As oil prices once again reach levels last seen before the global financial crisis, we are reminded that the long term trend is upwards.   Consequently, we can expect to see a number of changes in transportation over the coming decades more fuel efficient vehicles, greater use of public transport, a shift to hybrid or plug-in electric cars, and fuel switching from oil products to biofuels.

Biofuels are an appealing option as they can largely be dropped into existing internal combustion engines, rather than requiring vehicle replacement.   Biofuels are also advocated for other reasons such as lower carbon emissions, greater supply security increased employment.

Various potential sources of biofuel exist in New Zealand, including algae, dairy by-products and woody residues, but the most significant in term of its potential to contribute to the country’s liquid fuels need is probably purposely grown forest.

Whether large scale production of biofuels from forestry would make us economically better off than importing oil involves answering the question:   Should we use the nation’s resources (land, labour, capital) to produce goods and services that we can sell overseas (like dairy and meat products) and buy oil with the foreign exchange earned, or should we use the nation’s resources to produce biofuels to substitute for oil?

New Zealand is a highly efficient producer of agricultural products, but the degree to which we should invest in expanding agricultural exports depends on how much oil we can buy with the earnings.   The higher the oil price the less attractive is the option of exporting milk solids and importing oil, relative to making our own biofuels.

Think of it this way, assume that a country can produce either dairy products or biofuels.   Dairy products are exported and earn you $30/hour, with which you buy 10 litres of imported petrol at $3.00/litre.   Alternatively, in the biofuels industry you earn less per hour but you can buy 10 litres of biofuels at $2.00/litre.   At any wage rate over $20/hour you are better off.

With oil being a commodity that is in world demand, we would expect substitute products (biofuels) to emerge as the oil price rises.   Currently large scale biofuel production in New Zealand is not competitive with imported oil, although biofuels are currently used at a smaller scale in cogeneration and for producing industrial heat.   However, the previous government introduced measures to support the biofuels industry, but any policy that favours one industry will generate an economic cost elsewhere.   For example:

It could be worse.   In some countries assistance to the biofuels industry (such as subsidies to convert corn to ethanol) has horrible environmental effects and distorts efficient land use by effectively raising the cost of growing food.   So why support biofuels?

One reason offered is lower carbon emissions?   Lowering emissions is best achieved by imposing a price on carbon (which New Zealand now has) as this automatically raises the price of oil relative to biofuels.   A kilogram of CO2 saved by oil-biofuel substitution is as valuable as a kilogram of CO2 saved by reducing coal-fired electricity generation.   This is as it should be, but is in stark contrast to the current biofuel subsidy which is equivalent to about $400/tonne of CO2, compared to a current maximum carbon price under the New Zealand Emissions Trading Scheme of $12.50/tonne.

There is also the claim that biofuel production would generate employment.   Clearly, some labour input is required no matter what type of biofuels are being produced, but offsetting that is the loss in employment elsewhere.   For there to be a net gain in employment the biofuel industry has to be more labour intensive than other industries and there has to be surplus labour available.   Greater labour intensity is likely to mean lower wages.   And if unemployment exists, one would want to look carefully at why it exists before recommending that assistance tithe biofuels industry is the way to deal with it.

None of the above constitute arguments against biofuels as such.   Biofuels will play a key role in the adjustment of the economy to progressively higher oil prices.   The right combination of oil prices, carbon prices and efficiency in biofuels production can lead to biofuels being competitive with petrol and diesel at the pump, as well as making us economically better off.

The point though is that we do not need to endure poorly designed policy that merely transfers wealth from consumers to biofuel producers in the meantime.   Government has a role in funding research and development, and this is the mechanism by which support for biofuels should occur in competition with other demands on research and development funding.