U Chicago study proposes market-based approach to fuel economy standards to deal with impacts of fuel price volatility
Volatile gasoline prices have caused some regulators and carmakers alike to question the cost and effectiveness of current fuel economy standards, with some arguing they are too stringent and others saying they should be even stronger. A new study by Ryan Kellogg, a professor at the University of Chicago Harris School of Public Policy and author of the study, evaluates the current approach and proposes a novel, market-based alternative: indexing the standard to rise and fall with the price of gasoline.
When the US Environmental Protection Agency (EPA) and National Highway Traffic Safety Administration (NHTSA) developed the joint regulations for light-duty CO2 emissions and fuel economy respectively, they developed their estimates of future achieved efficiency levels, program costs and benefits on government projections of continuously rising fuel prices.
Researchers have demonstrated that as fuel prices rise, consumers tend to prefer more efficient vehicles because the fuel savings associated with such vehicles are greater. Thus, the regulators’ expectations about rising fuel prices underpinned their belief that the fleet would achieve high levels of efficiency while saving consumers on fuel and reducing greenhouse gas pollution.
However, gasoline prices are extremely volatile, presenting a serious challenge for regulations that are dependent on that price signal to achieve their optimal cost-effectiveness and environmental benefits, while also by nature being determined years in advance and updated infrequently. If gasoline prices are higher than expected at the time the rules are written, consumers will opt for vehicles that are even more efficient than the rules require, suggesting that the rules are too lenient and are missing out on potentially greater fuel and emissions savings. If prices are lower than expected, consumers will demand less efficient vehicles, raising compliance costs for automakers who must reduce prices for their most efficient models. For these reasons (among others), a wealth of academic literature suggests that fuel-economy standards are a costly and suboptimal approach to regulating environmental harm from vehicle emissions.—Ryan Kellogg, summarizing his research
Kellogg’s evaluation shows that allowing the standard to rise and fall with the price of gasoline more closely equates the costs and benefits. When gasoline prices are high, the standards would ratchet up to become binding, achieving maximum, cost-effective fuel and emissions savings. When gasoline prices are low, the standards would ratchet down, avoiding overly burdensome costs for automakers.
Based on past fluctuations, gasoline prices over the next ten years could be anywhere from more than twice what is expected to less than half what is expected. The reality is, we just don’t know what the cost of gas is going to be, and the success of fuel economy standards hinges on that price signal. Indexing the standards to rise and fall with the price of gasoline provides a sensible approach to account for this large unknown.
By allowing fuel-economy standards to adjust in tandem with the price of gas, such a policy would fully leverage consumers’ willingness to pay for more fuel efficient cars when gasoline prices are high and avoid saddling automakers with excessive compliance costs when fuel prices are low.—Ryan Kellogg
The current standards do aim to provide the flexibility needed to account for unpredictable gasoline prices. For example, the standards are footprint-based, meaning that vehicles with a relatively large wheelbase are assigned a relatively less stringent standard. This allows consumers to choose gas-guzzling cars when gasoline prices are low, and choose vehicles that offer greater efficiency when gasoline prices are high.
Kellogg evaluates this approach and finds it is not enough to compensate for the distortions to vehicle size that are introduced by a footprint-based standard. Instead, his approach would allow automakers to adjust vehicle production volumes to more closely match consumer preferences.
For example, automakers could manufacture more gas-guzzlers when gasoline prices are low and more efficient models when gasoline prices are high. In the medium-term, an indexed standard could potentially allow for even greater flexibility—although it would be important to ensure that standards only adjusted incrementally, to avoid implementing a set of standards in a given year for which automakers had not produced suitable vehicles.
Kellogg notes that a legitimate question to this approach is whether relaxing the standards when fuel prices are low would forgo needed reductions in fuel consumption. Addressing that, he argues that an indexed fuel economy standard could adjust within a relatively narrow band. The increase in fuel economy above whatever consumers would normally choose on their own should never be less than that determined by the social cost of carbon. The margin of the adjustment falls strictly within the range of private willingness to pay for fuel efficiency—which by definition varies with the fuel price.
Another major question is whether automakers would be able to respond to adjustable standards given the 3-5-year product planning cycles. To this, Kellogg points out that automakers already naturally adjust product offerings in accordance with consumer preferences and market conditions (e.g., the current surge in SUVs vs diminishing interest in small cars). Fuel economy standards are simply designed to increase vehicle efficiency above consumers’ base preferences.
This is potentially a solution that could satisfy automakers—who right now say complying with fuel economy standards is too expensive—while also delivering the maximum benefits for consumers and the general public by reducing greenhouse gas pollution at the lowest cost. Without the political will for a strong gasoline tax, this market-based approach is the best option. And, it doesn’t require new legislation from Congress.—Ryan Kellogg
Ryan Kellogg, “Gasoline Price Uncertainty and the Design of Fuel Economy Standards”, NBER Working Paper No. 23024