Biofuels, Energy Security, and Future Policy Alternatives

Wally TynerPurdue University

Ethanol Economics

• Ethanol has value as energy and as an additive to gasoline– The energy content is about 68% of gasoline– It has value as an octane enhancer since it has

octane of 112 compared with 87 for regular gasoline• The additive value has varied considerable

through time, averaging 25 cents per gallon over the past 7 years – could fall to near zero

Policy History

• The US has subsidized ethanol since 1978 with a subsidy ranging between 40 and 60 cents per gallon.

• The current federal subsidy is 51 cents per gallon, and there are some state subsidies as well.

• The price of crude oil ranged between $10 and $30/bbl. between 1982 and 2003

• With these crude prices, the ethanol subsidy did not put undue pressure on corn prices.

Crude Oil Price History

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10

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Jan-

78

Jan-

80

Jan-

82

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84

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86

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88

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90

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92

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98

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$/bb

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Breakeven Corn and Crude Prices with Ethanol Priced on Energy and Premium Bases

Plus $0.51 Ethanol Subsidy

0.00

10.00

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1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5

Corn ($/bu)

Cru

de ($

/bbl

) Energy basisPrice premium for octane/oxygen = 0.35

With 0.51 fixed subsidy and 0.35 price premium

Corn Use for Ethanol• By the end of this year about 3 bil. bu. of corn will be used

to produce about 8 bil. gal. of ethanol – about 23% of the crop

• It could go to 4 bil. bu. in 2008 – over 30% of the crop• With more corn used for ethanol, we might expect:

– More corn to be produced and higher prices – already here– Less corn to be exported– Somewhat less corn to be fed– Higher price volatility

Future Ethanol Prospects

• I expect that corn ethanol will continue growing a bit, but nothing like the recent past.

• Future prospects depend on the prices of crude and gasoline and ethanol plus the corn price

• Following graphs provide one version of that future based on current capital and operating costs and futures prices for gasoline, ethanol, and corn.

Corn and Ethanol Futures Prices, Aug 10, 2007

$3.33

$4.04

$1.83

$1.68

$3.10

$3.30

$3.50

$3.70

$3.90

$4.10

$4.3007

Sep

07D

ec

08M

ar

08M

ay

08Ju

l

08Se

p

08D

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Source: FCA-ORP from Chicago Board of Trade.

Cor

n $/

bu

$1.50

$1.60

$1.70

$1.80

$1.90

$2.00

$2.10

Etha

nol $

/gal

Corn Futures Price ($/bu)Ethanol Futures Price ($/gal)

Ethanol Prices and Gasoline Futures Price, Aug 10, 2007

$1.79$1.95

$2.07

$1.68

$1.83

$1.31

$1.20$1.32

$1.17$1.00$1.10$1.20$1.30$1.40$1.50$1.60$1.70$1.80$1.90$2.00$2.10$2.20$2.30$2.40$2.50$2.60

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ay

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Source: FCA-ORP based on Daily Futures Prices.

Pric

es, $

/Gal

lon

Unleaded Gasoline Futures Price ($/gal)Ethanol Futures Price ($/gal)67% Energy-Equivalent Ethanol PriceEthanol Futures Price less the Excise Tax Credit

Dry Mill Ethanol Plant: Net Returns per Gallon, (Based on Futures Prices for Corn and Ethanol)

$0.25

-$0.112

-$0.20-$0.15-$0.10-$0.05$0.00$0.05$0.10$0.15$0.20$0.25$0.30$0.35

07Se

p

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ay

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08Se

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Source:FCA-ORP Ethanol Model, prices from Chicago Board of Trade.

$ pe

r Gal

lon

08/03/07 08/10/07

Market Failures and Policy Alternatives

• Both energy security and GHG emissions are examples of situations when markets alone cannot deliver an optimal solution.

• Economists call these externalities, and suggest using taxes, subsidies, or some form of regulation to correct the market failure

• In the U.S., we do not generally use of taxes in this situation, so I will focus on subsidies and renewable fuel standards

Policy Alternatives• Stay the course with current policy• Reduce the fixed subsidy• Variable subsidy• Two part subsidy designed to include energy

security and GHG emission reductions• Special incentives for cellulose ethanol• Alternative fuel standard• Combination of alternative fuel standard and

variable subsidy

Stay with Current Policy• Staying with the current fixed 51 cent per gallon

subsidy would likely result in markets keeping the corn price high and stimulating investment in ethanol until the corn price chokes off profitability

• There would be some food cost increases due to higher corn prices

• Global impacts are very important and quite difficult to estimate

Variable Subsidy• The energy security externality can be handled through

either a fixed or variable subsidy.• A subsidy that varies with the price of crude oil would be

a means of reducing the cost of the government subsidy while still providing a safety net if crude oil prices fall significantly

• The variable subsidy has two parameters:– Crude price at which it begins ($60)– Increase in the subsidy for each $1 crude falls below

that price (2.5 cents/$)

Breakeven Corn and Crude Prices with Ethanol Priced on Energy and Premium Bases

plus Variable Ethanol Subsidy

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10.00

20.00

30.00

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50.00

60.00

70.00

80.00

90.00

100.00

1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5

Corn ($/bu)

Cru

de ($

/bbl

)

Energy basis

Price premium for octane/oxygen

With price premium andvariable subsidy ($60/0.025)

Two-Part Subsidy

• To handle both the energy security and global warming issues, we could have a subsidy that incorporated both

• According to Hill and Tilman, corn ethanol reduces GHG 12.4%, soy biodiesel 40.5%, and cellulose ethanol as much as 275%, depending on production conditions.

Two-Part Subsidy

• Biodiesel contains 1.5 times the energy of ethanol, so it would receive an energy security credit 1.5 times ethanol based on imported oil displaced.

• The next chart illustrates how such a two part subsidy might work with components for each fuel for energy security and GHG reductions

Two Part Bioenergy Subsidy

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1.2

Corn Eth Biodiesel Cell Eth

$/ga

l.

National security GHG Emission red.

Cellulose Ethanol Incentives

• One of the issues with our current system is that investors will continue to prefer corn ethanol over cellulose because cellulose is riskier

• We may need to consider other options for cellulose ethanol at the beginning to stimulate investment:– Investment guarantees or purchase contracts (reverse

auction) – Tax credits to ethanol producers for each ton of cellulose

used to produce ethanol or other liquid fuel

Alternative Fuel Standard• In his State of the Union message, the President

proposed a 35 billion gallon alternative fuel standard by 2017. The Senate passed 36 bil. By 2022:– Current production is about 5.3 billion– Seven fold increase in 10-15 years

• The administration estimates this would replace 15% of projected 2017 gasoline consumption

• With a binding mandate in place, it would no longer be necessary to subsidize alternative fuels

Difference Between a Fuel Standard and a Subsidy

• The fundamental difference between a fuel standard and a subsidy is who pays:– With a subsidy, the taxpayers pay the tax credits received

by fuel blenders – it is part of the government budget– With a fuel standard, consumers see changes in prices at

the pump depending on what the alternative fuel costs relative to gasoline from crude oil

• If we wanted to capture the higher GHG impacts of cellulose ethanol, the standard would need to be partitioned with cellulose receiving a higher proportion

Fuel Cost Change from Fuel Standard

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

20 30 40 50 60 70 80 90 100

Crude Equivalent Alternative Fuel Cost

Fuel

Cos

t % C

hang

e

$40 Crude $60 Crude

Assumes 15% fuel standardand energy equivalent pricing

Combination of Fuel Standard and Variable Subsidy

• An iron-clad fuel standard may be difficult to legislate, yet potential investors need some assurance the standard will hold

• The fuel standard combined with a variable subsidy might be a viable option

Cost of A Fuel Standard with a Variable Subsidy

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

20 30 40 50 60 70 80 90

Crude Oil ($/bbl.)

Fuel

Cos

t % C

hang

e

$60 alternative

Variable subsidy would begin if crude oil fell below $45

Policy Impacts• The current subsidy can lead to very high corn prices –

beneficial to corn farmers but not to livestock producers or consumers

• With this year’s ethanol production at 8 bil. gal., the subsidy will cost $4 bil., but CBO estimated in January that commodity payments will fall $4 bil. in 2007

• The variable subsidy, two-part subsidy, targeted cellulosic subsidies, or alternative fuel mandates are options

• Various combinations of these options could be evaluated

Summing Up• Today’s high oil prices are largely demand driven• Global recession could lead to significant oil price drops• Investments in alternative energy sources are risky in

the face of future potential price falls without policy measures that insure against major price drops

• If we want to reduce dependence on foreign oil, we must develop policy pathways that will lead us towards greater reliance on alternative energy

• The policy choices we make will be critical

Thanks very much!

Questions and Comments

For more information:http://www.ces.purdue.edu/bioenergy

Differences Between Purdue and Iowa State Numbers

• Purdue assumes an additive value of 35 cents; Iowa State assumes zero

• Purdue varies DDGS price with corn price; Iowa State has constant DDGS price

• Purdue uses ethanol yield of 2.65; Iowa State uses 3.0 gal./bu.

• Purdue has higher capital and operating costs than Iowa State