An economist looks at the ethanol mandate and still sees subsidies
The long drought will have real consequences for the nation's food and energy markets. But it also creates an opportunity for Washington to take a hard look at the Bush-era mandate known as the Renewable Fuels Standard (RFS), which requires that 10 percent of the gasoline we put in our cars be comprised of ethanol, most of which is made from corn.
Because both sides in the debate over the standard tend to exaggerate, we conducted extensive research into the issue. We conclude that the ethanol mandate has some significant negative consequences and few redeeming features. Even without a drought, the policy is inefficient; with a drought it is much worse. Two economic myths drive support for the ethanol mandate.
Myth 1: Ethanol lowers gas prices by about $1 per gallon.
Research backed by the Renewable Fuels Association (RFA) contends that ethanol reduced gasoline prices by $1.09 in 2011 and $0.89 in 2010, a claim picked up in numerous speeches by Secretary of Agriculture Tom Vilsack. But in a recent research paper, we found such claims to be based on implausible economic assumptions and spurious statistical correlations.
The research underlying the lower gas price claims assumes that oil refiners would earn much greater profits if ethanol production were reduced to zero. The profit margin for oil refiners (known as the crack spread), has never exceeded $0.60 per gallon for more than a few months. The price effects claimed by RFA would require it to jump to $1.40 and remain there indefinitely. Even if the profit margin were to get that large, it would soon decline due to competition from imports and increased production from existing refineries and new entrants into the industry.
In short, the lower-gas-price claim is based on a classic case of spurious correlation. Researchers observed an increase in one variable (ethanol production) and a decrease in another (the price of gasoline divided by the price of crude oil) and assumed that the first caused the second. In a recent paper, we used the same statistical models to estimate the effect of ethanol production on variables that have no connection to ethanol. The result? We could claim that ethanol production "decreases" natural gas prices but "increases" unemployment in both the U.S. and Europe. Or we could imply that ethanol production "increases" the age of each of our children. Obviously, anyone using these models to advocate eliminating ethanol production to end the Great Recession or make children age more slowly would be greeted by extreme skepticism. Similar skepticism should apply to the estimated effect of ethanol on gasoline prices generated from these models.
Myth 2: The federal government no longer subsidizes ethanol production.
On January 1, 2012, many celebrated the expiration of the volumetric ethanol excise tax credit. This federal program had existed in various forms since 1978 and gave $0.45 to ethanol producers for every gallon they produced and had cost taxpayers $6 billion in 2011. But the industry is still receiving a heavy subsidy.
The RFS mandates that a minimum quantity of ethanol be blended into gasoline each year. Under the RFS, about 25 percent of U.S. corn is diverted from the food system to ethanol production. Consumers pay for this mandate through increased corn prices -- this is an indirect subsidy, and a huge one.
The RFS, which was enacted in its current form in 2007, has been the Holy Grail for the ethanol industry. The industry was even willing to let the tax credit expire so as to earn political points in its fight to preserve the RFS. Jon Doggett, vice president of public policy for the National Corn Growers Association, recently said that his members "view the RFS as more important than the farm bill."
In short: The RFS has enriched corn farmers and it has not reduced gasoline prices significantly. Add in other documented drawbacks of ethanol production -- such as the negative environmental consequences of increased agricultural production and the devastating effects of increased food prices for the world's poor -- and we see few benefits but many costs.
Our government should not be picking big agriculture as winners over the environment and the poor. It's time to stop requiring cars to burn food.
Christopher Knittel is the William Barton Rogers Professor of Energy Economics at MIT Sloan School of Management. Aaron Smith is an Associate Professor of Agricultural Economics and the University of California, Davis.