GianCarlo Moschini
Professor and Chair
Department of Economics
Iowa State University
Presentation prepared for the workshop on “Strategic Directions in Social, Legal and Environmental Dimensions
of Research on Biofuels,” Energy Biosciences Institute, University of California Berkeley/University of Illinois,
Champaign, IL, September 25-26, 2010.
* This presentation is based on the following papers from an ongoing collaborative research project:
Lapan, H. and G. Moschini, “Biofuel Policies and Welfare: Is the Stick of Mandates Better than the Carrot of Subsidies?”
Working Paper No. 09010 , Dept of Economics, Iowa State University, June 2009 .
Cui, J., H. Lapan, G. Moschini and J. Cooper, “Welfare Impacts of Alternative Bioefuel and Energy Policies,” Working
Paper No. 10016 , Dept of Economics, Iowa State University, June 2010 .
September 2010 Moschini, Biofuel Policies & Welfare, Champaign, IL 1

Biofuels: The Driving Role of Policies
 US ethanol production : 1.65 (2000)  10.76 billion gallons (2009)
 Key federal policy instruments for ethanol:
• blender tax credit $0.45/gal (a production “ subsidy ”)
— and a $0.54/gal import duty (secondary tariff) + 2.5% ad valorem tariff
• Renewable Fuel Standard (a production “ mandate ”)
— dramatically enhanced by 2007 EISA (Energy Independence and
Security Act): 9 bg for 2008 to rise to 36 bg by 2022
— corn ethanol portion: 9 bg in 2008, 10.5 in 2009  15 bg in 2015
 The United States is now the largest world producer of ethanol
• surpassed Brazil in 2006
2

Why Biofuel Policies?
 Dwindling supplies of fossil fuels
• quest for renewable sources of energy
• national security concerns
 Environmental impacts of carbon emissions
• global climate change concerns
• but: indirect land use change effects
 To increase demand for farm output to support farm incomes
• countering the effects of increasing agricultural productivity
 How do these motivations/objectives compare with the assessed impacts?
3

Emerging Body of Literature
Many contributions, including:
 Rajagopal and Zilberman, World Bank, 2007 -- review
 Elobeid and Tokgoz, AJAE 2008 -- FAPRI models
 Hertel, Tyner and Birur, 2008 -- GTAP models
 Khanna, Ando and Taheripour, RAE 2008
 Holland, Hughes and Knittel, AEJ-EP 2009
 de Gorter and Just, AJAE 2009a and AJAE 2009b
 Lapan and Moschini, Iowa State University WP 2009
 Cui, Lapan, Moschini and Cooper, Iowa State University WP 2010
 much more . . .
4

This Presentation
 Derivation of an explicit multimarket equilibrium model
• energy sector
• agricultural sector
• domestic and foreign components
• market failures and scope for government intervention
• policy instruments: taxes/subsidies and biofuel mandates
 Emphasis is on the theoretical construction of a model suitable for
• second-best policy evaluation
• calibration and simulation
 Model provides analytical insights and a potentially useful quantitative assessment of alternative policies
5

The Model’s Structure export demand
Corn ethanol fuel food & feed
GHGs petroleum byproducts domestic oil unblended gasoline petroleum byproducts foreign oil
6

Demand
 (Quasilinear) utility of domestic consumption:
U y

 
     
 
 x g
  x e

 Domestic (inverse) demand fns: p c
  
( D c
) p h
  
( D c
)
— direct demand functions: … , h
)
 Externality effect : carbon emissions from gasoline and ethanol use
 Foreign sector — demand fn for corn:
 
7

Production Sector
 Convex aggregate cost function for US corn : C X c
)
• upward-sloping supply fn for US corn:  S p c
)
 Convex aggregate cost function for US oil

:
( )

( S p o s o
)
 S p o
)
 If no other distortions in the model, in the laissez faire equilibrium:
• world price = domestic price = marginal production cost of corn
• marginal utility of domestic corn consumption = price of corn
• world price = domestic price = marginal production cost of oil
• marginal utility of domestic fuel consumption = retail price of fuel
 Production of gasoline & ethanol : more structure is useful …
8

Production of Ethanol and Gasoline (  Fuel)
 Ethanol:
… account for by-products
… account for energy content
 Gasoline:
+ petroleum byproducts:
 Blended “ Fuel ”:
… or, in GEEG units: x v e
 min
 ax z e
 x e v  min
  x z e
 x e
 min
  x z e
 x g
 min

 x o
, z g
 x h
 
2 x g
 x f
 x g
  x v e x f
 x g
 x e
,
 
0.69
a

2.8
  a (1
 a (1
 x o

S o

S o
)
)
“Gasoline Energy Equivalent Gallons”
9

Policy Instruments and Welfare: First and Second Best
 Maximization of (domestic) welfare requires three policy instruments:
— an import tax on oil
WTO constraints; US law
— an export tax on corn
— a tax on pollution emissions political feasibility ?
 First-best solution: carbon tax, oil import tariff, corn export tax
 Second-best solution: consumption tax on fuel and subsidy on ethanol
(or: tax on fuel and production mandate for ethanol)
 Restricted second best: only one “active” policy instrument :
— subsidy on ethanol; or, production mandate
 Standard benchmarks: laissez faire (and, also, status quo )
10

Competitive Equilibrium
 

 

 
 x e
D f
 
 

 
 o
  

 x e
 
2

 
 o
  
. . . . . . Corn Market Equilibrium
. . . . . . Fuel Market Equilibrium
. . . . . . . . Petroleum Byproduct Equilibrium
 p g
 
2 p h
 p o
  g p e
 p c
  e
. . . . . . . . Zero Profit Condition Oil Refining
. . . . . . . . . . . . Zero Profit Condition Ethanol Industry p o
 p w o
  o p c w  p c
  c
. . . . . . . . . . . . Oil Import Arbitrage Relation
. . . . . . . . . . . . Corn Export Arbitrage Relation
 h
 and e
• Laissez faire:  p c
 p c w and p o
 p w o
CRTS
11

Equilibrium with Fuel Tax and Ethanol Subsidy
 Need to modify arbitrage relations: t
 tax on fuel b

  subsidy ethanol energy efficiency p g
 p f
 t p e
 p f b
  t
 Currently, and $0.45 / gal
• note: because the tax is levied on volume terms, it is biased against
12

Equilibrium with an Ethanol Mandate
 Quantity of ethanol is exogenously set and binding: x e
 x e
M
• Relevant arbitrage relation: zero-profit condition in blending industry
• price of fuel is a weighted average of its components, with the amount of ethanol exogenously given
 p f
 f
( f
)
 p g f
( f
)
 x e
M 
 p e
 e
M total fuel gasoline b

 b t (1
 
)
  ethanol
Result (Lapan and Moschini 2009): An ethanol mandate, per se, is equivalent to a combination of an ethanol blending subsidy and a fuel tax that are revenue neutral.
13

Welfare Maximization and Policy Analysis endowment of numeraire cost of domestic production net imports
W

   
 
    x
 p S o
 p D c
 x g
 x e

     
 
 x g
  x e

 utility of consumption disutility of pollution
(externality)
 Totally differentiate welfare function, use relevant arbitrage relations, can solve for optimal level of policy instruments under a number of scenarios . . .
 Calibration of the model uses linear demand and supply functions and:
• assume an elasticity value for each function
• choose a benchmark (observed) price-quantity data point ( year 2009 )
14

Welfare Maximization: First- and Second-Best Solutions
 First best: t
* b
*
   
 
  
 o
*
 c
*

S o

S
 o


D c

D
 c
 b
*  

1


   t (1
 
)
 Second best: where: t sb    
S o
  b sb 

1


 
S
 o



D c
Q

  
  

  
 

  

 

  
. . . . . supply of gasoline
. . . residual supply of corn for ethanol
15

Parametric Assumptions
Parameter
Domestic Supply Elasticity of Oil
Foreign Supply Elasticity of Oil
Domestic Supply Elasticity of Corn
Foreign Demand Elasticity of Corn
Domestic Demand Elasticity of Corn
Demand Elasticity of Fuel
Ethanol Production from corn
(gallons/bushel)
Ethanol Energy Equivalent Rate
Relative Pollution Efficiency
Marginal Emissions Damage ($/tCO
2
) symbol value
0.69
Source
 o
0.20 de Gorter and Just (2009b)
 o
2.63 de Gorter and Just (2009b)
 c
0.23 USDA (2007)
 c
-1.74 FAPRI (2004)
 c
-0.20 de Gorter and Just (2009b)
 f
-0.50
Toman, Griffin and Lempert
(2008) a 2.8 Eidman (2007)

 0.75
  
33
NREL (2008)
Farrel et al. (2006)
Wang (2007)
NHTSA (2009), EPA (2008)
Tol (2008, 2009)
16

Variables at Calibrated Point (2009 data)
Variable
Fuel tax ($/gal)
Ethanol subsidy ($/gal)
Oil price ($/barrel)
Corn price ($/bu)
Ethanol price ($/gal)
Domestic oil supply (billion barrels)
Foreign oil import (billion barrels)
Ethanol supply (billion gallons)
Fuel demand (billion gallons)
Domestic corn supply (billion bushels)
Corn net export (billion bushels)
Ethanol price ($/GEEG)
Fuel price ($/GEEG)
Gasoline price ($/GEEG)
Symbol Value Source/explanation t 0.39 federal 0.184 + state (avg) 0.206
b 0.45 p o p c p e v
S o
61.0
3.74
1.79
1.93
S o
3.29 x e v 10.76
D f v 134.4
S c
13.15
D c
1.86 p e
2.59 p f
2.50 p g
2.11
RFS2
EIA
USDA avg rack price in Omaha, NE
EIA
EIA
RFA
EIA
USDA
USDA p e
 p e v
/
 arbitrage arbitrage
17

Results: Optimal Instruments and Quantities
Laissez
Faire
0.00
No
Ethanol
Policy
0.39
Status
Quo
0.39
First
Best
0.37
Optimal
Tax &
Subsidy
Optimal
Subsidy
Optimal
Mandate
1.17 0.39 0.39 Fuel Tax ($/gallon)
Ethanol Subsidy ($/gallon)
Oil Tariff ($/barrel)
Corn Tariff ($/bushel)
0.00
0.00
0.00
0.00
0.00
0.00
0.45
0.00
0.00
0.18
19.20
1.10
1.16
0.00
0.00
0.68
0.00
0.00
0.00
0.00
0.00
Gasoline Quantity (bill gallons) 130.3 127.2 123.6 112.5 111.7 121.8 119.7
Ethanol Quantity (bill gallons) 6.32 0.58 10.76 13.84 15.22 15.92 17.94
Corn Production (bill bushels) 12.69 12.09 13.15 13.11 13.62 13.69 13.90
Corn Demand (bill bushels) 8.61 8.94 8.35 8.38 8.10 8.06 7.94
Corn Export (bill bushels)
US Oil Supply (bill barrels)
Oil Import (billion barrels)
2.36
1.95
3.56
2.99
1.94
3.43
1.86
1.93
3.29
0.95
2.03
2.72
1.36
1.91
2.81
1.29
1.93
3.22
1.06
1.93
3.13
18

Results: Optimal Instruments and Prices
Fuel Tax ($/gallon)
Ethanol Subsidy ($/gallon) 1
Oil Tariff ($/barrel)
Corn Tariff ($/bushel)
Fuel Price ($/GEEG)
Gasoline Price ($/gallon)
Ethanol Price ($/gallon)
U.S. Oil Price ($/barrel)
U.S. Corn Price ($/bushel)
Laissez
Faire
0.00
0.00
No
Ethanol
Policy
0.39
0.00
0.00
0.00
2.36
2.36
1.63
62.9
3.17
0.00
0.00
2.64
2.25
1.43
62.0
2.43
Status
Quo
2.50
2.11
1.79
61.0
3.74
0.39
0.45
0.00
0.00
0.37
0.18
19.20
1.10
2.85
2.48
1.78
76.2
3.69
First
Best
2.84
1.67
1.95
57.6
4.32
Optimal
Tax &
Subsidy
Optimal
Subsidy
Optimal
Mandate
1.17 0.39 0.39
1.16 0.68 0.00
0.00
0.00
0.00
0.00
0.00
0.00
2.44
2.05
1.97
60.5
4.41
2.47
1.97
2.04
59.9
4.67
19

Results: Welfare Effects (Changes from Laissez Faire )
Social Welfare ($ billion)
Pollution effect
Tax Revenue
P.S. Oil Supply
P.S. Corn Supply
C.S. Corn Demand
C.S. Fuel Demand
C.S. Petroleum byproducts
--
-49.8
0
--
--
--
--
--
Laissez
Faire
No
Ethanol
Policy
1.7
2.3
49.8
-1.7
-9.2
Status
Quo
8.0
-3.7
7.4
1.6
47.6
First
Best
15.0
5.2
Optimal
Tax &
Subsidy
Optimal
Subsidy
Optimal
Mandate
13.4 8.8 9.8
5.2 1.3
97.9 131.3 42.9
26.4
6.7
-10.2
15.1
-4.7
16.3
6.5 -4.9 -4.4 -9.6
-35.7 -18.5 -62.0 -61.3
-10.3
-9.6
-10.3 -21.6 -54.8 -57.1 -27.2
1.7
53.7
-5.9
19.9
-12.4
-13.4
-33.8
CO
2
Emission (million tCO
2
) 1,508 -69.0 -49.9 -157.6 -158.6 -40.3 -52.8
20

Welfare Maximization: Effectiveness of Alternative Policies
Optimal Mandate
Optimal Subsidy
Optimal Tax & Subsidy
Status Quo
No Ethanol Policy
First Best
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
21

Oil Import Reduction of Alternative Policies
(changes from laissez faire )
Optimal Mandate
Optimal Subsidy
Optimal Tax & Subsidy
Status Quo
No Ethanol Policy
First Best
0% 5% 10% 15% 20% 25%
22

Reduction in CO
2
Emissions (relative to laissez faire )
(tCO
2 millions)
Optimal Mandate
Optimal Subsidy
Optimal Tax & Subsidy
Status Quo
No Ethanol Policy
First Best
0 20 40 60 80 100 120 140 160
23

Corn Ethanol Production under Alternative Policies
(billions of gallons)
Optimal Mandate
Optimal Subsidy
Optimal Tax & Subsidy
Status Quo
No Ethanol Policy
Laissez Faire
First Best
0 5 10 15 20
24

Effects of the Status Quo Ethanol Policy
(changes relative to “no ethanol policy,” $ billions)
C.S. Petroleum Byproduct -11,3
C.S. Fuel Demand
C.S. Corn Demand
P.S. Corn Supply
-11,4
P.S. Oil Supply
Tax Revenue
Pollution Abatement
Social Welfare
-15 -10 -5
-2
-2,2
-0,7
0
17,2
16,6
5
6,3
10 15 20
25

Sensitivity Analysis
Parameter
Cost of CO
2 emission ($/tCO
2
)
Ethanol CO
2
emission efficiency
Elasticity of fuel demand
Elasticity of foreign corn import demand
Elasticity of foreign oil export supply
Elasticity of petroleum byproduct demand
Symbol Baseline
  
33

 f
 c
 o
 h
0.75
-0.5
-1.74
2.63
-0.5
Range
[ 2 , 100 ]
[ 0.52 , 1.70 ]
[ -0.9 , -0.2 ]
[ -3.0 , -1.0
[ 1.0 , 5.0 ]
[ -0.9 , -0.2 ]
26

Sensitivity Analysis Summary
 For all cases the status quo policies dominated laissez faire and delivered at least 40% of the maximal benefits achievable with first best
 In all cases the second-best (fuel tax/ethanol subsidy) regime is a close substitute for first best policy
 The welfare gains with the second best policy was greater than 81% of the maximum gains achievable with first best in all cases (average of 89%)
 The oil market plays a dominating role in determining the potential gains from government policy
27

. . . Sensitivity Analysis Summary
 In all cases carbon emissions reductions achieved the first best and the second best policies were very close, and far exceeded those achieved under one-instrument policies
 The optimal mandate policy dominated the optimal subsidy policy in all cases and gives the highest use of ethanol in all cases
But: In most cases it did not significantly outperform the status quo
 If ethanol pollutes less than gasoline, the optimal mandate results in lower pollution than the optimal ethanol subsidy
 First- and second-best solutions are very close in terms of their ability to reduce U.S. dependence on foreign oil
28

Conclusions
 We have developed a model that provides a theoretically-consistent framework for the economic assessment of major biofuel policies
• it accounts for market failures — (differential) externalities for gasoline and biofuels — as well as terms-of-trade effects that impact welfare
 Second-best solution (tax gasoline but not ethanol) is a close substitute for the (arguably not feasible) first-best policy
• 2 nd best: increases ethanol production by 41% relative to status quo decrease gasoline consumption by 10% ; reduce emissions by 7.5%
 If the tax on fuel is not a choice, an ethanol mandate is better than a subsidy
 The case for ethanol support is largely not about reducing pollution, it is mostly about the policy’s impact on the US gains from trade (via the terms of trade)
 Accounting for “ national security ” impacts would only strengthen this result
29

Thank you.
For more details please refer to the following papers available online:
Lapan, H. and G. Moschini, “Biofuel Policies and Welfare: Is the Stick of Mandates Better than the
Carrot of Subsidies?” Working Paper No. 09010 , Department of Economics, Iowa State University,
June 2009 .
Cui, J., H. Lapan, G. Moschini and J. Cooper, “Welfare Impacts of Alternative Bioefuel and Energy
Policies,” Working Paper No. 10016 , Department of Economics, Iowa State University, June 2010 .
30