Biofuels, Energy Security, and

Future Policy Alternatives

Wally Tyner
Purdue University
Ethanol Economics
Ethanol has value as energy and as an additive
to gasoline
The energy content is about 68% of gasoline
It has value as an octane enhancer since it has
octane of 112 compared with 87 for regular gasoline
The additive value has varied considerable
through time, averaging 25 cents per gallon over
the past 7 years could fall to near zero
Policy History
The US has subsidized ethanol since 1978 with
a subsidy ranging between 40 and 60 cents per
gallon.
The current federal subsidy is 51 cents per
gallon, and there are some state subsidies as
well.
The price of crude oil ranged between $10 and
$30/bbl. between 1982 and 2003
With these crude prices, the ethanol subsidy did
not put undue pressure on corn prices.
Crude Oil Price History
0
10
20
30
40
50
60
70
80
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8
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8
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0
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6
$
/
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.
Breakeven Corn and Crude Prices with
Ethanol Priced on Energy and Premium Bases
Plus $0.51 Ethanol Subsidy
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
90.00
100.00
1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5
Corn ($/bu)
C
r
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e

(
$
/
b
b
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)Energy basis
Price premium for
octane/oxygen = 0.35
With 0.51 fixed subsidy
and 0.35 price premium
Corn Use for Ethanol
By the end of this year about 3 bil. bu. of corn will be used
to produce about 8 bil. gal. of ethanol about 23% of the
crop
It could go to 4 bil. bu. in 2008 over 30% of the crop
With more corn used for ethanol, we might expect:
More corn to be produced and higher prices already here
Less corn to be exported
Somewhat less corn to be fed
Higher price volatility
Future Ethanol Prospects
I expect that corn ethanol will continue growing a
bit, but nothing like the recent past.
Future prospects depend on the prices of crude
and gasoline and ethanol plus the corn price
Following graphs provide one version of that
future based on current capital and operating
costs and futures prices for gasoline, ethanol,
and corn.
Corn and Ethanol Futures Prices, Aug 10, 2007
$3.33
$4.04
$1.83
$1.68
$3.10
$3.30
$3.50
$3.70
$3.90
$4.10
$4.30
0
7
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7
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8
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Source: FCA-ORP from Chicago Board of Trade.
C
o
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n

$
/
b
u
$1.50
$1.60
$1.70
$1.80
$1.90
$2.00
$2.10
E
t
h
a
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o
l

$
/
g
a
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Corn Futures Price ($/bu)
Ethanol Futures Price ($/gal)
Ethanol Prices and Gasoline Futures Price, Aug 10,
2007
$1.79
$1.95
$2.07
$1.68
$1.83
$1.31
$1.20
$1.32
$1.17
$1.00
$1.10
$1.20
$1.30
$1.40
$1.50
$1.60
$1.70
$1.80
$1.90
$2.00
$2.10
$2.20
$2.30
$2.40
$2.50
$2.60
0
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Source: FCA-ORP based on Daily Futures Prices.
P
r
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e
s
,

$
/
G
a
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l
o
n
Unleaded Gasoline Futures Price ($/gal)
Ethanol Futures Price ($/gal)
67% Energy-Equivalent Ethanol Price
Ethanol Futures Price less the Excise Tax Credit
Dry Mill Ethanol Plant: Net Returns per Gallon,
(Based on Futures Prices for Corn and Ethanol)
$0.25
-$0.112
-$0.20
-$0.15
-$0.10
-$0.05
$0.00
$0.05
$0.10
$0.15
$0.20
$0.25
$0.30
$0.35
0
7
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0
7
D
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0
8
M
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0
8
M
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0
8
J
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8
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0
9
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Source:FCA-ORP Ethanol Model, prices from Chicago Board of Trade.
$

p
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08/03/07 08/10/07
Market Failures
and Policy Alternatives
Both energy security and GHG emissions are
examples of situations when markets alone
cannot deliver an optimal solution.
Economists call these externalities, and suggest
using taxes, subsidies, or some form of
regulation to correct the market failure
In the U.S., we do not generally use of taxes in
this situation, so I will focus on subsidies and
renewable fuel standards
Policy Alternatives
Stay the course with current policy
Reduce the fixed subsidy
Variable subsidy
Two part subsidy designed to include energy
security and GHG emission reductions
Special incentives for cellulose ethanol
Alternative fuel standard
Combination of alternative fuel standard and
variable subsidy

Stay with Current Policy
Staying with the current fixed 51 cent per gallon
subsidy would likely result in markets keeping the
corn price high and stimulating investment in
ethanol until the corn price chokes off profitability
There would be some food cost increases due to
higher corn prices
Global impacts are very important and quite
difficult to estimate
Variable Subsidy
The energy security externality can be handled through
either a fixed or variable subsidy.
A subsidy that varies with the price of crude oil would be
a means of reducing the cost of the government subsidy
while still providing a safety net if crude oil prices fall
significantly
The variable subsidy has two parameters:
Crude price at which it begins ($60)
Increase in the subsidy for each $1 crude falls below
that price (2.5 cents/$)
Breakeven Corn and Crude Prices with
Ethanol Priced on Energy and Premium Bases
plus Variable Ethanol Subsidy
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
90.00
100.00
1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5
Corn ($/bu)
C
r
u
d
e

(
$
/
b
b
l
)
Energy basis
Price premium for
octane/oxygen
With price premium and
variable subsidy ($60/0.025)
Two-Part Subsidy
To handle both the energy security and global
warming issues, we could have a subsidy that
incorporated both
According to Hill and Tilman, corn ethanol
reduces GHG 12.4%, soy biodiesel 40.5%, and
cellulose ethanol as much as 275%, depending
on production conditions.
Two-Part Subsidy
Biodiesel contains 1.5 times the energy of
ethanol, so it would receive an energy security
credit 1.5 times ethanol based on imported oil
displaced.
The next chart illustrates how such a two part
subsidy might work with components for each
fuel for energy security and GHG reductions
Two Part Bioenergy Subsidy
0
0.2
0.4
0.6
0.8
1
1.2
Corn Eth Biodiesel Cell Eth
$
/
g
a
l
.
National security GHG Emission red.
Cellulose Ethanol Incentives
One of the issues with our current system is that
investors will continue to prefer corn ethanol over
cellulose because cellulose is riskier
We may need to consider other options for cellulose
ethanol at the beginning to stimulate investment:
Investment guarantees or purchase contracts (reverse
auction)
Tax credits to ethanol producers for each ton of cellulose
used to produce ethanol or other liquid fuel
Alternative Fuel Standard
In his State of the Union message, the President
proposed a 35 billion gallon alternative fuel standard by
2017. The Senate passed 36 bil. By 2022:
Current production is about 5.3 billion
Seven fold increase in 10-15 years
The administration estimates this would replace 15% of
projected 2017 gasoline consumption
With a binding mandate in place, it would no longer be
necessary to subsidize alternative fuels
Difference Between a Fuel
Standard and a Subsidy
The fundamental difference between a fuel standard
and a subsidy is who pays:
With a subsidy, the taxpayers pay the tax credits received
by fuel blenders it is part of the government budget
With a fuel standard, consumers see changes in prices at
the pump depending on what the alternative fuel costs
relative to gasoline from crude oil
If we wanted to capture the higher GHG impacts of
cellulose ethanol, the standard would need to be
partitioned with cellulose receiving a higher proportion
Fuel Cost Change from Fuel Standard
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
20 30 40 50 60 70 80 90 100
Crude Equivalent Alternative Fuel Cost
F
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C
o
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%

C
h
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g
e
$40 Crude $60 Crude
Assumes 15% fuel standard
and energy equivalent pricing
Combination of Fuel Standard
and Variable Subsidy
An iron-clad fuel standard may be difficult to
legislate, yet potential investors need some
assurance the standard will hold
The fuel standard combined with a variable
subsidy might be a viable option
Cost of A Fuel Standard with a
Variable Subsidy
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
20 30 40 50 60 70 80 90
Crude Oil ($/bbl.)
F
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C
o
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t

%

C
h
a
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g
e
$60 alternative
Variable subsidy would begin
if crude oil fell below $45
Policy Impacts
The current subsidy can lead to very high corn prices
beneficial to corn farmers but not to livestock producers or
consumers
With this years ethanol production at 8 bil. gal., the subsidy
will cost $4 bil., but CBO estimated in January that
commodity payments will fall $4 bil. in 2007
The variable subsidy, two-part subsidy, targeted cellulosic
subsidies, or alternative fuel mandates are options
Various combinations of these options could be evaluated
Summing Up
Todays high oil prices are largely demand driven
Global recession could lead to significant oil price drops
Investments in alternative energy sources are risky in
the face of future potential price falls without policy
measures that insure against major price drops
If we want to reduce dependence on foreign oil, we
must develop policy pathways that will lead us towards
greater reliance on alternative energy
The policy choices we make will be critical
















































Thanks very much!

Questions and Comments

For more information:
http://www.ces.purdue.edu/bioenergy

Differences Between Purdue and
Iowa State Numbers
Purdue assumes an additive value of 35 cents;
Iowa State assumes zero
Purdue varies DDGS price with corn price; Iowa
State has constant DDGS price
Purdue uses ethanol yield of 2.65; Iowa State
uses 3.0 gal./bu.
Purdue has higher capital and operating costs
than Iowa State