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A Way Around the Ethanol Blend Wall?

by Michael Levi
April 9, 2013

I wrote last week about a looming problem with the Renewable Fuels Standard (RFS2) that has parts of industry and many policy analysts concerned about rising gas prices. In this post I want to write about one regulatory tweak that might help deal with the problem without gutting the mandate: adding something like a safety valve to the RFS2.

The Problem

Let’s quickly recap what’s going on. The EPA has mandated that an increasing amount of ethanol be blended into fuel. Because U.S. fuel use is declining, if it were blended uniformly, the fraction of ethanol in fuel would likely exceed 10 percent, the so-called “blend wall” beyond which many U.S. vehicles can’t use (or at least are wary of using) the fuel. The resulting dynamics could, in principle, drive up prices for Renewable Identification Numbers (RINs), an instrument that refiners and blenders need to submit in order to demonstrate RFS2 compliance. That could push fuel prices way up.

As several people have noted, the way around this is to grow sales of E85, a blend of 85 percent ethanol and 15 percent gasoline that a subset of U.S. vehicles (flex-fuel cars and trucks) can use. If, say, the EPA effectively mandates that the U.S. fuel supply should be 11 percent ethanol, one way to meet that would be to have (roughly) 99 percent of fuel sales be E10 (10 percent ethanol) and the other 1 percent be E85. This would avoid the blend wall and let the mandate do its job.

The biggest problem that analysts have with this is that E85 has never been a significant seller. That’s largely because it’s always been more expensive than E10 or plain gasoline on an energy-equivalent basis. Very few are going to buy E85 if it costs more.

Barriers to E85

In a fascinating draft paper (“The Blend Bump”, forthcoming later this month), Phil Verleger points out something important: as RIN prices rise, it should become profitable to sell E85 at an ever greater discount. When you sell E85, you generate a large volume of RINs, most of which you don’t need to comply with your mandate obligations. You can sell that RIN surplus to refiners and blenders who sell E10 or pure gasoline and who need more RINs in order to meet their obligations.

How high would RIN prices need to rise to pump up E85 sales? A precise estimate is difficult. As Verleger notes, however, it’s pretty easy to establish an upper bound by asking a simple question: how valuable would RINs need to be to persuade companies to give away E85 for free? He estimates that, given current ethanol prices, RINs would need to sell for $3.50 to make that happen on the spot market, and for $5.00 to get sellers to give away the stuff at retail too. If RIN prices rose to $3.50, it would increase the prices of fuel by about 35 cents. Since this is an upper bound, one should in principle expect prices to rise by less than that – Verleger estimates that, given current RBOB gasoline and ethanol prices, if all it took to push E85 into the market was a 10 percent discount to E10 on an energy-adjusted basis, RINs would only need to sell for about $1.18 for the system to work.

What I find particularly interesting about Verleger’s paper, though, is the next step: it asks whether there might be reasons that this dynamic could fail to unfold. He flags three factors but highlights one particularly critical one. When a company sells E85, they generate surplus RINs immediately. They are unlikely, however, to find an immediate buyer, since most refiners and blenders wait until closer to the end of each compliance year to buy the RINs that they need. In the interim, the E85 sellers face a serious regulatory risk: given growing calls from parts of industry and Congress to investigate the RFS2, they have legitimate reason to worry that the mandate will be waived or watered down. In that case, their RINs will lose value, and their E85 gambit might fail to pay off. Given that prospect, they might not sell E85 (and generate lots of RINs) in the first place. In that case we’d stuck with the sort of debacle that many have warned of.

A Safety Valve?

That leads to my own suggestion for a possible policy tweak. We need a way to increase the credibility of the mandate without risking an unacceptable price spike. If E85 sellers can be made confident that the RFS2 will be sustained, there’s a decent chance that they’ll sell a substantial volume of their product, and that the RFS2 will be met. (No one can know for sure, though, particularly because there many not be enough E85 pumps to ramp up sales quickly enough.) If they are afraid that the mandate won’t hold, though, they won’t sell much E85; their predictions will become self-fulfilling, as fuel prices rise strongly and politicians react by severely weakening the mandate.

Congress could largely eliminate this latter possibility by adding a safety valve to the RFS2: it could commit the U.S. government now to selling an unlimited quantity of RINs in the future at some preset price. That price would need to be set high enough to keep E85 sales profitable.  If, for example, the safety valve were set somewhere between $1 and $2, strong incentives to sell E85 at a discount would probably remain, since sellers might be able generate decent volumes RINs for less than the safety valve price that way. (Picking a precise level for a safety valve would require considerably more robustness analysis than this blog post permits.) And if people are right that E85 provides a smooth way around the blend wall, no one will ever need to buy RINs from the government in the end. At the same time, the price would need to be set low enough to reassure everyone that the RFS2 won’t raise fuel prices too much, even if E85 fails to penetrate the market strongly. That would remove the risk that scared policymakers would drastically weaken the mandate or waive it entirely, again helping E85 sellers gain confidence. The same $1-$2 price could do that: it would allow fuel prices to rise by no more than 10-20 cents.

Some will find this idea odd: wouldn’t a floor price for RINs, rather than a ceiling, be the best way to incentivize more production of E85? The essential thing to keep in mind here is that the goal of the tweak would be to reinforce the political credibility of the RFS2, and then to let the market work. A ceiling, not a floor, is what’s needed to do that.

To be certain, it’s far from clear that the RFS2, even with this tweak, would pass a cost-benefit test. The current situation should also provide lessons on how not to design mandates (more on that in another post). But with the mandate in place, there could be serious damage from deeply weakening it, since that would harm the credibility (and hence effectiveness) of any future mandates. That should be reason enough to look for careful ways of modifying the mandate that protect consumers while maximizing the odds that it will survive largely intact.

9 Comments

  • Posted by carl

    Interesting ideas.

    RFS2 does not mandate ethanol. It mandates renewable fuel, which includes ethanol and advanced biofuel (which includes biodiesel and cellulosic ethanol), but yes, mostly it will be met with ethanol. [ML: Right. For all practical purposes, it mandates ethanol.]

    It confounds me that people are focusing on E85 when its more likely that E15 will become a more widely accepted reality. EPA has already issued a partial waiver on E15 use for certain vehicle model years from 2001. E15 is safer for cars than E85 and there is less legal risk for all parties involved. [ML: The issue here is that you'd need 100% of drivers to accept E11 or 1% to accept E85. Many people believe that the latter is more likely.]

    If there is a shortage of RINs, it is far more likely for the EPA to provide waiver credits (which they have done before when they mandated cellulosic RINs that the industry failed to produce) at discounted prices. Is there a precedence of capping RIN prices or other renewable energy credit (REC) prices? I am not aware of any. [ML: Selling waiver credits at a discount has a similar economic impact to setting a safety valve; the latter, though, provides less predictability, and so doesn't deal with the up-front problem of reinforcing RFS2 credibility.]

    There is no proof (and its difficult to find one) that the industry has hit the “blend wall” just by looking at the spike in ethanol RIN prices. If anything, its more likely that refiners are anticipating a blend wall to be hit in 2014, not 2013 (which seems to be the EPA’s expectation). Don’t forget, you can buy biodiesel RINs to meet the broader renewable fuel obligation (although, I concede, that this would be an expensive option historically speaking, but with ethanol RIN prices as high as they are, it doesn’t seem as expensive relatively speaking). [ML: Correct regarding 2013 vs 2014. No sure it changes the bottom line. The sooner you reinforce the credibility of the mandate, the better the odds that sellers will start figuring out ways to get E85 to market.]

    Just taking a step back though, I think EPA would be interested in “gently” nudging the industry for incremental renewable fuel adoption. So, all in all, E11 to E15 adoption is more likely and palatable than any strong push for E85 adoption (at least I would think from EPA’s point of view). [ML: Again, issue is that 100% E11 adoption is similar to 99% E10 and 1% E85; the latter may be much easier to achieve given existing car fleet and owner preferences.]

    Anyway, interesting analysis and idea.

    Its good to see some press on this topic. Its quite interesting I think. [ML: Thanks!]

  • Posted by glasnost

    It’s hard to express just how crazy is the idea that the EPA intends to increase the ethanol mandate. It’s actually worse for the environment than getting oil out of the ground, with the added demerit of diverting arable land away from growing food for human beings and thus raising food prices.

    Your total lack of interest in expressing opposition to this is dissapointing, but par for CFR’s course.

  • Posted by Vince

    Pretty good analysis but with a couple misleading statements or omissions.

    First, while a correct statement, your point that E85 is more expensive than E10 on an energy-equivalent basis leads the reader to the conclusion that it is not an economical fuel. The omission here is the implied equivalence of energy content and value. There are other fuel properties that provide value to the consumer. Principle among those is octane, and ethanol has an octane of over 110. This does two things.

    First, for engines that can take advantage of that high octane (and there are some), engine efficiencies are higher than with 87 octane regular gasoline. So, a higher price per unit of energy content could still be a better value to the motorist.

    Second, even if the engine does not have the compression ratio or turbocharging and engine timing diagnostic controls to boost its efficiency, the high octane of ethanol allows for the use of low octane, less expensive fossil blending components. This lowers the cost of Flex Fuel by about $0.10 per gallon of Flex Fuel. Admittedly, the consumer is not always seeing this benefit as retailers have been gouging motorists at the pump with huge retail mark-ups. This has recently started to fade with stations in my area now competitively pricing Flex Fuel. We may be at a virtuous tipping point for the consumer even without changes to the RFS as you suggest!

    By the way, I am referring to “E85″ as “Flex Fuel” because that is its new official name. Flex Fuel does not contain 85% ethanol as its composition now varies seasonally for driveability reasons to as low of a range as 51% to 70% in the winter in Chicago. If you are estimating Flex Fuel’s energy content as 85% ethanol + 15% “standard gasoline”, you will get the wrong (low) number. Note also that fossil gasoline’s energy content varies regionally and seasonally also for drivability and other reasons.

    The second misleading statement is with regard to your dimensioning of the magnitude of the issue. When discussing the price of a RIN, it is accurate to dimension the numbers at around $0.70 – $1.00 per RIN given that is where they are trading today. What needs to be mentioned, however, is that obligated parties only need to buy the number of RINs equal to the difference between what they are obligated to retire with the EPA each year and what they get for FREE when they blend their E10. The gap is a small fraction of the total RFS requirement. There are about 12.6-13 billion corn ethanol RINs generated each year from blending corn ethanol. For 2013, the implicit obligation is 13.8 billion so, there is a gap of 0.8-1.2 billion. Even at $1.00/RIN, this is at most $1.2 billion which, at 130 billion gallons of gasoline per year is less than a penny per gallon to the motorist. If RIN prices rose to $3.50, the price of gasoline would NOT rise by $0.35 per gallon as you state; it would rise by less than $0.035/gallon.

    This dimensioning shows how completely unnecessary a safety valve is. Giving away Flex Fuel is enough of a “safety valve”. A safety value is just not needed and providing the EPA or any regulator with the opportunity to be influenced by politics or back-room dealings just invites more uncertainty and ambiguity as oil-state senators petition for use of the authority, congressman hold hearings, and oil companies file suit for not using the authority.

    Don’t mess with the RFS. Just let it work. It’s doing exactly what it’s supposed to do.

  • Posted by dave

    Ethanol is costing cunsumers at the pump, in their garages (small engines), at the food store, and hurting the enviorment. The Fed is so concerned with renewables that it fails to objectively focus on ethanol’s ROI. The key term in this industry will always be “mandate” because it is a failed fuel source. Ethanol couldn’t go it alone and everyone knows, but we’d rather allow the lobbiest to control one more aspect of our daily lives.

  • Posted by carl

    Not to defend EPA here, but one of the commenter stated that EPA is increasing the mandate. This is not true. Congress has mandated annual increases of renewable fuel via the EPAct of 2005, further amended by EISA of 2007. EPA is the agency that interprets and carries out the mandate. Physical gallons of renewable fuels are listed in the bill itself, which originated from Congress (both under a Republic administration in ’05 and ’07). EIA gives gasoline and diesel consumption projections to the EPA and the EPA sets the percentages that would have the industry hit the mandated (absolute) volumes. At the same time, the EPA has the authority to lower or waive the required volumes. Given this, the EPA is always in a tough spot treading the fine lines between business interests and environmental interests (and of course political interests and pressures)…possibly more than other agencies. I can appreciate that.

  • Posted by David B. Benson

    Off topic:

    Should coal burners pay a health tax?

  • Posted by Jacob AG

    Why not just reduce (or even eliminate) the amount of ethanol that must legally be blended into fuel? Wouldn’t a carbon tax or cap-and-trade more efficiently sort out which fuels to use?

    Also, would it be on Congress or the EPA to reduce or eliminate the mandated amount of ethanol?

  • Posted by MarkB

    How about just eliminating the entire perverse, Rube Goldberg wealth destroyer? There is no need for a ‘way around’ your own failed policies. Just end them. The problem exists entirely as a corn state/agribusiness welfare program.

  • Posted by Geoffrey Styles

    Blend pumps or not, it’s hard to see either E85 or E15 as a viable near-term path out of the box created by the collision between the RFS and post-recession US fuel demand trends. Minnesota’s experience with E85, as outlined in a post on the EnergyTomorrow blog (http://energytomorrow.org/blog/minnesota-and-e85/#/type/all) suggests that E85′s popularity wth consumers peaked a few years ago and has declined since. As for E15, a review of carmaker statements concerning warranties indicates that consumers have far too much at risk to adopt this fuel until FFVs are widespread, and would have no recourse–not to carmakers, fuel producers or vendors, or the government–for expensive repairs. And by the way, most fuel retailers are in poor shape financially to make the kind of investments required for a large-scale rollout of either of these fuels.

    As for a safety valve, the current law has one. Unfortunately, it requires the EPA Administrator to assess economic harm beyond the agency’s purview, or to act contrary to its own goals for cellulosic biofuel development and RFS2 implementation. In the business world, that would be called a conflict of interest.

    The clear solution here, pending Congressional reform of the RFS mechanism and development of alternative fuels that are more compatible with existing fleets and infrastructure–so-called “drop-in” fuels–is a freeze at 2012 ethanol blending levels.

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