Think back to 2012, and consider everything you might have predicted for 2016. Would you have guessed that Donald Trump would be elected president? That the Cubs would win the World Series? Or, how about that the price of crude oil would be less than $50 a barrel for much of the year?
Yeah, you probably didn’t foresee any of those, not even the last one. But the U.S. Energy Information Administration missed the oil price fall too, as did the International Energy Agency and many other experts. As you may remember, oil was around $100 a barrel back in 2012, and gasoline was around $3.50 a gallon. Most predicted high prices would roll on. At the same time, the Environmental Protection Agency and the National Highway Traffic Safety Administration jointly issued new fuel economy standards for light-duty vehicles. In part because these agencies thought gas prices would stay expensive, their regulations specified increasingly aggressive fuel economy targets out to 2025: reducing transportation sector carbon emissions is cheap when high gas prices make consumers willing to pay for fuel economy. But now that the price of gas has cratered, consumers aren’t as keen on paying more for cars that will save them gas. What to do?
The Trump administration has said they will take a hard look at whether to adjust the level of the standards, as folks in the industry make noise about relaxing them because the gas prices have fallen so much that the standards are becoming too expensive to meet. But gas prices just as easily could have risen (imagine a global economic boom or a conflict between Iran and Saudi Arabia), so that consumers would voluntarily buy efficient hybrids by the millions. An honest gasoline price forecast would acknowledge that we have extraordinarily poor accuracy at predicting the price of gasoline years into the future. How should fuel economy standards deal with this uncertainty?
In a new paper, I get at the economics underlying this question, and I find a strong case for building flexibility into fuel economy standards—in particular, there are economic benefits from a mechanism that allows the standard to shift with gasoline prices. If the gas price rises, the miles per gallon standard can automatically rise with it. And if the gas price falls, the standard can as well.
This flexibility is valuable because it can be extremely costly to lock ourselves into a future regulatory target when we have no idea what the future costs of meeting that target will be. After all, the future price of gas could be half or double today’s price. If we commit to a fixed standard, and the price of gasoline subsequently falls, we will be stuck with a regulation that is extraordinarily costly to achieve because consumers will be disinclined to purchase efficient vehicles, and automakers will need to drop their prices in order to move them off the lot. Alternatively, if the price of gasoline rises, we will be left with a standard that is too easily met and therefore misses an opportunity to obtain additional low-cost CO2 reductions.
To be clear, the current standards do have some flexibility built in, but only at the cost of substantially distorting vehicle size. The 2012 standards are footprint-based, meaning that cars with a big wheelbase get a relaxed fuel economy target. For instance, a car with a 40 square foot wheelbase, like a 2012 model year Honda Fit, has a 2025 fuel economy target of 61 MPG. A car with a 53 square foot wheelbase, such as a 2012 model year Chrysler 300, only needs to hit a 2025 target of 48 MPG.
Footprint-basing adds flexibility, since if the price of gasoline falls, consumers can buy bigger, less efficient cars. On top of that, there are separate standards for cars versus light trucks, so that consumers can buy less fuel efficiency by buying trucks rather than cars. And to no surprise, consumers have been making exactly these kinds of decisions since gas prices started to fall in 2014, as my colleague Sam Ori notes here and here.
What’s wrong with this approach? It turns out, plenty, as my colleague Koichiro Ito and his co-author James Sallee recently found. Using data from Japan, which has been using a weight-based system for years, they found a substantial increase in purchased vehicles’ weight. It turns out the system gives automakers a strong, obvious incentive to obtain a relaxed standard by building cars with a big wheelbase—bigger than what they’d choose in the absence of regulation. This sort of incentive is a perfect example of a regulation-induced economic distortion: Automakers are investing materials, capital, and labor to build bigger cars than what is justified by consumer demand.
Instead of designing fuel economy standards that give automakers an incentive to super-size their vehicles, there is a simpler way forward that would both achieve emissions reductions and allow the vehicle fleet to respond to gasoline price shocks. We can set a single MPG standard that must be met, on average, across the fleet. Compact cars and hybrids could exceed the standard, while large cars and trucks could fall short, so long as average fuel economy meets the target. Then as the price of gas moves, the standard can move with it, thereby avoiding large swings in the cost of compliance. The changes to the standard need not necessarily be large or occur all at once; in fact, shifts to the standard would ideally match how fleet-wide fuel economy would respond to gasoline price shocks in the absence of regulation. In this way, a gasoline price-indexed standard provides flexibility while at the same time acknowledging the fact that it can take some time before automakers can shift their sales mix and, in the longer term, invest in new vehicle designs. And the standard would still achieve emission reductions, since, at any gasoline price, the standard would specify a higher MPG requirement than the vehicle market would achieve on its own. But by price-indexing the standard, we can avoid sticking automakers and consumers with a difficult fuel economy target when the price of gasoline falls, and we can capture additional, inexpensive emissions reductions when the price of gasoline rises.
Economists and policy-makers do not have crystal balls. And forecasts of future gasoline prices are, well, probably even less accurate than we’ve discovered polls to be this election cycle. Betting the success of a major policy like a fuel economy standard on the chance that actual future fuel prices will be close to what we expect is like betting that the next dart we throw will hit the bullseye, even though all of our previous throws didn’t even hit the board. Rather than take a losing bet, adopting a flexible gasoline price-indexed standard lets us avoid the gamble entirely while still reducing vehicle emissions.
By Ryan Kellogg, professor, Harris School of Public Policy
Photo Credit: Joe Goldberg