The government is set to introduce a mandatory sales target for bio-fuels with the goal of improving the security of New Zealand’s fuel supply.  However, the economic benefits from this policy could be outweighed by the additional costs imposed upon firms and consumers, as well as stifling longer-term efforts to produce efficient bio-fuel domestically.

In September last year, the government proposed mandatory sales targets for bio-fuels in New Zealand by 20081.  This requires that 0.25% of fuel sales (15-22m litres2) are through bio-fuel in 2008, rising each year to 2.25% by 2011 (UPDATE: A new target of 3.4% by 2012 was set by the government on the 13/02/2007. The new target does not change the conclusion of this article).   The government sees two social benefits from forcing the introduction of bio-fuels, which are:

But the government’s policy doesn’t necessarily guarantee a net benefit to New Zealand in either of these areas.   This article doesn’t attempt to address the environmental issues, but discusses the direct economic impact of a mandatory sales target for bio-fuel.

By introducing regulation, the government is implicitly assuming that there is a market failure that has prevented bio-fuels becoming established in New Zealand already.   The possible areas of failure are:

The two potential sources of bio-fuel in New Zealand are tallow (for bio-diesel)and whey (for ethanol).   Ethanol could also be produced from maize, but the opportunity for growing this in New Zealand is limited given that most of our flat land is used by dairy farms, which provide a higher return than maize.

The government believes that the 2008 target can be reached with domestic production alone, but this would require all the tallow and whey-based ethanol currently produced to suddenly be switched to domestic fuel markets.   Such a shift is unlikely to be profitable, however, as both tallow and whey-based ethanol offer substantial, low-risk export returns.   As a result, it is likely that New Zealand will have to import ethanol-based fuel.

One of the purposes of the sales target is to promote investment in bio-fuel facilities by reducing the uncertainty of future demand.   But setting a short-term sales target does not promote efficient long-run investment; instead it forces firms to invest now in a potentially sub-optimal way in order to reach the legislated target.

The uncertainty surrounding bio-fuel investment arises from:

This uncertainty prevents bio-fuels being sold without regulation in New Zealand, but is not necessarily a market failure.   The uncertain technological environment, for example suggests that it may be optimal for firms in New Zealand to wait until technological progress in bio-fuels is more mature before investing in them as an alternative fuel source.   The government’s sales target will force firms to invest now, potentially limiting the scope to invest in more efficient sources of fuel in the future.

The problem faced by the market is its inability to respond rapidly to an increase in the price of fossil fuels if bio-fuel infrastructure does not already exist.   However, it is not clear whether the benefits of forcing investment in infrastructure now outweigh the costs of maintaining that infrastructure for a product that is not economically viable given current fuel prices.

There are two broad costs for firms associated with ethanol-based fuel.   The first is the transaction cost of introducing the supply, which is substantial for fuel retailers and firms who transport fuel.   Vehicles and storage areas will need to be re-fitted to protect the fuel from contamination from water, and to mix the fuel close to the area where it will be sold.   The cost of changing tanks to contain the fuel could increase fuel prices by 70-90c/l for 15 years3.

The second, and more serious, cost is the risk associated with future ethanol prices.   Many governments are introducing incentives for consumers to use bio-fuel, and it is likely that increases in demand in the short-term will outstrip any lift in supply from ethanol-exporting countries.   Changes to producer subsidies (in the US, for example), could also affect future bio-fuel prices.   These potential shocks are out of New Zealand’s control, and could make bio-fuel even less economical than it already is.   In other words, switching to ethanol-based fuel is not a sure-fire way to guarantee medium-term stability in fuel prices.

Given that New Zealand is likely to have to import ethanol, potential suppliers of bio-fuel include Brazil, the US, Japan, Australia, and some Asian countries4.   The government believes that a more stable supply of fuel could be achieved by switching New Zealand’s reliance from potentially uncooperative nations to more friendly nations.

Trade relations with all the countries above are amicable, and Japan, Australia, and the US are all major New Zealand trading partners.   Furthermore, the countries that could provide bio-fuel are different from the countries that provide New Zealand oil.   This implies that introducing bio-fuel as a viable fuel source in New Zealand makes sense, in so far as it reduces the risk of supply disruption, and increases competition in providing a fuel source to New Zealand.   Ethanol-based fuel is currently sold in significant quantities on the world market, but bio-diesel is not5.

It is possible that some benefit could be achieved by diversifying New Zealand’s fuel sources, but there are costs associated with government regulation.   Domestic fuel production would seem to provide the most secure supply, but even the introduction of a mandatory sales target is unlikely to achieve this.   Other incentives to promote domestic production would be necessary, highlighting the inefficiency of New Zealand trying to produce its own fuel.

One of the purposes of a mandatory sales target is to reduce uncertainty surrounding firms’ investment decisions.  However, if the cost of imported bio-fuel is significantly greater than fossil fuels, the overall cost of fuel for consumers is likely to rise as firms meet their sales targets by cross-subsiding bio-fuels with higher pump prices for oil-based fuel.

Our view is that bio-fuels would be available in New Zealand if it was economically efficient to introduce them.   The role of the government should be limited to try and reduce the transaction costs of fuel retailers switching to a different fuel source such as bio-fuel when it is efficient, rather then forcing the industry to adopt an inefficient technology now.