Impact of Increased Ethanol Mandates on Prices at the Pump (2014)

The Environmental Protection Agency (EPA) proposed in November to reduce 2014 biofuel mandates. One concern expressed by EPA is that it will be difficult, if not impossible, to consume the 2014 target levels of ethanol in the Renewable Fuel Standard (RFS) because of infrastructure issues. Difficulty in meeting ethanol mandates is reflected into increased compliance costs and a measure of compliance cost is the price of the tradable ethanol credit known as a RIN (Renewable Identification Number). The price of RINs represents the gap between the cost of producing another gallon of ethanol and the price of ethanol that is needed to induce consumers to buy another gallon. Compliance with the ethanol mandates falls to owners of oil refineries who must purchase a specified number of RINs per gallon of gasoline produced. We show in previous work that increasing the number of stations that sell E85 decreases the ethanol price discounts needed to induce enough ethanol consumption to meet targets by making the fuel more accessible to consumers. Any reduction in required discounts directly leads to lower RIN prices and hence lower compliance costs. Thus, obligated parties faced with high RIN prices would have a strong incentive to invest in the infrastructure that would facilitate increases in ethanol consumption. As the cost of complying with RFS falls to owners of oil refineries, it is a natural position for them to oppose any further increase in mandated ethanol volumes. One argument that has often been made by the oil industry against increases in ethanol is that compliance costs will be passed on to consumers. This seems like a reasonable argument because this type of cost increase in any economic model will tend to lead to higher gasoline prices, hence higher consumer prices. Our objective in this study is to provide a transparent economic analysis of the impact on consumer fuel prices from increased ethanol mandates. One feature of our analysis is that it accounts for an increase in the consumption of E85, the most likely compliance path that would be taken in 2014 to meet increases in ethanol mandates. Each year, EPA establishes a percentage standard for ethanol by dividing the desired quantity of ethanol by the total anticipated domestic sales of unblended gasoline. Each producer of gasoline has an RVO (Renewable Volume Obligation) that is determined by multiplying the percentage standard by total domestic sales of gasoline. The RVO is met by acquiring RINs. If an obligated party's sales of gasoline increases, so too does the RVO. This means that an obligated party can reduce the number of RINs that it needs to comply with the RFS by decreasing the volume of gasoline sales. This direct link between the cost of RINs and gasoline sales implies that increases in the cost of RINs reduces the quantity of gasoline that refiners will provide to consumers at any given gasoline price. Our model has separate demand curves for E10 and E85. The two demand curves are related because increases in E85 consumption come at the expense of E10. The model calculates the retail price of E85 that is needed to induce consumers to buy enough ethanol so that the number of RINs generated is adequate to meet oil refineries' RVO obligations. The obligations are met through increased E85 consumption and reduced E10 consumption. Increased E85 consumption can only occur with a lower retail price of E85. Given E10 and E85 prices, we can calculate the value at wholesale for gasoline and ethanol. It is the difference between the value of ethanol at wholesale and the cost of producing the required quantity of ethanol that determines the RIN price. The compliance cost to oil refineries per gallon of gasoline is the product of the RIN price and the percentage standard. We find two direct effects of a binding ethanol mandate. The first is an increase in the wholesale price of gasoline because positive RIN prices increase the cost of producing gasoline. The second is a decrease in the ethanol price paid by blenders net of the RIN value. The net price of ethanol will decrease to induce consumers to consume enough ethanol to meet the mandate. Because most US consumers buy E10, the lower price of ethanol in the blend offsets at least some portion of the increased gasoline price. In addition to these two direct effects on the price of E10, there exists an indirect effect that works to lower E10 prices. To meet mandates beyond E10 requires an increase in E85 consumption, which results in a decrease in E10 consumption because some owners of flex vehicles switch fuels. The effect of substituting E85 for E10 is a net decrease in gasoline demand, which results in some reduction in wholesale gasoline prices. Whether the net effect of these three market forces results in a net increase or decrease in E10 pump prices requires the development of an economic model to sort out. We developed and calibrated such a model with the purpose of showing how feasible increases in ethanol blending mandates will affect the price of E10 under a range of possible conditions. We find that feasible increases in the ethanol mandate in 2014 will cause a small decline in the price of E10. That is, even though increased mandates increase gasoline prices, the offsetting effects from a decline in ethanol price and movement by motorists to E85 from E10 are enough to result in a net decrease in the price of E10. Our results should reassure those in Congress and the Administration who are worried that following the RFS commitment to expanding the use of renewable fuels will result in sharply higher fuel prices for consumers. There may be sound policy reasons that could justify Congress revisiting the RFS. However, concern about higher pump prices for consumers is not one of them.