From: William Charmley/AA/USEPA/US

To: "Achanta, Chandana L." <Ch andana_L._Achanta@ omb.eop.gov>
Cc: james.tamm@dot.gov, Maureen Delaney/D C/USEPA/US@EPA, rebecca.yoon@dot.gov, Robin Moran/AA/USEPA/US@EPA, steve.wood@epa.gov, Kathryn Sargeant/AA/USEPA/US@EPA

Date: 03/29/2010 10:11 PM Subjec

t: Edits to preamble section III.H.5: Impac t on US Veicle Sales and Payback Period

Chandana -

attached are the suggested edits to the pream ble section III.H.5 regarding the vehicle sales impact in response to the suggested edits from OMB on Friday. We have added the same text inserts to our RIA discussion on this topic

Thanks Bill Charmley

[attachment "Preamble III.H.5 on sales impact estimates.doc" deleted by Tad Wysor/AA/USEPA/US]1 [Section III.H.5]

5. Impacts on U.S. Vehicle Sales and Payback Period

a. Vehicle Sales Impacts

This analysis compares two effects. On the one hand, the vehicles will become more expensive, which would, by itself, discourage sales. On the other hand, the vehicles will have improved fuel economy and thus lower operating costs . If consumers do not accurately compare the value of fuel savings with the increased cost of fuel economy technology in their vehicle purchase decisions, as discussed in Preamble III.H.1, they will continue to behave in this way after this rule. If auto makers have accurately gauged how consumers consider fuel economy when purchasing vehicles and have provided the amount that consumers want in vehicles, then consumers should not be expected to want the more fuel-efficient vehicles. After all, auto makers would have provided as much fuel economy as consumers want. If, on the other hand, auto makers underestimated consumer demand for fuel economy, as suggested by some commenters and discussed in Preamble Section III.H.1 and RIA Section 8.1.2, then this rule may lead to production of more desirable vehicles, and vehicle sales may increase. This assumption implies that auto makers have missed some profit-making opportunities.

The methodology EPA used for estima ting the impact on vehicle sales is relatively straightforward, but makes a number of simplifying assumptions. According to the literature, the price elasticity of demand for vehicles is commonly estimated to be -

1.0. 1 In other words, a one percent increase in the price of a vehicle would be expected to decrease sales by one perc ent, holding all other factors constant. For our estimates,

EPA calculated the effect of an increase in vehicle costs due to the GHG standards and assumes that consumers will face the full increase in costs, not an actual (estimated) change in vehicle price. (The estimated increases in vehicle cost due to the rule are discussed in Section III.H.2) This is a conservative methodology, since an increase in cost may not pass fully into an increase in market price in an oligopolistic industry such

as the automotive sector. 2 EPA also notes that we have not used these estimated sales impacts in the OMEGA Model.

Although EPA uses the one percent price el asticity of demand for vehicles as the basis for our vehicle sales impact estimates, we assumed that the consumer would take into account both the higher vehicle purchasing costs as well as some of the fuel savings benefits when deciding whether to purchase a new vehicle. Therefore, the incremental

1 Kleit A.N., 1990. “The Effect of Annual Changes in Automobile Fuel Economy Standards.” Journal of Regulatory Economics 2: 151-172 (Docket EPA-HQ-OAR-2009-0472-0015); McCarthy, Patrick S., 1996. “Market Price and Income Elasticities of New Vehicle Demands.” Review of Economics and Statistics 78: 543-547 (Docket EPA-HQ-OAR-2009-0472-0016); Goldberg, Pinelopi K., 1998. “The Effects of the Corporate Average Fuel Efficiency Standards in the U.S.,” Journal of Industrial Economics 46(1): 1-33 (Docket EPA-HQ-OAR-2009-0472-0017).

2 See, for instance, Gron, Ann, and Deborah Swenson, 2000. “Cost Pass-Through in the U.S. Automobile Market,” Review of Economics and Statistics 82: 316-324 (Docket EPA-HQ-OAR-2009-0472-0007). Deleted: , which makes them more

attractive to consum ers. The basic question is, then, which effect dominates?2 cost increase of a new vehicle would be offset by reduced fuel expenditures over a certain period of time (i.e., the “payback period”). For the purposes of this rulemaking, EPA used a five-year payback period, which is c onsistent with the length of a typical new light-duty vehicle loan. 3 The one commenter on this analysis stated that use of the fiveyear payback period was reasonable. This approach may not accurately reflect the role of fuel savings in consumers’ purchase deci sions, as the discussion in Section III.H.1 suggests. If consumers consider fuel savings in a different fashion than modeled here, then this approach will not accurately reflect the impact of this rule on vehicle sales.

This increase in costs has other effects on consumers as well: if vehicle prices increase, consumers will face higher insuranc e costs and sales tax, and additional finance costs if the vehicle is bought on credit. In addition, the resale value of the vehicles will increase. EPA received no comments on these adjustments. The only change to these adjustments between the NPRM and this discussi on is an updating of the interest rate on auto loans. EPA estimates that, with corrections for these factors, the effect on consumer expenditures of the cost of the new technology should be 0.914 times the cost of the technology at a 3% discount rate, and 0.876 times the cost of the technology at a 7% discount rate. The details of this calculation are in the RIA, Chapter 8.l.

Once the cost estimates are adjusted for these additional factors, the fuel cost savings associated with the rule, discussed in Section III.H.4, are subtracted to get the net effect on consumer expenditures for a new vehicle. With the assumed elasticity of demand of -1, the percent change in this “effective price,” estimated as the adjusted increase in cost, is equal to the negative of the percent change in vehicle purchases. The

net effect of this calculation is in Table III.H.5-1 and Table III.H.5-2. The values have changed slightly from the NPRM, due to changes in fuel prices and fuel savings, technology costs, and baseline vehicle sales projections, in addition to the adjustment in financing costs.

The estimates provided in Table III.H.5-1 and Table III.H.5-2 are meant to be illustrative rather than a definitive prediction. When viewed at the industry-wide level, they give a general indication of the potential impact on vehicle sales. As shown below, the overall impact is positive and growing over time for both cars and trucks. Because the fuel savings associated with this rule ar e expected to exceed the technology costs, the effective prices of vehicles (the adjusted increase in technology cost less the fuel savings over five years) to consumers will fall, and consumers will buy more new vehicles. As a result, the lower net cost of the vehicles is projected to lead to an increase in sales for

both cars and trucks.

3 As discussed further in Section III.H.1, there is not a consensus in the literature on how consumers consider fuel economy in their vehicle purchases. Re sults are inconsistent, possibly due to fuel economy not being a major focus of many of the studies, and possibly due to sensitivity of results to modeling and data used. A survey by Greene (2010) finds that estimates in the literature of the value that consumers place on fuel economy when buying a vehicle range from negative – consumers would pay to reduce fuel economy – to more than 1000 times the value of fuel savings.3 As discussed above, this re sult depends on the assumption that more fuel efficient vehicles that yield net consumer benefits over five years would not otherwise be offered on the vehicle market due to market failures on the part of vehicle manufacturers. If vehicles that achieve the fuel economy standards prescribed by today’s rulemaking would already be available, but consumers chose not to purchase them, then this rulemaking

would not result in an increase in vehicle sale s, because it does not alter how consumers

make decisions about which vehicl es to purchase. In addition, this analysis has not accounted for a number of factors that might affect consumer vehicle purchases, such as changing market conditions, changes in vehi cle characteristics that might accompany improvements in fuel econom y, or consumers considering a different “payback period” for their fuel economy purchases. If consumers use a shorter payback period, the sales impacts will be less positive, possibly ne gative; if consumers use a higher payback period, the impacts will be more positive. Also, this is an aggregate analysis; some individual consumers (those who drive less than estimated here) will face lower net benefits, while others (who drive more than estimated here) will have even greater savings. These complications add considerable uncertainty to our vehicle sales impact analysis. Deleted: Note