The Mess of Mandated Markets

Few things prompt Washington policymakers to forget their professed belief in the efficiency of free markets faster than $100-a-barrel oil prices–or even the threat of them. In one of the most notable recent examples, as the price of crude oil edged toward the $100 mark late last year, the U.S. Congress passed, and President Bush quickly signed, the Energy Independence and Security Act of 2007.

Among its various provisions, the energy bill prescribes a minimum amount of biofuel that gasoline suppliers must use in their products each year through 2022. The new mandates, which significantly expand the Renewable Fuels Standard of 2005, would more than double the 2007 market for corn-derived ethanol, to 15 billion gallons, by 2015. At the same time, the bill ensures the creation of a new market for cellulosic biofuels made from such sources as prairie grass, wood chips, and agricultural waste. The standards call for the production of 500 million gallons of cellulosic biofuel by 2012, one billion gallons by 2013, and 16 billion gallons by 2022.

Not surprisingly, the ethanol industry is very happy. The Biotechnology Industry Organization, a Washington-based trade association whose members include both large manufacturers and startup companies developing new cellulosic technologies, suggests that “this moment in the history of transportation fuels development can be compared to the transition from whale oil to kerosene to light American homes in the 1850s.” The new push for biofuels, the trade association continues, is “larger than the Apollo project or the Manhattan project” and will require the construction of 300 biofuel plants, each with a capacity of 100 million gallons, at a cost of up to $100 billion.

In short, the federal government has legislated the growth of a sizable industry. The often stated aim of the biofuel standards is to reduce greenhouse-gas emissions and dependence on foreign oil. And biofuels, particularly cellulosic ones, could arguably play a significant role in achieving both those goals (see “The Price of Biofuels,” January/­February 2008). But quite apart from the value of ethanol and other biofuels, the creation of markets by federal law raises fundamental questions about the best way to implement a national energy policy. Can legislated markets survive economic conditions and policy priori­ties that change over the long term? And what role should the government play in promoting specific technologies?

$100 Crude Oil
Energy Independence and Security Act of 2007

Mandated consumption levels break the “one-to-one link” between market demand and the adoption of a technology, says Harry de Gorter, an associate professor of applied economics and management at Cornell University: “As an economist, I don’t like it. Economists like to let the markets determine what [technology] has the best chances.” The new biofuel mandates are “betting on a particular technology,” he says. “It is almost impossible to predict the best technology. It is almost inevitable that [mandates] will generate inefficiencies.” While de Gorter acknowledges that some economists might justify mandated markets as a way to promote a desired social policy, he questions the strategy’s effectiveness. “Historically, there are no good examples of it working in alternative energy,” he says.

One reason economists tend to be wary of mandated consumption levels is that they can have unintended consequences for related markets. Producing 15 billion gallons of conventional ethanol will require farmers to grow far more corn than they now do. And even with the increased harvest, biofuel production will consume around 45 percent of the U.S. corn crop, compared with 22 percent in 2007. The effects on the agricultural sector will be various and complex.

Perhaps most obvious will be the impact on the price of corn–and, indirectly, of food in general. Since it became apparent that the biofuel standards would become law, the price of corn has risen 20 percent, to around $5.00 a bushel, says Bruce Babcock, director of the Center for Agricultural and Rural Development at Iowa State University. He expects that prices will probably stay around that level for at least the next three years. Because corn is the primary feed for livestock in this country, that means higher prices for everything from beef to milk and eggs. (Less than 2 percent of the nation’s corn crop is eaten directly by humans; more than 50 percent feeds animals.) High corn prices could also make it harder to switch to cellulosic biofuels, because farmers will be reluctant to grow alternative crops. With the price of corn so high, says Babcock, “who is going to replace corn with prairie grass?”

At Purdue University, Wallace Tyner, a professor of agricultural economics, has calculated how different types of government policies, including the new mandated consumption levels, will affect the economics of corn ethanol. One of his most striking findings (though one that would surprise few agricultural experts) is that the fuel struggles to compete with oil on cost, in part because of extreme sensitivity to the commodity price of corn.

Because ethanol is generally blended with gasoline at a concentration of 10 percent, its market value is directly tied to the price of oil. But Tyner’s analysis illustrates the complexity of the interplay between the markets for oil, corn, and ethanol. In the absence of government subsidies or mandates, according to his model, no ethanol is produced until oil reaches $60 a barrel. But with oil at that price, ethanol is profitable only as long as corn stays around $2.00 a bushel, which limits production of the biofuel to around a half-billion gallons a year. As oil prices increase, so does ethanol production. But production levels continue to be limited by the price of corn, which rises along with both the demand for ethanol and the price of oil (farmers use a lot of gasoline). Even when oil reaches $100 a barrel, ethanol production will reach only about 10 billion gallons a year if there are no subsidies; and even then, ethanol is profitable only if corn prices stay below $4.15 a bushel. If oil hits $120 a barrel, ethanol production will, left to market forces, reach 12.7 billion gallons–still more than two billion short of the federal mandate.

In other words, the federally mandated consumption levels mean ethanol will not, for the foreseeable future, be truly cost-­competitive with gasoline. Indeed, says Tyner, setting the ethanol market at 15 billion gallons will mean an “implicit tax” on gasoline consumers, who will have to pay to sustain the high level of biofuel production. When oil costs $100 a barrel, the consumer will pay a relatively innocuous “tax” of 42 cents per gallon of ethanol used (the additional price at the pump will usually be only a few pennies for blends that are 10 percent ethanol). But at lower oil prices, the additional cost of ethanol will be far more noticeable. If oil falls to $40 a barrel, the implicit tax for ethanol will be $1.05 a gallon–or $15.77 billion for all the nation’s gasoline users. “If the price of oil drops substantially, is Congress going to say, ‘We didn’t really mean it’?” asks Tyner. “It gets really messy.”

History provides a lesson about the messi­ness of predicting the market for an energy technology. Almost three decades ago, as the price of oil reached $40 a barrel and many experts worried that it was headed for $80 or even $100, President Jimmy Carter signed the Energy Security Act of 1980. As is the case today, the high price of oil was straining the U.S. economy, and the Middle East was unstable. One key provision of the 1980 legislation created the U.S. Synthetic Fuels Corporation, which was meant to establish a domestic industry that produced liquid fuel from tar sands, shale, and coal. Despite the unknowns surrounding the economics of producing synthetic fuels on a large scale, engineers estimated that they could be produced for $60 a barrel. An initial production target was set at 500,000 barrels a day. But in the early 1980s, the price of oil fell to $20 a barrel. With no prospect of producing synthetic fuels at a price competitive with that of oil, the Synthetic Fuels Corporation was finally shuttered in 1986.

The corporation “didn’t fail because of the technology,” says John Deutch, who was undersecretary of energy in 1980 and is now an Institute Professor of chemistry at MIT. Rather, he says, it failed because “it focused on production goals, and that turned out to be a bad thing because the market prices went down.” Deutch believes that instead of targeting specific production levels, government should participate in the development of alternative fuel technologies by helping to assess their economics and determine whether they meet environmental expectations.

The Synthetic Fuels Corporation and today’s Renewable Fuels Standard differ in many ways. But the efforts behind them do reflect a common theme: the federal government’s attempt to select a particular tech­nology and create a market for it. The “harsh reality” is that such measures “are unlikely to be effective over the long term,” Deutch says. “And nowhere is this more obvious than in ethanol.” He and other experts, such as de Gorter and Iowa State’s Babcock, would prefer to see technology-neutral policies, such as a carbon or greenhouse-gas tax, that would allow the markets to choose the most cost-effective way of meeting political and environmental goals.

Besides creating the synthetic-fuels program, the 1980 energy bill also included a Biomass Energy and Alcohol Fuels Act, which provided $600 million to the Departments of Energy and Agriculture for research into biofuels made from cellulose or biomass. But that funding was slashed in subsequent years. And while the Energy Department is again aggressively funding research on biofuels, and the 2007 energy bill includes several measures supporting such work, overall federal funding for energy research and development has never fully rebounded from the cuts made during President Reagan’s administration. It’s one reason that, almost three decades after Jimmy Carter’s energy bill, the United States still has no effective answer to high-priced imported oil.

Distorting the markets through federal mandates for biofuels won’t help. What might: a well-considered federal policy that financially supports the development of promising new energy technologies and offers technology-neutral incentives for replacing petroleum.

David Rotman is Technology Review’s editor.