Building a Market for Biofuels

For the first time in many years I find myself in general agreement with one of the major ethanol trade associations on a key matter of energy policy. Last week Growth Energy, which represents a significant portion of the US ethanol and biofuels industry, announced its support for a phase-out of the federal Volumetric Ethanol Excise Tax Credit, or "blender's credit", in preference to using these funds to provide incentives for constructing the infrastructure needed to offer ethanol at every gas station, and to promote vehicles that can safely burn higher-percentage ethanol blends. This looks like a prudent shift for several reasons, and I hope that the Congress is paying close attention.

No, I haven't suddenly abandoned my aversion to ethanol subsidies that have dragged on for more than three decades and are now long overdue for full retirement, at least for ethanol derived from corn and other food crops. The Congressional Budget Office just released a study on these subsidies showing that when applied to volumes of biofuel equivalent to a gallon of gasoline, the current $0.45 per gallon ethanol blenders' credit equates to $0.73/gal., and the full cost to taxpayers of displacing a gallon of petroleum gasoline with ethanol works out to $1.78/gal. That doesn't count any of the actual production costs of the fuel, either. US ethanol output may thus displace roughly 500,000 barrels per day of imported gasoline (or the imported oil from which to refine it) but it's hardly a bargain. However, I'm also aware that the US has made an enormous policy--and political--commitment to biofuels, including advanced biofuels from cellulosic biomass.

We've done this for reasons that transcend economics. But unless we invest smartly to create a bigger market for these biofuels, the Renewable Fuel Standard will shortly collide with the "blend wall", and US biofuels policy will be stymied. That will happen sooner than might otherwise have been expected, because instead of growing at a steady 1-2% per year as they had prior to the enactment of this policy, US gasoline sales have actually shrunk since then. Trying to cram additional amounts of ethanol into this market--and into cars that weren't designed to use more than 10% of it without damage to engines, fuel systems, and emissions equipment--is a dead end. In order to keep growing, ethanol--including cellulosic ethanol--requires an independent outlet. That's where E85, the 85% ethanol/15% gasoline mix that's as close to straight ethanol as can effectively be delivered to the gas station and used in flex-fuel cars, comes in. So far, though, E85 occupies a tiny niche market mainly in the corn states of the Midwest.

Growth Energy appears to have assessed the longer-term environment for their fuel and reached a similar conclusion: paying refiners to blend ethanol into the shrinking space left in each gallon of ordinary gasoline--which is what the current VEETC does--now makes a lot less sense than helping the nation's 100,000-plus service stations (most independently owned) to adapt their forecourts to deliver a wider mix of products. Promoting flexible fuel vehicles--including wider awareness of which cars are already capable of safely using higher ethanol blends--is also an important element of creating a market for these fuels, though to some degree this is already underway through the government's Corporate Average Fuel Economy regulations and voluntary manufacturer initiatives.

This won't be easy. Growth Energy expresses confidence that ethanol can compete against gasoline without a per-gallon subsidy, as long as it's widely available and most cars are equipped to burn it. However, the industry must somehow overcome the fact that each gallon of pure ethanol contains just 66% of the energy of a gallon of petroleum gasoline. Most drivers don't notice the impact of this when they use gasoline blended with 10% ethanol, but at 85% ethanol and just 15% gasoline, this effect becomes impossible to ignore. Beyond those customers willing to absorb that hit for reasons of perceived patriotism or environmentalism, E85 must ultimately be priced at a discount that reflects the reality that a tank of it won't take you nearly as far.

As of last Friday, ethanol for August delivery traded for $1.61/gal on the Chicago exchange. (That doesn't include freight to market, mainly by rail, which can easily add another dime.) That works out to $2.46 per gasoline-equivalent gallon. Meanwhile Unleaded Regular without ethanol was worth $2.05/gal on the New York exchange (pre-tax.) Nor is this difference anomalous; over the last year wholesale gasoline was consistently cheaper than its energy equivalent in wholesale ethanol, to the tune of roughly $0.90/gal. Unless the ethanol industry figures out how to produce its product at a lower cost, or gasoline prices go up without ethanol prices following, as they did in 2008, then tax credits for distribution and sales infrastructure may not foster as big a market for ethanol as Growth Energy expects, or as profitable a market as I'm sure they'd like. Yet as a matter of policy equity, and from the standpoint of what taxpayers are getting for their money, guaranteeing access for ethanol looks like a better approach than guaranteeing sales, as we do now. It also has the additional benefit of having a logical end-point, instead of the open-ended support we've effectively provided ethanol since 1978.

The current ethanol blenders' credit expires at the end of 2010. The announcement by Growth Energy is even more notable because the Renewable Fuels Association, which represents a larger slice of the industry, has come out in favor of an extension of existing policy through 2015, when the subsidy in question would likely approach $7 billion per year. If this divergence within the ethanol industry is reflected among its supporters in Congress, we could see a surprisingly lively--and fruitful--debate over how best to integrate support for ethanol into a more cohesive national energy framework. Compared to continuing the status quo, Growth Energy's idea of investing to create a mass biofuels market, rather than just paying for space in gasoline, has considerable merit. This approach could also be done for a lot less than the current subsidy, because it wouldn't be necessary to install E85 pumps in every service station in the country. Most of the benefit could be achieved by focusing incentives on strategically-located high-volume outlets, and the rest of the money could go back into the Treasury, where it belongs.