The visible hand in economics

Biofuel regulation and carbon prices

Posted on: March 28, 2008

From the Hive we see that the government may be having trouble getting its mandatory biofuel regulation through parliament. Anyone that knows me will know that this makes me glad, not because I’m a climate change denialist (I’m willing to trust the experts on this one), not because I’m concerned about biofuel not having a net positive impact on carbon emissions, but because I don’t think the scheme is properly synchronized with the fact that we have a “carbon price” (through the carbon-trading scheme).

Why does setting a price for carbon mean that we don’t need to make biofuel’s mandatory? In order to explain this I’ll look at the three main criticisms I might get for this position (I’m hoping more criticisms can be added in the comments 😉 ):

Firstly someone may say that, when decreasing carbon emissions, there is a margin over which biofuel’s are an effective solution given the price of substitutes which produce more carbon (eg diesel and petrol).

My reply to this is fairly obvious – a “carbon price”, if set appropriately, will make the higher carbon inducing fuels more expensive. Given this, and given the value of consumer demand for fuel types, fuel retailers will adjust the composition of their fuel in order to maximise their profit. As they now have to pay the full social cost of the fuel, and given that we have intense price pressure amongst petrol firms (laugh if you want, but consumer reactions to petrol prices are more elastic than we would expect if the firms were acting as a cartel – indicating we are further down the demand curve (if my first year economics is right :P)) – then the choice of biofuels will be optimal, given the certainty we assumed in this example.

The second question is definitely the best. If there is uncertainty in the price of fuel types, and choosing a fuel type to sell is a irreversible (or costly to change but reversible investment), mandatory biofuel regulation makes sure that firms will invest in biofuel tanks, providing both flexibility of supply, security of supply, and ensuring that they are more responsive to changes in price.

This is the best defense of biofuel regulation IMHO, however in a cost benefit sense it might make more sense to directly subsidise the investment (or potentially just the replacement of) fuel tanks. This introduces the same flexibility as the biofuel regulation (at least), but retains the advantage of using market signals for choosing the optimal time to invest rather than strict regulation. However, this is something I would like to see some cost benefit work on (*wink wink* anyone that knows of any).

The third question involves consumer preferences. If biofuel’s are an experience good, then forcing people to try it will account for the transaction cost of trying, and will, in the end, lead to a higher take-up and no loss in welfare (if the fuels are equivalent). I will take the typical economist line here and state that a more effective solution would be to give people full information about biofuel’s – this reduces the transaction cost and allows people to choose what is best for them, rather than regulating what we believe is best for them.

If you read this please comment – I like you to tell me all the different ways in which I’m wrong 🙂

2 Responses to "Biofuel regulation and carbon prices"

Toast with butter, washed down with a glass of milk. That’s the best argument for a carbon price in the form of a universal tax, and the best argument against a targeted policy aimed at promoting biofuels.

Wheat and dairy prices are soaring (I’m coming from a U.S. perspective) thanks to Washington’s political decision to wean farmers off growing crops for human consumption and push them towards growing crops for fuel consumption. Put a seed in the ground in Iowa and up comes a tax break.

Biofuels were never really about global warming, but about energy security. Forget economics and think politics. A map of economic growth in the United States shows crisis on the (Democrat-voting) coasts but generally healthy expansion in the traditionally Republican Midwest.

Things may get better with a new administration, but maybe not. All three major candidates dismiss a simple carbon tax in favor of complicated solutions that might have all sorts of unintended consequences. It might be best to stock up on long-life milk. In a few years’ time we might look back and fondly recall how cheap it was in 2008.

[…] prices are rising should impact our decision on whether to make biofuels mandatory (something I don’t agree with), as NZ’s demand for biofuels will be so small that it won’t have an impact […]

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