Lieberman Testimony Before Congress on Gas Prices

Before the Subcommittee on Energy Policy, Natural Resources and Regulatory Affairs House Committee on Government Reform

June 14, 2001

Introduction

            Good morning. My name is Ben Lieberman and I am a senior policy analyst with the Competitive Enterprise Institute, a public policy organization committed to advancing the principles of free enterprise and limited government. My comments today will focus on the causes behind the recent increases in the retail price of gasoline.      

Gasoline prices have risen more than 20 cents per gallon on average over the past ten weeks, with consumers in some parts of California and the upper Midwest recently paying more than $2.00 per gallon. As with previous price spikes, Congress has sought to learn why this increase has occurred and what can be done about it.

Thus far, most of the attention has focused on allegations of illegal conduct on the part of the oil industry. Consequently, there have been many federal investigations of alleged collusion and price gouging, and in fact two Federal Trade Commission reports on previous gas price spikes have recently been released. However, these investigations have consistently pointed away from industry conduct as the cause of gasoline price increases.

            At the same time, evidence is emerging that the growing federal regulatory burden is having a substantial effect on gasoline prices, and is a major factor in the volatility seen in recent years. In particular, the regulations promulgated under the Clean Air Act, which both dictate the composition of gasoline and place limits on the refining infrastructure, are a major contributor to the high price of gasoline today.

            Fortunately, these laws and regulations were created by the federal government, and they can also be reformed by the federal government. Congress, working with the administration, can cut the red tape and reduce the price of gasoline, yet still provide the environmental protections the American people demand.

The Regulatory Burden

1. The Micromanagement and Balkanization of the Nation’s Gasoline Supply

            Prior to 1990, the composition of motor fuels was not extensively regulated by the federal government. Other than the phaseout of leaded gasoline and a few other measures, the 1970 Clean Air Act (the Act) focused on reducing motor vehicle emissions by regulating the vehicles themselves. This effort has been a success. Even with substantial increases in vehicle miles traveled, overall motor vehicle emissions have declined substantially, as have ambient pollution concentrations.[1] And the cars and trucks on the road today emit only a fraction of the pollution as did their counterparts in the 1970s.

The emphasis changed somewhat with the 1990 amendments to the Clean Air Act, which contains extensive motor fuel regulations.[2] Specialized blends, namely reformulated gasoline and oxygenated gasoline, were mandated for certain areas of the country. The Act also set standards applicable to conventional gasoline, and granted the EPA Administrator broad discretion to create additional fuel specifications.[3] These provisions were aggressively implemented by EPA Administrator Carol Browner during the Clinton Administration. At the same time, California and other states and localities began to set fuel requirements of their own, often in order to obtain EPA approval of their State Implementation Plans (SIPs). A decade ago, gasoline was a national commodity, but today there are many distinct types of motor fuels in use.

A. Reformulated Gasoline

Perhaps most problematic of these provisions was the requirement for reformulated gasoline (RFG), designed to fight smog.[4] RFG is mandated for the nine smoggiest areas of the country as well as any other area determined to be in severe non-attainment for ozone.[5] In addition, several other areas of the country have opted into program. In total, nearly one-third of the nation’s fuel supply is RFG.

The RFG program first took effect in 1995. RFG must meet several compositional requirements and performance standards designed to make it cleaner burning than conventional fuels. EPA used its discretion to set standards for RFG that are more stringent than those set out in the Act.[6] In addition, there are separate RFG formulations for northern states and southern states, and summer-specific requirements applicable between June 1st and September 15th of each year.

More stringent requirements for RFG took effect in 2000 (RFG II), with particularly tough summer requirements for fuels sold after June 1st. Currently, RFG averages $1.83 per gallon, 21 cents more than the $1.62 per gallon for conventional gas.[7]

Despite the higher cost, there are questions about the environmental benefits of using RFG. Although mandated primarily to help reduce ozone, the primary constituent of smog, it is unclear, despite more than 5 years of use, whether RFG has made a difference. A 1999 National Research Council report concluded that “although long-term trends in peak ozone in the United States appear to be downward, it is not certain that any part of these trends can be significantly attributed to the use of RFG.”[8]

In contrast to its questionable air quality record, RFG has clearly caused water quality concerns. The Clean Air Act requires that RFG contain 2 percent oxygen content by weight. This necessitates the addition of so-called oxygenates, usually methyl tertiary butyl ether (MTBE) or ethanol. Compared to ethanol, MTBE is cheaper and easier to incorporate into the fuel supply, and has become the oxygenate of choice in 85 percent of RFG. A few Midwestern markets, including Chicago and Milwaukee, use ethanol as the oxygenate.

Over the past several years, MTBE in RFG has contaminated water supplies throughout the nation, leading to phaseouts in California, New York and other states, and federal bills to reduce or eliminate the use of MTBE in motor fuels.[9] In 1999, EPA issued a report calling for reduction in MTBE use in fuels due to its effect on water supplies.[10]

Despite the impending state bans on MTBE, the Act still mandates oxygenates in RFG. The Bush Administration recently denied a request from the state of California to waive the Act’s oxygen content requirement.[11]

If MTBE is phased out in these states (or nationwide), but Congress does not repeal the 2 percent oxygen content requirement for RFG, the law would amount to a de facto ethanol mandate. This would almost certainly raise the average cost of RFG in the years ahead.

B.                  Other regulations

Beyond RFG, there are other requirements that dictate the composition of gasoline. There is an oxygenated fuels program, applicable in the winter months in areas not in attainment with the federal standard for carbon monoxide.[12] As with RFG, oxygenated fuels cost more than conventional gasoline.

In addition to specialized blends, conventional gasoline is also regulated. As with reformulated gasoline, there are regional and seasonal differences. For example, EPA has promulgated state and month-specific requirements for Reid Vapor Pressure (RVP), a measure of how readily fuel evaporates.[13]

C.                  The Balkanizing Effect

The additional 21 cents per gallon for RFG as compared to conventional gasoline is substantial, but represents only part of regulatory costs of gasoline, as conventional fuel is also subject to regulations that increase its price. But the emerging problem is not so much the higher price of individual blends but the balkanizing effect of so many distinct gasoline recipes simultaneously in use. In 1999, the Energy Information Administration noted that “the proliferation of clean fuel requirements over the last decade has complicated petroleum logistics,” and predicted that “additional clean fuels programs could make the system more vulnerable to local outages and price spikes.”[14] In fact, one pipeline operator reports having to handle 38 different grades of gasoline.[15] Many of these blends have to be refined, shipped, and stored separately from others.

2. The Strain on Refining Capacity

At the same time demand for motor fuels has grown and the challenge facing refiners to comply with gasoline requirements has never been greater, a number of regulatory constraints have impinged upon refinery capacity. In fact, no new refinery has been built in the United States in the past twenty years, due in part to market forces but also to the Clean Air Act’s New Source Review (NSR) and New Source Performance Standards (NSPS) programs.[16] Under these programs, both the construction of new refineries and major modifications to expand capacity at existing refineries are subject to strict procedural and substantive requirements.

1997 represented a turning point of sorts for domestic refining capacity. Over the past decade, capacity has been able to modestly increase through expansion at existing facilities. But during the summer of 1997, refineries were operating full out, yet still could not keep up with demand.[17] The United States has experienced occasional refining shortfalls since. Currently, refineries are operating at 96 percent utilization, essentially maximum, with little or no margin for error. With only slight capacity growth at existing facilities projected for 2001 and 2002, the refinery capacity problem will not be quickly resolved.[18]

Unfortunately, in 1999 EPA announced a new and more aggressive interpretation of NSR and NSPS as it applies to refineries and coal-fired electric power plants. Previously, routine maintenance at industrial facilities was exempt from these requirements, while major modifications were not. Thus, by retroactively redefining as major modifications many facility projects – most of which were known to EPA when they were performed and treated as routine maintenance at the time – the agency now argues that many refineries were not operating in compliance with the law. Some refiners have announced settlements with EPA rather than endure years of uncertainty from administrative enforcement actions and possible lawsuits.[19] Nonetheless, this enforcement initiative will further complicate any attempts by the refining industry to meet future demand. The National Petroleum Council, an advisory committee to the Secretary of Energy, has warned that this “[r]einterpretation of NSR rules will significantly hinder the industry’s ability to continue its historical expansion rate.”[20]

3. New Regulations on the Horizon

            Clearly, the many regulations already implemented under the 1990 amendments to the Clean Air Act are contributing to the volatility and high prices at the pumps. In addition, several more regulations are scheduled to take effect in the years ahead, which will further complicate petroleum logistics and increase the price at the pumps.

Most significantly, EPA recently finalized new rules that will mandate substantial reductions in the sulfur content in gasoline and diesel fuel.[21] These rules are predicted to add to the cost of motor fuels.[22] In addition, they are already having an effect on refinery operations. Despite current capacity shortages in the Midwest, one Chicago refinery recently shut down, in part because of the prohibitive costs of the overhaul necessary to comply with these new sulfur rules.[23] The National Petroleum Council “expects that individual refinery shutdowns will likely continue to occur in the future.”[24]

Further complicating matters is the controversial new National Ambient Air Quality Standard (NAAQS) for ozone, which was promulgated in 1997 but held up by legal challenges.[25] If implemented, this standard will result in many counties currently in attainment with the ozone standard going out of attainment, which would place even more severe operating burdens on refiners and may increase the number of areas using RFG or other specialized blends.

Recent Price Spikes and the FTC Report

            The pattern of recent price increases is a reflection of this costly regulatory burden. Indeed, the when and where of the greatest gasoline price spikes matches almost exactly with the when and where of the most burdensome regulations. The largest increases tend to occur in the April through June timeframe. For example, this is the second year in a row that Chicago has experienced a late spring/early summer surge to $2.00 per gallon. This is largely due to added complication of transitioning away from winter fuel specifications to summer specifications, at the time of year when demand is picking up.[26] This has been a particular challenge since the stringent new summer requirements for RFG II have been in effect.

The location of the sharpest price increases, California and the upper Midwest, is also traceable to the regulatory burden. These two parts of the country face the most unique and challenging fuel standards.[27] In addition to the federal RFG program applicable in Los Angeles, Sacramento and San Diego, California has instituted its own, more stringent RFG standard applicable in several other areas of the state.[28] Parts of the upper Midwest have opted to use ethanol in RFG, which has posed problems since the new RFG II standards took effect last year.[29] Both areas also have tight local refining capacity, therefore only a relative handful of refineries make these specialized blends. Even a single incident resulting in downtime at one facility has caused supply shortfalls and price jumps in these areas. In addition, neither location is well situated to quickly receive supplies from elsewhere in response to a price spike.

In contrast to the clear link between the federal regulatory scheme and the pattern of gas price increases, there is no such plausible connection to industry collusion and price gouging. Those who blame industry conduct for high prices have not offered an explanation why industry would limit such activities to the April–June timeframe, or why they would zero in on California and the upper Midwest. Indeed, if “big oil” had the ability to pull strings and create $2.00 per gallon gasoline, and the inclination to violate the law, one would strongly suspect that they would not be so selective in doing so.

The final report of the FTC investigation into the early summer 2000 Midwest gasoline price spike further underscores the role of regulations.[30] Launched amidst allegations of illegal oil industry conduct last summer, the report nonetheless “uncovered no evidence of collusion or any other anti-trust violation.”[31] While exonerating industry of illegal conduct, the report listed refinery production problems, pipeline disruptions, and low inventories as the primary factors behind the price increase. The unavailability in the Midwest of MTBE-containing RFG II, a patent dispute involving RFG, and the waiver of RFG II requirements in St. Louis were listed among the secondary factors.

Many of the primary and secondary factors listed by FTC are directly or indirectly related to the regulatory burden. For example, several of the refinery production problems were due to “difficulty in blending RFG II,” and the low inventories were “compounded by the need to drain storage tanks of winter-grade RFG before filling them with summer-grade RFG.”[32] Properly read, the FTC report can be used by Congress as a good roadmap for motor fuels regulatory reform.

The report did discuss the conduct of industry, but declined to list it as a primary or a secondary factor in the price increases. Instead, the forecasting mistakes of some refiners in underestimating both the demand for RFG II and the difficulties in refining it, and the actions of one refiner in not maximizing its RFG II production was relegated to a subsequent section. Unfortunately, some have taken these minor findings out of context and mischaracterized the report as evidence that industry participants created the price spike.[33] One FTC Commissioner, in a concurring statement, stated that the inclusion of this section creates a misleading impression at odds with the overall conclusions of the report.[34]

            In addition, the FTC recently concluded an investigation of gasoline prices in California and other western states. It also found no evidence of illegal activity by refiners.[35]

            The FTC’s findings were corroborated by the Energy Information Administration and Congressional Research Service, which both found that the new RFG II requirements and other rules were substantial contributors to the 2000 Midwest gasoline price increases.[36] The Congressional Research Service estimated that as much as 25 to 34 cents of the per gallon cost was due to the new RFG II requirements.[37]

Conclusion – What Needs To Be Done

            The Bush Administration’s recently released National Energy Policy contains several recommendations that, if properly implemented, will go a long way towards ensuring that future gasoline prices are as affordable as the market will allow. In particular, the plan directs EPA to study ways to reduce the proliferation of differing fuel requirements and increase the fungibility of the nation’s fuel supply while maintaining the environmental benefits.

 The President has also recommended that EPA and the Department of Energy consider ways to streamline the regulations that are impeding refineries from expanding to meet demand. The President has also urged a reassessment of the EPA’s new interpretation of New Source Review.

Further, the federal government should also reconsider past efforts to micromanage the nations’ gasoline supply. Specifically, the requirement that RFG contain 2 percent oxygen content by weight is largely unnecessary to reduce smog, but complicates the logistics of supplying RFG and increases the price at the pumps. The federal government’s role should be limited to setting environmental end goals for gasoline, but should not go so far as to dictate the specific ingredients and recipes by which those goals are met. I would urge Congress to amend the Clean Air Act to streamline the RFG program by eliminating the 2 percent oxygen content requirement.

In addition, in light of the role of regulations in recent gasoline price spikes, I would urge EPA and Congress to take a look at some of the new fuel regulations scheduled to take effect in the years ahead, such as the strict gasoline and diesel sulfur standards. These rules should be amended if they will lead to future price increases disproportionate to the expected environmental benefits. Thank you.