The Renewable Fuel Standard: How markets can knock down walls

February 14, 2014 |

By Philip K. Verleger, Jr. PKVerleger LLC

with valuable contributions from The Brattle Group

Most motorists don’t realize that they are the beneficiaries of a significant policy experiment that began several years ago during the Bush Administration, although they may have noticed signs at nearly all fuel pumps indicating that the gasoline contains up to 10% ethanol, called E10 by the fuel industry. The policy that helped make 10% ethanol the market norm—the Renewable Fuel Standard (RFS)—has helped moderate overall fuel prices and will continue to do so if given a chance to evolve in a way that preserves its basic structure.

The RFS requires a certain percentage of ethanol be blended into motor fuel, and creates a credit pricing system to rationalize that process. The price of these credits—called Renewable Identification Numbers or RINs—spiked last year, causing much consternation in oil markets and in some policy circles in Washington.

Nevertheless, even that episode showed that the basic policy works as intended, insofar as the higher RIN prices stimulated a substantial jump in sales of 85% ethanol gasoline blends (E85) purchased by owners of flex-fuel vehicles (FFVs).

The Obama Administration gets spooked

Cheered on by some segments of the oil industry, however, the Obama Administration proposed a retreat from the ethanol percentage requirements for 2014, apparently spooked by the prospect that high RIN prices might be blamed for high gasoline (E10) prices or some unspecified distortions in the market. This is particularly ironic, given that the RIN price is the primary vehicle for stimulating additional ethanol use to achieve the objectives of the program, and that the overall impact of the program is to reduce U.S. gasoline prices.

This concern regarding the effects of RIN prices on motorists is misguided and clearly refuted by market evidence. Our examination of the interplay between the RFS policy and transportation fuel markets shows that:

Ethanol use lowers crude oil prices.

rfs-lowers-prices

Continued tightness in world oil markets means that any reduction in U.S. crude oil demand—through more efficient vehicles, more conscientious driving habits or ethanol blended into motor fuels—will have a disproportionate impact on world oil prices. In the case of ethanol, we estimate that overall cumulative ethanol consumption since 2007 has reduced the current crude price by about $45 per barrel, or about $1.00 per gallon. The effect on crude oil price due to the volumes blended in 2013 alone (above 2007 levels) are responsible for a $10 per barrel crude oil price reduction from the actual price observed, or about 25¢ per gallon. Thus, motorists reap the benefit of lower overall fuel prices, even if RIN prices temporarily work their way into retail E10 gasoline prices. The RFS policy represents a win for consumers.

RIN prices work as intended.

The pronounced jump in E85 sales observed in mid-2013 was a result of higher RIN prices, and demonstrates conclusively that when retailers discount the price of E85 compared to E10 (regular gasoline) to reflect the higher value of RINs, owners of flexfuel vehicles respond by filling up their tanks with E85. The data from Minnesota shows that for every percentage point reduction in the ratio of E85 to E10 price, sales volumes of E85 rise by over 5 percent. This directly contradicts the oil industry’s claim that E85 cannot be effectively marketed to the nearly 15 million flex-fuel vehicle owners.

e85-breaks-walls

Using conservative assumptions regarding the current status of accessibility and marketing of E85, as well as competitive pricing by the oil industry, we estimate that a RIN price of about $1.00 would induce sales of about 600 million gallons of E85 from the existing FFV fleet. This would not negatively impact the price of regular (E10) gasoline. If E85 marketing improved and infrastructure expanded as a result of a growing RFS mandate, RIN prices could be significantly lower at any given level of E85 sales.

RIN price impact on retail gasoline (E10) prices is small and transient.

The retail price of gasoline depends on myriad factors that affect a complex web of transactions from refineries purchasing crude oil to blender/distributors marketing finished gasoline-ethanol blends to service stations. Over time, competition in these interrelated markets tends to drive out any windfalls that may emerge when refiners or blenders try to embed the RIN price into regular gasoline (E10) prices.

However, regular gasoline prices probably were affected by the RIN prices observed during 2013, by about 5¢ to 6¢ per gallon at most, an amount comparable to typical weekly average price changes. This effect would diminish as competition at the retail distribution level strengthens under a more predictable RIN price trajectory.

What of the so-called “blend wall” that supposedly prevents additional volumes of ethanol to be cost-effectively introduced into the vehicle fuel markets? While some infrastructure and market constraints do exist, the empirical evidence suggests that the blend wall is neither impossibly high nor impenetrable.

Blend step, not blend wall

 

It is more accurately described as a “blend step” that reflects the current constraint for conventional vehicles (e.g, 10% ethanol limit for fuel), but it is not an insurmountable barrier to achieving higher levels of ethanol use when RIN prices work to stimulate significant demand for E85 from the flex-fuel fleet. The increased demand levels for E85 enabled by RIN prices creates the market incentive to invest in additional E85 infrastructure.

Thus, the blend wall can be overcome by letting the RFS policy work as intended through RIN price levels sufficient to attract additional investment, encourage innovative pathways and expand choices for vehicle fuels.

The complete 53 page report can be downloaded here.

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