CHOICES

CHOICES

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A publication of AAEA

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Ethanol Policy Changes to Ease Pressures in Corn Markets: Could they Work?

Wyatt Thompson, Seth Meyer, Nicholas Kalaitzandonakes, and James Kaufman

The abrupt surge in corn and food prices in 2008 put the U.S. biofuel support policies under increased scrutiny. In the context of an active policy debate, some suggested that allowing more biofuel imports into the United States could soften the impact of ethanol on corn prices. Recent declines in commodity and food prices in the face of an expanding global recession have softened the policy debate. Whether this is a temporary reprieve remains to be seen. Links between biofuel policies and corn markets have been considered elsewhere (Tyner and Taheripour; Collins).

At least two policies are relevant in this context: a) the existing ethanol tariffs, which limit the potential for imported ethanol to displace domestically produced ethanol from corn; and b) the Renewable Fuel Standard (RFS), which leads to certain volumes of corn use as feedstock.

This article considers the potential impacts of policy changes that would allow the ethanol tariff to expire and the RFS mandate to favor feedstocks other than corn. Back-of-the-envelope analysis leads to an expectation of increased imported ethanol, less domestically produced corn ethanol, and thus a lower impact on corn prices—the presumed goal. However, the interaction between commodity markets and policies produce some unintuitive results that suggest the complexity of moderating such price impacts.

U.S. Ethanol Tariffs and Mandates

The current US ethanol specific tariff is a $0.54 per gallon tax on imported ethanol. Domestic ethanol production is also supported through a $0.45 ethanol blenders’ tax credit. The tariff is set, in part, to ensure that the blenders’ tax credits are not transferred to foreign ethanol producers. However, the ethanol tariff has been controversial and some policymakers have suggested that it should not be renewed when it is set to expire at the end of 2010.

The RFS affects the market differently by mandating greater and more diverse biofuel use. The broadest mandate of the RFS requires blenders to use a minimum of 11.1 billion gallons of renewable fuels in 2009, increasing to 36 billion gallons by 2022 (Figure 1A). This increased mandate is not expected to come exclusively from corn ethanol. Other renewable fuels, such as biodiesel, are also required to play a role. Indeed, much of the mandated biofuel use must come, not from corn, but from “advanced” systems. Cellulosic ethanol is considered “advanced” as it can be derived from renewable sources of cellulose, hemicellulose which comprises 20–40% of various agricultural residues, or lignin such as contained in crop residue, grasses, municipal waste, and woody biomass. Focusing on the near future allows us to sidestep the role that cellulosic biofuels might play in the RFS, the feasibility of which has been raised by Khanna. Other “advanced” ethanol systems could also include feedstocks like sugar cane, sugar beets and perhaps even sorghum. The advanced biofuel mandate is part of the overall ethanol mandate. Accordingly, use of advanced biofuels beyond certain levels could displace corn-based ethanol.

Since the type of feedstock used has no bearing on fuel quality or, by extension, on the retail fuel prices paid by consumers, differential production costs would imply different adoption paths for these biofuels in the absence of policy intervention. Forecasts suggest that conventional (i.e. corn) ethanol (CE) will be less costly to produce than “advanced” noncellulosic ethanol (OAE) in the United States which, in turn, would be less costly than cellulosic ethanol. As the RFS is currently understood, it seems likely that ethanol derived from sugar cane (presumably from Brazil) would count towards the advanced biofuel mandate, and in the absence of a tariff might be imported cheaply—perhaps even competitively with CE. Production costs for Brazilian ethanol have tended to be lower than US CE (Shapouri and Salassi). However, it would likely first be used to satisfy the advanced mandate, which is comparatively more costly for the United States to fulfill.

If in any given year the quantities of ethanol used in the U.S. market fell short of their mandated levels, fuel blenders would be compelled to handle more ethanol to meet the mandated limits. To sell more ethanol they would need to lower the retail price in order to make the ethanol blend more attractive to the retailer and the consumer. Lowering the price of ethanol can generate demand by giving consumers incentives to: 1) shift from straight gasoline to an ethanol blend (where the option exists), 2) increase the amount of fuel they are willing to buy, and 3) to buy vehicles that can use higher blends of ethanol (e.g. E85).

The last effect also depends on the pace of infrastructure development, such as retailers installing pumps to distribute higher ethanol blends. We expect consumer willingness to switch among fuels will over time lead to correlation between gasoline and ethanol prices. However, consumption may not shift quickly in response to large differences in prices (if any increase must come by expanding E85 use) or may respond very quickly (if there is substantial room for greater E10 use) (FAPRI-MU 2008b; Meyer and Thompson).

At the same time that blenders lower retail prices to meet a binding mandate, they would effectively bid up the wholesale price of ethanol through increased wholesale demand. The resulting gap in wholesale-to-retail prices represents a cost to blenders of a binding mandate. Further, because of the different RFS mandates for alternative feedstocks, their differential delivery costs including tariffs imply that this price gap may be larger for one fuel than the other at any given point in time.

The Effect of U.S. Ethanol Policy Change on Imports

To consider the impacts of potential changes in the ethanol tariff and the RFS, we use the U.S. model of crops and biofuel markets maintained by the Food and Agricultural Policy Research Institute at the University of Missouri (FAPRI-MU 2008b). This partial equilibrium model covers supply and demand quantities, including area planted, production, other domestic uses, trade, stocks, prices, and policies. It has long been used for policy analysis, and focuses on the mechanisms of federal policy (FAPRI-MU 2008a). Here, the U.S. markets are linked to a model of international markets that includes selected countries active in the production of biofuels or relevant feedstocks and details key cross-commodity and cross-market effects in food, feed and land. The Brazilian ethanol market is explicitly modeled and its structure implies significant substitution between fuels and a delayed but strong Brazilian ethanol supply response.

The analysis starts with the construction of a baseline reflecting current market trends and policies (Figure 1A). The ethanol tariff and tax credit are assumed to remain at their 2010 levels—$0.54 per gallon for the tariff and $0.45 for the tax credit—for the period of the analysis. Maintaining the tax credit will tend to encourage consumption, although it may not affect the quantity used if the mandates are binding. Mandates for cellulosic biofuel use and biodiesel are not shown here, although the biodiesel mandate is imposed on the market. Given the near future focus of the analysis and to isolate the impacts of the policy changes of interest, cellulosic biofuel use is assumed to remain small (less than 200 million gallons in 2012) and the corresponding mandate is assumed to be waived.

From this baseline we change the prevailing policy by increasing the OAE portion of the RFS mandate, effectively lowering the role CE can play without reducing the overall ethanol mandate (Figure 1B).We separately eliminate the import tariff, thereby removing the main barrier to imported OAE. Both policy scenarios start in 2009 and all other policies are held constant or at announced levels.

In addition to changing these policies, we also set crude oil prices at different levels and evaluate their conditioning impact. Rising oil prices should lead to higher gasoline prices, lower relative ethanol prices, and greater consumer demand for ethanol blended fuel. Ultimately this could have a large impact on whether the ethanol mandates are binding or not. We explore four different crude oil price scenarios with the West Texas Intermediate price at $55, $90, $125, and $160 (Figure 2).

Results

We begin by considering the impacts of changes in the RFS. In the base case, before introducing any policy change, consumer demand for ethanol tends to exceed the overall mandated level at least until 2012, if the crude oil price is higher than $90 per barrel. OAE similarly exceeds the required amount, at least through 2012, at all oil prices investigated here.

Against this baseline, we first examine the impacts of an increase in the mandate applied to OAE according to the schedule previously illustrated in Figure 1B. This leads to more OAE imports when ethanol consumption is less than the mandated level, as in the case of $55 oil (Figure 3). At this oil price, all the mandates are binding. An increase in imports to meet the higher OAE requirement then results in an equal reduction in the domestic production as less CE is needed to meet the mandate.

At $90 oil, the higher OAE mandate becomes binding and imports are driven higher. However, the overall mandate becomes nonbinding as more of the mandate is shifted to OAE, so domestic production falls by 0.2 gallon for every gallon of additional OAE imported. At $160 oil, consumer demand is significantly higher than the mandated level as ethanol becomes less expensive than gasoline. Since consumers and not mandates drive demand and imports, the assumed change in policy has a diminished effect.

Next we test the effects of an elimination of the $0.54 tariff in 2009 (Figure 4). The $125 and $160 oil price scenarios generate consumer demand for ethanol in excess of the overall mandate. When this demand is met with less costly ethanol imports there can be a large increase in imports and domestic consumption along with a potential decrease in domestic production. At $160 oil, for example, every additional gallon of OAE imported is associated with 0.2 gallon reduction in domestically produced CE. But here, again, the mandate can play a part in determining the market outcome even though the mandate itself is not changed. If a mandate is binding, as is likely when the oil price is $55, then making imports cheaper affects the decision of whether to import or to produce ethanol domestically, but the total use stays at the mandated level. At this oil price, an additional gallon of imported OAE displaces one gallon of domestically produced CE.

Once again, consumer response to prices matters. At $160 oil, for example, high ethanol demand leads to maximum E10 use but further expansion of ethanol use is tempered by an inherently slower E85 adoption. So a tariff reduction in the context of high oil prices has a smaller effect on the ethanol quantity consumed than if the oil price were $125 and there was still room for expansion in the E10 market.

Overall, the analysis suggests that changes in the mandate and tariff generally result in mild effects on the prevailing U.S. corn prices that tend to be largest when the mandate is binding (Figure 5). The corn price falls by more than $0.10 per bushel for either policy change if the oil price is $55 per barrel. The effect of reorienting the mandate towards, presumably, imported advanced biofuels has no effect on corn prices at a higher oil price because there is no effect on ethanol markets. The import tariff elimination can have an effect at higher oil price scenarios, but the effect tends to be larger when oil price is lower. Whereas imports replace domestic production at a one-for-one rate at low oil prices in either scenario because of the mandate, this is not true at higher oil prices and thus the effect on corn prices fades.

Suggestions Based on Analysis

The analysis presented in this paper suggests that the RFS may not impact corn prices with the magnitude that is often assumed. Further, implementation of policies that would presumably mitigate impacts on corn prices requires careful consideration. For example, increasing a mandate has little effect if it is not binding. Conversely, increasing a binding mandate can have large effects. In general, ethanol mandates are more likely to be binding when oil prices are low than when oil prices are high.

Ethanol tariff changes are similarly context-dependent. Tariff effects on corn markets are modest when mandates are not binding, but larger when mandates exceed prevailing demand. However, changes in the ethanol tariff tend to have a larger effect on U.S. ethanol imports and consumption compared to the changes to the RFS mandate explored here.

Our comparison of these two potential policy changes highlights the sensitivity of the impacts to external conditions, such as the oil price. At a low oil price, both policy changes would tend to increase imports and decrease domestic production, with little net effect on overall use. At a high oil price, the impacts could be quite different, as changes in nonbinding mandates may have no effect, whereas the lower tariff can increase imports and overall use without any large impact on domestic ethanol production.

For More Information

Collins, K. (2008). The Role of Biofuels and Other Factors in Increasing Farm and Food Prices. A Review of Recent Developments with a Focus on Feed Grain Markets and Market Prospects. Keith J. Collins LLC. www.foodbeforefuel.org/files/Role%20of%20Biofuels%206-19-08.pdf . June 19.

Food and Agricultural Policy Research Institute at the University of Missouri (FAPRI-MU). (2008a). Biofuels Impact of Selected Farm Bill Provisions and other Biofuel Policy Options. FAPRI-MU Report #06–08. www.fapri.missouri.edu .

Food and Agricultural Policy Research Institute at the University of Missouri (FAPRI-MU). (2008b). Model of the US Ethanol Market. FAPRI-MU Report #07–08. www.fapri.missouri.edu .

Khanna, M. (2008). Cellulosic Biofuels: Are They Economically Viable and Environmentally Sustainable? Choices, 23(3), 16-21.

Meyer, S., and W. Thompson. (Forthcoming). Demand behavior and commodity price volatility under evolving biofuel markets and policies. In M. Khanna, J. Scheffran, and D. Zilberman (Eds.), Handbook of Bioenergy Economics and Policy. Springer.

Shapouri, H., and M. Salassi. (2006). The Economic Feasibility of Ethanol Production from Sugar in the United States. Washington, DC: U.S. Department of Agriculture, Office of Energy Policy and New Uses and Office of the Chief Economist.

Tyner, W., and F. Taheripour. (2008). Policy Options for Integrated Energy and Agricultural Market, Review of Agricultural Economics, 30(3), 387-396.

Figure 1
Figure 1
Elements of the Biofuel Mandates that Relate to Conventional Ethanol and Other Advanced Ethanol, 20092012
Figure 2
Figure 2
Oil Prices and Assumptions
Figure 3
Figure 3
Effect of Changing RFS Mandate on U.S. Ethanol Production and Imports, 20092012 Average
Figure 4
Figure 4
Effect of Eliminating Tariff on U.S. Ethanol Production and Imports, 20092012 Average
Figure 5
Figure 5
Effect of Policy Options on the Average U.S. Corn Price, 20092012 Average
Wyatt Thompson is (thompsonw@missouri.edu) Assistant Professor, Food and Agricultural Policy Research Institute at the University of Missouri. Seth Meyer (meyerse@missouri.edu) is Research Assistant Professor, Food and Agricultural Policy Research Institute at the University of Missouri. Nicholas Kalaitzandonakes (kalaitzandonakesn@missouri.edu) is Professor and James Kaufman (kaufmanjd@missouri.edu) is Project Director, both at University of Missouri.

This study was funded in part by the Office of Science (BER), U.S. Department of Energy under Grant No. DE-FG02-07ER64504.