Understanding market reponses of U.S. ethanol policy : an empirical evaluation of historical programs and a simulation of future proposals

Abstract

Throughout 2011, several pieces of legislation aimed at modifying U.S. ethanol policy have been proposed in Congress. The current policy debate focuses on whether to leave the mandate for corn and sugarcane based ethanol at 15 billion gallons per year or to lower it. This study assesses the effects of proposed ethanol legislation by evaluating both the historical effects of U.S. ethanol policy and approximating the outcomes of currently proposed legislation. Historical effects are assessed following Luchansky and Monks (2009) and lengthening the monthly data series to 1994 to 2009, further controlling for autocorrelation and adding explanatory variables to control for the ethanol blender's credit and environmental policies encouraging ethanol use. The study finds there was a structural break in the U.S. ethanol industry in 2002 and that the interaction of environmental policies and a 186 percent increase in the retail gasoline price from 2002 to 2008 drove the rapid expansion in the U.S. ethanol industry starting in 2002 (U.S. Energy Information Administration, 2011f). The effects of proposed legislation are assessed using an Equilibrium Displacement Model (EDM). The classic EDM is expanded to determine whether or not policy outcomes diverge when using a linear versus a non-linear approximation procedure. Results suggest outcomes of current policy proposals for U.S. ethanol producers and corn farmers are determined by the ethanol mandate. In contrast, policy prescription outcomes for ethanol consumers and foreign ethanol producers are jointly determined by the mandate, subsidy and tariff. However, no economically significant differences resulted from using the linear versus the non-linear approximation procedure. This study finds that the future of the U.S. ethanol industry will be jointly determined by the level of the U.S. ethanol mandate and long-run retail gasoline prices.