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BACKGROUND

Federal reformulated gasoline (RFG) is currently required to be used in four southern New Hampshire counties Hillsborough, Strafford, Rockingham, and Merrimack. Conventional gasoline is used in the remainder of New Hampshire. Conventional gasoline is used in Maine except in the summer ozone season when 7.8 RVP conventional gasoline is required in Maine's southern counties. The RFG gasoline which is supplied to New Hampshire uses predominately MTBE as the oxygenate to meet the requirements of Federal law and regulations that require a minimum of 2 percent oxygen by weight. Over the past few years, attention has focused on alternatives that may be used in lieu of MTBE. The focus of many discussions by policymakers and regulators in New Hampshire and Maine has been to determine whether ethanol is a viable alternative.

ETHANOL AVAILABILITY

Last summer, the Coalition of Northeastern Governors hosted a forum on ethanol blending in gasoline in the Northeast and Mid-Atlantic. Because ethanol is not widely available in the Northeast, the forum presented information regarding the economic issues associated with its use in gasoline and the associated development of a regional infrastructure which would be necessary in order to ensure long term production capability. Additionally, the forum discussed issues regarding cellulosic biomass ethanol technology, which is of interest in New Hampshire and Maine because of its potential to be produced from biomass waste, including agricultural, wood and municipal solid waste.

Currently, the Agricultural Products Utilization Commission in Maine has issued a request for proposal to study the feasibility of building and financially sustaining a biomass-ethanol plant in northern Maine. What is important to note from both of these ongoing efforts, is that there is very little, if any, current production capacity for ethanol in either New Hampshire or Maine. API undertook an analysis of the cost and benefits of State-level oxygenate mandates to expand ethanol production in January 1999. This study provides an overview regarding Federal ethanol subsidies, and the market structure of the industry. It indicates that the total capitalization of a 15 million gallon per year ethanol plant is roughly $30 million. Thus the capital necessary for the startup of an ethanol plant would be significant here in northern New England. (I have attached a copy of the study to this statement.) Recent testimony before this committee's Subcommittee of Člean Air, Wetlands, Private Property and Nuclear Safety by Jason Grumet, Executive Director of the Northeast States for Coordinated Air Use Management (NESCAUM) acknowledged that the Northeast and northern New England do not currently have an available supply of ethanol. He said, it is possible to ship massive quantities of ethanol to the Northeast by barge, rail and truck. The question remains at what cost." Recently, Comm. Arthur Rocque, Connecticut Department of Environmental Protection has acknowledged that it is not prudent for the State of Connecticut to ban the use of MTBE effective October 2003, and bases his concern on a study evaluating ethanol as an alternative to MTBE which has been conducted by NESCAUM, and the New England Water Pollution Control Commission (NEIWPCC). In fact, Comm. Rocque indicates that to the State of Connecticut, banning MTBE would pose undesirable options to the State including: “the delivery of special or non-complaint (sic) gasoline or an increase in the price of gasoline conservatively estimated in the range of 3-11 cents per gallon." Comm. Rocque has indicated that the Department of Environmental Protection in Connecticut is prepared to recommend changing the date during the next legislative session.

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ETHANOL INFRASTRUCTURE

New Hampshire_receives its gasoline from marine barge shipments which come into terminals in Portsmouth and Newington, and from trucks which may pick-up products from terminals in Portland, Maine, Boston harbor, Springfield, Massachusetts and even as far away as Albany, New York. Gasoline containing ethanol needs to be transported and stored differently than does gasoline which contains ethers. Ethanol must be transported and stored separately from the gasoline until the point where it is loaded into the truck at the terminal rack, for delivery to retail locations. Terminals which are located in New Hampshire, Massachusetts, or Maine, which would be supplying gasoline with ethanol, would need to build new storage tanks and retrofit terminals with new blending equipment in order to supply the product. Many of our terminals may have difficulties in receiving siting approvals for such additional storage capacity; space constraints may prove to be a significant challenge in expanding existing petroleum terminals.

Exacerbating the separation and segregation requirements, are the number of fuels required in the northern New England area. New Hampshire requires two different fuels, Maine requires two different fuels also. Recently, some proposals have seemed to address only MTBE used in RFG rather than all fuels, which would result in an even greater strain on the gasoline infrastructure. If ethanol were required to be used to comply with the Federal oxygenate mandate in reformulated gasoline, then the terminals servicing New Hampshire marketers would in turn have to carry even more types of gasoline. Our refinery and distribution system is currently stretched to the breaking point. There are over 45 different types of gasoline required nationwide, so any additional requirements for gasoline would pose significant challenges for the industry.

Other infrastructure issues also arise with the consideration of gasoline containing ethanol, including possible changes that might be needed to either underground or aboveground storage tank systems. For example, some fiberglass reinforced plastic tanks may not be compatible with ethanol, and there are questions whether premature failure of leak monitoring systems, and other parts of the fuel dispensing equipment at a gasoline station may occur.

Ethanol is predominately produced in the Midwest and would have to be transported into the Northeast. Until such time as any ethanol is produced in the New England area, the alternative for transporting ethanol from the Midwest include barge, tanker, rail or truck. Infrastructure for this type of transportation will need to be developed prior to any ability to move significant quantities of ethanol to Northeast terminals for blending.

Finally also it is important to note that gasoline containing ethanol cannot be comingled with gasoline containing ethers. Terminals and gasoline stations would not be able to intermingle the two products in its tanks. Thus proposals which attempt to phase-down the use of MTBE or ethers in gasoline, without removing the Federal oxygenate mandate, are not feasible.

CONCLUSION

In conclusion, I appreciate the opportunity to present information to you today; API is committed to working with Congress, the Administration, and State policymakers and regulators to develop appropriate energy policies for our future. Thank you very much.

ATTACHMENT

[From the American Petroleum Institute, January 1999]

THE COSTS AND BENEFITS OF STATE-LEVEL OXYGENATE MANDATES TO EXPAND ETHANOL PRODUCTION

Considerable research has been carried out over the last several decades to address questions relating to the cost and benefits of ethanol programs at the Federal and State levels. Proponents argue that ethanol programs support agricultural production and boost farm income in particular States. In addition, various environmental benefits are attributed to ethanol use, and it is claimed that its use reduces the risk of dependence on foreign oil. New legislation that would significantly increase ethanol demand, e.g., requiring oxygenated motor fuel use statewide, is currently being considered by various State legislatures.1 On the other hand, opponents to ethanol subsidies argue that the cost to taxpayers and to consumers, e.g., in terms of decreased tax revenue, and increased gasoline and food expenditures, outweigh the benefits to farm producers and processors. The principal purpose of this paper is to assess the likely costs and benefits of additional State level mandates being considered by various State assemblies that, if implemented, would significantly increase ethanol demand and production. Before turning to this issue, a brief description of existing Federal and State ethanol subsidies is provided as well as a characterization of the market structure of the ethanol industry. Federal Ethanol Subsidies

The rationale for tax exemptions on alternative fuels at the Federal level grew out of energy security concerns associated with the 1973-74 Arab oil embargo. The objective was to displace gasoline by subsidizing renewable fuels. The nation's de

1Minnesota mandated the use of oxygenated fuel year round in both attainment and non-attainment areas in 1997 to be phased in over a number of years. Ethanol is the sole oxygenate in use in Minnesota.

pendence on foreign oil would decline as oil imports dropped, or so it was thought. A Federal exemption of 4 cents per gallon for alcohol fuels was initiated with the enactment of the Energy Tax Act (P.L. 95-618) in 1978, representing the full amount of the Federal gasoline tax. The magnitude of the Federal tax exemption has been changed periodically since that time, most recently with the Omnibus Budget Reconciliation Act of 1990 that established a rate of 5.4 cents per gallon of motor fuel containing 10 percent alcohol by volume. 2 This translates into a 54 cents tax exemption per gallon of ethanol. The act also introduced a tax credit of 10 cents per gallon of ethanol for small ethanol producers (less than 15 million gallons per year). The Energy Policy Act of 1992 extended the tax exemption to gasohol containing less than 10 percent alcohol. Mixtures containing 7.7 percent alcohol receive an exemption of 4.16 cents per gallon, and the exemption for the 5.5 percent mixture is 3.08 cents per gallon.

Magnitude and Types of State Level Ethanol Subsides and Mandates

States have justified ethanol subsidies on grounds ranging from local economic masons to environmental and energy security concerns. The levels and types of subsidies vary by State as seen in Table 1. Common types of programs include production subsidies, tax exemptions on motor fuel taxes, and guaranteed loans at below market rates for new production facilities. For example, Minnesota has provided a 5 cents per gallon blenders' credit, a 20 cents per gallon producers' subsidy, and low interest loans of up to $500,000 per plant through the Ethanol Production Facility Loan Program. More generally, the magnitudes of State level ethanol subsidies of the major producing States range from zero to 40 cents per gallon of ethanol.

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1. State Ethanol Programs in Place as of February 1987. In addition, the Federal motor fuels tax atcomption of 30.54 par gation of ethanol apples across all states. See Appendix for complete use of ethanol by states.

Sources: Ethanol Programs: A Program Evaluation Report, Office of the Legislative Auditor, State of MIN,
Federal Highway Administration. Highway Statistics, Table MP-332, 1997.

Statewide year-round use of motor fuel with 2.7 percent oxygen was mandated in Minnesota in October 1997.3 This will roughly double the amount of ethanol_consumption in the State when fully implemented. Such mandates go far beyond the already considerable levels of existing Federal aid State ethanol subsidies, and if en

2Motor fuel blenders have the alternative of taking an income tax credit of 54 cents per gallon of ethanol.

3The 2.7 percent oxygen requirement effectively precludes the use of oxygenates other than ethanol.

acted by a significant fraction of States, will result in soaring levels of ethanol demand and an aggressive expansion in ethanol production.

Market Structure of the Industry

U.S. ethanol production is concentrated in both large and small plants, e.g., large plants exceeding 130 million gallons per year account for over 50 percent of U.S. capacity while plants with capacity of 45 million gallons per year or less account for roughly 23 percent of total capacity as seen in Figure 1.4 Previous research [see, e.g., UŠDA, ERS, 1988, USDA, Office of Energy, 1986] shows that unit production costs at larger plants can be up to 45 percent less than those at smaller plants, i.e., increasing returns-to-scale characterizes ethanol production With average 5 ethanol production costs of roughly $1 00 per gallon, this suggests a range of between $85 per gallon and $125 per gallon across large aid small producers under current feedstock prices While the magnitude of these costs would change with changing corn prices, the differential, reflecting production economies, would remain. A natural question to ask is why small and medium size plants are built. Them are several reasons, primary among them are icing constraints and subsidies for small producers.

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The total capitalization of a 15 million gallon-per-year ethanol plant is roughly $30 million of which $8 million goes for construction, $10 million toward equipment, $6 million for engineering and design, and $6 million to working capital for startup of operations, The sale of common stock typically provides between 40 and 50 percent of the required capital with bank loans with terms ranging between 7 to 10 years supplying the rest. 6 Given existing producer subsidies and State mandates, bankers do not have to assume that the plant will be profitable, i.e., they provide financing at near zero risk! This follows since the loans are likely to be repaid even if the ethanol plant is an economic failure in States where producer subsidies exist. Assuming a $.20 per gallon producer subsidy, a 15 million gallon plant receives $3 million per year. This provides $30 million over a 10-year period, enough to build the plant (and pay back bank loans) and cover startup costs. State mandates that insure the continuation of local demand for ethanol, and shareholder equity, further reduce the risk of non-recoverable loan default to near zero. Bank financing of larger plants would put more bank capital at risk, and the evidence to date suggests that capital constraints become binding over the 15 million to 30 million gallon per

4Plant production by State is given in Table A-2 of the appendix.

5This reflects a weighted average across wet and dry ethanol plants at current corn prices. Average wet miller production casts are $.85 per gallon while these of dry millers are $1.25 per gallon. Wet millers supply roughly 60 percent of the ethanol brought to market, dry millers the remainder.

6 Some States provide low interest loans of up to $500,000 per plant for small producers.

year plant size. Hence, for the independent producers, capital constraints limit plant size before significant returns-to-scale can be realized. Large companies, e.g., ADM and Cargill, not subject to such capital constraints, build and operate large plants to realize lower unit production costs.

The Costs of State Oxygenate Mandates

A relevant policy question associated with any public expenditure (be it a highway, public park or a subsidy for motor fuel) is whether the societal benefits of the product or service will likely exceed the societal costs? In some cases the answer to this question is relatively straightforward, e.g., even at the time of project commencement the net benefits of the Federal interstate highway system were recognized, while in other cases the optimal amount of government support for a project may be less clear, particularly in its early stages, e.g. the optimal level of public expenditures targeted at global warming.

In the case of public expenditures for ethanol production, the evidence to date strongly suggests that societal costs have significantly exceeded societal benefits. In fact, there is widespread agreement among economists that ethanol production would not take place without the current level of Federal and State subsidies since it cannot compete on a level playing field with readily available substitutes. It follows that State mandates that significantly increase ethanol demand by requiring ethanol use in attainment as well as non-attainment areas, as in Minnesota, lead to further resource misallocation and waste. The cost-benefit analysis of the Minnesota program presented below provides evidence in support of this view. Motorists Could Pay More For Motor Fuel

areas

At a time when crude oil and hence gasoline prices are at historic lows, motorists could pay more for motor fuel under expanded oxygenate mandates like those in Minnesota (notwithstanding low corn prices and existing ethanol subsidies). This is borne out in the Energy information Administration's most recent weekly retail price data listed in Table 2. The estimates characterize prices of motor fuel sold in attainment areas (conventional), carbon monoxide non-attainment (oxygenated) and ozone non-attainment areas (RFG). The average of 5 weekly observations running from 11/9/98 to 12/7/98 reveals that oxygenated fuel in PADD 2 was selling for roughly $.03 per gallon more than conventional fuel. Since Minnesota is the only State in PADD 2 with an oxygenate requirement, oxygenated fuel prices in PADD 2 are Minnesota prices. Furthermore, ethanol is the sole oxygenate in use in Minnesota.

This data squares with a recent report Ethanol Programs: A Program Evaluation Report prepared by the State of Minnesota, Office of the Legislative Auditor in February 1997 that on p.9 states "... the retail price of gasohol (in Minnesota) will exceed the price of conventional gasoline by about 2 to 3 cents per gallon over the next several years". 7

Table 2 Midwest Self-Service Retail Gasoline Prices, All Grades
(dollars per gallon including taxes)

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PADD 2 includes Illinois, Indiana Iowa Kansas Kentucky Michigan Minnesota, Missouri, Nebraska
N. Dakota Ohio Oklahoma, S Dakota, Tennessee, Wisconsin

1. Minnesota is the only State in PADD 2 with an oxygenate requirement. Hence oxygenated fuel prices for PADD 2 are Minnesota prices. Furthermore, ethanol is the only oxygenate in use in MN

Source DOE, EIA, 12/98 Site Address: ftp://ftp era doe gov/pub/ol_gas/petroleum/data_ publications/weekly_retai_gasoline___...../rtigas.br

Before Minnesota imposed its statewide mandate, the use of an oxygenate was required under Federal law in the Twin Cities metropolitan area for one-third of the

"It is important to note that this conclusion could change given a significant relative price change between corn and crude oil.

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