First things first: This is just a DOE approval. Freeport will still need to get a permit from FERC. And, more important, it will still need a solid market for its LNG. There are a lot of credible people out there who believe that U.S. LNG exports will be very small – so small, perhaps, that Freeport will never ship any fuel despite having a permit and a set of contracts (PDF) lined up.

What would be the impact, though, if Freeport ultimately did sell LNG at its full approved capacity?

Analyses have typically suggested that prices might rise by $0.10-$0.20/MMBtu for every billion cubic feet a day in export demand. That points to a rise of $0.15-$0.30/MMBtu (against a likely base price of $4-6) if the facility ultimately sells LNG at full capacity.

Analyses also have typically suggested that somewhere between 50 and 80 percent of exported LNG would come from new production, rather than displaced domestic demand. That translates to 0.7-1.1 bcf/d in additional production. That’s equivalent to between 1-2 percent additional U.S. natural gas supply. With shale gas currently contributing about 30 percent of U.S. gas production, it’s about a 4-6 percent increase in U.S. shale gas output.

This increase will be the main source of environmental hazard – the climate impact of Freeport-sized exports will be very small.

What about broader economic impacts? Scaling from a study I published a year ago, my instinct is that this is good for the U.S. economy, but ultimately adds less than a billion dollars a year to GDP, and supports perhaps on the order of 10,000 jobs (many of which would employ people who would have been employed elsewhere otherwise). Most of this job growth would be in gas production and related industries. An export plant of this scale will also likely employ a couple thousand people at the peak of construction.

How about destinations? Freeport has contracted with BP for half of its capacity and with Osaka Gas and Chubu Electric (both Japanese) for the other half. At least half the output, then, would likely be headed to Asia. It’s also quite possible that much of BP’s capacity would be used to ship LNG to Asia too. This would help Asian buyers gain a bit more leverage with their traditional suppliers, and diversify their risks, but as I argued in congressional testimony a few weeks ago, it’s highly unlikely to be revolutionary. That’s particularly true if you’re looking at just one plant.

All told, this approval is good news, with benefits to U.S. relations with other countries even if Freeport never sells a drop of LNG, and the potential for some broader gains if it does. It also reinforces the importance of getting environmental protections right as shale gas production expands.

The problem, as many readers of this blog know, is that it’s never clear what time period one should focus on. Methane may have a 20-year GWP of 72, but it also has a 100-year GWP of 25. Which one should analysts use when thinking about the dangers posed by short-lived forcers?

An EPA working paper that I wish I’d read when it was published in January 2011 (it was also published as a peer-reviewed paper in Energy Policy in 2012) suggests a useful way of thinking about this. Instead of focusing on how much heat is trapped, we should be looking at how much damage is done.

There’s a huge literature aimed at estimating the damage done by a ton of carbon dioxide, a quantity known as the social cost of carbon (SCC). The literature is highly controversial, in part because damage estimates are uncertain, but also because the results depend sensitively on how deeply you discount the future economic impact of emissions. When the U.S. government estimated the SCC in 2010, for example, it found a value of $21 per ton. But had it assumed a discount rate of 5 percent rather than 3 percent, the answer would have come out at $5, and had it assumed a discount rate of 2.5 percent, the SCC would have been $35. Moreover, had it focused on the 95^th percentile of potential damages, it would have found an SCC of $65.

Here’s the neat thing that makes looking at damages a great way to think about short-lived forcers: the estimated damages caused by short-lived forcers are a lot less sensitive to the discount rate. That’s because they’re concentrated in the near future, which makes them less sensitive to the choice of discount rate. That makes it easier to approach agreement on what the social costs of short-lived forcers are.

So what’s the upshot? According to the EPA authors’ paper, if you assume a 5 percent discount rate, methane is 39 times as damaging as carbon dioxide when integrated over time; if you assume a 3 percent discount rate, methane is only 25 times as damaging, similar to the ratio suggested by the 100-year GWP; and if you assume a 2.5 percent discount rate, that factor drops to 21. (The ratio would be even smaller for the ultra-low discount rates that some have encouraged.) A similar pattern would prevail if one modeled other short-lived forcers. Moreover, if you focus on the 95^th percentile damages, you find methane is 27 times worse that carbon dioxide.

Those who claim that climate impacts from carbon dioxide emissions are well above the $21 figure used by the U.S. government typically argue for low discount rates and high-end damages to justify their stance. In order to be self-consistent, then, they should be treating methane and other short-lived-forcers based on something closer to their 100-year (or longer) GWPs than the 20-year ones that have become popular in some quarters in recent years.

Some analysts have responded by pointing out that low prices don’t signify failure per se. They’re correct up to a point. The goal of a cap-and-trade system is supposed to be to drive emissions down to preset levels at the lowest possible cost. If achieving those goals turns out not to require much effort, then carbon prices are supposed to fall, signaling to the energy system that it ought not work too hard. That’s what’s happened in Europe: a weak economy has reduced emissions already; the cap-and-trade market is telling power producers not to push too much more. Indeed this is a great feature of cap-and-trade, because it makes the system countercyclical, lowering costs when the economy is it its weakest.

But this analysis alone shouldn’t be satisfactory. The European experience is revealing (or, depending on your previous beliefs, reinforcing) a basic problem with cap-and-trade.

The problem underlying the European predicament is that politicians apparently don’t want to do all that much about climate change, at least not if they’re going to pay a price with voters. Alas cap-and-trade makes climate-change curbing effort highly visible: the more you’re trying, the higher the price of permits is, and the higher electricity prices rise as a result. Roger Pielke has pointed out repeatedly that consumers really don’t like this sort of thing. And as David Victor has argued, that makes politicians inclined to pursue policies whose costs are hidden rather than clear. The current experience with the ETS gives both of their arguments some reinforcement. The fundamental problem in Europe right now isn’t that cap-and-trade is a technically flawed mechanism; it’s that politicians don’t want to act strongly on climate change. And the fact that acting strongly through cap-and-trade is likely to inflame political opposition means that the centrality of the ETS to European policy doesn’t help if implementing an ambitious policy is your goal.

Would the same thing that’s happening in Europe have happened had cap-and-trade been implemented in the United States? The Waxman-Markey bill mandated a 3 percent emissions cut from 2005 levels by 2012; that would have been met with a zero carbon price. And it is extremely unlikely that U.S. policymakers would have stepped into push up carbon prices. In principle, though, this would have been mitigated by two features of the U.S. system: a long time horizon (targets were set through 2050) and permit banking that should have created an incentive to hoard permits today for use later, pushing up near-term carbon prices and driving near-term investments. Whether that dynamic would have actually happened the way I’ve described would have depended strongly on how credible people thought that system was; any threat that it would be weakened or scrapped would have reduced the incentive to hoard and kept carbon prices low.

What should all this teach us? One thing it should do is reinforce that a serious and transparent carbon price may be much tougher to pursue that clumsy and less cost-effective carbon policies. It also suggests, though, that in crafting a carbon policy, it may make sense to make lots of the tough decisions at once — a la Waxman-Markey with its targets through 2050 — rather than forcing politicians to repeatedly do things that voters dislike (e.g. tighten or extend emissions targets, as the European scheme ultimately requires). Alas these two lessons work against each other, since forcing larger numbers of difficult decisions to be made up front makes a policy less likely to be adopted in the first place. All of this suggests that, if we’re going to get serious about climate change, it will likely take considerably more than just carbon pricing in order to succeed.

Clean energy trade. The United States has adopted a strong stance against others’ restrictions against clean energy trade and investment. Most recently, it challenged local content requirements in India’s solar program. Several colleagues and I wrote a couple years ago about the pitfalls of taking too hard a line here: there’s a delicate balancing act to be played between capturing the benefits of open trade and letting countries create the political conditions required to boost clean energy use.

Natural gas exports. This is Department of Energy territory: a host of companies have applied for permission to freely export natural gas, and DOE will say yes or no. But if permit applications start being rejected, there’s a real potential for WTO lawsuits against the United States, which would land the issue over at USTR. In any case, one can only hope that USTR will be involved up front, since a decision against exports would have broader reverberations for U.S. trade relationships.

Carbon tariffs and U.S.-EU trade talks. Americans who have only focused on climate change in the last few years might be forgiven for believing that carbon tariffs are something that Congress considered using in conjunction with a cap-and-trade scheme to make sure that China wouldn’t get an unfair competitive advantage. But the idea originated more prominently in Brussels and Paris around 2008 as a way to protect Europe against the United States, and to prod Washington to impose its own carbon pricing. I wouldn’t be surprised to see this come back, perhaps in the context of ongoing U.S.-EU trade talks, which will undoubtedly see some in Europe ask for measures to make sure the United States doesn’t get an unfair edge.

More natural gas exports – and the TPP. Japan is set to join talks on the Trans-Pacific Partnership (TPP) trade agreement. If you’ve visited Tokyo recently, there’s a decent chance you’ve been asked whether joining TPP would give Japan special access to U.S. exports of LNG. While decisions on applications to export LNG to countries with which the United States doesn’t have special free trade agreements is housed at the DOE, a decision on whether to give Japan special access as part of a trade deal will need to run through USTR.

Europe’s aviation scheme. European efforts to expansively include foreign airlines in its Emissions Trading Scheme didn’t go down well in most of the world. Ongoing negotiations are aiming to find an alternative approach agreeable to all the major players. Froman and Todd Stern (at State) have been leading this for the United States. I have a tough time believing that a move to USTR will leave him less involved.

Wildcards? Oil exports (again, not a USTR decision, but with consequences for trade relationships), potential NAFTA fallout from a Keystone XL decision, border adjustment measures accompanying a (highly unlikely) U.S. carbon tax, and I’m sure much more.

May 2, Washington, DC: “The Power Surge”. I’ll be in conversation with Steve LeVine at the New America Foundation. This is the first event squarely about the book.

May 9, New York, NY: “In Print featuring Michael Levi – The Power Surge”. I’ll speak with former Foreign Affairs editor (and great reader) Jim Hoge about the book.

May 29, Calgary, AB: “Is Canada Becoming an Energy Superpower?”. A debate (I mostly say no) involving Ed Morse, myself, and a couple others. Not quite about the book, but I’m sure we’ll get into some closely related issues.

June 18, Dallas, TX: Details to come.

June 19, Houston, TX: “The Power Surge: Energy, Opportunity, and the Battle for America’s Future”.

June 20, San Francisco, CA: Details to come.

More cities and dates are in the works. I’ll also be doing some less-public speaking, at the Milken Global Conference, Aspen Ideas Festival, and the Council on Foreign Relations in New York, DC, and elsewhere. I hope to see some blog readers at these events!

Which view is right? Exploring a set of simulations just released as part of the Annual Energy Outlook published by the Energy Information Administration (EIA) provides some neat insight. For the first time, the EIA simulates not only the impact of low natural gas prices and the impact of carbon pricing but also what happens when you combine the two. The results are really interesting.

The plot below shows the two natural gas price assumptions that the EIA looks at. (I made all the plots using the EIA’s awesome AEO Table Browser.) The high natural gas price scenario is based on what analysts currently believe the natural gas resource looks like. The low price scenario results from assuming that each gas (and oil) well yields twice as much fuel as currently believed; well spacing declines so that more wells can be packed into a given area; and undiscovered oil and gas resources are 50 percent higher than currently assumed, among other tweaks. Expected prices, you’ll notice, diverge pretty sharply over time.

If you assume no price on carbon, you end up with the emissions in the figure below. Super-cheap natural gas cuts emissions (though barely) for the next couple decades. After that it actually begins to make things (barely) worse.

The next figure shows what happens when you put a modest price on carbon. Here the assumed carbon price is ten dollars a ton starting in 2013 and rising 5 percent annually through 2040. Now what you find is that cheap gas consistently helps. The carbon price cuts emissions relative to business as usual – but the carbon price combined with cheap gas does even more.

Things get even more interesting, though, when you step the carbon price up a bit. The next figure assumes that a carbon price starts at fifteen dollars in 2013. (The other details remain the same.) Now we’re back to a pattern that’s a bit more like the reference case: Cheap gas helps for the next couple decades before becoming a climate liability later.

Perhaps the most interesting chart, though, is the final one, displayed below. It shows what happens when you’ve got a carbon price that starts at twenty-five dollars in 2013. Now low natural gas prices help, though almost imperceptibly, for the next decade. After that, though, they actually hurt, and by the time you get out to 2030 and 2040, the penalty imposed by cheap gas becomes pretty large.

There are, as usual, caveats galore here. This is one model, and one set of technology and market assumptions, so its results should be treated with great care. It says nothing about the costs of emissions reductions — and abundant natural gas can make hitting the same emissions trajectory cost less. Moreover different people will interpret these figures in differing ways. Some will say the results they show that natural gas is bad news (at least in the long run) for climate change. Other will argue that they offer a series of misleading comparisons: in a world with cheap natural gas, it may be more politically feasible to impose a higher carbon price, and if that’s true, cheap gas could still mean considerably lower long-run emissions. A third camp (undoubtedly dominated by economists) might argue that these projections simply show that cheap natural gas might make a rational carbon policy consistent with higher emissions than it otherwise would be.

Who’s right? That’s a tough question. There’s a lot more to be analyzed here, and even more that’s probably not amenable to neat and clean analysis. What’s for certain, though, is that the consequences of natural gas for U.S. emissions are more complex and intriguing than most people have assumed.

• Better vehicle efficiency, cheaper car technology, higher fuel economy standards through 2040, better batteries, and less driving
• More natural gas in every transportation mode (truck, rail, etc), and more conversion of natural gas and coal into liquid fuels
• All sorts of successes for biomass-based fuels
• Shale gas and tight oil wells each produce twice as much oil as is currently expected and wells are able to be spaced much closer together
• Colorado oil shale and Alaska tight oil get developed
• There is 50 percent more undiscovered oil in the United States than currently believed

This is a pretty mind-boggling set of stars that would need to align. (And that’s setting the environmental consequences aside.) The EIA model, of course, only reflects one possible future; others surely will offer alternative schemes, including ones that push harder on the demand side and get less out of new supply. Still, it’s a useful reminder of how far away we are from energy self-sufficiency, and the leaps one needs to make to reveal a path that would take us there.

There’s also one more assumption that’s less prominently discussed in the EIA scenario: despite the spectacular turnaround in U.S. fortunes, the price of oil barely falls relative to the central case, remaining near or above $100 forever and reaching $220 in 2040. That’s essential to keeping U.S. demand suppressed while facilitating new supplies. In an excerpt from my forthcoming book published by Bloomberg View on Wednesday, I look at whether big gains in U.S. oil production could permanently crash world prices, and express doubt at that prospect. But if you take the sort of scenario that the EIA has outlined, and assume that other countries will see similar changes of fate, it becomes increasingly tough to see how the world can square that much supply growth with plausible world demand. At some point, something in the various scenarios that people are dreaming up will need to give.

One more interesting note on the EIA no-imports scenario, on which I’ll have more to say later: despite cranking up every source of petroleum under the sun, the scenario actually projects lower U.S. greenhouse gas emissions, a result of reduced fuel demand. The second Bloomberg View excerpt from my forthcoming book (the third will run on Friday) gives some insight as to why. It also gets briefly at the broader (and more fundamental) question of what the global consequences of growing U.S. oil output will be for climate change.

The Problem

Let’s quickly recap what’s going on. The EPA has mandated that an increasing amount of ethanol be blended into fuel. Because U.S. fuel use is declining, if it were blended uniformly, the fraction of ethanol in fuel would likely exceed 10 percent, the so-called “blend wall” beyond which many U.S. vehicles can’t use (or at least are wary of using) the fuel. The resulting dynamics could, in principle, drive up prices for Renewable Identification Numbers (RINs), an instrument that refiners and blenders need to submit in order to demonstrate RFS2 compliance. That could push fuel prices way up.

As several people have noted, the way around this is to grow sales of E85, a blend of 85 percent ethanol and 15 percent gasoline that a subset of U.S. vehicles (flex-fuel cars and trucks) can use. If, say, the EPA effectively mandates that the U.S. fuel supply should be 11 percent ethanol, one way to meet that would be to have (roughly) 99 percent of fuel sales be E10 (10 percent ethanol) and the other 1 percent be E85. This would avoid the blend wall and let the mandate do its job.

The biggest problem that analysts have with this is that E85 has never been a significant seller. That’s largely because it’s always been more expensive than E10 or plain gasoline on an energy-equivalent basis. Very few are going to buy E85 if it costs more.

Barriers to E85

In a fascinating draft paper (“The Blend Bump”, forthcoming later this month), Phil Verleger points out something important: as RIN prices rise, it should become profitable to sell E85 at an ever greater discount. When you sell E85, you generate a large volume of RINs, most of which you don’t need to comply with your mandate obligations. You can sell that RIN surplus to refiners and blenders who sell E10 or pure gasoline and who need more RINs in order to meet their obligations.

How high would RIN prices need to rise to pump up E85 sales? A precise estimate is difficult. As Verleger notes, however, it’s pretty easy to establish an upper bound by asking a simple question: how valuable would RINs need to be to persuade companies to give away E85 for free? He estimates that, given current ethanol prices, RINs would need to sell for $3.50 to make that happen on the spot market, and for $5.00 to get sellers to give away the stuff at retail too. If RIN prices rose to $3.50, it would increase the prices of fuel by about 35 cents. Since this is an upper bound, one should in principle expect prices to rise by less than that – Verleger estimates that, given current RBOB gasoline and ethanol prices, if all it took to push E85 into the market was a 10 percent discount to E10 on an energy-adjusted basis, RINs would only need to sell for about $1.18 for the system to work.

What I find particularly interesting about Verleger’s paper, though, is the next step: it asks whether there might be reasons that this dynamic could fail to unfold. He flags three factors but highlights one particularly critical one. When a company sells E85, they generate surplus RINs immediately. They are unlikely, however, to find an immediate buyer, since most refiners and blenders wait until closer to the end of each compliance year to buy the RINs that they need. In the interim, the E85 sellers face a serious regulatory risk: given growing calls from parts of industry and Congress to investigate the RFS2, they have legitimate reason to worry that the mandate will be waived or watered down. In that case, their RINs will lose value, and their E85 gambit might fail to pay off. Given that prospect, they might not sell E85 (and generate lots of RINs) in the first place. In that case we’d stuck with the sort of debacle that many have warned of.

A Safety Valve?

That leads to my own suggestion for a possible policy tweak. We need a way to increase the credibility of the mandate without risking an unacceptable price spike. If E85 sellers can be made confident that the RFS2 will be sustained, there’s a decent chance that they’ll sell a substantial volume of their product, and that the RFS2 will be met. (No one can know for sure, though, particularly because there many not be enough E85 pumps to ramp up sales quickly enough.) If they are afraid that the mandate won’t hold, though, they won’t sell much E85; their predictions will become self-fulfilling, as fuel prices rise strongly and politicians react by severely weakening the mandate.

Congress could largely eliminate this latter possibility by adding a safety valve to the RFS2: it could commit the U.S. government now to selling an unlimited quantity of RINs in the future at some preset price. That price would need to be set high enough to keep E85 sales profitable.  If, for example, the safety valve were set somewhere between $1 and $2, strong incentives to sell E85 at a discount would probably remain, since sellers might be able generate decent volumes RINs for less than the safety valve price that way. (Picking a precise level for a safety valve would require considerably more robustness analysis than this blog post permits.) And if people are right that E85 provides a smooth way around the blend wall, no one will ever need to buy RINs from the government in the end. At the same time, the price would need to be set low enough to reassure everyone that the RFS2 won’t raise fuel prices too much, even if E85 fails to penetrate the market strongly. That would remove the risk that scared policymakers would drastically weaken the mandate or waive it entirely, again helping E85 sellers gain confidence. The same $1-$2 price could do that: it would allow fuel prices to rise by no more than 10-20 cents.

Some will find this idea odd: wouldn’t a floor price for RINs, rather than a ceiling, be the best way to incentivize more production of E85? The essential thing to keep in mind here is that the goal of the tweak would be to reinforce the political credibility of the RFS2, and then to let the market work. A ceiling, not a floor, is what’s needed to do that.

To be certain, it’s far from clear that the RFS2, even with this tweak, would pass a cost-benefit test. The current situation should also provide lessons on how not to design mandates (more on that in another post). But with the mandate in place, there could be serious damage from deeply weakening it, since that would harm the credibility (and hence effectiveness) of any future mandates. That should be reason enough to look for careful ways of modifying the mandate that protect consumers while maximizing the odds that it will survive largely intact.

Exhibit A is a long essay this past Sunday in the New York Times by one-time Reagan budget guru David Stockman in which Stockman opens fire on everything he thinks is wrong with the U.S. economy. A lot of it is way out there, but for the most part, he at least goes after big targets: the debt, the dollar, and so on. Yet he somehow finds time to repeatedly go after the “nearly $1 billion giveaway to crony capitalists” that, he says, the “ruinous” green stimulus was. But how on earth can one billion dollars (you can almost hear Dr. Evil saying it) be ruinous? Even if you just burned that kind of money in a bonfire (which, to be clear, I’m not suggesting we do), is just can’t do all that much damage.

Exhibit B starts to explain what’s going on. In my forthcoming book The Power Surge (official publication in a month), I quote from Stockman’s memoir: “The ‘moral equivalent of war’ [a term that Carter had used to describe the energy crisis] and its attendant issues was really a front for state control of resources and the economy…. The current glut of oil on the world market [Stockman was writing in 1986] is eloquent refutation of how idiotic their position was, but at the time they were prosecuting their views with a determination befitting the smallness of their minds.” Here is energy spending as symbol rather than substance. The Obama administration could spend a trillion dollars or a hundred dollars on clean energy; to Stockman, and to many others, it’s all the same symbol of a disastrous approach.

Exhibit C is the broad reaction to President Obama’s proposal for an “Energy Security Trust”. It shows how the sort of attitude reflected in Stockman’s essay can get in the way of pragmatic deal-making on energy and climate. There is reasonable debate over whether such a trust, which would deploy funds devoted to support innovation on alternative fuel technologies, should be funded by revenues from any new oil and gas lease sales or only from lease sales that involve currently restricted lands. Those who say that they will only support the Trust if new lands are opened to drilling are taking a defensible position. But others are going a lot further. The Wall Street Journal has called the Trust an “Energy Security Trap” that would draw Republicans into supporting wasteful subsidies. An analyst at the Heritage Foundation has been even more blunt, writing that “Congress should reject the creation of a new pot of money for subsidies—whether tied to new exploration or not.” Now, last I checked, both the Journal and Heritage were pretty darn enthusiastic about new oil and gas production. I have no reason to doubt their sincerity when they write excitedly about the massive economic and security benefits that they expect oil and gas will deliver (though I quibble on some of the substance). So here’s what I don’t get: why on earth wouldn’t spending – even wasting – a piddling $200 million a year on alternative energy be a price worth paying for making real progress on the oil and gas production front?

The answer is the same one that’s revealed in Stockman’s essay and memoir. It’s the mirror image of the attitude in some corners of the environmental community that says no oil-and-gas-for-something-on-climate trade could ever be worthwhile. Both attitudes, in their extreme form, are a serious problem if you think that progress on energy will require compromise.

The basics of what’s happening are broadly agreed. There is controversy over whether large numbers of U.S. cars can safely use fuel that contains more than 10 percent ethanol. For all practical purposes, then, refiners and blenders don’t want to use more than 10 percent ethanol in the fuel they produce. Meanwhile, the RFS2 is mandating increasing use of ethanol – and, because of high gasoline prices and improving fuel economy, total U.S. fuel consumption is falling at the same time. This squeeze from both sides means that the United States has hit the “blend wall” – the point at which it can’t use any more ethanol without breaching the 10 percent threshold – far earlier than anyone expected. It is impossible to comply with the volume requirements of RFS2 and avoid the blend wall at the same time.

For the time being, though, there’s a way out. In years when ethanol producers make more ethanol than the mandate requires, they generate a surplus of something called Renewable Identification Numbers, or RINs. They can bank those for the next year. Before 2012, when ethanol subsidies stopped, producers built up a surplus of RINs; part of that surplus remains. Blenders and refiners can buy these RINs instead of actually blending ethanol into their fuel. That’s how they’re dealing with the current crunch: they’re buying RINs instead of blending the full mandated volume of ethanol. The problem is that there’s a limited supply of RINs, so prices for them have skyrocketed. It’s those super-high RIN prices that people are now blaming for higher prices at the pump.

The big question is this: How much are high RIN prices actually inflating fuel prices? And how might that impact evolve? The new industry association paper claims that the impact is tiny, and that, once you factor in the relatively low price of ethanol, RFS2 is still producing net benefits for consumers. But their analysis doesn’t hold up.

Let’s start with the biggest whopper. The white paper observes that wholesale gasoline (they measure this in Chicago) was $2.81/gallon on average this year, while wholesale ethanol cost $2.37/gallon. They thus claim that blending ethanol into gasoline lowers prices. Set aside for a moment some subtle issues about how prices are set; what’s amazing here is that they apparently don’t account for the fact that a gallon of gasoline has 50 percent more energy than a gallon of ethanol. Blending ethanol lowers the price of a gallon of fuel – but that gallon of fuel now gets you less mileage in your car. The net result is to increase the cost of driving. Claiming in this way that ethanol blending lowers fuel costs is like claiming that buying smaller boxes of cereal lowers the cost of getting yourself a nutritious breakfast.

Now for the more complicated part: the RINs. The industry white paper estimates the number of RINs that will need to be purchased in order to meet the RFS2 mandate and spreads their cost across the full U.S. fuel supply; they use that to estimate a price increase of between $0.004 and $0.02 due to RIN purchases. But prices aren’t set by average costs. What sets the price of fuel at the pump is the marginal cost, i.e. the cost of the most expensive gallon of fuel that’s sold. The big question, then, is what that marginal gallon is. The answer is either (a) a gallon of gasoline plus an appropriate volume of RINs, or (b) a gallon of fuel that’s a mix of gasoline and ethanol. (Perhaps it could be something in between too.) I can’t quite wrap my head around the answer –that might be the subject for another post or a real study (or someone will email along a good analysis) – but it certainly isn’t what the industry white paper claims. My instinct is that if the answer isn’t (a), things will eventually end up there, since the cost of ethanol is bounded above, while the price of RINs isn’t. And, if that’s right, we may see a big pump price run-up before too long.

It’s critical that we think through this now. At some point in the not-too-distant future, unless U.S. fuel demand rebounds, the surplus of RINs will presumably be exhausted. At that point all bets are off when it comes to the market impacts. Best to figure this out now, and come up with good policy adjustments if those are needed, rather than deal with this when things are much worse.