Understanding the Market and Welfare Impacts of Biofuel and Energy Policies *

1. Understanding the Market and Welfare Impacts of Biofuel and Energy Policies * GianCarlo Moschini Professor and Chair Department of Economics Iowa State University Presentation prepared for the workshop on “Strategic Directions in Social, Legal and Environmental Dimensions of Research on Biofuels,” Energy Biosciences Institute, University of California Berkeley/University of Illinois, Champaign, IL, September 25-26, 2010. * This presentation is based on the following papers from an ongoing collaborative research project: Lapan, H. and G. Moschini, “Biofuel Policies and Welfare: Is the Stick of Mandates Better than the Carrot of Subsidies?” Working Paper No. 09010, Dept of Economics, Iowa State University, June 2009. Cui, J., H. Lapan, G. Moschini and J. Cooper, “Welfare Impacts of Alternative Bioefuel and Energy Policies,” Working Paper No. 10016, Dept of Economics, Iowa State University, June 2010. Moschini, Biofuel Policies & Welfare, Champaign, IL

2. Biofuels: The Driving Role of Policies • US ethanol production: 1.65 (2000)  10.76 billion gallons (2009) • Key federal policy instruments for ethanol: • blender tax credit $0.45/gal (a production “subsidy”) — and a $0.54/gal import duty (secondary tariff) + 2.5% ad valorem tariff • Renewable Fuel Standard (a production “mandate”) — dramatically enhanced by 2007 EISA (Energy Independence and Security Act): 9 bg for 2008 to rise to 36 bg by 2022 — corn ethanol portion: 9 bg in 2008, 10.5 in 2009  15 bg in 2015 • The United States is now the largest world producer of ethanol • • surpassed Brazil in 2006

3. Why Biofuel Policies? • Dwindling supplies of fossil fuels • • quest for renewable sources of energy • • national security concerns • Environmental impacts of carbon emissions • • global climate change concerns • • but: indirect land use change effects • To increase demand for farm output to support farm incomes • • countering the effects of increasing agricultural productivity • How do these motivations/objectives compare with the assessed • impacts?

4. Emerging Body of Literature • Many contributions, including: • Rajagopal and Zilberman, World Bank, 2007 -- review • Elobeidand Tokgoz, AJAE 2008 -- FAPRI models • Hertel, Tyner and Birur, 2008 -- GTAP models • Khanna, Ando and Taheripour, RAE 2008 • Holland, Hughes and Knittel, AEJ-EP 2009 • de Gorter and Just, AJAE 2009a and AJAE 2009b • Lapan and Moschini, Iowa State University WP 2009 • Cui, Lapan, Moschini and Cooper, Iowa State University WP 2010 • much more . . .

5. This Presentation • Derivation of an explicit multimarket equilibrium model • energy sector • agricultural sector • domestic and foreign components • market failures and scope for government intervention • policy instruments: taxes/subsidies and biofuel mandates • Emphasis is on the theoretical construction of a model suitable for • second-best policy evaluation • calibration and simulation • Model provides analytical insights and a potentially useful • quantitative assessment of alternative policies

6. The Model’s Structure Corn ethanol unblended gasoline fuel food & feed petroleum byproducts petroleum byproducts export demand GHGs foreign oil domestic oil

7. Demand • (Quasilinear) utility of domestic consumption: • Domestic (inverse) demand fns: — direct demand functions: … , • Externality effect : carbon emissions from gasoline and ethanol use • — parameter allows for differential impact on GHGs • Foreign sector — demand fn for corn: • — supply fn of oil:

8. Production Sector • Convex aggregate cost function for US corn: • • upward-sloping supply fn for US corn:  • Convex aggregate cost function for US oil: • • upward-sloping supply fn for US oil:  • If no other distortions in the model, in the laissez faire equilibrium: • world price = domestic price = marginal production cost of corn • • marginal utility of domestic corn consumption = price of corn • world price = domestic price = marginal production cost of oil • marginal utility of domestic fuel consumption = retail price of fuel • Production of gasoline&ethanol: more structure is useful …

9. Production of Ethanol and Gasoline ( Fuel) • Ethanol: … account for by-products … account for energy content • Gasoline: + petroleum byproducts: • Blended “Fuel”: … or, in GEEG units: “Gasoline Energy Equivalent Gallons”

10. Policy Instruments and Welfare: First and Second Best • Maximization of (domestic) welfare requires three policy instruments: • — an import tax on oil — an export tax on corn — a tax on pollution emissions WTO constraints; US law political feasibility ? • First-best solution: carbon tax, oil import tariff, corn export tax • Second-best solution: consumption tax on fuel and subsidy on ethanol • (or: tax on fuel and production mandate for ethanol) • Restricted second best: only one “active” policy instrument: • — subsidy on ethanol; or, production mandate • Standard benchmarks: laissez faire(and, also, status quo)

11. Competitive Equilibrium . . . . . . Corn Market Equilibrium . . . . . . Fuel Market Equilibrium . . . . . . . . Petroleum Byproduct Equilibrium . . . . . . . . Zero Profit Condition Oil Refining CRTS . . . . . . . . . . . . Zero Profit Condition Ethanol Industry . . . . . . . . . . . . Oil Import Arbitrage Relation . . . . . . . . . . . . Corn Export Arbitrage Relation • Solve for: and • Laissez faire:  and 11

12. Equilibrium with Fuel Tax and Ethanol Subsidy • Need to modify arbitrage relations: • tax on fuel • subsidy • ethanol energy efficiency • Currently, and • • note: because the tax is levied on volume terms, it is biased against • ethanol (because of its lower energy content, ) 12

13. Equilibrium with an Ethanol Mandate • Quantity of ethanol is exogenously set and binding: • Relevant arbitrage relation: zero-profit condition in blending industry • price of fuel is a weighted average of its components, with the amount of ethanol exogenously given ethanol total fuel gasoline where is the net subsidy to ethanol (relative to gasoline) Result (Lapan and Moschini 2009): An ethanol mandate, per se, is equivalent to a combination of an ethanol blending subsidy and a fuel tax that are revenue neutral. 13

14. Welfare Maximization and Policy Analysis endowment of numeraire cost of domestic production net imports disutility of pollution (externality) utility of consumption • Totally differentiate welfare function, use relevant arbitrage relations, can • solve for optimal level of policy instruments under a number of scenarios . . . • Calibration of the model uses linear demand and supply functions and: • • assume an elasticity value for each function • • choose a benchmark (observed) price-quantity data point (year 2009)

15. Welfare Maximization: First- and Second-Best Solutions • First best: • Second best: where: . . . . . supply of gasoline . . . residual supply of corn for ethanol

16. Parametric Assumptions 16

17. Variables at Calibrated Point (2009 data)

18. Results: Optimal Instruments and Quantities

19. Results: Optimal Instruments and Prices

20. Results: Welfare Effects (Changes from Laissez Faire)

21. Welfare Maximization: Effectiveness of Alternative Policies

22. Oil Import Reduction of Alternative Policies (changes from laissez faire)

23. Reduction in CO2 Emissions (relative to laissez faire) (tCO2 millions)

24. Corn Ethanol Production under Alternative Policies (billions of gallons)

25. Effects of the Status Quo Ethanol Policy (changes relative to “no ethanol policy,” $ billions)

26. Sensitivity Analysis

27. Sensitivity Analysis Summary • For all cases the status quo policies dominated laissez faire and delivered at • least 40% of the maximal benefits achievable with first best • In all cases the second-best (fuel tax/ethanol subsidy) regime is a close • substitute for first best policy • The welfare gains with the second best policy was greater than 81% of the • maximum gains achievable with first best in all cases (average of 89%) • The oil market plays a dominating role in determining the potential gains • from government policy

28. . . . Sensitivity Analysis Summary • In all cases carbon emissions reductions achieved the first best and the • second best policies were very close, and far exceeded those achieved under • one-instrument policies • The optimal mandate policy dominated the optimal subsidy policy in all cases • and gives the highest use of ethanol in all cases • But: In most cases it did not significantly outperform the status quo • If ethanol pollutes less than gasoline, the optimal mandate results in lower • pollution than the optimal ethanol subsidy • First- and second-best solutions are very close in terms of their ability to • reduce U.S. dependence on foreign oil

29. Conclusions • We have developed a model that provides a theoretically-consistent • framework for the economic assessment of major biofuelpolicies • • it accounts for market failures — (differential) externalities for gasoline • and biofuels — as well as terms-of-trade effects that impact welfare • Second-best solution (tax gasoline but not ethanol) is a close substitute for • the (arguably not feasible) first-best policy • 2nd best: increases ethanol production by 41% relative to status quo decrease gasoline consumption by 10% ; reduce emissions by 7.5% • If the tax on fuel is not a choice, an ethanol mandate is better than a subsidy • The case for ethanol support is largely not about reducing pollution, it is mostly • about the policy’s impact on the US gains from trade (via the terms of trade) • Accounting for “national security” impacts would only strengthen this result

30. Thank you. For more details please refer to the following papers available online: Lapan, H. and G. Moschini, “Biofuel Policies and Welfare: Is the Stick of Mandates Better than the Carrot of Subsidies?” Working Paper No. 09010, Department of Economics, Iowa State University, June 2009. Cui, J., H. Lapan, G. Moschini and J. Cooper, “Welfare Impacts of Alternative Bioefuel and Energy Policies,” Working Paper No. 10016, Department of Economics, Iowa State University, June 2010.