The Unintended Consequences of the Renewable Fuel Standard

The Unintended Consequences of the Renewable Fuel Standard
AP Photo/Nati Harnik, File

Can Washington expedite America’s usage of renewable fuel through legislation that mandates the transition from the status quo?

That is what Congress thought when it created the Renewable Fuel Standard (RFS) in 2005. It even doubled down by expanding and extending it two years later. But has their plan worked?

If you ask some of the legislators that pushed the plan, the answer is an emphatic no. Rep. Henry Waxman (D-Calif.), the former chairman of the House Energy and Commerce Committee, said “we made a mistake” and that “the law hasn’t worked out as we intended.” Even Al Gore, once one of ethanol-based fuel’s leading proponents, has soured on the idea, adding that “It’s hard once such a program is put in place to deal with the lobbies that keep it going.”

The intention of the Environmental Protection Agency (EPA) when designing the RFS was for consumers to bear the cost of subsidizing the blending of renewable fuel into the nation’s gasoline, while requiring oil refiners to meet the RFS’ ever-increasing annual Renewable Volume Obligation (RVO) – the total amount of biofuel required to be blended into the nation’s fuel supply by the law.

Refiners comply with their obligation by providing to the EPA a sum of government-issued credits they earn for each gallon of biofuel they blend (called Renewable Identification Numbers or RINs) that equals their respective portion of the RVO. Every refiner must either generate the RINs they need by blending their own fuel or by purchasing RINs in a secondary market, where other market participants sell their excess RINs.

In a perfect world, the blending obligations imposed on refiners by the RFS would ensure that renewable fuel is blended into the nations fuel supply at a rate sufficient to ensure that both the U.S. is less dependent on foreign oil and is a leader in moving towards a more sustainable energy policy.

In a perfect world, this process will not be distortionary for any party involved in the production and sale of gasoline, and the cost of the RIN obligation is passed onto the retail consumers who bear the brunt of subsidizing the production of biofuel (typically corn ethanol).

In the real world, which is decidedly less than perfect, the implementation of the RFS compliance regime has been woefully insufficient, and the economic evidence that consumers are bearing the cost of the biofuel subsidy is inconclusive at best.

Instead, as the amount of biofuel required to be blended by EPA begins to exceed the amount that can be feasibly blended and sold in gasoline, the price of compliance has skyrocketed.

What was intended to be a relatively low cost way to both subsidize the burgeoning biofuel market and monitor compliance with the RFS has become big business in its own right, and the secondary market in which RINs are bought and sold has seen prices climb quickly over the past several years.

As RIN prices have risen the ability of the fuel market to pass the cost of compliance onto the consumer has been curtailed, and the evidence suggests that a larger portion of this cost is being shifted back on to the refiners upon whom the burden of complying with the RFS mandate has been placed.

The rising cost of RIN compliance has resulted in a significant financial burden for refiners of all sizes, but particularly for small independent refiners who, unlike their larger integrated peers (e.g. Shell, Chevron, and ExxonMobil), cannot generate RINS via their own blending capacity and thus must buy their RINs in the open market.

For some small refiners the RFS obligation has led to significant financial distress, with some refiners reporting that RIN costs now exceed labor costs, and at least one refiner citing the distortionary cost of RFS compliance as a major reason behind its recent bankruptcy.

Writing at The New York Times, Clifford Krauss detailed this problem well, stating that, “Unless the price of credits falls significantly, refinery executives warn of a wave of consolidation that could concentrate refining in fewer hands, leading to higher prices for drivers at gasoline and diesel pumps.”

While reform of the biofuel mandate is certainly needed, some absolutists are balking at the EPA alleviating some of the pain by using its statutory authority under the 2005 bill to issue hardship waivers.

Perhaps in part because of the recent distress of small refiners, the EPA has begun to grant a series of exemptions from the RVO because the RFS allows refiners with less than 75,000 bbd of throughput to be exempted from their obligation if they can show that compliance causes them undue financial hardship.

The amount of these Small Refinery Exemptions (SREs) has resulted in a de facto reduction in the total amount of biofuel that is required to be blended under the RVO. Which has caused some in the ethanol industry to complain to regulators that SREs are against the spirit of the RFS, and will cause ethanol production and consumption to decrease. They claim that this might negatively affect America’s goal of energy independence as well as decrease the incentive to continue to integrate renewable fuel into the broader fuel marketplace.

However, despite concerns that the physical consumption of ethanol would decrease due to EPA’s granting of SREs, the evidence suggests that there has been at most no change in ethanol consumption. In fact, limited evidence shows that there might have been an increase in ethanol consumption since the first slate of exemptions were granted in late 2017.

Why then is there still such concern from the ethanol and integrated oil lobbies? It seems likely that the provision of small refinery exemptions has affected these stakeholders in a significant way; it has reduced the outsize cash flows these companies were being provided via the sale of RINs. Instead of facing a reduction in demand for their actual product, they are instead experiencing a reduction in RIN “tax” revenue from the small refiners who receive exemptions from EPA. These small refiners, are in turn, experiencing lower RIN compliance costs, which is likely to lead to less financial distress in the sector. In short, the captive marketplace works better for RINs traders’ business interests, so they oppose any effort to suppress the price of these credits.

Perhaps the PES bankruptcy had a silver lining for the rest of the industry. It signaled to regulators that the current RFS compliance regime was unsustainable for small independent refiners and small gasoline retailers. While it’s critical that Washington craft a long-term reform solution to the RFS’ problems, in the short term the EPA must continue providing relief where it can. Doing anything less would do a disservice to the security of the American energy sector.

Dr. Alex Holcomb is an Assistant Professor of Finance at the University of Texas at El Paso.

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