What Caused the U.S. Ethanol Boom?

by Scott Irwin (University of Illinois/farmdoc daily) The U.S. experienced a major ethanol boom between roughly 2004 and 2011, with production nearly quadrupling from 3.4 to 13.3 billion gallons. By far the most common explanation for the cause of the ethanol boom is the Renewable Fuel Standard (RFS) mandates that were first passed in 2005 (RFS1) and then amended in 2007 (RFS2), with a particular emphasis on the increased level of mandates in the second. This is implicit in calls to waive the RFS mandates during periods of spiking grain prices, in an effort to relieve stress on livestock feeders and food consumers. The argument is simple: the mandates are responsible for rising ethanol production, and this puts upward pressure on grain prices; and consequently, waiving the mandates should help to reduce upward pressure on grain prices during periods of drought or other major market disruptions such as the Ukraine-Russia war (e.g., Carter and Miller, 2012). There is an alternative explanation for the ethanol boom that has received far less attention—the effective banning of MTBE (methyl tertiary-butyl ether) as an oxygenate and octane additive in gasoline that occurred in the U.S. during the early 2000s (Anderson and Elzinga, 2014). The purpose of this article is to investigate the timing of investment in U.S. ethanol plants and provide evidence about which of these explanations for the ethanol boom is most plausible.

Analysis

We begin the analysis with Figure 1, which shows the number of operating ethanol plants in the U.S. over 1998 through 2013. This data was kindly provided by the Renewable Fuels Association (RFA). In the late 1990s, there were around 50 operating ethanol plants, which doubled to more than 100 in 2006, and continued to rise rapidly until reaching a peak of 211 in 2012. The chart also highlights 2000-2003, which is the period when most state-level MTBE bans were put in place. The chart also marks the dates when the two RFS laws passed, August 2005 for RFS1 and December 2007 for RFS2. Figure 1 suggests that MTBE bans were not as important as RFS1 and RFS2 for stimulating investment in ethanol plants. In the two years following the MTBE bans (2004-2005), 23 ethanol plants began operation. By comparison, in the two years following RFS1 44 plants began operation. Similarly, 50 plants began operation in the two years following RFS2.

The evidence provided so far suggests the RFS mandates were more important than MTBE bans in driving the U.S. ethanol boom from 2004 through 2011, as the number and capacity of new ethanol plants increased more quickly following the passage of the RFS mandates compared to the period following MTBE bans. However, it is important to recognize that the data in Figures 1 and 2 are based on the initial year that operation started for a new ethanol plant. This raises the fundamental question of how to define “investment” in the context of building a new ethanol plant.

This suggests that the entire process from project initiation to operation takes at least three to five years. The critical question is where in this three-to-five-year timeline does “investment” in an ethanol plant actually take place?

The textbook economic definition of investment clearly demonstrates that equating ethanol plant startup dates with investment does not make sense. The timeline presented above indicates that plant construction takes 18-24 months, and this time period is undoubtedly the period of heaviest expenditures. At the same time, given lags in ordering capital equipment, some expenditures certainly occur in advance of construction, which would lengthen the lag between investment and plant startup even further. A reasonable compromise is to assume that, on average, investment in a new ethanol plant occurs two years prior to startup.

Note that Figure 3 shows the increment of new plants, whereas Figure 1 shows total plants in operation. Investment in 20 new ethanol plants occurred in the two years after passage of RFS2. By contrast, investment in 44 new plants occurred in the two years after MTBE bans and 50 the two years following passage of RFS1. Figure 4 shows the operating capacity of new ethanol plants using the same rule for year of investment. The results are even more striking, with investment in 3.5 billion gallons of new capacity following the MTBE bans and over 5 billion gallons following RFS1.

The change in timing for defining ethanol plant investment suggests a different conclusion than what was reached earlier: the main driver of the ethanol boom was the effective ban on MTBE and its codification in RFS1. Anderson and Elzinga (2014, pp. 260) provide a useful summary of how this process played out:

The bottom-line is that the banning of MTBE had a significant impact on the composition of gasoline blends in the U.S.

This revised understanding of the ethanol boom has important implications for policy debates and our approach to analyzing agricultural and energy markets. First, it calls into question the common argument that waiving or reducing RFS mandates would provide significant relief during periods of high grain prices. If the primary driver of ethanol production growth is the MTBE phase-out rather than RFS2 mandates, then the mandates are unlikely to be binding in terms of ethanol demand, and a waiver will have limited, if any, effectiveness in reducing ethanol use and grain prices. Second, the analysis highlights the importance of carefully identifying the timing of policy impacts when evaluating their effects on markets.

References

Anderson, S.T., and A Elzinga. 2014. “A Ban on One is a Boon for the Other: Strict Gasoline Content Rules and Implicit Ethanol Blending Mandates.” Journal of Environmental Economics and Management 67(3):258-273. https://doi.org/10.1016/j.jeem.2013.11.009