A brief economic primer on how U.S. fuel economy works.
New vehicles sold in the United States have long been subject to a set of fuel economy regulations known as the Corporate Average Fuel Economy (CAFE) standards. CAFE has been tightened several times during the program’s 40-year history, but no previous change was as significant as the new program rules which took effect starting in 2012. Four years into the new CAFE rules there has been surprisingly little discussion or analysis. This is about to change, however, as both proponents and critics of the policy begin gearing up for the US EPA’s required midterm review that will determine what form the program takes through 2025. The review formally kicks off in June 2016 when the EPA will release its Draft Technical Assessment Report for public comment.
Economists have long complained that fuel economy standards are an inefficient way to reduce gasoline consumption. In a University of Chicago survey, 93% of economists said they would prefer a gasoline tax over fuel economy standards. I know I would. That said, there are some interesting features of the new CAFE standards. From an economic perspective the design features of the new rules can be divided into three categories: (i) the good, (ii) the bad, and (iii) the ugly.
The new CAFE rules allow for trading. This is a good thing. As with any cap-and-trade program, the “cap” is a good start, but it is the “trade” that can substantially lower compliance costs.
How does it work? Each year, the standard is assessed for each manufacturer. If a manufacturer is above the minimum fuel-economy standard, then it has a surplus and receives credits. If instead a manufacturer is below the standard, then it has a deficit and must buy credits.
Under the new CAFE rules these credits can be traded across manufacturers. This trading improves efficiency by equalizing the marginal cost of improving fuel economy across manufacturers. Opportunities for improvements in fuel economy vary widely across manufacturers. For some manufacturers there is low-hanging fruit, e.g. they already have relative expertise in producing and marketing fuel-efficient vehicles, whereas for other manufacturers it can be much harder. Under trading, investments are made where there is the biggest bang-for-the-buck, achieving the targeted aggregate level of fuel economy at lowest total cost.
The new rules have particularly important implications for companies like Toyota and Honda who tend to already sell relatively fuel-efficient vehicles. Under the old CAFE rules, Toyota and Honda were usually well below the standard, so for them, it was as if the CAFE standards did not exist. There was no penalty, but also no incentive to make further improvements in fuel economy. (In fact, these manufacturers had an incentive to make larger vehicles to pull market share away from other manufacturers who were constrained by CAFE.) Fast-forward to the new CAFE rules. Now any improvement in fuel economy generates CAFE credits, and thus profit. All manufacturers now have an incentive to improve fuel economy, including those who are perennially well-above the standard.
Under the new rules manufacturers can also bank and borrow credits across years. This is good too. It means that manufacturers can smooth over year-to-year fluctuations in demand driven by macroeconomic shocks, changes in gasoline prices, and other factors. The banking and borrowing also provides stability for the permit market, helping to avoid permit price spikes and crashes, and mitigating concerns about market power in permit markets.
Unfortunately, the new CAFE rules also introduce a feature which makes little sense from an economic perspective. As has always been the case with CAFE standards, automakers are required to meet a minimum sales-weighted average fuel economy for their vehicle fleets. Unlike in previous years, however, with the new rules this target now depends on the footprint of vehicles in the fleet.
How does it work? Each vehicle sold has a different emissions target based on its footprint. Larger vehicles have larger targets.
My Mini Cooper has a footprint of 39 square feet so in 2012 would have received an emissions target of 244 grams of carbon dioxide per mile. Actual emissions are 296 grams per mile, significantly above the emissions target. Even though my car is one of the smallest on the road weighing only 2,500 pounds and with a paltry 115 horsepower, it is less fuel-efficient than its footprint-based target. Thus if BMW wants to sell more Mini Coopers, it also needs to sell more of some other vehicle that is below its target and/or BMW needs to buy permits from some other manufacturer.
This a bit surprising isn’t it? Mini Coopers can and probably should be made more fuel-efficient, but at the same time with a respectable 31 MPG (36 highway) most people don’t typically think of them as enemy #1 when it comes to climate change. Herein lies the main problem with footprint-based targets. For a given vehicle footprint, the standards encourage automakers to make their vehicles as fuel-efficient as possible. But the new standards create no incentive for consumers to switch to smaller vehicles. In fact, the footprint-based targets may actually incentivize manufacturers to increase the average footprint of their fleet. This may make sense from a political point-of-view because domestic manufacturers produce large numbers of SUVs and pickups, but it doesn’t make sense from the perspective of reducing GHGs. Jim Sallee and Koichiro Ito have a paper exploring the economic costs from this type of “attribute-based” regulation.
Another problem with the new CAFE rules is that they give preferential treatment to trucks. In one way or another, preferential treatment for trucks has long been a feature of CAFE (more here). The CAFE rules encourage manufacturers to sell more trucks and fewer cars, as well as to relabel vehicles as trucks. Remember the PT Cruiser? Back in the early 2000s, Chrysler was making big profits on its Dodge Ram pickups, and desperately wanted to sell more, but was running up against CAFE. Ingeniously, Chrysler responded by introducing the PT Cruiser which looked like a car but was built on a “truck” platform, thus raising Chrysler’s average MPG for trucks. This meant Chrysler could sell more low-MPG pickups. This distortion continues under the new CAFE rules because of the higher emissions targets for trucks.
Worst of all, CAFE continues to suffer from a couple of more fundamental problems which greatly reduce its effectiveness. These problems existed under the old CAFE standards and they continue to exist under the new CAFE rules. These are problems inherent in any policy aimed at trying to reduce GHGs through fuel economy standards for new vehicles.
First, fuel economy standards do not encourage people to drive less. To efficiently reduce gasoline consumption you need people to buy more fuel-efficient cars and to drive less. You have to have both working together. Second, CAFE only applies to new cars. Mark Jacobsen and Arthur van Benthem have shown that fuel economy standards cause old fuel-inefficient vehicles to stay on the road longer. Why scrap your 1996 Ford Bronco if there is nothing similar available in the new car market? A gasoline tax gets all of these margins right – both vehicle purchase and driving decisions – and both new and used vehicles.
Economists have estimated that per gallon of gasoline saved, the old CAFE standards cost 3 to 6 times as much as a gasoline tax. See here and here. As we approach the midterm review there is going to be a flood of new research and it is going to be interesting to see comparable estimates for the new standards. With both good and bad changes in program design it is not clear yet whether, on net, CAFE has become more or less cost-effective. For sure, however, the program is going to continue to be a very expensive way to reduce gasoline consumption compared to increasing the gas tax.
Lucas Davis is the Jeffrey A. Jacobs Distinguished Professor in Business and Technology at the Haas School of Business at the University of California, Berkeley. He is Faculty Director of the Energy Institute at Haas, a coeditor at the American Economic Journal: Economic Policy, and a Faculty Research Fellow at the National Bureau of Economic Research. He received a BA from Amherst College and a PhD in Economics from the University of Wisconsin. Prior to joining Haas in 2009, he was an assistant professor of Economics at the University of Michigan. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.