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Chapter 5 Biofuels Subsidies INTRODUCTION This chapter examines the greenhouse gas (GHG) impacts of federal bio- fuels policies: excise tax credits for ethanol and biodiesel, the tariff on ethanol, and the federal renewable fuels standard. Although the tax credits and the tariff have expired, the renewable fuels standards are playing an increasingly im- portant role in the motor fuels sector. The committee devoted considerable atten- tion to the taxation and regulation of biofuels for three principal reasons. First, ethanol credits have been widely used in the United States and abroad, have been among the largest energy-related tax expenditures in revenue foregone, and their impacts on GHG emissions are important public policy questions. Second, the results illustrate the often-unintended impact of tax expenditures, because of the complexity of the regulatory and interindustry feedbacks. Third, the biofuels standards interact significantly with motor fuels taxes and the use of petroleum. The tax provisions need to be analyzed in the context of the regulatory framework. The federal mandates for biofuels production arising from the Ener- gy Policy Act (EPAct) of 2005 and the Energy Independence and Security Act (EISA) of 2007 established requirements for the volume of renewable fuels that must be blended into transportation fuels. EISA, the currently binding policy, schedules the amount of required biofuels to increase from 9 billion gallons in 2008 to 36 billion gallons by 2022. The committee’s analysis finds that these regulatory mandates severely constrain the magnitude of the impacts of the tax incentives. FINDINGS FROM PRIOR LITERATURE Most studies analyzing the impacts of biofuels do not directly consider the GHG effects of specific tax code provisions. There are, however, several studies 91

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92 Effects of U.S. Tax Policy on Greenhouse Gas Emissions that consider important interactions between the tax code, renewable fuels man- dates, and crop price supports (Gardner, 2007, and Schmitz, 2007). Those stud- ies find that the Renewable Fuel Standard (RFS) mandates are more effective than the tax incentives, and furthermore that the RFS effectively limited the im- pact of the tax incentives on renewable fuels production and consumption (de Gorter, 2008). One study also found that the crop price supports for ethanol feedstocks, such as corn, combined with quantity mandates for ethanol may lead to an increase in petroleum consumption, similar to the results of our modeling efforts reported below (de Gorter, 2010). Beyond these studies, much of the rest of the literature focuses on ques- tions of whether or not ethanol production and consumption leads to a net in- crease or decrease of GHGs per Btu of fuel (75 Fed. Reg. 14760 [2010]; Yacobucci, 2010; Gelfand, 2011). While not directly linked to the impacts of specific tax provisions, such literature is still informative in determining whether those impacts are likely to be net positive or net negative (Mosnier et al., 2013). PROVISION-BY-PROVISION ANALYSIS BIOFUELS CREDITS AND ETHANOL TARIFF Legal Description Prior to 2013 the Internal Revenue Code (IRC) provided three income tax credits for alcohols used as a motor fuel. Fuel alcohols blended with gasoline or used pure as a fuel both qualified for a $0.45 per gallon credit under the Volu- metric Ethanol Excise Tax Credit (VEETC). Gasoline suppliers that blend etha- nol into their fuel could take this credit as an instant rebate against motor fuels excise tax liability or as a nonrefundable credit against their income tax liability, if any, for a given year. In practice, nearly all taxpayers preferred to claim the excise credit. Doing so immediately captured the credit’s benefits and eliminat- ed the risk of not having sufficient income tax liability to fully utilize the credit. While the law made the credit available to several types of alcohol, ethanol was and remains the principal alcohol used as motor fuel in the United States. Eth- anol from small producers qualified for a $0.10 per gallon credit. This credit was limited to the first 15 million gallons of annual ethanol production from producers capable of distilling less than 60 million gallons per annum. Producers of cellulo- sic biofuels received a $1.01 per gallon income tax credit until December 31, 2012, one year after the expiration of the general ethanol income tax credits. The cellulosic producer credit is commensurately reduced by the amount of any other tax credits applied to the fuel. For instance, if the VEETC is applied to the blender, the net producer credit is $1.01 $0.45 = $0.56 per gallon. Cellulosic biofuels are defined as any liquid fuel produced from any lignocellulosic or hemicellulosic

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Biofuels Subsidies 93 matter that is available on a renewable or recurring basis. Common sources for cellulosic biofuels include switchgrass, corn stover, and wood chips.1 The IRC provided similarly structured credits for biodiesel until December 31, 2011. Each gallon of biodiesel was eligible for a $1.00 per gallon credit while small agri-biodiesel producers, defined by the same volumetric limits as small ethanol producers, were eligible for a $0.10 per gallon credit. Agri-biodiesel refers to biodiesel made using virgin oil instead of reclaimed oil. Ethanol Tariff In addition to tax credits, a $0.54 per gallon ethanol tariff on imported eth- anol historically benefitted the U.S. ethanol industry by reducing the competi- tiveness of imported ethanol. The tariff was originally intended to prevent im- ported ethanol from benefitting from the U.S. tax credit. The ethanol tariff expired on January 1, 2012. The tariff’s expiration will primarily benefit Brazil, which has a large ethanol industry based on sugarcane. The energy produced by ethanol compared with the energy invested in its production (the energy return on energy invested) is higher for the sugarcane ethanol produced in Brazil than it is for conventional (corn-based) ethanol in the United States (75 Fed. Reg. 14760 [2010]). Thus, from a global perspective, the expiration of the ethanol tariff can be expected to increase the Brazilian sugarcane share of the U.S. etha- nol market and thereby decrease the GHG emissions from ethanol fuels used in the United States. Pathway to GHG Impact The various tax credits lowered the cost of biofuels and therefore should have encouraged their substitution for petroleum motor fuels. Because biofuels are almost always sold as a blend with petroleum fuels, however, the subsidies also effectively lowered the final delivered price of the petroleum-biofuel blend, thereby encouraging additional consumption of petroleum. Although the litera- ture shows a range of estimates for life-cycle GHG emissions from all biofuels, depending on whether agricultural practices and soil-based carbon is considered, most studies suggest reduced emissions for biofuels compared with petroleum- based analogs. Cellulosic ethanol shows significantly greater GHG reductions than corn-based ethanol, and may not be subject to the food-fuel substitution criticism often leveled at corn-based ethanol. The Environmental Protection Agency (EPA) estimates a much greater reduction in life-cycle GHG emissions from cellulosic ethanol than the reduction in life-cycle GHG emissions from 1 Kelsi Bracmort, Randy Schnepf, Megan Stubbs, and Brent D. Yacobucci, Cellulosic Biofuels: An Analysis for Congress, Cong. Res. Serv. Rep. RL34738 (Oct. 14, 2010), at 1. Internal Revenue Code Sections 40, 40A, 4041, 4081, 6426 and 6427(e).

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94 Effects of U.S. Tax Policy on Greenhouse Gas Emissions corn-based ethanol. The analysis in this chapter uses the standard EPA emission factors for different fuel types (75 Fed. Reg. 14760 [2010]) to estimate the net GHG effects and examines the sensitivity of the results to variation of these emission factors. Fiscal Impact Expenditures on biofuels subsidies represent only a small tax expenditure if measured solely by lost income tax revenue. Ignoring the recently expired excise tax credits, the Treasury Department and Joint Committee on Taxation estimate the 2010 tax expenditures on ethanol and biodiesel at $90 million and $100 million, respectively. Including the subsidy provided through the excise tax system, those estimates increase to $6.26 billion and $5.2 billion. Either of these estimates was the largest of the energy-related tax expenditures estimated by either group, and though small compared with broad-based tax expenditures such as that for the exclusion of employer-sponsored health care, are still sizable impacts to the Treasury. Renewable Fuels Standard Although not a tax provision, the Renewable Fuels Standard is an im- portant set of regulatory mandates that substantially affect biofuel use in the United States and thus must be included in the evaluation of the tax provisions outlined above. The RFS, created by Congress under the Energy Policy Act of 2005 (P. L. 109-58), established the nation’s first mandate for renewable liquid fuels. The original RFS program (commonly referred to as RFS1) required 7.5 billion gallons of renewable fuel to be blended into gasoline by 2012. The man- date was expanded by the Energy Independence and Security Act of 2007 (P.L. 110-140), and is now commonly referred to as RFS2. RFS2 expansion of the program included the following:2 It included diesel, in addition to gasoline; It increased the volume of renewable fuel required to be blended into transportation fuel from 9 billion gallons in 2008 to 36 billion gallons by 2022; It established distinct categories of renewable fuel, and sets separate annual volume requirements for each one (by 2022): o Conventional biofuels (e.g., corn-based ethanol): 15 billion gallons maximum 2 More information on the program can be found in the Congressional Research Ser- vice Report (Schnepf and Yacobucci, 2013) or on the EPA Web site (http://www.epa. gov/otaq/fuels/renewablefuels/index.htm).

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Biofuels Subsidies 95 o Advanced biofuels: 21 billion gallons minimum, including the fol- lowing minimums for specific advanced categories: Cellulosic ethanol (16 billion gallons) Biodiesel (1 billion gallons, or to be determined by U.S. EPA) Other advanced biofuels (e.g., sugarcane ethanol) may fill the gap between the cellulosic and biodiesel minimums and the 21 billion gallon total advanced biofuel minimum. It required EPA to apply GHG performance thresholds for each re- newable fuel category, so that each fuel would have demonstrated lower GHG emissions than the petroleum fuel it replaces (e.g., gaso- line or conventional diesel). This study examines the interaction of the RFS with the tax provisions by initially assuming that the RFS2 will remain in effect as stipulated by current law. Then alternative modeling results will be generated assuming the RFS is not in place in order to gauge the interaction effects between the tax provisions and the RFS mandates. Modeling Approach and Key Assumptions A large variety of approaches have been used to examine the economics of biofuels and biofuel policy. These include general equilibrium models (Gurgel et al., 2007; Tyner et al., 2010; Decreux and Valin, 2007), agricultural optimization models (Adams et al., 1996; Beach and McCarl, 2010), simulation models (Wise et al., 2009), and econometric-based simulation models (Babcock and Carriquiry, 2010). There are several challenging aspects of modeling biofuel policy: (1) the complex interactions with agriculture and agricultural policy, including compet- ing demands for crops and by-products supplies of animal feeds; (2) the com- plex policy requirements of the Renewable Fuel Standard (RFS2, as described below) and their interaction with investment and production tax credits that dif- ferentially treat different biofuel production pathways and feedstocks that are the focus of this report; (3) international linkages in agriculture and energy markets; (4) land-use change and competition for land; and (5) the carbon implications of land-use change. This chapter reports results of variations in biofuel-related federal tax pro- visions simulated using two different models: (1) the Food and Agricultural Pol- icy Research Institute at the University of Missouri (FAPRI-MU) model and (2) the National Energy Modeling System as run by OnLocation, Inc., for the Na- tional Academy of Sciences (NEMS-NAS). The chapter will focus initially on FAPRI-MU, because of its unique coverage and detail of the U.S. and world agricultural and motor fuel sectors. NEMS-NAS results will be shown as a sen- sitivity case later in the chapter.

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96 Effects of U.S. Tax Policy on Greenhouse Gas Emissions The FAPRI-MU model as employed here is a system of demand and sup- ply functions for 16 crops, 15 crop-based products, and 17 different types of livestock and livestock-based products (Meyers et al., 2010; Devadoss et al., 1993). Some of these functions are econometrically (statistically) estimated from historical data, while other functions are based on assumed forms and parameter values. In particular, the rapid changes in biofuel markets make direct estimation based on observed behavior difficult. A good example is E85 demand, which can be very important in future market projections but has not accounted for more than a very small amount of biofuels consumption in the past. The esti- mates are updated periodically using the most recent available data. FAPRI-MU’s focus is on the United States, with the rest of world either collapsed into a single rest-of-world supply-and-demand response, as in the case of animal products; composed of a similar rest-of-world aggregate response but with key countries identified, as in the case of ethanol; or represented with ag- gregate rest-of-world supply-and-demand aggregates, as in the case of main crops. This longstanding agricultural model has been recently augmented to in- clude detailed modules on oil markets (Thompson et al., 2011) and U.S. biofuels markets (Thompson et al., 2008). The strength of the model is in its detailed representation of agricultural markets, including global markets, modeling of the complex Renewable Identification Number (RIN) fuel credits with multiple fuel production pathways representing both conventional and advanced-generation processes, and links to global petroleum and refined fuel markets (Thompson et al., 2010). The FAPRI-MU approach does not explicitly consider land use or the car- bon implications of land-use change. These are highly uncertain responses with wide-ranging results in the literature (Plevin et al., 2010; Searchinger et al., 2008; Keeney and Hertel, 2009; Tyner et al., 2010; Hertel, 2011; Mosnier et al., 2013; and Melillo et al., 2009). Instead, the greenhouse gas implications of al- ternative policies are assessed by applying a fixed GHG coefficient per unit of fuel for different biofuel production pathways. Calculations are based on three sets of GHG emission factors based on differing assumptions about life-cycle energy use and indirect land-use change factors (ILUC). The default coefficients are the thresholds values stipulated in the EISA legislation for each fuel type. Alternative coefficients are evaluated in a sensitivity analysis included in the results discussion below. The FAPRI-MU model is benchmarked to government projections for en- ergy and agriculture, and is resolved annually for a 10-year period (2011 to 2021). For energy, the model is benchmarked against the Energy Information Administration’s (EIA) 2012 Annual Energy Outlook (AEO) for petroleum and refined oil markets until 2011, but AEO 2011 petroleum prices and other key variables guide the projections for consistency with the other modeling analyses undertaken for this study (U.S. EIA, 2012). EIA’s Outlook assumes gross do- mestic product (GDP) grows at an annual average rate of about 2.6 percent

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Biofuels Subsidies 97 through 2022, crude oil prices rise from $109 per barrel in 2013 to $135 per barrel in 2021, and gasoline prices rise from about $3.40 to $4.40 per gallon. On the agricultural side, the short-run projections are calibrated to the U.S. Depart- ment of Agriculture’s World Agricultural Supply and Demand Estimates. Pro- jections of market components outside of those two sources are calibrated to an early version of the FAPRI-MU agricultural baseline (Westhoff et al., 2012), but the model was resolved with an extension of U.S. biofuel blenders credits, etha- nol-specific duty, and cellulosic producer credit to generate the baseline used here. The corn price is a key input to ethanol and illustrative of crop prices in general. It rises from $5.16 to 5.50 per bushel over the analysis period of 2014 to 2021. To be consistent with other chapters in the report, Table 5-1 outlines as- sumed values used in the modeling analysis for several key factors. ANALYSIS OF VOLUMETRIC ETHANOL EXCISE TAX CREDIT (VEETC), BIODIESEL BLENDER CREDIT, CELLULOSIC BIOFUEL PRODUCER CREDIT, ETHANOL-SPECIFIC DUTY Modeling Results The FAPRI-MU model, described above, is used to estimate the impacts of the identified biofuel provisions on GHG emissions and other key variables. The model simulates for the period 2011–2021 key outcomes for three core sce- narios: 1. Reference Scenario: Continuation of policies (RFS2 and other) as they were in effect at the time of analysis (March 2012) and expected changes in energy and agricultural technology, markets, and macroeco- nomic factors. 2. Remove VEETC: Identical to Reference except that the Volumetric Ethanol Excise Tax Credit is eliminated. 3. Remove all Provisions: Identical to Remove VEETC except the Bio- diesel Blender Credit, Cellulosic Biofuel Producer Credit, and Ethanol- specific Import Duty are also eliminated. TABLE 5-1 Key Modeling Assumptions Assumptions Modeling Period 2014-2021 Real GDP Growth (% per year) 2.6% Oil Price (2014-2021, avg nominal) $123.47 Energy Consumption Growth From 2012 AEO Outlook GHG Included CO2, N2O, CH4 U.S. or World? World and U.S.

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98 Effects of U.S. Tax Policy on Greenhouse Gas Emissions In this chapter, as elsewhere, we report the results of the calculations with one- or two-digit precision because that is how the numbers are reported by the economic models. The committee notes that the numerical precision of the cal- culations does not imply a corresponding accuracy of the projections or esti- mates. As we note elsewhere, the committee did not prepare statistical uncer- tainty analyses of the estimates. Comparisons across models indicate that the uncertainties are large. So readers should be alerted that reporting model output at a specific precision does not imply that the actual results are similarly precise. The reference scenario represents a projection that assumes a particular set of policies, technologies, economic, and demographic phenomena during the projection period of the model (2011-2021) and provides the starting point for analysis of alternative policies. Of particular note, the current renewable fuels standard (RFS2) is assumed to remain in place during the entire simulation period. However, the modeling exercise assumes that the cellulosic ethanol component of the mandate will be waived each year, as it has since inception of the program, due to insufficient production capacity. The exercise assumes the EPA resets the cellulosic waiver amount to the level of output that would be produced economically in response to the market price for cellulosic ethanol, the separate renewable fuels credit (RIN) price, and the value of the applicable tax credits. This will generally cause production to drop below the mandated level. A share of the cellulosic shortfall (25 percent of it) is assumed to be met by other advanced biofuels in the future, and the remainder reduces the total mandate accordingly. The first reference scenario, Remove VEETC, focuses on removing the largest of the biofuel tax provisions, VEETC, which provides fuel blenders a per-gallon tax credit for using ethanol. The second reference scenario, Remove all Provisions, assesses the elimination of all three major biofuel tax code provi- sions, along with the ethanol-specific import duty. The duty, although not ex- plicitly part of the tax code, was included because of its potential effect on fed- eral revenues and on the composition of biofuels used and the GHG consequences thereof. Table 5-2 provides a summary of key modeling results for the baseline and biofuel policy scenarios. The results are summarized by category. GHG Effects Removing VEETC alone is projected to lead to a roughly 5 MMT reduc- tion in GHG emissions, globally. There are three noteworthy aspects to this es- timate. First, 5 million tons is a very small number, roughly 0.1 percent of total U.S. GHG emissions (U.S. Environmental Protection Agency, 2012), or about one-fifth of the emissions of one very large coal-fired power plant in the United States (Center for Global Development, 2007). Thus, the VEETC provision does not appear to have a meaningful impact on GHG emissions.

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Biofuels Subsidies 99 Second, the estimate is global, as it takes into account emissions in other parts of the world due to (1) fuel market feedback effects, wherein subsidized ethanol lowers blended fuel prices, thereby increasing the demand for gasoline, which increases consumption and emissions on the margin; and (2) indirect land-use change effects, in which subsidized ethanol leads to more agricultural feedstock used for fuel, which diverts it from other uses such as food, which leads to agricultural intensification and land clearing, which generates emis- sions. The fuel market feedback effect is captured in Thompson et al., 2011. The ILUC effects, as discussed in the chapter introduction are determined by exoge- nous emissions coefficients in FAPRI-MU and can vary widely. As a result, a sensitivity analysis to these coefficient values is presented further below in this section. The third and most striking result is that the calculations indicate that the VEETC actually increases GHG emissions. The sensitivity analysis using alter- native GHG emission coefficients below will show that this result is sensitive to alternative assumptions and that the impact of the VEETC is generally very small regardless of its sign (the first point above). The second policy scenario that removes all biofuel provisions has a very small incremental impact on GHG emissions, with a central estimate of an addi- tional 0.6 MMT emissions reduction if the three other biofuel provisions were also removed. One reason for this is that the RFS2 standard is still in place when the tax provisions are removed. Thus, total biofuel use is only marginally affect- ed by the removal of the provisions, though, as shown below, the mix of biofu- els to meet the target can change in response to the provisions being dropped. Revenue Effects Removing VEETC would lower federal tax expenditures by approximate- ly $7.2 billion per year between 2014 and 2021 (were the former policy to be in place during this period). This savings comes in the form of reduced tax credits issued to fuel blenders for their use of ethanol. Removing all provisions would reduce expenditures from the Treasury by about $12.6 billion per year, as pay- outs for biodiesel and cellulosic production are eliminated. This saving is re- duced slightly by the reduction in tariff receipts from imported ethanol as that provision is dropped. Table 5-2 includes a calculation of the tons of emissions generated (or avoided) per dollar of federal revenue affected. The values are 0.0007 and 0.0004 for the Remove VEETC and Remove all Provisions, respectively. The fact that these numbers are positive reflects that every dollar of federal revenue (that is, foregone in tax receipts) generates a small increase in emissions. One might have expected that a policy intending to reduce GHG emissions would,

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100 TABLE 5-2 Removal of Biofuel Provisions – Key Modeling Results Remove VEETC Remove all Provisions Change Relative Change Relative Key Variable (annual average, 2014-2021) to Reference Scenario to Reference Scenario CO2-e Emissions (MMT) -4.8 -5.4 Federal Expenditures ($ billion) -7.2 -12.6 Tons CO2-e per $ of Revenue (calculated) 0.0007 0.0004 Baseline (with RFS2) Change Relative % Change Relative % to Reference Scenario to Reference Scenario FUEL USE (billion gallons, gasoline equivalent) Gasoline Use World 360.10 +0.44 +0.1% +0.64 +0.2% U.S. 120.91 +1.29 +1.1% +1.30 +1.1% Ethanol Use World 27.75 -1.15 -4.1% -2.35 -8.5% U.S. 15.27 -1.60 -10.5% -1.72 -11.3% Conventional 11.90 -1.74 -14.6% -1.75 -14.7% Cellulosic 2.33 0.69 +29.5% -1.58 -67.9% Other Advanced 1.04 -0.55 -52.7% +1.61 +154.4% Diesel Use World 445.14 +0.25 +0.1% +0.42 +0.1% U.S. 73.20 -0.08 -0.1% -0.11 -0.2% Biodiesel Use

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World 9.43 0.00 __ -0.01 -0.1% U.S. 1.31 0.00 __ 0.00 __ U.S. FUEL PRICES (wholesale $ per gallon unless otherwise indicated) Petroleum Refiner’s Cost ($/barrel) 123.47 +0.63 +0.5% +0.91 +0.7% Gasoline 3.52 +0.06 +1.7% +0.07 +2.0% Ethanol Conventional 2.82 -0.30 -10.5% -0.26 -9.1% Cellulosic 4.12 +0.21 +5.0% -0.63 -15.3% Other Advanced 3.27 -0.24 -7.4% -0.07 -2.2% Diesel 2.90 +0.02 +0.7% +0.03 +1.0% Biodiesel 5.51 -0.09 -1.6% -0.11 -2.0% CROP AREA (MM ac) World Corn 439.9 -4.27 -1.0% -3.26 -0.7% Soybean 278.9 +1.27 +0.5% +1.09 +0.4% U.S. Corn 93.8 -3.32 -3.5% -2.47 -2.6% Soybean 73.4 +1.15 +1.6% +1.05 +1.4% U.S CROP PRICES ($/bushel) Corn 5.42 -0.34 -6.3% -0.30 -5.5% Soybeans 11.98 -0.23 -2.0% -0.27 -2.2% 101

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102 Effects of U.S. Tax Policy on Greenhouse Gas Emissions instead, generate a negative value for tons per revenue, giving a sense of the tradeoff between federal expenditures and emissions outcomes—the more spent, the lower the emissions. For the best-guess estimates of the parameters used in this study, the provisions lead to both revenue losses and higher GHG emissions. Fuel Consumption Effects As discussed below, removing the biofuel provisions changes the relative prices of motor fuels. This causes substitution among fuel types as indicated in Table 5-2. All fuel substitution reflects differences in energy content of the dif- ferent fuels (e.g., gasoline has higher energy content than ethanol). Ethanol use, of course, declines with the removal of the VEETC and gasoline use increases. The ethanol use changes are fairly substantial—world use declines 4.1 percent for all ethanol types, while U.S. use drops 10.5 percent. In the United States, the largest absolute reduction is in conventional (corn-based) ethanol, which is re- duced by 1.7 billion gallons per year (about 15percent). There is a projected increase in cellulosic ethanol of 690 million gallons per year (30 percent), as the RFS mandate remains in effect and the cellulosic ethanol subsidy remains in place and is increased automatically under current law if the VEETC is eliminated. That is because, as indicated above, the cellulo- sic producer’s credit ($1.01 per gallon) decreases by the amount of an existing VEETC ($0.45). When the VEETC is eliminated, the cellulosic credit returns to the full $1.01 value. Since both the cellulosic subsidy and import tariff (mostly on advanced sugarcane biofuel imports from Brazil) remain in effect, much of the increase in cellulosic is countered by a decline in advanced biofuels of 550 million gallons (53 percent). The substitution effects are strengthened by the need to meet the tiered RFS2 mandate. Changes in the use of diesel—conventional and biodiesel—are quite small in proportion: less than a 0.2 percent increase. The scenario removing all the biofuel provisions affects the scale and dis- tribution of effects. The overall absolute effects tend to be larger when all provi- sions are eliminated as more of the fuel base is affected. However, cellulosic ethanol declines substantially (68 percent) when all of the provisions—including the cellulosic subsidy—are dropped, in contrast to the large rise when VEETC alone is removed, as discussed above. Alternatively, advanced biofuels rise in use more than 150 percent when all the provisions are dropped, primarily be- cause one of those provisions, the ethanol import tariff, is essentially a barrier for imported advanced biofuels from Brazil, and because of the assumption about the implementation of a cellulosic mandate waiver. This creates an almost complete substitution of advanced imports for domestic cellulosic ethanol to meet the RFS2.

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Biofuels Subsidies 103 Fuel Price Effects Removing the biofuel provisions raises the price of petroleum and gaso- line slightly, because the demand for those products rises when the biofuel tax preferences disappear and ethanol production declines. The effects are larger when all provisions are removed, but all effects are no more than 2 percent of total production. At the same time, the price of biofuels declines as blenders lose tax preferences and, correspondingly, willingness to pay for biofuels. An excep- tion is that the price of cellulosic ethanol is projected to rise 5 percent when VEETC only is removed, because of the induced shift in demand discussed above. Further, the advanced ethanol price declines in both scenarios, but it de- clines less in the Remove all Provisions scenario, because the shift in demand for advanced ethanol caused by removal of the import tariff provides some price pressure on those imports, though not enough to counter the decline in price caused by removing the tariff in the first place. Crop Market Effects The biofuel provisions generally raise the demand for corn as the domi- nant feedstock for conventional ethanol. They do so in part by expanding crop area and by inducing growers to shift land from other crops, principally soy- beans to corn. As a result, removing the provisions would lead to a decline in corn acreage and an increase in soybean acreage. Globally these effects are small, and less than 1 percent of the crop base is affected. Within the United States, the effects are larger, with a decline of between 2.5 and 3.5 percent in corn acreage and an increase of 1.5 percent in soybean acreage. Correspondingly, corn prices are expected to decline as the demand for corn drops. Soybean prices drop as well, as land shifts back into soybean pro- duction and soybean production increases. The projected decline in corn prices is about 5.5 to 6 percent and the decline in soybean prices is 2 to 2.5 percent. These effects are not insubstantial and, while not the focus of this study, they could have a substantial (positive) impact on household budgets through a de- crease in food-related costs (Chakravorty et al., 2012; Hertel et al., 2010; and Roberts and Schlenker, 2010). Key Interaction Effect: Renewable Fuels Standard The modeling results above all assume that the RFS2 mandate remains in place. We now examine the importance of that assumption by testing the results against a scenario in which the renewable fuel standards are removed. That is, we analyze the results of the Remove all Biofuels Provisions scenario with and without the RFS2 mandate in place. This comparison of results is found in Table 5-3. Note that Table 5-3 has two separate columns for reference scenario values, as the when the RFS2 is assumed to hold for the projection period.

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104 Effects of U.S. Tax Policy on Greenhouse Gas Emissions We find that removing the RFS2 mandates amplifies the effects of remov- ing the biofuel provisions. In essence, the full substitution away from biofuels to conventional fuels when tax preferences are lifted is more limited when the RFS2 is in place, because the mandates must be met by the biofuels even when their cost advantages are reduced. There are a few exceptions to this rule. The effects of provision removal is smaller in the cases of advanced and cellulosic ethanol when there are no RFS2 mandates, primarily because there is very weak demand for those products when the mandate is removed and thus much less substitution among ethanol types. SENSITIVITY ANALYSES Sensitivity Analysis 1: Biofuel Net GHG Coefficients The net GHG effects of each biofuel component are exogenously deter- mined via coefficients used in the FAPRI-MU model. As discussed above, the central coefficients used to generate the results presented above were derived from the per-fuel thresholds established in the EISA legislation. Due to inherent uncertainty about key factors such as indirect land-use change, the model was rerun with different coefficients to gauge sensitivity to this and other factors, including considering the source of the estimate, EPA v. EISA, and alternative estimates of the biofuel emission factors based on the literature. The different coefficients capturing life-cycle emissions per gallon of gasoline are listed in Table 5-4. Results of the GHG coefficient sensitivity analysis are presented in Table 5-5 for the Remove all Provisions scenario. Note that the EISA column matches the net GHG results in Table 5-3. Using the EPA estimates, emissions can either decline slightly or increase slightly depending on whether ILUC emissions are included. Looking at the range of estimates in the literature, the “high biofuel emissions” estimates incorporate higher ILUC values and thereby more pro- nounced emission reduction benefits if biofuel provisions are removed. The op- posite is the case when “low biofuel emissions” are assumed, in which case dropping the biofuel provisions would lead to a net increase in GHG emissions. The high-low range is wide in relative terms, but small in absolute terms. Sensitivity Analysis 2: NEMS-NAS Model To examine how differences in modeling approach might change the na- ture of findings, the committee also used the NEMS-NAS model (see Chapter 3) to analyze impacts of the biofuel provisions. Unlike FAPRI-MU, NEMS-NAS does not capture international market effects for motor fuels or agricultural feedstocks, nor does it estimate the effects of ILUC. However, NEMS-NAS does

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TABLE 5-3 Effect of the RFS2 Mandate on Model Projections for the “Removing All Biofuel Provisions” Scenario: Key Modeling Results Key Variable (Annual Average, 2014-2021) With RFS2 Mandates No RFS2 Mandates CO2-e Emissions (MMT) -5.4 -7.0 Federal Expenditures ($ billion) -12.6 -10.1 Tons CO2-e per $ of Revenue 0.0004 0.0007 Reference Change Relative % Reference Change Relative % Scenario to Reference Scenario Scenario to Reference Scenario FUEL USE (billion gallons, gasoline equivalent) Gasoline Use World 360.10 +0.64 +0.2% 360.55 +0.76 +0.2% U.S. 120.10 +1.30 +1.1% 122.56 +1.75 +1.4% Ethanol Use World 27.75 -2.35 -8.5% 26.24 -2.40 -9.2% U.S. 15.27 -1.72 -11.3% 13.50 -2.15 -16.0% Conventional 11.90 -1.75 -14.7% 12.51 -1.85 -14.8% Cellulosic 2.33 -1.58 -67.9% 0.64 -0.63 -97.9% Other Advanced 1.04 +1.61 +154.4% 0.35 +0.32 +93.3% Diesel Use World 445.14 +0.42 +0.1% 445.3 +0.47 +0.1% U.S. 73.20 -0.11 -0.2% 71.97 -0.27 -0.4% Biodiesel Use (Continued on page 106) 105

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106 World 9.43 -0.01 -0.1% 8.49 -0.15 -1.7% U.S. 1.31 0.00 __ 0.36 -0.14 -39.0% U.S. FUEL PRICES (wholesale $ per gallon unless otherwise indicated) Petroleum Refiner’s Cost ($/barrel) 123.47 +0.91 +0.7% 123.89 +1.12 +0.9% Gasoline 3.52 +0.07 +2.0% 3.59 +0.10 +2.7% Ethanol Conventional 2.82 -0.26 -9.1% 2.88 -0.28 -9.8% Cellulosic 4.12 -0.63 -15.3% 3.44 -0.84 -24.5% Other Advanced 3.27 -0.07 -2.2% 2.88 -0.28 -9.8% Diesel 2.90 +0.03 +1.0% 2.89 +0.03 +1.2% Biodiesel 5.51 -0.11 -2.0% 3.67 -0.87 -23.6% CROP AREA (MM ac) World Corn 439.9 -3.26 -0.7% 441.70 -4.53 -1.0% Soybean 278.9 +1.09 +0.4% 276.56 +1.25 +0.5% U.S. Corn 93.8 -2.47 -2.6% 95.22 -3.45 -3.6% Soybean 73.4 +1.05 +1.4% 71.78 +1.22 +1.7% U.S. CROP PRICES ($/bushel) Corn 5.42 -0.30 -5.5% 5.45 -0.39 -7.2% Soybeans 11.98 -0.27 -2.2% 11.47 -0.38 -3.4%

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Biofuels Subsidies 107 TABLE 5-4 Alternative Emission Coefficients for Gasoline and Biofuels Based on Study EPA, EPA, High Biofuel Low Biofuel EISA with ILUC No ILUC Emissions Emissions Emission Coefficients (kg CO2-eq/gallon gasoline equiv) Gasoline 12.3 12.3 12.3 12.3 12.3 Diesel 12.2 12.2 12.2 12.2 12.2 Ethanol Conventional 9.9 9.9 6.2 12.3 6.2 Cellulosic 4.9 2.1 2.0 8.5 0.0 Other Advanced 6.2 4.8 4.1 6.2 4.1 Biodiesel 6.1 5.3 1.0 6.1 1.0 Key: EISA – Energy Independence and Security Act threshold values for biofuels; EPA – EPA Regulatory Impact Analysis of Renewable Fuels Standard; ILUC – Emissions from indirect land-use change; and High (low) biofuel emissions – expert judgment of high (low) emission values, based on literature. TABLE 5-5 Sensitivity of GHG Impacts from Variations in Biofuel GHG Emission Coefficients: Removing all Provisions Scenario (All quantities are changes from baseline, million t CO2-e, 2014-2021 annual average.) EPA High Biofuel Low Biofuel EISA EPA w/ILUC w/o ILUC Emissions Emissions With RFS2 -5.4 -2.2 +3.5 -14.9 +6.7 No RFS2 -7.0 -5.6 +2.4 -14.1 +3.7 capture impacts within the domestic U.S. energy sector—between sectors (e.g., transportation, industrial, commercial, and residential) and between energy sources that could be caused by the effect of the biofuel provisions and the inter- acting RFS on relative fuel prices within the United States. Moreover, NEMS- NAS has a longer time horizon (out to 2035) than FAPRI-MU (one decade), which allows insight into the temporal dynamics induced by the provisions. Figure 5-1 presents NEMS-NAS results on the effect of the biofuel provi- sions on the composition of biofuel production (use). The reference scenario is simply the baseline described above. “No Bio Subsidies” is equivalent to the “Remove All Provisions” scenario above. The results outlined in Figure 5-1 can be summarized as follows: The RFS continues to motivate biofuel production, even in the absence of the biofuel credits, though at slightly lower levels when the provi- sions are removed. Corn ethanol production decreases when the subsidies are removed be- cause ethanol’s value is reduced.

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108 Effects of U.S. Tax Policy on Greenhouse Gas Emissions FIGURE 5-1 Effects of biofuel provisions removal on biofuel production levels. On the other hand, ethanol imports (primarily Brazilian sugarcane eth- anol) increase when the import tariff is removed. Biodiesel decreases slightly, and the mix of cellulosic fuels produced shifts slightly as well with more cellulosic ethanol and lower biomass to liquids. NEMS-NAS does not separate out the effects of the provision on gaso- line use in the United States or other countries. Figure 5-2 reports the impacts of removing the biofuel tax provisions on total U.S. energy expenditures by sector. Higher transportation fuel prices mean higher household energy expenditures (maximum of 1.3 percent for transporta- tion in 2027 or 0.3 percent overall). Figure 5-3 shows the impact of removing the provisions on federal reve- nues, indicating: In the reference scenario, which projects the effects had the ethanol tax subsidies and import tariff stayed in force through 2035, the cost of the biofuel credits rises to roughly $18 billion per year while the ethanol import tariff brings in almost $0.8 to 1.1 billion per year. When the credits and tariff are removed, the gain to the Treasury is roughly $17 billion per year or $300 billion total from 2012 to 2035. Figure 5-4 presents NEMS-NAS estimates of the effects of the biofuel provisions on total CO2 emissions in the U.S. Key findings are: Removing the biofuel credits makes virtually no difference in CO2 emissions, because the RFS mandate requires continued production of biofuels.

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Biofuels Subsidies 109 FIGURE 5-2 Effects of removing the biofuel provisions on total energy expenditures. FIGURE 5-3 Effects of biofuel provisions removal on federal revenue. FIGURE 5-4 Effects of biofuel provisions removal on U.S. CO2 emissions.

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110 Effects of U.S. Tax Policy on Greenhouse Gas Emissions Lower corn ethanol production and coal with biomass to liquids leads to lower CO2 emissions in the industrial sector. Lower E85, lower biodiesel, and higher gasoline consumption leads to an increase in direct CO2 emissions from the transportation sector. One of the most important questions is to determine how the two models reviewed here compare in their projections. It should be emphasized that the modeling structures are highly differentiated (see Appendix A for a detailed review). Although the source of all emissions tracked by NEMS-NAS and FAPRI-MU differ in terms of sectors, types of gas, and countries covered, the essential finding is the same—the biofuels tax provisions have a very limited impact on GHG emissions. This result arises in part because the quantitative response on the fuel market is small and in part because the renewable fuel standards constrain the effects of tax changes on ethanol production. SUMMARY This chapter estimates the effects of biofuel tax provisions on global and domestic GHG emissions. While the biofuels provisions expired at the end of 2012, the committee included these in its list of provisions for several reasons: because ethanol credits have been widely used in the U.S. and abroad and raise important public policy questions, because the results illustrate the often- unintended impact of tax expenditures, and because the biofuels standards inter- act significantly with motor fuels taxes and the use of petroleum. The effects of removing the Volumetric Ethanol Excise Tax Credit indi- vidually and all provisions together are tested using the FAPRI-MU model and the NEMS-NAS model. The findings from both models suggest the VEETC has very little effect on GHG emissions relative to the baseline. Removal of the VEETC in the FAPRI-MU simulation results in a reduction of emissions of 4.8 MMT CO2-e per year during the first decade, at a value of 0.0007 tons CO2-e per dollar of revenue. Similarly, it is found that the remaining provisions have little effect on GHG emissions, with removal of all provisions resulting in a reduction of emis- sions of 5.4 MMT CO2-e per year, at a value of 0.0004 tons CO2-e per dollar of revenue (FAPRI-MU model). The global market linkages affect the net impact of the provisions on global GHG emissions. Removal of the provisions resulting in a decrease in world ethanol use and an increase in world gasoline use. It is also found that the RFS2 biofuels mandate—which requires a minimum quantity of biofuels to be mixed into motor fuel each year regardless of the subsi- dy—influences the impact of the biofuels provisions on global GHG emissions. Removing both the tax provisions and the RFS2 mandate results in a reduction of emissions of 7.0 MMT CO2-e per year, at a value of 0.0007 tons CO2-e per dollar of revenue. Therefore, as is intuitive, the mandates reduce (in absolute value) the

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Biofuels Subsidies 111 size of the impact of the tax subsidy on GHGs. This effect—in which regulatory mandates limit the size of the impact of taxes and subsidies—is a common finding that runs through this report. A key uncertainty in the estimates is the magnitude of indirect land-use change that is caused by the various biofuel feedstocks. However, the range of estimates of biofuels-induced ILUC from the literature suggests that increasing the use of certain forms of biofuel results in increased CO2 emissions. Taken together, the modeling results and existing literature suggest that, when the renewable fuel standards are in place, the biofuels provisions of the tax code have a small net effect on global GHG emissions. Although the effects are small, they are likely to increase GHG emissions slightly when key factors such as petroleum substitution and indirect land-use change are taken into account.

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