Just as motorists began the summer driving season, U.S. Department of Transportation Secretary Ray LaHood told Congress that the Highway Trust Fund will run out of money by August.   Rising gasoline prices and the recession mean less driving, and less driving means lower revenues from gasoline taxes for the Highway Trust Fund.

At the same time, President Obama wants to spend $13 billion as a downpayment on high-speed rail, an expensive form of transportation that will reach only small segments of the country and that will not substitute for highways.  The money would be better spent on developing a more stable  source of revenue for highways, based on miles driven rather than gasoline used, that would help to reduce traffic congestion and greenhouse gas emissions.

When the Highway Trust Fund ran out of money in 2008, Congress transferred $8 billion to the fund from general revenues as a repayment from 1998, when the fund was in surplus, and $8 billion was moved into general spending.  This year, if Congress transfers money, it would be a direct expenditure, with no fig leaf. Without a transfer, work on many projects would stop or slow down.

The federal government financed the interstate highway system by means of a fuel tax because that was the best method available. Legislation passed in 1956 provided that, on completion, the federal tax would be repealed and funding restored to the states. The highway system is now complete, so there is no rationale for continuing federal involvement in financing state roads.

The $13 billion allocated for high-speed rail would be better spent to encourage the states to adopt a new way of charging for road use.  Driving is the primary method of transportation for Americans. They own about 235 million registered passenger cars, vans, pickup trucks and sport utility vehicles, and drive over 2.5 trillion miles a year.

Mechanisms for improving road finance were addressed earlier this year in a pathbreaking bipartisan report by the National Surface Transportation Infrastructure Financing Commission entitled Paying Our Way: A New Framework for Transportation Finance.

The Commission concluded that America should move away from gasoline taxes as a way to fund roads.  With more efficient cars, motorists will be able to travel further using less gasoline while still imposing wear-and-tear on roads. Hence, maintenance and repair should be funded through direct user charges that are based on miles traveled on all streets and roads, rather than on gasoline purchased.

House Committee on Transportation and Infrastructure Chairman Jim Oberstar regards a vehicle mileage charge as one of a number of options under consideration as a complement or alternative to a gasoline tax, but he is not committed to any course of action, according to the committee communications director Jim Berard.

Ideally, a vehicle mileage charge would require a tamper-proof device that would track not only miles and time of day driven but also the route selected.  This would allow states and local governments to vary the charges based on route taken and time of day driven.  Motorists who travel on congested roads at peak times of day could be charged more, encouraging them to shift their travel away from rush hour.

Since the change in road financing cannot be made immediately, the Commission recommends setting up a user-charge system that would work in conjunction with the Highway Trust Fund until 2020, at which point the new system would be in place to take over.

Full transition to this new revenue system would require research, the purchase of technology, and pilot projects, all of which would be a better use of stimulus funds than high-speed rail. With prices of transponders and global positioning systems falling, sophisticated and efficient road pricing systems are now possible. GPS devices could be given to drivers who choose to participate, and drivers could pay as easily as they now pay for cell phones or E-ZPass tolls.

To make road user charges more politically palatable, participating motorists could be exempt from registration fees, but would pay road charges instead, charges that could vary by type of road used and time of day.  Technologies exist to ensure that detailed information on trips is not sent out to motorists so that privacy is preserved.

The vanishing Highway Trust Fund is a wake-up call to use new technology to make our roads flow better.

President Obama may have a political Midas touch, but his decision to tighten fuel efficiency rules for cars was assailed from two directions.

Some critics charged that the rules would force car prices higher at the worst possible time — dealing a possible lethal blow to the American auto industry and hurting struggling consumers at the same time. Others berated the president for preferring regulation over a simpler tax increase. The Corporate Average Fuel economy standards — or CAFE — are costly, inefficient and politically craven.

Both criticisms rest on mistaken assumptions about pricing. Firstly there is scant evidence that tightening fuel standards were a major force in pumping up the price of cars in the 1970s and 1980s. Between 1978 and 1985 U.S. automakers managed a 50 percent increase in fuel efficiency without breaking a sweat.

The notion that CAFE standards significantly push up prices assumes technological stasis. Auto research continually spins off fuel efficient technology. The automakers and buyers then face a trade-off between deploying this to cut down gas usage, or to enhance the power and size of the vehicle.

Since the United States stopped tightening the standards in the mid 1980s, carmakers have chosen he latter. Obama’s rules are expected to add just $1,300 to the price of a car by 2016 and it is fair to assume that the price increase would phase in gradually along with the standards.

It would take just three years for fuel savings to put car buyers back in the black, according to the American Council for an Energy Efficient Economy.

The second error is to assume that the car buying public can be swayed by a modest increase in fuel taxes.

Recent history suggests it would take huge and politically implausible tax increases to make much of a difference. Americans started to abandon the SUV only when gasoline prices soared to $4 a gallon in July 2007 — close to double the price at the end of 2006.

To have a significant impact Congress and the White House would need to increase the Federal tax on gasoline at least fivefold (at present, it is a mere 18.4 cents). Not even the wildly popular Obama could get away with that. It might be easier to confiscate all the guns in Texas.

Nor will the cap and trade proposals being mulled by U.S. lawmakers do the trick. If implemented these may add between 10 and 20 cents to the price of fuel, according to the American Council for an Energy Efficient Economy — insufficient to change the behaviour of even the most impecunious American.

The standards certainly have their flaws. They do nothing to discourage the guilty pleasure of using the car for trips within walking distance. By placing trucks in a separate, privileged category, the CAFE standards may have steered Americans towards heavier vehicles. But this is an argument for adjusting the rules rather than abandoning them.

Even so, they have produced results that a price signals alone would not have achieved — forcing auto companies to incorporate fuel saving technologies that might otherwise be used to boost the power of a car or increase its size.

Indeed, even the European Union — with gas taxes that most Americans would consider ludicrously punitive — is embracing fuel efficiency standards. Europeans are right to believe that taxes alone are not always sufficient.

ETHANOL ENTHUSIASM

Between 2000 and 2007, production of fuel ethanol quadrupled from 1.6 billion to 6.5 billion gallons, and the industry is on course to distill a record 9.3 billion gallons in 2008.

Ethanol production is not really economic at oil prices below about $60-70 per barrel (prices of grains and fats for ethanol conversion and processing costs are too high relative to oil). So the original boost to ethanol came from its use as an oxygenating additive in reformulated gasoline, rather than as fuel in its own right, when a number of states banned the use of MTBE.

As oil prices breached $50 in late 2004 and continued to climb steadily higher over the next four years, ethanol’s properties as a fuel suddenly became more attractive.  Blenders began to use ethanol as a cheaper (partial) substitute for conventional oil-derived blendstocks in making gasoline.

Prompted by national security concerns and encouraged by lobbyists for the farm sector, U.S. legislators tried to accelerate the use of ethanol by mandating a minimum ethanol content for all gasoline produced or imported into the United States.

The centerpiece of the government’s intervention is the Renewable Fuel Standard (RFS) which sets a steadily increasing minimum volume of ethanol that must be blended into the nationwide gasoline supply each year.

The original RFS set out in the 2005 Energy Policy Act was relatively modest — requiring blenders to incorporate 4 billion gallons of ethanol into the fuel supply in 2006, rising to 5.4 billion gallons in 2008 and 7.5 billion gallons by 2012.

But as soaring crude oil prices intensified concerns about energy dependence, the 2007 Energy Security and Independence Act imposed a set of much more ambitious targets. The RFS blending target for 2008 was almost doubled to 9 billion gallons, rising to almost 13 billion gallons in 2010 and to an extraordinary 36 billion gallons in 2022 (see chart https://customers.reuters.com/d/graphics/US_ETH1108.gif).

WORSENING ECONOMICS

Most attention has focused on the role of the RFS, but surging oil prices were probably more important in supporting ethanol.

RFS is designed to stimulate investment in the production facilities and distribution infrastructure needed for ethanol by guaranteeing a minimum level of demand for the fuel irrespective of oil prices.  But over the last three years, RFS has never been binding.

On a purely voluntary basis, gasoline blenders have always used more ethanol than the required minimum because increasingly high oil prices made ethanol an attractive fuel in its own right.

RFS mandated 4 billion gallons of ethanol in 2006, but blenders actually used 4.9 billion. It mandated 4.7 billion in 2007, when blenders actually used 5.7 billion (an extra billion gallons or 22 percent).

The apparent success of the ethanol industry on a voluntary basis because of favorable economics was one reason why legislators felt comfortable about amending the RFS to include more ambitious targets in 2007.

But as oil has tumbled below $70 per barrel, ethanol no longer looks competitive. On current trends, blenders will use 9.26 billion gallons of ethanol in 2008, just 260 million gallons or 3 percent above the RFS-mandated minimum of 9 billion gallons.

Unless oil prices rise substantially from current levels, the RFS is set to become binding for the first time in 2009. Gasoline blenders will have to use 11.1 billion gallons of ethanol because that is what the law tells them, not because it makes economic sense.

OBLIGATIONS AND CREDITS

In practice, RFS is expressed as a percentage requirement imposed on each gasoline refiner and importer to buy a specified volume of ethanol (or tradable credits) in proportion to their production/import volume - thereby ensuring the total quantity of ethanol used each year meets the mandated target.

The Environmental Protection Agency (EPA) uses total forecast gasoline consumption in the United States for the coming year (sourced from the October edition of the Energy Information Administration’s Short Term Energy Outlook) and adjusts it for gasoline consumption in Alaska (not currently included in the RFS requirement); production by small refineries and refiners (not subject to RFS until 2011); and the quantity of ethanol that has to be incorporated into the gasoline mix (there is no requirement to blend ethanol into itself).

EPA divides the total mandated ethanol volume into the adjusted gasoline supply to publish the percentage RFS requirement for the coming year. Each gasoline refiner and importer must purchase sufficient ethanol (or tradable credits from others blending more than the minimum) to meet this ratio.
So far, ethanol credits have been cheap (trading at around 3-6 cents per gallon in 2008). However, if oil prices fall further, and RFS becomes binding, the price of credits will have to rise to give blenders an incentive to use at least the mandated minimum volume.

THE BLENDING WALL

Ethanol is a good but not perfect substitute for gasoline.

It has around 66 percent of the energy content of regular gasoline. Almost all ethanol is sold is sold in a 90-10 gasoline-ethanol blend known as E10 and is the limit that can be used in regular motor vehicles under existing manufacturer warranties. A tiny percentage is sold in a 15-85 blend known as E85 that can only be used in vehicles with specially designed engines.

As a practical matter, the amount of ethanol that can be blended into the general gasoline supply is capped at around 10 percent of the total or about 10-14 billion gallons per year - known as the “blending wall”.

For 2008, EPA set the RFS obligation for refiners and importers at 7.76 percent, based on the need to blend 9 billion gallons of ethanol into forecast gasoline consumption of 144.5 billion gallons or 116 billion gallons after adjustments.

In the event, gasoline demand has proved much weaker than forecast. Without voluntary blending above the required amount in the first half of the year owing to high oil prices, the 7.76 percent blending requirement would not have been high enough to ensure 9 billion gallons were used.

On Nov. 14, EPA published an RFS for 2009 of 10.21 percent, based on the need to blend an even higher volume of ethanol (11.1 billion gallons) into a diminished amount of gasoline consumption (139 billion gallons, or 109 billion gallons after adjustments).

The industry is now very close to hitting the blending wall.

This was always going to happen, given the much more ambitious RFS volume obligations in the 2007 law. It was never going to be possible to blend 20.5 billion gallons into the gasoline supply by 2015 without much wider uptake of E85 vehicles or other modifications of the U.S car fleet. But the unprecedented cyclical reduction in gasoline demand has brought the blending wall much closer.

CONSTRAINTS BITE

In fact, the gasoline industry is now trapped in a vice.

Low oil prices are discouraging ethanol blending (RFS becomes binding) while slumping gasoline demand is tightening the technological constraints (the blending wall approaches faster).

Blending credits look set to become more expensive, as gasoline refiners and importers have to start paying far more to make it worthwhile to blend 11.1 billion gallons into the fuel supply next year at low oil prices.

Meanwhile, the limits of the system could prevent any more ethanol being blended for technological reasons. The RFS requirement for 2009 looks achievable, but 13 billion gallons in 2010 and 14 billion gallons in 2011 may be impractical unless the car fleet changes.

The looming wall explains why ethanol advocates are pushing the incoming Obama administration to set a much higher blend rate than E10, reaching E15 or E20, and require motor manufacturers to start redesigning cars to take much higher blends and produce a higher proportion of E85-enabled Flex Fuel Vehicles (FFVs) as a condition of any financial rescue package.

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