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:

(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.

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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.

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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

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.

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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.

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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.

References

Baumol, W.J., and W.E. Oates. 1988. The Theory of Environmental Policy. Cambridge: Cambridge University Press.

Copulos, M.R. 2003. "America's Achilles Heel: The Hidden Costs of Imported Oil." Alexandria VA: The National Defense Council Foundation, September, pp. 40-53.

--. 2007. "The Hidden Cost of Imported Oil--An Update." The National Defense Council Foundation, 2007, www.ndcf.org, (May 11, 2007).

Goulder, L.H., I.W.H. Parry, R.C. Williams III, and D. Burtraw. 1999. "The Cost-Effectiveness of Alternative Instruments for Environmental Protection in a Second Best Setting." Journal of Public Economics 72:523-54.

Hill, J., E. Nelson, D. Tilman, S. Polasky, and D. Tiffany. 2006. "Environmental, Economic, and Energetic Costs and Benefits of Biodiesel and Ethanol Biofuels." PNAS 103(30):11206-10.

Hughes, J.E., C.R. Knittel, and D. Sperling. 2006. "Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand," Working Paper No. 159, CSEM, University of California at Berkeley.

Parry, W.H. 2002. "Are Tradable Emissions Permits a Good Idea?" Resources for the Future, Issues Brief 02-33.

Tilman, D., J. Hill, and C. Lehman. 2006. "Carbon-Negative Biofuels from Low-Input High-Diversity Grassland Biomass." Science 314:1598-1600.

Tyner, W.E., and F. Taheripour. 2007. "Future Biofuels Policy Alternatives." Paper presented at the Farm Foundation/USDA conference on Biofuels, Food, and Feed Tradeoffs, St. Louis MO, 12-13 April.

U.S. Climate Action Partnership. 2007. "A Call for Action--Consensus Principles and Recommendations from the U.S." Climate Action Partnership, A Business and NGO Partnership, 2007, www.us-cap.org (May 11, 2007).

(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.