Policy uncertainty and the optimal investment decisions of second-generation biofuel producers

Abstract

Uncertainty has been cited as one possible explanation for the lackluster performance of the Renewable Fuel Standard, which was enacted to encourage investment in the production of advanced biofuel. The unpredictability of conventional fuel markets makes the revenues and costs associated with biofuel production uncertain. In addition, policy uncertainty, in the form of annual revisions and adjustments to the program, make the cost of complying with the Renewable Fuel Standard uncertain. This paper is the first to decompose the aggregate uncertainty facing biofuel producers and isolate the effect of fuel market uncertainty and policy uncertainty on the decision to enter and exit the biofuel market. Results indicate that the uncertainty in the conventional fuel markets and the uncertainty in status of the Renewable Fuel Standard program influence incentives to enter and exit the biofuel market in different ways. Annual adjustments to the standard coupled with the unpredictable expiration and reinstatement of blender tax credits can work to discourage investment in biofuels and undermine effectiveness of the program.