While preparing a lecture for the 4th Berkeley Summer School in Environmental and Energy Economics, I returned to contemplating the regulation of biofuels as part of a federal strategy to combat climate change and increase energy security. If we review policy approaches for increasing the share of biofuels in the transportation fuels supply across this great land, there are three main approaches. We have subsidies for the production of ethanol and biodiesel, renewable fuels standards (RFS) and low carbon fuels standards (LCFS).
The two main tools employed at the federal level are subsidies, which essentially provide a per gallon payment for producing a gallon of a certain type of biofuel, and renewable fuels standards, which require the production of different classes and quantities of biofuels over a prescribed time path. California has employed a low carbon fuel standard, whose goal it is to decrease the average carbon content of California’s gasoline by prescribed percentages over time. It relies on life cycle calculations for the carbon content of different fuels and allows producers to choose a mix of different fuels, which decrease the average carbon content, thus providing more flexibility in terms of fuels compared to the RFS.
If I were elected the social planner, I would recognize that I am most likely not smarter than the market, but also would not trust the market to make the right decisions when it comes to carbon reductions (see the demonstrated record of markets since 1850). The standard way an economist would approach the problem, assuming that we know what the right amount of carbon abatement is, is to set a cap on emissions and issue tradable rights to pollute (a cap and trade). This would in theory lead to the desired level of emissions reductions at least cost. While preparing for my lecture, I was thinking I should set up a simple model where profit-maximizing producers of fuels face different policy constraints (e.g., subsidies, RFS, LCFS or a cap and trade), a reasonable demand curve and my giant computer. As so often happens to many of us environmental and energy economists, EI@Haas’ all-star team captain Chris Knittel (MIT) and coauthors had already written the paper, which is titled “Unintended Consequences of Transportation Carbon Policies: Land-Use, Emission, and Innovation”.
[Skip this paragraph if you are not a fan of wonk]. The paper, which is a great and relatively quick read, simulates the consequences of the 2022 US RFS, current ethanol subsidies and constructs a fictional national LCFS and cap-and-trade (CAT) system, which are calibrated to achieve the same savings as the RFS. The paper assumes profit-maximizing firms which either face no policy, the RFS, subsidies, LCFS or CAT. Using an impressive county level dataset on agricultural production and waste, the authors set out to construct supply curves for corn ethanol and six different types of cellulosic ethanol. Chris’ daisy chained Mac Pros then maximize profits of the individual firms by choosing plant location, production technology, and output conditional on fuel price, biomass resources, conversion and transportation costs. Changing fuel prices and re-optimizing gets them county level supply curves. Assuming a perfectly elastic supply of gasoline and a constant elasticity demand curve for transportation fuels, they solve for market equilibria numerically.
They use the results to compare the consequences of each policy type for a variety of measures we might care about. Here is what happens:
The CAT leads to the greatest increase in gas prices and largest decrease in fuel consumption. It leads to no additional corn ethanol production and slight increases in second-generation biofuels. The RFS and LCFS both lead to less than half the price increase and fuel reduction compared to the CAT. Both policies see a four to nine fold increase in corn ethanol production relative to no policy and a massive ramp up in second generation biofuels production. All three measures lead to the same reductions in carbon emissions. The subsidies leave fuel costs constant, do not change fuel consumption and lead to a massive increase in first and second generation biofuels, but only achieve two thirds of the carbon reductions compared to the other policies (which is due to the authors using current subsidy rates rather than artificially higher ones which would lead to the same carbon savings).
Biofuels lead to lower gas prices and equivalent carbon savings! This is the point, where biofuels cheerleaders scream “everything is awesome!” But this ain’t a Lego movie. Especially since Legos are not made from corn. The paper evaluates the policies along a number of dimensions. First, compare the abatement cost curves for the CAT and the LCFS. When it comes to marginal abatement cost curves, the flatter, the better. What we see in the paper is a radically steeper marginal abatement cost curve from the LCFS compared to the CAT. In equilibrium the marginal abatement cost for the LCFS is almost five times higher that of the CAT. What about those emissions reductions? What happens in practice is that the CAT leads to higher emissions reductions from reduced fuel consumption (by driving less or more efficient cars) and a little bit of fuel switching. For the LCFS there is much more fuel switching and not much less driving.
What about land use? Well, since the non CAT policies incentivize ethanol production, significant amounts of crop and marginal lands will be pulled into production.
The paper shows that total land use for energy crops goes up about ten fold under the biofuels policies and only by about 30% under the CAT. The paper calculates that damages from erosion and habitat loss from these policies can reach up to 20% of the social cost of carbon compared to essentially 0% for the CAT.
Further, ethanol policies create the wrong incentives for innovation, where in some settings the incentives are too strong and in others they are too weak. A further aspect of the paper, which is incredibly clever, is that they show the cost of being wrong in terms of the carbon intensity (e.g., you get the indirect land use effect wrong, which is almost certainly the case) of different fuels can lead to massive amounts of uncontrolled emissions. The carbon damage consequences of being wrong by 10% in terms of the emissions intensity of corn ethanol are an order of magnitude (read 10 times!) the number for the cap and trade. Before I wonk you to death, I will close with some more general thoughts, but staffers of carbon regulators should read this paper. Now.
What this work shows is that in the case of biofuels setting a simple universal policy, which lets market participants choose the least cost ways of finding emissions reductions, is vastly preferred to complex renewable fuels or low carbon fuels standards. While I understand that producers of ethanol enjoy their subsidies (much like I enjoy my home interest mortgage deduction), this paper argues that they are a bad deal for society. And so is the RFS, as would be a national LCFS. As we go ahead and design a national carbon policy, I would hope that we take the lessons from this paper and the decades of environmental economics insight it builds upon to heart. This does not say that first or second generation biofuels are a bad idea, but if they want to compete for emissions reductions, they need to be fully cost competitive with other and currently lower cost emissions reductions alternatives.
[This post originally appeared on the Energy Institute at Haas Blog]
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