Ethanol: law, economics, and politics.

• Author: Hahn, Robert W.
• Position: Symposium: Creating a Legal Framework for Sustainable Energy

INTRODUCTION

Ethanol is a fuel that has been touted by politicians and technologists for a variety of reasons related to both energy security and the environment. It figures prominently in President Bush's strategy to address climate change. (1)

Largely as a result of government policies, the production of ethanol in the United States is expected to grow dramatically during the next decade. As of December 2007, there are 134 ethanol plants in the United States with a total capacity of more than 7 billion gallons per year. (2) This capacity is expected to exceed 13 billion gallons per year after current construction and expansion projects are completed. (3)

Interest group support for ethanol has been a major factor behind the increase in production. Many politicians see increased ethanol use as a way to promote environmental goals and energy security goals while catering to key interest groups, such as corn farmers and environmentalists. This paper analyzes legal, economic, and political issues surrounding the ethanol industry, with particular focus on ethanol policy in the United States.

At first glance, ethanol appears to be a regional issue because production is concentrated in the Midwest. Most plants are close to farm land, with more than 40 plants in the state of Iowa alone. The majority of plants are owned by corporations, which account for about 72% of total production capacity. (4) More than 80% of the ethanol in the United States is produced exclusively from corn.

Ethanol has widespread support in the United States. An April 2007 poll by CBS News/New York Times found that 70% of the public thought ethanol was a good idea, agreeing with the statement that ethanol made from corn is an American-made substitute for foreign oil that causes less air pollution. (5) Politicians are also jumping on the ethanol bandwagon, especially presidential hopefuls campaigning in Iowa, such as Hillary Clinton, Barack Obama, and Rudy Guiliani. (6) In January 2007, President Bush announced his plan to reduce U.S. gasoline consumption by 20% in ten years mostly through increased ethanol use. (7)

Most ethanol incentive programs are justified by concerns with improving energy security or air quality. Energy security is typically understood to mean reducing U.S. reliance on foreign oil or insecure sources of foreign oil. Because ethanol is currently made from corn and domestic corn production is limited by available land, ethanol is not expected to have a large impact on U.S. oil imports in the short term.

The environmental argument for ethanol relates to possible reductions in greenhouse gas emissions and improvements in local air quality. The evidence on environmental benefits is mixed. Although ethanol is likely to reduce carbon dioxide emissions, it may not decrease overall greenhouse gas emissions. (8) Ethanol use is also likely to reduce carbon monoxide emissions and some air toxics, such as benzene. (9) At the same time, ethanol use increases annual emissions of nitrogen oxides, and ethanol production and transportation may increase emissions of sulfur oxides, particulate matter, and volatile organic compounds. (10) There is also evidence that ethanol use may increase ground-level ozone and water contamination, especially in the Gulf of Mexico. (11)

Increasing the production of ethanol is likely to be costly relative to gasoline. On an energy basis, ethanol typically costs more than oil, and is also more costly to distribute in the United States. (12) In addition, one needs to take into account the deadweight costs of government programs aimed at promoting ethanol, such as the tax credit. The production of ethanol is also resource-intensive, using large amounts of electricity, natural gas, and an average of 4.7 gallons of water per gallon of ethanol. (13) As corn prices increase, corn production will move to marginal lands that will require more fertilizer use to make it arable, causing more emissions.

This paper has three objectives: first, to provide a systematic overview" of different aspects of the ethanol issue, including the various laws and regulations supporting ethanol in the United States and abroad; second, to provide a benefit-cost analysis of substantially increasing ethanol production; and third, to understand the politics behind ethanol support, and suggest how these politics could affect the development of sensible energy and climate policies.

I discuss laws and regulations related to ethanol in Part I. I explain ethanol's potential to address market failures in Part II. I analyze the likely benefits and costs of the future of ethanol in Part III. Part IV discusses the political support for ethanol, evaluates whether it is likely to continue, and discusses how politics is likely to affect the design of energy and climate policy. The Conclusion offers suggestions for better ethanol policy and concludes with suggestions.

In general, I find that policy rationales for ethanol do not justify its widespread support. Ethanol made from corn is not likely to boost energy security and its environmental benefits are uncertain. Costs of increased production are likely to exceed benefits by about three billion dollars annually in 2012 if current policies continue. (14) I also suggest that earlier attempts aimed at promoting ethanol would have likely failed a benefit-cost test. I believe that the growing opposition to ethanol from corn will contribute to decreased support for ethanol in the future. At the same time, I see little reason to believe that energy policy or climate policy will focus primarily on economic efficiency. Finally, I offer some suggestions for the more cost-effective development of energy alternatives that would rely less on prescriptive regulation that selects particular fuels or technologies.

1. LAWS AND REGULATIONS

   Ethanol production in the United States has been steadily growing and is expected to continue to grow. The growth in this industry is a direct result of subsidies and regulations at both the federal and state level aimed at promoting ethanol use, especially corn ethanol. (15) This Part provides an overview of laws and regulations in the United States and the rest of the world aimed at promoting ethanol.

   The major driver behind the development of the fuel ethanol industry in the United States is the Volumetric Ethanol Excise Tax Credit, the federal subsidy for ethanol that is used in gasoline. (16) In 2006, about $2.5 billion was distributed to gasoline blenders through the tax credit, which provides a $0.51 credit against gasoline taxes for every gallon of ethanol blended with gasoline. (17) The federal tax credit was created in 1978 by the Energy Tax Act, which provided blenders with $0.40 for every gallon of ethanol that they blended with gasoline. (18) Although only ethanol blenders could claim this credit, the subsidy indirectly benefits other groups, such as ethanol producers and owners of land where corn can be produced. (19) Congress has increased and decreased the federal tax credit for ethanol blending over the years, but it has always been extended. (20) Although recently lowered to $0.5 l, the total amount of the subsidy is actually rising rapidly due to the increased production of ethanol. For example, the Energy Information Administration (EIA) predicts that annual production of ethanol will exceed 11 billion gallons in 2010. (21) If the entire amount is blended into gasoline, the federal government could incur almost $5 billion annually in direct costs through the tax credit alone. Figure 1 shows the level of this tax credit subsidy over the years. The thick line is the nominal subsidy amount per gallon of ethanol determined by laws, which is measured on the left axis. (22) The thin line is the amount of federal subsidy distributed by the government measured in constant year 2004 dollars on the right axis.

   [FIGURE 1 OMITTED]

   The federal tax credit is not the only incentive program for ethanol production. (24) Other incentive programs include the tariff on imported ethanol, grants and loans, the renewable fuels standards, and corn subsidies. There are currently so many programs in place at different levels of government that it has become very difficult to keep track of all of them. One thing is certain: The effective annual subsidy totals are in the billions. In research sponsored by the International Institute for Sustainable Development, Koplow finds that ethanol received between $5 and $7 billion in subsidies in 2006 from federal and state governments. (25) In absolute size, these subsidies are lower than the subsidies given to energy sources such as fossil fuels and nuclear fission, but the subsidies exceed all other government subsidies to energy in per-unit energy terms. (26) Many of these programs have been in place for decades. Below I describe the various other tax, tariff, grant and loan incentive programs that support ethanol in addition to the federal tax credit.

   The predominant method of supporting ethanol is through tax incentive programs. The U.S. Government Accountability Office (GAO) estimates that more than $10 billion in support was given to the ethanol industry between 1979 and 2000 in the form of tax incentives. (27) In addition to the federal tax credit, the Small Ethanol Producer Tax Credit is a tax incentive program that provides a tax credit for small ethanol producers, defined as those with a production capacity of up to 60 million gallons. (28) The program allows a $0.10 tax credit on up to 15 million gallons of annual ethanol production, capped at $1.5 million per year per producer. (29) Originally enacted in 1990 under the Clean Air Act Amendments, the credit only applied to producers of up to 30 million gallons of ethanol. The definition of a small ethanol producer was revised in 2004 and the credit was extended. (30)

   One of the most controversial incentive programs is the Omnibus Reconciliation Tax Act enacted in 1980, which...