Tradable fuel economy credits: Competition and oligopoly

Abstract

Corporate average fuel economy (CAFE) regulations specify minimum standards for fuel efficiency that vehicle manufacturers must meet independently. We design a system of tradeable fuel economy credits that allows trading across vehicle classes and manufacturers with and without considering market power in the credit market. We perform numerical simulations to measure the potential cost savings from moving from the current CAFE system to one with stricter standards, but that allows vehicle manufacturers various levels of increased flexibility. We find that the ability for each manufacturer to average credits between its cars and trucks provides a large percentage of the potential savings. As expected, the greatest savings come from the greatest flexibility in the credit system. Market power lowers the potential cost savings to the industry as a whole, but only modestly. Loss in efficiency from market power does not eliminate the gains from credit trading.

Introduction

Corporate average fuel economy (CAFE) standards established by the US Energy Policy and Conservation Act of 1975 (PL94-163) specify minimum fleet average standards for fuel efficiency that US light-duty vehicle (car and light-truck) manufacturers must meet. Light-duty vehicles produced 59% of transportation CO₂ emissions in 2003 [35] and consume 36% of the oil used in the US [4].

In this paper, we investigate the potential economic cost savings from the implementation of a system of tradable fuel economy credits coupled with higher fuel economy standards. Additionally, we model the theoretical and empirical impacts of oligopolistic behavior in the market for fuel economy credits. Important to the magnitude of the cost of fuel economy improvements are the attitudes of consumers towards fuel savings. We examine alternative assumptions and estimate the impacts on costs. Omitted from our analysis are potential non-market benefits such as reductions in US GHG emissions and energy security benefits.

The effectiveness of CAFE standards in raising the light-duty vehicle fleet's fuel efficiency, and other effects of CAFE regulations, have been discussed in a large body of literature. It was debated whether the improvements in average fuel efficiency realized from 1978 (the first year that the CAFE standards went into effect) through 1987 were attained at a reasonable economic cost and whether the CAFE regulations induced undesirable changes in vehicles that could lower their safety [3], [11], [12], [27].

Thorpe [32] found that the CAFE standards have led to a shift toward larger, more luxurious models in the imported Asian fleet and may have led to a decrease in the fleet's average fuel efficiency. In addition, the CAFE standards themselves, by being less restrictive for trucks than for cars, likely had the effect of encouraging the shift in market share from cars to light-duty trucks. The light-duty truck share of new vehicle sales grew from 9.8% in 1979 to 42.1% in 1997 [9], [22]. Parry et al. [28] examine the social welfare of raising CAFE standards taking into consideration existing externalities. They find that higher CAFE standards can produce anything from moderate welfare gains to substantial welfare losses, depending on how consumers value fuel economy technologies and their opportunity costs.

In 2002, the National Research Council's comprehensive review of the effectiveness and impact of CAFE standards concluded that while the CAFE program has clearly increased fuel economy, certain aspects of the CAFE program have not functioned as intended. These include indirect consumer and safety costs, a breakdown in the distinctions between foreign and domestic fleets, and between minivans, SUVs and cars in the calculation of fuel economy standards, and the artificial creation of fuel economy credits for multi-fuel vehicles.¹ Moreover, the National Research Council concluded that technologies exist that, if applied to light-duty vehicles, would significantly reduce fuel consumption within 15 years (Finding 5).

The availability of improved technologies for fuel economy alone is not sufficient to encourage their widespread adoption. The National Research Council concluded that raising the CAFE standard would reduce future fuel consumption, but that other policies could accomplish this same end at lower cost and greater flexibility. The National Research Council concluded (Finding 11): “Changing the current CAFE system to one featuring tradable fuel economy credits and a cap on the price of these credits appears to be particularly attractive. It would provide incentives for all manufacturers, including those that exceed the fuel economy targets, to continually increase fuel economy, while allowing manufacturers flexibility to meet consumer preferences.”²

The Energy Independence and Security Act (EISA) of 2007 increases the Corporate Automotive Fuel Efficiency (CAFE) standards of the US light-duty vehicle fleet from the 2007 (combined) level of about 25 miles/gal (MPG) to the maximum feasible average to attain 35 MPG by 2020 – a 40% increase. In addition, starting in 2011, the CAFE program will include the large Sport Utility Vehicles that were previously exempt from CAFE requirements.³

The CAFE standard applies to all manufacturers, m, and is defined as the sales-weighted harmonic average fuel economy, measured in miles/gal. EISA changes the form of the standard from a uniform standard to one based on the sales-weighted footprint (wheel base times track width). There are separate standards $E_{\mathit{vo}}^{*}$ for each vehicle class v (passenger car or light-truck) and origin of manufacturing for cars, o (domestic or foreign).⁴ Thus, S_mvi are manufacturer m's sales in vehicle class v, all models I. The form of the harmonic average standard is given as follows⁵:

$$E_v^{*}\le \frac{S_{\mathit{mv}}}{{\sum }_i{S}_{\mathit{mvi}}/E_{\mathit{mv}}}\mathrm{where}{S}_{\mathit{mv}}=\sum _i{S}_{\mathit{mvi}}$$

If a manufacturer does not meet the standard, it is liable for a civil penalty of $5.50 for each 0.1 mile/gal (or $55/MPG) its fleet average falls below the standard, multiplied by the number of vehicles it sold in a given model year in each fleet. Credits are earned when a manufacturer more than attains the standard in any model year. These credits may be carried forward (banked) or carried back (borrowed) for 5 years on a rolling basis. As shown by Rubin and Kling [30] in the context of phasing in stricter standards for new vehicles for criteria emissions, a credit system can realize cost savings when firms are allowed to borrow and banking credits even if they do not trade. EISA reforms the CAFE system to allow manufacturers to average credits across vehicle types (cars and light-trucks) up to certain maximum increments (Section 104 (g)). Credit trading among manufacturers is also authorized with limitations (Section 104 (f)).

The current level of fuel economy standard for passenger cars is 27.5 MPG and for light-trucks, the standard is 22.5 MPG for model year (MY) 2008 (Federal Register, 49 CFR Part 533), rising to 24 MPG by MY 2011. Draft regulations promulgated by NHTSA give a phase-in schedule of increased fuel economy standards for cars and light-trucks through 2015 on the way towards EISA's 2020 goal of a fleet average standard of 35 MPG [26]. The proposed 2015 standard is 35.7 MPG and 28.6 for cars and light-trucks, respectively, for a combined estimated sales-weighted average of 31.6 MPG.

In their report, the National Research Council determined that the cost-effective average fuel economy could be increased by 12% for subcompact automobiles, up to 27% for large passenger cars and between 25% and 42% for light-duty trucks (depending on size) over the next 15 years [21]. Cost-effective technologies mean combinations of existing and emerging technologies that would result in fuel economy improvements sufficient to cover the purchase price increases they would require holding size, weight, and vehicle performance characteristics constant.

Given these benchmarks, and EISA, we examine the impact from a 40% improvement by 2020. Because the (draft) footprint standards for EISA are only available through 2015, with the 2016–2020 parameters not yet determined, we use uniform, not footprint, standards currently in place for cars and light-trucks.⁶ A 40% improvement implies targets of 38.5 and 29.0 MPG, for cars and light-trucks, respectively, and a combined light-duty fleet average of 33.8. Note that these targets are relative to the 2003 base year fuel economy standards (using the MY light-truck share of 48.9%) not the base year fleet fuel economy level actually attained [23].