The Ethanol Blenders' Tax Credit, Part I: Who Gets the Benefits?
AgMRC Renewable Energy and Climate Change Newsletter
Dr. Robert Wisner
This is the first of two articles discussing the benefits of ethanol blenders’ tax credits.
Congress has provided the motor fuel industry with a tax incentive for blending ethanol with gasoline in the form of 45 cents per gallon of ethanol tax credit. The tax credit was reduced to this level in 2009, from a previous 51 cents per gallon. This tax credit was provided years ago to encourage growth of the infant ethanol industry, to develop an additional market for corn, and to reduce the nation’s dependence on imported petroleum. At this writing, the blenders’ tax credit has become an important issue for policy discussions. It is scheduled to expire at the end of 2010 unless renewed by Congress. As we indicated in an article last month, the ethanol industry appears to be nearing its long-anticipated blending wall. For that reason, the industry wants high priority to be given to maintaining all current incentives for expansion. On the other hand, partly because of federal budget pressures, others are suggesting the industry has outgrown its need for the tax credit and that blending mandates from the late 2007 energy legislation are sufficient to maintain its growth.(1)
In this article, to shed further light on this discussion, we look at information that may help to understand who ultimately gets to keep the blenders’ credit. By law, the blenders of ethanol with gasoline are the receivers of the blenders’ credit, but does it stop there or is all or part of it passed back to ethanol producers in higher prices received? Or is part or all of it passed on to motorists who use ethanol blends in their vehicles in the form of lower retail prices? Also, what might be some implications of a failure to renew the blenders’ credit beyond the end of this year? So far, the biodiesel blenders’ tax credit has not been renewed. Despite government biodiesel blending mandates, industry reports indicate it has resulted in the idling of a large number of biodiesel plants.
The distribution of benefits from the blenders’ tax credit has varied over time, depending on conditions in the ethanol and petroleum markets. For example, in 2006 and early 2007 as the oxygen enhancing additive MTBE (methyl tertiary butyl ether) was phased out of use in California and some other states, demand for ethanol was extremely strong. Ethanol was the main alternative to MTBE in meeting clean air standards of states with serious air pollution problems. Ethanol prices were far above those for gasoline because it had a captive market that was forced to buy ethanol. At that time, most or perhaps all of the blenders’ credit appears to have gone to ethanol producers and firms blending ethanol with gasoline. Passing some of the benefits on to ethanol producers in the form of higher prices for their products was the market’s way of stimulating production to increase supplies. However, conditions in the ethanol market have changed dramatically since that time. Domestic ethanol production has more than doubled. With the sharp increase in production, returns to ethanol producers have dropped dramatically and at this writing are near break-even in some cases. The industry is facing possible excess production capacity later this year and in 2011 as the ethanol market approaches saturation levels.
Historical difference between ethanol and gasoline prices
To trace the distribution of ethanol blenders’ credit benefits, we start with Omaha rack prices for gasoline and ethanol. These prices are readily available to us through a Nebraska state government web site.(2) Rack prices are those at blending racks (essentially wholesale prices) where blenders mix ethanol with gasoline. Iowa has an advantage over some other states in tracing the distribution of tax credit benefits in that pumps at its motor fuel retail stations have labeling that identifies ethanol blends and ethanol-free gasoline. The Omaha wholesale prices provide a starting point in tracing values through the marketing chain to Iowa retail stations.
Figure 1 shows the historic difference between rack ethanol and gasoline prices in Omaha. Note that for this entire 28-year period, except for 2008 and so far this year, ethanol prices have been well above gasoline. In the first four months of 2010 rack ethanol prices have been at a large discount to unleaded gasoline prices. April ethanol prices were 71 cents below rack gasoline prices. Even larger discounts of ethanol to gasoline were present at times in some other markets, especially the Chicago and New York futures contracts for these products. The large price discount of ethanol to gasoline reinforces our conclusion in an article last month that the industry is nearing the blending wall.
Depressed ethanol prices relative to gasoline are the market’s way of attempting to lower prices enough to create an increased quantity of ethanol being demanded by consumers. Increased quantity being demanded can come by enticing consumers in states that label motor fuel pumps to buy ethanol blends if they have not been doing so. Another small but important potential area for market expansion is the E-85 market, a blend of 85% ethanol and 15% gasoline. This blend is only for flex fuel vehicles, which account for a small fraction of the total vehicle fleet. Thus, the E-85 market is quite limited. Also, studies by the Environmental Protection Agency (EPA) (3) and Consumers Report magazine indicate E-85 has around 25 to 28 percent lower fuel mileage than E-0. The actual mileage differential varies somewhat by vehicle brand and model. Because of sharply lower fuel mileage, expansion of the E-85 market requires a large price discount of ethanol to gasoline at the retail level to make it attractive to consumers.
Geographic price differential variations
Price differentials between gasoline and ethanol vary by geographic location, depending on local supply and demand conditions for both products, as well as infrastructure and environmental regulations. Ethanol needs to be shipped long distances by rail rather than by pipeline as gasoline is shipped. Thus, its transport cost from major producing areas of the Midwest to east, west, and southern coasts is greater than that for gasoline. Accordingly, rack price differentials in coastal regions can differ considerably from those in Iowa and Nebraska. Gasoline blends for these areas also can be different than those permitted in rural areas of the Midwest, thus affecting gasoline prices. Because of shipping costs, we expect ethanol to be priced at less of a discount to gasoline in areas long distances from the Midwest -- where much of the ethanol supply is produced. For this analysis, we used the Omaha rack prices because they allow us to work through to the retail level in Iowa, where pumps are clearly labeled as supplying gasoline (E-0), E-10, or E-85. The retail price differentials allow us to at least partially sort out who receives the benefit from the blenders’ credit.
Tracing the distribution of benefits
Figure 2 provides more detail for use in sorting out the impact of the blenders’ tax credit. It shows the E-100 to E-0 price differential on a volume basis when the federal blenders’ credit is deducted from ethanol prices. The blenders’ credit further lowers the cost of ethanol in the marketing system. After this adjustment, the wholesale cost of E-100 on a per gallon basis as an average for the first four months of 2010 was 85 cents less per gallon than E-0.
An additional influence on ethanol’s price competitiveness is its energy content. It should be noted that ethanol’s energy content per gallon is about 65 percent that of gasoline. So a gallon of ethanol contains 35 percent less energy than a gallon of gasoline. Thus, when a consumer buys a gallon of E-10 (10% ethanol), it has an energy content reduction of 3.5 percent versus straight gasoline (35% reduction x 10% ethanol). Moreover, when a consumer buys a gallon of E-85 (85% ethanol) the energy content reduction is 30 percent (35% reduction x 85% ethanol). So a consumer could expect a 3.5 percent mileage reduction from E-10 and a 30 percent mileage reduction from E-85, although there are other factors like ethanol’s higher octane level that may impact mileage.
Until recently, many analysts may have taken the view that the price differential without an energy-equivalent adjustment was appropriate since almost all of the production was used for E-10 blends. When purchasing E-10, most consumers may not check their mileage closely enough to notice the small fuel mileage reduction. However, when the market approaches the saturation point, pricing ethanol so that it is competitive on an energy equivalent basis becomes important in enticing increased use. Some consumers check their fuel mileage carefully, and to entice them to buy E-10, a moderate price discount to E-0 may be needed. Discounts clearly are needed for E-85.
If the Environmental Protection Agency (EPA) allows the E-15 blends that it is now testing, the lower mileage from this blend may be more obvious to motorists than it is for E-10. That would be a slightly negative influence on ethanol prices and would support the need for at least part of the blenders’ credit to be passed back to consumers to make it competitive with gasoline.
Figure 2, with adjustment for the blenders’ credit, indicates that much of the time since 1999, ethanol rack prices on a volume basis have been below gasoline prices, thus creating the appearance that ethanol is competitive with gasoline. However, we adjust for lower energy content in Figure 3, which also shows what the differentials would look like without the federal blenders’ credit. Removal of the blenders’ credit and adjustment for lower energy content would make ethanol prices uncompetitive with gasoline, even at recent low ethanol prices and the large volumetric differential to gasoline prices.
Iowa and some other states have state blender or retail credits for ethanol and/or lower motor fuel tax rates for ethanol blends that further increase their attractiveness to consumers. In some states, regulations mandate the use of ethanol so that motorists have no choice of ethanol versus non-ethanol motor fuels. Thus, other policy instruments beyond the federal blenders’ credit also influence the use of ethanol/gasoline blends.
Retail prices with the federal blenders’ credit
In comparisons made here, the precision of our analysis is slightly limited by the fact that retail prices available to us are on a daily basis versus the monthly average rack prices that are available from Omaha. Thus, our analysis is an approximation of conditions in April but should be close to actual conditions, the most recent month for which Omaha rack (wholesale) prices are available as this is being written. For April, we are using retail Iowa regular (E-0) gasoline prices of $2.859 per gallon. E-10 has been priced at a $0.12 lower price per gallon than E-0 in many stations across the state, although the differential may vary slightly in some cases. Table 1 shows the wholesale prices, indicated merchandising and transportation margin, state and federal tax credits for E-0 and E-10, and approximate average retail price for April 2010 in the table. Iowa has a lower state motor fuel tax for ethanol blends than for E-0 and also has retailer tax credits that vary, depending on the retailers’ percentage attainment of the RFS-2 mandates. Note that the mandates apply to the blenders, not the retailers unless they also are blenders. Thus, some retailers may sell less ethanol than required by the mandates. The comparisons in Table 1 are the wholesale price of gasoline plus federal and state taxes, and a merchandising and transport margin reflecting the cost of marketing and other expenses of getting the product from the wholesale location to retail stations. A similar comparison is shown for E-10 ethanol/gasoline blends, but with the different tax rates and deductions for the federal and state tax credits.
From these calculations, we conclude that in Iowa and probably in parts of surrounding states, at least half of the blenders’ tax credit has recently been passed on to consumers in the form of lower prices at the pump. About half of the blenders’ credit appears to have been retained for blenders and retailers through the larger merchandising margin than for E-0 (Note last line of Table 1).
There may be other economic incentives for blending ethanol with gasoline in addition to government incentives, depending on market conditions. One example might be the use of ethanol to increase the octane level of lower-grade and lower-cost gasoline to an acceptable level. We lack the necessary information at this writing to determine whether such an incentive exists and if so, the size of the incentive. Also, blending incentives vary by state since gasoline-ethanol price differentials change as ethanol shipping distance increases. In addition, a few states, California and Minnesota for example, have mandated use of ethanol.
Impact on retail E-10 prices from eliminating the federal blenders’ tax credit
The right-hand column in Table 1 compares E-10 with E-0, using the same wholesale prices, merchandising margin and taxes as in April 2010, but with the federal blenders’ tax credit eliminated. The comparison indicates that eliminating the blenders’ tax credit would be expected to increase the retail cost of E-10 by about 4.5 cents per gallon under April 2010 conditions. However, under recent gasoline-ethanol market conditions, removal of the blenders’ tax credit would still be expected to allow retail E-10 prices to be about seven cents below those of E-0. On an energy equivalent basis, E-10 under those conditions would be slightly more expensive than E-0. Since ethanol has about 2/3 the energy content of gasoline, we adjusted the energy content of E-10 downward proportionately to obtain an E-0 equivalent energy cost. If fuel mileage drops by the same percentage, this would reduce the value of E-10 to the consumer by about 10 cents per gallon versus E-0. The actual mileage reduction may vary by vehicle, and in some cases may be less than this because of higher octane levels of E-10 than in E-0.(4) There are anecdotal reports of greater mileage reductions than built into Table 1 for some light-duty trucks. A key question in evaluating the market impact of removing the blenders’ credit is whether the slightly higher energy-equivalent cost of E-10 relative to E-0 would discourage some motorists from using ethanol. Many users of E-10 may not check their mileage closely, and likely would continue to be attracted to it by the lower price than E-0.
For consumers who carefully compare fuel mileage of E-10 with E-0, the net energy cost differential if the blenders’ credit is eliminated might discourage them from using E-10 in states where pump labeling allows motorists to identify ethanol blends.
Impact on retail E-85 prices from eliminating the federal blenders’ tax credit
Table 2 shows blending economics for E-85 with and without the blenders’ tax credit, using the same wholesale prices, taxes, and format as in Table 1. Retail prices may vary some by state, individual station, and through time depending on whether the retailer is running a special on E-85. Retail price spreads versus E-0 used here are typical of recent spreads in the Central Iowa area. Prices for E-85 at other locations by state on a current-day basis and historically are available at http://e85prices.com/iowa.html. Earlier data suggested that the merchandising margin for E-85 blends in the past was substantially smaller than for E-10 and E-0 than at present.(5) At this writing, pricing of E-85 suggests the merchandising margin is considerably larger than for the other two fuel grades. The volume of E-85 sold through retail facilities is much less than for other blends and grades. Fixed costs of the retail tank and pump are spread over fewer gallons than with other fuel grades, thus increasing that portion of the cost per gallon substantially. Even so, low wholesale ethanol prices, state incentives for marketing E-85 and a desire to spread costs of facilities over a larger volume may be making retail prices for this product more competitive than in the past. Recently in Central Iowa, retail E-85 prices have been at a 33% discount to E-0 and about a 30% discount to E-10. The differential in Iowa is now large enough for most vehicles to justify a shift from E-0 to E-85, even when the energy content difference is considered. The differential versus E-10 also is large enough to attract the attention of many owners of flex-fuel vehicles and to cause them to consider shifting from E-10 to E-85, if retail E-85 stations are available in their area.
The analysis in Table 2 indicates a significant part of the blenders’ credit and/or low ethanol price in E-85 blends is being retained by Iowa E-85 retailers. To substantially expand this market, a sizeable part of these ethanol benefits needs to continue to be passed on to consumers as appears to be happening currently in Iowa. More E-85 retail stations and more flex fuel vehicles are needed to significantly expand this part of the ethanol market. Recent reports indicate flex fuel vehicles make up less than 5% of the total U.S. vehicle fleet, but manufacturers plan to expand production substantially in the next several years. E-85 incentives are less outside key ethanol producing area. We will look at this aspect of E-85 pricing in more detail in a forthcoming article.
An examination of retail E-85 versus E-0 prices by state shows large variations within states and from state to state. In general, most states that are far from the heart of the ethanol producing region have much lower price differentials of E-85 to E-0 than in Iowa. This is to be expected since costs of transporting ethanol are much higher than for gasoline, and most ethanol has to be transported from the Midwest to western states and costal areas. Thus, by far, the greatest incentive for using E-85 is in the Midwest.
Impact on E-85 demand if the blenders’ credit is eliminated
If the federal blenders’ credit is eliminated, with recent merchandising margins, we would expect the advantage of E-85 over E-0 and E-10 to disappear. This is shown in the third and fourth lines from the bottom of Table 2, where both the retail price of E-85 and its energy equivalent cost are above those of E-0. Thus, we would expect a serious shrinkage in the size of the already small E-85 market if the blenders’ credit is eliminated.
This is the first in a series of two articles examining the impacts of the U.S. ethanol blenders’ credit. In this article, we focus on the question of whether consumers, retailers, blenders or other participants in the ethanol industry receive most of the benefits from the blenders’ credit under recent market conditions.
If we had provided a detailed historical review, it would have shown that the distribution of benefits has varied over time. In the early 2000’s much of the benefit likely went directly to ethanol biorefineries. From late 2006 through mid-2008, it likely was shared by corn growers and the ethanol producers. More recently, as the ethanol market has approached a saturation point commonly called the blending wall, it appears that a substantial part of the benefit from the blenders’ credit has been passed on to motorists in lower prices for E-10 and E-85, relative to E-0, at least for the heart of the Midwest ethanol producing region, in an effort to expand the market
Total elimination of the blenders’ credit under current conditions likely would increase the cost of both E-10 and E-85 to consumers. For E-85, it would very likely shrink the already small market by creating an energy-equivalent-basis disadvantage for this fuel in the Midwest and increasing the current disadvantage in other parts of the country. Thus, eliminating the blenders’ credit would discourage fuel ethanol use and market expansion, especially for E-85. This is a small market for ethanol because of the limited number of flex fuel vehicles and a very limited number of E-85 retail facilities. The industry and policy makers have been viewing E-85 as a future growth market, but removing the blenders’ credit would likely reduce its long-term potential. For E-10, the 4.5 cent per gallon increase in price relative to gasoline along with its small reduction in energy content versus E-0 might cause a limited number of consumers who check fuel mileage closely to shift back to gasoline. That would be the case in states where retail pumps are labeled to indicate their fuel contains ethanol. However, for the majority of motorists, it is doubtful that the small increase in price per gallon relative to gasoline would have a big impact on their usage of E-10 ethanol blends.
Next month, we will address the issue of whether the mandates alone are a sufficient incentive to maintain U.S. ethanol production and use without the blenders’ credit. This is a critically important question for the ethanol industry as well as for other users of corn, the corn production sector and industries related to it. It also is a complex question that involves international competitiveness, trade policies, the degree to which the blenders’ credit has been capitalized into corn prices and land rents, and other factors.
1 Bruce Babcock, “Mandates, Tax Credits, and Tariffs: Does the U.S. Biofuels Industry Need Them All?” CARD Policy Brief 10-PB 1, CARD, Iowa State University, March 2010.
3 EPA web site showing fuel mileage of E-85 for various makes and models of vehicles.
4 In Iowa, E-10 typically is typically rated as 89 octane versus 87 octane for E-0. In some cases, E-10 in other states may have the same octane level as E-0.
5 For examples of implied E-85 merchandising and transportation margins at a previous time, See R. Wisner, Ethanol blending economics, the expected “blending wall” and government mandates, Ag Marketing Resource Center Renewable Energy Newsletter, January 2009.