A Way Around the Ethanol Blend Wall?

I wrote last week about a looming problem with the Renewable Fuels Standard (RFS2) that has parts of industry and many policy analysts concerned about rising gas prices. In this post I want to write about one regulatory tweak that might help deal with the problem without gutting the mandate: adding something like a safety valve to the RFS2.

The Problem

Let’s quickly recap what’s going on. The EPA has mandated that an increasing amount of ethanol be blended into fuel. Because U.S. fuel use is declining, if it were blended uniformly, the fraction of ethanol in fuel would likely exceed 10 percent, the so-called “blend wall” beyond which many U.S. vehicles can’t use (or at least are wary of using) the fuel. The resulting dynamics could, in principle, drive up prices for Renewable Identification Numbers (RINs), an instrument that refiners and blenders need to submit in order to demonstrate RFS2 compliance. That could push fuel prices way up.

As several people have noted, the way around this is to grow sales of E85, a blend of 85 percent ethanol and 15 percent gasoline that a subset of U.S. vehicles (flex-fuel cars and trucks) can use. If, say, the EPA effectively mandates that the U.S. fuel supply should be 11 percent ethanol, one way to meet that would be to have (roughly) 99 percent of fuel sales be E10 (10 percent ethanol) and the other 1 percent be E85. This would avoid the blend wall and let the mandate do its job.

The biggest problem that analysts have with this is that E85 has never been a significant seller. That’s largely because it’s always been more expensive than E10 or plain gasoline on an energy-equivalent basis. Very few are going to buy E85 if it costs more.

Barriers to E85

In a fascinating draft paper (“The Blend Bump”, forthcoming later this month), Phil Verleger points out something important: as RIN prices rise, it should become profitable to sell E85 at an ever greater discount. When you sell E85, you generate a large volume of RINs, most of which you don’t need to comply with your mandate obligations. You can sell that RIN surplus to refiners and blenders who sell E10 or pure gasoline and who need more RINs in order to meet their obligations.

How high would RIN prices need to rise to pump up E85 sales? A precise estimate is difficult. As Verleger notes, however, it’s pretty easy to establish an upper bound by asking a simple question: how valuable would RINs need to be to persuade companies to give away E85 for free? He estimates that, given current ethanol prices, RINs would need to sell for $3.50 to make that happen on the spot market, and for $5.00 to get sellers to give away the stuff at retail too. If RIN prices rose to $3.50, it would increase the prices of fuel by about 35 cents. Since this is an upper bound, one should in principle expect prices to rise by less than that – Verleger estimates that, given current RBOB gasoline and ethanol prices, if all it took to push E85 into the market was a 10 percent discount to E10 on an energy-adjusted basis, RINs would only need to sell for about $1.18 for the system to work.

What I find particularly interesting about Verleger’s paper, though, is the next step: it asks whether there might be reasons that this dynamic could fail to unfold. He flags three factors but highlights one particularly critical one. When a company sells E85, they generate surplus RINs immediately. They are unlikely, however, to find an immediate buyer, since most refiners and blenders wait until closer to the end of each compliance year to buy the RINs that they need. In the interim, the E85 sellers face a serious regulatory risk: given growing calls from parts of industry and Congress to investigate the RFS2, they have legitimate reason to worry that the mandate will be waived or watered down. In that case, their RINs will lose value, and their E85 gambit might fail to pay off. Given that prospect, they might not sell E85 (and generate lots of RINs) in the first place. In that case we’d stuck with the sort of debacle that many have warned of.

A Safety Valve?

That leads to my own suggestion for a possible policy tweak. We need a way to increase the credibility of the mandate without risking an unacceptable price spike. If E85 sellers can be made confident that the RFS2 will be sustained, there’s a decent chance that they’ll sell a substantial volume of their product, and that the RFS2 will be met. (No one can know for sure, though, particularly because there many not be enough E85 pumps to ramp up sales quickly enough.) If they are afraid that the mandate won’t hold, though, they won’t sell much E85; their predictions will become self-fulfilling, as fuel prices rise strongly and politicians react by severely weakening the mandate.

Congress could largely eliminate this latter possibility by adding a safety valve to the RFS2: it could commit the U.S. government now to selling an unlimited quantity of RINs in the future at some preset price. That price would need to be set high enough to keep E85 sales profitable.  If, for example, the safety valve were set somewhere between $1 and $2, strong incentives to sell E85 at a discount would probably remain, since sellers might be able generate decent volumes RINs for less than the safety valve price that way. (Picking a precise level for a safety valve would require considerably more robustness analysis than this blog post permits.) And if people are right that E85 provides a smooth way around the blend wall, no one will ever need to buy RINs from the government in the end. At the same time, the price would need to be set low enough to reassure everyone that the RFS2 won’t raise fuel prices too much, even if E85 fails to penetrate the market strongly. That would remove the risk that scared policymakers would drastically weaken the mandate or waive it entirely, again helping E85 sellers gain confidence. The same $1-$2 price could do that: it would allow fuel prices to rise by no more than 10-20 cents.

Some will find this idea odd: wouldn’t a floor price for RINs, rather than a ceiling, be the best way to incentivize more production of E85? The essential thing to keep in mind here is that the goal of the tweak would be to reinforce the political credibility of the RFS2, and then to let the market work. A ceiling, not a floor, is what’s needed to do that.

To be certain, it’s far from clear that the RFS2, even with this tweak, would pass a cost-benefit test. The current situation should also provide lessons on how not to design mandates (more on that in another post). But with the mandate in place, there could be serious damage from deeply weakening it, since that would harm the credibility (and hence effectiveness) of any future mandates. That should be reason enough to look for careful ways of modifying the mandate that protect consumers while maximizing the odds that it will survive largely intact.