Friday, August 17, 2012

Falling Out of Love with the RFS

Believe it or not, I actually do fun and engaging things at work, so forgive me if posting has been light.

An item of discussion around the office lately has been the current drought in the American Midwest.  This drought is likely to push wholesale prices of corn to levels that have never been seen before in the US. Jim Hilker of Michigan State University has a good overview here. The upshot of this is that there have never been more voices calling for the repeal of the Renewable Fuels Standard (RFS).

As usual, most of the political storm has left people swimming in misconceptions. For one thing, the magnitude of the American drought is often couched in relative terms or in absolute differences. For context, the 2012/2013 corn crop season is still expected by the USDA to be the 8th largest US corn harvest in history, easily beating out those at the start of the last decade. Despite the hit to yields, corn in the US will still be cheaper than almost anywhere else in the world, unrelated sweet corn prices will of course stay decoupled from field corn, and meat price increases may be delayed due to the early slaughter of many livestock herds in anticipation of higher prices. But the drought has now put agricultural and energy policy directly in the public's eyes, for better or for worse.

I figure it's now an appropriate time to ramble on a bit about the RFS, who's challenging it and why, whether or not it's good policy, and what ought to be done about it in the end.

Simply put, the RFS is a mandate for the blending and production of renewable fuels.  In 2007, the original renewable fuels standard was replaced with the new one, the RFS 2, which put in a mandated timetable for the blending of cellulosic ethanol. The RFS is administered by the EPA, but it is not the same thing as the "blend wall," which is a policy that determines the technical limit on the amount of ethanol that can be safely blended into gasoline and not harm a car engine.

The RFS isn't inflexible; credits for different types of ethanol and renewables can be freely traded as so-called renewable identification numbers (RINs), including for cellulosics.

The upshot of the RFS is that in times of falling ethanol production, a minimum is hit so that at some point ethanol producers can be guaranteed to sell their product at whatever reasonable price they offer.  The other part, the cellulosic purchase mandate, is similar except that it specifies the source of ethanol as being an approved, second-generation source.

The voices speaking against the RFS are now legion.  Some of these have been brought on by the recent drought, and others are more perennial critics.

Some of the regulars are predictable. American feedlot owners and meat producers have been speaking against the RFS for years, believing that without it, the high prices and high volatility that have characterized the corn market for the last decade will go away. The AFPM (nee NPRA) and API, both trade organizations for the petrochemical industry, are eager to see the RFS go away, mostly because they would like to sell more fuel (because it's less profitable to export it), though their main political argument is on the cellulosic ethanol mandate and RIN fraud.

Other voices are new, on the environmental left and free-market right, where the specter of the food-fuel substitution debate is rearing its head again.

To start with the food-fuel substitution argument, the latest research in agricultural economics focuses on the yield-price elasticity of corn, noting that (surprise!) US farmers respond to incentives to increase yield in times of high futures prices rather than bringing more land into production, making a large part of the environmental left's claim of indirect land use change from corn ethanol much less potent.  On the other side, the extreme free-market right claims that corn ethanol should be allowed to compete in a "free market" with petrofuels, careful to ignore the greenhouse gas emission externalities (or outright denying them) that might allow a truly level playing field.

Feedlot owners and meat producers may be surprised to know that the fundamentals for corn ethanol are sound enough - as I've blogged about before - and the RFS flexible enough that a waiver of the mandate for this year's drought will only have minor effects on pricing and ethanol production. Apparently, the head of the International Food Policy Research Institute didn't get the message (though calls for an end to Europe's wheat ethanol program are far from misplaced).

Of all of those opposed to the RFS, the AFPM and API have the best arguments.  That is not to say that the industry hasn't been spouting some hyperbole.  The NYT picked up the story of millions in fines for not using cellulosic ethanol without checking some of the facts.  That cellulosic biofuel doesn't now exist is also untrue, given the issuance of the first RINs for cellulosic ethanol earlier this summer.

That being said, the AFPM and API's concerns about that mandate and RIN fraud are both real and potent. It is entirely true that RINs are a flawed system. It's entirely true that the set mandate for cellulosics was poorly designed and smacks, however slightly, of a Soviet-style planned economy. But most of all, what really makes the RFS bad policy is that it's a quantity mandate that isolates an industry from market forces. It's a stealth subsidy, one that not only costs Americans money when the prices of corn and oil go the wrong way but also doomed the industry it spawned to a vicious boom-bust cycle, similar to what went on with the world solar industry in the past 10 years.

And yet, while the RFS is bad policy, I cannot bring myself to support those wishing for its suspension or repeal. The feasible alternative - i.e., the status quo ex ante - is a worse solution in every way.  The RFS has encouraged the growth of an ambiguously beneficial industry and inefficiently allocated vast amounts of wealth to bring about truly renewable biofuels. The RFS has subsidized fuels and, by lowering prices where they needed to be raised, has increased consumption where it needed to be curbed. The RFS has made trade in biofuels flow in the opposite direction that comparative advantage would dictate. But it succeeded in its goal, and the presented alternative is to let the nascent cellulosic biofuels industry collapse. Repealing the RFS without leaving something in its place almost instantaneously sets us back five years in terms of viable, renewable domestic fuels technology, and all the steel is in the ground and millions of gallons of capacity that will come online by year end 2012 will come to naught.

I have long favored a carbon emissions tax as an efficient, market-based solution to encouraging bio-based fuels production. I'm not the only one. In terms of solutions, the ideal one is right in front of us. To take a phrase from some members of Congress, the best philosophy at this point is "repeal and replace." But faced with the political stonewalling of that - in fact any - alternative, I can only reluctantly continue supporting the RFS as the lesser of two evils.

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