Bio-fuels arenand#39;t the silver bullet

Bio-fuels aren’t the silver bullet

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

Background

In September last year, the governmentproposed mandatory sales targets for bio-fuels in New Zealand by 2008[1].  This requires that 0.25% of fuel sales (15-22m litres[2]) are through bio-fuel in 2008, rising eachyear 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 forcingthe introduction of bio-fuels, which are:

  • environmental benefits, through reduced carbon emissions;
  • economic benefits, through increased security of supply.

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

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

  • the lack of local production;
  • the lack of investment in local infrastructure;
  • the over-reliance of New Zealand on fossil fuels and the select group of nations that produce them.

Bio-fuel production in New Zealand

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 theopportunity for growing this in New Zealand is limited given that most of ourflat land is used by dairy farms, which provide a higher return than maize.

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

The mandatory sales target and investment

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

The uncertainty surrounding bio-fuelinvestment arises from:

  • demand – what happens if the price of oil falls?
  • regulation – how will domestic and international governments changetheir support for bio-fuels over time?
  • technology – any investment made today comes with a significantchance of being made obsolete tomorrow.

This uncertainty prevents bio-fuels beingsold without regulation in New Zealand, but is not necessarily a market failure.   The uncertaintechnological environment, for example suggests that it may be optimal forfirms in New Zealand to waituntil technological progress in bio-fuels is more mature before investing inthem as an alternative fuel source.   The government’s sales target will forcefirms to invest now, potentially limiting the scope to invest in more efficientsources of fuel in the future.  

The problem faced by the market is itsinability to respond rapidly to an increase in the price of fossil fuels ifbio-fuel infrastructure does not already exist.   However, it is not clearwhether the benefits of forcing investment in infrastructure now outweigh thecosts of maintaining that infrastructure for a product that is not economicallyviable given current fuel prices.

Immediate costs of the mandatory sales target

There are two broad costs for firmsassociated with ethanol-based fuel.   The first is the transaction cost ofintroducing the supply, which is substantial for fuel retailers and firms whotransport fuel.   Vehicles and storage areas will need to be re-fitted toprotect the fuel from contamination from water, and to mix the fuel close tothe area where it will be sold.   The cost of changing tanks to contain the fuelcould increase fuel prices by 70-90c/l for 15 years[3].

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

Importing bio-fuel

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 countries[4].   Thegovernment believes that a more stable supply of fuel could be achieved byswitching New Zealand’sreliance from potentially uncooperative nations to more friendly nations.

Trade relations with all the countriesabove are amicable, and Japan, Australia, and the US are all major New Zealand trading partners.   Furthermore, the countriesthat could provide bio-fuel are different from the countries that provide New Zealand oil.   This implies thatintroducing bio-fuel as a viable fuel source in New Zealand makes sense, in so far as it reduces the riskof supply disruption, and increases competition in providing a fuel source to New Zealand.   Ethanol-based fuel iscurrently sold in significant quantities on the world market, but bio-diesel isnot[5].

Where to from here?

It is possible that some benefit could beachieved by diversifying New Zealand’s fuel sources, but there are costs associated with governmentregulation.   Domestic fuel production would seem to provide the most securesupply, but even the introduction of a mandatory sales target is unlikely toachieve this.   Other incentives to promote domestic production would benecessary, highlighting the inefficiency of New Zealand trying to produce its own fuel.

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

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



[1] http://www.beehive.govt.nz/ViewDocument.aspx?DocumentID=27081

[2] http://www.transport.govt.nz/assets/NewPDFs/BSO-Discussion-document-presentation.pdf

[3] http://www.transport.govt.nz/assets/NewPDFs/Covec-Biofuels-Economics-Final-Report-16.06.06.pdf, pg 1

[4] Brazil is the main producer and exporter of ethanol.   It aims to expandproduction, and should remain the main producers of ethanol-based bio-fuel overthe foreseeable future.   The US aims to produce 4.5% of theirdomestic fuel consumption with bio-fuels by 2012.   The US will become a major exporter of bio-fuels, but are focused ondomestic demand for the short run.   Japan is aiming for 500m cubic metres of production by 2010.   This heftytarget comes from its desire to be major exporters of bio-fuel.   China,India, and Thailand are expected to import bio-diesel in the long run,but potentially export ethanol based fuel.   Australia is investing heavily in both ethanol-based fuel and bio-diesel.   Itmay be able to export quantities of both to New Zealand by 2010.

[5] http://www.med.govt.nz/templates/MultipageDocumentPage____8057.aspx

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