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Commentary: The Redundant Subsidy

(Note: Commentaries do not necessarily represent the Peak Oil Review’s position; they are personal statements and observations by informed commentators.)

Even for staunch proponents of U.S. biofuel policy, it is hard to argue that the current subsidy on grain ethanol serves the purpose it was designed to serve. With ethanol mandates now in place in the form of the Renewable Fuel Standard (RFS), there is a mechanism – with penalties for non-compliance - to ensure that gasoline blenders use the mandated amount of ethanol. Maintaining a subsidy on top of a mandate would be like paying people to obey the speed limit. Such a program would be an inefficient usage of tax dollars, especially considering that some agency would have to administer and audit that program.

Ethanol subsidies have been firmly entrenched in U.S. farm and energy policy for over 30 years. In an effort to spur development of a domestic renewable fuel industry and wean the U.S. off of foreign oil, the government introduced tax credits for ethanol usage with the Energy Tax Act of 1978. The tax credit was an exemption to the Federal Excise Tax on gasoline, and originally amounted to $0.40 for every gallon of ethanol blended into gasoline at the 10% level.

During the 1980’s the subsidies were increased, government-backed-loans were provided to ethanol producers for plant construction, and an import fee was implemented to help protect domestic ethanol producers from cheap imports. Despite these measures, the ethanol industry struggled to make headway. The majority of the ethanol plants that were built in the early 1980’s were out of business by the mid-80’s. However, the plants that were able to stay in business increased production from under 200 million gallons per year in 1980 to 900 million gallons in 1990. Production slowly continued to grow, reaching 1.6 billion gallons by 2000 and 3.9 billion gallons by 2005.

However, there were still two glaring problems for the ethanol industry at that point. First, while ethanol production had ramped up over the years, it still amounted to a tiny fraction of U.S. gasoline demand. As ethanol production expanded by 3 billion gallons/yr from 1990 to 2005, U.S. gasoline demand grew by 30 billion gallons per year – to 140 billion gallons/yr. Petroleum imports grew by 5.7 million barrels per day (87 billion gallons per year). Clearly, if the purpose of U.S. biofuel policy was to reduce dependence on petroleum imports, ethanol was having neglible impact.

The second problem was that ethanol could not compete head-to-head with gasoline on price. The state of Nebraska has tracked gasoline and ethanol prices since 1982, and despite all the financial incentives for ethanol, the average annual price of ethanol had exceeded the price of gasoline in every single year on record through 2005. (See Ethanol and Unleaded Gasoline Average Rack Prices).

Not only was ethanol more expensive on a per gallon basis, it contains only 2/3rds the energy content of gasoline. So, consumers found themselves filling up more frequently when using ethanol blends. The result was that the cost per mile for consumers on the ethanol component of their fuel was often double or even triple the cost of the gasoline component. With low-percentage blends, the impact of the higher cost was diluted such that it was likely not obvious to most consumers. But for gasoline blenders, ethanol at equal to or higher than the cost per gallon of gasoline was not a price that would compel them to buy ethanol.

So the U.S. government decided to force the issue by mandating ethanol use with the Renewable Fuel Standard in the Energy Policy Act of 2005. This mandate started with 4 billion gallons of ethanol in 2006 – just about the amount that was being produced at that time - and initially increased each year to 7.5 billion gallons of ethanol by 2012.

An ethanol gold rush ensued, capacity was overbuilt, and suddenly the industry found itself in deep financial trouble as ethanol supply exceeded the mandates. Again, the government rode to the rescue by increasing the mandates in the Energy Independence and Security Act of 2007. Instead of mandating 7.5 billion gallons of ethanol in the fuel supply by 2010, the new mandate was for 12 billion gallons in 2010 and 15 billion gallons by 2015.

Implementation of the RFS has led to a tripling of ethanol production in just four years, hence it provided ethanol producers the boost they had long desired. The RFS accomplished what decades of subsidies had not. But one thing Congress did not do was eliminate the ethanol subsidy. This begs the question, “With the mandate in place, what is the purpose of the subsidy?”

As many ethanol producers have argued – the gasoline blender and not the ethanol producer receives the subsidy anyway. The gasoline blender – ExxonMobil for instance – buys ethanol for $1.70 per gallon (currently), receives a tax credit worth $0.45 per gallon (the credit was reduced to that level in 2009, but is set to expire at the end of 2010), and then blends it into gasoline that is presently wholesaling at approximately $1.90 per gallon. With the tax credit, the current price of ethanol on an energy equivalent basis to gasoline is just about equal to the $1.90 wholesale price of gasoline. So the tax credit compensates the gasoline blender for blending in a higher cost feedstock.

But what if the tax credit was not there? It wouldn’t matter. ExxonMobil is still mandated to blend a certain amount, and if they fail to do so they are subject to fines by the Environmental Protection Agency (EPA) if they fail to comply with the mandates. Since the EPA can wield a big hammer, companies willingly violate EPA regulations at great corporate risk. Therefore, gasoline blenders will use the amount of ethanol they have been mandated to use, regardless of whether there is a subsidy in place.

So in the event that blenders did not get the tax credit, the energy equivalent price they would pay for ethanol would be about $2.50 per gallon (based on ethanol’s current spot price). The subsidy amounted to about $5 billion last year, and continues to rise with increasing ethanol production. Assuming the oil companies passed on the additional costs, that $5 billion spread over 140 billion gallons of gasoline sold in the U.S. last year would increase fuel costs by just 3.5 cents a gallon. The only difference would be that the cost would then be borne directly by drivers in proportion to the number of miles they drive.

Further, elimination of the administration of the subsidy would net two additional benefits. First, there would be some efficiency and cost savings as the government got out of the business of administering the program and processing payments for gasoline blenders for the ethanol they use. (The program currently involves assigning a serial number to every gallon of ethanol produced in the U.S., and then tracking those gallons through the system).

Second, because of the slight rise in fuel prices (which should be more than compensated for by the savings from eliminating the subsidy), a small amount of fuel conservation may result. This would have the benefit of actually having some small impact on our petroleum imports.

On what grounds might the ethanol industry oppose eliminating the VEETC? A reporter from the Midwest that I regularly correspond with summed it. He suggested that the ethanol industry is terrified that if the tax credit is not extended when it expires at the end of this year, ethanol prices will collapse, and producers will be in the same dire straits as the biodiesel industry after their tax credit expired.

If that is really the case - that the ethanol industry is only being enabled by a combination of subsidies and mandates - isn't this then just one big charade? Also, if that is what the ethanol industry believes, then that is a direct admission that ethanol prices are driving the cost of fuel up - not down as they so often claim. After all, if the tax credit is propping up the price of ethanol, blenders are paying more for it than they should be, which means higher prices at the pump.

With the RFS in place none of the usual arguments for maintaining the subsidy apply. The worn argument that “oil companies get subsidies, and therefore so should ethanol producers” is irrelevant. With the mandate, the ethanol company isn’t competing with the oil company, because the oil company has to buy the product. The ethanol company is essentially competing against other ethanol companies for the blender’s business. So let’s eliminate this redundant subsidy, put the burden of our biofuel policy where it belongs, and save a few tax dollars in the process.

Robert Rapier, with a Masters in Chemical Engineering, is presently employed as the Chief Technology Officer for Merica International, a renewable energy holding company. At various times, he has worked on cellulosic ethanol, butanol production, natural gas production, oil refining, and gas-to-liquids. His articles often appear on The Oil Drum and R-Squared Energy Blog.

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