Published May 7, 2015 by Aaron Smith.
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The Renewable Fuel Standard (RFS2) is a US federal policy that mandates large increases in biofuel consumption and is implemented using a market for tradeable compliance credits. We develop a dynamic model of compliance with the RFS2 in which firms face uncertainty about future relative fuel prices and future enforcement of the mandate. Our model shows how changes in expected future enforcement can have dramatic effects on the price of compliance credits and thereby have large effects on the current cost of compliance. To illustrate, we estimate empirically the effect of three ‘policy shocks’ that reduced the expected 2014 mandates and introduced significant uncertainty regarding future compliance schedules. We estimate that one shock, the release of the 2013 Final Rule in which the Environmental Protection Agency suggested it would likely reduce the 2014 mandate, decreased the value of the subsidy (tax) provided by the RFS2 to the biofuel (fossil fuel) industry in 2013 by nearly $8 billion. Similar shocks followed with two subsequent events that released preliminary versions of the 2014 mandate reductions. We conclude that the goals of the RFS2 would be better served through active management of compliance credit markets.