Biofuels Policy Itself is Warning That It’s Near Breaking Point

[Below is a guest post by Bill Lapp & Dave Juday]

Millions of American motorists across all income levels could be impacted this year by an indirect fuel tax that could amount to as much as $11.5 billion, all due to failures of the Renewable Fuel Standard (RFS) — the nation’s flawed biofuels mandate.

Under the RFS, which was expanded under the 2007 Energy Independence and Security Act (EISA), two broad categories of biofuels — conventional biofuel from corn, and so-called advanced biofuel from sources including Brazilian sugar ethanol and biodiesel made from vegetable oil and rendered animal fats — were to be steadily phased into the gasoline supply over 15 years.   Now, just five years into the schedule, the program is nearing its breaking point.  The barometer indicating the pressure under which the biofuels mandate operates is an arcane mini-cap-and-trade system for biofuel compliance credits known as renewable identification numbers (RINs).

Basically, the system works like this.  Each gallon of biofuel is assigned a 38-digit code known as a RIN, which effectively act as a serial number that tracks that gallon of biofuel through the supply chain, from production to the retail fuel market. RINs are detached from the biofuel once it is purchased or blended by a refiner, and eventually are turned into the US Environmental Protection Agency (EPA) by refiners to demonstrate their compliance with the RFS.   Alternatively, refiners with excess RINs can sell them on a secondary market to other refiners who are short of their compliance obligations.

Consider, conventional ethanol RINs that sold at about four cents per gallon in December — and at about one cent a year ago — rose to a high of $1.06 in March.  Currently they are about 70 cents.  Likewise, advanced ethanol and biodiesel RINs are also now trading at 75 cents and 80 cents respectively.

With a 10 percent blend of biofuels mandated by the RFS and an average cost of RINs at more than 70 cents, the implicit cost could reach more than 7 cents per gallon for every retail gallon of gasoline and diesel fuel purchased. Across the whole fuel supply, this could equate to an annual hidden tax on motorists of more than $11.5 billion. And that could grow.  As Goldman Sachs has warned, “we believe that the risk to RIN prices is skewed to the upside over the near term.”

This inflated cost of compliance has garnered the attention of Congress.   In a letter to the EPA, Senator Ron Wyden (D-Oregon), Chairman of the Energy and Natural Resources Committee, inquired about this volatility.  He wrote, “given that ethanol is an increasingly important factor in the cost and supply of motor fuel in the US, it is critical that the committee have a better understanding of the causes and effects of RIN market volatility and developments.”  The basic answer to Wyden’s inquiry is that the RFS is structurally flawed, and current RINs prices are an internal warning sign.

The conventional biofuels component of the RFS effectively mandates the blending of corn-based ethanol. For 2013, the Environmental Protection Agency (EPA), which administers the mandate, has proposed that 13.8 billion gallons of corn-based ethanol be blended into the U.S. gasoline supply, as prescribed by the RFS. By 2015, the RFS mandates that corn-based ethanol blending must rise another 1.2 billion gallons to a total of 15 billion gallons.

This is problematic as the majority of motor fuel marketed in the U.S. is effectively limited to 10 percent ethanol.  While the EPA has approved e-15 blends for certain automobiles, there are a number of practical hurdles till in place.  These include efforts to prevent mis-fueling, state level regulatory compliance, auto warranties that are voided by using fuels with more than 10 percent gasoline, the cost of installing infrastructure to handle higher blends, and the liability that goes with all these issues.

Blending 13.8 billion gallons of conventional ethanol in 2013 exceeds the 10 percent effective cap on ethanol in place under the Clean Air Act; so would blending 15 billion gallons in 2015.  That was a significant matter overlooked during the approval of RFS in 2007.  Effectively under the RFS, the fuel supply will require more corn-based ethanol than is legally allowed under the Clean Air Act, and practically allowed by the nation’s fuel infrastructure.

As the infeasibility of blending enough ethanol to meet the RFS has become more apparent in recent months, refiners’ demand for ethanol RIN credits has skyrocketed, leading to the substantial price hike.  That has been exacerbated by last year’s drought which reduced corn production and in turn ethanol production.  Less ethanol production means fewer RINs generated, and thus places an even bigger squeeze on the fuel market next year as the mandated amount of biofuels rises again.

As for the advanced biofuels component of the RFS, a major obstacle to compliance is the absence of cellulosic biofuel, one of the very fuels the EPA presumes to regulate through the policy.  Indeed, virtually zero cellulosic ethanol was produced in 2012, despite the EISA original mandate that 500 million gallons be used. In other words, Congress mandated the use of a fuel that did not exist, and still does not practically exist even six years after the passage of the law.

The EISA mandate for cellulosic ethanol this year is one billion gallons; EPA projects that 14 million gallons – or 1.4 percent of the original mandate – will be produced this year.  Even though EPA has waived the full requirement for cellulosic ethanol, they have not lowered the overall advanced category in which cellulosic is included.  Thus, the RFS creates even more demand for other advanced fuels such as biodiesel and imported Brazilian sugar ethanol, propping up their RIN values.

Under the RFS, oil refiners, fuel blenders and importers bear the regulatory burden of meeting the mandates. That burden can be summed-up as a requirement to sell a fuel that is not available in the marketplace, and a fuel with more corn-based ethanol than the system can bear.  Moreover, with RFS mandates scheduled to rise from 16.5 billion gallons of combined ethanol and biodiesel to 33 billion gallons over the next eight years, the cost to consumers could be expected to double by 2021 if the situation is not addressed.

Back in 2007, the RFS was touted as a nearly a utopian policy — it would help America achieve energy independence at virtually no cost, according to biofuel advocates.  Yet, our biofuels policy has inevitably driven us toward a series of costly unintended consequences.  Congress should reform our biofuels policy and eliminate this hidden tax on consumers before it before it grows significantly worse.

Bill Lapp is President of Advanced Economics Solutions, a commodity market risk management advisory firm in Omaha, Nebraska.  Dave Juday is the principal of The Juday Group a commodity market and policy analytical firm in Washington, D.C.