Why The Ethanol Mandate May Be Inflating Prices At The Pump

Pumping Gas

An esoteric fight of the Renewable Fuels Standard (RFS2), which mandates that the United States use an increasing volume of ethanol each year, has become a bit more prominent in recent weeks, with some accusing the mandate of contributing to rising gasoline prices in new and troubling ways. I remain perplexed as to what exactly is going on – more on that a bit further down – but I do find the defence from the Renewable Fuels Association, published last week in the form of a white paper commissioned from Informa Economics, hugely unpersuasive.

The basics of what’s happening are broadly agreed. There is controversy over whether large numbers of U.S. cars can safely use fuel that contains more than 10 per cent ethanol. For all practical purposes, then, refiners and blenders don’t want to use more than 10 per cent ethanol in the fuel they produce. Meanwhile, the RFS2 is mandating increasing use of ethanol – and, because of high gasoline prices and improving fuel economy, total U.S. fuel consumption is falling at the same time. This squeeze from both sides means that the United States has hit the “blend wall” – the point at which it can’t use any more ethanol without breaching the 10 per cent threshold – far earlier than anyone expected. It is impossible to comply with the volume requirements of RFS2 and avoid the blend wall at the same time.

For the time being, though, there’s a way out. In years when ethanol producers make more ethanol than the mandate requires, they generate a surplus of something called Renewable Identification Numbers, or RINs. They can bank those for the next year. Before 2012, when ethanol subsidies stopped, producers built up a surplus of RINs; part of that surplus remains. Blenders and refiners can buy these RINs instead of actually blending ethanol into their fuel. That’s how they’re dealing with the current crunch: they’re buying RINs instead of blending the full mandated volume of ethanol. The problem is that there’s a limited supply of RINs, so prices for them have skyrocketed. It’s those super-high RIN prices that people are now blaming for higher prices at the pump.

The big question is this: How much are high RIN prices actually inflating fuel prices? And how might that impact evolve? The new industry association paper claims that the impact is tiny, and that, once you factor in the relatively low price of ethanol, RFS2 is still producing net benefits for consumers. But their analysis doesn’t hold up.

Let’s start with the biggest whopper. The white paper observes that wholesale gasoline (they measure this in Chicago) was $2.81/gallon on average this year, while wholesale ethanol cost $2.37/gallon. They thus claim that blending ethanol into gasoline lowers prices. Set aside for a moment some subtle issues about how prices are set; what’s amazing here is that they apparently don’t account for the fact that a gallon of gasoline has 50 per cent more energy than a gallon of ethanol. Blending ethanol lowers the price of a gallon of fuel – but that gallon of fuel now gets you less mileage in your car. The net result is to increase the cost of driving. Claiming in this way that ethanol blending lowers fuel costs is like claiming that buying smaller boxes of cereal lowers the cost of getting yourself a nutritious breakfast.

Now for the more complicated part: the RINs. The industry white paper estimates the number of RINs that will need to be purchased in order to meet the RFS2 mandate and spreads their cost across the full U.S. fuel supply; they use that to estimate a price increase of between $0.004 and $0.02 due to RIN purchases. But prices aren’t set by average costs. What sets the price of fuel at the pump is the marginal cost, i.e. the cost of the most expensive gallon of fuel that’s sold. The big question, then, is what that marginal gallon is. The answer is either (a) a gallon of gasoline plus an appropriate volume of RINs, or (b) a gallon of fuel that’s a mix of gasoline and ethanol. (Perhaps it could be something in between too.) I can’t quite wrap my head around the answer –that might be the subject for another post or a real study (or someone will email along a good analysis) – but it certainly isn’t what the industry white paper claims. My instinct is that if the answer isn’t (a), things will eventually end up there, since the cost of ethanol is bounded above, while the price of RINs isn’t. And, if that’s right, we may see a big pump price run-up before too long.

It’s critical that we think through this now. At some point in the not-too-distant future, unless U.S. fuel demand rebounds, the surplus of RINs will presumably be exhausted. At that point all bets are off when it comes to the market impacts. Best to figure this out now, and come up with good policy adjustments if those are needed, rather than deal with this when things are much worse.

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