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Biofuels, Energy Security, and Global Warming Policy Interactions

By Dr. Wallace E. Tyner
Professor, Department of Agricultural Economics, Purdue University

We have with biofuels two kinds of market failures, that economists call externalities.  The first is energy security, and the second is GHG emissions linked to global warming.  While the nation may be paying an energy security cost of up to $3/gal. for liquid fuels, consumers do not pay that cost at the pump.  Markets, in other words, have no way of incorporating the energy security cost into the market transaction.  To correct that market failure, we will focus in this paper on alternative fuel subsidies and fuel standards.  Since our energy security is increased in direct proportion to the extent to which a domestic petroleum alternative displaces petroleum, we will focus on petroleum import displacement in this analysis.

Similarly, there is currently no market mechanism to “price” greenhouse gas (GHG) emission reductions achieved by biofuels.  Thus, if we want to credit biofuels for that reduction, we will need to have a GHG credit incorporated into our subsidy mechanism.  In the rest of this paper, we will discuss and evaluate a set of alternative biofuel policies that could be designed to achieve the energy security objective alone or the energy security and GHG reduction objectives together.

What future federal policy options could be considered that would support the ethanol industry but provide less incentive for rapid growth in the industry leading to abnormally high corn prices?  There are several possible policy alternatives that could be considered:

• Make no changes 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 crude 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.
• Provide higher subsidies for cellulose based ethanol in hopes of accelerating development and implementation of that technology.
• 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

Under the current policy, ethanol producers could still invest profitably in new production with corn price as high as $4.72/bu.  One option is to make no change in current policy.  The other corn using sectors such as livestock production and corn exports would be forced to make the needed adjustments.  Less corn would be used in these sectors, and prices for all livestock products likely would increase.

If government is interested in reducing upward pressure on corn prices, alternatives to the current fixed 51 cent per gallon subsidy could be considered.  One option would be to lower the fixed subsidy.  This alternative would reduce the pressure on corn prices but would still provide ethanol subsidies under higher oil prices when they are not needed. 

A second option would be a variable subsidy that changes with the crude oil price.  The option evaluated in this paper provided no subsidy for crude oil priced above $60, and a subsidy that increased 2.5 cents per gallon for each $1 crude price is below $60.  This option yields a breakeven corn price for $60 oil of $3.12/bu. compared with $4.72/bu under the current policy.

If we want to correct both the energy security and global warming market failures, we can adopt a two-part subsidy that combines credits for energy security with credits for GHG emissions reductions.  That option would provide a greater incentive for cellulose based ethanol.  Other cellulose targeted incentives also could be considered.

Instead of continuing subsidies, another policy path would be to switch entirely to alternative fuel mandates.  The mandate approach takes the cost of stimulating production and use of alternative fuels off the government budget and, instead, puts it directly on the pump price of liquid fuels.  If we want to consider both the energy security and global warming dimensions, then it would be appropriate to partition the standard between corn and cellulose based ethanol.  If the risk of high pump prices in the face of possible low oil prices is deemed unacceptable, another policy alternative would be an alternative fuel mandate combined with a variable subsidy that kicked in at very low oil prices.  In that way, higher pump prices could be avoided if oil prices were quite low.

Much work is needed in delineating the impacts of alternative policy pathways.  This paper attempts to illustrate some of the alternatives that will need to be considered.

More articles by Dr. Tyner:

• Biofuels, Energy Security and Global Warming Policy Interactions
  (paper presented at the National Agricultural Biotechnology Council conference at South Dakota State University, Brookings, South Dakota)
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• What We Know and What We Need to Know on Biofuels, Food and Feed Tradeoffs
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