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The Economic Effect of Governmental Incentives on the

Ethanol Fuel Market

Quinn KelleyGraduate Student

University of Georgia

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Problem Statement

• Limited research available on the market for ethanol.

• To determine the effectiveness of current subsidies for ethanol, the economic structure of the fuel-blending market for ethanol is required.

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Objectives• Investigate the impact market determinants

have on the ethanol market.

• Develop an econometric model of the fuel-blending market demand and supply for ethanol.

• Based on this econometric model, elasticities are calculated and implications for this highly subsidized market are discussed.

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Alternative Fuel Legislation

• Alternative Motor Fuels Act (AMFA) of 1988

• Clean Air Act Amendments (CAAA) of 1990

• Energy Policy Act (EPACT) of 1992• Federal Ethanol Subsidy of $0.54 per

gallon• Additional State Subsidies

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Ethanol• Ethanol is an alcohol-based, colorless liquid

fuel with a characteristic odor.• Currently, ethanol is used as a fuel additive

in gasoline.• In the U.S., corn is the predominant

feedstock in ethanol production.• Ethanol is produced through a process of

fermenting and distilling starch crops that have been converted into simple sugars.

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Competition

Methyl Tertiary-Butyl Ether (MTBE)

• First synthesized in the early 1960s and commercial production began in 1979.

• Classified as a volatile organic compound (VOC).

• Produced by a chemical reaction between methanol and isobutylene.

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Empirical ModelDemand

QitD = β0 + β1Pwt + β2Pgt + β3Vit + β4CAAAit + Σ5

j=1βj+4Rji + εitD

Q = annual ethanol quantity soldPw = lagged price wedge (Peth – Pmtbe)Pg = annual grade-weighted wholesale price of gasolineV = annual number of registered vehicles by stateCAAA = Clean Air Act non-attainment dummy variableR = regional dummy variable

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Empirical ModelSupply

QitS = α0+ α1 Pwt + α2Pcit + α3Si + Σ5

j=1αj+3Rji + εitS

Pc = state-level annual corn price

S = state-level annual subsidy

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Data

• Data were collected from the Economic Research Service, the U.S. Department of Transportation, the Energy Information Administration, and the U.S. Environmental Protection Agency.

• The data set includes: 1988 to 2002 annual observations by state.

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Tobit Two-Stage Least Squares Results

Demand Coefficients

Standard

Errors Elasticities

Intercept -58.820* 8.490

Price Wedge -99.199* 12.924 0.81

Price of Gasoline 17.014* 4.565 0.86

No. of Vehicles 18.095* 2.613 0.28

CAAA 13.935* 2.613

Regions

1

2

3

4

5

3.329

8.339*

56.534*

-2.567

2.557

3.843

2.685

4.614

2.961

2.340*Significantly different from zero at the 5% significance level

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Tobit Two-Stage Least Squares Results

Supply Coefficients

Standard

Errors Elasticities

Intercept 347.292* 34.307

Price Wedge 0.889* 0.093 8.17

Price of Corn -38.804* 4.342 -4.23

Subsidy -0.837* 0.043 -2.36

Regions

1

2

3

4

5

-2.021

-20.211*

37.001*

-20.583*

-7.651*

4.207

3.569

8.131

3.070

2.863

*Significantly different from zero at the 5% significance level

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0

pf

pm

QS

QDQD’

Ethanol

PriceShare borne byfuel- marketing firms

Share borne bymanufacturers

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Market Implications• With fuel-marketing firms bearing the major

impact of any ethanol subsidy removal (91%), any reduction in the subsidy will negatively impact ethanol’s competitiveness over MTBE.

• A gradual phase-down of the subsidy will be dramatic for the industry.

• A 45% reduction in the ethanol subsidy will result in the elimination of the ethanol market.

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Impacts

• If a state is designated in non-attainment, ethanol demand will increase by 14 million gallons.

• An elastic input demand for corn limits any bargaining leverage corn producers have in their attempts to influence market price.

• The increases in state ethanol subsidies over the last decade have not resulted in inducing a positive ethanol supply response.

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Conclusions• The economic structure of the ethanol

market indicates ethanol agents are addicted to the federal tax exemption on ethanol blended fuels.

• The potential for demand expansion resides in structural shifts occurring from clean air and water regulations, health restrictions, renewable fuels, and global warming.