Streetwise Professor

About 19 months ago I wrote about RINsanity, i.e., the United States’ nutty ethanol (and other biofuel) program. RINsanity has long outlived the phenomenon (Lin-sanity) that inspired the neologism. A couple of weeks ago, the EPA announced the ethanol and biodiesel quotas . . . for 2014. Who said time travel is impossible? That Einstein. What an idiot!  (The EPA also announced quotas for 2015 and 2016.)

In a nutshell, despite protestations to the contrary, the EPA largely conceded to the reality of the E10 “blend wall” (the fact that the vast bulk of auto engines are incapable of burning fuel with more than 10 percent ethanol), and announced quotas that were (a) smaller than the market expected, and (b) smaller than the statutory amounts that Congress specified in its farseeing omniscience 10 years ago. At the same time, the EPA decreed larger quotas for biodiesel.

As a result, the market did the splits. The price of ethanol RIN credits that count towards the ethanol quota plunged, while the price of biodiesel RIN credits that count towards the biodiesel quota rose. Scott Irwin and Darrell Good have all the gory details here. (Those are the guys to follow on this issue, folks. I’m just kibitzing.)

As a result, pretty much everyone is upset. The nauseating biofuel lobby is screaming bloody murder because the ethanol quota is too small, and is threatening to go to court. Those holding ethanol credits are fuming due to the forty plus percent price decline.

This all points out the dysfunctional nature of environmental markets in which the supply is set by some opaque politicized bureaucratic process unhinged from economic reality. (The European CO2 credit market is another classic example.) The Congressional mandate set quotas (supplies) years in advance based on forecasts of future fuel demand that turned out to be wildly incorrect. So the EPA played Mr. Fixit, and through some unknown process, divined what Congress meant to do-really!-and announced some surprising numbers that caused prices to plummet.

The EPA’s reaction? It is shocked! Shocked! to find gambling going on at Rick’s (ethanol served here!):

The EPA didn’t intend for the program to create a speculative market, and an agency spokesperson declined to comment on RIN price movement.

“RINs are used to demonstrate compliance under the Renewable Fuel Standard program,” the EPA said. The agency manages an electronic system that tracks the RINs, but not their prices on the open market.

Earth to EPA! Earth to EPA! (And hey-aren’t you supposed to be earth’s stewards? So what are you doing orbiting Pluto?): if you create a scarce resource (ethanol credits) a market-and yes, one with speculation!-will appear. This is inevitable as the sun rising in the east. Another unintended but metaphysically certain event.

Indeed, the kind of speculation that these markets foster is particularly bizarre, because of the necessity of speculating on the feedback between the market and the EPA’s decisions on the amount of the scarce resource it creates. A big part of the RIN prices is market participants’ expectations about what the EPA will decide. If the EPA’s decision takes the market price into account, in some unknown (and almost certainly unarticulated) way, the reasoning chain becomes mind-numbingly complex very quickly. Mr. Market guesses what the EPA will do. That affects prices. The EPA takes the price, and guesses what this says about what the market knows about fundamentals . . . and what the market thinks about what the EPA is going to do. It adjusts its decision accordingly. Market participants have to make judgments about the feedback between the price and the EPA’s decision, which can affect the EPA’s decision, and on and on, ad infinitum. (This is analogous to Keynes’s beauty contest metaphor, and Soros’s theory of market “reflexivity.” Sign of the apocalypse alert: I gave Keynes and Soros a favorable mention in a single blog post.)

That’s no way to run a market, but the alternatives are  likely worse. One alternative would be to set quotas for years far into the future, and then not adjust them based on the evolution of other fundamentals that cannot be foreseen when the quotas are set.

It’s pretty clear that events like have just rocked the biofuel world are an inherent part of the system. Somewhat arbitrary, inherently difficult to predict (in part because they are politicized), and “reflexive” decisions are a major determinant of supply. These decisions are made at discrete times. It is extremely likely that there will be disconnections between the quantity the market thinks the EPA will select and what the EPA actually chooses. Given the inelasticity of demand for energy products, these supply surprises lead to big price impacts.

All of which goes to show that a better use of ethanol is imbibing it to cope with the craziness of a faux market.

Of course it’s not just that the market is crazy: it’s crazy that there is a market. Ethanol is an economic and environmental and humanitarian monstrosity. Yes, ethanol would play a role without subsidies or mandates. But a much smaller role. Forcing and inducing its use is costly, not environmentally beneficial, and raises the price of food, which hits the poorest the hardest. So this crazy market shouldn’t exist in the first place. I think I need another drink.