Ed. note: This piece was first published on Robert Rapier's R-Squared Energy Blog.

In my recent post Thoughts on an Ethanol Pipeline, I described what I feel would be a more rational approach to ethanol policy than some of the policies that have been pursued over the years. This gist is that the Midwest currently produces about 95% of the ethanol in the U.S. (12.5 billion gallons), but they export 70% of that ethanol out of the Midwest. At the same time, they import gasoline that is the energy equivalent of 37 billion gallons per year of ethanol.

It would seem to be a more sensible energy policy to utilize ethanol production closer to the source of production — especially given that the motor fuel demand in the Midwest is far greater than the volume of ethanol produced there. Many readers agreed, and following that essay, they provided a number of excellent comments. I drew on those comments in my latest essay for Forbes: The Midwest Should Use Its Own Ethanol.

Here I want to continue to develop policy recommendations around this theme. Reader Paul Nash came up with a specific plan, which I share below (here is the link to the original comments).

The Rationale for a Policy Change

• The industry wants a pipeline to support a greater market on the east coast.
• This market will likely only grow by either raising the blend mandate, or exporting ethanol
• From a national energy use point of view, it is much better to have the ethanol being used near to where it is produced (Midwest).
• Presently, this is only happening to the extent required by the blend mandate – there is relatively little E85 usage.
• Other than raising the blend mandate, the only real way to grow ethanol use is by E85.
• Many/most flex fuel drivers (today) do not run on E85 because it is either hard to find and/or there is little financial benefit to doing so.
• Some new flex fuel vehicles are optimized for E85, and their drivers will get a financial benefit, but they will only be a small portion of the market.

Specific Recommendations

1. Scrap the VEETC (since there is a mandate already and it expires at the end of 2010).
2. Maintain a producer’s credit for cellulosic ethanol, until 2015.
3. Double the VEETC credit for E85 sales (as well as for 85% blends of methanol and mixed alcohols).
4. Pay this credit to the retailer, not the fuel blender (if it is a different party).
5. Place an export tax on ethanol equal to all the producer credits (including corn grower’s credit).
6. Do not give any government subsidy for the pipeline – let the industry decide if they want to spend that money, or develop the market in their own backyard.
7. Relax law allowing drivers (not retailers) to blend any amount of ethanol they like into their fuel. i.e. mix E85 with regular gasoline in any proportion they want.

Projected Consequences

So, with a $0.90 tax credit on E85, drivers will have a real, immediate, and obvious monetary incentive to use it. Retailers, faced with making good margin on E85, will have good incentive to install pumps. The ethanol industry might even choose to partner with them to help pay for said pumps. The ethanol producers might even set up their own E85 stations at the distillery gate, just like wineries sell at the cellar door.

Fueling stations selling E85 and nothing else, supplied directly by the distilleries, will begin to appear, and would be VERY easy and cheap to set up, and would, of course, be within easy trucking range of said distilleries.

Drivers are legal to use higher mixes, but are not being forced to, and no one is selling higher mixes. The responsibility is purely with the drivers who decide to use higher mixes, or not, so the retailers/oil companies and ethanol industry are not liable for any engine problems (unless, of course, if the ethanol industry claims there won’t be problems).

Now, doubling the credit on E85 to $0.90 is a huge subsidy to the E85 users, but there are not that many of them (presently) so the total amount spent on this subsidy will be far smaller than the $6 billion/yr presently.

This plan leaves the oil refiners out of the ethanol subsidy business, but that is OK as they are mandated to blend x amount of ethanol, this is not destroying their business in any way – it is merely promoting an alternative fuel that they (to date) have refused to promote.

If the retailers and drivers “follow the money”, we would see a rapid increase in E85 usage, and I’ll bet it gets used more in corn country first, which is as it should be.

Conclusions

I agree with most of what Paul suggests, and believe it would create huge new opportunities for the domestic ethanol industry without the need for an E15 mandate. These policies would also move the industry closer to the generally accepted purpose of U.S. biofuel policy, which is to use biofuels to reduce demand for petroleum. The farther biofuels are moved from the point of production, the less petroleum they are able to offset due to the energy cost of moving the biofuels.

However, I don’t believe the subsidy would need to be as high as $0.90 per gallon. I certainly think such a high subsidy would result in explosive growth for the E85 industry, but then we would once again have to contend with a $6 billion ethanol subsidy in just a few years. I think the same goal could be accomplished with a subsidy of around $0.50/gallon.

According to E85.com, over the past year E85 has been anywhere from 10% cheaper to 22% cheaper than gasoline. Given an observed E85 energy penalty of 25-30%, it is likely that E85 would need to be consistently 30% cheaper than gasoline to build a substantial market. (Another possibility is the continued development of engines that can reduce the E85 energy penalty by using higher compression ratios; if you only lose 10% fuel efficiency on E85 then you will happily buy E85 at only a 15% discount to gasoline).

The narrowest spread between E85 and gasoline over the past year occurred in December 2009 when gasoline was $2.56 per gallon and E85 was $2.30 per gallon. To increase that narrowest price spread back to 30% would require an additional E85 subsidy of $0.51 per gallon. At the widest spread over the past year in May 2010, this level of subsidy could have had E85 undercutting gasoline by more than 40%. At that price spread, E85 demand would grow rapidly.

Given the meager level of E85 sales in the U.S. today, this level of subsidy would be far lower than present ethanol subsidies, while providing strong incentives to build out E85 infrastructure and E85 vehicles. Further, it would actually strengthen the energy security of the Midwestern states well beyond the status quo.