Timing of Startups of the Low-Sulfur and RFS Programs

On June 17, 2002, Senator Jeff Bingaman, Chairman of the Senate Committee on Energy and Natural Resources, requested (Appendix A) that the Energy Information Administration (EIA) provide analysis of eight factors related to the Senate-passed fuels provisions of H.R. 4, the Energy Policy Act of 2002. In response, EIA has prepared a series of analyses discussing the market impacts of each of these factors. This analysis addresses factor number 5 of the Senator’s request.

Because of the rapid delivery time requested by Sen. Bingaman, each requested factor related to the Senate-passed bill was analyzed separately, that is, without analyzing the interactions among the various provisions. In addition, assumptions about State actions, such as their implementation and timing of MTBE bans, influence the results. Discussions about some of these interactions have been included in order to explain the interconnected nature of such issues.

EIA’s projections are not statements of what will happen but what might happen, given known technologies, technological and demographic trends, and current laws and regulations. The Annual Energy Outlook 2002 (AEO2002) is used in these analyses to provide a policy-neutral Reference Case that can be used to analyze energy policy initiatives. EIA does not propose, advocate or speculate on future legislative or regulatory changes. Laws and regulations are assumed to remain as currently enacted or in force in the Reference Case; however, the impacts of emerging regulatory changes, when clearly defined, are reflected.

The analyses involve simplified representations of reality because of the complexity of both the issues examined and the environment in which they would occur. Projections are highly dependent on the data, methodologies, and assumptions used to develop them. Because many of the events that shape energy markets (including severe weather, technological breakthroughs, and geopolitical disruptions) are random and cannot be anticipated, energy market projections are subject to significant uncertainty. Further, future developments in technologies, demographics, and resources cannot be foreseen with any degree of certainty. These uncertainties are addressed through analysis of alternative cases in the AEO2002.

Introduction

The Renewable Fuel Standard (RFS) program is proposed to begin in January 2004. Most refineries must comply with the 30 parts per million (ppm) low-sulfur gasoline standards beginning in January 2005, and ultra-low-sulfur diesel fuel beginning in June 2006. In light of the recent implementation of the Mobile Source Air Toxics rule (MSAT) and evolving State MTBE (methyl tertiary-butyl ether) bans, Sen. Bingaman asked EIA if shifting the startup dates of these future fuel programs would improve the potential for a smooth transition from a supply perspective. This question focuses on whether supply problems could be reduced during the startup phases of these programs through timing changes.

Generally, fuel regulatory timing issues fall into three categories:

1) Setting implementation dates within an annual calendar. For example, should the date be set at a time when refiners are making a normal seasonal product change or during a low demand season (e.g., winter for gasoline)? The goal is to try to minimize the potential for supply problems and price surges when new requirements are implemented.

2) Synchronizing a regulatory change that has a logical connection with other regulatory changes affecting product quality requirements. An example is the relationship between potential MTBE bans and a waiver to the oxygenate requirement¹ in reformulated gasoline (RFG). The oxygenate waiver gives refiners more flexibility to meet RFG requirements. When the use of MTBE is restricted, refiners will have to make some significant changes, and providing suppliers with as much flexibility as possible during such changes can help smooth the transition. Thus, even though most MTBE-banned +RFG is expected to be made with ethanol initially, having an oxygenate waiver precede or coincide with MTBE ban dates allows as much supply flexibility as possible to minimize chances of product shortfalls.

3) Allowing an adequate planning and implementation period for large changes, such as large capital investments. There are three dimensions to consider when large changes are involved. First, adequate time must be allowed to promulgate the regulations. The time required in this case will vary with the complexity of the changes required by the legislation. Second, adequate advance notification must be provided to refiners so that they have time to plan and make the necessary investments. Third the timing must not be so short as to strain the construction and engineering sector such that costs become inflated, thereby adding excessive burden to refiners.

This particular issue deals mainly with the last two aspects of timing, synchronization with other regulations and the size of the changes required. The next subsection provides an overview of the main elements of the low-sulfur and RFS regulations needed to understand how timing changes might affect the programs’ start-up success. That is followed by a description of the information and logic used to reach this paper’s conclusions.

Background on Low-sulfur Regulations, RFS, and Related Regulations

As a part of the Clean Air Act Amendments of 1990, the U.S. Environmental Protection Agency (EPA_ finalized Tier 2 standards² for emissions from light duty vehicles in February 2000. Tier 2 requirements represent a reduction in emissions from the Tier 1 standards that had been in place since the 1994 model year for light duty vehicles. The final Tier 2 rule placed tighter emission standards on both vehicles and fuel. Since most light-duty vehicles use gasoline, the Tier 2 standard required that gasoline sulfur content be reduced because sulfur in gasoline affects vehicle control systems (in particular it interferes with catalyst performance) and increases emissions of hydrocarbons and nitrogen oxides. The final rule required that by the beginning of 2005, refiners must produce, on average, gasoline with sulfur levels no greater than 30 ppm. A sulfur averaging, banking, and credit trading program is included to give refiners flexibility in meeting the standards.

The Final Rule on Heavy-Duty Engine and Vehicle Standards and Highway Diesel Fuel Sulfur Control Requirements,³ was designed by EPA as part of a systems approach to reduce emissions from heavy-duty engines and vehicles. The rule requires year 2007 heavy-duty highway engines and vehicles to be equipped with high-efficiency exhaust/emission control systems, which will significantly reduce all emissions. However, the technology would be damaged and made ineffective by high levels of sulfur in the fuel. As a result, the rule includes a requirement for ultra-low-sulfur diesel fuel, which goes into effect on June 1, 2006. The timing requirements for diesel fuel were established to assure adequate ultra-low-sulfur fuel would be available for the model-year-2007 vehicles meeting this rule’s emission requirements.

Currently, on-road diesel fuel is required to contain 500 ppm or less of sulfur. The new Highway Diesel Fuel Sulfur Control Rule requires refiners to produce diesel fuel containing no more than 15 ppm sulfur at retail levels by June 2006, which means refiners must produce a product in the 7-10 ppm range to account for contamination during distribution and for testing tolerances – a level 50 times smaller than current requirements. Not only will production of this very-low-sulfur fuel require significant refinery changes, but also, distribution and storage systems and/or procedures will need to be modified to prevent contamination. At such low sulfur levels, exposure to very little additional sulfur can quickly contaminate an entire batch of product.⁴

The two low-sulfur programs require an enormous set of changes for the industry. A study by the National Petroleum Council (NPC)⁵ pointed out that the low-sulfur fuel changes for gasoline and diesel fuel affect virtually every refinery and many terminals in the United States, and represent a magnitude of change that is larger than anything that has occurred in the industry before. Investment costs provide a measure of the size of the activities that are involved. The NPC study estimated low-sulfur gasoline specifications would require about $8 billion in investments, and EIA’s study on ultra-low-sulfur diesel fuel indicated a cost range for this program to be between $6 and $9 billion.⁶ That means the industry is facing from $14 to $17 billion investment cost for these two programs.

When the studies on refining costs were being performed, the current Renewable Fuel Standard (RFS) was not being considered. Unlike the low-sulfur fuels regulations that stem from the Clean Air Act Amendments of 1990, the RFS is one of the fuels provisions being proposed in H.R. 4. It focuses on encouraging use of non-petroleum-based fuels by requiring an increasing volume of renewable fuel each year, starting at 2.3 billion gallons in 2004. EPA will assign a renewable volume quota to each gasoline supplier, based on the supplier’s gasoline market share, to assure that the target will be met. The first year’s RFS volume requirement should not strain the industry. In 2001, the United States was already using 1.7 billion gallons of ethanol. With the California MTBE ban alone, which will result in ethanol use in California reformulated gasoline, the industry is likely to be at or near the RFS target in 2004. (See discussion on Timing for Startup of the Renewable Fuel Standard.)

The RFS will require investment by ethanol producers and at terminals where ethanol is blended into gasoline. The RFS investments, however, will be far less than those required by the low-sulfur fuel programs, since major refinery changes are not required to implement the RFS. One study estimated that to get to the 2012 RFS target of 5 billion gallons of ethanol use, the refining and marketing industry would have to spend $0.4 billion,⁷ compared to an estimate to implement the two low-sulfur fuel programs of $14 to $17 billion. While the changes required by the RFS may be small in comparison to the low-sulfur programs, adding one more requirement to refiners on top of an already unprecedented investment and construction program to produce low-sulfur fuels raises the question of strain on availability of supply.

The Mobile Source Air Toxics rule (MSAT)⁸, which went into effect in January 2002, caps an individual refinery’s gasoline toxic emissions at its historical level during 19982000. Thus, refineries that were over-complying with Federal fuel emission regulations are not allowed to backslide. This, by itself, is not a problem. But when refiners have to remove MTBE and add ethanol, the ethanol increases total gasoline toxic emissions, and to comply with MSAT, refiners must reduce those toxic emissions. (See Appendix B for a discussion of MSAT and its interaction with MTBE bans.)

The MSAT/MTBE-ban issue is related to the low-sulfur-gasoline program in that both situations involve reduction of toxics in gasoline. Some State MTBE bans are occurring before the Federal low-sulfur-gasoline program is scheduled to be in place for most refineries. The issue of MSAT and MTBE bans, while an important supply issue, does not affect the timing of the Federal low-sulfur gasoline program, but rather suggests States may want to consider delaying their MTBE bans to coincide or occur after the low-sulfur gasoline program is in effect. Synchronizing toxic reduction programs can minimize the potential for cost-inefficient solutions or even temporary supply reductions as refiners try to deal with one program’s toxic implications a year or two before those of the next program. While some refiners might be able to begin compliance with the low-sulfur-gasoline program concurrently with State MTBE bans, not all refiners will be able to implement it ahead of schedule because of the size and complexity of the changes required to meet the Federal program. It would be impractical to move the Federal low-sulfur-gasoline program to an earlier startup date. Thus, the only way to coordinate this program with State MTBE bans would be to delay the latter. Since the timing issue for MSAT/MTBE ban issues rests at the State level, it is not discussed further in this paper, but is covered in the question addressing supply implications of MTBE bans.

Findings

Although every additional requirement on top of an already unprecedented set of requirements increases the potential for transition problems in general, the addition of the RFS to the changes being required by the low-sulfur fuel programs should not create a major problem for refiners. It is likely that the industry will produce the first year’s RFS volume requirements for ethanol as a result of State MTBE bans that are scheduled to begin in 2004. Thus, the industry is likely to comply without major transition problems.

EIA has found no information to suggest that a delay in the low-sulfur gasoline program would ease the startup transition. The key findings of the NPC study in 2000 were that implementing the low-sulfur gasoline program by 2005, while taxing the industry during the peak workload period, could be accomplished. Furthermore, with the low-sulfur gasoline program scheduled to begin 3 years from now, many refiners are already executing their plans to meet the requirements, and, as such, it does not seem advisable to shift this schedule.

The ultra-low-sulfur diesel fuel program, on the other hand, is still problematic for many refiners. The magnitude of the ultra-low-sulfur diesel fuel implementation workload and investments is expected to be large, following the large investments of the low-sulfur gasoline program. The issue is not only affordability on the part of refiners, but also strain on the construction and engineering firms that will make the changes. The NPC study pointed out that the short time between implementation of these two programs would likely result in “construction worker shortages, longer and more costly schedules for both programs, and severe permitting delays.”⁹

Unlike low-sulfur gasoline, refiners generally have a choice when producing distillate fuel.¹⁰ Nearly all refiners must produce gasoline if they are to stay in business, but a refiner does not necessarily have to produce on-road diesel fuel, which is what the ultra-low-sulfur diesel fuel program regulates. Refiners can produce only high-sulfur distillate fuel that is used in home heating, electricity generation and other off-road applications. This would allow some refiners the option of waiting until they can determine how the market and technologies will evolve. EIA’s study¹¹ on this matter showed that the variation in cost to comply with the diesel fuel rule was large among different types of refineries. With widely varying investment costs, one could expect some of the high-cost refiners to delay investing in ultra-low-sulfur diesel fuel production for competitive reasons. Refiners facing very high costs risk losing much more money than lower-cost refiners if technologies change or the market is over-supplied initially. In addition, several large uncertainties remain that could affect refiners’ investment decisions: the requirements for off-road diesel fuel, and further specification changes that may be required for on-road diesel fuel, such as further cetane or aromatics restrictions. If enough refiners postpone production of ultra-low-sulfur diesel fuel, supply could be inadequate at the beginning of the program.

The dilemma is that this regulation has disparate effects on different refiners. As explained in the EIA study on the impacts of changing to ultra-low-sulfur diesel fuel, the magnitude of change that refining companies must make depends on their current feedstocks, configurations, size, and competitive situation. A delay in the timing and/or reduction in the initial magnitude of compliance required could provide some relief to refiners just coming off of a large investment program for low-sulfur gasoline and reduce the potential for a supply shortfall during the transition. The new technologies involved in this program and the magnitude of investments required will be easier for some refiners to deal with than others. Complicating the issue, timing must take into consideration that this regulation was meant to coincide with heavy-duty-vehicle requirements beginning in model-year 2007 and to assure that adequate fuel would be available for these new vehicles.

Conclusion

The question from the Sen. Bingaman was whether changing startup timing for the RFS and low-sulfur fuel programs could ease the transition to these new programs to reduce the potential for supply shortages and price volatility. Because of impending States MTBE bans, the close introduction of the RFS and low-sulfur gasoline programs should not create a large problem. The industry will likely be meeting RFS requirements in 2004 when the RFS program is scheduled to start due to the State MTBE bans, so there does not seem to be a need to shift the relative startup dates between the RFS and the low-sulfur gasoline programs. In fact, ethanol capacity in 2004 is expected to exceed the RFS requirement. With the low-sulfur gasoline program due to begin 3 years from now, many refiners are already executing their plans to meet the program. As such, it does not seem necessary to shift schedules. The program that still may need consideration for altering the timing or startup requirements is the ultra-low-sulfur diesel fuel program. The magnitude of changes required for both the gasoline and diesel fuel programs and the outstanding issues that will affect diesel fuel production plans, such as requirements for off-road diesel fuel, need to be studied to ensure adequate supply during the transition. However, any proposal to change the timing of the ultra-low-sulfur diesel fuel program must take into account synchronization with the heavy-duty vehicle changes required in model year 2007.

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Appendix A: Request Letter from Senator Bingaman & EIA Response
Appendix B: Mobile Source Air Toxic Rule Interaction with MTBE Bans
Appendix C: Ethanol and MTBE Emissions Comparison
Glossary of Terms
Notes and Sources
Contacts