Taking a close look at the ethanol market

Over the weekend, the New York Times ran a story about alleged manipulation of ethanol credits by Wall Street banks. Big financial traders are not very popular, and their collective track record doesn’t inspire confidence, so when prices spike—or there are other fishy signs—it’s right to ask what is going on.

The Times piece raises three distinct questions for those concerned about energy policy and renewable fuels. First, can markets be a fair and efficient way to achieve the goals we want in this program – more low carbon fuels, less imported oil and reasonable energy prices? Second, does the current system have rules that make sense? Third, is ethanol a useful part of our energy mix? I think the answers are: yes, no and it’s complicated.

On markets, it seems clear that a well-designed market almost always distributes goods more efficiently than the alternatives. It’s not popular to defend Wall Street trading these days, yet a fair and open market allows flexibility for businesses, accurate pricing and incentives for efficiently meeting public demand. But a “free market” doesn’t mean a market with no rules. Without rules — or with bad ones — you get manipulation, inflated prices and even fraud.

Current rules are clearly not strong enough to keep the market in ethanol credits operating smoothly and fairly. Markets operate best when everyone has enough information and deals are made in public. Ethanol credit markets simply don’t have the kind of openness and transparency necessary to prevent manipulation. That needs to change.

There are several examples of well-functioning markets created to support a public policy goal. The trading system established in a 1990 Clean Air Act Amendments, for instance, has helped America reduce acid rain pollution faster and cheaper than anyone thought possible. The California cap-and-trade system for greenhouse gas pollution is helping the eighth largest economy in the world meets its ambitious emissions reductions goals, in a well-functioning and well-governed market.

The reported problems with the ethanol credits market doesn’t mean the federal renewable fuels program is a bad thing. That should be judged on its own merits – whether what we gain in domestic energy production is worth the cost, and whether the policy generates a net environmental benefit based on its impact on natural resources and greenhouse gas emissions. That’s a very complicated question over which we should have a rational national debate.

In the meantime, let’s get the rules for the market right. History has repeatedly shown that fair and well regulated markets promote prosperity, while secrecy and under-regulation leads to bad outcomes. Markets can’t solve every problem, but they be a powerful and effective tool, so policymakers have a responsibility to make changes to get this one right.