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CARD: Center for Agricultural and Rural Development

Spring 2009, Vol. 15 No. 2

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Intricacies of Meeting the Renewable Fuels Standard

Bruce A. Babcock

Consumption of biofuels is scheduled to ramp up to 36 billion gallons over the next 13 years if the timetable set in the Renewable Fuels Standard (RFS) is to be maintained. To ensure that fuel blenders meet this volume, the Environmental Protection Agency (EPA) uses the market for biofuel RINs (Renewable Identification Numbers) to create a sufficient incentive.

Gasoline producers and importers are assigned a number of RINs that they must give to EPA each year. Because each gallon of biofuels has a RIN associated with it, producers and importers can obtain RINs by buying biofuels and keeping the RINs. Alternatively, they can enter the RIN market and buy the RINs from somebody else. Sellers of RINs are companies who purchase biofuels but who have no obligation to meet an EPA requirement or who purchase more biofuels than they need to fulfill their EPA requirement. The market for RINs works because the demand for RINs increases when the quantity of biofuels purchased is insufficient to meet the RFS. An increased demand for RINs increases the RIN price, which improves the relative attractiveness of buying biofuels instead of RINs. An example shows why.

Suppose that the wholesale price of ethanol is $2.00 per gallon but the wholesale price of gasoline is only $1.50. With these prices, the demand for ethanol would be quite low. However if with every $2.00 gallon of ethanol a buyer obtains a RIN with a value of $0.25 per gallon, then ethanol is more attractive because the net cost of ethanol would be $1.75 per gallon. If the RIN price is $0.75 per gallon, then the demand for $2.00 ethanol would be quite high because the net cost of using ethanol to meet fuel demand would be only $1.25 per gallon. The RIN price will eventually settle at a level at which the demand for ethanol is just great enough to meet the RFS.

Meeting the RFS is more complicated than simply meeting a single RIN target, however. Individual mandates for conventional biofuels, cellulosic biofuels, other advanced biofuels, and biodiesel must all be met. Although the EPA has not issued final rules about how the RFS will be met, it seems plausible that there will be at least four separate RIN markets at work, one for each type of biofuel.

Determining the Price of RINs

The price of a RIN reflects the difference in the market value of a biofuel in meeting fuel demand and the price that is needed to allow biofuel producers to cover the costs of producing the required amount of biofuel. This means that RIN prices will reflect changes in both market values and production costs. Because biofuels substitute for petroleum-based fuels, the price of crude oil will be one factor that determines RIN prices. Higher crude oil prices will lead to lower RIN prices. Feedstock costs should remain the largest and most variable determinant of production costs. Thus, high crude oil prices and low feedstock prices would seem to create a favorable climate for biofuels, which would be reflected in low RIN prices. But a key factor in the determination of future RIN prices is how the U.S. market will value biofuels once U.S. consumption advances beyond about 12 billion gallons, which will happen in the next year or two. This valuation will depend on whether the advanced and cellulosic biofuels mandates are met with ethanol or with some other biofuel such as biocrude.

How to Use 35 Billion Gallons of Ethanol

Suppose non-diesel automotive fuel use in 2022 rises from its current level of 135 billion gallons to 150 billion gallons, of which 35 billion gallons comes from ethanol. If some small portion of the U.S. gasoline supply remains as unblended fuel (say 10 percent), then the fuel supply will consist of 106 billion gallons of E10, 15 billion gallons of gasoline, and 29 billion gallons of E85. This scenario assumes that there are sufficient flex-fuel vehicles in the fleet to use this amount of E85. The prices of these fuels must be such that a sufficient number of flex-fuel vehicles use E85 instead of E10. Because E85 has about 75 percent of the energy value of E10, E85 must have a retail price that is at least 25 percent less than E10. For comparison, Brazilian consumers pay 40% less for 100% ethanol relative to E25, a discount that is greater than the energy difference. The extra discount likely is needed to compensate drivers for the time required to make more frequent stops at the gas station.

Table 1

Consumers choose fuel based on retail prices. Blenders use wholesale prices to determine what fuel blends to use. Retail fuel prices equal the wholesale price plus taxes plus transportation costs plus a profit margin. Of key importance here is the share of the spread between retail and wholesale prices that are accounted for by cents-per-gallon taxes, rather than percentage taxes. The federal gas tax and most state taxes are cents-per-gallon taxes. A reasonable approximation for the spread between wholesale and retail fuel prices is that the retail price equals the wholesale price plus 10 percent plus 40¢. This formula allows for calculation of the wholesale price of ethanol that would be required to make E85 competitive with E10 at the retail level. Table 1 provides the results for crude oil prices ranging from $30 to $90 per barrel. The prices associated with the 25 percent discount will occur if consumers choose E85 at a retail price that reflects only the lower fuel economy of E85. Even with this optimistic assumption, the wholesale price of ethanol relative to gasoline will be discounted by more than its energy content because of the cents-per-gallon gas taxes. A larger retail discount implies an even larger ethanol discount at the wholesale level.

These prices hold even if U.S. policy is changed to allow E20 blends. If 10 percent of fuel will be pure petroleum gasoline and the rest an E20 blend, then a maximum of 27 billion gallons of ethanol could be used in an E20 blend. This implies that the remainder will need to be sold as E85, and the prices in Table 1 remain good estimates of the wholesale ethanol prices that would be needed to induce consumption of 35 billion gallons of ethanol.

Inexpensive crude oil in 2022 implies a wholesale ethanol price of between 39¢ and 56¢ per gallon (depending on the E85 discount needed at retail level) in order to make E85 competitive with blended fuel. Even if oil rises to $90 per barrel (which implies a retail gasoline price of $3.15 per gallon), the required wholesale ethanol price would fall to between $1.22 and $1.57 per gallon.

These prices are well below the levels needed to induce investors to spend the billions of dollars needed to meet the cellulosic biofuels mandate. These prices are not even high enough to induce investors to expand corn ethanol capacity to the RFS target of 15 billion gallons. However, the price outlook for ethanol would be brighter if the advanced and cellulosic biofuels mandates could be met by biofuels other than ethanol.

Alternatives to Ethanol

The economic drawback to using 35 billion gallons of ethanol to meet the RFS is that its lower energy content, combined with the way that we tax automotive fuels, means that the price of ethanol will need to be heavily discounted relative to gasoline to get consumers to choose E85. The situation may change, however, if 15 billion gallons of ethanol are used to meet the conventional biofuels mandate, the EPA allows blend levels to rise to 15 percent (E15), and the advanced biofuels mandate is met by biofuels other than ethanol.

Table 2

If we allocate the 150 billion gallons of fuel use to 15 billion gallons of corn ethanol and 20 billion gallons of other biofuels, then we have 100 billion gallons of E15 and 20 billion gallons of other biofuels, which may be part of the E15 blend or blended with the remaining 30 billion gallons of gasoline. Given the lower energy content of ethanol, fuel economy from E15 relative to gasoline would drop by about 4.8 percent, or 1.45 miles per gallon on a 30-mile-per gallon car. Most likely, not many drivers would even notice a drop of this magnitude. Table 2 shows the wholesale ethanol prices that would be needed to induce drivers to fill up with E15 instead of petroleum gasoline under three different discounts. A zero discount implies that drivers would be indifferent between E15 and E0, perhaps because of higher octane possibilities with E15. The 2.5 percent discount compensates for a small drop in fuel mileage. The 4.8 percent discount assumes that drivers suffer a 4.8 percent drop in miles per gallon and that they recognize the drop. A comparison of the estimates in Table 2 of required ethanol prices with the estimates in Table 1 shows that the worst-case scenario for E15 is equal to the best-case scenario for E85: namely, that ethanol is priced at its energy value at the retail level. For all other scenarios, limiting ethanol to 15 billion gallons and moving to other biofuels substantially increases the market valuation of ethanol.

RINs versus Direct Subsidies

Advocates of biofuels should pay more attention to the problem of closing future gaps between the market value of biofuels and the price needed to justify the large investments that will be required to meet the RFS. As previously discussed, one method of closing the gap created by conventional biofuels is to move away from ethanol and instead meet the advanced biofuels mandates with other types of biofuels, such as biobutanol or biocrude. If the advanced biofuels have higher energy content than ethanol (such as biobutanol) or can more easily be used by the existing vehicle fleet (such as products made from biocrude), then there is some hope that the market value of advanced biofuels could be equal to gasoline.

But a gap between the market value of biofuels and the needs of investors will likely continue to exist because of high feedstock prices or low crude oil prices. Current methods that are used to close the gap include tax credits and the market for RINs. At present, the RIN price reflects the difference between the ethanol price that is required to keep ethanol plants running and the market value of the ethanol plus the 45¢ tax credit for corn ethanol.

If the RIN market is to be used to induce investment in expanded capacity, the RIN price would have to be high enough to cover both the variable costs of producing biofuels and the risk-adjusted costs of capital for new plants as well. The risk adjustment is necessary because investors know the EPA can waive the RFS if the RIN-inflated cost of fuel becomes too high or if existing plant capacity or feedstock availability is inadequate to produce enough biofuels to meet the RFS. Furthermore, the market for RINs seems ill suited for inducing investment in plant capacity because of the time needed for a new plant to come online. Will investors risk their money today hoping that in two or three years the RFS for advanced biofuels will continue to be enforced and the market price of RINs will cover their capital costs as well as their production costs? The risk-adjusted return on capital would need to be very high indeed.

Higher tax credits to induce investment in expanded capacity would be more effective because tax credits are paid for by the U.S. Treasury rather than by fuel consumers. Thus, they are less likely to trigger requests for waivers from the RFS. Congress recognized this and decided to keep the 45¢-per-gallon tax credit for corn ethanol and to pass a new tax credit of $1.01 per gallon for cellulosic biofuels.

The promised ramp-up in the production of cellulosic biofuels will take more than legislation. It will require billions of dollars in private investment. It is doubtful that the required level of private investment will take place without significant involvement of the federal government. Funding for research, direct subsidies in the form of tax credits and loan guarantees, and guarantees of adequate fuel prices at the plant through enforcement of the RFS will all be needed. Supporters of biofuels will have to make the case that biofuels can increase energy independence and reduce greenhouse gas emissions at lower cost than other transportation technologies such as trains and plug-in hybrids. Only then can a strong case be made for an expanded federal role in the biofuels sector.