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Right now, all across the US, producers of an alternative fuel called "biodiesel" are in a state of panic.
Right now, all across the US, producers of an alternative fuel called “biodiesel” are in a state of panic.
Over the next year, up to three-quarters of them may have to shut down, eliminating nearly a third of this infant green industry’s capacity and thousands of jobs.
These are precisely the kind of relatively high-paying jobs that the Obama administration has claimed that it wants to promote, especially given the slowdown in job growth nationwide. Yet the fact is that this infant green industry, otherwise a success story for smart government policy, is being undone by sheer bureaucratic mismanagement.
On the surface, this crisis has all the makings of a classic Grimm Brothers fairy tale – libertarian style: relentless government regulation binding the wings of free market forces. Undoubtedly, many in Congress will try to spin it this way, as both the House and the Senate carry out investigations in the next few months.
In fact, the real story is almost precisely the opposite.
In this case the problem has not been too much government regulation, but too little.
And the moral is one that libertarians chronically ignore.
Efficient markets, especially new ones, cannot simply be left to their own devices, or the “law of the jungle.” Their survival actually presupposes effective regulation, effective investigators and courts, and the rule of law.
A GREEN ENERGY SUCCESS STORY
The deep crisis now facing the US biodiesel industry can’t be blamed on fundamental economics. In 2011 the industry’s total output was about a billion gallons, more than twice the 450 million gallons produced in 2007, with 20 percent of last year’s total derived from recycled feedstocks like waste grease and inedible animal fat, up from just 4.5 percent in 2007.
This increased biodiesel production is already making an important contribution to reducing US CO2 emissions. In the US, transportation is the second leading source of CO2 after electricity, and diesel fuel is the second leading source within that sector. Largely because of increased trucking, diesel-based emissions have shot up 53 percent since 1992, while gasoline-based emissions have increased only about 14 percent. Since biodiesel’s CO2 emissions are up to 80 percent less than those of ordinary diesel, the advantages of displacing regular diesel with biodiesel can be dramatic.
From a public health standpoint, biodiesel also promises dramatic reductions in diesel-generated pollutants that can create smog and acid rain, trigger asthma attacks, and increase cancer risks.
Finally, this nascent, relatively labor-intensive energy industry has already created more than 31,000 new jobs while supporting hundreds of small businesses, and in 2011 the industry as a whole paid over $630 million in taxes at the federal, state, and local levels.
Overall, therefore, while biodiesel is hardly a silver-bullet, we believe that it has a critical “bridge” role to play in curtailing the global warming menace, because it works in the diesel engines that people already own, and because it can be produced at the local level, community by community.
THE RIN MARKET
So why is this industry now in crisis? The problem lies in the EPA’s handling of fraud within the government’s program for promoting the use of biofuels.
Reminiscent of “cap-and-trade,” the EPA’s Renewable Fuels Standard (RFS) mandates annual volumes of biofuels, including biodiesel, for US oil companies to bring to market, while allowing them to purchase offsets (“Renewable Identification Numbers,” or “RINs”) in a spot market from other oil companies as well as from biofuel producers and distributors.
As government programs go, RFS is a surprisingly innovative alternative to traditional subsidies, which are often either too much or too little, and frequently outlive their purposes — viz the huge subsidies still received by the global fossil fuels industry each year. RFS enables biodiesel to be sold at a price that is competitive with regular diesel, and at a scale sufficient to meet annual biofuel production targets set by the EPA.
We might think of the RIN as a “self-adjusting” subsidy. The RIN market bids RINs up and down as projected prices for biodiesel feedstock and for regular diesel are updated
throughout the year. The harder it is expected to be for a given category of biofuel to meet its mandated level, the more support it receives from its RIN.
As an industry matures, the training wheels come off and the value of its RINs heads towards zero. For example, as the goals of RFS do not require any further expansion of corn ethanol production, current-year ethanol RINs have been trading at $.01-.03/gallon, down about 80 percent from their 2008 high. Current-year biodiesel RINs, meanwhile, now trade for about $1.80/gallon.
THE CURRENT CRISIS
Without adequate regulation, new financial markets, such as the spot market for RINs, are vulnerable to fraud.
Last fall, the EPA accused two companies in Maryland and Texas of selling fraudulent biodiesel RINs – about $40 million worth over a three-year period. In April 2011, the EPA issued a notice of violation to another Texas producer, alleging the fraudulent generation of 60 million bad RINs (equivalent to 40 million gallons of biodiesel) over a 2-year period.
Any oil company who’d purchased their RINs for RFS compliance—even in good faith—was liable for up to $37,500 per day under the Clean Air Act (a penalty designed for recalcitrant polluters).
In the wake of these fraud cases, there has been a flurry of lawsuits and countersuits. Oil companies have sued the traders they purchased RINs from. One of these traders has in turn sued the EPA for failing to warn the RIN market about the Maryland producer (“Clean Green Fuel”) until the completion of a 14-month investigation, during which time its fraudulent RINs continued to change hands. Just this week, the US District Court of Maryland reportedly convicted Clean Green’s owner of 42 criminal charges stemming from the EPA’s investigation.
In recent months, the biodiesel RIN market has slowed to a crawl, seeing fewer trades per week than it used to in a day. Though the EPA has now agreed to cap fines at $350,000 per oil company for 2011 violations, most major refiners are still refusing to accept RINs from any but the twenty largest biodiesel producers (the ones large enough to sue, if need be). RINs from small and medium producers can be sold, if at all, only at steep discounts, making it hard for those producers to survive in a market with razor-thin margins.
If a producer’s RINs cannot be sold, neither can its fuel. In the typical case, RINs remain “attached” to their gallons of biodiesel until a distributor blends those gallons with regular diesel (to be sold as, e.g., “B20,” meaning 20% biodiesel). However, if a distributor can’t sell RINs generated by a given producer, it becomes uneconomical to continue to buy their fuel.
By our count, about three-quarters of US biodiesel producers have annual capacities of 20 million gallons or less, comprising about a third of total industry capacity.
This tier of the market is also the greenest. Fully 90 percent of these producers use at least some waste/recycled feedstock (compared to 48 percent for the twenty biggest producers), and 29 percent use only waste/recycled feedstock (versus just 7 percent of the twenty biggest).
It’s also arguably the most innovative, since it includes all demonstration-scale plants, as well as smaller, innovation-focused firms like Piedmont Biofuels, which is pioneering inexpensive, enzyme-based pretreatments to make even the lowest quality waste grease into usable biodiesel feedstock.
If order is not restored to the RIN market, the biodiesel industry stands to lose some of its most dynamic and progressive producers.
THE EPA’S RESPONSE
Of course, this is not how the RIN market was supposed to work. In order to perform the function Congress intended, RINs—like any compliance market credit or allowance—must be fungible. Only then can RINs function as genuine offsets for the biofuel that an oil company decides not to bring to market itself.
However, when it comes to RIN market regulation, the EPA has adopted a “hands off” stance. According to the EPA, rooting out RIN fraud is not its job. It says the RIN market’s guiding principle must be “buyer beware,” and that oil companies will have to come up with auditing and enforcement mechanisms of their own.
But it would make sense to expect this outcome only if RINs were part of the oil companies’ core business. On the contrary, oil companies resent having to purchase RINs in the first place, and so they’re certainly not going to invest more money than they have to in meeting compliance mandates, especially not when the only consequence of inaction is the elimination of a competing industry.
In its defense, the EPA cites its arm’s length approach to anti-fraud regulation in other regulated fuel markets. However, while it is easy to check a gallon of fuel, say, for its sulfur content, the only way to make absolutely sure that a given RIN corresponds to a gallon of biodiesel someone actually made is to travel back in time.
Moreover, private auditors will always be insufficient unless the EPA also creates a mechanism for them to bar suspected counterfeiters from the program, at least temporarily. Neither Clean Green nor Absolute Fuels had any presence in the physical biodiesel market, which is the first thing RIN traders look to in assessing a producer. But there’s all the difference in the world between not being able to fool most buyers in the market and not being able to fool any buyers in the market.
WHAT IS TO BE DONE?
So what should the EPA do to fix the problem and restore this industry to fast growth?
First, for only about $8 million a year, the government could hire 80 full-time inspectors to canvass biodiesel plants across the country with random visits. These inspectors would have to be government employees because they’d have to have the power to suspend a suspect producer’s ability to generate RINs. Up until the end of last year when the $1/gallon biodiesel tax credit expired, the IRS in fact had two dozen biodiesel inspectors performing precisely the task in question, and that program could provide both the model and some of the human capital required here. Unfortunately that inspection program expired with the tax credit.
As for the money, $8 million is about what the EPA receives in total for cellulosic ethanol waivers, which oil companies must purchase instead of cellulosic ethanol RINs because cellulosic ethanol (made from starchy biomass like agricultural waste and recycled paper) is not yet being produced at commercial scale. The oil companies don’t like paying compliance costs on a fuel that doesn’t exist yet, and they don’t like bearing strict liability for good faith purchases in an under-regulated market, but perhaps the two can cancel out.
Simplest of all, the EPA should commit to prosecuting RIN fraud in a timely fashion—say 1-2 years—instead of the 7 year window it allows itself now (with daily fines accruing in the meantime). This should help attract insurance companies to the RIN market by making it easier to calculate the risks.
Lastly, the EPA should introduce a more rigorous registration mechanism for all biodiesel plants with annual capacity over 5 million gallons (the industry median), and should notify the market whenever a producer generates RINs in excess of its nameplate capacity. All of the fraudsters to date had pretended to be large producers, whereas it’s the small and medium biodiesel producers who are now facing financial ruin.
Could the EPA enact these changes? Yes. Will they? Probably not.
As easy as it is to caricature the EPA’s response to this crisis, the root problem may have more to do with institutional culture than with administrative flat-footedness. In general, the EPA’s enforcement style emphasizes symbolic acts of punishment—infrequent but severe—intended to teach a lesson to anyone else tempted to bend the rules. In the words of a former EPA administrator: “It’s kind of like how the Romans used to conquer little villages in the Mediterranean: they’d go into little Turkish towns somewhere, they’d find the first five guys they’d run into, and they’d crucify them. And then, you know, that town was really easy to manage over the next few years.”
If the Obama administration doesn’t care enough about the biodiesel industry—and small and medium producers in particular—to enact the minor reforms needed to save it, it should do so for the sake of its own political agenda. If the EPA cannot oversee the RIN market effectively, it’s difficult to see how they could administrate a US carbon offset market for cap-and-trade, which could easily be 25-50 times larger.
So where does this leave us? We have a commercial-scale alternative fuel, creating jobs and supporting small business while it paves the way for more scalable, next-generation feedstocks further down the line (e.g. algae). And we have an innovative government program which, until recently, had succeeded in catalyzing the growth of the biodiesel industry without locking-in the kind of subsidy that might outstay its welcome. Spoiling these achievements, we have a government agency adopting the regulatory strategy of medieval monarchs: tempering weak enforcement capacity with severe and unpredictable punishments.
Ruling through fear was bad for markets then, and it is bad for markets now.
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