New CAFE Standards: The Good, the Bad and the Ugly

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.

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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 Good

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.

 

The Bad

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.

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How does it work?  Each vehicle sold has a different emissions target based on its footprint. Larger vehicles have larger targets.

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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.

ptcruiser 

The Ugly

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.

About Lucas Davis

Lucas Davis is an Associate Professor of Economic Analysis and Policy at the Haas School of Business at the University of California, Berkeley. 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.
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20 Responses to New CAFE Standards: The Good, the Bad and the Ugly

  1. Pingback: New CAFE Standards: The Good, the Bad and the Ugly - Berkeley-Haas Insights

  2. Dan Sperling says:

    Professor Davis provides a good summary of what is well known about CAFE standards. But i can’t help chiding him with the observation that, like most economists, he misses the big picture about why the standards are the way they are and what realistically can be done about them. The standards were corporate fleet-based until 2012 (not footprint-based as they are now), which meant that, indeed, they did encourage downsizing of vehicles as Lucas desires (because each automaker had to meet the standards across all their vehicles–though the fleet standards were further broken into cars vs trucks and imported vs domestic, lessening the incentive for downsizing).

    The political deal made in 2012 was to sacrifice the incentive for down-sizing (ie, fleet standards) in return for much more aggressive standards. The point Lucas ignores is that the standards are now set at ~54 mpg, roughly double that of 2010. The US automakers and Toyota accepted that huge increase as a reasonable compromise. Overall, we are way ahead because of that compromise. Would i love to get rid of footprint standards? You bet! Maybe in 2025?

    As for that tired plea of economists for gas taxes over performance standards, get over it. What Lucas leaves unsaid is that the tax would have to huge, $10 or more, to get equivalent fuel (and GHG) reductions. Obviously, not gonna happen!

    • mcubedecon says:

      First, it’s the role of economists to point out where public policy deviates from more optimal solutions. Economists can acknowledge that political constraints exist, but they also need to point out what’s lost by acquiescing to those constraints. I hope that Dr. Sperling is not muffling such voices at the ARB when discussing various policy options.

      And most importantly, is Davis’ point about the failure to touch the existing fleet. The US EPA and ARB have failed to account for the increasing life of vehicles, resulting in overestimates of the effectiveness of such standards.

      As for the effectiveness of a gas tax, Dr. Sperling is focused solely on new vehicle sales as the only instrument for reducing fuel use. He’s ignoring the impact of both accelerating vehicle retirement (see comment above) and reducing VMT. Analysis of a fuel tax must be a systemic analysis, not unidimensional.

  3. Steve plotkin says:

    I have an issue with both professor Davis and my friend Dan Sperling….footprint standards, or any attribute based standards, provide an incentive to move to larger vehicles only if the standards are poorly designed…if the shape of the compliance curve is well drawn, there is no incentives….and such standards make the efficiency targets fairer across an industry with competing manufacturers aiming at different market segments…so an automaker making mostly smaller vehicles doesn’t get a free ride, but instead has to push technology just as hard as one focusing on large ones.

  4. mcubedecon says:

    The key phrase is “well drawn.” Dr. Sperling’s comment shows the political problems in trying to accomplish that goal. More often, rather than trying to achieve a complicated “optimal solution” that won’t fly in a political setting, it’s better to just put in the simple one.

    And the point is not to improve the fuel efficiency of individual market segments, but rather to reduce fuel use across the entire fleet. That means reducing sales in the larger vehicle segments. Seriously, how many of those suburban husbands need large pickups?

  5. Paul says:

    “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.”

    I do not see the logic of this statement. The reason to reduce gasoline consumption is to reduce greenhouse gas emissions. Ideally this should be a tax on greenhouse gas emissions, not just on gasoline or driving. In the long term this will have to be with technological changes to the vehicles we drive and how we produce energy. Being able to drive results in huge savings on housing cost, flexibility of where one can work, reduce cost of moving, etc. The best way of determining these costs is to let the individual decide on the basis of good information with the right incentives to reduce their greenhouse gas reduction.

    For example, wood biomass plants in California are shutting down as the price they get for electricity is not covering their operating costs, see:
    http://www.latimes.com/business/la-fi-biomass-closing-20160101-story.html

    If someone drove an electric car and was willing to pay the cost of biomass electricity they probably would be producing very low greenhouse gas emissions.

    • mcubedecon says:

      Thinking of a gas tax as one form of a GHG tax (since carbon context of gasoline is largely constant), it will get to the incentives that you are looking for. Note that an EV owner will not pay a gas tax. (Paying for road maintenance and congestion then becomes an important, but separate, issue.)

  6. Amazing how much CO2 his Mini Cooper produces though, compared with the European versions!

  7. Arthur Winer says:

    That’s because the European vehicles trade somewhat lower CO2 emissions for egregiously high emissions of NOx, leading to unhealthful exposures to nitrogen dioxide, fine particles and ozone resulting in increased morbidity and mortality for tens of millions of Europeans. That’s not a trade-off we should make in the U.S.

    • mcubedecon says:

      It’s not clear that we shouldn’t make that trade off. Economic valuations generally find that the GHG reductions are worth multiples of the criteria pollutant reductions on a per ton basis. I think it would be a useful exercise to weigh all of the costs and benefits of meeting different standards. Simple assertions about one’s own valuations should not trump a full debate.

  8. I’m in the market for a new car and want to be environmentally responsible. But under the CAFE rules, the *average* fuel economy of cars is set by law. I can’t affect that average. If I buy a fuel efficient car, that just frees up automakers to sell somebody else an inefficient one. (Or in economic terms, people who buy efficient cars drive down the price of the gas guzzlers.)

    Since I only drive 4 miles to work and back, I think my most environmentally friendly move would be to buy the *least* efficient car I can find. (To be really green, I’d buy a bunch of gas guzzlers and scrap them, but I don’t make that kind of dough.)

    Now all I need is a Sierra Club bumper sticker for my new Camero.

    • mcubedecon says:

      That’s an interesting perspective. I have friend who has bought several hybrids but has similarly short commutes (and until recently drove his family on vacation in a Ford Excursion thanks to business tax credits for trucks). I’ll use your argument to further nag him…

  9. Pingback: Zócalo on KCRW » Blog Archive » VW is Far From the Only Car Company Skilled in Evading the Green Police

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