituting into equation (2) allows for the supply curve for total fuel to thus be written as
(4) [S.sub.F]([P.sub.F]) = 1/[alpha] [S.sub.E] (1/[alpha] [P.sub.F] + (1 - 1/[alpha]) [P.sub.G]) = 1/[alpha] [[??].sub.E]([P.sub.F]).
The equilibrium condition for [P.sub.F] is defined by
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