The "Four-Gallon Rule": Another Unintended Consequence of Ethanol Policy

The energy field is replete with unintended consequences, and US policy promoting ethanol fuels has had more than its share.  The growing competition  between food and fuel uses of corn, amplified by the current drought, is a prime example, along with the so-called "dead zone" in the Gulf of Mexico that has been exacerbated by the extra fertilizer used to boost corn yields enough to meet the rising demands of the federal Renewable Fuel Standard (RFS).  Most of these effects occur out of the sight of average consumers, but here's a new one that could start showing up at a gas station near you, very soon: the EPA's "four-gallon" rule.  As a result of EPA's decision to allow gasoline blenders to sell fuel containing up to 15% ethanol, and in recognition of the adverse consequences of high-ethanol blends for small engines, gas stations will be required to post signs enforcing a minimum purchase of four gallons from certain pumps.  This is yet another indication that the EPA has put expediency above prudence in giving its approval to a fuel that is not ready for mass-market distribution. 

A little background is necessary to understand how we reached this point.  In 2007 the Congress passed the Energy Independence and Security Act that included the RFS, mandating dramatic increases in the quantity of ethanol blended into gasoline.  Unfortunately, its passage coincided with a sea change in the gasoline market. Prior to the financial crisis and recession, US gasoline demand had been growing by 1-2% per year for decades, and on that pace there should have been ample future gasoline demand growth to accommodate all the additional ethanol that Congress was instructing the EPA to require refiners and gasoline blenders to add, by means of the standard blend of 90% gasoline and 10% ethanol.  Instead, gasoline sales fell by more than 3% in 2008 and still haven't recovered their 2007 peak, running about on par with 2002 this year.  When you do the arithmetic, that means that instead of being able to absorb over 15 billion gallons of ethanol this year, the market can only handle around 13 billion gallons--barely enough to satisfy the 2012 mandate level and 2 billion short of the amount required in just three years.  (This ignores cellulosic ethanol requirements, which have been revised downward each year as commercial production fails to appear.)

With sales of 85% ethanol E85 trickling along at levels too low to stave off the approaching "blend wall", the ethanol industry applied in 2009 to be allowed to increase the ethanol dosage in gasoline from 10% to 15%, requiring an EPA waiver of existing regulations.  That waiver was granted in 2010 for cars made after model-year 2006 and later extended for cars made after model year 2000, in spite of continuing concerns about its impact on the engines and fuel systems of all cars not labeled as "flexible fuel vehicles", as well as testing by UL indicating that some existing gasoline dispensers failed in dangerous ways when ethanol blends above 10% were introduced. 

The four-gallon rule is part of the EPA's ongoing contortions, in the form of gas pump labeling and "misfueling mitigation plans", to make sure that E15 doesn't get into the wrong vehicles, or worse yet, into small engines--lawn mowers, string trimmers, boats, etc.--where it has been found to cause potentially serious problems.  So in addition to labels indicating that E15 is only approved for 2001 and later automobiles, the EPA is instituting a minimum sales quantity rule to prevent someone from filling a gas can for use in a small engine with E10 from a "blender pump"--one that can dispense either E10 or E15 on demand.  That's because even after the pump is switched to E10, enough higher-ethanol fuel could remain in the hose to skew the ethanol content of the first few gallons delivered. (I'd suggest that this ought to be of concern to motorists, as well.)

I'm sure the EPA sees its new four-gallon rule as a sensible measure to protect the owners of small consumer or industrial engines from damaging their equipment. Yet from my perspective outside the bureaucracy it looks like another symptom of an E15 policy that falls short of the prudence necessary when dealing with the retail distribution of motor fuels and borders on regulatory malpractice.  At some point in the process someone in EPA should have held up his or her hand and pointed out that the obvious solution was not layering increasingly impractical and downright weird regulations onto already overburdened gas station operators, but to call for a fundamental reexamination of a Renewable Fuel Standard that has been overtaken by unforeseen events.  And that's without even considering that the lower energy content of the extra ethanol equates to a new $0.07 per gallon tax on gasoline at current prices. The publicity surrounding this issue provides an ideal opportunity for one or both presidential candidates to commit to suspending the E15 program, pending a thorough review of the RFS and its implementation. 

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E15's Problems Are Symptomatic of A Failing Biofuels Policy

A new report on automobile engine durability casts further doubt on the compatibility of mid-level ethanol blends such as E15 (15% ethanol, 85% gasoline) with the existing US light-duty vehicle fleet. The report was issued this week by the Coordinating Research Council (CRC) under the auspices of API, Global Automakers, and the Alliance of Automobile Manufacturers.  It found that at least some of the vehicles included in EPA's certification of E15 for use in cars manufactured since 2001 experienced excessive valve wear and other mechanical problems over the course of a simulated engine lifetime.  Together with previous research highlighting the risks of E15 for gas station pumps, the report's findings raise serious questions about the federal government's current ethanol policy and who will ultimately bear its hidden costs.

I've written extensively about the EPA's approval of E15 for use in vehicles and the underlying rationale for increasing the ethanol content of most gasoline beyond the 10% limit (E10) for which most cars on the road today were designed.  At current volumes, domestically produced corn-based ethanol accounts for roughly 10% of all US gasoline and displaces the energy equivalent of 600,000 barrels per day of imported petroleum products.  However, without increasing the amount of ethanol blended into each gallon of gasoline, and in the absence of a miraculous transformation in the public's minuscule appetite for E85 (the 85% ethanol blend sold for flexible fuel vehicles) the US ethanol strategy has hit its natural limit.  Since US gasoline consumption, which prior to the recession routinely grew at 1-2% per year, has stalled at a level comparable to what we used ten years ago, the enthusiasm of the US ethanol industry for E15 to expand its market is entirely understandable.

The CRC's results have been criticized by both the ethanol industry and the Department of Energy.  Although I don't have the background to judge CRC's report assumption by assumption and result by result, it does appear that many of the criticisms raised by the DOE were addressed in the body of the report, including the choice of ethanol-free gasoline as the reference fuel.  As for complaints that the auto and oil producers have a vested interest in making E15 look bad, ethanol producers are at least as conflicted for their part.  Moreover, without impugning the integrity of the fine folks at the DOE, the federal government also has a significant conflict of interest in this matter: The administration and its cabinet agencies are stewards of a 2007 national biofuels policy that now depends on the adoption of mid-level ethanol blends like E15 if it is to have any chance of reaching its goal of 36 billion ethanol-equivalent gallons per year by 2022, from around 15 billion gallons per year today.  The apparent damage to some engines running on E15 under test conditions similar to those used by the car manufacturers for their own product testing highlights risks that must be addressed before consumers should be asked to put this fuel into their cars.

In addition to concerns about the safety of this fuel for the mechanical integrity of the tens of millions of vehicles for which the EPA has approved it, including both of my family's vehicles, E15 still faces substantial practical obstacles to its widespread distribution--obstacles that will likely require significant new federal funding to overcome. My industry contacts tell me that gasoline retailers considering selling E15 must install brand new gas pumps, because the nationally recognized testing laboratories like UL won't certify existing product dispensers for use with E15.  Anyone who ignores this requirement faces serious liabilities and could end up in violation of local fire codes.  So not only would retailers selling E15 instead of E10 be excluding a large portion of their existing market--at a minimum all pre-2001 cars--but they would have to make significant investments to do so.  Such investments are unlikely to be repaid by higher prices for E15 than for E10, because if anything, E15 should sell for a discount to E10.  Its nearly 2% lower energy content than E10 would translate into a requirement for roughly one extra fill-up a year for the average driver, or a penalty of about $37 per year at current prices.

There's an obvious solution for the risks that the administration is asking motorists to take on with E15 fuel.  Since neither vehicle manufacturers nor fuel retailers are prepared to accept the liability for excessive engine wear or fuel system damage from using E15 instead of E10 or purer gasoline--a position the Congress is considering granting statutory protection--the federal government should step up to this role.  The DOE and EPA claim E15 is safe for cars.  In the private sector, such claims would have to be backed up by warranties, explicit or implied.  Why should this situation be any different?  The President should therefore instruct DOE and EPA to carve out a portion of their annual budgets--after cuts--to fund a new federal warranty program for vehicles damaged by E15.  If these agencies are unwilling to stand behind their assessment of E15, then perhaps this fuel is not as ready for prime time as they suggest.  In any case, foisting this liability on consumers would represent a hidden and likely regressive new tax.

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Ethanol's Future Without Subsidies

Given the remarkable longevity of the tax credit for ethanol blended into gasoline, it seems fitting that it would take a problem on the scale of the massive US deficit and $14 trillion federal debt to trigger its demise. Yet despite a widely-publicized Senate vote in June and the announcement of a key compromise among three Senators last week--two from the corn belt and one from the West Coast--it remains unclear just when and how the cancellation of this subsidy will become law. And because the fate of the subsidy is linked to that of the parallel tariff and duty on imported ethanol, the US ethanol industry faces not just the prospect of a more challenging market by year-end, but one that could include competition from foreign suppliers with special advantages under US renewable fuels regulations. Some producers may end up wishing they hadn't expanded output quite so fast.

I've followed the ethanol subsidy for much longer than I've been blogging about it. As I was reading a two-part assessment of the changing ethanol situation in Biofuels Digest it occurred to me to take the dusty report from my long-ago M.B.A. project off the shelf. Its topic was the market for "gasohol", gasoline blended with up to 10% ethanol, on the West Coast in the early 1980s. At the time, blenders received roughly the same tax credit as today's $0.45 per gallon of ethanol blended, thanks to the 1978 Federal Energy Tax Act and the Highway Tax Act of 1983. That benefit was a lot more generous in then-current dollars than now, but much smaller in aggregate. In the intervening decades, gasoline with ethanol has expanded from around 2% of the market to nearly 100%. In much of the country it is now harder to find gasoline without ethanol than it was to find gasohol back then.

That's only one indication of the tremendous success this industry has enjoyed, due almost entirely to government policies like the Volumetric Ethanol Excise Tax Credit and the national Renewable Fuels Standard (RFS) established in 2005. In fact the eventual demise of the ethanol tax credit was virtually guaranteed by the passage of an even more ambitious RFS as part of the federal Energy Independence and Security Act of 2007. Under the RFS, blending ethanol into gasoline in steadily increasing proportions became mandatory, rendering the tax credit paid to refiners and other gasoline blenders redundant. Just as importantly, it expanded the scale of ethanol blending to such an extent that the total annual cost of the so-called blenders credit grew from roughly $1.8 billion in 2005 to a projected $6 billion this year--too big to ignore.

The deal agreed by Senators Feinstein (D-CA), Klobuchar (D-MN) and Thune (R-SD) last week would reportedly result in the early termination of both the ethanol tax credit, which was due to expire at the end of 2011 but could have been renewed, and the corresponding ethanol import tariff. It would devote $1.33 billion of the unspent funds to deficit reduction, while diverting another $668 million to extend tax credits for alternative fuel refueling (or recharging) infrastructure and cellulosic biofuel tax credits. This outcome appears to have pleased at least part of the ethanol industry. However, in order for it to become law, it must still be voted on by both houses of Congress, either by itself or as a provision within another bill, perhaps even the debt ceiling extension package that could emerge from the ongoing deliberations between the House, Senate and White House.

The ultimate effect of these changes on the ethanol industry remains somewhat uncertain, though it is hard to see them as a net positive, other than the longer-term benefit of supporting infrastructure investments that could be crucial in resolving a key bottleneck in ethanol distribution. Without much higher sales of gasoline blends containing more than 10% ethanol, the market is already nearly saturated with ethanol, and that's before factoring in the additional imports that the elimination of the tariff is likely to promote. And at least in the case of ethanol derived from sugar cane, those imports will enjoy an important advantage over ethanol derived from corn: most of them are likely to qualify for the stricter designation of "Advanced Biofuel" under the RFS, a category for which the annual quota is just starting to take off, and that cannot be satisfied by corn ethanol but also seems unlikely to be filled by domestic cellulosic ethanol any time soon.

Biofuels Digest suggested that long-dated ethanol futures have already nose-dived in anticipation of the end of the tax credit. It's true that ethanol for delivery in January 2012 is trading for around $0.35/gal. less than the August 2011 ethanol futures contract, reflecting a widening of ethanol's discount to the gasoline futures contract over that interval of around $0.11/gal. However, it also seems highly relevant that corn futures have recently retreated from their early-June peak of nearly $8/bushel to $6.80, with December corn--from which January ethanol might be produced--down at $6.20/bu. That leaves ethanol producers a small but still positive margin on that January futures price. So it is hardly certain that the end of the tax credit will, by itself, stress US corn ethanol producers. If anything, refiners and consumers--who have arguably received most of the benefit of the credit in recent years--stand to lose the most from its disappearance.

Import competition could have much more serious consequences, as the fuel ethanol industry truly begins to globalize. Brazil is the big player internationally, even if the recent rise in sugar prices and a smaller-than-expected cane crop have created the bizarre situation of Brazil actually importing corn ethanol from the US. The historically fragmented Brazilian sugar cane industry is currently both expanding and consolidating, led by companies like Raizen, the new joint venture between Shell and Cosan, which has indicated plans to double its ethanol capacity to 5 billion liters per year (1.3 billion gallons per year.) Nor is Brazil the only tropical country that can grow cane and produce sugar, ethanol and electricity from modern facilities. The Brazilian model could be replicated elsewhere in Latin America, the Caribbean, and West Africa. Not all of that extra ethanol will come here, but enough of it could, helped by the RFS, to put an effective cap on US ethanol prices. I'm not aware of a similar constraint on corn prices.

The US ethanol industry has matured in the last three decades. Today's ethanol plants are much more efficient than the ones supplying the small quantities used for gasohol in the early 1980s, and they now consume around 40% of the US corn crop. The industry has expanded on a scale that would have seemed nearly impossible thirty years ago, though in my view it has in the process fallen into the classic overcapacity trap of commodity manufacturers. Whether that situation is temporary or permanent depends on the success of blends containing more than 10% ethanol--blends that the market has so far treated with indifference. But either way, when the training wheels finally come off with the end of the blenders credit and import tariff, we shouldn't be surprised to see more of the small and higher-cost producers fall by the wayside. That will have local consequences, but the ethanol industry will survive, just as it survived the bankruptcies of some ethanol producers during the financial crisis. Ethanol is here to stay, and it is about to embark on a new career as a more normal commodity.

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Twilight of the Ethanol Subsidy?

The current tax credit for blending grain ethanol into gasoline, the Volumetric Ethanol Excise Tax Credit (VEETC), has outlived its usefulness. That's not just because I consider it unwise to subsidize any industry to such a generous extent for more than thirty years, but also because the passage of the ambitious federal Renewable Fuels Standard in 2007 made it redundant. Refiners aren't just paid to blend ethanol into gasoline; they're required by law to do so. One of the trade associations for the ethanol industry reached a similar conclusion last year, though presumably for different reasons. Nevertheless, the politics of such a big change looked dire. Now it appears that the unthinkable might be happening with the introduction of two separate bills in the Senate, one of which would scale back the ethanol credit significantly, while the other would eliminate it outright.

The tougher of the two bills comes from a pair of Senators representing states that consume far more ethanol than they produce. In fact, I couldn't find a single ethanol plant in Oklahoma, which Senator Coburn (R) represents. Whether the Feinstein-Coburn bill stands a chance or not, I'm much more interested in the equally bi-partisan measure from two farm state senators, Kent Conrad (D-ND) and Charles Grassley (R-IA). As described in the press, it would reduce the VEETC from $0.45 per gallon this year to $0.20/gal. for 2012 and $0.15/gal. for 2013, after which it would fall to a level indexed to oil prices. At the current price of West Texas Intermediate, it would be zero.

Of course the context for the Conrad-Grassley bill is that without legislative action the current blenders credit is due to expire completely at the end of this year. However, we've been in this position before, more than once, and each time the tax credit was rolled over with a few minor tweaks, such as the cut from $0.51/gal. to $0.45/gal. in 2008. My default assumption has been for a similar rollover this year, but with support from the largest ethanol trade groups in the country, the provisions of the Conrad-Grassley Bill appear to have become the new default. The bill also extends some tax credits for cellulosic biofuel and alternative fuel refueling facilities, including E85, and reduces the ethanol import tariff modestly, starting in 2012.

Although outright termination of the corn ethanol tax credit would be justifiable, it would also be highly disruptive to an industry that we've encouraged for so long, and that has struggled with thin margins even with the tax credit in place. A phase-out seems reasonable and would at least save taxpayers up to $3.3 billion next year and more the following year, depending on how much ethanol is actually sold and how many retailers take advantage of the incentives for installing E85 facilities. There's an argument that this might result in higher prices at the pump, as refiners' blending costs rise, though any such impact is likely to be lost in the noise of normal fuel price volatility.

Winding down this subsidy in an orderly fashion is important, but it's even more important that we learn the lessons it teaches. The cultivation of corn and its conversion to ethyl alcohol are subject to natural limits of scale that are lower than those for wind and solar power or plug-in electric cars, all of which also benefit from generous subsidies. Our pockets simply aren't deep enough to repeat our experience with ethanol subsidies with these other energy alternatives. In an era of fiscal limits, alternative energy tax incentives that are orders of magnitude higher per BTU or kilowatt-hour than those enjoyed by conventional energy sources should only be offered for a limited time, and then phased out on a predictable schedule before they take on the mantle of permanent entitlements.

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Flex-Fuel Competition for OPEC?

An op-ed in this morning's Wall St. Journal by former CIA Director James Woolsey makes an interesting and seemingly pragmatic suggestion for improving America's energy security. Instead of pushing new energy sources or new fuels, he seeks to break OPEC's cartel power by ensuring that US motorists have more choice at the pump, facilitated by flexible fuel vehicles (FFVs) that can operate on a variety of energy sources. The analogy to the electricity grid, in which no single source of generation can hold the entire market hostage, is clear. The question is whether this is really as useful as it sounds, to the point of justifying legislation that would force carmakers to make fuel flexibility the default, rather than an option on new cars.

Competition can be a powerful force, and Mr. Woolsey is correct that gasoline and other petroleum-based transportation fuels have had little competition at the point of sale to consumers. Even with ethanol making up 10% of most of the gasoline in the US, 94% of the energy we use for transportation still comes from oil. The idea of "multiple choice energy", which was the name of one of the corporate energy scenarios that I helped develop at Texaco more than a decade ago, is alluring. It's not hard to envision consumers being able to choose among gasoline, diesel, ethanol, other biofuels, natural gas (compressed or liquefied), electricity, hydrogen, and even exotic hydrogen-storing compounds such as ammonia borane, which recently appeared on my radar screen. As it has been for decades, however, the central problem is creating a market for these alternatives. That requires both cars and infrastructure.

Mr. Woolsey and his co-author are focused on the car side of the equation, suggesting that a $100 fix could enable most cars to run "a variety of liquid fuels in addition to gasoline." To make this happen, they espouse the Open Fuel Standard Act, a piece of legislation that has been floating around since at least late 2008 and that would mandate this hardware for all new cars. Then they extend this argument into natural gas vehicles and plug-in hybrid cars, both options costing a great deal more than $100 per car. While plug-in hybrids certainly provide very effective energy competition for oil, their cost and complexity ensure that their market penetration will be a long, slow process, pushing any real competitive benefits perhaps a couple of decades into the future. Nor do the natural gas cars I'm aware of--also much more expensive than simple FFVs--provide such a point-of-sale fuel arbitrage capability, because once converted to run on CNG or LNG, there's no going back to gasoline. (This feat isn't technically impossible, just impractical.) So for the near-to-medium term the main competition available would be from fuels like E85 and methanol.

I've written extensively about E85, a blend of 85% ethanol and 15% gasoline. The gist of it is that E85 has failed to take off so far, not because there aren't enough FFVs that can run on it--there are already millions on the road--but because its availability is limited and, more importantly, because its current pricing represents a poor value proposition for consumers. A gallon of E85 contains 27% fewer BTUs of energy than a gallon of gasoline with its typical 10% ethanol content. In cars not specially tuned to make the most of E85's high octane, that translates directly into a corresponding fuel economy penalty. So for E85 to be attractive to consumers, it should sell for at least 25% less than unleaded regular gasoline. As reflected on an industry website tracking E85 prices, that's only the case in a few locations, with the national discount currently averaging 16%. So on a miles per dollar basis, E85 is currently about 15% more expensive than gasoline. That doesn't sound like something that is likely to cause OPEC ministers to lose sleep.

Why is E85 so expensive? It's not mainly due to its limited availability, although its smaller scale relative to gasoline distribution probably costs it a few extra cents per gallon. Fundamentally, it's because ethanol prices reflect high input costs, including corn. Even at the current futures price on the Chicago exchange this morning of $2.72/gal., which does not include transportation and blending costs that can easily add another dime or more, wholesale ethanol costs 85% as much as wholesale gasoline, equating to 87% on an E85 basis. It's hard to see how you could start there and end up with pricing on the forecourt that offers a big enough discount to compensate consumers for the fuel economy penalty and the more frequent refueling that results from it. And in fact, EPA analysis of refueling data for 2008 found that it "equates to an estimated 4% E85 refueling frequency for those FFVs that have reasonable access to the fuel." So without a fundamental change in the pricing relationship, it's not clear that either more FFVs or even more E85 pumps will result in consumers purchasing large volumes of E85.

Mr. Woolsey's arguments about fuel competition make intuitive sense, although it does not necessarily follow that legislation requiring carmakers to produce more FFVs would achieve the results he suggests, particularly when GM, Ford and Chrysler have already agreed that half the cars they produce will be flex-fuel capable by 2012. $100 per car isn't an astronomical sum for this kind of experiment, but is there really a compelling reason to make it compulsory, rather than a matter of consumer choice?

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Carbon-Neutral Gasoline

I see that Google's venture capital fund is investing in a startup company that would produce hydrocarbon fuels from cellulosic plant matter, with the added twist of sequestering carbon in soil. This is another signpost of the growing interest in non-alcohol biofuels, often referred to as "drop-in" fuels, for both oil replacement and climate mitigation. With cellulosic ethanol developers having mainly disappointed for the last several years, and with so much current policy focus on electric vehicles and their infrastructure, I find it reassuring that there are smart people out there working on alternative fuels that fit today's cars, with today's infrastructure. That's important not just for the obvious reasons, but because the end result of energy policy must create successful business models, not just neat technology.

I haven't delved deeply enough into the technology of CoolPlanetBioFuels to form an opinion about its potential, though I do have some questions about how their front-end "thermal/mechanical processor", which will apparently be produced in 1-million gallon-per-year modules, would mesh with the catalytic fuel production processes needed to turn its output into consumer-ready fuels. Those processes normally operate at scales 100 times larger than CoolPlanet's processor, and when it comes to the efficiency of industrial chemistry, smaller is rarely better. However, if their technology works as advertised, the company's pursuit of the mainstream fuel market looks like a smart business decision.

A few years ago, the main buzz in alternative fuels concerned the production of ethanol from cellulose, and companies large and small were pouring money and resources into different ways to do this, as were governments. That's still happening, despite many of the companies involved missing their early production targets so badly that the Environmental Protection Agency twice had to revise its annual Renewable Fuel Standard (RFS) mandate to compensate for the shortfalls. However, the bigger worry about cellulosic ethanol might not be its production, though that is quite challenging enough, but its ultimate market. That's because corn ethanol has effectively filled up the easiest outlet, consisting of the 10% of a gallon of ordinary gasoline that ethanol can occupy without potentially compromising the fuel systems of cars not designed as flexible fuel vehicles, as well as refueling infrastructure that appears not to be up to handling more ethanol. The EPA has approved a 15% blend, but it faces both litigation and significant practical constraints.

Then there's E85, the 85% ethanol/15% gasoline blend that was expected to provide all the market headroom that ethanol producers would need, when the RFS goals were enacted in 2007. Yet despite generous tax incentives for E85 station conversions and a price that currently averages 53¢ per gallon less than regular unleaded gasoline on a volumetric basis--though still about 50¢/gal. more on an equivalent energy basis-- E85 remains something of a dud, even in the heart of corn country. E85 sales set a record last year in Iowa, but the 9 million gallons sold through 138 outlets there accounted for just 0.7% of the gasoline sold in the state in 2010.

If you want to make money selling motor fuel--or as in the case of CoolPlanet making the hardware for making fuels--then you must come to grips with the commodity nature of its markets. After water, motor fuels are probably the world's largest commodity business. That means that volume, rather than high margins, is the main driver of revenue and profits. The major oil companies struggled with this for decades, pursuing the last penny a gallon of margin by means of additives and advertising. Many of them have left this segment entirely to franchisees, because it's typically not profitable enough to compete with their other investment opportunities. Niche markets can be attractive if they offer unusually high margins, such as those available in the 200 million gallon-per-year aviation gasoline business, which supports just a few players. However, it's not obvious that ethanol and E85 fall into that category. So if you want to develop your business based on its growth potential, and your technology gives you a choice between selling into an at least temporarily saturated ethanol market or the much larger market for fuels that don't require special infrastructure or dedicated fleets, opting for the latter looks like a no-brainer.

The extra angle CoolPlanet offers comes in the form of its sold carbon byproduct called "biochar". This is sometimes referred to as "terra preta", which was a pre-Columbian charcoal-based fertilizer used in South America. The idea is that by returning this product to the soil, rather than allowing the carbon of the biomass to decay into CO2 and enter the atmosphere, the entire process can be made carbon neutral or even carbon negative, sequestering as much or more carbon as the liquid fuels produced will emit when burned. Terra preta is something of a hot topic lately, though the logic of burying solid carbon in one location at the same time that others are mining solid carbon--a.k.a. coal--from the earth elsewhere somewhat escapes me. Nor would the gasoline produced from CoolPlanet's process be any more carbon neutral in effect than conventional gasoline produced by a company that scrupulously bought matching emissions offsets for its products, which could currently be had for a cost of around 9¢ per gal. via an organization like CarbonFund.org.

It's hard to assess the value of the climate-friendly aspects of CoolPlanet's technology in the US, given the uncertainties about pending EPA greenhouse gas regulations and Congressional legislation. However, the attractiveness of a renewable energy technology that unlike wind, solar and geothermal power could actually displace oil on a barrel-for-barrel basis, and that isn't subject to ethanol's limitations and drawbacks, is understandable. All that remains is for CoolPlanet to demonstrate that their device really works and that they can bring it to market at a price that allows the fuels it would produce to compete with commodity fuels from petroleum. That would be big news, indeed.

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The Regulatory-Ethanol Complex

The US Environmental Protection Agency has a problem, and that problem is ethanol. Last Friday the EPA expanded its previous waiver on ethanol in gasoline to allow blends of up to 15% to be used in cars built in model year 2001 and later, compared to the earlier threshold of model year 2007. Because it did this just three months after granting the initial waiver, it's not clear how much additional testing was actually done, despite the agency's obligatory reference to "sound science". This step is a further indication that EPA is presiding over a failed biofuel mandate created by Congress in the expectation that a massive cellulosic biofuel industry would spring forth at their command, in parallel with a massive upsurge in sales of the 85% ethanol/15% gasoline blend, E85. None of that has happened, and for now the corn ethanol industry is the only horse that EPA has left to ride in this race. Until these waivers were issued, that horse was rapidly running out of track on which to run.

It's not that EPA loves corn ethanol. In fact, the first draft of its RFS2 renewable fuel standard incorporated an emissions-measurement basis that was distinctly unfavorable to older conventional ethanol facilities. That was subsequently toned down, after reinterpreting the science relating to "indirect land use impacts". Unfortunately for EPA, however, corn ethanol is the only avenue for continuing to comply with the annually escalating biofuel mandate set in the Energy Independence and Security Act of 2007, unless they want to flood the US with Brazilian cane ethanol. Oilseed-based biodiesel remains a niche product, and the US biodiesel industry is half-dead after the EU imposed anti-dumping tariffs as punishment for biodiesel exports to Europe that were subsidized by a $1.00 per gallon US biodiesel tax credit--a credit that lapsed at the end of 2009 but was reinstated retroactively as part of the Lame Duck Congress's tax deal.

The central problem relates to the so-called blend wall, the annual quantity of ethanol that can be accommodated in gasoline under the previous 10% blending limit. With US gasoline sales having dropped in 2008, rather than continuing on their path of 1-2% annual increases, and still not recovered to their former level, the entire US gasoline pool can only absorb 13.9 billion gallons per year of ethanol. As a practical matter, the blend wall is probably a billion gallons lower than that, given the challenges of getting ethanol to the remotest corners of the country. By coincidence, the RFS target for 2011 after backing out the renewable diesel requirement is roughly 13 billion gallons. The production capacity of the US corn ethanol industry already stands at 14 billion gallons per year, with more ethanol plants under construction or expansion.

Accommodating all that extra ethanol would have been easy if E85 had taken off as planned. However, if Minnesota's E85 statistics are any indication, E85 sales appear to have declined since 2008. In the absence of E85 demand, the EPA's waivers have the effect of moving the blend wall and giving the ethanol industry more headroom to grow. In theory, this would also have been needed to make room for cellulosic ethanol, but so little of that is being produced that EPA has had to scale back its quota for that category two years in a row, with a further adjustment in 2012 a virtual certainty.

Expanding the waiver to cover earlier car model years was crucial to making it useful. The first round didn't encompass enough cars--and thus enough annual fuel volume-to make it likely that refiners, distributors and retailers would incur the cost and risks of introducing it into the market. Going back to 2001 adds roughly another 90 million cars and light trucks and includes some of the highest car-sales years in US history. As a result, the broader waiver now probably covers about half of the 240 million light-duty vehicles on the road in the US.

The consequence for consumers will be higher taxes, in several forms. First, there's the tax associated with paying for fuel that has less value, due to ethanol's lower energy content, yet carries the same pump price. At current gasoline prices a gallon of E15 is worth about 5.5 ¢ less than the E10 blend most of us are buying today. Then there's the indirect tax associated with the higher maintenance and repair expenses that some motorists are likely to experience. Despite the EPA's reassurances about having tested E15, the focus of their testing was explicitly on emissions, not on performance and longevity. And finally there's the tax or debt we'll incur for the ethanol blenders credit that will be paid out on the incremental ethanol volumes facilitated by the waiver. That could eventually amount to an extra $3.2 billion per year, unless the current Congress finally ends this redundant subsidy that has been in place for more than thirty years.

Although it is probably best viewed as a marriage of convenience, for now the EPA and the corn ethanol industry are joined at the hip, forming a sort of regulatory-industrial complex. For political reasons EPA can't afford to abandon its partner, because the administration is fully committed to the RFS2 biofuel targets as part of its broader approach to energy security and emissions--even though corn ethanol does little or nothing to reduce the latter. Until and unless E85 takes off, the only real alternative to the E15 waivers would be to admit that the 2007 biofuel standards were unrealistically ambitious and must be suspended pending the arrival of so-called drop-in fuels--synthetic hydrocarbons derived from biomass sources such as algae, cellulose or sugar cane. Drop-ins could provide the same renewables energy benefits as ethanol, but without the latter's blending, fuel economy and logistical disadvantages. In the meantime, I will not knowingly fuel either of my family's 2004 model cars with E15, as long as I have a choice.

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UL Study Raises New Questions About E15

One of the energy stories I've followed with great interest all year concerns efforts to increase the proportion of ethanol blended into ordinary US gasoline. This began last year when Growth Energy, an ethanol trade association, asked the Environmental Protection Agency for a waiver to increase the allowed percentage of ethanol in gasoline from 10% to 15%. In October EPA issued a partial approval of the request, but only for vehicles built in model year 2007 or later. However, a new report from Underwriters Laboratories (UL) indirectly casts doubt, not only EPA's ruling, but on whether the agency was assessing all the relevant issues.

I ran across the UL report on the compatibility of mid-level ethanol/gasoline blends in gasoline dispensing equipment--the pumps, hoses and tanks in gas stations--in a posting on API's EnergyTomorrow blog. It cited the UL study, which had been commissioned by the Department of Energy, as evidence that E15, the 15% blend of ethanol and gasoline that the EPA just approved for use in newer cars, could result in serious failures of gas pumps. Yet when I read the report, I immediately encountered its innocuous-sounding conclusion stating, "The overall results of the program were not conclusive insofar as no clear trends in the overall performance of all equipment could be established." It went on to say that the equipment "generally performed well." If I had stopped reading there, I'd have concluded that API was blowing the whole story out of proportion.

When I read the data included in the report, however, a different story emerged. Of the new and used gasoline dispensers and associated equipment tested, very few exhibited no problems on the 17% ethanol test fuel used. In fact, in UL's long-term exposure test, many hoses, nozzles and swivels leaked. 100% of the meter, manifold and valve assemblies tested leaked or failed to shut off. Perhaps most worryingly, two-thirds of the breakaway couplings tested leaked, failed their pressure tests, or required more than the recommended pull to separate. (A breakaway is designed to pop the hose off the dispenser when a customer forgets to remove the nozzle from his car's gas intake and attempts to drive off. This happens a surprising number of times a year, and before the deployment of breakaways such incidents imposed significant repair costs on dealers, even when the resulting spills didn't cause fires.)

The common denominator in these failures was what the report refers to as "nonmetals", gaskets, seals and parts made from various polymers. From that I would draw two conclusions: First, it ought to be possible to design new dispensers and retrofit existing dispensers with new gaskets, seals and plastic parts designed to withstand higher concentrations of ethanol, just as the fuel systems in flexible fuel vehicles are designed to tolerate blends of up to 85% ethanol. However, considering that the US has between 90,000 and 160,000 gas stations, depending how you count them, the number of dispensers that would have to be modified is at least in the high tens of thousands, if not well into the hundreds of thousands. To my knowledge the ethanol industry has not offered to defray the cost of these conversions for a retail fuel industry that operates with extremely lean margins. Nor is it obvious that dealers would qualify for federal assistance, as they do when they add E85 capability.

My second conclusion--really more of a suspicion--has nothing to do with gas pumps or gas stations, and everything to do with cars. After reading the UL report I went back and reread portions of the EPA's official waiver response, which ran to 58 pages in the Federal Register. From what I can tell, EPA wasn't really looking at whether cars would suffer damage from operating on a higher percentage of ethanol than the fuel for which they were designed. The waiver was granted on the basis of those cars not emitting more pollutants than on the fuel for which they were designed. Quoting from the EPA document:

"For MY 2007 and newer light-duty motor vehicles, the DOE Catalyst Study and other information before EPA adequately demonstrates that the impact of E15 on overall emissions, including both immediate and durability related emissions, will not cause or contribute to violations of the emissions standards for these motor vehicles. Likewise, the data and information adequately show that E15 will not lead to violations of the evaporative emissions standards, so long as the fuel does not exceed a Reid Vapor Pressure (RVP) of 9.0 psi in the summertime control season. The information on materials compatibility and drivability also supports this conclusion."

That's good as far as it goes, but from my perspective this finding reflects a necessary but hardly sufficient standard for putting a new fuel into the marketplace, particularly when the failures of the dispensers in the UL study point to the possibility of similar failures of "nonmetals" in the fuel systems of cars or other devices not designed to run on more than 10% ethanol. Even if the leaks found in the testing of product dispensers didn't result in safety hazards, they would at a minimum increase the evaporative emissions from infrastructure, aside from the automotive impact on which EPA apparently focused. I also find it interesting that a bill was introduced in Congress this summer, as EPA was considering the waiver request, that would appear to make it more difficult for consumers to recover the cost of damages resulting from compatibility problems in approved vehicles or misfueling of non-approved vehicles.

As I've noted in my previous postings on this topic, I'm sympathetic to the box into which altered circumstances have placed both the ethanol industry and the federal government with regard to ethanol blending. US gasoline sales, which stagnated after the financial crisis and are only growing by a historically modest 0.7% this year (through November) according to API's latest statistics, are not expanding fast enough to accommodate the output of all the ethanol plants that have been built or are under now construction. When the Renewable Fuels Standard was enacted as part of the Energy Independence and Security Act of 2007, the bill's architects presumably expected that E85 sales would take up any slack. The fact that that hasn't happened does not justify creating a new outlet for additional ethanol in automobiles not designed to accommodate it, any more than it would justify running a new fuel through infrastructure that has been shown not to be up to the challenge. If EPA doesn't revisit the more comprehensive aspects of this question as part of its deferred decision on allowing E15 for cars made before 2007, then perhaps it's time for another government agency with a broader charter to take over this issue.

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Splitting the Baby on E15

I've been going over the EPA's ruling yesterday partially granting the waiver request from Growth Energy, an ethanol trade association, to allow gasoline with up to 15% ethanol to be used in cars not specifically designed as flexible fuel vehicles. The request had created a serious dilemma for the EPA, because granting it could jeopardize the integrity of millions of consumers' car engines and fuel systems, but turning it down would call the entire national renewable fuels strategy into question. What looks like the agency's attempt to find a middle ground that could satisfy all parties might turn out to have little practical impact on the ethanol market for some time, while still unleashing a potentially very disruptive shock wave on the entire motor fuels industry in this country.

If that sounds contradictory, you have to look at the specifics of what the EPA has agreed to here, and overlay them on the highly-competitive, relatively low-return network of gasoline blending, distribution and sales infrastructure through which it must eventually feed. Instead of approving E15, a blend of 15% ethanol and 85% gasoline for all vehicles, or even just for vehicles produced since 2001--as many had speculated they would--the agency has only given the green light for putting this fuel into cars made in the last four years. I might note that this interval includes some of the lowest US car sales rates in recent memory, so yesterday's ruling affects just a fifth or so of the total US light-duty vehicle fleet. The decision for another tranche of cars built between 2001-2006 is to be made after further study, perhaps by the end of the year.

In essence this means that no fuel producer can afford to stop supplying the E10 (or less) fuel that is compatible with all those pre-2007 cars, and precious few retailers are likely to take a bet on switching one of their tanks to a new fuel that only a fraction of their customers can take advantage of, once all the other legalities of introducing E15 into the market have been satisfied. So while this decision might seem to be about promoting the use of more home-grown, renewable fuel in preference to petroleum products that depend on deepwater wells and foreign suppliers, its implementation hinges on a very lopsided business decision for a group of mainly independent fuel retailers and distributors, rather than the major oil companies whose brands we see on filling station polesigns.

A retail gas station has a finite number of product dispensers drawing on an even smaller number of underground storage tanks. In order for a retailer to introduce a new fuel without ripping up the forecourt (which entails being out of business for several months and possibly longer, should he have the misfortune to discover a leak in the process) then he must do the math on how many gallons per month of the new product he might sell, and at what margin, against how many gallons and how much margin he'd lose from the discontinued product. This is the dynamic that has contributed to the excruciatingly slow lift-off of E85, which is at the heart of why E15 even became an issue. It was never supposed to be necessary, because the extra ethanol mandated under the federal Renewable Fuel Standard (RFS) was intended to be sold in big, 85% at-a-time chunks, not little 10-15% slices, and into a gasoline market that was still growing at its historical 1-2% per year clip.

So as a retailer--a small and not very lucrative business--do you give up premium unleaded? Seems an obvious choice, since it's probably your lowest-volume offering. But unless you have a dedicated mid-grade tank, you need premium to blend in the pump to make mid-grade, which accounts for more of your sales. Worse yet, your margin per gallon on premium is your best, followed by your margin on mid-grade. Or you could give up diesel, though if you do, you'll never see those customers again: not on the forecourt, and not in your store, where you make much of your monthly profit. The alternative is an expensive investment in a new tank and dispenser, against a highly questionable return. By now it should be obvious this is a losing game for retailers, who as far as I can see would choose to continue to sell E10 to everyone, including post-2006 cars affected by the E15 ruling, and just ignore the EPA.

The folks who won't be able to ignore the EPA will be the refiners and major fuel blenders. That's because they continue to fall under the authority of the steadily increasing RFS mandates, requiring them to sell a higher percentage of biofuel every year until 2022, or pay large penalties. And while the EPA was kind enough to reduce the mandate for cellulosic ethanol last year and this year--for the very good reason that it isn't yet available in the expected quantities--the chances of getting a waiver in the future because a company has run out of room to blend ethanol into E10 look pretty low, when the EPA can just insist that you make E15 or E85, both now legal. This sets up a situation in which suppliers will shortly need to induce their retailers to take on one or both of these products and make it worth their while, further depressing the margins in this part of the business and making an exit strategy even more attractive.

It's hard to gauge exactly what this could mean for consumers. At a minimum, it might lead to drivers of older cars pulling into some gas stations only to find that the unleaded fuel advertised on the sign is actually not compatible with their particular car. (The EPA as part of yesterday's ruling has promised pump labeling sufficiently clear that no one will fill up with E15 by mistake.) Or in a bigger station, all the E10 pumps might be over on one side of the convenience store, and all the E15 pumps on the other. And of course this raises the awkward question of why consumers would ever consciously choose to fill up with a fuel containing at least 2% fewer BTUs and thus offering 2% lower mpg and range, unless it's going to be cheaper for them--which is inconsistent with E15 carrying sufficiently higher margins to make it worth the retailer's effort to sell.

The result looks like a dog's breakfast, although I can't honestly say I'd have ruled much differently if I were running the EPA and only charged with upholding the RFS and making this ruling on the basis of whether it would increase the overall pollution from the affected vehicles, rather than on whether its policy and ostensible environmental benefits outweigh its costs and risks for vehicle longevity and consumer value. The EPA's supporting documents included evidence that a significant proportion of E10 already approaches 11% ethanol, so E15 means routinely exposing engines and fuel systems to a mix of 16% or more ethanol, even if they were only designed with 10% in mind. Who will bear the liability for the expensive repairs that some cars will require? There are few aspects of this situation that offer consumers any upside, but I see ample downside, if only from having to bear the additional costs that will be passed on by retailers who are in no position to absorb them.

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Building a Market for Biofuels

For the first time in many years I find myself in general agreement with one of the major ethanol trade associations on a key matter of energy policy. Last week Growth Energy, which represents a significant portion of the US ethanol and biofuels industry, announced its support for a phase-out of the federal Volumetric Ethanol Excise Tax Credit, or "blender's credit", in preference to using these funds to provide incentives for constructing the infrastructure needed to offer ethanol at every gas station, and to promote vehicles that can safely burn higher-percentage ethanol blends. This looks like a prudent shift for several reasons, and I hope that the Congress is paying close attention.

No, I haven't suddenly abandoned my aversion to ethanol subsidies that have dragged on for more than three decades and are now long overdue for full retirement, at least for ethanol derived from corn and other food crops. The Congressional Budget Office just released a study on these subsidies showing that when applied to volumes of biofuel equivalent to a gallon of gasoline, the current $0.45 per gallon ethanol blenders' credit equates to $0.73/gal., and the full cost to taxpayers of displacing a gallon of petroleum gasoline with ethanol works out to $1.78/gal. That doesn't count any of the actual production costs of the fuel, either. US ethanol output may thus displace roughly 500,000 barrels per day of imported gasoline (or the imported oil from which to refine it) but it's hardly a bargain. However, I'm also aware that the US has made an enormous policy--and political--commitment to biofuels, including advanced biofuels from cellulosic biomass.

We've done this for reasons that transcend economics. But unless we invest smartly to create a bigger market for these biofuels, the Renewable Fuel Standard will shortly collide with the "blend wall", and US biofuels policy will be stymied. That will happen sooner than might otherwise have been expected, because instead of growing at a steady 1-2% per year as they had prior to the enactment of this policy, US gasoline sales have actually shrunk since then. Trying to cram additional amounts of ethanol into this market--and into cars that weren't designed to use more than 10% of it without damage to engines, fuel systems, and emissions equipment--is a dead end. In order to keep growing, ethanol--including cellulosic ethanol--requires an independent outlet. That's where E85, the 85% ethanol/15% gasoline mix that's as close to straight ethanol as can effectively be delivered to the gas station and used in flex-fuel cars, comes in. So far, though, E85 occupies a tiny niche market mainly in the corn states of the Midwest.

Growth Energy appears to have assessed the longer-term environment for their fuel and reached a similar conclusion: paying refiners to blend ethanol into the shrinking space left in each gallon of ordinary gasoline--which is what the current VEETC does--now makes a lot less sense than helping the nation's 100,000-plus service stations (most independently owned) to adapt their forecourts to deliver a wider mix of products. Promoting flexible fuel vehicles--including wider awareness of which cars are already capable of safely using higher ethanol blends--is also an important element of creating a market for these fuels, though to some degree this is already underway through the government's Corporate Average Fuel Economy regulations and voluntary manufacturer initiatives.

This won't be easy. Growth Energy expresses confidence that ethanol can compete against gasoline without a per-gallon subsidy, as long as it's widely available and most cars are equipped to burn it. However, the industry must somehow overcome the fact that each gallon of pure ethanol contains just 66% of the energy of a gallon of petroleum gasoline. Most drivers don't notice the impact of this when they use gasoline blended with 10% ethanol, but at 85% ethanol and just 15% gasoline, this effect becomes impossible to ignore. Beyond those customers willing to absorb that hit for reasons of perceived patriotism or environmentalism, E85 must ultimately be priced at a discount that reflects the reality that a tank of it won't take you nearly as far.

As of last Friday, ethanol for August delivery traded for $1.61/gal on the Chicago exchange. (That doesn't include freight to market, mainly by rail, which can easily add another dime.) That works out to $2.46 per gasoline-equivalent gallon. Meanwhile Unleaded Regular without ethanol was worth $2.05/gal on the New York exchange (pre-tax.) Nor is this difference anomalous; over the last year wholesale gasoline was consistently cheaper than its energy equivalent in wholesale ethanol, to the tune of roughly $0.90/gal. Unless the ethanol industry figures out how to produce its product at a lower cost, or gasoline prices go up without ethanol prices following, as they did in 2008, then tax credits for distribution and sales infrastructure may not foster as big a market for ethanol as Growth Energy expects, or as profitable a market as I'm sure they'd like. Yet as a matter of policy equity, and from the standpoint of what taxpayers are getting for their money, guaranteeing access for ethanol looks like a better approach than guaranteeing sales, as we do now. It also has the additional benefit of having a logical end-point, instead of the open-ended support we've effectively provided ethanol since 1978.

The current ethanol blenders' credit expires at the end of 2010. The announcement by Growth Energy is even more notable because the Renewable Fuels Association, which represents a larger slice of the industry, has come out in favor of an extension of existing policy through 2015, when the subsidy in question would likely approach $7 billion per year. If this divergence within the ethanol industry is reflected among its supporters in Congress, we could see a surprisingly lively--and fruitful--debate over how best to integrate support for ethanol into a more cohesive national energy framework. Compared to continuing the status quo, Growth Energy's idea of investing to create a mass biofuels market, rather than just paying for space in gasoline, has considerable merit. This approach could also be done for a lot less than the current subsidy, because it wouldn't be necessary to install E85 pumps in every service station in the country. Most of the benefit could be achieved by focusing incentives on strategically-located high-volume outlets, and the rest of the money could go back into the Treasury, where it belongs.

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Ethanol and the Gulf Spill

The implications for the oil industry from the ongoing Gulf of Mexico oil spill are already taking shape, with the administration calling for a Challenger-style investigation and rewriting the playbook for oil & gas leasing and the issuance of safety and environmental permits for offshore drilling. It's less clear how the spill might affect other aspects of energy, beyond boosting the public's interest in pursuing clean energy options. However, it would be ironic if a problem perceived to have arisen because of a "cozy relationship" between oil companies and regulators resulted in an even cozier relationship between the government and the ethanol industry that depends on it for both financial support and the rules that mandate the use of its product. Yet that's exactly what could happen as the administration decides whether to increase the allowable percentage of ethanol in gasoline.

Perhaps you've seen the new ads from Growth Energy, an ethanol trade association: "No beaches have been closed due to _____ spills", with the word "ethanol" fading slowly into view. Then there's "We won't have to wait millions of years to replenish our _____ reserves," and other statements emphasizing ethanol's employment and energy security benefits. It's a clever campaign, and well-timed. On one level, using more ethanol in gasoline seems an obvious response to concerns about our dependence on oil. For all its many shortcomings, ethanol remains the most successful oil substitute in the US market, thanks to the combination of a $0.45 per gallon blenders' tax credit and the steady ratcheting-up of the annual federal renewable fuels standard. Ethanol currently displaces the equivalent of approximately 500,000 barrels per day of gasoline that would otherwise be imported or refined here from imported crude oil. The problem is that the market penetration of ethanol is rapidly approaching the 10% blending limit that has been approved as safe for use in engines that haven't been modified to run on higher-percentage ethanol blends, such as E85. And because E85 has so far failed dismally to take off--accounting for just 0.01% of US gasoline sales in 2008, based on EPA's analysis--any additional ethanol would have to be squeezed into ordinary gasoline, at least in the near term.

Our proximity to this threshold, referred to as the "blend wall", is determined by two factors, in addition to the federally-mandated ethanol blending volume: total US gasoline sales and US ethanol output. Last year Americans bought just under 138 billion gallons of gasoline (including the ethanol blended into it), a reduction of about 3% from the 2007 peak. Without further growth in demand, 10% of that would be 13.8 billion gallons per year (gpy). According to the Renewable Fuels Association, another ethanol trade association, the capacity of existing US ethanol facilities plus those under construction already totals 14.7 billion gpy. In other words, once all the ethanol plants now being built are finished, the industry could supply more than 10% of US gasoline demand without breaking a sweat. But without either a higher blending limit in gasoline or a sudden, unexpected surge in E85 sales, any additional ethanol beyond that level would have no home in the US fuels market. Nor is it obvious that corn ethanol exports represent a viable long-term outlet. Left unresolved, this is a guaranteed train-wreck.

Under the circumstances, it's natural for the ethanol industry to ask its patron for help, in the form of a request for a waiver to blend more than 10% ethanol into each gallon of gas. Last winter, the Environmental Protection Agency told Growth Energy that it was studying their request and would respond by mid-2010. That deadline is nearly upon us, and with more oil spilling into the Gulf of Mexico every day, the pressure on EPA to agree must be mounting. This can't be an easy call to make, especially with the auto makers citing test results indicating that ethanol blends above 10% could harm some car engines. Saying no would call into question the nation's entire long-term renewable fuels strategy, at a time when green jobs and green energy are being widely promoted as the key to a new, more competitive economy. Yet granting that request, either as a favor to the ethanol industry or as a hasty response to the Gulf Coast oil spill would be a mistake that could have serious repercussions, both for consumers and for the administration making such a call. Stay tuned.

Update as of 6/18/10: EPA delays its decision on E15 until the fall.

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Half a Loaf

When I wrote Monday's posting mentioning the impending conflict between the government's requirement to increase the volume of biofuels blended into gasoline and the current approved maximum ethanol blending limit of 10%, I was unaware that the EPA was about to issue a response to the industry group that had requested a waiver to increase that limit to 15%. But while the letter the agency sent to Growth Energy yesterday deferred any ruling until mid-2010, it gave a clear indication that the EPA is considering splitting the baby, in the form of an increase for part of the fleet: those cars built in 2001 or later. Sometimes such a quasi-Solomonic decision reflects wisdom and flexibility; at other times it elevates compromise above common sense. I'm sure you won't be surprised to learn that I suspect this case falls into the latter category.

First, we should applaud the EPA for declining to be stampeded by an interest group into making a decision before its own test results are all in, particularly concerning the impact of blends containing higher proportions of ethanol on the durability and emissions (air pollutants, not CO2) of a representative cross-section of the US vehicle fleet, which numbers roughly 240 million passenger cars and light trucks/SUVs. The agency is right to insist that the science should be clear before the blending limit is increased. Unfortunately, there's more than science involved.

If any group outside the energy industry ought to have a clear understanding of the consequences of fragmenting the marketplace through the creation of Balkanized environmental specifications for fuels, it ought to be the EPA, since they and their state regulatory counterparts have presided over just such a system in the last couple of decades. This is why gasoline blended for use in Oregon or Washington can't be sold in California, and gasoline blended for rural areas can't be sold in metropolitan areas that have been designated as "non-attainment" areas for ozone and other pollutants. This has a direct impact on consumers by raising the cost of suppliers' inventories and deliveries to areas with divergent specifications, and more significantly by delaying the response to local supply outages. If the EPA is seriously considering establishing two blending standards for ethanol, it would further fragment the fuels market, not along geographic lines, but down to individual service stations, because the likelihood of them all carrying Unleaded Regular (E10), Unleaded Regular (E15), Mid-grade (E10), Mid-grade (E15), and so on, in addition to diesel and eventually E85 and whatever else they dream up is essentially zero.

Let's rewind the tape for a moment to recall how the situation the EPA is attempting to address arose in the first place. When the Congress set the new Renewable Fuel Standard as part of the Energy Independence and Security Act of 2007, it was obvious to all involved that even if US gasoline sales had continued to grow at 1-2% per year, as they consistently had prior to the Great Recession, we would rapidly reach the point at which the quantity of ethanol mandated for use would exceed 10% of our annual motor fuel use--long before the mandate reached its 36 billion gallons per year (gpy) target in 2022, including a billion gpy for biodiesel. That wasn't deemed to be a problem, since E85 sales were expected to take off in a big way, soaking up all that extra ethanol. In fact, before it started to shrink the gasoline pool looked like it could accommodate the entire 35 billion gpy of ethanol with an E85 sales percentage as low as around 18%. Today you'd probably have to bump that up to nearly 25%. Unfortunately for this scenario, E85 sales are not on any kind of trajectory to reach that threshold.

One E85 website reports that 2,211 gas stations around the US sell E85. Finding reliable statistics on actual E85 sales is time-consuming, but if all these stations sold at the current Minnesota average of around 4,000 gallons per month, then total US E85 sales are just over 100 million gpy. That's less than 0.1% of US gasoline sales, or just about enough to absorb the output of one typical ethanol plant. These figures also suggest that the roughly 6 million "flexible fuel vehicles" apparently on the road today are consuming E85 less than 10% of the time, either because of availability, or because the average discount between E85 and gasoline is typically much less than the 25% or so necessary to compensate for its lower energy content. And availability is a function of the significant expenses involved for service stations in either converting an existing tank and pumps for a higher-volume product to E85, or investing in additional tanks and pumps--including the downtime involved in such a project.

In other words, the ethanol industry (and the EPA) are in a bind now because the strategy for increasing ethanol use hinged on the expansion of sales for a new blend of ethanol and gasoline that is incompatible with existing service station infrastructure and with most vehicles on the road, and their best solution to the breakdown of that strategy appears to involve introducing yet another new blend of ethanol and gasoline that is incompatible with existing service station infrastructure and many cars on the road. Using this logic, the answer to the financial crisis would have been to launch another wave of new financial derivatives and sub-prime loans. Perhaps it's time for a simpler answer: If the tests by the EPA and DOE indicate that a significant number of vehicles could be harmed by a 15% blend of ethanol in gasoline, or that such a blend would increase local air pollution, then surely it is time to call a halt to the annual increases in mandated ethanol use until a more practical solution can be found.

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Raising A Hidden Tax

Since the administration has apparently ruled out an increase in the gasoline tax to cover declining Highway Trust Fund revenues, it's surprising that it appears to be giving serious consideration to a proposal that would raise a hidden tax on gasoline. This is even more perplexing, when you realize that this increase would actually reduce the government's net take on every gallon of gasoline sold, while simultaneously diminishing the value of the product for consumers. As reported in today's Washington Post, the US ethanol industry is petitioning the government to increase the percentage of ethanol allowable for inclusion in gasoline from 10% to 15%. At the current average gasoline pump price of $1.93 per gallon, this would effectively raise the price by 3.4 cents per gallon, while reducing federal tax revenue by 2.2 cents.

It's entirely understandable that the ethanol industry would seek such a change. Having overbuilt capacity just as demand for the fuel into which their product was blended collapsed and the easy credit that enabled their expansion tightened drastically, ethanol producers aren't in much better shape than Detroit. Several are already in bankruptcy, and others are idling capacity because of poor margins and tight cash flow. And if that weren't bad enough, the primary market for their product--"E10" gasoline, a blend containing 10% ethanol--is approaching saturation at current production levels. Nor have E85 sales grown sufficiently to relieve the pressure created by the combination of a steadily-escalating federal Renewable Fuel Standard and weak motor gasoline sales. However, even if there were no risk of higher ethanol blends damaging the engines and fuel systems of cars not designed as Flexible Fuel Vehicles, increasing the ethanol limit in gasoline would cost us all at the pump.

A gallon of ethanol contains one-third less useful energy than a gallon of petroleum gasoline. This dilution effect is already at work in the standard E10 blend, which contains 3.4% fewer BTUs than "E0". E15 would increase this gap to 5.1%. The Oak Ridge National Laboratory of the Department of Energy recently tested a representative group of cars on fuel blends containing up to 20% ethanol and confirmed a fuel economy loss proportional to the energy dilution effect. An average car driving 10,000 miles per year would require an extra 7 gallons of fuel, compared to one using E10. The extra cost at current pump prices works out to the $0.034/gal cited above. The loss of tax revenue is even more straightforward. Every gallon of ethanol blended into gasoline confers a $0.45/gal excise tax credit on the blender. Blend 10% ethanol and get $0.045 for every gallon of gasoline; blend 15% and receive $0.067.

The long-term success of the government's ethanol policy hinges on increasing the sales of E85 into Flexible Fuel Vehicles, not on foisting inferior mid-level blends of fuel on the public in the guise of "gasoline" without a price discount to reflect its poorer fuel economy, such as has evolved for E85 in most markets. If a soft-drink bottler or beer brewery were watering down its product, while charging the same price, the outcry would be deafening. Yet that's precisely what the government would be encouraging fuel marketers to do, by raising the blend limit. As consumers and taxpayers, we have more than a nickel per gallon at stake in this decision.

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