oversight

Alcohol Fuels: Impacts From Increased Use of Ethanol Blended Fuels

Published by the Government Accountability Office on 1990-07-16.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

               .---
.July J!t!)O
                         ALCOHOL FUELS
                         Impacts From
                         Increased Use of
                         Ethanol Blended Fuels




                                                                         141807




                      RJWIWCTED --Not       to be released outside the
                      General Accounting Office unless specifically
                      approved by the Office of Congressional
                      Relations.
                                                       RELEASED
                                   =fi
Resources, Community, and
Economic Development Division

B-238439

July 16, 1990

The Honorable Philip R. Sharp
Chairman, Subcommittee on Energy
  and Power
Committee on Energy and Commerce
House of Representatives

Dear Mr. Chairman:

As you requested, this report presents information on the ethanol industry’s capability to
expand its production capacity, the effects that expanded ethanol production could have on
the agricultural sector and consumer food prices, and how the increased production could
affect certain aspects of the federal budget. The preliminary results of our work were
presented in our Statement for the Record (GAO/T-RCED-90-23)  submitted for the February 1,
 1990, House Committee on Ways and Means hearings on certain alcohol fuel tax and trade
initiatives.

As arranged with your office, we plan no further distribution of this report until 30 days
from the date of this letter. At that time, we will send copies to the Secretary of Agriculture,
the Secretary of Energy and other interested parties. We will also make copies available to
others upon request. Should you need further information, please contact me on (202) 275
1441. Other major contributors to this report are listed in appendix III.




Victor S. Rezend&
Director, Energy Issues
Executive Summary


             Ethanol is an alcohol that, when blended with gasoline, provides an
Purpose      effective renewable fuel additive, extends gasoline supplies, and
             increases gasoline octane levels. Because ethanol fuel blends burn
             cleaner than gasoline, they also reduce harmful auto emissions. Ethanol
             blends currently account for about 8 percent of the gasoline sold in the
             U.S. Since most ethanol is made from corn, its production provides a
             valuable market for American farmers. Although ethanol costs more to
             produce than gasoline, federal and state tax incentives make ethanol
             blends competitive with gasoline. For example, ethanol fuel blends are
             currently exempt from 6 cents of the g-cent per gallon federal tax on
             motor fuels.

             Congressional proposals to encourage greater use of alternative motor
             fuels could increase the demand for ethanol. In view of such proposals,
             the Chairman, Subcommittee on Energy and Power, House Committee on
             Energy and Commerce, requested GAOto determine (1) if the domestic
             ethanol industry could expand to meet the increased demand that such
             legislation could create, (2) the effects that expanded ethanol produc-
             tion could have on the agricultural sector and consumer food prices, and
             (3) how the increased production and use of ethanol could affect the
             federal budget.


             Ethanol is widely used in the U.S. as a gasoline additive-generally  in a
Background   10 percent ethanol-90 percent gasoline blend called gasohol. The US.
             ethanol industry has the capacity to produce about 1 billion gallons per
             year. About 96 percent of the ethanol is made from corn-representing,
             on average, about 4 percent of domestic corn production in a typical
             growing year.

             GAOdeveloped two scenarios depicting an approximate doubling and
             tripling of current annual ethanol production capacity (to 2.2 billion and
             3.3 billion gallons) over an 8-year period to allow a realistic time frame
             for industry to expand. GAO'Sgrowth scenarios were compared with a
             baseline scenario that assumed normal crop production, a continuation
             of current agricultural trends and policies, and little expansion in eth-
             anol production, GAOused the Wharton Econometric Forecasting Associ-
             ates (WEFA) model of U.S. agriculture in estimating the effect of these
             production increases on the agricultural sector, federal farm program
             costs, and consumer food prices.




             Page 2                      GAO/RCED-90-166   Increased   Use of Ethanol   Blended Fuels
  .
                   Executive   Summary




                   The ethanol industry is capable of doubling or tripling domestic ethanol
Results in Brief   production to 2.2 or 3.3 billion gallons per year during the next 8 years,
                   and American farmers could supply the corn needed for this production
                   increase. However, industry officials caution that continued government
                   incentives and/or a legislative requirement for the use of alternative
                   fuels, such as ethanol, would be needed to maintain such growth.

                   GAO'Smodeling showed that the expanded use of ethanol fuels would
                   have mixed effects on various sectors of American agriculture. Corn
                   producers would benefit the most because of the increased demand for
                   corn to make ethanol and the resulting higher corn prices. However,
                   through a complex system of economic relationships, some other sectors
                   would not fare as well. For example, soybean processors and producers
                   would face lowered demand and prices for their products because the
                   conversion of corn into ethanol generates protein-rich feed and corn oil
                   by-products that compete with soybean meal and soybean oil. Increased
                   corn prices would raise feed costs and hurt cattle producers, but the
                   lower cost of high-protein feeds could benefit poultry producers. Overall
                   net farm cash income would increase, and there would be a slight
                   increase in consumers’ food prices.

                   GAO'Smodeling also showed that expanded ethanol production would
                   decrease federal farm program outlays as the increase in demand for
                   and the price of grains, primarily corn, would cause fewer farmers to
                   participate in these support programs. The estimated decrease in out-
                   lays showed annual fluctuations depending, in general, on the relation-
                   ship among market prices and projected federal program target prices
                   and loan rates. At the same time, the increased use of ethanol fuels
                   would reduce federal motor fuel tax revenues because of ethanol’s par-
                   tial tax exemption. Motor fuel tax revenues were projected to decrease
                   with the expansion in the use of ethanol over the simulation period. On
                   average, the reductions in farm program outlays would exceed the
                   increased tax revenue losses over the 8-year period. However, in
                   response to the primary interests of the Chairman, GAO'Sstudy was lim-
                   ited to the impacts of expanded ethanol production on the agricultural
                   program outlays and motor fuel excise tax revenues on the federal
                   budget; it did not explore all the federal budget or consumer impacts
                   that might result from expanded production, such as the income taxes
                   paid by farmers; ethanol producers, and fuel distributors.




                   Page 3                      GAO/RCED-96-156   Increased   Use of Ethanol   Blended Fuels
GAO’s Analysis

                        According to industry officials, the ethanol industry has the capability,
Industry Expansion      experience, and resources to operate additional production facilities.
                        Ethanol production capacity in 1989 was about 1 billion gallons per
                        year. GAO'Shigh-growth scenario assumes that ethanol production
                        capacity would grow by 288 million gallons in each of the 8 expansion
                        years, which is in line with past industry growth. However, because of
                        the relatively high production costs, the ethanol industry relies heavily
                        on federal and state tax incentives to remain competitive with pro-
                        ducers of gasoline and other fuel additives, and industry officials cau-
                        tioned that assurances of continued government incentives and/or a
                        legislative requirement for the use of alternative fuels, such as ethanol,
                        would be needed to sustain such growth.


                        According to GAOmodel simulations, corn farmers would significantly
Impact on Agriculture   benefit as additional ethanol production would increase the demand for
                        and price of corn. By 1997, the expanded ethanol production under
                        GAO'Shigh-growth scenario would increase corn demand by nearly 6 per-
                        cent and corn prices by about 15 percent. The availability of additional
                        high-protein feed by-products from the conversion of corn into ethanol
                        would, however, reduce the price of soybean meals and soybean oils and
                        lower the demand and price of soybeans. Corn is the principal feed used
                        in livestock operations, and the higher corn prices, caused by increased
                        demand from added ethanol production, would increase cattle pro-
                        ducers’ feed costs and lower their profits. On the other hand, the lower
                        prices for soybean meal and other high-protein feed could benefit
                        poultry producers.

                        GAO'Smodeling also showed that farmers’ overall net farm cash income
                        would increase by an average of about 1.3 percent and that consumers
                        would face slightly higher food prices. The overall food component of
                        the consumer food price index would increase by an average of 0.1 per-
                        cent-an approximate lo-cent increase on a $100 food purchase.


                        GAO'Smodeling showed that an expansion of ethanol production would
Impact on Federal       reduce the federal farm program outlays by an annual average of about
Budget ”                $930 million and $1.421 billion under its low- and high-growth scena-
                        rios, respectively, during the 8-year growth period. On the other hand,


                        Page 4                      GAO/RCED-96-156   Increased   Use of Ethanol   Blended Fuels
     .

 L
                  Executive   Snmnuuy




                  the increased use of ethanol fuels, if coupled with an extension of the 6-
                  cent per gallon tax exemption for ethanol blended fuels (past its sched-
                  uled 1993 expiration date), could further reduce annual motor fuel tax
                  revenues by an average of about $442 million and $813 million, respec-
                  tively, for GAO’stwo scenarios.

                  Summing-up only the impacts that expanded ethanol production would
                  have on federal farm program outlays and motor fuel tax revenues,
                  GAO'Sprojections indicate that reductions in farm program outlays
                  would exceed the additional tax revenue losses, on average, by about
                  $488 million and $608 million per year, respectively, under the low- and
                  high-growth scenarios. However, GAO'Smodel simulations showed wide
                  variations in yearly farm program outlays that resulted in net budget
                  impacts varying widely from year to year. For example, in one year tax
                  revenue losses exceeded farm program outlay reductions by $924 mil-
                  lion, In another year, the outlay reductions exceeded the revenue losses
                  by $2.7 billion. As agreed with the Chairman’s office, GAO'Sstudy was
                  not designed to explore all the impacts that expanded ethanol produc-
                  tion could have on the federal budget, such as changes in income tax
                  revenues from farmers, ethanol producers, and the petroleum industry.
                  GAO'Sstudy, however, indicated that the expanded use of ethanol will
                  cause higher ethanol production costs, and it may be necessary to
                  increase the level of government subsidies or to pass the costs on to the
                  consumers through higher motor fuel costs.


                  GAOis not making recommendations in this report.
Recommendation

                  GAOobtained and incorporated the views of Department of Agriculture
Agency Comments   and Department of Energy officials on the information presented in this
                  report. These officials generally agreed with GAO'Sanalysis and facts.
                  However, as requested, GAOdid not obtain official agency comments on a
                  draft of this report.




         Y




                  Page5                       GAO/RCED-90-156   Increased   Use of Ethanol   Blended Fuels
Contents


Executive Summary                                                                                              2

Chapter 1                                                                                                      8
Introduction             Characteristics of Ethanol
                         Government Support of Ethanol
                                                                                                               8
                                                                                                              10
                         Objectives, Scope, and Methodology                                                   12

Chapter 2                                                                                                     15
Ethanol Production       The Ethanol Industry Today
                         Feasibility of Ethanol Industry Expansion
                                                                                                              15
                                                                                                              16
Capacity Can Be          Impact of Expansion on Feedstock Suppliers                                           17
Expanded                 Conclusions                                                                          18

Chapter 3                                                                                                    19
Agricultural Impact of   Impact on the Corn and Other Feed-Grain Sectors
                         Impact on the Soybean Sector
                                                                                                             19
                                                                                                             21
Expanded Ethanol         Impact on the Livestock Sector                                                      22
Production               Impact on Net Farm Cash Income                                                      22
                         Impact on Consumer Food Prices                                                      23
                         Conclusions                                                                         23

Chapter 4                                                                                                    25
Impact of Expanded       How Ethanol Production Affects Agriculture Program
                             Outlays
                                                                                                             26
Ethanol Production on    Impact on Farm Support Program Outlays                                              28
Federal Programs         Impact on Motor Fuel Tax Revenues                                                   29
                         Summary of Budget Impacts on Farm Program Outlays                                   30
                             and Motor Fuel Tax Revenues
                         Conclusions                                                                         32

Appendixes               Appendix I: Modeling Procedure and Assumptions                                      34
                         Appendix II: Federal Farm Support Programs                                          37
                         Appendix III: Major Contributors to This Report                                     42




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                         Page 0                     GAO/RCED-90-156   Increased   Use of Ethanol   Blended Fuels
         Contents




Tables   Table 4.1: Federal Agriculture Program Outlay                                        28
             Reductions Over &Year Model Simulation Period
         Table 4.2: Foregone Motor Fuel Tax Revenues Over                                     29
             Baseline Amounts
         Table 4.3: Budget Impacts on Farm Program Outlays and                                30
             Motor Fuel Tax Revenues




         Abbreviations

         Ascs       Agricultural Stabilization and Conservation Service
         ccc        Commodity Credit Corporation
         DOE        Department of Energy
         EC         European Community
         ETBE       ethyl tertiary-butyl ether
         GAO        General Accounting Office
         MTBE       methyl tertiary-butyl ether
         USDA       IJnited States Department of Agriculture
         WEFA       Wharton Econometric Forecasting Associates


         Page 7                      GAO/RCED-90-166   Increased   Use of Ethanol   Blended Fuels
Chapter 1

Introduction


                     Ethanol is an alcohol that, when blended with gasoline, provides an
                     effective fuel additive. Ethanol increases the fuel octane level of gaso-
                     line, and, because it burns cleaner than gasoline, it can reduce carbon
                     monoxide emissions from motor vehicles. Most ethanol is made from
                     corn, providing a valuable market for America’s farmers. Ethanol
                     blended fuels also reduce the country’s dependence on oil for its trans-
                     portation needs because less oil is needed to produce a gallon of motor
                     fuel.

                     Gasoline/ethanol blends currently account for about 8 percent of all
                     motor fuel sold in the U.S., making ethanol one of the most commonly
                     used alternative fuels. Although not marketed in the U.S., straight eth-
                     anol can also be used as a motor fuel replacement for gasoline-as it is
                     in Brazil. However, compared to gasoline, ethanol costs more to produce
                     and poses additional distribution problems. Federal and state tax and
                     financial incentives have been a major factor in the growth and develop-
                     ment of this country’s ethanol industry. These incentives enable ethanol
                     fuel blends to compete with gasoline and other blending agents in many
                     U.S. markets.

                     Recent Congressional and Administration proposals would require a
                     greater use of alternative fuels and could increase the demand for eth-
                     anol in this country. While the Congress is considering this issue, it is
                     also considering whether to extend federal tax incentives for ethanol
                     production and use.


                     Ethanol can be made from almost any raw material containing sugar or
Characteristics of   carbohydrates. As of August 1989, about 95 percent of U.S. ethanol was
Ethanol              made from corn, a readily available domestic feedstock that stores well
                     and can be converted to ethanol and other valuable products (including
                     sweeteners, oils, and starches). Wheat, sorghum, barley, and food
                     processing wastes are among the other feedstocks used in the U.S. to
                     make ethanol. Brazil, which uses straight ethanol and gasoline-ethanol
                     blends as motor fuel, produces most of its ethanol from sugar cane.

                     Ethanol’s use as a motor vehicle fuel in the U.S. is generally in a 10
                     percent ethanol-90 percent gasoline blend, commonly called gasohol. The
                     use of ethanol fuels grew out of concern over our nation’s increasing
                     dependence on foreign oil and the abundant supplies of domestic corn.
                     Replacing a portion of a gallon of gasoline with ethanol helps reduce
                     America’s reliance on petroleum used in producing motor fuels and pro-
                     vides additional markets for domestic corn and other grains. In 1988,


                     Page 8                      GAO/RCED-96-166   Increased   Use of Ethanol   Blended Fuels
Chapter 1
Introduction




812 million gallons of ethanol were produced in the U.S.’ -the                           motor
fuel equivalent of about 23 million barrels of crude oil.

Ethanol is also blended with gasoline to raise the fuel octane level and to
reduce motor vehicle emissions. Ethanol is an effective substitute for
lead as a gasoline octane booster. Also, some urban areas in Colorado,
Arizona, New Mexico, and Nevada-where        carbon monoxide emissions
are a serious problem during winter months-currently       require the
blending of ethanol, or other high oxygen additives (oxygenates), with
gasoline during the problem periods.” Blending gasoline with oxygenates
significantly reduces carbon monoxide emissions, especially in older
vehicles. Ethanol and MTBE(methyl tertiary-butyl ether)3 are the most
commonly used oxygenates.

The cost of ethanol and its handling properties, however, complicate its
use as a motor fuel. For example, it costs between $0.94 to $1.73 to pro-
duce a gallon of ethanol (with corn prices at about $2.40 per bushel)
according to 1989 estimates provided by Information Resources, Inc.
The ethanol feedstock used and the type and size of the production
plant will affect the product cost. By comparison, with crude oil prices
at or about $20 per barrel (as they were in September 1989), gasoline
production costs range between 45 to 55 cents per gallon, according to
estimates from the American Petroleum Institute. Ethanol also requires
special handling because it attracts water. Moisture in a motor vehicle’s
fuel system can lead to poor operating performance. Therefore, fuel dis-
tributors must ensure that their storage tanks and transport facilities
are moisture-free when ethanol fuel blends are used. Ethanol fuels are
generally transported by truck or rail, rather than by the more econom-
ical oil pipelines, because of their susceptibility to contamination by
pipeline moisture. While measures can be taken to move ethanol fuels
through oil pipelines, this method is more costly.

Ethanol can also be used to produce ETBE(ethyl tertiary-butyl ether)4 ,
which has recently received considerable attention as a potential high-


‘According to Information Resources, Inc., Washington, DC.

‘Denver, Colorado and the surrounding area have required the blending of oxygenates during the
past three winter seasons.Albuquerque, New Mexico; Phoenix, Arizona; and Las Vegas, Nevada are
other urban areas that now require the use of high oxygenated additives in the winter months.

“MTBE is an organic ether produced from a reaction of methanol with isobutylene-a      chemical pro-
duced from various refining-type processes.

4ETBE is an ether produced from a reaction of ethanol with isobutylene.



Page 9                                GAO/RCED-90-166     Increased   Use of Ethanol   Blended Fuels
                                                                                                               .


                     Chapter 1
                     Introduction




                     oxygen motor fuel additive. Although not yet commercially available,
                     supporters contend that ETBEblends will outperform ethanol and MTBE
                     as a gasoline additive without the distribution problems associated with
                     ethanol and ethanol blends. While ETBEprovides promise for reaching
                     additional fuel markets, its commercial use may also depend on the
                     availability of government incentives for its production and use.


                     Federal and state incentives continue to play an important role in the
Government Support   development and use of ethanol blended fuels. Since 1978, the federal
of Ethanol           government has provided research funds to encourage the development
                     of ethanol fuels, loans and loan guarantees to encourage construction of
                     ethanol production facilities, and tax credits and exemptions to make
                     ethanol blended fuels more cost competitive with unblended gasoline.
                     Also, surplus federal grain was, on occasion, distributed to ethanol pro-
                     ducers. In addition to the federal support, 23 states-as of August
                     1989-provided     tax incentives on ethanol fuel blends and/or direct pay-
                     ments to ethanol producers. This federal and state support reduces the
                     effective cost of producing ethanol and enables ethanol to compete with
                     gasoline and other fuels and additives.

                     The principal federal incentive to promote the use of alcohol fuels is a 6-
                     cent exemption from the g-cent per gallon federal motor fuel excise tax.
                     The g-cent tax, which is levied on each gallon of gasoline sold, helps
                     build and maintain roads and bridges in the U.S. Each gallon of gasoline
                     blended with at least 10 percent ethanol produced from renewable
                     resources, such as corn, is eligible for the exemption.” Using a 10 percent
                     blend, each gallon of ethanol could be blended with nine gallons of gaso-
                     line to make 10 gallons of an ethanol blended motor fuel. All 10 gallons
                     would be eligible for the 6-cent per gallon exemption, which equates to a
                     total exemption of 60 cents on each gallon of ethanol.

                     Also, an equivalent 60-cent per gallon federal blenders’ income tax
                     credit or refund is available to fuel distributors that blend ethanol with
                     gasoline for use as a motor fuel; the tax credit or refund can be taken in
                     lieu of the excise tax exemption. Because of the tax exemption and
                     credit, ethanol can be offered to the retail market at a lower price.

                     Changes in the federal fuel-tax exemption and tax credit coverage could
                     significantly affect domestic ethanol production. Current and previous

                     “Exemption applies to alcohol (ethanol or methanol) but does not include alcohol made from natural
                     gas, petroleum, or coal.



                     Page 10                               GAO/RCED-SO-166     Increased   Use of Ethanol   Blended Fuels
Chapter 1
Wroduction




Congresses have considered extending, amending, or eliminating eth-
anol’s tax exemption and blenders’ tax credit provisions-currently
scheduled to expire in September 1993 and December 1992, respec-
tively. In addition, in March 1990, the Treasury Department issued regu-
lations extending the blenders’ tax credit to ETBEblended fuels.

Several proposals introduced in the 100th Congress would have affected
the use of ethanol fuels. Two bills would have required that, by 1992, on
the average, at least 5 percent of all motor fuel sold in the U.S. (by
volume) contain ethanol-which       would require ethanol production of
over 6 billion gallons per year.” Another bill would have required that,
beginning in 1988, all gasoline sold in the U.S. be blended with alcohol-
half in the 10 percent ethanol blend, and half in a 5 percent methanol/
2.6 percent ethanol blend.7 This would have required ethanol production
of over 6 billion gallons per year. Neither of these bills was enacted.

Proposals to amend the Clean Air Act from the Administration and Con-
gressional sponsors could also expand the use of clean-burning alterna-
tive fuels, such as ethanol. The Administration’s July 1989 proposal,
among other things, would have required the manufacture, sale, and dis-
tribution of over 9 million vehicles capable of using clean alternative
fuels-from model years 1996 through 2004-for use in urban areas
with populations of 250,000 or more, which are not in compliance with
national ozone abatement mandates.* The Senate and the House of Rep-
resentatives passed their versions of the Clean Air Act Amendments on
April 3, 1990” and May 23, 199011’, respectively, without this production
requirement. While the Senate and House have not reached agreement
on the clean alternative fuels section of the Clean Air Act Amendments,
each of the proposals contains provisions requiring the use of clean-
burning automotive fuels.




“The Ethanol Motor Fuel Act of 1987, H.R. 2062, 100th Gong., 1st Sess.(1987); S. 1304, 100th Cong.,
1st Sf5.3.(1987).
7H.R. 2031,lOOth Gong., 1st Sess.(1987).
‘Clean Air Act Amendments of 1989, H.R. 3030,lOlst Gong., 1st Sess.(1989).

“Clean Air Act Amendments of 1990, S. 1630, 1Olst Cong., 2nd Sew. (1990).

“‘Clean Air Act Amendments of 1990, H.R. 3030, 1Olst. Cong., 2nd Sess.(1990).



Page 11                              GAO/RCED-90-150      Increased   Use of Ethanol   Blended Fuels
                            Chapter 1
                            Introduction




                            Because proposals to increase the use of ethanol as a fuel or fuel blend
Objectives, Scope,and       could significantly affect the agricultural and other sectors of the
Methodology                 economy, the Chairman, Subcommittee on Energy and Power, House
                            Committee on Energy and Commerce, requested that GAOdetermine

                        . whether the domestic ethanol industry could expand to meet an
                          increased demand for ethanol that legislation could create,
                        . the impacts that expanded ethanol production could have on the agricul-
                          tural sector and consumer food prices, and
                        l how the increased production and use would affect the federal budget.

                            In conducting this review, we drew upon various studies on ethanol
                            recently conducted by the Departments of Agriculture and Energy, the
                            Congressional Research Service, the American Petroleum Institute, and
                            a special panel established by the Congress in 1987. We also met with
                            officials from the Departments of Agriculture and Energy, the Congres-
                            sional Research Service, and the American Petroleum Institute.

                            To assess the current capacity and expansion potential of America’s eth-
                            anol industry, we interviewed and obtained documentation from ethanol
                            industry officials and ethanol and motor fuel trade associations-prima-
                            rily the Renewable Fuels Association and Information Resources, Inc-
                            who provided information on the current makeup, capacity, and opera-
                            tions of the industry. We discussed the potential for industry expansion
                            with current ethanol producers, a potential producer, and other affected
                            parties-including    oil companies, chemical industries; and the corn
                            milling and corn processing industries.

                            We then developed and modeled two growth scenarios; a low-growth
                            projection with ethanol production increasing to 2.2 billion gallons annu-
                            ally (about double the current 1 billion gallon per year capacity) and a
                            higher-growth projection with production increasing to 3.3 billion gal-
                            lons annually (about triple current capacity).

                            To capture the widest range of impacts our ethanol growth scenarios
                            could have on American agriculture, consumer food prices, and federal
                            farm program outlays, we used a large scale econometric model of
                            United States agriculture maintained by WEFA.We selected the WEFA
                            model because it could capture the interactions between major crops and
                            livestock sectors and it could estimate the impact on key variables such
                            as demand and prices for crops and livestock, farm income, consumer
                            prices, and federal agricultural budget outlays. We used three scenarios
                            for our analyses. Our starting point was WEFA'Sbaseline scenario, which


                            Page 12                     GAO/RCELMO-156   Increased   Use of Ethanol   Blended Fuels
Chapter 1
Introduction




provides long-term projections for U.S. agriculture and assumes normal
crop production, a continuation of current agricultural trends and poli-
cies, and little expansion in ethanol production. To the extent possible,
our analyses captured all major and quantifiable impacts of an expan-
sion of ethanol production on agriculture sectors. However, we made
some necessary simplifying assumptions to reduce the scale of the
problem to a more manageable size. The major assumptions underlying
our modeling procedure and the baseline scenario are discussed in
appendix I.

We then compared the projections from the two growth scenarios with
the baseline scenario to measure the results of changes due to increased
ethanol production. We chose an &year period for our analyses to allow
a realistic and reasonable time frame for ethanol industry expansion to
the described production levels. Our choice of 8 years was based on the
time frames used in analyses on this subject by others-usually     6 to 8
years -and discussions with government and industry officials. The
growth in ethanol production required under our scenarios is less ambi-
tious than that required under legislative proposals introduced in the
previous Congress- 6 billion gallons per year within 5 years (H.R. 2052,
S. 1304) or 6.26 billion gallons per year within 1 year (H.R. 2031). Our
analyses of these earlier proposals showed that they seemed to call for
ethanol production levels that would be beyond what would be reason-
able for the industry to accomplish in these periods of time. We also
assumed that legislation requiring the greater use of alternative fuels
would probably provide additional market opportunities for ethanol. We
estimated that our high-growth scenario would provide about one-third
of the alternative fuel needed to meet the requirements of the adminis-
tration’s July 1989 Clean Air Act proposal (H.R.3030). Given the uncer-
tainty of the Clean Air Act provisions that the Senate and House will
enact, we could not determine the potential impact of these provisions
on the use of ethanol fuels.

Recognizing that current market conditions and government incentives
are not likely to stimulate such growth, we assumed that the added eth-
anol production would (1) increase to the levels used in our scenarios for
the purpose of analyzing impacts and (2) actually occur only if man-
dated by legislation, regulations, or other means. Furthermore, we rec-
ognize that efforts to stimulate any large scale expansion could raise
ethanol feedstock prices (namely corn) to a point that ethanol could not
compete with other fuels under current conditions. However, we did not
determine the level of ethanol subsidy that would be needed or the
increase in fuel prices that would result under our scenarios.


Page 13                     GAO/RCED-90-166   Increased   Use of Ethanol   Blended Fuels
                                                                           I




chapter 1
Introduction




We assumed that provisions of the current (1986) farm program legisla-
tion remained in place over our I)-year simulation period. While market
adjustments due to ethanol expansion would continue after 1997, our
estimates did not consider changes beyond 1997. Our modeling effort
utilized 1988-1989 agricultural information, including results of the
drought-stricken 1988 crop year. We discussed and obtained agreement
on our modeling approach and procedures with WEFAanalysts and
Department of Agriculture officials familiar with agricultural modeling
and the importance of underlying model assumptions.

In assessing the federal budget impacts of expanded ethanol production
and use under our scenarios, we assumed that the current federal tax
incentives-the   fuel excise tax exemption and blenders’ tax credit-
were the only federal incentives in place and were extended through
1997. While the expansion of ethanol production and use could influence
other federal revenues and/or outlays, this report does not identify or
evaluate those other impacts.

This report does not assess the market place economics of ethanol fuel
blends or compare ethanol’s attributes with those of gasoline or other
fuel additives. Furthermore, this report does not assess the impact of
ethanol imports on the development of the domestic ethanol industry or
the impact on air quality of ethanol fuel blends.

Our review work was performed from May 1988 through January 1990.
We discussed the factual information in this report with officials from
the Renewable Fuels Association, Information Resources Inc., the Amer-
ican Petroleum Institute, the Department of Energy (Office of Alcohol
Fuels), and the Department of Agriculture (Office of Energy, Economic
Research Service and Agricultural Stabilization and Conservation Ser-
vice). These officials generally agreed with our analyses and with the
information contained in this report, On the basis of these discussions,
we made clarifications in the report, where appropriate. However, as
requested, we did not obtain official agency comments on this report.




Page 14                    GAO/WED-W-150   Increased   Use of Ethanol   Blended Fuels
      I




Chapter 2

l3thanol Production Capacity GUI Be Expanded


                       The 1989 production capacity of ethanol plants operating in the United
                       States was about 1 billion gallons per year-actual   production in 1988
                       was 812 million gallons. Our analysis showed that it is feasible to
                       increase production to the amounts used in our growth scenarios-2.2
                       or 3.3 billion gallons annually. The industry has the capability and expe-
                       rience to design, build, and operate ethanol plants, and the feedstock
                       supplies needed to produce 3.3 billion gallons per year are available.
                       However, an expansion of this scale would be a major financial under-
                       taking and, according to industry officials, would be contingent on the
                       continued availability of government incentives for ethanol fuels and/or
                       a legislative requirement to use ethanol fuels.


                       Current ethanol production capacity is concentrated among a few large
The Ethanol Industry   producers. The largest producer operates four ethanol plants with a
Today                  combined annual capacity of 600 million gallons-about 60 percent of
                       U.S. production capacity. The 43 ethanol plants in operation as of
                       December 1988 had production capabilities ranging from 0.6 to 276 mil-
                       lion gallons per year- their combined annual capacity totalled about
                       974 million gallons. In 1988, actual production was 812 million gallons
                       of ethanol.

                       Faced with uncertain market conditions, some ethanol plants have dis-
                       continued operations. In addition to the 43 producing plants, there were
                       70 idle ethanol plants-with   combined production capacity of about 340
                       million gallons per year- as of December 1988, according to Informa-
                       tion Resources, Inc. These included old, small, or technically obsolete
                       plants that have stopped operating for extended periods of time. It is
                       uncertain, according to industry officials, whether these idle plants
                       would reopen.

                       While the largest ethanol producers are located in or near large corn-
                       producing states, small ethanol producers can be found throughout the
                       country. Large ethanol plants generally operate more efficiently than
                       smaller units because of the operating economies of scale, according to
                       industry officials and a recent Department of Energy (DOE) study’ . One
                       industry official said that the most efficient plants are those capable of
                       producing at least 60 million gallons of ethanol per year. Small plants,



                       ‘Understanding the Challenges and Future of Fuel Alcohol in the United States (prepared for the U.S.
                       Department of Energy, Office of Alcohol Fuels, by Information Resources, Inc.), Sept. 1988.



                       Page 16                              GAO/RCFD!80-156      Increased   Use of Ethanol   Blended F’uela
                                                                                                                    --
                         Chapter 2
                         Ethanol Production   Capacity   Can
                         Be Expanded




                         nevertheless, can take advantage of local situations and remain competi-
                         tive with the large ethanol producers. A 1989 U.S. Department of Agri-
                         culture (USDA)study said that small producers can find market niches
                         that will permit ethanol production at sites with access to low cost grain
                         supplies, such as locations distant from major grain market centers;
                         unconventional ethanol feedstocks, such as cheese or other industrial
                         processing wastes; and local ethanol by-product markets, such as adja-
                         cent feedlots that will buy the ethanol feed by-products.2


                         There are no technological reasons why domestic producers could not
Feasibility of Ethanol   supply the ethanol required for either of our growth scenarios,
Industry Expansion       according to industry and government officials familiar with the ethanol
                         industry. These officials said that an expansion of annual ethanol pro-
                         duction to 3.3 billion gallons within 8 years was achievable, the logistics
                         of such an expansion are reasonable, and the timeframes are realistic.
                         Furthermore, some industry officials said that with appropriate govern-
                         ment incentives-such     as an extension of the ethanol fuel-tax exemp-
                         tion-annual    ethanol production could potentially double within 4 or 6
                         years and might eventually reach 6 billion gallons per year. However,
                         according to a USDA1988 report, large scale ethanol production growth
                         becomes self-limiting once it raises feedstock prices so high that ethanol
                         cannot compete with other alternative energy sources such as liquid fuel
                         from coal or shale oiL3 USDAsaid that doubling or tripling current eth-
                         anol production would begin to place strong upward pressure on agricul-
                         tural feedstocks.

                         According to industry officials and information regarding past industry
                         growth that we analyzed, the ethanol industry seems to have the capa-
                         bility, the experience, and the resources to build and operate additional
                         production facilities. Our low- and high-growth scenarios assume that
                         ethanol production capacity would grow by 160 million and 288 million
                         gallons in each of the 8 years, which is in line with past industry
                         growth. Some of the added capacity would likely come from expanding
                         existing plants or adding ethanol production to other corn processing
                         plants, which, according to industry officials, are less costly options
                         than building new facilities.



                         %conomics of Ethanol Production in the United States (U.S. Department of Agriculture, Economic
                         Research Service, Mar. 1989.)

                         “Ethanol: Economic and Policy Tradeoffs (USDA, Economic Research Service, Apr. 1988.)



                         Page 16                               GAO/RCED-90.156   Increased   Use of Ethanol   Blended Fuels
                      Chapter 2
                      Ethanol Production   Capacity   Can
                      Be Expanded




                      Capital costs are important considerations in the expansion of ethanol
                      production capacity. The type of production facility and the accessi-
                      bility to transportation and utilities will also affect construction costs.
                      Expanding an existing plant is less costly than building a new plant on
                      an undeveloped site. According to industry officials, the cost of con-
                      structing an ethanol plant could range from $0.60 per gallon of added
                      annual capacity at an existing grain processing facility to $3.00 per
                      gallon at a new undeveloped site. Therefore, expanding current capacity
                      by 2.3 billion gallons -enough to reach our high-growth target-could
                      cost from $1.2 billion to nearly $7 billion, depending on development
                      patterns.

                      According to the 1989 USDAreport mentioned above, the ethanol
                      industry would need to see a reasonable likelihood of favorable condi-
                      tions over the next 10 to 16 years to justify significant expansion. The
                      ethanol industry has relied heavily on government incentives, and,
                      according to industry officials, ethanol fuels are likely to require contin-
                      uing government incentives to remain competitive with the price of gas-
                      oline. Industry officials told us that special incentives, such as tax
                      credits, an extension of motor fuel tax exemptions, or fuel taxes based
                      on vehicle tailpipe emissions, might be required to encourage industry
                      expansion. A potential producer said that reliance on government incen-
                      tives could entail risk for producers because there is no assurance of the
                      continuity of these incentives in the future. Some industry officials,
                      however, indicate that if ethanol fuel use were mandated, other govern-
                      mental incentives may not be necessary.


                      An expansion of ethanol production would place new demands on
Impact of Expansion   America’s farmers. Expanding annual ethanol production to 3.3 billion
on Feedstock          gallons per year-our high-growth scenario-would        represent an
Suppliers             approximate one billion-bushel increase in the demand for corn as eth-
                      anol feedstock . A bushel of corn converts to about 2.6 gallons of eth-
                      anol. Assuming that all ethanol is made from corn, the 812 million
                      gallons of ethanol produced in 1988 would represent about 326 million
                      bushels of corn. The production of 3.3 billion gallons per year would
                      represent about 1.3 billion bushels of corn. Producing 2.2 billion gallons
                      of ethanol per year under our low-growth scenario would represent
                      about 880 million bushels of corn.

                      4This is the gross increase in ethanol’s corn demand. The overall net corn demand increase would be
                      smaller due to subsequent adjustments in corn demand by other sectors, such as livestock production.
                      This is discussed further in chapter 3.



                      Page 17                               GAO/RCEDBO-166      Increased   Use of Ethanol   Blended Fuels
              Chapter 2
              Ethanol Production   Capacity   Can
              Be Expanded




              While an additional billion bushels is a significant requirement, recent
              corn production levels would indicate that America’s farmers, under the
              right market and weather conditions, could meet this demand. During
              the 1980s normal corn harvests ranged from about 7 to 8 billion
              bushels, and WEFAforecasts they will exceed 9 billion bushels by 1997.
              In 1988 the drought-reduced harvest was about 4.9 billion bushels. The
              326 million bushels of corn needed to meet 1988 ethanol production
              levels (812 million gallons) represents about 4 percent of a typical 1980s
              harvest.

              The National Corn Growers Association supports the expanded use of
              corn for ethanol production and estimates that ethanol-based demand
              for corn could increase to 1.2 billion bushels by 1996. Furthermore, it is
              unlikely that all the additional ethanol will be made from corn.
              Although corn currently accounts for 96 percent of ethanol feedstock
              usage, it is likely that some wheat, sorghum, food processing wastes,
              and other feedstocks will continue to be used.


              No technical barriers preclude an expansion of annual ethanol produc-
Conclusions   tion to 3.3 billion gallons over the next 8 years, The ethanol industry has
              shown that expansion of production capacity is possible. While drought
              and other weather conditions can disrupt ethanol’s corn feedstock
              supply and price, production levels in the 1980s indicate that America’s
              farmers could meet the demand generated by the expansion in ethanol
              production under our scenarios. However, the ethanol industry con-
              tinues to be heavily reliant on federal incentives to remain competitive
              with gasoline and other fuel additives. The construction of additional
              ethanol facilities will, likely be based on economic and other factors,
              including continued federal incentives, that go beyond the technological
              capability to expand. Implementing an ethanol-use mandate would
              result in domestic capacity expansion only if producers find that pro-
              duction incentives outweigh the risks of investing in a product that cur-
              rently depends on long-term government support.




              Page 18                               GAO/RCED-90-166   Increased   Use of Ethanol   Blended Fueb
       .
Chapter 3

l@kultural Impact of Expanded
EXhmol Production

                       The expansion of domestic ethanol production would have a marked
                       impact on American agriculture. Based on model simulations, the corn
                       sector-which    is ethanol’s primary feedstock supplier-would  be the
                       sector most affected by expanding ethanol production. Corn farmers
                       would benefit as the demand for and price of corn would increase. How-
                       ever, through a complex system of economic relationships, other sectors
                       of American agriculture would also be affected-some positively and
                       some negatively:

                       Soybean producers would be adversely affected by the lower demand
                       for and price of soybeans because soybean meal and soybean oil would
                       face increased competition from the feed by-products of ethanol produc-
                       tion in the high-protein animal feed and vegetable oil markets.
                       Cattle producers would face increased corn-feed costs and lower profits,
                       causing them to reduce their herds.
                       Poultry producers could benefit from the additional supply and lower
                       price of high-protein feeds.
                       Overall net farm cash income would increase as increased cash income
                       from crops would offset decreased cash income from livestock and
                       higher cash expenses.

                       Consumers would face slightly higher food prices because of these agri-
                       cultural impacts.


                       Corn is the primary ethanol feedstock and the crop most affected by
Impact on the Corn     expanding ethanol production. Expanding the production of ethanol
and Other Feed-Grain   would increase both the demand for and price of corn. The size of the
Sectors                increase depends on the amount of ethanol produced, the amount of
                       acreage farmers would shift into corn production, and the sensitivity of
                       livestock and export markets to changes in corn prices.

                       The initial demand for corn to make ethanol would increase (over the
                       projected baseline) under our high-growth scenario by about 970 million
                       bushels per year at the end of our 8-year simulation period.’ However,
                       this increase would be partially offset as higher corn prices trigger a
                       reduction in the corn demand for livestock feed or for export. With
                       these offsets, our model shows that the net increased demand for corn
                       would be about 640 million bushels by 1997-about a 6-percent increase
                       over the projected baseline demand.


                       ‘All modeling results discussed are for our high-growth scenario unless otherwise specified.



                       Page 19                               GAO/RCED-90-156      Increased   Use of Ethanol   Blended Fuela
                                                                                              c
                                                                                                          ?



                                                                                                    v
Chapter 3
Agricultural Impact of Rxpanded
Ethanol Production




The model results showed that corn prices would increase over baseline
projections by 32 cents a bushel (16 percent) and 19 cents per bushel (9
percent)-under our high-growth and low-growth scenarios-by the
end of the simulation period. The average annual price increase over the
8-year period was 22 cents per bushel for the high-growth and 12 cents
per bushel for the low-growth scenario.

As increased prices make corn a relatively more profitable crop, farmers
would respond by planting corn on idle land and by switching other crop
acreage (mainly soybean acreage) into corn production2 . Soybeans are
the primary competitor for corn acreage, especially in the Corn Belt
states where about 65 percent of the corn is grown.3 Our modeling esti-
mates showed that by 1997, about 4.2 million acres of idle acreage or
other crop acreage would be placed into corn production. The resulting
increased corn production and supply would partially offset corn price
increases.

Higher prices would also trigger adjustments in demand for corn in live-
stock and export markets. The higher corn prices raise livestock-feed
costs and reduce the amount of corn purchased for animal feed. Export
markets for corn would also be negatively affected, as higher prices
would reduce the foreign demand for American-grown corn. Our mod-
eling estimates showed that corn exports would decline, on average, by
5 percent and 2 percent for the high- and low-growth scenarios,
respectively.

While corn is the dominant feed grain in the United States-accounting
for 83 percent of feed grains used in 1986 and 1987-sorghum, barley,
and oats are also used in livestock feeding. In our model simulation we
assumed that corn would be the only feed stock used in producing eth-
anol. Other animal-feed grains would be substituted for corn that would
be redirected toward ethanol production. With concurrent changes in
demand and supply, the overall price of other feed grains increased by
about 2 cents per bushel. The net impact of increasedethanol produc-
tion on the demand for and price of other feed grains would likely be
different if these grains were also used as ethanol feedstock.




2Federal agriculture policies and programs could also affect the farmer’s incentive to shift acreage
(see chapter 4).

‘The Corn Belt states are Illinois, Indiana, Iowa, Missouri, and Ohio.



Page 20                                GAO/RCED-90-156       Increased   Use of Ethanol   Blended Fuels
                        Chapter 8
                        AfjlmlturalImpactofBxpanded
                        Ethanol Production




                        Our model simulation showed that the domestic soybean sector would be
Impact on the Soybean   adversely affected by the increased production of ethanol, with both
Sector                  soybean production and prices declining.* The expanded ethanol produc-
                        tion would increase the supply of protein-rich feed and corn oil by-prod-
                        ucts resulting from the conversion of corn to ethanol. These by-products
                        compete with soybean meal in the high-protein animal-feed markets and
                        with soybean oil, which competes in the vegetable oil markets. This
                        would reduce soybean meal and soybean oil prices, decrease soybean
                        processors’ profit margins, and lower the demand for and price of soy-
                        beans. Soybean production would also decline as soybean growers-
                        faced with lower soybean prices and the higher corn prices-switch
                        acreage to corn.

                        Our model results showed that at the end of the 8-year high-growth
                        model simulation period, the average annual price of soybeans would
                        decrease about 35 cents per bushel from the baseline-about a 6-percent
                        decline. At the end of the high-growth simulation period, the model
                        showed soybean prices would be 66 cents per bushel below baseline
                        prices. An initial estimated decrease in soybean prices would be higher.
                        However, the initial decrease would be partially offset as soybean
                        farmers adjust production and domestic and export demands increase in
                        response to lower prices.

                        Increasing ethanol production to 3.3 billion gallons per year would
                        increase the supply of high-protein animal-feed by-products by about
                        6.1 million tons-as measured on a soybean meal protein-equivalent
                        basis, a 17-percent increase in the supply of high-protein feeds. Cur-
                        rently, some ethanol by-product feeds are exported, primarily to Euro-
                        pean Community (EC) countries, and foreign markets offer potential
                        outlets for the additional supply of high-protein feed. However, if future
                        tariffs and trade restrictions limit America’s access to ECand other for-
                        eign markets, the additional high-protein feed supply produced by eth-
                        anol would likely have to be absorbed by domestic markets. The larger
                        the restrictions on ethanol by-product feed exports, the greater the
                        impact on domestic soybean meal demand and price. In our simulations
                        we assumed that both domestic and export demands expand in response
                        to lower prices for soybean meal,

                        The negative impact of lower soybean prices would be less on those
                        farmers who are willing and able to switch from soybean acreage to

                        *Our simulation results are for the soybean sector; however, ethanol expansion would have similar
                        impact on other oil seeds.



                        Page 2 1                              GAO/RCEWO-150       Increased   Use of Ethanol   Blended Fuels
                     Chapter3
                     &Phdtural    Impact of Expanded
                     Ethanol Production




                     more profitable grains, especially corn. Our model results showed that
                     farmers would shift nearly 1.4 million acres out of soybeans by the end
                     of the simulation period. However, in some areas, primarily outside the
                     Corn Belt, soybean farmers would be unable to shift acreage and, faced
                     with lower soybean prices, would realize a decline in their overall crop
                     income. The degree of crop switching would affect the supply and final
                     equilibrium price of soybeans.


                     Corn and other feed grains are an important component in the livestock
Impact on the        production process- accounting for about half the feed used in live-
Livestock Sector     stock operations. Therefore, any change in feed prices would have a
                     major effect on the profitability of livestock production and could cause
                     production adjustments. Our model simulation showed that higher feed-
                     grain prices and lower prices for high-protein supplements have mixed
                     results in the livestock markets.

                     Higher corn prices would increase cattle producers’ corn and other feed-
                     grain costs and lower their profits. As a result, there may be increased
                     slaughter of grain fed cattle. Our model simulation showed that the
                     higher corn prices (induced by expanded ethanol production) would lead
                     to a lo-percent increase in feed costs by the end of our simulation
                     period. In response to higher feed costs, producers would reduce the
                     total number of cattle by 4 percent-from     106 to 101 million head by
                     1997.

                     In contrast, to the extent that high-protein feed by-products of ethanol
                     production could be used in poultry feeding, poultry producers would
                     respond positively to the lower prices for this feed and increase their
                     production of turkeys and chickens. All changes in livestock markets
                     would eventually translate into changes in the price of meat, poultry,
                     and dairy products.


                     While expanded ethanol production would increase overall net farm
Impact on Net Farm   cash income, some agriculture sectors would not benefit. Higher prices
Cash Income          coupled with increased production would increase farm income from the
                     sale of cash corn crops. On the other hand, lower prices and reduced
                     production for soybeans and some other feed grains would reduce cash
                     crop income.
          Y
                     Our model showed that an expansion of ethanol production would result
                     in an overall average increase in net farm cash income (excluding


                     Page 22                           GAO/RCED-90-166   Increased   Use of Ethanol   Blended Fuels
                      chapter a
                      lrrpnculturalImpaetofErpanded
                      Ethanol Production




                      changes in government cash payments to farmers) by about $415 mil-
                      lion, or an annual average increase of 1.3 percent over the 8-year model
                      simulation period. Overall combined net cash receipts from crops and
                      livestock would increase by an average of about $814 million per year,
                      while farm cash expenses would increase by an average of about $399
                      million per year.6 Individual farmers would be affected differently.

                      Since federal agriculture support programs, to a large extent, insulate
                      the farmers from market price changes, the increase in farm cash
                      income from higher corn prices would be offset by reduced program
                      payments. Conversely, the lower cash income from other program crops
                      would trigger higher program payments from the government. Indi-
                      vidual farmers would be affected differently, depending on their crop or
                      livestock production, Federal agriculture support programs are dis-
                      cussed further in chapter 4 and appendix II.


                      Increased production of ethanol would have a small impact on the
Impact on Consurner   overall consumer food price index, raising it by an average of about 0.1
Food Prices           percent over our model baseline projections6 This represents a lo-cent
                      increase for a $100 food purchase. The O.l-percent increase in the con-
                      sumer food price index, as shown by our model simulation, translates to
                      about a O-02-percent increase in the overall consumer price index.7

                      Some individual price indexes would increase more than 0.1 percent
                      with expanded ethanol production. Our model simulation showed that
                      with higher feed costs and lower livestock production, the consumer
                      price index for meat, poultry and fish products would increase by an
                      average 0.28 percent-a 28-cent increase for a $100 purchase. The
                      higher grain prices would also increase the consumer price index for
                      cereal and bakery products by an average 0.21 percent. There would be
                      very slight increases in the price of dairy products under our model
                      simulations.


                      Our model showed that a major expansion of corn-based ethanol produc-
Conclusions           tion would benefit America’s agriculture sector. The impact of these

                      %wludes changes due only to agricultural impacts. Potential changes in other factors, e.g., changes in
                      fuel prices due to ethanol expansion or interest rates are not included.

                      %?e footnote 5.
                      7A l-percent increase in the food price index translates to about a 0.16- to 0.17~percent increase in the
                      overall consumer price index.



                      Page 23                                GAO/RCED-SO-156       Increased   Uee of Ethanol   Blended Fuels
Chapter 3
Agricultural Impact of Expanded
Ethanol Production




changes would vary, depending upon one’s position in the agriculture
production and food process chain. However, modeling complex eco-
nomic relationships, such as those existing in the agriculture sector, is
subject to great uncertainty, especially when models deal with events
such as large-scale increases in demand for corn. Our modeling results
provide insights into the interaction of various agriculture sectors and
the general order of magnitude of change associated with these sectors
only for the period under study. However, the results should not be con-
sidered as exact predictions. Any change in assumptions, such as timing
and size of the expansion scenarios, market and weather conditions,
government agricultural policies, or farmer’s responses to these policies
could materially affect the final results and estimates of the model.




Page 24                           GAO/BCED-90-156   Increased   Use of Ethanol   Blended Fueb
      *
Chapter 4

Ikpact of Expanded Ethanol production on
Federal Programs

                      The expanded production of ethanol would reduce federal outlays for
                      farm support programs. But at the same time, federal revenues from
                      motor fuel taxes would also be reduced, if existing exemptions and
                      credits are retained. Our model showed reductions in federal outlays for
                      farm support programs that would average about $930 million and
                      $1.42 1 billion per year, respectively, under our low- and high-growth
                      scenarios. Our analysis of potential tax impacts showed that a continua-
                      tion of ethanol’s tax exemption could further reduce federal tax reve-
                      nues by an annual average $442 million and $813 million, respectively,
                      under the 8-year low- and high-growth scenarios.

                      Summing-up only these two impacts would indicate that there would be
                      an average annual savings to the federal budget of about $488 and $608
                      million, respectively, due to expanded ethanol production under our sce-
                      narios. The impact on the budget, however, shows wide year-to-year
                      fluctuations. For example, the yearly net budget difference over the 8-
                      year period ranged from a negative budget impact of $924 million to a
                      positive impact of $2.7 billion. However, these are modeling estimates,
                      and there are no assurances that the impacts projected will actually
                      occur during, at the end, or after the modeling period. Furthermore, our
                      study did not explore all the impacts of expanded ethanol use on the
                      federal budget. For example, we did not analyze changes in income tax
                      revenues from farmers, ethanol producers, and oil companies that could
                      result from an expanded ethanol industry. Our study, however, indi-
                      cated that the expanded use of ethanol will cause higher ethanol pro-
                      duction costs, and it may be necessary to increase the level of
                      government subsidies or to pass the costs on to the consumers through
                      higher motor fuel prices. Thus, an overall federal budget impact assess-
                      ment is precluded.’


                      Federal outlays for farm support programs significantly increased since
How Ethanol           1980-from $2.8 billion to a high of $25.8 billion by fiscal year 1986.
Production Affects    Net program outlays dropped sharply to $12.6 billion in fiscal year 1988
Agriculture Program   partly due to the 1988 drought. Increased ethanol production would
                      reduce these farm support program outlays because the additional eth-
Outlays               anol production would increase prices of corn and some other grains,
                      resulting in

                      ‘Given the uncertainties surrounding production costs of ethanol and gasoline, we do not know the
                      extent of government subsidies needed to induce expansion of ethanol production to the levels of our
                      scenarios. On the other hand, a legislative requirement leading to an expanded use of ethanol could
                      change the economics of ethanol production to the extent that tax exemptions or other subsidies
                      would not be needed but fuel prices would increase.



                      Page 25                               GAO/RCEDBO-156      Increased   Use of Ethanol   Blended Fuels
                                                                                                                      L




                                                                                                                            .
                             Chapter 4
                             Impact of Expanded   Ethanol   Production   on
                             Federal Progrmna




                         l fewer farmers defaulting on their government backed loans, thus
                           reducing federal outlays to cover loan losses and storage costs of the
                           forfeited crops;
                         . reduced federal deficiency payments to farmers, as the grain prices rise
                           toward or surpass the federally established target price; and
                         . lower federal payments for acreage diversion and other associated costs
                           as the incentives for farmers’ participation in agriculture programs
                           decreases.

                             For our analysis, we only assessed the effect of increased ethanol pro-
                             duction on federal outlays for commodity loan, farmer-owned reserve,
                             deficiency payment, and land diversion programs established to support
                             producers of corn and other feed grains, soybeans, and wheat. Our
                             model considered program outlays for corn, wheat, soybeans, barley,
                             sorghum, and oats, but did not include dairy programs, export assis-
                             tance, or disaster program payments. We generally assumed that the
                             provisions of the 1986 Food Security Act-which      defines the regulatory
                             framework for the farm programs-would       be continued throughout the
                             simulation period. The farm support programs and the results of our
                             analyses are discussed in the following sections and in more detail in
                             appendix II.


Commodity Loan Program       Expanded ethanol production would decrease program outlays made
                             under the commodity loan program. Under this program, according to
                             USDAdocuments, participating farmers receive loans (the amount is
                             based on government-determined loan rates) and offer their crops as col-
                             lateral. After harvest, farmers (1) have nine months to repay the loan,
                             with interest, and reclaim their crops, or (2) forfeit their crops to the
                             government in lieu of repayment. It is a nonrecourse loan; therefore, the
                             government must accept the collateralized crops in lieu of repayment of
                             the loan principal and interest. When the crop prices are relatively low
                             and there is no profitability through use of generic certificates, farmers
                             are better off forfeiting the crops than repaying the loan and the
                             interest. In case of default, the cost to the government would be the
                             amount of the loan (loan rate times the number of bushels under loan)
                             plus the storage cost for the crops forfeited to the government.
                             Expanded ethanol production would reduce federal outlays for these
                             loans by increasing crop prices-particularly     corn which has the largest
                             share of the program costs- and thereby reducing the incentive for
                             farmers to default on their loans.




                             Page 26                               GAO/RCED-90-166   Increased   Use of Ethanol   Blended Fuels
                           Chapter 4
                           Impact of Expanded     Ethanol   Production   on
                           Federal Frogram




Farmer-Owned Reserve       Crop loans can also be extended or originated under the Farmer-Owned
Program                    Reserve Program. Under this program, according to USDAdocuments,
                           wheat and feed grain producers can receive storage payments on their
                           collateralized grain after their nonrecourse loan matures. The partici-
                           pating farmers receive storage payments for keeping their crops off the
                           market. Expanded ethanol production and the resulting higher grain
                           prices, would reduce the cost of this program as higher prices would
                           reduce the need for the government to keep crops off the market.


Deficiency Payment         Expanded ethanol production would also affect the Deficiency Payment
Program                    Program. Under this program, according to USDAdocuments, farmers
                           producing eligible crops2 receive income support payments equal to the
                           difference between a legislatively-set target price for the crops and
                           either (1) the average national market price or (2) the basic loan rate-
                           whichever is higher- for the crops. Farmers receive these income-sup-
                           port payments when crop prices are below the target prices. As the
                           expanded ethanol production increases the market price for corn, the
                           deficiency payments to farmers would be reduced. If the market price
                           were to surpass the target price, deficiency payments would be
                           eliminated.


Acreage Control Programs   According to USDA documents, farmers participating in the loan or the
                           deficiency programs may be required to set aside a predetermined per-
                           cent of their land under the Acreage Reduction or Paid Land Diversion
                           Programs. They are not allowed to plant any cash crops on these set-
                           aside acres. However, under the Land Diversion Program, farmers can
                           be paid a specified per acre amount in exchange for idling their land.
                           Expansion of ethanol production would create higher crop prices that
                           would reduce farmers’ incentives to participate in the loan and defi-
                           ciency programs. This, in turn, would reduce the need for land-diversion
                           payments.




                           ‘Wheat, rice, feed grains, and cotton.



                           Page 27                                  GAO/RCEJMO-156   Increased   Use of Ethanol   Blended Fuels
                                                                                                                                   c




                                         Chapter 4
                                         Impact of Expanded    Ethanol   Production   on
                                         Federal Program




                                         Our modeling results show that overall federal agriculture program out-
Impact on Farm                           lays for the commodity loan, farmer-owned reserve, and deficiency pay-
Support Program                          ment programs would be reduced if ethanol production was expanded to
Outlays                                  meet our low- and high-growth scenarios.3 We were interested in the
                                         overall impacts on federal farm program outlays and chose not to dis-
                                         cuss the impacts on the individual farm support programs. These reduc-
                                         tions would average about $930 million and $1.42 1 billion per year,
                                         respectively, under our low- and high-growth simulations. The cumula-
                                         tive outlay reductions over the 8-year period would total about $7.4 bil-
                                         lion and $11.4 billion, respectively. With more ethanol produced, the
                                         demand for and the price of corn would increase, causing fewer farmers
                                         to participate in farm support programs, fewer farmers to default on
                                         their commodity loans, and deficiency program and acreage diversion
                                         program payments to decrease. Table 4.1 shows the cumulative and
                                         average annual savings during our model simulation period.

Table 4.1: Federal Agriculture Program
Outlay Reductions Over (I-Year Model     Dollars in billions
Simulation Period                                                                                         High-growth           Low-growth
                                                                                                             Scenario             Scenario
                                         Cumulative reductions (8 years)                                          11.371                7.440
                                         Average annual reductions                                                 1.421                0.930


                                         Our model results show that under these programs, the major reductions
                                         would come from corn support programs, with smaller reductions in
                                         wheat program outlays and small increases in outlays for soybean and
                                         sorghum programs.

                                         The reduction in agriculture program outlays due to expanded ethanol
                                         production are dependent on the current and the future provisions of
                                         the agriculture programs as well as agriculture market conditions. Our
                                         program reductions are based on baseline projections that assumed pro-
                                         gram “target prices” for feed grains would continue their downward
                                         trend from 1990 to 1995 and remain constant afterwards. Our baseline
                                         projections also assume a generally downward trend in market prices
                                         over the simulation period. Changes in either the baseline projections for
                                         the crop prices (especially for corn) or in the provisions of federal agri-
                                         culture programs, over the simulation period, could substantially affect
                                         the outlay.


                                         “Under the Acreage Reduction Program, there are no payments to participating farmers. However,
                                         acreage set aside may be required as a condition for participation in government programs.



                                         Page 28                                 GAO/RCED-99-156   Increased   Use of Ethanol   Blended Fuels
                                     Chapter 4
                                     Impact of Expanded    Ethanol   Production   on
                                     Federal Programs




                                     Other analysts who have recently assessed the impact of expanded eth-
                                     anol production on government outlays also found that there would be
                                     net reductions in agriculture program outlays. A 1988 USDAreport4 esti-
                                     mated outlay reductions of about $1 billion per year, and a 1987 Con-
                                     gressional Research Service report6 cited potential reductions ranging
                                     from about $3 billion to about $7 billion per year. These estimates vary
                                     depending on the size of ethanol expansion, the years of coverage, the
                                     agricultural programs considered, and the future course of agriculture
                                     markets and programs depicted in the analysis. Because of these
                                     varying assumptions, no meaningful comparison of these estimates with
                                     our results was attempted. Even though the assumptions and methods
                                     behind each study varied, they all imply that there will be overall reduc-
                                     tions in federal agricultural program outlays with expanded ethanol
                                     production.


                                     The expansion of ethanol production and the increased use of ethanol
Impact on Motor Fuel                 blended fuels would reduce collections of federal motor fuel taxes. The
Tax Revenues                         federal government collected nearly $9.3 ,billion in motor fuel excise
                                     taxes for fiscal year 1988. The 6-cent per gallon tax exemption on fuels
                                     blended with ethanol reduced 1988 motor fuel tax collections by an esti-
                                     mated $480 million. We assumed that the current 6-cent exemption was
                                     available throughout our simulation period. Our analysis of potential
                                     tax exemption impacts showed that, under our baseline projection, the
                                     annual tax revenue losses would reach $530 million at the end of 8
                                     years. We estimate that a continuation of ethanol’s tax exemption could
                                     further reduce tax revenues by an annual average $442 million and
                                     $813 million, respectively, over the 8-year low- and high-growth scena-
                                     rios. The cumulative reductions in tax revenues over the 8-year period
                                     would total about $3.6 billion and $6.6 billion over the baseline amounts
                                     for our low- and high-growth scenarios. Table 4.2 shows the cumulative
                                     and average annual tax revenue reductions under our scenarios.

Table 4.2: Foregone Motor Fuel lax
Revenue8 Over Bareline Amounts       Dollars in billions
                                                                                                       High-growth           Low-growth
                                                                                                          scenario              scenario
                                     Cumulative tax revenue reductions (8 years)                               $6.506              $3.536
                                     Average annual tax revenue reductions                                      $.813               $.442


                                     4Ethanol: Economic and Policy Tradeoffs (USDA, Economic Research Service, Apr. 1988.)

                                     6Analysis of Possible Effects of H.R.2062, Legislation Mandating Use of Ethanol In Gasoline (Congres-
                                     sional Research Service, Oct. 1987.)



                                     Page 29                                GAO/RCED-99-186    Increased   Use of Ethanol   Blended Fuela
                                     Chapter 4
                                     Impact of Expanded    Ethanol   Production   on
                                     Federal Program




                                     Foregone annual fuel tax revenues would increase, over the baseline
                                     amounts, by about $0.79 billion and $1.46 billion, respectively, in the
                                     final year (1997) of our simulation period when the use of ethanol fuels
                                     would reach 2.2 billion and 3.3 billion gallons per year.


                                     Summing-up only the budgetary impacts on federal farm program out-
Summary of Budget                    lays and federal motor fuel tax revenues due to the expanded produc-
Impacts on Farm                      tion of ethanol would indicate that, over the 8-year period of our low-
Program Outlays and                  and high-growth scenarios, there would be net savings to the federal
                                     budget. Table 4.3 shows the net cumulative and net average annual
Motor Fuel Tax                       savings.
Revenues
Table 4.3: Budget Impact8 on Farm
Program Outlays and Motor Fuel Tax   Dollars in billions
Revenue8                                                                                                 High-growth           Low-growth
                                                                                                            Scenario             Scenario
                                     Cumulative impacts over 8 years
                                       Farm program savings                                                      11.371                7.440
                                       Foregone tax revenues                                                    -6.506               -3.536
                                     Net cumulative savings                                                       4.865                3.904
                                     AveragGnua&%gs          over 8 years
                                       Farm program savings                                                       1.421                  ,930
                                       Foregone tax revenues                                                     -.813                -.442
                                     Net average annual savings                                                    ,608                 ,488
                                     Note: All figures represent impacts due to the increased ethanol production over the baseline
                                     production.

                                     We chose to show the annual average and cumulative impacts for the 8-
                                     year period covered by our scenarios rather than year-by-year impacts
                                     in order to provide insights into the magnitude of change that would
                                     result from increased production of ethanol. Our model projections of
                                     federal farm program outlays under both our low- and high-growth sce-
                                     narios show wide year-to-year fluctuations, depending primarily on the
                                     relationship among market prices as well as federal program target
                                     prices and loan rates. On the other hand, there was a constant rate of
                                     decrease in motor fuel tax revenues as we projected a constant expan-
                                     sion in the use of ethanol fuels under our scenarios. When the two
                                     impacts are combined, the net budget impacts vary widely on a year-to-
                                     year basis. For example, under our high-growth scenario the impacts
                                     ranged from a negative budget impact in one year where tax revenue
                                     losses exceeded farm program outlay reductions by $924 million to a


                                     Page 80                                GAO/RcEpBO-156       Increased   Use of Ethanol   Blended Fuels
Chapter4
Impact of EkI.mndcd Ethanol   Froduction   on
Federal Programs




positive budget impact in another year where farm program outlays
exceeded the tax revenue losses by $2.7 billion. Under our low-growth
scenario the impacts ranged from a negative budget impact of $391 mil-
lion to a net positive impact of $2.6 billion. Whether the overall
favorable comparison between outlays and revenues would continue in
follow-on years is speculative.

The above mentioned reductions in federal farm program outlays and
motor fuel tax revenues are but two monetary impacts on the federal
budget. There also are many other possible budgetary impacts, outside
the scope of our study, that preclude an overall budget impact assess-
ment, such as changes in income tax revenues from farmers, ethanol
producers, and the petroleum industry. The budget could also be
 affected by the prevailing market conditions and government incentives
 available to producers when ethanol production is expanded. Ethanol
 currently costs more to produce than gasoline, and our study indicates
that the cost to produce ethanol will likely increase with an expansion
 of production to the levels in our scenarios. The higher production costs
 can be attributed to (1) higher corn prices (as shown by our model pro-
jections in chapter 3) since most ethanol is made from corn, (2) an uncer-
tainty as to whether the level of ethanol by-product cost offsets can be
 maintained with the expanded production, and (3) the cost of con-
 structing additional ethanol production facilities. Any efforts to increase
 ethanol’s use, therefore, must somehow cover these higher production
 costs. If ethanol production costs, net of existing subsidies, increase
 more than those for gasoline, it may be necessary to increase the level of
 government subsidies, pass the additional costs on to the consumer
 through higher fuel prices, or various combinations of these approaches.

Given the uncertainties surrounding production costs of ethanol and
gasoline, we do not know the extent of government subsidies needed or
the costs that might be passed on to the consumer under our scenarios.
Some industry officials, however, indicated that government subsidies
may not be necessary if ethanol fuel use is mandated and the costs are
passed on to the consumers. Our study assumed that the current motor
fuel tax exemption and the tax credit on gasohol blends would be the
only federal incentives provided to ethanol fuels. Under this assumption
and with current market conditions, the expansion of ethanol produc-
tion to levels envisioned in our scenarios is unlikely to occur without
additional government incentives (i.e., subsidies) or requirements (i.e.,
mandates).




Page 31                               GAO/RCED-30-156   Increased   Use of Ethanol   Blended Fuels
              chapter 4
              Impact of Expanded   Ethanol   Production   on
              Federal Progcama




              For example, assuming a gallon of ethanol that costs $1.10 to produce is
              used in the 10 percent gasohol blend and receives an equivalent 60-cents
              per gallon tax subsidy, it would be cost competitive with gasoline that
              costs 60 cents a gallon to produce (as it did in October 1989-see
              chapter 1). If ethanol production costs increased 10 percent (or 11 cents
              per gallon) to $1.21, the additional cost in federal and state government
              subsidies or in consumer fuel prices could total as much as $242 million
              and $363 million annually under our low and high scenarios, respec-
              tively. A SO-percent increase in ethanol production costs (equal to 66
              cents per gallon) could necessitate either additional government subsi-
              dies or higher consumer fuel prices of about $1.2 billion or $1.8 billion
              annually under our two scenarios. Conversely, any new Clean Air Act
              requirements to reformulate gasoline and oil supply interruptions could
              increase gasoline production costs. Increased gasoline costs would make
              ethanol more cost competitive and could reduce government subsidies.

              The impact of an expanded use of ethanol fuels would extend beyond
              the economic and marketplace changes discussed above. While the
              transportation fuel industry, especially the producers and distributors
              of gasoline and ethanol, would be most directly affected, other agri-busi-
              nesses and various related support industries could also be affected. We
              did not attempt to measure these other economic impacts. However, if
              motor fuel prices increase because of higher ethanol production costs,
              the overall cost of living would also increase. For example, a SO-percent
              increase in ethanol production costs could increase the overall cost of
              living-as measured by the consumer price index for urban con-
              sumers-by slightly more than 0.3 percent.


               Our modeling simulates a transition to the expanded use of ethanol fuels
Conclusions    over an 8-year period-through     1997-and we are not projecting
              impacts beyond that point. Our model simulations showed that farm
               program outlays would decrease because of the expanded ethanol pro-
               duction. The reductions would differ from year to year, depending pri-
               marily on the relationship among market prices, target prices, and loan
               rates. Our analysis of tax revenue impacts reflects a consistent buildup
               in ethanol production and use over the 8-year period and, therefore, a
               consistent decrease in tax revenues. Considering just the impacts that
               expanded ethanol production would have on federal farm program out-
               lays and motor fuel tax revenues indicates a net average annual savings
               to the federal budget of $488 million and $608 million, respectively,
               under our low- and high-growth scenarios, However, expanded ethanol
               production could mean higher ethanol production costs, which could


              Page 32                               GAO/RCED-B&l56   Increased   Use of Ethanol   Blended Fuels
Chapter 4
Impact of Expanded   Ethanol   Production   on
Federal Programa




increase the level of government subsidies and therefore offset, or more
than offset, these budget savings. Other possible budgetary impacts,
outside the scope of our study, would have to be considered to deter-
mine an overall federal budgetary impact.




Page 33                               GAO/RCBD-O-166   Increased   Use of Ethanol   Blended F’uela
Appendix I

ModelingProcedureand Assumptions


                         This appendix describes the modeling procedure and assumptions used
                         in estimating impacts of expanded ethanol production on the agricul-
                         tural sector and federal farm support program outlays. We used the
                         WEFAlong-term quarterly model of U.S. agriculture to simulate potential
                         impacts of expanded ethanol production between 1989 and 1997. To
                         measure these impacts, we developed two scenarios for the possible
                         expansion of ethanol production1 and compared the simulation results
                         against a third “baseline” scenario. For our baseline scenario, we used
                         WEFA'Slong range forecast for U.S. agriculture.2 Changes resulting from
                         the expansion of ethanol production were measured as additions or sub-
                         tractions from the baseline scenario.


                         The baseline forecasts used in our analysis are projections for U.S. agri-
Baseline Forecasts and   culture that assume continuation of current trends and policies con-
Assumptions for U.S.     cerning agriculture markets. Baseline projections provide a forecaster’s
Agriculture              best judgment of the future performance of the economy. They take into
                         account the economic trends that could affect the conditions, but do not
                         address unexpected or unpredictable future change-such as a drought,
                         which could have a major impact on the forecasts.

                         The baseline forecast used in our analysis projects a moderate improve-
                         ment in U.S. agriculture over 8 years. Agriculture sectors were expected
                         to gradually recover from the drought of 1988. Farm prices, though high
                         in comparison to pre-drought levels, were expected to show a decline by
                         1997. Domestic and export demand were expected to respond to the
                         drop in prices and show moderate increases by 1997.

                         In general, the corn, soybean, other feed grain, and livestock sectors
                         were expected to gradually recover from the impact of the 1988
                         drought. Corn prices were expected to drop from a high of $2.55 per
                         bushel in 1989 to $2.07 in 1991, rise to $2.39 by 1994, and then drop to
                         about $2.14 per bushel in 1997. Total carryover stocks for corn, esti-
                         mated to drop to a low of 1.4 billion bushels in 1989, were forecast to
                         increase to 2.7 billion bushels in 1997. Corn production that was esti-
                         mated to be as low as 4.7 billion bushels in 1989 is projected to increase
                         to 9.2 billion bushels in 1997.




                         ‘See chapter 1 for a description of the scenarios.

                         ZThe baseline projections are as of December 1988.



                         Page 34                                GAO/RCED-30-156   Increnaed   Use of Ethanol   Blended Fuels
                     Appendix   I
                     Modeling   Procedure   and Assumptions




                     The provisions of the 1986-1990 farm program were assumed to con-
                     tinue after 1990. Generally target prices for grains were projected to
                     continue their downward trend as was specified in the 1986 Food
                     Security Act. The Acreage Reduction Program-set at 20 percent in
                     1988, idling about 14.6 million acres for corn-was by assumption set at
                     10 percent throughout our simulation period (1989-1997). The baseline
                     projections assumed there was no Paid Land Diversion Program.


Modeling Procedure   long-term projections to 1997 and incorporated the changes associated
and Assumptions      with the expansion of annual ethanol production to 2.2 and 3.3 billion
                     (our low and high-growth scenarios). We separately adjusted the main
                     (core) model and solved it for each scenario to measure the impacts on
                     major crops and livestock sectors. The impact on farm income, prices
                     received by farmers, and consumer prices were then simulated by using
                     the WEFA’S Summary Statistics sub-model.3 The impact on federal pro-
                     gram outlays were then estimated using a third, Lotus spreadsheet sub-
                     model by WEFA.

                     For each scenario, we assumed corn would be the only feedstock used in
                     the production of additional ethanol. We first calculated the additional
                     demand for corn due to the projected ethanol expansion and increased
                     the overall demand for corn in the model by this amount. The additional
                     supply of feed by-products- that result when corn is used to produce
                     ethanol-was then converted (based on protein content) to its soybean
                     meal equivalent and was added to the baseline soybean meal supply. We
                     assumed the additional supply of feed supplements from ethanol pro-
                     duction would replace soybean meal from domestic soybean processing
                     and would be used to meet additional domestic and export demands.
                     Domestic and export demands for soybean meal were then adjusted
                     using appropriate elasticity measures provided by WEFA.

                     The WEFA model treats some variables exogenously-i.e., the values of
                     which were determined outside the model and then put into the model.
                     However, when we believed these variables should be responsive to
                     changes due to our scenarios, we used measures of elasticities or devel-
                     oped additional mathematical equations to determine their values exoge-
                     nously. For example, we used measures of export-demand elasticity

                     30ur expansion scenarios start from the fourth quarter of 1989 and continue through the third
                     quarter of 1997. All crop numbers and subsequent averages are based on the crop year and all live-
                     stock and income or expense numbers are in the calendar year and are averaged on the calendar year
                     basis.



                     Page 36                                  GAO/RCED-90.156   Increased   Use of Ethanol   Blended Fuels
Appendix   I
Modellng   Procedure   and Asmmptione




from WEFAand USDApublications to make necessary adjustments in
export demand for key crops. Numerous iterations of the models were
needed to produce the final results for each scenario. Where appro-
priate, we also adjusted some livestock variables to ensure sensible
results. All our modeling changes were based on consultation with, and
the recommendation of, WEFA’S agricultural modeling specialists.

Federal farm program outlays for our simulations were estimated using
a Lotus spreadsheet sub-model and projections for crop prices, domestic
demand, and exports from the core model. To develop program outlays
for major crops affected by ethanol production, we assumed that provi-
sions of the 1986 farm bill would continue through 1997. That is, target
prices would be set to continue a gradual decline and crop loan rates
would be set at 86 percent of the average market price from the pre-
vious 6 years--excluding the year with the highest and lowest price4 . We
also assumed that, throughout our simulation period, Acreage Reduction
Program requirements would be set at 10 percent for feed grains other
than oats, 6 percent for oats, and 6 percent for wheat.

Finally, we also allowed the farmers’ participation rate in programs to
change from the baseline as tighter markets and higher grain prices
reduced producers’ incentives to put their crops under the program. By
allowing changes in the participation rate, we, in effect, assumed that
the additional acreage needed for corn production would come from the
acreage switched from other crops (primarily soybeans) and set-aside
acreage.




4We assumed that target prices for feed grams would decline through the 1994-1996 crop year and
then stay at that same level for the remaining years. Wheat target prices were set at the 1990 level
for the entire simulation period. To measure the sensitivity of our simulation results to this assump
tion we also ran the model with target prices for feed grams (including corn) fixed at the expected
 1990 level. Under this alternative, federal program outlay savings increased by over 160 percent-
from an average of about $1.4 to $3.6 billion per year. On the other hand, a more rapid decline in
target prices than shown in our baseline could limit or entirely eliminate the potential program outlay
savings.



Page 36                                 GAO/RCED-!40-156    Increased   Use of Ethanol   Blended Fuels
Appendix II
   c
Federal Fam Support Programs’


                The 1986 Food Security Act defines the framework within which the
                Secretary of Agriculture will administer agriculture programs for the
                years 1986 to 1990. This appendix describes the provisions of the act
                that would be affected by an expanded ethanol production Increased
                ethanol production will primarily affect three types of agriculture pro-
                grams and costs-price support programs, income support programs,
                and programs to manage agricultural supplies.

                To become eligible for federal income or support programs, farmers reg-
                ister with their local Agricultural Stabilization and Conservation Service
                (ASCS)offices, Once enrolled, the farmer is assigned a base acreage,
                which is the amount of land used to farm eligible crops over the past
                years. The farmer is then eligible to participate in nonrecourse loan and
                deficiency payments programs. Participating farmers may also be
                required to participate in acreage reduction and/or paid land diversion
                programs, which involve setting aside a predetermined percentage of
                the farmer’s base acres and not planting any cash crops on that land.
                Also, farmers using nonrecourse loans usually become eligible for the
                Farmer-Owned Reserve Program, if available. Participation in any of
                these programs does not exclude the farmers from participating in the
                other programs.


                The Commodity Credit Corporation (ccc)2 nonrecourse loan program is
Price Support   the main part of the price support programs. By registering with ASCS,
Programs        farmers can place certain crops- including wheat, feed grains, soy-
                beans, cotton, and rice-as collateral under this loan programe3 Farmers
                receive a loan based on a per unit support price or loan rate for respec-
                tive commodities. The loan rate is established by law, although the Sec-
                retary of Agriculture has limited discretion to adjust loan rates.4
                Farmers can reclaim their crops by repaying the loan principal and
                interest (the interest rates are established by CCC) or they can forfeit


                ‘The information in this appendix is drawn primarily from USDAdocuments.

                2CCCis a federally owned corporation within the Department of Agriculture.

                3To become eligible for the loans, the producers of wheat, feed grain, cotton, and rice must first agree
                to acreage reduction program (ARP) requirements, where available. The ASP will be discussed later.
                4For 1987-1990, basic loan rates-prior to any discretionary reduction by the Secretary-were set at
                76 to 86 percent of the average prices received by producers during the 6 preceding market seasons,
                excluding the high and low price years. Any discretionary reduction in the loan rate may not lower
                the rate more than 6 percent from the rate in the previous year. The regular loan rate-a national
                average-for crop year 1989 was $2.06 for wheat and $1.66 for corn and other feed grams.



                Page 37                                GAO/RCED-W-156       Increased   Use of Ethanol   Blended Fuels
Appendix II
Federal Farm Support     Progran~




their crops to the government and keep the loan proceeds.6 Loans are
nonrecourse because ccc has no option except to assume ownership of
the collateral crops if farmers choose to default. The loan rate, net of
storage costs, is in effect a support price since farmers can receive that
price even when market prices are lower. Nonrecourse loans provide
farmers with interim financing for 9 months, after which the loan is to
be repaid or the crops forfeited to the government. However, the
farmers can repay the loan, with interest, at any time during this period.
When the crops are forfeited, the government takes title and assumes
any storage costs. However, at the end of 9 months farmers have the
option to join the Farmer-Owned Reserve Program, if it is available.”

The Farmer-Owned Reserve Program allows farmers participating in the
nonrecourse loan program to extend their loans beyond the initial 9
months by putting their crops in storage. The program allows eligible
wheat and feed grain producers to store the crops they used as loan
collateral for 3 additional years and to receive annual storage payments
from the government.7 Program provisions also allow the Secretary to
waive interest charges after the first year in reserve.

The Farmer-Owned Reserve Program attempts to stabilize prices by
taking the commodities off the market when prices are low and by put-
ting them back on the market when prices rise. Once the crop is in this
reserve program, it cannot be sold for at least three years or until the
market price reaches a specified level-commonly      known as the release
or reserve trigger price.*

Program provisions also specify stock levels that determine the size of
the Farmer-Owned Reserve. Currently, the minimum reserve level is 300
million bushels for wheat and 450 million bushels for feed grains. If
reserve stock levels fall below these limits, and if the market price for
the commodity falls below the release price level, the Secretary must


“When corn is used for loan collateral, it is placed in a storage with either the farmer/lender or a
commercial storage company and the storage cost is paid by the farmer.

‘With the availability and issuance of generic certificates, farmers have yet another option-they can
exchange certificates for loan commodities. For a detailed discussion on how these certificates affect
government costs, see Benefits and Costs of Trading in USDA Commodity Certificates, (GAO/
RCED-88-142BR, June 2,1988).
7For the 1989 crop year, the storage rate for corn, wheat, sorghum, and barley was 26.6 cents per
bushel-it waa 20 cents per bushel for oats.
sThe 1989 crop year release prices for wheat and corn were $4.10 and $2.84 per bushel, respectively.



Page 38                                GAO/RCED-90-156       Increased   Use of Ethanol   Blended Fuels
    .


                 Appendix II
                 Federal Farm Support    Prograxw




                 encourage producers’ participation by offering increased storage pay-
                 ments, interest waivers, or other incentives.

                 Ethanol production will reduce the loan program costs because it will
                 increase crop prices, particularly the price of corn. A higher price can
                 affect farmers’ participation in the loan program, and lower loan
                 defaults and government surpluses. If prices are above the loan rate
                 (plus interest) there will be little incentive for farmers to default on
                 their loans. They can sell their crops, pay off their loans, and keep the
                 difference. Higher prices can also decrease large surpluses of govern-
                 ment-owned commodities, reduce storage costs for these crops, and
                 reduce the volume and expenses of the loan program.


                 The main income support program for eligible crops (wheat, rice, feed
Income Support   grains, and cotton) is the deficiency payment program. In accordance
Program          with the 1985 Food Security Act, the deficiency payment is authorized if
                 the national weighted average market price received by farmers during
                 the first five months of the market year is below the target price for
                 that crop year. In this case, the program provides farmers with a pay-
                 ment rate equal to the difference between target price and either (1) the
                 national weighted average market price or (2) the basic loan rate,
                 whichever is higher.O When crop prices do not meet the legislatively-set
                 target prices, participating farmers can receive cash or in-kind pay-
                 ments as an income supplement. Deficiency payments for the 1986-90
                 crops are determined by multiplying (1) the payment rate times (2) the
                 individual farm program acreage times (3) the yield established for the
                 farm by the government. The program acreage is the base acres a
                 farmer has normally planted for a particular crop over the past years,
                 excluding any required set-aside acreage. Payments received under the
                 wheat, feed grain, cotton, and rice programs are limited to $50,000 per
                 person each year for all payments, except for disaster payments. The
                 limit does not include several payments such as ccc crop loans or defi-
                 ciency payments that resulted from the 1986 act’s reduction of basic
                 loan rates for wheat and feed grains. Total payments, including those
                 exempt from the $50,000 limit, can reach up to $250,000 per farmer per




                 ‘For the 1089-90 crop year, the target price for wheat is $4.10 per bushel and for corn $2.84 per
                 bushel. The deficiency payment rate was set at $1.63 per bushel for wheat and at $1.lO per bushel
                 for corn. Deficiency payments for both these crops have dropped significantly for the 1989-90 crop to
                 rb.89and $50 per bushel, respectively.



                 Page 39                               GAO/RCED-90-156     Increased   Use of Ethanol   Blended Fuela
                      Appendix II
                      Federal Farm Support     Programs




                      year. In-kind payments may be used to cover up to 6 percent of the defi-
                      ciency payments.10

                      A major part of the program outlay savings resulting from increased
                      ethanol production will come from reduced deficiency program pay-
                      ments. The expanded ethanol production will increase the market price
                      for corn, reducing the deficiency payment rate-the difference between
                      the target price and either the loan rate or the market price for corn.
                      Furthermore, the higher market prices for corn and other crops will
                      reduce the farmers’ incentive to participate in the program, thereby
                      reducing the amount of crops eligible for deficiency payments.


                      The goals of the 1985 act, to manage the production of agricultural com-
Other Acreage         modities, are carried out with other programs to reduce the acreage
Management Programs   under production. The Secretary is authorized to require reductions in
                      the acreage planted for wheat and feed grains, if it is determined that
                      the total supplies of these crops will be excessive.


Acreage Reduction     Under the Acreage Reduction Program, farmers must set-aside or idle a
Program               percentage of their base acres to be eligible for loans and deficiency pay-
                      ments applicable to wheat and feed grains. The USDAdetermines the
                      acreage that may be planted (permitted acreage) by uniformly reducing
                      the allowable crop acreage base of each farm. In recent years, USDAhas
                      varied the base acreage reduction requirements in order to manage the
                      supplies and stocks of eligible crops and to raise the market prices.ll




                      %-kind payments are commonly made with generic certificates that have a flxed dollar value and
                      an 8-month life. They are a claim on WC assets and backed by commodities owned by CCC. They are
                      generic, as they can be exchanged for a variety of commodities under loan in CCC inventories. 8ee
                      GAO report Cost and Other Information on USDA’s Commodity Certificates, (GAO/RCED-87-117BR,
                      Mar. 26, 1987) for more information on the commodity certificates programs.
                      i 1For the 1988-1990 period, USDA allowable acreage reductions for wheat was 0 to 20 percent for
                      carryover stocks of 1 billion bushels or less, and 20 to 30 percent for stocks greater than 1 billion
                      bushels. The allowable reductions for feed grains was 0 to 12.6 percent for carryover stocks of 2
                      billion bushels or less and 12.6 to 20 percent for larger stock levels. There is an additional 2.6 percent
                      paid land diversion requirement if carryover stocks exceed the lower limits-i.e., 1 billion bushels for
                      wheat, 2 billion bushels for corn. For the 1989-1990 crop year, the announced acreage reduction was
                      10 percent for wheat and feed grains and 6 percent for oats.



                      Page 40                                 GAO/RCEDW=lf56        Increased   Use of Ethanol   Blended Fuela
                      Appendix II
                      Federal Fum   Support   Programa




Paid Land Diversion   The Paid Land Diversion Program, as authorized by the Secretary, pays
Program               farmers for the foregone production from their base acreage in exchange
                      for idling their land. For example, in the 1988-89 crop year, corn pro-
                      ducers participating in the program were required to reduce their base
                      acreage by an additional 10 percent, and they were compensated at the
                      rate of $1.76 per bushel, based on diverted land and the farm program
                      yield.


O-92Program           Another supply control provision of the 1986 act is the 60-92 Program.
                      This program allows farmers to plant as little as 60 percent of their per-
                      mitted acreage and earn deficiency payments on 92 percent of the per-
                      mitted acreage. The Omnibus Budget Reconciliation Act of 1987
                      authorized a O-92 supply management program. The O-92 Program
                      allows wheat and grain producers to still earn deficiency payments on
                      92 percent of their permitted acres, while planting none of the acres.




                      Page 41                            GAO/RCEB-[H)-150   Increased   Use. of Ethanol   Blended Fuels
                                                                                                    4
                                                                                                        .

Appendix III

Major Contributors to This Report


                        Judy England-Joseph, Associate Director
Resources,              James A. Fowler, Assistant Director
Community, and          Mehrzad Nadji, Assistant Director for Economic Analysis
Economic                Barry R. Kime, Assignment Manager
Development Division,
Washington, DC.

Chicago Regional        Richard R. Calhoon, Senior Evaluator
Office                  Milo Dukic, Evaluator




(308803)                Page 42                    GAO/RCED-90-166   Increased   Use of Ethanol   Blended Fuels
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