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Agricultural Commodity Support and Biofuels Policy

Jul 18, 2011
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Agricultural commodities supports and biofuels subsidies are multibillion dollar federal programs that affect many of the same crops. One might expect that by raising demand for these crops, biofuels subsidies would reduce the cost of other programs, but the interactions between the policies are often complicated and sometimes counterintuitive.

Agricultural Commodity Support and Biofuels Policy
Joseph Cooper
July 18, 2011

FarmAgricultural commodity support in the form of direct payments and disaster assistance alone cost the U.S. government over $12.7 billion per fiscal year on average from 2003 to 2010. In addition, the federal government currently pays around 60 percent of total crop insurance premiums on behalf of insured producers. A logical expectation is that policies promoting the use of biofuels will reduce these costs because many commodity supports are lower when crop prices are high, and biofuels programs raise demand for crops and their prices. But a look at the fiscal interactions between biofuels programs and commodity supports reveals a more complex relationship. This commentary provides a brief overview of U.S. agricultural commodity support and biofuels polices, then discusses their combined effect on field crops and government expenditures.

Overview of U.S. Agricultural Commodity Support

Federally funded agricultural commodity supports have a long history, going back to the 1930s. A traditional form of producer support is to provide benefits when market prices for certain crops fall below their legislated levels, as with Loan Deficiency Payments (LDPs) and Counter-Cyclical Payments (CCPs).  Introduced in the 2008 Farm Act is a new revenue-based support programs known as Average Crop Revenue Election (ACRE). In return for enrolling in ACRE, farmers forgo CCPs, and receive reduced LDP benefits and reduced lump sum payments. The ACRE revenue payments are based on losses in state-level revenues relative to the expected revenues, but the farmer must also have a farm-level revenue loss as well. Farmers also can enroll in the federal crop insurance program, in which the government subsidizes insurance provided by the private sector, and the farmers who do enroll have the possibility of receiving Supplemental Agricultural Disaster Assistance (SURE) benefits. Other disaster assistance is available on an ad hoc basis. The legislation currently covering LDP, CCP, ACRE, and SURE expires in 2012.

Because nearly all these policies are countercyclical to prices, yields, or revenues, the federal costs of direct commodity support can vary substantially from year to year. Whereas government commodity program payments for LDPs and CCPs alone averaged $3.1 billion over FY2003–2010, they ranged from a high of $9 billion in 2006 to a low of $365 million in 2008, due to the relatively low and high program crop prices, respectively in those years. Disaster assistance across all crops was also quite variable over the same time period, being tied to yield shocks. ACRE is a new program, with payments estimated to be $447 million for FY 2011. In 2010, government subsidies to insurance premiums amounted to $4.7 billion of $7.6 billion total premiums, covering 256 million acres.

Overview of U.S. Biofuels Policy

Federal support for biofuels also takes several forms. Here I focus on those policies most relevant to corn. Scheduled to expire at the end of 2011, the volumetric ethanol excise tax credit has provided blenders a credit (currently $0.45 per gallon) for every gallon of pure ethanol blended into gasoline since 2004. With the renewable fuels standard (RFS) in the Energy Independence and Security Act of 2007, up to 12 billion gallons of the renewable fuel production mandate can be met with conventional biofuels such as corn ethanol in 2010, with this figure reaching up to 15 billion gallons each year from 2015 to 2022. The United States also taxes imported ethanol with a tariff of $0.54 per gallon and 2.5 percent ad valorem tax. Finally, methyl tertiary butyl ether (MTBE) was phased out as a gasoline additive around 2004–2006, which boosted demand for ethanol a substitute oxygenate.

Given that ethanol accounted for about 11 percent of corn use in 2003 and the U.S. Department of Agriculture predicts it to account for around 36 percent over 2010–2020, how has federal support for ethanol affected corn prices? Between 2006 and 2009, corn prices increased by more than a factor of two. A recent Iowa State study has concluded that 8 percent of this price increase was due to ethanol programs. The MTBE phaseout and agricultural market forces (for example, livestock feed demand) accounted for another 28 percent of the average increase in corn prices over this period. According to the study, other market forces, including oil prices, explain the remaining 64 percent. An earlier study by the International Food Policy Research Institute found that biofuel production accounted for 30 percent of the increase in weighted average grain prices and 39 percent of the rise in corn prices between 2000 and 2007. At any rate, there is no definitive conclusion on the effect of biofuels policy on crop prices, except to say that it is likely positive. Many factors contribute to agricultural price changes, but these are beyond the scope of this commentary.

Economic Linkages between Biofuels and Commodity Policy

Currently, for corn, wheat, and soybeans, the expected value at planting time per bushel of LDPs and CCPs is $0 because the market prices of these crops are high. But this does not mean that biofuels support has offset the costs of commodity support.

One reason is that the empirical analysis of biofuels policy’s contribution to increased corn prices suggests that the farmer’s expected value of the traditional price-based support would be $0 even without the biofuel support—that is, market forces alone, not biofuel policy, explain a sufficiently high price increase to induce this situation.

Second, this conclusion ignores the costs of crop insurance, disaster assistance, and ACRE. Crop insurance premiums, disaster assistance, and ACRE are tied to recent market prices without reference to legislated levels. Hence, while the fiscal cost of “traditional” countercyclical policies decreases with increasing market prices, yield-based crop insurance and ad hoc disaster assistance increase with market prices. The cost of revenue-based commodity supports, crop insurance, and disaster assistance also increase (assuming that price volatility, expressed as a percentage of price, is not decreasing).

A final reason is that biofuels policy likely has increased not just the price of corn, but also the volatility of corn price. For example, the RFS represents an inflexible source of demand for corn, and this inflexibility can increase the volatility of corn prices. In particular, when corn supplies are tight and corn prices are high, the RFS has a greater chance to be binding. If so, the biofuels sector can do little to adjust its demand for corn. In this situation, the price impact of a supply shock is higher than when the RFS is not binding. To the extent that the price of other field crops are positively correlated with corn prices, increasing corn price volatility may increase volatility of prices for these other crops.

Farm supports such as revenue-based insurance, SURE, and ACRE can mitigate the impact on farmers of the greater volatility, but the costs of these programs can increase when price volatility increases, all else being equal. The reason for the positive correlation between price volatility and the costs of revenue-based insurance is that an insurance premium is actuarially correct if set to the mean of the distribution of indemnity payments. If increasing the volatility of price increases the volatility of revenue, then the frequency with which indemnity payments are made increases, thereby increasing the insurance premium. Similar statistical principles apply to the positive correlation between price volatility and the mean government costs of ACRE and SURE.

The direct and market-based linkages between biofuels policy and commodity support suggest that the economic efficiency of these policies could be increased if the policy designs explicitly accounted for the linkages. To the extent that they address overlapping policy goals, joint economic analysis of these policies could lead to different recommendations for program levels than separate analyses. At a minimum, economic evaluation of changes to either policy should also examine the economic implications for the other to provide a fuller picture of their costs.      

Joseph Cooper is a senior economist with the U.S. Department of Agriculture’s Economic Research Service. He has also served as a senior economist on the President’s Council of Economic Advisers. The views expressed herein are those of the author and not necessarily of the Economic Research Service or the U.S. Department of Agriculture.


Further Reading

Cooper, J. 2010. Average Crop Revenue Election: A Revenue-Based Alternative to Price-Based Commodity Payment Programs. American Journal of Agricultural Economics 92(4): 1214–1228.

Babcock, B., and J. Fabiosa. 2011. The Impact of Ethanol and Ethanol Subsidies on Corn Prices: Revisiting History. CARD Working Paper 11-PB 5. Ames, Iowa: Iowa State University.

Hertel, T. and J. Beckman. 2011. Commodity Price Volatility in the Biofuel Era: An Examination of the Linkage between Energy and Agricultural Markets. NBER Working Paper No. 16824.

De Gorter, H., and D. R. Just. 2009. The Welfare Economics of a Biofuel Tax Credit and the Interaction Effects with Price Contingent Farm Subsidies. American Journal of Agricultural Economics 91(2): 477–488.