Flex-Fuel-Vehicles-and-Alternative-Fuel-Infrastructure-A-Chicken-or-Egg-Question

Drivers will not adopt alternative-fuel vehicles until such fuel is convenient to purchase. But, the fuel won’t become widely available until there are enough vehicles to support the infrastructure. Kenneth Corts finds that state and federal policy can help solve this chicken-or-egg problem.

The 2007 Energy Independence and Security Act set a renewable fuel goal of 36 billion gallons of U.S.-grown biofuels by 2022, a dramatic increase from 6 billion gallons in 2007. Biodiesel counts toward the goal, but much of the increase is expected to come from ethanol.

Ethanol is sold in low-percentage blends (typically 10 percent ethanol) that can be burned in regular gasoline vehicles. However, growth in ethanol consumption increasingly comes from an 85 percent ethanol blend, E85, which can be burned only in special “flex-fuel vehicles” (FFVs). An FFV has sensors that determine the level of ethanol in the fuel, allowing the car to function efficiently on any blend of gasoline and ethanol.

Because increasing consumption of E85 requires both the widespread adoption of FFVs and a retail distribution infrastructure for it, this market exhibits indirect network effects similar to those found in other markets such as personal computers, video games, and mobile communications devices. In this context, hardware demand is driven in large part by software availability, but software providers focus their efforts on applications for devices that are already popular. A new system or platform must find a way to break this cycle. The widespread adoption of an alternative fuel requires solving a similar chicken-or-egg problem. Should policies focus first on vehicles purchases or fuel availability?

Vehicles First

To stimulate the purchase of FFVs and development of an E85 retail distribution infrastructure, federal and state regulations mandate that many state and local government fleets buy FFVs (or, in many cases, other alternative-fuel vehicles). The goal is to reduce conventional fuel consumption by government fleets directly, but also to reduce private consumption of gasoline by making alternative fuels and alternative-fuel vehicles widely available to the public. In addition, tax credits and other subsidies provide incentives for production, distribution, and retailing of E85.

How effective are the policies intended to spur the development of a retail infrastructure for alternative fuels?

E85 is sold at retail primarily through traditional gas stations. The number of stations offering E85 has increased dramatically in recent years, from around 400 in 2005 to over 2,300 at the end of 2010. Almost any traditional gasoline station can, for a relatively modest investment, install the required equipment. Prospective E85 station operators must evaluate three things: the fixed cost of converting or installing the required tanks and dispensers, the profit margins they expect to earn on each gallon of E85, and the volumes of E85 they expect to sell. The National Renewable Energy Laboratory concludes that installation of an E85 pump, even with the expense of a new tank, is profitable if profit margins for E85 are similar to those for regular gasoline and the volume of E85 is about equal to an average station’s premium gasoline volume.

To estimate the effect of government-fleet FFV acquisitions on the expansion of the E85 fueling infrastructure, I gathered data for the 567 counties in Illinois, Indiana, Iowa, Minnesota, Missouri, and Wisconsin. These six states accounted for more than 60 percent of U.S. E85 stations at the end of 2007.

Across those counties, the number of E85 stations is determined by many factors, such as market size, the number of gas stations that might potentially carry E85, the geographic proximity of stations to each other, the intensity of vehicle use in a market, and so on. I controlled for these potentially confounding factors by using variables that reflect the conditions of the local gasoline market (station density and gas price), local economic conditions (agricultural employment share and growth), and demographics (age, race, income, political, and education), as well as population and population density.

The main result is that government FFVs have a significant and sizable effect on the presence of E85 stations: for every 100 to 170 government FFVs in a county, on average the number of E85 stations increases by one. By incorporating information on the size of the overall government fleet in each county, the statistical methodology ensures that this finding is not simply a correlation that reflects government fleet managers’ decisions to locate their FFVs in counties with relatively high E85 availability. The finding validates the basic premise of the government fleet mandate programs: forcing FFV technology into use through government fleet mandates increases the incentive for private gasoline station owners to sell E85.

One might expect different patterns of responsiveness to government FFVs related to differences in state tax credits and fleet mandates. The study finds little evidence of this: government FFVs generally have a robust and positive impact on E85 availability across a wide array of state environments. In addition, the presence or absence of gasoline stations affiliated with integrated oil companies, which have sometimes been accused of being slow to embrace alternative fuels, does not seem to affect the impact of these policies on the availability of E85.

A Possibly Costless Policy?

The logic of using government mandates to encourage private adoption of new technology relies on two premises. First, adoption of FFVs by government fleets is presumed to increase the incentive for private gasoline stations to offer E85 by creating demand for the fuel. The validity of the first assumption is demonstrated by the main results.

Second, the wider availability of E85 is presumed to increase private demand for FFVs by stimulating the provision of the necessary complement, E85 fuel. Unfortunately, the available data shed little light on the validity of this assumption. Work on the determinants of demand for alternative-fuel vehicles remains a topic for future research.

It is important to note that there are at least two reasons why the market for E85 FFVs is particularly well-suited to this kind of “vehicles first” policy. First, FFVs are fully backward-compatible with conventional gasoline. This means that policies forcing government fleets to buy FFVs before E85 was widely available did not risk stranding unusable vehicles or requiring local fleet operators to invest in costly fueling facilities. A fleet purchase mandate applied to a technology that is not backward-compatible with a widely available fuel could lead to the use of dedicated fleet-fueling facilities that are not accessible to the public, which would prevent any spillover effect of alternative fuel availability for the general public. This is often the case with public transit buses fueled with natural gas, for example.

Second, FFV versions of a given car or truck model typically cost the same as gasoline-only models. As a result, a fleet mandate that results in no distortions in fleet composition (that is, fleet managers do not buy more expensive vehicles in order to meet the FFV mandate) does not raise fleet acquisition costs. If, in addition, the fleet then fuels with E85 only when it is economical, a government fleet mandate is essentially a costless initiative that apparently yields sizable benefits in terms of stimulating E85 availability.

Kenneth S. Corts is a professor and the associate dean of the Rotman School of Management at the University of Toronto.

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