US and French Biofuels Policy Possibilities for the Future by Wallace E.

. Tyner and Maxime Caffe Purdue University This paper provides an analysis of biofuels policy in the United States and in France. In both cases we compare the current fixed subsidy policy with a possible future variable subsidy. The first section is on the United States and the second on France. U.S. Ethanol Policy Ethanol has been produced for fuel in the United States for at least 26 years. The industry launch was initiated by a subsidy of 40 cents per gallon (10.6 cents/liter) provided in the Energy Policy Act of 1978. Between 1978 and today, the ethanol subsidy has ranged between 40 and 60 cents per gallon (10.6 and 15.9 cents/l). The history of subsidy changes is provided in Table 1. The federal subsidy today is 51 cents per gallon (13.5 cents/l). Throughout all the history, the subsidy has always been a fixed amount that is invariant with oil or corn prices (Tyner and Quear, 2006). In addition to the federal blending credit subsidy, there are also some other federal and state subsidies. In fact, Koplow (Koplow, 2006) calculates the total subsidy available for ethanol in 2006 to range between $1.05 and $1.38 per gallon of ethanol (27.8 36.5 cents/l) or between $1.42 and $1.87 per gallon of gasoline equivalent (37.6 49.5 cents/l). Many would regard these figures as being high, but they do demonstrate that the ethanol industry has been one with substantial subsidies. Ethanol economics Ethanol gets its value from the energy it contains and its additive value. Ethanol has value as a gasoline additive because it contains more oxygen than gasoline (and therefore causes the blend to burn cleaner) and because it has a much higher octane than gasoline (112 compared with 87 for regular gasoline). Historically, ethanol prices have been higher than gasoline because of the additive value and because of the federal and state subsidies. Figure 1 provides the monthly ethanol and gasoline prices for Omaha, Nebraska, between 1982 and 2006. Examining Figure 1, one can see that the relationship between gasoline and ethanol prices began to change in 2002. Figure 1 also contains the regression fits for the entire period, and for the separate periods 1982-2001 and 2002-2006. The coefficients are all significant, and the regressions explain between two-thirds and three-fourths of the variance in ethanol prices.

2 Except for the summer of 2006, the spread between ethanol and gasoline was greater in earlier years than in the period 2002 and after. Ethanol even fell below gasoline for a few months in 2005 leading some to believe that the natural price for ethanol would be on an energy equivalent basis with gasoline. The spread increased substantially in summer 2006 because of a change in federal rules that took effect May 8, 2006. As of that date, the federal requirement for blending a certain percentage of oxygen ended. One of the major sources of oxygen had been a compound named MTBE. However, this compound is highly toxic and had been found in the water supplies in several areas. With there no longer being a requirement to blend a certain amount of oxygen, many companies feared legal prosecution if they continued to use MTBE and switched to ethanol, which increased substantially the demand and price of ethanol.
Table 1 History of Ethanol Subsidy Legislation $0.40 per gallon of ethanol tax exemption on the $0.04 gasoline excise tax Promoted energy conservation and domestic fuel development Increased tax exemption to $0.50 per gallon of ethanol and increased the gasoline excise tax to $0.09 per gallon Increased tax exemption to $0.06 per gallon Created research and development programs and provided fuel economy credits to automakers Ethanol tax incentive extended to 2000 but decreased to $0.54 per gallon of ethanol Acknowledged contribution of motor fuels to air pollution Tax deductions allowed on vehicles that could run on E85 Ethanol subsidies extended through 2007 but reduced to $0.51 per gallon of ethanol by 2005 Changed the mechanism of the ethanol subsidy to a blender tax credit instead of the previous excise tax exemption. Also extended the ethanol tax exemption to 2010. Established the Renewable Fuel Standard starting at 4 billion gallons in 2006 and rising to 7.5 billion in 2012.

1978 1980

Energy Tax Act of 1978 Crude Oil Windfall Profit Tax Act and the Energy Security Act Surface Transportation Assistance Act Tax Reform Act Alternative Motor Fuels Act Omnibus Budget Reconciliation Act Clean Air Act amendments Energy Policy Act Transportation Efficiency Act of the 21st Century

1982 1984 1988 1990 1990 1992 1998

2004

Jobs Creation Act

2005

Energy Policy Act

Source: (Commerce, 2006), North Dakota Chamber of Commerce.

As indicated above, there are three components to the market value of ethanol: energy, additive, and subsidy. It is interesting to portray these values in terms of the relationship between crude oil price and the maximum a corn dry mill could afford to pay for corn at each crude price. To estimate such a relationship

3 many assumptions were needed, and these assumption are detailed in Appendix A. displays the relationships between crude oil price and break-even corn price on the basis of energy equivalence, energy equivalence plus additive value (assumed to be 25 cents per gallon (6.6 cents/l) for this illustration, and energy equivalence plus additive value plus the current federal blending subsidy of 51 cents per gallon (13.5 cents/l). The energy equivalence line was done assuming a figure of 70 percent, slightly more than the direct energy equivalent. Using Figure 2 one can trace out the break-even corn price for any given crude oil price. For example, with crude oil at $60/bbl., the break-even corn price is $4.82/bu. ($189.70/mt) including both the additive premium and the fixed federal subsidy. This figure is for a new plant and includes 12 percent return on equity and 8 percent debt interest. If we consider an existing plant with capital already recovered, we add $0.78 per bushel $30.70/mt) to yield a break-even corn price of $5.60 ($220.40/mt).
Figure 1

Historic Ethanol and Gasoline Prices

$4.00 $3.50

Omaha, NE

Ethanol = 0.671 + 0.870 * gasoline (1982 - 2006)

$3.00

Ethanol = 0.212 + 1.121 * gasoline (2002 - 2006)

$2.50

$/gal.

Ethanol = 0.547 + 1.096 * gasoline (1982-2001)

$2.00 $1.50 $1.00 $0.50 $0.00
94 82 83 84 85 86 87 88 89 90 91 92 93 95 96 98 99 97 20 02 20 03 20 04 20 05 20 06 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 00 01

Gasoline

Ethanol

Any number of sensitivity analyses could be performed on the calculations contained in this paper. Table 2 provides results on some important sensitivity analyses. All the reported results are the corn breakeven for $60 crude oil. First, suppose that not all the subsidy gets passed through to dry millers and to the corn price. The first sensitivity assumes the subsidy is effectively 40 cents (10.6 cents/l) instead of 51 cents. The breakeven corn price with the fixed subsidy becomes $4.50 ($177.11/mt) instead of $4.82 ($189.70/mt). Next suppose that the additive value is 30 cents per gallon instead of 25. The corn breakeven price becomes $5.02 ($197.57/mt). With the additive value of 40 cents, the corn breakeven becomes $5.37 ($211.35/mt). There is no doubt that ethanol has an additive value as an oxygenate and for octane, but it is impossible to predict what it will be as ethanol production increases beyond the needs for octane and added oxygen.

4 Another type of sensitivity would be to assume that ethanol might be priced equivalent to gasoline on a volumetric basis instead of energy basis. Some argue that in the long term refiners will choose to modify their refining process to produce a lower octane gasoline, say 84 octane, which could be blended at 10 percent ethanol to produce the standard 87 octane regular gasoline. We conducted two sensitivity analyses one with the supplemental additive value then at zero and one with the additive value at 20 cents (5.3 cents/l). With volumetric equivalent pricing and no additional additive value, the corn breakeven becomes $6.20 ($244.01/mt). With volumetric pricing and 20 cents additional additive value, the corn breakeven becomes $6.89 ($271.17/mt). In all these cases except the lower subsidy pass through, dry millers could afford to pay more for corn than in the base case. Combination of these cases could be done as well, but the approximate outcomes can be inferred from these results.
Figure 2

Breakeven Corn and Crude Prices with Ethanol Priced on Energy and Premium Bases plus Ethanol Subsidy
100.00 90.00 80.00 Crude ($/bbl) 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5 Corn ($/bu) With subsidy and price premium Price premium for octane/oxygen Energy basis

Table 2 Sensitivity Analysis for Corn Breakeven Prices with the Current Subsidy

Sensitivity Case

Corn Breakeven with $60 Crude Oil Subsidy pass-through equal to $0.40 instead of $0.51 $4.50 Additive value equal to $0.30 instead of $0.25 $5.02 Additive value equal to $0.40 instead of $0.25 $5.37 Ethanol priced equal to gasoline on a volumetric basis $6.20 instead of energy basis with no supplemental additive value Ethanol priced equal to gasoline on a volumetric basis $6.89 instead of energy basis with $0.20 supplemental additive value

5 During most of the history of the federal ethanol subsidy, crude oil prices ranged between $20 and $30 per barrel. With crude oil price in that range, the fixed federal subsidy did not put significant pressure on corn prices. However, with crude oil today around $60, there is significant pressure on corn prices. Ethanol investments in the United States have been during the past two years highly profitable with payback periods as short as one year. This high profitability has attracted significant new investment in the industry as shown in Figure 3. Ethanol production grew 1 billion gallons in 2005 and 2006 and is expected to grow 3 billion gallons in 2007, a doubling in two years. Because of this current and expected future growth in ethanol production, corn prices have skyrocketed in fall 2006. In just a few months, prices are up from about $2.25 ($88.55/mt) to $3.70 per bushel ($145.62/mt), an increase of about 65 percent. This leap in corn prices is provoking an emerging opposition to ethanol subsidies on the part of animal agriculture and other corn users. Some are also concerned about the $4 billion cost (Euros 3 billion) of the subsidy in 2007.
Figure 3

Ethanol Production
8000 7000 6000

1000 gal./yr.

5000 4000 3000 2000 1000 0

19 8 19 0 8 19 1 82 19 8 19 3 8 19 4 85 19 8 19 6 87 19 8 19 8 89 19 9 19 0 9 19 1 92 19 9 19 3 9 19 4 9 19 5 96 19 9 19 7 98 19 9 20 9 00 20 0 20 1 0 20 2 0 20 3 04 20 0 20 5 06 20 07

Policy alternatives In essence, the situation is that we are living an unintended consequence of the fixed ethanol subsidy. When it was created, no one could envision $60 oil, but today $60 oil is reality, and many believe oil prices are likely to remain high. So given this reality, what changes in federal policy could be considered that would support the ethanol industry but provide less incentive for rapid growth in the industry leading to abnormally high corn prices? There are several possible policy options that could be considered:

6 Keep the subsidy fixed but reduce it to a level more appropriate for crude oil prices around $60 Find a way to limit the quantity of ethanol that would receive the subsidy thereby permitting better control of the growth of corn based ethanol Provide higher subsidies for cellulose based ethanol in hopes of accelerating development and implementation of that technology Convert the subsidy from a fixed subsidy to one that varies with the price of crude oil

Any of these options could be considered, but the remainder of this paper presents an alternative subsidy in which the level of the subsidy varies with the price of crude oil. Variable subsidy In designing such a variable subsidy, there are two key parameters: the price of crude oil at which the subsidy begins, and the rate of change of the subsidy as crude oil price falls. We will illustrate the variable subsidy using $60 crude as the point at which the subsidy begins. That is, when crude is higher than $60, there is no subsidy, but some level of subsidy exists for any crude oil price lower than $60. In this illustration, we will use a subsidy change value of 2.5 cents per gallon (0.66 cents/l) of ethanol for each dollar crude oil falls below $60. Thus, if crude oil were $50, the subsidy per gallon of ethanol would be 25 cents. If crude oil were $40, the ethanol subsidy would be 50 cents per gallon. Therefore, for any crude oil price above $40, the ethanol subsidy would be lower than the current fixed subsidy. For any crude price less than $40, the subsidy would be greater than the current fixed subsidy of 51 cents per gallon. Figure 4 illustrates the corn break-even price for different crude oil prices if this variable subsidy were in effect. In this case, the corn break-even price for a new ethanol plant would be $3.08 per bushel ($121.22/mt), compared to $4.82 with the fixed subsidy shown in Figure 3. With oil at $50, the corn break-even would be $2.77 ($109.02/mt) for a new plant with the variable subsidy. $40 oil would support a corn price of $2.27 ($89.34/mt) for a new plant and $3.05 ($120.04/mt) for an existing plant with capital recovered. So the variable subsidy provides a safety net for ethanol producers without putting inordinate pressure on corn prices. The difference between the two subsidy approaches can be visualized in Figure 5, which displays both the fixed and variable subsidies. From examining this figure, it is clear why the variable subsidy provides so much less pressure on corn prices. For any crude oil price above $60, there is no ethanol subsidy with the variable subsidy, so ethanol plant investment decisions are made based on market forces alone instead of being driven by the federal subsidy. For any crude price between $40 and $60, the variable subsidy is less than the fixed subsidy thereby providing less incentive to invest and less pressure on corn prices, but maintaining a safety net. However, with the fixed subsidy, ethanol plant investment decisions

7 continue to be heavily influenced by the government subsidy even at crude oil prices that render ethanol very profitable in the absence of a subsidy. Thus, the variable subsidy alternative is one option that merits further consideration in the policy decision process.
Figure 4

Breakeven Corn and Crude Prices with Ethanol Priced on Energy and Premium Bases plus Variable Ethanol Subsidy
100.00 90.00 80.00 Crude ($/bbl) 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5 Corn ($/bu) With price premium and variable subsidy ($60/0.025) Price premium for octane/oxygen Energy basis

Figure 5

Breakeven Corn and Crude Prices with Ethanol Priced on Energy and Premium Bases plus Variable Ethanol Subsidy
100.00 90.00 80.00 Crude ($/bbl) 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5 Corn ($/bu) With price premium and variable subsidy ($60/0.025) With fixed subsidy Energy basis Price premium for octane/oxygen

8 French Biofuels Policy Analysis This section provides analysis of the impacts of implementation of a variable ethanol and biodiesel subsidy in France, compared to the current fixed subsidy approach. It is based upon a recently completed M.S. thesis at Purdue (Caffe, 2006). The recent law of agricultural orientation n 2006-11 from January 5, 2006, aims to increase the share of biofuels in total French fuel consumption to 7 percent, on an energy basis, by 2010. In 2005, French drivers incorporated 1 percent of biofuel in their automobile tanks. Liquid biofuel support programs launched in 1993 in France are implemented through a fixed tax exemption. The current tax credits are 25 Euros/hl for biodiesel and 33 Euros/hl for ethanol. If the level of these tax exemptions stays the same, total spending by the French government could reach 1,350 billion Euros by 2010. The objectives of this study were first to analyze the feedstock and biofuels costs of production in France and secondly to compare the current policy and a variable subsidy depending on crude oil prices. In order to estimate the future feedstock and biofuel cost of production as well as tax exemption levels, a microeconomic biofuel activity model (OSCAR) containing both a detailed agricultural and biofuel industry sector was used. Due to land scarcity in France, feedstock cost of production for the biodiesel sector will increase compared to historical levels. On the other hand, French ethanol production could be moderately expanded compared to the current government objective. We estimate that future biofuel cost of production, using feedstock produced by most productive farms by the year 2010 would be 56 Euros/hl for biodiesel and 39 Euros/hl for ethanol. The value of any government subsidy or tax exemption must be judged on how well it achieves its intended objective. In our case, the tax exemption must provide to the biofuel industry a fiscal advantage in order to be competitive with regular fuels and allowing biofuel production to meet the government biofuel incorporation objectives. It is possible to measure the efficiency of this tax exemption by comparing the main objectives versus the cost to the government and consequently to the tax payers. Comparing the fixed and variable subsidy In this section we compare the current fixed subsidy with a subsidy that varies with the price of crude oil. We will examine the cost of the two approaches and the risk reduction brought about by the alternatives. We choose to use the example of RME and ETBE, as prior to 2005 ethanol direct incorporation into gasoline was practically non-existent. We used the difference between the cost of production, corresponding to the volume produced, and the valuation of biofuel on an energy basis to compute the variable tax exemption. Figure 6 shows the cost of the variable

9 tax exemption from January 2002 until May 2006 for RME. We also can remark that when crude oil price is close to an equivalent of 60-65 $/bbl, biodiesel becomes competitive.
Figure 6 - Variable Tax Exemption vs. Existing Tax Exemption for RME from January 2002 until May 2006
80 70 60 50
/hl

80 70 60 50 40 30 20 10 0
$/bbl

40 30 20 10 0

Figure 7 shows the cost of the variable tax exemption for ETBE from January 2002 until May 2006. We can see that in April 2006 the variable tax exemption cost for the government and consequently for the tax payer would have been close to 0. Effectively, the cost for the government corresponds to the area under the tax exemption times the volume of biofuel produced under agreements.
Figure 7 - Variable Tax Exemption vs. Existing Tax Exemption for ETBE (2002-2006)
80 70 60 50 /hl 40 30 20 10 0 80 70 60 $/bbl 50 40 30 20 10 0

Ja n02 A pr -0 2 Ju l-0 2 O ct -0 2 Ja n03 A pr -0 3 Ju l-0 3 O ct -0 3 Ja n04 A pr -0 4 Ju l-0 4 O ct -0 4 Ja n05 A pr -0 5 Ju l-0 5 O ct -0 5 Ja n06 A pr -0 6

Variable subsidy Existing tax exemption Crude oil

Ja n02 A pr -0 2 Ju l-0 2 O ct -0 Ja 2 n0 A 3 pr -0 3 Ju l-0 O 3 ct -0 Ja 3 n0 A 4 pr -0 4 Ju l-0 O 4 ct -0 Ja 4 n05 A pr -0 5 Ju l-0 5 O ct -0 Ja 5 n06 A pr -0 6

Variable tax exemption Existing tax exemption Crude oil

10 The total estimated cost for the government in the period 2002-2005 is estimated at 60.9 million Euros due to the tax exemption. If the variable tax exemption were implemented, this cost would shrink to 24.6 million Euros. As mentioned previously, the variable tax exemption reduces government costs, while giving the biofuel industry a safety net and truncating its down side returns. Also, this will automatically reduce the cost of saving one ton of CO2 for society. The variable tax exemption corresponds to a zero economic profit. A zero economic profit is different from its meaning in accounting. A zero economic profit allows the biofuel industry to benefit from a normal rate of return. We decided to compute two different variable tax exemptions, one with a zero economic profit and a second one where the value of the difference between the cost of production and the valuation is increased by 10 percent assuring that the industry would be profitable. We used the biofuel cost of production, obtained from the OSCAR model results at the future volume required by the government objectives by the year 2010. If we use an exchange rate of 1.25, the government would subsidize the biodiesel industry until crude oil reaches approximately $85.5/bbl in both cases. It would subsidize the ethanol industry until crude oil reached approximately $89/bbl in both cases. Also considering the current tax exemption, the variable tax exemption would exceed the current tax exemption if crude oil price would decrease under $46.8/bbl for the biodiesel industry and $9/bbl for the ethanol industry in the case of no extra profit. In the case of extra profit, the variable tax exemption would exceed the current tax exemption if crude oil price would decrease below $43/bbl for the biodiesel industry and $1/bbl for the ethanol industry. In order to see the total effect on the government expenditure, we computed the total cost of the current tax exemption policy versus our variable tax exemption under three scenarios, where crude oil price is set up at $40/bbl, $60/bbl, and $80/bbl corresponding to the low, and high price scenarios of the Annual Energy Outlook (AEO) and the high of the crude oil market in 2006. Table 3 provides the total cost for the French government of the tax exemption under three scenarios of crude oil price for the year 2010.
Table 3 - Total Tax Exemption Cost for the French Government in Year 2010
in x1000 Crude oil price Biodiesel Ethanol ETBE Total Actual tax exemption Variable tax exemption-ep Variable tax exemption-nep $40/bbl $60/bbl $80/bbl $40/bbl $60/bbl $80/bbl $40/bbl $60/bbl $80/bbl 913,788 913,788 913,788 1,061,822 583,728 105,634 966,057 531,825 97,593 339,518 339,518 339,518 204,739 118,317 31,894 186,940 108,543 30,145 98,824 98,824 98,824 63,547 31,833 412 57,977 29,138 1,029 1,352,130 1,352,130 1,352,130 1,330,108 733,878 137,940 1,210,974 669,506 128,766

Notation: -ep stands for extra profit variable tax exemption case and -nep stands for no extra profit variable tax exemption

If the government does not change its policy regarding the tax exemption scheme, the total cost of supporting biofuel could reach 1.35 billion Euros, if 100

11 percent of the volume agreements are produced. If the price of crude oil stays on average at $60/bbl in year 2010, the cost of supporting biofuel under a variable tax exemption would fall to 0.733 and 0.669 billions Euros for the extra profit and no extra profits cases respectively. This corresponds to a decrease of 46 or 50 percent of total costs depending on the type of variable tax exemption implemented. Also using the market condition as of November 10, 2006 for December crude oil future and implementing them in the Black/Scholes model, we find out that the market values the odds of crude oil being bellow $40/bbl in 2010 at 9 percent, 55 percent being above $60/bbl and 28.5 percent being above $80/bbl using delta values1 of the options of the corresponding strike for the December 2010 contract. By weighting those probabilities, we find that under those market conditions the total expense for the government with the variable tax exemption would be 0.601 billion Euros for the extra profit case and 0.549 billion Euros for the no extra profit case, which is 55 and 60 percent respectively less than the amount that the government would pay by keeping the current tax exemption. Comparison of cost of CO2 saved Then, concerning the cost of saving one ton of CO2 the current cost for the biodiesel sector is 159 /ton of CO2 saved. This cost is not effective compared to other alternative subsidies such as the efficiency enhancement of conventional power plants. However, if the price of crude oil reaches $60/bbl, this cost decreases to 102 or 93 /ton of CO2 saved depending on the type of variable tax exemption implemented, but it could decrease even to 17-18 /ton of CO2 saved if the crude oil price reaches $80/bbl. Table 17 provides the cost of saving one ton of carbon dioxide under different oil price scenarios.
Table 4 - Cost of Saving One Ton of Carbon Dioxide under Different Oil Price Scenarios.
in /ton of CO2 saved Crude oil price Biodiesel Ethanol from wheat Ethanol form sugar beet Actual tax exemption $40/bbl $60/bbl $80/bbl 159 159 159 355 355 355 385 385 385 Variable tax exemption-ep $40/bbl $60/bbl $80/bbl 185 102 18 214 124 33 232 134 36 Variable tax exemption-nep $40/bbl $60/bbl $80/bbl 168 93 17 196 114 28 212 123 31

Notation: -ep stands for extra profit variable tax exemption case and -nep stands for non extra profit variable tax exemption

It is important to note that the exchange rate has an important effect on those costs. If the exchange rate decreases to 1.15 $/, then the total cost for the government with a crude oil price at $80/bbl would be zero, so the cost of avoiding one ton of carbon dioxide would be also zero.

The delta of an option for a specific strike price can be interpreted at the odds that the underlying contract being above or below this strike price at its expiration; below for a put delta and above for a call delta.

12 To sum up, a variable tax exemption would decrease the cost for the tax payer by 12 to 100 percent, depending on crude oil price and exchange rate, and would still stimulate investments in the biofuel industry market but decrease the biofuel industry profit, while still providing the industry a normal rate of return. The industry would have a safety net and less profit variability. By comparing the current fixed tax exemption and a variable tax exemption, we find that the second option could decrease pressure on taxpayers while still providing a safety net to the biofuel industry despite profit erosion in the industry. Moreover, the risk side for the government would be a fall in the crude oil price, but even if the crude oil price falls to $40/bbl, the government would still save 0.142 billion Euros with an exchange rate of 1.25 $/. Conclusions Ethanol has been subsidized in the US since 1978. Currently the subsidy is 51 cents per gallon, and combined with $60 oil, ethanol production has become highly profitable. This profitability has stimulated a huge increase in ethanol production capacity with 6 billion gallons of new capacity under construction as of January 2007. This increase in ethanol production is increasing corn demand and prices. Under the current policy, ethanol producers could still invest profitably in new production with corn price as high as $4.82/bu. ($189.70/mt). Other assumptions could yield substantially higher corn prices. If government is interested in reducing upward pressure on corn prices, alternatives to the current fixed 51 cent per gallon subsidy could be considered. One option would be to lower the fixed subsidy. This alternative would reduce the pressure on corn prices but would still provide ethanol subsidies under higher oil prices. It is also invariant to underlying market conditions. A second option would be a variable subsidy that provided an ethanol subsidy, which changes with the crude oil price. The option evaluated in this paper provided no subsidy for crude oil price above $60, and a subsidy that increased 2.5 cents per gallon for each $1 crude price is below $60. This option yields a breakeven corn price for $60 oil of $3.08/bu. ($121.22/mt) compared with $4.82/bu under the current policy. Another option, clearly, is to make no change in current policy. With this alternative, the other corn using sectors such as livestock production and corn exports would be forced to make the needed adjustments. Less corn would be used in these sectors, and prices for all livestock products likely would increase. Similarly, the French government could save substantial sums of Euros with a variable subsidy based on crude oil prices. Using the Black/Scholes approach to calculating the savings, the percentage saved would range from 55-60 percent. It could also achieve reductions in CO2 emissions at a much lower cost using the variable subsidy approach.

13 References Caffe, Maxime. "Economic Analysis Of The French Biofuel Sector: Comparison Of Current Policy And An Alternative Variable Subsidy Policy." M.S., Purdue University, 2006. Commerce, North Dakota Department of. "National Legislative History." 12/8/2006. http://goefuel.com. Hurt, Chris, and Wallace E. Tyner. "Economics of Ethanol." Purdue UniversityExtension, BioEnergy, 339 2006. Koplow, Doug. Biofuels - At What Cost? Government Support for Ethanol and Biodiesel in the United States. Geneva, Switzerland: Global Subsidies Initiative of the International Institute for Sustainable Development, 2006. Tiffany, Douglas G., and Vernon R. Eidman. "Factors Associated with Success of Fuel Ethanol Producers." University of Minnesota, Department of Applied Economics, Staff Paper Series, Staff Paper P03-7. Tyner, Wallace E., and Justin Quear. "Comparison of a Fixed and Variable Corn Ethanol Subsidy." Choices 21, no. 3(2006): 199-202.

14 Appendix A The link between crude oil price and breakeven corn price requires numerous assumptions. Following are the most important assumptions updated to November 2006: 1) Relationship between crude oil price and gasoline price This relationship is given by the equation below: Wholesale gasoline price ($/gal.) = 0.3064 + 0.03038 * crude oil price ($/bbl.) The data for this equation was monthly data 2000-2006 from EIA/DOE. However, longer and shorter time periods were tested, and the results are remarkably stable. The adjusted R2 for the equation is 0.93, meaning that 93% of the variability in gasoline price over time is explained by changes in the crude oil price. 2) Relationship between gasoline price and ethanol price The energy equivalent price of ethanol is assumed to be 70% of the gasoline price. That is slightly higher than the pure energy equivalence. 3) Relationship between corn price and DDGS price DDGS price is a function of the prices of corn and soybean meal as follows: DDGS price ($/ton) = 1.52 + 0.205 * soybean meal price ($/ton) + 21.98 * corn price ($/bu.) Substituting a price for soybean meal of $200/ton into this equation yields the equation used in the model: DDGS price ($/ton) = 42.52 + 21.98 * corn price ($/bu.) All data is from USDA, monthly 2003-06. Illinois prices were used for corn and soybean meal, and Lawrenceburg, IN, for DDGS. It is assumed that 18 pounds of DDGS is produced per bushel of corn used. 4) Ethanol yield per bushel of corn is assumed to be 2.65 gallons. Newer plants may have higher yield, but this figure is close to the industry average. 5) Capital cost for the plant is assumed to be $1.80 per gallon of capacity, which translates to about 29 cents per gallon produced. Older plants had considerably lower capital cost, and much of the capital probably has already been paid off. The plant is assumed to operate at full capacity. 6) Financial assumptions:

15 The plant is 40% equity and 60% debt finance. The debt interest rate is 8%, and the equity return is 12%. 7) No value was assigned to the CO2 produced. 8) Energy costs: Natural gas LP Electricity Total energy $9.00/mil. BTU $1.20/gal. $0.06/KWH $0.383/gal. of ethanol

9) Other costs (assuming $60 crude oil): Chemical and enzyme costs Other processing costs $0.23/gal. of ethanol $0.09/gal. of ethanol

Non-corn operating costs total $0.70 per gallon of ethanol. Given these assumed relationships and values, the Tiffany/Eidman (University of Minnesota) spreadsheet model (Tiffany and Eidman, 2003) of a dry-mill ethanol plant was used to calculate profitability and thus derive the breakeven prices. Breakeven was assumed to be the point of zero economic profit; that is, it includes the payment of debt and stipulated return on equity. Clearly, any of these assumptions and values could be modified in the future as conditions change. Source: (Hurt and Tyner, 2006)