Date Issue Brief # ISSUE BRIEF. Carolyn Fischer. May 2009 Issue Brief # 09 06

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1 Date Issue Bref # ISSUE BRIEF Let s Turn CAFE Regulaton on Its Head Carolyn Fscher May 2009 Issue Bref # 09 06

2 Resources for the Future Resources for the Future s an ndependent, nonpartsan thnk tank that, through ts socal scence research, enables polcymakers and stakeholders to make better, more nformed decsons about energy, envronmental, natural resource, and publc health ssues. Headuartered n Washngton, DC, ts research scope comprses programs n natons around the world P Street NW Washngton, DC PAGE 2

3 Let s Turn CAFE Regulaton on Its Head Carolyn Fscher 1 In thnkng about fuel economy, Amercans have chosen to focus on mleage: how far can I travel on a gven amount of fuel? In Europe and most other countres, however, they ask the nverse ueston: how much fuel does t take to go a certan dstance? Of course, these uestons are really two sdes of the same con: the former asks about value, whle the latter asks about cost. However, snce our regulatory polcy s motvated by costs the costs of fuel to consumers, the envronmental costs of burnng t, and the energy securty costs of dependng on t there are some mportant practcal reasons why focusng on gallons per 100 mles (GPHM) would be a better ndcator of fuel economy than our current mles per gallon () metrc. Reason 1: Help Consumers When purchasng a car, consumers want to wegh the costs and benefts of dfferent alternatves. Most consumers know how much drvng they want to do: t depends on ther commute, ther famly lfestyle, recreatonal habts, and so on. It does not depend on whch model they choose; rather, the opposte s the case. Therefore, t makes more sense to hold that value constant and thnk about comparng the costs of achevng that value across dfferent vehcles. Yet, consumers have a hard tme comparng costs usng ratngs; n fact, they systematcally msjudge actual fuel economy mprovements (Larrck and Soll 2008). The U.S. Envronmental Protecton Agency has recognzed the dffculty of gong from to fuel costs. In ts revson to fuel economy labels n 2006, t made the estmated annual fuel costs much more promnent; however, t may stll be dffcult for a consumer to change the assumptons about gas prces, annual mles traveled, and shares of cty and hghway drvng. For many people, t s much easer to multply than to dvde (Huff et al. 1999), but any personalzed calculaton of fuel costs from the label would reure some dvson to get there.. 1 Carolyn Fscher s a senor fellow at Resources for the Future, 1616 P Street, NW, Washngton, DC Emal: fscher@rff.org. I am grateful to Davd Bernsten for callng my attenton to ths ssue. All errors and omssons are my own. PAGE 1

4 Calculatng fuel costs s much smpler usng GPHM. You just multply the ratng by however many hundreds of mles you drve per year, month, or trp and multply that by the gasolne prce to get your fuel costs for that tme frame. No need for dvson, allowng for much easer back of the envelope calculatons. Reason 2: Improve Transparency Another nce feature of GPHM s that fuel costs rse drectly n proporton to that ratng. Thus, a 10 percent decrease n GPHM euals a 10 percent reducton n fuel costs. On the other hand, not all ncreases n are eual, although consumers erroneously expect them to be (Larrck and Soll 2008) 2. A 10 percent ncrease n does not correspond ncely to a reducton n fuel costs t depends on what mleage you re startng from. Suppose you drve 10,000 mles a year and a gallon of gas s $2. Gong from 10 to 11 s worth $180, whle gong from 30 to 33 s only worth $60. The followng graph llustrates the dfference, usng the same example of someone who drves 10,000 mles a year when gasolne s $2 per gallon. For the same annual fuel costs, t plots the correspondng and GPHM you would need. GPHM s a nce, straght functon, a proportonal relatonshp., on the other hand, s a relatvely flat functon at hgh costs, where small mleage ncreases save a lot of money, and a steep functon at low costs, when bg mleage ncreases save only a lttle bt of money. Ths fact turns out to be mportant not only for consumers but also for regulators. GPHM 10 GPHM Annual Fuel Costs Reason 3: Pave the Way for CAFE Credt Tradng Current Corporate Average Fuel Economy (CAFE) regulatons set an average fleetwde standard n mles per gallon. However, they do not use a smple average because, as we just saw, a one ncrease means dfferent thngs dependng on whether t s added to a small car or a bg car. Instead, they use harmonc averagng, whch s a complcated formula, but t ends up beng euvalent to a standard set n gallons per mles, whch s what we want when we care about fuel costs. (The harmonc average s calculated by takng the recprocal of the average of the recprocals of the fuel economes of the vehcles n the fleet. To parse. 2 See also PAGE 2

5 that out, the recprocal of s GPM. So CAFE takes the smple average of the GPM of the fleet, and then takes the recprocal agan to convert that average back to.) So why change, f t means the same thng? Because t doesn t mean the same thng for companes that fal to meet the standard. Currently, that manly apples to some luxury car companes lke Porsche and BMW who pay fnes rather than meet CAFE standards, because they don t sell small fuel effcent cars to balance out ther powerful cars. Whle the average ctzen may not sympathze wth luxury car owners or dealers, the pont s that the polcy sn t as effectve at reducng fuel consumpton. Some economsts at the Federal Trade Commsson have shown that, because of the harmonc averagng rule, for these knds of manufacturers, sellng an addtonal fuel effcent vehcle can actually result n a hgher CAFE fne (Tenn and Yun 2005). That means the regulaton s actually dscouragng some sales of more fuel effcent vehcles. Under current CAFE rules, the vast majorty of vehcle sales are by manufacturers meetng ther fleetwde averages. However, the Energy Independence and Securty Act of 2007 set the stage for allowng CAFE credts to be traded across manufacturers. 3 The dea s to allow automakers for whom t s more expensve to comply wth CAFE, perhaps because they have a comparatve advantage n the large vehcle segment of the market, to purchase excess credts from manufacturers for whom t s nexpensve to overcomply, rather than forcng large car manufacturers to sell small cars ther customers don t want. Both companes would beneft from the exchange of credts: the purchaser would have lower complance costs, and the seller would proft from the sale and have extra ncentve to mprove ts fleet s fuel economy even further. (See Fscher and Portney 2004). However, to mplement tradng n CAFE, we need to calculate the approprate number of credts to buy and sell. Suppose CAFE credt reurements were determned n the same way as the current cvl penalty, under whch a manufacturer s lable for each 0.10 ts fleetwde average falls below the standard, multpled by the number of vehcles sold n a gven model year. We see from the graph that as average goes further and further below the standard, the ncrease n fuel costs gets bgger and bgger, but the ncrease n the credt lablty (or fne) stays the same. Smlarly, f a manufacturer exceeds the standard, ts excess credts would ncrease the same amount wth every 0.10 ncrease, but the correspondng fuel savngs would get smaller and smaller. Let two manufacturers trade, then, and we see a bgger ncrease n fuel costs from the credt purchaser than the decrease from the seller. In other words, just as all ncreases are not eual, all dfferences n harmonc averages are not eual. So, to be correct n meetng a natonwde fuel economy standard, we d need a harmonc average of all the manufacturers harmonc averages. Of course, dedcated EPA regulators, auto manufacturers, and traders would be able to fgure out those complcated formulas, but there s a much easer and more transparent way. Instead, all we have to do s swtch to GPHM, and all fuel consumpton s treated the same. We can use a smple average to calculate manufacturer averages, and we can use the smple dfference between that. 3 The Secretary of Transportaton may establsh, by regulaton, a fuel economy credt tradng program to allow manufacturers whose automobles exceed the average fuel economy standards prescrbed under secton to earn credts to be sold to manufacturers whose automobles fal to acheve the prescrbed standards such that the total ol savngs assocated wth manufacturers that exceed the prescrbed standards are preserved when tradng credts to manufacturers that fal to acheve the prescrbed standards. (Sec. 104 (f)) PAGE 3

6 average and the standard to calculate the number of credts per vehcle a manufacturer can buy or sell. Then the fuel cost ncreases by the credt purchasers are exactly offset by the fuel savngs from the sellers. We d know we re httng our natonal targets, and we d be gvng every manufacturer the same opportunty and ncentve to nnovate and mprove the fuel economy across all of ts passenger cars and lght trucks. Ths s an arcane problem. It was ntally hard for me to grasp, so I ve ncluded the mathematcal reasonng n the appendx. But the soluton s so smple. Let s turn CAFE on ts head and put our focus on the costs of fuel consumpton and then we ll see how far we can go. References Fscher, C. and P. Portney Tradable CAFE Credts, n New Approaches on Energy and the Envronment: Polcy Advce for the Presdent, edted by Rchard D. Morgenstern and Paul R. Portney. Washngton, DC: RFF Press. Huff, Darrell, Krsty Mara Huff, and Carolyn R. Knsey The Complete how to Fgure t: Usng Math n Everyday Lfe. New York: W.W. Norton & Company. Larrck, Rchard P. and Jack B. Soll The Illuson. Scence 320 (June 20, 2008): Tenn, Steven and John M. Yun When addng a fuel effcent car ncreases an automaker s CAFE penalty. Manageral and Decson Economcs 26: Tenn, Steven and John M. Yun On the Dsncentve to Sell an Addtonal Fuel Effcent Lght Truck under the Revsed CAFE Regulaton. Avalable at SSRN: Appendx: CAFE Math CAFE standards reure that each fleet meet or surpass a harmonc average for fuel economy, measured n mles per gallon, for the vehcles of that type. (Let s gnore the new sze based standards for lght trucks; they complcate the math but do not change the fundamental problems wth the standards; f anythng, they may exacerbate the problems. [Tenn and Yun 2008]) In other words, f s the sales uanttes of vehcles of model wth mleage, CAFE standards mandate that for each fleet of autos the harmonc average be hgher than the standard, or reurement as 1. We can rewrte ths, or (wth a lttle more rearrangng and adjustng both sdes by PAGE 4

7 GPHM GPHM 100). Thus, ths reurement s euvalent to mandatng that the average fuel consumpton rate for the fleet be below the correspondng standards. The trcky part comes when thnkng about devatons from the standard, as would be allowed by CAFE tradng. Because companes would not be ndvdually reured to meet the standard, ther fleet (harmonc) averages wll vary. I dscussed how credts for sales by above average manufacturers would not fully offset the ncreased fuel use from sales by below average manufacturers. But there exsts the addtonal ueston of the ncentves that system would create for mprovng and sellng more fuel effcent vehcles. Usng based credts would spawn the same knd of problems as for the manufacturers facng CAFE fnes. Wth a market for credts, all manufacturers wll face the same credt prce, much lke a fne (except sellers collect the fne). To llustrate the effect on sales ncentves, let us reframe the analyss by Tenn and Yun (2005). Suppose a manufacturer s CAFE credt lablty L s defned the same way as wth the cvl penalty: L= How does ths lablty change wth addtonal sales of vehcle model? That turns out to be a complcated functon of all the dfferent fuel economes and sales uanttes: L = 2 + = A + A A ( ) ( / 1) 2 1 where A s the harmonc fleet average. If we convert ths nto GPHM, t s no smpler: L 1 GPM = GPHM GPHM GPM The change n lablty depends not only on that model s fuel consumpton rate compared to the standard, but also total sales of that model and all the other models and ther fuel economes. PAGE 5

8 Meanwhle, suppose the lablty were defned nstead n terms of the devaton n GPHM from a standard: GPHM ˆ L= GPHM = GPHM GPHM ( ) The change n the credt lablty from addtonal sales of model s then a constant and smple functon of the dfference n the fuel consumpton rate from the standard for that model, and that model alone: Lˆ = GPHM GPHM The lablty goes up f that model has an above average fuel consumpton rate, and t goes down f t s relatvely fuel effcent. The GPHM metrc also makes t easer to ncorporate sze based standards (SB), n whch the fuel economy standard vares by model : ˆ SB = ( ) L GPHM GPHM Agan, the lablty from addtonal sales only depends on the dfference between actual and target fuel economy for that vehcle. For harmonc averagng, however, ncorporatng sze based standards only makes the lablty determnaton more complcated and less lkely to produce an effcent outcome: L SB =. Swtchng from to GPHM wll make CAFE regulatons easy for anyone to understand and also allow for effcent credt tradng and decsonmakng, even wth sze based standards. PAGE 6