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Ed Dolan

Ed Dolan

Edwin G. Dolan holds a Ph.D. in economics from Yale University. Early in his career, he was a member of the economics faculty at Dartmouth…

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U.S. Ethanol Policy Contradicting Every Principle of Sound Economics

U.S corn farmers and ethanol distillers are among those celebrating passage of last month's tax bill. A little-noticed provision of the law extends ethanol tax credits ($.45 per gallon, plus a bonus for small producers) and tariffs on ethanol imports ($.54 per gallon), previously set to expire at the end of 2010. Should the rest of us also celebrate? I think not.

U.S. ethanol policy contradicts every principle of sound economics. It encourages use of fuels whose opportunity costs are high while discouraging use of those whose costs are low. It promotes trade flows that run opposite to comparative advantage. It creates new market failures instead of correcting those that already exist.

First consider opportunity costs. Economists use this term to mean the full costs of goods and services, taking into account all opportunities sacrificed to produce and use them. The opportunity costs of petroleum, ethanol, and other transportation fuels include costs of production, most of which are reflected in market prices, plus other costs, which are not. The effects of pollution, including both climate impacts and harm to local air quality, are one reason that opportunity costs exceed market prices. National security risks arising from dependence on foreign energy suppliers are a further important opportunity cost. The ostensible purpose of ethanol policy is to offset these costs by encouraging substitution of low-carbon domestic fuel for high-carbon foreign fuel, but in reality, the policy makes the situation worse, not better.

One problem is that corn-based ethanol, the kind produced in the United States, saves little if any carbon and produces little if any net gain in energy compared with petroleum. Measuring the exact carbon and energy efficiency of corn ethanol is not easy. Different assumptions regarding technologies, fuels consumed in farming and distilling, energy value of byproducts like cattle feed, land use impacts, and so on, give answers ranging from small net carbon and energy gains to small net losses. But even the most optimistic studies give corn ethanol only a tiny advantage over petroleum, nowhere near large enough to justify the scale of current subsidies.

What is more, even if corn ethanol were much more carbon- and energy-efficient than petroleum, subsidies would be the wrong way to bring prices into line with opportunity costs. Instead of subsidies, every type of fuel, including but not limited to ethanol and oil, should bear a surcharge equal to its external costs, calculated to account for climate change, local local air pollution, national security, and any other external effects of production and consumption. Gasoline, ethanol, biodiesel, compressed natural gas, and electricity would each bear a larger or smaller charge. Whereas ethanol subsidies act only to encourage substitution between ethanol and gasoline, a broader system would encourage many kinds of substitution. It would spur use of low-carbon, domestic energy sources like natural gas and electricity at the expense of both gasoline and gasoline-ethanol blends. At the same time, it would encourage across the board reduction in transportation fuel use by giving people incentives to buy smaller cars, move closer to work, use more local goods, and make other life-style changes. The fuel surcharges would be likely to generate considerable revenue, which could be used to reduce the marginal rates of other taxes or used to reduce the government's deficit.

Let's turn next to trade and comparative advantage. In the case of ethanol, comparative advantage belongs, hands down, to sugarcane-based ethanol from Brazil. The net energy yield from sugarcane-based Brazilian ethanol is about 8:1, compared to barely more than, or perhaps less than, 1:1 for the U.S. corn-based product. Unfortunately, Brazilian ethanol is saddled with a prohibitive $.54 per gallon tariff, just renewed. The result is an enormous loss of potential gains from trade in the form of a cleaner environment and lower consumer costs--gains that far outweigh the added profits of U.S. corn farmers and ethanol distillers. Need I add that Brazil is a friendly, democratic country, unlike the often corrupt, hostile, or authoritarian regimes from which we import much of our petroleum?

Comparative advantage in ethanol trade takes another kick in the face from a quirk of policy under which some Caribbean sugarcane producers can export ethanol to the United States duty free. For years they did not do so. Their inefficient sugar industries instead catered to the European Union, which granted them the same subsidized prices set for even less efficiently produced European beet sugar. Now the EU has reformed its sugar regime, and that particular free ride has ended. Rather than look for something they can produce efficiently, the Caribbean sugar producers are closing sugar mills and opening distilleries that cater to the sheltered U.S. ethanol market.

The trade effects of ethanol policy would be bad enough if they only involved the closing of U.S. markets to imports, but in reality, matters are even worse. When the effects of tax credits are added to those of import tariffs, they are, together, enough not just to block imports, but to turn the United States into a net exporter of ethanol. Ethanol exports are officially expected to run a record 315 million gallons this year, more than double the 2009 figure. True exports might be half again that if ethanol blended with exported gasoline is included. Exactly how do subsidized ethanol exports promote U.S. energy independence? Go figure.

The bottom line? Yes, there are market failures in transportation fuels. Yes, this is an area where government intervention in markets could actually make us better off. But current policy does not do so. Instead of mitigating market failures arising from pollution and national security effects, U.S. ethanol policy exacerbates them. A 2008 study by Robert W. Hahn of the AEI-Brookings Joint Center estimated that the costs of U.S. ethanol policy exceeded its benefits by more than $3 billion per year. Letting ethanol subsidies and tariffs expire as scheduled would have been a fine holiday gift for the U.S. economy. The next step would be a comprehensive rationalization of energy policy that took into account all opportunity costs of all fuels. Would this mean the end of ethanol as a motor fuel? Not necessarily. Some might still be imported from Brazil and elsewhere, boosting national security by diversifying energy sources. Research into cellulose-based ethanol would continue, although that potential clean domestic energy source has been slower to come on line than some have  hoped. But our goal need not be a world free of ethanol--just one free of bad ethanol policy.

By. Ed Dolan

"This post originally appeared on Ed Dolan's Econ Blog at Economonitor.com, and is reprinted here with permission."

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  • Anonymous on January 17 2011 said:
    This is an interesting and in some sense important article, but even so I am not completely convinced that the writer is singing the right song.My prescription for the optimal energy policy for the US is more nuclear - which I am always prepared to argue - and more renewables and alternatives. The problem is that I don't know exactly what renewables and alternatives, and I am too busy to try to find out, and if I tried to find out I might get it wrong. It could be however that ethanol is one of them.What bothers me is that the US Energy Department cannot tell us more about the optimal renewables and alternatives for the US. As for their opinion about nuclear I am not interested - assuming that it is not the same as mine.
  • Anonymous on January 17 2011 said:
    Thank you for this article. It should be emphasized that ethanol, while being a fine octane booster (used to be used by drag racers back in the day), is a poor substitute for real gasoline. After finding a nearby source of E0, my gas mileage is back up to where it should. Besides reducing damage to my car from moisture.
  • Anonymous on January 17 2011 said:
    Fred: You say "The problem is that I don't know exactly what renewables and alternatives, and I am too busy to try to find out, and if I tried to find out I might get it wrong." I am with you 100% on this. I don't know either. That is why we need a policy that puts a load on every kind of energy--fossil, renewable, nuclear--proportional to the pollution and national security costs of that fuel. Then we let them compete in the market place and see who wins. Maybe it will be nuclear (no carbon, nice), maybe unconventional gas (lots of it at home, no security load and half the carbon of oil), maybe even ethanol but probably an advanced technology, not corn. My biggest gripe is when Congress picks winners arbitrarily, for example, backs corn ethanol, blocks sugar ethanol, yawns at gas (boring or bad lobbyists?) and so on.
  • Anonymous on January 18 2011 said:
    I don't think that we are going to argue about this, Ed. Something is definitely wrong in the Big PX, and the main thing as far as I am concerned is that the right people may not be in the Energy Department, and if they are there they are not doing what they are paid to do.As for letting the market decide, I say wonderful, but if that means that the market will will not give nuclear the status it deserves, then I say to hell with the market. I don't see why snotty 'masters of the universe' in the financial districts should be encouraged to believe that they understand something that in reality they don't understand - by which I mean energy economics - and therefore keep 'the real/physical market' from getting the finance capital it needs.
  • Anonymous on January 18 2011 said:
    Comment Part I - Bush, a Texas oil President, said very clearly that the United States is addicted to oil. He said it as a President who saw how it indirectly caused the bombing of the Twin Towers and directly committed this nation to an era of military intervention in the Persian Gulf. If we want to protect ourselves from the kind of cultural friction that leads us to terrorism, protect our access to the energy life-blood of all Western nations transportation and war-fighting capability, then we HAVE to compensate for our lack of liquid fuel self-reliance. The only liquid fuel alternatives are biofuels.
  • Anonymous on January 18 2011 said:
    Comment Part II -The 2007 Energy Independence and Security Act "mandates" the development of alternative fuels. You can't really mandate availability of these fuels, especially when the economy is so desperate and the entrenched global oil industry has so much market power. Market entry for oil alternatives has a 100 year history of periodic failure because of oil's monolithic power, the availability of cheap oil, and ignorance of the negative consequences.The corn ethanol industry is playing its part. It is leading the development of cellulosic biofuels while building a lasting infrastructure for its distribution and use. Decrying short-term ethanol subsidies ignores the long-term diplomatic, economic, consumer, and environmental benefits of having non-oil choices at the pump. The oil industry should jump on the alternative fuel bandwagon rather than see their markets evaporate through economic collapse and global energy resource wars.
  • Anonymous on January 18 2011 said:
    Mr BIO blogger, what is the point in citing George Bush, one of the worst presidents the US has ever had, and who is largely responsible for the bad things that have happened IN THE WORLD over the last 7 or 8 years. Of course, Mr Obama´and his stupid war is just as bad, but without Bush Mr O might still be on the South Side of Chicago, and we would have a president who understood what kind of energy issues face the world.As for biofuels, I'm sure that some is necessary, but the issue is how much, and how fast should they be made available. I would love to say that I should be able to give some answers here, but the truth is that I don't have a clue, although I am certain that somebody does. What about telling somebody to find that other somebody or somebodies who can give us the answers we need, and sooner rather than later.
  • Christopher Calder on May 05 2012 said:
    The more oil the world produces, the lower the cost of food. The more biofuels the world produces, the higher the cost of food.

    1) The National Food Security Act immediately ends all federal mandates and subsidies for the production of any liquid biofuel used for transportation, heating, or the production of electricity.

    2) The National Food Security Act makes illegal the manufacture, sale, import or export of any biofuel made from edible food products, and bans biofuel farming on any land deemed of sufficient quality for human agriculture. This provision will take effect within three years of the bill being signed into law. The National Food Security Act will not ban the production of biofuels made from algae or bacteria using waste water and true garbage as growth medium, even though their development as economically viable, energy efficient fuel sources is highly unlikely.

    3) The National Food Security Act makes illegal the manufacture or sale of any biofuel that requires the use of agricultural grade fertilizer to grow. This provision will take effect within three years of the bill being signed into law.

    4) The National Food Security Act makes illegal any biofuel made from corn stalks, or other so-called “crop waste,” which must be plowed under to protect our precious, rapidly declining supplies of topsoil from erosion and degradation of agricultural fertility. This provision is to take effect immediately upon the bill being signed into law.

    5) The National Food Security Act publicly admits that our government failed to protect the human food supply in its promotion of biofuels, and our government is thus responsible for the deaths of millions of innocent people around the world through malnutrition and related illness. Government leaders were warned in advance by responsible scientists and economists that biofuel farming would skyrocket the price of fertilizer, farmland, and food all over the world, and thus cause large numbers of human deaths. The higher the cost of food, the more people die; the equation is that simple.

    The National Food Security Act admits that biofuel farming has done tremendous harm to the environment, increasing air and water pollution, causing deforestation and erosion, and increasing the cost of living for everyone with higher food bills, higher fuel bills, higher engine repair bills, and larger state and federal budget deficits.

    For better energy solutions, Google “The Renewable Energy Disaster”

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