REGULATED AND UNREGULATED SUBSTITUTES: AVERSION EFFECTS OF AN ETHANOL MANDATE

I. INTRODUCTION Regulation is a tool policymakers can use to steer markets away from private outcomes deemed to be socially suboptimal or inefficient. Regulations work either by altering market incentives or changing consumers' choice sets. As they attempt to reshape or restrict private market equilibria, they can sometimes lead to unexpected consumer reactions and unanticipated consequences, such as higher consumer costs or reduced effectiveness in meeting goals. The extent to which a regulation can have adverse and unanticipated consequences depends on the nature and design of the regulation. In this article, we highlight a case where the design of an unpopular and hurried regulation led to especially adverse consequences. The case is that of the recent ethanol mandate in the state of New South Wales (NSW), Australia. Ethanol mandates have become popular with legislators over the past decade and currently 62 countries have some form of one (GRFA 2014). A typical mandate requires producers to blend a certain percentage or certain volume of ethanol into the overall supply of gasoline. The U.S. mandate, for example, requires 18.2 billion gallons of renewable fuels, primarily ethanol, be blended into the gasoline supply in 2014, up from 16.6 billion in 2013 (EPA 2013). The European Union mandate requires 5.75% renewable fuels in gasoline by 2010 and 10% by 2020 (EU 2003, 2009). Ethanol mandates have been controversial, however (Griffin 2013; Grafton, Kompas, and Van Long 2012; Rodriguez et al. 2009; Serra and Zilberman 2013; Westbrook et al. 2014; and others). Proponents argue they help slow greenhouse gas accumulation, promote renewable energy, and reduce dependence on foreign oil. They also point out benefits to the domestic farming and ethanol production industries which is sometimes a goal in itself. Critics, on the other hand, question their environmental value, the need for fossil fuel replacement, the lower energy yield, and potential for food price inflation when crops grown for food are converted to ethanol use (Carter, Rausser, and Smith 2013). (1) They also point out that ethanol blends tend to be more expensive for consumers, on an energy-adjusted basis, than unblended gasoline. Mandates tend to be, on net, unpopular with consumers. (2) An important consideration when transitioning to a new ethanol mandate or a higher ethanol blend under an existing mandate is ensuring compatibility with the vehicle fleet. Ethanol is an alcohol and, in higher concentrations, can be corrosive to engine valves, seals, and gaskets in older vehicles not designed with ethanol's properties in mind. An option many jurisdictions have used in implementing ethanol mandates is to limit the ethanol blend to a level tested and widely believed to be compatible with the vast majority of vehicles on the road. In the United States and Canada, for example, a 10% blend has been implemented almost universally, while a 5% blend has been used universally in many European countries. If regulators instead deem that higher blends are desirable, another option is to mandate that newly built vehicles be compatible with the new higher blend and then implement the fuel mandate once the vehicle fleet has largely turned over. However, vehicle turnover can take decades and this approach has not been as popular with regulators. A third option that has found some favor is to introduce a higher ethanol blend that a majority of vehicles can use while still making the previous (possibly ethanol-free) blend available as long as there are those who still need it. In principle, this "dual blend" approach promises to accommodate more aggressive ethanol mandates and lead to more ethanol in the fuel supply more quickly. However, we show that this kind of dual blend or "selective" mandate, in its efforts to hurry ethanol blending beyond the capabilities of the vehicle fleet as a whole, or beyond the confidence of consumers in its safety, can have severe negative consequences. …