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Why are the automakers complaining?

Lucas Davis, Professor, Haas School of Business | April 22, 2016

With gasoline prices averaging $2 per gallon, Americans are flocking to gas-guzzling vehicles. Last year was the biggest year ever for the U.S. auto industry with 17.5 million total vehicle sales nationwide. Trucks, SUVs, and crossovers led the charge with a 13 percent increase compared to 2014.

The one problem with selling all these gas guzzlers is that it makes it harder to meet fuel economy standards. U.S. Corporate Average Fuel Economy (CAFE) standards have been around for a long time, but the new “super-size” version introduced in 2012 mandates a steep climb in fuel economy each year until 2025.

trucks

Back in 2012 when the Obama Administration announced the new standards, gasoline prices were $4 per gallon and Americans were buying smaller, more fuel-efficient vehicles.  Sales were increasing rapidly for the Chevrolet Volt, Tesla Model S, and other electric vehicles, and there was great optimism about reducing the carbon-intensity of the U.S. transportation sector.

Fast forward to 2016, and the automakers can’t believe they ever agreed to this. The new CAFE rules are scheduled to be reviewed this summer, and automakers are pushing back hard, seeking adjustments that would weaken the standards to reflect this new reality of cheap gasoline.

In pleading their case, one of the automakers’ favorite approaches is to try to shift the focus to consumers.  “One of the areas that needs to be addressed is consumer demand,” recently argued Gloria Bergquist, spokeswoman from the Alliance of Automobile Manufacturers, “Automakers can build models that are extremely fuel-efficient, but they can’t control sales.”

But, of course, automakers can control sales. In the short-run, automakers can adjust prices. And in the long-run, automakers can design new fuel-efficient vehicles that Americans want to buy. Nobody expected this to happen by itself. The whole rationale behind CAFE is that there are externalities associated with gasoline consumption. If we thought consumers were going to perfectly internalize these externalities, then we wouldn’t need CAFE in the first place.

What Bergquist probably meant to say instead is that $2 gasoline makes it harder to get consumers to switch. This is certainly true. Cheap gasoline provides huge benefits to U.S. consumers, but it also leads drivers to prefer larger, more powerful vehicles.

Fortunately for the automakers – though not for the environment – there is a built-in mechanism that relaxes the standard when consumers choose larger vehicles. The new standards are “footprint” based so that the fuel economy target for each vehicle depends on its overall size.  Larger vehicles have less stringent targets.

footprint

The standards are also more generous for trucks than cars. Most of the best-selling vehicles are “trucks” from a CAFE perspective including, of course, pickup trucks, but also SUVs, crossovers, and minivans. And as Americans switch from “cars” to “trucks” this makes it easier for automakers to comply with CAFE.

The real but more subtle challenge for manufacturers is that cheap gasoline makes consumers prefer more powerful engines (for a given footprint) and makes them less willing to buy EVs and hybrids. The automakers can adjust their prices to sell lower horsepower engines and more EV’s and hybrids, but this reduces profits.

There is one more loophole, however, to help soften blow. And it is a big one. My colleague Jim Sallee and former student Soren Anderson worked on this topic several years ago (here), but until I looked at it again, I had no idea how large this loophole was, nor had I known that the loophole would last so long after being initially introduced in 1993.

I’m talking about flex-fuel vehicles. Over two million flex-fuel vehicles are sold each year in the United States. These vehicles can run on E85 (a blend of 85 percent ethanol and 15 percent gasoline), but in practice, most end up running on gasoline and many sales of flex-fuel vehicles occur in parts of the country where there is limited E85 availability.

gascap

Under CAFE, however, these vehicles have a near-magical property. They are assumed to be operated 50% using E85 and 50 percent with gasoline — a very optimistic assumption. But even more optimistic, each gallon of E85 is assumed to have the carbon content of only 0.15 gallons of gasoline. This is, the ethanol component of E85 is assumed to be zero carbon. It is notoriously difficult to quantify the lifetime carbon impacts of biofuels but most studies find that, at best, ethanol is only marginally less carbon-intensive than gasoline. As a result of these overly generous assumptions, flex-fuel vehicles like the GMC Terrain end up being treated by CAFE as if they were extremely fuel-efficient.

terrain

Not surprisingly, manufacturers have been producing flex-fuel vehicles like crazy.  There are today more than 100 different models of flex-fuel vehicles for sale in the United States (who knew?).  And while you used to always see a “flex fuel” sticker on the back, many flex-fuel vehicles today aren’t even identified. You might be driving one and not even know it.

Thankfully, the flex-fuel loophole ended with model year 2015. These credits were so lucrative, however, that many manufacturers are now sitting on large stores of surplus credits. Under CAFE rules these credits can be “banked” until 2021, ensuring that the legacy of this loophole will live on, allowing manufacturers to produce lower-MPG vehicles for years to come.

flex

So let’s not feel too sorry for the automakers. Yes, the CAFE screws are beginning to tighten, but the automakers’ situation is not nearly as dire as they would have us believe.

Cross-posted from the blog of the Energy Institute at Haas.

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