The Renewable Fuel Standard: A Path Forward

by James H. Stock* (Columbia University Center on Global Energy Policy) America’s renewable fuels policy is at a crossroads. The Renewable Fuel Standard (RFS) is derided by some as an inefficient program that is driving up costs for fuel suppliers and a threat to motorists at the pumps, while others insist it is a valuable tool to reduce US dependence on foreign oil that will also pay future dividends in the fight against climate change. Developed initially in 2005 and expanded in the Energy Independence and Security Act (EISA) of 2007, the RFS seeks to reduce both greenhouse gas emissions and US dependence on oil imports by establishing increasing quantities of renewable fuels that must be blended into transportation fuels. In part because of the RFS, the volume of renewable fuels in the US surface transportation fuel supply more than doubled from 2007 to 2013. But even though the twin climate and energy security goals of the RFS remain as valid as when the EISA was enacted, today the RFS is facing multiple challenges.

Because the first-best option of a carbon tax combined with substantial early-stage research and development funding remains politically unlikely, it is important to keep options open by supporting research and investment in a wide range of low-carbon technologies.

This paper examines the economics of the RFS in order to understand the challenges it has faced since 2013 and takes a critical look at the choices currently facing the RFS and US biofuels policy. In brief, the RFS serves as a tax on petroleum fuels and a corrective subsidy to renewable fuels. As a matter of economics, such a system is justified when one of the fuels generates more costs not borne by its users (i.e. externalities) than does the other fuel. That is the case here: renewable fuels both reduce dependence on foreign oil and generate less greenhouse gas emissions than do petroleum fuels. Under the RFS, the subsidy to renewable fuels operates through the market for RFS compliance permits, which are called Renewable Identification Numbers (RINs). The fundamental driver of RIN prices is the difference in the price at which a renewable fuel can be produced and the price at which it can be sold, at a given mandated volume of the renewable fuel. Because RINs can be banked, the RIN price depends not only on this fundamental subsidy value in the current year, but on expectations of future fundamental subsidy values. These current and future subsidy values in turn depend on economic factors, such as the price of oil and the cost of producing biofuels, as well as on current and future RFS policy about the volume (or fraction) of renewable fuels in the fuel supply. In summary, the paper finds:

• The current combination of RFS policy uncertainty, the E10 blend wall, high RIN prices, and low investment means that the RFS currently is imposing costs while failing to provide the future benefits associated with domestic, low-greenhouse gas, second-generation advanced biofuels.

• The RFS broadly faces three paths forward. One path is to maintain the status quo, but the status quo is both costly and ineffective. A second path is for EPA to reduce RIN prices by keeping mandated volumes away from the blend wall, using the legal tools provided under the EISA. While this path, if successful and credible, would reduce compliance costs, it would fail to promote the development of second-generation biofuels, which hold the promise of large greenhouse gas reductions. Indeed, current low oil prices will increase the demand for petroleum fuels and make the task of reducing carbon emissions in the transportation sector even more challenging and pressing. Just as natural gas is a transitional fuel in reducing carbon emissions in the electricity generation sector, second generation biofuels might play a key transitional role in the transportation sector, but those fuels, technologies, and dispensing infrastructure must first be developed.

• The third path is for EPA to expand the renewable content of the fuel supply, consistent with the policy goals of the EISA. The challenge for this third path is how it can be achieved while controlling its costs. Because the two main drivers of those costs are policy uncertainty and the blend wall, implementation of this path requires combining policy clarity and commitment with a credible set of steps to expand the ethanol content of the fuel supply.

Given the unlikely prospect of broadly expanding federal research support for low-carbon transportation technologies (or for other first-best climate policy solutions such as a carbon tax), the RFS is the main tool available for supporting development and commercialization of advanced biofuels. But to be successful in promoting advanced biofuels and for it to be viable in the long run, RFS policy must be economically efficient. Perhaps paradoxically, I argue that this third path has the potential to achieve low long-run compliance costs and, of the three, to be the most economically efficient in the long run because it is the most likely to bring forth the investments that will relieve the underlying source of pressure on compliance costs produced by the E10 blend wall.

* James H. Stock is the Harold Hitchings Burbank Professor of Political Economy, Faculty of Arts and Sciences and member of the faculty at Harvard Kennedy School, and a non-resident Fellow at the Center on Global Energy Policy at Columbia University. He previously served as Chair of the Harvard Economics Department from 2006-2009, as Co-Editor of Econometrica from 2009-2012, and as Member of the President’s Council of Economic Advisers from 2013-2014.