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Analysis

Ethanol Subsidies: Adding Fuel to the Fire?

By Gary Clark and Rachel Ziemba

EXECUTIVE SUMMARY

In the wake of the Republican Party’s capture of the House of Representatives at the midterm elections, U.S. policy toward the use of biofuels for transportation could be about to change. U.S. policy has been based on the use of blender credits to encourage the mixing of biofuels with gasoline, and a tariff levied on imports of ethanol—the most widely used biofuel. These subsidies and the ethanol import tariff are due to expire at the end of this year and (Republican) deficit hawks do not want to see them renewed. This is despite an estimated net (of subsidies) US$2 billion-3 billion generated in tax revenues by the ethanol industry in 2009. The possible repeal of current policy, rather than a number of new initiatives designed to increase demand for biofuels, pose the most immediate source of uncertainty for ethanol production in the U.S. and could drive up prices.

THE ETHANOL MARKET

In 2009, 10.8 billion of the 11 billion gallons of biofuel sold in the U.S. was ethanol, mainly produced from corn. Biodiesel produced from soybean oil made up most of the remainder. Supported by subsidies, almost all of these biofuels were produced domestically with only 2% imported (the majority of which was sugar cane ethanol from Brazil). The U.S. Department of Agriculture (USDA) forecast ethanol production to rise in 2010, with producers expected to consume 37% of the 12.7 million bushels of U.S. corn crop to make approximately 13 billion barrels of ethanol. The ethanol import tariff of 54 cents/gallon, combined with tax breaks for domestic blenders has kept ethanol imports low. Brazil has suspended a tariff on ethanol imports until the end of 2011, after tariffs helped it achieve a 60% global market share of ethanol. Brazilian sugar-based ethanol is much cheaper and more energy efficient than U.S. corn-based ethanol. In the past, U.S. ethanol production surpassed mandated blending quotas, which the Congressional Budget Office (CBO) attributed to tax credits and relative fuel prices. Tougher biofuel requirements, scheduled for coming years, could drive demand for ethanol, absorbing the new supply.

Stronger ethanol prices pose a risk to demand, as higher input prices are passed on to consumers, which might diminish ethanol’s appeal. Although gasoline typically trades at a premium to ethanol (23 cents/gallon in the past three years), ethanol prices regularly surpass oil prices (see Figure 1). From May through to August 2010, the price of ethanol rose above that of gasoline for the first time since December 2009. This price reversal reflected a slowdown in global growth, leading to subdued driving patterns in the U.S. and a buildup in gasoline inventories that, along with depressed oil prices, weighed on gas prices. Later in the period, corn prices rallied following a severe drought in Russia and a ban on corn exports, which along with other weather woes, added to distortions in the grain markets, discouraging refiners from blending ethanol and instead selling corn at higher prices. The terms of the blender tax credit also provided further upward pressure as it discouraged refiners from increasing ethanol production while the price of ethanol was 45 cents/gallon greater than the final fuel price. (See RGE’s Strategy Flash: Commodities: Ethanol/Gasoline Spread Collapses for more on the relative prices of transport fuels.)

Figure 1: Ethanol-Gasoline Spread

Source: Bloomberg

Current Legislation: Fermentation Incentivization

Under Federal mandates, blenders and importers must mix a minimum volume of 12.95 billion gallons of biofuel with gasoline or diesel in the fuels they make. This biofuel quota, set out in 2007 legislation, is scheduled to increase annually, with a minimum of 13.95 billion gallons to be blended in 2011, 22.5 billion gallons in 2016 and 36 billion gallons in 2022. These totals are apportioned between conventional biofuel, which is primarily ethanol produced from corn, and so-called advanced biofuel, which mostly comprises cellulosic ethanol, made from wood, grasses and non-edible parts of plants. Cellulosic ethanol currently forms only a small amount of total production.

Figure 2: Renewable Fuel Volume Requirements

Source: U.S. Environmental Protection Agency

Legislation due to expire at the end of 2010

To further encourage the uptake of biofuels, fuel blenders receive tax breaks in the form of subsidies for every gallon of biofuel they mix with gasoline or diesel. A 54 cents/gallon tariff is also imposed on ethanol imports to restrict low cost imports, such as cheaper sugar cane ethanol from Brazil. Blenders receive different tax credits according to the biofuel they use; the most commonly produced, corn ethanol, has a credit of 45 cents/gallon. While other biofuels receive greater subsidies, they comprise only a tiny fraction of the U.S. market—for instance, biodiesel received US$1/gallon before this provision expired at the end of 2009. Both the biofuel subsidies and the ethanol import tariff are due to expire at the end of 2010 and it will be difficult to pass an extension in the lame duck session of Congress or a retroactive extension, as was secured for 2010.

Recent initiatives

Motivated perhaps by the impending election and tight races in farm belt states, the U.S. administration has recently introduced several new regulations designed to speed up ethanol production and demand. On October 13, the U.S. Environmental Protection Agency (EPA):

  • increased the cap on the amount of ethanol that can be blended with gasoline from 10% (E10) to 15% (E15) for vehicle models from 2007 and later.

On October 21, the Agriculture Secretary Tom Vilsack announced a series of new initiatives intended to boost the biofuel industry. The main points were:

  • providing farmers with 75% of the cost of starting biomass crop production with up to 15 years of further financial help;
  • financial assistance to help retailers install 10,000 “blender” pumps, which can handle ethanol and gasoline mixtures, over the next five years; and
  • a joint program between the USDA and the Federal Aviation Administration to research the production of jet fuel from forest and crop residues and other “green” food stocks.

PLAYING POLITICS: ETHANOL THE LAME DUCK?

When promoting increased domestic production of biofuels for transportation, biofuel advocates cite a triumvirate of good: Reduced dependence on foreign oil; reduced greenhouse gas emissions; and a happy agriculture sector. In addition, proponents of the tax credit argue that in 2009 it contributed to US$8 billion in tax revenue from related industries and directly supported over 110,000 jobs (the subsidies themselves cost the U.S. tax payer US$5 billion-6 billion a year).

Critics of ethanol subsidies, which include various environmental, tax-payer, livestock and food industry groups, argue that subsidies are too expensive, are of little benefit to the environment and do not increase the use of ethanol in transportation. There is some consensus on both sides that things have to change. The ethanol industry itself wants a more “open” market with import tariffs reduced from 56 cents/gallon to 36/cents gallon in 2011, before being eliminated altogether in 2012. At the same time however, they would like a one-year extension of subsidies as a temporary measure before moving to a new four-year subsidy for producers based on their greenhouse gas emissions.

The altered landscape of Congress after the midterm elections (see RGE Critical Issue: U.S. Midterm Elections: GOP Takes House, Democrats Keep Senate), could play a significant role in the future of subsidies and tariffs and the price of ethanol. In a reversal of Bush-era policies, in 2008 John McCain and the Republican Party came out against ethanol mandates; however, it is not clear where Republican consensus on mandates and subsidies lies now. The bill to extend subsidies had bipartisan support in the Senate in early 2010 and Iowa Republican House candidate Brad Zaun flipped-flopped on the issue during the midterms, under pressure from both pro-subsidy farmers and anti-subsidy Tea Partiers.

Meanwhile, the Detroit News claims that there is little support for ethanol subsidies from members of Congress outside of the farm belt. Should deficit hawks dominate proceedings, then any attempt at a renewal of subsidies would likely be blocked. After all, it is uncertain how willing the Republican-led House and the barely Democrat Senate will be to compromise—especially since the Democrats were particularly vulnerable in the farming and industrial states in the Midwest. That said, Iowa Republican Jim Nussle, former White House Office of Management and Budget director under George W. Bush, now heads the pro-subsidy ethanol trade group Growth Energy.

On the flipside, the Democrats seem to favor an extension of ethanol subsidies, at least for another year. Vilsack reportedly asked Congress to approve a “fiscally responsible short-term extension” of ethanol subsidies. The House Ways and Means Committee was in favor of a one-year extension of the subsidy, but with a 20% cut, which would reduce it from 45 cents/gallon to 36 cents/gallon. An extension to ethanol subsidies and tariffs will need to pass both the Senate and House—a biodiesel subsidy expired at the end of 2009 after the Senate failed to pass a bill ratified by the House.

WILL NEW INITIATIVES AFFECT ETHANOL PRICES?

The new ethanol initiatives may not affect prices until H2 2011 as concerns about litigation make garage owners reluctant to sell E15, the 15% ethanol mix. With E10 already on sale and E15 only suitable for car models from 2007 and later, gas station owners will have to clearly demarcate E10 and E15 on their pumps. At present, it is not clear who would be liable should the owner of a pre-2007 vehicle fill up with E15 and damage their engine as a result.

 Secondly, the number of cars affected by the increase in ethanol limits is small. Vehicle models from 2007 and later only comprise a small fraction—18% —of U.S. cars on the road. The U.S. Department of Energy is awaiting test results on car models 2001 to 2006, before mandating E15 for these models too, which would create more of a critical mass, and remove liability risks. Demand for ethanol could rise if the use of E15 is expanded to automobile models from 2001 and later, which encompasses an estimated 60% of U.S. vehicles on the road.

A serious underlying problem in the take up of ethanol for transportation is poor fuel infrastructure. Despite the 100,000 to 170,000 gas stations in the U.S., there are only about 250 blender pumps, according to ethanol industry group Growth Energy—a small proportion of the total. This constrains the use of ethanol in regular vehicles. At between US$2,000 and US$80,000 (in 2005 dollars), the cost of retrofitting a fuelling station to dispense ethanol blends is deemed by some to be prohibitive. In the medium term demand for ethanol should increase as retailers are given help to install 10,000 blender pumps across the U.S. over the next five years. This support, included in Vilsack’s package, should have a greater effect on ethanol demand than subsidies.

So-called flexible fuel vehicles, which take both gasoline and higher concentration ethanol blends—up to 85%—are not affected by the E15 announcement; however, this market would benefit from increased ethanol supply and lower prices. An estimated 8 million flexible fuel vehicles run on U.S. roads, while it only costs US$100 to US$500 to retrofit a regular car (that can take E10 and for some, E15) to take higher concentration ethanol fuels. These vehicles have better access to ethanol than regular automobiles with over 2,300 stations in the U.S. In the medium to long term, helping new biomass producers set up production could help grow the flexible fuel market.

2022: AN ETHANOL ODYSSEY

In the long term, the USDA estimates that domestically produced ethanol and improved fuel efficiency could reduce oil imports by 16-17% by 2022, cutting the U.S. crude oil import bill by US$61 (low oil price scenario: US$80 a barrel) to US$68 billion (high oil price scenario: US$101 a barrel), should the U.S. stick to its current phased-in mandates. There are several obstacles and sources of uncertainty. Ultimately, demand for ethanol blends will be driven by the price of oil and oil products. Although oil is forecast to rise in the long term, supply shocks can easily drive ethanol prices up, and demand destruction can drive oil prices down (see RGE Critical Issues: Oil Prices in the Long-Term: High, Low or Oscillating and Has Oil Production Peaked?). Temporary factors that led to ethanol trading at a premium for five months this year—high corn prices, and low gas prices due to reduced driving—could recur. Upward pressure on ethanol prices could also come from increased competition for agricultural land for growing food—by 2015, biofuels might absorb 50% of the U.S. corn crop—although, a transition to cellulosic ethanol could avert this distortion.

The biggest threat to the ethanol industry would be a cancellation or delay of the graduated mandate to increase ethanol use in fuel blends, a move that was supported by the Republican Party in 2008 since this would unsettle the policy environment, deter retailers from converting distribution mechanisms and change incentives of blenders. The CBO expects the scheduled rise in mandated ethanol volumes to determine the future levels of ethanol production rather than tax subsidies. A continuation of biofuel tax credits would reduce the costs borne by producers and consumers with some of the cost shifting to the U.S. tax payer. Meanwhile, efforts to research “green” jet fuel and help new biomass producers set up production are definitely long-term policies, if they are to have any meaningful effect.

OUTLOOK

With the Republican Party holding a majority in the House, deficit hawks may get the upper hand, allowing existing subsidies to expire as the focus shifts to whether or not to extend the Bush tax cuts. A scenario in which minority Democrats and corn belt Republicans exert pressure to extend lower ethanol subsidies is possible. In the current climate, one in which job creation is a priority, it is highly unlikely that the ethanol import tariff would be dropped, with the prospect of a flood of cheap ethanol imports from Brazil too great. Nevertheless, a discussion on import tariffs would likely include a discussion on subsidies. The mandated annual increase in volume of biofuels to be used for transportation will drive demand for ethanol with or without ethanol subsidies.

The removal of ethanol subsidies would see the cost of lost subsidies passed on to the consumer via an increase in ethanol blended fuel prices—especially at times of high grain prices. A push to allow individual states to opt out of these Federal mandates, or a scrapping of this mandate altogether, could also lead to upward pressure on the price of ethanol if supply falls and the transportation market created for ethanol remains. Finally, new initiatives designed to increase demand (allowing the use of E15 in 2007 and later vehicles, and an increase in the blender pump network) are likely to soak up new supply generated with the help of biomass crop production subsidies. The transportation market for ethanol will not grow if the price of domestic production of ethanol outweighs the price of gasoline.

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