Ethanol: Train Wreck Ahead?

The new vogue in energy policy is plant-derived alternative fuels. Corn-based ethanol, and to a lesser extent oilseed-based biodiesel, have emerged from the margins to take center stage. However, although ethanol and biodiesel will surely play a role in our energy future, the rush to embrace them has overlooked numerous obstacles and untoward implications that merit careful assessment. The current policy bias toward corn-based ethanol has driven a run-up in the prices of staple foods in the United States and around the world, with particularly hurtful consequences for poor consumers in developing countries. U.S. ethanol policies rig the market against alternatives based on the conversion of cellulosic inputs such as switchgrass and wood fibers. Moreover, the environmental consequences of corn-based ethanol are far from benign, and indeed are negative in a number of important respects. Given the tremendous growth in the corn-based ethanol market, it should no longer be considered an infant industry deserving of tax breaks, tariff protection, and mandates.

In place of current approaches, we propose initiatives that would cool the overheated market and encourage more diversified investment in cellulosic alternatives and energy conservation. First, we would freeze current mandates for renewable fuels to reduce overinvestment in and overreliance on corn-based ethanol. Second, we would replace current ethanol tax breaks with a sliding scale that would reduce incentives to produce ethanol when corn prices are high and thus slow the diversion of corn from food to fuel. Third, we would implement a wide-ranging set of federal fees and rebates that discourage energy consumption and encourage conservation. Fourth, we would shift federal investment in cellulosic alternatives from subsidies for inefficient production facilities and direct them instead to upstream investment in R&D to improve conversion technologies. Together, these four changes would still retain a key role for biofuels in our energy future, while eliminating many of the distortions that current policy has created.

Infant industry no more

Since 1974, when the first federal legislation to promote corn-based ethanol as a fuel was approved, ethanol has been considered an infant industry and provided with increasingly generous government subsidies and mandates. Ethanol’s first big boost came in the late 1970s in response to rising oil prices and abundant corn surpluses. A tax credit for blending corn-based ethanol with gasoline created a reliable market for excess corn production, which was seen as an alternative to uncertain export markets.

But the real momentum for ethanol resulted from environmental concerns about the use of lead to boost the octane rating of gasoline. The phase-out of lead as an additive began in 1973, and ethanol replaced it as a cleaner-burning octane enhancer. In recent years, it has replaced the oxygen additive MTBE, which was phased out because of concerns about groundwater pollution. Ethanol’s increasing value as a gasoline additive has allowed it to receive a premium price, and by 2005 corn-based ethanol production in the United States reached 3.9 billion gallons.

More recently, increases in oil prices during the past two years brought ethanol into national prominence. From $52 a barrel in November 2005 to more than $70 in mid-2007, higher oil prices coincided at first with cheap corn: a prescription for supernormal ethanol profits. Investment in new capacity took off, and 2006 production topped 5 billion gallons.

Although high oil prices have given ethanol the headroom it needs to compete, the industry is built on federal subsidies to both the corn farmer and the ethanol producer. Direct corn subsidies equaled $8.9 billion in 2005, but fell in 2006 and 2007 as high ethanol-driven corn prices reduced subsidy payments. These payments may soon be dwarfed by transfers to ethanol producers resulting from production mandates, tax credits, grants, and government loans under 2005 energy legislation and U.S. farm policy. In addition to a federal ethanol tax allowance of 51 cents per gallon, many states provide additional subsidies or have imposed their own mandates.

In the 2005 energy bill, Congress mandated the use of 7.5 billion gallons of biofuels by 2012, and there is strong political support for raising the mandate much higher. President Bush, in his January 2007 State of the Union speech, called for increasing renewable fuel production to 35 billion gallons by 2017. Such an amount, if it were all corn-derived ethanol, would require about 108% of total current U.S. corn production.

In addition to providing domestic subsidies, Congress has also shielded U.S. producers from foreign competition. Brazil currently produces about as much ethanol as the United States (most of its derived from sugarcane instead of corn) at a significantly lower cost, but the United States imposes a 54-cent-a-gallon tariff on imported ethanol.

Negative effects

As the ethanol industry has spiked, a larger and larger share of the U.S. corn crop has gone to feed the huge mills that produce it. According to the Renewable Fuels Association, there were 110 U.S. ethanol refineries in operation at the end of 2006, another 73 were under construction, and many existing plants were being expanded. When completed, this ethanol capacity will reach an estimated 11.4 billion gallons per year by the end of 2008, requiring 35% of the total U.S. corn crop even with a good harvest. More alarming estimates predict that ethanol plants could consume up to half of domestic corn supplies within a few years. Yet, from the standpoint of energy independence, even if the entire U.S. corn crop were used to make ethanol, it would displace less gasoline usage than raising fleet fuel economy five miles per gallon, readily achievable with existing technologies.

As biofuels increasingly impinge on the supply of corn, and as soybeans and other crops are sacrificed to grow still more corn, a food-versus-fuel debate has broken out. Critics note that domestic and international consumers of livestock fed with grains face steadily rising prices. In July 2007, the Organization for Economic Cooperation and Development issued an outlook for 2007–2016, saying that biofuels had introduced global structural shifts in food markets that would raise food costs during the next 10 years. Especially for the 2.7 billion people in the world living on the equivalent of less than $2 per day and the 1.1 billion surviving on less than $1, even marginal increases in the cost of staple grains can be devastating. Put starkly: Filling the 25-gallon tank of a sport utility vehicle with pure ethanol would require more than 450 pounds of corn, enough calories to feed one poor person for a year.

The enormous volume of corn required by the ethanol industry is sending shock waves through the food system. The United States accounts for some 40% of the world’s total corn production and ships on average more than half of all corn exports. In June 2007, corn futures rose to over $4.25 a bushel, the highest level in a decade. Like corn, wheat and rice prices have surged to 10-year highs, encouraging farmers to plant more acres of corn and fewer acres of other crops, especially soybeans. The proponents of corn-based ethanol argue that yields and acreage can increase to satisfy the rising demand. However, U.S. corn yields have been trending upward by a little less than 2% annually during the past 10 years. Even a doubling of yield gains would not be enough to meet current increases in demand. If substantial additional acres are to be planted with corn, the land will have to be pulled from other crops and the Conservation Reserve Program, as well as other environmentally fragile areas.

In the United States, the explosive growth of the biofuels sector and its demand for raw stocks of plants has triggered run-ups in the prices not only of corn, other grains, and oilseeds, but also of crops and products less visible to analysts and policymakers. In Minnesota, land diverted to corn to feed the ethanol maw is reducing the acreage planted to a wide range of other crops, especially soybeans. Food processors with contracts with farmers to grow crops such as peas and sweet corn have been forced to pay higher prices to keep their supplies secure. Eventually, these costs will appear in the prices of frozen and canned vegetables. Rising feed prices are also hitting the livestock and poultry industries. Some agricultural economists predict that Iowa’s pork producers will be driven out of business as they are forced to compete with ethanol producers for corn.

It is in the rest of the world, however, where biofuels may have their most untoward and devastating effects. The evidence of these effects is already clear in Mexico. In January 2007, in part because of the rise in U.S. corn prices from $2.80 to $4.20 in less than four months, the price of tortilla flour in some parts of Mexico rose sharply. The connection was that 80% of Mexico’s corn imports, which account for a quarter of its consumption, are from the United States, and U.S. corn prices had risen, largely because of surges in demand to make ethanol. About half of Mexico’s 107 million people live in poverty; for them, tortillas are the main source of calories. By December 2006, the price of tortillas had doubled in a few months to eight pesos ($0.75) or more per kilogram. Most tortillas are made from homegrown white corn. However, industrial users of imported yellow corn in Mexico (for animal feed and processed foods) shifted to using white corn rather than imported yellow, because of the latter’s sharp price increase. The price increase of tortillas was exacerbated by speculation and hoarding. In January 2007, public outcry forced Mexico’s new President, Felipe Calderón, to set limits on the price of corn products.

The International Food Policy Research Institute (IFPRI), in Washington, DC, has monitored the run-up in the demand for biofuels and provides some sobering estimates of their potential global impact. IFPRI’s Mark Rosegrant and his colleagues estimated the displacement of gasoline and diesel by biofuels and its effect on agricultural market prices. Given rapid increases in current rates of biofuels production with existing technologies in the United States, the European Union, and Brazil, and continued high oil prices, global corn prices are projected to be pushed upward by biofuels by 20% by 2010 and 41% by 2020. As more farmers substitute corn for other commodities, prices of oilseeds, including soybeans, rapeseed, and sunflower seed, are projected to rise 26% by 2010 and 76% by 2020. Wheat prices rise 11% by 2010 and 30% by 2020. Finally, and significantly for the poorest parts of sub-Saharan Africa, Asia, and Latin America where it is a staple, cassava prices rise 33% by 2010 and 135% by 2020.

Is ethanol competitive?

Although there are possible alternatives to corn and soybeans as feedstocks for ethanol and biodiesel, these two crops are likely, in the United States at least, to remain the primary inputs for many years. Politics will play a major role in keeping corn and soybeans at center stage. Cellulosic feedstocks are still more than twice as expensive to convert to ethanol as is corn, although they use far fewer energy resources to grow. And corn and soybean growers and ethanol producers have not lavished 35 years of attention and campaign contributions on Congress and presidents to give the store away to grass.

Yet because of the panoply of tax breaks and mandates lavished on the industry, the competitive position of the biofuels industry has never been tested. Today, however, the pressures and distortions it has created encourage perverse incentives: For ethanol to profit, either oil prices must remain high, further draining U.S. foreign exchange for petroleum imports, or corn prices must come off their market highs, allowing reasonable margins in the corn ethanol business. But high oil prices are what allow ethanol producers to pay a premium for corn. Hence, oil and corn prices are ratcheting up together, heedless of the effects on consumers and inflation. Bruce Babcock, in a study for the Center for Agricultural and Rural Development at Iowa State University, predicted in June 2007 that ethanol’s impact on corn prices could make corn ethanol itself unprofitable by 2008.

Apart from ethanol-specific subsidies, tax breaks, and mandates, it is also important to recall that the ethanol market has been made in large part by shifts in U.S. transportation and clean air policies. When these policies are considered, it is clear that ethanol is not really competitive with petroleum, but has served instead as its complement. As increased production capacity allows ethanol to move beyond its traditional role as a gasoline enhancer (now a roughly 6-billion-gallon market) and become a gasoline replacement, several major concerns have arisen.

One critical factor involves a key ethanol liability: its energy content. Because it will drive a car only two-thirds as far as gasoline, its value as a gasoline replacement (rather than a gasoline additive) will probably gravitate toward two-thirds of gasoline’s price. A lower ethanol price would then lower the breakeven price that ethanol producers could pay for corn. Meanwhile, the domestic market for corn has been transformed from chronic surplus stocks and carry-forwards into bare shelves. Tighter supplies have led to higher prices, even in good-weather years. And what if dry hot weather produces a short corn crop? A 2007 report for the U.S. Department of Agriculture by Iowa State’s Center for Agricultural and Rural Development estimated that with a 2012 mandate of 14.7 billion gallons, corn prices would be driven 42% higher and soybean prices 22% higher by a short crop similar to that of 1988. Corn exports, meanwhile, would tumble 60%. In short, ethanol is switching from a demand-builder to a demand-diverter.

Another factor involves energy efficiency. If net energy efficiency is thought of as a dimension of competitiveness, a recent Argonne National Laboratory ethanol study summarized by the U.S. Department of Energy is revealing. It showed that ethanol on average uses 0.74 million BTUs of fossil energy for each 1 million BTUs of ethanol delivered to the pump. In addition, the total energy used to produce corn-based ethanol, including the solar energy captured by photosynthesis, is 1.5 to 2 million BTUs for each 1 million BTUs of ethanol delivered to a pump. If corn for ethanol is just an additional user of land, it is fair to ignore the “free” solar energy that grows the corn. But if corn-based ethanol is diverting solar energy from food or feed to fuel through subsidies or mandates, policymakers cannot so easily ignore it. Similarly, because ethanol has only two-thirds the energy content of gasoline, its greenhouse gas emissions per mile traveled (rather than per gallon) are comparable to those of conventional gasoline.

Yet another concern is the net environmental effect of ethanol. It takes from one to three gallons of water to produce a gallon of ethanol, which raises concerns about ground and surface water supplies. Although ethanol has some advantages over conventional gasoline in terms of its contribution to air pollution, it also has some disadvantages. One is its higher volatile organic compounds (VOCs) emissions, which contribute to ozone formation. Ethanol also increases concentration of acetaldehyde, which is a carcinogen. In addition, corn and soybeans are row crops that encourage the runoff of fertilizers and pesticides into streams, rivers, and lakes. As acres come out of soybeans and into corn (of the 12 million acres of new corn planted in 2007, three-fourths came out of soybeans), they require more nitrogen fertilizer. This nitrogen runs off into waters, encouraging algae blooms that choke off oxygen for fish and other creatures. All of the above belie ethanol’s reputation as “greener” than gasoline.

Finally, the logic behind the renewable fuels standard is that the raw material used—such as corn for ethanol—is renewable. Corn is renewable in the sense that it is harvested annually. But corn production and processing consume fossil fuels. So what is the net renewable benefit? Most estimates place the net renewable energy contribution from corn-based ethanol at 25% to 35%. Using a midpoint of 30%, that means that a mandate of 7.5 billion gallons, if filled by corn-based ethanol, yields a net renewable energy gain of only 2.25 billion gallons. Other products or processes may be more cost-effective in replacing gasoline.

As these problems become clearer, so does the appeal of cellulose as the feedstock for ethanol. The best role for corn-based ethanol then becomes simply building a bridge to the more promising world of cellulosic ethanol. But it is not clear why building a corn-based ethanol industry much beyond its current size as a producer of a gasoline additive makes sense as a prelude to cellulosic ethanol, for a number of reasons, First, technological progress in producing corn-based ethanol is not likely to be relevant to the technology challenges facing cellulosic ethanol. Second, growing areas for cellulose may well be different than for corn; if switchgrass is to be grown on current corn acres, it will have to beat high current corn prices in profitability. Third, the low energy density of cellulosic materials suggests that the handling and processing infrastructure they need is likely to be different in scale than for corn-based ethanol. Fourth, the economics of cellulosic ethanol are currently very high cost, with many other petroleum substitutes likely to be attractive before cellulosic ethanol. Finally, land-use conflicts—between food/feed and fuel or between conservation and fuel—differ in degree, not kind, between corn and cellulose and are likely to constrain a cellulosic industry’s capacity to well below the 35 billion gallons called for by President Bush. And whatever plant material is used to make biofuels, an estimate in the August 17, 2007 issue of Science suggested that substituting just 10% of U.S. fuel needs with biofuels would require 43% of U.S. cropland.

In short, there is enough uncertainty about ethanol’s supply and demand prospects to argue for a pause in the headlong rush into ethanol production. Turning corn surpluses into a gasoline additive was a strategy that made food and fuel complementary. But turning a tightening corn market into a less rewarding gasoline-replacement strategy heightens the conflict between food and fuel uses, with major environmental externalities and limited environmental benefits.

Fundamental change needed

If we are to avoid a situation in which ethanol becomes a demand diverter for corn, a fundamental reorientation in farm and energy policies is required. The alternative policy model will require replacing the mandates, subsidies, and tariffs designed to help an infant industry with a new set of policy instruments intended to broaden the portfolio of energy alternatives and to create market-driven growth in renewable energy demand.

Today, politicians compete with one another to raise the biofuels mandate. Little apparent consideration is given to the potential consequences of building markets on political fiat rather than sound finances. The result is that capacity is built too fast, at uneconomic scale, and in the wrong locations. Competing interests such as domestic feeders and foreign consumers can get trampled in the process, especially during a short crop, when the mandate functions as an embargo on other uses. Eventually, competing suppliers take over the traditional markets imperiled by ill-considered mandates. As this scenario unfolds, the burden of false economics and competitive responses may become too much to bear, and the shaky superstructure will crash, stranding assets and bankrupting many. In order to avoid such a crash, the United States should not increase the biofuels mandate beyond the current level of 7.5 billion gallons.

Next, consider subsidies to ethanol. The blender’s tax credit of 51 cents per gallon enabled ethanol to compete with gasoline in a market characterized by low gasoline prices and surplus corn supplies. That market no longer exists. Gasoline prices have skyrocketed because of high petroleum prices. The fixed per-gallon subsidy generated high profit margins for ethanol producers, which led to excessive growth in production. Some suggest correcting for this effect by replacing the fixed subsidy with a variable one that would decline as oil prices rose. This approach essentially would link ethanol to the volatile petroleum market.

Linking to the demand side of the equation, however, may not be the best avenue for reconciling food and fuel uses. We should consider the subsidy’s effect on the supply side of the equation. To the extent that an ethanol subsidy reduces surpluses, it is likely to enjoy continued and significant political support. But if it creates shortages and diverts corn from food and feed to fuel uses, it will become increasingly controversial and politically vulnerable, as will the tariff walls erected to keep cheaper Brazilian ethanol out of the U.S. market.

For these reasons, we should replace today’s fixed subsidy policy with a variable subsidy linked to corn supplies. As corn prices rise, the subsidy should be phased down. This would provide an incentive to convert corn to energy when supplies are ample, while allowing food and feed (and other industrial) uses to compete on an equal footing as supplies tighten and prices rise. When corn prices rise above some set level, the subsidy would fall to zero. At the same time, we should lower the tariff on imported ethanol.

An approach to ethanol incentives along these lines has three distinct advantages over current policy. First, it will function more like a shock absorber for corn producers and corn users; in contrast, a fixed subsidy in a volatile petroleum market functions like a shock transmitter that amplifies the effect of price swings. Second, it should largely disarm the emerging food- versus-fuel and environment-versus-fuel debates by letting market forces play a larger role in the industry’s future expansion. Finally, it preserves incentives for developing fuel uses in surplus markets, which would encourage continued technological progress in the breeding, production, processing, and use of corn for ethanol. Such developments should continue to improve corn-based ethanol’s competitive position.

Now consider energy policy. With better throttle control on ethanol’s role in the farm-food-feed economy, a fresh approach could also be taken toward U.S. energy policy and ethanol’s place within it. Current policy is too dependent on the political process: picking winners and losers and anointing technologies such as ethanol as favored approaches. Such an approach confronts two huge risks. The first resembles the risk Alan Greenspan foresaw in the U.S. stock market at the beginning of this century: an “irrational exuberance.” In the case of ethanol, the concern is that the enthusiasm for ethanol’s political rewards may run ahead of the logic that governs its economic realities.

A third element in our proposed mix of policies would be the creation of a wide-ranging set of fees and rewards to discourage energy inefficiencies and encourage conservation. Milton Friedman once proposed a negative income tax in which at a certain base income, taxes would be zero and below which subsidies would be paid to families. We propose a broad-based set of fees on energy uses that are carbon-loading and inefficient, but we would subsidize energy efficiency improvements that exceed a national standard. Simple examples would be progressive taxes on automobile horsepower and rebates to hybrid vehicles; fees on housing spaces in excess of 3,500 square feet; and rebates for energy-compliant, economical use of housing space. These “negative pollution taxes” would encourage conservation, while discouraging energy-guzzling cars, trucks, and homes. In particular, these policies could help encourage full–life-cycle energy accounting, tilting the economy toward the use of renewable fuels based on cellulosic alternatives to corn.

Finally, instead of subsidizing the current generation of inadequate cellulosic or coal gasification technologies, we would invest government resources in upstream R&D to bring further innovation and lower costs to these technologies so that they could compete in the market.

To move from our current devotion to corn-based ethanol and toward a new set of policies for renewable fuels will require bravery on the part of those who lead the reforms. The courage to admit that current policies have stoked the ethanol engine to an explosive heat may be in short supply. But unless the ethanol train slows down, it is likely to go off the tracks.