Wednesday, May 18, 2011

Will Shifting Political Winds Finally Kill Ethanol Subsidies?

As recently as last December, the coalition backing U.S. ethanol subsidies appeared to be alive and well, despite the fact that everyone knew they were bad for the environment, bad for energy efficiency, and bad for the budget. The largest subsidy, a tax credit for blending ethanol into gasoline, was set to expire at the end of 2010. At the last minute, though, ethanol's friends rallied to slip a little-noticed one-year renewal of the subsidy into a bill extending the Bush tax cuts and benefits for the long-term unemployed. As I blogged at the time, it looked like ethanol subsidies were a classic case of a bad policy that refused to die.

Now ethanol subsidies are back in the news, and this time they may be on the way out. One piece of legislation, introduced by Senators Tom Coburn (R-OK) and Dianne Feinstein (D-CA), would not only end the 45-cent per gallon tax credit, but also eliminate the 54-cent per gallon tariff on imported ethanol. To understand what has changed, we need to look at the economics behind the shifting pro- and anti-ethanol coalitions.

One shift is that environmentalist support for ethanol has pretty much evaporated. Environmentalists originally joined the ethanol coalition in the belief that using more ethanol, a renewable biofuel, would reduce greenhouse gas emissions. Years of study, however, have shown that corn-based ethanol, over its full life cycle, does little to reduce carbon emissions and may actually increase them. Late last year even Al Gore, long an ethanol booster, reversed his position. While serving as vice-president, Gore had cast a critical tie-breaking Senate vote to secure support for corn-based fuel. Now he admits that there are no environmental benefits, and that his original support was motivated, in part, by the hope of getting Iowa caucus votes in a later run for president.

Environmentalists are not the only ones to fall away from ethanol. As time has gone by, it has proved easier than once thought to find fault lines in the seemingly solid ethanol coalition. At first glance, it might appear that subsidies would find strong support all along the supply chain, from landowners to corn growers to ethanol distillers to fuel suppliers who blend ethanol with gasoline. However, closer economic analysis has shown that benefits are not distributed equally among the parties.

An interesting paper by Farzad Taheripour and Wallace Tyner of the Purdue University Department of Agricultural Economics analyzes the way subsidies are distributed by looking at elasticity of substitution between ethanol and gasoline as a motor fuel, and at the elasticity of supply at various points along the supply chain. (Elasticity means the percentage by which one variable, like quantity supplied, changes in response to a one percent change in another variable, like price.) The authors reach two conclusions that are relevant to the politics of ethanol.

One is that ethanol distillers and corn growers are engaged in a tug-of-war over the benefits of the subsidies. Who wins the biggest share depends partly on government policies that encourage blending of ethanol with gasoline and partly on the supply elasticity of corn. The authors find that over time, as the share of total corn production that goes to ethanol increases, corn farmers can be expected to capture more of the subsidy, leaving less for blenders and distillers. According to USDA data, the percentage of the U.S. corn crop going to ethanol increased from about 7 percent in 2001 to almost 40 percent by 2010. The predictable result would be for ethanol producers to become less attached to the subsidy, and farmers to become more attached.

A second conclusion is that farmers, in turn, are driven by market forces to pass much of the benefit of the subsidy along to landowners. That happens because land suited to growing corn is in less elastic supply than farm inputs of labor and capital. The pass-through to landowners, too, tends to splinter the ethanol coalition. Farmers who own their own land and landowners who lease to corn farmers remain solidly in favor of ethanol subsidies, but farmers who grow corn on leased land gain little or nothing.

Still another factor behind shifting pro- and anti-ethanol coalitions is the effect of corn ethanol subsidies on food prices. A paper by economist Bruce Gardner of the University of Maryland explains how the effect on food prices helps farmers capture a larger share of ethanol subsidies. The gain comes because demand for corn as food is less elastic than the demand for corn as an ethanol feedstock. If corn were used only for ethanol, distillers and blenders would capture a large part of the subsidy. Instead, though, farmers lose part of the benefits of the subsidy to ethanol producers but they more than gain it back when diversion of corn to ethanol drives up the price of corn as food.

When it comes to coalition building, the effect on food prices cuts both ways. Although higher corn prices increase the tenacity with which landowners cling to subsidies, they generate opposition from corn consumers. Those include both domestic consumers of everything from cornflakes to corn-fed beef, and people who are concerned about the effects of high corn prices on consumers in poorer countries.

All of the above suggests a paradox: Subsidies have succeeded in increasing the percentage of the corn crop that goes to ethanol, but that very success has narrowed the originally broad pro-ethanol coalition. Too much of the benefit goes to too small a group, landowners, and others in the supply chain have too small a stake. The Coburn-Feinstein proposal further splits ethanol producers from downstream users by removing the tariff on imports. Fuel suppliers would be quite happy to blend in tariff-free imported ethanol in place of subsidized domestic ethanol.

The final blow is likely to come less in the form of defections from the pro-ethanol camp than from a powerful addition to the anti-ethanol forces, namely, Congressional deficit hawks. True, ethanol subsidies, estimated to cost the budget about $6 billion a year, are chump change beside the trillions needed to close the federal budget gap. Still, everything helps. Many fiscal conservatives—at least those who do not plan to participate in next year's Iowa caucuses—know that farm subsidies must be cut back across the board, ethanol included.

The present relationship of the deficit to ethanol subsidies is a little like that of inflation to transportation regulation during the Carter administration. At that time, captive regulatory agencies had long propped up cartels in trucking, airlines, and railroads, and the cartels, in turn, were keeping prices high. Realistically, inflation was mostly a macroeconomic problem. The effect of the cartels on inflation was small. Still, the effect was there, and it was enough to allow free-marketeers, who favored deregulation as a matter of principle, to bring inflation hawks into their coalition. The outcome: the transportation cartels were busted once and for all. (Disclosure: I myself played a bit part in the deregulation drive as a transportation analyst for the Department of Justice and later the Interstate Commerce Commission.)

The bottom line: Ethanol subsidies may not be dead yet, but they are breathing their last. A symptom of their weakened position is that pro-ethanol forces are no longer trying to maintain the status quo. Instead, the counterproposal to Coburn and Feinstein's ethanol legislation is a bill being pushed by Sen. Chuck Grassley (R-IA) that would phase the subsidies out gradually rather than ending them cold turkey. The only remaining element of suspense is whether ethanol subsidies will go before the firing squad as part of current negotiations over the debt ceiling, or will instead be left to expire peacefully at midnight on December 31.

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