AUTUMN 2015 GROUP 21

Transcription

1 Advantages and Disadvantages of Ethanol as a Motor Fuel Cross-Country Comparisons between the U.S. and Brazil Prepared By: Jessica Loo Raymond Dong Ted Barrett Basak Sunar Clay Fisher Jiani Chen Andrew Lindsay AUTUMN 2015 GROUP 21 Prepared For: Dr. George Tolley Dr. Stephen Berry Jing Wu Jaeyoon Lee 1

2 Table of Contents Abstract. 3 PART I Introduction...5 Overview of Ethanol....5 Uses of Ethanol....6 Ethanol and Its Significance....7 Global Ethanol Production. 11 Overview of the U.S. Ethanol Market 13 Overview of the Brazilian Ethanol Market 17 PART II - Production Process of Ethanol.22 Overview.22 Dry Milling Process 23 Wet Milling Process...26 Dry Milling and Wet Milling Comparisons 27 PART III - Science of Ethanol as Fuel.28 Introduction to Types of Crops..28 Ethanol Production from Starch.29 Implications for Cars and Engines.33 Ethanol Production from Cellulose 34 Combustion Process of Ethanol vs. Gasoline.37 PART IV - U.S. and Brazil Economic Analyses..38 Costs and Benefits of Ethanol for the U.S. 38 Literature Review on Cost-Benefit Analysis for the Ethanol Industry...40 Literature Review on Cellulosic Ethanol 43 Literature Review on the Effects of Ethanol Subsidies..45 Household s Demand for Ethanol Economic Model..48 Commodities Pricing Economic Model..54 Cost Benefit Analysis Economic Model...59 Costs and Benefits of Ethanol for Brazil 62 PART V Policy Implications.64 U.S. Ethanol Regulation and Policy History..64 U.S. Regulation and Production Forecasts.66 RINS in Depth 67 Ethanol Blend Regulations.70 Relationship Between RINS and Gas.71 Brazil Ethanol Regulation and Policy History 73 U.S. and Brazil Policy Comparison 77 PART VI Conclusion and Recommendation.81 Glossary 85 Works Cited..88 Pictures Cited 92 2

3 Abstract The U.S. is currently the world s largest producer and exporter of corn-based ethanol, with output levels double those of Brazil, the second largest producer of corn-based ethanol. The low-cost production along with an excess supply enabled the U.S. to not only be the leading producer of ethanol, but also be the leading exporter of ethanol as of In order to secure such a position in the global ethanol market, the U.S. took several measures that led to its international success. Although biofuels in the U.S. have been in existence since the 1930s, the government launched tax credits in the 1970s that in turn stimulated the biofuel market to expand. More specifically, the government supported the producers by implementing a 40 cents per gallon tax credit, and increased that to 51 cents per gallon in 2005, the level it s still at today. Beyond the tax credit, the most significant regulation on ethanol in the history of the U.S. has been the Energy Policy Act of 2005, which resulted in the formation of the Renewable Fuel Standard program. The Energy Independence and Security Act of 2007 (EISA) further enhanced the scope of the Renewable Fuel Standard program to set specific annual fuel requirements to be met by the production of particular biofuels, which in turn impacted the ethanol production targets in the U.S. Following these stimulating changes in policies and regulations, ethanol production has been a growing part of the American energy sector over the past few years. Ethanol has become a key component of fuel production in the pursuit of switching from depletable fossil fuel to sustainable energy sources, and particularly for the U.S., to achieve American fuel independence from foreign fossil fuel sources. 3

4 Yet, despite the rapid growth of ethanol in the U.S. to make up a US$40 billion industry, which has been stimulated by the 2005 and 2007 federal mandates such as the Renewable Fuel Standard, ethanol is far from fulfilling the energy targets set by the U.S. Even though the global demand of ethanol is growing, the fuel ethanol domestically accounts for is only 10% of the total volume of consumed motor gasoline, and it has been difficult to increase ethanol s share of motor fuel beyond 10%. The higher cost of ethanol to the consumer given a per mileage basis, as well as its market limitations regarding higher gasoline blends of ethanol such as E85, is also not helping. In addition, corn, the main feedstock for ethanol in the U.S. is less efficient, less environmentally friendly than the sugarcane used in Brazil for making ethanol, and has traditionally been heavily subsidized by national and state governments. In light of these limitations on ethanol, the purpose of this paper is to determine whether the U.S. can take further measures to improve its ethanol market via a cross-country comparison between the U.S. and Brazil. By utilizing an array of various government reports, academic resources and other published research papers relevant to the topic, the paper explains the relevant background information on the subject, summarizes the cost-benefit analysis of the ethanol policies in recent years, and delivers a forward-looking policy recommendation to lay out measures that the U.S. can take to further improve its ethanol market. 4

5 PART I: Introduction An Overview of Ethanol Ethanol, also commonly known as ethyl alcohol, is a chemical with the formula CH3CH2OH (C 2 H 6 O), mostly seen in the form of a colorless, flammable and volatile liquid. It is mainly produced in two different ways, one chemical and one biological. The chemical method utilizes the hydration of ethylene (a colorless flammable gas which can be produced by converting ethanol to water and ethylene, and has the formula C2H4), whereas the biological method involves the fermentation of starch, sugar, cellulosic, and other feedstocks, where each feedstock results in different theoretical ethanol yields as shown in Figure 1.1. Figure 1.1 5

6 Uses of Ethanol Ethanol has many uses for the average household. For instance, ethanol is used as an intoxicating ingredient for alcoholic beverages such as wine, beer and distilled spirits. Additionally, ethanol is also widely used as a solvent to dissolve compounds that are insoluble in water. Due to this property, ethanol is found in perfumes, cosmetics, and medicines. However, the most promising application of ethanol is fuel, where it provides high quality and high octane, resulting in better engine performance as well as reduced emissions. In fuel production, ethanol functions as both an effective fuel additive to form common fuel types such as E10 (10% ethanol, 90% gasoline) and E85 (85% ethanol and 15% gasoline) as well as a stand-alone fuel, which is 100% made up of ethanol and is denoted as E100. Unlike the E10 mix, which can be used by all major auto brands, E85 can only be used by Flex-Fuel Vehicles (FFVs) - vehicles that are designed to run on gasoline or gasoline-ethanol blends of up to 85% ethanol (E85) (EPA). The high-octane characteristics of ethanol also mean that the vehicle can have higher power, torque, and efficiency on average, leading to better performance. For instance, ethanol s octane rating of 113 causes it to remain as the highest rated performance fuel available at the moment such as gasoline and diesel variations with different additives. Another additional benefit of using ethanol as a fuel is that it can prevent issues arising from low temperatures. Normally, antifreeze, an additive that lowers the freezing point of a water-based liquid, is used in the gasoline engines to prevent a rigid gas line from exploding due to expansion when water freezes. Since ethanol already acts as a gas-line antifreeze, there is no need to use other chemicals to keep the gas-line from freezing. 6

7 Ethanol and Its Significance Today, more than ever, clean energy is the key to a sustainable world. Our energy needs have been exponentially increasing in the past decade, and studies have proven the unsustainability of our energy consumption both with regards to scarcity of energy and the increasing severity of global pollution. Over the past couple of decades, while the environmental impacts of petroleum production and usage have gradually gotten worse, the environmental impacts of ethanol production have significantly been reduced due to technological advances in the production processes which will be further discussed in The Production Process of Ethanol. These technological advances have caused the amount of natural gas required to make a gallon of ethanol to fall 36% since 1995, while electricity use [has decreased by] 38%. Water use has also been cut in half since 1998 (Renewable Fuels Association). Since ethanol is a renewable energy source, it is also more environmentally friendly than fossil fuels while also handling the issue of fossil fuel depletion. Fossil fuel depletion explains how oil, natural gas, and coal exist in limited, irreplaceable reserves. Due to our global dependence on these resources, we may run out in the relatively near future, and therefore must find alternate means of fulfilling our energy requirements (Al-Suwaidi). An example that shows how ethanol is more environmentally friendly than fossil fuels is that when biofuels are used as fuel, their carbon emissions are recycled; however, in the use of fossil fuels as an energy source, the carbon emissions that are released during the combustion process remain in the atmosphere. Deposits of fossil fuel resources were formed and contained for millions of years, effectively partitioned from the carbon cycle, but upon their combustion, they are released into the atmosphere and never return to their deposits. In contrast, plant-based 7

8 fuels are derived from atmospheric carbon, release carbon upon combustion, and then a new generation of fuel crops uptake that carbon dioxide. In theory, all carbon released in the burning of biofuels came from carbon that was originally taken out of the atmosphere, although some amount of the input energy typically comes from nonrenewable sources. Figure 1.2 Figure 1.2 reflects an idealized usage of biofuel. However, in virtually all cases, some type of non-renewable energy source is used as an input energy in the production of biofuel, so atmospheric carbon dioxide does increase to some degree in the biofuel combustion cycle. In addition to combusting more sustainably, there are typically low environmental risks that result from transportation, storage, processing, and conversion of biomass energy. Very little or no net carbon dioxide is produced when energy crops are grown and harvested properly. The ash 8

9 nutrients that result from the combustion process are also recyclable, and growing perennial plants for use in biomass energy protect the local soil from erosion. Moreover, the advantages of ethanol are even more apparent due to the increase in efficiency of production, where producers are able to generate 12% more ethanol from the same amount of raw material. Ethanol s energy balance is [also] continually improving, [where] 1 unit of energy invested in making ethanol yields up to 2.3 units of energy available to the consumer (Renewable Fuels Association). Adding on, a study published by Yale University s Journal of Industrial Ecology (What is Ethanol?) has shown that greenhouse gas emissions can be reduced by 48-59% by simply replacing gasoline with ethanol. Beyond the greenhouse gas emissions, ethanol also decreases carbon monoxide emissions. We believe that these benefits of ethanol make it the cleanest available energy source for octane. Another compelling reason that makes ethanol essential is its significant role in energy security. The U.S. is becoming more dependent on other countries to fulfill its energy needs for personal and industrial purposes. In 2014, ethanol displaced gasoline refined from 512 million barrels of crude oil, slightly more than the amount of oil imported annually from Saudi Arabia (Renewable Fuels Association). This comparison illustrates how much impact ethanol can have in the energy independence of the U.S. as well as other countries. Furthermore, achieving this energy independence through a sustainable, renewable energy source would enable the U.S. to keep its leading market position in the long run and allow it to remain unaffected by shifts in foreign energy prices. The U.S. ethanol industry has been growing rapidly over the last decade as displayed in Figure 1.3 (Renewable Fuels Association). Compared to just 1% over 20 years ago, 10% of the 9

10 U.S. gasoline supply today consists of ethanol. Total production from the domestic ethanol refineries has also reached 14.3 billion gallons in 2014, up from 350 million gallons before. The growth of the ethanol industry also played an essential role in spurring employment and income levels in the rural areas. In 2014, ethanol production supported 83,949 direct jobs, as well as 295,265 indirect jobs across all sectors of the economy. The industry also added US$52 billion to the nation s Gross Domestic Product and boosted household income by US$26.7 billion by creating job opportunities (Renewable Fuels Association). Beyond leading to the increase in stable and well-paying jobs, ethanol production also benefits the average U.S. customer by causing a decrease in fuel prices. This decrease has been discussed in a 2011 paper published by the Center for Agriculture and Rural Development (CARD). This paper written by economists from Iowa State University and the University of Wisconsin found that the use of more than 13 billion gallons of ethanol reduced gasoline prices by an average of US$0.89/gallon in Nonetheless, considering the extremely low oil prices that have been prevalent for the past year, the calculations based on 2010 prices may not give a result that holds true today (Du). 10

11 Global Ethanol Production Figure 1.3 The U.S. is the world s largest producer of ethanol, accounting for almost 60% of global output in 2014 as seen in Figure 1.3 above. The other players in the market are Brazil with 25%, the E.U. with 6% as well as China and Canada as of Since 2011, U.S. ethanol has been the lowest cost motor fuel and octane source on the planet (Renewable Fuels Association). The low-cost production along with an excess supply enabled the U.S. to be not only the leading producer of ethanol, but also the leading exporter of ethanol as of Responding to the demand in the international markets, the U.S. exported nearly 825 million gallons in 2014 to 51 different countries, surpassing Brazil as the leading exporter, as illustrated by Figure 1.4 (Renewable Fuels Association). 11

12 Figure

13 Overview of the U.S. Ethanol Market In recent years, ethanol production has been a growing part of the American energy sector, and FFV s have been a growing part of the country s automotive industry. While ethanol has become a key component of fuel production in an attempt to shift towards sustainable energy sources as fossil fuels deplete, even more importantly for the U.S., a large factor in the shift to ethanol and other biofuels is moving away from foreign fossil fuel sources and moving towards American fuel independence. As shown in Figure 1.5, both production and consumption of ethanol have grown, and, as of 2013, the U.S. has gone from a net exporter to a net importer of ethanol as ethanol has grown in popularity as a source of energy. Figure

14 Yet, on the whole, domestic ethanol consumption has plateaued in recent years. The 2009 recession led to people purchasing smaller, less fuel-intensive vehicles, diminishing sales of more expensive FFVs. The recession also led to a decreased amount of funding for alternative energy projects, especially for newer, more advanced biofuels that are not corn-based, because of the inherent risk of investing in new technology. Adding on, although the U.S. government has mandated large-scale consumption of cellulosic biofuel, targeting 250 million gallons consumed in 2011 in a 2007 mandate, the U.S. has grossly undershot these mandates and refiners ended up only producing 280,000 gallons in just over 1% of the 2007 mandate s target. Refiners have also been able to mitigate fines for their underproduction, and were able to pass along a lot of the charges onto consumers (Gay). The combined effect of this severe underproduction of cellulosic ethanol and halt in technological development to utilize more efficient ethanol sources has resulted in our ethanol remaining almost entirely corn-based, despite it being less efficient that a number of ethanol sources. The inefficiency of corn-based ethanol, coupled with concerns about food security as we use more corn for fuel instead of food, has lowered public support for biofuels, ultimately stagnating U.S. ethanol production growth (Gay). This ultimately leads to the motivation of our paper, where we seek to determine ways in which the U.S. can enhance the efficiency of its ethanol program through learning from Brazil or redirecting more of its efforts towards developing cellulosic ethanol and reaching its targets for cellulosic biofuels. Despite the slowdown in domestic ethanol consumption in the U.S., virtually all gasoline pumps have up to around 10% of ethanol, but may or may not specify its inclusion as such a low percentage of ethanol has a negligible effect on the engine and can run in any standard American 14

15 vehicle. In terms of FFVs available in the American market, the largest part of the market share belongs to E85 vehicles. However, these vehicles and their fueling stations are found almost exclusively in the Midwestern U.S., where the bulk of corn production occurs, as it is most effective to produce, transport, and sell ethanol there. Figure 1.6 shows a breakdown of the number of ethanol production plants by state, as well as national net annual ethanol production by year, highlighting how most ethanol production plants, like fueling stations, are also concentrated in the Midwestern U.S. Figure

16 Additionally, Figure 1.7 shows a breakdown of biomass resources grown in the U.S. It is worth noting that, despite the large amount of biomass resources in certain southeastern states, such as Louisiana and Florida, these states have bagasse and sugarcane, which have not yet been readily adopted by American ethanol producers at the level that corn has. Figure

17 Overview of the Brazilian Ethanol Market Brazil is the world s second largest producer and exporter of ethanol. To put this in numbers, in 2014, Brazil produced approximately 25.0% of the world s (or 6.76 billion gallons) ethanol and exported approximately 1.4 billion gallons of ethanol (USDA). The relative historical successes of ethanol in Brazilian markets have several sources. The first is the relatively low production costs of Brazilian sugarcane ethanol. In 2011, it was estimated that the production costs for sugarcane ethanol was US$0.48/liter, or 58% lower than the production costs of U.S. produced corn ethanol (Du). Much of the lower production costs can likely be attributed to sugarcane s efficiency in land usage, as sugarcane can produce 45% more ethanol per unit of land than corn. The second source of ethanol s relative historical success in Brazil is the continuing expansion of the FFV fleet. These FFVs are able to run using pure gasoline, pure ethanol, or a mixture of the two. In fact, the gasoline sold at pumps is actually gasohol, or a blend of gasoline and 18-25% ethanol (Moreira). Though there was previously technology available that allowed cars to run solely on pure ethanol, FFVs were beginning to be developed in the late 1990s. FFVs began to enter the Brazilian market in 2002, and by 2005 had captured about 10% of the vehicle market. Since then, the FFV fleet has flourished, making up over 40% of the entire vehicle fleet in 2010 (Du). As shown in Figure 1.8 below, it is estimated that FFVs could make up as much as 86% of the fleet by As of 2009, more than 80% of new vehicles produced in Brazil have flex-fuel capabilities, up from 30% in 2004 (Balat). 17

18 Figure 1.8 It must also be noted that, as of the last few years, the Brazilian ethanol industry has seen considerably lower levels of success, as is shown in Figure 1.9 below. In their analyst report from 2014, Bain & Company claims that the reason ethanol prices are now higher than gasoline prices in Brazil is related to higher production costs for ethanol (Gay). However, this is in direct contradiction to the above research done by other economists, who all contribute Brazil s historical success in the ethanol industry to the nation s technological and productive capabilities. To address this contradiction, we argue in Brazil Ethanol and Policy History that the success and recent decline of the Brazilian ethanol industry is primarily due to the government s regulations and policies surrounding biofuels, and conclude that the recent attempts to reenact 18

19 previously successful policies are promising for a future revitalization of the ethanol industry. For instance, the main reason for the fall in Brazilian exports of ethanol in 2014 was due to a lower sugar-cane harvest with reduced demand from the U.S. Adding on, growth in domestic consumption of ethanol has also slowed. In order to address these problems, the Brazilian government raised the blend mandate in Brazil from 25% to 27%, which should spur growth in its ethanol industry (USDA). Figure 1.9 Another interesting point that past research shows is that a vast majority of FFV users in Brazil choose their fuel based on which is more cost-effective, not whether their fuel is from a renewable source; Brazilian policy leads to increased production of FFV and greater availability of ethanol fuel, but this shift to biofuel usage is usually only adapted by consumers when it is 19

20 financially beneficial to them. Because of the energy yield of ethanol as compared to E20 gasoline, FFV owners tend to purchase E100 fuel, which is a fuel blend with almost 100% ethanol, when ethanol is under 70% of the price of E20, a fuel blend with 20% ethanol and 80% gasoline. Alternatively, FFV owners tend to purchase E20 when the price of ethanol is 70% over the price of E20. Because of this 70% efficiency ratio shown in Figure 1.10 below, prices tend to dip either above or below the ratio and then come back to the 70% breakeven point as consumers adapt to the more cost-effective fuel. Because of the proximity of production facilities and local policies, different regions of Brazil tend to have higher or lower ratios of ethanol to fuel prices. This is telling for the American market; while there is a large environmentalist driven push for divestment from fossil fuels, ultimately pricing incentives may drive American consumers to purchase biofuels such as ethanol for their vehicles if they otherwise would have had no other desire to move away from fossil fuels such as gasoline. Nevertheless, as will be further analyzed in Combustion Process of Ethanol vs. Gasoline and Household s Demand for Ethanol Economic Model, it is also important to look at the differences in mileage per gallon of fuel for both ethanol and gasoline when coming up with policy incentives. Although many consumers look at the price at the pump to determine whether or not they should use ethanol or gasoline, pricing is not the only factor that should be considered as the costs per mile or costs per gallon differ between ethanol and gasoline. 20

21 Figure

22 Part II - Production Process of Ethanol Overview Ethanol is produced using different processes based on the starting product. In this section we will discuss the two methods of fermentation, whereas in Science of Ethanol as a Fuel we will discuss the overall scientific methodologies. In regards to fermentation, the two processes are wet milling and dry milling, which differ in how the grain is treated prior to fermentation. In dry milling, the process begins with grinding the whole grain into flour before the next step, whereas in the wet milling process the first step is to soak the grain in water to separate the grain kernels. 22

23 Dry Milling Process Figure 2.1 displays the steps of the dry milling process, and illustrates how ethanol is produced for use in fuel production and what co-products it has (Renewable Fuels Association). Figure 2.1 At first, the whole starchy grain (mostly corn kernel in the U.S.) is grinded into flour, and that is mixed with water to make up a mash. In order to convert the starch in the mash to dextrose, a simple sugar, enzymes are added. After this, some ammonia is also added as a nutrient to the yeast and as a ph controller. The mash is then processed in high temperature to eliminate bacteria, and then is cooled down. The yeast is then added, and the conversion of sugar to ethanol and carbon dioxide (CO 2 ) takes place (Renewable Fuels Association). After 40 to 50 hours in the fermentation phase, the distillation columns separate the ethanol from the remaining stillage. Ethanol is then concentrated, dehydrated and blended with approximately 5% denaturant (e.g. natural gasoline) to distinguish it as an undrinkable liquid that 23

24 is not subject to any alcoholic beverage taxes as it becomes ready to be sent to gasoline terminals (Renewable Fuels Association). As for Brazil, the biggest competitor of the U.S., the production of ethanol is typically from sugarcane rather than corn. Sugarcane s bagasse (crop wastes) is used in the energy conversion process. In order to process the sugarcane, a process that is similar to that of corn s is followed: first the sugar is pressed out of the sugarcane, and then fermented (C2ES). As for the co-products, the CO 2 released during fermentation is used in carbonating beverages and in producing dry ice. The remaining stillage is centrifuged to distinguish the solubles from the coarse grain. As the solubles become more concentrated and dried with the grains, it makes up a nutritious livestock feed that is more formally called dried distillers grains with solubles (Renewable Fuels Association). Thus, beyond generating ethanol, ethanol production also proves to have some co-products that are incredibly useful as exemplified here with the high quality livestock feed and manufacturing of ice and beverages. 24

25 Figure 2.2 According to the data from Renewable Fuels Association (RFA), a modern dry-mill ethanol refinery produces approximately 2.8 gallons of ethanol and more than 17 pounds of distillers grains from a bushel of corn and in 2014, ethanol bio-refineries produced approximately 39 million metric tons of feed, making the renewable fuels sector one of the largest animal feed processing segments in the U.S. This shows that the benefits of ethanol production go beyond the usage of ethanol as fuel. Figure 2.2 also illustrates how U.S. exports of distillers grain were at record levels in 2014, which is in line with the widespread acceptance that distillers grains volumes have grown in the international markets. 25

26 Wet Milling Process Figure 2.3 Figure 2.3 (RFA) displays the steps of the wet milling process. Unlike dry milling, where the grain is grinded into flour, in wet milling, the grain is soaked for 24 to 48 hours in water and dilute sulfurous acid to help separate the grain into its components. Then, the corn germ is separated from the slurry after going through several grinders. As the corn oil is extracted from the germ, the remaining components are centrifuged. The concentrated water and fiber components make up a gluten free livestock feed, and the gluten component also turns into a corn gluten meal that is used as a feed in the poultry industry. Finally, starch and all the other remaining components get fermented into ethanol, get sold as cornstarch or get processed into corn syrup. Even though the fermentation process of wet milling is very similar to that of dry milling described above, most of the ethanol refineries use the dry milling process to produce ethanol fuel along with high quality livestock feed products. 26

27 Dry Milling and Wet Milling Comparisons When comparing the two different ethanol production processes, it is important to note that wet milling is more capital intensive and costly than dry milling, although it often produces a wider range of byproducts. Dry milling, on the other hand, can lead to higher ethanol yields because it is more efficient in retaining the key substance within the ethanol it produces. Hence, we consider dry milling less capital intensive and less versatile than wet milling because the process s focus is on the production of ethanol rather than its byproducts. Therefore, in the U.S., most of the existing plants use dry mill technology and most of the future expansion is expected to use dry mill technology. Dry mill plants produce about 82% of total U.S. ethanol production and specialize in producing one product, ethanol, from the starch that is processed; whereas wet mill plants produce the remaining 18 % of U.S. production as they usually have higher investment costs albeit being more flexible (Eidman). In the U.S., corn has historically been the feedstock for ethanol production; in other countries such as Brazil, ethanol is more commonly made from starch, sugar or cellulosic feedstocks. Although corn-based ethanol production technology has become increasingly effective over the years, some experts argue that this method has already matured with slight possibility of further innovation (DiPardo). Experts have argued that substantial cost reductions may be possible if cellulose-based feedstocks are used instead of corn. This claim will be further analyzed in the Cost Benefit Analysis Economic Model subsection. 27

28 PART III: Science of Ethanol as Fuel Introduction to Types of Crops In order to fully understand the costs and benefits of ethanol as a motor fuel, the scientific underpinnings of its production and consumption must also be analyzed. To start, the base raw materials for ethanol are sugar, starch, or cellulosic crops. Sugar crops, such as sugarcane and sugar beets, are used to produce a sugar-containing solution that can be directly fermented by yeast because they contain simple glucose molecules. Both starch and cellulosic feedstocks require additional conversion steps before fermentation can occur. Brazil uses sugarcane for ethanol and has a more straightforward scientific conversion process relative to the U.S., which uses complex carbohydrates to produce ethanol. 28

29 Ethanol Production from Starch We will start this section with a scientific explanation for the production of ethanol from complex carbohydrates, which is what we see in the U.S. On the other hand, since Brazil uses simple glucose sugars from sugarcane, the production process would just start with the conversion of glucose into ethanol as shown in Figure 3.1. Figure 3.1 Chemically, starch is a long-chain polymer of glucose as shown in Figure 3.1 that must be broken down into simple glucose units through hydrolysis. During the hydrolysis reaction, water is mixed into the solution to produce a final mash containing 15-20% starch. Two enzymes are added as the mash is boiled to result in the final glucose product. Once glucose is retrieved (either directly or through the intermediate step), yeast is added to form ethanol, carbon dioxide, and heat as shown in the reaction below in Figure 3.2 below. 29

30 Figure 3.2 From stoichiometry, we expect that the maximum conversion efficiency of glucose to ethanol is around 51% on a weight basis, in that 1 kg of glucose results in 511 g of ethanol. In practice, the glucose-to-ethanol conversion rate is only actually 40-48% because of cell mass and metabolic production constraints. Distillation is then used to separate ethanol from the rest of the mash based on differences in boiling point between ethanol (78.1 degrees Celsius) and water (100 degrees Celsius). Because ethanol and water form an azeotrope (a binary mixture with the same composition in the liquid and vapor phases that boils at a constant temperature), ethanol can only be concentrated to 95.6% by volume via fractional distillation. Figure 3.3 below shows that at around 351 kelvin, which is the boiling point of the azeotropic solution, we should have close to pure azeotropic ethanol in the distillate. 30

31 Figure 3.3 To achieve pure anhydrous ethanol, dehydration is required following distillation. One method to do this is to add benzene to the ethanol/water mixture to change the boiling characteristics of the solution to separate the anhydrous ethanol. The more commonly used method, especially because benzene is carcinogenic, is to use a molecular sieve to run on the ethanol to gradually distill the 96% ethanol into more pure forms. A molecular sieve works due to the differences in molecular size between water and ethanol. As shown in Figure 3.4 below, water is a smaller molecule than ethanol and will be captured by the sieve. 31

32 Figure 3.4 The final ethanol product is a volatile, flammable, colorless liquid with a slight chemical odor. It also has the following chemical properties in the below table (Figure 3.5). Figure 3.5 Property Value Molecular Weight g/mol Density (at 20 degrees Celsius) g/cc Boiling Point 78.5 degrees celsius Heat of Combustion 1,300 kj/mol Heat of Vaporization Kcal/mole Octane Rating

33 Implications for Cars and Engines Based on the above science discussed, there are some conclusions to draw about the usage of pure ethanol versus azeotropic ethanol as a fuel in engines. If the ethanol is kept in its azeotropic form, it can be used in cars with engines that are only fit with accepting ethanol, which does not include the majority of U.S. cars. If the ethanol is to be purified into a pure form, then it can be used in normal engines which normally consume gasoline in combinations of up to 20% ethanol (80% gasoline). It may be more cost effective at times to keep ethanol in its azeotropic form to use as fuel because that eliminates the need for the costly dehydration steps. However, normal cars will require engine conversions to handle the azeotropic ethanol. Deciding whether to use azeotropic or pure ethanol as a fuel becomes a question of the cost of the engine conversion versus that of dehydration. 33

34 Ethanol Production from Cellulose Cellulosic ethanol production has a lot of potential as a source of biofuels because it often makes up approximately half of plant biomass. However, there are production barriers that make it tougher to extract ethanol from. We can see the structural difference below in Figure 3.6. Although both starch and cellulose are polymers of the glucose monomer, they are oriented differently geospatially due to their chemistry. Starch polymers are alpha-glucose whereas cellulose is beta-glucose. This is an important distinction because enzymes are specific for a particular type of chemical bond and there are few organisms with enzymes capable of breaking down cellulose links. Figure

35 To make matters even more complicated, cellulose molecules are packed in tight crystalline forms and wrapped around with lignin and hemicellulose, which works to create plant cell walls. We see the complexity of the structure in Figure 3.7. In the current process, pretreatment, or disentangling the cellulose from the rest of the structure is the most expensive step in the process. For future research, there is tremendous potential to harness energy from cellulosic plants if scientists can separate cellulose effectively as well as find enzymes or organisms to break down cellulose into its monomeric glucose form. Figure

36 As a summary of the different scientific processes, there are three main starting points from which to create ethanol from plants. In Figure 3.8 below we see ethanol can be formed from various starting materials, including glucose, starch, and cellulose. It is most efficient to produce ethanol from simple glucose because it requires the fewest steps in the process. Brazil is able to capitalize on these efficiencies because it uses sugarcane as the simple glucose form to make ethanol. In the future, if the U.S. is able to expand large-scale technologies in the pretreatment and digestion of ethanol, there is significant potential to bring cheaper ethanol to the market. Figure 3.8 Source: Great Lakes Bioenergy Research Center 36

37 Combustion Process of Ethanol vs. Gasoline Thus far in the science section, we have discussed the production of ethanol from different starting points. For ethanol to actually translate into energy to move cars, it must be combusted based on the equation below in Figure 3.9. The heat of combustion for pure ethanol fuel (E100) is 29.7 kj/g, which is only about 63% as much energy as the 47.0 kj/g released from gasoline. This number is better for E85 (85% ethanol), which has 76% of the fuel mileage compared to 100% gasoline. As of July 2015, E85 ethanol prices were 48 cents cheaper than gasoline per gallon ($2.36 vs. $2.82) but this doesn t fully reflect the value of these two fuels. Adjusted by the amount of energy, ethanol is actually slightly more expensive than gasoline ($3.07/GGE vs. $2.82/GGE) (U.S. Department of Energy). This is a very telling fact, as in Overview of the Brazilian Ethanol Industry we mentioned how past research has shown that Brazilian consumers tend to purchase fuel that is cheaper at the pump. Yet, in reality, ethanol has less mileage per gallon as shown above. As households become more educated about the differences in energy content between ethanol and gasoline, policymakers must take the mileage differences into consideration when coming up with price incentives to promote ethanol usage. This crucial point will be further studied in the upcoming Household s Demand for Ethanol Economic Model. Figure

38 Part IV - U.S. and Brazil Economic Analyses Costs and Benefits of Ethanol for the U.S. In order to further understand the costs and benefits of utilizing ethanol as a fuel, several papers on the ethanol industry were examined. One of the main benefits of ethanol discussed for the U.S. include energy security, where ethanol use reduces U.S. reliance on foreign oil as discussed in Ethanol and Its Significance. An increase in ethanol use also leads to a decrease in U.S. consumption of oil, reducing problems that arise due to sudden changes in energy supply and prices. Additionally, ethanol usage decreases greenhouse gas emissions due to a reduction in carbon monoxide emissions and air toxic emissions such as benzene, leading to improvements in local air quality. Ethanol production has also brought on an increase in wages and employment in many states in the Corn Belt, as the U.S. primarily uses corn-based ethanol. For instance, the increase in corn prices in the Corn Belt states has bolstered earnings of farmers (Cecot). Yet, there are also significant costs to ethanol for the U.S. that have to be analyzed. Even though the biofuel is found to reduce carbon dioxide emissions, it may not decrease the overall level of greenhouse gas emissions, as ethanol usage increases other emissions like sulfur oxides and nitrogen oxides. Ethanol production and distribution is also more costly than gasoline due to the infrastructure needed for the transportation and pumping of the fuel. Since a majority of ethanol produced in the U.S. is corn-based, specific fertilizers and pesticides are also needed to ensure that the crops are suitable for the production processes. These fertilizers and pesticides in return result in excess nitrogen that eventually leaks into the groundwater and rivers, causing ground level ozone and water contamination. Additionally, although the rise in corn prices may 38

39 be a benefit for farmers, it is seen as a cost for the average consumer. The increase in corn saved for ethanol production also leads to a decrease in corn available in the global market, which is particularly harmful for third world countries that rely on U.S. exports of corn (Cecot). Because of this, some argue that the U.S. will never be able to produce enough corn-based ethanol without compromising the food supplies of other developing countries (Cason). 39

40 Literature Review on Cost-Benefit Analysis for the Ethanol Industry Due to the different costs and benefits of ethanol, it is important to conduct a cost benefit analysis to quantify whether or not ethanol brings more benefits or costs to the U.S. To do so, we examined the papers Ethanol: Law, Economics and Politics by Robert Hahn, The Benefits and Costs of Ethanol: An Evaluation of the Government s Analysis by Caroline Cecot and Robert Hahn and A Cost and Benefit, Case Study Analysis of Biofuels Systems by Matthew Cason and Rohit Satishchandra. Ethanol: Law, Economics and Politics and The Benefits and Costs of Ethanol: An Evaluation of the Government s Analysis both come to the same conclusion that the costs of corn-based ethanol production in the U.S. outweigh the benefits of corn-based ethanol production and that policy rationales for [corn-based] ethanol do not justify its widespread support [since] ethanol made from corn is not likely to boost energy security and its environmental benefits are uncertain (Hahn). Both papers start off by presenting two different scenarios to measure the impact of increased ethanol usage. The first scenario is the Renewable Fuel Standard (RFS), in which ethanol usage is increased from four billion gallons per year to seven billion gallons per year. The second scenario is the Energy Information Agency (EIA) case, in which ethanol production reaches the level of ten billion gallons per year by The RFS scenario does not hold if the EIA scenario does. Both papers then utilize the benefits transfer method, meaning benefits and costs were monetized based on findings from literature and the Environmental Protection Agency (EPA). For the benefits, EPA s regulatory impact analysis provides numbers on oil displacement and air toxic emission reductions. Data from the Intergovernmental Panel on Climate Change was also 40

41 used in determining the average value of greenhouse gas emission reductions from increased ethanol usage. Similarly, for the costs, EPA s estimates for production costs and increased emissions from ethanol usage and production were utilized. Most emission increases are a result of producing and transporting ethanol. Government subsidies were also taken into account, where a deadweight loss (DWL) was calculated by multiplying government subsidies by a factor of 0.25 due to economic inefficiency. Figure 4.1 Figure 4.1 above illustrates that the costs exceeded benefits by US$1.2 billion in the RFS scenario and US$2.5 billion in the EIA scenario. We tried replicating Figure 4.1 with updated numbers and updated standards for both the RFS and EIA scenarios, but EPA officials told us that no updated data is available. Hence, given the lack of more recent figures that may reflect new advances, we are unable to conclude that the costs of corn-based ethanol outweigh the 41

42 benefits of corn-based ethanol in the U.S. today and that the policies that promote corn-based ethanol are of no use today. For instance, technological advances have increased the efficiency of ethanol production, possibly causing the benefits of corn-based ethanol to outweigh the costs. In order to address the costs and benefits of corn-based ethanol, we decided to turn to alternative economic models presented in Household s Demand for Ethanol Economic Model and Commodities Pricing Economic Model. Our results eventually led us to conduct a cost and benefit analysis on cellulosic ethanol, where this will be presented in Cost Benefit Analysis Economic Model. Lastly, a case study will be conducted between the U.S. and Brazil to determine if there is anything the U.S. can gain from Brazil s successful sugarcane based ethanol program. 42

43 Literature Review on Cellulosic Ethanol In addition to the costs and benefits of corn-based ethanol, we also hope to understand the costs and benefits of cellulosic ethanol. The reason for this is because the U.S. mandated largescale consumption of cellulosic biofuel in 2011 based on a 2007 mandate, but the target was not met. A possible explanation to why the target was not met may be because the high production costs outweighed the benefits, which may explain why the U.S. reduced its funding for alternative biofuels during the recession. Therefore, in order to fully understand the U.S. ethanol program and to give appropriate recommendations, it is important to determine if it is beneficial for the U.S. to continue implementing policies that encourage usage of cellulosic ethanol or if it should only focus its time on corn-based ethanol. Since we hope to further understand the costs and benefits of cellulosic ethanol, the paper A Cost and Benefit, Case Study Analysis of Biofuels Systems by Matthew Cason and Rohit Satishchandra was further analyzed. The paper speaks of the difference between First Generation (1G) and Second Generation (2G) Biofuels, where 1G biofuels include those made from energy crops such as corn, sugarcane and grains, and 2G biofuels include those made from agricultural residues such as sugarcane bagasse, and forest residues (Cason). The authors argue that developed countries such as the U.S. should switch to 2G biofuels while continuing to develop their 1G biofuel programs. On the other hand, developing countries such as Brazil should stick to 1G biofuels due to the cost of infrastructure, input costs, as well as initial setup costs (Cason). Ultimately, the authors suggest that 2G biofuels are generally profitable and desirable for developed countries, but will require a large investment to develop the necessary facilities to support production. The authors view this as a positive investment, as the socioeconomic and 43

44 environmental sustainability of 1G biofuels have repeatedly been called into question. Therefore, it is possible that the U.S. should increase its investments and research and development for alternative forms of ethanol such as cellulosic ethanol, a form of 2G biofuel. Figure 4.2 Despite the authors conclusions, we believe that there are technological production and efficiency lessons that the U.S. can learn from Brazil to enhance its own ethanol program, whether or not it chooses to continue using 1G biofuels or switch to 2G biofuels. For instance, as seen in Figure 4.2, Brazil generates more 1G revenue in comparison to a developed country such as Germany. Hence, we believe that a comparative case study between the U.S. and Brazil will still provide us with additional insights to improve the U.S. s ethanol program. 44

45 Literature Review on the Effects of Ethanol Subsidies In order to better construct a cost and benefit framework for our analysis, we will also analyze the negative economical and environmental externalities resulting from ethanol subsidies in this section. The reason for this is that in Literature Review on Cost-Benefit Analysis for the Ethanol Industry, it is seen that Cecot and Hahn estimated a US$340 million DWL from government subsidies in the RFS scenario and US$720 million deadweight loss from government subsidies in the EIA scenario, as government subsidies create inefficiencies in the market. Government ethanol production subsidies total over US$3 billion annually, which is roughly US$0.79 per litre of ethanol produced. The cost of production of ethanol combined with the subsidy results in the cost of ethanol to be US$1.21 per litre, which is around US$4.58 per gallon. This total subsidy per litre is 45-times greater than that of gasoline, and virtually all of the benefits from current ethanol production subsidy policies in the U.S. are captured by the producers of ethanol rather than the consumers, as the subsidy is funded by higher taxes (Cecil). 45

46 Figure 4.3 Source: The main reason why some view the subsidies to ethanol as negative is because of the DWL that it creates. From an economic perspective, DWL exists in the economy when total welfare of the consumers and producers are not maximized. The economy encounters DWL when there are externalities in the market or government interventions that do not let the markets move towards equilibrium, or to exhibit perfect competition. According to Figure 4.3, without any government intervention, the economy will be at Q* where the price of ethanol will be at P*, hence supply price = demand price. When the government subsidizes the production of ethanol, the quantity is increased to Q subsidy, where Q subsidy > Q*. The increase in quantity supplied causes the supply curve to shift to the right, resulting in a higher price received by suppliers (Pd), and a 46

47 lower price paid by consumers (Ps). Often, taxpayers fund the difference in prices between Pd and Ps. Moreover, the green area in Figure 4.3 represents the DWL as a result of the government subsidy on the production of ethanol. Again, the reason why DWL arises in this case is that government intervention causes inefficiency in the markets. Nevertheless, we argue that despite the DWL in the market due to the subsidy, it is important to note that consumers are paying a lower price (despite the fact that taxpayers fund the subsidy), and that producers are receiving a higher price. Since we have learnt that pricing incentives matter, it is possible that producers will not produce ethanol without this subsidy and consumers will not purchase ethanol. Additionally, past research from Du and Hayes suggest that the high cost of these ethanol subsidies are actually cost saving. The authors claim that the resulting increased ethanol production prevented gasoline price increases that would have resulted from refineries working at maximum capacity if ethanol had not been produced. Thus, a large subsidy would actually save money in the range of US$0.29 per gallon - US$0.40 per gallon. Hence, although many economists argue that the efficiency losses from subsidies far outweigh the benefits consumers gain as they also lose a significant portion of the benefit to taxation, we believe that without the pricing incentives from the subsidy, both producers and consumers will turn to cheaper alternatives, such as fossil fuels, leading to a decline in the ethanol industry. 47

48 Household s Demand for Ethanol Economic Model Given the literature review above, we turn to alternative economic models to analyze the costs and benefits of corn-based ethanol. One way in which to do so is to understand the costs and benefits of corn-based ethanol in terms of pricing. In order to further our understanding, we turn to The Demand for Ethanol as a Gasoline Substitute by Soren Anderson. The model presented is one of household utility, where ethanol and gasoline are linearly combined to provide the household s transportation services. Assumptions of the Model: 1) Each household owns a single flexible-fuel vehicle 2) Utility is quasilinear in transportation services V(.) and other goods 3) V(.) is strictly increasing and strictly concave 4) Ethanol and gasoline are perfect substitutes Household s Utility Function: V(e+rg) + x e = consumption of ethanol g = consumption of gasoline x = consumption of all other goods r = rate at which household converts gallons of gasoline into the equivalent amount of ethanol 48

49 If a household only cares about mileage, then r is equal to the ratio of the household s mileage when it uses gasoline to the household s mileage when it uses ethanol. The rate r also takes into account households who choose to use ethanol because of its environmental benefits. Because of this, the rate r varies across households and fully takes into account households preferences for ethanol as a substitute to gasoline. Household s Budget Constraint: y - p e e - p g g - x = 0 p e = Price of ethanol p g = Price of gasoline y = Household s Income Given the household s utility function and budget constraint, we seek to understand if the household will choose to use gasoline or ethanol. Since the utility function is linear, a corner solution exists, where the household will purchase ethanol if p e < p g / r and will purchase gasoline if p g / r < p e. Since ethanol and gasoline are viewed as perfect substitutes, the household will choose the fuel at the lower ethanol-equivalent price. Alternatively, the household will choose ethanol when r < p g / p e, where r functions as a fuel switching price ratio (Anderson) and determines the type of fuel the household chooses. 49

50 Household s Demand: The household s demand for the quantity of fuel depends on absolute price levels, where the household equates the marginal utility of ethanol equivalent fuel consumption to the ethanol-equivalent price of [the] fuel it chooses (Anderson). If ethanol is chosen, the optimal quantity demanded is: e* = q(p e ) If gasoline is chosen, the optimal quantity demanded is: g* = q(p g / r) / r Aggregate Demand: Assumptions 1) N households in the market 2) Each household owns a vehicle 3) Fraction φ of the vehicles are flexible-fuel vehicles 4) The fuel switching price ratios r are distributed according to a differentiable cumulative density function H(r) defined over [0, ] In order to determine the fraction of households that choose ethanol over gasoline, we can evaluate the cumulative density function at H(p g / p e ). We can then figure out the aggregate demand of households to be the total number of households multiplied by the fraction φ that owns flexible fuel vehicles. We then multiply this number by the fraction of households that 50

51 choose ethanol based on H(p g / p e ). We then take this number and multiply it by the average ethanol consumption among households that choose ethanol over gasoline to give the equation: Qe(p e, p g ) = NφH(p g / p e )*avgq(p e ) Price Elasticities: To determine the price elasticity of aggregate demand for ethanol, we can take the natural logarithms of both sides of the equation above: LnQe(p e, p g ) = LnNφ+LnH(p g / p e )+Lnavgq(p e ) We then differentiate by the p g to determine the gasoline-price elasticity of the aggregate demand of ethanol: ζ g = [H (p g / p e ) * p g ] / [H(p g / p e )*p e ]. This equation tells us that a 1% increase in the prices of gasoline leads to a ζ g % increase in the quantity demand of ethanol. In general, the price elasticities vary across all households, therefore changing the shapes of the distributions of the price-switching ratio r. As seen in Figure 4.4, if households are nearly identical, then the fuelswitching behavior occurs at a single peak or single price ratio. If this behavior holds in the market, policies that promote ethanol must be targeted towards achieving a huge price difference that will lead to this fuel switching behavior, potentially causing large distortions in the market. If households are heterogenous, there is not one single price ratio that can cause households to substitute from gasoline to ethanol or vice versa. Additionally, price elasticities are much smaller in magnitude as demand is less sensitive to prices. Because of this, policies that promote ethanol can induce households to switch to ethanol by causing fewer distortions in the market prices. 51

52 Figure 4.4 Findings: In order to conduct the analysis above, Anderson uses a dataset that consists of 5000 monthly observations of corn-based ethanol prices and sales volumes between at over 200 retail gas stations in Minnesota. Anderson s findings show that the demand for corn-based ethanol has an average elasticity of about , hence showing that demand for corn-based ethanol is sensitive to relative prices, and that policies that promote corn-based ethanol usage are capable of causing huge distortions in the market. Yet, Anderson s findings also show that fuel switching behavior occurs throughout a wide range of relative prices, and that preferences for [corn-based] ethanol among households are quite diffuse (Anderson). 52

53 Based on Anderson s findings, we must consider the fact that households are not identical, and that preferences not only depend on the mileage aspect of fuel consumption. Many households were willing to pay a per-mile premium for corn-based ethanol due to its perceived environmental benefits and role as a clean form of energy, leading to a wide range of priceswitching ratios. Because of this, it is possible that households that have strong preferences for corn-based ethanol still choose to use ethanol without any large government price subsidies in place. This is something to take into consideration given the DWL that results from government subsidies as discussed in the Literature Review of the Impacts of Ethanol Subsidies. Adding on, despite the fact that Anderson s findings are based on corn-based ethanol, it is important for the U.S. to evaluate the impact pricing and household preferences have on cellulosic ethanol or other 2G biofuels when coming up with policy incentives. 53

54 Commodities Pricing Economic Model Based on Anderson s findings above, it is seen that policies that promote corn-based ethanol usage are capable of causing huge distortions in the market. One way to analyze possible distortions in the market is to understand the effect corn-based ethanol has on the pricing and availability of food products, as a cost previously mentioned is that corn-based ethanol leads to an increase in food prices. In order to do so, we refer to two NBER papers, Biofuels, Binding Constraints And Agricultural Commodity Price Volatility by Philip Abbott and Identifying Supply and Demand Elasticities of Agricultural Commodities: Implications For the US Ethanol Mandate by Michael Roberts. In Abbott s paper, the share of U.S. corn production used to produce ethanol increased drastically in the past decade, as seen in Figure 4.5. Even after accounting for return of corn byproducts to the feed market, there is a large and persistent new demand for corn that has changed price dynamics. Incentives such as the RFS mandates, subsidies to ethanol, regulations on gasoline chemistry and import tariffs have created more capacity for ethanol production, and to use corn for fuel rather than food. Abbott discusses researchers who say that the presence and emergence of biofuels have caused a global food crisis, while others assert that biofuel shocks should only affect corn prices, as other common factors across commodities are more important in explaining price increases (Abbott). 54

55 Figure 4.5 Roberts takes Abbott s work one step further to try to quantify the price impact due to corn being used for ethanol rather than for food. To do this, first we must understand the theoretical model. The equation below represents the theory of competitive storage, in which consumption can be substituted over time by transferring food from periods of scarcity to periods with plenty. Here, amount consumed c t is equivalent to total food supply at the beginning of period, z t, minus how much food is stored. Any food not stored is consumed. Theoretically, we obtain the Bellman equation for the social maximization equation that is shown below. To start, the social planner makes two decisions for x t, how much to store for the next period, and λ t, the amount of effort put into new production (such as how many acres to plan for the following year). The planner maximizes the utility consumed u(z t - x t ) minus a function for the cost of storage ϕ(x t ) and a function for the cost of effort g(λ t ). The last term in 55

56 the maximization is a discounted expected value gained from total food supply in the following period. The law of motion equation z t+1 = x t + λ t ω t+1 just says that the total amount of food in the following period is a function of the amount λ t stored plus your effort multiplied by random weather shocks ω t+1 in the following period. The weather shocks are unpredictable and exogenous. The final constraints just show that you cannot store or expend negative units of food and effort. Lastly, consumption z t - x t must also be positive each period. Empirically, Roberts takes production and storage data from the Food and Agriculture Organization (FAO) for the years He uses the empirical model shown below. In the supply equation, we have log of supply s t, an intercept α s, weather yield shock ω t, time trends in supply (from technological change, population, income growth) f(t), and an error term u t. The most important value in the regression is the price term β s log(e[p t t-1 ]). The log of expected prices is an expected value based on the previous period. The β s term is valuable because it represents the supply elasticity, or the unit change in log supply for each unit increase in log prices. The demand equation is very similar to the supply except for there is no weather shock term affecting demand and the price is not an expectation. This is because on the supply end, farmers make planting decisions before a year s weather shock whereas consumers face prices in the present period. β d is the elasticity of demand in the demand equation. 56

57 In order for the empirical model to work, both equations must be identified. The authors check to ensure the independent variables are not correlated with the unobserved factors that could affect supply or demand. More importantly, weather shocks are an exogenous variable because weather affects farmers decisions but not vice versa. Weather is also random at planting time (for the most part) but does have an obvious causal connection to supply. From the 2SLS and 3SLS regressions, it is found that the supply elasticity for food varies between 0.08 and 0.13 while the demand elasticity for food varies between and The U.S. ethanol mandates, which are explained further in U.S. Ethanol Regulation and Policy History, increase global biofuel production by 5% approximately. Using this policy change, the elasticities translate into a 30% increase in global food prices which will reduce consumer surplus by 155 billion dollars annually. The change in consumer surplus is calculated based on the prices in 2007, 7.06 billion total people globally, and that the 30% price increase reduces consumption by 1.5%. Although Roberts findings show that corn-based ethanol leads to a 30% increase in global food prices, it is important to consider how much consumers eat corn relative to total consumption of other foods. It is possible that higher corn prices do not actually lead to a 30% increase in global food prices, as the value of corn is only a small proportion of the final consumer food dollar (Babcock). Additionally, it is important to note that ethanol production is not the only factor that influences corn prices as corn prices still move with typical equilibrium supply and demand. Nevertheless, due to the pricing effects that corn-based ethanol has on 57

58 global food prices, we will turn our attention to alternative forms of ethanol, such as cellulosic ethanol, for the rest of the paper. The reason for this is that a major advantage of using 2G biofuels, such as cellulosic ethanol, is that it does not require additional land to grow, as seen in a 2010 report by the World Bank. Therefore, cellulosic ethanol will not have that great of an impact on global food prices as corn based ethanol, and will also not compromise the food supplies of developing countries. Although there are only a few small cellulosic plants that are in operation or under construction in the U.S. (Gay), we believe that this is an area that should be further studied based on our understanding of previous literature and our analysis of economic models. Moving forward, it would also be interesting to look at producer surplus in order to get an idea of the total social welfare consequences of corn-based ethanol. Among the producers, we can think about who benefits from these increases in prices, whether it is the farmers or the large food manufacturer conglomerates. Further economic analysis and research is needed to answer these questions. 58

59 Cost Benefit Analysis Economic Model In the Literature Review on the Cost Benefit Analysis for the Ethanol Industry subsection, we found that developed countries like the U.S. should invest in 2G biofuels. To test this hypothesis quantitatively, we built a simplified NPV model for a cellulosic ethanol production plant. The following assumptions were made from this model based on data from Wu et. al (2010) and from the Center for Climate and Energy Solutions (Sperow): A ethanol plant producing 50 million gallons of cellulosic ethanol has a life-span of 20 years The fixed costs for such a plant is US$265 million, and yearly maintenance/operational costs of US$27.7 million Price and variable cost per gallon of cellulosic ethanol is constant over the life of a plant The fixed cost is paid in year 0 and production of ethanol starts in year 1 Figure 4.6 below gives an example of the calculation using the formula: 20 NPV = FC 0 + [(P t VC t ) Gallons t MO t ] (1 + R) t t=1 59

60 Figure 4.6 From this simplified model we get a NPV of US$75 million over 20 years when assuming a 5% interest rate. The 5% was used because it is slightly more conservative than the interest rate offered by the 20-year average yield of the U.S. Treasury. With a lower interest rate of around 3%, our NPV estimate would go above US$140 million. Of course, there are many variables that can change which may alter our analysis. For example, prices of ethanol are constantly fluctuating and the variable cost per gallon of ethanol is seeing global declines as there are more investments in technology. However, our estimate is close to the US$68 million US$84 million NPV calculated by Wu (2010). To further refine our cost-benefit NPV model, we would like to include more variables that will affect both the costs and benefits. Taxes and capital depreciation will increase our costs while usable electricity generation will be an added benefit. Further, there are also environmental costs like pollution that are hard to quantify but are important for a complete analysis. 60

61 Although these results suggest that the investment of a cellulosic ethanol producing plant is beneficial monetarily, we should think about the costs and benefits for different stakeholders in society. For the normal consumer, they will receive more environmentally friendly fuel options, see fewer increases in prices of corn-based foods, and will face less pollution (relative to gasoline), which could have positive health outcomes. The oil companies will face costs due to competition from these factories arising and government may have to invest money to help incentivize private companies to start cellulosic ethanol plants. If government subsidizes these factories, then this could be translated into higher taxes as a cost for taxpayers. From an economic development standpoint, cellulosic ethanol production can also affect farmers through prolonging employment past the harvest season which may be able to spur job creation (Eisentraut, 2010). 61

62 Costs and Benefits of Ethanol for Brazil Given the results from our cost benefit analysis above as well as studies of the economic models, the last step we have to take before determining the appropriate recommendations for the U.S. is to study the ethanol market in Brazil and the ways the U.S. can learn from it. Some of the benefits of ethanol for Brazil is that its massive sugarcane ethanol fuel production program allowed the country to avoid large oil price shocks triggered by the OPEC, which led to financial crises in other nations. Additionally, according to the EPA, the production and use of sugarcane-based ethanol only generates two-fifths of the carbon emissions of petroleum and half the carbon emissions of corn-based ethanol for one unit of energy. Beyond the environmental benefits of sugar-cane based ethanol, economists also estimate that Brazil s focus on sugar-cane ethanol production has increased the country s economic output by 35% than if it were to rely on offshore oil (Halasz). Similar to the U.S., the costs of ethanol are also present in Brazil. For instance, dramatic land use changes have been found in the Northeast and Southeast regions of Brazil, areas of intensive sugarcane production. These changes are mainly due to Brazil s Proalcool program further discussed in Brazil Ethanol Regulation and Policy, which is a government program that encourages production of alcohol as an alternative energy source. Although only less than 1% of Brazil s total territory is needed to reach the production level of 30 billion liters of alcohol per year, the Northeast and Southeast regions of Brazil have been affected by the effects of having only one species of crop (sugarcane) grown densely over a large area. The high density requires an increased use in pesticide, which causes further negative effects by destructing natural habitats. Further, since most of the land in the Northeast and Southeast regions of Brazil are 62

63 devoted to sugar-cane production, other crops were driven out of these areas, leading to an increase in their prices as the price of land surrounding land used for sugarcane production has increased due to high demand (Halsaz). Yet, despite the costs of ethanol for Brazil, it provides around 40% of transportation fuels in Brazil, the highest number amongst other nations. Adding on, although Brazil is a developing country, it is able to efficiently produce ethanol due to its low production costs, favorable climate and mature infrastructure built up over several decades. The main reason for this success is due to the favorable policies that Brazil has implemented throughout its history. For instance, the Brazilian government required that all gasoline sold contains a minimum percentage of ethanol, with the blending ratio currently set at 20%. The government also provides a tax benefit towards the purchase of new FFV s that run on ethanol, where a 14% sales tax is applied instead of the usual 16% for gasoline-only vehicles (Sandalow). Because of this, it is important to further analyze the policies and regulations in place for both the U.S. and Brazil, so that we can effectively draw comparisons and make appropriate recommendations for the U.S. 63

64 PART V - Policy Implications U.S. Ethanol Regulation and Policy History Biofuels have existed since the 1930s in the U.S., but it took until the 1970s for the market to grow, when the government launched tax credits (Gay). Specifically, in 1978, the government instituted a 40 cents per gallon tax credit for producers, which in 2005 was increased to 51 cents per gallon, a level it remains at today (Gay). In 2005, Congress passed the most significant regulation on ethanol, the Energy Policy Act of 2005, which launched the Renewable Fuel Standard program, known as RFS (EPA). In 2007, the Energy Independence and Security Act of 2007 (EISA) enhanced the scope of RFA. The program sets an evolving annual fuel requirement (up until 2022) for the production of cellulosic biofuel (a biofuel produced from wood, grasses, or the inedible parts of plants), biomass based diesel (made from vegetable oil or animal fats), advanced biofuel (fuels that can be manufactured from various types of biomass), and total renewable fuel. The volumes by year in the statute are listed below from the EPA website and is seen in Figure 5.1 below. 64

65 Figure 5.1 The Act also allowed for the EPA to amend the volume mandates in the EISA through a rulemaking procedure. The EPA s yearly announcements are closely followed by ethanol and corn producers. The EPA allows two methods for producers to fulfill specified ethanol volume requirements: 1) meeting the standard through the production of ethanol or 2) by obtaining credits called Renewable Identification Numbers, known as RINs (EPA). RINs are obtained through the production of renewable fuels (ethanol) and can be freely traded. This is why producers who produce below standard can still meet the requirements by purchasing RINs from sellers who produce above standard. RINs will get a closer examination in RINS in Depth later in this paper. 65

66 U.S. Regulation and Production Forecasts Due to the RFS mandate discussed above, ethanol production is expected to grow at a rate of 400 thousand barrels a day from 2011 to 2040, according to the U.S. Energy Information Administration (EIA). Despite the mandate, energy production is expected to grow modestly due to projected declines in gasoline consumption (EIA). If gasoline consumption declines to the consensus estimated production level of 8.1 million barrels per day in 2022, biofuels will not meet the volume standard set forth in the EISA of 2007 (Cason). Thus, ethanol consumption is expected to decline to 14.9 billion gallons in 2014, but will still be the predominant alternate fuel source used (Cason). 66

67 RINS in Depth RINs have a lifecycle of their own and are the currency of the RFS program (EPA). Figure 5.2 below outlines the cycle of 1 RIN: Figure 5.2 Source: EPA The first step in a RIN s lifecycle is its production. A new RIN is created when new ethanol is produced. Once a RIN is produced, it can then be traded in the market in two ways. The first is what the EPA calls assigned RINs. This means that ethanol producers can trade the RIN by trading the production of ethanol it originally came from. Thus in an assigned RIN transaction, a purchaser obtains both the RIN and its associated fuel. RINs can also be decoupled or separated from the ethanol volume it was associated with. This is the second type of RIN trade, and is called a separated RIN transaction. In this type of transaction, the ethanol volume stays with the producer, and only the RIN is traded (EPA). This almost always happens when a 67

68 blender mixes ethanol into gasoline or diesel, and has more RINs than needed for compliance and thus sells it to a party who has less RINs than needed to meet compliance. Sometimes, production of renewable fuel is greater than mandated (this happened in 2012, for instance). In these cases, producers stock the excess RINs to be able to reduce production in the next year. The EPA allows producers to use up to 20% of previous year RINs to meet production for the current year. Thus, separated RIN prices exist to close gaps between supply and demand due to the existence of mandates. Figure 5.3 Source: USDA, Economic Research Service, based on Thompson et al., 2009b. RIN is the delta that bridges supply and demand gap due to imposition of mandate 68

69 Finally, the last part of the RIN lifecycle is when it is retired. This happens when parties surrender their RINs to the EPA to satisfy compliance with the ethanol mandate. The EPA regulates what parties can participate in RIN transactions. Currently, obligated parties (refiners and importers of gasoline and diesel who use ethanol for blending purposes), ethanol exporters, ethanol producers, and finally registered RIN market participants, are allowed to trade RINs. Type of RINs: A RIN is a 38-digit code that identifies single gallon fuels (gallon-rin) or multiple gallons (a batch-rin) (Christensen). Specifically, a RIN has a unique structure KYYYYCCCCFFFFFBBBBBRRDSSSSSSSSEEEEEEEE where K=designates if RIN is separated or assigned; YYYY=Year of production; CCCC=designates associated company through a Company ID; FFFFF=Designates associated facility through a Facility ID; BBBBB=Batch number; RR=designates Equivalence Value; SSSSSSSS=Beginning of RIN block; EEEEEEEE=End of RIN block (Christensen). 69

70 Ethanol Blend Regulations As discussed earlier, ethanol production is primarily designed as a fuel additive to enhance the efficacy of fuel by increasing octane and in theory make blending economics more favorable than pure fuel. Ethanol additives, and gasoline blends used for highway motor vehicles must be registered with the EPA but fuel designed for off-road vehicles or engines has no registration requirement. There are two broad categories of ethanol blends: higher ethanol blends and mid-level blends. Higher ethanol blends include E10 (10% ethanol, 90% gas) and the newly announced E15 standard (15% ethanol, 85% gas). The E10 standard was launched with the Clean Air Act Amendments of 1990, which required oxygenated fuels in areas with high levels of carbon monoxide. More than 95% of U.S. gasoline is blended with 10% ethanol or less. While ethanol, a renewable fuel, is used in E10, the blend itself is not classified as one (DOE). The E15 standard was sanctioned by the EPA in 2011 for use by car model years 2011 up until now. E15 is still not commonly used because of limited availability, and is sold primarily in the Midwestern U.S. (DOE). 70

71 Relationship Between RINs and Gas Figure 5.4 illustrates of the historical market price of one RIN compared to the price of gasoline in 2014 up to the beginning of 2015: Figure 5.4 The difference between the cost of production of 1 RIN and the cost of production of gasoline (in this case RBOB, which is the price of unleaded gas futures) is a key spread for ethanol producers because they use it to decide to make more ethanol or obtain RINs through purchase. When ethanol is significantly cheaper than RBOB gas, producers are motivated to blend more ethanol into gasoline. There is also one other factor that influences ethanol producers: the prices of different types of RINs for different variants of ethanol. The market price of the D6 RIN, the RIN used for corn based ethanol, can change from speculation given it is traded freely. Most of the time, the D6 RIN has a higher price near EPA announcements of RFS standards or compliance deadlines. In 2014, and 2015, the D-6 RIN has been relatively high. While gas prices have continued to be low, the higher D-6 RIN provides a cushion on the spread, what is 71