Ethanol Boondoggle

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					                          The
              Ethanol
     Boondoggle

               T
                                                    By Jerry Taylor and Peter Van Doren


                       The closest thing to a state religion in
                       America today isn’t Christianity – it’s corn.
                       Whether liberal or conservative, Democrat or Republican,
                       urban or rural, virtually everyone in the business of offer-
                       ing opinions is in firm and total agreement that America’s
                       ills, from Islamic terrorism to global warming to economic
                       stagnation in the heartland, could be solved by a hefty dose
                       of 200-proof grain alcohol.
                           Virtually everyone, however, does not include economists
                       worthy of their No Free Lunch buttons. To them, the diz-
                       zying array of federal, state and local subsidies, preferences
                       and mandates for ethanol fuel are a sad reflection of how a
                       mix of cynical politics and we-can-do-anything American
                       naiveté can cloud minds and distort markets. If ethanol
                       had economic merit, no government assistance would be
                       needed. Investors would pour money into the ethanol busi-
                       ness and profits would be made, even as alcohol displaced
                       oil in the markets for liquid fuels.
                                                                                          jupiterimages




                           If ethanol lacks economic merit, however, no amount of
                       subsidy is likely to provide it. And make no mistake – welfare


16   The Milken Institute Review
associated press




                   First Quarter 2007   17
     boondoggle
                                                                    vention with a number of arguments. Ethanol
     directed now (and for many decades) at the                     subsidies, we are told:
     ethanol industry is staggering. A comprehen-                   • Level the playing field, which is distorted
     sive study recently published by the nonpar-                     by subsidies to the oil industry.
     tisan International Institute for Sustainable                  • Move us closer to energy independence,
     Development estimates that federal and state                     which reduces the economic, political and
     subsidies for ethanol in 2006 were somewhere                     national-security costs associated with oil
     between $5.1 billion and $6.8 billion, and that                  consumption.
     they will soon increase, to as much as $8.7 bil-               • Reduce the flow of oil revenues to the Middle
     lion annually, assuming no further change in                     East and, as a consequence, starve the mili-
     policy.                                                          tary capabilities of Islamic terrorists.
         Those estimates, moreover, are conserva-                   • Promote cleaner-burning fuel, which, in
     tive, because they do not include the benefits                    turn, improves air quality and reduces
     bestowed by federal and state ethanol-con-                       greenhouse gas emissions.
     sumption mandates, loan guarantees, subsi-                     • Provide an economic stimulus to rural
     dized loans, implicit subsidies provided by                      America by creating jobs and income that
     tax-exempt bond financing for the construc-                       would otherwise not exist.
     tion of ethanol processing plants, subsidized                      Close examination reveals that these are
     water for corn production, and state vehicle-                  flimsy rationales for the real purpose of the
     purchase incentives. Don’t forget the regula-                  program – to convince urban voters and their
     tory loophole given to manufacturers of flex-                   representatives to willingly hand over their
     fueled vehicles – cars that can run on gasoline                money to corn farmers and the rapidly grow-
     or blends of gasoline and ethanol – under                      ing ranks of investors in ethanol plants.
     federal automobile fuel-efficiency mandates.
         Without those subsidies, there would be                    ethanol and the unlevel
     no corn-based ethanol production at all. Ac-                   playing field
     cording to the U.S. Department of Agricul-                     Contrary to popular belief, federal oil subsi-
     ture, corn ethanol’s variable production costs                 dies are quite modest. When the Department
     are 96 cents a gallon, while capital costs av-                 of Energy examined those subsidies in 1999
     erage $1.57. The upshot is that ethanol costs                  (the most recent year in which a compre-
     an average of $2.53 a gallon to produce in the                 hensive analysis was performed), researchers
     United States, far more than the cost of con-                  found that they totaled a mere $567 million
     ventional gasoline. The stuff only makes it to                 per year. That figure did not change signifi-
     the pump because the feds and the states give                  cantly until passage of the 2005 Energy Policy
     it a big financial boost. In 2006, the subsi-                   Act, which added an estimated $1.4 billion of
     dies translated into $1.05 to $1.38 per gallon                 subsidies for the oil industry, spread out over
     of ethanol, or 42 percent to 55 percent of its                 a decade. So, while no comprehensive up-to-
     wholesale market price.                                        date assessment of federal oil subsidies is cur-
         Proponents justify this marketing inter-                   rently available, the 2006 total is certainly less
                                                                    than $1 billion – which translates to 0.3 cents
                                                                    per gallon of gasoline.
     J E R RY TAYLO R is a senior fellow at the Cato Institute in
     Washington. P E TE R VAN DO R E N is a senior fellow at the
                                                                        More important for our purposes, howev-
     Cato Institute and the editor of the journal, Regulation.      er, is the fact that federal oil subsidies do not


18   The Milken Institute Review
                   significantly affect gasoline prices.
                   That’s because U.S. oil prices are
                                                                                 The real purpose of
                   established in global crude oil                               the program is to
                   markets, and subsidies to U.S. oil                            convince urban
                   producers have little effect on
                   global supply and demand.                                        voters to willingly
                   Oil subsidies may generate
                   modest windfalls for cor-
                                                                                     hand over their
                   porations in the oil busi-                                        money to corn
                   ness and their employees, but
                   they do not have a noticeable                                   farmers and the
                   effect on oil prices and, thus,                               rapidly growing
                   on the efficiency of energy
                   markets.                                                     ranks of investors
                       Oil subsidies might reduce
                   prices if they increased glob-
                                                                                in ethanol plants.
                   al oil supply by enough to affect
                   global crude oil prices. But a Tufts                          ure at close to zero, because the
                   University economist, Gilbert Metcalf, calcu-      great bulk of these military outlays would be
                   lates that federal oil subsidies increase United   made even if there were little risk of oil dis-
                   States production by no more than 0.3 per-         ruptions in the Middle East. We think that
                   cent and that global prices are no more than       assessment is correct, and that there is no
                   0.7 percent lower as a consequence.                national security externality specifically asso-
                       In any case, the proper remedy for an ob-      ciated with gasoline consumption. Conse-
                   jectionable subsidy is its elimination, not the    quently, there is no need for federal interven-
                   imposition of a countervailing subsidy. The        tion in fuel markets to address it.
                   riposte that oil subsidies are impossible to          Moreover, energy independence, on its
                   eradicate, thus necessitating a “second-best”      face, would do nothing to protect the Ameri-
                   response of counter-subsidy – is hardly per-       can economy from supply disruptions abroad.
                   suasive. Oil subsidies have been eliminated in     Since oil prices are established in world mar-
                   the past – most recently, during the Reagan        kets and oil is a fungible commodity moving
                   administration.                                    anonymously around the globe, a supply dis-
                                                                      ruption in the Middle East means that the
                   ethanol and energy independence                    price of crude oil everywhere goes up by
                   Many people believe that the less oil we im-       roughly the same amount, and it does so in-
                   port from the Middle East, the less vulnerable     stantaneously. Thus, the only way a country
                   we are to supply disruptions and, as a conse-      that produces as much oil as it consumes
                   quence, the less we need to spend to keep the      could actually protect domestic consumers
                   sea lanes clear, the production facilities safe    from changes in global oil prices linked to
                   and the region at peace and friendly to the        supply disruptions elsewhere would be to em-
associated press




                   United States. But many analysts who have          bargo oil exports – behavior that our allies in
                   tried to calculate the national security costs     Europe and Asia would not take lightly.
                   associated with oil consumption put the fig-           Nor would energy independence protect


                                                                                                    First Quarter 2007   19
     boondoggle
                                                             will cause to our pocketbooks and to the
     the economy from embargoes by foreign pro-              economy as a whole. But consumers have
     ducers. Once oil enters the world market,               plenty of ways to hedge against future supply
     buyers – not sellers – dictate its ultimate des-        disruptions if they are so inclined. They can
     tination. Only if every single nation on Earth          buy fuel-efficient cars, choose to live near
     refused to sell to the embargoed nation would           mass transit hubs, buy stock in oil companies
     an oil embargo keep foreign petroleum out of            or invest in oil futures. There is now even an
     that nation’s ports. An attempt to deny oil to          exchange-traded mutual fund (the United
     a specific country thus becomes a supply re-             States Oil Fund) that permits anyone to bet
     striction with a lesser impact on the entire            on the price of oil at minimal cost. Govern-
     world market.                                           ment should not force consumers to hedge
         During the 1973 oil embargo, when the               against their will, or to dictate the manner in
     major Arab producers cut sales to support-              which hedging will occur (in this case, via
     ers of Israel in the Yom Kippur war, transpor-          ethanol consumption).
     tation costs increased slightly because of the              Economists disagree about whether oil-
     diversions, reroutings and transshipments               supply disruptions lead to recessions and/or
     that followed, but the flow of oil from abroad           inflation – externalities that could, in theory,
     was otherwise unaffected. The long lines and            justify measures to diversify fuel sources. Hill-
     shortages that coincided with the embargo               ard Huntington of Stanford University esti-
     were a result of domestic price controls, pro-          mates that the external macroeconomic costs
     duction cutbacks and consumers’ efforts to              associated with oil supply disruptions may
     hoard existing supplies – not of the embar-             approach $5 a barrel (12 cents per gallon of
     go directly.                                            gasoline). But Rajeev Dhawan and Kartsen
         Energy independence might reduce the in-            Jeske, economists at the Federal Reserve Bank
     terest that politicians have in the geopolitical        of Atlanta, argue that as long as the economy
     situation in the Middle East, but then again,           is free of wage and price controls, the effect of
     it might not. As a major energy producer it-            disruptions on GDP is likely to be minor.
     self, the United Kingdom does not import                    In any event, shifting to ethanol would not
     substantial amounts of oil from the Middle              necessarily provide consumers with a more
     East. But it remains heavily engaged in the             reliable source of energy. First, corn yields
     region nonetheless. By the same token, there            vary with the weather, and corn prices are
     are many reasons why the United States is po-           relatively volatile as a consequence. A major
     litically and militarily involved in the Mid-           push to displace oil with corn-based ethanol
     dle East, including the defense of Israel, the          might simply result in the substitution of one
     hunt for Al Qaeda terrorists and the worry              price-volatile commodity for another. Sec-
     that producers might use oil revenues to build          ond, relying exclusively on one set of pro-
     nuclear weapons. Those reasons won’t vanish             ducers (in this case, farmers in the American
     if oil imports decline, particularly given that         Midwest) is arguably riskier than relying on
     supply disruptions there affect our econo-              a multiple producers via international trade.
     my whether we’re importing oil from the re-             Putting all of our eggs into one basket is as
     gion or not.                                            risky in fuel markets as putting all our 401(k)
         It is still fair to say that the less oil we con-   money into one company’s stock.
     sume, the less damage that supply disruptions               Regardless, the goal of price stability is in


20   The Milken Institute Review
                              itself is a poor argument for investing in corn   to the Middle East would reduce the capabil-
                              rather than oil for transportation needs. Oil     ities of a whole host of problematic state and
                              markets deliver low-cost energy most of the       non-state actors.
                              time and high-cost energy some of the time.           Well, hardly. A robust ethanol market
                              Ethanol markets deliver high-cost energy all      would reduce oil revenues for producer states,
                              of the time and may – or may not – prove less     but not by much. That’s because ethanol can-
                              volatile than oil markets. The fact that no one   not be produced in sufficient volume to sig-
                              has found it profitable to offer price-smooth-     nificantly affect global demand for other liq-
                              ing services (such as long-term supply con-       uid fuels. If all the corn produced in America
                              tracts) to motorists suggests that consum-        in 2005 were dedicated to ethanol production
                              ers are disinclined to pay more for protection    (only 14 percent of it is so dedicated today),
                              against volatile fuel prices.                     it would have reduced U.S. demand for gaso-
                                                                                line by, at most, 12 percent. By Department
                              ethanol and the war on terror                     of Energy estimates, in order for corn ethanol
                              Some foreign-policy analysts and political        to displace gasoline completely in the Unit-
                              pundits are touting ethanol subsidies as a        ed States, we would need to appropriate all
saeed khan/afp/getty images




                              vital component of America’s defense against      crop land in the country, turn it over to corn-
                              terrorism. The less we spend on oil, the argu-    ethanol production and then find 20 percent
                              ment goes, the less we need to spend fighting      more land on top of that.
                              Islamic terrorists, who finance their activi-          Economic reality, of course, precludes any
                              ties to a large extent with American petrodol-    such thing. The Department of Energy ar-
                              lars. In this view, reducing the flow of dollars   gues that 700,000 barrels per day by 2030 is


                                                                                                              First Quarter 2007   21
     boondoggle
                                                         endeavor and oil revenues appear to be un-
     the “practical limit” for U.S. corn ethanol pro-    necessary to pay for it. The fact that just a few
     duction, which would amount to about 6 per-         hundred thousand dollars paid for the 9/11
     cent of the U.S. transportation fuels market        attacks suggests that the limiting factor for
     by that time.                                       terrorism is expertise, fanaticism and man-
         If the government is correct, ethanol will      power – not petrodollars.
     have, at best, a modest impact on global oil            That probably explains why there is no
     demand – and thus, on global oil prices and         correlation between Persian Gulf oil revenues
     profits. Because ethanol has only three-quar-        and terrorist activity. Inflation-adjusted oil
     ters of the energy content of petroleum,            prices and profits during the 1990s were rath-
     700,000 barrels of ethanol would displace           er low. But the 1990s also witnessed the world-
     about 525,000 barrels of oil. Accordingly, if       wide spread of Wahhabi fundamentalism, the
     America could fully reach its realistic poten-      buildup of Hezbollah and the coming of age
     tial for ethanol production as soon as next         of Al Qaeda. Note, too, that Al Qaeda ter-
     year, it would reduce global oil demand by          rorists in the 1990s relied on help from state
     only about six-tenths of 1 percent. Over the        sponsors, including Afghanistan and Pakistan
     long haul, that would reduce oil prices by all      – nations that aren’t exactly known for their
     of three-tenths of 1 percent – about 20 cents       oil wealth or robust economies.
     per barrel at current world prices. It’s un-            What terrorists need most is a recruiting
     likely that such a modest drop in oil profits        pool from which to draw. If oil prices fall, that
     would have any measurable effect on the dol-        would mean smaller producer-state subsidies
     lars flowing to Islamic terrorists.                  to young, underemployed Muslims and less-
         But even if ethanol subsidies were to re-       prosperous Middle Eastern economies. Thus,
     duce the price of crude oil by a substantial        to the extent that deteriorating economic
     amount, it’s not clear that would hurt Islam-       conditions breed social discontent and politi-
     ic terrorists. Terrorism is a relatively low-cost   cal resentment, promoting ethanol to reduce
                                                                revenues flowing to Islamic terrorists

The fact that just a                                              might perversely increase the recruit-
                                                                   ment pool for Islamic terrorists and
few hundred thousand                                                make matters worse.
                                                                        Reducing oil revenue to noxious
dollars paid for the                                                regimes might be a risk worth tak-
                                                                    ing if billions were finding their way
9/11 attacks sug-
                                                                         from such regimes into Al Qa-
gests that the                                                               eda’s coffers. But that seems
                                                                             unlikely. Everything we
limiting factor                                                              know suggests that Al Qaeda
for terrorism is                                                          cells are pay-as-you-go opera-
                                                                      tions that rely on Islamic chari-
expertise, fanati-                                                  ties, smuggling, and garden-vari-
                                                                                                             associated press




                                                                   ety crime to finance their activities.
cism and manpower —                                              Given that the governments of Saudi
not petrodollars.                                              Arabia, Kuwait and other petro-states in


22   The Milken Institute Review
the region are slated for extinction should bin        The picture is a bit better for greenhouse
Laden have his way, those governments have         gas emissions, but not by much. Niven’s re-
no interest in facilitating the transfer of oil    view found that E10 offers only a 1 percent to
revenue to post office boxes in Pakistan.           5 percent reduction of greenhouse emissions
    Producer states do, indeed, use oil revenues   over conventional gasoline. The use of pure
to finance ideological extremism; Saudi financ-      ethanol as a transportation fuel, however, as
ing of madrassas and Iranian financing of Hez-      is used in Brazil, might reduce this category
bollah are good examples. But given the im-        of emissions by up to 12 percent.
portance of those undertakings to the Saudi            Note, though, that even this latter num-
and Iranian governments, it’s unlikely they        ber is hard to pin down because of the larg-
would cease and desist simply because oil          er disagreements about the energy needed to
profits were down. They certainly weren’t de-       produce ethanol. Those who believe that eth-
terred by meager revenues in the 1990s.            anol production requires more fossil fuels –
                                                   something has to power the tractors that till
ethanol and the environment                        the fields, provide feed stocks for the chemi-
One of the most commonly heard claims              cal fertilizers and fire the boilers that distill
about ethanol is that it reduces automobile        the alcohol – than it actually generates, as-
pollution. Archer Daniels Midland, the gi-         sert that ethanol has little impact on overall
gantic commodities processor, has paid for an      greenhouse gas emissions. Those who believe
avalanche of advertising for some years now        that ethanol has a positive net energy balance
suggesting that ethanol is the thin yellow ker-    produce higher estimates for greenhouse gas
nel standing between us and environmental          savings. The debate surrounding ethanol’s net
Armageddon.                                        energy balance is highly uncertain and data to
   Calling these claims the equivalent of the      settle the matter is not available.
Big Lie is probably harsh, but it’s also accu-         In any event, this debate about life-cycle
rate. The only thorough appraisal of the peer-     emissions from ethanol misses the point that
reviewed and technical literature of which we      reducing greenhouse gas emissions via etha-
are aware of was published last year by Prof.      nol would be an incredibly costly proposition
Robert Niven of the Australian Defense Force       – $250 per ton according to a recent report by
Academy at the University of New South             the International Energy Agency. Moreover,
Wales. He found that when evaporative emis-        that’s a conservative estimate, because the
sions are taken into account, E10 (fuel that’s     agency considered only greenhouse gas emis-
nine parts conventional gasoline to one part       sions from automobile tailpipes. Given that
ethanol, the standard mix in service stations      most of the emissions associated with etha-
in the United States) actually increases emis-     nol come from upstream in the production
sions of total hydrocarbons, non-methane or-       process, a full accounting would inflate its es-
ganic compounds and volatile toxins. Photo-        timate dramatically.
chemical smog is worsened by ethanol con-              Spending $250 (at the very least) to re-
sumption, while ambient concentrations of          move a ton of carbon from the atmosphere
toxic chemicals are higher as well. By no coin-    is an incredibly expensive way to get the job
cidence, air pollution is even worse from E85,     done – and one that surely costs more than
the 85 percent ethanol fuel now being heavily      it benefits the environment. William Nord-
promoted by General Motors.                        haus of Yale, for example, calculates that an


                                                                                  First Quarter 2007   23
     boondoggle
                                                        the subsidies will do something to reverse the
     optimal policy of greenhouse gas controls          long-term economic decline that has plagued
     would embrace abatement costs of between           rural towns and farms since the mechaniza-
     $15 and $22 per ton of carbon in the United        tion of agriculture in the late 19th century.
     States. Accordingly, employing ethanol to re-          But as a morally uplifting project, ethanol
     duce greenhouse gas emissions is fantastical-      gets poor grades. For starters, the belief that
     ly wasteful.                                       the transfer of wealth from non-farmers to
        Wait, it gets worse. Although the environ-      farmers is progressive is not supported by the
     mental debate regarding ethanol is almost ex-      data. U.S. farm households earn about 11 per-
     clusively concerned with air-quality issues,       cent more on average than non-farm house-
     a forgotten dimension concerns the effect          holds, and there is no particular reason to be-
     of ethanol consumption on land use. Prof-          lieve that the primary beneficiaries of more
     itable corn production requires tremendous         farm largesse would go to the poorest of those
     amounts of fertilizer, pesticide and water.        who still work the land.
     Increasing the demand for ethanol would                 And even if redistribution from the rela-
     increase the amount of land dedicated to           tively poor to the relatively rich is something
     corn production. And that would mean more          that political majorities wish to engage in, di-
     water pollution, less water for other uses, and    rect transfer payments would be preferable
     more ecosystem destruction.                        to the indirect transfer payments that follow
        In short, then, ethanol promises to reduce      from the ethanol program. That’s because
     greenhouse gas emissions, but not by very          ethanol subsidies generate collateral damage.
     much and at an unacceptable cost since there       For instance, while rising corn prices (which
     are any number of less expensive means to the      are expected to go up 50 percent in 2007, due
     same end. To add to the insult, ethanol wors-      largely to the federal ethanol mandate) cer-
     ens air and water quality and contributes to       tainly help corn farmers, they hurt poultry,
     habitat destruction.                               hog and cattle farmers, who rely on corn feed
                                                        for their livestock. Increases in market de-
     ethanol and rural economic                         mand for ethanol likewise help those who
     revitalization                                     own ethanol-processing facilities, but harm
     While all of these arguments are made to jus-      soybean farmers, because many of the deriva-
     tify ethanol subsidies, it’s clear that the main   tive products associated with ethanol produc-
     reason the program has support in Washing-         tion (like high-protein animal feed) compete
     ton is because ethanol subsidies increase corn     in markets once dominated by soybean pro-
     prices and thus, farm and corn-processor in-       ducers. In short, ethanol subsides help some
     come. The program concentrates great ben-          agribusinesses but hurt others.
     efits on a few but diffuses costs to the many           Subsidy proponents also frequently over-
     – the classic recipe for interest-group-driven     look the fact the benefits bestowed by ris-
     government initiatives.                            ing corn prices are capitalized into land val-
         The rationales offered for the subsidies       ues, and thus the wealth transfers associated
     are useful narratives designed to convince         with ethanol subsidies are almost completely
     non-farmers to embrace a program that will         captured by incumbent landowners. Accord-
     make them poorer so that some farmers can          ingly, those who wish to enter into or expand
     be richer. The highest-minded hope is that         in the farming business by buying or renting


24   The Milken Institute Review
                      land will find that the subsidies provide lit-    advocate turning back the clock in this way
                      tle benefit to them. Note, too, that the more     – unless, of course, rural job creation were to
                      land one owns, the larger one’s share of the     trump all other considerations.
                      federal subsidy will be – which highlights the
                      truly regressive nature of the ethanol subsi-    subsidies and market
                      dy program.                                      transformation
                          Whether rural America witnesses a net in-    Would long-term, government subsidies trig-
                      crease in jobs as a consequence of the subsi-    ger technological and organizational gains
                      dies is almost immaterial from an economic       that transform the ethanol industry into a
                      perspective. After all, if the metric by which   more productive enterprise, capable of deliv-
                      we were to judge public policy was the impact    ering fuel at competitive prices? Subsidy pro-
                      that a specific program might have on jobs in     ponents point to the Brazilian experience,
                      one narrow but favored slice of the economy,     where ethanol fuels have a big chunk of the
reuters/joshua lott




                      then banning all mechanized farm equipment       market, as evidence of the miracle to be had.
                      and prohibiting farm imports would create            A close examination of Brazil’s ethanol
                      far more jobs in rural America than is created   market, however, reveals that major subsidies
                      by ethanol subsidies. No sane person would       still persist and that ethanol there (made from


                                                                                                     First Quarter 2007   25
     sugar cane rather than corn) almost certainly    on competing diesel-powered cars (whose
     couldn’t compete in the market without gov-      fuel costs are substantially below the cost of
     ernment support.                                 25 percent sugar-cane fuel), maintains a fed-
         Brazil’s ethanol program was launched in     eral alcohol-storage program to subsidize in-
     1975, when its dictator, Gen. Ernesto Geisel,    ventory holdings, and enforces a 21.5 percent
     ordered the country’s gasoline to be mixed       import duty on foreign ethanol.
     with 10 percent ethanol. That requirement            As a consequence, ethanol’s share of the
     was increased to 25 percent over the next five    Brazilian motor vehicle fuels market has
     years and, under democratically elected gov-     ranged between 40 and 55 percent since the
     ernments, it has since varied between 20 and     mid-1980s. It’s impossible to say, howev-
     26 percent. Generous subsidies were initially    er, what the market share for ethanol might
     provided to sugar cane growers and ethanol       be without government-mandated use and
     processors, as well as to car manufacturers      other forms of assistance. The fact that Bra-
     who built vehicles that could run on signifi-     zil was importing ethanol even with a steep
     cant concentrations of ethanol fuels. But the    import duty in place as late as January 2001 –
     oil price collapse of 1986 led the government    and from the United States no less! – suggests
     to cut back on some of the most financially       that the marginal production cost of sugar
     burdensome of those subsidies.                   ethanol may be substantially higher than that
         At present, Brazil provides a liberal tax    of American corn ethanol.
                                                                                                        scott olson/getty images




     subsidy to hydrous-ethanol producers (fuel           In short, Brazil’s subsidy program worked
     that is about 95 percent ethanol and 5 percent   if we define “worked” as creating a significant
     water) and manufacturers who produce vehi-       market. It probably has not worked, howev-
     cles that can run on high-ethanol fuel blends.   er, if we define it as creating an industry that
     The government also imposes a national ban       could compete without government help.


26   The Milken Institute Review
    The American experience has been no bet-      of cellulosic ethanol production facilities in
ter. Two economists, Richard Duke (McKin-         the world, the Department of Energy’s best
sey) and Daniel Kammen (University of Cal-        guess is that cellulosic ethanol probably costs
ifornia at Berkeley) constructed a model in       about $3.35 a gallon to produce at present. If
1999 to compare the benefits and costs of          all goes well, that might drop to $2.43 per gal-
various federal market-transformation pro-        lon by 2020.
grams. While they found some evidence for             Cellulosic ethanol is, in theory, more at-
the proposition that subsidies might help un-     tractive than corn ethanol because many of
economic industries become economically           the plants we might harvest for processing
competitive in some cases, they found that        require less fertilizer, pesticide and irrigated
federal ethanol subsidies have provided no        water to produce than corn does. Unfortu-
net economic benefit despite more than 20          nately, though, the energy yields are also sig-
years of handholding.                             nificantly lower. Accordingly, even if produc-
    “The ethanol market would collapse with-      tion costs come down, cellulosic ethanol is
out the federal subsidy,” they found, and ad-     unlikely to ever contribute more than a trivial
ditional subsidies were unlikely to improve       amount to the transportation fuels market.
matters because there are virtually no econo-         Of course, what the future holds for tech-
mies of scale associated with ethanol process-    nology is unknowable. Perhaps scientists will
ing, production costs have declined only gla-     engineer energy-intensive crops that can be
cially over time, and ethanol production is a     harvested and processed at minimal cost. If
very mature technology. “It is therefore dif-     that were to happen, we would have no com-
ficult to imagine a scenario,” they conclude,      plaint. But subsidies for existing technolo-
“under which continuing the ethanol pro-          gies are unlikely to hasten that sort of market
gram can yield” a net gain to the economy.        transformation and have been economically
                                                  and environmentally counterproductive.
the big picture                                       One might be tempted to cite the invasion
Thus far, we have confined our discussion to       of Wall Street into the ethanol industry as ev-
corn and sugar cane ethanol. But what about       idence that smart people with a lot of money
cellulosic ethanol? The former uses the fruit     are willing to bet to the contrary. But there
of the plants in question, where a greater por-   is a better explanation: many ethanol invest-
tion of the energy content is concentrated.       ments make perfect sense in light of existing
The latter uses all of the plant’s biomass –      mandates to use the stuff and the lavish sub-
stalks, leaves, everything – to produce etha-     sidies available to distill it. Without govern-
nol, and is the great long-term hope of etha-     ment favoritism, it’s unlikely that investment
nol proponents. Congress mandated that            would be more than a tiny fraction of its pres-
hope into law: the 2005 Energy Policy Act re-     ent level. In short, people are investing based
quires refiners to use 250 million gallons of      on the politics of ethanol subsidies, not the
cellulosic ethanol a year, starting in 2012.      economics of ethanol production.
    The prospects aren’t attractive, however,         Corn ethanol, as we noted at the outset, is
because the production costs of cellulosic eth-   more a religion than a reasoned proposition.
anol are even higher than the costs of making     People are entitled to their religious beliefs.
alcohol from the fruit of the plant, and are      But there ought to be a steep wall between
likely to remain higher. With only a handful      church and state.                             M




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