M-RCBG Associate Working Paper No. 2
The Unintended Consequences of Government Interventions in the Domestic Ethanol Market
This paper examines the effects of the Volumetric Ethanol Excise Tax Credit (VEETC) and the 2005 Renewable Fuels Standard (RFS) on the domestic ethanol market. Employing a two-stage least squares regression on ethanol and commodity price data from January 1998 to November 2007, this paper finds that while the VEETC and RFS were effective in spurring large domestic capacity growth, the secondary effects of the policies ultimately facilitated the recent decline of the domestic ethanol industry by driving down the long-term price of ethanol and consequently reducing the long-term profitability of domestic production. By instantaneously increasing demand for ethanol in a capacity-constrained industry, the policies drastically increased the short-term price of ethanol in early 2006. Exceedingly high short-term ethanol prices induced substantial entry into the supply side of the market, which lowered ethanol prices in the long-term. Combined with an increase in ethanol input prices following a wheat drought in the fall of 2006, this long-term price decrease dramatically decreased producers' profit margins and has put a number of domestic producers on the brink of financial insolvency.