January 11, 2010

MEMORANDUM

TO: Docket EPA-HQ-OAR-2005-0161

SUBJECT: Economy-Wide Impacts of Renewable Fuels Standards

EPA has undertaken an analysis of the ec onomy-wide impacts of the renewable fuels standards (RFS2) as an exploratory exercise th at EPA believes could provide additional insights into the potential impacts of the increased use in renewable fuels. The results presented in this memo were not a factor regarding the appropriateness of the RFS2 st andards. It is important to note that the results of this modeling exercise ar e dependent on the assumptions associated with the cost of renewable fuels relative to petroleum prices in the future.

It is anticipated that the increase in renewabl e fuels associated with this RFS2 rulemaking will have impacts on the U.S. economy that extend beyond the U.S. transportation sector. By requiring 36 billion gallons of renewable fuels in the U.S. transportation se ctor, it is anticipated that the price of motor vehicle fuels will decrease modestly by 2022. This is due to two reasons. First, the costs of renewable fuels are estimate d to decrease over time, while the price of petroleum is projected to increase over time. Therefore, by 2022, the cost of renewable fuels is expected to be lower than the co st of gasoline and diesel fuels. Secondly, the decreased demand for petroleum products as a result of using more renewable fuels will modestly lower the world price of oil. The resulting overa ll decrease in the price of motor vehicle fuels will affect all sectors of the economy that use these fuels as in termediate inputs to production. For example, firms that transport products (i.e., shipping co mpanies) will see a decline in their costs of production. Also, households will also be benefici ally affected as consumers of these goods, and directly as consumers of motor vehicle fuels.

In the U.S. agriculture sector, it is anticipa ted that the production of renewable fuels will increase the demand for farm products, and incr ease farm incomes. U.S. food prices are anticipated to increase modestly as a result of higher agri cultural commodity prices. For example, corn and soybean prices are anticipated to increase with the RFS2 rule since there is greater demand for these commodities for use as feedstocks to produce ethanol and biodiesel fuels. Increased agricultural commodity prices will have ripple effects on sectors of the economy that supply inputs to the farm sector (e .g., tractors), and sectors that demand outputs from the farm sector. The sum of all of these market impacts, both fuel market and agricultural sector impacts, will affect th e total levels of output (i.e ., Gross Domestic Product) and consumption of the U.S. economy.

A further issue that arises in assessing th e economy-wide impacts of the RFS2 rule is renewable fuel subsidies. For example, for co rn ethanol, the current subsidy is $0.45/gallon. Alternatively, for biodiesel, the current subsidy is $1.00/gallon. Cellulosic biofuel qualifies for a subsidy of $1.01/gallon. By the year 2022, the incr ease in renewable fuels volumes associated with the RFS2 rule will result in an incr ease in renewable fuel subsidy expenditures ofapproximately $14.2 billion annually. To account for the economy-wide impacts of the renewable fuel subsidies associ ated with the RFS2 renewable fuel volumes, we look at two cases. Case one looks at the economy-wide impacts of the increased renewable fuel volumes required by the RFS2 rule without accounting for th e increase in renewable fuel subsidies. Case two examines the impacts of the RFS2 renewabl e fuel volumes with renewable fuel subsidies included. For case two, we assume we assume that the biofuel subsidies will be offset by raising taxes to maintain the “revenue neutrality” of the U.S. federa l government’s overall budget. Since it is not clear what taxes would be raise d, we have assumed that the marginal tax rate on labor income will be raised to offset the impact of the increase in renewable fuel subsidies on the federal government’s budget. Any remaining adju stments required to restore real government expenditures to their reference case levels ar e accomplished through changes in zero bracket exemptions (i.e., lump-sum transfers).

To estimate the impacts of this rule on U.S. Gross Domestic Product (GDP) and personal consumption, EPA has used an economy-wide, co mputable general equilibrium (CGE) model. The economy-wide model used in this analysis is the Intertemporal Ge neral Equilibrium Model (IGEM). 1 IGEM is a model of the U.S. economy w ith an emphasis on the economy’s energy and environmental aspects. IGEM is a dynamic mode l which depicts growth of the economy due to capital accumulation, technical change and population change. The model utilizes a unified accounting framework consistent with the Na tional Income and Product Accounts and the Industry Classification System.

IGEM is a detailed multi-sector model coveri ng thirty-five industries, consisting of five energy and thirty non-energy sectors. The model ensures market balances (i.e., supply equals demand) in value and quantity terms, including limits placed on private investment dictated by domestic and foreign saving behavior and by the fiscal policies of fede ral, state and local governments. Capital accumulation in the model ar ises from the saving and investment behavior of households and businesses and provides an es sential input to production and consumption. Households in the model make choices regarding present and future consumption (i.e., saving) and make choices regarding the allocation of time between labor and leisure. The model covers all aspects of long-run growth including the s upply of capital, labor, imported and intermediate inputs to production; the rates and directions of exogenous and endogenous technical change for each producing sector; and the degrees of s ubstitutability among input s and commodities in production and final demand (i.e., consumption, i nvestment, governments and foreign trade). The substitution possibilities for both producers and consumers in IGEM are driven by model parameters that are based on observe d market behavior revealed over th e past forty to fifty years.

5.5.1 Impacts on U.S. GDP

In order to estimate the real U.S. GDP imp acts of the renewable fuel volumes required by the RFS2 rule, the CGE model uses outputs of th e transportation and agricultural sector models as inputs to determine the economy-wide impact s of this rule. Specifically, IGEM uses information from other models on the change in fuel costs and renewable fuel subsidies, the

1 The model is developed and run by Dale W. Jorgenson Associates for EPA. Model Homepage: http://www.dja.insightworks.com/change in agricultural sector pric es, and the change in the world oi l price. The change in fuel costs were calculated as descri bed in Chapter 4.4 of the RFS2 RIA. The value of the renewable fuel subsidies through time were calculated by mu ltiplying the per gallon value of the renewable fuel subsidies by the volumes of renewable fuel s required by the RFS2 rule. The data on changes in agricultural sector prices were taken from the FASOM model, as described in Chapter 5.1 of the RFS2 RIA. Finally, the estimates of the chan ges in world oil price were estimated using the Oil Security Metrics Model maintained by Oak Ridge National Laboratory, which is discussed in more detail in Chapter 5.2 of the RFS2 RIA. It is important to note that the economy-wide analysis does not include a repr esentation of the benefits asso ciated with reducing greenhouse gas emissions, and thus the GDP impacts presen ted here do not repres ent the results of a complete cost benefit analysis. Figure 1 a nd Table 1 show the Reference Case GDP and GDP with the two cases, without and w ith renewable fuel subsidies.

F igure 1. Annual GDP Impacts for the RFS2 Contro l Case vs. the AEO2007 Reference Case (Billions of 2007 dollars)

GDP

$0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000

2017 2022 2030Billion 2007$ Reference Case

Control Case with Subisidies

Control Case Without Subsidies

Table 1. Annual GDP Impacts for the RFS2 Contro l Case vs. the AEO2007 Reference Case (Billions of 2007 dollars)

2017 2022 2030 AEO2007 Reference Case $17,648 $19,853 $24,315 Case One: Without Renewable Fuel $17,636 $19,859 $24,368Subsidies Case Two: With Renewable Fuel Subsidies $17,631 $19,847 $24,358

In the reference case, GDP rises from approximately $17.6 trillion in 2017 to $19.9 trillion in 2022, and $24.3 trillion in 2030. In case one (without renewable fuel subsidies), GDP rises from approximately $17.6 trillion in 2017 to $19.9 trillion in 2022 and $24.4 trillion in 2030. In case two (with renewabl e fuel subsidies), GDP rises from approximately $17.6 trillion in 2017 to $19.9 trillion in 2022 and $24.4 trillion in 2030.

Figure 2 and Table 2 show the percentage chan ge in GDP with the RFS2 renewable fuel volumes. The combined impact of higher agricultural commodity prices and higher transportation fuel prices decrease GDP in the ea rly years of the program. However, the costs of renewable fuels are projected to decrease over ti me, while the cost of petroleum products is projected to increase over time. By 2016, renewabl e fuels are projected to be cheaper than the gasoline and diesel that they replace. By 2030, th e impacts of lower transportation fuel costs and lower world oil prices outweigh the impacts of higher agricultural commodities, resulting in an increase in GDP in the two RFS cases relative to the AEO2007 reference case. Lower prices permit additional purchases of investment goods from an unchanged saving-investment balance which, in turn, leads to a larger capital stock. Th ese price reductions also allow higher levels of real government spending while improving U.S. competitiveness thus promoting increased exports relative to the growth driven increase in imports. These combined impacts have a favorable impact on GDP over time.

Figure 2. Percentage Change in Gross Domestic Product for the RFS2 Control Case vs. the AEO2007 Reference Case

Percentage Change in GDP

-0.15% -0.10% -0.05% 0.00% 0.05% 0.10% 0.15% 0.20% 0.25%

2017 2022 2030 Control Case with Subsidies

Control Case Without SubsidiesTable 2. Percentage Change in Gross Domestic Product for the RFS2 Control Case vs. the AEO2007 Reference Case

2017 2022 2030 Case One: Without Renewable Fuel Subsidies -0.07% 0.03% 0.22% Case Two: With Renewable Fuel Subsidies -0.10% -0.03% 0.17%

5.5.2 Impacts on U.S. Consumption

In addition to showing the impacts of the R FS2 renewable fuel volumes on U.S. GDP, we also show their impacts on real personal consum ption expenditures. The following Figure 3 and Table 3 show estimates of the Reference Ca se Consumption and Consumption after the imposition of the RFS2 renewable fuel volumes for Case One and Two.

Figure 3. Annual Consumption Impacts for the Cont rol Case vs. the AEO 2007 Reference Case (Billions of 2007 dollars)

Consumption

$0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 $14,000 $16,000

2017 2022 2030Billion 2007$ Reference Case

Control Case with Subsidies

Control Case Without SubsidiesTable 3. Annual Consumption Impacts fo r the RFS2 Control Case vs. the AEO2007 Reference Case (Billions of 2007 dollars)

2017 2022 2030 AEO2007 Reference Case $10,936 $12,333 $14,945 Case One: Without Renewable Fuel Subsidies $10,923 $12,325 $14,955 Case Two: With Renewable Fuel Subsidies $10,921 $12,320 $14,949

In the AEO2007 reference case, consumption rises from approximately $10.9 trillion in 2017 to $12.3 trillion in 2022, and $14.9 trillion in 2030. In case one (without renewable fuel subsidies), consumption rises from approxima tely $10.9 trillion in 2017 to $12.3 trillion in 2022 and $15.0 trillion in 2030. In case two (the case with renewable fuel subsidies), consumption rises from approximately $10.9 trillion in 2017 to $12.3 trillion in 2022 and $14.9 trillion in 2030.

Figure 4 and Table 4 show the estimated percentage change in consumption with the RFS2 rule volumes. The combined impact of hi gher agricultural commodity prices and higher transportation fuel costs decrease consumpti on in the early years of the RFS2 program. However, as the cost of renewable fuels decreases over time, this impact gradually outweighs the impact of higher agricultural commodity prices. As a result of the lower renewable fuels costs through time, consumption increases relative to the reference case in both RFS2 cases by 2030. The increase in labor taxes needed to offset th e renewable fuel subsidies partially erodes the benefits observed in case one. In case two, the increase in labor taxes reduces the opportunity cost of choosing leisure instead of labor. Th erefore, households work less when faced with higher labor taxes, thereby reduc ing overall household consumption slightly compared to case

one.Figure 4. Percentage Change in Consumption for the RFS2 Control Case vs. the AEO2007 Reference Case

Percentage Change in Consumption

-0.15% -0.10% -0.05% 0.00% 0.05% 0.10%

2017 2022 2030 Control Case with Subsidies

Control Case Without Subsidies

Table 4. Percentage Change in Consumption for the RFS2 Control Case vs. the AEO2007 Reference Case

2017 2022 2030 Case One: Without Renewable Fuel Subsidies -0.12% -0.06% 0.07% Case Two: With Renewable Fuel Subsidies -0.13% -0.11% 0.03%

In addition to showing the impacts of the rule on U.S. GDP and consumption, the impacts of the RFS2 renewable fuel volumes on pers onal consumption expenditures per household are estimated. The following Figure 5 and Table 5 show estimates of the reference case annual consumption per household and consumption per household after the imposition of the RFS2 renewable fuel volumes for both case one and case two.

In the reference case, annual consumption per household rises from $83,041 in 2017 to $88,298 in 2022, and $98,139 in 2030. In case one (wit hout renewable fuel subsidies), annual consumption per household rises from a pproximately $82,941 in 2017 to $88,243 in 2022 and$98,203 in 2030. In case two (with renewable fuel subsidies), annual consumption per household rises from approximately $82,930 in 2017 to $88,203 in 2022 and $98,167 in 2030. Thus, consumption per household is roughly $100 lower in case one (without renewable fuel subsidies) in 2017 compared to the reference case, and consumption pe r household is roughly $55 lower than the reference case in 2022. By 2030, consumption per household is roughly $64 higher in case one compared to the reference case. For case two (with renewable fuel subsidies), consumption per household is roughly $111 lo wer than the reference case in 2017 and consumption per household is roughly $95 lowe r than the reference case in 2022. By 2030, however, consumption per household is higher th an the reference case in case two, by $28.

Figure 5. Consumption Expenditures Per Household for the RFS2 Control Case vs. the AEO2007 Reference Case (2007 dollars)

Consumption Per Household

$75,000 $80,000 $85,000 $90,000 $95,000 $100,000

2017 2022 20302007$ Control Case with Subsidies

Control Case Without Subsidies

Reference Case

Table 5 Consumption Expenditures Per Household for the RFS2 Control Case vs. the AEO2007 Reference Case (2007 dollars)

2017 2022 2030 AEO2007 Reference Case $83,041 $88,298 $98,139 Case One: Without Renewable Fuel Subsidies $82,941 $88,243 $98,203 Case Two: With Renewable Fuel Subsidies $82,930 $88,203 $98,167