Blend-wall economics: Relaxing US ethanol regulations can lead to increased use of fossil fuels☆
Introduction
The history of economic theory has revealed many paradoxes or anomalies from Adam Smith’s diamonds and water paradox to winner’s curse in auctions. By offering logical explanations of these anomalies, economic theory is not only interesting to study, but it enriches our understanding of the economic environment and leads to improved policy prescriptions. A recently discovered anomaly is how a relaxation of a US fuel-ethanol regulation, resulting in increased ethanol consumption, could under very plausible conditions also lead to increased petroleum gasoline consumption.
The economic theory underlying this ethanol-regulation anomaly is developed along with associated market consequences. The ethanol-regulation in question is popularly termed the “blend wall,” where regulations currently require no more than 10% ethanol, E10, be used in fueling US conventional, non-flex-fueled, vehicles. Any higher blends, including E85 with 85% ethanol, require a flex-fuel vehicle capable of running on any ethanol/gasoline blend. When the US average ethanol blend approaches or exceeds 10% ethanol, further supply of ethanol will have to be channeled into E85. This is termed the blend wall. The US E85 market is currently limited, with a small number of retailers and flex-fuel vehicles. The popular prediction states as more ethanol is forced into the E85 market, ethanol prices will decline relative to petroleum gasoline. This will place greater pressure on ethanol producers, which is of major concern to this renewable fuels industry.
The approaching blend wall is partially a consequence of infrastructure limitations including transportation equipment and facilities, wholesale distribution systems, and availability of flex-fuel vehicles. The 2007 energy bill along with other legislation provide incentives for dealing with these limitations. However, lacking are policies addressing the potential downward pressure on ethanol prices (Wisner, 2009). Ethanol mandates under the Renewable Fuel Standard (RFS) program do provide a production floor for the ethanol industry leading to long-run industry security.1 However, the current blend wall cap of E10 places the RFS at risk (Nuembery, 2009). As noted in an interview with PhyOrg.com (2009), a prominent bioenergy economist W. Tyner stated, “So the blending wall is perhaps the biggest issue the ethanol industry will face in 2009–10. Without a resolution of this issue, ethanol industry growth is about finished”.
Growth Energy (2009), a US advocacy group promoting ethanol and biofuels, has submitted to the US Environmental Protection Agency, on behalf of 52 US ethanol manufacturers, a request for a “green jobs” waiver allowing an increase in the ethanol blend limit from 10% (E10) up to 15% (E15). Besides improving the environment with enhanced “green” economic development and American jobs, the wavier cites accelerating renewable fuel consumption will increase energy security by lowering transportation costs in the form of reduced vehicle fuel prices and less consumption of foreign petroleum gasoline.
As examined in the following section, the anomaly in this blend-wall waiver is a lowering of vehicle-fuel prices elicits an increase in gasoline demand. As shown under a wide range of elasticities, this demand response can actually increase the consumption of petroleum gasoline and thus lead to greater energy insecurity. The economics supporting this result and associated policy implications are provided in the subsequent sections. As supported by economic theory and discussed below, the long-run objectives of the ethanol industry should be to restrict the demand for conventional vehicles by advocating policies which increase the fuel costs of conventional vehicles relative to flex-fuel vehicles. This will provide strong market incentives for the purchasing of not only intermediate ethanol blended fuels, E10 to E20, but also for higher ethanol blends including E85. In contrast to the blend-wall waiver, such policies will increase the percentage of renewable fuels consumed and lead to greater energy security.
Section snippets
Blend wall economics
The literature on biofuel economics has proliferated with the emergence of biofuel use in both the liquid vehicle fuel and co-power generation markets. Based on this literature, Zhang and Wetzstein (2008) conclude that government incentives and regulations will maintain a bright short-run future for biofuels, while biofuels will contribute, but unlikely dominate our long-run future fuel supply. The current US maize-based ethanol is sustainable at least on economic grounds with present
Conclusions
As the theoretical analysis indicates, relaxing regulations by a positive shift in the blend wall will likely increase the prices for ethanol and E85 and lower the price for Eγ. These price effects are caused by a higher demand for ethanol and increased supply of Eγ and a lower supply of E85. A positive shift in the blend wall drives a larger price wedge between Eγ and E85. This creates a reduced demand for E85 and potentially retards the shift toward flex-fuel vehicles. Making higher ethanol
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Under the RFS each blender has an obligated mandate (quota) for ethanol use. Blenders who are unable to meet their quota will purchase RINs (renewable identification numbers) from blenders who exceed their quota. A RIN is a 38-character code that is attached to a gallon of ethanol. When ethanol is used in blending the RIN is removed and used as an accounting tool for meeting the mandated ethanol quota.