Monday, December 11, 2006

Avoiding Another Milk Market

These days, most conversations about energy security inevitably turn to biofuels, and to ethanol in particular. Unlike hydrogen, ethanol is compatible with essentially every gasoline-powered car on the road today--at least in blends up to 10% ethanol--and with the existing petroleum products distribution system, except for pipelines. It is largely home-grown, and production is expanding at a remarkable rate, building from 1.8 billion gallons in 2001 to nearly 5 billion gallons this year. Ethanol supporters, including members of Congress on both sides of the aisle, expect it to grow at least as much over the next five years. But as ethanol moves out of the small niche that it has filled until recently, we must begin to consider how ethanol will affect the price of motor fuels in the US when it accounts for 20 or 30% of the market, rather than 2%. An article on the milk industry in Sunday's Washington Post provides a cautionary tale for ethanol's future.

Few sectors of the American economy are more heavily regulated than agriculture, and few markets are more distorted by the influence of regulations and subsidies than those for the products of agriculture, and milk is no exception. The Post article details the struggles of a maverick dairy owner who tried to work outside the federal and industry price-support system, lowering prices to consumers in the process. According to the Post, the industry responded by using its influence to promote legislation that brought Mr. Hettinga back into the system, against his will and at considerable expense. Now, we can debate which state of affairs is in the greater long-term interest of consumers, a free market in which people like Mr. Hettinga can innovate and pass along the savings, or one in which supply is carefully managed and prices are effectively controlled to limit competition. Either way, despite the importance of milk in the American diet, the result doesn't change our lives very much. Fuelling our cars is a different story.

For the last three decades, ethanol for cars has been a creature of government regulations and subsidies, and I don't see that changing any time soon. The current boom in ethanol, which has benefited so many farm communities in the Midwest, would be much smaller in extent without the 51-cent per gallon ethanol tax credit, various state incentives, and a web of federal and state renewable fuel standards, which mandate the use of increased percentages of fuels like ethanol.

Setting aside all of the technical issues that have bedeviled ethanol, including its low energy return, constraints on shipping it in pipelines, and an energy energy content at least 20% lower than gasoline by volume, we need to think seriously about the structure of the future ethanol market, and by extension the larger market for motor fuels in this country. One of the public's biggest concerns about gasoline is that they see its production and distribution dominated by a small number of very large oil companies, which they believe control prices to their advantage. Never mind that OPEC, not the majors, manages the price of oil by restricting its supply, or that government intervention, in the form of pervasive environmental regulations and permitting restrictions, has created most of the structural problems that give rise to the public's concerns about gasoline pricing. Perception counts for a lot, and the industry has never dispelled the public's doubts in this area.

In the process of reducing our reliance on the Middle East, a topic to which I will return in the next day or two, we ought to ensure that we don't exchange one controlled market for another. Having the price of gas at the pump set by an approved cartel of large ethanol producers--and don't think that the ethanol business will be anything less than Big Business in the future--won't be any more satisfying for consumers than having it set indirectly by a small group of Middle Eastern and Latin American national oil companies.

How do we prevent such an outcome? It won't be easy, but a good first step would be to announce the gradual phaseout of the ethanol subsidy, say over 10 years, while offering a narrower range of incentives skewed toward small companies, new technologies, and new entrants, rather than large, established ethanol producers. If we're going to pin our energy hopes on ethanol to any larger degree than we already have, then it should have to compete on a level playing field, at least relative to other domestic energy sources.

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