Evaluating the Effect of State Ethanol Production Subsidies in the Upper Great Plains
AgMRC Renewable Energy Newsletter
Dr. Gregory McKee,
Department of Agribusiness and Applied Economics, North Dakota State University
Dr. Gary W. Brester and Joel Schumacher, MS
Department of Agricultural Economics and Economics, Montana State University
The U.S. ethanol industry has received subsidies from Federal and State governments in recent years. Federal ethanol tax credits were first established by the Energy Tax Act of 1978 and remain the most significant subsidy for the ethanol industry. In recent years, the value of this subsidy has ranged between 1/3 and 1/6 of per gallon ethanol prices. State subsidies are generally smaller than Federal subsidies.
Federal and State legislatures have considered reducing ethanol subsidies because of budget deficits or changes in policy goals. In this report, we discuss the possible effects of reductions in State ethanol subsidies in Minnesota, South Dakota, North Dakota, and Montana. For purposes of this report, these states are collectively referred to as the Upper Great Plains (UGP). Because of smaller operating margins, it is likely that smaller ethanol plants using older technology are most likely to be affected by the loss of State ethanol production subsidies. Plants of this capacity probably experience zero or negative returns-over-variable costs and negative profits more frequently than larger plants (McKee, Brester, and Schumacher, 2010). In this article, we calculate the effect of ethanol plant shutdowns on corn prices near those production facilities. We then calculate the likely combined effect of corn price changes and State ethanol subsidy reductions on corn producer surplus.
Changes in Corn Basis Using a Spatial Equilibrium Model
A potential shutdown of ethanol plants would cause changes in local corn supply and demand conditions. Specifically, some local corn prices would decline in response to the loss of local markets. These lower prices would cause some producers to reduce corn production and increase the production of alternative crops. In addition, other nearby markets would experience an increase in corn availability which would lower prices in those markets.
A spatial arbitrage model of grain trade in the UGP is used to estimate the impact on local/regional corn prices if one or more ethanol plants ceased operations. The model provides a framework for assessing the impacts of localized structural changes on cash grain markets. The model estimates the extent of price impacts and measures the spatial diffusion of these impacts across markets in response to production shortfalls, disruptions in grain transportation flows, and changes in the demand for corn.
Based on McKee, Brester, and Schumacher (2010), we assume that 8 smaller, older ethanol plants (those with capacities less than 30 million gallons/year in Minnesota, South Dakota, and North Dakota) may close in the absence of State subsidies. For these 8 plants, the model considers supply and demand conditions that would exist at other plants that continue to operate within a 200 mile radius of each of the shuttered plants (65 in total). These plants serve as the basis for corn demand and price competition as shown in figure 1.
Figure 1. Ethanol plants in the analysis
Using an historical database of cash prices, 896 cash markets within 200 miles of any of the 73 ethanol plants in this region were identified. Daily price data from these 896 markets were collected from January 1999 through December 2008. From these daily values, average prices for each location were computed.
Corn prices decline at closed plant sites because of associated demand losses. Some nearby ethanol plants also experience declines in corn prices because, as purchasers of corn, they face fewer competitors. Comparing these lower prices to the baseline model provides an estimate of corn price impacts resulting from the 8 plant closures (table 1). In general, corn prices are lowered by between $0.05/bushel to $0.18/bushel. Along with direct corn price reductions at each closed plant, minor spillover impacts occur at nearby ethanol plants. However, these were generally small -- about $0.01/bushel.
Table 1. Change in Local Corn Price Due to Plant Shutdowns
|City||Corn Price Decline|
The map presented in figure 2 illustrates the estimated impact from plant closures in the region. The most significant impacts occur where: (1) plants are in relative close proximity of each other, and/or (2) few competing plants exist to serve as a demand buffer. Because changes did not occur in Central North Dakota and Wisconsin, these areas are not shown in figure 2.
Figure 2. Corn price impact from plant closures
Corn Producer Surplus in the Absence of State Ethanol Subsidies
The economic well-being of some corn producers would be negatively affected by the elimination of state-level ethanol subsidies. One method of measuring this reduction is by calculating changes in producer surplus.
Producer Surplus as a Measure of Producer Well-Being
The shutdown of an ethanol plant reduces corn demand at that particular location. Corn that was used “locally” must now be transported to more distant locations. Thus, the local corn basis widens as the difference between a terminal market price and a local price increases. The decrease in local corn prices causes producers to reduce corn production and increase the production of other crops. In addition, lower corn prices are realized for corn that continues to be produced in such areas.
The concept of producer surplus is used to estimate the impacts of a reduction in local demand on corn producers. Producer surplus refers to the phenomenon that, at any given market price, some (but not all) producers would be willing to produce corn even if prices were lower than those currently offered by the market. Essentially, aggregate producer surplus is the difference between an industry’s total revenue and total variable costs of producing a product. Note that this is not synonymous with profit because measures of profit must necessarily include costs which do not vary with output (i.e., fixed costs). Decreases in producer surplus represent an aggregate reduction in the economic well-being of producers within a sector of an industry.
Estimating Changes in Corn Producer Surplus in the Upper Great Plains
The closure of 8 plants in the UGP region will reduce local corn prices at each site from $0.05/bushel to $0.18/bushel depending upon plant location. Additional “spillover” effects would occur at 6 additional plants as local prices at each would decline by $0.01/bushel. Therefore, we use an estimate of long-term corn prices at each of the 14 affected plants as the initial corn price for each plant. Furthermore, we assume that the initial quantity of corn demanded is the amount of corn that is demanded by each plant if they were operating at full capacity. For smaller plants (those less than 30 million gallons of annual capacity), we calculate corn usage based upon a conversion rate of 2.6 gallons of ethanol per bushel of corn. For larger plants, we use a conversion rate of 2.8 gallons of ethanol per bushel. The reduction in corn price is then applied to the initial price to arrive at a new, lower price at each plant location. The new equilibrium quantity is calculated for each plant using the slope of a supply function based on a short-run, own-price elasticity of supply of corn estimate of 0.57 (Babcock, 2008). This process is repeated for each of the 14 affected plants and results in an estimated loss of corn producer surplus of approximately $9.4 million. This represents a reduction of about 0.25% of the total value of corn production in the four-state region.
Changes in corn producer surplus in Minnesota. The loss of State ethanol subsidies could cause some plants in Minnesota to experience negative returns-over-variable costs for extended time periods. Based on age, size, and plant efficiencies, it is possible that 5 Minnesota ethanol plants may cease operations. In addition, the spillover effects of these shutdowns could slightly reduce corn prices at two additional plants. The combination of these effects would cause a reduction in Minnesota corn output of 1.2 million bushels which is a 0.1% decrease in total corn production for the state. Lower corn production and local prices would reduce Minnesota’s corn producer surplus by $5.7 million. This represents a 0.19% reduction of the total value of Minnesota corn production.
Changes in corn producer surplus in North Dakota. The loss of State ethanol subsidies could cause 2 North Dakota ethanol plants to cease processing operations, and the reduction in demand for corn by these plants would have a small, negative effect on the price of corn at one other North Dakota plant. The combination of these effects would cause a reduction in North Dakota corn production of 400,000 bushels which is a 0.14% decrease in total corn production for the State. Lower corn production and local prices would reduce North Dakota’s corn producer surplus by $1.8 million which represents 0.23% of the total value of the state’s corn production.
Changes in corn producer surplus in South Dakota. The loss of State ethanol subsidies could cause the shutdown of 1 South Dakota ethanol plant, but would not lead to additional spillover effects on corn prices at other regional plants. The shutdown would reduce corn production in South Dakota by 240,000 bushels (a 0.04% decrease in total corn production for the State). Lower corn production and local prices would reduce South Dakota’s corn producer surplus by $1 million (which is 0.07% of the total value of South Dakota’s corn production).
Changes in corn producer surplus in Iowa. The loss of UGP state-level ethanol subsidies could cause spillover effects on corn prices at three ethanol plants in Iowa. That is, these plants would have less competition for regional corn inputs, which would lower corn prices at those plants. The price declines, however, are small (about $0.01/bushel). In turn, Iowa’s corn production would decline by 150,000 bushels (a negligible amount of the State’s 2008 production of 2.2 billion bushels). Lower corn production and local prices would reduce Iowa’s corn producer surplus by $700,000.
The loss of state ethanol production subsidies may cause some small ethanol production facilities in the Upper Great Plains to cease operations. A spatial arbitrage model of grain trade in the UGP is used to assess the effects of facility shutdowns on cash corn markets. In general, corn prices decline by between $0.05/bushel to $0.18/bushel in markets near shuttered facilities. Minor spillover impacts occur at nearby plants as well (about $0.01/bushel). This price decline causes producers to reduce corn production and increase the production of other crops. We estimate that declines in cash corn prices cause a $9.4 million decline in corn producer surplus.
Note that at least some of this producer surplus would be transferred to providers of transportation services. That is, although corn production is estimated to decline by about 2 million bushels in this region, the demand for transportation services for the remaining production will increase as corn is transported to more distant locations.
Perhaps a larger issue involves the potential reduction of Federal ethanol production subsidies. These subsidies have already declined from $0.54/bushel to $0.45/bushel. Budgetary or policy changes could cause further reductions. The loss of a significant portion of these subsidies could cause larger, newer production facilities to struggle to generate positive returns-over-variable costs. Of course, if some plants shut down, ethanol prices may increase to those plants with low enough cost structures to continue production. But, one would expect significant reductions in national corn prices and local basis changes as the result of such a restructuring. The modeling approach outlined above provides a methodology for considering the economic impacts of further reductions in Federal ethanol production subsidies.
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McKee, G.J., G. Brester, and J. Schumacher. “Economic Impacts of Eliminating State Ethanol Production Subsidies in the Upper Great Plains.” Agricultural Marketing Resource Center, Iowa State University. 2010.
Seeley, T. “Ethanol May Not Need its US Tax Credit, GAO Finds.” Downloaded December 2009.
State of Minnesota Office of the Legislative Auditor. “Biofuel Policies and Programs.” April. St. Paul, MN, 2009.
U.S. Government Accounting Office. Biofuels: Potential Effects and Challenges of Required Increases in Production and Use. August. Washington DC, 2009.