Solving the Midwest Ethanol Problem
Ed. note: This piece was first published on Robert Rapier’s R-Squared Energy Blog.
What Ethanol Problem?
If you live in the Midwest, you are in the midst of a thriving ethanol industry. But the problem is that the Midwest does not control its own destiny when it comes to ethanol. That is still controlled by the federal government.
When I first started writing about energy nearly a decade ago, many of my early articles were addressed at the ethanol policies we were pursuing in the US. Even though I supported renewable energy, I felt like we were going about things in the wrong way. While I acknowledged that you could subsidize lots of ethanol production into existence, there needed to be a clear path for sustainability in the event that strong government intervention waned.
Today, nine years after I began writing about energy, we have an ethanol industry that has undergone rapid growth, but it is an industry that still relies heavily on the hand of government in the form of the Renewable Fuel Standard (RFS). One need look no further than the uproar over the Environmental Protection Agency’s (EPA) decision to lower the RFS for 2014.
This situation could have been avoided — and could still be avoided — but the ethanol industry continues to chase policies that will ensure that they remain dependent on the federal government to create their markets.
An Unsustainable Industry
The roots of the ethanol industry’s current problems go back to 1978, when the United States Environmental Protection Agency (EPA) set the maximum legal limit of ethanol in motor gasoline at 10 percent ethanol. Three decades later the RFS deemed that increasing amounts of ethanol had to be blended into the gasoline supply, but because US gasoline consumption has been falling, the 10 percent limit of ethanol in the gasoline supply was reached. As the gasoline pool was approaching that limit – commonly referred to as the “blend wall” – the ethanol lobby requested that the EPA allow 15 percent ethanol blends.
Once more, I thought this was the wrong policy to pursue. (See Ethanol Lobby Agitates for E15 Mandate). Car manufacturers said they wouldn’t warranty models for ethanol blends higher than 10 percent, and even though the EPA did grant a waiver that allowed E15 in most modern cars, it was not the mandate that the ethanol lobby really wants – and thus E15 sales have been near zero.
I would have pursued a different policy. I am a firm believer that to the greatest extent possible, locally-produced energy should be used to satisfy local needs first, before exporting any excess energy. This is a position I explained in Thoughts on an Ethanol Pipeline and E85 Case Study: Iowa.
But this isn’t the way our ethanol policy is designed.
Fuel Demand in the Midwest
The United States is divided into five Petroleum Administration for Defense Districts (PADDs). PADD 2 encompasses most of the Midwest. The states in PADD 2 are Illinois, Indiana, Iowa, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, Oklahoma, South Dakota, Tennessee, and Wisconsin.
In 2013, US ethanol production averaged 852,000 barrels per day (bpd). PADD 2 — the Midwest — was responsible for 93.5 percent of total US ethanol production (796,000 bpd). Gasoline consumption in PADD 2 in 2013 was 2.1 million bpd of conventional gasoline and 380,000 bpd of reformulated gasoline (which contains 10 percent ethanol). So on the conservative side, PADD 2 used about 2.4 million bpd of gasoline. This is the energy equivalent of 3.6 million bpd of ethanol — 4.5 times all of PADD 2′s 2013 ethanol production.
But imagine if the Midwest could figure out a way to transfer the demand for gasoline to demand for E85. In that case, the region would never again have to worry about federal ethanol mandates. The ethanol industry would then be forever racing to catch up to demand, instead of spending money lobbying Congress for continued mandates.
How to Drive E85 Demand
There is one primary factor that will cause drivers to favor E85 over gasoline: Price. Yes, there needs to be enough E85 vehicles and enough stations offering E85, but both will be in strong demand if the E85 price is right.
Because of the loss of fuel efficiency when using E85, drivers need a discount to keep their cost per mile competitive with gasoline. E85 contains about 25% less energy than regular gasoline (approximated as E10). Therefore, drivers can achieve price parity with E85 when it is priced at a discount of at least 25% to regular gasoline. (Some will argue that the discount doesn’t have to be this large to drive E85 sales; I am just setting the discount according to energy content).
However, over the past few years, this has seldom been the case. According to E85prices.com, the current national average discount for E85 is 18 percent. The discount is greater across the Midwest as might be expected closer to the source of production, but South Dakota with a 29 percent discount is the only Midwestern state reporting an E85 discount of greater than 25 percent.
US ethanol policy has certainly been good for the Midwest, but the good times could vanish if the US ever abolished the RFS — which is what some lawmakers would like. If I happened to be a Midwestern governor, I would work to better ensure I am in control of my own destiny. In fact, I would want my entire passenger car fleet to be powered by E85. That would render the RFS moot. (Cummins is even working on “an E85 powertrain concept for medium-duty truck operation.”)
A massive migration to E85 would be expedited if a >25 percent discount relative to gasoline could be sustained over time. This could be accomplished with a revenue-neutral tax scheme that raises taxes on regular gasoline, while offsetting them elsewhere and exempting E85. Consumers would demand E85. E85 vehicles would be in high demand, and consumers would flock to gas stations that offer E85.
Case Study: Iowa
Take Iowa as a basis for an exercise. Currently, the average price of gasoline in Iowa is $3.20. The nationwide average for E85 is $2.48 – a 22.5 percent discount to regular gasoline. If we wanted to move that discount to 27 percent, we could increase the price of gasoline to $3.40 – an increase of $0.20/gallon from the current price.
This could be achieved with a $0.20/gallon increase in the gasoline tax. That would give Iowa a state gasoline tax of $0.42/gallon, which would still be lower than that state gasoline taxes in New York, California, Connecticut, and Hawaii — while driving consumers to buy a locally produced alternative.
To offset the increased cost of the gasoline tax, the government could reducing income taxes or sales taxes. Or, they could simply rebate some or all of the actual gas taxes paid. A family with a $1,000 increase in taxes could get that back when they file their state income tax return. The discount would still drive E85 sales as most people would opt to have their money now, and not have to save gasoline receipts. But for someone who, for whatever reason, was unable to opt for E85, the option is there to get those excess gasoline taxes back. The government should more than make up for that loss of revenue as higher ethanol consumption supports more jobs in the state.
Conclusion: Courage Required
Would it be easy to implement? No, any time you are messing around with gasoline taxes, there is going to be a knee-jerk reaction from short-sighted people who can only focus on what’s directly in front of them: higher gasoline taxes. Implementing a policy like this would take courageous and visionary leaders willing to defend the idea on the basis of the greater long-term good. But because the discount across the Midwest is already greater than the national average, it might only take an increase of a dime to see E85 demand skyrocket. (I realize Midwestern demand for E85 has been growing anyway, but I am targeting a demand change of an order of magnitude).
The alternative is that failure to take control of their own destiny will leave it in the hands of the federal government, and they may ultimately decide that what’s good for the Midwest – the RFS — isn’t necessarily what’s good for the rest of the country.
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