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Renewable Energy Policy Alternatives for the Future
Wallace E. Tyner and Farzad Taheripour1
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 U.S. refinery acquisition cost in nominal terms has
ranged between $10 and $30/bbl between 1978 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 around $60/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
Tyner and Taheripour are Professor and Post-doc, Department of Agricultural
Economics, Purdue University.
2
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 2006-07. 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 percent 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.
3
Without the subsidy, the breakeven corn price would be $3.12. These figures are for a
new plant and include 12 percent return on equity and 8 percent 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 is
currently 20 cents higher than the value assumed here, but this high level is not likely to
persist.
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 the economic
efficiency using tax and subsidy policies (Baumol and Oates 1988). Although tax and
subsidy policies are well-know policy instruments for dealing with externalities, there are
other alternatives such as alternative fuel standards and cap and trade as well (Bamoul
and Oates, 1988; Goulder et al., 1999; Parry, 2002). In this analysis, we consider only
subsidies and renewable fuels standards. In the U.S. today, the major externalities often
mentioned in the context of renewable fuels are national security and the global warming
associated with greenhouse gas (GHG) emissions. The national security externality
derives from the notion that the U.S. 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
4
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) ),( AAAA qxCC =
(2) ),( BBBB qxCC = .
Here CA and CB represent costs for firms A and B; xA and xB are vectors of inputs prices;
and qA and qB represent firms’ outputs. Both firms use primary and intermediate inputs
such as capital, labor, energy, water, and chemicals. In addition, the firm A uses corn, and
the 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: )()( AABB qMCqMC >
for all values of AB qq = . 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 crud oil Po 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
5
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:
(3) iii qE α= for i = A, B and AB αα > ,
(4) ii qN β= for i = A, B.
Here iα and β 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 optimization model for given input prices of
xA and xB:
(5) [ ]∑=
−++=BAi
iiiiiiioqq
qxCqqqPPMaxBA ,,
),()).(( βαπ
The following first-order conditions would determine the optimal production levels in the
presence of external benefits:1
(6) ),()( iiiio qxMCPP =++ βα , for i=A and B.
We denote the potential optimal production levels with *Aq and *
Bq . We consider two
options to achieve these production levels: a subsidy or a renewable fuel standard.
Option 1 – Subsidy
To achieve *Aq and *
Bq the following subsidies should be paid to firms A and B:
(7) iiSE α= , for i=A and B,
6
(8) β=iSN , for i=A and B.
Here SEi and SNi 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: βα += AAS and βα += BBS . With these
subsidies, the firms will chose to produce *Aq and *
Bq . Now since we assume that
AB αα > 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, AB SS > . 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 ***BA qqq += as the goal for liquid biofuel production and
force it through a penalty system. If the government announces *q for the standard, since
firm A has cost advantages, it will produce more than *Aq and firm B will produce less
than *Bq . In this case while the government can achieve the goal of *q , firms will not
produce at the levels which are socially optimal. To achieve *Aq and *
Bq , the government
needs to announce two levels for standards – the total standard must be partitioned
between the two sources.
7
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 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.
8
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
9
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.
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
10
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 CO2 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.
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 percent
11
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 seven 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.
12
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.
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, e.g.,
$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
13
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.
14
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
Copulos, M.R. 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, 523-554.
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):11206-11210.
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.
15
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).
16
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Figure 1. Crude Oil Price History
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0.00
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1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5
Corn ($/bu)
Cru
de
($/b
bl) Energy basis
Price premium for octane/oxygen = 0.35
With 0.51 fixed subsidy and 0.35 price premium
Figure 2. Breakeven corn and crude prices with ethanol priced on energy and
premium bases plus $0.51 ethanol subsidy
18
0.00
10.00
20.00
30.00
40.00
50.00
60.00
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1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5
Corn ($/bu)
Cru
de
($/b
bl)
Energy basis
Price premium for octane/oxygen
With price premium andvariable subsidy ($60/0.025)
Figure 3. Breakeven corn and crude prices with ethanol priced on energy and
premium bases plus variable ethanol subsidy
19
0
0.2
0.4
0.6
0.8
1
1.2
Corn Eth Biodiesel Cell Eth
$/g
al.
National security GHG Emission red.
Figure 4. Two-part bioenergy subsidy
20
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
20 30 40 50 60 70 80 90 100
Crude Equivalent Alternative Fuel Cost
Fu
el C
ost
% C
han
ge
$40 Crude $60 Crude
Assumes 15% fuel standardand energy equivalent pricing
Figure 5. Fuel cost change from fuel standard
21
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
20 30 40 50 60 70 80 90
Crude Oil ($/bbl.)
Fu
el C
ost
% C
han
ge
$60 alternative
Variable subsidy would begin if crude oil fell below $45
Figure 6. Cost of a fuel standard with a variable subsidy
22
Endnotes
1 We could also consider another variant of this model in which ß 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.) 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.