Ethanol policy: past, present, and future.

Author:Duffield, James A.
 
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  1. INTRODUCTION

    Corn ethanol is one of the fastest growing industries in the United States, with production growing from about 175 million gallons in the early 1980s to almost 6.5 billion gallons in 2007. (1) This remarkable growth rate has benefited farmers by pushing corn and other agricultural commodity prices to near-record highs (2) and has stimulated economic activity in rural areas. Besides benefiting the farm sector, many U.S consumers find ethanol appealing for its environmental attributes and because it is made from domestic resources, not imported oil from the Middle East. However, ethanol is beginning to draw attention from critics arguing that using corn for ethanol is driving up world food prices and that further growth could result in land use expansion (e.g., cultivating land in rain forests) that would be harmful to the environment. (3)

    There are other factors behind ethanol's remarkable growth rate, but the ethanol industry owes much of its success to government policies and regulations. The early development of the U.S. ethanol industry was sparked by government policy; the recent expansion in ethanol plant capacity can be directly linked to government regulations; and the future of ethanol will greatly depend on continued government support. The three primary motivations behind government support for ethanol are environmental, energy independence, and rural development. Ethanol initially entered the U.S. fuel market as a replacement for lead additives to gasoline, which were being phased out by the Environmental Protection Agency (EPA) during the 1970s. (4) The 1970s was also a time of gasoline shortages caused by political unrest in the Middle East, and for the first time policymakers began to think about alternatives to petroleum fuel. Policymakers began to look to the U.S. agricultural sector as a source of energy supply, which had the ability to turn corn and other crops into renewable fuels. There was also interest in creating a new market for farmers who suffered from persistently low commodity prices caused by frequent crop surpluses. (5)

    While ethanol has many desirable characteristics, it often has a higher production cost compared to gasoline. (6) In addition, the potential supply of ethanol made from corn is very limited relative to the size of the gasoline market, (7) so ethanol has primarily been used in the United States as a fuel additive that is blended with gasoline at a level between five and ten percent. Because of its high octane and oxygen content, ethanol began to establish a role as an octane additive to replace lead in gasoline in the late 1970s. (8) In order to encourage more investment in the fledgling ethanol industry, ethanol production received its first tax credit in 1978. (9) Ethanol advocates argued that government support for ethanol was justified because it provided public benefits in terms of reduced air pollution, enhanced energy security, and economic growth in rural areas. Since the private sector generally lacks direct price incentives to provide public goods, (10) it is the government's role to provide energy security, a clean environment, and economic opportunity to all citizens. Government support for increasing energy production and developing an energy infrastructure has a long history in the United States. As early as 1902, the Reclamation Act provided hydroelectric power in many areas of the West. (11) The Tennessee Valley Authority increased energy production in the Mid-South. (12) The Rural Electrification Act of 1936 helped finance rural electrification. (13) The early development of the U.S. oil and gas industries benefited from federal energy tax policies that encouraged increasing domestic oil and gas reserves and production. (14)

    The purpose of this paper is fourfold: (1) to provide a comprehensive review of ethanol policy over past thirty years; (2) to describe the convergence of energy policy with agricultural policy via the enactment of the 2002 Farm Bill; (15) (3) to review new and proposed energy legislation aimed at increasing ethanol production; and (4) to look at the effect ethanol policy has had on ethanol production, energy security, agricultural and energy markets, and the environment.

  2. EARLY HISTORY OF ETHANOL POLICY

    Government polices to encourage ethanol production were first adopted to establish domestic fuel reserves during emergencies, (16) such as World War II, when imported and regional fuel supplies were interrupted by enemy forces. After the war, the United States and other industrialized countries continued to increase their reliance on petroleum as an economical and dependable source of energy needed to fuel economic growth. However, by the early 1970s, U.S. oil reserves were shrinking rapidly and the United States was transforming from a major oil producer to a nation dependent on foreign oil. Rapid growth in world energy demand began to outpace world supply, and after years of abundance, oil shortages began to appear in the industrialized world. (17) Taking advantage of tight supplies, the Organization of Petroleum Exporting Countries (OPEC) increased prices, causing the market price for crude oil to double between 1970 and 1973. The early 1970s was also a period of increasing political tension between Middle Eastern countries and the United States. In October 1973, the Arab oil ministers cut oil production and embargoed the United States, causing a worldwide energy crisis.

    The Arab oil embargo symbolized a new era, demonstrating that the United States was no longer the dominant leader in world oil. (18) The embargo quickly caused gasoline shortages, gas lines appeared throughout the United States, and retail prices climbed forty percent. Shortages continued into the early months of 1974, but with oil supply controls beginning to lose their effectiveness, diplomatic efforts finally succeeded in lifting the embargo on March 18. Oil supplies quickly returned to normal; however, retail gasoline prices never retreated to pre-embargo levels. (19) By the mid-1970s, U.S. oil companies had lost their grip on foreign oil and OPEC had transformed itself into a powerful cartel. Its members controlled vast financial resources, and the embargo showed the world that controlling oil supplies could also be an effective political weapon.

    The next energy shock took place in 1978 when political unrest in Iran, the second largest oil exporter, resulted in labor strikes, seriously curtailing production. In December 1978, the Iranian oil industry shut down and exports were halted. Revolution in Iran disrupted world oil supplies causing uncertainty in oil markets and triggering panic buying that sent prices on an upward spiral. (20) U.S. refineries dependent on Iranian oil experienced shortages, and gasoline inventories fell in some parts of the country. Gasoline lines once again formed around the country and retail prices increased thirty percent from December 1978 to June 1979. (21)

    About the time the Iranian oil industry began to recover and oil markets stabilized, war broke out between Iran and Iraq in September 1980. Exports from Iran and Iraq soon dissipated and world oil production dropped significantly, causing prices to rise sharply. However, market conditions had changed since the two previous energy shocks and high prices were not sustained. This potential third energy shock was avoided due to declining demand from a worldwide recession and increasing oil supplies from non-OPEC countries. Higher oil prices since 1973 had spurred investment in new oil sources from Alaska, Mexico, Norway, Russia, and other non-OPEC countries. (22)

    After 1973, the private and government sectors developed strategies to respond to both supply and demand issues. On the supply side, oil companies increased exploration activity in non-OPEC countries, and the supply of oil and oil reserves increased significantly. (23) Natural gas development increased in North America and became the fuel of choice for power generation. Industries switched their energy sources from liquid fuels to coal, natural gas, and electricity. The U.S. Congress funded the Alaskan pipeline and created the strategic petroleum reserve. (24)

    Policymakers began to look to agriculture as a source of energy supply, and legislation was passed to encourage ethanol and other renewable energy production. In 1978, the first major piece of legislation related to ethanol was passed and named the National Energy Act of 1978; it gave ethanol blends of at least ten percent by volume a $0.40 per gallon exemption from the federal motor fuels tax. (25) This law expired September 30, 1984. In 1980, the Energy Security Act (26) was enacted to offer insured loans to small ethanol plants producing less than one million gallons per year. Under this act, the Secretary of Agriculture and Secretary of Energy were ordered to prepare a plan that would increase ethanol production to at least ten percent of total gasoline supply by the end of 1990. Also in 1980, the Crude Oil Windfall Profit Tax Act (27) extended the ethanol motor fuel excise tax exemption to December 31, 1992, and provided blenders the option of receiving the same tax benefit by using an income tax credit instead of the fuel tax exemption. Since 1980, various tax laws have been adopted which change the level of the motor fuel tax credit that currently stands at $0.51 per gallon through 2010.

    The energy crisis also motivated the government and private sectors to adopt a number of polices aimed at conserving energy. American households became more conservation minded and industries increased their energy efficiency. The U.S. Congress set fuel efficiency standards for the automobile industry, adopted building energy efficiency standards, and required government motor fleets to purchase alternative-fueled vehicles. (28) Supply and demand adjustments helped reverse the trend of rising oil prices evident in the 1970s. OPEC's market...

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